3.1 Introduction

Japan introduced formal banking supervision earlier than most other developed countries. As detailed later, the first modern banking system in Japan was basically a copy of the United States (US) national banking system. The US National Bank Act included provisions for formal banking supervision, and thus the Japanese government also included provisions for a formal banking supervisory system when it created the banking system with the National Bank Decree in 1872. During the Edo period (1603–1868), before the introduction of the modern banking system, Ryōgae (financial merchants) provided several financial services including remittance, exchange, and loans. The issuance of remittance bills to reduce the cost of carrying gold/silver coins between Tokyo and Osaka and significant lending to feudal lords (Daimyō-gashi) provided most of the business of the financial merchants. However, their activity differed from that of the modern banking sector in that the financial merchants did not operate proper deposit-taking businesses including elements such as term deposits and current deposits.

While the history of Japanese banking supervision is highly relevant for developed countries, few studies have been published in English and limited information is available.Footnote 1 The purpose of this chapter is to identify the driver of the formalizationof banking supervision in Japan by tracing the formalization process that began with the introduction of the national banking system and that was completed with the enactment of the Banking Act of 1927. Additionally, this chapter focuses on the creation of an independent agency for banking supervision within the Ministry of Finance.

Because the formalization of banking supervision in Japan included a reversal, this chapter also examines the cause of this reversal and how the reversal transformed formal banking supervision after its reintroduction in 1915–1916.

3.2 Development of Commercial Banks

In Japan, a significant increase in the number of commercial banks, the enhanced position of commercial banking in the national economy by the early twentieth century, and a policy of rapid industrialization facilitated by the Industrial Revolution provided the background for the formalization of banking supervision (see Table 3.1).

Table 3.1 Japan’s population and gross domestic product, 1885–1920 (5-year intervals)
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As Tamaki (1995: 21–45) noted, a modern banking system was introduced to Japan following the Meiji Restoration in 1868 and quickly developed via multiple paths. Commercial banks, exchange companies, lending companies, savings associations, and regional development companies were the main financial institutions before the banking system was formalized and integrated in the 1890s. The commercial banks were especially important in relation to the emergence of the modern Japanese banking system. The commercial banks (officially known as ordinary banks) were derived from two streams—Kokuritsu Ginkōand Shiritsu Ginkō.Footnote 2 The former was basically modeled on the US national banking system, whereby each bank took deposits, provided loans, and issuing its own banknotes. The number of banks (Kokuritsu Ginkō) increased to 150 during the boom of 1877–1879; to maintain the value of their banknotes, the establishment of new banks was no longer permitted after 1879. Furthermore, the creation of the Bank of Japan in 1882 saw the centralization of note-issuing.Footnote 3 Each Kokuristu Ginkō was transformed into a commercial bank by 1899, and these constituted a significant share of the commercial banking sector. The Shiritsu Ginkō, which were mostly the successors to the financial merchants who operated in the Edo period (1603–1868), provided deposit and loan services. The number of banks increased from 1880 onwards, especially during the first industrial boom (1886–1889) and the Sino–Japanese War boom (1894–1896). Under the Bank Decree of 1890, each Shiritsu Ginkō was formally categorized as a commercial bank.

The number of commercial banks(ordinary banks) peaked at 1,890 in 1901 (Goto 1970: 56–57), and by 1910 there were 1,600 commercial banks operating a total of 3,300 offices, which meant that the average population per office was approximately 15,000 (see Table 3.2). This meant that even the general public could access commercial banking services (deposits and loans) within their community (town or city) from around 1910.Footnote 4 Most importantly, the total deposits of the commercial banks increased more than 14-fold from 1895 to 1910 (Bank of Japan1966: 198–199) as the Japanese commercial banks were gradually transformed into deposit-taking banks during the 1900s.

Table 3.2 Development of ordinary banks, 1895–1910 (5-year intervals)
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Around the turn of the century, zaibatsu banks rose to prominence in the Japanese economy, especially in the commercial banking sector. Five major zaibatsu banks (Mitsui, Mitsubishi, Sumitomo, Yasuda, and Daiichi) accounted for 17.2% of all loans and 21.5% of all deposits in 1910 and accounted for more than 25% of both loans and deposits by the 1920s (Goto 1970: 86–93). The main activities of the zaibatsu banks varied. While Mitsui Bank and Mitsubishi Bank provided loans to their group companies (e.g., trading, mining, cotton spinning, and shipping companies), Yasuda Bank focused on business activities involving national and state governments such as underwriting public bonds. This strategy eventually enabled Yasuda Bank to expand its market share by amalgamating failed country banks following an informal rescue request from the government (Kato 1970).

Following the Taisho bubble economy period (1915–1919), the banking sector suffered a series of financial crises in 1920, 1922, 1923, 1927, and 1930. Many banks were either bankrupted or purchased by larger banks, and the number of commercial banks decreased from 1,794 in 1922 to 680 in 1931 (Kato 1957: 278–279). The Showa financial crisis of 1927 was particularly serious and led to a run on banks throughout the country, and not only small banks but also several large banks (Jūgo Ginkō, Oumi Ginkō, Fujita Ginkō, and Kajima Ginkō) were forced to suspend their business. Following these crises, the surviving banks were forced to become more conservative in line with the prudential recommendations of the bank supervisors (Ministry of Finance), and thus the Japanese banking system did not experience any further serious financial crises until 1997.

While the banking sector has been a major component of the Japanese financial system since 1872, the stock market (especially the formal market) remained inactive until the financial “Big Bang” (1996–2001).Footnote 5 Although the Tokyo Stock Exchange was created in 1878, the trading volume was dominated by futures transactions. Shimura (1969: 38–42) noted that the volume of futures transactions was much larger than that of physical-delivery (spot) transactions.Footnote 6 The defectiveness of the formal stock exchange and lack of related institutions such as reliable investment banks meant that many companies (e.g., textile, mining, and trading companies) preferred to do business with commercial banks (particularly when seeking loans). Even railway and electricity companies partially depended on loans from commercial banks to avoid the high cash dividend payments that accompanied increases in capital through the stock market. The aggregate assets of the commercial banks increased tenfold from 1895 to 1910, reaching 1,600 million yen in 1910, while the ratio of aggregate assets to GNP increased from 11 to 54% during the same period (Bank of Japan1966: 32, 198–199). In the early twentieth century, the interests of the commercial banks became increasingly intertwined with the development of modern industries and with middle-class people’s daily business.

3.3 The Development of Commercial Banking Regulation

Commercial banking regulation was gradually introduced to Japan in the second half of the nineteenth century. With the National Bank Decree of 1872, the organization of the Japanese banking system (Kokuritsu Ginkō) was modeled on the US national banking system. Similar to the US guidelines, the National Bank Decree of 1872 set out the terms in relation to the issuance of national bank notes, limited large loans to certain borrowers,Footnote 7 and included specific provisions for bank examinations (Articles 73 and 74). Under the Decree, the national banks were also required to obtain a bank license.

Following the establishment of the Bank of Japan in 1882,Footnote 8 the issuance of banknotes was finally centralized with the establishment of a national currency, although regulatory power was not granted to the Bank of Japan. Following the creation of a central bank, the national banking system was abolished and the existing national banks were incentivized to convert to ordinary banksFootnote 9 that essentially engaged in commercial banking. The most critical incentives to undertake this conversion was the deregulation of large loans to certain borrowers and much looser banking supervision, including the suspension of on-site examinations. During this period of lax bank regulation and supervision (1893–1914), the number of Japanese banks increased threefold, and this expansion was accompanied by a significant increase in problems related to insider lending (the “Kikan Ginkō” problem). Kasuya (2000: 8–28) detailed the transition of the Bank Decree from 1890 to 1916 and noted that Japanese bankers were slow to recognize the importance of systemic risk, even after the spectacular failure of the Hyaku-Sanjū Ginkō in 1904.

This historical journey provides an interesting example of the reversal of the institutionalization process. Similarities are apparent between this period in Japan and the antebellum period in the US that featured “free-banking.” The US Free Banking era coincided with the Industrial Revolution in the US, wherein the railway, shipbuilding, and telegraph industries developed rapidly. In the US, the Civil War was the trigger for introducing national banking. In Japan, the period of lax bank regulation and supervision coincided with the Meiji Industrial Revolution. Following this period of socialand economic development and the advent of well-educated bankers, the outbreak of the First World War was the trigger for reintroducing prudential regulation and supervision.

The Ministry of Finance issued an official notice on 31 August 1901 stating that the government would no longer grant banking licenses to newcomers. In addition to this administrative entry barrier, banking regulation was incrementally reintroduced from 1916 to 1927. For commercial banks, special disclosure rules, including a distinction between various types of loans, and the use of balance sheet and profit-and-loss statement templates were prescribed under the Bank Decree of 1916. Together with the Bank of Japan, the Ministry of Finance supported the existence of cartels among the commercial banks in each region in relation to deposit interest rates from December 1918.Footnote 10 In 1923, the Ministry of Finance issued an official notice stating that commercial banks were no longer permitted to open a new branch office or agency except in the case of a merger. On 25 December 1924 (and each year thereafter until 1934), the Ministry of Finance issued an official notice recommending a reduction in the stock dividends paid by the commercial banks.

On 28 September 1926, the Financial System Research Committee was established to discuss the reform of bank regulation in Japan.Footnote 11 The committee was chaired by the Minister of Finance and comprised approximately 40 members including government officers from the Ministry of Finance, Ministry of Commerce, and Ministry of Agriculture, zaibatsu bankers, stockbrokers, members of the Diet (Parliament), and financial experts (academics). The top priority among many items on the agenda was the reform of the ordinary (commercial) banking system, and the committee’s recommendations presented in November 1926 were mostly embodied in a new bank bill, Ginkōhō (the Banking Act), which was passed on 30 March 1927 (Bank of Japan1956: 1–16). The banking crisis occurred in April 1927, and hence the Banking Act of 1927 was not the “product” of a financial crisis.

Under the Banking Act of 1927, the scope of the commercial banking business was basically limited to “proper” kinds of business—loans, deposits, and exchange services (i.e., there was a separation of the banking and securities businesses). With regard to multiple directorships, every bank director was required to obtain permission from the government (Article 13). Notably, the minimum capital requirement was increased from half a million yen to one million yen (Article 3), and the commercial banks were forced to comply with this regulation. Furthermore, the commercial banks were now obliged to submit their financial statements to the Minister of Finance for inspection. If an error was found, the government issued an official guidance to correct the error. Legal sanctions, including fines and imprisonment, were applicable in relation to breaches including accounting fraud and window dressing.

A bank consolidation policy was also implemented under the Banking Act of 1927, and the Ministry of Finance dispatched its officers (bank examiners) to commercial banks to provide “constructive advice” together with officers of the Bank of Japan as well as officers of the financial division of the local government in the area where negotiations regarding bank mergers were taking place. There were more than 600 amalgamations between 1927 and 1932.Footnote 12

The formalization of the regulatory system for commercial banks in Japan was completed in 1927 (see Table 3.3).Footnote 13 Entry barriers, branch opening restrictions, regulation of the services provided through the banking business, and special disclosure rules remained the main banking regulatory measures until the next major revision of the Banking Act in 1981.Footnote 14

Table 3.3 List of major bank regulations (up to December 1927)
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3.4 Formalization of the Banking Supervisory System

The formalization of banking supervision in Japan began in the second half of the nineteenth century (see Table 3.4). The Ministry of Finance had been responsible for licensing banks under the national or ordinary banking system since 1872. The first official on-site examination of the First National Bank of Tokyo was conducted in 1875. However, neither a specific organization nor a specialized post for banking supervision was created within the Ministry of Finance until 1915. Officers from the Ministry of Finance engaged in multiple tasks such as taxation-related activities, and hence were not properly trained to act as examiners or supervisors.Footnote 15 These multiple roles in relation to fiscal and monetary policy strengthened the Ministry of Finance’s influence over the banking sector and eventually led to abuses of power and corrupt behavior by officers (especially in the 1990s).Footnote 16The commercial banks were not charged any examination fee because the costs of banking supervision such as travel expensesfor on-site examinations were covered by tax revenue, unlike the situation in the US and Sweden.

Table 3.4 Timeline of the formalization of banking supervision in Japan
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In August 1915, a specialized bank inspection position was established, and in April 1916, the Banking Bureau was recreated within the Ministry of Finance, including the bank inspection position (Hotori 2006: 48, 54). Initially, there were only two examiners and four assistants, but these numbers gradually increased to eight and 22, respectively, by 1922 (Hotori 2011: 34). Accordingly, the number of ordinary banks per examiner decreased from 221 in 1920 to 70 in 1925 (see Table 3.5). However, the burden on the bank examiners remained heavy as the number of banks per examiner was almost the same as that of the US OCC examiners about twenty years before (in the 1900s). The number of banks per OCC examiner was 64 in 1907 (see Chapter 2 for further details).

Table 3.5 Burden on Ministry of Finance Bank examiners (1915–1940, 5-year intervals)
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Following discussions among the Financial System Research Committee in 1926,Footnote 17the Bank Inspection Section was created as part of the Banking Bureau in May 1927. Subsequently, the numbers of examiners and assistants increased to 18 and 54, respectively (see Table 3.5), which allowed the frequency of on-site examinations to increase to at least once every 2 years (see Table 3.6). Newly recruited officers were expected to have spent part of their career in a private company after having been educated at a commercial college (Hotori 2006: 94), and in 1927 these newly recruited officers received numerous lectures on subjects including banking and bookkeeping at the Ministry of Finance. Additionally, in 1928 the Bank Examination Division was created within the Bank of Japan, with the main aim of supporting the on-site examination activities of the Ministry of Finance.

Table 3.6 Frequency of on-site bank examinations by the Ministry of Finance in Japan (1915–1934)
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Following a series of financial crises in the 1920s, most Japanese bankers came to understand the high cost of systemic risk, and thus zaibatsu bankers did not oppose the implementation of the new Banking Act of 1927, which contained much stricter regulations including a restriction on multiple directorships (Hotori 2006: 76–77). Zaibatsu banks were already well-capitalized and pursuing a relatively conservative strategy by 1927; therefore, the regulations introduced under the new Banking Act were initially aimed at smaller banks. The examiners were appointed from among high-ranking officers in the Ministry of Finance until 1942, when on-site examinations were suspended because of the Second World War.Footnote 18

3.5 The Purpose and Practice of Banking Supervision

The Meiji Restoration in 1868 paved the way for the Japanese people’s first experience with modern banking. Strange as it might seem to contemporary readers, the main purpose of a bank examination was the “education” of bankers,Footnote 19 that is, training the bankers in relation to practices such as double-entry bookkeeping, risk management, and distinguishing between deposits and capital. Thus, the banking supervisor was initially engaged in providing organizational learning for the commercial banks rather than banking supervision. Daiichi Bank (1957: 214–235) documented the earliest bank examiner’s report of their examination of the First National Bank of Tokyo in 1875.Footnote 20The on-site examination was directed by Alexander Shand, who was the Secretary for the Ministry of Finance at the time.Footnote 21 Many of the points made in his examination report concerned the proper and prudent management of the bank’s affairs. As could be expected, Japanese banks experienced numerous problems in relation to their banking business and operations in the early stages, and examiners primarily endeavored to detail the problems of each bank as clearly as possible, and provide instructions on how to address these problems. The priority for on-site bank examinations was the inspection of ledgers and the provision of instructions on correct bookkeeping practice, which was a crucial part of the British principles of prudence as taught by Shand and his staff. For example, bank examiners visited the 26th National Bank of Osaka and found evidence of fraudulent accounting in relation to the capital account involving the inclusion of some large deposits from ex-feudal lords.Footnote 22 The bank was required to correct the ledger based on “advice” (which was nearly a threat) from the chief bank examiner and was also recommended to dismiss the director in charge.

If necessary, the Ministry of Finance appointed an officer to the board of a problem bank. For example, Shuzo Toyama, a former bank examiner of the Ministry of Finance, was appointed as the president of the 32nd National Bank of Osaka under an informal order from the Minister of Finance in January 1879 to supervise the reconstruction of the bank.

The examination trip in the early period was quite tough, since there was no nationwide railway network until the 1890s. Harada Sekizen-kai (1938) documented a diary of one examination trip schedule from April to May 1875 directed by Jiro Harada (Table 3.7). This material indicated that on-site examination was carried out during two or three days per national bank, and the main focusing points were inspection of ledgers, instruction on bookkeeping, and check of large loans and/or insider lending. If an error or a fault was identified through the examination, bank examiners instructed the bank how to correct. Examiners spent more time in headquarters than in branches, and on branch visit examiners often found the old fashion Japanese ledgers—single bookkeeping with secrecy (Dai Fuku-chō). These bank examinations were to be unannounced, yet bankers could predict an approximate visit date, once they had arrived at their first destination.

Table 3.7 Bank examination trip of Harada’s group (April–May 1878)
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Following the aforementioned period of lax or no on- and off-site examinations in the late nineteenth century and early twentieth century, the financial crises of 1900 and 1907 led more bankers to understand the importance of systemic risk. Shibuya (1975) documented a series of special bank investigation reports of the Ministry of Finance that covered failed or badly performing banks. These reports illustrated the seriousness of the financial crises that occurred during the period 1907–1914. It was subsequently reported (Anonymous 1914: 6–8) that a number of bankers had called for the resumption of the on-site examination system. The period of lax supervision led to some hard-earned lessons for Japanese bankers in relation to identifying systemic risk in the financial markets, and the gradual maturing process that occurred around the turn of the century brought about a positive transformation in the supervisor’s role in relation to the banking system. In addition to the financial crisis of 1914, the outbreak of the First World War prompted a return to the banking supervisory system by the Ministry of Finance (Hotori 2006: 48).

At this point, the nature of the supervision changed from the education of bankers to proper prudential supervision. In 1915, the Ministry of Financerecommenced on-site examinations, and the Banking Bureau was created in 1916. Strict sanctions were also introduced in an effort to force bankers to comply with the examiners’ orders. These sanctions were reinforced by the enactment of the Banking Act of 1927, which included provisions for the forcible replacement of bank directors and possible imprisonment for a period of up to one year. An important suggestion, that a summary of the bank examination report should be made available to the public each year to discourage banks from engaging in excessive risk-taking, was also discussed in the Financial System Research Committee on 19 November 1926. However, the suggestion, which was designed to promote banks’ self-disciplinary behavior, was not pursued because of the perceived risk of the public mistakenly assuming that the Ministry of Finance guaranteed the soundness of banks that had been examined (Bank of Japan1956: 380–384). This meant that the bank examination system in Japan differed from the private auditing system typically adopted in Continental Europe, such as in Switzerland. Instead, commencing in 1935, the commercial banks were required to submit confidential reports including an explanation of the banks’ risk management measures (Hotori 2011: 37–38).

The main objective of bank examinations during the period 1915–1934 was to ensure the soundness of banks by minimizing the incidence of bad loans and insider lending (Hotori 2011: 36–37). To achieve this objective, the conduct of an on-site bank examination was fully detailed through 42 provisions in the bank examination manual. The focal points of an on-site examination were summarized as follows:

  1. a.

    to identify any violation of laws, guidelines, or articles of incorporation

  2. b.

    to evaluate management and business performance

  3. c.

    to confirm the details of the bank’s assets

  4. d.

    to investigate any close relationships between the bank and companies or individuals.

Specifically, bank examiners were required to look for evidence of insider lending with any special conditions such as low-interest loans. For example, bank examiner of the Ministry of Finance, Makoto Okada, pointed out much amounts of insider transactions (borrowing) between the vice-president, Kahichi Yamazaki, of the Daihachijū-go Bank in Kawagoe (25 km northwest of Tokyo). In response, the president of the bank directed to reduce such transactions, and the rest of insider transactions should be audited by the internal auditors.Footnote 23

Due to the financial crises in the 1920s, the Ministry of Finance got more cautious about bad loans and insider lending. There are many examples to show this—we just introduce a case of medium-sized regional bank, Seibu Bank in Chichibu (50 km northwest of Tokyo).Footnote 24Through bank examination on Seibu Bank taking place in October 1931, bank examiners classified the bank’s doubtful loans by uniformed category as: (1) uncollectible, (2) delayed repayment, or (3) need early collection. In addition, examiners identified huge amount loan (one-fourth of all loans) with applying special lower interest rate to the president of the bank, Manzo Kakihara. On 18 June 1932, the business improvement order was issued to Seibu Bank, and the bank was obliged to submit a monthly report on the disposal of those problem loans to the Ministry of Finance.

The bank examination manual also contained the sequence to be followed during the on-site examination: (1) cash and securities, (2) bills, notes, and paper, and (3) books and records. Moreover, the Ministry of Finance provided every examiner with official pre-printed forms on which they were required to record the bank’s assets, liabilities, and other key information (e.g., insider lending lists).

Kiyoji Hoshino (1893–1979), whose father was a merchant of a Sake brewing company, and a graduate of the University of Tokyo, entered the Ministry of Finance in 1918. After working initially as a bank examiner, he was promoted to the Director of the Bank Inspection Section. In October 1937, he made a speech on bank examination to country bankers, which provides details of bank examination and its philosophy at that time.Footnote 25

First, the “protection of depositors” was de novo emphasized as the main purpose of bank examination. This reflected the increase of middle-class depositors as the result of the economic growth. Second, the main role of bank examiners shifted from education to consultation with bankers regarding their management. On this issue Hoshino stated that:

Cooperation between bankers and examiners was indeed important. Without hesitation bankers should ask examiners the ways of improvement. Examiners shared similar ‘mindset’ with banks which enabled improvement… A bank examiner was just like a ‘doctor’. Although ‘a good medicine sometimes tastes bitter’, bankers should follow the examiners’ advices after on-site examination.Footnote 26

Third, Hoshino stressed the following lending items should be examined carefully: bad loans, large loans, and insider loans. Especially, insider loans were the most “troublesome” because the directors were tempted to break the rules of sound banking. In his view, bank failures had been caused by such bad insider loans. To make matter worse, if a bank had already given insider loans, non-insider borrowers blamed such bank management to avoid collection.

Hoshino’s speech represented the shift in the nature of bank examination. The priority of bank examination changed to reflect growing concerns over the insider loans (and large loans at the same time). The enhanced stricter sanctions introduced in 1927 made it simpler for examiners to instruct bankers for improvement of the bank management.

The on-site examination took approximately 1 week for an average-sized bank, and the arrival of the examiners was supposed to be a surprise, although some bankers were able to receive early warning of an impending visit through their community network, such as a call from a hotel or railway station.Footnote 27 A typical on-site examination proceeded as follows. The first day was spent checking cash and securities held in the bank’s safe, and the relevant pre-printed forms were required to be completed by the chief examiner. The second day was dedicated to examining the books, records, and forms kept by the bank’s head office. The third and fourth days were spent conducting interviews with the managers of the bank’s major branch offices. The fifth day was dedicated to interviews with the president and directors of the bank, wherein they were presented with any formal queries generated by the bank examination. On the sixth day, the bank submitted their response to the aforementioned queries (Hotori 2006: 102).

* * *

The main driver of the formalizationof banking supervision in Japan was not a financial crisis. The gradual development of the banking sector and better-educated bankers in the early twentieth century provided the background for the positive transformation of the supervisor’s role.Footnote 28 The major trigger for the introduction of formal banking supervision was the outbreak of the First World War, which made it necessary to minimize confusion among depositors.Footnote 29 The costs of banking supervision such as travel expensesfor on-site examinations were covered by tax revenues. The political rationale for formalizing and enhancing banking supervision was the government’s desire to protect small depositors at a time when the universal suffrage movement was becoming widespread.Footnote 30 Notably, the Japanese case shows that not only the supervisors’ but also the bankers’ good understanding of systemic risk enabled the implementation of supervision because it included a reversal of the formalization processFootnote 31 that was in place in the decades prior to the First World War. Essentially, the formalization of banking supervision in Japan was largely a process of maturation, including a reversal, which aligned with the incremental change approach.