Lesson from Japan

Japanese state banks provide valuable lessons for the development of Climate Bonds, according to Climate Bonds Advisory Panel Member Prof. John Mathews. Governments should use them as marketplace aggregators, channelling savings from insurance and pension funds to multiple, policy-driven, investment destinations, small and large.

Prof. Mathews muses that perhaps some Treasuries would be more comfortable with licencing banks rather creating new ‘Green Banks’ using public funds.

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“Financial, climate and energy crises – and how climate bonds can go some way to addressing them"

By Prof. John Mathews, ENI Chair of Competitive Dynamics and Global Strategy, LUISS University, Rome.


We face a triple crisis – a financial crisis caused by lack of confidence in traditional financial instruments and continuing credit crunch for industrial investors; an energy crisis caused by the imminent decline of fossil fuel energy sources and/or their rising price, scarcity and unreliability; and a climate crisis caused by the slow uptake of renewable energy sources and low-carbon technologies with their capacity to displace fossil fuel sources and their carbon emissions. Solutions are offered for these crises individually – but as yet there has been little discussion of a solution that can span all three.

The ‘Climate Bonds Initiative’ is canvassing a new financial instrument called a ‘climate bond’ as an intermediary between potential investors with large funds at their disposal but nowhere safe to put these funds, and renewable energy projects that promise much but are currently starved for capital and are therefore failing to displace unreliable fossil fuel energy sources.

In this note I discuss the rationale for this proposal and some of the historical precedents.

Bonds as instruments of intermediation

Bonds are essentially financial instruments designed to bring investors with funds to spare together with project promoters looking for capital. What is needed to bridge this gap is a financial instrument issued by an intermediary institution that can meet the needs of both parties – in the sense that it can frame the financial instrument so as to offer regular returns to investors while providing the sums raised to promoters of viable and sustainable industrial projects.

The purest expression of such an arrangement was the long-term credit banking system created in Japan to fuel its period of ‘high-speed growth’ that began in the 1950s and gathered pace in the 1960s and 1970s. Three institutions were licensed under the Long-Term Credit Act of 1952 as Long-Term Credit Banks (LTCBs) – the Industrial Bank of Japan (IJB), the (appropriately named) Long-Term Credit Bank of Japan, and a third bank based on the former colonial Bank of Chosun (Korea) later renamed Nippon Credit Bank. These institutions were given special authority to raise funds through issuing their own 5-year bonds and lending the proceeds at low-interest rates as long-term loans to viable firms in targeted industries. They were thus distinguished from the ‘Main banks’ associated with the groups of enterprises known as keiretsu, which could accept deposits from the general public and provide short-term credit, but were not allowed to issue their own bonds, and from the so-called ‘city banks’ which likewise could accept deposits and make commercial and private loans.

This could be described as a ‘pure’ system of long-term finance in that the role of the financial intermediation agency was particularly clear. One of the three LTCBs tapped available funds (largely in the hands of institutional investors) by offering attractive rates of interest on their 5-year bonds, and invested the proceeds in a wide portfolio of attractive industrial projects where the government was offering various kinds of subsidies, tax incentives or R&D assistance so as to reduce the risks for the firms involved in entering these targeted industries. The government reduced the risks while the LTCBs provided the capital, raised through issuing their own bonds. The LTCBs generated a flow of funds needed to pay the coupons on their bonds through the interest payments made on the loans they provided the firms, each one of which was judged to be credit-worthy after exhaustive investigation. The resale market for bonds thus issued was initially thin, but became more liquid as the Japanese government encouraged the creation of a bond market through the sale of its Treasury securities. Treasury bonds and LTCB-issued bonds were initially the major forms of paper traded on the nascent Japanese bond market. The LTCBs were regulated by the Ministry of Finance.

The bonds issued by the LTCBs were thus different from, say, municipal bonds issued to raise funds for infrastructure and utility projects (e.g. water and sewerage works or gas supply projects) where the issuing institution is a municipal government and the revenues needed to meet the coupon payment obligations are generated from taxation and/or the tariffs charged by the utilities for their services. The bonds issued by the LTCBs were also different from current ‘asset-backed securities’ where it is the ‘asset’ which generates the income needed to meet the coupon repayment obligations.

In the Japanese case, the LTCB system worked extremely well in providing the driving force behind Japan’s ‘miracle’ years of high-speed growth. It was a closed system where the flow of funds could be readily identified, and where no particular party was running undue risk or making undue profits. It thus differed fundamentally from the US system of capital markets where funds were raised on either debt (bond, debenture) or equity markets, and where private firms could both raise debt through issuing their own debentures, or raise equity capital by issuing stock (shares) – both regulated closely by the Securities and Exchange Commission.

The weakness of the Japanese system was that it allowed little room for evolution and development. Firms wanting to issue their own debentures were given limited opportunity to do so, while other financial institutions wishing to issue bonds were prevented from doing so -- in Japan. Thus both kinds of players looked to create their own financial instruments for trading on US and European securities markets, thereby evading domestic Japanese regulations. This worked well for a time – but eventually proved to have defects that multiplied as the Japanese domestic financial system grew to be top-heavy, and eventually crashed in the 1997 financial crisis. This led to the ignominious end of the Long-Term Credit Bank itself, which was eventually taken over by a group of American financial investors, and refloated as Shinseida.

The point of this story is that the Japanese created a financial system that proved to be extremely efficient at channelling funds from investors with funds to spare (e.g. insurance and pension funds as well as public authorities like the Postal Savings system) to projects looking for capital, where the risks were kept low through careful discrimination of the projects eligible for funding (unlike the case of open capital markets) and through indirect government guarantees in the form of tax breaks and subsidies provided to eligible projects. The revenues generated by these industrial projects as they morphed into products and services wanted by consumers met the interest payments on the loans provided by the LTCBs, which in turn met the coupon payment obligations towards the bond holders. Everyone was satisfied in such a system – until it started to fall apart at the edges as individual industrial firms agitated for the right to issue bonds of their own (debentures) and other banks agitated to have a piece of the private bond action.

Now in regard to finance, climate and energy issues, we have a different but similar situation, and framed at a global rather than at a national level. We again have a group of potential investors with funds to spare (indeed insurance and pension funds have more than enough funds to invest) but lacking sound credit-worthy projects. Most of the projects they find themselves being presented with involve fossil fuel energy systems and unacceptable levels of carbon emissions, and for this reason such projects present unacceptable risks of default. For the most part, the kinds of low-carbon projects that they would like to invest in are unsuitable, in that they small, or under-insured and guaranteed, or are found in emerging markets where risk spreads are high. So there is scope here for some innovative financial institutions to step forward with investment vehicles (bonds) that overcome these obstacles.

Thus, firstly, they overcome the liability of smallness (diseconomies of scale) through aggregation. While individual projects might be small, when aggregated or bundled into a single portfolio of similar (but carefully scrutinized) projects, they are much more attractive to investors. Secondly, they overcome the problem of guarantees by arranging for government or multilateral guarantees of the bond, as part of its design and implementation. The bond-issuing institution plays the role of agent, securing the necessary guarantees based on the credit-worthy character of the projects it is investing in. And third, the majority of projects will in fact be found in emerging market countries, where the renewable resources of sun, wind and water and land can be found in abundance, and where risk premiums would act as a block on investment without safeguards. Again it is the job of the bond-issuing financial institution to arrange for such safeguards, and to test the market with bond issues that pay less attention to traditional risk premiums based on the low-carbon character of their underlying investment projects. If the market does not accept such bonds at just a few basis points above ‘normal’ then the exercise will have failed, and the world will still have a problem on its hands.

It is open to any particular country to allow several institutions to play this role, licensing them as ‘green banks’ in an analogous way to the Japanese approach to framing Long-Term Credit Bank legislation in the 1950s -- and then letting banks themselves take the initiative of seeking such a licence. This would no doubt prove to be preferable in the eyes of conservative Treasuries to the creation of new ‘Green Banks’ using public funds as their seed capital.

The key issue with regard to low-carbon projects is their viability and real sustainability, i.e. their contribution to real carbon emission reductions. This is where standards come to play an important role. It is open to any organization – such as the Climate Bonds Initiative, for example, acting as a de facto industry organization – to issue a set of standards which viable and sustainable investment projects would be expected to meet. The development of such a set of standards would seem to be a priority for the Climate Bonds Initiative.