Joe Peek and Eric S. Rosengren explain how regulatory incentives contribute to the persistent mis-allocation of capital by Japanese banks.

Bank regulation and supervision policies in Japan provide banks that have significant nonperforming loans and impaired capital little incentive to be strict with troubled borrowers. In fact, it is in the self-interest of banks to follow a policy of forbearance with their problem borrowers in order to avoid pressure on the banks to increase their own loan loss reserves, further impairing their capital. This leads to a policy of banks “evergreening” loans, whereby a bank extends additional credit to a troubled firm to enable the firm to make interest payments on outstanding loans and avoid or delay bankruptcy. By keeping the loan current, the bank’s balance sheet looks better, since the bank is not required to report such problem loans among its nonperforming loans. Although banks have the incentive to evergreen loans, their ability to aggressively pursue such policies requires government complicity. Our evidence is consistent with the government being unwilling to force recognition of asset quality problems in bank portfolios in an attempt to limit costly bailouts of the banking sector and additional firm closures.

For Discussion. Is the value of the national capital stock in Japan likely to be overstated, because investment is being misallocated?