Financial System and Monetary
Policy Implementation:Long and Winding Evolution
in the Way of Thinking
Opening Speechby Masaaki Shirakawa,
Governor of the Bank of Japan

Good morning. I am very pleased to address the Bank of Japan international conference.
On behalf of my colleagues at the Bank of Japan, I welcome all the participants from
central banks, international organizations, and academia.

I. Interaction between the Financial System and Monetary Policy
This year’s conference focuses on the theme of “Financial System and Monetary Policy Implementation.” The two things in the theme are closely interacted. That interaction has been consistently posing important policy challenges to the Bank of Japan
since the late 1980s, when the bubble emerged. That seems to be increasingly the casefor central banks in other countries as well. In fact, the interaction has gradually but
steadily attracted both policymakers and academics, and has become a popular theme
for research conferences. We have certainly benefited from such developments. For thisconference, leading economists have contributed six stimulating papers. Distinguishedpolicymakers are getting together to discuss the current policy challenges at the policy
panel session.
I look back, with somewhat mixed feelings, on the past discussions on the policy
responses to the bubble and its bursting. Several points come to mind immediately:
20 years ago, when Japan’s bubble was at its peak. Ten years ago, when Japan’s financial
crisis was at its peak. Several years ago, when the global economy was in the era of“great moderation.” Two years ago, when the global credit bubble came to the surface
as the U.S. subprime mortgage problem. And even more recently just at this time lastyear. I see long and winding evolution taking place in the way of thinking over time.
Up until the mid-2000s, Japanese participants in international conferences, including myself, often felt frustrated both at home and abroad: on the one hand, the delay innecessary actions at home such as injection of public capital, and, on the other hand, theMONETARY AND ECONOMIC STUDIES/NOVEMBER 2009
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difficulty in sharing the economic reality in Japan under the malfunctioning financialsystem after the bursting of the bubble.1 The delay in policy actions was in part due tothe political difficulty of persuasion. One factor behind this seems to be the fact that
financial institutions were unpopular, as always. But, most fundamentally, we were notequipped with economic theory to fully address the core of the problem.
In those days, we made the most of academic wisdom, but we often encounteredsituations that were not well captured by the existing economic theory. For example,
financial imbalances were built up under benign economic conditions, through sharp
credit expansion, outsized leverage, and soaring asset prices.2 After the bursting ofthe bubble, market participants suddenly lost their confidence and reduced their risktaking capacity. As a result, the effectiveness of monetary policy was severely constrained. Further monetary policy responses with unorthodox measures were adopted.
The effectiveness of monetary policy measures crucially depends on the central bank’scredibility, which is partly affected by the soundness of the central bank balance sheet
and the central bank’s neutrality perceived by the public at large. All in all, those experiences seem to show that textbooks on macro and monetary economics need some newchapters on the interaction between the financial system and monetary policy.
The way of thinking about monetary policy management has certainly changed
since the outbreak of global financial market turmoil in the summer of 2007. In particular, since the collapse of Lehman Brothers in September last year, the policy discussions
have changed further with the first-hand experiences of the downward spiral in both thefinancial and real sectors of the economy. It has turned out that Japan’s experience is nolonger unique.

II. Adoption of Unprecedented Policy Measures:Japan’s Experiences
I will provide a basis for discussion by reviewing the Bank of Japan’s policy implementation during the financial crisis after the bursting of the bubble, especially since
the late 1990s. Of course, various measures were taken in the fields of central banking.
Here my focus is on monetary policy.
The Bank of Japan’s policy responses can be summarized into five points. First,
the Bank lowered overnight interest rates in the interbank market down to virtuallyzero, eventually just one-10th of a basis point (0.001 percent). Second, the Bank provided ample excess reserves by using various tools for monetary operations, including
an increase in the outright purchase of long-term government bonds. For the smoothprovision of ample liquidity, the maturity of monetary operations lengthened, runningfor 10 months in bill-purchase operations at the final stage of the quantitative easing
policy. “Quantitative easing” is often used in a rather vague manner, but the policy
action we adopted can be regarded as a pure form of “quantitative easing.” Third, the1. Japan’s 1990s is often referred to as the “lost decade.” For the appropriateness of such characterization andpolicy responses, see Shirakawa (2009a).
2. Among the papers contributed to the conference, Hattori, Shin, and Takahashi (2009) revisit Japan’s bubble inthe 1980s by shedding light on the changes in money flow behind the expansion of the bubble.

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Financial System and Monetary Policy Implementation: Long and Winding Evolution in the Way of Thinking

Bank adopted “credit easing” in the current terminology. The assets purchased includedasset-backed securities (ABSs) and asset-backed commercial paper (ABCP). Fourth,the Bank made a commitment to continuing with the zero interest rate policy and thequantitative easing policy. The conditions for commitment were expressed as “untildeflationary concerns are dispelled” at the time of the zero interest rate policy and“until core CPI inflation becomes stably zero or above” at the time of the quantitativeeasing policy. Fifth, the Bank took unprecedented measures to secure the stability of
the financial system, including purchases of stocks held by financial institutions.
You may find striking similarities between the policy measures formerly taken by
the Bank of Japan and those currently taken by central banks in major countries. I neverimagined that a host of unconventional measures taken by the Bank of Japan would beadopted by other central banks just a few years later. I also guess that my colleagues
at central banks in other countries never imagined employing such policy measures.
Of course, such measures are not perfectly identical, reflecting the differences in thestructure of financial intermediation and severity of stress in financial markets, as wellas the differences in legal and social restrictions on policy measures available for central
banks. Notwithstanding such differences, the aforementioned striking similarities standout. It is quite natural that a central bank facing a financial crisis takes similar measures,
because a central bank, after all, pursues the same objectives with the same capacity,that is, the capacity to adjust the amount of liquidity in the economy.3

III. Importance of Liquidity
This leads me to discussing liquidity, which, I think, is the most important concept
in understanding the current financial crisis, though it is hardly possible to sort out
a single factor. During the expansion period of the credit bubble, complacency basedon unfounded expectations about the unlimited availability of liquidity was behind theaggressive risk-taking attitude. By contrast, during the period of bubble bursting, it was
fear of the exhaustion of liquidity that caused an extraordinary contraction of economicactivity. In addition, liquidity conditions significantly changed the valuation of financial
assets, thereby influencing the capital positions of financial institutions.
Here, I use the term of “liquidity” as the concept incorporating both funding liquidity and market liquidity. But I have to admit that “liquidity” is hardly defined precisely
and measured exactly in a quantitative manner, and thus it remains somewhat elusive.
Nevertheless, anybody can surely assess “liquidity” to a certain extent. After all, liquidity is the core concept in understanding interdependence between the real and financial
sectors of the economy from the beginning of central banking. The principal functionof central banks has been and will be the guardian of liquidity.
From the standpoint I just mentioned, it is crucially important for a central bankto adequately control the aggregate amount of liquidity in the economy. Please note,however, that the concept of liquidity here does not necessarily correspond just to
the terms of broad monetary aggregates or reserves. In fact, the reversed correlations
3. Among the papers contributed to the conference, Goodfriend (2009) argues central banking under financial
turmoil by classifying central bank initiatives into monetary policy, credit policy, and interest rate policy.

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between money stock and economic activity are almost consistently observed in recent
years in Japan: money stocks increase when economic activity weakens, while they
decrease when economic activity expands. The money multiplier is also quite unstable.

IV. Challenges for Central Banks
If this is the case, what does it mean practically to say liquidity is important? I will
touch briefly upon some issues and challenges for central banks, based upon therecent experiences.
First of all, I want to draw your attention to a fine line between liquidity provisionand capital provision. Currently, central banks are faced with an imminent challengeof implementing unorthodox policy measures. The traditional role of a central bank isin providing liquidity. In times of crisis, a central bank attempts to provide liquidity
aggressively sometimes with taking some credit risk. The relaxation of collateral eligibility is a case in point. In a dysfunctional market where prices are not “discovered,”
it is not so certain that a central bank is protected from credit risk, even if central
bank lending is “collateralized.” That makes it difficult to distinguish liquidity provision from capital provision. Outright purchases of credit instruments imply that acentral bank shoulders credit risk in a more straightforward manner. In that regard,monetary policy approaches the region of fiscal policy. Under such circumstances, acentral bank should be cautious about the risks of undermining its credibility, which isprerequisite for any policy implementation. The issues such as deterioration in financial
soundness and massive intervention for resource allocation at an individual level are
now recognized. Central banks in major countries manage to strike a balance between
the ultimate responsibility of maintaining price and financial stability on the one hand
and the accountability in a democratic society on the other hand. Although there is noclear-cut answer holding true universally, the public needs to understand the role ofcentral banks correctly.
Second, central banks are supposed to work hard as a “plumber” in facilitating
the smooth and efficient flow of funds.4 An important area is the payment and settlement system and our own procedure of monetary operation. Taking an example of thecross-border collateral arrangement, the Bank of Japan decided last week to expand
its eligible collateral to foreign government bonds denominated in foreign currencies
as a temporary measure. That arrangement enables financial institutions to use foreign
currency denominated foreign bonds as collateral for yen-fund provision operations
by the Bank.
Third, redesigning financial regulation and supervision, jointly with other relevant
authorities, is called for.5 In view of the current crisis, not only credit risk but also
market and funding liquidity risk need to be addressed. Specifically, the problem of
pro-cyclicality should be addressed by establishing proper incentive structures for rules
and market practices to control the incentives at both micro- and macro-levels.

4. See Tucker (2009).
5. See also Shirakawa (2009b).

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Financial System and Monetary Policy Implementation: Long and Winding Evolution in the Way of Thinking

Last but not least, I will draw your attention to how monetary policy should be conducted, once we fully recognize the importance of liquidity. Here, research activity at
central banks is crucial. For example, the current financial crisis sheds light on the risktaking channel of monetary policy, stemming from the changes in liquidity conditions.
The risk-taking channel works in the nexus between monetary policy and behaviorof financial institutions.6 The prolonged low interest rates under benign financial andeconomic conditions tend to create overconfidence and thus boost asset prices and collateral values as well as incomes and profits, thereby leading to affecting risk perception
as well as enhancing risk tolerance. As a result, aggressive risk-taking behavior in thefinancial system surges, while a resultant build-up of financial imbalances is likely to beleft unchecked. Such financial imbalances come to the surface only once the economicenvironment starts deteriorating.
Considering the complicated transmission channel and the behavioral aspect ofvarious economic agents, how to frame monetary policy is quite a challenge. For instance, in its explanation, the time horizon for monetary policy needs to be extended,compared with the standard time horizon generally assumed in the formal inflation
targeting. In this case, another important policy challenge is posed as to how to ensure
the transparency of monetary policy.

V. Closing Remarks
Let me conclude now. In response to the current financial crisis, the policy discussions are continuing about wide-ranging issues on not only monetary policy management but also financial regulation and supervision. Dialogue between academics andpolicymakers plays a crucial role in discussing and formulating necessary actions inboth short- and medium- to long-term perspectives. In that regard, I am convincedthat this year’s conference will produce further insights into more effective central
bank policymaking.
Thank you.

6. See Borio and Zhu (2008).

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References

Borio, Claudio, and Haibin Zhu, “Capital Regulation, Risk-Taking and Monetary Policy: A Missing
Link in the Transmission Mechanism?” BIS Working Paper No. 268, Bank for International
Settlements, 2008.
Goodfriend, Marvin, “Central Banking in the Credit Turmoil: An Assessment of Federal Reserve
Practice,” mimeo, 2009.
Hattori, Masazumi, Hyun Song Shin, and Wataru Takahashi, “A Financial System Perspective on
Japan’s Experience in the Late 1980s,” mimeo, 2009.
Shirakawa, Masaaki, “Way Out of Economic and Financial Crisis: Lessons and Policy Actions,”
speech at the Japan Society in New York, April 23, 2009a.
, “Preventing the Next Crisis: The Nexus between Financial Markets, Financial Institutions,and Central Banks,” speech at the London Stock Exchange, May 13, 2009b.
Tucker, Paul, “Remarks at the Turner Review Conference,” March 27, 2009.

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