Hiroshi Nakaso: Challenges toward financial stability and the policy
frontier - unconventional monetary policy, macroprudence, and financial
institutions' low profitability
Speech by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, at the IVA (The Royal
Swedish Academy of Engineering Sciences) - JSPS (The Japan Society for the Promotion of
Science) Seminar, Stockholm, 21 March 2016.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
Good evening, ladies and gentlemen. It is a great honor and pleasure for me to be able to
speak to you at this esteemed institution today.
Before I get into the substance of this speech, let me first thank the person who made this
event possible: Mr. Robert Stenram. Mr. Stenram was the Tokyo representative of Swedbank
in the 1990s, during the acute financial crisis in Japan. While he was posted in Tokyo, he
was instrumental in liaising very closely with the Japanese banking industry. I benefitted from
his deep insights and thoughtful advice based on his experiences as a professional banker. It
was indeed the most turbulent of times, but we also became friends, and I have long enjoyed
his friendship since then. I deeply regret that he no longer is with us, and wish to pay my
tribute to the great work he has accomplished in linking Sweden and Japan in the world of
finance. Robert, I will not forget how much we owe to you. May his soul, now joined by his
beloved wife Siv, rest in peace.
Over the years, both Sweden and Japan have confronted a few very difficult issues in terms
of monetary policy and financial stability. In the late 1980s, we saw financial bubbles develop
and burst. From 2008 to 2009, we tackled the most recent global financial crisis together,
and today the two countries are fighting deflationary headwinds. As you know, the Riksbank
and the Bank of Japan have adopted negative interest rate policies so as to achieve their
respective price stability targets.
In order to discharge our responsibilities for maintaining price and financial stability, central
banks must be prepared to meet new challenges as they appear. Reflecting on my
experiences, I have been on the front lines as a central banker during Japan's financial crisis
in the 1990s and 2000s, and during our Bank's long battle with deflation for nearly two
decades. Not once during all those years could I forget the importance of financial stability.
With this background, I will describe today the importance of financial stability and the policy
implications of newly emerging challenges from three perspectives: unconventional monetary
policy, macroprudence, and low profitability of financial institutions.
Financial crisis and growth inflection
To begin with, let me go back to the 1990s and explain my experiences during the bursting of
the bubble economy in Japan. As I touched on at the beginning, both Sweden and Japan
experienced financial bubbles. Nevertheless, the subsequent paths of the two countries were
quite different (Chart 1).
In Sweden after the crisis in the early 1990s, capital was quickly injected into the banking
system and the stability of the financial system was restored. In addition, the Swedish krona
was floated, and the Riksbank was able to ease monetary policy. With the tailwind of the
depreciating krona contributing, the Swedish economy began to recover as early as 1993.
Furthermore, following Sweden's accession to the European Union in 1995, factors such as
the growth of the IT industry benefitting from the increases in inbound investment contributed
to productivity growth. In fact, Sweden's potential growth actually increased after the bursting
of the bubble.
In contrast, Japan only managed to inject capital into financial institutions on a meaningful
scale after the "Dark November" in 1997, when it experienced a series of failures of large
financial institutions.1 That was nearly eight years after the bubble had burst. During those
years, financial institutions' behavior, such as evergreening their loans to practically failed
businesses by extending additional loans, resulted in a further buildup of impaired assets,
which made it all the more difficult to cleanse financial institutions' balance sheets of problem
loans, and which distorted the allocation of resources. The layering of these multiple factors
pushed the Japanese economy into deflation, and concurrently, productivity growth
declined.2 Furthermore, this period overlapped with rapid changes in demography, resulting
from a declining working-age population against the backdrop of a low birth rate and aging.
The confluence of the two currents - financial sector problems and demographic changes -
significantly pulled down Japan's potential growth rate (Chart 2). That in turn exacerbated
over-leveraging in the corporate sector and discouraged corporate investment. From a
macroeconomic perspective, lower investment depressed productivity growth, which again
negatively impacted potential growth. There was a vicious cycle: over-leveraging in the
corporate sector led to the decline in the potential growth rate, which in turn exacerbated the
difficulty of resolving non-performing loans in the banking sector and over-leveraging in the
corporate sector. Admitting one can be wise only after the event, in retrospect, the
forbearance policy at an early stage after the bursting of the asset bubble and the
underestimation of the systemic nature of what was going on in the financial sector allowed
the problem in the banking sector to develop into a full-blown financial crisis.3 This is the
shorthand account of the extended stagnation and deflation following the bursting of the
bubble: the so-called "lost two decades" in Japan.
From this painful episode, we have learned two things. One is that financial stability is the
foundation of sustained growth of the economy, and another is that changes in potential
growth amplify the financial cycle and consequently impact financial stability. The widespread
recognition in the international policy fora of the need to take account of the macroprudential
perspective may be a consequence of the recent global financial crisis, but Japan's
predicament that preceded it seems to amply underscore the importance of such a
perspective. To me, this was a formative experience as a central banker. I have attached
importance to macroprudence ever since.
Stability consequences of QQE with a negative interest rate
Next on my agenda today is the implementation of monetary policy by the Bank of Japan and
its relationship with macroprudential policy. After the bursting of the bubble, the lowering of
potential growth brought about a large decline in the natural rate of interest, which is the
guidepost for monetary policy formulation (Chart 3). As you know, monetary easing is used
to bring down real interest rates below the natural rate of interest. Mindful of the prevailing
views then that there was a zero lower bound for nominal interest rates, quantitative and
qualitative monetary easing (QQE) introduced by the Bank of Japan in April 2013 was a
breakthrough in the following sense: the Bank made a strong commitment to achieve the
price stability target of 2 percent at the earliest possible time, which encouraged expected
inflation to rise. Concurrently, the Bank, recognizing that there was only limited room for
short-term interest rates to decline, exerted downward pressure on nominal interest rates
across the entire yield curve by purchasing a large amount of long-term government bonds,
so that together with higher inflation expectations, real interest rates would be brought down.
The QQE with a negative interest rate framework that was introduced by the Bank of Japan
this January aims at reinforcing the existing QQE and supports the activities of firms and
households, thereby ensuring the earliest attainment of the 2 percent inflation target. The
policy will work through the same channels, by bringing down real interest rates. As I just
noted, the conventional wisdom was that there was a zero lower bound for nominal interest
rates, but the demonstration by a few European central banks, including the Riksbank, that
such limitation could be overcome to some degree led the Bank of Japan to adopt the new
policy framework. In fact, after the introduction of the negative policy rate, the financial
environment has further relaxed, with the yield curve shifting significantly lower and financial
institutions lowering their lending rates (Chart 4). In addition, rebalancing of the portfolios of
financial institutions is also starting to take place, with increased interest in investing in
foreign currency denominated bonds, although this trend is somewhat masked by the effects
of recent market turmoil.
Against the backdrop of these positive developments in financial intermediation, from the
macroprudential perspective, their effects on financial stability must be carefully monitored. I
believe that we need to be mindful of two angles. One is the "overheating" risk, where the
extremely relaxed financial environment could destabilize the financial system through
excessive risk taking. The other is the "contraction" risk, where low revenue streams resulting
from low interest rates could erode the risk appetite and/or undermine the soundness of
financial institutions.
For the time being, we believe that there is generally no need to be overly concerned as
regards the overheating risk. There is evidence of increasing real estate transactions, with
prices of apartments in the Tokyo area topping their previous peak during the bubble years,
but leverage in the real estate sector is still not excessive. Our general view is that the
financial sector has a robust capital base relative to risks taken and its resilience in the face
of stress is sufficient, and thus it could undertake positive risk taking and portfolio
rebalancing under QQE with a negative interest rate framework.
At the same time, we believe that the contraction risk at present is also small. The extended
period of monetary easing has tended to pressure the interest rate margins of financial
institutions, negatively impacting their revenue streams (Chart 5). This is not something that
is unique to a setting of unconventional monetary policy, but in an economic environment
where such exceptional policy needs to be adopted, there tends to be less room for deposit
rates to fall - in other words, the interest rate margins are tighter than ever - and additional
easing of policy could result in a non-linear compression of margins.4 Having said that,
Japanese financial institutions have been able to remain sound because the reduction in
margins thus far has been more than offset by revenue improvements against the backdrop
of improving economic conditions under monetary easing, such as increases in lending
volume, lower credit costs, and higher investment incomes.
The policy framework of QQE with a negative interest rate maintains monetary easing in
terms of quantity and quality and boosts it strongly with a negative policy rate. As such, it will
strongly influence the financial system. Accordingly, the Bank of Japan must thoroughly
monitor and analyze the state of the financial system from a macroprudential perspective. To
this end, the Bank of Japan is publishing its Financial System Report twice a year. In this
report, it assesses the stability of Japan's financial system from various angles, including the
balance between the amount of risks borne by financial institutions and their financial bases,
macro stress testing, and macro risk indicators (i.e., the "heat map"). I believe that
independent examination of developments from a financial perspective will enhance the
credibility of QQE with a negative interest rate.
Macroprudential policy and monetary policy
Even if the risks are contained at this juncture, what should we do if, in the future, the
overheating risk becomes more apparent? There are two contrasting views on the
relationship between monetary and macroprudential policies: the separation principle and
leaning against the wind. The former says to render unto monetary policy things that concern
price stability, and render unto macroprudential policy things that concern financial stability.
On the other hand, the latter holds that, if the amplification of financial imbalances is
expected to threaten price stability in the long run, the central bank should resort to monetary
policy in order to dampen the financial cycle, notwithstanding a temporary deviation of
inflation from the target. Let me offer you my views, which are influenced by the experiences
of the Japanese bubble.
Up until the 1980s, the Bank of Japan was requiring banks to comply with guidance that set
their loan growth at levels individually assigned by the Bank. This arrangement, called
"window guidance" was then regarded as a tool for monetary policy, but under the current
taxonomy, it would be regarded as a time-varying macroprudential policy tool, akin to
regulation of loan-to-value (LTV) or debt-to-income (DTI). There were two schools of thought
regarding the effectiveness of the tool: the "independent tool theory," which held that window
guidance was effective by itself, and the "complementary tool theory," which held that
window guidance had to be used alongside the mainstream monetary policy of official
discount rate adjustments to be effective. The subject was actively discussed in academia,
and those supporting the independent tool theory argued that a tightening of window
guidance could dampen the financial cycle, even if the official discount rate was held steady.5
The Bank of Japan, in the meantime, basically adopted the complementary tool theory and
explained window guidance as a tool to support general policy instruments, such as changes
to the official discount rate, rather than an independent policy instrument.
Notwithstanding such an official position, in the last half of the 1980s, as the call for
international policy coordination necessitated the maintenance of a low interest rate
environment with a view to expanding domestic demand, the Bank of Japan attempted to
respond to signs of financial excesses through the tightening of window guidance. As a
result, the growth of bank lending slowed gradually, but large corporates were still able to
raise funds from outside the banking sector through the issuance of bonds (Chart 6). The
period coincided with the gradual relaxation of underwriting guidelines for corporate bonds,
and the buoyant stock market, which was partly a reflection of monetary easing, that reduced
the costs of equity financing, such as convertible bonds and bonds with embedded warrants.
The resulting increases in capital market financing sustained the relaxed financial
environment, and corporate balance sheets kept on expanding. The Bank of Japan could not
effectively deal with the signs of overheating.
Another notable feature of the Japanese bubble in the late 1980s was that potential growth
and the natural rate of interest were both fairly high at the time (Charts 2 and 3). The degree
of monetary easing at one particular level of the policy rate depends on whether the natural
rate of interest is high or low. When the natural rate of interest and expected growth were
high, there were likely to be strong incentives for both financial institutions and corporates to
circumvent the restriction imposed by window guidance.
In light of the Japanese experiences, while I fully subscribe to the view that narrowly confined
imbalances should be countered by macroprudential policy as the first line of defense, the
effectiveness of such policy by itself is very uncertain, considering the changes in financial
market structure due to deregulation and the level of the natural rate of interest. Accordingly,
I cannot fully uphold the separation principle, which reflects the view that time-varying
macroprudential policy measures are by themselves effective. I believe we should leave
open the possibility of responding to widening financial imbalances with fiscal policy,
including tax policy, and monetary policy. Such thinking is reflected in how the Bank of Japan
conducts monetary policy, where the Bank examines economic and monetary conditions in a
two-pillar approach: the deliberation of the most likely outcomes for the first pillar, and the
deliberation of other risk factors relevant for the conduct of monetary policy, financial
imbalances in particular, for the second pillar.
Low profitability of financial institutions
Let me now turn to the other risk: the contraction risk. What should we do if this risk becomes
apparent? More specifically, what should we make of the low profitability of financial
institutions from a macroprudential perspective? This question seems to be attracting more
and more attention in Europe as well. In order to properly think about this issue, it is
important to distinguish between low profitability due to acute problems and that due to
chronic issues.
When profits of financial institutions severely decline because of acute stresses, it is
necessary to have sufficient capital in order to maintain financial stability. Looking at current
developments, the international banking system has significantly raised the capital ratio,
reflecting the strengthening of the capital rules following the recent financial crisis. Such
capital strength is also important for the effective transmission of monetary policy. Given that
monetary easing pressures interest margins at financial institutions in the short run, weakly
capitalized institutions will not be able to increase lending, undercutting the positive effects of
easing. As I noted earlier, the fact that Japanese financial institutions were able to increase
lending as the Bank of Japan implemented unconventional monetary policies and margins
were compressed demonstrates how well capitalized the institutions are.
In short, even if the economy suffers an acute stress and profits of financial institutions are
negatively impacted, as the cushion provided by sufficient capital prevents the instability of
the financial system, stimulus from monetary easing should provide the shot in the arm that
would turn around the economy and thence the profits of financial institutions. Such an
outcome, however, is not assured when the financial system is confronted with more chronic
stresses, even if current levels of capital are adequate. This is because the persistence of an
environment in which financial institutions cannot get sufficient net returns on capital would
eventually erode the capital of financial institutions.
One example of such chronic stress is foot-dragging by financial institutions in their
recognition of non-performing loans and its flip side: the over-leveraging of corporates.
Another is the inflection of the potential growth rate, which would lower firms' expectations for
growth and depress investment. In fact, in many developed economies, excess savings are
observed in the corporate sector (Chart 7). With the stagnation of investment comes the
decline in productivity growth, which would again negatively impact the potential growth rate.
As the process unfolds, financial institutions would face downward pressure on their lending
rates. Financial institutions facing the resulting compression of interest rate margins would
then pursue volume to increase their revenue flows. Such increases in competitive pressure
would further depress lending rates and revenues as well. Excessive competition by financial
institutions in lending would thus make it easier for low-productivity firms to survive, hindering
the efficient allocation of resources in the economy and the so-called "creative destruction,"
and consequently would prevent the lifting of the potential growth rate. If the low levels of
profits at financial institutions and the depressed potential growth rate are tied together by
excessive lending competition by financial institutions, the risk that profits become "too low to
recover" could gradually increase, unless financial institutions succeed in changing their
business models.
The quest for innovations in financial intermediation
Joseph Alois Schumpeter, in his seminal The Theory of Economic Development, stresses
the important role played by the "banker," as well as that of the "entrepreneur"6 The banker
profits from her ability to identify those entrepreneurs who develop truly innovative
undertakings that are high-quality startups, and from generating information that leads to
improved corporate performance. Schumpeter expects that such profit motives of the banker
backed up by her exceptional ability to pick winners would bring about a more efficient
reallocation of risks in the macroeconomy and lead to an endogenous rise in the economic
growth rate.7
This role of the banker - promoting the creative destruction through financial intermediation -
has not changed since the time of Schumpeter. However, as economies mature, the nature
of investment that supports innovations by entrepreneurs changes gradually from
investments in tangible assets to those in intangible assets, such as research and
development, information technology, and human and organizational capital. Accordingly,
investment in intangible assets is now identified as an important element of new sources of
growth in the developed economies.8 If I may point out the findings of one recent research
study, investments in intangible assets are more sensitive to the availability of internal funds
(or cashflow) compared with investments in tangible assets.9 If financial markets were perfect
markets, the sources of funds - that is, internal financing or external financing including bank
financing - would be completely substitutable, and corporate investment would not be
affected by the availability of internal funds. Nevertheless, the fact that investments in
intangibles are more sensitive to the availability of internal funds suggests that firms could be
facing financial constraints due to information asymmetries. One could say that such
asymmetries result from the difficulty of assessing the collateral value of intangible assets
compared with tangible assets. Consequently, there are opportunities for the banker to profit
from overcoming information asymmetries.
In Japan, the ratio of investments in intangible assets to nominal GDP is lower than that in
the United States and other major peers (Chart 8). If financial institutions are able to tease
out the corporate demand for investments in intangible assets, that not only would enhance
the productivity of the whole economy but also would contribute to solving the structural
problem of low profitability of financial institutions. The future path of the Japanese economy
would be influenced by the behavior of financial institutions whether financial institutions
would continue their war of attrition under their existing business models or would expand
their business frontiers by unearthing new financing needs. Just as in human beings, for
whom chronic syndromes demand fundamental changes in lifestyles, financial institutions
must be prepared to fundamentally change their business models in order to extricate
themselves from a structural lack of profitability.
The Bank of Japan has implemented a few measures that would encourage financial
institutions to implement their essential reforms. One is to adjust the way in which the Bank
injects liquidity into the financial system - for example, the fund-provisioning measure to
support strengthening the foundations for economic growth, and purchases of ETFs
composed of stocks issued by firms that are proactively investing in physical and human
capital. These measures are expected to play catalytic roles in enhancing the financial
intermediation functions of financial institutions and capital markets, which would foster
productivity increases and ultimately lead to improvements in the potential rate of growth.
Another set of measures is designed to enhance the function of financial institutions to
efficiently allocate resources. The Bank of Japan is actively providing financial institutions
with information and know-how through seminars, etc., so that they can enhance the value of
their financial intermediation through, for example, support for startup businesses, business
matching, rejuvenating businesses, and utilizing information technology. These undertakings
by the Bank of Japan are somewhat different from those found in the conventional
macroprudential toolkit, but I believe that they perform important functions in promoting
financial stability.
Unconventional policy and beyond
Before concluding my remarks today, I would like to emphasize that, if changes in the
potential growth rate would influence the effectiveness of monetary and macroprudential
policies, and ultimately affect price and financial stability, that would naturally affect central
banks' thinking on policy formulation. As a matter of fact, in the area of monetary policy, the
effectiveness of policy had been constrained in Japan by the concurrent decline in expected
inflation under persistent deflation and in the potential growth rate. In this regard, the current
pursuit by the Bank of Japan of the 2 percent inflation target through QQE with a negative
interest rate will contribute to lifting potential growth through purging the deflationary mindset
and encouraging capital formation. At the same time, in the area of macroprudential policy,
the current focus on strengthening regulation does not solve the structural problem of low
profitability at financial institutions. With regard to this problem, in the global policy fora, the
jury is still out, so to speak, as regards how to expand the policy frontier. Central banks
perhaps need to be a little more flexible in the designing of macroprudential policies to serve
this end. Of course, structural problems cannot solely be solved by central bank actions.
Economic policies of the government and undertakings by firms and financial institutions
aimed at encouraging innovation are also essential. The Bank of Japan is working with these
actors in order to tackle the new challenges in terms of financial stability.
Thank you for your attention.
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