Japan’s government is finally forcing the country’s financial sector to restructure after years of ever higher nonperforming loans and terrible performance for shareholders. In 1999, it made direct capital infusions of $92 billion and allowed several banks to fail. It also indirectly suggested that Japan had room for only three or four global banks, not the two dozen it then had. In August 1999, Dai-Ichi Kangyo Bank, Fuji Bank, and the Industrial Bank of Japan (IBJ) announced plans to merge, an announcement followed by the merger of Sumitomo Bank and Sakura Bank. The number of banks had shrunk from 21 to 10 and is now down to 8.

Three means to an end

Is consolidation the answer to the profitability problems of the Japanese banking system? Mergers garner media attention and signal dramatic change. They also tend to create a domino effect, inducing other banks to respond with similar announcements. Amid this great show of activity, it is important to remember that mergers are just a means to an end—higher profits—and must be judged on that basis. In reality, a level-headed analysis of the costs and benefits of recent and prospective mergers raises many doubts. Let us look at...