Lending to Unhealthy Firms in Japan during the Lost Decade: Distinguishing between Technical and Financial Health
The bursting of the stock market and real estate bubbles of the 1980s dramatically shocked and changed the performance of the Japanese economy and the functioning of its banking system, resulting in a prolonged period of economic malaise in Japan, commonly known as the "Lost Decade," although it extended well beyond 10 years. The conventional wisdom appears to be that Japanese banks were "evergreening" loans (for example, Peek and Rosengren 2005; Caballero, Hoshi, and Kashyap 2008), narrowly defined as extending additional credit to enable unhealthy firms to continue making interest payments on existing loans, but more generally to enable an otherwise-insolvent firm to meet its expenses to avoid default. Because evergreening would contribute to a misallocation of credit, the extent to which it occurred could account for much of the depth of the malaise and the protracted length of the Lost Decade. For the most part, the existing literature has interpreted the evidence as strongly confirming evergreening behavior by Japanese banks; however, this evidence has been primarily based on firms' financial health rather than on measures of a firm's technological efficiency. This study investigates the misallocation of credit in Japan associated with banks' evergreening loans, distinguishing between financial distress, which may be temporary, and technical distress, which reflects weak operational capabilities as indicated by low total factor productivity. The paper also distinguishes among types of lenders based on the strength of their incentives to undertake evergreening behavior and considers the relative volume of lending to healthy versus unhealthy firms as well as the extent to which loans from these lender types were prudent.
- Firms were more likely to obtain increased loans the more financially distressed they were, not only in the Lost Decade of the 1990s, but to a similar extent even during the boom period of the 1980s.
- Firms that were operationally healthy were more likely to obtain increased loans, especially during the crisis years of the 1990s, when the underlying health of the firms became a more important determinant of bank lending, perhaps because of the increase in firm bankruptcies.
- In contrast to the pure evergreening story, banks appear to have distinguished clearly between operationally viable and nonviable firms, with secondary banks (banks whose lending to a firm constitutes a small percentage of the firm's bank borrowing) and main banks (banks whose lending to firm constitutes the majority of the firm's bank borrowing) in good health tending to increase loans to technically healthy firms, while unhealthy main banks tended to increase loans to technically unhealthy firms.
The fact that financially more-distressed firms were more likely to obtain increased loans in the boom period of the 1980s suggests that previous findings based on similar evidence from the 1990s may have been misinterpreted as evidence of widespread evergreening of loans, when, in fact, such increased lending may have, in large part, reflected increased loan demand due to firms' larger cash-flow shortfalls as their distress increased. However, the fact that unhealthy main banks tended to increase loans to technically unhealthy firms, together with evidence that bank-firm relationships matter, provides strong evidence that evergreening behavior by unhealthy Japanese main banks did occur. This conclusion is reinforced by evidence that loans from unhealthy main banks, which had the greatest incentive to evergreen loans, were associated with a deterioration in the subsequent performance of unhealthy firms, while loans from secondary banks and healthy main banks, with a weaker incentive to evergreen loans, were associated with enhanced subsequent firm performance.
We investigate the misallocation of credit in Japan associated with banks' evergreening loans, distinguishing between two types of firm distress: (perhaps temporary) financial distress and technical distress, which reflects weak operational capabilities, as indicated by low total factor productivity. We show that previous evidence related to firms' financial health is problematic due to the mixing of loan-demand and loan-supply effects. Using a direct measure of operational health, we provide unambiguous, direct evidence of evergreening behavior, as well as confirming evidence based on the relative impacts on subsequent firm viability of loans by bank types with different incentives to evergreen loans.