DP2010-16

Pol icy Reactions to the Fina ncial Cris is
in Japan:Lessons from the 1990s *Uwe VOLLMER
Ralf BEBENROTH
May 7, 2010

* The Discussion Papers are a series of research papers in their draft form, circulated to encourage
discussion and comment. Citation and use of such a paper should take account of its provisional character.
In some cases, a written consent of the author may be required.

Policy Reactions to the Financial Crisis in Japan:
Lessons from the 1990s
Uwe Vollmer
Ralf Bebenroth

Abstract:
We describe the propagation of the recent financial crisis to Japan and compare current
monetary policy reactions by the Bank of Japan (BoJ) with actions taken during the 1990s
and with current policy reactions by other major central banks. First, we review the recent
literature on the origins and propagation mechanisms of financial crises. Then, we ask
how the financial crisis was transmitted to Japan and describe the policy responses by
BoJ. We proceed and ask what lessons have been learned by other central banks from thefinancial crisis of the 1990s.
JEL Classification: G21, E42, E52
Keywords: Financial crisis · Quantitative/qualitative easing · Exit strategy · JapanUwe Vollmer
University of Leipzig, Economics Department, Institute for Theoretical Economics,
Grimmaische Straße 12, D-04109 Leipzig, Germany, tel.: +49-341-9733571; fax: +49341-9733549; E-Mail address: vollmer@wifa.uni-leipzig.de
Ralf Bebenroth
Kobe University, Research Institute for Economics and Business Administration (RIEB),
Kobe University, Rokko, Nada Kobe 657-8501, Japan, tel.: +81-78-803-7021; fax: +8178-803-7021; E-Mail address: rbeben@rieb.kobe-u.ac.jp

1. Introduction
Japan has recently experienced the second major financial crisis of the lasttwo decades. While the first crisis of the 1990s was entirely home-made and had
effects that were largely confined to Japan, the recent crisis originated outside
Japan – mainly in the US and the UK – and was transmitted not only to Japan but
to all other major economies worldwide. 1 The Bank of Japan (BoJ) and otherJapanese government agencies, such as the Financial Services Agency (FSA),
started to react to the financial crisis in September 2008 – taking into accountexperiences made during the first financial crisis. Compared with measures taken
in other countries, especially in the US but also in Europe, the policy reaction
taken in Japan was rather modest quantitatively and temporary. This modest
reaction may not only be due to the fact that Japan was hit less hard by the current
crisis but also because authorities learned from experiences made during the
1990s.
In this paper, we describe the propagation of the current financial crisis toJapan, analyze the policy actions taken by BoJ and compare them with policy
reactions in the European Monetary Union (EMU), the UK, and in the US.
Though the current financial crisis is a global phenomenon, the Japanese case is of
special interest for the following three reasons: First, already during the first
financial crisis, BoJ had to act as a lender of last resort and to provide financial
assistance to single financial institutions and to financial markets to prevent a
meltdown of the financial system. Differences between policy reactions then andnow help us to understand what kind of financial assistance is appropriate during
a financial crisis to regain financial stability. 2 Second, all major central banks
have significantly reduced policy interest rates and have almost shifted towards azero interest rate policy (ZIRP) and a policy of quantitative/qualitative easing(QEP). While this is new territory for most central banks, the Bank of Japan had
already followed such a policy until 2006 (see, e.g., Bebenroth and Vollmer,2007). Hence, the monetary policy measures taken by BoJ in the 1990 may serve
as a blueprint for the conduct of ZIRP and QEP in other countries during afinancial crisis. Finally, BoJ – as some other major central banks – has augmented
her monetary policy framework and has, e.g., introduced a deposit facility which
did not exist in Japan during the first financial crisis. Hence, the Japanese caseallows us to understand what functions such a deposit facility serves and why
other central banks started to adjust their monetary policy toolkits.
The literature offers so far only few analyses of the impact of the current
world financial crisis on Japan and of the policy actions taken by BoJ. One
exception is Kamezaki (2009) who provides a short chronological overview overpolicy reactions by BoJ after the collapse of Lehman Brothers in September 2008
without comparing them with policy reactions in other countries; another is Sato
1

2

While the World`s real GPD growth is expected to be minus 1.3 percent in 2009, the world
economy experienced a positive growth during the 1990s, even combined with the Asian crisis.
See Kamezaki (2009).
In doing so one has to keep in mind that Japan has in the meantime improved its regulatory
framework and has adopted a financial safety net which is widely regarded as being state of theart (Tamaki, 2008; Tanaka, 2008); hence, differences in policy reactions during the 1990s andthe actual financial crisis may also be due to an improved quality of the regulatory framework.

1(2009) who describes the current situation of Japan’s financial system andanalyzes FSA’s recent policy responses. Borio and Nelson (2008), Chailloux et al.
(2008), Committee on the Global Financial System Report (2008), Bank of Japan(2009a, 2009b), and Bank for International Settlements (2009a, 2009b) analyze
rescue programs that were adopted in several countries, after Lehman Brothers’
default, in order to support banks and other financial institutions. Neither of these
papers, however, relates the current policy measures taken in Japan to theexperiences as made during the first financial crisis but rather take the recent
financial crisis as a historically single event. 3 They neglect to explain what
lessons were learned in Japan from the financial crisis during the 1990s.
In this paper, we compare the policy reaction in Japan during the current
crisis with policy reactions taken in Japan during the 1990s and with policy
actions taken recently in the member countries of EMU, in the UK, and in the
US. 4 Our aim is to find out how strongly Japan was hit from the recent financial
crisis and whether Japanese authorities reacted differently to the current crisis
than during the 1990s or then authorities in other countries. We ask to what extent
the actual policy reactions by the Japanese authorities can be traced back toexperiences made during the first financial crisis and what lessons have beenlearned from the experiences made during the 1990s. We find out that Japanesebanks were hardly involved in the production and distribution of subprime-related
products and show how the financial crisis was transmitted to Japan throughcapital outflows. We argue that Japanese authorities reacted differently to theactual financial crisis than other central banks not because Japan was hit lessbadly by the current crisis but because Japan learned from experiences madeduring the first financial crisis.
The rest of the paper is organized as follows: Section 2 briefly reviews therecent theoretical and empirical literature on the origins and the propagation of afinancial crisis in general. Section 3 turns to the Japanese case, describes theorigins of the recent financial crisis and analyzes recent policy reactions by the
BoJ. Section 4 compares them with policy actions taken during the 1990s andwith recent policy reactions in other countries. Section 5 provides someconcluding remarks.

2. Origins and propagation of a financial crisis: An overview over the
recent literature
The recent literature on financial crises addresses three interrelated
questions: What causes a financial crisis? What makes it spread over a nationalbanking industry, across borders and into the real sector of the economy? What
are the proper policy responses to a financial crisis?

3

4

An exception, however, is Shiratsuka (2009) who re-examinizes Japan`s experience of QEP
until 2006 in light of current policy reactions. Another exception is Hoshi and Kashyap (2009)
who analyze the tools taken by the US government to rehabilitate the US banking industry andcompare them with measures taken in Japan during the 1990s.
We thus follow the case study approach which envolves data collections through personal
interviews, verbal or written reports, or observations; see Yin (2003).

2

With respect to the first question, it is consensus that a financial crisis ischaracterized by a crisis of the national banking industry. 5 Banks are fragile
institutions that simultaneously grant loans and issue demandable deposits. They
thus create liquidity but, at the same time, are exposed to the risk of a bank run, i.e.
a situation where all depositors, even without actually facing liquidity needs, wish
to withdraw their deposits. Such a run may result either from a coordination
failure among depositors, i.e., depositors withdraw deposits because they believethat other depositors will also do so (Diamond and Dybvig, 1983). More
important, a bank run may also be triggered by changing fundamentals and by
expectations that a bank`s capital cushion will be used up when assets devaluate(Jacklin and Bhattacharya, 1988; Diamond and Rajan, 2000).
The literature offers three major explanations for such a devaluation ofbanks’ assets. 6 One strand accuses swings in asset prices to monetary policychanges and asserts that bank failures stem mainly from a less accommodative
monetary policy, resulting in a collapse of the housing market and of the
securitization market. According to this view, monetary policy, measured, e.g., by
the US federal funds rate, has a statistically significant effect on housing starts.
During the early 1980s, US monetary policy has been relatively predictable andsystematic, resulting in a substantial decline in the volatility in residential
construction; after September 11, 2001, however, the Fed had reduced the federal
funds rate considerably to an all-time low in 2003/2004. This helped to foster an
extraordinary surge in the demand for interest-sensitive sectors as housing andcaused a house-price boom. 7 As the federal funds rate began to return to normal
levels after 2004, housing demand fell and brought down construction price andhousing price inflation which resulted into a sharp rise in delinquency andforeclosure rates (Ahearne et al., 2005; McQuinn and O’Reilly, 2007; Taylor,2007: 8-10). 8
Housing prices also rose in other countries but financial innovation wasmuch more elaborated in the US (and in the UK). Hence, a second strand of theliterature blames the increased diffusion of the ‘originate-and-distribute-business’in banking and the massive increase in the size of all types of markets for credit
risks for the emergence of the banking crisis. ‘Originate-and-distribute-business’means a bank not holding a loan on its balance sheet either to sell it directly or tobuy a synthetic product – such as a credit default swap (CDS) – that effectively
insures the bank against non-performance. 9 Both, direct loan sales and the use of
5

6

7

8

9

Sometimes, banking crises are accompanied by currency crises and/or a state default. This was
also true in some countries during the current financial crisis but not yet in case of theeconomies considered here (the Greece case notwithstanding).
For surveys over the causes of the recent financial crisis see Acharya et al. (2009); Rajan(2009).
The US Fed motivated the decrease in interest rates by a ‘global savings glut’, i.e. an increasein net capital exports by some emerging markets in combination with the capital exports bytraditional exporters, such as Japan and Germany. To prevent a recession, the Fed had to toswitch to a more accommodative monetary policy. See Bernanke (2005).
Measured by the S&P/Case-Shiller-Index, US housing price inflation reached 20 percent
during parts of the period 2000-2004. See Taylor (2007: 3). Since the peak in 2006 residential
and industrial real estate prices dropped by more then 30 per cent.
For more details on the functioning of the ‘originate-and-distribute-business’ see European
Central Bank (2008a).

3

CDS allow for such a separation of credit risks off from loans. This strengthens
banks` ability to manage risk because credit risks can be valued more accurately
and can be more easily diversified (Deutsche Bundesbank, 2004: 36); on the other
hand, asymmetric information may cause efficiency problems due to adverse
selection and moral hazard (Parlour and Winton, 2008; Heyde and Neyer, 2008).
Because the risk shedder is in a better position to assess the risk of an asset (i.e.
the probability of an insurance event or the amount of a potential loss) than therisk taker, he has an incentive to pass on the bad risks. Moreover, the risk shedder
can influence the probability of the insurance event or the amount of loss bylosing his incentives to monitor loan customers. In consequence, a high market
price for insurance protection is generated as a result of both adverse selection andmoral hazard (Deutsche Bundesbank, 2004: 40).
Finally, the third strand accuses the decrease in asset prices to the burstingof an asset bubble, i.e., to the sudden revision of a speculative price increase(Kindleberger, 1978). An asset bubble is a situation where market participants buy
assets in expectation of a further increase in asset prices; in that situation, an
increase in asset demand is financed by loans which are expected to be repaid bygains from asset price increases. Then, the expectation of rising asset prices canbe self-fulfilling. If asset prices, however, reach a certain ceiling, the process isreversed and asset prices start to fall. According to the explanation, housing prices
in the US increased because market participants expected further future priceincreases and prices started to fall after housing prices reached unsustainablelevels relative to borrowers income in 2004.
While all these explanations motivate why banks with large exposures on
the housing and subprime markets start to get into troubles, they fail to explain
why other banks without such exposures also come into difficulties. Suchfinancial contagion may be caused by imperfections on the interbank markets
which channel liquidity from banks with excess liquidity to banks with liquidity
needs. Normally, the interbank market works smoothly, with interest rates for
unsecured interbank loans being only slightly higher than interest rates on secured
interbank loans or on central bank loans. Then, interbank markets tend to be veryliquid, with a large number of participants and a high turnover. During a financial
crisis, however, the funding of interbank markets becomes severly impaired, withrising interest rates and increased liquidity hoarding by banks. 10 Instead oflending at the unsecured interbank market, banks start to use central bank`sdeposit and lending facilities excessively. Banks, therefore, take refuge at central
banks which are forced to simulate the functioning of the interbank markets.
Such a breakdown in the functioning of the interbank markets may becaused by either increases in aggregate credit risk or by increases in aggregateliquidity risk. The first cause, an increase in aggregate credit risk, is relevant
primarily for the unsecured segment of the interbank markets. It refers to a10

Liquidity hoarding and interbank market spreads are reported, e.g., for US interbank markets
and interbank markets in the Euro area. A standard measure of tensions in the unsecured
interbank market is the spread between three months loan borrowing costs (measured by e.g.
Euribor or LIBOR) and the overnight index swap (OIS) in three months` time which measuresthe difference between unsecured and secured interbank loans and hence serves as an indicatorfor liquidity. See Heider et al. (2009: 2); Eisenschmidt and Tapking (2009).

4

situation where participants perceive a decline in the repayment probability of aninterbank loan, i.e. an increase in counterparty risk. This increase in counterparty
risk causes an increase of interbank interest rates. As long as the overall level ofcounterparty risk is low, interest rates are low and there is full participation in theinterbank market. Once counterparty risk rises, however, interest rates in theinterbank markets rise beyond a certain treshold level and safer banks drop out of
the interbank markets; this adverse selection causes a further increase in interest
rates. In this situation, an increase in the dispersion of counterparty risk alone,
without an increase in the level of risk, can lead to a breakdown of the interbank
market either because lenders hoard liquidity (i.e. supply dries up) or borrowers
drop out because of too high interest rates (i.e. demand dries up) (Heider, Hoerova
and Holthausen, 2009). 11
The second potential cause of an interbank market breakdown is anincrease in aggregate liquidity risk which, in contrast to increases in aggregate
credit risk, is relevant for both secured as well as unsecured segments of theinterbank market. It refers to a situation where participants in the interbank
markets perceive either a decline in the quality of available collateral or an
increase of the probability of a liquidity outflow in the near future. Such aparticipant may be a bank with a liquidity surplus. It can offer unsecured funds
either in the overnight money market or in the term money market. If the banklends funds in the term money market, it has to raise funds itself, if it faces
liquidity outflows before the loan matures. To prevent this situation, the bank may
prefer to lend repeatedly overnight until it receives the liquidity shock. As aconsequence, with an increased liquidity risk, term money markets become
illiquid while overnight money markets become more liquid, and the interest rate
spreads between term money markets and overnight money markets increase.
Increased liquidity hoarding hence leads to a rising liquidity interest rate premiumand to a significant decline in unsecured term money market volumes (Eisenschmidt and Tapking, 2009: 6-7). Moreover, it may result in a drying-out ofinterbank markets if central banks offer a deposit facility and banks prefer to holdexcess liquidity reserves at central banks instead of lending to the interbank
markets. 12
If interbank markets fail, banks` leverage problems and liquidity problems
spread over to other banks, and this may also have a substantial impact on real
activity. It may cause macroeconomic phenomena such as credit crunches andliquidity shortages. A credit crunch is a situation where banks` equity has fallen
substantially and where banks are capital constrained and are not able to offerloans to investors (Tirole, 2007: 478-9). 13 This may occur in a situation where
11

12

13

For other papers that model the influence of credit risk on bank lending see Freixas and Parigi(2008); Longstaff (2008).
For other models of a liquidity risk, based on Diamond and Dybvig (1983), see Allen and Gale
(2000); Allen, Carletti and Gale (2009).
This situation is sometimes also refered to as the “lending channel” and focuses on theinfluence of banks’ balance sheets on economic activity. A related situation is called the“balance sheet channel” which focuses on the influence of firms` balance sheet on theireconomic activity; it refers to a situation where firms` cash flows and collateral values havefallen substantially and where firms’ increased leverage reduces investments. See Tirole (2007:
471).

5

information is distributed asymmetrically between a loan applicant (investor) anda large number of financiers (Holmstrom and Tirole, 1997). The investor hasaccess to an investment project and project returns are random but depend on theinvestors behaviour which is not observable by financiers. Such informational
asymmetries may cause moral hazard on the part of the investor who will only
receive external finance without a financial intermediary if he has enough assets
available that can be invested into the project. A bank as a financial intermediary
may improve on the situation because it can monitor the investor and preclude
excess misbehaviour by the loan applicant. Since the bank also has an
informational advantage over financiers, it may also be subject to moral hazard
and has to invest its own capital into the project which is more expensive thanuninformed capital because monitoring is costly. In this scenario, the bank is able
to finance projects of investors who have not enough assets available to receive
finance directly from financiers. Some investors with assets above a thresholdvalue receive intermediated finance from the bank but not directly from financiers.
This threshold value, however, increases if investors projects become more risky
or if the volume of informed capital available to banks in the economy falls, i.e. ifbanks face increased leverage, leading to a credit crunch. 14
Capital regulations, such as minimum capital adequacy ratios set by theBasel committee and enforced by national regulatory authorities, may influencebanks lending behaviour procyclically, i.e., they have a relatively more severe
impact on banks` lending during a recession then during a boom. This results fromthe fact that under Basel II regulations minimum capital adequacy ratios dependon the internal or external rating of the bank`s assets which often varies procyclically because ratings are downgraded during recessions and upgraded during
booms (Monfort and Mulder, 2000; Segoviano and Lowe, 2002; Amato andFurfine, 2004). It results in a similar procyclicality of risk weights which aresmaller during recessions than during a boom. Banks, hence, possess more leeway
during a boom to leverage their capital then during a recession.
Policy makers may react to bank leverage and liquidity problems by (i.)
bank recapitalizations and by (ii.) supplying liquidity assistance to banks;
moreover, they may (iii.) conduct a policy of quantitative or qualitative easing tofacilitate corporate financing. Bank recapitalizations may in principle beconducted in two ways: Either (via the asset side of the banks’ balance sheet) bybuying toxic assets and transferring them to a ‘bad bank’, or (via the liability sideof the banks’ balance sheet) by injecting fresh equity capital (or junior debt) into
the bank. Purchases of assets by regulators may cause inefficiencies if the banks’solvency is private information of the bank management and not known by theregulators. In that case, either a ‘tough’ bail-out policy (where the regulator closes
down every insolvent bank) or a ‘soft’ bail-out policy (where the regulator
supports every insolvent bank) induces adverse incentives for the bankmanagement. In case of a tough bail-out the regulator is too rigid and inducesbank managers of insolvent banks to conceal insolvency; in case of a soft bail-out
policy, on the other hand, the regulator is too indulgent and induces managers ofsolvent banks pretending to be insolvent. Bank managers may be able to14

For a survey of recent literature on the evolution of bank lending during the business cycle see
European Central Bank (2009a).

6

camouflage their true solvency state by liquidating banks’ assets and choosing toliquidate more (less) assets than would be optimal under symmetric information(Aghion, Bolton and Fries, 1999). 15
If regulators inject equity capital into the bank, the regulator has to decide
ex ante on a repayment scheme which guarantees incentive compatibility. Two
extreme schemes are alternatively conceivable, one, where the regulator dispenses
with a repayment and in effect grants a subsidy to the bank, or another where theregulator assumes the property rights from the bank owners and nationalizes thebank. The regulator’s optimal choice should depend on the bank manager’s
behaviour: If the manager chooses a low-risk project, a subsidy is appropriate; if
he, however, chooses to invest into a risky project, the bank should benationalized. By announcing such behaviour, the regulator gives incentives to thebank manager not to invest into risky projects (Osano, 2002). 16
While recapitalizations ensure the solvency of insolvent banks, emergency
liquidity assistance by a lender of last resort (LLR) intends to restore the liquidityof either a single bank or the whole banking industry. Emergency liquidity
assistance may be necessary when there is an increased liquidity preference in theeconomy which results into a run of a single bank or in a banking panic (Allenand Gale, 2000). The provision of emergency liquidity by the central bank (or thedeposit insurance corporation) as a LLR may protect banks against these incidents.
Financial assistance may either take the form of lending to the whole market or
the provision of liquidity on special terms to a single institution. Liquidity
provision to the whole market is inefficient as long as the interbank market does
not work smoothly and the transfer of liquidity from one bank to another isimpaired. In that case, the central bank or the deposit insurance has to ensure thatsingle solvent banks with a liquidity shortage will receive the liquidity neededagainst collateral (Flannery, 1996).
Though a LLR may shield the banking sector against financial crises, thedrawback is that liquidity assistance may create moral hazard on the part of banks
that are insured against mismanagement of all types of risks. 17 To limit theseadverse effects, the LLR may provide liquidity to the market only at a penalty rate,i.e. at an interest rate higher than the market rate. Demanding a penalty rate,
however, aggravates the bank’s solvency problem and it may also send signals tomarket participants that the bank is in trouble; moreover, it may even give an
incentive to managers to ‘gamble for resurrection’, i.e. to invest in projects withhigher risks and higher returns in the hope of surviving. ‘Constructive ambiguity’
may be another device to constrain moral hazard. It can be defined as a situationin which the central bank retains discretion as to whether, when and under what
conditions financial support of an individual financial institution will be provided.
If the central bank keeps secret whether or not financial support will be granted,
banks will not know individually whether they will be rescued or not; moreover,this might avoid imitation effects. If the central bank is ambiguous about the
15

16

17

For other papers that model a bank recapitalization via the asset side see Boot and Thakor(1993); Povel (1999); Corbett and Mitchell (2000) and Mitchell (2001).
For other models that discuss a bank recapitalization via the liability side see Osano (2005) andOviedo and Sikdar (2008);
For a survey over the literature on the lender-of-last-resort-literaure see Freixas et al. (2004).

7

conditions of financial assistance, it keeps a bank’s shareholders and management
uncertain about the costs they have to bear in the case of financial assistance
As a consequence, the central bank should make use of conditionality andmake financial assistance conditional on the amount of uninsured debt issued by
the failing bank. If the central bank is able to commit to a policy, it should follow
a mixed strategy for small banks, i.e. exercising constructive ambiguity for all
financial institutions below the uninsured debt requirement, but never bail-out a
distressed bank above the debt requirement. Such a mixed strategy will always
dominate a policy of systematic liquidation, because some inefficient liquidation
is prevented; investors exert more effort in monitoring the bank, and the bank will
choose a less risky portfolio. Under commitment, a central bank`s ambiguity tosupply LLR functions is hence ‘constructive’, because it produces an endogenous
uncertainty that reduces moral hazard on behalf of commercial banks. Moreover,
it is advantageous to not publicly announce this policy because the variable onwhich this policy is based is not readily observable or verifiable within the shortperiod of time in which decisions have to be taken (Freixas, 1999; Cordella andLevy-Yeyati, 2003). 18
While a LLR targets the financial industry, central banks may also reduce
policy interest rates, intending to exert an expensionary influence on real activity.
Such a policy, however, comes to a limit after interest rates have reached zero;then, a ZIRP is sometimes accompanied by a policy of quantitative and qualitativeeasing (QEP). Under ‘quantitative easing’, the central bank expands the size of its
balance sheet through an increase in its monetary liabilities, i.e. base money.
Because conventional monetary policy instruments address short-term money
markets, central banks have to take unconventional monetary measures, like open
market operations or direct lending to companies, which are not part of themonetary policy toolkit during normal times. This usually means either that grossbank reserves expand beyond the threshold necessary to achieve the policy
interest rate target; or it means that the central bank is providing liquidity directly
to borrowers and investors to credit markets.
The aim of both measures is to reduce long-term interest rates which are
relevant for investments and long-term consumption decisions. Since central
banks do not control long-term interest rates directly, they try to influence
expected short-term interest rates in the future; if market participants expect a fallin short-term interest rates in the future as a result of quantitative easing, longterm interest rates will fall which might have an expansionary influence on thereal activity (Bini-Smaghi, 2009; Benford et al., 2009). To have such an influenceon market participants’ expectations of future short-term interest rates and hence
on long-term interest rates, the continuation of QEP has to be credible and its
termination has to be linked to the occurrence of a verifiable event, like, e.g. theend of consumer price inflation and the increase of the rate of consumer priceinflation above zero percent.
18

A central bank may also practice ‘constructive ambiguity’ not because it wants to constrain
moral hazard but it receives a random and non-verifiable signal about bank’s solvency andmakes financial assistance dependent on the outcome of the signal which cannot be observed
by outsiders. See Repullo (2000).

8This indirect influence might be supplemented by ‘qualitative’ or ‘credit
easing’, were the central banks changes the composition of the assets on its
balance sheet towards less liquid and more risky assets. Normally, the provisionof liquidity to financial institutions via interbank markets exposes central banks to
low risk, as loans are usually short-term, over-collateralized and collateralizedwith high quality assets. Under qualitative easing, however, the central bank takes
more term risk and credit risk in its portfolio, provides loans for longer terms andaccepts less quality assets as collateral. This also may reduce expected short-term
interest rates and long-term interest rates as well (Bank for International
Settlements, 2009a: 66; Bernanke, 2009a).
To conclude, the literature offers precise answers to the question asked at
the beginning of this section, but leaves open another possible reason why central
banks actually took the policy measures taken during the recent financial crisis.
Possibly, these policy reactions do not only reflect results of academic discussions
but also experiences made by policy makers during former crises. Japan has
experienced such a crisis during the 1990s, and it is worthwhile to explore
whether these experiences may explain some of policy actions taken during therecent crisis in Japan as well as in other countries.

3. The Financial Crisis and Policy Reactions in Japan
In the US, the recent financial crisis started in autumn 2006 when – after along-lasting boom in the housing markets – real estate prices in the US began tofall. 19 During the housing boom the percentage of subprime mortgages had
increased and a large number of them had been securitized as mortgage backed
securities and sold to financial institutions other then the originators. Especiallycollateralized debt obligations (CDO’s) which allowed a securitization of
subprime loans gained in importance. With an increased number of nonperforming loans fire-sales of houses increased which led to a downward pressure
on housing prices. Financial instruments that were issued to finance these realestate investments lost in value and endangered financial stability of mortgage
banks. In April 2007, ‘New Century Financial’, the largest US mortgage bank inthe subprime segment, went into bankruptcy.
In July 2007, rating agencies started to downgrade a large number of
securities, collateralized with mortgage loans, which lost in value. As aconsequence, financial firms which were dependent on financial funds borrowed
on international money markets and which used asset backed securities as
collateral, got into liquidity problems. In the US, two hedge funds belonging to‘Bear Sterns’ failed and large European banks suffered from liquidity shortages.
In August 2007, the US Fed and the European Central Bank enlarged the liquidity
supply and the Fed started to reduce policy interest rates (from 5.5 percent toalmost zero percent now). In September 2007, the British mortgage bank
‘Northern Rock’ suffered from a liquidity shortage which resulted in a bank run;the bank was nationalized in February 2008. In September 2008, the US
Government assumed ‘Fannie Mae’ and ‘Freddy Mac’, the largest US home loan
19

Acharya et al. (2009) and Scharff (2009) give a short chronology of the current financial crisis
between April 2007 and March 2009.

9

banks, under public conservatorship. On September 15, 2008, the US investmentbank ‘Merrill Lynch’ was assumed by ‘Bank of America’, and ‘Lehman Brothers’
collapsed.
Unlike banks in Europe or the US, Japanese banks, however, were only
marginally affected by the financial crisis until the failure of Lehman Brothers
because they neither invested directly into subprime-related products nor
conducted the ‘originate-and-distribute’-business with structured financial
products, such as CDS, on a large scale. 20 This low engagement in the markets for
subprime-related and structured financial products followed from experiences
made during the first financial crisis that resulted into more conservative business
policies; besides, Japanese banks are more focused on traditional banking services
and less involved in the production and distribution of securitized financial
products. In consequence, Japanese banks suffered only from small subprime
related losses which amounted to 1,040 billion Yen until June 2009 (Table 1).
These losses represented less than 2,2 percent of banks’ Tier-1-capital and werelargely absorbed by capital buffers which exceeded mandatory requirements
before the outbreak of the financial crisis (International Monetary Fund, 2008: 4;
Bank of Japan, 2008a: 12; Shirakawa, 2008: 9).
Table 1: Exposure of Japanese deposit-taking institutions1) to subprime-related
products (in billion Yen)
Date2)

Tier-1Capital

Direct Investments‚Originate-and-Distribute’BusinessBook value

Realized
Losses6)Book value

Realized Losses6)

09/200749,4083)

1,407

141

138

19

12/200749,4083)

1,519

442

202

85

03/2008

50,071

4)

1,019

725

107

288

06/2008

50,0714)

958

754

64

305

09/2008

50,071

4)

797

803

26

316

12/2008

50,0714)

565

919

21

317

03/200947,929

5)

449

1,001

17

324

06/200947,9205)

407

1,040

17

1)

323
2)

Major Banks, regional banks, co-operative financial institutions. End of month. 3) End-March
2007. 4) End-March 2008. 5) End-March 2009. 6) Accumulated since April 1, 2007.
Source: Financial Services Agency; http://www.fsa.go.jp/en/news/2009/20090911-10.html

Due to this limited subprime involvement of Japanese banks, funding costs
on unsecured interbank markets increased much less and showed much lessvolatility than in Europe and the US. Since June 2007, the three month LIBOROIS spread for Japanese Yen increased to around 50 basis points which are muchless than spreads for European Euros and for US Dollars which increased to20

Japan shared this feature with other Asian economies where financial institutions’ losses andpublic capital injections were small, too. See Bank of Japan (2009a: 9).

10around 200 basis points (Euro) resp. 350 basis points (USD) (Bank of Japan2009a: 6-7). Besides this, the Tokyo interbank market rate (TIBOR), the reference
interbank rate for prime Japanese domestic banks – also remained stable. This wasdue to – in addition to the low subprime involvement – a stable deposit base ofJapanese banks which finance only 10 percent of their liabilities in the interbank
market. 21 Finally, corporate bonds spreads over government bond yields rose inJapan much less than in the US and in Europe (International Monetary Fund,
2008: 6; Bank of Japan, 2008a: 9; Bank of Japan, 2009a: 7). Hence, there arebarely any signs that the recent financial crisis was originated inside Japan or a
result of a too high risk appetite of Japanese financial institutions.
This completely contrasts with the financial crisis of the 1990s in the runup to which Japanese banks were implicitly protected under the “convoy system”.
Under this system, banking supervision and regulation were conducted “in such a
way as not to undermine the viability of the weakest banks” (Nakaso, 2001: 2).
Instead, financial firm`s survival was implicitely guaranteed as long as all
guidance by BoJ or the Ministry of Finance was observed. Disclosure rules werelax and takeover bids were hard to implement. As a consequence, market
discipline was missing and banks did not behave like profit-maximizers but
increased their loan supply far beyond the profit-maximizing level (Aoki et al.,
1994; Porter et al., 2000; Revankar, Yoshino, 2008; Bebenroth et al., 2009).
Increased loan supply by banks fueled housing prices that started to fall after 1989,
resulting in a financial break-down as described above (Nakaso, 2001; Baba et al.,2005).
In September 2008, after the failure of Lehman Brothers, the recent
financial crisis began to be transmitted to Japan. International capital movements
were a major transmission channel. Despite the fact that interest spreads did notincrease significantly, Japan’s interbank markets shrunk considerably as banks
began to limit their provisions of funds. Amounts outstanding in the Call Money
Market fell from more than 659.000 trillion Yen in December 2007 to around250.000 trillion Yen in September 2009. Mainly foreign banks in Japan reduced
their supply of funds on the Japanese interbank markets substantially while
regional banks became more reluctant about investing funds under thecomplementary deposit facility introduced by BoJ (see Table 2; Bank of Japan2009a: 43). 22 In addition to this short-term liquidity outflow, foreign investors
turned into net sellers on Japanese stock markets, and net foreign purchases ofJapanese equities became negative. Especially hedge funds that faced liquidity
constraints in funding and increased risk exposure sold stocks (Bank of Japan,
2009a: 56). This was crucial since foreign holdings of Japanese stocks account fora quarter of market capitalization and foreigners account for nearly two thirds ofmarket turnovers. In consequence, Nikkei stock index fell from 18.000 JPY in
21

22

Unlike interest spreads inside Japan, spreads between three month (Japanese Yen) TIBOR and(Japanese Yen) LIBOR started to rise since September 2007. While TIBOR features mainly
Japanese banks in the Tokyo market, Yen-LIBOR is dominated by offshore European and US
banks. Hence, a rising spread reflected concerns by Japanese banks about a perceived credit
risk towards foreign banks. See International Monetary Fund (2008: 6) and Iwada (2009).
Because of this outflow of short-term liquidity, it seems that Japanese financial markets helped
to stabilize financial markets abroad. See also Kumakura (2008).

11

July 2007 to 7.000 JPY in March 2009; afterwards, it started to rise again. This
fall in stock prices depressed the asset value of Japanese banks which hold around
one third of their Tier-1-capital in stocks; it heavily impaired their capital basis,
especially of major banks. Though banks’ stock holdings are valued at acquisition
prices and included considerable unrealized gains (from which, under Basel rules,
45% may be included into Tier-2-capital), the equity not only completely
eliminate these unrealized gains but also affected Tier-1-capital (International
Monetary Fund, 2008: 8).
Table 2:

Japanese Call Money Market: Amounts Outstanding (2007-2009, in
Trillion Yen)

Date

Major
banks

Regional
banks

Trust
banks

Foreignbanks

OthersTotal

09/2007170.440

26.72848.030228.927160.404

634.529

12/2007206.044

29.43651.314204.722167.491659.007

03/2008214.27137.22445.324207.040

171.477675.336

06/2008

209.398

35.84251.307210.696

166.619673.862

09/2008

212.477

35.85950.578153.534

149.690602.138

12/2008207.69350.45853.60953.619146.334

511.71303/2009170.71040.82544.46421.171121.044398.21406/2009159.22717.39951.59318.893108.972

356.084

09/2009112.709

11.04930.74314.73079.643248.874

Source: Bank of Japan: Time-series data. http://www.stat-search.boj.or.jp/index_en.html.

As a result of the increased liquidity preference worldwide, interest rate
spreads on commercial papers (CPs) and on commercial bonds (CBs) over
government bonds increased sharply, in particular for companies with lower
ratings (Juhara, 2009). 23 At the same time, the volume of CPs and CBs
outstanding decreased considerably (Bank of Japan, 2009a: 44), and especiallycompanies with lower or medium credit ratings became difficulties to sell papers.
This occurred mainly because of rising concerns about the funding availability offirms and decreased risk appetite by investors which preferred to increaseprecautionary liquidity demand, instead of holding corporate bonds (Nichikin
Tankan, 2009). Large companies were able to compensate for this decreased
turnover in CPs and CBs by increasing their bank borrowings; for small andmedium-sized companies, however, bank borrowings fell under the level of 2007
(Shirakawa, 2008: 9; Bank of Japan, 2008c).
The Bank of Japan reacted to these developments in financial markets after
September 2008 and implemented two reductions in policy interest rates andmade several adjustments in their monetary policy framework. The intentions ofthese measures were, first, to ensure stability in financial markets and, second, to

23

Besides, the ratings of a large number of firms were downgraded. See Bank of Japan (2009a:
60).

12

facilitate corporate finance. 24 To ensure financial market stability, Bank of Japan
had signed immediately after the failure of Lehman Brothers - together with 13
other central banks - a bilateral currency liquidity agreement or swap facility with
the US Fed that allows BoJ to acquire US Dollars from the Federal Reserve andlend them to domestic financial institutions (Bernanke, 2009a). On September 18,
2008, BoJ started to conduct USD funds-supplying operations against pooledcollateral as a coordinated measure with five other central banks. 25 This was thefirst time BoJ supplied USD to domestic financial markets against domestic assets
as collateral. The purpose of these measures was to satisfy the increased
worldwide liquidity demand for US-Dollars and to elevate pressures from US
short term money markets. 26 The amounts outstanding in this facility (and in otherfacilities) end of May 2009 and end of September 2009 are given in Table 3.
To ease financing especially for small and medium-sized companies and toprevent a Yen appreciation, the Bank of Japan decided to lower the target rate forthe uncollateralized overnight call rate twice by 20 basis points; the new target
rate was lowered from 0.5 percent to 0.3 percent on October 31 and to 0.1 percent
on December 19, 2008. 27 At the same dates, the basic loan rate and the basic
discount rate were reduced to 0.5 percent and 0.3 percent, respectively. Moreover,
BoJ introduced a ‘complementary deposit facility’ that allows banks to receive
interest payments on excess balances with the central bank; the interest rate paid
by BoJ was fixed at 0.1 percent. 28 This facility allows BoJ to attract liquidity andprevents the uncollateralized overnight call rate from falling significantly below
the target rate.
Beginning on October 14, 2008, Bank of Japan introduced several
measures to secure the stability of the financial system. To enhance stability of thestock market and in order to gauge market development, BoJ decided to suspend
the sale of stocks purchased from financial institutions on the stock exchanges.
Furthermore, on February 3, 2009, BoJ decided to resume its purchases of stocks
held by financial institutions. Both measures were announced to be temporary andserved a twofold purpose: to stabilize stock market prices and to reduce market
risk associated with stockholdings. Finally, on March 17, 2009, BoJ announced its
readiness to provide subordinated loans to financial institutions up to a total
amount of one trillion Yen; a limit of 350 billion Yen per financial institution was
set by BoJ. Eligible are banks which are subject to international capital standards
and which are deemed creditworthy. The amount of each loan and the floating
24

25
26

27

28

Appendix 1 offers a chronological compilation of the policy measures taken by BoJ. The
information presented in this chapter refers to Bank of Japan (2009c) and Kamezaki (2009: 69). For further information see also the website of Bank of Japan.
Bank of Canada, Bank of England, Federal Reserve, ECB, and Swiss National Bank.
The first two operations were conducted through market-rate competitive auctions; from
October 31 on, funds were provided at a fixed interest rate for an unlimited amount against
pooled collateral. See Kamezaki (2009: 6).
Since the end of first quantitative easing policy in March 2006, the uncollateralized overnight
call rate is the main policy target of BoJ. By use of its policy instruments, BoJ encourages thiscall rate at the target level. See, e.g., Bebenroth and Vollmer (2007).
The “complementary lending facility” is equivalent to the Eurosystem’s “deposit facility”
which already exists since 1999. The US Fed., like BoJ, also introduced a deposit facility
during the recent financial crisis in October 2008. See Borio and Nelson (2008); European
Central Bank (2009b).

13

interest rate for the first five years are determined by an auction; the interest rate
will increase after five years of loan disbursement (plus 1.5 percent). Auctions andloan disbursements are once every quarter. As an additional measure to ensurestability of the financial markets, BoJ expanded on October 18, 2008, its securities
lending facility which allows BoJ to sell Japanese Government Bonds (JGBs)
with repurchase agreements; the minimum fee rate applied for this facility was
lowered from 1.0 percent to 0.5 percent. Moreover, BoJ announced that it will add
floating-rate JGBs, inflation-indexed JGBs and 30-years Government bonds to thelist of eligible JGBs for its repo operations.
Table 3:

Amounts Outstanding of Short-term and Long-term Operations by
Bank of Japan (May 29, 2009 and September 30, 2009)

Operation

Amounts outstanding

Upper limit

May 29, 2009

Sep. 30, 2009

US Dollar fund-supplying
operations

25 billion USD

1.5 billion USD

Unlimited

Outright purchases of JGBs

46.1 trillion Yen

46.3 trillion Yen/

JGB repo operations

7.4 trillion Yen

7.0 trillion Yen/

Special fund-supplying operations
to facilitate corporate financing

7.2 trillion Yen

6.9 trillion Yen

Unlimited

Stock purchases held by financial
institutions

9.0 billion Yen

127.2 billion
Yen

1 trillion Yen

Corporate debt as eligible collateral

10.3 trillion Yen

10.6 trillion Yen/

CP repo operations

2.8 trillion Yen

2.8 trillion Yen/

Outright purchases of CPs

0.5 trillion Yen

0.1 trillion Yen

3 trillion Yen

Outright purchases of CBs

142.0 billion Yen

0.3 trillion Yen

1 trillion yen

Provision of subordinated loans to
banks

/

/

1 trillion Yen

Source: Bank of Japan (2009c).

Two months later, on December 19, 2008, BoJ started a policy of “credit
easing” which has already been followed during the first financial crisis. Since thetarget rate for the uncollateralized overnight call rate has been lowered to 0.1
percent with further cuts almost impossible, BoJ decided to increase the amountof outright purchases of JGBs to 16.8 trillion Yen per year (from 14.4 trillion Yen
per year); in March 2009, this amount was further increased to 21.6 trillion Yen
per year. Also on December 19, the range of JGBs accepted in these outrightpurchases was expanded (floating-rate JGBs, inflation-indexed JGBs and 30-years
Government bonds were added to the list of eligible JGBs). Later, debt
instruments (bonds, dematerialized commercial papers, bills, commercial papers
and loans on deed) issued by real estate investment corporations, government
guaranteed dematerialized CBs and loans on deeds to the government and tomunicipal governments were all accepted as eligible. The same applied to bonds
issued by foreign governments (US, UK, France and Germany).

14

To facilitate corporate financing, Bank of Japan announced on October 14,
2008, that it would increase the frequency and size of its commercial paper (CP)repo operations which were generally conducted quarterly. On December 2, therange of corporate debt was expanded that was accepted as eligible collateral in
repo operations: While before debt instruments with credit ratings of “A- or
higher” were accepted this criteria was eased to “B- or higher”. The BoJ also
introduced a new credit facility called “Special Funds-Supplying Operations to
Facilitate Corporate Financing” which utilizes corporate debt as eligible collateral.
Under this facility, financial institutions may borrow from BoJ unlimited amountsof (three months) funds at an interest rate equal to the target rate for theuncollateralized overnight call rate. These operations were first conducted twice amonth, but from February 2009 on, once a week (Bank of Japan, 2008b).
Also on December 19, 2008, the BoJ announced the introduction of
outright purchases of commercial papers (CPs) as a temporary measure. This
meant a much higher degree of credit risk taking than when commercial papers
are taken as collateral for providing credit to financial institutions; it also meant a
deeper involvement of BoJ into microeconomic resource allocation. For thesereasons, BoJ decided not to buy these instruments directly from the issuer but only
from financial institutions that are counterparties of the Bank and to buy them bymeans of competitive auctions. The total amount of purchases was limited to threetrillion Yen; the outstanding amount if a single issuer’s CP purchased by BoJ shallnot exceed 100 billion Yen. CPs bought by BoJ must be eligible as the Bank’s
collateral, a-1 rated, issued before the auction date, and with a residual maturity
up to three months. All purchases shall be conducted by December 31, 2009. Asof end September 2009 the amount purchased by BoJ was 0.1 trillion Yen (seeagain Table 3).
On January 22, 2009, BoJ announced outright purchases of corporate
bonds. Bonds to be purchased had to be rated “A or higher” and the maturity dateshould fall within a year at the end of the month in which the purchase wasconducted. As with outright purchases of CPs, all purchases should be conductedby December 31, 2009, with a maximum purchased amount not more than 1
trillion Yen and the outstanding amount of a single issuer’s CB purchased by BoJ
shall not exceed 50 billion Yen. As of end September 2009 the amount purchased
was 0.3 trillion Yen.
As a consequence of BoJ’s operations, tightness in money market
conditions eased and interest rate spreads declined. BoJ evaluated the impact of its
measures on the spreads between issuing rates on CP’s with credit ratings a-1+, a1, and a-2 and three months OIS rates (Bank of Japan, 2009a: 48-50): The spreads
show risk premiums on corporate credit risk and on CP market liquidity risk.
These dependent variables were regressed against three independent variables,such as the implied volatility of stock prices (as a proxy variable for changes in
uncertainty over corporate financing), spreads between TIBOR and OIS rates (as ameasure for the cost of unsecured bank lending) and the share of funds obtained
through operations by BoJ in the amount outstanding in CPs (as a proxy for Bankof Japan’s measures to facilitate corporate financing). The results show significant
downwards effects of the corporate financing measures taken by BoJ on CP
issuance rates. Hence, these measures were effective in lowering CP issuance15

rates (without going through the conventional transmission channels of policy
interest rate cuts). 29

4. Past and Recent Crises: Lessons Learned
Policy measures taken by Bank of Japan and other central banks during therecent financial crisis differ significantly from the reactions by Japanese
authorities in the 1990s. During the first financial crisis, the Japanese interbank
market almost collapsed when in early November 1997 ‘Sanyo Securities’ failed,a securities house which acted as a borrower in the interbank market. Though theamount of the default was relatively small, lender banks preferred placing theirmoney with the Bank of Japan to lending in the interbank market for fear of beingcaught by another default. The consequence was that major financial institutions
failed almost on a weekly basis until BoJ stepped in and injected massive liquidity
into the market in late November 1997, i.e., several weeks after the outbreak of
the crisis (Nakaso, 2001). In contrast to this episode, all central banks reacted
immediately after the collapse of Lehman Brothers by injecting liquidity into themarket, knowing that a collapse of the interbank markets might result in a domino
effect and financial system instability. Providing immediate financial assistance tobanks was probably the first major lesson learned by Japanese authorities from thefinancial crisis of the 1990s.
The second lesson learned concerns the introduction of accommodative
policy measures and the switch to a more expansionary monetary policy. Whileduring the 1990s, BoJ reduced its policy rate only gradually, from six percent in1992 to zero percent in 1999, almost the same interest rate reduction was
implemented by all major central banks during the recent crisis within 16 months(Shirakawa, 2009). After the Lehman collapse, the sharpest cut was implemented
by BoE (450 basis points), followed by the ECB (325 basis points) and the Fed(175 basis points) which had already lowered interest rates from 5.25 percent inJune 2006 to 2.0 percent in April 2008; since interest rates were already very low
in Japan, interest rate cuts by BoJ were less pronounced (Bank of Japan, 2009a:
16). While monetary policy in Japan during the 1990s was often critizised as
doing ‘too little, too late’, the recent policy reaction by central banks was fasterand much more aggressive.
Because market participants might lose incentives to trade at market rate
slightly above zero percent (if margins do not cover transaction costs anymore),
all central banks started to pay interest on excess reserve balances and offered a‘complementary deposit facility’. 30 Introducing a deposit facility was the second
lesson learned. Such a facility did not exist in Japan during the 1990s andauthorities learned that if the key policy interest rate is lowered to zero, this may
impede the functioning of the money market (Mizuno, 2009; Shiratsuka, 2009:

29

Actually, the effects on CP issuance rates varied considerably by credit rating and were mostpowerful on a-1 ratings. See Bank of Japan (2009a: 50).
30
In the case of the Euro-system, such a facility already existed and ECB raised interest rates paidon excess reserve balances; this increase was recalled later, but partially reintroduced in May
2009.

16

9). 31 A purpose of an interest bearing deposit facility is to prevent such asituation. 32 Its drawback, however, is that it drains off liquidity from the interbank
markets (Furfine, 2003). Banks with excess liquidity deposit funds at accounts
with the central bank instead of lending it to the market. Banks with a liquidity
shortage become dependend on fund-supplying operations by the central bank. As
a consequence, central banks have to recycle liquidity and to play the role ofmoney market brokers. In other words: they have to practice ‘quantitative easing’.
Quantitative easing also happened during the recent financial crisis in theUK, the US, and in EMU where banks’ accounts with the central bank explodedand central banks’ balance sheets rose dramatically. This expansion wasespecially pronounced in the case of BoE and the US Fed, followed by theEurosystem (Mizuno, 2009; European Central Bank, 2009b). Quantitative easing
was accompanied by qualitative easing in the case of the Fed and the Eurosystem– but less in case of BoE which accepted only a limited degree of credit risk –where the volume of market operations outstanding increased, especially buying
long-term securities and targeted lending programs. The Fed started to buy risky
assets until February 2009 when it decided to start outright purchases of long-term
Treasury Securities. Eurosystem increased the average term of its operations
significantly and on June 23, 2009, it even started to carry out a series ofrefinancing operations with a maturity of twelve months, applying a fixed-ratetender with full allotment; two days later, it injected 442 Billion Euro throughlonger-term refinancing operations (European Central Bank, 2009c: 86). Besides,
ECB lowered the minimum rating of assets eligible as collateral to “BBB” andeven accepted asset backed securities with a minimum rating of “A-“ as eligible
collateral (European Central Bank, 2008b; Neumann, 2009). Due to thissubstantial provision of long-term liquidity, tightening of money markets in the
US and in Europe eased and the values of market operation outstanding returnedto the levels before the Lehman collapse.
Compared with the other central banks, however, Bank of Japan followed
both a policy of quantitative and credit easing to a much lesser degree (Table 4
compares policy reactions by BoJ with policy measures taken by other major
central banks after failure of Lehman Brothers). The Bank prevented an expansionof its balance sheet which remained almost constant during the recent financial
crisis; BoJ, hence, resisted from acting as a money market broker despite the factthat amounts outstanding on the call money market decreased significantly (Bankfor International Settlements, 2009a: 98; Bank of Japan, 2009a: 20). In addition,
Bank of Japan generated excess reserves after the Lehman collapse mainly byproviding short-term funds in form of its ‘special fund-supplying operations tofacilitate corporate financing’ which have a duration of three months. Besides, it
has set ceilings for the amounts outstanding of government bonds it purchased, foroutright purchases of CPs and CBs and for provision of subordinated loans to

31

32

See also Baba et al. (2005: 16), who report from the 1990s the situation that when the interbank
rate was 0.001 percent the return of an investment of 10 billion Yen in the interbank market
was only 273 Yen which did not cover trading costs anymore.
Another purpose is to prevent central banks from taking too much counterparty risks inintraday real time gross settlement systems. See Ennis and Weinberg (2007).

17

Table 4: Policy Reactions by Major Central Banks after the Collapse of Lehman
Brothers
Objective
Reduction offunding costs

Policy measure Policy interest rate cutsa)

Consistency ofmarket rates
with policy
rates








Financialsystemstability







Supporting
non-bank
credit markets






a)

b)
c)
d)
e)
f)

Interest rates on excess
reserves
Exceptional fine-tuning
operations
Introduction of fixed-ratetenders with full allotment
Narrower corridor on
overnight rates
Change in reserve
requirements
US Dollar repos/intercentral-bank swap lines
Expansion of eligible
collateral
Provision of subordinateddebt
Exceptional long-term
operations
Purchases of stocks heldby financial institutions
Supporting measures ofindividual financial
institutions
CP funding/ purchase/collateral eligibility
CB funding/ purchase/collateral eligibility
Outright purchases ofGovernment Bonds
ABS funding/ purchase/collateral eligibility

BoJ
From
0.50% to
0.10%

ECB
From
4.25% to1.00 %

BoE
From
5.00% to0.50 %

+

+b)

+

Fed
From
2.00% to0.000.25%
+

+

+

+

+

+c)

+d)

-

-

-

+

+

+

-

-

+f)

-

+

+

+

+

+

+

+

+

+

+

+

+

+

-

-

-

+

-

-

-

-

+e)

-

+

+

-

+

+

+

-

+

-

+

-

+

+

-

+

+

+

Bank of Japan (BoJ): Target rate for the uncollateralized overnight call rate; Eurosystem(ECB): Main refinancing operations (fixed rate); Bank of England (BoE): Bank rate paid oncommercial bank reserves; US Federal Reserve (Fed): Target federal funds rate.
Temporary increase of interest rate on excess reserves.
Special fund-supplying operations to facilitate corporate financing.
Fixed-rate tenders in main refinancing operations.
By single NCBs.
Expanded range over which reserves are remunerated.

Source:Bank for International Settlements (2009b: 97); Bank of Japan (2009a: 15); Central Bank’s
Websites.

18

banks and has set a time limit for the various special measures (Mizuno, 2009).
Finally, Bank of Japan has developed an exit strategy from quantitative andqualitative easing, and this was the third lesson learned by BoJ which was notassumed by the other central banks. Already in 2006, the Bank of Japan was able
to exit from its policy of quantitative easing smoothly and swiftly for thefollowing reason: When the termination of quantitative easing came in sight, thestarting and ending dates of these operations were adjusted so that both did not
fall on the same date; this allowed the Bank to avoid a rollover of such operations
and to reduce total assets in its balance sheet. During the recent crisis, the bankalso decided to decrease the frequency of outright purchases of corporate
financing instruments as market conditions improves, so that BoJ’s balance sheet
will shrink accordingly (Mizuno, 2009).
Such an easy exit from quantitative and qualitative easing is not possible inthe case of the other central banks where rising bank reserves were financed byissuing or collateralizing long-term and risky assets. If market participants
perceive a reduction in counterparty and liquidity risks they will reduce theirdeposits with the central bank and look for better opportunities to lend out theirreserves; that would produce faster growth in broad money, which could
ultimately result in inflationary pressures - unless countervailing policy measures
are adopted. When the financial crisis comes to an end, central banks must either
eliminate these large reserve balances or, if they remain, neutralize any potential
undesired effects on the economy. To reach this end, the US Fed will either pay
higher interest on reserve balances or take various actions that reduce the stock ofreserves; these actions embrace outright sales of long-term securities in the open
market, arranging large-scale reverse repurchase agreements with financial market
participants, including banks, that involve the sale by the Fed of securities from its
portfolio with an agreement to buy the securities back at a slightly higher price at
a later date, or selling bills by the Treasury depositing the proceeds with theFederal Reserve (Bernanke, 2009b, 2009c, 2009d). In addition, the US Fed
announced the establishment of a term deposit facility in December 2009.
Observers cast doubt on whether this exit strategy is likely to be successful(Mizuno, 2009). Critics argue that neither the Fed nor the Eurosystem nor BoE
have yet made clear when and under what conditions they will terminate their
QEP, start lifting interest rates or trigger the use of the tools mentioned before.
While BoJ had announced in October 2003 that it will maintain QEP until core
CPI inflation becomes stable zero (or above), a similar announcement would not
be credible in the current situation. When, e.g., the Eurosystem injected 442
Billion Euro of one-year liquidity at one percent interest rate against subprime
collateral, it in fact subsidized the banking system. It helped politicians to avoid
the unpleasant political drawback of using taxpayers’ money to recapitalize banks
and undertook a quasi-fiscal rescue operation, hoping that banks use risk-free
profits generated from financial assistance to clean-up their portfolios and torecapitalize their balance sheets (Münchau, 2009). If exiting from this rescue
operation is not credible, banks will not use their extra-profits to recapitalize theirbalance sheets and central banks will be forced to prolongate QEP. Hence, acredible exit strategy will be of outstanding importance.

195. Conclusions
This paper describes the reaction by the Bank of Japan during the recent
financial crisis and compares them with measures taken during the 1990s and withrecent policy reactions by other central banks. It argues that after the failure ofLehman Brothers, central banks immediately offered financial assistance to thefinancial sector, enlarged the range of eligible collateral and increased the numberof counterparties. In addition, central banks quickly reduced interest rates andstarted to pay interest on banks’ excess reserves to prevent interbank markets fromcollapsing. With these measures, current monetary policy reactions differ from thepolicy reactions in Japan during the 1990s, when BoJ waited several weeks before
acting as a lender of last resort, only gradually reduced policy rates and did not
pay interest on excess balances. Immediate financial assistance, quick transition toa more accommodative monetary policy and introduction of a deposit facility areprobably the major lessons learned by central banks from the Japanese financial
crisis of the 1990s.
Though all major central banks joined the ‘ZIRP-club’, Bank of Japan wasmuch more resistant than the US Fed or the Eurosystem during the recent crisis toswitch to QEP. Though the amounts outstanding on Japanese interbank markets
shrunk considerably between September 2008 and April 2009, BoJ did not
significantly enlarge its balance sheet. It neither engaged in credit easing because
it mainly increased its short term lending to banks, nor did it accept asset backed
securities with low ratings as eligible collateral. Bank of Japan hence did not takesuch a large swing from the bottle of ‘quantitative/ qualitative easing’ whichmakes it easier to exit from QEP. This reluctance may be understandable because
the question how to exit from QEP is not answered yet. Three problems have to beconsidered: One is what tools should be used. Another is what circumstances will
trigger the use of these tools. Finally, central banks have to build credibility thatthey will start exiting only when these circumstances occur.
Allthough the paper argues that some of the policy decisions taken during
the recent financial crisis probably reflect experiences made in Japan during the
1990s, this does not mean that academic discussions, as reviewed in section 2, did
not excert an influence on the the policy reactions. Quite the opposite is probably
true. The recent literature on financial crises explains, e.g., why interbank markets
fail, what role capital regulations play in the propagation of a crisis, or why direct
financial assistance to single institutions may be helpful. These results, however,may be supplemented by experiences made in Japan during the 1990s to improve
our understanding of the policy reactions taken during the last two years. It is forthis reason why a case study, like this one, may be helpful.
Acknowledgments
The authors are indebted to Keikichi Honda (Business and Industry Advisory Committee
to the OECD, Tokyo) Keiichiro Kobayashi (RIETI – Research Institute of Economy,
Trade and Industry, Tokyo), Hiroshi Nakaso (Bank of Japan, Tokyo), and Nobusuke
Tamaki (Japanese Government Pension Investment Fund, Tokyo) for interesting
discussions. Of course, the usual disclaimer applies. Research assistance by Michael
Diemer is gratefully acknowledged. Parts of this research were done while Uwe Vollmer

20was on leave at Kobe University. He wants to thank Kobe University for its hospitality
and the “Stiftung Geld und Währung” for financial support.

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Appendix:
Date
2008
Sep. 18, 2008
Sep. 29, 2008
Oct. 14, 2008

Oct. 31, 2008

Dec. 02, 2008

Dec. 19, 2008

2009
Jan. 22, 2009

Feb. 3, 2009
Feb. 19, 2009

Mar. 17, 2009
Mar. 18, 2009
Apr. 7, 2009
Apr. 10, 2009
May 22, 2009
Jul. 15, 2009
Oct. 30, 2009

Time Line of Policy Measures taken by the Bank of Japan (2008-2009)
MeasureIntroduction of US Dollar fund-supplying operations
Expansion of of US Dollar fund-supplying operations
Expansion of the securities lending facility;
Expansion of the purchase of JGBs with Repo agreements;
Expansion of US Dollar fund-supplying operations;
Provision of sufficient funds over the year-end (40 trillion Y);
Increase in frequency and size of CP repo operations;
Expansion in the range of ABCP as eligible collateral;
Suspension of selling stocks held by the Bank of Japan;
Reductions in policy interest rates: New target for the uncollateralized overnight call rate: around 0.3%;
 New basic loan rate: 0.5 %;Introduction of complementary deposit facility (rate applied: 0.1 %)Introduction of “special fund-supplying operations to facilitate corporate
financing”;
Expansion in the range of corporate debt as eligible collateral;
Reductions in policy interest rates: New target for the uncollateralized overnight call rate: around 0.1%;
 New basic loan rate: 0.3 %;Expansion in the range of JGBs accepted in outright purchases;
Outright purchases of JGBs (16.8 trillion Y per year));Inclusion of Development Bank of Japan as counterparty in operations such as
CP Repo op.;
Expansion of “special fund-supplying operations to facilitate corporate
financing”;
Introduction of outright purchases of CPs;
Acceptance of debt instruments issued by real estate investment corp. as
eligible collateral;
Expansion in the range of JGBs accepted in outright purchases;
Expansion of outright purchases of CPs;
Introduction of outright purchases of Government bonds
Resumption of stock purchases held by financial institutions (rating BBB- or
better)Inclusion of government-guaranteed dematerialized CP in eligible collateral;
Expansion of “special fund-supplying operations to facilitate corporate
financing”;
Expansion of outright purchases of Government bonds;
Expansion of the securities lending facility;
Provision of subordinated loans to banks;
Outright purchases of JGBs (21.6 trillion Y);
Expansion in the range of eligible collateral for loans on deeds to the public
sector;
Provision of subordinated loans to banks;
Acceptance of US, UK, German, French Government Bonds as eligible
collateral;
Prolongation
Expiration of temporary measures announced

Source: Bank of Japan (2009c)

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