96-F-13. Horiuchi, Akiyoshi and Katsutoshi Shimizu, "The Deterioration of Banks' Balance Sheets in Japan: Risk-Taking and Recapitalization", June 1996.

This paper empirically investigates whether the slowdown of Japanese banks' credit supply observed in the early 1990s was caused by deterioration of their equity capital as suggested by the capital crunch hypothesis. The panel data of the major banks shows that the banks with higher capital/equity ratios tended to reduce their credit supply. Thus, the empirical analysis rejects the capital crunch hypothesis. Rather, our test supports the moral hazard hypothesis that an increase in banks' equity capital induces them to take conservative stance toward expansion of their credit supply. We also observe that, after substantial declines in their capital/asset ratios, the Japanese major banks used the subordinated debt to recover their deteriorated capital. Most of the subordinated debts were absorbed by financial and nonfinancial companies closely tied with the issuing banks. The traditional relationships with other firms helped the major banks to recapitalize in the face of increasing bad loans in the early 1990s.