The Financial Crisis and the Ensuing Reform: Neglected Wisdom
Akinari Horii
Former Assistant Governor of the Bank of Japan
Adviser to the President, The Canon Institute for Global Studies
Harvard University Asia Center
Cambridge, Massachusetts
November 12, 2010

Good afternoon, ladies and gentlemen. It is a great pleasure to speak on thisoccasion. I have frequently come to Harvard during the past decade and a half. In
the late 1990s, when I worked in New York as head of the Bank of Japan’s office there, I
visited here to collect wisdom with respect to banking reform in Japan.

After I

returned to Tokyo in 2000, I continued to visit Cambridge and Boston in order to discussmonetary policy with eminent people here as well as to see my daughter, who wasstudying music at New England Conservatory as long as seven years.
After those frequent visits, however, this is s special occasion for me. It is thegreatest honor of mine to be invited to speak as one of the first beneficiaries of Ezra
Vogel Distinguished Visitor Program. It is an honor not because I am considered to bea distinguished visitor but because I am associated with a distinguished man ofachievements, Professor Ezra Vogel. His achievements cover not only academics but
policy making and practice. His contributions span not only the United States but
many countries across the Pacific Ocean, including my country Japan. Thank you,
Ezra for your invitation!
This afternoon, I would like to discuss the on-going financial crisis and thefinancial reform under discussion at international as well as national fora. I haveexperienced several financial crises, fighting – or to be more precise, having been forced
to fight – on the front line, sometimes in Tokyo, and other times in New York and Basel,
Switzerland. In other words, I am a veteran soldier who spent more time in the field
than at the defense headquarters. I am not so sure if this is a very respectable career,
but I think I can offer you some pragmatic thinking rather than hypothetical
propositions. Because of the nature of my talk, allow me to express a central banker’s
usual disclaimer although I am now an ex-central banker, i.e., the views I express here
are my own and do not represent the Bank of Japan or the Canon Institute for Global
Studies.
It was in early August 2007, when a crisis erupted in Europe’s interbank
market.

Triggered by bad news about French hedge funds, liquidity in European

markets dried up all of a sudden, putting the financial systems of major economies onthe verge of a meltdown. That morning, I was on holiday and sleeping comfortably in
my mountain house. The previous evening, I had set the alarm on my cell phone for 7
a.m. to wake up for a golf game with my neighbors. The cell phone rang and I reached
for it to stop the alarm. Unexpectedly, a voice came out of the phone. It was a call at 6
a.m. from New York, telling me that Tim Geithner, the then-president of the New York
Fed, wanted to hold a conference call with a few central bank governors that evening.
The first thing I had to do after I hung up was of course to call off my golf game. Then,
I telephoned my Governor, Mr. Fukui, and a few colleagues to begin preparations for the
conference, and went back to Tokyo, terminating prematurely my summer holiday. By
the time the conference call began, the list of participants had become a little longer
than just a few. This was the beginning of rough three years for me, during which
period I had to make more than a few oversees trips every month, and a lot of telephone
and video conferences in the late evening or early morning.
Even worse at times of crisis like Bear Sterns of March 2008, Lehman Brothersof September 2008, a few European banks of October 2008, and the European sovereign
debt crisis of May 2010, my colleagues and I had to stay up all day and night. You
know that the Tokyo market opens ahead of European and American markets because
Tokyo is located closer to the International Date Line. Therefore, Monday morning
becomes particularly sensitive in Tokyo if a Western financial institution is rumored to
be in trouble. The Bank of Japan might have to decide whether it provides it withliquidity, when its mother market is closed on Sunday. In the case of Bear Sterns, it
was at 7 p.m. Sunday, New York time that the assisted purchase of Bear Sterns by JP
Morgan Chase was announced. It was 8 a.m., Monday, Tokyo time. It was of course
not a coincidence that the arrangement was completed before Tokyo opened. At thetime of Lehman Brothers’ collapse six months later, Monday, September 15 wasstressful for us again but to a lesser extent this time because that Monday was anational holiday in Japan and the Tokyo market was closed. So was it in Hong Kongand Singapore. The first wave of tsunami hit the European markets, where there wasno clear mechanism for an orderly resolution of a large, complicated financial
institution.

The debacle of Lehman Brothers turned the prevailing unrest in thefinancial system into a real crisis. Banks became so sensitive about counterparty risks
that financial intermediation virtually stopped in the market.

Banks became soconcerned about capital shortage that banking de-leveraging accelerated despite
monetary policy easing

The financial disintermediation quickly invited a deep

recession in the world economy
This episode reminded us of one bitter lesson: the health of the financial system
is hard to restore once it has been lost and that this loss of health can cause costly
damage to the economy. This is by no means a new lesson. The Japanese had bitter
memories of the decade-long banking crisis before the present episode began in 2007.
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So did the Scandinavians about their own banking crisis of the 1990s. For Emerging
Market Asians, the boom and the bust of the speculative bubbles a decade ago rankled
for a long time in their hearts. In the United States, too, some people remember with
bitterness the S&L crisis and the Latin American debt crises of the 1980s, the latter ofwhich had happened at the same time as the East European debt crisis for European
banks. What is truly new about the current situation is perhaps the very global natureof the financial crisis, which covers virtually all the financial markets in the world
simultaneously.
During the period of financial turmoil, the Bank of Japan, the Federal Reserve,
the European Central Bank, the Bank of England, the Swiss National Bank and manyother central banks tried to provide the financial market with liquidity. They did so
initially by expanding the types of collateral for their lending, and lengthening theduration of the liquidity supply. While short-term target interest rates were loweredcloser to zero, some central banks widened the list of counterparties they do businesswith and also expanded the list of assets they buy in the market beyond what monetary
policy had usually been associated with.

Quantitative easing (QE) and QE II,

whatever termed, monetary policy has gone beyond the conventional sphere.

The

central banks of major financial markets, as well as some emerging markets, also
engaged in supplying their own markets with US dollars, which they acquired throughswap arrangements with the New York Fed.
Outside the monetary policy area, too, there have been a number ofextraordinary policy measures taken by the governments as well as the central banks.
On the financial stability side, many governments guaranteed banking debts andprovided capital for systematically important financial institutions.

On the fiscal

policy side, the governments stepped up budgetary spending in the United States,
Japan, China, and many other countries. These extraordinary policies were successful
in arresting downward momentum of economic activity and led to a recovery of theworld economy in 2009.
As the inventory restocking became complete, however, the recovery lost
momentum in 2010. The final demand still remains lackluster in the United Statesand other industrial countries.

For one thing, the household sector of the UnitedStates is still over-leveraged after a prolong period of spending spree. That excessleverage was masked at a time when housing prices were expected to rise, but loomed
large after prices had turned downwards.

As personal consumption weakens,producers of goods and services are facing a secular decline in demand. There aremany such producers in many parts of the world. Thus, corporate restructuring isunderway on a global scale, cost-minimizing on both investment and employment,
which also curbs growth in final demand.
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The financial systems of the United States and Europe have also yet to regain
full confidence in their resilience, although the public intervention has made theprobability of a systemic meltdown remote. A sizable amount of bad assets remain on
the balance sheets of financial institutions.

Even if bad assets are identified andprovisioned properly, the Japanese experience of the banking crisis of the 1990s andearly 2000s tells us that until those bad assets are removed from the balance sheet ofthe financial institutions, there remains a significant degree of uncertainty overcash-flows and profitability of the financial institutions. As a consequence, banks tend
to be cautious about credit risks, and bank lending remains weak.
It is therefore a good idea to have banks discharge their non-performing assets
from the balance sheets and remove the non-performing businesses from the banks’business lines. This is easy to say but difficult to do in practice. The Japanese andSwedish episodes of the 1990s tell us how painful this process can be. The negative
feedback from asset sales to a decline in property prices and to an increase in
non-performing assets tends to create a strong downward pressure on economic activity,
which the then Federal Reserve Chairman Alan Greenspan referred to as “fifty miles
per hour headwind” to the economy at the time of S&L crisis. You may say there is
now a hundred miles per hour headwind in light of the magnitude of the problems in US
and European financial systems.
In these circumstances I believe that fiscal policy has a role to play to preventthe negative feedback from becoming too strong. However, it would be too optimistic to
expect that fiscal policy will engineer a sustainable economic growth. Once again, theJapanese experience of repeated fiscal stimuli in the 1990s shows that the financial
stimuli supported economic growth while they were applied to the economy, but the sadreality is that the effect quickly faded when the stimuli were removed. There wasvirtually no multiplier effect stemming from the fiscal expenditure and tax reduction inthese instances. This is not surprising. In general, when the economy has a lot ofexcesses to work out, fiscal policy will help ease the adjustment process, but is not likely
to reverse the course of corporate and/or household restructuring. Particularly when
the banking system is de-leveraging in order to discharge its bad assets, banks are quite
naturally reluctant to expand their balance sheets, which limits the pump-priming
effect of fiscal stimuli.
In short, extraordinary measures deployed by monetary policy, financial
stability policy, and fiscal policy have had a positive impact on the economy but only to alimited degree in terms of sustainability of economic growth. At the same time some
negative aspects of the extraordinary policies loom large. With respect to monetary
policy, the balance sheets of a few major central banks are bloated with riskier assets.
Government budgets are deep in the red, and there are mountains of debt in many parts4

of the world. A large amount of toxic assets still sit on the balance sheets of financial
institutions. Worst of all, people are angry, blaming banks, the government, and thecentral bank for the loss of jobs, incomes, and property value. They have of course goodreasons for their anger and bank regulators are under intense political pressure topenalize banks. All this is liable to create a political momentum to kill the animal
spirit, which is in any case in short supply in a depressed economy.
Discussion of financial reform has been going on in this political climate. A
number of problems have been pointed out as causes for the credit bubbles in the earlyand mid-2000s and the subsequent turmoil in the financial system. One obvious cause
was poor risk management on the part of individual financial firms. For example,
pricing models for structured products proved to be based on too optimistic assumptions.
Corporate governance of some large complex banks was poor and the bank management
was not as “fit and proper” as was expected by US Banking Act. However, the fact thata large number of banks and other financial institutions went into trouble indicatesthat there were defects and deficiencies in regulations, guidelines and supervision of thefinancial industry.
The Financial Stability Board, the Basel Committee on Bank Supervision, andother international standard setting bodies have examined a long list of regulatory
issues and have come up with recommendations for reform.

To be more specific,

lopsided incentive mechanism in financial institutions seem to have fueled risk taking
without proper control of risks.

Thus, the guidelines of compensation have been

published by the FSB, and “skin in the game” will also be introduced in the UnitedStates under the Dodd-Frank Act. Weak regulations on bank capital and liquidity
have been considered to allow risk taking easily, and thus a higher level and quality ofcapital will be introduced under so-called Basel III together with a tough liquidity
regulation. Large, complex, interconnected financial institutions have been regarded
as systemically important financial institutions (SIFIs) and thus too big to fail, which
entailed moral hazard on the part of those banks and their counterparties. Against
this problem, SIFI surcharge and the so-called Volcker rule have been proposed to checkexpansion of their business. In order to minimize moral hazard, resolution mechanism
has also been examined. Poor infrastructure is responsible for opaqueness of somederivatives transaction and insufficient risk management.

Thus, the central

counterparty for OTC derivatives has been promoted by the Committee on Payment andSettlement System.

During the past decade, financial innovation cum theoriginate-to-distribute model of banking spawned peripheral financial entities, and as aconsequence, a vast structure of shadow banking were built outside the regulatedbanking system, where risks accumulated undetected. Thus, oversight on non-bankfinancial firms will be tightened under the Dodd-Frank Act.

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Besides these discussions of risk management and prudential regulations,
there is an argument that the current crisis occurred because of a lack of a cohesiveframework by which to assess systemic risks in finance. It goes on to argue that therisk profile of the financial system as a whole needs evaluating, bearing in mind theinteractions between segments of the financial system and real economic activity. This
argument called for the establishment of a framework for systemic risk oversight, andin fact the Financial Stability Oversight Council has been decided to be created in the
United States and the Systemic Risk Board in Europe.
I took part in the discussion of all this before I stepped down from the Bank ofJapan five months ago, and I hope these reforms will help reduce the probability offinancial crisis and the cost thereof. I am afraid however they will not prevent the nextcrisis from breaking out some day. A crisis will happen just like automobile accidents
do happen despite tight traffic regulations. Risk taking becomes excessive before it
backfires. In my view it is because human nature is pro-cyclical in the sense thatpeople believes “nothing succeeds like success” and get carried away.

Building asystem of regulations which make financial activity less prone to pro-cyclicality is agood thing but in order to guard against easy risk taking, it takes prudent supervision,
which I mean prudent supervision of not only individual financial institutions but theentire financial system.
In this regard there are a few important things which I learned when I was ayoung economist at the Bank of Japan, e.g., “fit and proper” test for bank management,“constructive ambiguity” on the part of the central bank over the lender of the lastresort, and central bank lending being “not a right of borrowers but a privilege.” These
were supported by traditional wisdom, whenever they were put into practice. In recent
years, however, room for such traditional wisdom to work has become narrower since
central bankers and bank regulators are increasingly required to be transparent withrespect to their specific actions.
The idea of inflation targeting has, in my view, made the situation worse byconfining the role of the central bank in price stability and also requiring the central
bank to be transparent about it. Although none of the BOJ, the ECB, or the Fed
adopts formal inflation targeting, they have been influenced by the inflation targeting
mentality. In fact, the lack of inflation threat was the reason that the Fed raisedinterest rates in 2004 and 2005 only at a measured pace, and also that the Bank ofJapan exited very gradually from its quantitative easing regime in 2005 and 2006.
Because central bank actions were so transparent as to be nicely predicted in themarket in those years, funding risks were minimized, which fueled speculative trading,including yen carry trade.

6The recent episode stimulated discussion over the stability of the financial
system. As I mentioned a minute ago, both the US and EU have decided to create afinancial stability board or council.

The central bank is of course an importantmember of the board, and therefore responsible, at least in part, for financial stability.
How does the central bank reconcile price stability with financial stability when there
are conflicting signs? Discussion has just begun. Some suggest a combination of thetwo objectives, and others argue for lexicographic ordering, i.e. pursue financial
stability when price stability is secured.
I am not an academic theorist but a veteran soldier, and my preference is to
avoid rules, by which I mean not only inflation targeting or its grafted versions but any
rules. The central bank is a guardian of the integrity of money because the central
bank is the supplier of money. The integrity of money is maintained not only by pricestability but also efficiency of the payment system and the soundness of the financial
system.

The central bank should choose the best combination of these elements,

depending on circumstances.
By saying so, I am sure I will collect criticism from both academic and politicalcircles for being too undemocratic.

If the central bank is not allowed to be so

independent as to be opaque, then I would like to offer an idea instead: the central banksells put options of fixed income assets. The central bank changes the amount of
option sale, depending on the degree of certainty that it wants to convey to the market.
Take a situation similar to the mid-2000s for example! Suppose the Fed wants to raiseinterest rates because it believes the current level is lower than the long-term
equilibrium. The Fed begins to raise the target interest rate but at the same time sells
options by a large amount if it doesn’t want to see a shocking increase in rates. When
the Fed believes the interest rates have come to the equilibrium but the funding
conditions are still too easy, then it decreases or even stops selling options in order todecrease the certainty of future interest rates. As a consequence, term rates will begin
to fluctuate more widely to depress unfounded optimism about the future funding.
Central bank sale of options can thus be an innovation in the toolkit of central banking,which influences not only the mean of expected interest rates but their standard
deviation. It will give the central bank an additional weapon of maneuver and yet
being transparent enough. This is nothing but an idea of a veteran soldier and it is up
to academic profession to consider this and other features of monetary policy framework
theoretically.
To conclude my remarks this afternoon, allow me to repeat my preference withrespect to central banking in general, that is a framework which enables central
bankers use more discretion so as to maintain the integrity of money. They should be7

reminded of the wisdom they tended to neglect during the past decade and a half, when
inflation targeting was the leading philosophy of monetary policy.
Five months ago I stepped down from the Bank of Japan and I have been
extremely happy since I travel only once a month or less frequently these days.
Moreover, I am no longer responsible for all the troubles associated with the Bank ofJapan or any other central bank. But at the same time I am sorry for my former
colleagues who continue to work under stressful circumstances. I hope you give themencouragement to do their best as well as theoretical inputs into deliberation of central
banking.
Thank you for your attention!

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