Introduction: A mere decade ago Japan’s financial system, and especially its banking system, was not only the largest but the strongest in the world. Nine of the world’s top ten banks in asset size were Japanese; the Big Four Japanese securities companies were the world’s largest; and its life and casualty insurance companies were likewise huge. Banks had ample, low cost, deposit funds and the highest credit ratings. The largest were expanding their international operations vigorously, and performed 34 per cent of the world’s international lending business, more than banks domiciled in any other country. Today presents a completely different picture. Japan’s financial system is weak and in disarray. Banks no longer rank among the world’s top ten, and their credit ratings have declined dramatically. Two of Japan’s top 21 banks have already collapsed, as has one of the Big Four securities companies, and a mid-sized life insurance company. This is not only unprecedented in Japan’s postwar history, until the 1990s it was unthinkable. This paper focuses primarily upon the problems of the Japanese banking industry, although the analysis applies in many respects to the securities and insurance industries as well. It does not consider Japan’s fiscal mess: its budget deficits, tax system, government fiscal and loan programs, or the special account debts that cannot be serviced. This is a Pacific Economic Papers comprehensive overview rather than a detailed analysis of specific issues or topics. It provides the groundwork for the conference Financial Reform in Japan and Australia by addressing two themes: the ‘postwar’ financial system and its implications; and causes of the current banking difficulties. The objectives of any financial system in a market-based economy are threefold: the safety of the system in order to prevent bank runs and monetary panics; its effectiveness in mobilizing savings and allocating them to productive, efficient uses by financial intermediation through banks or capital (stock and bond) markets; and efficiency in the provision of financial services, best achieved in a highly competitive system. These objectives can be in conflict, depending on how the system is organized and what constitute the rules of the game. The achievement of these objectives depends on the overall economic environment, including the level of economic development, the degree of competition, and the extent of global financial market integration. In designing the postwar financial system, the regulatory authorities, essentially the Ministry of Finance, always placed great emphasis on system safety, and maintained or built upon the wartime bank-based financial system.
