508

Tokiko Shimizu and Takashi Ui

Contagious Expectations and Malfunctions ofMarkets: Some Lessons from Japanese Financial
Institution Failures of 1997*
Tokiko Shimizu
Bank of Japan

Takashi Ui
Bank of Japan

Abstract
This paper discusses contagious effects of expectation in financial markets. We
first review developments of Japanese financial markets towards the end of 1997
when a number of financial institutions collapsed. We then consider a simple
model and study conditions under which contagious expectation triggers a financial crisis. Finally, based upon these, we derive some policy implications regarding the role of central bank lending.

1

Introduction

Successive failures of the major Japanese banks and securities companies in
November 1997 provoked a sharp increase in market awareness of credit risk andliquidity risk. At one point, the overnight uncollateralized call rate, which isusually lower than the official discount rate, exceeded it. Term rates in the money
markets and yields on corporate bonds also rose, while yields on risk-free assets
such as government bonds declined.
In response to the rapid rise in short-term interest rates, the Bank of Japan
provided ample funds to the market in an effort to stabilize them, creating excess
reserves. As a result, the overnight call rate regained stability at the end of November. Interest rates on term instruments such as CD rates, however, did notshow any sign of declining immediately. They finally began to decline in Febru*
The views expressed here are those of the authors. They do not necessarily reflect those of the
Bank of Japan.

Contagious expectations and malfunctions of markets509

ary 1998 reflecting the substantial increase in the Bank’s provision of funds.
From a theoretical viewpoint, this paper tries to explain how the financial
institution failures triggered a sharp increase in market awareness of risk in termsof changes in people’s expectations. We are especially interested in why somefinancial institutions’ failures drastically changed market participants’ behavior
toward other financial institutions, whose information was not directly provided
by the failed institutions.
We consider a simple game in which players decide whether or not to supply
funds to a fund-raiser. We study conditions under which players choose not tosupply funds and then demonstrate that failures of other fund-raisers can makeplayers withdraw funds from the fund-raiser contagiously. We also discuss how
the contagious withdrawal of funds can be prevented, stressing the role of central
bank lending.
Our model is a variant of that of Morris and Shin (1998) who studied selffulfilling currency attacks. They investigated the role of expectation of market
participants with asymmetric information and studied when financial crises occur.
Pursuing and developing their arguments, we study when financial crises more
likely and contagiously occur, and apply the results to explain what happened inJapan.
This paper is organized as follows. Section 2 briefly reviews what happenedin the Japanese financial markets from the end of 1997 to the beginning of 1998.
Section 3 studies the model. Section 4 discusses policy implications. Section 5
concludes the paper.

2

Developments in Japanese financial markets

This section briefly reviews some of the individual failures and the subsequent
rises in interest rates.

2.1

Successive failures of financial institutions

Since the bursting of the bubble in the early 90’s, Japanese financial institutions
have had to deal with increasing non-performing loans. From October to December in 1997, three banks and three securities companies failed (see Tables 1, 2, 3,
and 4 for more details) due to solvency problems.
Among these failures, the cases of Sanyo Securities Co., Hokkaido Takushoku
Bank, and Yamaichi Securities Co. are considered to have had a large impact onfinancial markets. Let us take a closer look at them.

Sanyo’s failure
Sanyo Securities Co., a second-tier securities firm in Japan, had a solvency problem caused by a loss from writing off non-performing loans. Thus, it strongly
depended upon subordinated loans to meet regulatory capital requirements. Lifeinsurance companies, which provided the loans, finally rejected Sanyo’s request
for suspending maturity, which led Sanyo to file for corporate reorganization on
November 3. After the decision, Sanyo defaulted in the inter-bank markets, which
had never happened before in Japan.

Hokkaido Takushoku’s failure
Hokkaido Takushoku Bank, one of Japan’s top 21 banks, also had a solvency
problem caused by a loss from writing off non-performing loans. The failure wastriggered by a liquidity crisis due to deposit withdrawals, which became
widespread when its rating was downgraded to speculative. Due to these events,
Hokkaido Takushoku Bank decided to transfer its business to Hokuyo Bank on
November 17. It was the first of Japan’s top 21 banks, which the government had
suggested would never fail, that required a bail-out.

Yamaichi’s failure
Yamaichi Securities Co., the 4th largest securities firm in Japan, had a solvency
problem and a liquidity shortage, which became serious when its rating wasdowngraded to speculative.The solvency problem arose when an investigation
uncovered previously undisclosed losses. Against these backgrounds, on November 24, Yamaichi decided to close all of its branches and overseas affiliates. It was
the largest business failure in Japan since World War II at that time.
Yamaichi had illegally covered up losses, and such scandals repeatedly took
place in Japan, which is considered to reduce the credibility of information disclosed by Japanese financial institutions.

2.2

Developments in market interest rates

These failures, together with the sluggishness of the Japanese economy and the
spreading instability of Asian financial systems and Asian economy, provoked asharp rise in market awareness of credit risk and liquidity risk. To see this, wewill briefly review developments of market interest rates following the Bank ofJapan (1998).
At one point in mid-November, the overnight uncollateralized call rate exceeded the official discount rate, when large financial institutions successively
failed, due to mounting uncertainty about fund availability and growing concern
about credit risk. Term instrument rates such as CD rates (3-month) and Euro-yen
TIBOR (3-month) also rose sharply in mid-November (Figure 1). In addition to
the rise in their average rates, the differential between rates offered to banks also
expanded during the same period (Figure 2), reflecting market awareness of risk.
In response to the rapid rise in these interest rates, the Bank of Japan provided
ample funds to the market in an effort to stabilize interest rates from late November, and clearly established its policy stance by expanding the “excess reserves asof the morning” to over 1 trillion yen (Figure 3). In supplying these funds, theContagious expectations and malfunctions of markets

511

Bank actively utilized new bond-borrowing (“repo”) operations introduced in lateNovember, and also substantially increased commercial paper purchase operations, in trying to assist firms in raising funds.
As a result, the overnight call rate regained stability at the end of November.
Interest rates on term instruments such as CDs, however, did not show any signsof declining. This is because financial institutions and firms were less willing to
supply funds and more eager to raise funds, reflecting their concern about liquidity risk at the end of the fiscal year. Consequently, there were many cases ofsignificant rises for interest rates of term instruments which were to mature after
the end of the fiscal year.
Interest rates on term instruments finally began to decline in late February
1998, reflecting the substantial increase in the Bank’s provision of funds maturing
after the end of the fiscal year (Figure 4), as well as the formulation of various
financial stabilization measures by the government. Differentials in TIBOR
between reference banks also slowly narrowed, in pace with the decline in average rates on term instruments.

3

Contagious expectation

3.1

A modelIn order to study when market participants become less willing to supply funds,
we consider a game in which 2 fund suppliers choose whether or not to lend funds
to a fund-raiser. Mathematically, the model is a variant of that of Morris and Shin(1998).1
The set of players, or fund suppliers, is denoted by I = {1, 2}. The strategy setof player i Î I is denoted by Ai = {S, N} where S is to supply one unit of funds
and N is not to supply it.
Let q Î [0, 1] be a measure of credit risk of the fund-raiser, where larger q
implies lower credit risk. We assume that players cannot observe q directly.
Instead, player i observes his private signal xi which is a random variable uniformly distributed on [q – e /2, q + e /2] where e > 0 is assumed to be verysmall.2 Let p(xi|q ) denote the conditional density function of xi, i.e. p(xi|q ) = 1/e
if xi Î [q – e /2, q + e /2] and p(xi|q ) = 0 otherwise. With respect to q, both players
have a common prior probability density m (q ).
There are 2 periods. At period 1, each player, who has one unit of funds,
observes his private signal and chooses S or N. If a player chooses S, he lends one
unit of funds to the fund-raiser with interest rate r ¹ 1, which is exogenously
1
These studies build on the incomplete information game analysis of Carlsson and van Damme(1993) and Morris, Rob and Shin (1995). This field is closely related to equilibrium refinement
literature. See Kajii and Morris (1997a), Kajii and Morris (1997b), and Ui (1998).
2
In addition to publicly disclosed information about the fund-raiser, players try to get further
information individually, and/or they give their own interpretations. This is why players maintainprivate information about credit risk.

given.3 If a player chooses N, he does nothing. When both players choose S, thefund-raiser borrows 2 units of funds. When one player chooses S and the otherchooses N, the fund-raiser borrows 1 unit of funds. When both players choose N,
the fund-raiser borrows no funds.
At period 2, a player choosing S receives 1 + r as long as the fund-raiser does
not default. A player choosing N gets 1. Let r (q, k) be a default probability when
the fund-raiser borrows k units of funds. r (q, k) depends upon k because a fundraiser with less funds is more vulnerable to liquidity shocks. For the sake ofsimplicity, we assume that, for given q and q̄ , where 0 < q < q̄ < 1,
· r (q, 2) = 1 if q £ q and r (q, 2) = 0 otherwise,· r (q, 1) = 1 if q £ q̄ and r (q, 1) = 0 otherwise.
Note that r (q, 2) £ r (q, 1).4
Let um (xi, k) be such thatum (xi, k) = (1–Em [r (q, k)|xi])(1+r)
where Em [r (q, k)|xi] is an expected value of r (q, k) conditional on xi under m, i.e.
Em [ r (q , k ) | xi ] =xi + e 2
ò r (q , k ) p ( xi | q ) m (q ) dq ò xi - e 2 r (q , k ) m (q )dq=.
ò p ( xi | q ) m (q ) dq
ò xxi-+ee 22 m (q )dqi

Note that um (xi, k) is continuous in xi. Then, the game has the following expected
return matrix at period 1.

S
N

3.2

S

N

um (x1, 2), um (x2, 2)
1, um (x2, 1)

um (x1, 1), 1
1, 1

Results

In this paper, we concentrate on symmetric equilibria. When e > 0 and q is uniformly distributed, a symmetric equilibrium is almost unique according to thefollowing theorem, which is mathematically equivalent to Theorem 1 of Morrisand Shin (1998):

3

risk.
4

It is straightforward to extend the model in such a way that an interest rate depends upon credit
As far as r (q, 2) £ r (q, 1), we can relax these assumptions.

Contagious expectations and malfunctions of markets

513

Theorem 1 Suppose that m (q ) = 1 for q Î [0,1]. In any symmetric equilibriumof this game, there exists x* such that a player observing xi < x* chooses N and aplayer observing xi > x* chooses S.
Proof. For a symmetric equilibrium, let p(x) be the probability of choosing S
when observing x, which hereafter we simply call an equilibrium. The expected
payoff of player 1 when choosing S isFm ( x1 , p) = E m [ p( x2 ) | x1 ] u m ( x1 ,2) + (1 - E m [p( x2 ) | x1 ]) u m ( x1 ,1)
where
Em [p( x2 ) | x1 ] =ò ò p( x2 ) p ( x1 | q ) p ( x2 | q ) m (q )dqdx2.
ò p ( x1 | q ) p ( x2 | q ) m (q ) dqdx2

Note that F m (x 1 , p) is continuous in x 1 . Note also that if p 1 £ p 2 th enFm (x1, p1) £ Fm (x1, p2) since Em [p1 (x2)|x1] £ Em [p2 (x2)|x1] and um (x1, 2) ³ um (x1, 1).
In order for p to be an equilibrium, it must be true that if Fm (x1, p) > 1 thenp(x1) = 1 and if Fm (x1, p) < 1 then p(x1) = 0.
Let s x (x 2 ) be such that s x (x 2 ) = 0 if x 2 £ x and s x (x 2 ) = 1 if x 2 > x. Note thatEm [sx (x2)|x1] = 1/2. Let fm (x) = Fm (x, sx). Thenf m ( x) =1
1
u m ( x, 2) + u m ( x, 1)
2
2= ( 2 - E m [ r (q , 1) + r (q , 2) | x])(1 + r ) 2.
It is straightforward to see that E m [ r ( q , 1) + r ( q , 2)|x] is continuousand decreasin g in x. If x Î [q – e/2, q + e/2] or x Î [q̄ – e/2, q̄ + e/2] thenEm [r (q, 1) + r(q, 2)|x] is strictly decreasing in x. Otherwise
Em [r (q, 1) + r (q, 2)|x] = 2 or 1 or 0. These imply that fm (x) is continuous, increasing, and strictly increasing if fm (x) ¹ 0 or fm (x) ¹ (1 + r)/2 or fm (x) ¹1+ r.
Thus, fm (x) is strictly increasing when fm (x) = 1 and there exists unique x* suchthat fm (x*) = 1.
We show that, in any equilibrium, a player observing xi < x* chooses N and aplayer observing xi > x* chooses S. Definex̄ = sup{x|p(x) < 1},
x = inf{x|p(x) > 0}.
First, compare p and sx̄ . Since p(x) ³ sx̄ (x) for all x ,Fm (x, p) ³ Fm (x, sx̄ ).
Since Fm (x̄, p) =1, fm (x̄) = Fm (x̄, s x̄ ) £ 1. This implies that x̄ £ x*. Next, compare p
and sx. Since p(x) £ sx(x) for all x,
Fm (x, p) £ Fm (x, sx).
Since Fm (x, p) = 1, fm (x)=Fm (x, sx) ³ 1. This implies that x ³ x*.
By definition, x £ x̄. Therefore, x = x̄. This implies that, in any equilibrium, aplayer observing xi < x* chooses N and a player observing xi > x* chooses S. •The intuition of the result is as follows. Player 2 observing any signal below
q – e /2 chooses N because he knows that the fund-raiser will default withprobability 1. Knowing this, player 1 observing x1 that is slightly greater thanq – e /2 chooses N because he believes that player 2 will choose N with a reasonably high probability. Knowing this, player 2 observing x2 that is slightly greaterthan x1 chooses N because he believes that player 1 will choose N with a reasonably high probability. Knowing this, player 1 observing x3 that is slightly greaterthan x2 chooses N because he believes that player 2 will choose N with a reasonably high probability. If we repeat this argument, we obtain x* = limn®¥ xn such thata player observing x < x* always chooses N. A similar argument is also possible
by starting from q̄ + e /2.
The point is that player 1 considers what player 2 considers and vice versa,
and that they have slightly different information. Due to this, a “grain of doubt”
about credit risk expands contagiously as described above, and the game has aunique equilibrium.
According to the theorem, both players supply funds when q ³ x* + e /2, but
no players supply funds when q £ x* – e /2. Thus, the threshold x* plays a very
important role. If the threshold increases, players are less likely to supply funds,
triggering another liquidity crisis. The following two theorems consider when thishappens.
Suppose that players observe defaults in other fund-raisers. Then it is natural
to assume that they will change their prior distribution for q to a more pessimistic
one in which more probability is put on a smaller q. The next theorem shows thata pessimistic prior distribution implies a larger threshold and less willingness ofplayers to supply funds.
Theorem 2 Let m'(q) be a prior probability density of q and suppose that m'(q)is decreasing. In any symmetric equilibrium of this game, there exists x** such thata player observing xi < x** chooses N. In addition, x** ³ x*.
Proof. Define fm' (x) as in the proof of the previous theorem. Thenfm' (x) = Em' [sx (x')|x]um' (x, 2) + (1–Em' [sx (x')|x])um' (x, 1).

Contagious expectations and malfunctions of markets

515

It is straightforward to see that
Em' [sx (x')|x] £ Em [sx (x')|x],um' (x, 2) £ um (x, 2), um' (x, 1) £ um (x, 1),
um' (x, 2) ³ um' (x, 1), um (x, 2) ³ um (x, 1).
Thus, we have fm' (x) £ fm (x) for all x. This implies that
x**º inf{x|fm' (x) ³ 1} ³ inf{x|fm (x) ³ 1} = x*.
Let p be an equilibrium. Define
x =inf{x|p(x) > 0}.
Compare p and s x . Since p(x) £ s x (x) for all x, F m ' (x, p) £ F m ' (x, s x ). Since
Fm' (x, p) = 1, fm' (x) = Fm' (x, sx) ³ 1. This implies that x ³ x**. Therefore, p(x) = 0
for any x < x**. •Suppose players find that disclosed information of another fund-raiser is notcompletely reliable. Then it is natural that they think their private signals also
include more noise than previously thought. The next theorem shows that thisleads to a larger threshold when players have a pessimistic prior distribution for q
and the initial uncertainty is small enough.
Theorem 3 Let m'(q) be a prior probability density of q and suppose that m'(q)is continuously differentiable and decreasing. Let x**(e) be as given in theprevious theorem. Let x** = lime®0 x**(e). Then x** £ x**(e') for any e ' such that0 < e' < min{(x** – q )/2, (q̄ – x**)/2}.
Proof. Define f em' (x) as in the proof of the previous theorem. Thus
f em' (x) = Eem' [sx (x')|x]uem' (x, 2) + (1 – Eem' [sx (x')|x])uem' (x, 1).
Let e' be such that 0 < e' < min{(x** – q )/2, (q̄ – x**)/2}. Then it is straightforward
to see that
lim ume ' ( x, 2) = ume '' ( x, 2) ³ lim ume ' ( x, 1) = ume '' ( x, 1).

e ®0

e ®0

In addition, we can calculate that lime®0 Eem' [sx (x')|x] = 1/2 ³ Eme '' [sx (x')|x]. Sinceuem' (x, 2) ³ uem' (x, 1), lime®0 f em' (x) ³ f me '' (x). This implies thatlim x** (e ) = lim inf{x | f em' ( x) ³ 1} £ inf{x | f em'' ( x) ³ 1} = x** (e ' ). •

e ®0

e ®0

The final theorem is about how to recover the equilibrium with the original
threshold.
Theorem 4 Let m'(q ) be a prior probability density of q and suppose that m'(q )is decreasing. Let r'(q, k) be such that r'(q, 1) = r (q, 2) for q Î [x* – e /2, x* + e ]and r'(q, k) = r (q, k) otherwise. If the default probability is given by r', then inany equilibrium, a player observing xi > x* chooses S.
Proof. For x ³ x* + e, let tx(x1) be such that tx(x1) = 1 if x* £ x1 £ x and tx(x1) = 0
otherwise. Define gm' (x)=Fm' (x, tx). Thengm' (x)=Em' [tx (x')|x]um' (x, 2) + (1–Em' [tx (x')|x])um' (x, 1).
For x > x* + e, Em' [tx (x')|x] ³ 1/2, um' (x, 1) ³ um (x – e, 1), um' (x, 2) ³ um (x – e, 2).
Thus
g m' ( x ) ³11
11
um' ( x, 2) + um' ( x, 1) ³ um ( x - e , 2) + um ( x - e , 1)22
2
2
= f m ( x - e ) > f m ( x*) = 1.

This implies that gm' (x) > 1 for x > x* + e.
Let p be an equilibrium. It is straightforward to see that for any x Î [x*, x* + e]p(x) = 1 because r'(q, 1) = r (q, 2) = 0 for q Î [x* – e /2, x* + e]. Suppose thatx̄' º inf {x|x ³ x*, p(x) < 1} < 1.
D u e t o t h e co n t i nu i t y o f u m ' (x, k), x̄' > x* + e. Compare p and tx̄'. Sincep(x) ³ tx̄' (x) for all x ,Contagious expectations and malfunctions of markets

517

Fm' (x, p) ³ Fm' (x, tx̄').
However, Fm' (x̄', p) = 1 and Fm' (x̄', tx̄') = gm' (x̄') > 1, which is a contradiction. Therefore, x̄' < 1 is not true, and p(x) = 1 for any x ³ x*. •Suppose that the threshold has increased from x* to x** and that e is very small
compared to x**– x*. Then fund-raisers with q Î [x* + e /2, x** – e /2], who wereable to borrow funds when the threshold was x*, cannot borrow funds any more. If
the threshold x** is considered temporary, then it can be economically justified forauthorities to provide funds to any fund-raisers with q Î [x* + e /2, x** – e /2].
Is this the only way for authorities to recover the original equilibrium by
providing funds? Theorem 4 says no and proposes another method. Namely, it isenough for authorities to provide funds to fund-raisers with q Î [x* – e /2, x* + e ],and to make everyone believe this as common knowledge.5 If e is very small
compared to x**– x*, this method is very efficient in the sense that the amount offunds for authorities to supply is reduced.

4

Discussions

What can we learn from the theoretical results in light of Japan’s experience?
First, they provide one explanation of how successive financial institution failures
triggered a sharp rise in market awareness of risk.
As discussed in Section 2, market participants observing the financial institution failures learned the following:· Defaults are possible in the inter-bank market, even though there were noprior defaults.
· Even top 21 banks can default, despite the government’s suggestion thatthey would never fail.
· Disclosed information of financial institutions might not be absolutely
reliable.
These lessons are enough for market participants to change their expectations, i.e.
they thought that financial institutions were more likely to default and that information about credit risk contained more noise than previously thought.
Using the terms of our model, we can say that they adopted m' instead of mand e' instead of very small e. Theorem 2 and Theorem 3 suggest that thesechanges in expectation increased the threshold of private signals x*. As a result of
the increase, private signals of some fund suppliers became below the new5
Something is said to be common knowledge if one knows it, one knows that another knows it,
one knows that another knows that another knows it, one knows that another knows that anotherknows that another knows it, and similar statements with any number of hierarchies are true.

threshold, and a portion of fund-raisers emitting those private signals found it
difficult to borrow new funds.
If it is possible for authorities to control the expectations of market participants, the spreading difficulty in raising funds can be prevented. Namely, thefollowing may work to decrease the threshold:· Make market participants less pessimistic.
· Provide market participants with more accurate information.
The former does not seem so easy. The latter seems feasible. There is, however,
little evidence that financial institutions or the authorities actually provided theinformation, though the authorities have been stressing its importance. These may
explain one of the settings in which a rise in market awareness of risk remained
for a long time.
Second, the theoretical results explain the role of central bank lending when
there is a sharp rise in market awareness of risk. If the sharp rise can be regarded asa temporary phenomenon, it can be economically justified to provide funds publicly
to those who find difficulties in raising funds after the sharp rise. Central banklending can fill this role. The Bank of Japan actually provided ample funds, expanding excess reserves, as discussed in Section 2. The Bank of Japan also released
a statement in which it ensured smooth inter-bank transactions by providing necessary funds with a view to ensuring the stability of the financial system.
Theorem 4 indicates there is a more efficient way to provide funds and obtainthe same results. Namely, the following can reduce the amount of funds a central
bank needs to provide:· Make a commitment to provide funds to financial institutions with credit
risk measures within a pre-specified range.
· Make market participants believe this is common knowledge.
This does not necessarily coincide with what the Bank of Japan did. In that sense,
although what the Bank did was necessary and economically justified, it may nothave been the most efficient way if Theorem 4 is true.

5

Concluding remarks

This paper has set out to explain what happened in Japanese financial markets
when a number of financial institutions failed. Our model provided one possible
explanation and demonstrated the mechanism in which contagious effects of
expectation can trigger another liquidity crisis, shedding light on another aspectof systemic risk. Based on the model, we derived policy implications, which is a
first step in the study of optimal announcements from authorities.

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519

Table 1: Events in October 1997
10/3 Fri The ex-vice president of Yamaichi was arrested on charges of illegally
paying off Sokai-ya corporate racketeers and compensating them for investment losses.
6 Mon Tokyo-Mitsubishi Bank, Daiwa Bank, and Nippon Credit Bank provided
emergency loans and Nomura Securities announced that it was discussing
the acceptance of capital injection to Sanyo. These actions were planned inorder to support Sanyo in the negotiations with the life insurance companies
about suspending the maturity of subordinated loans.
8 Wed Echigo Securities was liquidated, affected by misappropriation of customers’ funds.
Kyoto Kyoei Bank decided to transfer its assets to Kofuku bank.
14 Tue
MOF began the examination of Hokkaido Takushoku Bank (HTB) to
support HTB in the negotiations for capital increase by reducing ambiguity
in its financial condition.
15 Wed The executive director of Japan Life Insurance announced that they would
not accept Sanyo’s offer for suspending the maturity of subordinated loans.
S&P downgraded the rating of HTB and Hokkaido Bank to speculative
grade.
16 ThuThe former president of Yamaichi was indicted on charges of illegally
paying off Sokai-ya and compensating them for investment losses.
19 SunThe big four securities companies were expected to announce losses in
September 1997 as their interim settlement. Yamaichi’s ordinary P&L fell
into the red.
21 TueShareholders of Yamaichi filed suit against Yamaichi for the charge ofillegally paying off Sokai-ya as shareholders’ derivative action.
The Supervisors Committee of Security Markets accused the former executives of Nikko Securities.
22 Wed The former executives of Nikko Securities were arrested and prosecutors
conducted search and seizure on the headquarters of Nikko Securities.
23 ThuThe former president of Yamaichi was re-arrested on suspicion of covering
losses of Showa Lease.
The big securities firms in the second tier fell into the red in September
1997 as their interim settlement.
24 Fri
Yamaichi’s loss amounted to 2.7 billion.
29 Wed Moody’s interviewed Yamaichi.
Four of the former executives of Daiwa Securities were arrested on suspicion of illegally paying off Sokai-ya.
The big four securities firms were expected to receive administrative action.
30 SunThe cumulative volume of deposit withdrawals from HTB since February
reached 1,200 billion, which amounted to 10% of the outstanding amount at
the end of last October.
Zenshinren Bank provided a loan to Hokkaido prefecture as a substitute for
HTB.
S&P downgraded the rating of Sumitomo Bank.

Table 2: Events before and after the shocks of Sanyo and Hokkaido
Takushoku Bank
11/1 Sat
3 Mon
4 Tue

6 Thu

7 Fri

13 Thu14 Fri17 Mon18 Tue19 Wed20 ThuConcerned life insurance companies announced their reservation for theissue of subordinated loans.
Sanyo Securities filed for corporate reorganization.
The main banks provided 15 billion in bridging loans to the Deposited
Securities Insurance Fund.
A default in the inter-bank call market occurred for the first time.
Newspapers reported that the life insurance companies were about to write
off the subordinated loans.
Trading of JGBs in London became inactive as market participants avoided
holding JGBs registered in Sanyo’s name.
Moody’s announced Yamaichi’s rating under investigation for downgrading
to speculative grade.
The Nikkei Index fell below 16,000. Yen declined to 124 ¥/$. Long-term
interest rate reached 1.570%, a historical low. Japan premium increased to
0.1%.
The ex-vice president and executives of Daiwa Securities were arrested on
suspicion of illegally paying off Sokai-ya. The number of arrested people
from the big four securities firms and DKB amounted to 36.
Yamaichi’s stock price suddenly plunged and the Nikkei Index dipped
below 16,000 during day-time trading.
IBCA downgraded the rating of IBJ.
IBCA downgraded the ratings of Asahi, Tokai, and Yokohama Bank.
Nikkei Index reached a new low for the year.
Stock prices of the bank sector fell to the lowest since the bubble burst.
Hokkaido Takushoku Bank transferred its assets to Hokuyo Bank, andasked the DIC to purchase its non-performing loans. BOJ supplied 600
billion of special loans to HTB.
The five city banks in Korea faced settlement problems caused by reluctance of foreign financial institutions to provide credit to Korean banks.
Japan premium reached 0.5%
MOF began examination of Hokkaido Bank.
Korean Won and Taiwanese dollar suddenly plunged.
BOJ supplied additional 150 billion of special loans.
Moody’s announced that downgrading of Fuji Bank was under consideration.
S&P announced that downgrading of DKB, Sakura, and Sanwa Bank wasunder consideration.
The Nikkei Index plunged 884, the largest decline in the year.
The DIC announced that it would purchase sound assets as well as nonperforming assets in the process of winding up HTB.

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521

Table 3: Events in November 1997, before and after the Yamaichi Shock
11/14 Fri S&P downgraded Yamaichi’s rating to speculative.
Yamaichi’s stock price dipped below par value (100 yen). MOF and BOJ
announced that subordinated loans to HTB would be secured.
16 SunYamaichi announced plans for restructuring including separation of thecompany, the first time for a Japanese securities firm and a reduction of
2,500 employees.
19 Wed Trading in Yamaichi stock was halted as the price reached 58 yen. The
Nikkei Index suffered its largest fall of the year and anxiety about theJapanese financial system among the markets spread.
The trading system of the Osaka Stock Exchange malfunctioned.
Fuji Bank announced that it would consider supporting Yamaichi.
21 FriMoody’s downgraded Yamaichi’s rating to speculative.
O/N interest rate in uncollateralized call market rose to 0.54% over theofficial discount rate. Japan premium increased and DJIA in NY fell because of the shock of Yamaichi.
22 Sat
The media reported that Yamaichi had decided to close down.
The head of the Security Bureau of MOF revealed the existence of off-thebook loans of Yamaichi. The executive director of BOJ announced that “ourfirst priority is to stabilize the financial markets.” MOF and BOJ announced
that all investors would be protected as a first priority and that subordinatedloans to HTB would be secured. The authorities of Japan and England
announced that they would collaborate in the operation.
23 SunThe board of Yamaichi confirmed that it would close down.
24 Mon BOJ announced “we are discussing liquidity support for Yamaichi Trust
Bank since these loans will not be irrecoverable and Yamaichi is solvent,”
and that “we will ask FRB New York to supply dollars if necessary.” The
Prime Minister and Minister of Finance announced that they would accept
the use of public funds.
Stock markets in the U.S. and European countries declined.
25 TueThe head of the Security Bureau of MOF suggested termination of Yamaichi’s license.
MOF could not find the off-the-book loans during its examination in 1993
and 1995. SCSM began a special examination.
Fuji Bank announced that Yamaichi had reported the existence of off-thebook loans in October.
TSE announced that they had examined whether the facts are claimed for
default event. Trading in Yamaichi’s CB was halted.
An executive of BOJ announced that no default event had occurred because
Yamaichi is solvent. BOJ supplied 800 billion of special loans.
Yamaichi decided to close all of its branches and affiliates abroad.
BOJ supplied unprecedented liquidity through Open Market Operation.
Long-term yield suddenly declined reflecting the unexpected BOJ operationof outright purchasing of government bond. Yen (to ¥/$128) and Nikkei
Index plunged. Trading in Nikkei 300 futures was halted by the circuit
breaker. Most of the stock indexes in Asian countries simultaneously
collapsed. Japan premium increased by 0.7%.

Table 4: Events and measures adopted by the authorities after the shocks
11/26
Wed

Minister of Finance and Governor of BOJ announced a state of emergency.
Tokuyo City Bank transferred its assets to Sendai Bank.
Kiyo Bank rejected the rumors of business problems, and MOF and BOJ announced their support.
Moody’s announced that most Japanese banks’ ratings were under investigation.
27 Thu
BOJ announced that it would flexibly utilize loans and did not expect defaults tooccur serially.
28 Fri
Yamaichi was prosecuted for the charge of false reporting.
12/1 Mon LDP announced that public funds should be injected to the Deposited Securities
Insurance Fund, which should be covered by the BOJ’s special loan.
Prime Minister announced plans for stabilizing the financial system.
3 Wed
MOF ordered security firms to investigate off-the-book liabilities.
BOJ conducted unexpected bond purchasing operation.
6 Sat
Yamaichi announced that it had an off-the-book liability in an Australian affiliate amounting to 106.5 billion yen.
MOF announced that foreign currency deposits and financial bonds are secured
by deposit insurance.
9 Tue
Yamaichi insider alleged that the company had reported its tobashi to MOF.
Prime Minister suggested that 10 trillion yen obtained by new type of government bonds should be utilized to stabilize the financial system.
10 WedHTB suggested the possibility of its insolvency at the Diet.
LDP announced that it would investigate widening the coverage of the Resolution and Collection Bank’s operation.
11 ThuSCSM recommended administrative action against Daiwa and Nikko to MOF.
12 FriAmendment Deposit Insurance Act was passed.
16 Tue
MOF announced that it would flexibly implement the PCA, i.e., i) the PCA
would not be activated against banks which adopted the domestic standard until
2001, ii) banks can choose either way of accounting for stock prices: original
book method or lower price method.
Nikko and Daiwa admitted they had illegally paid off Sokai-ya.
17 WedThe limit of borrowing by the Deposit Insurance was increased to 10 trillionyen.
19 FriToshoku Co. filed for corporate reorganization.
22 MonThe Nikkei Index declined below 15,000.
23 TueMaruso Securities Co. filed for voluntary bankruptcy.
24 WedLDP and the government announced that of the 10 trillion fund for financial
system stabilization, 3 trillion would be used for purchasing preferred stock, and7 trillion for securing depositors and for delivering to the Special Account of the
DIC. MOF announced that it had begun to investigate the feasibility of a new act
in which the financial authorities would have the autonomy to file for liquidationof securities firms.
25 ThuOrix Co. was reported to be merging with Yamaichi Trust.
S&P downgraded the ratings of Sanwa and Sakura.
26 Fri
MOF disclosed the result of the HTB examination.
27 SatOutstanding amount of BOJ’s CP purchasing operation increased.
29 Mon
MOF announced that the Deposited Securities Insurance Fund was secured by
the government.

Contagious expectations and malfunctions of markets

523

Figure 1: Interest rates on term instruments (3-month)1

Note : 1. The latest data are those for end-May 1998.
Source : Bank of Japan (1998).

Figure 2: Euro-yen TIBOR (3-month)1

Notes: 1. The latest data are those for end-May 1998.
2. The highest and lowest rates are those quoted by 15 Japanese banks with areference contract with the Quotation Information Center K. K. (QUICK) until
February 1998 and those quoted by 16 Japanese banks with a reference contract with the Federation of Bankers Associations of Japan (Zenginkyo) fromMarch 1998.
3. Average rates are arithmetic averages of those quoted by 15 Japanese bankswith a reference contract with the Quotation information Center K. K.
(QUICK) until February 1998 and those quoted by 16 Japanese banks with areference contract with the Federation of Bankers Associations of Japan (Zenginkyo) from March 1998.
Source : Bank of Japan (1998).

Figure 3: Money market operations(1) Excess reserves as of the morning1(2) Supply of funds2

Notes: 1. The amount of “excess reserves” is calculated by subtracting the daily averageof reserves to be deposited in the remaining reserve maintenance period fromthe current amount of reserves. The Bank of Japan conducts major market operations at 9:20 a.m. in principle. The resultant amount of excess reserves
based on the operations announced at 9:20 a.m. is referred to as “excess reserves as of the morning.” Data are for all business days in the period from the
beginning of October 1997 to the end of May 1998.
2. Data are amounts outstanding at the end of each month.
Source : Bank of Japan (1998).

Contagious expectations and malfunctions of markets

525

Figure 4: The Bank of Japan’s supply of funds maturing after the fiscal
year-end1

Notes: 1. Supply of funds refers to those supplied through the following measures:
market lending operations (excluding those conducted pursuant to Article 25of the former Bank of Japan Law); bill-purchasing operations; and funds
through treasury bill (TB) operations, bond-borrowing (“repo”) operations,bond gensaki operations (purchase with resale agreement), and commercial
paper (CP) operations.
2. Data include funds offered on March 31, 1998.
Source : Bank of Japan (1998).

References
Bank of Japan, 1998, “Annual Review of Monetary and Economic Developments
in Fiscal 1997,” Bank of Japan Annual Review, 57-154.
Carlsson, H., and E. van Damme, 1993, “Global Games and Equilibrium Selection,”
Econometrica 61, 989-1018.
Kajii, A., and S. Morris, 1997a, “Robustness of Equilibria to Imcomplete
Information,” Econometrica 65, 1283-1309.
Kajii, A., and S. Morris, 1997b, “Refinements and Higher Order Beliefs: A Unified
Survey,” mimeo, University of Pennsylvania.
Morris, S., R. Rob, and H. S. Shin, 1995, “p-Dominance and Belief Potential,”
Econometrica 63, 145-157.
Morris, S., and H. S. Shin, 1998, “Unique Equilibrium in a Model of SelfFulfilling Currency Attacks,” American Economic Review 88, 587-597.
Ui, T., 1998, “Robust Equilibria of Potential Games,” mimeo, Bank of Japan.