Takehiro Sato: Macroprudential policy and initiatives by the Bank of
Japan
Speech by Mr Takehiro Sato, Member of the Policy Board of the Bank of Japan, at the Japan
Society, London, 12 November 2014.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
Thank you, Mr. Fraser, for your kind introduction. Distinguished guests and members of the
Japan Society, I am truly honored to have this opportunity to speak to you.
Today, I will talk mainly about the Bank of Japan's initiatives on the prudential front, focusing
on macroprudential policy rather than microprudential.
Microprudential policy aims to ensure the financial soundness of individual financial
institutions. By contrast, macroprudential policy aims to ensure the stability of the financial
system as a whole by analyzing and assessing risks within that system and formulating,
based on the findings, institutional designs and policy responses to mitigate such risks.
Microprudential measures to prevent the failure of individual financial institutions are
important in that they can address signs of risk that will threaten the stability of the entire
financial system. Based on the efficacy of microprudential measures, macroprudential
measures focus on avoiding a situation in which vulnerability arising from the interaction
among the real economy, financial markets, and financial institutions makes the entire
financial system unstable.
A central bank conducts monetary policy with the aim of achieving price stability, and
monetary policy is not directly aimed at ensuring financial system stability. However, as I will
explain later, there is a close relationship between monetary policy and financial system
stability. Once the functioning of the financial system is significantly impaired following the
bursting of a bubble, the effects of monetary policy will be largely restrained. It is becoming
clear through recent studies that an economic trough following a financial crisis tends to
become deeper and last longer than troughs arising from different situations.1 Taking that into
account, there has been a growing tendency worldwide to place greater emphasis on
macroprudential policy since the global financial crisis. The Bank of Japan has been placing
emphasis on a macroprudential perspective in its conduct of monetary policy since before
the crisis.
In today's speech, I will share with you my views on the issues regarding the implementation
of macroprudential measures, and then elaborate on the Bank's initiatives on the
macroprudential front. Lastly, I will touch on the recent conduct of monetary policy by the
Bank of Japan.
I. Issues involved in implementing macroprudential measures
As I mentioned earlier, macroprudential policy aims to ensure the stability of the financial
system as a whole by analyzing and assessing risks within that system and formulating,
based on the findings, institutional designs and policy responses to mitigate such risks, with
particular attention paid to the interaction among the real economy, financial markets, and
financial institutions. In view of the experience of the global financial crisis, in addition to the
analysis and assessment of risks in the overall financial system, a macroprudential
perspective has been actively adopted worldwide in institutional designs and policy
responses.
For example, countercyclical capital buffers (CCBs) are to be introduced, as stipulated in the
Basel III requirements. They aim to limit financial institutions' excessive risk taking by
requiring an increase in their capital at the time of credit expansion. They also are expected
to function as a buffer when losses are actually incurred. Other types of policy measures aim
at containing systemic risk arising from credit expansion and overheating of demand by
imposing direct regulations on credit expansion by financial institutions, such as limits on
total credit supply, loan-to-value (LTV) caps, and debt-to-income (DTI) limits (Chart 1). Some
countries and regions have already introduced those measures and have produced policy
effects.2
In Japan, such macroprudential measures were taken in the past. One example is the
quantitative ceiling on banks' real estate loans, which was set in 1990 to contain the
excessive growth in bank lending to the real estate sector by keeping the growth rate of such
loans to a level equal to or below that of total bank lending. Regardless of how the ceiling
was categorized at that time, it now can be considered a macroprudential measure.3 The
measures I have mentioned so far are regarded as typical macroprudential measures.
However, other measures - that is, those which already have been implemented, such as
on-site examinations and inspections of individual financial institutions and oversight of
payment and settlement systems - should also be conducted, taking into account a
macroprudential perspective, in cooperation with the relevant parties.
Let me turn to the issues regarding the implementation of macroprudential measures. I
believe there are three (Chart 2). First, it is important to implement - with appropriate timing
- policy measures that are considered effective, among a wide range of choices, in
containing financial imbalances that have been identified at that time. In that regard, an
empirical study shows that a failure to get the timing right can push down the average level of
economic activity and increase its volatility.4 It has been pointed out that the implementation
of the quantitative ceiling on banks' real estate loans in 1990 was too late to contain
excessive hikes in land prices when it was necessary, and instead, once land prices turned
to a decline, the policy implementation ended up accelerating the decline in land prices.5 To
be sure, it is recognized that the timing of the implementation is of critical importance, but it
seems that there is still not enough understanding as to how to identify financial imbalances,
which is the premise of such implementation. That might be because the buildup of
imbalances that threatened the financial system and the ensuing collapse occurred through
different mechanisms in each instance in the past. At any rate, it is a significant challenge to
first gauge on a real-time basis whether the imbalances that could lead to systemic risk are
emerging within the financial system, and then to judge the timing of policy implementation.
Second, and related to the first issue, there is difficulty of communication to the public at the
time of policy implementation. It is difficult to prove "in advance" the rightness of the policy
authorities' judgment about emerging signs of financial imbalances. The difficulty in noticing
the signs of financial imbalances with certainty at the same time suggests the difficulty in
persuasively arguing for the need for a policy response to such signs. Even though the
financial authorities are able to judge, based on their analysis and experience, that signs of
financial imbalances are clear, they might be unable to gain sufficient support from
stakeholders at an early stage regarding the need for a policy response. Or, if the authorities
wait until the buildup of financial imbalances becomes clear in many people's eyes, the
timing of policy implementation could be too late.
At one point, in international discussions following the global financial crisis, there were
divided views. One view was that it was necessary to identify financial imbalances in
advance as early as possible and address them. The other view was that it was difficult to
identify such imbalances in advance, and therefore it was enough to address them after the
bursting of a bubble actually occurred. That division suggests the difficulty in policy judgment
and communication mentioned in the first and second issues. At present, many countries
design their institutions and policy frameworks with the intent to work to identify financial
imbalances as early as possible and take action, although there is some degree of difference
among countries.
Third, it is also difficult to find a way to prevent the leakage of policy effects. Regulatory
arbitrage is one example. Even though regulated banks reduce their lending in response to
certain measures, policy effects could be offset if reduced lending amounts are provided
instead by non-regulated financial institutions such as shadow banking institutions. The same
was true for Japan's quantitative ceiling on banks' real estate loans, which I mentioned
earlier. If regulations are to be imposed on a wide range of shadow banking institutions to
minimize the leakage of policy effects, cooperation among several other authorities is
considered to be necessary. Without full cooperation, policy effects might be diminished.
There also could be a vicious cycle in which advancements in financial technology give rise
to new financial products that are not subject to regulation. The authorities will respond to
that by expanding the scope of regulation, but other new products will still emerge. In the
future, it may become necessary to facilitate international regulatory coordination under free
capital mobility.
II. The Bank's initiatives on the macroprudential front
With those three issues in mind, I will now elaborate on the Bank's initiatives on the
macroprudential front. In Japan, reflecting the emergence of the asset bubble in the late
1980s and its subsequent bursting, a number of measures were taken from the late 1990s to
the early 2000s. Those measures include the establishment of the Financial Services Agency
(FSA), the amendment of the Bank of Japan Act with a clear statement of its on-site
examinations, and the formulation of a crisis management framework. At present, on the
basis of those, the FSA - which is legally authorized to conduct industry-wide supervision
and inspections - and the Bank - which contributes to financial system stability, such as
through the "lender of last resort" function - take the initiative in carrying out macroprudential
policy. They fulfill their respective functions in monitoring risks and financial imbalances in
the entire financial system.
The Bank regularly releases the Financial System Report, which analyzes and assesses the
stability and functioning of the financial system as a whole. The Bank began its release back
in 2005, before the global financial crisis occurred. Since then, this semiannual report has
been released to convey the Bank's thinking on risks and issues facing Japan's entire
financial system. Through this release, the Bank works to grasp risks in the financial system
as a whole, and to share a common understanding with a wide range of participants in the
system, including financial institutions. I think this process is fundamental to identifying
financial imbalances at an early stage and implementing, with appropriate timing, measures
that are considered to be effective in containing risks. In relation to the three issues I
mentioned earlier, there are two key points. First, it is important to improve the quality of the
assessment of financial developments so that macroprudential measures can be
implemented with appropriate timing. Second, it is also important to increase the scope of
analysis to cover not only banks but also the entire financial system.
From that viewpoint, the results of various analyses are set out in the Financial System
Report. As an example, let me introduce the Financial Activity Indexes (FAIXs) (Chart 3). The
Bank began their compilation in 2012. The FAIXs aim to detect, as early as possible,
overheating in financial activity that could lead to systemic risk. They are a selection of
14 financial indicators, such as the total credit-to-GDP ratio and the land prices to GDP ratio,
and measure how far individual indicators deviate from their historical trends. The Financial
System Report provides overheating or overcooling assessments of individual indicators in a
"heat map" format, where red shading shows that the indicator in question is tilted toward
overheating, blue indicates overcooling, and green represents everything in between.
Through a comprehensive analysis and assessment of these indicators, the Bank works to
gauge the accumulation of macro financial imbalances. Of course, the heat map is not
perfect. Let me offer the example of the total credit-to-GDP ratio, which is a typical indicator
of the financial cycle (Chart 4). It is difficult to grasp the underlying trend of the ratio, given
the overwhelming magnitude of the emergence and bursting of the asset bubble from the late
1980s to early 1990s in Japan. The financial cycle is long and unstable, and the associated
recovery in robustness of the financial system requires time. Therefore, for this kind of
financial cycle indicator, it is ultimately a matter of judgment as to how long the deviation
from the underlying trend should be accepted. Although there are such issues to be
considered, the FAIXs are a useful tool for gauging the buildup of financial imbalances.
In the Financial System Report, in addition to presenting the FAIXs, the Bank conducts
macro stress testing (Chart 5). Through such testing, it aims to analyze the degree of
accumulation of risks in the entire financial system and the uneven distribution of risks
among financial institutions, and then utilize such analysis in its policy judgment. Macro
stress testing assesses the degree of resilience of the financial system assuming that severe
stress occurs in the real economy and financial markets. First, by devising stress scenarios,
the testing enables to some extent assessment of how an unprecedented shock would affect
the entire financial system. Second, an industry-wide analysis using the same scenario
enables the identification of an uneven distribution of risks in the financial system. In
conducting macro stress testing at the Bank, particular emphasis is placed on the importance
of working to bring together economic analysis skills accumulated so far and data/knowledge
obtained from individual financial institutions through the process of on-site examinations and
off-site monitoring. For example, when assuming stress scenarios, the Bank focuses on risk
factors that are considered to be the most important at that particular point in time. Before the
Lehman shock, when the global economy overheated and newly established real estate firms
actively developed real estate projects in Japan, the Bank conducted stress testing focusing
on credit risk in lending to real estate-related sectors. When concern about the European
sovereign debt crisis heightened, the Bank assessed its spillover impact by taking account of
co-movements in domestic and international financial markets, and also conducted stress
testing against foreign currency liquidity risk based on the assumption that the foreign
currency funding markets had become dysfunctional. Most recently, the Bank has conducted
an analysis by assuming scenarios involving an economic downturn of approximately the
same magnitude as that observed at the time of the Lehman shock and an approximately
2 percentage point rise in long-term interest rates leading to an economic downturn.
As noted, in the Financial System Report the Bank clarifies risks and challenges for Japan's
financial system by examining a number of indicators. It examines a wide range of indicators
and conducts various analyses, and ultimately makes a discretionary judgment as to whether
the implementation of measures is indeed necessary. With a view to analyzing and
assessing financial system stability and making use of macroprudential measures, close
cooperation between the FSA and the Bank is also important. In that regard, the two entities
together established in June 2014 a task force with the aim of holding regular joint meetings
to exchange views on financial stability, with participants including the FSA Commissioner
and the Bank's Deputy Governor. The FSA and the Bank have been exchanging views
frequently at various levels and maintaining close cooperation, and the meetings will further
strengthen such cooperation.
III. The relation between monetary policy and macroprudential policy
Now let me turn to the issue of how much a central bank should involve itself in
macroprudential policy. As is the case here in the United Kingdom, having experienced the
recent financial crisis, a central bank's involvement in ensuring the stability of the financial
system has strengthened globally. The Bank of Japan Act stipulates that the purpose of the
Bank is to carry out currency and monetary control as well as to contribute to the
maintenance of the stability of the financial system, and therefore the Bank is responsible for
taking care of both tasks equally (Chart 6).
Looking back, the following two cycles have often synchronized: the cycle of economic
activity, or the output gap, and the financial cycle - in other words, the buildup of financial
imbalances and their collapse. That is because of a feedback loop in which changes in the
output gap and changes in the financial cycle have reinforced each other, leading to larger
changes for both. In Japan, monetary policy and macroprudential policy are therefore
considered to be complementary. The Bank's activities on the macroprudential front are in
line with its mission as stipulated in the Bank of Japan Act, just like its microprudential
activities, such as on-site examinations and off-site monitoring. Based on that, the Bank also
allocates considerable management resources to conduct prudential policy that aims to
ensure the stability of the financial system, as well as monetary policy that aims to maintain
price stability.
Even if monetary policy and macroprudential policy are considered to be complementary to
each other in the long run, depending on the economic phase, there may be cases in which
asset prices surge under low inflation. Therefore, in the short run, where there is a trade-off
between price stability and financial system stability, the question over which one a central
bank should place greater emphasis on when taking action may well become an issue of
debate. One approach to that issue would be a policy framework based on a dictionary-like
ordering. That is, as long as price stability - an objective of the highest priority - has been
met, a central bank can pursue its other objectives. For example, in advanced economies in
general, where prices have been maintained at low levels as a trend, financial system
stability is sometimes viewed as more important than price stability, which is considered to
have been achieved already. That would sound reasonable, considering that a large-scale
formation of financial imbalances and their collapse, just like the one observed before and
after the Lehman shock, occurred when price stability had generally been maintained. On the
other hand, in the case of Japan, since deflation persisted for a prolonged period, one might
take the view that, for the time being, a higher priority should be placed on price stability than
financial system stability. The background to this view could include the fact that risk-taking
activities of financial institutions have been limited, even in a low-interest rate environment,
and that a buildup of financial imbalances has not been observed so far.
I would not reject that way of thinking, but I am personally uncomfortable with accepting the
dichotomy between monetary policy for price stability and macroprudential policy for financial
system stability. That is because the dichotomy is seemingly easy to understand, but it is not
always valid in every circumstance. Of course, there are cases in which responses are
possible under such a dichotomy. However, let us assume a situation in which the financial
cycle is not sufficiently contained, leading to a feedback loop in which changes in the output
gap and changes in the financial cycle reinforce each other. In that case, it inevitably
becomes necessary to make use of not only macroprudential policy but also monetary policy,
which has far-reaching effects. As in the case of the policy responses made after the bursting
of the bubble economy in Japan, if monetary policy measures are taken only after
fluctuations in the financial cycle have become substantial, there is a risk that policy
responses will become extremely difficult to implement at that point. Therefore, what is
desirable for a central bank is to give a certain consideration not only to the output gap but
also to containing the financial cycle when pursuing monetary policy.
Based on that view, the Bank of Japan's monetary policy is conducted within a framework in
which the Bank examines various risk factors, including those related to financial imbalances,
in addition to the assessment of the current developments and outlook for economic activity
and prices, from the perspective of achieving sustainable growth with price stability. When
too much priority is placed on short-term price stability, there is a risk that the financial
system will become unstable in the future, which in turn could undermine medium- to
longterm price stability. On the other hand, when too much emphasis is placed on financial
system stability, confidence in a central bank's efforts toward achieving price stability could
deteriorate. In order to avoid falling into such situation, a central bank needs to conduct
monetary policy in a balanced manner.
IV. The Bank's recent conduct of monetary policy
Lastly, I will briefly touch on the Bank's recent conduct of monetary policy.
At the Monetary Policy Meeting (MPM) held on October 31, 2014, the Policy Board decided
to expand quantitative and qualitative monetary easing (QQE). As I cast a dissenting vote on
this decision, I may be in a delicate position to talk about this policy change. However, I take
this opportunity to explain the policy decision and provide my views to the best possible
extent.
The Bank's assessment is that Japan's economy has continued to recover moderately as a
trend, despite being affected by the consumption tax hike in April 2014, and is expected to
continue to do so. Although weakness remains in exports, production, and some indicators
relating to consumption, the mechanism for economic recovery has been steadily maintained
on the back of the firm employment and income situation as well as resilient household and
business sentiment. On the price front, somewhat weak developments in demand following
the consumption tax hike and a substantial decline in crude oil prices have been exerting
downward pressure recently. A temporary weakness in demand has already started to wane,
and the decline in crude oil prices will have positive effects on economic activity from a
somewhat longer-term perspective and eventually will push up prices. Nevertheless, if the
current downward pressure on prices remains, albeit in the short term, there is a risk that
conversion of the deflationary mindset, which has so far been progressing steadily, might be
delayed. To pre-empt manifestation of such risk and to maintain the improving momentum of
expectation formation, the Bank judged it appropriate to expand QQE, with an aim of offering
kind of insurance.
Regarding the monetary base, the Bank will conduct money market operations so that it will
increase at an annual pace of about 80 trillion yen. That is an addition of about 10-20 trillion
yen compared with the past. To that end, the Bank will purchase Japanese government
bonds (JGBs) so that their amount outstanding will increase at an annual pace of about
80 trillion yen. Compared with the past, it is an addition of about 30 trillion yen. The Bank
also tripled the amount of some risk asset purchases, compared with the past (Chart 7).
The effects of QQE have a tendency to become stronger in a cumulative manner with the
progress in asset purchases by the Bank. Those effects have already become clearly evident
in both the front and back ends of the yield curve, and are expected to strengthen further with
the progress to be made in such purchases.
With regard to my own view on the policy decision that I have mentioned, I refrain from
providing details at this point, as the minutes of the MPM have not been released at this
stage. However, as I have been presenting my personal views on the meaning of "achieving
the price stability target of 2 percent" and of the time frame "as long as it is necessary for
maintaining that target in a stable manner," I take this opportunity to reconfirm them.
The price stability target is set based on the consumer price index (CPI) for all items, but I do
not think that QQE can be considered to have accomplished its mission simply when the rate
of increase in the CPI reaches 2 percent on a year-on-year basis. The price stability that the
Bank aims to achieve should be a situation in which prices rise with an improvement in
wages in a well-balanced manner, amid favorable overall economic conditions both in terms
of the real economy and the asset market. To that end, it is important that people's medium-
to long-term inflation expectations - which are said to have consistently remained lower than
those in other leading countries - be raised to and re-anchored at around 2 percent,
comparable to the level in the United States, so that people's behavioral pattern will be
based on the assumption of around 2 percent inflation.
Fortunately, people's short-term inflation expectations appear to be rising on the whole from
a somewhat longer-term perspective, in part because the year-on-year rate of increase in the
core CPI, excluding the effects of the consumption tax hike, has continued to be stable at
around 11⁄4 percent. In re-anchoring medium- to long-term inflation expectations, it is
conceivable that people revise their expectations not only in a backward-looking manner
based on the rise in short-term inflation expectations, but also in a forward-looking manner
considering, for example, developments in wage revision. In that regard, the result of wage
revision this year marked an important step toward a breakthrough in changing people's
pessimistic expectations that base salaries will not rise under deflation. Regarding wage
negotiations next year, three-way discussions among the government, employers, and labor
unions are taking place under the government's initiatives. I expect that they will lead to
actual wage increases and exert a positive effect on the formation of people's inflation
expectations, thereby having favorable effects on medium- to long-term inflation
expectations.
To be sure, the time frame for continuing QQE is based on the idea of forecast targeting -
namely, as long as it is necessary for maintaining the target in a stable manner. The price
stability target is expressed in terms of the year-on-year rate of increase in the CPI for all
items. Considering the aim behind this, I think it will remain important to focus on the
formation of people's inflation expectations - as I have mentioned earlier - and to carefully
examine future developments in a wide range of price indicators including those relating to
wages. It should be noted that there is no silver bullet for estimating people's medium- to
long-term inflation expectations on a real-time basis, and therefore the necessity of
continuing QQE should be judged by the Bank's Policy Board at each MPM.
Thank you.
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