let banks themselves count their bad loans, not only are they apt to lie – but investors will disbelieve anything they say

TO BE NOTED: From the FT:

"US belatedly learns lesson from Japan

By Gillian Tett

Published: May 8 2009 18:47 | Last updated: May 8 2009 18:47

In recent months, Japan’s sorry banking history has provided the world with plenty of reasons to worry about America. Now, however, it might offer a crumb of comfort, too.

The reason? In part, it lies with those stress tests that Washington has just conducted on its largest 19 banks.

During most of the past two years, the American leadership has been in a state of procrastination and denial in relation to its banking woes: first it tried to pretend that the financial woes were not too serious, since they were “contained”. Then it insisted that free market pressures would be enough to force the banks to come clean about their mess – without the need for the government to act.

In reality, the Americans were not at all unusual in taking that stance: when Japan’s banks first became plagued with bad loans in the early 1990s, the government in Tokyo took an identical stance – and continued denying the scale of woes for almost a decade.

But precisely because the Japanese were such past masters of procrastination – and learnt the hard way what that can do – they have been quietly dubious about much of what Washington has said about the banking woes in the past two years.

As long ago as the autumn of 2007, for example, Daisuke Kotegawa, a canny former financial bureaucrat who was central to Japan’s own banking clean up, pointed out to me that what was missing from the American debate was any effort to conduct an audit of Western banks.

For Kotegawa is convinced that it was only when the Japanese government finally went into its banks and did a thorough, independent review of their operations – and then published the collective bad loan estimate and forced the banks to plug any capital gaps – that the Tokyo financial dramas started to heal.

The point is: if you let banks themselves count their bad loans, not only are they apt to lie – but investors will disbelieve anything they say, even if they do tell the truth. “What is needed [to solve the credit crisis] is not [just] cash but wiping out widespread mistrust,” Kotegawa observed back then.

Now, at last, it would seem that men such as Tim Geithner are finally – belatedly – learning that lesson too (and Mr Geithner is a man who knows this Japanese tale only too well since he worked there himself in the 1990s).

You can argue at length about whether the stress tests are completely “correct” or not. But what is undisputable is that they have taken place in a fairly thorough manner. In a world that has been marked by cognitive fog, in other words, investors now have something tangible to cling to. At last, there is a sense that someone is in charge – and a bottomless pit might not be so bottomless after all.

That is potentially very important for sentiment. Back in the 1990s, when Japan’s government was procrastinating and fudging, there seemed to be no limit to just how big the estimates of bad loan numbers could become: they started the decade at around $50bn, but then rose to over $1,000bn (and Goldman Sachs even slated in $2,000bn, which back then seemed unimaginably large).

But when the Japanese finally performed their own versions of a stress test, those ever-rising projections suddenly stopped growing, not least because confidence started to return – and the wider economy picked up. These days, economists now guess that Japanese credit losses were actually around $800bn – which is very large, but less frightening than $2,000bn.

There is, of course, no guarantee that America can repeat exactly that trick. One crucial difference is that men such as Kotegawa only had the Japanese banks to worry about. Mr Geithner does not share that luxury: irrespective of whether he has measured bad loans at American banks correctly, who knows what is sitting in European banks now?

Nor does America have the luxury of sitting in a world where there are other export markets that are booming – a sharp contrast to Japan, which started to enjoy an economic uplift when Chinese demand boomed soon after it reformed its banks.

Moreover, another reason for feeling cautious is that the slant of American policy still appears to be more focused on avoiding damaging bank collapses rather than trying to build truly vibrant institutions that could lend money again. Simply removing the patient from the critical list, in other words, does not make him truly healthy again – let alone ensure that the economy will properly heal. Recapitalisation is a necessary not sufficient condition for recovery, as the history of Japan shows.

Yet, even with those caveats, the fact that the stress tests have now taken place is certainly reason to cheer. The only crying shame is that it took such a ridiculously long time for the American administration to listen to that lesson from Japan – while many of Mr Geithner’s counterparts in Europe continue to ignore it, even today.

gillian.tett@ft.com"