Bail-out: lessons from Japan

From the Free Exchange blog comes a link to this NBER working paper, Will the TARP succeed? Lessons from Japan by Takeo Hoshi (University of California-San Diego) and Anil Kashyap (University of Chicago).

The paper compares the current situation in the US with that of Japan during its decade-long banking crisis. Hoshi and Kashyap argue that the US bail-out plan, as originally envisioned, risks repeating the many errors made in Japan.

The U.S. government is hiring asset managers to purchase up to $700 billion of toxic real estate securities that are the center of the current credit crisis. Buying up assets, if done properly, might address the collective under-capitalization that is the fundamental problem plaguing the financial system. But, experience with financial crises in other countries suggests that success is by no means guaranteed. Japan was the largest other country where the banks were seriously undercapitalized and where asset purchases were a critical part of the government's response to the problem. The U.S. bailout plan is similar to the Japanese approach in that it does not clearly identify the capital problem as critical and instead proposes using AMCs to remove distressed assets from bank balance sheets. When Japan used AMCs, their effectiveness was limited in part because they did not purchase enough assets. AMCs did not help recapitalization, either, and Japan had to come up with different mechanisms to use public funds for recapitalization. Both these risks are also present for the U.S. plan.

The TARP is Troubled Assets Relief Program and AMCs are asset management companies. The Free Exchange notes

Japan created no fewer than four AMCs between 1992 and 2003. The first were funded by the private sector because of “vigorous public resistance” to the use of taxpayer funds. The amount of assets they purchased was small and more importantly, because they were designed not to overpay for bad loans, they did little to boost bank capital. Not until 1997 did Japan create a mechanism to inject capital into banks, and that was initially shunned because of stigma and because public claims would be senior to common stock holders. The government recapitalised two major banks in 1998 and in 1999 created a larger $238 billion recapitalisation plan. All the major banks except one applied, and the government ultimately injected $71 billion in the form of preferred shares and subordinated debt.

The Free Exchange also notes that the US TARP differs form the approach taken in Japan in that

... there are no insolvent debtor companies that need to be restructured, and the Treasury is explicitly authorised to modify the loans of homeowners. But it shares, with the Japanese, the problem that it does not explicitly deal with the capital inadequacy of the banking system.