Japan illustrates what happens from protecting bank book equity levels

In his Bloomberg column, William Pesek summarizes what happens to countries that pursue the Japanese model for handling a bank solvency led financial crisis.

Under the Japanese model, policies are adopted with the goal of protecting the level of  bank book capital. As a result, losses on the excesses in the financial system are not recognized today.  Rather, they are recognized over time as banks generate earnings in excess of banker bonuses, dividends and modest capital retention.

While the losses are slowly being realized, prices are distorted in the real economy.  Banks continue to fund zombie borrowers rather than recognizing the losses on these loans.  As a result, asset prices are artificially propped up.  This in turn creates a drag on the real economy.

To overcome this drag on the real economy, central banks resort to zero interest rate policies in an effort to boost demand.  Unfortunately, these monetary policies create their own headwind as savers realize they need to save even more to make up for the loss in earnings on their savings.

As Mr. Pesek observed

Japan (JGDPAGDP)’s problem isn’t really the size of its debt. It’s that there has been no real growth since the 1980s-era asset bubble burst. At the start of 2012, Japan’s inflation-adjusted gross domestic product was smaller than it was in 1992....

Here is overwhelming empirical evidence that pursuing the Japanese model and its related policies for handling a bank solvency led financial crisis is a bad idea.

[Japan's prime minister] should work with the Bank of Japan to devise ways to get banks to lend. Wave after wave of central-bank liquidity isn’t resulting in the credit creation Japan needs to jump-start growth .... Why not force bankers to do their jobs?

Wave after wave of central-bank liquidity isn't resulting in the needed credit creation in the US, UK or Eurozone either.

That central bank liquidity would not result in the needed credit creation was completely predictable.  Banks are senior secured lenders.  Bankers know that asset prices are being artificially propped up.  In deciding how much to lend, banks have to determine what the real value of the collateral would be if prices stopped being artificially propped up.

As a result, borrowers have to cover the gap between the real value and the artificially propped up price of the collateral.  It is the need to come up with this additional equity that is the barrier to credit creation.