Kiyohiko G Nishimura: Unconventional policies of central banks -
restoring market function and confidence
Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel
Session "Monetary Policy Boundaries: Alternative Instruments and Policy Coordination" at
the Money and Banking Conference 2009, Central Bank of Argentina, Buenos Aires,
1 September 2009.
* * *
Thank you, Chairman. It is an honor to be invited to this prestigious conference, and I am
very grateful to Governor Redrado and the colleagues of the Central Bank of Argentina. I am
particularly delighted, literally thrilled, to come to Argentina, the land of silver and
warmhearted people, for the first time in my life.
The topic of this panel, "Monetary Policy Boundaries: Alternative Instruments and Policy
Coordination" is particularly timely, since many central banks including the Bank of Japan
have already crossed conventional boundaries. They have been conducting unconventional
policies since the current crisis erupted a couple of years ago. Some call them credit easing,
and others describe them as quantitative easing. This kind of nomenclature is eye-catching,
but it is sometimes a distraction, hiding the real picture of what the central banks have done.
In fact, if we look at these unconventional policies from a functional viewpoint, they all have
this in common: the desire to counteract market dysfunction and confidence erosion.
In this short presentation, I will first explain what we, the major central banks have done to
prevent market meltdown. Then, from this experience, I will extract four practical principles of
unconventional policies that should be borne in mind. Finally, based on these principles, I will
point out possible fallacies in assessing these unconventional policies, especially at the time
economic conditions improve and seem to offer a glimmer of light at the end of the tunnel.
Specifically, I will present five Don'ts for your consideration in contemplating a way out from
the emergency measures.
1. One prerequisite of conventional monetary policy: smoothly functioning
financial markets
To start the discussion of unconventional policies, it is worth taking a few moments to
consider what conventional monetary policies are.
Two pillars of smooth-functioning financial markets
In a stylized framework of conventional monetary policies in developed countries, we take
well-functioning financial markets for granted. There are two pillars supporting their smooth
function. First, the various segments of the financial markets are integrated well through
smooth inter-market arbitrage, and thus we have relatively stable inter-market relationships
of interest rates called yield curves. Second, market participants have confidence in the
markets and thus counterparty risks are contained well.
Assuming these well-functioning financial markets, the central bank sets the policy rate at a
level consistent with its stated goal of price stability (and possibly other goals which vary with
countries). The bank manages its liquidity provision to ensure that short-term market interest
rates are in line with the policy rate. The change in the policy rate affects the yield curve
structure with term and risk premiums. In this way, the central bank affects financial markets
and financial intermediation, and ultimately exerts influence on prices and economic activity.
Thus, well-functioning financial markets are prerequisites of conventional monetary policy. In
fact, the functional breakdown of financial markets is the major culprit leading central banks
to take unconventional measures. We learned this fact from Japan's so-called Lost Decade
more than a decade ago and more strikingly, more painfully, from the current global financial
turmoil.1
Three phases of financial markets' functional breakdown in the current crisis
Let me briefly explain how markets stopped functioning in many countries in the current
crisis. Roughly speaking, there were three phases, though their timing and severity were
different from country to country. In the first phase, confidence in the markets was lost. The
failure and the fear of failure of large international financial institutions made market
participants fearful of the possibility of the failure of their counterparties. Counterparty risks
were heightened and spread rapidly from market to market. In the second phase, we saw a
severe dearth of arbitrage activities and consequent dislocations in many markets. Financial
markets became severely segmented and some specific markets, such as the US
assetbacked securities markets, collapsed. Prices no longer provided sufficient information about
market conditions. In the third phase, severe strains on financial markets and banking
systems hampered financial intermediation as the losses on non-performing, legacy or toxic
assets mounted, and thus a negative feedback loop kicked in between financial strains and
real economic slumps. In short, the conventional monetary transmission mechanism broke
down.
2. Unconventional policies: coping with market dysfunction and confidence
erosion
Given the severe adverse effects of market dysfunctions, the utmost policy priority of central
banks was to find a way to alleviate market dysfunctions and thus to enhance financial
intermediation, thereby restoring the monetary transmission mechanism. This is what
unconventional policies are all about. This means unconventional policies are not exotic but
extensions of conventional policies. However, central banks had to go beyond their traditional
role as a liquidity provider, and to engage themselves in complementing and enhancing
market functions.2
Central banks' response to market dysfunction
This was in fact what four major central banks (Fed, ECB, BOE, BOJ) and others did during
the last two years in addition to a series of policy rate cuts down to the proximity to zero.
Market dysfunctions and severe strains on a banking system significantly reduced the
effectiveness of an ultra-low policy rate, which was evident in our experience of Japan's lost
decade. Thus, unconventional policies were devised and implemented essentially as
measures to support and enhance the effects of ultra-low policy rates on prices and
economic activities.
First, in order to ease confidence erosion and tension in money markets, the central banks
conducted ample and enhanced liquidity provision by offering more frequent operations, to
more counter parties, at longer maturities, and against broader collateral. This was more
applicable to the period of August 2007 to August 2008.
Then, as the erosion of confidence intensified after the failure of Lehman Brothers and
market dysfunctions and financial distress became more pronounced, the central banks
began intervening in specific market segments to support market functioning by measures
including the introduction and expansion of asset purchase programs for commercial papers,
corporate bonds and government debts. Also, the Fed expanded swap lines with other
central banks to enable other central banks to provide further dollar liquidity. This was what
largely took place in the period from September 2008 to March 2009.
Currently conditions in money markets have improved and investors' appetite for risk has
recovered to some extent and accordingly usage of some market-supporting facilities such
as the Fed's and BOJ's commercial paper programs has declined markedly.
As an example of central bank policy actions in this financial crisis, I summarize what the
BOJ did in the last two years in Chart 1. You can find a similar and sometimes longer list of
policy actions at other central banks.
Four practical principles to cope with market dysfunctions
Unconventional policies entail microeconomic intervention and explicit risk-taking by central
banks. Thus, these policies should satisfy two basic criteria. First, the benefits of market
intervention should outweigh the costs of distorting resource allocation. Second, central
banks should have a sufficient capital buffer of their own and appropriate burden-sharing
agreements or understandings with the government to guard against possible credit losses.
The latter is of the utmost importance to maintain central banks' credibility in pursuing price
stability.
Besides these considerations, there were four practical principles in considering
unconventional policies, which produced both differences and similarities among countries.
Principle 1. Select and concentrate
Although dysfunction was widespread, it was clear that no central bank had the operational
capacity and capital buffer to intervene in all markets showing dysfunction. It was also
evident that some markets were more important than others for the purpose of restoring the
monetary transmission mechanism. Thus, the first practical principle is to select the most
important markets and most cost-effective interventions, and to concentrate on them.
In practice, this required cross-checking of bottom-up and top-down considerations. Bottom
up, we started by examining the degree of dysfunction of particular financial markets, and
then determined specific target segments of the markets for intervention. We worked out our
specific intervention conditions and possible exit mechanisms. At the same time, top down,
we carefully examined the pros and cons of allocative distortion, resource constraints and
operational capabilities of the central bank, and capital constraint of the central bank if the
intended measures exposed it to market and credit risks. The cross-checking of these two
was particularly effective.
The immediate corollary of this principle is that, firstly, the nature and the magnitude of a
particular central bank's market intervention depends on the nature and the magnitude of its
country's financial market breakdown, and secondly, the resulting increase in the balance
sheet of a central bank differs considerably from country to country. Table 1 reports
crosscountry differences in corporate finance. In the United States, securities markets were far
more important than in Japan, and even financial institutions depend heavily on CP markets
for their own finance. And the collapse of securities markets was widespread. Thus, the Fed
was obliged to undertake massive and wide-ranging intervention. In contrast, the strain on
the Japanese securities markets was mostly contained in CP and corporate bond markets,
and we saw a relatively smooth transition from security market funding to bank borrowing.
Consequently, the Bank of Japan's market intervention was limited to CP and corporate bond
markets, indirectly through the banking system, which was still functioning relatively well
(Item 3 of Chart 1, measures to facilitate corporate financing). Consequently, the Fed's
increase in balance sheets is far greater than the Bank of Japan's, which is depicted in Chart
2. Europe's structure of corporate finance is closer to Japan's, so the ECB's increase in
balance sheets was similar to the BOJ's.
Principle 2. Avoid further dysfunction
When we are coping with market dysfunction in some markets, it is counterproductive to take
action that undermines the functioning of other markets. That is, no policy measure should
damage the incentive to trade actively in financial markets, especially if these markets' full
functioning is prerequisite for normalcy. The decision taken by many central banks to have a
policy rate close to, but sufficiently above, zero is based on this consideration.3
Principle 3. Provide safety nets
The current financial crisis has shown how devastating the erosion of market confidence can
be. When confidence is eroded, investors are "excessively" averse to uncertainty (or the
socalled unknown unknowns), and become sensitive to any news having some bearing on the
worst possible case scenario.4 Actions that may be rational at the level of individual market
participants can lead to a "fallacy of composition," which prevents the markets from restoring
their functions. Even worse, functional breakdown and confidence erosion aggravate each
other. In this respect, a safety-net facility, which works like a put option to mitigate damages
that would be incurred in the worst possible case, is likely to reduce the degree of this
"excessive uncertainty aversion."
The measures to secure stability of the financial system (Item 4 of Chart 1) were intended to
be the safety-net measures we are discussing here. Japanese banks held sizable amounts of
corporate stocks, which turned out to impose serious risks when stock prices went down
sharply. The Bank of Japan resumed purchases of stock held by financial institutions and
began to provide subordinated loans to banks. These were measures to help banks to
reduce stockholding risk by selling their cross holding, and to improve their capital positions
when they thought it was necessary. In addition, to some extent, ample liquidity provision
(Item 2 of Chart 1) could also be considered as a form of safety net. Also, outright purchases
of CP and Corporate Bonds from eligible financial institutions (in Item 3) had this safety-net
feature. Similar safety-net measures were also found in many countries.5
Principle 4. Design measures to be self-fading as conditions improve
Unconventional policy measures entail possible side effects distorting resource allocation.
They also impose financial risks and possibly reputation risks on central banks. Accordingly,
these unconventional measures should be temporary and designed to unwind themselves as
market functions improve. We describe measures with this inbuilt characteristic as
selffading.
Some of the unconventional measures I have outlined have this characteristic. For example,
the term of outright purchases of CP and corporate bonds is substantially higher than the
"normal" one, though lower than that in distressed conditions. Therefore, as conditions
improve, market participants find it unprofitable to use these facilities, as exemplified in the
recent decline in the usage of these facilities.
3. Five don'ts in assessing unconventional policies
Many of these unconventional policies are emergency measures: they are implemented as
measures to enhance the effects of ultra-low policy rates on prices and economic activities
under the condition of severe financial market dysfunctions. Thus, when market conditions
improve, many of them will eventually be terminated. However, timing and sequencing are
crucial: financial markets may still be severely segmented even though inter-market arbitrage
starts again. Market participants' confidence may be still fragile. In such circumstances, it is
absolute necessity to avoid fallacies and misinterpretations with respect to assessing
unconventional policies. I will present five Don'ts in order to avoid the fallacies which might
otherwise mislead us.
(1) Don't take the central bank's balance sheets as a measure of monetary easing
First, do not assume the size of the central bank's balance sheets is indicative of the degree
of monetary easing. Many unconventional policy measures are designed to be selective and
are tailored to a specific market dysfunction. Thus, there is no common yardstick evaluating
all market intervention. Moreover, the usage of unconventional policy facilities declines as
market functions improve. Shrinkage of a central bank's balance sheet reflecting this
mechanism should not be interpreted as a monetary tightening but rather as a sign of
improving market conditions.
(2) Don't look only at the segments of financial markets subject to intervention
Second, do not look at the conditions of only those segments of financial markets where
intervention has taken place. In fact, there might be spill-over effects to other segments.
Given resource and capital constraints, the central banks target their market interventions
quite specifically. However, in so doing, central banks expect positive spill-over effects to
other segments not so targeted. A good illustration of this lies in Japanese CP markets. We
see improvements, as expected and hoped for, in the A2-rated CP market even though they
are not eligible for the BOJ's purchase program. The A2-rated CP market is apparently
affected by our purchase of A1-rated CP.
(3) Don't underestimate safety nets
Third, do not underestimate the beneficial effects of safety-net measures especially when
investors' confidence is fragile. When market confidence is eroded, investors are
"excessively" averse to uncertainty and tend to "wait and see" until they feel more confident
about making market transactions. A "safety net" facility has some of the characteristics of
insurance or put options and thus substantially reduces this sort of uncertainty. Just as
insurance is an umbrella for unexpected rain, a safety net builds confidence whether or not
dire events come to pass. An underutilized facility does not necessarily mean it is ineffective
or useless.
(4) Don't ignore heterogeneity among countries and regions
Fourth, do not ignore heterogeneity among countries and regions. It is not the case that
every country should follow a common sequence of policies to exit from unconventional
policies. Economists, including me, have a tendency to ignore statutory differences and
institutional subtleties among countries and regions, to get clear-cut empirical results and
policy recommendations. There are always pitfalls in this tendency, which we should be very
careful to avoid.
At the outset of my presentation, I described a stylized framework of conventional monetary
policy that assumed well-functioning financial markets. However, in fact, the description of
well-functioning financial markets there is an idealized one, not always true even for
developed countries. For example, Japanese financial markets experienced temporary
segmentation in some segments from time to time even before the current crisis, and the
BOJ conducted painstaking market operations. An immediate corollary of this is that an
unconventional policy in one country is not necessarily unconventional in other countries.
The outright purchase of government bonds is a case in point. The Fed stated the purpose of
purchasing longer-term Treasury securities is "to help improve conditions in private credit
markets" in March 2009; the BOE conducts its purchase of gilts as a means of "Quantitative
Easing." However, the BOJ has been conducting outright purchases of Japanese
governments bonds as a traditional tool of market operation, to provide longer-term liquidity.
(5) Don't assume a return to the way it was
Now I come to the last of the five Don'ts: Do not assume we will return to "the way it was."
Although the collapse of the global financial markets took place in a surprisingly short period
of time, their rebuilding and restructuring is likely to be a long and slow process. The
"normalcy" to which we are returning is the one in which rebuilding and restructuring are still
under way. Moreover, "the way it was," that is, as financial markets were before the crisis,
with high leverage and dubious securitized products, has been shown to be unsustainable.
We live in a world of irreversibility, a world in which we cannot undo what we have done. Both
financial markets and real economies have changed in an irreversible way. Now we have to
be flexible enough to adjust ourselves to this changing reality. Thank you for your kind
attention.
(Chart 1) BOJ's Policy Actions (Selected)
1. Reductions in policy interest rate
3. Measures to facilitate corporate
0.5% ⇒0.3% (Oct. 08)⇒0.1% ( Dec.08)
financing
• Increase in frequency and size of CP repo
operations (Oct. 08)
2. Measures to ensure stability in
• Introduction and expansion of special
financial markets
fundssupplying operations to facilitate corporate
• Introduction and expansion of US dollar financing* (Dec. 08, Feb. 09)
fundssupplying operations (Sep, Oct. 08)
• Introduction of outright purchases of CP from
eligible financial institutions (Jan. 09)
• Increase in outright purchases of JGBs
14.4 trillion yen/year⇒16.8 trillion yen/year (Dec.
• Introduction of outright purchases of corporate
08)⇒21.6 trillion yen/year (Mar. 09)
bonds from eligible financial institutions (Feb.
09)
• Expansion of the JGB repo (Oct. 08) and securities
lending facility (Oct. 08, Feb .09)
• Expansion in the range of corporate debt as
• Introduction of complementary deposit facility (Oct. eligible collateral (Dec. 08)
08)
4. Measures to secure stability of
• Broadening eligible collateral for funds supplying
operations (Jan, Feb, Apr, May 09)
financial system
• Resumption of stock purchases held by
(Chart 2) Central Banks' Balance Sheets
Jun. 2007=100
350
300
BOJ FRS
ECB BOE
250
200
150
100
50
Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Jul-09
(Table 1) Funding Sources of corporate finance
(Amount outstanding, billion USD, End of 2007)
CP, Bonds (A) Loans (B) Ratio (A/B)
Japan 706 2,935 24%
USA 3,872 2,937 132%
Europe 1,015 10,995 9%
UK 706 2,290 31%
Sources: BOJ, FRB, ECB and ONS.
BIS Review 102/2009 7