The evergreening of bank loans for 'cosmetic purposes' was widespread, with banks more likely to increase loans to firms with weaker financial health.
In Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan (NBER Working Paper No. 9643, commissioned for an NBER Project on Japan and originally presented at a conference in Tokyo), co-authors Joe Peek and Eric Rosengren investigate what they consider an important factor in the long-running economic stagnation in Japan: Japanese banks' practice of continually extending credit to very weak or even insolvent firms. The authors maintain that in Japan's bank-centered economy, where banks often have responsibility for corporate monitoring and governance, many lending decisions are strongly influenced by a perceived duty to support troubled firms, rather than by the sort of credit-risk analysis practiced in the United States. Peek and Rosengren point out that both government policy and bank regulations in Japan actually encourage banks to keep extending credit to problematic borrowers. As a result, the banks "evergreen" loans:.
To investigate how Japanese banks allocated credit across firms in the 1990s, Peek and Rosengren examine the pattern of loans obtained by all firms included in the Pacific-Basin Capital Market Databases, which encompass all first- and second-section firms traded on the Tokyo stock exchange, and information from several bank capital and loan monitoring databases. Their analysis bears out a number of their suspicions.
First, they confirm that banks "evergreen" loans: that is, they fund firms to enable the firms to make interest payments on outstanding loans, and thus to avoid, or at least delay, bankruptcy. This practice allows the banks to have healthier looking balance sheets, because the banks report fewer problem loans and make smaller loan loss provisions. The evergreening of bank loans for "cosmetic purposes" was widespread, with banks more likely to increase loans to firms with weaker financial health. With "balance sheet cosmetics" in mind, banks had more of an incentive to extend additional credit to troubled firms with loans already outstanding as those same banks' reported risk-based capital ratios neared their required capital ratios. What was important was the appearance rather than the reality of adequate capital.
Second, the data confirm that corporate connections make it even more likely that banks will extend such credit. Third, government-controlled banks were also more likely to increase loans to financially weak firms. Finally, the data strongly indicate that the only lending institutions apparently not subject to the incentives and pressures to evergreen loans to the weakest firms are non-affiliated, non-bank lenders.
From their analysis, Peek and Rosengren conclude that just as forbearance by bank regulators has allowed the banks to neglect restructuring, bank support for troubled and noncompetitive firms has prevented the needed restructuring of non-financial firms. The evergreening of loans in Japan clearly insulated many severely troubled Japanese firms from market forces and may have prevented a bank credit crunch. Yet that practice only made economic problems worse by promoting the allocation of an increasing share of bank credit to many of the firms least likely to use it productively. In other words, to the degree that banks reacting to perverse incentives extended credit to firms with poor prospects, overall economic recovery was hampered.
By insulating troubled, and perhaps insolvent, firms from market forces that would force either a major restructuring or bankruptcy of the firms, Peek and Rosengren say, the misallocation of credit severely prolonged the malaise as seen in "the lost decade" of the 1990s. Furthermore, such a misallocation of credit, by inhibiting the needed restructuring of the economy, adversely affects the long-run prospects for growth of the Japanese economy.
-- Matt Nesvisky