We examine the reason that there have coexisted the two opposing views on distressed banks’ lending behaviour in Japan’s post-bubble period: the one is the stagnant lending in a capital crunch and the other is the forbearance lending to low-quality borrowers. To this end, we address the measurement problem for bank balance sheet risk. We identify the credit supply and allocation effects of bank capital in the bank loan equation specified at loan level, thereby finding that the ‘parallel worlds’, or the two opposing views, emerge because the regulatory capital does not reflect the actual condition of increased risk on bank balance sheet, while the market value of capital does. By uncovering banks’ engagement in patching-up of the regulatory capital in the Japan’s post-bubble period, we show that lowly market capitalised banks that had difficulty in building up adequate equity capital for their risk exposure decreased the overall supply of credits. The parallel worlds can emerge whenever banks are allowed to overvalue assets with their discretion, as in Japan’ post-bubble period. This study is joint work with Kiyotaka Nakashima at Konan University and Koji Takahashi at the Bank of Japan.

Hitoshi Inoue is a Visiting Fellow at Crawford School of Public Policy and an Associate Professor at the Faculty of Economics, Sapporo Gakuin University. He has a PhD in Economics from the Osaka University. His research interests are bank lending, monetary policy, and applied econometrics.

A light lunch will be provided.

The AJRC Seminar Series is a forum for researchers to engage on issues relevant to Japan. Topics include, but are not limited to, economics, international relations, politics, and national security. Seminars are typically very frank and early stage studies are most welcome.