Does the Japanese Stock Market Price Bank-Risk? Evidence from Financial Firm Failures

Abstract

The efficiency of Japanese stock market to appropriately price the riskiness of Japanese firms has been frequently questioned, particularly with respect to Japanese banks which have experienced severe financial distress in recent years.This paper examines the response in the stock market returns of Japanese commercial banks to the failure of four commercial banks and two securities firms between 1995 and 1998.The analysis finds that the stock market responded to new information of the failures and did so rationally.Financially weaker banks were affected more adversely by the failure of other banks and financial institutions than were healthier banks.This suggests that the Japanese stock market is more efficient, even for banks, than often perceived. DOES THE JAPANESE STOCK MARKET PRICE BANK RISK? EVIDENCE FROM FINANCIAL FIRM FAILURES I.At about the same time as the U. S. banking system started to recover during the early 1990s, the Japanese banking system started to deteriorate.By the late 1990s, many of the larger Japanese banks appeared to be market value insolvent and most of the others barely solvent.In 1998, nonperforming loans at Japanese banks were estimated to be as high as $1 trillion or 20 percent of their on-balance sheet assets and considerably higher at some institutions.Only liberal accounting treatment permitted most Japanese banks to satisfy the Basle capital standards and only conjectural government guarantees permitted most major banks to continue to operate without depositor runs.However, despite the favorable accounting treatment and government guarantees, Japanese financial institutions continued to suffer severe liquidity problems in the interbank markets and several had to be rescued or closed in recent years.At the same time and in response to the problems, the stance of the Japanese regulators towards banking problems and their resolution strategies underwent significant changes.In short, Japanese financial institutions experienced fundamental shifts in their operating environment during the 1990s.In light of these events and the ongoing attempt by the Japanese government to resolve the insolvencies and restructure and recapitalize the banking system, it is of considerable interest to explore whether the Japanese stock market was able to price the securities of Japanese banks efficiently and provide market signals to bank management.It is often argued that the Japanese capital markets are not as efficient as those in the United States due to differences in regulatory, institutional, accounting, and disclosure practices.For instance, until 1993, Japanese banks did not report the amount of nonperforming loans in their portfolios and it was not until 1998 that they reported nonperforming loans by U.S.standards.The lack of extensive information on bank asset quality is an obvious impediment to

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