IMES DISCUSSION PAPER SERIESA Financial System Perspective
on Japan’s Experience in the Late 1980s

Masazumi Hattori, Hyun Song Shin, and Wataru Takahashi
Discussion Paper No. 2009-E-19

INSTITUTE FOR MONETARY AND ECONOMIC STUDIESBANK OF JAPAN
2-1-1 NIHONBASHI-HONGOKUCHOCHUO-KU, TOKYO 103-8660
JAPAN

You can download this and other papers at the IMES Web site:

http://www.imes.boj.or.jp
Do not reprint or reproduce without permission.

NOTE: IMES Discussion Paper Series is circulated inorder to stimulate discussion and comments. Views
expressed in Discussion Paper Series are those of
authors and do not necessarily reflect those of
the Bank of Japan or the Institute for Monetaryand Economic Studies.

IMES Discussion Paper Series 2009-E-19
August 2009

A Financial System Perspective
on Japan’s Experience in the Late 1980s
Masazumi Hattori*, Hyun Song Shin**, and Wataru Takahashi***
Abstract
This paper revisits the events of the 1980s bubble in Japan in light of the lessons
learned from the subprime crisis in the United States. Our focus is on the role
played by sectoral developments in the financial system in Japan. We highlightthe transformation of a subset of non-financial firms (the large manufacturingfirms) from being net debtors to the banks to becoming net creditors to the banks,
thereby becoming part of the financial intermediary sector. In this way, large
manufacturing firms in Japan played the role of surrogate wholesale banks that
increased the overall supply of credit to the economy. When good borrowers
already had credit and yet loose monetary conditions encouraged greater credit
supply, credit availability to marginal borrowers and to real estate-related sectors
increased. We discuss the role of market conditions and monetary policy in thisdevelopment.
Keywords: Balance sheet; Commitment; Credit supply; Financial liberalization;
Financial system perspective; Japan; Subprime crisis
JEL classification: E51, G21, G28, N22, N25*Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan(E-mail: masazumi.hattori@boj.or.jp)**Professor, Princeton University (E-mail: hsshin@princeton.edu)***Director-General, Institute for Monetary and Economic Studies, Bank of Japan (E-mail:wataru.takahashi@boj.or.jp)
This paper was presented at the 16th International Conference hosted by the Institute for
Monetary and Economic Studies, Bank of Japan, May 2009. We are grateful to some of thestaff members of the Bank of Japan for their helpful comments and suggestions in the
preparation of this paper. We are also grateful to Jouchi Nakajima and Hiroyuki Ooi for theirassistance. We appreciate the comments from Grant Spencer and Tsutomu Watanabe as a
discussant and we also appreciate the comments from Akira Ariyoshi, Katrin Assenmacher,
Marvin Goodfriend, Christopher Kent, Donald L. Kohn, Bennett T. McCallum, John Murray,
Maurice Obstfeld, Paul Tucker, and Kazuo Ueda at the conference. Views expressed in thispaper are those of the authors and do not necessarily reflect the official views of the Bank ofJapan.

1. Introduction
Financial booms and busts are complex phenomena that defy a simple explanation. The
fact that such booms and busts have taken place throughout history even as financial
institutions and instruments have undergone very dramatic changes over the centuries
should give us pause for thought before assigning blame to any particular feature or set of
economic developments in place at the time.
The global financial crisis that started with the subprime mortgage crisis in the UnitedStates in the summer of 2007 gained further momentum in 2008, engulfing not only otherdeveloped countries in Europe and elsewhere, but spreading its influence to emerging
market economies also. The lessons that we are learning from the current global
financial crisis provide valuable insights with which to revisit past episodes of financial
booms and busts. In particular, the US mortgage crisis provides many lessons on the roleof financial innovation and the importance of the increased supply of credit that resultsfrom securitization and the tapping of new sources of funding beyond the traditional
deposit funding for the banking sector. Whereas retail deposits were the traditional
funding source for the bank-based financial system, the shift to a market-based financial
system and the securitization of financial claims enables the tapping of new sources offunding for the banking sector – both domestic and foreign.
In this paper, we offer a re-assessment of the financial boom that took place in Japan in
the late 1980s in the light of the lessons learned from the subprime crisis in the UnitedStates. The empirical features of the 1980s bubble that we draw attention to have been
discussed by others before us.1 Our contribution is to gather them in a financial systemperspective where the interlocking balance sheets of banks and non-financial firms are
considered as a unified whole.
In the US subprime crisis, understanding the role of securitization in opening up new
sources of funding is important in understanding the overall increase in mortgage funding
to household borrowers. As we will see below, securitization enabled the increased
funding to US households by increasing the overall leverage of the US financial system
as a whole. In the case of Japan in the 1980s, our particular focus is on corporate lending
following the sectoral changes that took place in Japan after the liberalization of bothsecurities markets and the rules governing bank deposits.
Securities markets enabled the opening up of new funding sources – both domestic andforeign – away from traditional retail deposits. We highlight the role played by a subset
of non-financial firms: the large manufacturing firms in Japan. As recently as the early
1980s, manufacturing firms in Japan received virtually all of their financing from thebanking system, both for long-term investment as well as for short-term liquidity needs.
However, with the liberalization of the securities market that began in the mid-1980s,
non-financial companies were able to tap new sources of funding from outside thetraditional banking sector. New stock, corporate bonds, warrants and commercial paper1

For example, Borio and Lowe (2002), Borio and White (2003), Okina, Shirakawa and Shiratsuka (2001),
Posen (2000) among others.

1(CP) increasingly became important sources of funding for non-financial firms. The newfunding was supplied by domestic savers and other non-leveraged financial institutions
such as life insurance companies who purchased the bonds and other securities issued by
Japanese companies. Foreign investors also figured among the new funding sources.
As new funding sources opened up, it became profitable for non-financial firms to act asfinancial intermediaries by raising funding in the capital markets through securities, andthen supplying the new funds raised to the banking system by means of newly introduced
time deposits with liberalized interest rates. The financial assets of non-financial
corporations increased dramatically together with their financial liabilities in the late1980s. For a brief period in the late 1980s, the financial assets of non-financial
companies overtook their financial liabilities.
In this way, the non-financial companies became de facto financial intermediaries. They
became financial intermediaries that drew market-based finance and supplied financing to
the banking system by holding large deposit claims on the banks.
From the banks’ point of view, such a development was a double blow. First, they losttheir traditional customers – their traditional corporate borrowers. Second, they had to
deploy their newly acquired funding from corporate deposits. Hence, the banks were
under an even greater imperative to expand their lending to new borrowers. Not only had
they lost their traditional corporate borrowers, there was a reversal of roles in which thecorporate borrowers became creditors to the banks. They become depositors who
supplied additional funding that needed to be lent out.
The imperative to expand lending meant that Japanese banks had to lower their lending
standards in order to find new borrowers. Increasingly, such borrowers were the lesscredit worthy firms such as small and medium sized enterprises (SMEs) that werepreviously shut out of the credit market, and toward borrowers that relied on real estatecollateral. As real estate lending increased, the property bubble gained impetus. Oncethe structural shift had taken place toward greater credit supply to real estate-based
lending, the familiar property boom took hold.
In the rest of this paper, we will outline the argument in more detail. We begin with aconceptual framework that allows us to quantify the total credit supply to an economy bytracing the role of financial intermediaries in an interlocking system of creditor-debtor
relationships. The overall supply of credit in a financial system should be seen as theoutcome of many interrelated decisions of financial intermediaries in the system.
We then outline the empirical evidence on the broad sectoral developments in theJapanese financial system in the 1980s, as well as chart the role played by particularepochs of financial liberalization. We highlight in particular, the importance of securities
markets, and the role played by new securities in tapping sources of financing that weretraditionally off limits to borrowers and the role played by newly introduced time
deposits with liberalized interest rates that helped banks to expand their liability size.

2

Through this exercise, we can point to several points of similarity between the US
mortgage boom that led up to the crisis of 2007/2008 and the 1980s bubble in Japan. In
particular, the following parallels are striking:•In both cases, new securities increased the supply of overall credit to the economy
through the tapping of new credit sources. In the US mortgage crisis, the new
securities were mortgage-backed securities issued by the US government
sponsored enterprises (GSEs), as well as by the private-label mortgage pools that
contained subprime mortgages. In the 1980s bubble in Japan, the new securities
were corporate bonds, warrants and CP issued by Japanese non-financial
companies.

•

In both cases, non-leveraged purchasers of the new securities were important new
funding sources. In the US mortgage crisis, foreigners (especially foreign central
banks) bought the mortgage-backed securities (MBSs) of the US GSEs. In the
1980s bubble in Japan, non-leveraged institutions such as life insurancecompanies and foreign investors were the buyers of Japanese corporate
securities.2•

In both cases, the expansion of credit provided by the commercial banking sector
received impetus from the integration of the commercial banking sector with thecapital markets. In the US mortgage crisis, although it did not become obvious
until the end of the financial boom, the balance sheet expansion of commercial
banks occurred in tandem with market-based credit and the associated expansionof the balance sheets of investment banks. In the 1980s bubble, the balance sheet
expansion of commercial banks was closely related to that of large non-financial
firms that raised funds by tapping capital markets.

However, there are also important differences between the US mortgage boom and bustand the 1980s bubble in Japan:•

In the US mortgage crisis, the borrowers were households, while in the 1980s
bubble in Japan, the borrowers were companies.

•

In the US mortgage crisis, the new securities were primarily debt securities thatenabled the financial system as a whole to become more leveraged. In the 1980s
bubble in Japan, the credit boom coincided with a boom in the stock market sothat a large proportion of the securities were equity issues and the leverage of thebanking sector actually declined.

The importance of securities funding and the role of market-based financial instruments
points to the importance of monetary policy in determining the overall tenor of financial
market conditions and the credit spreads that sharpen the incentives of market players.
This is because the incentives that govern funding and lending are ultimately driven by2

In the Flow of Funds Accounts Statistics, the prime holders of securities issued by non-financial firms in
the late 1980s were foreigners categorized as “Overseas”. However, we should be careful in interpreting
statistics for “Overseas” because the amounts held by foreign subsidiaries of Japanese firms are also
included in this category.

3

market prices. We return to this issue later in our paper, when we comment on theimplications of our study for the conduct of monetary policy.

2. Financial System Perspective: Theory and Recent US Case
A simplified analytical framework for our analysis can be given in the diagram below.
The financial intermediary sector channels funds from equity holders and ultimate
lenders (“outside claim holders”) to the ultimate users of those funds (“end-user
borrowers”).
The identity of the end-user borrowers depends on the particular case studied. In the US
mortgage boom and bust, the end-user borrowers are households who have borrowed tobuy residential property.
In the case of the 1980s bubble in Japan, the group of
borrowers who figure in the story will be mainly corporate borrowers.

equityend-userborrowers

loans

financialintermediaries

outsidedebt claims claim holders

The constituents of the financial intermediary sector itself will depend on the context.
For the US mortgage boom and subsequent crisis, the intermediary sector includes theoriginating banks, but also includes the entities such as the GSEs and GSE mortgage
pools that were involved in the securitization process.
In the case of the 1980s bubble in Japan, the financial intermediary sector includes thebanking system as a whole, but we will argue below that non-financial companies
became incorporated as part of the financial intermediary sector.
Irrespective of the context, at the aggregate sector level (i.e., once the claims andobligations between leveraged entities have been netted out), the lending to ultimate
borrowers must be funded either from the equity of the intermediary sector or byborrowing from creditors outside the intermediary sector. To see this, consider asimplified balance sheet of an individual bank, as follows:4Assets

Liabilities

Loans to firms,
households

Liabilities to non-banks(e.g. deposits)

Claims on otherbanks

Liabilities to other banks
EquityIndividual bank

By “bank” we mean any leveraged institution that could be construed as part of thefinancial intermediary sector. In the US context, the “banking system” therefore denotes
the whole of the leveraged financial sector, which includes the traditional commercial
banking sector, but also encompasses leveraged institutions such as investment banks,
hedge funds and (in the United States especially) the government sponsored enterprises(GSEs) such as Fannie Mae and Freddie Mac. When we aggregate across banks, all theclaims and obligations across banks cancel out. So, the aggregate balance sheet for thebanking sector as a whole looks as follows.
AssetsLiabilities

Total lending toFirms and households

Liabilities to non-banks(deposits + securitized debt)
Total equity

Banking sector

In other words, aggregate lending to end-user borrowers by the banking system must be
financed either by the equity in the banking system or by borrowing from creditors
outside the banking system. For any fixed profile of equity and leverage acrossindividual banks, the total supply of credit to ultimate borrowers is larger when the banks
borrow more from creditors outside the banking system. Put differently, the leverage ofthe financial sector is increasing as banks increase the proportion of their funding thatcomes from creditors outside the banking sector.3
Indeed, it is possible to derive a formula based on accounting identities alone (see Shin(2008)) in which the total lending to ultimate borrowers can be written as a function of
the profile of equity, leverage and funding source of the individual financial
intermediaries. In particular, when we denote:yi : lending of bank i to ultimate borrowers plus holding of real assets
ei : equity of bank i
3

See Greenlaw, Hatzius, Kashyap and Shin (2008).

5

λi : leverage of bank i (ratio of total assets to equity)z i : proportion of bank i’s funding that comes from outside the banking system
Then, the sum of yi across all banks (i.e., total lending to ultimate borrows plus holdingof real assets) can be written as:∑ y = ∑ e (1 + z (λ − 1))
i

i

i

i

i

i

In the appendix to the paper, we derive the above formula. The point to emphasize hereis that the zi terms are crucial in determining aggregate lending to end-users. Note that zi
refers to the proportion of funding that comes from sources outside the banking sector.
Even if we fix the leverage profile of individual banks, a shift in the funding source of
those banks toward greater use of non-leveraged claim holders would increase the total
supply of lending to end user borrowers.
One way in which zi can increase is when banks issue securities which are then bought by
non-leveraged institutions, such as mutual funds or insurance companies. In a traditionalbanking system that intermediates between retail depositors and ultimate borrowers, thetotal quantity of deposits represents the obligation of the banking system to creditors
outside the banking system. However, securitization opens up potentially new sources offunding for the banking system by tapping new creditors. The new creditors are those
who buy mortgage-backed securities (MBSs), claims that are written on MBSs such as
collateralized debt obligations (CDOs), and (one step removed) those who buy the assetbacked commercial paper (ABCP) that are ultimately backed by CDOs and MBSs. The
new creditors who buy the securitized claims include pension funds, mutual funds andinsurance companies, as well as foreign investors such as foreign central banks. Foreign
central banks have been a particularly important funding source for residential mortgage
lending in the United States.
Although securitization may facilitate greater credit supply to ultimate borrowers at theaggregate level, the choice to supply credit is taken by the constituents of the banking
system taken as a whole. For a financial intermediary, its return on equity is magnified
by leverage. To the extent that it wishes to maximize its return on equity, it will attempt
to maintain the highest level of leverage consistent with limits set by creditors (forinstance, through the “haircuts” on repurchase agreements). As measured risk fluctuates,
so will leverage itself. In benign financial market conditions when measured risks are
low, financial intermediaries expand balance sheets as they increase leverage.
Securitization enables the tapping of new creditors, thereby increasing the proportion of
the banks’ funding that comes from creditors outside the banking sector. In this way, theleverage of the banking sector as a whole increases.
Although the intermediary could increase leverage in other ways – for instance, returning
equity to shareholders or buying back equity by issuing long-term debt – the evidence
suggests that they tend to keep equity intact and adjust the size of total assets (see Adrianand Shin (2007, 2008)).

6

As balance sheets expand, new borrowers must be found. When all prime borrowers
have a mortgage, but still balance sheets need to expand, then banks have to lower theirlending standards in order to lend to subprime borrowers. The seeds of the subsequent
downturn in the credit cycle are thus sown.
When the downturn arrives, the bad loans are either sitting on the balance sheets of thelarge financial intermediaries, or they are in special purpose vehicles (SPVs) that thefinancial intermediaries sponsor. This is so, since the bad loans were taken on precisely
in order to utilize the slack on their balance sheets. Although final investors such aspension funds and insurance companies will suffer losses, too, the large financial
intermediaries are more exposed in the sense that they face the danger of seeing theircapital wiped out. The severity of the credit crisis of 2007/2008 lies precisely in the factthat the bad loans were not all passed on to final investors. Instead, the “hot potato” sits
inside the financial system, on the balance sheet of the largest and most sophisticatedfinancial intermediaries.
A complete disaggregation of the funding source for the banking sector is not possible
due to the lack of detailed breakdowns in the data between funding from leveraged andunleveraged creditors. However, we can gain glimpses from different perspectives. One
way is to examine the identity of the holders of US agency and GSE-backed securities.

Trillion Dollars

Figure 1. Holdings of GSE-Backed Securities
8.0
7.0

Rest of the world
6.0

Non-financial sectors

5.0
4.0

Non-leveraged financial
institutions

3.0

Leveraged financial
institutions

2.0
1.0
0.0
2001

2002

2003

2004

2005

2006

2007

Source: Flow of Funds Accounts, Federal Reserve.

The above figure plots the total holdings of US agency and GSE-backed securities broken
down according to the identity of the creditor. The data are from the US Flow of Funds
Accounts (table L.210). Leveraged financial institutions include commercial banks,
broker dealers and other securitization vehicles. The non-leveraged financial institutions
include mutual funds, insurance companies and pension funds. The “non-financial
sector” includes household, corporate and government sectors. Finally, the “rest of the7

world” category indicates foreign creditors, especially foreign central banks or otherofficial sector holders. The figure below charts the holders by percentage holdings.
Figure 2. Holdings of GSE-Backed Securities (percentages)
100%
90%
Rest of the world
80%
70%
Non-financial sectors
60%50%

Non-leveraged financial
institutions

40%
Leveraged financial
institutions

30%
20%
10%
0%
2001

2002

2003

2004

2005

2006

2007

Source: Flow of Funds Accounts, Federal Reserve.

The key series for our illustration is the proportion held by other entities than leveraged
financial institutions. US leveraged institutions have been holding a declining proportionof the total. At the end of 2002, leveraged financial institutions held 48.4% of the total,
but by the end of 2007, that percentage had dropped to 36.7%. There has been aconsequent increase in the funding provided by the non-leveraged sector. Notably, theholdings of the “rest of the world” category (which itself is mostly accounted for byforeign central banks) have more than tripled from $504 billion at the end of 2001 to$1,540 billion at the end of 2007. In this sense, foreign creditors have been an
increasingly important funding source for residential mortgage lending in the UnitedStates.
According to the picture painted here, the subprime crisis has its origin in the increased
supply of loans – or equivalently, in the imperative to find new assets to fill the
expanding balance sheets. In this way, it is possible to explain two features of thesubprime crisis: first, why apparently sophisticated financial intermediaries continued tolend to borrowers of dubious creditworthiness, and second, why such sophisticatedfinancial intermediaries held the bad loans on their own balance sheets, rather thanpassing them on to other unsuspecting investors. Both facts are explained by theimperative to use up slack in balance sheet capacity during an upturn in the credit cycle.

8

3. Financing of Non-Financial Companies under Financial Liberalization: Japan’s
Bubble CaseAs with the mortgage boom in the United States, the 1980s bubble in Japan is also linked
with the development of securities markets as a funding source. The corporate bondmarket had started in the late 1970s, but was initially off-limits to most firms due to strict
qualifying standards. However, during the 1980s, the corporate bond market became
increasingly accessible.
In 1979, issuing of unsecured bonds and convertible bonds were permitted, but thecriteria were so stringent that only two companies in Japan qualified (Toyota Auto andMatsushita Electric). However, by 1988, the number of firms qualifying for unsecured
straight bonds increased to approximately 300, while the number of firms qualifying forconvertible bonds increased to around 500.4 Also, starting in 1987, the issuing of CP(unsecured short-term liabilities) was permitted for Japanese firms for the first time.
As a result of the opening up of market-based funding for non-financial companies, therelationship between the banking system and the non-financial company sector
underwent a fundamental shift in the late 1980s. A subset of the non-financial companies– especially the large manufacturing firms – ceased to rely on bank financing, and tapped
the capital markets instead.
Even more significantly, the non-financial companies that had good access to market
financing raised surplus funding from the markets, and then deposited the surplus in thebanking system in the form of time deposits with liberalized interest rates that attracted
high rates of interest. The time deposits with liberalized interest rates were introduced in
the process of financial liberalization in 1985. 5 In effect, the non-financial companies
transformed their roles vis-à-vis the banking system. They went from being a debtor to
the banks to becoming a creditor to the banks.
The implications for the total supply of credit to the economy as a whole can be seenfrom the equation:nn∑ y = ∑ e (1 + z (λ − 1))
i

i =1

i

i

i

i =1

The non-financial firms in effect became integrated into the financial system byintermediating between the capital market and the banking sector. The number of banks
in the intermediary sector (given by n) increased. They borrowed from the capital
markets by issuing bonds, or raised new equity by issuing new stock. Then, they
supplied this funding to the banking system by depositing the proceeds in the banks.
Ultimately, these deposits would be matched by assets on the banks’ balance sheets.
4

Hoshi and Kashyap (2001, p. 229-230).
The role played by time deposits with liberalized interest rates in the flow of funds was significant. This
was not only because the financial product yielded competitive market interest rates, but also because it had
flexible terms above the regulated minimum term. We discuss their role in detail in a later section.
5

9

Just as the US mortgage boom relied on high values of zi in the equation above, the 1980s
bubble in Japan rested on the appearance of new financial intermediaries who fundedthemselves by tapping the capital markets, and who supplied funds to the banking sector
in the form of newly liberalized bank deposits. The new funding came ultimately from
non-leveraged institutions such as life insurance companies and foreign investors.6
The diagram below illustrates the main structural change. A subset of non-financial firms(depicted by the colored rectangle in the diagram) underwent a transformation in its
relationship vis-à-vis the financial intermediary sector. Whereas previously it was aborrower from the intermediary sector, the firms underwent a reversal of roles, to become
net creditors to the banks, thereby becoming integrated into the financial intermediary
sector.
Just as with the US subprime crisis, the structural change coincided with financial
innovation, especially with the development of the securities market. Whereas the US
subprime crisis was primarily one about debt financing through securities, the 1980s
Japanese experience is also about equity financing, as well as debt financing.

end-userborrowers
households

firms

financial intermediary sector
equityloans

banking
sectordeposits

outsidedebt
claim
holders
claimsequity andsecurities

firms

The sums raised by Japanese firms in the capital markets rose very substantially in thelate 1980s. For instance, in 1984, newly issued securities by all listed Japanese firms wasaround 5.4 trillion yen. That figure had gone up to 28.4 trillion yen in 1989. In thisincrease of securities funding for the Japanese financial system, foreign investors playeda key role. For instance, the proportion of bonds issued outside Japan was 60% of thetotal in 1989. The parallel with the US mortgage boom is striking (Table 1).

6

It is also notable in the late 1980s that individuals’ preference for time deposits at banks over postal
savings was strong and it led to increases in deposits held by individuals at banks. This can be captured asa factor increasing zi in the equation. The related figures are shown in a later section.

10

Debt financing through bond offerings was not the only source of capital market
financing available to Japanese firms. Listed firms were able to issue new stock andraised substantial funding through the capital markets. In 1986 the total stock financingof listed firms in Japan stood at 0.87 trillion yen. By contrast, in 1989, the total stock
financing rose ten-fold to 8.8 trillion yen (Table 2).

Table 1. Securities Financing by Listed Firms, 1972-98
Distribution (%)

year

Total securities(million yen)

Stock

Bonds

1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

1,784,689
2,240,766
1,741,396
3,187,449
2,302,001
2,543,740
2,972,270
3,298,028
2,883,285
4,400,028
4,084,502
4,048,420
5,409,408
6,890,503
8,395,196
14,455,291
17,636,098
28,410,407
14,441,448
12,500,454
9,619,910
11,143,567
8,499,604
8,094,650
13,616,878
10,162,545
15,906,750

58.4
41.9
31.2
31.4
29.9
36.3
30.2
28.9
36.5
43.8
33.0
19.8
19.3
12.5
10.4
20.8
27.1
31.1
26.3
6.5
4.4
7.4
11.0
7.9
15.2
11.4
9.7

41.6
58.1
68.8
68.6
70.1
63.7
69.8
71.1
63.5
56.2
67.0
80.2
80.7
87.5
89.6
79.2
72.9
68.9
73.7
93.5
95.6
92.6
89.0
92.1
84.8
88.6
90.3

Source: Hoshi and Kashyap (2001).

11

Foreign bonds
as %
as %
total
total bonds
0.0
0.0
0.1
0.2
3.4
4.9
11.7
17.0
18.1
25.8
14.7
23.1
16.4
23.5
24.0
33.8
24.1
37.9
19.8
35.2
27.7
41.3
44.8
55.9
44.0
54.5
51.0
58.2
48.2
53.8
39.9
46.6
30.5
41.9
41.4
60.0
35.8
48.5
63.5
67.9
60.2
62.9
45.0
48.6
22.6
25.4
23.2
25.1
18.3
21.6
23.4
26.4
10.0
11.1

Table 2. Stock Financing by Listed Firms, 1972-98
Year

Total
(million yen)

1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

1,041,409
939,266
544,007
1,001,104
688,723
922,601
896,653
953,439
1,052,076
1,926,415
1,349,335
801,757
1,043,132
859,113872,5143,013,048
4,782,307
8,848,608
3,792,439
807,733
419,907822,790935,740
638,4132,073,967
1,162,369
1,540,397

Distribution (%)
Publicoffering
63.9
60.2
51.0
22.1
70.9
65.4
63.1
65.9
83.7
72.5
79.5
58.8
78.1
58.9
45.8
46.3
54.0
65.9
52.1
15.6
1.0
0.9
14.6
5.2
14.7
11.0
18.5

Warrant
exercise
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.2
3.8
6.3
16.0
42.7
35.6
27.4
24.7
17.9
44.6
48.4
75.0
48.2
46.9
32.5
31.7
5.7

Other
36.1
39.8
49.0
77.9
29.1
34.6
36.9
34.1
16.3
27.5
20.3
37.4
15.6
25.2
11.4
18.1
18.6
9.4
30.0
39.8
50.7
24.1
37.2
47.9
52.8
57.3
75.8

Source: Hoshi and Kashyap (2001).

4. Financial Intermediation by Non-Financial Companies
As a result of the increased access of non-financial companies to the capital markets, thenature of the balance sheets of these companies began to undergo fundamental changes.
First, in aggregate terms, the role of private non-financial companies in their relationshipwith the rest of the economy changed from being net debtors to net creditors. The change
can be seen in the following figure, obtained from the Flow of Funds Accounts for Japan.

12Figure 3. Net Financial Position of Private Non-Financial Corporations
1000
Difference between financial assets andliabilities: A-B
Financial liabilities (excluding shares and other
equities): B

800

Financial assets: A

Trillion yen

600

400

200

0

-200

-400
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Note: End of fiscal year. Source: Flow of Funds Accounts, Bank of Japan.

We can see from this figure that the financial assets of Japanese non-financial firms
increased rapidly in the late 1980s. In 1986, financial assets exceeded financial liabilities
for the first time, and this difference continued to increase. The peak came in 1988, whenthe excess financial assets of non-financial firms reached 29 % of nominal GDP.
The nature of the financial assets is crucial for the rest of our argument, as we will show
now that the non-financial firms were raising capital market funds, and then channelingsuch funding into the banking system.
One indicator is the liquidity ratios for non-financial firms, as measured by the sum of“cash and deposits” and “securities in liquid assets (hereafter, “securities”)”. We firstexamine the “liquidity ratio”, which is defined as follows:
Liquidity Ratio = (cash and deposits + securities assets) / sales
In this ratio, “sales” are used as the standardizing variable so that we gain an indication of
the holding of cash and deposits as a transactions buffer in the course of everyday
business. A high liquidity ratio indicates aggressive financial investments by that firm.
The figure for all industries by size shows the liquidity ratio was high for all size groups
in the bubble period, but was especially pronounced for large enterprises (Figure 4).
These were the companies that had the best access to the capital markets, and so it
indicates that they were the most aggressive in re-cycling such funding to the banking
sector.

13

Figure 4. Liquidity Ratio of All Industries by Size25%
Large enterprises
Medium-sized enterprises
20%

Small enterprises

15%

10%

5%
1976 77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Source: Financial Statements Statistics of Corporations by Industry, Ministry of Finance.

Looking at the manufacturing and non-manufacturing enterprises separately, we have thefollowing observations (Figures 5 and 6):•

Non-manufacturing enterprises of all sizes increased their liquidity ratio.

•

Large enterprises had larger increases in the liquidity ratio in the bubble period.

•

Large manufacturing enterprises had achieved the highest liquidity ratio.

•

Medium-sized and small manufacturing enterprises did not have large increases in
the liquidity ratio.
Figure 5. Liquidity Ratio of Manufacturing Firms by Size25%
Large enterprises
Medium-sized enterprises
20%

Small enterprises

15%

10%

5%
1976 77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

Source: Financial Statements Statistics of Corporations by Industry, Ministry of Finance.

14

92

93

94

95

Figure 6. Liquidity Ratio of Non-Manufacturing Firms by Size25%
Large enterprises
Medium-sized enterprises
20%

Small enterprises

15%

10%

5%
1976 77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Source: Financial Statements Statistics of Corporations by Industry, Ministry of Finance.

In effect, a high liquidity ratio is indicative of a type of “carry trade” conducted by thenon-financial firms. The transaction is a purely financial one in which funds are raised in
the capital markets by issuing securities, and then deposited in the banking sector in theform of deposits.
The purely financial aspect of the transaction can be verified also by looking at changes
in correlation between liquidity held by non-financial firms and the timing of theirbusiness fixed investments (Figure 7). In the 1970s, there was a negative correlation
between the liquidity ratio and the lagging growth rate of business fixed investments by
non-financial firms. It means that liquidity holdings decreased when they were used forthe disbursements for business fixed investments. But, in the 1980s, the negative
correlation started becoming much weaker. Eventually, it virtually vanished with a large
increase in the liquidity ratio in the second half of the decade.

15

Figure 7. Liquidity Ratio and Business Fixed Investment Annual Growth Rate
50%
Liquidity ratio (lhs)

70%

40%

Business fixed investmet growth rate (rhs)

30%

60%
20%
10%

50%
0%
-10%

40%

-20%

30%
1970 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95-30%

Note: Large enterprise. Four-quarter backward moving average. The 4th lag for business fixed investment
annual real growth rate. Quarterly data. Source: Financial Statements Statistics of Corporations byIndustry, Ministry of Finance.

The reason for the collapse of the negative correlation between the liquidity ratio andbusiness fixed investments can be attributed to the introduction of time deposits withliberalized interest rates. Before the financial product was available, Japanese firms
could not hold the funds in their deposit accounts yielding competitive market interest
rates. Therefore, the opportunity cost of holding unused liquidity was so high that thefirms needed to carefully schedule the timing of fund raising and the disbursements forbusiness fixed investments to avoid timing mismatches. The introduction of time
deposits with liberalized interest rates enabled the firms to raise funds by tapping capital
markets without paying much attention to the timing of the disbursements. The reason
was twofold. First, as already noted, interest rates of time deposits with liberalizedinterest rates were as high as competitive market interest rates and the opportunity cost ofholding unused liquidity effectively vanished. Second, the term of time deposits withliberalized interest rates could be chosen flexibly by depositors, provided that it was
longer than the minimum term set by the regulation. The regulated minimum term wasgradually shortened, contracting from three months to one month in late 1987. The
flexibility in the term of time deposits and their competitive interest rates enabled nonfinancial firms to raise funds in the capital markets and keep them in the form of time
deposits without opportunity cost for potential disbursements for business fixed
investment in the future. 7
We next examine a more detailed picture of the composition of the corporate balance
sheets in an aggregate form from the Flow of Funds Accounts.

7

A more detailed discussion is provided in Bank of Japan (1991a).

16

We begin with the liabilities side of the corporate balance sheet, and in particular theflows of new liabilities (Figure 8). A notable difference between the period before 1987
and the bubble period (say, 1987 to 1989 or 1990) is the funding raised by “shares andother equities” and “securities other than shares”. Also notable is the large item
classified as “loans”.
Since we are examining the aggregate corporate series, we have put together companies
that tap the securities markets with those that rely on bank financing. What is notable ishow both market-based and bank-based funding increased during the bubble period in thelate 1980s.
Figure 8. Fundraising by Private Non-Financial Corporations(Total)120
OthersTrade credits and foreign trade credits
Securities other than shares
Shares and other equities
Loans
Total

100

Trillion yen

80

60

40

20

0

-20
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Source: Flow of Funds Accounts, Bank of Japan.

Still on the liabilities side of the corporate balance sheet, a more detailed breakdown of
the “securities” category can be seen in Figure 9, below.
Securities here mean “shares and other equities” and “securities other than shares” thatare a component in Figure 8. Some features are noticeable. First, it is notable how thefunds raised through the securities market increased in the late 1980s. This confirms our
discussion earlier on the increased importance of capital market funding for Japanesecompanies in the late 1980s.
Note also the emergence of CP as a funding source for companies. CP was permitted in
November of 1987, and saw a rapid adoption by the corporate sector.
One feature that distinguishes the 1980s bubble in Japan from the US mortgage boom is
the increased use of equity financing. We can see that the funding raised from “sharesand other equities” was very substantial in the bubble period.

17

Figure 9. Fundraising by Private Non-Financial Corporations(Securities)
30
Other "securities other than shares"
Commercial paper
External securities issued by residents
Industrial securities
Shares and other equities
Total

25
20

Trillion yen

15
10
5
0
-5
-10
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Source: Flow of Funds Accounts, Bank of Japan.

We now turn to the asset side of the balance sheet, and examine how the firms used thefunding that they raised in the capital markets. The most notable feature is the “carrytrade” mentioned above, in which funds raised in the capital markets were reinvested in
the banking system through deposits. Note in Figure 10 that the inflows into deposits in
1987 to 1989 were very high.
The deregulation of bank deposit interest rates can be expected to have played a key rolein this development of the “carry trade”. In 1985, time deposits with liberalized interest
rates were introduced. The increase in deposits picked up more noticeably later in thedecade. The role of market interest rates and the stance of monetary policy are crucial inunderstanding those trends, and we will return to this issue in a later section.

18

Figure 10. Financial Investments by Private Non-Financial Corporations(Total)100
OthersTrade credits and foreign trade credits
Securities other than shares
Shares and other equities
Currency and deposits
Total

80

Trillion yen

60

40

20

0

-20

-40
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Source: Flow of Funds Accounts, Bank of Japan.

A more detailed breakdown of the currency and deposits category can be seen in Figure
11. We see that the biggest increases in the deposits took the form of time deposits thatearned the highest interest rates. During the midst of the bubble period, almost all of theincrease in bank deposits took the form of time deposits. In 1990, once the bubble had
burst, time deposits were drawn down substantially by firms that withdrew cash for theirown use.
Figure 11. Financial Investments by Private Non-Financial Corporations(Currency and Deposits)
25
Others including demand
deposits
Certificates of deposits

20
15Time and savings
deposits
Currency and deposits

Trillion yen

10
5
0
-5
-10
-15
1980

81

82

83

84

85

86

87

Source: Flow of Funds Accounts, Bank of Japan.

19

88

89

90

91

92

93

94

95

It should also be remembered that during the bubble period, household savers alsopreferred time deposits at banks to postal savings. This was due to the higher interest rate
paid to time deposits at banks that were based on market interest rates, as opposed toregulated postal saving rates. In 1980-84, 41% of the increase of individuals’ time andsaving deposits including postal savings went to postal savings. In 1985-89, that share
was down to 35.7%. In 1990-94, it rose again, to 45.6%.
Figure 12 below shows that time deposits at city banks as a share of total deposits
increased from about 60% to 70% during the bubble period.

Figure 12. Share of Time Deposits in Total Outstanding Deposits
75%

70%

65%

60%

55%

50%
1975 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

Note: City banks. Excluding offshore accounts. Source: Economic Statistics Annual,Bank of Japan.

Market interest rate-based time deposits as a share of total time deposits at city banks
increased dramatically in the late 1980s. It was 8.4% in 1985, rising to 88.0% in 1990.
Over the same period, the share of market interest rate-based time deposits as aproportion of total deposits at city banks increased from 5.2% to 61.6%.
The effect of the increase in the share of market interest rate-based time deposits was
twofold. First, it raised the cost of deposit funding for banks in comparison withregulated deposit interest rates. Second, it gave banks the flexibility to raise deposits
without increasing the number of branch offices and resorting to non-price, laborintensive competition measures at branch offices, such as frequent visits to customers. It
is plausible that it became easier for city banks especially to increase deposits via theirwholesale business because large-sized time deposits with liberalized interest rates weretypically from companies. They could get such deposits at the wholesale sections of themain office and existing branch offices.
Concurrent with the increased proportion of time deposits in the deposit base for thebanking sector, there was also a shortening of maturities, reflecting the greater short-term
20nature of the deposits held by the companies. The “carry trade” interpretation of thedeposit claims appears consistent with this evidence. Figure 13 below shows the average
maturity of the deposits at all banks. There is a conspicuous shortening of maturities
during the bubble period. By accepting time deposits with shorter terms, banks could
lower the cost of deposits. As we have already seen, the minimum term of market
interest rate-based time deposits was gradually shortened and this deregulation enabledbanks over the years to accept time deposits with increasingly short terms.
Figure 13. Average Maturity of Time Deposits
15

Months

10

5

0
1985

86

87

88

89

90

91

92

93

94

95

Source: Economic Statistics Annual, Bank of Japan.

A more detailed picture of the maturity structure of time deposits can be seen in Table 3.

21

Table 3. Breakdown of Time Deposits by Term
Ordinary Time Deposits
Corporations
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995

1 month or more 3 months or more 6 months or more
but less thanbut less thanbut less than 1
3 months
6 months
year
4.2
6.5
8.6
6.0
19.8
6.9
16.3
18.8
7.0
24.5
24.8
6.7
38.9
28.3
8.2
38.2
30.5
9.8
41.0
26.1
8.2
39.0
23.4
7.4
42.0
21.2
9.6
37.2
23.7
11.0

1 year or more

Sub-total

Maturity-designatedTime Deposits

Total

88.0
84.3
72.4
57.2
43.4
24.2
21.1
24.1
29.8
26.9
27.8

98.7
98.9
99.1
99.3
99.4
99.6
99.6
99.5
99.6
99.6
99.7

1.3
1.1
0.9
0.7
0.6
0.4
0.4
0.5
0.4
0.4
0.3

100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0

1 year or more

Sub-total

Maturity-designatedTime Deposits

Total

44.7
42.5
41.9
41.8
37.2
35.3
41.9
42.1
49.5
48.0
56.6

50.2
47.1
47.0
48.6
49.2
68.1
83.3
75.7
73.2
73.9
80.7

49.8
52.9
53.0
51.4
50.8
31.9
16.7
24.3
26.8
26.0
19.3

100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0

Ordinary Time Deposits
Individuals
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995

1 month or more 3 months or more 6 months or more
but less thanbut less thanbut less than 1
3 months
6 months
year
2.4
3.0
1.9
2.6
2.3
2.8
1.4
2.6
2.8
4.4
4.2
3.4
11.5
13.0
8.2
11.1
16.8
13.5
12.1
13.3
8.1
7.9
8.9
6.8
9.2
8.4
8.3
6.3
8.0
9.8

Source: Economic Statistics Annual, Bank of Japan.

A more direct indication of the “carry trade” nature of financial intermediation of thenon-financial corporate sector can be seen from the annual changes in liquidity (cash anddeposits, securities in liquid asset on the balance sheet) versus the amount of bankborrowings.
Large enterprises as a group expanded their balance sheets by increasing their financial
integration with the banking sector, in the following sense. When the sector balance
sheet is taken as whole, the asset side of the aggregate balance sheet grew throughincreases in holdings of cash, bank deposits, and liquid securities, while the liabilities
side increased through greater bank borrowing. Thus, the large enterprise sector as awhole both borrowed and lent more to the banking sector. Figure 14 below should beread as follows: Liabilities enter with a negative sign. Therefore, bank loan (borrowing)
are shown as negative bars. We see that both assets and liabilities increased
simultaneously, whereby firms (collectively) increased their claims on banks throughdeposits, and then received loans from the banks through increased loans.
The plausible interpretation is that the banking system was used as the conduit between
different classes of firms, where some firms acted as net lenders while others acted as net
borrowers. In aggregate, the firms increased both their borrowing as well as their lending22

vis-à-vis the banks. These “double-sided transactions” were a well-known phenomenon
observed in the bubble period.

Figure 14. Assets and Liabilities(Large Enterprises, All Industries)
20
15

Securities
Cash and deposits
Bank loan (negative)

10

Trillion yen

5
0
1976

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

-5
-10
-15
-20

Note: Changes from the previous year. Source: Financial Statements Statistics of Corporations by Industry, Ministryof Finance.

As for medium-sized enterprises, the double-sided transactions were observed in 1986
but were not obvious in other years. Indeed, for these firms, their relationship with thebanking system took on the more standard appearance of a debtor relative to the banking
system. Medium-sized firms were primarily borrowers from the banks, rather thanlenders to the banks. The difference between large and medium-sized firms can be
attributed to the fact that only large firms had easy access to the capital markets in raisingfunds. Medium-sized firms had to rely on the traditional bank-based financing (Figure
15).

23

Figure 15. Assets and Liabilities(Medium-Sized Enterprises, All Industries)
20
15

Securities
Cash and deposits
Bank loan (negative)

10

Trillion yen

5
0
1976

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

-5
-10
-15
-20

Note: Changes from the previous year. Source: Financial Statements Statistics of Corporations by Industry, Ministryof Finance.

We can also detect a difference between manufacturing and non-manufacturing firms.
The large manufacturing enterprises actually were paying back their bank borrowing.
This is shown as the positive value in Figure 16 below (remember, the bank loan figure isconverted as a negative value.) At the same time, they increased liquid assets on theirbalance sheets. Those observations are consistent with the fact that large manufacturing
enterprises had achieved the highest liquidity ratio in the bubble period, and were
engaged in the “carry trade” of borrowing from the capital markets in order to lend to thebanks through deposits.

24

Figure 16. Assets and Liabilities(Large Enterprises, Manufacturing Firms)
6

Securities
Cash and deposits
Bank loan (negative)

4

Trillion yen

2

0
1976

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

-2

-4

Note: Changes from the previous year. Source: Financial Statements Statistics of Corporations by Industry, Ministryof Finance.

As for medium-sized enterprises, they performed the double-sided transactions in 85, 86,
87 and 88 (Figure 17).
Figure 17. Assets and Liabilities(Medium-Sized Enterprises, Manufacturing Firms)
6

Securities
Cash and deposits
Bank loan (negative)

Trillion yen

4

2

0
1976

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

-2

-4

Note: Changes from the previous year. Source: Financial Statements Statistics of Corporations by Industry, Ministryof Finance.

25

Non-manufacturing enterprises behaved in a different way (Figure 18). Large nonmanufacturing firms borrowed a lot as well as increased their liquid assets. The doublesided transactions were distinguished at large non-manufacturing enterprises. Note thatthe scale of the vertical axis is bigger in the chart for large non-manufacturing enterprises
than the one for large manufacturing enterprises.
Figure 18. Assets and Liabilities-(Large Enterprises, Non-Manufacturing
Firms)
10
Securities
Cash and deposits
Bank loan (negative)

5

Trillion yen

0
1976

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

-5

-10

-15

-20

Note: Changes from the previous year. Source: Financial Statements Statistics of Corporations by Industry, Ministryof Finance.

The medium-sized enterprises increased borrowings (Figure 19). In some years in the
bubble period, they performed the double-sided transactions but by and large they
increased borrowings more than liquid assets.

26

Figure 19. Assets and Liabilities(Medium-Sized Enterprises, Non-Manufacturing Firms)
10
Securities
Cash and deposits
Bank loan (negative)

5

Trillion yen

0
1976

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

-5

-10

-15

-20

Note: Changes from the previous year. Source: Financial Statements Statistics of Corporations by Industry, Ministryof Finance.

5. Shifts in the Composition of Bank Lending
The developments highlighted so far had an impact on the banking sector in several ways.
An inevitable consequence of the increased financial intermediation role played by nonfinancial companies was that the banks were pressured on both sides of their balance
sheets.
On the asset side, the banks lost many of their traditional borrowing customers. In
particular, large non-financial companies that previously relied on the banking systems to
supply credit could turn to the capital markets to raise funds.
The increased role of capital market funding by non-financial companies also hadrepercussions for the banking sector through the liabilities side. The “carry trade”
engaged by the non-financial companies resulted in the increased funds available for use
by the banks through the increased time deposits with liberalized interest rates.
Banks faced higher costs of funding through market interest rate-based deposits. In
comparison with the regulated deposit rates, market interest rate-based deposit rates
resulted in higher rates. The share of funds raised without regulation in the total funds atcity banks rose from about 17% in 1980 to about 70% in 1990 (Bank of Japan (1991b)).
According to an estimate in the Bank of Japan report (Bank of Japan (1991c)), thischange in the composition of deposits meant that the average deposit rate was 150 bps
higher in 1990 than it would have been assuming that all deposits were raised underregulated interest rates in the same year.

27

These changes meant a less favorable earnings environment for banks than before.
Indeed, the short-term deposit and lending rate spread shrunk from about 300 bps in thefirst half of the 1980s to about 160 bps later in the decade. Nonetheless, the profit of theJapanese banking sector in the second half of the 1980s broke historical records. The
reasons for this are instructive. Pressured on both sides of their balance sheets, the banks
had to search for new borrowers, both in order to replace their traditional borrowing
customers, but also to utilize the new funding resources supplied to them by corporate
depositors. The natural response of the banks was to lower their lending standards so thatthey would attract more business (Bank of Japan (1991c)).
The response by the banks was reflected on the asset side of their balance sheets in termsof the changed composition of loans. The banks increasingly resorted to riskier loans
along three dimensions:•••First, they began to lend more to smaller firms that were previously shut out of thecredit market.
Second, they resorted to longer-term loans.
Third, they increased loans to real estate-related sectors.

We consider these three issues in turn.
The size profile of corporate borrowers from the banks can be seen in Figure 20. At theend of 1975, large enterprises accounted for more than 40% of total loans to domestic
corporations, but this figure decreased to about 20% at the end of 1990. Conversely, theshare of loans to small enterprises increased from about 35% to about 65% over the same
period. At the same time, loans to individuals as a share of total outstanding loans alsorose, from 7.9% to 16.3%.

28

Figure 20. Breakdowns of Corporate Borrowers by Size
100%
90%
80%

Large enterprises
Medium-sized enterprises
Small enterprises

70%
60%
50%
40%
30%
20%
10%
0%
1975

80

85

90

Note: Total outstanding loans used for calculations are outstanding loans and discounts to domestic
corporate borrowers excluding overdrafts. Large enterprises are corporations with capital of 1 billion
yen or more and more than 300 regular employees. For the wholesale trade industry, the criterion for
the number of regular employees is more than 100 persons. For the retail and service industries, it ismore than 50 persons. Small enterprises are unincorporated enterprises as well as corporations withcapital of 100 million yen or less or with regular employees of 300 persons or fewer. For thewholesale trade industry, the definition is corporations capitalized at 30 million yen or less or with
100 regular employees or fewer. For the retail trade and service industries, it is corporations
capitalized at 10 million yen or less or with 50 regular employees or fewer. Outstanding loans for
medium-sized enterprises are calculated by excluding those for small enterprises and large
enterprises from total outstanding loans. Source: Economic Statistics Monthly, Bank of Japan.

The increased maturity of loans can be seen in the following figure (Figure 21), whichplots the proportion of loans with maturities longer than one year. We can see that theloan portfolio lengthened dramatically during the bubble era, especially for city banks.
Figure 21. Ratio of Long-term Loans in Total Outstanding Loans
70%
City banks
60%

Regional banks

50%

40%

30%

20%
197576 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
Note: Long-term loans are loans with maturity longer than 1 year. Source: Economic
Statistics Annual, Bank of Japan.

29

An increased weighting was placed on lending to real estate-related sectors (construction,
real estate, non-bank financial), as shown in Figure 22. The non-bank financial
intermediaries engaged mainly in lending to the real estate industry, and so was a prime
channel through which increased credit fuelled the property bubble. In this way, thecomposition of bank portfolios shifted toward riskier, speculative activity.
Figure 22. Bank Lending to Real Estate-Related Sectors
50%
45%Construction

40%

Real estate35%

Non-bank financial

30%
25%

Total of real estate-related
sectors

20%
15%
10%
5%
0%
1975

80

85

90

Note: Real estate-related sectors include real estate, construction, and non-bank financial.
Total outstanding loans used for calculations are outstanding loans and discounts todomestic corporate borrowers excluding overdrafts. Outstanding loans to the non-bankfinancial industry are the sum of those to the other financial industry and the leaseindustry. Source: Economic Statistics Monthly, Bank of Japan.

Nevertheless, bank profitability remained high, due to the benign macroeconomic
conditions and the economic boom that was an integral part of the lending boom that
resulted. The parallels with the US mortgage boom in the early years of this decade are
striking. Measured loan quality remained very high during the bubble era, as seen in
Figure 23 below that shows the quarterly series of ratios of the total debts of defaulted
firms to total bank loans outstanding to all industries.

30

Figure 23. Default Rate
2.5%

2.0%

1.5%

1.0%

0.5%

0.0%
1971 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05 06 07 08

Note: The ratio of total debt of defaulted firms to total outstanding loans of all banks. Quarterly
data. Source: Tokyo Shoko Research, Economic Statistics Monthly, Bank of Japan.

According to these statistics, the default rate of loans was lower in the bubble period thanit was in other periods. The default rate also continued to fall from 1987 to the end of
1990.
Bank profitability remained high during this period, resulting in a strong accumulation of
surpluses at the banks. In accordance with this, the capital position of the banks in thelate 1980s period strengthened dramatically. The following figure (Figure 24) shows thetime series of the capital composition at the banks.
Figure 24. Compositions of Bank Capital
35
Undivided profits
Voluntary reserves

30

Retained surplus
Capital reserves
Common stock

Trillion yen

25

20

15

10

5

0
1975

76

77

78

79

80

81

82

83

84

85

Source: Economic Statistics Annual, Bank of Japan.

31

86

87

88

89

90

91

92

93

94

95

The increased profitability of the banks bolstered their common stock. The banking
sector itself was able to raise new equity financing on the back of the buoyant stock
market. Just as non-financial firms were able to raise more equity funding, so were thebanks able to tap the same market. An increased flow of equity funding by issuing new
stocks was seen. Part of the increased capital raising was associated with the impending
BIS capital regulation. Figure 25 shows the evolution of common stock plus capitalreserves. The capital raised by issuing new stocks is eventually booked either ascommon stock or capital reserves. As can be seen, it increased during the bubble era.8
Figure 25. Common Stock and Capital Reserves16

All domestically licenced banks
14
City banks

12

Trillion yen

10

8

6

4

2

0
1975

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Source: Economic Statistics Annual, Bank of Japan.

A consequence of the strong capital position was the low leverage ratio of the banks.
This is another important instance in which the 1980s bubble period in Japan differs fromthe US mortgage boom of the early years of this decade. Whereas the market-based
financial intermediaries based in the United States increased their leverage sharply in theyears immediately prior to the current financial crisis, this was not the case for banks inJapan in the 1980s bubble.
The following (Figure 26) is the time series of leverage for Japanese banks from 1980 to
1995, where leverage is defined as the ratio of “assets” (or “loans and discounts”) on
aggregated city bank balance sheet to the sum of “common stock” and “capital reserves”
on the balance sheet. As we can see, the leverages went down during the bubble era.
This is one respect in which the outward appearance of the 1980s bubble in Japandiffered from the recent boom and bust cycle among US financial intermediaries –
especially the market-based intermediaries such as the investment banks.

8

After the bubble era, it was stable until the government injected public money into the capital of ailingbanks.

32

Figure 26. Leverage
160

Assets/(Common stock + Capitalreserves)(Loans and discounts)/(Common
stock + Capital reserves)

140

120

Times

100

80

60

40

20

0
1975 76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Note: City banks. Source: Economic Statistics Annual, Bank of Japan.

The fact that leverage went down is an indication of the rapid pace of new equity
issuance, as we have discussed already. Some of the new stock issues had a regulatory
dimension, associated with the impending adoption of the Basel capital accord of 1988.
Banks had a heightened sense of concern about the BIS capital regulation and possible
change of official attitude toward the banking sector. The concern was the weakening of
the implicit guarantee in place before the financial liberalization of the 1980s. Ironically,
however, the buoyant nature of the stock market in Japan during the bubble era created afavorable environment in which the banks could ease the severity of the capital constraint
on their lending activities. Instead, the banks continued to extend riskier loans to SMEs
based on lower collateral standards, as well as to the non-bank financial intermediaries
that provided real-estate financing.

6. Short-Term Interest Rate Spreads
To this point, we have not explained why non-financial firms had the incentive to engage
in their “carry trade” by borrowing in the capital markets and then lending to the banks
via time deposits with liberalized interest rates. However, as with any “carry trade”, theinterest rate differential is all important in determining the profitability of the trade, andhence the incentive to engage in such trades.
The final piece in the jigsaw puzzle that will complete our argument is thus to show thatthe short-term interest rate spreads were such that the carry trade was profitable. The
particular interest rate spread of interest to us is the difference between the market

33interest rate in the capital markets at which non-financial firms could borrow, and thebank deposit interest rate at which the non-financial firms could lend. For the carry trade
to be profitable, the deposit rate should be higher than the capital market rate.
Unfortunately, appropriate data on capital market interest rates for short-term instruments
such as CP in the bubble period are not available now. But, there are some reports
pointing to the profitability of the arbitrage between such instruments and bank deposits
in the period. The Bank of Japan (1989) refers to the fact that large non-financial firms
could gain interest rate margins by issuing CP and depositing the raised funds at banks astime deposits with liberalized interest rates. It concludes that this arbitrage opportunity
worked toward the rapid expansion of the CP markets in the bubble period to a great
degree. De Brouwer (1996) similarly notes that a positive spread between the interest
rate on certificates of deposit (CD) and CP gave firms an incentive to borrow at the low
CP rate and deposit the proceeds in CDs at a higher rate.
We can show a more striking fact illustrating how anomalous the bubble period was. The
figure below (Figure 27) shows time deposit interest rates (regulated and unregulated)and prime lending rates (short-term and long-term). From 1985 when time deposits withliberalized interest rates were introduced to the middle of 1990, the 3-6 month time
deposit rate (unregulated, new receipts) was consistently higher than the short-term (lessthan 1 year) prime rate for the highest credit quality borrowers.
Indeed, for some of the time, the time deposit rate was even higher than the long-term
prime lending rate. This happened just after the introduction of the deposit product andjust before 1990 – the peak of the bubble. So it was possible for high credit quality
borrowers (presumably large firms and borrowers with good collateral), to profit byborrowing funds at the short-term prime lending rate from banks and depositing theborrowed funds at banks as time deposits with liberalized interest rates. This arbitrage
opportunity remains even after the introduction of the new short-term prime lending ratein January 1989 that was determined by reference to actual funding costs for banks rather
than the official discount rate.

34

Figure 27. Time Deposit Rates and Prime Lending Rates
10%
Introduction of time deposits
with liberalized interest rates

9%

Abolishment of regulation ontime deposit interest rates

8%
7%
6%
5%
4%
3%
3-6 month time deposit rate(unregulated, new receipts)
Short-term prime lending rate2%

Long-term prime lending rate1%

3 month time deposit rate (regulated,
new receipts)

0%
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

Note: The “3-6 month time deposit rate (unregulated, new receipts)” is the average interest rate on newly received time deposits
with unregulated interest rates of terms between 3 and 6 months. “3 month time deposit rate (regulated, new receipts)” is theinterest rate set by the regulation on newly received 3 month time deposits. Source: Economic Statistics Annually, Bank ofJapan

A very natural question is why the banks themselves did not raise short-term funding
from the capital markets directly – for instance, by issuing market-based bills or CP.9 An
answer here is that the banks were not permitted to issue CP or other such bills due toregulatory hurdles until much later.10 Thus, the interest rate spread that gave rise to the“carry trade” was itself part of the regulatory landscape. Another reason is that banks
offered favorable terms on time deposits for large non-financial firms, aiming to expand
the potential customer base in businesses that they would enter in the future. We believe
this business expansion motive is the most plausible explanation for the anomalous
pricing of deposit and lending rates.

9

The three long-term credit banks issued medium term bank debentures.
While non-financial corporations were permitted to issue commercial paper in 1987, banks were notpermitted to do so until 1998.

1035

7. Macroeconomic Background
The financial system perspective adopted in this paper provides a useful approach tounderstanding the process of aggregate credit expansion. The perspective allows us topin down the relationship between funds from non-leveraged institutions in the interlocking system of balance sheets with leveraged financial institutions, the equity ofleveraged financial institutions, the leverage of leveraged financial institutions in thefinancial system, and the total credit produced in the financial system. We have so far
discussed the case of the United States and Japan in light of the financial systemperspective and illuminated the mechanisms behind the observed phenomena.
However, the financial system perspective is incomplete without an explanation of what
motivated the leveraged institutions in the system to expand their capacity and thereby
lend so aggressively. It is here that we believe that the macroeconomic backdrop in termsof monetary conditions and the reform of the regulatory landscape play key roles.
Financial Liberalization
As already discussed, the funds raised by large non-financial firms flowed into thebanking sector and this led to the expansion of credit provided by the banks in the late1980s in Japan. Although monetary policy easing and the increase in asset prices
contributed to the credit expansion, it is difficult to explain the credit expansion in the
bubble period without the role played by deregulation in the capital markets that relaxed
existing restrictions on bond issues and by the introduction of time deposits withliberalized interest rates.
The key feature of financial liberalization in Japan was its gradual implementation. The
liberalization process was initiated in the late 1970s and was not completed until the socalled Financial Big Bang in 1998. The whole process thus took a full twenty years.
There were three main strands to the financial liberalization, namely (1) the deregulationof deposit and lending interest rates, (2) relaxation of the separation of business between
banking and securities firms, and (3) the integration of domestic financial markets into
the global capital markets. In the late 1980s, the deregulation of deposit interest rates
was in its final stages. As for the deregulation of the separation of business between
banks and securities firms, the process got underway in the 1980s: securities firms started
sales of medium-term government bond funds in 1980 that was an equivalence of NOW
account in the United States, and banks started sales of public sector bonds to customers.
With expectations of further deregulation to come, banks had a strong incentive toaugment the foundations of the securities business they would launch in the future.11 The
internationalization of financial markets also made significant progress. For example, thereal demand requirements for forward exchange transactions and the restrictions on
11

The discussion on the deregulation of the separation of business between banks and securities firms
began in the 1980s and was once materialized as the Financial System Reform Law legislated in June 1992,
which allowed banks and securities firms to enter each others’ business via subsidiaries. It took six more
years to complete the whole process as the “Financial Big Bang” in 1998.

36

banks’ net short spot positions in foreign currencies were both eliminated, in April andJune 1984, respectively.
Rather than focusing on innovations to their business model that kept pace with thechanges in financial landscape, banks focused instead on profit maximization via
expansion of the balance sheets.12 The behavior of Japanese banks was not only the
result of inertia in their business model under the regime of regulated interest rates.
Banks were highly motivated to expand the potential business base of securities business,
as well as fee businesses such as the cash management service, in advance of their entry
into the securities business after further deregulation of the separation of businessbetween banks and securities firms. Taking their entry into the potentially profitablebusiness into account, the banks were trying to keep or strengthen the business
relationship with large non-financial firms by providing financial products withcompetitive market interest rates vis-à-vis capital market products, namely time deposits
with liberalized interest rates. As we have already seen, these liabilities were deployedon the asset side of the banks’ balance sheets and this resulted in expansion of theirbalance sheet size.
Another phenomenon observed in the late 1980s was the reduced stringency of somepolicy measures implemented in the regime with regulated interest rates. Under the
regime, increases in deposits and loans outstanding almost directly led to increases inbank profits. This feature stemming from the regulatory framework motivated banks toexpand their balance sheets as much as possible and this motivation would have resulted
in excessive lending. One policy measure for decelerating volume expansion was theregulation on the establishment of new branch offices by the Ministry of Finance that
effectively put a curb on the availability of deposits for banks. In the process of financial
liberalization, banks found new ways to raise funds, such as time deposits withliberalized interest rates, and the effectiveness of the regulation on new branch officeestablishment decreased. Moreover, as part of financial liberalization, the regulation was
operated in a more flexible or less stringent way than before.
With respect to the asset side of the balance sheet of banks, the window guidance by the
Bank of Japan had the role of decelerating balance sheet expansion by banks. The
window guidance “had the function to complement interest rate policy for monetary
policy implementation” (Suzuki (1984)). However, in the process of financial
liberalization, the Bank of Japan started respecting more autonomy for banks to choose
the level of loans outstanding and the window guidance was eventually abolished in 1991.
Hoshi et al. (1993) pointed out that the window guidance did not work as a measure to
curb loans outstanding in the late 1980s.
12

A report publishes by the Bank of Japan summarizes its assessment of risk management by banks in thelate 1980s as “There were many cases in which the evaluation of collateral such as real estate was not strict
enough in an environment of rising land and stock prices. Moreover, identification of the purpose of thefunds and evaluation of the borrowers’ ability to repay, etc, were not appropriate in many loan contracts.
On the whole, it is hard to deny that some slackness in each step of the loan practice, i.e., prior examination,interim-monitoring and loan asset protection, was observed.” (Bank of Japan (1991)).

37

Actually, the role of the window guidance was wider than mere lending volume controls,
and it worked as a means of communication on macro credit demand between the Bankof Japan and private banks. Although the window guidance has often been criticized as adiscretionary policy measure against market principles, the measure could have been used
to send an effective warning (“moral suasion”) to the banking sector directly about its
excessive behavior. In other words, the policy measure could have been used for macro
prudential policy communication.
Expectation of Continuation of Monetary Policy Easing due to the Government Policy
Commitment
It has been noted that monetary policy was accommodative for longer than was necessary
and that this was a fundamental factor in the appreciation of asset prices and the
expansion of credit in the late 1980s. However, a noteworthy fact concerning monetary
policy in this period was the emergence of expectations of continued monetary policy
easing. The background to this was the government’s commitments in the international
policy coordination pledged in the period.13, 14
One of the primary policy issues in the late 1980s was the increasing current accountsurplus, especially with respect to the United States. The current account was almost inbalance at the beginning of the 1980s, but it had moved into a substantial surplus of 3.7%
of GDP in 1985. The government policy stance to curb the increase in the current
account surplus was to introduce policy measures designed to bolster imports through an
expansion of domestic demand, rather than by restricting exports. This policy stancewould have been interpreted as a commitment to a continuation of monetary policy
easing as a measure to expand the domestic demand as long as a significant current
account surplus existed.15
13

Okina, Shirakawa, and Shiratsuka (2001) points to the expectations of continued monetary policy easing
by referring to the yield curve flattening in the late 1980s in Japan.
14
It has been noted that the so-called Mayekawa Report (Report of Studies Group on the Structural
Adjustment for International Coordination) published by the government in April 1986 was a symbolic
manifestation of the government’s commitment to the international policy coordination in this period.
Moreover, the Mayekawa Report has often been referred to as the government’s firm commitment tokeeping eased monetary policy as a means of expanding domestic demand. This understanding of thereport is not correct. In fact, the main message in the report was the need to reform the structure of theeconomy with low income elasticity of imports and high income elasticity of exports, so as to reduce thecurrent account surplus. The proposed policy direction in the report was increasing imports throughderegulation and improved access to the domestic markets, rather than by restricting exports withprotectionist measures such as quantity controls. The emphasis in the report on the importance of domestic
demand-led growth was a reflection of the policy consensus in Japan and the report carefully pointed to theimportance of eliminating obstacles for increasing domestic demand in various aspects. For example, itwarned that a rapid appreciation of housing prices would hinder housing purchases and that warning proved
to be correct.
15
In the formation of expectations of a continuing real estate price boom, the “public information”
disseminated by the government would have contributed to a great degree although we can not call it a“commitment” pledged by the government. Yoshikawa (2002) claims that the estimates on the scarcity ofoffice space in Tokyo reported in the “Metropolitan Reconstruction Plan” (1985) and “The 4th National
Comprehensive Development Plan” (1987) by the National Land Agency worked to form bullish
expectations held by banks on future demand for real estates, and large increases in bank lending to real38

After the Plaza Accord in September of 1985, the Japanese yen appreciated considerably.
As a result, the current account surplus in terms of quantity started decreasing although
the decrease was not large. In contrast, it took more time for the current account surplus
in nominal terms to begin decreasing, because of the so-called J-curve effect. Actually, itreached 4.2% of GDP in 1986 and it was still 2.1% of GDP in 1989. On top of the slow
pace of reduction of the current account surplus, the monetary policy easing in somedeveloped countries following the plunge of stock prices in October of 1987 (“Black
Monday”) strengthened expectations that monetary policy easing would continue inJapan.

8. Lessons for Monetary Policy
Need for a More Comprehensive Assessment of Financial Institutions
In liberalized modern financial markets, the intermediation of funds is through numerous
channels. The inflow of international funds into the financial sector via mortgage-backed
securities in the US case shares similarities with the Japanese experience in the 1980s
bubble, which saw inflow of funds raised in the capital markets by large non-financial
firms into time deposits with liberalized interest rates at banks. In both cases, thestructure of the financial system was undergoing rapid change. In these circumstances,previously reliable indicators of the soundness of financial institutions such as capital
asset ratios and liquidity ratios may not remain effective indicators that ring alarm bells.
In the US case, although the liquidity ratio was deteriorating, the capital asset ratio wasthought to be satisfactory. In the Japanese case, neither ratio warned of any serious
future problems in the midst of the bubble. Those experiences suggest that policy
authorities should be wary of the complacent belief that existing indicators of financial
conditions are still always reliable. In particular, new approaches to assessing financial
conditions should be adopted as the financial system evolves. To the extent that funds
raised in the capital markets play an important role, market-based liability figures may be
more useful, as argued by Adrian and Shin (2007, 2008). In the Japanese case,qualitative aspects in lending activities like loan standards and collateral evaluation could
have been very indicative.
Role of Prudential Policy Communication
It will be important for the policy authorities to point to some excesses in financial
markets and the behavior of financial institutions as part of their communication strategy.
If market functions lack self-correcting mechanisms for certain forms of excess, active
warnings about such excess from the policy authorities will have value. In the case ofJapan, in the ongoing financial liberalization, interventions by the policy authorities werereduced significantly. The effectiveness of some policy measures for prudential policy
communication such as the window guidance by the Bank of Japan, which worked as aestate projects in addition to the aggressive behavior of real estate developers accelerated the real estate
price appreciation.

39

moral suasion measure, decreased and there could be a larger role to be played by suchmeasures.
Reconsidering the effect of “Commitment”
For both the US and Japanese cases, monetary policy easing was a factor behind theexcesses of financial institutions and the flow of funds that backed their behavior.
Moreover, in both instances, the monetary policy stance was assessed to be based on acommitment to the continuation of loose monetary policy. The announced measured
pace of future policy changes in the United States and the emphasis in Japan onincreasing domestic demand as a commitment in international policy coordination
seemed to lead to this perception.
It is true that “commitment” to a future path of monetary policy helps to increasetransparency of monetary policy, but the experiences in the United States and Japandiscussed in this paper give us pause for thought on the desirability of commitment,
especially on the unintended side-effects of forward-looking policy statements. To theextent that such forward-looking statements reduce the uncertainty surrounding future
central bank actions, the risk premiums will be artificially compressed relative to asituation in which the central bank does not issue forward-looking statements on the
future direction of short-term policy interest rates.
Role of Short Term Interest Rate for Funding Cost for Financial Institutions
When financial intermediaries are placed explicitly in the monetary policy transmission
through credit supply, short-term interest rates take on significance for monetary policy.
This perspective on the importance of the short-term interest rates as a price variable is incontrast to current monetary thinking, where short-term interest rates matter only to theextent that they determine long-term interest rates, which are seen as being risk-adjusted
expectations of future short-term interest rates. Alan Blinder (1998, p.70) in his book on
central banking puts it in the following terms:“central banks generally control only the overnight interest rate, aninterest rate that is relevant to virtually no economically interestingtransactions. Monetary policy has important macroeconomic effects
only to the extent that it moves financial market prices that reallymatter – like long-term interest rates, stock market values and exchange
rates.”For this reason, current models in monetary economics emphasize the importance ofmanaging market expectations. By charting a path for future short rates andcommunicating this path clearly to the market, the central bank can influence long rates
and thereby influence mortgage rates, corporate lending rates, and other prices that affectconsumption and investment. The “expectations channel” has become an importantconsideration for monetary policy, especially among those that practice inflation
targeting. In contrast, the role of the short-term interest rate in regulating credit supply

40

suggests that short-term interest rates have significance as a price variable in their own
right.16
In the context of the Japan’s 1980s bubble, low short-term interest rates gave banks the
incentive to increase deposits by using newly introduced time deposits with liberalizedinterest rates. In a sustained environment of low short-term interest rates, banks resorted
to maturity transformation between liabilities (deposits) and assets (loans) to increase
their profits. In relation with the role of commitment discussed in the last subsection,
when an expectation emerges that short-term interest rates will remain low, there will begreater motivation for this behavior because the funding cost for rolling over theliabilities is expected to be low. Therefore, the role of the short-term interest rate leveland expectations about its continuation will both have a role that does not explicitly
appear in current models in monetary economics.

9. Conclusions
This paper has offered a perspective on the 1980s bubble years in Japan in the light of theexperiences of the subprime credit boom in the United States and its subsequent
unwinding in the current financial crisis. The incremental contribution of our account has
been to offer a financial system perspective with an emphasis on the supply of credit.
The ingredients that make an appearance in our discussion (such as the lending to realestate-related sectors, the increase in lending to SMEs) have been discussed by manyothers before us. Our contribution is to bring them together in a systems perspective.
Our main argument is that as new funding sources opened up to non-financial firms, it
became profitable for them to act as financial intermediaries by raising funding in thecapital markets through securities, and then supplying the new funds raised to thebanking system by means of newly introduced time deposits with liberalized interest rates.
The financial assets of non-financial corporations increased dramatically together with
their financial liabilities in the late 1980s. In this way, the non-financial companies
became de facto financial intermediaries. They became financial intermediaries thatdrew market-based finance and supplied financing to the banking system by holding large
deposit claims on the banks.
We have also emphasized how the boom in the stock market contributed to the lending
boom by increasing the funding available both to financial and non-financial firms. Thus,
the stock market boom and the lending boom can be seen as intimately linked. The
financial system perspective offers many insights which may have applicability in othercontexts.

16

Adrian and Shin (2008) explore these issues further.

41

Appendix
Relationship between Loans to End-Users and Aggregate Balance Sheets
There are n entities in the financial system that we will call “banks” for convenience. We
gather together all non-leveraged players such as mutual funds and insurance companies
as one entity and give it the label “ n + 1 ”. Thus, apart from entity n+1, all other entities
are leveraged financial institutions of one sort or another.
Bank i has two types of assets. First, there are loans to end-users such as corporates orhouseholds. Denote the loans by bank i to such end users as yi . Next, there are theclaims against other financial institutions. Call these the “interbank” assets, although theterm covers all claims on other intermediaries. The total interbank assets held by bank i
are

∑x π
j

ji

j

where x j is the total debt of bank j and π ji is the share of bank j’s debt held by bank i.
Since “bank” n+1 is not leveraged, we have xn = 0 . The balance sheet identity of bank i
is given by

yi + ∑ x jπ ji = ei + xijThe left-hand side is the total assets of the bank. The right-hand side is the sum of equity
and debt. Letting x = [x1 L xn ] and y = [ y1 L yn ] , we can write in vector notation
the balance sheet identities of all banks as
y + xΠ = e + x

where Π is the matrix whose (i, j ) th entry is π ij . Solving for y,y = e + x (I − Π )Define leverage as the ratio of total assets to equity, given by

ai
= λi
ei
Then defining Λ as the diagonal matrix with λi along the diagonal,42y = e + e(Λ − I )(I − Π )where Π is the matrix of interbank liabilities. By post-multiplying the above equation by
the unit vector

1u = M
1
We can sum up the rows of the vector equation above, and we have the formula in thetext, namely that∑ y = ∑ e (1 + z (λ − 1))
i

i

i

i

i

i

where zi is the proportion of liabilities that come from outside the intermediary sector,

and is given by the i th row of (I − Π )u .

43

References
Adrian, Tobias and Hyun Song Shin “Liquidity and Leverage” forthcoming in the
Journal of Financial Intermediation, 2007.
Adrian, Tobias and Hyun Song Shin “Financial Intermediaries, Financial Stability andMonetary Policy” paper presented at the 2008 Jackson Hole Symposium of the Federal
Reserve Bank of Kansas City.
Bank of Japan, “Shouwa 63 nendo no kinyuu oyobi keizai no doukou (the Financial
Markets and Economy in 1988),” (in Japanese), in Chosa Geppo, May, pp 1-61, 1989.
Bank of Japan, “Kinyuujiyuuka nomotodeno kigyoukinnyuu no macro-tekidoukou (AMacro Perspective Analysis of Corporate Finance under Financial Liberalization)” (inJapanese), The Bank of Japan Monthly Bulletin, March, pp 1-16, 1991a.
Bank of Japan, “Kinyuukikan no kashidashi ni kakawaru shinyou-risk-kanri ni tsuite (OnLoan Credit Risk Management at the Financial Institutions)” (in Japanese), The Bank ofJapan Monthly Bulletin, June, pp 37-50, 1991b.
Bank of Japan, “Kinnen niokeru kashidashikinri no hendou ni tsuite – Kinrijiyuuka
nomotodeno ginkoukoudou no ichisokumen (Determination of Interest Rates in Recent
Years: A Study on Banks’ Behaviors under Financial Liberalization)” (in Japanese),
The Bank of Japan Monthly Bulletin, September, pp 1-26, 1991c.
Bank of Japan, “Japan’s Financial Structure since the 1980s – in View of the Flow ofFunds Accounts,” Research Papers, 2005.
Blinder, Alan Central Banking in Theory and Practice, MIT Press, Cambridge, 1998.
Borio, Claudio and Philip Lowe (2002) “Asset Prices, Financial and Monetary
Stability: Exploring the Nexus,” Bank for International Settlements Working Paper 114.
Borio, Claudio and William White (2003) “Whither Monetary and Financial Stability?
The Implications of Evolving Policy Regimes,” Proceedings of the Federal Reserve
Bank of Kansas City Symposium at Jackson Hole 2003. http://www.kc.frb.org/publicat/sympos/2003/sym03prg.htm
De Brouwer, Grodon, “Deregulation and the Structure of the Money Market” in Paul
Sheard, editor, Japanese Firms, Finance and Markets, pp.274-99, Melbourne, Addison
Wesley, 1996.
Greenlaw, David, Jan Hatzius, Anil Kashyap, and Hyun Song Shin “Leveraged Losses:
Lessons from the Mortgage Market Meltdown” US Monetary Policy Forum Report
No.2, 2008.

44

Hoshi, Takeo, David Scharfstein, and Kenneth J. Singleton “Japanese Corporate
Investment and Bank of Japan Guidance of Commercial Bank Lending” in Japanese
Monetary Policy, National Bureau of Economic Research Project Report, pp 63-94,
University of Chicago Press, 1993.
Hoshi, Takeo and Anil Kashyap, Corporate Financing and Governance in Japan, MIT
Press, Cambridge, USA, 2001.
Okina, Kunio, Masaaki Shirakawa, and Shigenori Shiratsuka “The Asset Price Bubble
and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons” Monetaryand Economic Studies, 19(S1), Institute for Monetary and Economic Studies, Bank ofJapan, pp 395-450, 2001.
Posen, Adam, The Japanese Financial Crisis and its Parallels with U.S. Experience
Institute for International Economics, Washington DC, 2000.
Royama, Shoichi “Kinyuseido Kaikaku Sairon (Reconsidering Financial System
Reforms),”(in Japanese) in Nikkei Financial 93, Nihon Keizai Shimbun, Inc, pp.228236, 1992.
Shin, Hyun Song, “Securitization and Financial Stability,” Economic Journal, 119, 309 –
332, 2009.
Suzuki, Yoshio “Nihon no Kinyuu-Seisaku: Kouka-hakyuu-keiro to Yuukousei(Monetary Policy in Japan: Transmission Mechanism and Effectiveness),” (inJapanese), Monetary and Economic Studies, 3(2), Institute for Monetary and Economic
Studies, Bank of Japan, pp.1-15, 1984.
Yoshikawa, Hiroshi “Tochi-bubble: Genninn to Jidaihaikei (Land Price Bubble: theCauses and Historical Backgrounds),” in Michio Muramatsu and Masahiro Okuno(Eds.) Heisei-bubble no Kenkyuu – Keisei-hen, (in Japanese), Toyo Keizai Shinposha,
pp.411-430, 2002.

45