Preemptive Strategies for the Assessment and Management of Financial System Risk Levels: An Application to Japan with Implications for Emerging Economies

We estimate the current potential default cost of the large amount of bad loans in the Japanese banking system to fail to range from 30 trillion yen to 45 trillion yen or higher. For many banks this would deplete at least 50% of their capital. However, it would also fix the loss and avoid potentially larger losses if weak credits continue to be supported. Using a simulation methodology, we also find that the assumed level of credit risk, equity investment, bank operating expenses, bank net interest margin, and the assumed future financial environments interact to determine future bank risk levels. If the negative financial and real estate market conditions of the recent past persist over the next three years, it is very likely that the major Japanese banks will suffer further large losses and exhaust their already low levels of capital. Alternatively, a return to a more positive economic and financial environment would moderate the risks and the cost of resolving the current problems. Nevertheless, under both scenarios, the risk of further bank failures appears to be substantial and additional large capital infusions will likely be needed to avoid losses by depositors. The implications of this analysis for emerging economies, center on the management and regulation of financial institutions in countries where financial market regulatory structures are in a state of change and asset price bubbles also occur.