Credit

In the story presented on the thematically. Org describes the process and the behavior patterns of parties involved. Mike Francis, Moody, and Standard and Poor represent the lending or investors side. When Mike Francis devised the mortgage backed securities which gave birth to Cods Investors jumped onto these securities based on AAA ratings given to these securities by rating agencies such as Moody, and Standard and Poor. These rating agencies did collect lot of data which were barely few years old. They did not have enough relevant and good quality data and collected data was simply to enough.

These rating agencies used their preexisting theory – houses don’t lose value In America – to Interpret the evidences that the performance of these securities were AAA (Heath, et al. 1998). Individuals use their preexisting theories to Interpret the evidence (Heath, et al. 1998) is a bias which played a major role here. The investors from the global pool of money jumped in with all guns for these securities. As demand grew more and more these mortgages were bought and more and more securities were created to investors. The entire process showed a confirmation bias.

People who took risky adjustable loans to buy houses which they really could not afford were essentially following other people. Since most of the people were buying houses by taking these loans, it made sense for other to replicate the act. Calling explains, In his book Influence Since and Practice (5th edition), this behavior as “the principle of social proof”. This principle states that we determine what Is correct by finding out what other people this Is correct (Lund et al. , 2007). Before 2000 most of people with low Income and low credit score were not able to afford buying the kind f house they bought during the period after 2000.

In the radio program “Giant Pool of Money”, case of Clarence Nathan is presented. Clarence works 3 jobs, did not made good income and had bad credit rating. “l wouldn’t lend to myself” said Clarence. Even then he took the loan because everyone else was talking these kinds of loans and in fact the loan was made available to him. Even the behavior of investors, banks, and Wall Street followed the same pattern. Early on, investment banks were not interested in risky mortgages but when one bank started buying hose supreme mortgages others Jumped in. It was acceptable to invest in supreme mortgages.

Emerging nations such as China and India have also allowed companies to reduce production costs and target wider developing consumers. With these opportunities and with many of the other opportunities surrounding globalization economics now look at the economy on a lobar scale as opposed to a national scale which has led to conflicting perspectives on the use of the nation-state.

As early as 1969 economics such as Charles Kindergärtner sparked the perspective that “the nation state Is Just about through as an economic unit” (Eagleburger 1969: 207) The following essay will look at globalization in terms of the economy and look at two of these businesses currently operating globally to see if the role of the individual nation-state government remains vital despite the trend towards globalization. Firstly one must define what libations actually Is and what type of organizations qualifies as a ‘global company.

Researchers suggest that globalization is ‘one of the most misused and one of the most confused words around today (Dickens, 2007). Globalization is a widely used term that has no simple definition; Instead researchers suggest that the word has become a ‘convenient summary term’ used by many to ‘bundle together virtually all the goods and bad facing contemporary societies’ (Dickens, 2007). There is one definition that most globalizes will agree upon and that’s that it is a “process by which the experience of everyday life, marked by the diffusion of commodities and Ideas, Is becoming standardized around the world. In terms of the economic globalization that essay will be concentrating on, “Globalization Is a level of economic activity that has outgrown national markets through industrial combinations and commercial groupings that cross national frontiers, and international agreements that allow businesses to operate Internationally” (Hirsh, 1996) Lloyd TTS Is one company that can be defined as a global organization. Lloyd TTS Is an International bank that’s part of Lloyd banking group. Its head office is in London and it originated in 1745 as a personal banking service with one single office in Birmingham.

In the 1 sass Lloyd began to expand offices through Europe, India and South America. In the late sass’s Lloyd acquired other International businesses and soon had hundreds of offices in over 50 different countries. McDonald’s is a fast food restaurant. It was formed in 1948 in California and is currently the largest fast food restaurant In the world. It currently has 31,000 restaurants in 118 countries. Macdonald has become global as more than 75% of McDonald’s restaurants relied are owned as a franchise.

Both companies are huge global companies that are as successful as they are as they view the world as one place and not in terms of nation-state governments. Although both companies are similar In the sense that they operate globally they are both very different organizations. Lloyd TTS began in the UK and have bought other companies and diversified to gain its global recognition. McDonald’s however, 1 OFF operates In ten T sector Ana stall manly operates alertly In ten A It galena global standing by franchising the brand and the products across the world

There are also other key differences between the companies. As well as operating in different economic sectors, Researchers suggest that although both organizations operate as transnational organizations their global operations are completely different. Lloyd TTS is a ‘global organization’ as its overseas operations are delivery of the same service to Just different consumers, whilst the same researchers would describe McDonald’s as a ‘Multinational Organization’ as it views much of its overseas operations as a portfolio of independently run businesses (Bartlett, 2000)

On both Lloyd TTS and McDonald’s there are major influences affecting them as they operate in the globalizes economy. Globalization and international companies arriving in individual national-states have always been met with a mixture of positive and negative opinions due to the instant challenge it brings to the uses and the very existence of the nation-state. There are currently 194 individual nation-states in the world (Rosenberg, 2009). Each state has its own common culture and has its own way of governing its state.

With new technologies, transportation and communications and the fact that organizations are now creating a standardized way of living it can be assumed that the power and control once held by the nation-state is being severely reduced. Due to the claims by theorists such as Kindergärtner (1969) there has been much debate sparked into the existence of the nation-state and the uses of globalization. In the globalization debate there are three conflicting perspectives on the uses of the nation-state.

The first perspective is that of the Hyper-Globalizes, who argue that we live in a borderless world and the nation- state is no longer relevant. The Hyper- Globalizes view globalization as a new development and suggest that the world’s cultures and experiences are becoming homogeneous through standardized global products. The second opinion is the ‘Skeptical Internationalists’ who accept that globalization exists however believe that it’s not new and the grounding globalizes who believe that quantitative date is Just as important as qualitative date in the debate.

According to Dickens (2007:IPPP) the roles of the nation-state in the contemporary global economy has four key roles; containers of institutions and cultures, regulators of economic activities, competitors with other states and elaborators with other states and when globalization intrudes these roles its often met with a degree of negativity Lloyd TTS and McDonald’s are diversifying into these individual nation-states and as a result are sometimes met with this negativity and political concern targeted towards the hyper-globalizes perspective.

These companies and most of the companies that are isolating are often from Western dominated economies and arrive with western values and cultural interests. Hilton (1998) suggests that one of the main negative impacts on these organizations and libations in general is that they are incorporating third world and developing economies into the global economy only as ‘passive consumers of standardized products and nothing more’ suggesting that although these companies are operating globally the economic wealth and growth still lives within its original national economy which widens the gap between the rich and poor countries.

Omaha (1995) considers the ‘standardization of culture’ as a negative impact on globalization. These Uninominal nation-states Tanat companies Like Lloyd Dank Ana c an ass are penetrating have individual cultural values and beliefs. Both companies are bringing their Western cultural values into these individual nations and creating a standardized culture within. McDonald’s for example has a very western cultural style to its food, items on its menu such as ‘French fries’ and ‘hamburgers’ are very much western orientated foods.

The very way in which McDonald’s delivers its food in fast food restaurants, through American style diners and drive trough’s again reflect the western cultural values which are now being adapted and ‘standardized’ around the world. Omaha (1995) suggests that these changes can be seen as negative impacts and are seen as a challenge to the importance and use of a nation-state if the world is starting to live in a standardized way.

There are many negative opinions in the role of the nation-state debate and evidence to suggest that we are beginning to live in a homogeneity environment however, there have been many recent events that have shown that despite the trend to globalization the nation-state is still vital and that we do not live in a homogeneity world. One recent event that’s affected nearly everyone is the global recession or the ‘Credit Crunch’ the world is currently experiencing.

The Credit Crunch can be defined as “a severe shortage of money or credit” (BBC, BBC NEWS, 2009) and is caused by banks not lending out money. Lloyd TTS is one of many financial institutions affected in the credit crunch due to the very nature of the business and the fact that deregulation in the global financial economy allowed banks to lend money in insecure ‘lax’ borrowers, especially in the American mortgage economy Where billions of dollars was invested into mortgages made available to sub-prime borrowers (people with bad credit rating, no Jobs, no repayment amounts) at a low interest rate.

When interest rates started to increase people began to default on borrowings which meant the value of these investments plummeted resulting in huge losses for banks globally (Badmouth, 2009), including Lloyd TTS. As a result of this lax lending Lloyd and many other global banks were forced to write off millions of pounds of debts. Lloyd were ‘left 250 million short’ (BBC 2007) which left them at a huge loss and unconfined to lend out more money. As a result of the financial difficulties Lloyd were forced to make over two thousand people redundant and were left to turn to the nation-state for help.

In terms of the nation-sate debate it’s evident in economic downturns such as the global ‘credit crunch’ and the current recession the nation-state is vital for companies such as Lloyd to survive. The British government used tax-payers funds to ‘bail’ out the bank by supplying them with over a billion pounds worth of investment. McDonald’s, operating in a completely different economic sector completely survived the economic downturn as people looked to them for a cheap source of food and drink.

McDonald’s made a profit through the economic downturn and look set to do the same this year (McDonald’s. Com 2009). Further to the debate that we do not live in a homogeneity world is the fact that states regulate trade, foreign investment and industry and each state takes an individual stance on how they do this. Policies towards imports and exports are individual in every state and McDonald’s and Lloyd TTS have to comply with these policies in each individual state.

Memo to Client In this memo one will Include a summary of the facts, Including the names, ages, educational background, and Income status for Mr.. And Mrs.. Close and their two dependents. Loose CPA will also discuss two of the Close’s goals and concerns. This memo will also summarize the findings and key elements of the personal budget, balance sheet, and the statement of cash flow.

Loose CPA will also make recommendations and support for improving the financial situation for the Close’s. Summary of Facts Clients- Ken and Tina Close are married with two children, Tyler (16) and Nikkei (14). Ken Is 42 years old disabled ex-factory worker with a high school education. Tina Is a 37 year old Event Planner with an Associates Degree in customer service. Although Ken is disabled he does receive disability benefits of $14,500 annually and Titan’s annual income is $32,500.

Tyler is a Junior at BBS and works part-time at Culler’s with an annual income of $3,100. Nikkei is a freshman at BBS and is not employed. The family’s goals are to reduce credit card debt and to save for a vacation. The vernally biggest concerns are that their credit will suffer if they do not pay off the debt and that Tyler and Nikkei will both need vehicles soon. Key Items and Findings The balance sheet compiled for the Close’s shows total assets to be worth $188,250 and total liabilities at $115,320. 24.

Ken and -rattans net worth $72,929. 76. The statement of cash flow compiled includes monthly income from Ken’s Social Security Disability and Titan’s net income from event planning for a total monthly income of $3,294. 16. The total cash outflows of $2629. 69 can be divided Into fixed expenses of $1475. 49 and variable expenses of $1 154. 20 for the month of February. The monthly inflows minus monthly outflows gives the Close’s a cash surplus of $664. 47 each month to divide up for emergencies, savings, and a family vacation.

The monthly gadget show no variance for inflows but does show a small variance for outflows. The savings variance was ($4. 53), the fixed expense variance was zero, and the variable expense variance was $6. 23. Thus giving a total outflow variance of $1. 70. Loose CPA recommends that Mr.. And Mrs.. Close try to limit the amount spent on credit cards in the future and for the balance due on the current credit cards to be paid in an amount higher than the monthly minimum due in order to pay the cards off faster and reduce interest charges.

There Is a meticulous proverb about the bank’s lending -“If you owe the bank take problem. ” To be frank, lending to the businesses, governments, and Individuals Is one of the most Important services banks and their closest competitors provide, and It Is the riskier. The principal reason banks and many competitor lenders are issued charter of incorporation by government is to make loans to their customers.

Banks, thrift institutions, and other chartered lenders are expected to support their local immunities with an adequate supply of credit for all legitimate business and consumer financial needs and to price that credit reasonably in line with competitively determined market interest rate. Indeed, making loans to fund consumptions and Investment spending Is the principal economic function of banks and their closest competitors. How well a lender performs In fulfilling the lending function has a great deal to do with the economic health of Its region, because loan support the growth of new business and Jobs wealth the lender’s trade territory.

Despite all the benefits of lending for both the institutions that makes loan and for their customer, the lending process bears careful internal and external monitoring at all the times. When a bank or other lender gets into serious financial trouble, its problems usually spring from loans that have become unconvertible due to mismanagement, illegal manipulation, misguided landing policies or an unexpected economic downturn. No wonder, then, that when examiners appear at a bank or other regulated lending Institution they conduct a thorough review of its loan portfolio.

Usually this Involves detailed analysis of the documents and collateral for the largest loan, a review of a sample of small loans, and an evaluation of loan polices to ensure their sound and prudent In order to protect the public funds. 1. 2 Background of National Credit & Commerce Bank Ltd (UNCLE) National Credit and Commerce bank Limited bears a unique history of its own. The organization started its Journey in the financial sector of the country as an investment company back in 1985.

The aim of the company was to mobile resources from within and invest them n such way so as to develop country’s Industrial and Trade Sector and playing a catalyst role In the formation of capital market as well. Its membership with the bourse helped the company to a great extent In this regard. The company operated up to 1992 with 16 branches and thereafter with the permission of the Central Bank converted In to a full-fledged scheduled private commercial bank In May 1993 with paid up capital TX. 39. 00 core to serve the nation from a broader platform.

During providing sincere personalized service to its customers in a technology-based environment. The Bank has set up a new standard in financing in the Industrial, Trade and Foreign Exchange business. Its various deposit and credit products have also attracted the clients-both corporate and individuals who feel comfort in doing business with the Bank. The initial authorized capital of the Bank was TX. 75. 00 core and, paid-up capital TX. 19. 50, core at the time of conversion, which is now raised, to TX. 9. 00 cores. The present authorized capital is TX. 250. 00 core and paid up capital is TX. 60. 78 core. The sponsors of the new bank consisted of 26 (Twenty six) Members, who comprised the iris Board of Directors. The share price of the bank is currently being quoted at both Dacha and Chitchatting Bourse at an average price of TX. 320/- against per value of TX. 100/-. NC Bank based upon its commendable business performance for the year ended 2004, has meanwhile declared stock dividend at the rate of 30%.

The Bank which started with 16 branches in 1993, has at present 41 (forty one) branches and 03 (three) Booths located in prime commercial areas of Dacha, Chitchatting, Sylphs, Fine, Chula, Josser and Ranging District Headquarters, out of which as many as 17 seventeen) are Authorized Dealer Branches, fully equipped for dealing in direct foreign exchange businesses. 1. 3 Scope of the Report This report has been prepared through extensive discussion with my colleagues and with the clients.

While preparing this report, I had a great opportunity to have an in depth knowledge of all the banking activities practiced by the NC Bank limited. It also helped me to acquire a first-hand perspective of a leading private bank in Bangladesh. This report covers overall areas of UNCLE. It can be grouped into the allowing sections: Origin and historical background of UNCLE. Theoretical description about the products and services, general banking activities and departments of the bank.

Analysis of the performance of UNCLE through some ratios. 1. 4 Objectives of the Report Primary Objectives The primary objectives of the report are to orient the real life nature of the bank and to measure the Job satisfaction of the staffs of the NC Bank Ltd, Mailbags branch, Dacha. Secondary Objectives To measure the level of Job satisfaction of employees with respect to the company. To understand the components that trigger Job satisfaction of the staffs.

To know the reasons behind the Job dissatisfaction of the employees from the findings. To Judge the level of Job satisfaction of employees on various parameters: Working Conditions Rewards and other benefits Relationship with employees of company Job Security 1. 5 Methodology This report is made based on my theoretical and practical knowledge and as project report. National Credit Bank Limited is one of the well-known private commercial bank in Bangladesh. Its public reporting system is appreciable. Data are well managed.

This arrangement is logical that helps easy application of analytical tool. Two sources are used to collecting data. These are: Primary Source Secondary Source Primary Source: Face to face conversation with the bank officers and staffs Study of different files of different section of the bank. Un-official discussion with bank official. Secondary Sources: Annual report of NC Bank limited (2009-2013). Website. Literature summery. 1. 6 Limitations of the Study 1. Data Insufficiency 3. Lack of Updated Information.

MINI CASE a. Why is corporate finance important to all managers? Corporate finance is important to all managers because it provides managers the skills needed to identify and select the corporate strategies and individual projects that add value to their firm and forecast the funding requirements of their company and devise strategies for acquiring those funds. b. Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form.

The organizational forms a company might have as it evolves from a start-up to a major corporation are proprietorship, partnership, or corporation. The advantages of a proprietorship are: •Easy and inexpensive to form, •Subject to few government regulations, and •Income not subject to corporate taxation. The disadvantages of a proprietorship are: •May be difficult to obtain the capital needed for growth, •Unlimited personal liability for the businesses’ debts, and •Limited to the life of its founder. The advantages of a partnership are: •Relatively easy to establish, •Increased ability to raise funds, Prospective employees become attracted to the business if given the incentive to become a partner, •May benefit from the combination of complementary skills of two or more people, •Can be cost effective, and •Provide moral support and will allow for more creative brainstorming. The disadvantages of a partnership are: •Partners are jointly and individually liable for the actions of the other partners, •Profits must be shared, •Disagreements can occur, •May have limited life, •Has limitations that keeps it from becoming a large business, •Partners have to consult with each other before making decisions, and •Unlimited liability.

The advantages of a corporation are: •Unlimited life, •Easy transferability of ownership interest, and •Limited liability. The disadvantages of a corporation are: •Earnings may be subject to double taxation, and •Complex and time-consuming set up. c. How do corporations go public and continue to grow? What are agency problems? What is corporate governance? Corporations go public and continue to grow by selling stock to outsiders or venture capitalists, attracting lending from banks or raising additional funds through an initial public offering (IPO) by selling stock to the public at large.

Agency problems are conflicts of interest arising between creditors, shareholders and managers because of differing goals. Corporate governance is the relationship between all the stakeholders in the company. d. What should be the primary objective of managers? The primary objective of managers is stockholder wealth maximization, which means to maximize the fundamental price of the firm’s common stock and not just the current market price. 1)Do firms have any responsibilities to society at large? Yes, firms have responsibilities to society at large.

Corporate social responsibility is operating a business in a manner that accounts for the social and environmental impact created by the business. This means a commitment to developing policies that integrate responsible practices into daily business operations and to reporting on progress made toward implementing these practices. 2)Is stock price maximization good or bad for society? Stock price maximization is good for society. Shareholders are members of society. Consumers benefit when companies develop products and services that consumers want and need, which leads to new technology and new products.

Employees benefit generally when companies successfully increase stock prices, it opens up growth and addition for more employees. 3)Should firms behave ethically? Yes, firms should behave ethically. There is no room for unethical behavior in the business world. Most executives believe that there is a positive correlation between ethics and long-run profitability. Conflicts often arise between profits and ethics. Companies must deal with these conflicts on a regular basis. Failure to handle these situations properly can lead to huge product liability suits and even bankruptcy. e.

What three aspects of cash flows affect the value of any investment? The three aspects of cash flows the affect the value of any investment are the amount of expected cash flows, the timing of the cash flow stream, and the risk of the cash flows. f. What are free cash flows? Free cash flows are the monies available for distribution to all investors after paying current expenses, taxes, and making the investments necessary for growth. g. What is the weighted average cost of capital? The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets. . How do free cash flows and the weighted average cost of capital interact to determine a firm’s value? Free Cash Flow = Sales Revenues – Operating Costs and Taxes – Required Investments in Operating Capital. Weighted Average Cost of Capital (WACC) is affected by market interest rates, market risk aversion, cost of debt, cost of equity, firm’s debt/equity mix, and firm’s business risk. Therefore, free cash flows and the weighted average cost of capital interact to determine a firm’s value by the following equation: Value=FCF1+FCF2+ … +FCF00 (1 + WACC)1(1 + WACC)2(1 + WACC)00 i.

Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers? Households and some foreign governments are the providers (savers) of capital. Non-financial corporation’s net users and U. S. governments are users (borrowers) of capital. Financial corporations are slight users (borrowers), but almost breakeven. Capital is transferred between savers and borrowers by direct transfer, through an investment banking house, or through a financial intermediary. j. What do we call the price that a borrower must pay for debt capital? What is the price of equity capital?

What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? The price that a borrower must pay for debt capital is called the interest rate. The price of equity capital is the cost of equity equals required return equals dividend yield plus capital gains. The four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy are production opportunities, time preferences for consumption, risk, and expected inflation. k. What are some economic conditions (including international aspects) that affect the cost of money?

Some economic conditions (including international aspects) that affect the cost of money are country risk and exchange rate risk. Country risk depends on the country’s economic, political, and social environment. Exchange rate risk is dependent on the non-dollar denominated investment’s value. l. What are financial securities? Describe some financial instruments. Financial securities are pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values. Some financial instruments are: •U. S. Treasury Bills ­Sold by U. S.

Treasury ­Default-free risk ­91 days to one year – original maturity •Money Market Mutual Funds ­Invest in short-term debt; held by businesses and individuals ­Low degree of risk ­No specific maturity (instant liquidity) •Consumer Credit Loans ­Loans by banks/credit unions/finance companies ­Risk is variable ­Original maturity is variable •U. S. Treasury Notes and Bonds ­Issued by U,S, government ­No default risk, but price falls if interest rate rises ­2-30 years – original maturity •Municipal Bonds ­Issued by state and local government to individuals and institutions ­Riskier than U. S. overnment guides, but exempt from most taxes ­Up to 30 years – original maturity m. List some financial institutions. Some financial institutions are commercial banks, investment banks, savings and loan, mutual savings bands, credit unions, life insurance companies, mutual funds, pension funds, and hedge funds and private equity funds. n. What are some different types of markets? Some different types of markets are physical asset markets, financial asset markets, spot markets, future markets, money markets, capital markets, mortgage markets, consumer credit markets, and world, national, regional and local markets. . How are secondary markets organized? Secondary markets are organized by location and the way that orders from buyers and sellers are matched. 1)List some physical location markets and some computer/telephone networks. Some physical locations markets are New York Stock Exchange, the American Stock Exchange (AMEX), the Chicago Board of Trade (CBOT), and the Tokyo Stock Exchange. Some computer/telephone networks are NASDAQ, government bond markets, and foreign exchange markets. 2)Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs).

Auction markets are markets where participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients. The two largest auction markets for stocks are the New York Stock Exchange and the American Stock Exchange. The New York Stock Exchange is a modified auction with a “specialist. ” Dealer markets are markets where “dealers” keep an inventory of the stock (or other financial assets) and place bids and ask “advertisements”, which are prices at which they are willing to buy and sell. There are often many dealers for each stock.

A computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers. Examples of dealer markets are the NASDAQ National Market, NASDAQ Small Cap Market, London SEAQ, and German Neuer Market. networks (ECNs) are computerized systems that match orders from buyers and sellers and automatically execute the transaction. It is a low cost to transact. Examples of ECNs are Instinet (U. S. stocks owned by NASDAQ), Archipelago (U. S. stocks owned by NYSE), Eurex (Swiss-German futures contracts), and SETS (London stocks). p.

Briefly explain mortgage securitization and how it contributed to the global economic crisis. Mortgage securitization is the pooling of various mortgage loans and their usage as collateral to issue securities. This process allows the originator of the mortgage loans to restructure its balance sheet by reducing the receivables and using the funds received from the sale of securities to invest elsewhere. Mortgage securitization allows the originators of the loans to diversify their risk besides enabling them to secure immediate liquidity for assets which would otherwise have face some difficulty in trading. http://www. economywatch. com/finance/high-finance/mortgage-securitization. html) Mortgage securitization contributed to the global economic crisis in many ways. •Homeowners wanted better homes than they could afford. •Mortgage brokers encourage homeowners to take mortgages even though they would reset the payments to amounts that the borrowers might not have been able to afford because the brokers got a commission for closing the deal. •Appraisers were over-appraising house values and getting paid at the time of the appraisal. •Originating institutions (e. . , Countrywide) were quickly selling the mortgages to investment banks and other institutions. •Investment banks created CDOs and got rating agencies to help design and then rate the new CDOs with rating agencies making big profits despite the conflicts of interest. •Financial engineers used unrealistic inputs to generate high values for the CDOs. •Investment banks sold the CDOs to investors and made big profits. •Investors bought the CDOs but either didn’t understand or didn’t care about the risk. •Some investors bought “insurance” via credit default swap. When the mortgages were reset and the borrowers defaulted on them, the values of the CDOs plummeted. •Many of the credit default swaps failed to provide insurance because the counterparty failed. •Many originators and securitizers still owned sub-prime securities, which led to many bankruptcies, government takeovers, and fire sales including New Century, Countrywide, Fannie Mae, Freddie Mac, and many more. PROBLEMS (2-6)In its most recent financial statements, Newhouse, Inc. reported $50 million of net income and $810 million of retained earnings.

The previous retained earnings were $780 million. How much in dividends was paid to shareholders during the year? Dividends Paid= (Previous Retained Earnings + Net Income) – Recent Retained Earnings = ($780 million + $50 million) – $810 million = $830 million – $810 million = $20 million (2-7)The Talley Corporation had a taxable income of $365,000 from operations after all operating costs but before (1) interest charges of $50,000, (2) dividends received of $15,000, (3) dividends paid of $25,000, and (4) income taxes.

What are the firm’s income tax liability and its after-tax income? What are the company’s marginal and average tax rates on taxable income? Taxable Income$365,000 Less: Interest Charges(50,000) Plus: Dividends Received4,500? $15,000(1 – 0. 70) = $4,500 Total Taxable Income$319,500 Tax Liability= $22,250 + ($319,500 – $100,000)(0. 39) = $22,250 + ($219,500)(0. 39) = $22,250 + $85,605 = $107,855 After-Tax Income: Total Taxable Income$319,500 Less: Tax Liability(107,855) Plus: Non-taxable Dividends Received10,500? 15,000(0. 70) = $10,500 Net Income$222,145 Marginal Tax Rate = 39% Average Tax Rate= Tax Interest Income/Taxable Operating Income = $107,855/$319,500 = 0. 33757 or 33. 76% (2-9)The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds, which yield 7. 5%, state of Florida muni bonds, which yield 5% (but are not taxable), and AT&T preferred stock, with a dividend yield of 6%. Shrieve’s corporate tax rate is 35%, and 70% of the dividends received are tax exempt.

Find the after-tax rates of return on all three securities. AT&T Bonds – $10,000 x 7. 5% = $750 Taxes = $750 x 35% = $262. 50 $750 – $262. 50 = $487. 50 AT&T Bond Yield = $487. 50/$10,000 = 0. 04875 or 4. 875% AT&T Preferred Stock – $10,000 x 6% = $600 Tax Exemption = $600 x 70% = $420 Taxable Income = $600 – $420 = $180 Taxes = $180 x 35% = $63 $600 – $63 = $537 AT&T Preferred Stock Yield = $537/$10,000 = 0. 0537 or 5. 37% Florida Muni Bonds – $10,000 x 5% = $500 Not taxable, so no tax deductions Florida Muni Bonds Yield = $500/$10,000 = 0. 05 or 5%

Asset Transformation Purchase primary securities by selling financial claims (secondary securities) to households Secondary securities are more marketable BECAUSE Less information asymmetry Less monitoring costs More liquid Less risky Without financial intermediaries, households will find direct investments in corporate securities unattractive due to information/monitoring costs, liquidity cost and price risk.

Thus flow was funds are less, little monitoring and risk of investments would increase.

Specializes of financial institutions General areas (LIP TM) Liquidity services Information services Price- risk reduction services Transaction cost services Maturity intermediation services Institution- specific (McCall) Money supply transmission Credit allocation Denomination intermediation Intergenerational transfers Payment services Information costs Agency costs 0 costs relating to the risk that firm owners and managers use savers’ ends not in the best interest of the savers Financial institutions collect funds from households in order to avoid free- rider problem (incentive for information collection and monitoring), reduce costs of information collection and monitoring and to develop new secondary securities to more effectively monitor borrows.

Liquidity and price risk Financial intermediaries provide secondary claims to household savers – high liquidity and low price risk and invest in these illiquid and risky sectors Advantage of financial institutions managing liquidity and price risk Diversification (due to size of funds) Development of better risk management techniques Disadvantage of delegated institutions Intermediary services are not free Agency issues Risk management Monitoring financial institutions Other special services Reduced Transaction Cost, I. E. Economies of scale Maturity Intermediation 0 Ability to bear the risk of mismatched maturities of assets and liabilities.

Credit Allocation (Depository Flu) – Financial intermediaries are the major source of finance in particular sectors of an economy: residential real estate (US and UK), farming (Australia) . Intergenerational Wealth Transfer or Time Intermediation (life insurance, superannuation and pension funds) Payment Services – IFS provide efficient payment services to the society. Denomination Intermediation – Give individuals indirect access to large denomination markets (Money market managed funds, Debt-equity managed funds, Unit trusts) The Transmission of Monetary Policy (Banks) Financial intermediaries are widely used medium of exchange in the economy.

Intermediaries’ liabilities play significant role in the transmission of monetary policy Money supply in Australia (Don’t need to know these term 0) MI : currency + bank rent deposits by private non-bank sector MM: currency + all bank deposits by private non-bank sector Broad money: MM + net borrowing of Non-bank IFS from private sector Specializes and Regulation Financial institutions receive special regulatory attention Negative externalities caused by IFS is costly to households and firms using financial services Special services provided by IFS Institution- specific functions Example: money supply transmission, credit allocations, payment services Australian Regulation System The traditional industry- based regulation entailed separate regulators for individual industry sectors – banking, insurance and security firms. Asses 0 Australia’s current financial regulatory framework originated from ‘Financial System Enquiry (Wallis Committee), Australia switched from industry-based regulation to function- based regulation. This introduced 3 regulatory agencies, each in charge of specific functional responsibilities. This reform was necessary as the distinction between the activities of different types of financial institutions was becoming more vague and also because of the overlap in regulation and grey areas.

Reserve Bank of Australia (ARAB) 0 Responsible for the development and implementation of monetary policy and for overall financial system stability Australian Prudential Regulation Commission (PARA) 0 Responsible for the prudential regulation and supervision of the financial services industry Regulation of deposit- taking institutions Life and general insurance Superannuation Australian Securities and Investments Commission (ASIA) 0 Responsible for market integrity, consumer protection across the financial system and ensures equal and fair access to financial services. Protects against abuses (example: insider trading), lack of disclosure, malfeasance, breach of fiduciary responsibility.

Major types of regulation(Scale) Safety and soundness regulation Consumer protection regulation Credit allocation regulation Investor protection regulation Monetary policy regulation Entry and chartering regulation 1. Risk reduction Encouragement for intermediaries to diversify assets Disclosure of large credit exposure 2. Minimum capital requirements 3. Safety valve Central banks’ open market operations to provide exchange settlement fund 4. Monitoring and surveillance The ARAB directly controls outside money and the bulk of the money supply is inside money (deposits). Regulators commonly impose a minimum level of cash reserves to be held against deposits. Cash reserves add to intermediaries’ net regulatory burden. There is no explicit liquidly requirement in Australia but Flu’ liquidity management policy need to be approved by PARA.

Supports lending to socially important sector Example: US’ Qualified Thrift Lender test (QUIT) set a minimum amount of loans made to residential mortgages to quality as Thrift Entry Regulation Regulations define scope of permitted activities under a given charter Increasing/ Decreasing entry barriers affect profitability of existing competitors. High direct/ indirect entry costs result in larger profits for existing companies Future of Regulation Implications of SGF questioned – more regulations or more efficient regulations The major provisions include expanding and centralizing powers for Federal agencies, more restrictions and disclosures about risk taking activities by financial institutions and enhancing protection of investors and consumers. The changing dynamics of specializes Potential secular trend away from intermediation by investing directly in primary securities Decline in the relative cost of direct securities investment Growing sophistication of investors

Falling costs of information acquisition and transaction Credit Risk: Individual Loan Risk Types of loans 1. Commercial and industrial loans Short term (1 year) – financing the purchase of real assets, new venture start up costs Syndicated loans 0 financing provided by a group of lenders, usually to finance large commercial and industrial loans Secured/Unsecured loans Fixed/Floating rate Spot loan 0 borrower takes down the entire loan amount immediately Loan commitment 0 can taken down anytime any amount, as long as within a maximum loan amount and a maximum period of time predetermined Commercial paper 0 unsecured short- term debt instrument 2. Real estate loans 3. Individual (consumer) loans 4.

Other loans, such as, government loans, farms loans Calculating the gross return on a loan Factors affecting the promise loan return Loan interest rate = Base/Prime lending rate (BRB) + Credit risk premium (m) Direct fees (f), such as loan origination fee Indirect feeds, such as, compensating balance requirement (b), reserve requirement Credit Risk and the Expected Return on a Loan 1 -p = probability of default 0

MAYBE there is a negative relationship between k and p, however k and p are not independent. As return (k) increases, the probability (p) that the borrower pays the promised return may decrease. Simply increasing k does not lead to a higher return (r). As a result, IFS usually have to control for credit risk – price/promised return and the quantity or credit availability dimensions. Retails Loans Size = Small Higher cost associated with collection of borrower’s personal credit information Control credit risk through credit rationing – limit the total exposure/amount loaned Wholesale Loans Different interest rates to compensate for different levels of risks Credit rationing to limit credit exposure Measuring credit risk 1.

Qualitative credit risk models Borrower- specific factors Example: reputation, leverage, volatility of earnings, collateral Market- specific factors Example: business cycle, level of interest rate 2. Credit scoring models Calculate a score as a proxy of borrower’s default probability Sort borrowers into efferent default classes The scoring model should establish factors the help explain default risk and evaluate the relative importance of these factors Major models 1. Linear probability model 1 if default, otherwise Weakness: the estimated default probability Z may lie outside of [0,1] Employing linear probability model is not often used as superior statistical 2.

Logic model Overcomes weakness of the linear probability model using a transformation that restricts the probability to the [0,1] interval 3. Linear discriminate models Altar’s Z score model for manufacturing firms Z 2. 9, highly quality loans, low default risk Z < 1. 81, very low quality loans, high default risk 1. 81 2. 99, hybrid Weaknesses Ignore hard-to-quantify factors Variables and weights in a credit scoring model are unlikely to be constant over long periods of time No centralised database on defaulted business loans for proprietary or other reasons – hard to test the validity of any model/develop new models Broad difference between bad and good borrowers 3.

Term structure based methods Under market equilibrium, expected return of a risky loan = risk- free rate (after accounting for probability of default (1 -p)) Assuming a zero default recovery rate 0 p(l+k) = 1+1 p: probability of repayment k: return on the corporate debt I: expect return on the risk- free treasury security Example: What is the default probability for a one- year corporate bond? 10% expected return on the risk- free treasury bond k= 15. 8% expected return on the risky corporate debt p = 0. 95 Therefore the probability of default is 0. 05 Realistically, the Fl lender can expect to receive some partial repayment even if the borrower becomes bankrupt. Alton and Ban estimated that when firms defaulted on their bonds in 2002, the investor loses 74. % on average. = recovery rate when default occurs (1 – p) y (1 + k) = payoff to Fl when default occur p (1 + k) = payoff when no default Marginal default probability 0 probability that a bond will default in any given year t Conditional on the fact that the default has not occurred earlier = Marginal probability of default in individual periods Example: 2-period bond Default probability in period 1 Marginal default probability in period 2 Cumulative probability of default over 2 periods We can extract from these yield curves the market’s expectations of the multi- period default rates for corporate borrowers Example: Yield Yield Year 1 Year 2 T- Bonds Corporate Bonds 15. 8% One year forward rate on risk- free T-bonds One- year forward rate on corporate bonds 0 The expect probability of default in year 2 0 4.

Mortality rate models Marginal mortality rate (MR.) Forward- looking 0 extract expected default rates from the current term structure of interest rates Backward looking 0 analyses the historic or past default risk experience, the mortality rates, of bonds and loans of a similar quality Non- default probability in year 1 the probability of the loan surviving in the 2nd year given that default has not occurred during the firs year, I. E. Prop(default in year 2 | survive yearly) Cumulative mortality rate (CM) Cumulative probability of default MR. is based on historic or backward-looking data, and it is highly sensitive to the period over which the Fl calculates the Mars. 5. RAZOR models It is based on market data.

ROAR concept – balanced expected interest income against expected loan risk Loan approval 0 RAZOR > benchmark return on capital, example: return on equity One year net income on a loan 0 (spread + fees) * dollar value of loans outstanding Loan risk 0 duration or loan default rate Method 1: Use Duration to estimate loan risk The percentage change in the market value of an asset such as a loan is related to the duration of the loan and the size of the interest rate shock Capital at risk (Vary approach) 0 the potential loan Los under adverse credit scenarios 0 Increase in risk premium under adverse credit scenarios Example: Suppose we want to evaluate the credit risk off $1 million loan with duration of 2.

The rise of the ‘bubble’ economy during the second half of the 1980s was characterized by a speculative boom in asset prices and its eventual collapse at the beginning of the nineties proved to be detrimental to Japan’s financial and business sectors. The aftermath of the ‘bubble’, including the severe banking crisis, caused the monetary authorities to introduce important administrative and financial reforms. This paper rounds up the reasons behind the rise of the so-called ‘bubble economy’, why Japan was not able to sustain the ‘bubble’ and how it affected the downturn of the economy in Japan after the bubble burst. The conclusion about the bubble and its burst have revealed fundamental problems in Japan’s economic and financial system. Japan’s financial bureaucrats blindly ignored the obvious collapse of the bubble, simply because they had already decided to pursue fiscal austerity.

The stagnation of the Japanese economy is due to an exceptionally long-term shortage of aggregate demand. Apart from the lessons learned about the financial deterioration that the bubble economy had brought up, it is important to consider the roots of how the rise and fall of the bubble economy grew in Japan to avoid committing the same mistakes that almost threatened Japan’s economic security. Introduction Below par performance of the economy, an annual growth rate of Gross Domestic Product (GDP) nailed at 0. 5 percent and some ridiculously high rates of bankruptcies. This was the characteristics of a strange phenomenon in Japan’s financial sector from 1991 to 1999. After steady catch-up for 35 years rising from the ashes of the World War II, Japan’s economy did not only stop catching up, but lost ground relative to its potential to become an industrial leader around the world. Everything just slowed down in the late 1990s after enjoying a short p of a bubble economy. Do you know that 

Government Can Sometimes Improve Market Outcomes?

In the wake of the economic conflicts between Japan and the USA and Europe in the 1980s, the growth of East Asia as a market as well as a production platform, and the general rise in the value of the yen during the past decade, which has made investments in neighboring countries especially attractive, many Japanese businesses have forged ahead with strategic investments in the three core regions of the global economy. Read what to do when inflation is skyrocketing, and prices are out of control. What are banks most likely to ask the federal reserve to do with regards to government bonds and reserve requirements.

The major boost in Japanese foreign direct investment (FDI) following the Plaza Accord of 1985 reached a peak in 1989, at the height of the Japanese bubble economy, and then fell back in the early 1990s after the bursting of the bubble (Harukiyo & Hook, 1998, p. 25). The rise of the ‘bubble’ economy during the second half of the eighties, which was characterized by a speculative boom in asset prices, and its collapse at the beginning of the nineties. The aftermath of the ‘bubble’, including the severe banking crisis, caused the monetary authorities to introduce important administrative and financial reforms.

But, what were the reasons behind the rise of the so-called ‘bubble economy’ that occurred in Japan during the 1980s? Why was Japan not able to sustain the ‘bubble’ that it suddenly burst in the late 1980s? What was the effect of the downturn of the economy in Japan after the bubble burst? The Definition and the Cause of the Bubble Economy What is the Bubble Economy? Harukiyo & Hook (1998) acknowledged that the ‘bubble economy’ is a metaphor used to refer to the hyperinflation of Japanese assets (e. g. stocks and shares, land and property) starting in the mid-1980s and the collapse of asset prices in the 1990s. Prices expanded in the mid-1980s, as in a bubble forming, and collapsed in the 1990s, as in a bubble being pricked. Experiencing an impressive economic growth between 1960 and 1985, Japan led a skyrocketing economy that was beyond their expectations. Japan experienced a strong surge in asset prices during the eighties, in particular in the second half. The Nikkei 225 stock-index rose from a level of 13,000 at the end of 1985 to a maximum of 38,915 on the last trading day of 1989.

During the 1985–1990 period, property prices surged, rising on average by 22% compared with a year earlier; in 1989 it was calculated that the property value of metropolitan Tokyo exceeded the value of the entire United States (Werner 1992, p. 22). This situation of excessive asset price inflation gave rise to the terminology of the ‘bubble’ economy. The Cause Van Rixtel (2002) generally believed that the following factors were behind the surge in asset prices: Increased Competition, More Regulation.

The process of financial reform increased competition not only among banks but between banks and other private financial institutions such as securities companies and insurance companies as well. The increased competition put heavy pressure on the banks’ profit margins. As a result, banks started to look for more profitable, less traditional, but riskier projects: they expanded their lending to real estate and construction companies and non-bank financial institutions such as consumer credit institutions and leasing companies.

Because of existing regulations, these institutions were virtually denied access to the open financial markets, and therefore relied heavily on bank credit (Takeda and Turner 1992, p. 61). The figures show this development clearly: according to Nakajima and Taguchi (1995), p. 59, “between 1985 and 1992, bank loans to the real estate industry grew 13. 7 percent annually, compared with 6. 6 percent for total bank lending, and the share of such loans in total bank lending rose from 7. 5 percent in 1985 to 12. 1 percent in 1992”. In addition, lending to “non-banks” also grew rapidly, from 10. 4 percent to 14. 0 percent of total bank lending. It has to be mentioned that a number of these institutions were established by the banks themselves or were members of the same keiretsu or industrial grouping, thereby increasing the exposure of banks to these risky sectors. Furthermore, Japanese banks extended considerable amounts of credit to the corporate sector for investment in stocks and other financial assets.

This development of financial investments by non-financial private companies was called ‘financial engineering’ (zaitech or zaiteku), which means, literally, know-how in the management of financial assets (Hsu 1994, p. 406). For many non-financial firms, this became a major profit-generating activity. In addition, lending by so-called housing loan companies or jusen, which had been established at the end of the seventies under the guidance of the Ministry of Finance (MoF) and often in affiliation with large banks, grew rapidly (Rosenbluth and Thies, 1999).

In the end, Japan experienced a rather classic credit-induced real estate boom and financial assets’ bubble, fuelled by a vicious spiral of rising asset prices, higher collateral value and increasing bank credit. This development was certainly not a unique Japanese experience, but occurred in a significant number of other developed and developing countries as well. Existence of Informal Policy Instruments and Networks. An important explanation of the creation of the ‘bubble’ is related to the use of informal policy instruments and the existence of informal networks between the monetary authorities and banks.

In general, the use of the former often turned out not to be effective, and the existence of the latter on numerous occasions prevented the use of prudent and stringent measures. For example, as will be asserted in this chapter, MoF’s administrative guidance regarding the jusen’s lending policy was not very effective, most likely owing to a combination of political factors and the large presence of MoF retirees on their boards. Also the informal guidance of bank lending by the Bank of Japan (BoJ), the so-called ‘window guidance’ (madoguchi shido), proved to be ineffective and was even abolished in 1991.

Steady Control of Short-Term Financial Markets

In personal interviews former staff members from the MoF and BoJ noted that one of the reasons for the rise of the ‘bubble’ could lie in the fact that the BoJ was in control of the short-term financial markets, but that the capital markets were mainly the domain of the MoF, and that coordination between the two was less than perfect. As a matter of fact, the MoF used several and predominantly informal macro monetary policy instruments that primarily affect capital market developments, sometimes contrary to the policy objectives of the BoJ.

Furthermore, arbitrage deficiencies between money market and capital market interest rates and the existence of the ‘dual interest rate structure’ hampered the pass-through of changes in policy rates to long-term interest rates. Protracted Easing of Macro Monetary Policy. The ‘bubble’ was fuelled by the accommodative stance of Japanese macro monetary policy, partly caused by international exchange rate considerations and related pressure from the MoF (Hamada 1995, p. 277).

This protracted monetary easing has been more or less acknowledged by the BoJ in its monthly report (Nippon Ginko Geppo) of April 1990, which has been interpreted as a self-critique of the Bank’s policy stance during 1987–1989, and later in several other publications as well (Ito 1992, p. 48). The Louvre Accord of February 1987 aimed to stabilize the dollar and prevent a further depreciation against other major currencies. Consequently, the BoJ eased its policies: in February the official discount rate was reduced to an (at that time) historic low of 2. 5%. It remained at that level until the end of May 1989.

The low-interest-rate policy resulted in the creation of excess liquidity, and enabled the banking industry to keep the asset price boom going. In addition, the position of the BoJ was further complicated by the fact that the MoF was unwilling to boost public spending given its concern for the budgetary situation, so the BoJ had to provide the economic stimulation (Ueda 2000, p. 18). The accommodative policy stance during the middle and latter half of the eighties is clearly reflected in the high yearly monetary growth rates, which depicts the sharp increase in the Nikkei 225 stock index during the ‘bubble’ years.

Laxity of BoJ and MoF officials. During the creation of the ‘bubble’, Satoshi Sumita, a former high-ranking MoF official, was serving as Governor of the BoJ. Since the early seventies – and until the appointment of Mr. Masaru Hayami in April 1998 – the positions of Governor and Senior Deputy-Governor of the BoJ have been filled alternately by BoJ and former MoF top executives (in the case of the MoF, a former Administrative Vice-Minister). Furthermore, one retired MoF official occupied one of the BoJ’s executive director positions, and another retired MoF official was employed as Executive Auditor.

The presence of these retired MoF officials in the highest executive positions of the BoJ, predominantly the consequence of MoF’s need to find post-retirement positions for its staff in the private sector (amakudari), could have been instrumental in the implementation of the relatively loose monetary policy stance during this period. As pressures of inflation threatened to supersede, the BoJ changed its policy stance and began to tighten its policy in May 1989. This changed partially triggered the start of the collapse of the ‘bubble’.

After some delay, the rise in interest rates deflated the value of assets such as land, real estate and stocks. According to Takeda and Turner (1992), the asset prices came down sharply. From its peak of around 39,000 in 1989, the Nikkei 225 dropped to the 14,000 range in August 1992; a similar development took place in real estate and land prices. Hamada (1995) explained that the bursting of the ‘bubble’ initiated severe problems for the Japanese banking industry.

Significant number of real estate companies and other non-banks found it increasingly difficult to service loans. Furthermore, the decline of asset prices diminished the value of the collateral of extended loans, in many cases below those of the loans they secured. Consequently, banks became saddled with non-performing loans, classified by the MoF as loans on which interest had not been paid for six months or more. The collapse of the ‘bubble’ and the subsequent deflation of asset prices caused problems in meeting the BIS solvency requirements.

According to the 1988 Basle Accord, international operating banks would, by the end of 1992, have to meet a capital to weighted assets ratio of 8%. The MoF interpreted this date as the end of Fiscal Year 1992, i. e. the end of March 1993. The capital taken into consideration consisted of core or Tier I capital, that is equity and disclosed reserves, and supplementary or Tier II capital, i. e. subordinated debt and revaluation reserves. In the case of Japan, up to 45% of banks’ latent gains on securities holdings were allowed to be counted as Tier II capital.

According to the Anti-Monopoly Law, Japanese banks were allowed to hold up to 5% of the equity of a single firm. Given the rise in share prices during the ‘bubble’ period, these cross-shareholdings embodied substantial revaluation reserves, and consequently the unrealized gains on these securities holdings were included in Tier II capital (Frankel and Morgan 1992, p. 588). Naturally, the burst of the ‘bubble’ and the unbelievable drop in stock prices eroded this part of Japanese banks’ Tier II capital, causing concern among Japanese and international supervisory authorities.

The erosion of the revaluation reserves of the major Japanese banks at the beginning of the nineties clearly showed a sharp decline. From 1991 to 1992 the reservation reserves were halved, resulting in a significant worsening of the solvency position of the Japanese banking sector. The rise in the issue of subordinated debt was also observed in this period, which was issued to compensate for the decline in Tier II capital that resulted from the decline in revaluation reserves.

The mistake clearly stood on the attempt to over-expand the economy and blatant misallocation of the capital. The Aftermath of the Burst Bubble As a result of the collapse of the bubble economy, the 1990s were detrimental for Japan, where it attained a measly average annual growth in real GDP of less than 1 percent from 1992 through 2002 and zero growth projected until 2004. High levels of corporate debt and stagnant domestic demand resulted in record numbers of bankruptcies, reaching 19,565 in 2001 and including 14 listed companies.

Losses associated with these bankruptcies also reached record levels, rising from 9 trillion yen in liabilities in 1995 to 21 trillion yen in 2000—a figure inflated by the failure of two major life insurance companies—and over 16 trillion yen in 2001. Moreover, unemployment increased every year from 1990 and 2002, rising from 2. 1 percent of the work force to 5. 3 percent. The proportion of the total unemployed who had been without a job for more than one year increased from 15 percent to 26 percent between 1993 and 2001.

The government’s fiscal budget declined from a 1. 5 percent surplus in 1992 to a 9. 2 percent deficit in 2000, and Japan’s public debt is the highest among the OECD nations (over 100 percent of GDP in 2002). Japan suffered from sustained deflation during the end of the 1990s and beginning of the 21st century, with the largest declines occurring in the investment goods sectors. Land prices declined at double-digit rates in the late 1990s but by only 9 percent in 2000. In 2001, consumer prices registered their largest decline since Second World War.

According to Ball (2004), the declining terms of trade after the collapse of the bubble economy have caused many Japanese firms to move investment overseas, particularly to low cost countries such as China, producing declining or negative trade balances with countries in recent years. Furthermore, Ball listed several conditions brought about by the collapse bubble economy: Declining Ranking on Competitiveness. The experiences of the 1990s and early 2000s have had a negative impact on the competitiveness ranking of Japan.

In the Global Competitiveness Report, Japan’s ranking declined from 13 to 21 between 1996 and 2002. The World Competitiveness Scorecard suggested an even greater decline in Japan’s relative competitiveness, from 3 to 30 between 1994 and 2002. Although Japanese multinationals have received great praise for their operational efficiency and Japan’s educational system has produced students who perform near the top in world comparisons, Japanese business has encountered problems in recent years.

Average annual growth in Japanese manufacturing productivity declined from 3. 9 percent in the 1980s to 2. 2 percent in the 1990s, compared to a rise in the United States from 3. 9 percent to 4. 1 percent, respectively. Annual growth in total factor productivity in the Japanese business sector was approximately 0. 75 percent during the 1990s, about 50 percent of the rate in the 1980s (Callen ; Nagaoka, 2001). Productivity levels among Japanese manufacturing exporters, including steel, auto, consumer electronics, and machine tools, exceed their U. S. counterparts by about 20 percent, but productivity in the domestic Japanese manufacturing and service sectors is approximately 68 percent of that in the United States (IMF Country Report, December 2001). Declining Investment in R;D. Japan ranks at the top in terms of international innovativeness (Porter ; Stern, 1999). Indeed, many Japanese companies invested heavily in R;D during the 1990s and early 2000s despite the overall economic problems in Japan, and they have established strong international positions as a result of their innovativeness.

Historically, Japan’s expenditures on R;D as a percentage of GDP have been the highest of any of the major world economies. Japanese investment in R;D has declined substantially since the early 1990s, however, and the proportion of GDP invested in R;D in the period 1993–1997 was lower in Japan than it was in the United States, France, and Germany. Barriers to Innovation and Entrepreneurship. The formation of new businesses has an important role in economic growth, exploitation of new ideas for innovative products and services, and efficient utilization of labor and other resources.

By international standards, Japan has low levels of new business formation. Japan ranked 20th in the Economic Creativity Index 2000 and was the lowest ranked among the top 25 nations in terms of the start-up index, a reflection of the substantial barriers to entrepreneurial initiative in Japan. Constraints on new business formation did not hinder the high rates of growth experienced in Japan until the late 1980s, since opportunities for technological catch-up and the opening of new export markets allowed for high rates of expansion by existing firms.

However, changes since the late 1980s have raised questions about the ability of large, traditional Japanese firms to develop the structural flexibility and entrepreneurial skills needed to generate growth in sales and employment. According to the Japan External Trade Organization, establishing a manufacturing facility is from 5 to 11 times more costly in Japan than it is in nations such as the United States, Germany, France, and the United Kingdom and even more costly than it is in the Asian NICs and NIEs (JETRO, 2000).

Limited Penetration of Information and Communication Technology

Although Japan represents an important source for developing ICT products and a lead market for many advanced cellular communication technologies, there is much room for improvement in the role of ICT. On most measures, the use of ICT in Japan exceeds that of the overall European region but is lower than that in the United States, U. K. , and Australia. Internet penetration and access to PCs among consumers, the educational use of the Internet, and the use of electronic commerce in Japan are considerably below those in the United States and other leading nations (Callen ; Nagaoka, 2001). In comparison, 40. 4 percent of the Japanese population had access to the Internet in 2002, versus 59. 1 percent for the United States. Most of Japan’s Internet is built on ordinary voice lines, with limited penetration of high-speed internet connection services.

In the business sector, a 2001 METI survey found that ICT investments in Japan tend to be focused on improved efficiency within existing operations and transactions, rather than oriented toward more far-reaching changes in corporate structure and operations. Comfort and familiarity of Japanese executives with the Internet was reported at 15 percent, compared to 64 percent among U. S. executives (Callen ; Nagaoka, 2001). Declining Role in Foreign Direct Investment. After the liberalization of capital controls in the early 1980s, Japan emerged as an important source of FDI, surging in the second half of that decade to nearly $50 billion in 1990. The growth in FDI reflected both strong economic growth in Japan and abroad as well as rapid appreciation of the yen, which encouraged Japanese firms to relocate production abroad to maintain cost competitiveness (Callen ; McKibben, 2001). Initially, much of the capital was directed to the United States, especially within real estate, service, finance, and insurance sectors.

This was followed by a dramatic increase in the level of investment going to emerging Asian markets, with a focus on industrial sectors. From 1987 to 1989, Japan accounted for over 40 percent of FDI into Korea and Thailand, and over 30 percent into Taiwan. The sharp decline in Japanese asset prices in the first half of the 1990s, combined with a slowdown in growth and the emergence of serious debt problems among businesses, yielded a substantial slowdown in FDI in the first half of the 1990s (IMF Country Report, December 2001).

Regulations and Restructuring

Despite continued pressure to promote restructuring and deregulation, relatively limited progress was achieved by the Japanese in the 1980s and early 1990s. Notably, the keiretsu continued to exercise strong influence, the financial sector was insulated from international competitiveness, and inefficient, often corrupt practices characterized many public works projects. In a cultural setting that did not allow for corporate or bank failure, problems were only papered over, not resolved, which prolonged the post–bubble economy crisis and permitted a chronic lack of confidence to settle in the business sector.

What the Japanese Government Do to Remedy the Situation

The extreme pressure of the sustained economic downfall caused by the collapse of the bubble economy did not disappear on its own. The Japanese government recently concerted its efforts to promote a number of institutional changes. To restructure the business sector, more than $1 trillion in bad loans, a situation exacerbated by sharp declines in the stock market that raise further concerns about the adequacy of banks’ capitalization, the Japanese government restructured the banking sector.

Changes include a number of mergers and sales of previously bankrupt banks and consolidation among the major banking conglomerates, although this sector continues to be plagued by nonperforming loans and weak balance sheets. In reaction, the Japanese government pumped more than $25 billion each year into public-works projects to generate economic activity. Then, to cut government spending, it raised the age for receiving national pension benefits from 60 to 62, and eventually to 65. The number of government ministries was cut to 13 from 22 to reduce redundancies.

Prime Minister Junichiro Koizumi, who enjoys the highest approval ratings of any Japanese leader since World War II, is trying to achieve structural reform, including the privatization of the post-office system, which handles mail and acts as a government savings bank. Mr. Koizumi also has promised an annual government bond issuance cap of 30 trillion yen (about $250 billion) from fiscal 2001, but the spending might exceed the amount with sudden uncontrollable expenditures like the deployment of the Japanese Self-Defense Forces to support the U. S. -led war against terrorism in Afghanistan (Tsukimori, 2001, p. 16). Significant performance problems among life insurance firms, and the failure of a string of mid-sized insurance companies, have also raised concerns about that sector and its need for restructuring. Five of Japan’s the initial 7 major insurance companies that failed were taken over by major foreign companies, along with 3 smaller insurance companies. Thus, all of the government’s efforts were collectively called the “Big Bang” restructuring of Japan’s financial sector after 1997.

This has resulted in a continuing surge of entry by foreign financial institutions from the United States and Europe (Ball, 2004). With his onerous yet insightful analysis of all the events that transpired, Tokyo University Economics Professor Hiroshi Yoshikawa comprehensively explains in his book Japan’s Lost Decade (2001) how the world’s second largest economy has stagnated in the 1990s and the difficult choices Japan confronted at this crucial moment of transition. After the collapse of the “bubble economy” of the late 1980s, the 1990’s ushered in with a bleary phenomenon tagged as the Japan’s “lost decade”.

Since this has been one of the most extraordinary economic phenomena, no other country has moved so quickly from the top to the bottom of the world’s economic growth league. What could be the possible causes of the long stagnation of Japan during the 1990s? Since the bubble burst, economists have focused on the financial problems. A fall in asset prices allegedly had the negative wealth effect on household consumption. Through deterioration of collateral, it also hurt investment of small firms. And banks suffering from bad loans became reluctant to make new loans (kashi-shiburi), and further depressed investment.

Three factors have been pointed out to be the main causes of the “lost decade”, namely, the structural decline in labor input growth (Yoshikawa described the labor market in the “ice age”), slowdown of the total factor productivity (TFP) growth and the scarcity of demand. In addition, the characteristics of the early stages of Japan’s “bubble economy” saw the rise in land prices, the rates of increases differed greatly depending upon the land use (commercial, residential or industrial) and the location (major population centers such as Tokyo, or elsewhere).

In other words, land prices were driven up because of increasingly brisk investment in land by companies, particularly by medium-sized and small non-manufacturing firms, due to rises in expected rates of returns from land in commercial areas in Tokyo, and partly because of erroneous measures implemented by the government, and were not closely related to interest rates. These companies bought up land using funds borrowed from banks, so after the collapse of the bubble economy, their financial state deteriorated drastically and the loans became bad debts.

By providing an overview of the Japanese economy, Yoshikawa elaborated the extremely poor performance of corporate investment is the most important factor to explain the long stagnation of the Japanese economy during the 1990’s. Another question that we could draw out in the book is why investment stagnated during that time. The popular answer is a credit crunch caused by bad loans banks hold. There is a good consensus that the effect of credit crunch is much more serious on investment of small firms than that of large firms because large firms have better access to capital markets.

On the other hand, much controversy is bared as two groups have differing views on the real causes of the “lost decade. ” A group of scholars attributes the disappointing performance to a lack of effective demand and a liquidity trap caused by deflation, while another group points out that there are several important supply-side factors, which reduced Japan’s economic growth. For example, Japan’s aging population and a gradual reduction in the statutory work-week have contributed to a slowdown in the growth of labor input.

Japan also experienced a decline in total factor productivity (TFP), which has important effects on economic growth not only because it reduces output growth by itself but also because it diminishes the rate of return to capital and discourages private investment (Motonishi and Yoshikawa, 1991). Although there are as many different estimates for Japan’s recent TFP growth as there are studies on this issue, most economists seem to agree that Japan’s TFP growth substantially declined in the 1990s.

Probably the most popular explanation of Japan’s TFP growth slowdown is the “zombie” hypothesis. This states that in order to conceal their bad loans, Japanese banks have been keeping alive money-losing large borrowers by “evergreening” loans and discounting lending rates, although the chance that these borrowers will recover is slim (Caballero, Hoshi and Kashyap 2004). Because of the existence of zombie firms, the entry and growth of more productive firms are impeded and TFP growth slows down in industries infested by zombies (Ahearne and Shinada 2004). Japanese banks’ bad loans are concentrated in non-manufacturing sectors, such as real estate, construction, commerce, and services, since a major cause of the bad loans is the burst of the land price bubble in the early 1990s. The effects of the real factor on investment are much more significant than those of the financial factor. In particular, a fall of investment during 1992 to 1994 was basically caused by worsening real profitability; during the same period, financial factor was supportive.

However, beginning 1997 amid recession, the credit crunch finally occurred. Based on Yoshikawa’s investment equations, the estimates of the effects of the credit crunch on investment as a whole. Conclusion If the circumstances in Japan’s “lost decade” or the bursting of the ‘bubble’ are viewed from the aspect of the macroeconomics, the parties selling land to companies at inflated prices during the bubble economy were households. Therefore, households realized huge capital gains by selling land to companies at high prices.

A more detailed investigation into the capital gains made by households revealed that during the bubble economy a very limited number of households with high income realized huge capital gains, while most households saw little rise in their assets. The enormous gains realized by very few households were deposited and did not lead to effective demand. Japan’s magnificent liquidity machine for the financing of its “total war” economic mobilization achieved its aim, and then, unchecked, went on to drown Japan and the world in excess savings.

The system was destroyed by its own processes. All the elements of the 1940 structure are, by design or by default, now coming undone. The revisions to the Bank of Japan Law, while thoroughly inadequate, will give the central bank more independence to run monetary policy in the best interests of balanced economic growth rather than a frenetic economic mobilization. Most of Japan’s commercial banks came under extreme duress and many failures were realized (Hartcher, 1998). Thus, the collapse of the system should not come as a surprise to the finance bureaucracy. Prior to that phenomenon, Dr. Sakakibara in 1977 already warned that the financial system had “at last begun to disintegrate”, and understood that “monetary and fiscal controls cannot work where a strong demand for investment does not exist. ” Or, in other words, where there is too much saving and not enough investment.

And it was Sakakibara and Noguchi, who likened the postwar economy of Japan to a bicycle: “Unless one pedals fast enough, there is a danger the bicycle will fall over. ” The high-growth postwar economy, the “1940 system” catch-up model, was, they wrote, “a contradictory and unstable structure that could only be sustained by continued growth”(Sakakibara and Noguchi, 1977). The bubble and its burst have revealed fundamental problems in Japan’s economic and financial system. Japan’s financial bureaucrats blindly ignored the obvious collapse of the bubble for well over a year, simply because they had already decided to pursue fiscal austerity. The stagnation of the Japanese economy is due to an exceptionally long-term shortage of aggregate demand. As Japanese firms currently strive to sustain their competitive advantage in their superior ability, the collapse of the “bubble economy” should just be viewed as a thing of the past.