The Japanese Example Is There For All To See

Several years ago I was discussing the situation in the UK credit and housing markets with a fellow banker in a bar in London, and explaining why I thought that the situation was becoming potentially dangerous. One of the comparisons that I drew, which I happened to think was one that should be taken seriously, was between Japan in the 1980s, and the UK early in the millennium.

For most of the 1980s, Japan was a stellar performer, with a number of booming industry sectors, particularly in areas related to technology. As the economy prospered, people became wealthier, and standards of living rose.

However, there was a problem that was building up in the background, because of the situations in both the housing market and in the banking system. In Japan there was significant pressure on housing, lack of space meant that housing was expensive. Demand for housing consistently outstripped supply, and so as wealth grew, so did the price of property - Japanese property became notoriously and outrageously expensive.

Because of the disparity between the supply and demand of property, it was quite common in Japan for children to stay at home, living with their parents, well into their twenties, and even thirties.

At this point a flaw in the Japanese banking and financial system started to take on serious proportions. Japan was booming, people were wealthy, and property prices were extraordinary. The Japanese banks lent a lot of money, which was essentially 'secured' against valuable property assets.

Presumably, the reasoning went, that given the almost unavoidable mismatch between supply and demand in the Japanese property sector, the balance sheets of the banks were 'as safe as houses'.

To avoid taking this parallel too far, it is perhaps worth pointing out that this situation was made worse by the financial regulations and accounting rules that were in place in Japan at that time. If UK rules had been applied, then it is likely that most Japanese banks would have been declared technically insolvent.

In risk management terms, the result was a huge concentration risk in property, and the creation of a highly unstable dynamic market equilibrium. These are the classic circumstances under which a significant 'shock' to the system can result in a catastrophe.

In Japan, this shock took the form of the Kobe earthquake, which triggered a stock market slide, a collapse in the value of property and other assets, a credit crunch, and almost a complete failure of the Japanese financial system.

At one point Japanese interests rates actually dipped below zero - this is so unfamiliar that it is perhaps worth explaining that this means that if you deposited Yen with a bank, you would actually have to pay them to look after your money. In 'the city', negative interest rates were an eventuality that many of those who created the mathematical models for modelling risk in the markets had never catered for. In some cases these models stopped working altogether.

The result of this collapse was, although economists might argue about the precise technical definitions, an economic slump that lasted a decade.

As I drew this parallel in risk management terms with the financier in the London wine bar, after some disagreement, the crux of his response was: “We Don't Have Earthquakes in Britain”.

I rest my case.