Ever since Junichiro Koizumi became prime minister of Japan, in 2001, he has argued that structural reform of the country's financial system is vital for long-term national economic growth. His approach seems to contrast favorably with that of past administrations, which failed to tackle this issue in earnest, fearing the political consequences of the pain brought about by change. Koizumi is absolutely right to seek new directions in fiscal policy, the privatization of state-owned entities, and regulatory reform, but he has gone neither fast nor far enough. Indeed, structural changes have yet to get under way, and now the question is whether the momentum for reform will continue.

Some progress has been made. Big Japanese banks are at last shedding bad loans, and the balance of nonperforming ones is down by 13 percent compared with March 2003. All of the major banks, with the exception of Resona, posted positive interim results on a consolidated basis last September, and the share prices of some big banks are recovering. The government has stiffened the accounting requirements for calculating deferred tax assets, making it harder for Japanese banks to book them as equity capital. And banks have reduced their holdings of these questionable assets to 6.5 trillion yen ($60 billion), down 18 percent from the level in March 2003 to September 2003.

Furthermore, last year the government gave 15 banks (including 3 mega-banks) that have received injections of public funds a business-improvement order calling on them to increase their earnings sharply or face financial penalties. A more practical and fact-based system for determining the value of assets has been developed, and the clarification of the rules on converting government-owned preferred shares into ordinary shares has made the financial impact of these regulations more transparent.

But banks remain in a critical state: their earning power at all levels is weak, and nonperforming loans are still a huge burden. Japan faces three major issues in the overhaul of the financial sector, and government intrusion lies at the heart of all of them.

Too many banks

The government should resist bailing out any more unsustainable institutions—overcapacity is one reason Japanese banks have trouble improving their profitability. Risk-appropriate lending rates are needed, but banks fear that their numerous rivals will undercut them, so they continue to provide financing even if it isn't profitable. By contrast, when excess capacity leads to dumping in manufactures, money-losing companies accumulate debt and are ultimately driven from the market. Attrition of this kind is the only way for Japan's private-sector economy to advance to a new stage of efficiency and competition.

When the government 'saves' a bank, that may sound good to the public, yet bailouts make the financial system less sustainable

But instead of allowing failing financial institutions to go bankrupt, the Japanese government props them up with taxpayer money. The case of the Resona Bank, the fifth largest in Japan, is typical. In May 2003 the government put 1.96 trillion yen into Resona to maintain the value of its shares, in effect nationalizing it. Because banks, even if they are failing, never withdraw from the scene but instead continue to lend unprofitably, Japan has too many of them, and resources are wasted. When the government "saves" a bank, that may sound good to the public, but such bailouts definitely make the financial system less sustainable. Last year, however, the government took a step in the right direction by forcing shareholders, not taxpayers, to bear the burden when it rescued the smaller regional Ashikaga Bank without sustaining the value of that institution's shares.

The Diet (Japan's national legislature) is now considering a potentially problematic bill that aims to let banks receive preventive injections of public funds, which under current law can be used only in exceptional circumstances to maintain credit order. The new system, if enacted, would enable the state to provide capital to financial institutions, with the aim of enhancing their profitability and accelerating their realignment. Should this bill pass, Japan's financial institutions—sound or struggling—will be eligible to request infusions of public funds.

As it happens, the persistent funding of institutions with unsound management practices simply prolongs the problem and keeps regional economies weak. The government must encourage failing financial institutions to withdraw or restructure.

Unlimited deposit guarantees

Current law calls for the introduction of a deposit-guarantee cap on demand deposits—money that can be withdrawn at any time—by April 2005. Over the past ten years, however, the government has repeatedly delayed the implementation of a ten-million-yen limit on the amount that the authorities could reimburse any depositor at a failed bank. (In the United States, the limit is $100,000.) A ten-million-yen cap already exists for term deposits.

What little trust the Japanese people have in the financial system might evaporate completely if the government fails to implement the cap next year. Some politicians argue that the measure shouldn't take effect until existing financial institutions are deemed sound. This approach, however, puts the cart before the horse: the government must commit itself to the deposit-guarantee cap and then prompt the private sector to prepare for the new system. After all, the cap is a problem of bank-management discipline, not an issue that ordinary depositors should be worrying about.

An omnivorous state bank

Moreover, public and private financial institutions should be placed on an equal footing. A major structural factor preventing the private sector from standing on its own feet is the mammoth state bank: the Fiscal Investment and Loan Program (FILP). Its 400 trillion yen in assets is more than the total of Japan's four largest private banks. This relic of the socialist economic model—discredited by the collapse of the Soviet Union and increasingly abandoned by China—remains at the core of the Japanese economy and deserves closer scrutiny. Under a program created half a century ago, funds are gathered from asset-rich sources (such as the state-run postal savings system and pension reserves) for use in public projects. Many have wasted huge amounts of money.

The postal savings system holds an unfair advantage over private banks and absorbs a huge amount of household assets

The government has claimed success in reforming the FILP, arguing that its investments and loans have been halved in the past ten years—from about 40 trillion yen in 1995 to 20 trillion yen in 2004. In fact, that decline is the result of different accounting rules; the actual sum hasn't changed as dramatically. What's more, the government uses fiscal year 1995 as its benchmark even though the FILP's investments and loans have increased drastically from the 27 trillion yen of fiscal year 1990. At a minimum, the government needs to show exactly how much money is actually being invested, to come clean with the public about the amount of the FILP's bad assets, and to write them off.

More compromising to the integrity of the financial system, however, is the fact that the state-run postal savings system receives preferential treatment from the government: unlike private banks, it is exempt from corporate taxes and pays no risk premium to the deposit insurance fund. Although both the postal savings system and private banks now enjoy an unlimited government guarantee on most deposits, only the private banks are scheduled to lose it next year. The postal savings system thus holds an unfair advantage over private banks and absorbs a huge amount of household assets. As the public's confidence in private banks has eroded, the postal savings system's assets have steadily increased.

Prime Minister Koizumi is a strong advocate of privatizing the postal savings system, and a plan to do so is scheduled to be completed this autumn. Some economists argue that privatization will help level the playing field for the postal savings system and private banks. But will privatization go far enough? The best solution may be to reduce dramatically or even abolish the postal savings system to achieve true balance. Talk of such a radical move is taboo because so many people in Japan benefit from the status quo. At a minimum, then, the preferential treatment of the system must end. It also should be required to disclose the profit-and-loss statements of its three main businesses—postal savings, insurance, and the post office—and details of its profitability by region.

Further reform of financial supervision and bank governance in Japan is essential. For one thing, the state shouldn't remain the largest shareholder in most of the biggest institutions. Banks are under constant government pressure to lend to small and midsize companies, even when such lending is unprofitable; the government also controls the number of employees and branches of banks in which it has injected money. Without autonomy, banks can't allocate credit in an optimal way and the financial sector won't be capable of supporting economic growth. In the absence of a clear strategy, issues will persist and a sustainable financial system will remain elusive.

Real economic growth will come only well down the road to structural change. Prime Minister Koizumi's slogan—"no growth without reform"—is now more appropriate than ever.