Kiyohiko G Nishimura: Financial system stability and market confidence
Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Japan
Society of Monetary Economics' Spring Annual Meeting, Tokyo, 16 May 2009.
* * *
1. Preface
I am grateful for this opportunity to speak before the time-honored Japan Society of Monetary
Economics. Taking advantage of the occasion to address leading scholars, I would like to
make half of my remarks today as a Deputy Governor of the Bank of Japan, and the other
half as a former Economics Professor of the University of Tokyo, where we meet today. I
hope that I can in some way contribute to your debates over the current financial crisis.
When Lehman Brothers went bankrupt last September, the financial crisis entered a new
level of acuteness, though more recently it has begun to subside thanks to bold policy
initiatives taken by countries around the world. Nevertheless, the financial crisis has had
significant negative impacts on the real economy. The IMF has revised its 2009 real growth
rate forecast for the world economy down to negative 1.3 percent. At the current point in
time, the Japanese financial system is stable on the whole and our financial institutions
remain sound. However, it is also a fact that Japanese financial institutions are facing a much
more difficult earnings environment. We will therefore continue to carefully monitor whether
the banking sector is able to maintain a sufficient level of robustness and appropriately
provide financial intermediation functions.
While governments and central banks have been focused on current crisis management, the
G20 Summit and many other fora have seen vigorous discussions of policies that will prevent
recurrence of financial crisis. However, the primary interest in most of these debates is how
to strengthen regulation, and it is my impression that critical re-examination of the
effectiveness of existing regulations or consideration of the possible side effects of
reregulation have taken a back seat.
As a central banker whose mission is to maintain the stability of the financial system, I
believe we should genuinely reflect whether our previous policies led financial institutions in
the correct direction. Where there are mistakes, we must correct them and help financial
institutions to set off again on the proper path. At the same time, we should recognize that
regulation must not impede the growth of the financial services sector. The ultimate goal of
regulation should be the creation of a sufficiently flexible financial system that is able to
smoothly absorb internal and external shocks.
In my remarks today, I would like to focus on how we design systems that will prevent the
recurrence of financial crisis, and consider this from a broad perspective that is not bound by
established concepts and approaches. Obviously, the design of desirable policies and
regulations requires a deep understanding of what is behind the crisis. Therefore, while it
may strike many of you as being a bit roundabout, I would like to begin my remarks by
reviewing the background to the current crisis and the mechanisms that have exacerbated it.
2. Emergence of the "credit bubble"1
At the outset, I would like to set out the causes of the current financial crisis in my own way.
We are currently in the midst of financial crisis. The global financial system may be in a lull,
but we do not know when another challenging issue could erupt. The situation surrounding
us does not allow for premature conclusions. Therefore, I would like to ask you to understand
that my remarks are based on the information that is available to us at the current point in
time and necessarily represent a provisional diagnosis.
No one would deny that the prologue to the current financial crisis was the subprime housing
loan crisis in the United States. But that was essentially a problem in a portion of the home
mortgages in a single country - albeit the United States - and it would normally be
inconceivable for that alone to plunge global financial markets into chaos. It is therefore more
appropriate to look to macro global problems as the true background to today's financial
crisis. It is undeniable that the low interest rates and excess liquidity that have prevailed
around the world since the collapse of the IT bubble are behind the crisis. In that sense, we
were in a situation in which it would have been quite plausible for a financial crisis to occur
anywhere and in any form.
Why did the US subprime housing loans trigger the crisis? The US current account deficit
has begun to expand rapidly since the latter half of the 1990s. Meanwhile, emerging Asian
economies, including China and oil producing countries, have begun to see their current
account surpluses expand. This is the phenomenon that has come to be called "global
imbalances." I am sure that you will recall a variety of discussions over whether this situation
would be sustainable.
In fact, when there are significant differences in the degree of development of individual
countries' financial markets, a situation like the global imbalances that appear on the surface
to be a disequilibrium can in fact be one kind of equilibrium itself.2 In emerging economies
and oil producing countries, many imperfections may be observed in the domestic financial
markets. Stock markets are undeveloped, deposit interest rates are fixed at low levels by
regulation, and so on. Because of this, these countries may lack financial assets that offer a
safe store of wealth gained by rising incomes. One solution is to purchase "safe" financial
assets from other countries. The development of information and telecommunications
technologies has made it far easier to purchase foreign assets than it was in the past. And it
was the United States that supplied those "safe" financial assets. For emerging economies
and oil producing countries, this translated into current account surpluses, since the
purchase of foreign assets is, ultimately, the export of capital. Conversely, for the United
States, this resulted in current account deficits because the savings shortfall due to excess
consumption was covered by importing capital. This set the stage for the spread of a
USmade "credit bubble" to the rest of the world.
Obviously, the global imbalance on its own is insufficient to generate a "credit bubble" that is
completely divorced from economic fundamentals. For that, we must turn to the problems
inherent in the process by which subprime housing loans were turned into securitized
instruments. On this point, I would like to focus on the question of the agency problem and
how it relates to the expansion of the securitization business.3
The primary characteristic of the securitization business is its complexity. Today's securitized
instruments have extraordinarily complex structures. For example, they bundle together
thousands of subprime housing loans, dissect the cash flow that these loans produce and
turn them into a number of different financial instruments with different levels of priority.
Furthermore, these financial instruments are again bundled together and chopped up to
create more financial instruments. As this process of synthesis and partition is repeated, the
risk structure becomes too complex and it is no longer an easy task to measure risk
exposure. Certainly, one could argue that instruments should not be purchased if the risks
are not clear, but what happened was that many investors placed excessive faith in the
ratings issued by ratings agencies for these securitized instruments and began to gobble up
complex products regardless.
There is the second feature of securitization that we must also discuss: "functional
differentiation." Most of the subprime housing loans in the United States were issued by
financial operators called "mortgage banks." Instead of continuing to hold the credits after
making the loan, these operators sold them to investment banks and other institutions.
Investment banks and others then took the home mortgage credits that they had purchased,
pooled them together and used them to back securitized instruments that were sold to
investors. This is called the "Originate To Distribute" (OTD) model, whose process starts with
the origination of home mortgages and ends with the sale of securitized products based on
them. One of the problems with the OTD model is that it lends itself to moral hazards. If
mortgage banks are able to sell home mortgage credits and transfer the risks, they have no
incentive to seriously screen the loans. It is not hard to imagine loans being made to
applicants who could not meet credit standards in normal times. This is a typical moral
hazard, and I believe it is what planted the seeds of the "credit bubble."
Through this process, an enormous volume of securitized instruments backed by and related
to subprime housing loans came onto the market. Moreover, many of these instruments were
given "AAA" ratings, indicating the highest levels of creditworthiness. What is surprising is
that the yield on these AAA-rated securitized instruments was often much higher than the
yield on Treasuries even though they also had the same AAA rating. Had market functioned
normally, this price distortion could not have been maintained over the long term. But in point
of fact, no one questioned this state of affairs; not the banks, not the rating agencies, not the
investors, not the regulators. Whether people thought the situation strange or not, everyone
seems to have agreed to ignore it.
Why could such an abnormal situation continue for so long? Some would argue on this point
that an important factor came from organizational behavior and a certain "responsibility
avoidance" attitude on the part of organization members - what is referred to in the literature
as "plausible deniability".4 The sellers of securitized instruments maintain that they bear no
responsibility, and to demonstrate that there were no problems with their instruments they
point to the fact that other operators were selling the same kinds of instruments. They claim
that they, like others, calculated the prices of their instruments on the basis of historical data
and experience, and they were given the blessing of ratings agencies. In other words,
nobody could have possibly foreseen the current price drops, and therefore nobody is
responsible. It just happened. Meanwhile, the buyers of securitized instruments - institutional
investors - use the similar logic to justify their purchases. Everybody else was buying the
same financial instruments and nobody had a problem with it, the excuse goes. It is natural
to believe that this plausible deniability was one of the reasons that the "credit bubble" in
securitized instruments emerged and was maintained for such a long period of time.
Along with the emergence of the "credit bubble," there is another feature that distinguishes
the current crisis - the fact that virtually very few market participants believed that such a
serious financial crisis could actually occur. How is it that market participants came to believe
this? It has something to do with the phenomenon of so-called "Great Moderation." Beginning
in the 1990s, the United States and other countries saw a significant decline in the volatility
of their GDPs and other real economy indicators and, as a result, the volatility of financial
indicators was stable as well. This situation remained in place for a long time and
presumably market participants had an illusion that the same situation would persist in the
future and economic upheavals could never occur.
There is an opinion that such an illusion was reinforced by the "Greenspan Put," named after
Alan Greenspan, former chairman of the Federal Reserve Board (FRB). In other words, even
if financial crisis were to occur, former chairman Greenspan and the FRB would certainly be
able to use monetary policy to fix it. If the Greenspan Put were true, it could be rational for
market participants to take risks on the assumption that the tail risk (the rarely-occurring risk
such as financial crisis) would never emerge. In short, the misplaced faith of market
participants in monetary policy generated overconfidence in the market.
3. Erosion of confidence and deepening of the crisis
I would now like to turn to the collapse of the "credit bubble" and the deepening of the
financial crisis that resulted. One of the distinguishing features of the current financial crisis is
the liquidity crisis caused by the materialization of counterparty risk. On July 10, 2007, S&P
and Moody's announced that they would be reviewing the ratings of several residential
mortgage-backed securities (RMBS) backed by subprime housing loan assets. As a
consequence, the AAA ratings of asset-backed commercial paper (ABCP) backed by these
instruments were also downgraded. Indeed, an unremarkable change in the ratings of risk
assets that were not all that important in the context of the market as a whole directly shook
the global financial system.
In the United States, money market funds (MMFs) have been considered to be extremely
safe financial assets. One of the primary reasons for this is that MMFs are only allowed to
invest in AAA-rated assets. When ratings were downgraded for ABCP, MMFs did not
reinvest. Naturally, funds that originated ABCP and used it to raise money found themselves
in fund-raising difficulties: Funds under the Bear Stearns umbrella went bankrupt; BNP
Paribas moved to freeze its affiliated fund's new applications and redemptions. The
structured investment vehicles (SIV) created by banks to issue ABCP were unable to find
funding sources, and then these banks were forced to provide liquidity enhancement instead.
Banks, which frequently lend each other money, suddenly became aware of counterparty
risk, the risk that the other party of a transaction might suddenly go belly up. They began to
worry that some bank somewhere might suddenly be unable to secure liquidity and fail.
Indeed, on August 9, a liquidity crisis actually occurred, with liquidity drying up quickly in the
interbank market. The event has come to be known as the "Paribas Shock." Many European
banks were among those facing liquidity difficulties. Confronted with this situation, the
European Central Bank (ECB) promptly announced that it was prepared to supply massive
amounts of liquidity into the short-term money market.5
Some argue that there may be an excessive maturity mismatch on financial institutions'
balance sheets as a background factor that triggered the liquidity crisis. Certainly, a close
observation of the facts in the current financial crisis exposes not only the maturity mismatch
but also the "liquidity uncertainty" that is the fundamental risk inherent in all financial
instruments. It is a truism that liquidity is largely unrecognized while it exists and only
understood once it disappears. For example, the design of ABCPs assumes that they can be
sold on the market at any time if necessary, but when crisis actually occurred, these
instruments could not immediately be sold. Had institutional fund-raising been a little more
long-term, there would have been a time cushion that might have enabled them to deal with
the crisis in liquidity. Although it may not be possible to take every possibility into account in
the selection of assets, a constant awareness of the uncertainty of liquidity and continuous
assessment of the maturity gaps between assets and liabilities are key factors in improving
the soundness of financial institutions.
One often-heard opinion is that credit default swaps (CDS) and other financial derivatives
amplified the instability of the financial markets in the current financial crisis. Opinions will
differ on the merits of CDSs themselves, but no one would deny that the dysfunction of the
over-the-counter (OTC) market, where these instruments were primarily traded, undermined
confidence in financial markets as a whole. On September 15, 2008, Lehman Brothers
declared bankruptcy. Right around the same time, the market began to talk about American
International Group, Inc. (AIG) being on the rocks as well, and its share price plummeted.
AIG sold large volumes of CDS protection, in which it was believed that there were many
contracts that used Lehman Brothers as a reference company. The bankruptcy of AIG would
nullify CDS hedges. Were this to happen, financial institutions that had dealings with AIG
would be unable to fulfill their CDS contracts with other financial institutions, raising the
specter of a chain reaction. Market participants were suddenly forced to recognize this
counterparty risk. Faced with these circumstances, the US government had little choice but
to place AIG under its de facto administration.
Most CDSs are traded directly. As long as counterparty risk is limited to the parties directly
involved in the negotiated transaction, the market as a whole does not recognize any broad
risk. The reason the market as a whole became aware of this risk is that the market
participants recognized that they are in complex intertwined relationships among themselves
arising from the negotiated transaction network. If counterparty risk is recognized in some
transaction somewhere - in other words, if there is thought to be a risk that the other party
will go bankrupt - everyone who has dealings with that party is at risk of being pulled down
too in a chain reaction of bankruptcies. So the initial counterparty risk spreads and spawns
new counterparty risks for the parties that have dealings with the counterparty. These
"network externalities" certainly played a major role in the process by which the current
financial crisis expanded. Counterparty risk can be significantly reduced by centralizing
transactions (institutionalizing a "central counterparty"), but in practice, many of the
transactions were so complex that the creation of a central counterparty was a daunting task.
I do not think that the current sense of paralysis that pervades financial markets can be
explained merely as the rupture of a "credit bubble." When bubbles rupture, one would
ordinarily expect economies to return to their fundamentals. In other words, economies get
back to functioning as they should. But I do not think there is anyone who would say that
economies at the moment are functioning properly. The global economy today has fallen far
beneath its potential and is seemingly unable to pull itself up.
The root cause of this is the erosion of confidence in the market. When confidence is eroded,
market participants become extremely fearful that they might be confronting a completely
unpredictable and uncertain world. In this case, for market participants who want to behave
rationally, the most natural course is to assume the most pessimistic scenario and make the
best of it.6 Such market participants will react more readily to bad news, to information about
the worst conceivable circumstances, than they will to good news. What is more, in situations
such as these, market participants tend to adopt a strategy of standing still until confidence
has been restored.7 Actions that may be rational at the level of individual market participants
can lead to a "fallacy of composition," which delays the restoration of functions for the market
as a whole.
4. Institutional issues on the financial system
I would next like to explore the background of the current financial crisis from the following
two perspectives: monetary policy implementation and financial system design. Let me begin
by considering monetary policy in the context of the so-called "bubble" phenomena.
It is extremely difficult for central banks to be aware in real time of the emergence and
collapse of "bubbles".8 There are two schools of thought about how to deal with bubbles.
One says that you should wait and clean up after the collapse because it is difficult to be
aware of bubbles as they emerge. The other argues that they should be dealt with quickly by
reading the signs of a bubble from numerous indicators like asset prices. Both positions,
however, acknowledge that it is difficult to identify the emergence and collapse of bubbles in
real time.
When a large bubble collapses and severely damages the financial system, monetary policy
has extremely limited effects, as we have seen in the current financial crisis. Furthermore, if
the process of bubble formation involves "Greenspan Put"-type expectations among market
participants, it may lead to excessive risk-taking activities.
Thus, the current financial crisis raises the extraordinarily difficult question of how central
banks should conduct monetary policies to stabilize financial systems, and ultimately,
economies. While it is very important that this be discussed in detail, I will refrain from doing
so in my remarks today because I wish to highlight another important question regarding the
design of financial systems.
The "credit bubble" and its collapse we have witnessed have resulted in a growing impetus in
Europe and the United States to reconsider the existing regulatory framework. In the
background is the financial deregulation that made great strides after the 1990s. The United
States, under the Glass-Steagall Act, maintained a clear delineation between the banking
and securities businesses ever after 1933. The Glass-Steagall Act came out of the lessons
learned from the Great Depression and was designed to protect depositors by separating
banking business from securities business so as to improve the soundness of banks.
However, in 1999, amidst a global deregulatory movement, the Gramm-Leach-Bliley Act
effectively tore down the walls between banking and securities businesses. This enabled
large commercial banks to enter the securities business.
Meanwhile, in 2004, the Securities and Exchange Commission (SEC) relaxed the leverage
restrictions on investment banks. This deregulation was of decisive importance in the current
financial crisis.9 It is said that this deregulation resulted in a sharp increase in the leverage of
US investment banks from a multiple of 12 to 33.
Recent years have, in addition, seen a growing role for the "shadow banking system" of
financial operators outside the framework of banking regulation. Hedge funds and private
equity funds epitomize the rise and fall of this shadow banking system. Able to freely engage
in financial transactions without being bound by banking regulation, these financial operators
used leverage to earn large profits. Investment banks can also be considered part of this
shadow banking system because their regulation was looser than that imposed on
commercial banks. There is nothing particularly wrong with the enlargement of shadow
banking system itself if failure here does not pose a systemic risk. However, large
commercial banks also developed close ties with the shadow banking system by having
hedge funds under their umbrellas or by creating special purpose companies off their
balance sheets to transfer related operations. It reached the point where the performance of
these companies began to impact the soundness of major commercial banks themselves. In
addition, the shadow banking system also had greater influence on the global financial
system. When it began to face liquidity shortfalls, it accelerated the sale of its assets,
bringing a downward spiral to asset prices, which in turn became one of the factors in
systemic risk. The current financial crisis indicates that some form of regulation is necessary
for the shadow banking system.
Another important point to be raised concerns the relationship between the Basel Accord
(BIS rules) and the financial crisis, specifically the procyclicality of capital adequacy
requirements. When the economy improves, bank lending increases and the economy
accelerates because capital requirements become smaller, corresponding with reductions in
downside risk. Conversely, when the economy deteriorates, bank lending decreases and the
economy decelerates because capital requirements become larger as downside risk
increases. Thus, capital adequacy requirements are considered to have the effect of
amplifying business cycles.10 The procyclicality of capital adequacy requirements has been
criticized for exacerbating the economic downturn in the current financial crisis. Nonetheless,
it does not appear that a consensus has been reached on exactly how serious the
procyclicality is. It will be important in the future that a new quantitative analysis be
performed of the procyclicality to facilitate a more objective debate.
5. Re-stabilizing the financial system
For the remainder of this speech, I would like to trace the recent debates from those
concerning regulations to maintain the soundness of individual financial institutions to those
about safety nets to maintain the stability of the entire financial system. In so doing, I will add
some theoretical examinations.
In reviewing the recent debate, the framework of the "3 Cs" can be of some assistance.11
The 3 Cs stand for the words "comprehensive," "contingent" and "cost-effective."
"Comprehensive" regulations are best understood as regulations without loopholes. Unless
the regulatory net spans all financial institutions comprehensively, the more regulations are
beefed up, the more funds will flee from strictly regulated sectors to more loosely regulated
sectors.
"Contingent" regulations have the following properties. During the up-phase period, they
should mitigate overconfidence to prevent the accumulation of systemic risks Once systemic
risk actually emerges, however, they should impose few restrictions to avoid reinforcing
economic deterioration. In preparation for a severe erosion of confidence, they may be
furnished with some policy incentives to restore confidence. To sum up, it is desirable that
regulations be contingent on risk-taking attitudes of market participants, and thus strict during
booms and loose during busts.
"Cost-effective" regulation is a concept which is important in the evaluation of regulations.
This standard dictates that when one or more regulations could achieve the same results, the
least expensive approach should be chosen. For example, if it is desirable to induce financial
institutions to raise capital, it is better to do so during boom times when funding is readily
available as opposed to slump times when the economy has begun to turn sour and the
funding cost is higher. This standard is also important when considering how to use public
funding. When making the decision between injecting capital and purchasing nonperforming
credits, one must consider costs involved as well as benefits of policy effects.
Currently, the Basel Committee on Banking Supervision and many other fora, interest groups
and ad hoc groups are floating many different proposals about how best to regulate finance.
Taking the "3 Cs" in mind, I would like to take up several regulatory reform proposals that
have come out of the international debate and examine their significance. In doing so, it is
perhaps easiest to divide regulations into two categories: "ex ante measures" to be taken to
prevent the crisis and "ex post measures" to influence how the crisis plays out when it
happens. These could also be termed "policies for normal times" and "policies for emergency
times."
(1) Ex ante measures
The Basel Committee on Banking Supervision is taking the lead in a discussion on ways to
alleviate the procyclicality of capital adequacy requirements. As I explained, current capital
adequacy requirements are considered to have procyclicality properties. In response, the
discussions focus on the idea of introducing variable "buffer capital." This would make it
acceptable for institutions to accumulate capital when the economy is booming and draw it
down when the economy slumps. However, one can also critique this argument in terms of
the "3 Cs." Capital adequacy requirements are meaningless if they do not apply to all
broadly-defined financial institutions, not just banks.
Even if this proposal is understood as being desirable from a qualitative standpoint, there are
still many problems that would be involved in actual implementation. For example, on the
idea of accumulating capital during boom times, there still is the question of specifically how
much capital and at what pace it should be accumulated. And therein is the even more
difficult question of how one defines and determines the business cycle. Implementation
involves real-time judgments about when it is allowed to begin drawing down the buffer.
However, as can be seen from the business-cycle dating problem for the Japanese
economy, a long period of time is required before the peaks and troughs of the business
cycle can be identified. There is also the need to clearly articulate how time lags between
national business cycles will be treated. These are just a handful of issues that must be
resolved before any such regulations could be fleshed out.
There is another international debate taking place on liquidity monitoring. As I noted, the
current financial crisis initially emerged as a liquidity crisis. At the time, the system used by
regulators to monitor the liquidity of internationally-active banks was inadequate. The
discussion therefore turned to ways to increase the effectiveness of international monitoring
by developing common liquidity metrics and sharing information among regulators. At the
current point in time, the debate focuses on which liquidity metrics would be appropriate to
use. However, there are significant differences from country to country in the effectiveness of
liquidity monitoring. Japan engages in detailed monitoring with the cooperation of the
institutions involved, but there are some countries where the quality of monitoring is not very
high. One-size-fit-all-type arguments are therefore not very realistic. Mechanisms must be
sufficiently flexible and adaptable to the circumstances of individual countries.
With this in mind, I would like to mention a very interesting approach to the liquidity risk.12
Without a doubt, when the financial crisis is viewed as a liquidity crisis, the root cause is the
excessive maturity mismatch on the balance sheets of funds and the like. Therefore, it would
be desirable to have regulations that would provide incentives to alleviate this maturity
mismatch, thereby preventing crisis. One possible solution would be to link the maturity
mismatch between assets and liabilities with the capital requirement. For example, a bank
raising funds from longer-term deposits would have a lower capital requirement than one
raising funds in the overnight money market. This scheme would give banks an incentive to
take longer maturities on the liabilities side in particular. Putting aside the question of
whether it is desirable to link maturity mismatches with capital requirements, it is clear that
the continuous monitoring for appropriate liquidity at financial institutions is an effective tool
for detect the early-warning signs of financial crisis.
The G20 meetings held in April decided to reorganize the Financial Stability Forum (FSF) as
a new "Financial Stability Board" (FSB). Previously, four international institutions, the Basel
Committee on Banking Supervision, International Organization of Securities Commissions,
International Association of Insurance Supervisors and International Accounting Standards
Board, made independent judgments and took independent actions. The FSB is expected to
serve as a kind of supervisory body of these institutions and provide coordination functions.
The measure aims to overcome the differences among sectors and create regulations and
rules that are consistent throughout the financial system. The G20 also decided to regulate
hedge funds. This is the first step in bringing the shadow banking system within the net of
regulations.
(2) Ex post measures
The global economy is in the midst of a financial crisis. The ex post measures that I am
about to describe are the policies and programs that are actually being implemented by
governments and central banks today.
The United States and European countries have taken initiatives to address liquidity and
fund-raising difficulties as part of steps to stabilize the financial system. These efforts can be
organized into two categories: "granting government guarantees for market-based
fundraising" and "expanding deposit protection." Government guarantees for market-based
fundraising attempt to stabilize the market conditions for fund-raising, particularly for bond
issuance by financial institutions, at a time when financial markets are increasingly strained.
Most countries h