Masaaki Shirakawa: How to address tail risks
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Annual General
Meeting 2011 of the Foreign Bankers' Association in the Netherlands, Amsterdam, 27 June
2011.
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I. Introduction
Today I am privileged to have the opportunity to speak before the Foreign Bankers'
Association in the Netherlands, a respected association with a rich history and tradition. I
would like to express my gratitude to Chairman Freddy Boom for the warm introduction.
Since I believe this marks the first time for a governor of Japan's central bank to address the
association, let me begin my remarks by briefly reviewing the historical relationships between
the Netherlands and Japan. As many of you may know, the two countries have nurtured
close ties for centuries. The first contact between them dates back to 1600, when a Dutch
trading ship named De Liefde drifted to the land called Bungo. I happened to have worked at
our branch located near the point of landing and have long been interested in this episode. A
Dutch national named Jan Joosten became a diplomatic adviser to the first Shogun of the
Tokugawa government, which maintained a national isolation policy for some two hundred
years from the early 17th century to the mid-19th century. Nevertheless, as an exception, the
Netherlands continued to be a trading partner with Japan during this period. For Japan, the
Netherlands was not merely a provider of foreign merchandise but also a window on
advanced western science and technology, such as medical science, physics, and chemistry.
The intellectual class in Japan referred to such subjects as rangaku, or "Dutch studies." Let
me also note that the Enlightenment thinker Yukichi Fukuzawa, whose portrait is on the ten
thousand yen bill, made strenuous efforts in his younger days to master Dutch and learned
about western civilization from Dutch literature.
When I was given this chance to make remarks in the Netherlands, the first thing that came
to my mind was the fact that both the Netherlands and Japan have devoted significant
energy to dealing with the war against nature. With a quarter of its land below sea level, the
Netherlands is well known for its history of repeated hardships caused by great floods.
Historically, Japan has lived with earthquakes. Floods and earthquakes do not happen
frequently but do cause significant damage when they occur. In this regard, within the short
period of the past three years, Japan experienced not only the recent Great East Japan
Earthquake but also another significant event. Needless to say, this was the global financial
crisis, or the Lehman shock. The two differ from each other in that one was an economic
shock and the other a natural disaster, but they share a common feature in that both have
had enormous impact on the economy and society. How to address such events is definitely
a big challenge for the authorities in many countries and for the management of financial
institutions including the members of this association.
When describing these events, we often use the term "tail events" (Slide 1) and refer to risks
arising from such events as "tail risks" (Slide 2). The word "tail" implies that such events
rarely happen and rest within the tail of a probability distribution. To be more precise, tail
events or tail risks involve two types of events. One would be along the lines of the recent
earthquake in Japan. This had a magnitude of 9.0, and was followed by an enormous
tsunami that hit a wide area of east coast of Japan. The last time in recorded history that a
comparably sized tsunami hit eastern Japan was in the year 869. This type of event is
therefore extremely rare and rests far beyond the end of the tail (Slide 3). Another type of tail
event is a financial shock, like the Lehman shock. The financial crisis with the most
comparable seriousness and geographical scale as the Lehman shock was the Great
Depression of the 1930s. Such events therefore occur with low probability but not as rarely
as once in a thousand years. Looking back at the past twenty years, however, financial
crises have occurred more frequently than would be assumed in a normal probability
distribution. In any case, both types of tail events have a devastating impact on the financial
markets, the economy, and society (Slides 4, 5, and 6).
In cases where extremely rare events far beyond the end of the tail occur and where rare
events within the tail happen more frequently than anticipated, the common feature is that
such unanticipated events invite devastating turmoil. The global financial crisis triggered by
the subprime loan problem in 2007 was attributable to the formation and bursting of the credit
bubble at a scale that had not been anticipated in the preceding period. Natural disasters
such as earthquakes, tsunami, hurricanes, and floods as well as diseases including the
pandemics of highly virulent new types of influenza could develop into tail events once their
magnitude and the scope of damage surpass expectations. The same could be said for
large-scale computer disruptions, acts of terrorism, and wars. Responses to risks related to
tail events are important not only as part of national economic policy but also in terms of
management of the financial institutions for which many of today's participants are
responsible.
Today, I will talk about how to address tail risks while focusing on the recent financial crisis
and the March 11 earthquake in Japan.
II. The great east Japan earthquake
The damage
With regard to significant tail events that have materialized in recent years, many that are
related to the global financial crisis have already been discussed. Therefore, I would like to
share with you some factual information about what exactly happened following the Great
East Japan Earthquake.
This time Japan suffered the interrelated tragic events of an earthquake, a tsunami, and an
accident at a nuclear power plant. The toll of dead and missing persons was less than the
105 thousand recorded at the time of the Great Kanto Earthquake of 1923 but still reached
nearly 23 thousand. The amount of damage to capital stock from the recent earthquake has
been placed at about 3 to 5 percent of Japan's GDP, according to government estimates
(Slide 7). In the disaster areas, the infrastructures of electricity, gas, water, and
communications services were interrupted across a wide area. Transportation networks such
as roads, railways, and ports became dysfunctional all at once. To make matters worse, a
serious fuel supply shortage followed due to problems at oil refineries and the disruption of
transportation services. The tsunami seriously damaged the nuclear power plant, causing an
electric power shortage problem. Most of the key infrastructures and fuel supplies have
already been restored in disaster areas. But the situation at the nuclear power plant has not
yet reached the stable stage of a cold shutdown. The estimated amount of damage I have
just mentioned covers only capital stock and does not include damage to human resources
or the economic impact of the nuclear power plant accident. Overall, this was truly the
materialization of tail risk.
The effects on economic activity
I will now briefly describe the impact of the earthquake on Japan's economy, focusing on the
points relevant to considering how we should address tail events.
First, needless to say, production has declined sharply and significantly (Slide 8). Although
the March 11 earthquake clearly had no impact on the initial ten days of the month, a reading
for the industrial production index in March showed that this fell by 16 percent on a
month-tomonth basis, the largest one-month decline on record. This is attributable to the devastating
damage to the production facilities in the disaster areas as well as electricity supply
constraints and supply-chain disruptions experienced across wider areas. The pronounced
production decline led to an export decline. As a result of the production decline, exports
registered an almost 15 percent cumulative drop from February in the subsequent two
months combined.
Second, the earthquake also affected the sentiment of economic entities. Private
consumption declined as voluntary restraint by consumers dampened spending, particularly
for services such as tourism and eating out. Moreover, the impact of the disaster went
beyond just the sentiment of the Japanese people to affect the global perception of Japan
being safe and secure. Although the current radiation levels in Tokyo are roughly the same as
in Amsterdam, Berlin, or Paris, the number of visitors from abroad for business purposes or as
tourists fell sharply below the level registered a year before, declining by 50 to 60 percent after
the recent earthquake (Slide 9).
Third, despite such a sharp and significant drop in production, the economy is returning to a
gradual recovery path with the easing of the supply-side constraints. The current downward
pressure on the economy following the disaster is basically arising from the abrupt
supplyside shock. The fundamental conditions for growth - namely, expansion of overseas
economies - remain intact. In this regard, the current situation differs from the period
following the Lehman shock when demand evaporated both at home and abroad due to
financial contraction. In fact, the restoration of supply-chain disruptions has been making
steady progress, thanks to strenuous efforts by private firms. Regarding the electric power
shortage problem, although uncertainty and concerns remain in the medium and long run
depending on the outcome of the ongoing discussion about future nuclear power policy, we
are seeing better prospects for surviving the summer, when demand peaks due to the use of
air conditioners. We have seen more thermal power plants resume operations, more firms
install in-house power generation facilities, and firms and households make various efforts to
conserve electricity. Manufacturing production is gradually recovering from the bottom in
March and is expected to be restored to the pre-disaster level sometime in the third quarter
of this year.
Fourth, with regard to the global implications of the recent earthquake, its negative impact
spread to overseas economies through supply chains with a certain time lag. Production in
the auto and electronic products industries dropped in Europe, the United States, and Asia
(Slide 10).
The impact of supply-chain disruptions
As I will explain shortly, the recent earthquake taught us various lessons. In terms of how to
address tail events, the following facts require special attention.
First, I would draw attention to the importance of supply-chain disruptions. More specifically,
the magnitude of the economic downturn was much larger than implied by the share of
disaster areas in terms of economic size and population (Slide 11). The share of disaster
areas was 6 percent in terms of GDP and 7 percent in terms of population. As I have said,
however, the rate of decline in production was as high as 16 percent. The negative impact
was amplified by the supply-chain disruptions. In disaster areas, there are many firms
producing hard-to-replace parts for automobiles and electronics, including a producer of
microcontrollers for automobiles with a global share of 40 percent. As automakers have
relied on highly customized parts, a stoppage of production in disaster areas significantly
affected production in other areas, including overseas firms dependent on imported parts
from Japan. The significance of the impact of such complicated supply chains had not been
fully recognized before the recent earthquake.
There are two important reasons for the greater-than-expected impact of the recent
supplychain disruptions. The first is the low level of parts inventory. In normal times, a lower level of
inventory contributes to increased efficiency and higher profits. Once hit by an enormous
shock, however, firms are forced to curtail production sharply within a short period of time,
and this creates a chain reaction to other firms. The second reason is the concentration risk
in procurement. Tracing back to the most upstream stage of the complicated supply-chain
network, it turned out that procurement greatly relied on specific firms in specific areas. As a
result, the termination of production at a certain firm had a serious impact on the production
activity of many firms, including those abroad. While supply chains increase production
efficiency, our experience of the recent earthquake called attention to the problem of
concentration risk in inventory management and procurement for the purpose of
strengthening resiliency against shocks.
The importance of maintaining stability in the financial system
Now I would like to call your attention to the second factual observation deemed crucial when
considering how to address tail events. This is the importance of maintaining stability in the
financial system. Production started to recover from a plunge caused by the earthquake at a
relatively fast pace, which is in a stark contrast to the situation in the period following the
Lehman shock. One of the reasons for this early recovery is the fact that stability has been
maintained in financial markets and the financial system. Both private financial institutions
and the Bank of Japan have been doing their utmost to preserve stability on the financial
front since immediately after the earthquake.
In terms of payment and settlement systems, although some clearing houses in the
quakestricken areas had to suspend their operations, major payment and settlement systems
including the BOJ-NET - the settlement system for funds and government bonds - continued
to operate smoothly. The buildings that store the computer center for the main payment and
settlement systems sufficiently proved their resilience to the magnitude 5-plus earthquake in
the Metropolitan Tokyo area. Moreover, at the time of the rolling blackouts that were
temporarily implemented with a short notice soon after the earthquake, financial institutions'
branch networks and computer centers maintained their operations by resorting to backup
measures such as the use of in-house power generation facilities. Over a period of
successive days following the earthquake, the Bank of Japan provided financial markets with
ample liquidity that significantly exceeded the amount provided at the time of the Lehman
shock. Furthermore, on the first business day after the earthquake, the Bank decided to
expand the size of its program to purchase risk assets including commercial paper (CP),
corporate bonds, exchange-traded funds (ETFs), and Japanese real estate investment trusts
(J-REITs). This decision was made in a forward-looking manner to prevent any deterioration
in business sentiment and heightening of risk aversion in financial markets from adversely
affecting economic activity. If the financial system had lost its stability this time, the extent of
the economic downturn would have been much larger. Therefore, it is quite important to
secure stability in the financial system.
Although we have managed to maintain overall financial stability, as I have just described,
we have also learned some lessons.
First, a combination of various factors could lead to unexpected trouble. In disaster areas,
key social infrastructures such as electricity, gas, communications, and transportation
services simultaneously stopped functioning. Although the offices of financial institutions
were equipped with in-house power generators to cope with blackouts, the sustainability of
such backup measures was threatened as disruptions to transportation made it difficult to
procure fuel. Disruptions to transportation and associated fuel shortages also made the
delivery of cash difficult.
Second, various rumors spread after the earthquake. For instance, when the yen appreciated
sharply immediately following the earthquake, there was a baseless rumor that Japanese
insurance companies would sell foreign currency assets due to an increase in insurance
claim payments. However, these companies actually had no need to conduct such sales in
order to make the payments, as they held a considerable amount of liquid assets in yen. In
the week after the earthquake, rumors had spread among some foreign financial institutions
that the Tokyo financial market would close. To our surprise, there was also a groundless
rumor that the Bank of Japan was planning to resort to a backup computer center in Osaka,
which is located more than 500 kilometers away from Tokyo. Clearly, extreme anxiety in itself
can proliferate sensitive market reactions.
III. Addressing tail risks: measures by financial institutions
While specific measures to address tails risks differ depending on the pertinent risk factors,
conceptually, they could be categorized into ex-ante and ex-post efforts. Before tail events
take place, efforts should be made to measure tail risks as accurately as possible to make
the internalization of expected losses possible and take actions accordingly. If tail risks
unfortunately materialize, efforts should be made to prevent the impact of tail events from
spreading. Such ex-ante and ex-post efforts should be made by individual financial
institutions and firms as well as by the government and the central bank. Needless to say,
there are no perfect solutions to the conundrum of addressing tail risks. At the same time,
however, we are not allowed the luxury of being fatalists. We must keep thinking about how
to make things better.
Holding sufficient amount of capital and liquidity
Let me start with ex-ante measures by financial institutions to address tail risks. As
completely avoiding tail events is not possible, it is indispensable to secure resiliency against
shocks, namely a sufficient amount of capital and liquidity. Firms that are part of supply
chains consider how much inventory they should retain by striking a balance between
efficiency in normal times and stability in an emergency. In other words, the balance between
"just in time" and "just in case." Financial institutions also face an issue of a similar nature.
They are confronted by the difficult question of choosing the right balance between efficiency
and stability. The starting point for making a proper judgment is to grasp the significance of
tail risks to which they are exposed. Given that tail events occur with very little probability but
entail gigantic losses once they occur, it is extremely difficult to quantify potential losses
using statistical methods. In addition, as was the case both with the global financial crisis and
the supply-chain disruptions, losses from tail risks could change significantly depending on
how the concerned parties respond to the initial shock; for example, in terms of whether a
central bank appropriately plays the role as a lender of last resort. The widely used
Value-atRisk (VaR) model is useful for managing risks but its shortcomings should also be properly
recognized. The VaR model has certain limitations in capturing tail risks because it assumes
a specific probability distribution and relies on data about past events. Moreover, even when
the VaR model shows that there is a 0.1 percent probability of realizing a certain amount of
losses, it tells nothing about the more detailed probability distribution of losses within the
realm of 0.1 percent probability.
Given such constraints, in order to capture the impact of tail risks consistent with a unique
risk profile of individual financial institutions, it is useful to conduct a stress test based on
various risk scenarios instead of solely relying on risk measurement techniques based on
assumed probability. Taking the example of an earthquake, financial institutions' stress
scenarios could include the loss of business function in some branches, widespread credit
default, and the collapse of market functioning. In the process of constructing stress
scenarios and assessing the results of a stress test, the active involvement of management
is indispensable. For private financial institutions, the extent to which they should prepare for
tail events is a crucial management decision that will affect their capital plans and investment
in key infrastructures.
Avoiding the concentration of risk exposures
Second, financial institutions need to make efforts to avoid concentration of risk exposures.
Similar to the problem of concentration risk in supply chains I mentioned earlier, in the
context of financial institutions, the concentration of credit risk and liquidity risk has particular
importance. Of course, prudent financial institutions do not intentionally concentrate risk.
What is worrisome is the situation where financial institutions concentrate risks without
knowing they have actually done so. The subprime loans and related securitized products in
the United States were believed to be safe, protected by sufficient risk diversification. With
respect to mortgage loans, risk was geographically well diversified based on the assumption
that housing prices would not fall on a national scale. Also, in Japan, the myth that land
prices would never fall was widely believed during the bubble period in the late 1980s.
Stable business continuity
Third, on the operational front, financial institutions need to make sufficient preparations for
possible physical damage, including that caused by natural disasters. In other words,
preparations are required to ensure stable business continuity. To strengthen the resiliency
of a business continuity plan, it is desirable not to rely solely on the first line of defense, but
rather to have multilayered safety measures. For example, it is not enough to simply secure
the sufficient strength of major buildings such as a headquarters and a computer center, nor
is it enough to just have backup facilities. You also need to have in-house power generators
to prepare for blackouts and always maintain a sufficient amount of fuel for them. When
diversifying risks, it is important to check the extent of concentration risk on the operational
front by giving consideration to changes in the environment surrounding financial institutions;
for example, proliferation in the scope of financial business and leanings toward business
outsourcing. Based on a thorough examination, financial institutions should take necessary
measures to avoid concentration risk of business operations by diversifying essential
facilities and functions geographically, securing alternative energy sources, and maintaining
multiple counterparties for business outsourcing.
Furthermore, of crucial importance to business continuity at a time of crisis are measures to
strengthen the human infrastructure by regularly reviewing the effectiveness of the existing
business continuity plan and providing staff with sufficient training. The other day I had a
chance to read a magazine article on an interview with the Dutch Ambassador to Japan, and
was impressed by how calmly the Dutch Embassy had responded to the recent earthquake. I
learned that the Embassy had conducted training under the guidance of a crisis management
consultant in November last year. The training was quite detailed and covered how to
evacuate, how to communicate with concerned parties, how to check the safety of Dutch
nationals living in Japan, and how to respond to media inquiries. This is exactly what the
famous slogan "Be Prepared" tells us to do.
Global risk sharing
Fourth, it is important to make efforts to share risk, especially on a global scale. We are not
able to avoid the materialization of the risk of natural disasters. However, it is possible to
mitigate casualties and losses to some extent by signing in advance a contingent
losssharing contract between insurance companies and investors. In the case of the Great East
Japan Earthquake, physical and human losses were covered not only by Japanese
insurance companies but also reinsurance companies abroad. Moreover, as significant
natural disasters occurred one after another recently, we have seen an increase in the
issuance of catastrophe bonds as a means of diversifying the risks. Needless to say, to make
such risk transfer effective, it is necessary to further promote the sound development of
markets for products with a risk transfer function.
Calm and orderly response
I have discussed ex-ante measures to address tail risks by financial institutions. How about
ex-post measures? In this regard, there is not much I can offer in terms of generalities. The
most important thing is to effect a calm and orderly response. Coming back to the interview
with the Dutch Ambassador to Japan, the article reported that he was surprised by the fact
that the earthquake did not cause panic among the Japanese people. Although I cannot
make an objective assessment of the calmness exhibited by my fellow Japanese people, I
can say that being calm is crucial to preventing the proliferation of damage caused by an
initial shock. Another important factor is cooperation within the private sector. As I have
mentioned, the restoration of supply chains has been making swift progress. Looking at
worksites in the manufacturing industry, various efforts and attempts involved putting aside
the usual rivalries; for example, firms in the same industry temporarily covered the production
of disaster-stricken rivals and several manufacturers of final products cooperated in terms of
sending staff to parts manufacturers to support their restoration efforts. Private financial
institutions cooperated in various ways. For example, to help people who evacuated to
places somewhat distant from the disaster areas, financial institutions in the non-affected
areas allowed for the withdrawal of deposits at affected financial institutions through a
simplified procedure. In the face of fuel shortages, neighboring financial institutions jointly
operated cash delivery cars together, so as not to interrupt cash delivery.
IV. Addressing tail risks: measures by the authorities
Next I would like to consider the case of the authorities, especially the central bank as well as
the regulatory and supervisory authorities. To address tail risks, while appropriate efforts by
individual private business firms and financial institutions are undoubtedly necessary, the role
of the authorities is also crucial.
First, the involvement of the authorities is indispensable because addressing tail risks entails
significant costs and placing all of the burden on the private sector could hamper economic
growth. This is especially the case when dealing with catastrophic natural disasters. The
second reason why public sector involvement is required relates to the concentration of risk.
When completely relying on market competition in the private sector, it is difficult to expect
the complete internalization of extreme tail risk. In that situation, some kind of public sector
involvement is necessary. Even in that case, however, if the authorities make a commitment
in advance or are perceived as making an advance commitment, the private sector would
stop making efforts to address tail risks. This is a typical moral hazard problem. It is difficult
to set concrete criteria with regard to how much the private sector should shoulder the
burden and to what extent the authorities should intervene as a last resort. In any case, to
address tail risks, it is very important to properly design and put in place a society-wide risk
management framework.
Resilient payment systems
In this regard, I would like to highlight the importance of building resilient payment systems
with the cooperation of private financial institutions and central banks. Major payment
systems should be designed to have sufficient resiliency against tail events including natural
disasters. Taking the example of the BOJ-NET, the large-value settlement system for funds
and government bonds, the main computer center is proud of its strong resistance to
earthquakes and a backup center is located in Osaka. At the same time, on the operational
side, in order to lessen payment risk at a time of crisis, major payment systems need to
adopt safe settlement features such as Real Time Gross Settlement,
Delivery-versusPayment, and Payment-versus-Payment.
Financial regulation and supervision
Second, financial regulation and supervision is an important component of a society-wide risk
management framework. In the wake of the Lehman shock and with the aim of preventing
another financial crisis, an agreement was reached on the Basel III framework, which
includes a higher capital requirement, a strengthening of liquidity regulation, and the
introduction of regulation on leveraging. The new framework requires the internalization of
tail risks by financial institutions and provides the institutions with more incentives to lessen
risks. In this context, there are discussions about the issue of "too big to fail." These cover
additional loss absorption capacity to reduce the likelihood of the failure of global SIFIs, or
Systemically Important Financial Institutions, and measures to remove obstacles to the
resolvability of global SIFIs, which would enable orderly restructuring and resolution. These
measures aim at controlling the negative externality of global SIFIs. When designing the
overall framework, it is important to choose a balance between those measures to promote
the internalization of risks, such as additional loss absorption capacity, and those measures
to lessen the externality itself, such as improving resolvability.
Appropriately conducting monetary policy
Third, I would like to discuss the appropriate conduct of monetary policy. Before the Lehman
shock, the prevailing view among academics and the authorities was that aggressive easing
after the bursting of bubbles could prevent a serious economic downturn. I myself had felt
uncomfortable with such a view based on my experience following the bursting of bubbles in
Japan. In the end, the Lehman shock crushed this optimistic view.
One important issue is the possibility that an accommodative monetary policy itself might
heighten tail risks endogenously. In the process of lowering interest rates, financial
institutions and institutional investors enjoy an increase in profits due to capital gains, as well
as widened yield spreads between short-term and long-term interest rates. However, if a low
interest rate environment continues for a long time, financial institutions and institutional
investors can no longer enjoy such a profit increase because of narrower credit and yield
spreads. As a result, they tend to bet on further declines in long-term interest rates or further
squeezes in credit spreads, and attempts to profit from leveraging become more evident. In
other words, financial institutions start to pursue profits by bearing the cost of tail risks by
themselves. One of the factors supporting such actions is the perception that a low interest
rate environment will be maintained and a situation of abundant liquidity will continue. In
retrospect, during the periods of credit bubbles preceding financial crises, various financial
imbalances were widely observed in the economy, such as asset price inflation, credit
expansion, increasing leveraging, and a widening of term mismatch. A low interest rate
environment is not the sole cause of these phenomena. But it is also true that these could
not take place without the expectation that a low interest rate environment would continue for
long time. The goal of monetary policy is to achieve sustainable growth with price stability.
But if a central bank maintains a low interest rate environment with too much focus on the
near-term inflation outlook, this could consequently encourage the formation of financial
bubbles. In that sense, a central bank should pursue price stability through the conduct of
monetary policy with a sufficiently long time horizon.
Macroprudential perspective
Fourth, I would like to highlight the importance of a macroprudential perspective. Maintaining
the soundness of individual financial institutions is important but not sufficient to secure the
stability of the financial system. For example, the global financial crisis underlined the need
to enhance the cross-sectional assessment of risk concentration in the financial system. This
is very similar to the case of supply-chain disruptions in which efficient supply-chain
management from the perspective of individual firms did not guarantee the risk management
of the economy as a whole. As these examples demonstrate, a risk assessment from a
macro perspective is very important. Someone has to present analysi