Posted on July 4, 2014 By Eiji Okuyama Economics/Business. Japan

Since the onset of the global financial crisis which originated in the subprime meltdown in the United States, “shadow banking” has attracted considerable attention.

Shadow banking, unlike traditional banking, is not subject to strict regulations. It is believed that financial transactions carried out via shadow banking were one of the main causes of the crisis. Now there are concerns about shadow banking in China.

This problem poses many questions, one of which is how financial regulation influences the behavior of financial institutions. Some answers may be gleaned from the history of the Japanese jusen companies, which are essentially mortgage lending institutions.

Although the demand for home loans was strong in Japan in the 1970s, bank lending was primarily to corporate clients. In response to this situation, seven jusen were established under the control of the Ministry of Finance and jointly financed by banks and other institutions. These jusen raised funds from financial institutions and financed home loans.

Financial regulations in Japan at the time established clear walls of separation between different kinds of financial activity. Moreover, companies mainly raised funds from banks as the capital markets were subject to strong regulations.

From the 1980s, large companies were able to raise funds directly from the capital markets as a result of an easing of financial regulation in these markets. This in turn resulted in distancing these companies from banks.

However, because of strict regulation, banks could not become players in capital markets. They therefore shifted their focus to lending to individual customers. Consequently, the jusen, which were reliant on these financial institutions for customer introductions, found themselves facing an extremely tough business environment where their original role of providing home loans was diminishing quickly. They thus switched to a business model of raising revenue by increasing their financing of commercial-use real estate.

Share and land prices increased significantly in Japan during the second half of the 1980s. This eventually became a social problem as land prices rose to such an extent that it became difficult for people to buy homes at all. In response to this situation, the Ministry of Finance established new regulations for real-estate financing.

These regulations limited land-related financing by financial institutions, with the goal of controlling excessive real-estate development. However, these regulations had a major flaw — they did not apply to the jusen, nor did they apply to agricultural cooperative-related financial institutions. In other words, a huge loophole existed: the agricultural cooperative-related financial institutions provided money to the jusen, and the jusen subsequently provided real estate-related financing.

After the collapse of the economic bubble at the beginning of the 1990s, the loans provided by the jusen turned sour. Ultimately, the jusen were allowed to go bankrupt and were dissolved.

Jusen became a way of getting around the regulations that were strengthened during this period. There may well be a connection between this and the problem of shadow banking — though the jusen problem differs from the shadow banking problem in that the latter makes use of high-level technologies for securitization. The shadow banking that took place during the subprime loan crisis in the United States became an effective ‘work-around’ mechanism for banks to evade the regulations imposed on them, such as regulations on capital adequacy ratios. Today, shadow banking in China has become an effective mechanism for banks to avoid directly financing regional government real-estate development projects.

Japan experienced a severe financial crisis in the second half of the 1990s and terrible financial conditions continued until a large-scale financial reorganization took place. The financial confusion continued on until the early 2000s. But over this period, financial system reform was implemented steadily. Financial regulations in Japan eased after the mid-1990s, and the barriers separating the different types of financial activity were slowly broken down.

One example of this is that banks are now permitted to sell mutual funds, life insurance, and non-life insurance. As holding companies, major financial institutions are able to manage banks, trust banks, securities companies and other financial institutions as corporate groups. In addition, financial supervision through the Financial Services Agency is conducted independently from the Ministry of Finance.

Of course, the situation in Japan, where the main financial groups are dominated by commercial banks, differs from that of the United States, which has large capital markets, and of the major nations of Europe, where universal banking is permitted. Some work has been carried out on financial regulations and the actions of financial institutions, but this research field is expanding because financial regulations are constantly being debated and amended.

With economic development and increasing global capital mobility, easing the regulation of interest rates and business commissions has become a significant issue. Many Asian nations are now confronting these questions and trying to design appropriate regulatory architecture. Regulation needs to take into account the practical economic and financial situation in each country if it is to be effective. Japan’s experience with the jusen can provide important clues about the process of regulation reform in this area.

Eiji Okuyama is Associate Professor of Finance at the Faculty of Commerce, Chuo University, Tokyo. This article is reprinted from the East Asia Forum.