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žLegislation was passed to authorise the use of special service vehicles (SPVs) for asset backed securitisation.

1998

A new foreign exchange law, passed in 1997, took effect.

žFinancial institutions could engage directly in foreign exchange transactions, rather than having to use authorised foreign exchange banks.

žIt was no longer necessary to seek permission and/or prior notification for foreign settlements and capital transactions.

žTo reduce settlement risk, netting was allowed; with real time gross settlement to be introduced by the turn of the century.

These changes will reduce the cost of foreign exchange related transactions for all firms, financial and non-financial. Cross-border capital transactions were also liberalised, widening the choice of investment and borrowing for households and firms alike.

žTighter regulations on money laundering were introduced to bring Japan up to international standards. Under the new foreign exchange law, banks and other financial institutions are required to provide the identities of foreign remittances, and custom authorities must be informed if exports or imports are paid for by cash.

žStockbroking commissions were relaxed. Fixed commissions no longer applied to transaction values above 50 million yen (about $400 000). All fixed commissions were to be abolished by the end of 1999.

žRestrictions on non-life insurance premium rates were removed.

žFinancial holding companies were introduced, with bank, securities and trust company subsidiaries, though insurance firms were excluded. It meant FHCs could offer a broad range of financial services to customers. At the same time, new laws were to be passed to protect depositors, investors and policy holders.

ž‘‘Prompt corrective’’ guidelines were to be applied to troubled banks. For banks engaged in domestic and international operations, the Basel risk weighted capital adequacy ratio96 was to be used as an objective, early warning indicator. External auditors and the Financial Services Agency are required to monitor the banks’ computation of their ratio. If a bank is rated as poor, it will be required to improve its management as quickly as possible. Specifically, a capital restoration plan must be submitted if the ratio is between 4% and 8%.97 Further action must be taken if the ratio falls between 0 and 4%, such as reducing or stopping the payment of dividends and bonuses to directors, closing branches or subsidiaries, and reducing assets and/or higher rate paying special deposits. Banks will be ordered to cease operations partially or completely if liabilities exceed risk weighted assets, i.e. the risk assets ratio is <0.

96A Japanese capital adequacy ratio is applied to banks if their activities are confined to the domestic markets. No ‘‘PCA’’ is required until the ratio falls below 4%, compared to 8% for banks required to meet Basel standards.

97For domestic banks operating in Japan, the respective ratios are 2–4%, 0–2% and <0.

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žTypes of investment trusts can be expanded to include corporate and private placement investment trusts.

žOrdinary banks can issue their own bonds.

žNon-bank financial firms to be allowed to issue bonds and take out other commercial loans to fund lending activities.

žPension fund rules were relaxed:

(a)Companies may use investment advisors to manage their pension funds, in addition to life insurance and trust companies.

(b)In April 1999, the ‘‘5-3-3-2’’ rule was abolished. It specified that 50% of funds had to be invested in ‘‘safe’’ assets, less than 30% in stocks, less than 30% in foreign currency denominated assets, and less than 20% in real estate.

(c)Regulations on the management of public pension funds have been eased.

žAccounting procedures will be tightened:

(a)Financial firms to be required to report accounts on a consolidated basis.

(b)Marking to market for securities, derivatives and other financial instruments to be introduced.

(c)Auditing will comply with international standards. For example, accounts will have to be signed off by an independent auditing firm.

2000

žBanks’ securities subsidiaries allowed to engage in bond issues, initial public offerings and secondary trading.

žAll stockbroking fixed commissions abolished.

žBanks, trusts and securities firms can create area specific securities to enter each other’s markets.

2001

žInsurance firms are allowed to enter the banking sector and vice versa.

žLife insurance firms may sell other types of insurance such as medical insurance; non-life insurance firms can offer life insurance.

žBanks to be permitted to sell life insurance and insurance taken out with housing loans (e.g. fire and default insurance) through their branches.

Appendix 8.2. Reform of the Regulators

In June 1997, new legislation created the Financial Supervisory Agency. It assumed responsibility for bank supervision, which, up to this time, had been shared between the MoF banking bureau100 and the Bank of Japan (BJ). The Financial Supervisory Agency was empowered to:

100 As a result of the reduced role of the Ministry of Finance, the Banking and Securities Bureaux were merged to form the Financial Planning Bureau, with a consequent reduction in staff. The MoF’s Banking Inspection Department and Exchange Surveillance Commission were abolished.

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žLicense, inspect and supervise banks. All banks’ loan portfolios are subject to an internal grading, to be certified by a public auditor.

žClose insolvent lenders, issue and revoke financial licences, and arrange mergers.

žSupport the Deposit Insurance Commission (DIC). The Agency will examine cases for merging sick with healthy banks, with support from the DIC.

žSupervising the financial sector, i.e. banks, securities firms, insurance companies and some non-bank lenders.

The Financial Supervisory Agency reported to the Financial Reconstruction Commission (FRC), created to manage the financial crisis and institution failures, as well as supervise and examine financial institutions. As non-ministerial agencies, both institutions report directly to the Prime Minister’s Office, not the MoF.

The functions of the Financial Reconstruction Commission and the Financial Supervisory Agency were merged on 6 January 2001, to create the Financial Services Agency. The merger was supposed to signal that the problems which have plagued the Japanese financial sector were largely resolved. Independent of the Ministry of Finance,101 it reports to the Prime Minister’s Office. The FSA will carry out all the functions of the former Supervisory Agency and assumes an important policy-making role with respect to financial regulation.

The autonomy of the Bank of Japan was increased by the April 1998 Bank of Japan Act. The BJ’s Policy Board takes the final decision on monetary policy. The Finance Minister is no longer allowed to issue directives to the BJ or conduct an on-site inspection of the Bank. The Governor, Vice-Governor and Policy Board are appointed by Cabinet,102 but it cannot dismiss them. The MoF and Economic Planning Agency have been removed from the membership of the BJ’s Policy Board, though their representatives can express opinions at meetings.

To encourage greater transparency, the new Act makes it mandatory for the BJ to publish minutes of its meetings and a summary of the proceedings.

These changes fall short of granting complete independence to the Bank of Japan. The MoF continues to have control over the maintenance of currency stability. The Finance Minister has the right to approve the BJ’s budget, and the BJ’s semi-annual report is sent to the Japanese Diet, but via the MoF. The Finance Minister can also require the BJ to make loans to troubled banks and other financial institutions.

101Though the FSA has statutory independence from the MoF, many of its workers have been transferred by the Ministry, leading some to question how really independent the Agency is.

102Subject to the Diet’s approval.

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customers access the machine more frequently than they would visit the branch, the cost savings may be lower than expected. Also, to the extent that visits to a branch help foster a relationship, banks may find that electronic delivery methods reduce their ability to cross-sell other financial products.

As was discussed in Chapter 1, banks provide customers with many services, including intermediation (deposits, loans), liquidity and payment services, and non-banking financial services ranging from management of investment portfolios to protection of valuables. In some bank systems, direct payment for these services is the exception rather than the rule. For example, demand deposits may be paid interest, in exchange for ‘‘free’’ services. Or ‘‘free retail banking’’ may be offered to all customers in credit, but those with an overdraft are charged very high fees and interest, meaning these customers are effectively subsidising those in credit. Corporate clients normally receive a package of banking services to accompany a loan or overdraft facility, but depending on the size of their custom, are often charged for every transaction (direct debits/credits, fund transfers, etc.) they use.

In aggregate, bank output, for the purposes of a country’s national accounts, should be based on value-added, that is, adjusted operating profits less the cost of shareholder equity. When looking at the financial sector as a share of GDP, net interest receipts are normally included in value-added; in the USA these are attributed to depositors, while in the UK they include depositors and borrowers. However, empirical studies on banking do not normally use the national accounts definition of bank output. Instead, a ‘‘production’’ or ‘‘intermediation’’ interpretation of bank output is employed.

9.2.1. The Production Approach

The production approach measures bank output by treating banks as firms which use capital and labour to produce different categories of deposit and loan accounts. Outputs are measured by the number of these accounts or the number of transactions per account. Total costs are all operating costs used to produce these outputs. Output is treated as a flow, that is, the amount of ‘‘output’’ produced per unit of time, and inflation bias is absent. An example of the use of this type of measurement may be found in Benston (1965). There are several problems with this approach. First, there is the question of how to weight each bank service in the computation of output. Second, the method ignores interest costs, which will be important if, for example, deposit rates fall as the number of branches increase. Furthermore, data from banks in countries using different accounting systems may not be comparable, making accurate measures of relative efficiency difficult to obtain. It is hoped the move towards International Accounting Standards (IAS) will address this problem.

The total factor productivity (TFP) approach employs a single productivity ratio, using multiple inputs and outputs. Humphrey (1992) measured productivity and scale economies using flow and stock measures of banking output in identical models. He employed both a non-parametric growth accounting procedure and the econometric estimation of a cost function. A structural model of bank production was used, which incorporated both the production of intermediate deposit outputs as well as ‘‘final’’ loan outputs. Thus, both the input and output characteristics of deposits were simultaneously represented.

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With data on 202 US banks from the Federal Reserve’s 1989 Functional Cost Analysis survey, Humphrey employed a general production function:

where

Q : bank output

A : efficiency

K, L : capital and labour, respectively

D : demand deposits

S : small time and savings deposits

F : purchased funds

Humphrey used three different measures of bank output

QT: a transactions flow measure – the number of deposits and loan transactions processed QD: a stock measure – the real $ value of deposit and loan balances

QA: a stock measure of output – the number of deposit and loan accounts serviced

The growth of production efficiency is the residual, obtained after subtracting the growth in inputs from the growth in outputs. The residual from the dual cost function also shows productivity growth: the shifts in the average cost curve after controlling for changes in input prices. Expenditure share weights were estimated rather than being computed directly. A translog cost function1 was used for the econometric estimation. TFP was derived from these equations, decomposed into cost reductions arising from either technical change over time or scale economies. Humphrey specified scale economies of 0.9 (slight scale economies), 1.00 (constant costs) and 1.1 (slight diseconomies). Humphrey reported on the equation that assumed constant costs because the total factor productivity results did not appear to be sensitive to the scale economies imposed.

Humphrey’s key findings are as follows.

žUsing the QT definition (number of deposits and loans processed), banking productivity was found to have been flat over 20 years, with an annual average rate of growth of only 0.4%.

žIf output is defined as QD (dollar value of loans and deposits), TFP actually fell between 1968 and 1980 but rose thereafter. The overall average rate of TFP growth was 1.8% per annum.

žThe real value of total assets (QTA): the average TFP rate fell by about 1.4% per year.

Humphrey finds the TFP result using the parametric/econometric approach is virtually the same as when a growth accounting approach (non-parametric) is used. Nor was there much

1 This is a fairly common specification of a cost function, and the equations for it will not be derived here. Readers are referred to equations (2) and (3) in Humphrey (1992), or see any good introductory textbook on econometrics.

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difference in the predictive accuracy of the stock and flow measures of bank output. By the flow measure, productivity growth was slightly positive; it was slightly negative when the stock measure was used. During the 1980s, both measures generated a small positive productivity growth. Two reasons are offered for the relatively low US bank productivity growth. First, banks lost low-cost deposit accounts as corporate and retail customers shifted to corporate cash management accounts and interest-earning cheque accounts. Second, the study largely ignored quality differences in bank output. For example, the quality of bank services may have improved because banks started to pay interest on most accounts but did not raise charges for bank services such as transfer of funds, cheque clearing and monthly statements.

9.2.2. The Intermediation Approach

This approach recognises intermediation as the core activity – banks are not producers of loan and deposit services. Instead, output is measured by the value of loans and investments. Bank output is treated as a stock, showing the given amount of output at one point in time. Total cost is measured by operating costs (the cost of factor inputs such as labour and capital) plus interest costs. Sealey and Lindley (1977) argued that earning assets (loans, securities, etc.) make up bank outputs, so deposits, capital and labour should be treated as inputs. Others favour deposits being treated as outputs. However, if banks offer an extended range of services, such as trust operations or securities, the intermediation approach will make their unit costs appear higher than for banks that engage in traditional intermediation. The relative importance of different bank products may also be ignored in the computation, unless weighted indices are used. Greenbaum (1967) suggested one method for obtaining weights: he used linear regressions to obtain average interest rate charges on various types of bank assets.

Most bank productivity studies use the intermediation approach because there are fewer data problems than with the production approach. They tend to follow Sealey and Lindley (1977), where earning assets are produced from several factor inputs. In the more recent literature, in an attempt to recognise the multiproduct nature of the firm, outputs typically include loans, other earning assets (e.g. securities, interbank assets), deposits and non-interest income, which acts as a proxy for off-balance sheet ‘‘output’’. Inputs include the price of labour, the cost of physical capital (proxied by non-interest expenses/fixed assets) and the price of financial capital (proxy: interest paid/purchased funds).

The empirical work suffers from a number of difficulties. First, the way output is measured varies considerably. Some studies use the number of deposit accounts because customers are getting services (e.g. intermediation, liquidity) from the account. Though banks incur costs from offering these services, all but a fraction of deposits earn revenue when they are loaned out. Studies that rely on the underlying production and cost functions for banks encounter these problems. The literature on X-efficiency, scale and scope economies and structure – conduct – performance often employ different definitions of output. Furthermore, deposits may be treated either as inputs, outputs or, in some studies, both.

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The intermediation and production approaches fail to address a number of issues. No account is taken of the different risks attached to each loan, or, for example, the reputation of the bank in terms of the perceived probability of failure. The maturity structure of loans and deposits, critical in banking, is generally ignored. Finally, any change in the structure of the banking market could distort output measures. For example, increased competition may narrow interest margins, which in turn will reduce output as reported in the national income accounts. In the production approach, the output measure is affected if the change in margins affects the volume of loans – a fall in margins could increase the volume of loans and deposits. If the number of loan accounts increases, the intermediation approach will record a rise in output; but using the flow measure, a decline in margins, all else equal, would trigger a fall in output.

9.3. X-efficiency, Scale Economies and

Scope Economies

9.3.1. Cost X-efficiency

X-efficiency2 can be measured in terms of cost or profit but the emphasis of much of the banking literature is on cost X-efficiency. Since managers have the ability to control costs (cost X-efficiency) or revenues (profit X-efficiency), greater X-efficiencies can be achieved by superior management. The cost efficiency frontier is shown in Figure 9.1.

Figure 9.1 Cost and Profit X-efficiency.

2 Farrell (1957) was the first to provide an empirical measure of X-efficiency.