Will Bank Recapitalization Succeed?

I recently presented a new working paper co-written with Takeo Hoshi at the Law, Economics and Organizations workshop at Harvard Law School entitled Will the U.S. Bank Recapitalization Succeed? Lessons from Japan. In the paper, we look back at Japan’s decade-long response to its financial crisis and evaluate what has and hasn’t worked, and draw on the Japanese experience to evaluate the Troubled Assets Relief Program (TARP), which focused on the idea of purchasing troubled assets to stabilize the financial system, and the Capital Purchase Program (CPP), which focuses on acquiring stakes in banks in the form of preferred shares and warrants.

While it is widely known that the banking problems in both countries began after a sharp increase in land prices, the events in Japan from late 1997 to early 1999 closely track developments in the U.S. in 2008. One important similarity is the bank credit crunch that prevailed in both instances. More importantly, the Japanese banks emerged from the acute phase of its crisis with seriously undercapitalized banks. We identify four main problems with the string of Japanese asset purchase plans and capital injection programs that were pursued to combat the banking problems. First, the asset purchase plans were too narrow. The scope of assets to be purchased and the set of financial institutions included were limited, thus precluding a comprehensive plan. Second, the loan purchases that did take place, especially in the 1990s, involved little restructuring of the borrowers. This resulted in many of the companies operating with few changes while typically receiving more loans that subsequently went bad. Third, the capital purchase plans ran into trouble in getting the banks to accept funding. Fourth and most importantly, the overall amount of government money committed was too small to recapitalize the banks. Hence, the banks only really returned to being adequately capitalized in 2006 and 2007, when macroeconomic conditions improved and after supervision policy had changed.

In broad terms, the TARP and CPP programs mimic many elements of the Japanese plans. We present data comparing the largest U.S. banks, particularly in terms of the risks that they face from continued deterioration in the economy. Based on publicly available data it is hard to make confident assessments about the solvency of the banks. The lesson from Japan is that the details of the potential recapitalization program will be critical in determining whether any injections will increase the banks’ capital levels and hence their lending capacity. While the U.S. plans are still in flux, it appears that U.S. is at risk for running into some of the same problems that hobbled the Japanese policies.

The full paper is available for download here.