Kiyohiko G Nishimura: "The past does not repeat itself, but it rhymes" -
four lessons learned from the financial crises
Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel
Session "Responding to the Financial Crises: Lessons Learned" at the 45th Annual
Conference on Bank Structure and Competition, sponsored by the Federal Reserve Bank of
Chicago, Chicago, 8 May 2009.
* * *
Thank you, Chairman. It is always pleasant to come to Chicago, even when the topic of the
discussion is challenging, and I am grateful to the Chicago Fed for inviting me to this
esteemed conference.
Needless to say, we have already learned many hard lessons from the current crisis. For the
sake of better financial regulation, I would like to focus on four lessons in particular.
1. Lesson One
The first lesson is encapsulated in Mark Twain's famous line, "The past does not repeat
itself, but it rhymes". It is now fair to say that many thought Japan's so-called "lost decade"
was a problem peculiar to Japan, and also, by learning well from that problem, it was not
going to be repeated elsewhere. Unfortunately, this has turned out not to be the case.
In fact, we can see a remarkable resemblance in the development of the financial crises and
subsequent policy responses between the current US situation and Japan's lost decade.
Chart 1 shows a rough mapping of events in the time line between the current US crisis and
Japan's lost decade.
In both countries, the problem had its root cause in the property markets. In the US, the
legacy or toxic assets were sub-prime RMBS and their related securitized products; in Japan,
they were commercial properties in central business districts, particularly in Tokyo. It was
these toxic assets that gradually began to hurt banks' balance sheets.
We then saw an adverse feedback loop develop between financial distress and economic
activity. The subsequent policy responses by both Japan and the US also bear a marked
resemblance.
However, the past does not repeat itself exactly, as the "time scale" and the degree of
"acceleration" in the two crises were different. In the early stages, one month in the
development of the US crisis seemed to be equivalent to three months in the development of
Japan's, but the pace later accelerated, and it now appears that one US month is equal to
five or six months in Japan of the 1990s.
What made the difference to the time scale and acceleration? Innovations and structural
changes over the last two decades have no doubt played an important role, namely
globalization, advances in information communication technology, and financial innovations
and sophistication. Indeed, compared with Japan in the 1990s, the current crisis is far more
complex, interconnected and global.
Accordingly, the velocity of market dysfunction has been much faster and its contagion much
more widespread than in Japan's case, and the damage inflicted on the global financial
system and economy has been far more devastating than Japan's non-performing loan
problem.
2. Lesson Two
The second lesson we have learned from the crises is that once an adverse feedback loop
has been started, it is extremely difficult and costly to stop it and to restore confidence.
This was the essence of Japan's experience; a series of fiscal stimulus packages and an
accommodative monetary policy could not generate sustained economic growth, as the
financial system was severely impaired and market confidence continued to be eroded.
Injections of public capital in 1998 and 1999 were also, in retrospect, not sufficient to
convince the market to jump-start the economy.
This is evident in Chart 2. At the same time, it was clear that the Japanese economy was
suffering from a significant productivity slowdown from its peak in the 1980s.
So when and how did Japan's adverse feedback loop stop? With hindsight, perhaps the
turning point was October 2002, when the Financial Services Agency urged major banks to
halve their NPL ratios by the end of March 2005, and pledged to monitor their efforts
continuously and rigorously. The Bank of Japan also urged banks to carry out more rigorous
evaluations of NPLs, and to dispose of them promptly based on those evaluations.
In retrospect, the timing coincided with the reflection point at which the economy had just
passed the trough of the 2001 recession, and began to recover, thanks to strong export
demand due to the vigorous world economy.
This was also the time when substantial progress was being made in corporate restructuring
with respect to the so-called "three excesses": debt, employment and production capacity.
This restructuring helped the final pick up. In this way, the Japanese economy was, in
general, out of the woods around 2005, although some regional economies lagged behind,
having benefited less from the global growth.
3. Lesson Three
I will move on to the third lesson and ask the following question: "Is it possible to solve
problems with troubled assets at an early stage?" I find the answer is unfortunately negative:
"It is very difficult".
This is because when the valuation of troubled assets becomes highly uncertain, in the way
Frank Knight described here in Chicago eighty-some years ago, a "wait and see" strategy
may be the natural reaction for both sellers and buyers1. So, private initiatives alone may not
be sufficient to solve the problem. We have a list of such private attempts, with the fate of the
M-LEC among them, as well as the Cooperative Credit Purchase Corporation in Japan in
1993.
At the same time, it becomes increasingly difficult and costly for financial institutions with
troubled assets to raise capital once the market becomes suspicious.
However, governments usually face severe difficulty gaining public support for intervention in
the early stages of a crisis, as we have seen recently, while the financial institutions
themselves seek to avoid stigma and government interference.
4. Lesson Four
What is the core of the problem? Lesson Four of the crises is that it is the difficulty in getting
"reasonable estimates" of losses and a "reasonable pricing" of troubled assets, on which both
sellers and buyers can agree, that leads to erosion in confidence. It is this erosion in
confidence which then leads to an "excessive" aversion to uncertainty.
There are a number of related factors which have contributed to the current erosion in
confidence. Firstly, troubled assets have had macro-systemic effects, including
unprecedented levels of downside-correlation.
Secondly, these troubled assets' losses were dynamic and evolved over time. The
"estimated losses" increased continuously as the economy slid into stagnation. Valuation of
these assets, based on pre-crisis norms, grossly and consistently underestimated the losses,
leading to an erosion of confidence in valuation methods and ultimately in the solvency of the
institutions with these assets.
Moreover, troubled assets were very heterogeneous, and the erosion of confidence in
existing valuation methods set an adverse selection mechanism in motion, leading to a
marked deterioration in market liquidity.
Let me briefly summarize the implications of erosion (or contamination) of investors'
confidence in financial institutions. Once they lose confidence, these investors face
"unknown unknowns" that they never dreamed of before. They then become "excessively"
averse to uncertainty surrounding the future prospects of financial institutions. That is, they
make decisions based on the "worst possible case scenario" and try to minimize the losses
they would incur in this worst possible case2. Their valuation of these financial institutions
thereby turns out to be "excessively" pessimistic, and they become very sensitive to any
news that supposedly has some bearing on the worst possible case scenario. Moreover, they
tend to "wait and see," until they feel more confident about the valuation of troubled assets.
The result of these factors and their erosion of confidence is a significant undervaluation of
financial institutions at the trough of an economic downturn.
5. Concluding remarks: so what should we do?
Having seen the devastating effects of the adverse feedback loop and erosion of confidence,
the natural reaction or desire would be to make every effort to avoid macro-systemic financial
distress, and thus to regulate macro-systemically important financial institutions more closely
and comprehensively, as was agreed at the G20 London summit, in order to prevent another
crisis from developing.
However, at the same time, it is also important to bear in mind the following three points:
Firstly, we should avoid any "pro-cyclicality" of reforming zeal, such as strengthening
regulations in the downturn when it may further exacerbate the slump, or deregulating the
industry in the upturn when vigilance is called for. Past experience, as exemplified in Lesson
One, suggests we are very much prone to this tendency.
Secondly, we should also bear in mind that no regulation is perfect. The origins of financial
crises often lie in financial institutions' regulatory arbitrages and investors' complacent
behavior based on "plausible deniability". Also, we live in a dynamic world and are always
subject to innovations and structural changes so that, as we have just learned, it is virtually
impossible to identify and eliminate in advance all possible causes of financial distress.
Thus, thirdly, we should prepare for the conceivably worst case in "normal" times, when
confidence is still maintained. Lessons Three and Four show the fundamental problem of the
financial crises is the difficulty in raising capital when it is most needed, because of the
adverse feedback loop and erosion of confidence. It is worth exploring the feasibility of
macroeconomic pre-committed or pre-paid "safety-net" schemes to complement ex-ante
regulations. In this regard, contingent capital schemes and their variants are particularly
worth exploring when designing regulatory reforms for macro-systemically important financial
institutions.
Several such schemes have been proposed within the framework of private initiatives: capital
insurance by Kashyap, Rajan, and Stein; reverse convertible debenture by the Squam Lake
Working Group; and "margin calls" on shareholders by Hart and Zingales. For example, in
the capital insurance scheme, participating institutions pay "systemic-risk insurance"
premiums to insurers in good times, and get capital from them in bad times when a systemic
risk materializes. Since what we are preparing for is macro-systemic risk, the trigger should
be a macroeconomic event. Other proposed schemes also rely on private incentives to
supply capital to financial institutions when they need it.
However, private initiatives are not likely to be sufficient to cope with financial institutions'
capital shortages in macro-systemic events, since insurers may find themselves in distress
and unable to provide the necessary capital3. Moreover, a large-scale systemic risk is very
rare, and its probability is very hard to measure, if not impossible. Insurers would demand
much higher premiums than usual to take on such almost totally unknown risk ("uncertainty"
in the spirit of Frank Knight, as mentioned before). In that case, it may be reasonable to have
a public-private partnership capital insurance scheme in which private insurers insure the risk
up to a certain point and a government takes the rest (up to a pre-specified limit). This is in
fact quite similar to earthquake insurance in Japan.
These schemes, however, have their own problems. When insured, an institution may find it
attractive to take further risk. We need appropriate supervision to prevent this moral hazard
behavior. A non-participating institution may benefit from financial stability without paying its
fair share of the costs. To avoid this free-rider problem, all systemically important institutions
are required to participate. And so on. Although contingent capital schemes need further
elaboration, they deserve discussion as a complement to the regulatory reforms currently
under consideration.
Let me stop here for the time being. Thank you for your attention.
Chart 1: Rough mapping of events between US and Japan
red bracket: major events, blue: monetary policy, yellow: fiscal policy, pink: bank
rescues
Japan U.S.
Commercial land price started to decline sharply 26% decline in ABX-HE (BBB) in one month
4Q 1990 Feb. 2007
July 1991 First Policy Rate Cut Sept. 2007 First Policy Rate Cut
20% decline in commercial land price in one quarter 18% decline in ABX-HE (AAA) in four months
2Q 1992 Oct. 2007
Citigroup, BoA and JPMC announce plans for $80
Govt. announces first significant
fiscal stimulus
billion
Aug. 1992 Oct. 2007 Master Liquidity Enhancement
package
Conduit (to be abandoned in Dec. 07)
Financial institutions collectively establish
Jan. 1993 President Bush signs the Economic Stimulus
Cooperative Credit Purchase Corporation Feb. 2008
Act of 2008
fiscal stimulus packages
'93, '94, '95
Govt. announces full protection for deposits for FHFA places in
Fannie Mae and Fredie Mac
Jun. 1995 Sep. 2008
five years (to be extended further)
government conservatorship.
Government establishes Resolution and Collection
Lehman Brothers Holdings files for Chapter 11
Jun. 1996 Bank (later to be reorganized as Resolution and Collection Sep. 2008
bankruptcy protection
Corporation)
Failure of Sanyo Securities, Hokkaido
FRB authorizes FRB NY to lend up to $85 billion to
Nov. 1997 Takushoku Bank, Tokuyo City Bank and Sep. 2008
AIG
Yamaicihi Securities
Public capital fund injection to 21 major
Establishment of $700 billion TARP
Mar. 1998 Oct. 2008
banks (1.8 trillion yen)
Introduction of temporary nationalization scheme,
Treasury Dept. purchases a total of $125
new scheme for public capital fund injection and
Oct. 1998 Oct. 2008 billion in preferred stock in 9 U.S. banks (more
etc. Temporary nationalization of Long Term
to follow)
Credit Bank of Japan.
Treasury, FRB and FDIC jointly announce an
fiscal stimulus packages
'98, '99
agreement with to provide a package of
Nov. 2008 Citigroup
Feb. 1999 BoJ introduces zero interest rate policy
guarantees, liquidity access and capital
FOMC votes to establish a
Public capital fund injection to 15 major target range for the
Mar. 1999 Dec. 2008
banks (7.5 trillion yen)
effective federal fund rate of 0 to 0.25 percent
Chart 2: Japan's Real GDP Growth and Fiscal and Monetary Policy
%, y/y changes and contributions % at end of FY
5 4.5
4 4
3 3.5
2 3
1 2.5
0 2
-1 1.5
-2 1
-3 0.5
-4 0
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
FY
NetExports Private Demand
Public Demand RGDP Growth
Monetary policy rate (right scale)