Masaaki Shirakawa: Some thoughts on incentives at micro- and
macrolevel for crisis prevention
Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Eighth Bank for
International Settlements, Annual Conference, Basel, 26 June 2009.
* * *
Introduction
The current financial and economic crisis has posed wide-ranging challenges to
policymakers and academics. Already, various proposals have been made for the reform of
financial supervision and regulation. The traditional approach in this area is based on a
microprudential perspective. From that perspective, financial system stability will be achieved
by assembling sound financial institutions with adequate capital and liquidity positions as well
as proper risk management.
That approach certainly plays an important role, but I am still uncertain whether the
cumulative efforts in that approach will eventually ensure the financial system being shielded
from a future crisis. In fact, the financial regulatory and supervisory framework was
reformulated from the microprudential viewpoints every time a financial crisis occurred.
In that respect, I will raise two questions. The first question is: "Has legally effective netting
contributed to reducing the overall degree of risk in the financial system?" It is true that
netting is effective in reducing counterparty risk. However, once the risk is reduced to a
certain degree, a financial institution tends to take further risk. As a result, it is still not certain
whether netting contributes to reducing aggregate risk.
The second question is: "Will a financial institution take a different business strategy not to
expand its leverage when facing again a benign economic condition, comprised of low
inflation, high growth, and low interest rates?" Some financial institutions will surely take a
conservative strategy, considering the lessons from the current crisis. But, most financial
institutions will find it hard to resist pressures from equity holders to raise the returns on
equity under severe competition.
Those examples seem to show the need for analyzing the incentives of financial institutions
from the viewpoints of the macro- as well as micro-level. Incentives for a financial institution
are underpinned not only by the framework for financial regulation and supervision at a micro
level but also importantly by the financial and economic environment at a macro level. At a
micro level, "too big to fail" is the single most important issue. At a macro level, monetary
policy is important. Today, I will mainly focus on monetary policy responses to a bubble.
Then, I will briefly touch upon some issues on supervision and regulation.
Importance of risk-taking channel
Before the current global financial crisis, the majority view about the monetary policy
responses to a bubble can be summarized into two points. First, before the burst of a bubble,
monetary policy should respond to asset price movements, whether driven by the
fundamentals or not, only to the degree that those movements have implications for future
inflation and economic growth. Monetary policy should not go beyond that or should not step
into "extra operations," by which I mean a policy decision to intentionally deviate from a
monetary policy rule, like the Taylor rule. Second, in contrast to the bubble period, central
banks should be proactive after the burst of a bubble. Monetary policy should carry out
"mopup operations" aggressively responding to the adverse effects stemming from the burst of a
bubble. This line of argument is generally premised on the assumption that a bubble is very
difficult to be identified on a real time basis, and that a preemptive action by monetary policy
alone is likely to require a large hike in interest rates, thus exerting a devastating adverse
impact on economic activity.
To discuss the monetary policy responses to a bubble, it matters a great deal how to
understand the transmission mechanism of monetary policy. The recent monetary policy
analysis, based on new Keynesian macroeconomics, explores optimal monetary policy to
stabilize inflation and output. The declines in volatility of inflation and economic growth
themselves certainly improve the economic welfare, but dynamics in the economy do not
stop there. Once macroeconomic stability is achieved, another transmission channel outside
the standard New Keynesian macroeconomics gets crucial. That is often referred to as the
"risk-taking channel" of monetary policy.
More precisely, risk perception and risk tolerance of economic agents change gradually but
steadily under benign economic and financial conditions, thereby affecting their risk-taking
behavior. That induces an expansion of credit and leverage at financial institutions, and
results in the accumulation of financial imbalances behind the scenes. Such imbalances
abruptly manifest themselves by some shock when the imbalances exceed the critical point.
As a result, the financial system becomes unstable, and economic activity deteriorates
significantly.
We see various forms of risk-taking channel. First, it appears as maturity mismatches. When
the interest rates are reduced, financial institutions expand maturity mismatches by
shortterm funding and long-term lending. That eases liquidity constraints in the non-financial
private sector, thereby stimulating economic activity. Financial institutions also create
maturity mismatches on their off-the-balance-sheet, for example, by investing in structured
credit products through structured investment vehicles (SIVs). In addition, financial
institutions generate maturity mismatches beyond the national border, as witnessed in the
surge in cross-border lending during the credit boom preceding the current crisis.
Second, the risk-taking channel appears as an increase in asset prices. The availability of
funds directly influences asset prices, and, more importantly, it also influences asset prices in
an indirect way by influencing market liquidity of particular assets. As the availability of funds
improves and more investors participate into the markets, the market transactions become
easier in both sale and purchase, thus expanding market liquidity at an accelerated pace.
The increases in asset prices and the expansion in market liquidity enhance the risk
tolerance capacity of investors, thereby pushing asset prices further upward. Economic
activity is consequentially stimulated.
In addition, the two forms of risk-taking channel just I mentioned interact with each other. The
expansion of maturity mismatches, generally associated with the expansion of leverage,
stimulates asset prices, and higher asset prices, in turn, facilitate the expansion of maturity
mismatches and leverage.
Considering the risk-taking channel, it is crucially important to realize two points in
formulating monetary policy. First, banks play an important role as a mediator of transmitting
the effects of monetary policy. In this context, the behavior of banks influences the economy
significantly, regardless of the share of the banking sector in financial intermediation. During
a period of interest rate reduction, for example, expansions in maturity mismatches and
increases in asset prices are observed on a bank's balance sheet. When the cycle is moving
upward under benign economic and financial conditions, the amplification process between
maturity mismatches and asset prices takes place very gradually but steadily, and, in any
case, the risks in the financial system are unlikely to manifest themselves. Once the cycle is
reversed, however, the situation deteriorates suddenly. Maturity mismatches exaggerate the
shortage in funding liquidity. In addition, the sharp declines in asset prices result in losses,
possibly inducing a shortage in capital, and the deterioration in market liquidity, thereby
provoking a further shortage in funding liquidity due to margin calls and lowered collateral
values. Those developments eventually hit banks' balance sheets.
Second, there exists an asymmetry between the upward and downward phases. Although
the upward phase proceeds gradually, the downward phase proceeds in an asymmetrically
quick manner, since banks are forced to take immediate action to counter the shortage in
funding liquidity. In addition, once confidence is lost, it takes a long time to restore the eroded
confidence. As market participants explain, the credit line can be cut off at once, but the
reestablishment of the credit line takes a much longer time.
Issues related to monetary policy
Mop-up operations
Given the understanding on the risk-taking channel I have discussed so far, what
consequences will follow from the asymmetric monetary policy responses before and after
the burst of a bubble? Suppose a central bank is considered to make a commitment to
refrain from taking any monetary policy responses until the burst of a bubble, the private
agents will surely take action based on such unfounded expectations. That will accelerate
maturity mismatches and asset price increases, thus further accelerating the bubble and the
adverse consequences of its burst.
One of the basic messages from standard New Keynesian macroeconomics is that "the
policy commitment is effective in stabilizing the economy, given the forward-looking behavior
in the private sector." Standard New Keynesian macroeconomics does not incorporate the
risk-taking channel, but its basic message suggests the importance of the symmetric
monetary policy responses to a bubble.
Extra operations
Then, what is an idea about extra operations against a bubble? I agree with the principle that
monetary policy should respond to asset price movements, whether driven by the
fundamentals or not, only to the degree that those movements have implications for future
inflation and economic growth. I should also say that the real issue here is how to understand
the expression of "only to the degree that asset price movements have implications for future
inflation and economic growth" in implementing monetary policy.
The transmission dynamics of the risk-taking channel, I have just mentioned, differs
significantly from those of the standard interest rate channel through housing investment and
capital investment. The risk-taking channel produces asymmetric effects between the initial
positive impact and the later negative impact. And, more importantly, it also accompanies
considerable uncertainty about the timing when negative impacts occur. Given such nature of
the risk-taking channel, conventional macroeconomic models in a central bank's toolkit do
not sufficiently incorporate the effects stemming from maturity mismatches and asset prices
in the short term as well as in the longer term.
Policy challenges for central banks
In light of the previous discussion, I will raise some issues for discussion regarding the
actions by central banks.
Monetary policy responses to a bubble
The first is monetary policy responses to a bubble. That issue is often debated simply as
whether monetary policy should lean against the wind or excessive asset price increases.
However, I believe that such a way of addressing the issue just confuses the discussion. No
central banker believes that a bubble can or should be prevented by monetary policy alone.
A more proper way of addressing the issue would be "how should monetary policy be
conducted in an environment in which all the symptoms of the economy except for inflation
signal a need for policy tightening: asset prices are rising, credit and leverage are increasing,
maturity mismatch is widening, and the economy is being overheated, while only inflation
remains low and stable?" My answer is that monetary policy responses are needed anyway,
and it is just semantic whether to call them extra operations. I should hasten to add that the
build-up of excesses, of course, cannot be contained by monetary policy alone, and needs to
be addressed by a combination of policy measures. That leads me to the second issue of the
role of policy measures other than monetary policy.
Two objectives and two instruments?
It is often argued that achieving the two objectives, price stability and financial system
stability, requires two policy instruments. Active discussions are continuing regarding the
need for developing prudential policy measures, including the countercyclical implementation
of minimum capital adequacy requirements. I completely agree with the necessity of
developing prudential policy measures. Having said that, I am wondering whether it is valid to
employ the Tinbergen principle in this context.
The two objectives are not independent but closely connected with each other. It does
appear that an intra-temporal trade-off exists between current price stability and current
financial system stability. However, a real trade-off does exist in an inter-temporal direction
between the current economic stability and the future economic stability. If that is the case,
financial system stability and price stability are not independent objectives, but just differ in
the time-horizon. I should say that central banks need one large toolkit to achieve one large
policy objective, rather than need two policy instruments for the two objectives.
Versatility of regulation
The third is regulatory and supervisory issues at a micro level. Among various issues for
discussion, I will focus on the versatility of the regulation to fit a variety of financial
institutions. On the one hand, heterogeneity in financial institutions is quite important in
enhancing the robustness of the financial system against shocks. On the other hand,
onesize-fits-all treatments of heterogeneous financial institutions in designing prudential
regulation, such as capital adequacy regulation and liquidity regulation, entail a risk of
deteriorating the robustness of the financial system.
If regulatory capital is set at the level above economic capital, pressures on financial
institutions from equity holders to earn sufficient profits become all the more intense. As
financial history tells, too much as well as too little capital has caused problems. That is,
excess capital is likely to induce a pile-up of financial imbalances. If a risk measurement
framework is inappropriate, and minimum capital requirements based on such a risk
measurement framework are excessively high, that will produce perverse incentives for
individual financial institutions, resulting in a trigger for macroeconomic instability.
Capital and liquidity positions for financial institutions depend crucially on the business
model. A business model for financial institutions varies according to countries, or times,
institutions. The issue here is the ability of regulatory authorities to assess the business
model. Given differences in business model, redesigning capital adequacy regulations is an
important challenge, along with the conduct of monetary policy.
Closing remarks
In closing, I ask myself what are the determinants of the amount of economy-wide risk-taking
after all. There is no simple answer. Yet, I believe both micro and macro approaches are
needed for preventing a future crisis.