Japan Follows Through With Reform

August 2, 2002

Japanese Financial Services Minister Yanagisawa announced today that the agency intends to follow through with plans to cap deposit insurance at Japanese banks.

The move is an attempt to discipline depositors and banking institutions alike.

The agency is seeking to eliminate the moral hazard faced by depositors (either households, firms or other financial institutions), who have an incentive to shift the risk of holding funds in financially shaky banks onto the government because the generous deposit insurance program insulates depositors from financial loss.

Limiting deposit insurance will expose depositors to financial loss in the event of bankruptcy, and provide them with an incentive to monitor the solvency of their financial institutions.

The government had recently backtracked on its intentions to withdraw the insurance coverage amid the plunge in the Tokyo stock exchange. Japanese banks hold large quantities of equities as so-called tier 1 capital to act as a cushion against asset loss such as loan default. The recent plunge in the value of Japanese equities has eroded the ratio of this capital cushion to asset value, which makes shaky banks (and in Japan, all banks are shaky banks) more susceptible to default by a single borrower. In response, the Koizumi administration had been considering a delay the reduction of deposit insurance caps.

FSM Yanagisawa is hedging the reform, however, by stating that the government will act to protect accounts used for settlement purposes-either by households or financial institutions. This caveat effectively waters down the attempt to remove the moral hazard, as there is not an effective way to differentiate between accounts that are used for settlement purposes from those that are not. As such, the agency's announcement represents another attempt at reform for which the substance of action is considerably less than the rhetoric.

News Forum