Steven M. Dickinson ^*
& Takeo Kosugi ^{* *}

VI. Assessment: Concerns About the Commercial Paper Market in Japan

Creating a viable commercial paper market and an effective treasury bill market is essential to stimulate the short-term financial market in Japan and to internationalize the yen. If the attempt to create a commercial paper market fails, it is probable that Japan's short-term market will continue to lose funds to the Euroyen market.

A successful commercial paper market would mark an important change in the Japanese business environment. The main bank system, in which major city banks control and influence their corporate customers through continuous short-term lending, is still prevalent in Japan. A viable commercial paper market would present an alternative to short-term bank lending and could signal the end of the main bank system by shifting power away from the banks and into the hands of the customers.

Analysts have estimated that the domestic commercial paper market has the potential to grow to an annual outstanding balance of ¥10 trillion to ¥20 trillion.²⁰⁰ At that size, the market would displace the bill discount market as the major component of Japan's short-term financial market.²⁰¹ In its first three months alone, the domestic commercial paper balance grew to ¥2.5 trillion, exceeding the expectations of government regulators.²⁰² The potential size of the market and its potential adverse impact on the banking system explain the struggle between the banks and the securities companies to influence this market.

A. Legal Concerns

The struggle between these two industries has resulted in a legal framework for regulating commercial paper that preserves the existing regulatory framework. The MOF has avoided applying article 65 of the SEL (which separates the banking and securities industries) to dealings in commercial paper, thus achieving its goal of balancing the interests of the banking and securities industries.

However, the achievement of this balance has raised a number of legal problems. As mentioned earlier, construing domestic commercial paper as a promissory note does not fit neatly within the Japanese system of bills and notes under the Law on Bills. Since domestic commercial paper has not been designated as a valuable security under article 2 of the SEL, the disclosure, anti-fraud and business regulation provisions of the SEL and related statutes are not applicable to domestic commercial paper. The MOF has attempted to fill in this legal vacuum by using administrative guidance. While such guidance may be sufficient to regulate the activities of the banks and securities companies, it remains to be seen whether investors will be adequately protected under this system.

B. Practical Concerns

The rules and regulations promulgated by the MOF to govern commercial paper have diminished the attractiveness to issuers and investors of commercial paper as a financial instrument. The problems which have led to this result will need to be overcome before the domestic commercial paper market reaches its full potential.

One such problem is that the domestic commercial paper market is currently over-regulated. First, there is an inadequate volume of issuing funds because the number of eligible issuers is limited. Second, the stamp tax and other costs make the cost of issuance prohibitively high for many issuers. Third, the flexibility of domestic commercial paper, which is vital to the success of commercial paper in the U.S. and European markets, is severely limited by the minimum amount and maturity restrictions. Moreover, these restrictions require issuers of domestic commercial paper to compete directly with bank CDs and large-lot deposits for investors' funds. Without flexibility, commercial paper issuers can compete only in terms of price, which places them at a significant disadvantage vis-à-vis the banks. It is therefore desirable that the amount and maturity restrictions on domestic commercial paper be eased to enhance flexibility and the potential for success.²⁰³

A second practical problem is that domestic commercial paper must compete directly with CDs and large-lot deposits, forcing issuers to offer rates that approximate the CD rate to attract the same pool of investors. However, domestic commercial paper has consistently been offered at well below the CD rate, and has therefore attracted little interest from these investors. Dealers have been forced either to hold the commercial paper to maturity, or to sell it at a loss.

The low issuing rates have been due to the intense competition between dealers for the opportunity to underwrite the issuance of domestic commercial paper. In this new market, dealers have been concerned more with establishing their market share than with making a profit.

The structure of the issuing market has also contributed to this competition, and has provided issuers with a significant advantage. They have been issuing domestic commercial paper through a group of dealers resembling a loan or bond underwriting syndicate.²⁰⁴ Generally, the issuer plays all the dealers in the group against each other in competition for the lowest rate. Since the dealers are committed to pay the issue price whether or not the issue can be sold to investors, the issuer is unconcerned with whether or not the rate makes sense in the market. Instead, the issuer's only concern is in getting the lowest possible price. Since dealers are concerned with establishing a market share, none wants to be cut out, even if they lose money. Therefore, everyone stays in the bidding, and harakiri prices result.

As securities dealers begin to carve out market shares in Japan's developing domestic commercial paper market, they will become less concerned with cut-throat competition and more interested in establishing fair and sensible underwriting procedures. Such procedures could be patterned after the underwriting system found in loan syndication and bond underwriting.²⁰⁵ By adopting similar procedures for the issuance of domestic commercial paper, dealers will be able to gain leverage in negotiations with issuers.

A final practical problem is the artificially low interest rates on short-term bank loans which have been a significant barrier to the full development of the domestic commercial paper market. While significant steps have been taken recently to liberalize interest rates,²⁰⁶Japan is still operating under a dual interest rate structure, with one set of open market rates and a parallel set of fixed rates.²⁰⁷The fixed rates are consistently lower than the open market rates.²⁰⁸One of the fixed rates is the short-term prime rate, which is set at a fixed spread over the BOJ discount rate.²⁰⁹ As of the end of January 1988, the discount rate was at an all time low of 2.5%, and the short-term prime rate was set at 3.375%.²¹⁰ The latter rate was significantly lower than the CD rate, which serves as a benchmark for the free market rates.²¹¹ This situation is the reverse of that in the United States, where the prime rate has been consistently higher than the CD rate.²¹²

The potential issuers of domestic commercial paper normally obtain their short-term funds in the form of loans from banks at a rate that is based on the short-term prime rate. While such loans usually specify interest at the prime rate, banks in fact ask for compensating deposits and other fees that raise the effective interest rate to about 4.0%.²¹³ Banks can offer this rate, which is lower than the CD rate of 4.3%, because deposits of amounts less than the large-lot deposit limitation of ¥100 million are also part of the fixed interest rate system. The rates on small-lot deposits vary depending on the terms, but all are set below the short-term prime rate.²¹⁴ This system is gradually breaking down, and banks are receiving more funds from market rate instruments such as CDs.²¹⁵ However, since banks still receive a large amount of funds through deposits on which they pay an artificially low interest rate, they are able to lend to their corporate customers at a rate that is below what a market-based prime rate of interest would be. Therefore, issuers will not be interested in issuing commercial paper if the rate they must pay exceeds 4.0%, which they can obtain on bank loans. In fact, since the payment of stamp tax and service fees substantially increases the issuer's cost, the issuer must pay an even lower interest rate on commercial paper in order to achieve an effective rate comparable to that of bank borrowing. Thus, as the rate for domestic commercial paper begins to rise into the range that investors will demand (4.2% to 4.3%), businesses will become less likely to issue domestic commercial paper, except in cases of pressing, unmet financial needs.

So long as borrowers are able to obtain short-term funds from banks at a rate that is substantially below the open market rate, it is unlikely that domestic commercial paper can be offered at rates which will be attractive to investors. Market forces are pressuring banks to begin setting the short-term prime rate at a level based on the market rate of interest. If this happens, then domestic commercial paper will become an attractive fund-raising device for issuers.²¹⁶

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