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Optimal Timing in Banks' Write-Off Decisions under the Possible Implementation of a Subsidy Scheme: A Real Options Approach
Abstract
This paper provides a formal model that investigates optimal timing in banks' writing off their nonperforming loans. The motivation comes from the recent episodes of Japanese banks, which have been slow to clean up their nonperforming loans after the collapse of the "bubble" economy in the early 1990s. A real options approach is employed to measure the value of the rationality of the "forbearance policy." It is assumed that uncertainty will arise from the following sources: (1) the reinvestment return from freeing up funds through write-offs; (2) liquidation losses; (3) the possible implementation of a subsidy scheme; and (4) the reputational repercussions from not immediately writing off their nonperforming loans. This paper attaches particular importance to the uncertainty from the possible implementation of the subsidy scheme to explore its desirable features. Also, this paper examines the possible role of monetary policy in boosting the banks' incentive to write off.
... From competition point of view, Koskela (2000) shows that more competition generates lower loans and so tend to higher investments and less chances of bankruptcy. Another study of Baba (2001) using real option theory shows that some banks have uncertainties in writing off the nonperforming loans such as they are not sure the releasing of funds by writing off or their liquidation cost or the expected possible subsidy schemes by the government. These factors encourage banks to hold on in writing off NPLs. ...
Non-performing loans has become an important part of commercial banking of a country. This paper empirically tests the macroeconomic and bank-specific covariates of non-performing loans for a panel of 13 commercial banks for period of 2003-2012. Using fixed effects with Driscoll and Kraay standard errors, the influence of macroeconomic and bank-specific covariates is found meaningful. Recommendations include the policy steps to complement the sound financial system with a healthy macroeconomic environment to reduce non-performing loans in commercial banks in Pakistan. Moreover, need is highlighted for a policy approach with emphasis on the apposite credit culture and lending policy designed with pertinent economic and financial factors.
... There are several explanations for why banks are willing to roll over nonperforming loans. Sunk costs under information asymmetry between the bank and the firm can cause a soft-budget constraint (Berglöf and Roland [1997], Dewatripont and Maskin [1995]); bank managers may be inclined to cover up the true financial state of their bank from the regulators (Aghion, Bolton, and Fries [1998], Mitchell [1998], Sakuragawa [2001]); the existence of deposit insurance may induce bank managers to gamble on the recovery of insolvent firms (Tsuru [2001]); bounded rationality that bank managers perceive today's losses more " saliently " than tomorrow's losses may induce procrastination (Hoshi [2000]); and banks may want to buy time if the option value of waiting before writing loans off is substantial (Baba [2001]). All these explanations formalize forbearance lending as (quasi-) rational behavior of banks in a restrictive informational environment, which is ...
The Japanese economy has suffered from three anomalies since the beginning of the 1990s: persistently low economic growth, continuously declining asset prices, and prevalence of procrastination over the serious problems of nonperforming loans (NPLs). We present the notion of a ¥emph{complexity externality}: coordination failure by which inefficiency in one firm affects other firms' productivity through the network of the division of labor. A simple model illustrates that the spreading of the complexity externality, which was triggered by NPL problems, may lead the economy into a bad equilibrium where these anomalies become conspicuous. Our empirical results suggest that the Japanese economy shifted to a bad equilibrium at the beginning of the 1990s.
... The real options model gives a threshold level of firm value for the bank's decision on exiting under uncertainty of firm value. Baba (2001) developed a theoretical model to investigate optimal timing in a bank's writing off its NPL using a real options approach. ...
We develop a dynamic credit risk model for the case in which banks compete to collect their loans from a firm in danger of bankruptcy. We apply a game-theoretic real options approach to investigate banksf optimal strategies. Our model reveals that the bank with the larger loan amount, namely, the main bank, provides an additional loan to support the deteriorating firm when the other bank collects its loan. This suggests that there exists rational forbearance lending by the main bank. Comparative statics show that as the liquidation value is lower, the optimal exit timing for the nonmain bank comes at an earlier stage in the business downturn and the optimal liquidation timing by the main bank is delayed further. As the interest rate of the loan is lower, the optimal exit timing for the non-main bank comes earlier. These analyses are consistent with the forbearance lending and exposure concentration of main banks observed in Japan.
... There are few researches on the issue of NPLs from the point of microcosmic view. Naohiko Baba (2001), a scholar from Japan, researched the optimal timing in banks' write-off decisions to NPLs under the possible implementation of a government subsidy scheme, with a real option approach, according to the characteristic of Japanese banks' NPLs and the financial assistance policy of Japanese government. But what he researched was housing mortgage loans in Japan. ...
This paper employs a real option approach to evaluate the value of the option to delay write-offs non-performing loans(NPLs) in commercial banks. On the assumption that the callback rate of NPLs follows the standard geometric Bronian andthe reinvestment return follows jump-diffusion model, the partial differential equation which the value keep to is obtainedusing dynamic programming technique. With the condition of value-matching and smooth-pasting, the solution of theequation is obtained. The optimal timing in banks’ writing off their NPLs is gained with the solution, along with the conditionto put off disposal of NPLs.
... relaxation of bank capital requirements, in order to "buy time" during the collapse of its real estate and stock market bubbles . Japanese banks delayed charging o¤ non-performing loans, and even engaged in "forbearance lending" where banks extend further loans to troubled borrowers in the hope that economic conditions might recover (Baba, 2001; Sekine et al., 2003; Chen and Chu, 2003; Peek and Rosengren, 2005; and Schüle, 2007). However, discretionary behavior in banks'loan charge-o¤ decisions is not necessarily con…ned to crisis episodes like the Japanese one. ...
Using a stylized real options model, we show that discretion over the timing of charging off a non-performing loan could be economically justified when collateral values are uncertain and there is a chance of loan recovery. The implied hypothesis of an “uncertainty dependence” aspect in loan charge-offs is empirically tested and validated using a panel of European banks. A welfare-maximizing regulator might want to let banks pursue such discretionary loan charge-off behavior, with the problem of distinguishing it from alternative capital management and income smoothing objectives, while transparency-seeking accounting standards setters would presumably not.
... The critical problem is that by absorbing the shocks and then unnecessarily postponing the final disposal of the bad loans, the banks have sharply increased the total cumulative costs. Employing the real options theory, Baba (2001) demonstrates that when banks foresee a rise in the asset prices of land and other collateral, they recognize greater ex ante value from postponing the disposal of bad loans than from immediately writing them off. With hindsight, however, the cumulative social ex post costs ballooned because of the continued decline in land prices, contrary to the ex ante expectations. ...
This paper discusses Japan's financial system, in particular its perspective and the authorities' roles in redesigning and administering the system. Japan's financial system, characterized by the "main bank system," depends heavily on banks and differs greatly from the U.S. financial system, which depends heavily on capital markets. We focus on changes in the financial environment such as IT innovation, globalization, and financial deregulation. We argue that these changes influence the functions and roles of banks and capital markets in favor of the latter. Many economists now regard the U.S. system as a model to be emulated. We claim, however, that Japan's system is not likely to shift rapidly toward the U.S. system in the near future, given Japan's unique financial structure including the large share of public finance. The Japanese authorities are expected to seek an optimal balance between capital markets and banks with a view to ensuring the efficient and stable functioning of the nation's overall financial system.
By constructing an artificial micro economy including a central bank and a commercial bank, this paper attempts to examine
strict decision-making in loan supply and bad loan management by private banks as well as the degree of monetary intervention
by the central bank, and how this affects the emergence and collapse of asset bubbles. The virtual experiment demonstrates
that the intervention is unnecessary if the commercial bank manage credit creation and nonperforming loans in a self-controlling
way. Otherwise, the intervention is both welcoming and effective.
This paper examines the culture clash at Rover when BMW took over the company from British Aerospace. Research hasshown that the globalisation of business across national and cultural boundaries has resulted in some culture-clashes andthere has also been an increase in interest in the impact of culture on business. This paper explains the breakdown incommunication and the different approaches to car manufacturing in Rover under BMW’s ownership.Both Rover and BMW were symbols of national pride and therefore deeply embedded in their own culture. When BMWtook over the Rover group, the company was making profits and Rover had won numerous quality awards. Six years later,BMW decided to sell Rover at a substantial loss but retained the new mini which has been very successful. Although someof the problems faced by BMW were outside their control, the culture clash certainly exacerbated the problem.
International Business Research, Vol.1, No.1, January 2008. All in one file.
After the collapse of the asset price bubble, Japanese banks are said to refinance firms, even in cases where there is little prospect of firms repaying the loans extended. This phenomenon is known as " forbearance lending." We find the evidence which is consistent with the view that forbearance lending certainly took place, and that it suppressed the profitability of inefficient nonmanufacturing firms. First, contrary to the usual expectation, we find that outstanding loans were apt to increase to a firm whose debt-asset ratio exceeded a certain level: after the bubble burst, this nonlinear relationship between loans and debt-asset ratios became evident for nonmanufacturing firms, especially those in the construction and real estate industries. Furthermore, we also find that an increase in loans to highly indebted firms in these industries lowered their profitability.
This chapter discusses corporate investment in the Japanese economy over the last few decades and the policy prescriptions that are now required to induce efficient investment. The chapter complements that by Hashimoto and Higuchi, since both discuss the problems at the real side of the Japanese economy and their possible solutions. The present chapter is closely related to that by Hoshi and Kashyap; while they deal with the nonperforming loan problem from the perspective of financial institutions, I discuss the problem here from the perspective of companies. Macroeconomic issues are discussed first, followed by microeconomic issues. The next section assesses aggregate nonpublic investment in the Japanese economy. Section 2 discusses the necessity of structural change and the absence of ethe cleansing effectf of the recession in the postbubble economy period -- the reallocation resources to more efficient uses as companies restructure or close down and workers shift to other jobs. In the traditional Japanese emain bankf system in the 1960s and 70s, banks played a key role in reallocating capital to more productive investment opportunities and in restructuring old companies. However, in the second half of the 1990s, the nonperforming loan problem overwhelmed and paralyzed both the banks and any prospects for the development and implementation of a sustained corporate restructuring policy. In Section 3, several individual corporate restructuring cases are examined and the reasons that the restructuring process in Japan has been so ineffective and inefficient are discussed. Section 4 draws policy implications and concludes the chapter.
The contributions in this book provide a unique view of its emergence and growth in a number of different national settings in an area of the Third World where the industry is most advanced.
In The Political Economy of Japanese Monetary Policy, Cargill, Hutchison, and Ito investigate the formulation and execution of monetary and financial policies in Japan within a broad technical, political, and institutional context.Their emphasis is on the period since the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s, and on the effects of policies and institutions in shaping the modern Japanese economy. The authors present basic themes and recent developments, as well as their own research findings.They also review and integrate the large literature in the area. They consider theoretical arguments and empirical evidence for each topic discussed.
Topics covered include Japan's low inflation record (despite the central bank's lack of formal independence from the government); politically motivated business cycles and the timing of elections; exchange rate policy and international policy coordination; the historical development of central banking; Japan's "bubble economy" of the 1980s; and the causes, magnitude, and regulatory responses to Japan's banking and financial crisis of the 1990s.
We examine the separation of ownership and control for 2,980 corporations in nine East Asian countries. In all countries, voting rights frequently exceed cash-flow rights via pyramid structures and cross-holdings. The separation of ownership and control is most pronounced among family-controlled firms and small firms. More than two-thirds of firms are controlled by a single shareholder. Managers of closely held firms tend to be relatives of the controlling shareholder's family. Older firms are generally family-controlled, dispelling the notion that ownership becomes dispersed over time. Finally, significant corporate wealth in East Asia is concentrated among a few families.
Financial intermediation is currently a subject of active research on both sides of the Atlantic. The integration of European financial markets, in particular, highlights several important issues. In this volume, derived from a joint CEPR conference with the Fundacion Banco Bilbao Vizcaya (BBV), leading academics from Europe and North America review 'state-of-the-art' theories of banking and financial intermediation and discuss their policy implications. The principal focus is on the risks of increased competition, the appropriate regulation of banks, and the differences between Anglo-American and Continental European forms of financial markets. Relationship banking, stock markets and banks, banking and corporate control, financial intermediation in Eastern Europe, monetary policy and the banking system, and financial intermediation and growth are also discussed.
The banking and financial crisis that started with the collapse of asset prices in 1990 and 1991 and dominated the 1990s stands
in stark contrast to Japan’s previous postwar record of economic growth, financial stability, and progress toward financial
liberalization.
This chapter discusses the causes of the instability of the Japanese financial system in the 1990s. Bad loans have been the
immediate cause of many of the problems facing the Japanese financial system in the 1990s, and real estate lending during
the boom period of the late 1980s is generally considered a principal source of the bad loans. This chapter seeks to explain
why the real estate lending took place, and to measure the actual impact it has had since the bubble burst. Real estate lending
is, however, only one source of Japan’s banking problems, so data on bad loans at individual banks are used to estimate the
importance of several other variables as contributing factors. The volatility of monetary policy that led to wide swings in
asset prices, the impact of liberalization on bank behavior, and the role bank regulation has played in aggravating the situation
are considered.
In the 1990s the dream economy that had impressed the world and brought Japan to the forefront of the advanced economies has
become more like a nightmare. What went wrong? What will lift the Japanese economy from stagnation? These are questions addressed
in this chapter. In answering them, I also consider the inter-relationship between Japan and the Asian economies, and the
parallels between them.
Recent studies argue that the spread-adjusted Taylor rule (STR), which includes a response to the credit spread, replicates monetary policy in the United State. We show (1) STR is a theoretically optimal monetary policy under heterogeneous loan interest rate contracts in both discretionay and commitment monetary policies, (2) however, the optimal response to the credit spread is ambiguous given the financial market structure in theoretically derived STR, and (3) there, a commitment policy is effective in narrowing the credit spread when the central bank hits the zero lower bound constraint of the policy rate.
This paper focuses on bank rescue packages and on the behaviour of troubled banks in light of rescue offers. A puzzling feature of experience with banking crises is that in many cases policy authorities make offers of bank rescue, and banks are reluctant to accept these offers. We study situations in which regulators have decided to offer bank rescue plans, and we show that a combination of factors, including bankers' reputational concerns can explain banks' potential reluctance to accept offers of recapitalisation.
Using a large sample of Japanese firm level data, we find that Japanese banks act primarily in the short term interests of creditors when dealing with firms outside bank groups. Corporate control mechanisms other than bank oversight appear necessary in these firms. When dealing with firms in bank groups, banks may act in the broader interests of a range of stakeholders, including shareholders. However, our findings are also consistent with banks "propping up" troubled bank group firms. We conclude that bank oversight need not lead to value maximizing corporate governance. Copyright The American Finance Association 1999.
Pigovian taxation of externalities has limited appeal if the tortfeaser has insufficient resources to pay the damage when it occurs. To defend Pigovian taxation in the presence of judgement-proof agents, its proponents point at the many institutions extending liability to third parties. Yet little is known about the validity of Pigou's analysis in this context. The paper analyses the costs and benefits of extended liability and investigates whether full internalization is called for in the presence of agency costs between potential tortfeasers and providers of guarantees. Its contribution is two-fold. It first shows that the better the firms' corporate governance and the stronger their balance sheet, the more closely taxes should track the corresponding externality. It then develops the first analysis of extended liability when guarantors themselves may be judgement-proof, and the extension of liability may give rise to further externalities. Relatedly, it derives the curvature of the optimal taxation of externalities in a multi-plant firm. Copyright © 2009 The Review of Economic Studies Limited.
Naze Nihon ha Ryudousei no Wana kara Nogarerarenainoka? (Why Is the Japanese Economy Unable to Get Out of a Liquidity Trap?)
- T Hoshi
Hoshi, T., " Naze Nihon ha Ryudousei no Wana kara Nogarerarenainoka? (Why Is the Japanese
Economy Unable to Get Out of a Liquidity Trap?), " in M. Fukao and H. Yoshikawa, eds.
Zero Kinri to Nihon Keizai (Zero Interest Rate and the Japanese Economy), Nihon Keizai
Shimbunsha, 2000 (in Japanese).
Institute for Monetary and Economic Studies
———, " What Happened to Japanese Banks? " Monetary and Economic Studies, 19 (1), Institute for
Monetary and Economic Studies, Bank of Japan, 2001, pp. 1–30.