Masaaki Shirakawa: Macroprudence and the central bank
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Seminar of the
Securities Analysts Association of Japan, Tokyo, 22 December 2009.
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Introduction
It is my honor to speak today at the Securities Analysts Association of Japan.
I believe that most of you here today have been directly or indirectly involved in the securities
market, and that, needless to say, efforts by many related parties are essential for the sound
growth of the securities market. One critical element of such efforts is the expert provision of
securities analysis, and in this, securities analysts have been playing an important role. The
Securities Analysts Association of Japan was established in 1962 in order to train such
securities analysts, and since then has consistently and greatly contributed to the
development of Japan's securities market. So let me start by expressing herewith my sincere
respect for the Association's many years of effort.
Sparked by the recent global financial crisis, there have been active discussions on how to
prevent a recurrence of such a crisis. Those discussions cover securities market as well as
financial markets more generally and the financial system. Last week, the Basel Committee
on Banking Supervision (Basel Committee), for example, announced a package of proposals
on capital adequacy rules and liquidity regulations and made this available for consultation
until mid-April 2010.1 Given that the recent crisis originated in the United States and Europe,
there appear to be some mixed feelings at Japanese financial institutions about the
discussions in progress. However, any instability in the global financial system inevitably
affects Japanese financial institutions. Moreover, just as one of the causes of the recent
crisis was that concerned parties in the United States and Europe had not sufficiently learned
the lessons from the bubble and financial crisis in Japan and the Asian financial crisis, so
Japanese financial institutions might face similar problems in the future if they fail to
sufficiently learn the lessons from the recent financial crisis in the United States and Europe.
For this reason, it is important for Japanese financial institutions to actively take part in these
discussions.
Because discussions revolve around a large number of issues, it is difficult to summarize
them in a few simple words. However, when it comes to lessons from the crisis and
measures to prevent a recurrence, the most important keywords in my view are "liquidity"
and "macroprudence." Against this background, today I would like to focus on the role of
"macroprudence" and discuss initiatives by the Bank as well as efforts that private market
participants and public authorities should make to ensure the stability of the financial
system.2
I. Microprudence and macroprudence
I should start with an explanation of the concept of "macroprudence," but in order to do so, it
is useful to first explain the concept of "microprudence," with which it contrasts. It could be
said that microprudence describes the conventional ideas behind the policy approach to
ensure financial system stability. Simplifying somewhat, microprudence consists of the idea
that if the management of individual financial institutions is sound, the financial system, which
is the aggregate of individual financial institutions, should be stable, and regulations and
supervision should therefore focus on realizing soundness at such micro level. On the other
hand, the idea underlying the concept of macroprudence is that stability of the financial
system cannot be achieved solely by such micro-level efforts, and that it is necessary to
assess risks in the financial system as a whole by taking account of the interconnectedness
of economic activities, financial markets, and the behavior of financial institutions, and to take
conscious steps to base institutional design and policy responses on such assessments. As I
will discuss in detail later, relying on only one of the two approaches is not sufficient to
ensure financial system stability. Rather, both approaches are necessary, and one of the key
lessons from the recent global financial crisis is that we need to pay greater heed to the
approach that incorporates what the term "macroprudence" seeks to capture. In order to see
what this means specifically, let us consider the background of the recent financial crisis.
Background of the global financial crisis
The recent financial crisis may have reached a global scale and involved new financial
products and players, but essentially it is a classic example of the rise and collapse of an
economic bubble.3 In the period preceding the recent crisis, especially around the
mid2000s, the United States and some European economies experienced a large-scale credit
bubble. It was the bursting of that credit bubble that triggered the financial crisis, which was
further aggravated by the failure of Lehman Brothers in the autumn of 2008. During the
bubble period, risk-taking was excessive. Looking at the behavior of financial institutions, for
example, this involved the accumulation of excessive leverage and maturity mismatches
between assets and liabilities. Typically, excessive leverage is taken to refer to an increase
in debt beyond a point where there is an appropriate balance between capital and debt. More
generally, however, excessive leverage can be taken to mean excessive risk-taking,
including off-balance transactions, relative to the capital base. At a time of financial crisis,
excessive leverage will show itself in capital shortages and solvency problems suffered by
financial institutions. On the other hand, the term "maturity mismatch" refers to the financing
of long-term assets using short-term debt, and in the run-up to the recent financial crisis,
there was a considerable increase in such mismatches. A typical example of this is
structured investment vehicles (SIVs). These SIVs invested in medium- to long-term
securitized products related to subprime mortgages and raised funds by issuing short-term
asset-backed commercial papers with those securitized products as underlying assets.
However, once some kind of a shock occurs, funding becomes difficult, and such liquidity
risks materialize not only in terms of the domestic currency but also in terms of foreign
currencies. In the recent global financial crisis, apart from the United States, U.S. dollar
liquidity risk was particularly serious for European financial institutions and, as you will know,
Japanese financial institutions, too, faced shortages of U.S. dollar funds from the autumn of
2008 through the beginning of 2009. Once there is a liquidity shortage, financial institutions
are forced to sell their assets, resulting in a fall in asset prices, and, for financial institutions
as a whole, further intensifies liquidity shortages. Thus, during the financial crisis, the
negative spiral intensified as capital shortages and liquidity shortages mutually affected each
other.
Responses based on microprudence
Crises - as I just discussed - appear in the shape of capital and liquidity shortages suffered
by financial institutions. Therefore, a natural regulatory and supervisory approach to prevent
the recurrence of a crisis is to sufficiently raise the minimum levels of required capital and
liquidity financial institutions should hold. This approach focuses on reducing the possibility
that individual financial institutions fail and could therefore be described as a response based
on microprudence.
With regard to capital shortages suffered by financial institutions, the recent crisis revealed a
variety of issues. One of these is that the most remarkable increase in leverage took place
not in the traditional banking business but outside the banking business. For example,
financial institutions held securitized products on their trading books, for which risk
weightings under capital adequacy regulations are small, although they later turned out to be
highly risky financial products. While the size of trading books was less than 10 percent of
total assets for Japanese financial institutions, for some financial institutions in the United
States and Europe, it reached about 40 percent. Consequently, when risk-asset based
capital ratios were used as a yardstick, major financial institutions' leverage, at least
superficially, did not seem that excessive, and their capital bases appeared sufficient.
Investments in securitized products by major financial institutions were carried out through
SIVs they had set up, and the funding for these SIVs was provided through credit from their
parent financial institutions. As a result, as later revealed, risks were shouldered by the
parent financial institutions themselves. In a case such as this, the necessary regulatory and
supervisory response would have been to accurately gauge the risks carried by financial
institutions and the necessary capital, and to require individual financial institutions to hold
more capital.
Can problems be solved through microprudence alone?
Such regulatory and supervisory responses based on microprudence are necessary and
their importance should not be underestimated. As I will explain in detail later, the Bank also
conducts on-site examinations and off-site monitoring of financial institutions, carrying out
various examinations of financial institutions' capital, liquidity, and risk management, and
giving necessary advice. However, I believe that the recent global financial crisis has shown
that it is difficult to achieve financial system stability and to contribute to the sustainable
growth of the economy, which is the ultimate aim of financial system stability, relying only on
such regulation and supervision based on microprudential principles.
The first reason is that without considering the relationship between economic and financial
activities, it is essentially impossible to determine the optimal level of capital and liquidity
requirements. If absolute priority is given to financial system stability, then capital and
liquidity requirements inevitably have to be raised significantly, but the inherent role expected
of financial institutions is to engage in leveraging and maturity mismatches between assets
and liabilities. Financial institutions carry out financial intermediary functions with a certain
amount of capital, raising funds with short-term debt instruments and investing in long-term
assets, and provide value added through the provision of liquidity and settlement services. If
financial institutions cannot properly fulfill their financial functions, the economy will not grow.
Of course, in reality, a capital adequacy ratio of 100 percent is not required, but as
highlighted here, conventional regulation and supervision has also in fact been based on
some sort of macroeconomic assessment of the relationship between the financial system
and economic activity as well as the interaction between financial systems. However, I
believe that efforts to take such a macroeconomic perspective into account in a more
systematic manner have been insufficient.
The second reason why I think microprudence alone is insufficient is that financial
institutions' incentives are greatly affected by macroeconomic factors. On this point, I recall
the famous remark made before the surfacing of the subprime mortgage problem by the then
CEO of a major financial institution that "while the music is playing, you have to dance." If, in
the future, benign economic conditions similar to that time, namely high economic growth,
low inflation, low interest rates, and low market volatility continue for a long time, would
managers of financial institutions and investors choose different management and
investment strategies? Moreover, even if one were to choose a different strategy oneself,
what strategy would one expect competitors to take? Following this line of reasoning, it
becomes clear that there will always be someone who takes on the risks. Ultimately, the risks
in the financial system as a whole are affected not only by micro-level incentives but to a
great extent also by macro-level incentives, that is, the economic and financial environment.
If we follow this line of reasoning, in order to ensure the stability of the financial system,
microprudence, which secures the soundness of individual financial institutions, and
macroprudence, which pays attention to risks to the financial system as a whole, are both
equally necessary.
II. Macroprudential perspectives
There are various ways in which to assess risks in the financial system as a whole from a
macroprudential perspective, that is, from a perspective that pays attention to the
interconnectedness between economic activity, financial markets, and financial institutions'
behavior. Recently, two perspectives or "dimensions" have been recognized as important:
the first concerns the cross-sectional risk at a particular point in time, while the second
concerns the evolution of risk in the future.
The cross-sectional dimension
The "cross-sectional dimension" concerns risks in the financial system as a whole at a
particular point in time and particularly focuses on the interconnectedness of the risks of
each financial institution's portfolio and financial products. When the loans and investments
of a financial institution are concentrated in a specific industry, the financial institution
assumes a large risk. The concentration of loans to the real estate industry is a classic
example. And what goes for a specific financial institution goes also for the financial system
as a whole. Even if the exposure of each individual financial institution is not concentrated in
a specific industry, if many financial institutions are taking similar positions, the financial
system as a whole assumes a large risk. If there is a shock that affects the value of a specific
type of exposure, for example, the value of real estate, financial institutions will try to reduce
their exposure to such assets all at the same time, but when all financial institutions take the
same action, such a reduction of exposure will be difficult. Under these circumstances,
market liquidity of the assets in question and funding liquidity decline significantly, and that
will further exacerbate losses. Such herding behavior is called "crowded trade" and can arise
for a variety of reasons. While it typically arises through a convergence of market
participants' view of economic prospects, it can also be spurred by a convergence of risk
management methods. As financial techniques advance, the management of risk also
becomes more complicated. In this situation, the incentive for financial institutions that do not
have sufficient resources to develop their own risk management methods to adopt the risk
management methods developed by other financial institutions increases. When this kind of
situation becomes widespread, not only does financial institutions' exposure to types of
assets become similar, but market swings also become volatile as the timing of transactions
becomes more synchronized.
The time dimension
The second macroprudential dimension, the "time dimension," concerns dynamic changes in
risks, focusing on how risks inherent in the financial system change over time. In the run-up
to a crisis, as seen in the period prior to the recent crisis, benign economic conditions
continue for some time, economic actors become too optimistic in their risk assessment, and
their risk tolerance increases. As a result, as economic actors' risk-taking stance becomes
more aggressive, asset prices rise and leverage increases, leading to even more aggressive
risk-taking stances. Our understanding of such endogenous changes in the risk-taking
stance, that is, the risk-taking channel, is extremely limited. What is clear, however, is that
such changes are greatly influenced by the economic and financial environment, as I
mentioned earlier.
Financial imbalances that accumulate in the process of risk-taking cannot be sustained
indefinitely and eventually balance sheet adjustments will take place. Such adjustments
proceed gradually in the beginning. However, triggered by some kind of a shock, a crisis will
emerge in the form of funding liquidity shortages and become more severe as confidence
among market participants in each other collapses. This phenomenon that the profit-seeking
behavior of financial institutions amplifies the financial and economic cycle is referred to as
"procyclicality" and is another important dimension of assessment apart from the
aforementioned cross-sectional network perspective.
III. Approaches taking account of macroprudence
With the importance of macroprudence having been recognized, what sort of approaches
should central banks and regulatory and supervisory authorities take to protect the stability of
the financial system?
Monetary policy
First, it is necessary for the central bank to take a macroprudential perspective in the conduct
of monetary policy. Needless to say, the purpose of monetary policy is to contribute to
sustainable growth through price stability. Looking back at price developments in the past
quarter century, inflation gradually declined and it can be said that many central banks have
been successful in terms of achieving price stability. However, in terms of financial system
stability, the frequency of bubbles and financial crises has increased in the past quarter
century, with major episodes including Japan's financial crisis following the burst of the
bubble, the East Asian financial crisis, the credit bubble in the United States and Europe, and
the recent global financial crisis. Moreover, ironically, all these bubbles arose in an
environment of low inflation. While the causes of bubbles are complex, one major cause in all
cases has been the emergence of a sense, amid continued benign economic conditions of
high growth, low inflation, and low interest rates, that liquidity is always available at the drop
of a hat. While I do not think that accommodative monetary conditions alone can lead to a
bubble, it seems that it also cannot be denied that expectations of a prolonged
accommodative monetary environment lead to excessive leverage and maturity mismatches,
thereby accelerating the generation of a bubble. Price stability is an extremely important
policy objective for a central bank, but if a central bank conducts monetary policy by just
watching short-term price developments, this may induce large economic fluctuations and
result in harming price stability in the medium- to long-term. Although a frequently used
phrase in this context is that there is "a trade-off between price stability and financial system
stability," this should in fact be understood in the sense that the true trade-off lies between
"current economic stability and future economic stability." The intensified discussions
following the recent financial crisis on the appropriate monetary policy framework, including
discussions in countries that have adopted inflation targeting, reflect these considerations.
Therefore, in the conduct of monetary policy, it is necessary to get into the habit of assessing
the economy both through the lens of price developments and through the lens of financial
imbalances. This is exactly what the Bank of Japan with its assessment of monetary policy
from "two perspectives" aims at.
Financial supervision based on risk assessment of the financial system as a whole
Second, I would like to emphasize the importance of proper supervision. The experience of
the recent crisis reconfirmed that the behavior of financial institutions sometimes becomes
excessive, and proper supervision is necessary to prevent that from happening. In this
context, it is of course important for supervisory authorities to assess the soundness of
individual financial institutions by focusing on risks unique to those financial institutions and
to provide the appropriate supervision. In addition, it is also important to assess, while noting
the "dimensions" I have explained, the risk in the financial system as a whole and utilize the
information gained to conduct supervision of individual institutions. This may be a typical
example of "easier said than done," but it represents an unavoidable challenge.
Designing financial regulation and supervision
The third point concerns the design of financial regulation and supervision taking account of
a macroprudential perspective. Various discussions on this issue are going on at the moment
and one of them focuses on reviewing capital adequacy requirements from the perspective of
mitigating procyclicality. Concerning capital adequacy ratios for banks, one issue that has
been identified is the procyclicality caused by the decrease in credit risk during an economic
boom and the increase in credit risk during a recession, but profits and losses related to
financial market transactions show a similar procyclical tendency. When benign financial and
economic conditions continue for a certain period, the market risk being estimated by using
data obtained during that period is likely to underestimate the actual size of the risk. As a
result, during an economic boom, financial institutions lend aggressively as their capital
bases increase due to high profits, leading to further increases in lending through, for
example, a further rise in asset prices. Similarly, the reverse occurs during a recession.
Discussions are therefore underway on how to mitigate such procyclicality, with ideas
including the lengthening of the period assets are included in risk accounting to avoid
excessive fluctuation in risk-weighted assets and whether to introduce a framework for
countercyclical capital buffers. The underlying idea of such a framework is to implement
capital adequacy rules in a countercyclical manner by requiring financial institutions to build
up capital when economic conditions are favorable, which could then be drawn down when
economic conditions deteriorate.
I believe that proposals to use capital adequacy regulations to mitigate procyclicality and
reinforce capital bases go in the right direction and are likely to contribute to financial system
stability. However, from a macroeconomic perspective, it must be avoided that the
strengthening of regulations impairs economic stability. For this reason, it is important to
secure flexibility, for example, in the procedure and timing of the implementation of new
capital adequacy rules by taking financial and economic conditions in countries around the
world into account. In this regard, as also articulated in the consultative proposals for the
review of rules recently released by the Basel Committee, the new rules should be
implemented once financial conditions have improved and economic recovery is ensured.
The accounting system
The accounting system is also an element affecting the behavior of financial institutions in
addition to monetary policy and financial regulation and supervision.
The accounting system directly affects the assessment and profitability of assets held by
financial institutions. For instance, from autumn 2008, as the functioning of markets declined,
prices of securitized products fell all at once, leading to concerns about capital shortages at
financial institutions. This further paralyzed market functioning and intensified the downward
spiral. This course of events illustrated once more that the method of assessing financial
products and the accounting system overall affect financial institutions' behavior and the
financial system. Therefore, various international discussions are taking place to design a
system in the field of accounting that could contribute to financial system stability. For
example, it was shown that when market liquidity appeared to have dried up, it was possible
to value financial assets at prices calculated by models. There are also proposals regarding
a revision of loan loss provisions. The reason is that current accrual basis accounting
methods tend to reinforce procyclicality as banks' profits are rapidly squeezed when
economic conditions deteriorate because banks have to increase provisions. While
provisioning methods on the basis of expected losses, which allow for earlier recognition of
future losses, are currently being discussed, my view is that it is necessary to consider such
proposals from a variety of aspects, such as to what degree they would fulfill the intended
goal of mitigating procyclicality, whether they can be put into practice, and whether they will
be able to ensure transparency, which after all is the primary role of accounting.
IV. The role of the Bank of Japan
Having explained the role of macroprudence, I would now like to explain the role of the Bank
in ensuring stability of the financial system. I would like to emphasize the following five points
in particular.
The first point is that the Bank of Japan not only aims at price stability but also financial
system stability. The Bank of Japan Act clearly stipulates that one of the Bank's institutional
objectives is "to ensure smooth settlement of funds among banks and other financial
institutions, thereby contributing to the maintenance of stability of the financial system." The
fact that the Bank of Japan during the recent financial crisis decided to implement measures
that are extraordinary for a central bank, such as the purchase of stocks held by financial
institutions and the provision of subordinated loans, was ultimately to achieve the objective
stipulated in the Bank of Japan Act.
The second point is that the Bank plays the role of "lender of last resort." The Bank of Japan
is "the bank of banks" and can contribute to ensuring financial system stability by providing
funds as the lender of last resort when it judges this to be necessary to prevent the
materialization of systemic risk. To avoid that the provision of funds gives rise to moral
hazard, the Bank has clarified its basic thinking in the form of the so-called "four principles for
special loans."
The third point is that the Bank collects various types of information from financial institutions
to secure the objective of ensuring the stability of the financial system. While macroprudence
is important, as a prerequisite for that, microprudence is also critical. As long as the Bank
extends loans to financial institutions as the "lender of last resort," it needs to have sufficient
knowledge of financial institutions' business performance and the quality of their assets. For
this reason, the Bank of Japan Act grants the Bank the right to conduct on-site examinations
of financial institutions that have deposit accounts with the Bank. Of course, it is conceivable
that a situation arises where, by the time a financial institution comes to the Bank, it is
already too late. Therefore, in conducting on-site examinations, the Bank not only carries out
inspections but also provides various kinds of advice and guidance when the need arises. In
addition to conducting such on-site examinations, the Bank also strives to gauge the
business performance and risk management, such as the liquidity management, of a wide
range of financial institutions, including securities companies, through daily off-site
monitoring. At a time that financial markets are undergoing substantial changes, it is
important to have a channel for obtaining information directly from financial institutions -
something that was strongly reaffirmed in the phase from the autumn of 2008 onward.
The fourth point is that the Bank conducts risk assessments of the financial system as a
whole. The Bank analyzes and assesses the financial system as a whole from a
macroprudential perspective by making use of information from individual financial
institutions as well as information obtained through its daily monetary policy operations and
operation of the payment and settlement system. At the same time, the Bank strives to use
the macro-assessment obtained in this way to inform its on-site examinations and off-site
monitoring. However, although everyone would agree that integrating macro and micro
perspectives is an important task, to do this properly, research is indispensable. Because
they are charged with the conduct of monetary policy, the necessary organizational culture to
assess the economic situation based on macroeconomic analyses is well established within
central banks. As for us at the Bank of Japan, we will continue to attach great importance to
the information and insights we gather through on-site examinations, off-site monitoring, and
the Bank's banking business, and to strive to accurately gauge the risks to the financial
system as a whole through our macroeconomic analyses and research activities.
The fifth point is that the Bank is participating in the international discussions on regulation
and supervision and is engaged in the review of such regulation and supervision. Reflecting
the globalization of finance, there is a growing tendency for the broad framework of financial
regulation and supervision to be determined in international discussions. The Bank, together
with the Financial Services Agency (FSA), has been taking part in discussions on financial
regulatory and supervisory reform at various international forums such as the Basel
Committee on Banking Supervision and the Financial Stability Board, and I myself have been
attending many of those forums. Given that a robust global financial system is in the common
interest of all countries, I believe it is critical for each country to contribute to the construction
of internationally consistent rules and to establish a regulatory and supervisory framework
that properly reflects differences between countries, such as in their financial structure. The
Bank will continue to make contributions in these areas.
When comparing systems to ensure financial system stability immediately before the recent
crisis from a central bank's point of view, countries can be divided into two groups. In one,
which includes the United States, Italy, the Netherlands, and many Asian countries,
regulation and supervision was carried out by the central bank, either alone or in cooperation
with other authorities. In the other group, which includes the United Kingdom and Australia,
the central bank was not involved in regulation and supervision. Japan could be regarded as
falling in between these two groups: the Bank of Japan does not have regulatory authority
over financial institutions, but, as mentioned earlier, based on provisions in the Bank of
Japan Act, it conducts on-site examinations of financial institutions and provides various
kinds of advice and guidance when the need arises.
Financial regulatory and supervisory systems around the world have been decided upon
reflecting differences in countries' financial structure, stage of economic development, and
historical background, and thus there is no uniform set-up that is correct for all countries. Be
that as it may, the recent crisis has shown clearly that it is indispensable for central banks to
be involved in one form or another in ensuring the stability of the financial system and that
central banks should play a significant role in the area of macroprudential supervision. Here
in Japan, we have a system where the FSA, which is in charge of financial administration
dealing with regulation and supervision, and the Bank of Japan, which is the central bank,
cooperate with each other and each fulfills its respective functions to ensure the stability of
the financial system. While it seems fair to say that Japan's financial system has remained
relatively stable compared with those of the United States and Europe during the recent
crisis, the Bank will, in cooperation with the FSA, continue to strive to ensure the stability of
the financial system.
Closing remarks
In closing, I would like to say a few words about the importance of information infrastructure
in ensuring financial system stability. In order to analyze the financial system as a whole, it is
essential to have information that is accessible to investors and other market participants. On
this point, disclosure regarding risks inherent in individual financial institutions and specific
financial products is critical. In addition, from a macroprudential perspective the importance
of statistics that cover financial markets as a whole needs to be underscored. At the
beginning, I pointed out as one of the causes of the recent global financial crisis the widening
of maturity mismatches at financial institutions with regard to liquidity and the lack of a habit
to check such developments on a ma