Japan may be brewing a financial crisis that will see runs on deposits, government bond yields blowing out and a forced state-funded recapitalisation of the banking system, according to Indosuez WI Carr Securities. The large amount of savings held in call deposits by deeply conservative Japanese households could prove to be the undoing of a banking system already saddled with a heavy burden of non-performing loans, WI Carr economist Michael Taylor said. Banks had at least 44 trillion yen (about HK$2.62 trillion) in non-performing loans as of March, according to official figures. The real figure could be as high as 100 trillion yen against capital of only 13 trillion yen, Mr Taylor said. 'The weakness of the banking system is itself now a factor in the deterioration in the underlying economy and the deterioration of the economy will further visibly weaken the banking system,' he said. 'At some stage, unknowable in advance, the shortage of capital in the banking system is likely to undermine confidence. It seems doubtful that the regulatory authorities can act with sufficient speed and size to offset this feedback.' Since the property and stock market bubbles burst in 1990, households have put most of their money in bank deposits rather than spend or invest it. That has meant 23.8 per cent of the banking system is funded by deposits and the ratio of M1 money supply to currency in circulation is as high as 4.4 in Japan, against 2.4 in South Korea and 2.1 in the United States. 'A spate of bankruptcies among bank [loan] clients is the messenger which delivers the bad news to the Japanese saver that his banks are no longer safe,' Mr Taylor said. 'If this message gets through, the result is likely to be a liquidity rush and the forced recapitalisation of the banks as a precondition for halting the rush.' If depositors rushed to remove their money, banks would be forced to sell down their huge positions in Japanese government bonds to raise the cash, sending bond prices down and raising yields. The banks had 40 per cent of their 168 trillion yen securities holdings in government bonds and owned 16.3 per cent of the market in the instruments, WI Carr said. Rising government bond yields would add significantly to Tokyo's massive debt burden. Mr Taylor said a 1 percentage point rise in yields would cost the Government an additional 2.4 per cent of tax revenues in higher debt-servicing costs. The Government already uses 34 per cent of tax revenues in debt servicing. A vicious cycle could ensue of rising government bond yields hitting Tokyo's creditworthiness, leading to a further rise in yields. 'Given this scenario, nationalising and recapitalising the banks in order to forestall a serious bank run seems like a bargain,' Mr Taylor said. Banks would have existing shareholder capital written down, then be given new government bonds in return for Tokyo taking all the 100 trillion yen in bad loans off their books. If skilfully handled, the financial crisis need not result in a disaster for the yen in the long run, Mr Taylor said. But he warned: 'Any financial crisis will inevitably cause the currency to fall in the short term, no matter what the ultimate monetary implications of the crisis turn out to be.' A catalyst for the crisis might be further bankruptcies such as seen recently with retailer Mycal, which was not classified as a bad debtor by many banks. Bank regulators' inspections into how loans have been categorised, which are expected to reveal under-reporting of problems, might also spook depositors.