St a Glance ZI r Bank FPD Note No. 32 December 1994 Developing long-term finance in emerging markets Using bank debentures: Lessons from Japan Masakazu Watanabe From the early 1950s until quite re- speed the development of long-term cently, the Japanese government took funding instruments, especially for an active role in promoting a bank infrastructure projects. debenture market. This :Note explains *j 4 %j! ho,V the Japanese bank debenture For example, the World Bank has iimarket developed and what role these recently helped to establish bank de- debentures played in establishing a bentures in Argentina. The debentures bond market. The debenture market are issued by prime domestic banks started life at a time when massive with a backstop facility as a safeguard amounts of long-term capital were scheme. The backstop facility stands needed for reconstruction. Capital ready to purchase the bank debenture markets had not yet developed, and in case of market difficulties. This market-based long-term funding was kind of innovative support makes it seen as too risky by both investors possible to use the bank debentures and financial institutions. to develop long-term funding with fewer government interventions than Japan's government was especially in Japan (see FPD Note 29). successful in promoting a liquid de- benture market. First, it created a uni- Creating the Japanese form bank debenture instrument with debenture market the sarme coupon or discount rate. This debenture was adopted by six Issuers issuers, all carrying the same implicit Bank debentures were introduced in credit ratings. Second, the government 1952 with the designation of six banks developed a strong investor base by by a special law.' Although all six providing incentives. The Japanese were commercial banks, three special- experience shows that it is possible to ized in long-term credit and the other create a government-supported bench- three served specific sectors of the mark in the securities market even if economy. The banks were broadly the government itself is not borrowing owned, with one-third of shares held to finance budget deficits. This experi- by individuals and two-thirds by fi- ence should be of interest to clevelop- nancial institutions and industrial cor- ing countries looking for ways to porations. None had a dominant Financial Sector Development Department Vice Presidency for Finance and Private Sector Development shareholder: no single shareholding exceeded 5 Ministry of Finance gradually withdrew from pur- percent. Along with implied support from the gov- chasing bank debentures, it was replaced in the ernment, the broad ownership was an important market by commercial banks encouraged by a range factor in maintaining consistent creditworthiness of policies giving preferences to the bank debenture across all six institutions. instrument. Although the Ministry of Finance contin- ued to refinance its previous purchases, and from All long-term credit banks issued identical securities time to tim.e made new investments in bank deben- that were identically priced, with no differentiation tures for sector-specific loans such as those for the by issuer credit. These coupon bank debentures steel and shipping industries, the share of its pur- were issued on tap. Competition among the long- chases declined significantly. term credit banks took the form of distribution effort rather than price, which helped to expand the inves- Phase II. Maturity transformation. In 195645, com- tor base.2 With most bank debentures issued on tap, mercial banks were the main investors in bank de- investors had a simple instrument to purchase. The bentures, holding 70 percent of the total amount bulk (70 percent) of the debentures issued were for outstanding. A number of preferences for bank de- a five-year maturity with a fixed coupon rate. The bentures made them attractive to commercial banks: balance was in one-year discount debentures. These * They could be used in Bank of Japan Loan and characteristics contributed to liquidity. Open Market Operations. Bank debentures were specified as eligible collateral for commercial Investor base banks borrowing funds from the Bank of Japan. There were three main phases of investor base de- In addition, the Bank of Japan added bank deben- velopment. In the initial phase, the Ministry of Fi- tures to its intervention account through which it nance purchased debentures using the deposits of sold or bought securities to carry out its monetary the postal savings system.3 By 1955, commercial policy. Thius banks that held coupon debentures banks had become major purchasers of bank deben- could raise funds whenever they wanted to, either tures, supported by special incentives (described by selling the debentures to the Bank of Japan or below). In later years, as these incentives for com- mercial banks were wound back, individuals be- came the main debenture purchasers. (See box on Figure I investor base for bank debentures in Japan, page 3 for a summary of support structures.) Indi- 1952-92 viduals now hold more than half the bank deben- tures issued by long-term credit banks (figure 1). 100 i Over the period 1955-93, the volume of bank de- 80 _ bentures rose rapidly-from Y347 billion to Y74,435 F-77 billion. While bank debentures accounted for the 60 - X bulk of the bond market in the early years, they dropped to 20 percent by 1993 as other bonds were 40 - introduced. 20- Phase 1: Inception. The first step was to create an investor base. At the start, bank debentures were 01952-s5 5 19 ; 6, i976-85 1986-92 purchased primarily by the Trust Fund Bureau of the Ministry of Finance. This Fund invested the savings Individuals Commercial banks mobilized through the extensive postal savings sys- r Nonfinancial institutions * Ministry of Finance tem. This phase lasted only a couple of years. As the 2 'free" to invest in bonds. The first (since World War Market support structures II) government bonds were issued in 1966. The Bank of Japan removed coupon debentures from its since their inception, hank debe ntures have received intervention accounts, eliininating most of the bene- strong government support tlhrough a variety of incentives fo .. .. . . ~~~~~~~fits of buv-ing bank debentures for the commercial and privileges. Strong official hacking was the kev sup- port factor, ensuring that the long-term credit banks were banks. It was especially difficult for city banks to perceived as highly creditworthy. Support mechanisms continue purchasing debentures because of the in- have included the following: creasing burdeni of having to underwrite large * Mlobilization of the pool of savings in the M[inistry of amnounts of government bonds. Long-term credit Finance's Trust Fund Bureau created the initial dermand banks therefore had to broaden the investment ap- for debentures. * The inclusion of bank debentures in the Bank of peal of bank debentures. japan's intervention account for open market opera- tions encouraged commenrcial banks to buy the m. The following steps were taken to ensure that bank * competing security issues were tightly regulated. debentures would be attractive to individual inves- * Special tax preferences wvere given to individual inves- tors and nonfinancial institutions: tors to encourage them to buy debentures. Precludi competition. The five-year maturity . Irterest rate regulation and other policies assured a a rising yield curve. was reserved for bank debentures. The maxi- * Uniform credit w-as posted on all bank debenture issu- mum maturity of bank deposits was set at one ens to provide simple prnduct characteristics. This year (until 1976), and government and corporate he-lped to build liquidity. bonds were issued at nmaturities of at least seven years. Grantingpre/frred tax treatment. Starting in 1967, by borrowing from the bank while using the de- a 5 percent tax was levied on the discount ele- bentures as collateral. ment of discount debentures, much lower than - The purchase of debentures held the promise of the withholding tax rate on interest and dividend leveraged cofinancing. In return for purchasing income, which was raised to 20 percent. That bank debentures, a commercial bank could ask gave a tax advantage to discount debentures rela- the long-term credit bank to provide a long-term tive to other financial instruments, such as coupon loati to an industrial corporation that it designat- bonds and time deposits. Because discount de- ed. As a matter of general practice, the long-term bentures were issued on a bearer basis, the tax crebiit bank- would provide that corporation with a advantage provided a strong incentive for individ- loan for twice the amount of bank debentures ual investors to buy. purchased by the commercial bank. In addition, * Provicling a yield advantage. The discount rate on the commercial bank would obtain a flow of de- discount debentures, closely linked to the call rate posits from the client corporation that received until the 1950s. was set at a certain number of the long-term loan. basis points above the interest rate on one-year * The coupon for bank debentures was set at about time deposits starting in 1967. Sales of discount 200 basis points above the regulated interest rate debentures expanded rapidly as a result of the for time deposits. Commercial banks thus earned lower tax rate and relatively higher yield during a reasonable profit by investing in this low-risk 1966-75. asset. * Developing neuw products. New types of savings accounts were created at the long-term credit Phase fII Mallri-ket broaden,ing. By the 1960s, the gov- banks to encourage investors to buy bank deben- ernment was keen to develop the bond market. tures. An example is the "'Wide" account, in which Thus it needed to help create a new investor base the interest rate is compounded semiannually and for debentures so that commercial banks would be one complete payment is made at maturity. Most 3 new product development has occurred since the The Japanese experience also shows that official early 1980s. support can take a variety of forms without neces- sarily distorting the structure of interest rates. The Implications for developing capital markets slope of the yield curve remained positive through- The Japanese model for developing a successful out the markelt development period, while a variety bank debenture market is premised on a high sav- of measures provided incentives for commercial ings ratio and the ability of government to regulate banks and individuals to invest in bank debentures. the structure of interest rates. While there is no These measures involved both fiscal and monetary doubt about the tremendous contribution of the incentives that could be calibrated to reflect the rela- long-term credit banks and bank debentures to tive importance of bank debentures in the develop- Japan's postwar economic development, protecting ment of financial markets. the six issuing banks and promoting bank deben- tures had costly side effects. Interest rate controls Finally, the evolution of the bank debenture market favored financial institutions at the expense of de- over four decades in Japan shows the merit of start- positors, the preferences for certain borrowers dis- ing with a simple instrument and strong official sup- torted loan allocations, and excessive protection of port for market development. In later phases, official the bank debenture market slowed the develop- support was gradually diminished, forcing bank de- ment of corporate bond markets. Although the bentures to compete in a wider market. development process was essentially sound until the mid-1970s, after that time the government The six banks were the Industrial Bank of Japan, the Long-Term Credit should have acted more rapidly to remove the Bank of Japan, the Nippon Credit Bank, the Central Cooperative Bank preferences for the instrument and the six issuing for Agriculture and Forestry, the Central Cooperative Bank for Com- banks. merce and Industry, and the Bank of Tokyo. b,anks. 2 Both the branch networks of the long-term credit banks and the secu- rities brokers networks were fully utilized in marketing the bank Nevertheless, the experience of Japan shows that in debentures. countries where governments have not borrowed to 3 The postal savings system is a nationwide banking system adminis- tered by the Ministry of Post and Telecommunications. About 19,000 finance budgetary deficits, it is still possible to estab- post offices provide banking services. Total deposits exceeded $800 lish a government-supported benchmark in the se- billion in 1990. The system is the largest deposit-taking institution in curities market. Until Japan started issuing govern- the world and accounts for a quarter of all Japanese savings. The ment bonds in 1965, debentures were used by savings deposits are held in the Trust Fund Bureau of the Ministry of ment bonds in 1965, bank debentures were used by Finance and loaned to public corporations or invested in instruments the Bank of Japan for open market operations and such as bank debentures. served as a market benchmark. This benchmark is crucial for setting the base rate for long-term lending Masakazu Watanabe, Senior Financial Specialist, Financial Sector Devel- and borrowing. opment Department This series is published to s4are ideas and invite discussion. It covers financial and private sector development as well as industry and energy. The views expressed are those of die authors and are not intLended to represent an official statement of Bank policy or strategy. e Printed on recycled paper, Comments are welcome. Please call the FPD -Note line to leave a message: 202-458-1111, or contact Suzanne Smith, editor, Room G8105, The World Bank, 1818 H Street, NW, Washington, DC 20433, or Internet a.ddress ssmith7(¢worldbank.org. 4