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The Banking Crisis in Japan:Policy Paralysis in the Network State

Jennifer A. Amyx1

[Written for Daniel Okimoto, ed. From Bubble to Bust: Japan’s Political Economy,

1985-2000]

The most important thing the Finance Ministry should have done rightafter the bubble economy collapsed was to have financial institutions

address the issue of nonperforming loans. … If the bad loans had beendisposed of quickly, we would be suffering much less damage today.

Masayoshi Takemura, Finance Minister, 1994–962

I. The Puzzle of Delayed State Intervention

In 1991, a massive speculative asset bubble burst in Japan, leaving the nation’sbanks with an enormous burden of nonperforming loans. Banking crises areintrinsic to capitalism, however, and have been particularly prevalent in thepast two decades.3 What was distinctive about the Japanese case was theunusually long delay before the government intervened to aggressively addressthe bad debt problem.

Governments across the globe have used publicly funded recapitalizations ofbanking sectors as a means of market intervention to successfully quell financialcrises. Typically, a capital injection into banks with bad loans substantiallyreduces the degree of short-term credit risks, thereby improving marketconfidence and aiding restoration of the banking sector to health. Since aninjection of public funds is always politically unpopular, governments oftendelay before mustering the political will to allocate taxpayer money to this end.Nonetheless, mechanisms seem to exist in other countries to spur a moreprompt response to financial crisis than that seen in Japan. According to anInternational Monetary Fund (IMF) study, those countries that made the

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greatest progress in the wake of crisis took a little less than 10 months onaverage before embarking on systemic bank restructuring. Meanwhile, thosecountries slowest to respond took, on average, approximately 4 years.4 In Japan,however, authorities waited eight years after the bursting of Japan’s asset bubbleto inject funds to credibly recapitalize the banking sector.5 Clearly Japan’sextraordinary delay places the country well outside even the upper bounds ofnormalcy.

Importantly, the postponed response by Japanese authorities to the nation’sbanking crisis has had enormous political and economic consequences. It hasled the price tag associated with cleanup to escalate considerably, costingtaxpayers hundreds of billions of dollars. The delay, furthermore, retarded thedevelopment of institutional mechanisms to facilitate bad debt disposal,derailed the Japanese economy for at least an extra half decade, and may yetundermine the last vestiges of Liberal Democratic Party (LDP) dominance.6

Depressed economic output, weak consumer demand, and slowed credit flowsfrom Japan—all by-products of the unresolved banking problems—have alsoprofoundly affected the greater regional economy, particularly in the wake ofthe Asian financial crisis.

The length of the government’s delay in responding to the banking crisischallenges the conventional wisdom of Japanese political analysis. While mostscholars emphasize the incremental nature of policy change in Japan in regulartimes,7 most do see a crisis as spurring significant change.8 Examples of adeptJapanese government response to past crises make the mismanagement of thebanking sector woes in the 1990s all the more enigmatic. The response topotentially destabilizing problems in the financial sector in the mid-1960s wasswift and decisive;9 similarly, the nation’s response to the oil crises of the 1970swas widely appraised as a success.10

Why then did Japan’s regulators wait so long to credibly recapitalize thenation’s banks with public funds once the bubble had burst? Among variousexplanations that might be offered are those that focus on interest grouppolitics, bureaucratic politics, or principal-agent relationships. Through an

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examination of post-bubble developments in Japan, this chapter tests thesetheories and, while finding that each sheds some light on the government’sprocrastination through 1995, concludes that none is able to account for delayfrom 1996 on—the period that truly distinguishes the Japanese case fromothers. The chapter argues that an alternative conceptualization of Japanesepolicymaking that depicts Japan as a network state provides a more powerfulinterpretive framework.11

The network state characterization of public policymaking posits a central rolefor the web of informal relational ties emanating from the bureaucracy to theDiet, regulated industry actors, and other government agencies.12 Financialpolicy networks, intersecting in the Ministry of Finance (MOF), comprised adistinctive institutional reaction to common dilemmas faced by Japanese bankregulators and elected officials. After the bursting of the bubble, however, theinformation dynamics promoted by these networks led to distortions inmanagement which promoted delay in dealing with the nation’snonperforming loan problem and encouraged counterproductive fiscal policies.The chapter identifies two intervening variables that upset the politicaleconomic system, bringing about a functional shift in the Finance Ministry’spolicy networks: domestic political change under coalition government and adramatic rise in information requirements for effective regulation. As a result ofchange in these variables, networks once enhancing policymaking capacity inJapanese finance became “paralyzing networks,” with disastrous results.

There are important substantive and theoretical implications of these findings.By revealing the sources of policy breakdown in Japanese finance in the 1990s,the chapter provides a metric against which Japan’s new system of financialregulation may be evaluated. The findings also contribute to a betterunderstanding of the determinants of state capacity. An increasing amount ofattention has been given in recent years to “networks” as a means ofconceptualizing governance. Cross-national studies of state-market relationsand institution building have focused in particular on the role of formal orinformal networks in helping transmit information and knowledge amongdifferent actors and organizations. In doing so, these studies have focused on

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the role of networks in enhancing the capacity of state institutions to mobilize,find reliable and relevant information quickly, and link this information toappropriate responses. Some even pointed to Japan as the embodiment ofsuccess in this area, where institutionalized consultative processes made thestate highly responsive to new demands even as the state retained a forward-looking autonomous core.13 In citing the network structure of governance inJapanese finance as the source of policy inertia in the 1990s, the chapter temperssuch positive assessments of Japanese network institutions and underscorescontingencies in the effectiveness of Japan’s network state.

The chapter is organized as follows. Section II lays the groundwork for theparalyzing network thesis by giving an overview of the nature of relational tiescomprising the regulatory network in Japanese finance. Section III turns todevelopments after the bursting of the bubble. Through testing the moremainstream explanations for policy outcomes in Japan centered on interestgroup dominance, bureaucratic dominance, and legislative dominance, thissection begins to build the case for the paralyzing network argument. Section IVcompletes this argument by reviewing and deepening the examination ofrelational ties and information dynamics over the 1991–98 period. Finally,section V summarizes the findings and uses the case of delayed response tobanking crisis as a platform from which to comment more generally about theJapanese “network state.”

II. The Regulatory Network in Japanese Finance

Policy outcomes in Japanese finance through 1998 represented the product ofnegotiation among actors within the context of informal but institutionalizednetwork associations intersecting in the MOF.14 The content and strength of thisnetwork were shaped by the ministry’s wide range of authority, encompassingfiscal, monetary, and exchange rate politics, in addition to the regulation andsupervision of private sector financial institutions (see Figure 1). Legallydefined relationships—such as those between the elected arena and the state

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bureaucracy—were also important. Yet, informal ties of an interdependentnature overshadowed these formal, hierarchical relationships that feature moreprominently as political constraints in most democratic polities. The distinctiveattributes of exclusivity and opacity attached to these informal networks hadimportant consequences for the flow of information among the actors.

Three “hubs” in the network structure were crucial: connections to thegoverning party and the Diet, connections to private sector financial firms, andconnections to other government agencies and the Bank of Japan (BOJ). Each ofthese relational ties served numerous functions. Of particular importance tounderstanding the post-bubble developments at the center of this study was theway these ongoing relationships served as established routes forcommunication, negotiation, and the transmission of information. We turn nowto examine these ties more closely, paying greater attention to the nature ofinformation flows and information asymmetries among the actors.15

Ties to the LDP Leadership and the Diet

Governments everywhere face common dilemmas in regulating their bankingsectors. The danger that runs on banks create for a nation as a whole hasprompted most countries to identify the prevention of bank runs as a publicgood and to institute deposit insurance systems. Yet, in the presence of depositinsurance, banks have incentives to hide negative information from regulatorsin the face of solvency problems, and to “gamble for resurrection” through thepursuit of high-risk high-return investments. This is because neither bankshareholders nor management have anything to lose when shareholder equitynears zero or becomes negative. At the same time, financial regulators, likeregulators everywhere, have incentives to hide negative information frompoliticians, for the disclosure of regulatory breakdown exposes regulatorincompetence. Because these incentives for banks and bank regulators to hideinformation are well known, the use of “police patrol” rather than “fire alarm”oversight by elected officials is common.16 In other words, banking committeesin national lawmaking bodies tend to exercise relatively constant and close

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oversight of the government financial regulator, rather than making theirintervention contingent on the occurrence of problems.

Through 1998, however, financial regulation in Japan deviated from this norm,with Diet members employing “fire alarm” rather than “police patrol”oversight of the MOF. Japan’s financial industry was governed by very fewpieces of formal legislation and the large majority of financial governancecircumscribed the Diet. The structure of the nation’s electoral system andpaucity of legislative staff encouraged politicians to focus their politicalresources in times of perceived financial system stability on more locally-basedniches of the economy such as agriculture, small and medium enterprises, andconstruction.17 Policymaking in these areas with more day-to-day electoralsalience relied on the support of senior LDP officials called zoku (literally,“policy tribe”), politicians who specialized in such policy areas. While apowerful “finance policy tribe” (okura zoku) did exist, the focus of these Dietmembers was on fiscal policy issues such as budget and taxation, rather than onissues of financial supervision.18

The LDP served as Japan’s governing party for an uninterrupted 38 year periodbeginning in 1955, so the maintenance of smooth relations with the okura zokuand the LDP leadership became a major concern to the MOF’s fiscal policybureaus. The ministry’s effective performance in these areas required closecooperation with LDP frontbenchers in the passage of annual budget and tax-related legislation. The high value placed on mutually supportive relationsbetween elected officials and the MOF in these areas was reflected in tworelational networks linking the organizational actors. The first tie was the flowof former MOF officials possessing extensive experience in the Budget or TaxBureaus into national politics as elected representatives of the governingparty.19 The LDP embraced these officials, giving those who reached especiallyhigh posts within the ministry a “bonus” within the party’s seniority rankings.Notably, former MOF officials were heavily represented among the okura zoku.

The second institutionalized relationship between the MOF and the LDPleadership involved the placement of MOF bureaucrats on temporary

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assignment to the Diet. Ministry officials—again, typically those with primaryexperience in one of the fiscal policy bureaus—regularly occupied positions inthe legislation bureaus and standing committee offices of both houses, whereDiet members were assisted with drafting bills, and in the Cabinet LegislativeBureau, through which all legislative proposals passed.20 MOF officials alsoassumed advisory or administrative support positions in the Prime Minister’sOffice, Cabinet, and Minister’s Secretariat. These points of regular contact withLDP leadership provided the ministry with numerous opportunities to gatherintelligence helpful in gauging the receptivity of elected officials to policyproposals. They also gave the ministry numerous opportunities to influence thepolitical agenda and the policymaking process once any legislation entered theDiet.21

To summarize, MOF officials in the Budget and Tax Bureaus were engaged inconstant interaction with the LDP leadership in the fiscal policymaking arena,while MOF officials in the Banking and Securities Bureaus enjoyed relativedecision-making autonomy in their supervision of private sector finance.Importantly, little information flowed across bureaus in the ministry.22 Thus,information concerning the state of the financial sector did not typically passfrom the Banking and Securities Bureaus through the fiscal policy bureaus andinto the Diet.

Ties to Individual Financial Firms

A defining feature of Japan’s system of financial regulation was also thereliance on informal ties linking government regulators and financialinstitutions. Dense networks linked the MOF and private sector financial firmsand provided a functional equivalent to more formal and arms-length modes ofregulation. By facilitating constant communication between these actors, thenetworks provided a means for conveying advice to financial institutions andassisted regulators in the early detection of problems.

The MOF had a high degree of discretion in filling in the details of the broadand vaguely worded laws related to financial regulation. This was donethrough the issuance of cabinet ordinances, ministerial regulations and

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administrative notices. Instruction of private sector actors through extra-legalwritten notifications or informal verbal instructions—a practice known as“administrative guidance”—was one of the most notable characteristics ofregulation of the sector. When regulatory changes were deemed necessary, theministry preferred in most cases to secure cooperation from private sectoractors rather than legislate change, as the enactment of legislation was not onlytime-consuming but also risked politicization of the regulatory process.23

The All Japan Banking Federation or Zenginkyo served as one conduit forinstruction to banks and represented the industry as a whole on particularissues, such as its opposition to the government-backed postal savings system.Yet, the highly compartmentalized nature of the sector meant a significantdivergence in interests across the membership on many other regulatorymatters. In addition to a firewall in place between the banking and securitiesindustries, the banking sector was separated into long-term, ordinary, and trustbanking. And, until 1998, only a single foreign exchange bank was permitted.

The high degree of sector compartmentalization and MOF discretion thusencouraged the development of more exclusive relations between the MOF andindividual financial institutions. These included daily face-to-face contactbetween financial institution employees designated as mofu-tan or MOF“liaisons” and officials in the banking, securities, and international financebureaus. In addition, retired MOF officials found positions with some financialinstitutions (a practice known as amakudari or “descent from heaven”) andprivate sector employees were often assigned to temporary positions within theMOF (a practice known as ama-agari or “ascent to heaven”). Through theserelations, unofficial communication were maintained between banks and theMOF, providing a means both for the ministry to make its desires known tobanks and for banks to convey concerns and troubles to the MOF withoutalarming depositors or other sector actors. The flow of retired MOF officialsinto lucrative positions in financial sector institutions also gave the ministry astake in regulatory outcomes, and suggested that officials were likely toexercise their considerable discretion in a way that maintained stability in the

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sector. Any bank that went under meant one less potential depository forofficials retiring from the ministry.

As noted earlier, banks in most countries hide information about solvencyproblems from regulators when a system of deposit insurance or a governmentguarantee against failure is in place. Rather than disclose their financialtroubles, they typically prefer to pursue an active strategy of “gambling forresurrection” through high-risk, high-return investments. Japanese banks,however, shared information through informal liaison channels with theministry, especially because doing so helped ensure that no financial institutionfell through the cracks, and worked to support the maintenance of a cartel-likeindustry arrangement benefiting all members. If a particular financialinstitution revealed solvency problems to the ministry, MOF officials drew onrelational ties to arrange an assisted merger (kyusai gappei) behind the scenes topreclude formal failure. Amid heavy regulation and only the occasionalemergence of problems in particular banks, the ministry easily enticed strongerbanks into cooperating with this informal mode of problem resolution. Thecooperating bank gained valuable retail branches and thereby boosted itscompetitiveness in a way not permitted in normal times. Thus, the ministryeffectively lowered incentives for banks to “gamble for resurrection”. And, withits unblemished track record through the mid-1990s in guaranteeing banks inthis way, the MOF faced little pressure to disclose its privately held informationto the Diet or the public.

In contrast to the perceived benefits of sharing information with the MOF’sBanking and Securities Bureaus, the banks saw little benefit in sharinginformation with politicians. In fact, doing so potentially incurred significantcosts. LDP leaders were staunch supporters of the government-subsidizedpostal savings system, which competed with private sector banks for deposits.Furthermore, information “leaks” were more common in the political world.24

Career-long employment systems and incentive structures in the bureaucracyand banks, on the other hand, placed a priority on organizational loyalty,therefore minimizing the leakage of “private” information that might otherwiseoccur with a more fluid labor market for bankers and bureaucrats. The resulting

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information asymmetry between the MOF and the Diet was particularlyimportant because banks faced few disclosure requirements. Most notably, theywere not required to publicly disclose amounts of bad debt, even on anindustry-wide basis.

To summarize, private sector financial institutions provided information toofficials in the MOF’s Banking and Securities Bureaus primarily in informalsettings through contact between individual officials in these bureaus andindividual employees of the banks and brokerages. The MOF officials in thesebureaus receiving the information then chose whether or not to share it with therest of the ministry or the governing party. The ministry also attempted toresolve problems with ailing banks or brokerages via informal means, awayfrom the public eye, and in the context of particular cases rather than on thebasis of more universal principles.

Ties to Other Government Agencies and the Bank of Japan

The MOF’s relations with other government agencies served as a third pillar ofits relational network. The breadth of the MOF’s authority—particularly itscontrol of the budget—altered conventional bureaucratic arrangements, makingrelations between the ministry and other agencies hierarchical in nature, andthe network ties uniquely dense compared to those of other governmentministries and agencies. The density of the MOF’s ties to other governmentagencies was reflected in the number of MOF officials sent on special duty toother agencies and in the rank of the posts they assumed in these agencies. Theministry regularly sent officials to temporarily occupy top and mid-rankingposts in the agencies attached to the Prime Minister’s Office, as well asexchanged small numbers of personnel with other ministries.

Most relevant for understanding the delayed capital injection was the ministry’sstaffing of posts in the BOJ, the nation’s central bank, and in the EconomicPlanning Agency (EPA), an agency that produced the government’s economicprojections. Until 1998, the post of the BOJ Governor alternated between acareer central bank official and the MOF’s former top civil servant. MOFofficials on special duty also consistently served as the EPA’s Commissioner—

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the top civil servant position—coordinating policies and views of all the EPA’sbureaus.25 As with the ministry personnel that flowed into the Diet, MOFofficials sent on special duty to the BOJ and other government agencies tendedto be individuals who had spent most of their careers working in the fiscalpolicy bureaus.

Importantly, the three hubs in the MOF’s relational network describedabove—its connections with politicians (particularly the governing party),financial sector actors, and other government agencies— were complementedby another iteration of the relational network in the private sector. Japaneseindustry was heavily dependent on bank-centered financing and manyJapanese companies belonged to horizontal keiretsu or enterprise groupingswhere a so-called “main bank” stood at the center. Firms in the group procuredthe largest portion of funds from this bank and used it to obtain all financialservices. The main bank, in turn, served as a major stockholder of its corporateloan client and committed itself to extending extraordinary financial assistancein case of borrower hardship.26 Cross-shareholding arrangements among firmsin the keiretsu also meant that corporate management of these firms faced lesspressure from shareholders to produce profits or restructure in times ofhardship, since cross-held shares were rarely traded. Consequently, investorrelations specialists were notably absent from Japanese firms and financialinstitutions.

III. Weighing the Evidence

Let us now turn to the government’s response to the nonperforming loanproblem in the 1990s and assess the explanatory power of the interest groupdominance, bureaucratic dominance, and legislative dominance hypotheses.While these three mainstream explanations contain elements of truth through1995, they fail to provide convincing answers as to why the Japanesegovernment continued to postpone recapitalization of the banking system

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thereafter. As noted earlier, it is this additional period of delay that made theJapanese case distinctive and led to such grave economic and politicalrepercussions.

Rejecting Interest Group Dominance

Was the reluctance of the Japanese government to inject public funds into thebanking sector simply a product of opposition from powerful vested interestgroups? Given the critical role played by banks in mediating credit flows in theJapanese economy, a multitude of organized interests would be representedamong borrowers and affected by the government’s response to the bad debtproblem. Among those most heavily in debt, and lacking alternative sources offinancing through the capital markets, were key LDP support groups such asthe construction industry.27

The use of public funds to recapitalize banks need not have threatened theviability of borrowers, however, and might even have been expected to makebanks more favorably disposed toward rolling over loans.28 Yet, until the large-scale financial institution failures of November 1997, and the onset of a creditcrunch in the same month, most organized interests representing borrowershad little motivation to initiate debate over a public fund injection, or articulatea stance on this issue. The MOF’s regulatory forbearance toward bankstranslated into leniency toward borrowers, given the nature of the main banksystem and the relational ties linking banks and private sector firms.29 Mainbanks renegotiated debt claims and the ministry permitted financial institutionsto avoid classifying loans as nonperforming through such practices as issuingnew loans to borrowers to enable them to make interest payments. The MOFfurther encouraged banks to provision for—but not liquidate—theirunderreported bad debt.30 In these ways, many of the government’s initialpolicy responses clearly supported the interests of politically powerfulborrowers. Evidence for opposition by borrowers to the bank recapitalizationoption, however, is lacking.

The banking industry lobby was another obvious candidate for shaping thegovernment’s response to the nonperforming loan problem. The level of

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financial contributions made by Zenginkyo to the LDP throughout most of thepostwar period ranked the sector among the party’s top three industry backers.The pay-offs of such financial support were undeniably evident in the previousdecade with the passage of the 1981 Banking Law Revision, when the industryassociation successfully lobbied the LDP to stop MOF-proposed policies frommoving forward.31

Like major borrowers, the Bankers’ Federation adopted a passive stance towardthe use of public funds, and refrained from publicly seeking any type of capitalinjection to aid in the disposal of bad debt or to boost capital ratios. Mostindustry actors expressed confidence in their ability to solve these problems ontheir own.32 Underlying this assertion of self-reliance was a strategy of self-defense: any injection of public funds would invite criticism and scrutiny ofbank management as well as of management practices, including the dubiouslending practices banks engaged in during the bubble period.32 This criticism, inturn, would likely force the resignation of senior bankers. Banking industrysalaries were also widely known to be out of step with the rest of corporateJapan, and the restructuring plans likely required to accompany the receipt ofpublic funds would threaten this high salary structure.33Acceptance of suchpublic assistance would additionally invite political interference in bankmanagement and lending decisions.34 Furthermore, the receipt of public fundsinvolved the banks’ issuance of new shares for purchase by the governmentand would dilute the value of existing shares held by investors.

In these ways, the government’s immediate lack of response corresponded onthe surface with prevailing banking industry preferences in the initial yearsafter the collapse of the bubble. As we will see below, however, the clout ofJapan’s banking industry was already on the wane in this period. Causal linksbetween the delay in the use of public funds to recapitalize banks and theinterest group structure of this industry would be tenuous at best from 1996 on.

Banks Fall from Grace

The banking sector’s ability to influence government policy was always largelydetermined by the degree of sectorwide unity on a particular issue, the

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maintenance of a positive public image, and the relative strength of anycountervailing organized interests. Throughout the postwar period, when bankinterests collided with those of more electorally salient constituencies, such asover the issue of privatizing postal savings, banks inevitably lost out. Thepolitical clout of the banking industry—like that of any organized interest—wasalso contingent to some degree on the maintenance of a positive public image.In the face of volatile party politics in Japan in the 1990s, this link betweenpublic reputation and political clout grew stronger, as political support for anunpopular industry meant the loss of critical votes at the polls.

After the collapse of the bubble, banks came into conflict with the politicallypowerful nokyo agricultural cooperatives over how to resolve the problems ofspecial housing finance corporations called jusen.35 The jusen were created in the1970s as subsidiaries of banks, life insurance companies, and brokerages, andengaged in aggressive lending to the real estate sector from the 1980s through1991. When the bubble burst, these corporations were left with massiveamounts of nonperforming assets. This, in turn, left the jusen’s two largestlender groups, the 21 largest banks and the nokyo, holding trillions of yen in badloans.

In 1992–93, some of the largest commercial banks that served as main banks tothe beleaguered jusen attempted to gather together fellow creditors to requestdissolution of the crippled borrowers and cut their losses. MOF officials,however, put a stop to such plans, because this route of resolution endangeredthe viability of smaller financial institutions also serving as jusencreditors—most notably the nokyo. Importantly, a series of scandals engulfedthe financial industry at this time, weakening the political clout of banks andproviding MOF officials with more leverage in banking supervision than theyhad enjoyed in the previous decade.36 Consensus on principles of creditor andshareholder responsibility was also lacking within the banking industry at thistime, weakening the leverage of those banks pursuing the dissolution of thejusen.37

In the spring of 1993, the Banking Bureau introduced a 10-year restructuring

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program for the jusen, premised on the future recovery of land prices andaimed at resolving the problem without causing any failures.38 While this planpreempted the failure of any actor involved, its provisions clearly reflected therelative clout of the banks to the nokyo at this time. The plan required that thejusen’s “parent banks” (major shareholders) reduce the interest rate onoutstanding loans to zero, and that other bank creditors reduce the interest rateto 1.5 percent. Meanwhile, the plan permitted nokyo creditors to receive 4.5percent in interest income from the jusen.39 The critical turning point in thebanks’ ability to exercise political clout came in 1995, however. Beginning in1994, MOF’s Banking Bureau began to assert a somewhat more proactive stancein dealing with the smallest financial institutions under severe financialdistress. The Bureau’s actions in this period represented a shift away from theprevious wait-and-see strategy fueled by optimism that asset prices, and theeconomy in general, would soon rebound. After overseeing the closure of anumber of small credit cooperatives, Banking Bureau Director-GeneralYoshimasa Nishimura made the decision in 1995 to close down the jusen. Bythis time, it was clear that the restructuring plan for the jusen was inadequate,and that resolution of the jusen problems could no longer be postponed amidcontinued asset deflation.

At first, Nishimura tried to resolve the jusen problem in accordance with“lender responsibility”—a solution preferable to the large commercial banks,which would not necessarily require the use of public funds. Such a solutionthreatened the collapse of the nokyo, however. In the end, the political clout ofthe agricultural cooperatives far exceeded that of the banks. The governmentdisbursed $695 billion in public funds from the general account to aid in thedissolution of the jusen and required banks to bear more than a pro rata share oflosses.40 As a direct result of this burden, all large commercial banks were in thered in 1996. Even more devastating for the banks than the economic cost of theresolution scheme was its political cost. Painting the banks and the MOF aspublic enemies, the LDP skillfully deflected public outrage over the use oftaxpayer money away from itself and the agricultural cooperatives—the realbeneficiaries of the fund infusion.

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In March 1996, LDP officials pressured the heads of top banks to resign, to takeresponsibility for the jusen debacle. In April, the presidents of the IndustrialBank of Japan (IBJ), Fuji Bank, and Mitsui Trust Bank complied, although theyvehemently denied that their resignation signified an acceptance ofresponsibility for the jusen debacle. Tensions between the banks and the LDPwere at an all-time high, and after 1996, the Bankers Federation ceased its time-honored practice of funneling contributions to the LDP through the JapanFederation of Economic Associations (Keidanren). Although the jusen resolutionwas a separate issue from the recapitalization of banks, the negative publicity itgenerated toward the industry effectively depleted any political stock thebanking sector had, making it virtually impossible to call on the party for favorsthereafter.

Escalating Costs to Banks Fail to Trigger Fund Injection

There is further evidence of the weakness of an interest group dominanceargument focusing on the banking sector: when the costs to banks of forgoingpublic fund injection escalated, this shift in costs and benefits to the sector failedto translate into changed policies. By the second half of the decade, industryinterests clearly were no longer being served by policy delay. Uncertainty overthe soundness of the Japanese financial system, and market concerns over theburden imposed on Japanese banks by the jusen resolution scheme reduced thecredit worthiness of Japanese banks in overseas markets. The larger banks thatoccupied the rotating leadership of the Bankers’ Federation, and operatedinternationally, found themselves paying a record high surcharge on theirborrowing in overseas capital markets from mid-1995 on, despite the MOF’sexplicit promise to guarantee all Japanese bank deposits. Deposit insurance feesfor banks were also raised to a record level—from 0.012 percent to 0.048 percentof total deposits annually—and a special insurance fee of 0.036 percent imposedthrough 2001.

Even with the raised premiums, the Deposit Insurance Corporation (DIC)remained insufficiently funded to deal with the number and scale of financialinstitution failures. Thus, major banks continued to be pressured by the MOF to

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swallow the losses of regional banks and credit unions under the pretext ofsupporting the system. Beginning in 1996, banks also found themselves urgedto cooperate in the rescue of large commercial banks such as HokkaidoTakushoku Bank. In earlier years of financial sector stability, rescue mergerswere a positive sum game for all involved. But all banks were now burdened bynonperforming loans, and participation in such rescue mergers threatened tofurther damage the capital ratios and credit ratings of cooperating banks.41 By1997, the major banks being strong-armed by the MOF into covering the lossesof weaker banks also found themselves heavily exposed in Asia, wherefinancial crisis had broken out.

Refusal to cooperate with the MOF, however, naturally increased the chances offailure for the banks already on the verge of collapse, and the failure of onebank had the potential to bring down the stock prices of all in the industry. Onebank’s failure also had the potential to lead to a surge in nonperforming loansfor other banks, as most borrowers relied on credit from multiple sources andthe severing of one of these credit lines raised the likelihood of default on otherloans. Clearly, more aggressive and comprehensive measures to restore thesector to health—such as public fund injection—were needed to replace such adhoc rescue attempts that relied on increasingly costly sacrifices by other privatefinancial institutions.

In summary, while the delay in the recapitalization of the banking sectorseemingly corresponded with dominant banking industry preferences in thefirst half of the decade, the evidence suggests that banking industry preferenceswere not the primary reason behind the delay thereafter. Ultimately, the LDPused banks as scapegoats for the public’s anger. Numerous policy decisions—particularly those made from 1996 on—clearly collided with industrypreferences. When the costs to banks of forgoing a public fund injectionescalated in the later years of policy delay, the government failed to shift intoaction. The informal, exclusive, and opaque nature of ties between the MOF andbanks further fostered division and suspicion among banks as financial duressdeepened, thereby working against a unified lobbying effort by this organizedinterest. While the MOF refrained from proposing—formally or informally—a

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public fund injection into the banking sector, the banks and their preferenceshad little to do with that decision.

Rejecting Bureaucratic Dominance

A second hypothesis for the delayed capital injection might be termedbureaucratic dominance. Here the interests and preferences of Finance Ministryofficials serve as the primary explanatory variable, and standard operatingprocedures developed and employed by the bureaucracy play a prominent role.Two main strands of this argument are found in the literature. Both depict thebureaucracy as powerful, in control, and acting as a coherent unified actor. One,however, sees the bureaucracy—and the “pilot” ministries of the Ministry ofInternational Trade and Industry (MITI) and the MOF in particular—ascoherent actors that are forward-looking and elevate national interest above allother interests.42 The other depiction also sees the Finance Ministry as apowerful and coherent actor in control, but suggests that the MOF was simplyout to maintain its power at all costs. To do so, the MOF took steps that were inits own organizational interests but not in the interests of the economy as awhole.43

The Finance Ministry’s reluctance to propose the use of public funds torecapitalize the banking sector in the early years following the collapse of thebubble, seemed indeed to correspond to a number of the ministry’s well-knownorganizational interests. The ministry has been accused of prioritizing budgetsover banks, for example,44 and the use of public funds was clearly contrary to“balanced budget” (kinko yosan) or “sound budget” (kenzen zaisei) principles inthe short term. Additional organizational interests included the maintenance ofamiable ties with banks, so as to retain lucrative positions in the private sectorfor retired ministry officials. And, as noted earlier, banking industry oppositionto the explicit use of taxpayer funds for recapitalization was expected—at leastin the initial years following the collapse of the bubble. Like all bureaucraticagencies, the MOF typically downplayed its failures. The use of taxpayermoney to deal with the consequences of regulatory breakdown would highlightthe magnitude of the ministry’s incompetence in supervising banks, and

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thereby invite upon it large-scale public criticism. Such criticism, in turn, wouldjeopardize the regulatory autonomy the ministry’s Banking Bureau had longenjoyed. In these ways, the delayed capital injection seemingly correspondedwith MOF preferences in the initial years after the bursting of the bubble. Yet,the ministry’s regulatory inadequacies in this period largely reflected previouspolitical decisions rather than simple entrenched bureaucratic interests. From1996 on, it became increasingly difficult to depict the MOF as a coherent andforward-looking actor in control. The unprecedented political attack on theministry in this year placed MOF on the defensive, spurred a drastic reorderingof organizational preferences, and further narrowed the ministry’s alreadylimited policy options.

Regulatory Inadequacies from Prior Political Choices

The Banking Bureau’s regulatory options and capacities heading into the post-bubble period reflected the impact of previous political choices. In the earlypostwar context of a well-functioning main bank system, scarcity of capital,heavy regulation, and controlled competition, the information requirements foreffective regulation were minimal and a system of relational regulation provedeffective. The 1970s and 1980s brought slowed growth, however, and thesupply of capital soon exceeded demand. Liberalization and partialderegulation further raised competitive exigencies. As capital increasinglyflowed in and out of Japan and corporations were given the exit option,monitoring costs for banks increased, undermining the effective functioning ofthe main bank system. Because the system of relations-based regulation hadevolved to complement the information sharing and relational ties linkingbanks and their borrowers under the main bank system, the same informalmodes of monitoring and coordination between the MOF and banks were nolonger compatible with bank governance structures. Amid this environment ofheightened moral hazards, the information requirements for effectiveregulation and supervision rose, suggesting a need to shift away from suchheavy reliance on informal mechanisms.

At two critical junctures, the ministry made clear attempts to shift away from

20

informal monitoring and problem resolution mechanisms. In both cases,however, the LDP’s veto of such moves, or the party’s unwillingness to lendactive support to reforms in the presence of bank industry opposition,narrowed the MOF’s regulatory options thereafter. In 1971, the Banking Bureauattempted to replace the implicit government guarantee of banks with anexplicit deposit insurance scheme. The implementation of a credible depositinsurance system would have facilitated a more transparent and open means ofresolving bank solvency problems, but was strongly opposed by Zenginkyo.Lacking sufficient political backing to impose this on the industry, the ministrywas forced to settle with a deposit insurance system that lacked sufficientfunding to even credibly bail out a second-tier regional bank. 45 Hence, sectorstability continued to rely on the MOF’s informal and behind the scenesarrangement of “rescue mergers.” Likewise, the LDP’s veto of a MOF proposalto widen financial disclosure requirements for banks as part of the 1981Banking Reforms, forced the ministry to try to address the heightenedinformation requirements for regulation through other means. Ministry officialsdid this through the deepening of existing informal ties.46

Attacks on the Ministry Constrain Policy Options

The unprecedented attack on the MOF from the mid-1990s put furtherconstraints on the ministry’s supervision of banks. The jusen debate served as aturning point not only for the banks in their relationship with the governingparty, but also for the MOF in its relationship with the LDP. Although criticismof the ministry by the Diet—spurred by the revelation of scandals andregulatory breakdown—had been mounting throughout the first half of thedecade, the LDP leadership tempered these criticisms prior to 1995. In this year,however, the LDP too articulated the need for MOF reform.47 Most majornewspapers and opposition parties toed the LDP line and, as a result,arguments about “dismantling” the ministry began to gain currency with thepublic.48

In December 1996, the LDP, Sakigake, and Social Democratic parties signed anagreement to transfer the supervision of private sector finance to a new and

21

independent Financial Inspection and Supervisory Agency.49 The specificdetails concerning which functions would be taken from the MOF, were to beworked out over the next 18 months, before the new agency commencedbusiness in the summer of 1998. In the hope of minimizing their loss ofauthority, MOF officials did all in their power to avoid further wrath from theDiet. Reneging on an earlier public promise not to use taxpayer money again tofix financial sector problems would surely raise the public’s ire—particularly ifsuch funds were earmarked for the direct rescue of banks.50 In the interests oforganizational defense, then, the Banking Bureau eliminated fromconsideration any means of resolving the nonperforming loan problem thatinvolved the explicit use of public funds.51

The Banking Bureau, however, was not entirely wedded to standard operatingprocedures.52 Initially, it explored options other than the traditional rescuemerger. Sensing that the public would be supportive of a tougher stance towardbanks, officials ordered Hanwa Bank to suspend operations in November 1996without first finding a “receiving bank” (ukezara ginko) to take over. Theministry drew on a new Financial Stabilization Fund, established through loansfrom the BOJ, to create a special settlement bank to take over Hanwa Bank’sdeposits.53 Public reaction to this policy shift, however, was harsh. Hanwa Bankemployees threatened to strike and the management issued a formal statementof disagreement with the decision of MOF regulators. For Banking Bureauofficials, both developments were firsts, and the experience rattled the Bureau,sending the signal to officials that such an alternative mode of problemresolution was inimical to the ministry’s efforts to improve its public image andthereby fend off dismemberment. MOF officials were left with little choice butto resume the traditional informal and opaque mode of problem resolution: the“rescue merger”.

Declining Organizational Coherence

Given that by 1996 the MOF’s supervisory functions had become anorganizational liability, one might have expected the ministry’s fiscal policybureaus to exercise more oversight of the Banking and Securities Bureaus

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thereafter, so as to ensure that all components of the ministry were acting tofurther organizational interests. After all, the use of public funds to bail out thejusen was antithetical to the Budget Bureau’s efforts to rebuild the nation’sfinances. The Diet deliberations and political controversy surrounding the jusenlegislation delayed the passage of the 1996 budget until four weeks after thestart of the fiscal year.

In fact, in the beginning of 1996, the MOF’s Secretariat gathered together agroup of young and mid-ranking elite MOF officials to discuss the proposedreform. From mid-1996 on, however, this group was totally absorbed indeveloping strategies to defend the ministry from being split into two.54 Oncethe ministry became the target of reform, therefore, resources were directedtoward organizational defense rather than toward developing new responses tothe nonperforming loan problem, monitoring the actions of the financialsupervisory bureaus, or relaying information from those bureaus to officials inthe governing coalition. This fractionalization led the fiscal and financialregulatory sections of the MOF to work at cross-purposes, as we will seebelow.55

Rather than supporting the argument for the ministry as a unitary actor whollyin control, the evidence from the post-bubble period suggests that the MOF wasincreasingly losing both control and organizational coherence. The BankingBureau, already rendered weak in its regulatory capacities as a consequence ofprior political choices, found itself under further constraints in the second halfof the 1990s in dealing with the nonperforming loan problem. Had the ministrynot become the political target of reform and been forced to prioritizeorganizational survival over all other considerations, the jusen housing and loanresolution—a blow to the MOF’s fiscal policy bureaus—would likely havespurred a more coherent response to banking sector woes. Instead, the attack onthe MOF exacerbated the ministry’s tendency toward compartmentalization,and led the fiscal and financial supervisory bureaus to work at cross-purposes,as we will see in the next section. When the bureau tried to make a policy shift,and deviate from standard operating procedures by closing severely ailingbanks such as Hanwa, the public’s reaction was harsh. If sustained, such a shift

23

would have led problems in the financial sector to translate more quickly intoproblems in the real economy, and thereby made the need for an injection ofpublic funds increasingly self-evident. Amid severe political constraints,however, the prospects for a forward-looking policy response from the ministrywere virtually reduced to nil.

Rejecting Legislative Dominance

A third hypothesis might be termed legislative dominance. This is a perspectivethat depicts the policymaking framework as a principal-agent relationship, withthe Diet acting as the legislating principal and the MOF as the implementingagent.56 The legislative dominance hypothesis suggests that the interests andpreferences of elected officials were the key explanatory variables behind policydelay.

We know that the use of taxpayer money to bail out banks is a politicallysensitive issue in any country. Given the unprecedented volatility in thepolitical party system, it could be expected to be a particularly sensitive issue inJapan in the 1990s. In 1993, after almost forty years of one-party rule, the LDPwas toppled from power and replaced by an anti-LDP coalition. Although theparty returned to power in the following year, it was forced to rule as aminority government or in coalition thereafter. The LDP’s sensitivity to abacklash over squandered tax money might thus be expected to affect policydecisions. As we will see, however, the massive inter-governmental informationgap promoted by the MOF’s relational network meant that LDP officials wereunable to realistically approximate the political costs and benefits of actionversus delay. In the absence of recapitalization and in ignorance of the trulydire state of bank affairs, the policies LDP officials pursued would work atdirect cross-purposes with the desire to protect valued constituencies and boostelection prospects.

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The “Fire Alarm” Fails to Ring

As noted earlier, the LDP had electoral incentives to play a passive role infinancial regulation in stable times. The party relied on “fire alarm” rather than“police patrol” oversight of the MOF. Yet, the “fire alarm” failed to ring untilNovember 1997, despite the dire nature of regulatory breakdown many yearsearlier.

The financial sector was buffeted to a large extent by market forces through themid-1990s due to the lack of information disclosure, stable shareholdingarrangements, and the accumulation of domestic rather than foreign debt in thefinancial system. With regulatory forbearance, the MOF staved off large-scalebankruptcies, job losses, and a credit crunch for some time, despite the direstate of the sector. In doing so, the ministry preempted the ringing of the “firealarm” by important LDP constituencies.

Without a boost to their capital ratios, however, the banks were extremelyvulnerable to a short-term liquidity crisis. This, in turn, translated intovulnerability for politically powerful borrowers highly dependent on bankfinancing, such as general contractors and small and medium enterprises. From1996 on, the market, foreign financial institutions, and rating agencies broughtforth more information into the public domain about the condition of Japanesebanks, and the MOF’s privileged information flow showed signs of faltering.The mistake of the LDP leadership was to assume that even if the situation wasas bad as believed by outside analysts, that the traditional opaque rescuemerger approach used by the Banking Bureau would still work. In theperception of party officials, an injection of public funds was unnecessary aslong as healthier banks could be persuaded to absorb those under threat offailure.

In reality, however, the Banking Bureau’s capacity to carry out the standardrescue procedure for banks was becoming increasingly difficult. Not a singlebank had been allowed to fail in the postwar period prior to 1995, and in thecontext of the MOF-backed guarantee against bank failure, individual bankshad incentives to share information about their financial soundness, even

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though disclosure was not legally required. With the collapse in 1995 of HyogoBank and others thereafter, banks realized that the MOF no longer had thecapacity to credibly guarantee all banks. Banks therefore became reluctant tovoluntarily expose their vulnerabilities—particularly at a time when theministry itself was under pressure to demonstrate a tougher stance toward thesector. Rescue mergers, however, relied on the voluntary cooperation ofbanks—not only in the sharing of information concerning financial troubles, butalso in the recapitalization of weaker banks. When banks no longer hadincentives to share information or cooperate with the MOF as before, theministry lacked a legal basis for securing this cooperation or information. In theabsence of prospective merger partners for large ailing banks such as NipponCredit Bank, Banking Bureau officials sought to collect funds from variousfinancial institutions for a private sector recapitalization. By mid-1997, MOFofficials had resorted to guaranteeing the principal of any funds contributed insuch behind-the-scenes recapitalization efforts in secret contracts withindividual financial institutions.

It is not uncommon for governments to coerce private financial institutions tohelp avert financial crises.57 Yet, because the Banking Bureau’s attempts topreempt financial institution failure were carried out behind the scenes andthrough informal means, party officials were unaware, until the eruption ofacute financial crisis in mid-November 1997, of the degree of difficulty officialswere encountering in executing the standard rescue merger procedure. Had theparty been more aware of the situation, there is little doubt that public fundswould have been introduced earlier as a means to preempt the shock that befellboth the financial sector and corporate Japan in 1997. Instead, the LDP’sinformational disadvantage vis-à-vis financial regulators had seriousconsequences for the party’s capacity to effectively represent the interests ofvalued constituents.

Repercussions of the Information Gap on Fiscal Policy Decisions

The information gap between the MOF’s Banking Bureau and the legislaturecontributed to the delay in the resolution of the nonperforming loan problem. It

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also contributed to the legislation of ill-informed fiscal policies. These policies,in turn, tied the hands of politicians in moving forward with a public fundinjection even after public opinion had shifted in favor of the use of taxpayermoney. In addition, the execution of these policies at a time of increasingbanking sector fragility set the stage for the economy’s plunge into deeprecession.

At the same time as the Banking Bureau struggled to arrange rescue mergersand thereby evade the public’s wrath, the Budget Bureau sought to improve theministry’s political fortunes by supporting the Hashimoto administration’sdrive for “fiscal reconstruction”. Although fiscal consolidation had beenachieved in 1989, the surge in populist spending that accompanied the onset ofthe coalition government in 1993, coupled with attempts to revive the economythrough massive amounts of fiscal stimulus, had since plunged the nation’sfinances again into disrepair.58 By 1996, debt as a proportion of GDP rivaledlevels found in Italy.

When Ryutaro Hashimoto became Prime Minister in 1996, the MOF’s BudgetBureau was presented with an opportunity to reduce spending and repair itsdamaged relationship with the LDP. Hashimoto staked his administration onmajor policy reforms and was persuaded by the MOF official on special duty tothe Prime Minister’s office that fiscal reconstruction should be one of six majorreforms launched by his administration.59 After successfully raising theconsumption tax from 3 to 5 percent and substantially increasing the health costburden on citizens, Hashimoto campaigned in the fall of 1997 for the passage ofa fiscal reform law that would mandate a balanced budget.60 Once in place, anyissuance of deficit bonds to cover a bail out of the banking sector wouldnecessitate the simultaneous introduction of a politically unpopular tax hike.

Notably, the Hashimoto administration’s macroeconomic policy agenda anddecisions in this period would have been less likely had the government’seconomic projections not been overly optimistic. The Economic PlanningAgency—heavily staffed in key posts with officials on loan from the MOF—significantly overprojected growth rates for every year from 1991 to 1998.

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Consequently, the argument that banks might simply grow out of theirnonperforming loans did not seem as unrealistic as it might haveotherwise—particularly since the Diet was not receiving up-to-date informationon the state of the sector as a whole.61 The LDP leadership’s failure to grasp thegravity of the nonperforming loan problem also meant that the dangers of fiscalausterity were not well known. Other government agencies were unable to fillthe information gap, since the ailments of the financial system were not yetclearly linked to the real economy and the MOF exercised comprehensiveauthority over financial supervision.62 Banks continued to serve as a bufferbetween the collapse of the bubble economy and the numerous firms that hadinvested heavily in land-related enterprises in the bubble period.

Macroeconomic policy decisions made in this period, however, seriouslyexacerbated financial sector problems by leading to depressed consumerspending and intensifying the real economy effects of the financial sector’swoes. Ironically, the passage of Hashimoto’s highly symbolic Fiscal ReformLaw came at the very peak of the financial crisis, on November 28, 1997,following the failures of Sanyo Securities (November 4), Hokkaido TakushokuBank (November 17), Yamaichi Securities (November 24) and Tokuyo CityBank (November 26).63 The collapse of Hokkaido Takushoku Bank—the tenthlargest commercial bank in the nation—and that of Yamaichi Securities—thenation’s fourth largest brokerage—were particularly shocking to the Diet andthe public. Until then, a general perception that the ministry was in control hadbeen supported by the opacity and informality of network-managedforbearance.

With the collapse of Hokkaido Takushoku Bank and Yamaichi Securities came adramatic shift in public sentiment and greater receptivity to the use of publicfunds to stabilize the financial sector.64 Nonetheless, the Hashimotoadministration delayed capital injection into the banks, the hands of the PrimeMinister being tied due to the newly passed Fiscal Reconstruction Law. Repealof the law so soon after its passage would suggest that Hashimoto’s overallpolicy of fiscal restraint had been a big mistake.65

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On November 29, 1997, the Prime Minister finally gave the go-ahead for aformal discussion within the party on the use of taxpayer money to stabilize thefinancial system.66 Although stocks surged in reaction to the news of publiclyfunded recapitalization of the banking sector, a long period of politicalwrangling ensued, as Hashimoto and others sought ways to portray the processas compatible with the fiscal reconstruction policies.67 Hashimoto repeatedlyasserted in the months to follow that the fund injection would not represent apolicy shift. Accordingly, by the time the legislation passed in February 1998 toauthorize the use of public funds, the markets were convinced that therecapitalization simply represented another ad hoc stop-gap measure.68

Amounts injected the following month were negligible considering thesuspected magnitude of nonperforming loans. Furthermore, the injectionprocess, marred by opacity, was clouded in suspicion, and failed to alleviate thecrisis. Only after the government came up with a systematic scheme for dealingwith ailing banks at the end of 1998, and funds were secured for a crediblerecapitalization of the banking sector, would the crisis become less severe.

In summary, the legislative dominance thesis misses a critical component of theexplanation behind the delayed use of public funds: the significant informationadvantage that the MOF’s Banking Bureau possessed over the LDP. Withoutaccess to accurate information concerning the state of the nation’s bankingsector, or the effectiveness of standard procedures for problem resolution, LDPleaders lacked the basis for making informed decisions. Their ignorance wasevidenced not only by the delay in using public funds despite the mountingfinancial vulnerability of key constituencies, but also by their fiscal policydecisions in this period. These decisions tied the hands of the leaders, and at thesame time seriously exacerbated the problems, hurting valued constituencies.There is no doubt that Prime Minister Hashimoto and the rest of the LDPleadership (as well as MOF Budget Bureau officials) would have exercisedgreater caution in the making of fiscal policy if they were aware of the realcondition of the nation’s banks.69 Proponents of the principal-agent approachtend to downplay the ability of bureaucratic actors to consistently exploit theirinformation advantage over the legislature in a way that impacts policymaking.

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Yet, the magnitude of information asymmetry in inter-governmental and intra-ministerial relations in Japanese finance in the 1990s—a product of the networkform of governance—provides a key piece of the puzzle underlying thegovernment’s delay in reacting to the nonperforming loan problem.

IV. Paralyzing Networks

The paralyzing networks thesis places the web of informal relational tiesintersecting in the MOF at the center of our story , and focuses on the roleplayed by these networks in facilitating communication and negotiation amongkey actors and in “managing” information. This depiction of policymakingposits that networks behave in ways that cannot be understood solely in termsof their component parts. More specifically, networks affect outcomes in waysthat cannot be explained purely in terms of easily observed interest groupactivity, principal-agent relations, or theories of bureaucratic behavior.

As noted at the outset of the chapter, governments often initially delay beforemustering the political will to allocate public funds to stem a banking crisis.Concurrent with initial delay, government officials typically pursue a strategyof regulatory forbearance, permitting banks to postpone the realization of theirtrue loan portfolio values in the hopes that the problem will simply go awaywith an upturn in the economy. Typically, such forbearance involves electedofficials intervening to prevent regulators from doing their jobs until theproblem becomes too large to contain, and the political need to supportconstituencies through the use of public funds at last outweighs the politicalcosts of drawing on taxpayer money. Forbearance in Japan was MOF-centeredand network-managed, however, rather than simply the product of a politicalimpasse. The actions of MOF officials reflected ministry anticipation of thepreferences of key actors comprising the relational network—most notably, thepreferences of the LDP leadership and the banks. The MOF’s privilegedinformation flow, facilitated by its institutionalized relational ties to individualbanks, also meant, however, that Banking Bureau officials were privy toinformation about the condition of individual financial institutions that was notshared with LDP leaders or the general public.

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With the request to use public funds to dispose of the jusen housing and loancorporations, the ministry came under attack from the Diet, and the BankingBureau’s incentives for monopolizing information concerning the state of thefinancial sector and the effectiveness of standard operating procedures rose.Political leaders were clearly aware by the time of the 1995 Hyogo Bankcollapse that at least some of Japan’s second tier regional lenders were introuble. Yet, the MOF’s modus operandi, of drawing on its informal andparticularistic ties with financial institutions to arrange ad hoc rescue mergersbehind the scenes, hindered the flow of systemwide information into the politicalarena, and kept the declining effectiveness of standard problem resolutionprocedures largely hidden from the public. Moreover, the ministry’s relationalties with other government agencies and the LDP leadership permitted officialsto “manage” information about the state of the economy as a whole in such away as to downplay the extent of regulatory breakdown and crisis. Thisinformation management then laid the foundations for uninformed butextremely consequential fiscal policy decisions. These decisions not onlyworsened the conditions in which financial institutions operated, and therebyprecipitated the crisis, but also tied the hands of politicians in proceeding withpublic fund injection even after bad debt woes were clearly being transmittedinto problems in the “real economy”. Thus, the downgrading of Japanesesovereign debt, unprecedented numbers of corporate bankruptcies, postwarhigh unemployment rates, and a plunge to negative growth rates did notimmediately induce a shift from inaction to action.

The informality of the relation-based mode of regulation in Japan facilitatedinformation manipulation to a degree that would have been rendered moredifficult in the context of a more arms-length, rules-based regulatoryframework.70 The passage of legislation in October 1998 to establish a moreformal problem resolution framework and set aside funds for the crediblerecaptalization of banks would mark a major turning point in the conduct offinancial regulation in Japan. The catalyst for for change in the regulatoryparadigm was a shift in the nature of the market for information relating tofinancial regulation and the soundness of Japanese financial institutions.

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With the jusen housing and loan resolution, the political salience of financialregulatory issues rose significantly, giving opposition parties, in particular,incentives to invest more of their political capital in this area and explorealternative information sources and policy responses. As LDP backbenchersfound themselves facing heightened electoral vulnerability due to the public'soutcry over the jusen resolution, they too had incentives to engage in policyentrepreneurship.71 The collapse of major financial institutions in November1997 led to greater access to non-bureaucratic information sources for theseactors, as the market brought forth new information concerning the state ofJapanese banks and the financial system as a whole. At the same time, foreignfinancial institutions and former employees of failed Japanese financial firmsbecame important alternative sources of policy relevant information.

Until the LDP’s abysmal showing in the July 1998 Upper House elections,however, those outside the network—the Opposition and LDP backbenchers—had little opportunity to use this new information to influence policy outcomes.With the LDP’s electoral devastation, the Opposition gained the opportunity tomake use of this information to credibly contest the LDP leadership’s policiesand formulate an alternative response. Facing a potential meltdown of thefinancial system and a political impasse, backbencher reform elements withinthe LDP also at last received a mandate from party leadership to work with theOpposition on these issues. This cross-party group of reformers then drew upthe first package of financial reform legislation passed in the Diet in October1998.72 This legislation established a formal problem resolution framework thathelps ensure that the “fire alarm” will not again fail to go off in a timelymanner. A second package of legislation followed soon thereafter, providing forthe credible recapitalization of the banking sector. 74

V. Conclusion

Conventional wisdom was that the structure of financial governance inJapan—including the web of interpersonal relational ties—had many efficiency-

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enhancing characteristics, and allowed Japan to develop smoothly. The relativestrength of network governance in Japan across most of the postwar period wasarguably linked to the way in which these network “hubs” centered onindividuals who were, in turn, firmly embedded in stable institutions withconsiderable legitimacy and historical continuity. The stable institutionsincluded the ministries in the central government bureaucracy, the governingparty (the LDP), and the mainstay firms and financial institutions of corporateJapan.75

In solving the puzzle presented by the Japanese government’s delayed responseto the nonperforming loan problem in the 1990s, this chapter contended that thesame network variable proves critical in explaining the unprecedented degreeof financial regulatory and policy breakdown in the 1990s. The MOF's extensivenetworks enabled it to work out interests and skillfully manage competinginterests in a positive sum-like fashion for many years. But, a rupture in one ofthe network hubs due to domestic political change under coalition governmentled to a series of misjudgments, throwing the system into disarray. As a result,the web of relational ties emanating from the MOF served instead in this periodas a means for information distortion, opportunism, and the erosion of trust.

From 1955 to 1993, the LDP enjoyed uninterrupted one-party rule andcomprised a critical node in the MOF’s network of relational ties. The LDP’s fallfrom power in 1993, after nearly 40 years at the helm of national affairs, thusrepresented a significant disruption in longstanding cooperative ties linking theMOF with the political arena. This disruption came at a critical time, amid theministry’s first real indisputable policy failure in the postwar period, and ledthe legally hierarchical relationship between the legislature and the ministry toovershadow the more cooperative, supportive, and informal ties that had longlinked the LDP and the MOF. For the first time, the ministry came under attackfor regulatory incompetence and failed to be defended consistently by itslongtime ally, the LDP. Instead, the ministry became a scapegoat of the party asthe LDP sought to survive a volatile period of electoral instability and regainpublic support.

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The disruption in the MOF’s ties with the LDP meant that simple survivaldominated the MOF’s organizational priorities, as it never had before. Astrategy of organizational defense, in turn, required postponing any wholesaleshift away from a system of informal relations-based regulation to a system ofarms-length and rules-based regulation. A more formal system of prudentialregulation would expose the true severity of banking problems— problemsmuch deeper than those previously acknowledged—and expose the necessity ofusing public funds to resolve financial sector problems. The effectiveness of theinformal mode of dealing with ailing banks had declined considerably,however, and organizational survival meant an active strategy of information”management” to prevent public exposure of the true magnitude of thebanking sector’s woes. Ministry officials thus drew on their network ties notonly with financial institutions but also with other government agencies toinfluence the nature of publicly available information and the interpretation ofthis information.

The rupture in the MOF’s ties with the LDP had particularly severerepercussions because it occurred on the backdrop of inadequate adjustment inthe financial regulatory framework. A dramatic rise in informationrequirements for effective financial regulation emerged even prior to thebursting of the bubble out of mounting competitive pressures on banks,increasing internationalization of finance and breakdown in the traditionalmain bank system. As a result, the system of relation-based discretionaryregulation that once facilitated the constant flow of information between thebanks and the MOF had grown miserably inadequate by the latter 1980s. Aseries of political decisions made in this earlier period effectively weakened theMOF’s regulatory capacity to respond to the crisis in the banking system afterthe bursting of the bubble and information flows between the MOF and banksfell into a dysfunctional void between relational intimacy and formal disclosurerequirements. Accordingly, a significant portion of the blame for the financialand economic catastrophe of the 1990s must also be placed on the LDP and thepolitical system itself for rendering Japan’s financial regulator so weak in itssupervisory capacities heading into this decade.

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Today the structure and characteristics of Japan’s network state in the realm offinance differ significantly from the portrayal given in the preceding pages. Asa result of greater pluralism in party politics and the proliferation of newgovernment agencies, councils and other entities to deal with financial sectorissues, financial policy networks have become more “egalitarian”, with lessconcentration of connections in a few “hubs.”75 This change in networkstructure has introduced greater transparency to Japanese financial politics andprovided room for public opinion to play a more prominent role in thepolicymaking process. Japan’s “network state” is now plagued by severecoordination problems and indecisive political leadership, however.Accordingly, resolution of the nation’s financial sector problems remainselusive. Clearly, the time and cost required to transition from one politicaleconomic structure to another is affected by the nature of the previousinstitutional framework. Japan’s shift away from a relation-based regulatorysystem in finance is proving to be a particularly tortuous process.

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Figure 1: The Ministry of Finance’s Breadth of Authority(Prior to June 1998 reforms)

- Taxation

- Budget

- Government Bonds

- Banking

- Securities

- National Property

- Custom Duties

- Foreign Exchange

- Tobacco

- Minting Currency Printing

- Insurance

-Trust Funds

MINISTRY

OF

FINANCE

Note: The MOF central organ makes tax policy, while the National Tax Administration, anexternal organ of the MOF, implements these policies through tax collection and auditing. TheMOF also shared authority over the issuance of Government Bonds, Banking and ForeignExchange with the BOJ. 77

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NOTES 1. The author wishes to thank participants in the US-Japan Foundation Stanford project onJapan’s economic crisis and Dan Okimoto, Harukata Takenaka, Yves Tiberghien, in particular,for their helpful comments and criticisms. Sincere thanks also goes to Greg Noble for hisfeedback on an earlier draft of this chapter.

2. Quoted in “How ministry gambled in case of NCB”, Daily Yomiuri On Line, 29 July 1999.3. The IMF finds that approximately three-fourths of the countries in the world have

experienced some degree of crisis in their financial systems since 1980. Paul Hilbers, “TheIMF/World Bank Financial Sector Assessment Program” Economic Perspectives (Vol.6, No.1,February 2001) U.S. Department of State Office of International Information Programs) at<http://usinfo.state.gov/journals/ites/0201/ijee/ifis-hilbers.htm>.

4. Claudia Dziobek and Ceyla Pazarbastoglu, “Lessons and Elements of Best Practice” inWilliam E. Alexander, Jeffrey M. Davis, Liam P. Ebrill, and Carl-Johan Lindgren (eds) (1997),Systemic Bank Restructuring and Macroeconomic Policy (Washington, D.C.: International MonetaryFund), p. 119, Figure 2.

5. The question of injecting public funds into the Japanese banking system again became amajor topic of debate both inside and outside of Japan between 2001 and 2003. Some foreignbank analysts argued in 1999 that the capital injection made in that year was too small, giventhe massive size of the nonperforming loan problem. At the time, their views were the minorityview within Japan but in retrospect it is clear that the amount set aside for capital injections in1999 was insufficent. At the time, however, it was not immediately evident that bad debtdisposed of would be replaced so rapidly by new non-performing loans arising out of thestagnant economy.

6. By the time an injection of public funds was made into major banks in 1999, total bad debtin the Japanese banking system was estimated at $1 trillion. The government’s latent lossesfrom the bank recapitalization program finally carried out in 1999 were estimated in September2001 to total more than 1 trillion yen (approximately $830 million)

7. See, for example, Steven Vogel, Freer Markets, More Rules, Ithaca, NY: Cornell UniversityPress, 1996; James Horne, Japan’s Financial Markets: Conflict and Consensus in Policymaking, NY:George Allen & Unwin, 1985; and R.A. Feldman, Japanese Financial Market, Cambridge, MA:MIT Press, 1986.

8. Kent Calder, Crisis and Compensation, Princeton, NJ: Princeton University Press, 1988.9. In the mid-1960s, a cyclical downturn in the economy, combined with a depressed stock

market, led a number of brokerages including Yamaichi Securities and Ogi Securities to facecollapse. The government extended extraordinary assistance through the BOJ to bail out thesefirms and assist in the establishment of stock-buying bodies. All loans extended by the centralbank were later repaid in full.

10. Consider that the Organization for Economic Cooperation and Development (OECD)declared in 1984 that Japan “weathered the second oil shock and protracted internationalrecession better than any other country,” and that the country’s distinctive performance “owedmuch to the timely and appropriate response of policies…”. OECD Economic Survey: Japan(1984:7).

11. Daniel Okimoto coined the term “network state” in reference to Japan. See DanielOkimoto, Between MITI and the Market, Stanford, CA: Stanford University Press, 1989. Amultitude of references to institutionalized networks in Japanese public policymaking are alsofound elsewhere. See, for example, Kent Calder, Crisis and Compensation: Public Policy andPolitical Stability in Japan, 1949-1986, Princeton, NJ: Princeton University Press, 1988; and JeffreyBroadbent, Environmental Politics in Japan: Networks of Power and Protest, Cambridge: CambridgeUniversity Press, 1998.

12. Okimoto’s (1989) characterization of Japan as a network state focused on the mutualinterdependence of government and industry, emphasizing an exchange of information amongequals. The present study extends the scope of the network state analysis to include relationalties and information exchange occurring among government actors.

13. See, for example, Peter Evans, Embedded Autonomy: States and Industrial Transformation,Princeton, NJ: Princeton University Press, 1995.

14. Japan’s central bank effectively exercised its powers under the supervision of the MOF

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until April 1, 1998, when revisions in the BOJ law granted the central bank greater legalautonomy and devolved responsibility for monetary policy to the bank.

15. This section draws heavily on Jennifer Amyx, Japan’s Financial Crisis: Institutional Rigidityand Reluctant Change, Princeton, NJ: Princeton University Press, forthcoming, which providesmicro data on promotion and staffing patterns within the MOF and a systematic diachronicanalysis of the relational ties extending from the MOF to these actors.

16. See Matthew D. McCubbins and Thomas Schwartz, “Congressional OversightOverlooked: Police Patrols versus Fire Alarms.” American Journal of Political Science, 28: 165-79,1984, for more on the “police patrol” versus “fire alarm” concept.

17. For more on the distinctive attributes of Japan’s electoral system, see J. Mark Ramseyerand Frances McCall Rosenbluth, Japan’s Political Marketplace, Cambridge, Massachusetts:Harvard University Press, 1993.

18. Although the Bankers Federation funneled huge amounts of funds to the LDP throughthe Keidanren’s Peoples’ Association Fund, this financial support was viewed largely as aninsurance premium paid to ward off the possibility of the Socialist Party, the largest oppositionforce, coming to power.

19. Although Japanese bureaucrats tend to be rotated into a different position approximatelyevery two years, much of the personnel rotation involves placement in a different section ordivision within the same bureau. Historically, MOF officials have tended to identify themselvesas members of a particular ministry “clique” such as the “budget clique” (shukei-bata) or “taxclique” (shuzei-bata)—a reflection of the relative specialization that one tends to develop withinthe ministry. See Amyx (1998 and forthcoming 2002) for more on the character of the personnelsystem and staffing patterns in the MOF.

20. Until 1998, the opposition parties almost never drafted legislative alternatives to LDPproposals. Rather, when points of opposition emerged, they sought amendments to LDPproposals. Thus, this tie extending from the MOF to these areas of the Diet involved with thedrafting of legislation effectively excluded LDP backbenchers and opposition party members,both of whom played little role in the actual drafting of legislation.

21. Officials in the Cabinet Legislative Bureau are in a particularly strong position toinfluence the final wording of bills.

22. Author interviews with MOF officials, 1996–98. The number of Japanese language booksand articles also making this point are legion. The ministry’s compartmentalized nature iscaptured in the often-used phrases of “a collection of bureaus but no ministry” (kyoku atte shonashi) and “a bureaucracy within a bureaucracy” (kancho no naka no kancho).

23. Author interview with former Banking Bureau Director-General, Yoshimasa Nishimura,2000.

24. Japan’s prewar banking crisis, in fact, was triggered by a careless remark by a Dietmember about the financial health of a major bank.

25. The MOF official in this post was typically an individual on track to be the MOFAdministrative Vice-Minister, the highest civil servant post in the MOF. He therefore tended tobe one well experienced in the annual budget negotiations and well connected.

26. For more on the Japanese main bank system, see Masahiko Aoki and Hugh Patrick, TheJapanese Main Bank System: Its Relevance for Developing and Transforming Economies, NY: OxfordUniversity Press, 1994; Luke Gower, “A Simple Model of Main Bank Monitoring” PacificEconomic Chapter No. 240, February, Canberra: Australia-Japan Research Centre, 1995; MarkScher, Japanese Interfirm Networks and their Main Banks, NY: St. Martin’s Press, 1997; Paul Sheard,Main Banks and Structural Adjustment in Japan, Canberra: Research School of Pacific Studies,Australian National University, 1985.

27. This industry included thousands of small-sized firms. Construction-related businessesalso employed approximately 10 percent of the population and funneled large amounts offunds to the governing party. Since the 1970s, many have referred to Japan as the dokken kokka or“construction state” due to the massive amounts of public works spending carried out by thegovernment. For studies that highlight the political clout and size of Japan’s construction sector,see Jacob Schlesinger, Shadow Shoguns: The Rise and Fall of Japan’s Postwar Political Machine, NY:Simon & Schuster, 1997; Brian Woodall, Japan Under Construction: Corruption, Politics, and PublicWorks, Berkeley, CA: University of California Press, 1996; and Gavan McCormack, TheEmptiness of Japanese Affluence, NY: M.E.Sharpe, 1996.

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28. Indeed, with the eventual recapitalization of Japanese banks in 1998 and 1999, banks

receiving public funds were required to allocate a set portion of their lending to small andmedium sized enterprises (SMEs). Many unhealthy borrowers, including numerousconstruction firms, were also kept on a lifeline even after their financiers went into governmentreceivership.

29. The lending balance of domestically active Japanese banks registered no decline untilOctober 1996, and only beginning in November 1997 were there clear signs of a so-called “creditcrunch”, according to analysis carried out by the MOF’s Banking Bureau and the BOJ.Tomohiko Nishino, Kensho: Keizai Meiso—Naze Kiki ga Tsuzuku no ka (Examination: EconomicStraying/Wandering —Why does the Crisis Continue?), Tokyo: Iwanami Shoten, 2001, p.46.

30. Additionally, massive financial stimulus in this period provided the constructionindustry with a steady flow of work, leading to an increase in the number of construction firms.

31. See Frances McCall Rosenbluth, Political Dynamics in Contemporary Japanese Finance,Ithaca, NY: Cornell University Press, 1989.

32. In 1992, for example, Japan Federation of Economic Organizations (Keidanren) ChairmanHiraiwa, told then Prime Minister Kiichi Miyazawa that “[the financial world] say they willsolve [the problem] in their own way.” “Kensho Baburu: Han’i Naki Ayamachi “(BubbleExamination: Unintentional Mistakes), Tokyo: Nihon Keizai Shimbun-sha, 2000: 10.

33. Author interviews with financial industry actors and MOF Banking Bureau officials,1998–2000; Nihon Keizai Shimbun-sha (2000: 10).

34. Japan Federation of Employers’ Associations (Nikkeiren) Chairman Nagano, speakingafter Prime Minister Kiichi Miyazawa’s suggestion in 1992 at an LDP seminar that the LDPshould be willing, if necessary, to use public support to help liquidate the real estate held asloan collateral by banks. Nagano pointed out that it would be impossible to obtain the public’sunderstanding of the use of tax money to bail out banks, without banks first publicly disclosingsalaries paid to the management and other management-related bank information which hadlong been shrouded in opacity. Nikkei Shimbun-sha (2000: 11). The fear of governmentauthorities interfering in bank salary structures proved well founded in 2001 when FinancialSystem Minister Hakuo Yanagisawa ruled out approving bonuses for retiring directors at majorbanks that were in receipt of public funds. “Koizumi Reform: Bad Debt Disposals Mired inDifficulties.” Nikkei Net Interactive, November 15, 2001 athttp://www.nni.nikkei.co.jp/FR/TNKS/finance.htm.

35. Author interviews with Japanese bankers, 1998–99. This sentiment of seeking to avoidincreased government interference was also conveyed repeatedly by Japanese banking sectorrepresentatives in Keidanren. Nihon Keizai Shimbun-sha (2000:10).

35. The nokyo derived political leverage from their ability to mobilize voters at election time.The nokyo’s clout in the policymaking process was evident throughout the postwar period in thegovernment’s protection of domestic agriculture. For more on the clout of the nokyo and thefarm lobby in general, see Aurelia George Mulgan, The Politics of Agriculture in Japan, London:Routledge, 2000.

36. One former Securities Bureau official testifies, “The MOF was weak relative to the cloutof the banks and brokerages in the 1980s and the ministry’s heavy reliance on the Mofu-tan [asa means for obtaining tacit consent for proposed reforms before submitting proposals to theLDP] in this period was a sign of this weakness. With the financial scandals in the early 1990s,however, the MOF finally gained the upper hand vis-à-vis the private sector actors and wasable to impose its will on banks at last.” Author interview with former MOF Securities Bureauofficial, 1999. The scandals included fraudulent loan scams by five banks, exposed in July 1991;loss compensation scandals by brokerages, exposed in 1991–92; illegal stock trading by DaiwaSecurities in March 1992; and Sokaiya or “racketeering” scandals surrounding banks andbrokerages wherein these firms paid thugs to ensure that shareholder meetings proceededwithout disruption. When MOF officials privately solicited the opinion of three top bank headsconcerning policy options to halt a serious stock market slide in mid-1992, two of the threesuggested public funds be used to dissolve the jusen. All three bank heads were ridiculed byMOF officials, however, for suggesting “ridiculous proposals” premised on the use of publicfunds, when the banks remained in the black and salaries of bank officials were known to beamong the highest offered anywhere. Notably, the ministry’s reluctance to consider the use ofpublic funds to dissolve the jusen at this time was also a reflection of self-interest, as these

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institutions had long served as depositories for retired MOF officials. Subsidizing theirdissolution with taxpayer money would inevitably lead to criticism of the ministry and placenumerous ex-MOF officials at the center of an inquiry into management responsibility. NihonKeizai Shimbun-sha (2000: 11–12).

37. Under the main bank system, the so-called “main” or “parent” banks had always borne adisproportionate share of losses, so those banks seeking dissolution were seen by many non-main bank financiers—as well as by many MOF officials—as attempting to shirk theirresponsibilities. Author interview with former MOF official, 1999.

38. Author interview with MOF Banking Bureau official, 1999.39. Thomas Cargill, Michael Hutchison, and Takatoshi Ito, “Japan’s ‘Big Bang’ Financial

Deregulation: Implications for Regulatory and Sueprvisory Policy” Japan Information AccessProject, at http://www.nmjc.org/jiap/dereg/chapters/deregcon/hutchison.html.

40. For a more in-depth examination of the jusen resolution process, see Ulrike Schaede,“MOF, Money, and the Japanese Banking Crisis of 1995” in Angelika Ernst, Peter Poertner(eds.), Die Rolle des Geldes in Japans Gesellschaft, Wirtschaft und Politik (The Role of Money inJapan’s Society, Economy and Politics), Hamburg: Institute for Asian Studies, 1998: 95-128; andCurtis J. Milhaupt and Geoffrey P. Miller, “Cooperation, Conflict, and Convergence in JapaneseFinance: Evidence from the ‘Jusen’ Problem”, Law and Policy in International Business Vol.29,No.1 Fall.

41. For example, when rumors emerged that a particular bank was a candidate to absorbanother ailing bank, the market severely penalized the candidate with lower share prices.

42. Chalmers Johnson, MITI and the Japanese Miracle, Stanford, CA: Stanford University Press,1983.

43. Peter Hartcher, The Ministry: How Japan’s Most Powerful InstitutionEndangers World Markets, Harvard Business School Press, Boston, 1998; Christopher Wood,

The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ‘80s and the Dramatic Bust of the‘90s, NY: The Atlantic Monthly Press, 1992.

44. Hartcher (1998).45. Zenginkyo argued that a deposit insurance institution was unnecessary. The possibility of

a “regular” bank failing seemed beyond imagination, and officials argued that if any creditcooperative or small financial institution encountered trouble, the banking sector would rescuethem. In the end, the MOF succeeded in having the DIC established but failed to obtain enoughcooperation from the banking sector to have it credibly funded (Author interview with formerBanking Bureau Director-General Yoshimasa Nishimura, 1999).

46. It was from this point on that Banking Bureau officials began to rely more heavily on theMofu-tan. See Jennifer Amyx (2001) “Informality and Institutional Inertia: the Case of JapaneseFinancial Regulation”, Japanese Journal of Political Science 2 (1), p.58. For a detailed examinationof the way in which these ties were self-perpetuating, see Jennifer Amyx, Japan’s Financial Crisis:Institutional Rigidity and Reluctant Change. Princeton, NJ: Princeton University Press,forthcoming.

47. The reasons for this shift were three-fold. The party leadership felt betrayed by theministry when its top bureaucrat lent visible support to opposition party leader Ichiro Ozawaduring the party’s brief absence from power in 1993–94. Furthermore, the party now governedin coalition with the Sakigake and Socialist Parties, whose members were among the ministry’smost vociferous critics. Finally, by encouraging criticism of the MOF and the banks, the partydeflected criticism from itself and the agricultural cooperatives.

48. In February 1995, the Policy Chairman of the Sakigake Party published a book titledOkurasho Kaitairon or ”Dismantling the MOF”, which the media often quoted.

49. The name was later shortened to Financial Supervisory Agency.50. The Director-General of the MOF’s Banking Bureau made this promise during Diet

deliberations over the jusen legislation. Arguably, the jusen legislation had little chance ofpassing without such an assurance, given the LDP’s weak position in the legislature at the time.

51. Author interviews with MOF officials, 1999–2000.52. See Robert J. Brown, The Ministry of Finance: Bureaucratic Practices and the Transformation of

the Japanese Economy, Quorum Books, 2000, for an argument that acknowledges the politicalconstraints operating on the MOF but places central emphasis on the role played by

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“bureaucratic practices,” represented foremost by persistent adherence to standard operatingprocedures.

53. Importantly, this historic departure from the traditional rescue merger arrangement andthe decision to allow not only credit unions but also regional banks to fail was made within theBanking Bureau, without any prior consultation with Diet members. In fact, the order forHanwa Bank to cease business appeared in newschapters before Finance Minister Mitsuzuka orPrime Minister Hashimoto were informed. Kensuke Karube and Tomohiko Nishino, Kensho:Keizai Shissei (Examination: Economic Policy Failure), Tokyo: Iwanami Shoten, 1999, p. 9.

54. Karube and Nishino (1999: 11).55. Only in the end of November 1997, after particular LDP party executives began to call for

the resignation of Finance Minister Mitsuzuka and MOF Administrative Vice Minister Komura,did the Budget Bureau become actively involved again in formulating a response to thenonperforming loan problem. Notably, even then the Budget Bureau worked independentlyfrom the Banking Bureau to formulate proposals for the LDP regarding the use of public fundsto stabilize the banking sector. Nishino (2001: 23).

56. The principal-agent model is an analytic expression of a relationship in which one party,the principal, enters into a contractual relationship with another party, the agent, as a means toinduce the principal to act in a way that produces outcomes desired by the principal. For anapplication of this model in the Japanese context, see Ramseyer and Rosenbluth (1993).

57. For example, the U.S. Federal Reserve prompted “voluntary” assistance by private sectorfinancial institutions when the failure of a large hedge fund, the Long Term CapitalManagement (LTCM) Fund, seemed imminent in 1998.

58. Fiscal consolidation was symbolized in 1989 by the government’s refraining fromutilizing deficit-financing bonds in raising government revenues in the general account of thenational budget. Notably, fiscal consolidation in this year was due primarily to the surge in taxrevenue during the bubble period rather than to fiscal austerity measures.

59. Karube and Nishino (1999). Unlike most prime ministers who preceded him, Hashimotolacked a gang of “disciples” within the party who were devoted to him. It may be surmised thatthis was one reason he staked his administration so explicitly on the attainment of major policyobjectives.

60. The law was passed in the Diet on November 28, 1997, immediately after the failure ofthe following financial institutions: Sanyo Securities (November 4), Hokkaido Takushoku Bank(November 17), Yamaichi Securities (November 24), and Tokuyo City Bank (November 26).

61. Reflecting on this time period, then Prime Minister Hashimoto attests, “When problemswith an individual financial institution arose, they [MOF officials] came [to give a report oncountermeasures taken], but they did not come to talk about the financial system as a whole. Irepeatedly asked how many nonperforming loans there were but received no certain reply.”Quoted in Karube and Nishino (1999: 12).

62. MITI officials, for example, attest that their ministry’s failure to “check” the MOF wasbecause MITI was unaware of the severity of problems in the banking sector. Author interviewswith mid-career MITI officials, 1999.

63. On the day of Tokuyo city Bank’s collapse, depositors around the country also staged arun on banks in eight other locations, making it clear that financial panic was in the air.

64. Author interview with numerous Diet politicians, 1999.65. Because his major challenger for power within the party, Seiroku Kajiyama, was a

supply-sider, Hashimoto’s acknowledgement of policy error would likely have led to hispolitical demise.

66. Nikkei Net, 30 Nov. 1997.67. For a detailed account of this political wrangling, see Chapter 1 of Nishino (2001).68. Karube and Nishino (1999:345). This legislation was titled The Financial Stabilization

Law.69. The stance assumed by the MOF’s Budget Bureau in 2000–01 on fiscal policy provides a

clear contrast with the Budget Bureau’s position in this earlier period and serves as evidence insupport of this statement. With publicly available information concerning the state of thenation's banks considerably more abundant from 1999 on, the Budget Bureau has closelymonitored developments related to nonperforming loans while at the same time prepared forthe fiscal reconstruction it perceives as inevitable and necessary to introduce at some point. In

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this way, the Bureau sees that the introduction of fiscal retrenchment policies as contingent onthe disposal of nonperforming loans. Author interview with Budget Bureau official, 2000 and2001.

70. While it is beyond the scope of this analysis to carry out a detailed comparison of theMOF’s networks with those of other Japanese ministries and agencies, one can speculate that asimilar degree of information management and distortion would have been less likely in aministry such as MITI. In MITI’s bureaus, intra-organizational networks facilitated theregularized flow of information across bureaus at three different levels, thus decreasing thelikelihood either for information distortion or for various parts of the ministry to work at cross-purposes. Author interview with former high-ranking MITI official, Takashi Isayama, 2001. Seealso Daniel Okimoto, Between MITI and the Market: Japanese Industrial Policy for High Technology,Stanford, CA: Stanford University Press, 1989, pp. 156–57. This observation suggests that theeffect of the network mode of governance on state capacity may vary significantly across issueareas where there is notable variation in the organization of the state institution at the center ofpolicy networks. Accordingly, employing the analytical lens of the network state requires asolid anchoring in the substance of organizations—particularly those at the center of thenetwork.

71. Most prominent among the LDP backbenchers spurred into action were former BOJofficial, Yasuhisa Shiozaki and Nobuteru Ishihara.

72. This group of Diet members became known thereafter as the “new policy tribe” (seisakushinjinrui) or “young turks.”

73. For a detailed documentation and analysis of changes since October 1998, see Jennifer Amyx, “TheMinistry of Finance and the Bank of Japan at the Crossroads” in Jennifer Amyx and Peter Drysdale (eds.),Japanese Governance: Beyond Japan Inc., London: Routledge, 2003; Jennifer Amyx, “Reforming Japanese Banksand the Financial System,” in Jeffrey Graham and Saved Maswood (eds.), Continuity and Change in Japan,Curzon Press, 2002; and Jennifer Amyx, “A New Face for Japanese Finance? Assessing the Impact of RecentReforms” in Gil Latz (ed.), Challenges for Japan: Political Leadership, U.S.-China-Japan Triangle, FinancialReform, and Gender Issues. Tokyo: International House of Japan, for the Shibusawa Eiichi MemorialFoundation, forthcoming 2003 (in English and Japanese.

73. For a detailed documentation and analysis of changes since October 1998, see Jennifer Amyx, “TheMinistry of Finance and the Bank of Japan at the Crossroads” in Jennifer Amyx and Peter Drysdale (eds.),Japanese Governance: Beyond Japan Inc., London: Routledge, 2003; Jennifer Amyx, “Reforming Japanese Banksand the Financial System,” in Jeffrey Graham and Saved Maswood (eds.), Continuity and Change in Japan,Curzon Press, 2002; and Jennifer Amyx, “A New Face for Japanese Finance? Assessing the Impact of RecentReforms” in Gil Latz (ed.), Challenges for Japan: Political Leadership, U.S.-China-Japan Triangle, FinancialReform, and Gender Issues. Tokyo: International House of Japan, for the Shibusawa Eiichi MemorialFoundation, forthcoming 2003 (in English and Japanese.

74. Notably, this form of embedded network with “hubs” embedded in institutionscontrasted sharply with the structure of network governance in countries such as Indonesia orMalaysia, where networks intersected in individual national leaders such as Suharto orMohammed Mahathir, and were thereby more susceptible to individual whims and sufferedfrom greater variability. Similarly, the continuity and predictability in Japan’s policy networkscontrasted sharply with the highly fluid policy networks in China documented by numerousscholars.

75 Buchanan (2002) argues that network types range between “aristocratic” networks, in which theconcentration of connections goes through a few “hubs” and “egalitarian” networks in which connectionshave bo particular concentration. See Mark Buchanan. Small Worlds and the Groundbreaking Scienceof Networks. New York: W.W.Norton & Company, 2002.