Does Japan Want Real Banks or Not?

A stroll through Bank of Tokyo-Mitsubishi UFJ, one of Japan's megabanks, feels like a throwback to the 1980s: gray, fluorescent-lit hallways, patchy carpets, cigarette-smoke wafting through offices and salarymen shuffling to meetings. Except that while the rest of the world has moved on from that era, Japan and its policy makers are stuck there, still trying to figure out what role, exactly, they want banks to play in their economy.

That's the hidden subtext to the biggest financial issue dominating headlines in Tokyo today: a proposed loan repayment moratorium for small- and medium-sized businesses. The idea is the brainchild of Shizuka Kamei, the new banking and postal-services minister. Mr. Kamei thinks SMEs, the engine of employment for developed economies, need help in the downturn, but not the tough love of competition or—perish the thought—bankruptcy. So he commissioned Kohei Otsuka, a senior vice minister at the Financial Services Agency, to study how the government might force lenders to forgive SME debts. Financial-sector stocks promptly tanked. They may take another hit when Mr. Otsuka's proposals are made public, possibly as early as today.

Bankers are understandably in an uproar, and Mr. Kamei's proposal may be watered down. But it underlines a fundamental truth: Japan may not have a state-owned financial system like China, but it is still state-directed. Japan runs an essentially circular financial system where savers deposit money at domestic banks, the banks buy ever-more worthless government debt, and then the Diet shovels that money back out to favored political constituencies and export industries. The current Democratic Party of Japan-led government, headed by Yukio Hatoyama, plans to tweak this model, but not fundamentally change it: rather than redistribute the public's money to business, the DPJ wants to give it to families.

This model works if there's huge external demand for Japanese exports and capital is flooding the world and washing up in Japan. But in a global recession, when export demand falls away and the money tide rolls out, Japan's banking model is exposed for what it is: an inflexible system that depresses returns to savers to service a mercantalist approach to economic growth. Banks can't look at domestic lending opportunities to take up the slack, either, because Japan never liberalized enough to create productive lending opportunities. Loan-to-deposit ratios today linger between 60% and 70%. Akio Mikuni, who runs Japan's only independent ratings agency, notes the banks have "almost no retained earnings." "They haven't been making money for years," he tells me. Even years of easy monetary policy can't induce the banks to lend.

Add possible higher global capital requirements for banks to this morass, and the profit pool shrinks even further. Nomura raised $4.8 billion in equity markets this week partially in anticipation of regulatory changes, on top of the $3 billion raised earlier this year. Mizuho, Sumitomo Mitsui and others will likely soon follow. Analysts in Tokyo wonder who's going to buy all the stock—and how much further bank shareholders can be diluted. Some suggest the government might buy the paper, making public control of Japan's banks more explicit.

The one slight piece of good news here is that Japanese banks don't have the piles of bad loans they had back in the 1990s. NPL ratios are at 2 to 3% at the megabanks, and a little higher at regional lenders. But as the economy slows, these ratios are rising again for the first time in years. Regulators are reacting by making disclosure standards more, not less, transparent. Mr. Kamei said late last month "financial inspections should aim at turning around struggling corporate borrowers instead of leading them to go bankrupt." That's a recipe to paper over a problem, not fix it.

Without a financial system that efficiently channels money from lenders who have it to borrowers who need it, Japan will have a hard time growing its moribund economy, already projected to contract over 5% this year. Corporations in Japan still rely more heavily on bank loans than their peers in other developed economies. Financial-sector reform becomes even more urgent as the country piles on public debt, which is spiraling toward 200% of GDP, and faces an aging population.

Mr. Kamei's proposal may be a dead letter, but the fact that government isn't speaking up loudly for more competitive financial markets isn't a good sign. The last time Japan tried to paper over a growing pile of bad loans, bail out failing lenders and businesses and pay off political constituencies, the world's second-largest economy sunk into a lost decade of growth. Then again, maybe it never really escaped.