The banking sector problem and the credit crunch in Japan

During the 1990s, the Japanese banking sector suffered from a plummeting stock portfolio value and massive loan defaults. It is widely argued that these problems in the banking sector depressed the supply of bank loans and the overall investment activities of firms. My thesis provides an innovative approach which investigates the validity of this supply-based claim by utilizing a microeconomic data set on banks and firms in Japan.; One explanation for why the financial problems of banks have contracting effects on the loan supply is the constraint implied by the risk-based capital requirement. Chapter 2 empirically tests for the presence of this binding capital-constraint using panel data on Japanese banks from 1992 to 1998. In order to test this hypothesis, I employ a regime switching regression model to simultaneously estimate both (1) loan sensitivity to internal capital in two financial regimes (capital-constrained and unconstrained regimes) and (2) the probability of being in the capital-constrained regime. The main empirical results from this model show that poorly-capitalized banks tend to be in the capital-constrained regime that is characterized by a large sensitivity of loans to fluctuations in internal capital. These findings are consistent with the view that the capital-requirement acted as a binding constraint to poorly-capitalized banks in Japan.; The empirical results in Chapter 2 show that a financially distressed bank faces constraints that inhibit the growth of its loan supply. However, if a borrower faces a frictionless capital market, the disruption of credit from one source does not affect the total flow of credit to a borrower since the borrower can simply switch its lenders. Thus, the effect of a bank's financial constraints on the total flow of funds depends critically on whether firms face “switching costs”. However, the presence of switching costs is yet to be investigated. Chapter 3 begins to explore whether the financial distress of a bank has any effect on the total flow of external funds into the firms for which it serves as their primary lender (main bank). The main findings are that firms do not expand their borrowing from non-main bank lenders even when their main bank faces financial difficulties; consequently, firms at financially weak main banks tend to borrow less than firms at financially strong main banks. This empirical evidence is consistent with the notion that firms face costs of moving away from their informed main banks to uninformed non-main bank lenders.; Finally, Chapter 4 addresses the remaining and yet most critical question about the credit crunch in Japan: did the financial problem in the banking sector play a role in reducing the investment spending of firms? To investigate this, I use a unique longitudinal data set that links firm-level investment in tangible assets and R&D investment to the financial conditions of the main bank with which these firms have maintained a long-term relationship. I find that a bank's financial health indeed has effects on its client firms' investments. In particular, firms at severely distressed banks invest 70 percent less in tangible assets relative to firms at financially healthy banks; these findings are strong evidence for the view that the declining financial health of Japanese banks had adverse effects on the investment spending of their borrowers.