'1940 System' Hurts Japan's Banks

ONE byproduct of Japan's ongoing financial crisis is that talk of reform has become more urgent.

The pressure for change derives in part from the increasingly strident criticism of Japan's economic system, including a popular new book that traces its underpinnings to the central planning that created Japan's wartime economy.

Another factor is simpler: Lately, the problems of Japan's banks and credit institutions have become an embarrassment to the government and caused Japanese credibility to suffer overseas.

If the precarious situation of Japan's financial system leads to restrictions on Japanese institutions from foreign authorities, particularly those in the US, "this is going to be a tremendous shock to the Ministry of Finance," says Haruo Shimada, professor of economics at Tokyo's Keio University. "Losing the American market and losing credibility overseas," he adds, "are very painful for Japan."

Japanese banks already have to pay slightly higher interest rates when they borrow money abroad - a so-called Japan premium - because of concerns about their credit worthiness.

In the United States, the Federal Reserve has agreed to purchase billions of US Treasury bonds held by Japan's central bank if that country suffers a cash crunch. This is said to be part of a broader package of technical assistance to help Japanese regulators resolve any financial crisis.

Early last week, Finance Minister Masayoshi Takemura telephoned US Treasury Secretary Robert Rubin to discuss Daiwa Bank's loss of $1.1 billion at its New York branch. American regulators were upset that it had taken so long for the ministry to inform its US counterpart about the loss, which a single trader racked up over an 11-year period.

The trader wrote a letter to his superiors in late July, and Daiwa's president first notified the ministry of the problem on Aug. 8. But US officials did not hear from Tokyo until Sept. 18. Japanese officials say they acted properly in asking the bank to investigate the matter and return with a report, which the bank did on Sept. 12.

Nonetheless, Mr. Takemura offered an apology to Mr. Rubin, a deputy finance minister told reporters the day after the phone call. Not so, said another official a few hours later. Takemura provided an explanation, not contrition, says Eisuke Sakakibara, head of the ministry's international finance bureau.

The conflicting accounts are but one illustration of how difficult it has been for Japan's officials to reckon with a financial system that increasingly appears capable of a crisis. These officials, particularly those at the Ministry of Finance, are much more accustomed to reverence at home and abroad, since they sit at the pinnacle of Japan's bureaucratic structure.

This bureaucracy has led Japan's transformation from a war-ravaged country into the world's second-largest economy in five decades. But this economic system is now in a stall. The country has been in a recession for four years. Japan's traditionally tiny rate of unemployment is starting to grow. And the strength of the Japanese yen has made cost-cutting a necessity at export-oriented companies.

In the financial arena - the ministry's central responsibility - stall is too kind a word. In a little more than six months, a major regional bank and four large credit unions have failed. Daiwa's losses appear to be something of an exception, but the banking community is full of rumors about major losses.

These problems are one reason why Yukio Noguchi's book "The 1940 System: Farewell Wartime Economy" is selling well. Professor Noguchi, who teaches at Tokyo's Hitotsubashi University, argues that the country's economic woes date back to the days when the government set up control mechanisms to boost industrial production and maintain social stability during World War II.

In his view the two most troublesome legacies of this government intervention are limited worker mobility and an overly regulated financial system that limits entrepreneurs' ability to raise money. In a world where Japanese companies are facing increasing competition from abroad, Noguchi says they are incapable of innovation and flexibility. It was not always this way, he says. Japan had a more market-driven and free-wheeling economy in the decades before the war.

Economic observers say that while this analysis is not new, it is catching hold as never before. The media are filled with critiques of bureaucratic power, and there are even calls to disband the ministry, which combines many regulatory powers under a single, monolithic roof.

Last week even ministry officials acknowledged that the traditional way of doing business appears to have failed them. Commenting on Daiwa's eight-year cover-up of an unrelated $97 million loss in the 1980s, The ministry's Mr. Sakakibara said: "We may have trusted our financial institutions a little too excessively. We many have to increase the number of our bank examiners 10- or 20-fold."

Trust, in this instance, is a way to describe the close ties that bankers have had to maintain with bureaucrats. In exchange, the ministry guaranteed the longevity of banks and arranged regulations so that companies were encouraged to borrow money from them rather than raising it directly through stocks and bonds.

Toru Nakakita, an expert on the financial system at Tokyo's Toyo University, likens the ministry's administration of banks to a "ship convoy moving forward at the pace of the slowest vessel ... proceeding with care to see that this ship does not fall behind."

"This is linked," he writes in a recent article, "to the perceived duty of maintaining credit order by protecting banks from failure and of preserving the assets of the Japanese public."

Noguchi, Nakakita, and others say part of the economy's salvation lies in radically liberalizing the financial sector, creating vibrant stock and bond markets where Japanese entrepreneurs could raise money without relying on risk-averse loan executives. This would cause massive dislocation in Japan's huge banks, which have largely benefited from the "1940 system."

Concludes Keio's Professor Shimada, "There is institutional fatigue in the '1940 system.' In this era of globalization ... the institution doesn't work."

Noguchi acknowledges that recent trends have forced the erosion of some parts of the "1940 system" - farmers and retailers, for instance, are now forced to compete with cheaper foreign goods. But he adds, "Piecemeal reform efforts will not succeed.... In order to change the system we need some kind of shock."