October 18, 2011
Bank of JapanThe Bank of Japan's Initiatives on the Macroprudential Front

Since the failure of Lehman Brothers Holdings in the United States, it has become globally
understood that preventing a financial crisis from reemerging involves analysis andassessment of risks in the entire financial system and adequate measures to prevent systemicrisk from materializing. This is the so-called emphasis on the macroprudential framework.
The Bank of Japan has implemented a number of advanced initiatives on the macroprudential
front. One example is the release in October 2011 of the new Financial System Report, which
was formed by integrating the Financial System Report and the Financial Markets Report,with the aim of further improving analysis of the financial system.
Below is a description of the Bank's macroprudential perspective and initiatives.

I. Importance of the macroprudential framework
A. Macroprudential perspective
The macroprudential perspective contrasts with the so-called microprudential perspective,
which involves ensuring the financial soundness of individual financial institutions. In themacroprudential framework, risks are analyzed and assessed from the viewpoint of the entire
financial system, and institutional designs and policy responses are formed on theseassessments, thereby ensuring stability of the entire financial system. Particular attention ispaid to the consequences of the following factors in the macroprudential framework: theinterconnectedness among financial institutions, financial markets, and other components ofthe financial system; and a feedback loop between the real economy and the financial system.1
The emphasis on the macroprudential framework has increased its presence following various
financial crises worldwide, including the emergence and bursting of the bubble economy inJapan. It has become a worldwide trend to attach importance to the macroprudential
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The financial system comprises financial institutions, financial markets, and financial infrastructures,such as payment and settlement systems.

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framework since the recent global financial crisis triggered by the failure of Lehman Brothers
Holdings. Behind this trend lies a growing perception that the stability of the entire financial
system is not necessarily achieved solely by ensuring the financial soundness of individual
financial institutions. More specifically, the underlying recognitions are as follows.
First, risks that are supposed to be contained at individual financial institutions could in theaggregate destabilize the entire financial system, if similar risk-taking positions andsimultaneous unwinding of their positions cause market prices to fluctuate and credit
expansion or contraction to occur more than expected. Taking the situation before and after
the recent global financial crisis as an example, many financial institutions and institutional
investors aggressively took on risks before the crisis by purchasing increased amounts of U.S.
subprime mortgage loans and securitized products backed by these loans. As a result, theamount of credit extended through securitized products backed by U.S. real estate assets orresecuritized products accumulated globally, and real estate prices in the United States
continued to rise in line with active housing investment. Under these circumstances, domestic
and overseas investors further increased investment in securitized products, and thus the risein their prices continued. However, in 2007, credit downgrades of securitized products caused
financial institutions and institutional investors to sell these products in haste. Then, market
prices dropped, and market transactions contracted immediately. Consequently, somefinancial institutions suffered greater-than-expected losses from securities investment andeven faced difficulty in funding due to inability to sell the securitized products. As they
reduced their credit such as loans within a short period to ease their funding conditions, asset
prices dropped and the real economy deteriorated, thereby aggravating the instability in thefinancial system.
Second, the spread of new financial technologies such as derivatives and the rise of new typesof investors such as hedge funds have made it difficult to identify risks in the financial system
and gauge their degrees. For example, in U.S. financial markets before the global financial
crisis hit, banks actively traded securitized products and credit derivatives with various
institutional investors and financial institutions in order to transfer credit risk. On the other
hand, institutional investors received credit and liquidity support from banks and actively
carried out funding and investment in repo transactions with securities companies. Suchdiverse and complex transactions hindered individual financial institutions from gauging
properties and degrees of their risks as well as supervisory authorities and central banks fromgrasping risks in the entire financial system. The abrupt contraction of many market
transactions following the failure of Lehman Brothers Holdings is attributed to extremely
cautious risk-taking of financial institutions and institutional investors with the growing
anxiety over obscure properties and degrees of risks.
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B. Macroprudential policy
What kinds of policy framework and measures should be taken to put the abovementioned
macroprudential perspective into practice -- in other words, macroprudential policy -- havebeen discussed internationally. In general, macroprudential policy is understood to include thefollowing functions: (1) analyzing and assessing the conditions of the entire financial systemand systemic risk; and (2) conducting and recommending policy measures to contain systemicrisk.
With respect to the first function, many central banks and international organizations havealready been releasing their analyses and assessments regularly in the form of financial
system reports or other means. In doing so, importance is being attached to the following two
dimensions.
i. Analyzing and assessing the risks of the entire financial system at a particular point intime in the cross-sectional dimension.
The financial system comprises various participants, such as banks, securities companies,
insurance companies, and investment funds. These participants interact with each otherthrough links formed by daily transactions and settlements. As described earlier, in theface of the recent global financial crisis, loss in market confidence in securitized products
eventually tightened funding conditions of securities companies and banks through thetransactions involving investment funds and other financial institutions. Therefore, inassessing the entire financial system, the behavior of and risks borne by a broader type ofparticipants and their interconnectedness should be analyzed.
ii. Analyzing and assessing evolving risks of the financial system in the time-series
dimension.
A feedback loop between the financial system and the real economy becomes operativewith the passage of time. For example, in benign economic conditions, asset prices tend torise. Such a rise in asset prices prompts financial institutions to take on more risks. This
could result in a further rise in asset prices and overheating of the economy.2 As a result,unsustainable financial imbalances could accumulate within the financial system.
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In accommodative financial conditions, financial institutions tend to take on more credit and interest raterisks, which could narrow credit spreads and yield spreads between long-term and short-term instruments.
As a result, profitability of bank loans and securities investment declines, and financial institutions strive tosecure profits by further increasing the leverage and widening the maturity mismatch between investment
and funding.

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Conversely, a possible decline in risk tolerance of financial institutions and investors due
to an adverse shock could prompt a decline in asset prices. This could further exert
downward pressure on the economy. Therefore, in assessing the entire financial system,
developments in financial markets and the real economy, as well as a feedback loop
between them and the probability of its occurrence, should also be analyzed.3
As for the second function, the supervisory authorities and central banks utilize
inspections/on-site examinations and off-site monitoring to perform the function. The conductof these to encourage individual financial institutions while attending to risks and financial
imbalances in the entire financial system should be considered crucial policy measures.
Moreover, in light of the experience of the global financial crisis, there have been moves toemphasize the active use of macroprudential tools.
Macroprudential tools refer to the measures to directly or indirectly encourage the financial
system and the real economy to restrain systemic risk. These measures include a restriction on
the loan-to-value (LTV) ratio for real estate loans and the countercyclical capital buffer in the
Basel III capital adequacy requirements to be introduced in 2013.4,5 Other macroprudential
tools cited by some countries include restrictions on cross-border capital flows and those on
the loan-loss provision ratio in accordance with the business cycle. At present, theunderstanding of macroprudential tools varies from country to country.
Although they are not part of macroprudential tools, measures to strengthen the structure of
the financial system -- such as enhancing the framework of banks' resolution or crisis
management as well as the safety and efficiency of payment and settlement systems -- aim tocontain systemic risk, as do macroprudential tools.
Moreover, the conduct of macroeconomic policy, such as monetary policy, does not aim toensure stability in the financial system, but largely influence developments in asset prices andthe financial system over the longer term. With the experience of the recent global financial
crisis, central banks are increasingly aware of the importance of paying due attention to the3

Risks detected from the cross-sectional dimension may abruptly change their form over time reflecting
new investors' participation in financial markets and deeper trading ties between market participants.
Accumulation of risks detected from the time-series dimension may be greater at some financial institutions
depending on the type of business models they take. Therefore, it becomes important to analyze both typesof risks simultaneously rather than separately.
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The restriction on the LTV ratio is concerned with the ratio of loans to the collateral market value in
extending real estate loans. When risks in the financial system are expected to increase, lowering the LTV
ratio would contain further credit expansion and accumulation of financial imbalances.
5

The countercyclical capital buffer indicates a variable capital surcharge, one of the Basel III capital
adequacy requirements. Capital reserves are required for materialization of potential losses in the banking
sector, when risks in the financial system are expected to increase due to excessive credit extension.

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feedback loop between the real economy and the financial system. The confidence in fiscal
sustainability could also be a major factor affecting developments in the financial system, as
evident from the impact of the sovereign debt problems in Europe after the recent global
financial crisis.

II. The Bank's initiatives on the macroprudential front
A. Macroprudential policy and the central bank
As for the policymaker and its institutional framework for the macroprudential policy,
reviews have been carried out in various countries based on the lessons learned from therecent global financial crisis. In Japan, reflecting the post-bubble experience, a number ofmeasures were taken during the period from the late 1990s to the early 2000s, including theestablishment of the Financial Services Agency, the amendment of the Bank of Japan Act
with a clear statement of its on-site examinations, and the formulation of crisis management
framework.6 At present, on the basis of these, the Financial Services Agency -- which islegally authorized to conduct industry-wide supervision and inspections -- and the Bank ofJapan -- the central bank in Japan -- take the initiative in carrying out macroprudential activity.
They cooperate to fulfill their respective functions in monitoring risks and financial
imbalances in the entire financial system. The Bank's macroprudential activity, similar to its
conduct of microprudential activity of on-site examinations and off-site monitoring, is in linewith the purpose stated in the Bank of Japan Act.7
Among the various types of post-financial crisis reviews of the institutional framework, afeature common across the border is to enhance the role of central banks to implement themacroprudential perspective. Central banks have the purpose of contributing to achieving
sustainable economic growth by ensuring stability in prices and the financial system. To thisend, they have the following functions and characteristics, which are effective in
implementing the macroprudential perspective.
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In 2001, a financial crisis response committee was established, chaired by the Prime Minister. The
committee discusses guidelines to respond to financial crises such as a series of large-scale bankruptcies offinancial institutions and encourages the administrative institutions concerned to take adequate measures
based on the guidelines. The Bank's Governor is a member of this committee. Article 102 of the Deposit
Insurance Act stipulates that funds can be injected into financial institutions when the stability of thefinancial system becomes extremely difficult to maintain and when decided by the committee.
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Article 1 of the Bank of Japan Act prescribes the purpose of the Bank as to issue banknotes and to carryout currency and monetary control as the central bank of Japan and to ensure smooth settlement of funds
among banks and other financial institutions, thereby contributing to the maintenance of stability in thefinancial system.

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i. Central banks have been working to rigorously gauge developments in the macroeconomy,
financial markets, and financial transactions by conducting monetary policy and operating
payment and settlement systems.
ii. Central banks have a function as the lender of last resort for individual financial
institutions and other entities in order to ensure financial system stability.
iii. In pursuit of the above roles, central banks gauge and analyze developments in the real
economy and financial system from a macro perspective.
iv. Central banks are deeply involved in financial markets and financial systems worldwide
and have constructed a global network for exchanging information and making
cooperation.

B. The Bank's approach to macroprudential tools
As shown by a series of financial shocks -- such as the bursting of Japan's bubble economy,
the Asian currency crisis, and the Lehman shock -- a shock threatening the financial systememerges through a different channel each time. This reflects the fact that financial innovationand structural changes in the economy have caused risks to take new forms and channels of
spillover.
Based on these lessons, as prerequisites to take macroprudential tools, risks in the entire
financial system must be adequately gauged and measures effective to restrain risks must be
taken at an appropriate time. To this end, the Financial Services Agency and the Bank should
appropriately cooperate to analyze and assess the financial system stability and then to takemacroprudential tools.

C. The Bank's initiatives
The Bank makes use of its characteristics as a central bank in taking various initiatives on themacroprudential front. The following list describes the Bank's specific initiatives with
importance attached to the macroprudential perspective, which pays particular attention torisks and accumulation of financial imbalances in the entire financial system and to a
feedback loop between the financial system and the real economy.

1. Analysis and assessment of the financial system stability
The Bank analyzes and assesses risks in the entire financial system and regularly releases its

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findings in the Financial System Report. The Report aims to gauge risks in and challenges forJapan's financial system and to share recognition of the risks with a broad range of concerned
parties, including financial institutions, so as to ensure stability of the financial system.
Throughout the issues of the Report, risks and the robustness of the banking system inparticular have been analyzed and assessed. In October 2011, the Bank integrated theseparately released Financial System Report and Financial Markets Report, and started torelease the new Financial System Report in order to further advance its analysis made fromthe macroprudential perspective. The Bank strives to better analyze and assess risks indomestic and overseas financial systems, including the examination of risks observed infinancial markets. The enhanced contents of the new Report are as follows.
i. Better assessment of the robustness using macro stress testing
The Bank has effectively used macro stress testing to better assess the robustness of thefinancial system. The Bank, for example, strives to examine whether or not materializationof credit and market risks in Japan's financial system would seriously threaten thefinancial sector's prospective profits and capital bases by applying diverse stress scenarios
in macro stress testing.
ii. Assessment of a dynamic feedback loop between the real economy and the financial
systemThe Bank has enhanced analysis and assessment of the feedback loop between thefinancial system, financial markets, and the real economy. Specifically, the Bank strives togauge, using the newly developed Financial Macroeconometric Model, the feedback
process of a stress exerted on economic conditions and asset prices spreading to the real
economy through behavioral changes of financial institutions.
iii. Cross-sectional analysis of risks borne by the financial sector
The Bank has enhanced its analysis of risks borne by the nonbank financial sector that
includes insurance companies, securities companies, credit card companies, and consumer
finance companies. The Bank strives to gauge risks across the entire financial system inview of the interconnectedness between the nonbank financial sector and the banking
sector.
iv. Assessment of financial imbalances using macro indicators
The Bank has been developing indicators useful in analyzing excessive credit expansion
and the financial sector's risk-taking as well as in detecting signs of instability in the7

financial system, based on macro financial and economic data. With the comprehensive
analysis and assessment of these indicators, the Bank strives to gauge accumulation ofmacro financial imbalances.
v. Identification of risks observed in financial markets
The Bank has been striving to detect risks and their changes in the financial system byanalyzing developments in market prices and transactions of, for example, derivatives andsecuritized products from multilateral perspectives. The Bank has also expanded its
analysis of correlations between domestic and overseas asset prices to gauge risks thatmight spill over from domestic and overseas financial markets to Japan's financial systemand to grasp the channels of such spillover.

2. Coordination with microprudential activity of on-site examinations and off-site monitoring
The Bank reinforces coordination of macroprudential and microprudential activity in order toprevent the financial system from becoming destabilized.
The Bank draws on various micro information obtained from on-site examinations andoff-site monitoring of individual financial institutions both in assessing their financial
soundness and in gauging and analyzing risks in the entire financial system. The Bank aims tocapture the sign of systemic risk as early as possible by using the analysis of this micro
information together with macroeconomic and financial data to compensate for the
publication lag of the latter.
The Bank's analysis and assessment of the financial system from the macroprudential
perspective are reflected in its on-site examinations and off-site monitoring, seminars of theBank's Center for Advanced Financial Technology, and international discussions. For
example, the Bank decides points to be focused in on-site examinations and states them in its"On-site examination policy" released every fiscal year, taking into account issues concerning
individual financial institutions' business conditions and risk management as well as analysis
and assessment of the entire financial system. Moreover, the frequency and scope of on-siteexaminations of individual financial institutions are determined by considering theirrespective financial soundness and the degree of possible impact on the financial system if afinancial institution triggers systemic risk. Furthermore, the Bank, in cooperation with the
Financial Services Agency, provides guidance and advice to individual financial institutions
through daily off-site monitoring in view of the risks they bear and domestic and overseas

8financial system conditions.8

3. Implementation of measures to ensure stability of the financial system
The Bank implements necessary measures in order to ensure stability when it detects risks
threatening the stability of the entire financial system.
Specifically, the Bank provides necessary liquidity as the lender of last resort, when shocks
such as a failure of a financial institution could render the entire financial system unstable.
Upon the need to prevent systemic risk from materializing, the Bank extends uncollateralizedloans to the financial institution based on the so-called four principles for extending special
loans and a decision made by the Policy Board.9,10

4. Operation and oversight of payment and settlement systems
The Bank provides central bank money such as banknotes and deposits in current accounts
that financial institutions hold at the Bank. It operates a funds transfer system via current
accounts and Japanese government bond (JGB) settlement system, and operates a computer
network system -- the Bank of Japan Financial Network System (BOJ-NET) -- thereby
ensuring smooth settlements. The BOJ-NET serves as Japan's core payment and settlement
system, and therefore its secured safety and efficiency is essential to ensure stability of Japan's
financial system. The Bank has continually worked, while taking account of user needs, toenhance the safety and efficiency of the BOJ-NET, as evident from the introduction of thedelivery-versus-payment mechanism for both funds and JGB transactions and the real-timegross settlement system.
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The Bank, where necessary, makes public its views and actions concerning points to be focused in daily
off-site monitoring. For example, from the experience of the recent global financial crisis, when funding
conditions rapidly deteriorated amid the turmoil in global financial markets, the Bank released two reports
to encourage financial institutions to reinforce their liquidity risk management of both domestic and foreign
currencies: (1) "The Bank of Japan's approach to liquidity risk management in financial institutions,"
released in June 2009; and (2) "Liquidity risk management in financial institutions following the global
financial crisis," released in July 2010.
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The Bank articulated and made public four principles that should be met to provide loans (the so-called"special loans") pursuant to Article 38 of the Bank of Japan Act: (1) there must be a strong likelihood thatsystemic risk will materialize; (2) there must be no alternative to the provision of central bank money; (3)all relevant parties are required to take clear responsibility to avoid moral hazard; and (4) the financial
soundness of the Bank itself must not be impaired.
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In addition to this, the Bank has taken the following measures extraordinary for a central bank in orderto ensure stability of the financial system: (1) purchases of stocks held by financial institutions (fromNovember 2002 through September 2004 and from February 2009 through April 2010); and (2) provisionof subordinated loans to them (from April 2009 through March 2010).

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The Bank oversees payment and settlement systems and clearing houses, which are privately
operated. 11 Oversight is defined as the activity to monitor the institutional design, risk
management arrangements, and operations of systems by the private sector; to assess thesystems against established safety and efficiency objectives; and to induce improvements
where necessary. Oversight of payment and settlement systems plays an important role inensuring stability in Japan's financial system, since payment and settlement systems
potentially pose systemic risk.

5. Conduct of monetary policy
Monetary policy is conducted to achieve price stability and not to ensure financial systemstability. However, as stated previously, there is a close interactive relationship between
monetary policy and financial system stability. For example, the experience of domestic andoverseas financial crises to date shows that the prolonged monetary easing might have causeda bubble to form and expand through various channels before the crisis occurred. Once thefunctions of the financial system deteriorate significantly due to the bursting of a bubble, themonetary policy effects are largely constrained.
In view of this, the Bank also emphasizes the macroprudential perspective when conducting
monetary policy. The Bank assesses the economic and price developments from two
perspectives when it decides the monetary policy. The first perspective involves assessing themost likely outlook for economic activity and prices over the coming one to two years andexamining whether the economy is on a sustainable growth path with price stability. The
second perspective assesses the risks considered most relevant to the conduct of monetary
policy, including risks that have a longer time horizon than the first perspective, in order torealize sustainable economic growth with price stability. The Bank examines risks in thefinancial system as one of risk factors with a medium- to long-term horizon according to thesecond perspective.

Japan's financial system is maintaining its stability, following the recent global financial crisisand the Great East Japan Earthquake. However, risks threatening the stability of the entire
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For the Bank's approach concerning the payment and settlement system, see Payment and Settlement
Systems Report. For the purpose and guidelines of the Bank's oversight, see its papers released in May
2010: "Policy on oversight of payment and settlement systems" and "Policy on oversight of offshore yen
payment systems."

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financial system have emerged so far through a different channel each time. The Bank withthe macroprudential perspective in mind will constantly strive to analyze and assess risks inthe entire financial system and to plan and conduct necessary policy measures, and willcontribute further to ensuring financial system stability with the effective use of its
characteristics as a central bank, in cooperation with the Financial Services Agency and withoverseas central banks and supervisory authorities.

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