Recently, we have seen many comparisons between Europe now to Japan after it emerged from its deep and protracted cycle (from 1989 to 1999). In this note, we address why this analogy, and by extension the comparison between their respective banking systems, lacks merit.

The Europe/Japan comparison has emerged much more of late given both Japan and the eurozone (over 50% of Europe’s GDP) have adopted a central bank policy incorporating negative rates. In our view, there is a crucial difference between the two cycles; Europe took significant steps to restore the health of its banking system, while Japan did not.  

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Europe, from 2007 to the present, was significantly impacted by the credit crisis and the sovereign debt crisis. However, since the cycle began eight years ago, the European banks have increased their reserves and capital by a combined €930 bln or ~US$1.0 trillion[1]. In addition, to increase market confidence in the solvency of the eurozone banks, the ECB completed the Asset Quality Review (AQR) to evaluate the sufficiency of recognition of problem loans[2] (similar to the U.S. stress tests). This effort clearly had an impact on reserve levels, which increased by almost €100 bln in 2013 heading into the first system-wide test[3].

Japan, from 1989 until 1997, saw a massive collapse in property values (~70% decline in land values)[4] and its stock market (TOPIX down ~60%). This represented a severe and direct shock to the solvency of the banking system, the impact of which was felt for nearly a decade (the indirect impact is arguably still being felt). In terms of a policy response, Japan took a completely different route than Europe after its downturn began in 1989; it essentially did nothing. Japan adopted what could best be described as extreme regulatory forbearance, allowing its insolvent banking system to operate without any significant efforts to fix the problems.

Despite widespread insolvency (although not failures), Japan still had no meaningful policy response to recapitalize its banks eight years after the bubble burst (i.e., where Europe is now). Once the devastating impact on bank solvency became apparent, the Japanese government should have either nationalized the banking sector (or large parts of it), and/or established a massive government-backed “bad bank” to take the non-performing loans and restore solvency to the system.

Not only did Japanese banks not take any steps to build capital, the sector operated as if nothing had happened. Banks also took virtually no significant action for years to recognize loans as non-performing and provision against them, as the changes in reserve ratios were minimal compared to the size/scope of the problem[5].  Banks continued to pay out dividends even as profits plummeted. Once the banks began to meaningfully increase provisions against bad loans in 1995, it resulted in a 4-year period of net losses, further draining capital[6]. In fact, eight years after the cycle began, total equity in the Japanese banking system was actually ~20% lower than it was in 1989 and leverage (i.e., assets to equity) was a staggering~60-to-1[7].

Unlike Europe, eight years into Japan’s cycle, the banks were still essentially insolvent and the country’s regulators were only beginning to come to grips with the problems facing the sector. This lack of policy response resulted in a multi-decade deleveraging of its banking system, which was arguably the root of the vicious deflationary cycle from which the country has yet to emerge.

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By contrast, Europe followed the U.S. example of widespread recapitalization, government stakes in large systemically important banks, and an effort by regulators to add to transparency through a credible review of bad loans. The result: a doubling of tangible common equity (the highest quality capital), and a four-fold increase in reserves, which together total US$1 trillion.

In effect, there are one trillion reasons why Europe is not Japan.


Notes

[1] Between 2007 to 2015, tangible common equity – the highest quality capital – doubled for the European banks from ~€600 bln to ~€1.2 trillion, while reserves rose from ~€85 bln to almost €400 bln.
[2] This was part of a comprehensive assessment that also included an EU-wide stress test in conjunction with the European Banking Authority.
[3] The system entered the cycle with ~€85 bln.
[4] Source: Japan Real Estate Institute. By 2004, commercial land prices for the six largest cities had declined by over 80%, from the peak in 1989.
[5] The reserve ratio for the sector increased from 150 bps to 280 bps from 1994 to 1995, though this was far from sufficient.
[6] Source: IMF. In 1997, Japanese banks recorded ¥9.7 trillion in after-tax losses and still paid out ¥687 billion in dividends. Other financial information for Japanese banks is from the Bank of Japan and represents domestically licensed banks, excluding trust subsidiaries and foreign trust banks.
[7] In 1989, there was no Basel capital regime in place (initial implementation occurred in 1992), so Japanese banks entered their downturn with much higher financial leverage than European banks did in 2007. Specifically, Japanese banks entered the cycle at an already very high 40-to-1.

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