Kiyohiko G Nishimura: Macro-prudential lessons from the financial crises -
a practitioner's view
Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Asian
Development Bank Institute (ADBI) - Central Bank of Malaysia (Bank Negara Malaysia/
BNM) Conference on Macroeconomic and Financial Stability in Asian Emerging Markets,
Kuala Lumpur, 4 August 2010.
* * *
I would like to express my sincere gratitude to the hosts for inviting me to the ADBI-
Bank Negara Malaysia Conference, and especially to this timely session: Macroeconomic
Frameworks to Support Financial Stability.
In this presentation, I will touch on the issues of financial stability and central bank policies,
based on two episodes of financial crisis: one dating from 20 years ago in Japan, and the
other from two years ago in the United States. I first present one "stylized account" from a
macro-prudential perspective of the buildup in financial imbalances that led eventually to the
financial crisis in the late 1980s in Japan. Then, I illustrate the startling similarities between
the recent US subprime-triggered experience and that of Japan in the 1980s. Examining
these two crises, I will draw four implications for macro-prudential policy which are likely to
be universally relevant, particularly in emerging economies. The message is simple and
straightforward: Beware. So-called macro-prudential measures may not always be sufficient.
This leads to the final topic, the role of monetary policy during the buildup of financial
imbalances, a role which I would argue is, in a word, crucial. I will explain why in the course
of this presentation.
1. Financial imbalances in 1980s Japan: a stylized account
I first present one "stylized account" from a macro-prudential perspective of the buildup to
financial imbalances in Japan in the late 1980s.1 This account is intended to be rather
descriptive and schematic in the way that macro-prudential issues are highlighted. It is
admittedly simplistic, but I believe this is a good starting point for discussion.
Deregulation-induced "financial innovations" and financial anomalies
A number of "financial innovations" introduced as a result of deregulation appear to have
played a role in the late 1980s bubble in Japan. Under the designation of Financial
Liberalization, deregulation sparked the arrival of new products such as CPs and large time
deposits with unregulated rates, which nourished the atmosphere of profit-seeking through
these "financial technology" products.2
Financial Liberalization was a gradual process that started in the late 1970s and spanned
twenty years. Around 1986, signs of "financial anomaly" emerged, brought about by the
innovations associated with Financial Liberalization. The most notable anomaly was the
apparent no-risk arbitrage opportunity for large non-financial corporations. In 1985, banks
became allowed to offer large time deposits with no regulation on their rates. Banks then
offered short-term large time deposits to major non-financial corporations with rates higher
than the corresponding-term CP rates. Thus, large non-financial corporations could profit
from raising funds by issuing CPs and depositing them in these unregulated large time
deposits (BOJ 19893). By a similar token, 3-6 month unregulated time deposit rates were
substantially higher than short-term prime lending rates (see Chart 1).
Chart 1
Time deposit rates and prime lending rates
Note: "3-6 month time deposit rate (unregulated, new receipts)" is the average
interest rate on newly received time deposits with unregulated interest rates of
terms between 3 and 6 months. "3 month time deposit rate (regulated, new
receipts)" is the interest rate set by the regulation on newly received 3 month
time deposits. Regulations on time deposit interest rates were abolished in
1993. The end-of-month data for 3 month time deposit rate (regulated, new
receipts) are available up to May, 1992.
Source: Economic Statistics Annual, Bank of Japan.
These anomalies were often explained as banks' investment in "customer capital" in large
non-financial corporations. These large non-financial corporations, who were once the good
customers of the banks, had gained increasingly good access to capital markets through
deregulation. If the banks could obtain and keep long-term customer relations with these
corporations, the banks could profit from their clients' increased financial and other activities
through increased fees and commissions. This was not an implausible position, since the
banks themselves were being gradually deregulated and allowed to expand their business
into securities markets and other activities.
Favorable capital market conditions and loosening of lending standards
At the same time, banks' profits surged and their capital positions strengthened, as shown in
Chart 2. Banks tapped capital markets to raise capital easily, and their leverage ratio
declined dramatically from around 160 in 1986 to around 60 in 1989, as shown in Chart 3.
Chart 2
Net income/loss of Japanese banks
Chart 3
Leverage
Note: All domestically licensed banks, excluding member banks of the Second
Association of Regional Banks.
Source: Economic Statistics Annual, Bank of Japan.
With strong profit positions, loosened capital constraints through new equity issues, and
substantial inflows of time deposits from large non-financial corporations, bank lending to real
estate-related sectors surged, as did lending to small enterprises (see Charts 4 and 5), partly
compensating for lackluster growth in lending to large non-financial corporations. Around this
time, anecdotal evidence also emerged to suggest that banks had loosened their lending
standards. Some banks transferred their loan-examination function from the
loanexamination division of their headquarters to the loan-making divisions. Hence, the ratio of
loan examination officers at the headquarters declined sharply in the 1980s, as shown in
Chart 6.
Chart 4
Breakdown of corporate borrowers by size
Note: All banks, excluding member banks of the Second Association of
Regional Banks. Total outstanding loans used for calculations are
outstanding loans and discounts to domestic corporate borrowers,
excluding overdrafts. Large enterprises are corporations with capital of
1 billion yen or more and more than 300 regular employees. For the
wholesale trade industry, the criterion for the number of regular
employees is more than 100 persons. For the retail and service
industries, it is more than 50 persons. Small enterprises are
unincorporated enterprises as well as corporations with capital of
100 million yen or less or with regular employees of 300 persons or
fewer. For the wholesale trade industry, the definition is corporations
capitalized at 30 million yen or less or with 100 regular employees or
fewer. For the retail trade and service industries, it is corporations
capitalized at 10 million yen or less or with 50 regular employees or
fewer. Outstanding loans for medium-sized enterprises are calculated
by excluding those for small enterprises and large enterprises from
total outstanding loans. Figures are deflated by GDP deflators. Total
borrowings in 1975 in real terms = 100.
Source: Economic Statistics Monthly, Bank of Japan and National
Accounts, Cabinet Office.
Chart 5
Bank lending to real estate-related sectors
Note: All banks, excluding member banks of the Second Association of
Regional Banks. Real estate-related sectors include real estate,
construction, and non-bank financial. Total outstanding loans used for
calculations are outstanding loans and discounts to domestic corporate
borrowers, excluding overdrafts. Outstanding loans to the non-bank
financial industry are the sum of those to the other financial industry
and the lease industry. Figures are deflated by GDP deflators. Total
lendings in 1975 in real terms =100.
Source: Economic Statistics Monthly, Bank of Japan and National
Accounts, Cabinet Office.
Ratio of examining officers at the headquarters
by bank-type and year
Source: Figure 1 in Fukao, K., K. G. Nishimura, Q.-Y. Sui and M. Tomiyama,
"Japanese Banks' monitoring activities and the performance of borrower firms:
1981-1996," International Economics and Economic Policy, 2 (2005), 337-362.
Overlooked signs of excessive optimism
Around this time, there were signs of excessive optimism among investors, especially in
property markets. Chart 7 illustrates the price-to-rent ratio in residential property markets in
Tokyo,4 based on hedonic price and rent price indexes of condominiums, and taking due
account of vast differences in quality. (Rents here are market-determined new-contract rents,
not institutionally rigid continuing-contract rents.5) This ratio surged from around 23 in 1986,
which in retrospect looked like the long run average, to around 40 in one year, suggesting
substantial overheating in property markets. After a short pause, the price-to-rent ratio shot
up to a peak of around 50 in the fall of 1990 (even after the collapse of the stock markets).
However, it should be noted here that this quality-adjusted price-to-rent ratio has only
recently become available. In the late 1980s, only appraisal price indexes for residential and
commercial lands were available, with a substantial lag of half a year. There were no reliable
rent data. Thus, there were no contemporaneous hard data showing investors' excessive
optimism in property markets, though there were lots of anecdotes of property investors'
excessive optimism. Moreover, in retrospect, the government itself was overly optimistic: it
anticipated a substantial scarcity of office space partly because of internationalization of the
Japanese financial markets in its "Metropolitan Reconstruction Plan" (1985), and in "The
4th National Comprehensive Development Plan" (1987).
Price-to-rent ratio of Tokyo residential area
Source: Author's calculation.
Central bank policy
Facing investors' excessive optimism and banks' loose lending standards, the Bank of Japan
used its then-conventional window guidance to control banks' lending volumes. Although the
direct control of lending through the practice of window guidance was criticized as a
discretionary measure contrary to market principles, window guidance at a time of seemingly
excessive optimism could be interpreted as one form of macro-prudential measure, albeit a
crude one, to dampen excessive optimism through the exercise of moral suasion. However,
as financial deregulation got under way, window guidance proved to be ineffective and failed
to curb loans outstanding in the late 1980s.
What was the monetary policy stance at that time and the public's expectations about the
policy? Around 1986, the market expectation was that the easy monetary policy would
continue for a substantial period. This was partially due to the government's commitments in
the international policy coordination pledged during that period. There were also confounding
issues at the time: the fallout of Black Monday (October 19, 1987), the fear of a recession
stemming from the substantial appreciation of the yen, and the lack of significant inflationary
signs in the CPI. In fact, the policy rate was cut from 5% in December 1985 to 2.5% in
February 1987, and remained unchanged for more than two years.
Then, as we know only too well, the stock market began to drop in January 1990, falling from
more than 38,000 to around 16,000 in two and a half years.6 The quality-adjusted Tokyo
condominium price index continued to climb up until October of 1990 to triple the price of
1986, and then declined by about 30% in three years.7 It continued declining through the
1990s, with the price in 2000 being approximately the same as that of 1986.
2. Similarity of the recent US experience to that of Japan in the 1980s
When considering this stylized account, one cannot help noticing the similarities between
Japan's experience in the 1980s and recent events in the United States triggered by the
subprime mortgage crisis.
First, financial innovations were at least partly responsible for the buildup of financial
imbalances. Securitization was thought to improve risk allocation, as risk was now borne by
those who were more able to bear it. This reduced risk premiums (equilibrium or sustainable)
for previously very risky investments, such as subprime mortgages. The financial sector
could earn substantially higher profits from originating and distributing these securitized
products. Taking advantage of this and other innovations, banks' profits increased and their
capital market standing became more solid.
Second, there were signs of financial anomalies and loose lending standards. For example,
CDO squares based on CDOs, which were in turn based on subprime mortgage pools,
sometimes had a thick AAA tranche. It was argued that their pricing was based on a model
proven to track the history well, but the history was usually too short to assure the model's
sustained reliability. Again as we know only too well, their assumed correlations turned out to
be wrong. In addition, there were reports of "low doc loans" and "no doc loans," especially in
subprime mortgages.8
Third, there seemed to be signs of excessive optimism, at least in the booming states,
though not as obviously as in late 1980s Japan. Unlike in late 1980s Japan,
semicontemporaneous house price indexes were available in the United States, including OFHEO
(now FHFA) and Case-Shiller indexes, taking account of vast differences in quality of
housing stock. In some parts of the United States, notably Los Angeles and Miami, price
increases accelerated in the early 2000s, and more than doubled from 2001 to 2006.
Unfortunately, there were no corresponding (new-contract) rent data, comparable to that
shown before for Japan, with which to gauge excessive investor optimism by calculating
price-to-rent ratios. However, since there was no report showing substantial rent increases
relative to CPI in these areas, it might be appropriate to assume that the real price change
coincided with the change in the price-to-rent ratio. Then, the real house-price change in ten
large US cities (whose residents constitute roughly 10% of the US population) was
comparable to that in Tokyo (where a similar percentage of the Japanese population lives) in
the late 1980s, as shown in Chart 8.
Chart 8
Real house price developments in the United States and Japan
Source: S&P Case-Shiller Indexes, RRPI Indexes, US and Japanese CPI.
The course of central bank policy in the United States is well known, and I will not repeat it in
detail here. I will just point out that firstly, whatever macro-prudential measures were
implemented at that time, were inadequate to curb excessive optimism, and secondly,
monetary tightening was "measured" and long-term rates remained relatively low, stirring
debates about this "conundrum".
3. Beware of anomalies and excessive optimism: implications for
macroprudential policy
So what lessons should we draw from these two episodes? Each crisis seems different from
every other, so I should avoid oversimplification. However, the following four points are likely
to be universally relevant, and especially so from the perspective of emerging economies.
Firstly, financial innovations often provide fertile ground for financial excesses or imbalances.
This may not be surprising, since innovations sometimes make old knowledge obsolete:
Veterans become novices and pros become amateurs. The old prudential measures look out
of date. We are told that "this time is different," and that we should embrace these new ways
of thinking. Often, these new ways of thinking disguise excessive optimism, as exemplified in
the two episodes we have discussed. So, Beware.
Secondly, in the process of the buildup of imbalances, there are often signs of anomalies. In
the past, these anomalies were often ignored as being isolated and having no macro
significance, or explained as rational choices, such as investment for future returns. But if
these anomalies are found to coexist with other signs of excessively optimistic investor
forecasts, these are likely signs of the buildup of financial imbalances. This point is especially
relevant if the signs are found saliently in property markets, which usually move slowly.
Thirdly, timely information about excessive investor optimism is of utmost importance in this
regard. Price-to-rent ratios in property markets are one indicator of investor sentiment.
Whereas information about price-to-earnings ratios is easily available in stock markets,
corresponding (properly quality-adjusted) price-to-rent ratios in property markets are not
easily available. This has, and still does pose a serious problem for macro-prudential policy,
especially for emerging economies where property markets are becoming increasingly
important.
To have timely information about proper price-to-rent ratios, or at least price indexes that are
reliable and internationally comparable, is not only important for assessing the magnitude of
financial imbalances that need rectifying, but also vital to communicate with the public, both
inside and outside of the country. In this respect, it is highly recommended that price indexes
be constructed consistent with prospective United Nations recommendations (due next year)
on residential property price indexes, and that these indexes be published regularly in a
timely manner. The Japanese price-to-rent ratios presented before are calculated from large
data sets using hedonic regression methods, and are available monthly with approximately
two weeks' lag.
Fourthly, if investors are excessively optimistic, a modest increase in capital requirements
and leverage restraints may not be sufficient to curb such unwarranted optimism. The case in
point is the increase in banks' new stock issues in Japan in the late 1980s and the dramatic
decline of their leverage ratio during the buildup of the financial imbalances. This point is also
relevant in contemplating maximum loan-to-value ratio requirements as macro-prudential
policy. When the price doubles in a few years, it is relatively easy to comply with seemingly
stringent maximum loan-to-value requirements, since the property's assessed value
increases in tandem with market prices.
To curb excessive loans, it is important to have measures to restrain leverage. But at the
same time we should better understand their limitations. They may be effective in some
cases, especially for rather small buildups of financial imbalances, but perhaps not in other
cases.
4. Excessive optimism and policy expectations: implications for monetary policy
Finally, let me turn to the role of monetary policy during the buildup of financial imbalances,
and consider the implications of the analysis so far.
There are two strands of thought on this issue. One strand emphasizes that monetary policy
is a blunt instrument affecting activity across a wide variety of sectors, many of which may
not be experiencing speculative activity. To dampen speculative bubbles may require
substantial changes in interest rates, which may hurt unaffected sectors. So in principle, it is
better to use macro-prudential measures to counter financial imbalances, rather than
monetary policy.9
The other strand of thought points out that letting financial imbalances balloon and then
collapse may be too costly to bear, depending on the magnitude of these imbalances.
Moreover, although regulatory reforms and other macro-prudential measures are now under
consideration in addressing the issue of the buildup of financial imbalances, there remains
substantial uncertainty about their effectiveness in the real world. It is therefore not wise to
rule out categorically the use of monetary policy to address the issue of financial imbalances.
Monetary policy could be used in tandem with macro-prudential measures, if, firstly,
substantial imbalances are building up and, secondly, regulatory policies have proved to be
insufficient.10
In retrospect, events in Japan in the late 1980s seem to support the second view. In
particular, that episode satisfied the two requirements for the use of monetary policy in
addition to macro-prudential measures to counter the buildup of financial imbalances.
Let me summarize what the stylized account of late 1980s Japan shows from the perspective
of monetary policy. Around 1986, investors' expectations of investment returns were
substantially elevated, especially in property markets, though grossly erroneously in
retrospect. And at the same time, market expectation was that monetary easing would
continue and the policy rate would remain low for a substantial period. This combination of
elevated investment-return expectations and market expectation of continuously low policy
rates accelerated property investment, both residential and commercial, though especially
the latter.
Property investment is a long-term, irreversible investment. It is a lengthy process from
starting to find a lot to final dedication, and once built for a particular purpose, it is difficult to
change usage. This is especially important in Japan, where some urban redevelopment may
take years. Thus, not only the current policy rate but also the expectations of its future course
have a significant effect on investment decisions. Consequently, the expectation of
continuing monetary easing significantly encouraged property investments, and particularly
those in commercial properties.
Because of the inherent irreversibility, the excessive optimism inflicted a huge scar on
Japanese commercial property markets. The quality-adjusted commercial land price index of
Tokyo's central business districts was 2.161 in 1999 (1975 index = 1), down from its height
16.556 in 1990.11 It is mind-boggling to imagine how this 87% decline in commercial land
prices in the heart of Tokyo, which is the center of the Japanese economy, affected business
activity in general. The same is true for residential property markets, though to a lesser
extent. Moreover, since investment in industrial sectors is often long-term and irreversible,
they also suffered serious overcapacity and misallocation problems caused by the excessive
optimism of the late 1980s and its subsequent collapse.
In retrospect, taking account of the devastating effects of excessive optimism and also the
ineffectiveness of macro-prudential measures (in particular, window guidance as explained
before), few would disagree that monetary policy should have played a role in attempting to
rein in excessive optimism, provided that this had been detected at the time.
This episode teaches two lessons about the role of monetary policy and its relation to
macroprudential measures in the process of the buildup of financial imbalances.
Firstly, when excessive optimism prevails in the market, macro-prudential measures alone
may prove to be insufficient, and we may need monetary policy on top of these
macroprudential measures to rein in such excessive optimism. When investors are overly
optimistic, asset prices go up to make it easy for banks to comply with, for example,
increased capital-buffer requirements and more stringent loan-to-value ratio requirements.
Moreover, when financial imbalances are sizable, they are likely to broadly affect many
sectors of the economy, as exemplified by 1980s Japan, and this may justify the use of
monetary policy.
Secondly, when excessive optimism prevails and investment-return expectations rise
erroneously, the central bank should be careful to avoid nourishing expectations of prolonged
low interest rates relative to their long-run, sustainable levels. These expectations are likely
to fuel investment activities further, especially in property markets. This increases the
magnitude of possible future winding down.12
In this respect, there is an important informational factor through which the central bank's
action or inaction influences market expectations. When excessive optimism emerges, a lack
of action by the central bank may convey the wrong signal to the public. The central bank is
responsible for the price stability that ultimately ensures the stability of economic activity. If
there is no correspondent increase in prospects for economic growth, a sharp increase in
investment return expectations may lead to strong pressure on prices, raising concerns over
inflation. If the central bank does not show concern over inflation when investment return
expectations are raised, this may be interpreted as a sign that the central bank has also
raised its expectations for growth potential and is thus "underwriting" market expectations.
In practice, the most difficult task in combating excessive investor optimism and the buildup
of financial imbalances is to detect the excess as early as possible in a transparent way.
Unfortunately, at the time of writing, conventional macroeconomic models are of little help in
detecting excesses, though progress has been made in incorporating some characteristics of
financial imbalances and thus in explaining their propagation mechanism. Taking account of
this state of our understanding, it seems to me that significant efforts in the following two
areas are needed from the practitioner's viewpoint.
Firstly, it may be desirable to develop and operationalize so-called early warning indicators,
to detect signs of a buildup in financial imbalances and to rein them in as early as possible
before it is costly to do so. Attempts to develop early warning indicators are sometimes
criticized as ad hoc because of the lack of microeconomic foundations, so to speak.
However, what we face are "tail risk" phenomena or more precisely, unknown unknowns,
where past regularities apparently no longer hold true. In this respect, though atheoretical,
the development and continuing improvement of early warning indicators is valuable in
discerning factors that might be important though somewhat overlooked in conventional
thinking.
Secondly, it is important (though admittedly not easy) to have timely and persuasive market
information related to the possible buildup of financial imbalances, particularly information
about investor optimism. As has been shown before, the Japanese government (or more
precisely, some of its divisions) was partly responsible for the excessive optimism of the late
1980s. This suggests that it is not an easy task at all to convince the market (and parts of the
government) plagued by excessive optimism. Many central banks and international
institutions are working to obtain first-hand broad asset market information that is as reliable
and as timely as possible. Here market intelligence plays an important role in detecting signs
of anomalies in these markets. In doing so, we should also duly recognize heterogeneity
among regions. These are challenging tasks for emerging-economy central banks, especially
with respect to property markets, which are traditionally not the main focus of central bank
business, and anomalies originating in financial innovations, which often "mutate" and
"disguise" themselves in subtle ways.
We usually regard financial crises as rare events, and most of the time, our model of the
economy evolves around some form of economic equilibrium in a linear, though
stochastically stable way. In reality however, we too often find, very painfully, that these rare
events are not in fact rare, and the economy moves rather drastically from stability to
instability in a short period time. The case of Japan in the late 1980s and the recent US case
highlight dramatically this pattern of crisis occurrence. To contemplate best practices in
macro-prudential and monetary policy, we should take proper account of our intellectual
limitations in modeling the real economy, and at the same time, we should be practical in
coping with the many-faceted problems of financial crises.
I will stop here for now. Thank you for your kind attention.