Kiyohiko G Nishimura: Unconventional policies against fear of "unknown
unknowns"
Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel
Session "The Repositioned Role of Central Banks in Today's Economic Environment" at the
CME Group's Global Financial Leadership Conference, Tokyo, 2 November 2009.
* * *
First, I would like to take this opportunity to briefly comment on the unconventional policies1
of central banks and their gradual wind-down.
Aggravator of the global financial crisis: fear of "unknown unknowns"
I would like to remind you of what aggravated and transformed a peripheral U.S. subprime
mortgage problem into a full-blown global crisis: Namely, the contagious erosion of
confidence, or the fear of "unknown unknowns" in financial markets. Market participants
become excessively fearful that they might be confronting a previously unknown, essentially
uncertain and unpredictable world. They assume the most pessimistic scenario possible and
try to make the most of it.2 What is more, market participants tend to stand on the sidelines
until market confidence has been restored. The failure and the fear of failure of large
international financial institutions caused market participants to be fearful of the possibility of
the failure of their counterparties. Haircuts for the collateral rose rapidly and financial
institutions were obliged to sell their assets at distressed prices to obtain immediate liquidity.
Financial markets became severely segmented and some literally collapsed.
Central banks' policy responses: "catastrophe insurance" provider
In order to address this problem, the central banks of developed countries first conducted
ample and enhanced liquidity provision by offering more frequent operations to more counter
parties at longer maturities and against broader collateral, in addition to series of policy rate
cuts. Then, as the erosion of confidence intensified after the failure of Lehman Brothers and
market dysfunctions became more pronounced, the central banks began intervening in
specific market segments by introducing and expanding asset purchase programs for
commercial papers, corporate bonds and government debts.3
By these augmented liquidity provisions and market function-enhancing interventions, the
central banks effectively provided "catastrophe insurance," or put-like options for a broad
range of financial institutions to hedge against some unknown, possibly grave downside
risks. In this way, these measures were intended to reduce the fear of "unknown unknowns".
1
For a more detailed account on the topic, see Nishimura, K. G., "Unconventional Policies of Central Banks:
Restoring Market Function and Confidence," Remarks at the Panel Session "Monetary Policy Boundaries:
Alternative Instruments and Policy Coordination" at the Money and Banking Conference sponsored by the
Central Bank of Argentina on Sept.1, 2009, available online at
http://www.boj.or.jp/en/type/press/koen07/ko0909a.pdf.
2
If a decision maker's confidence is "contaminated" or eroded in the sense that he/she thinks, though with a
small probability (say ε), that he/she is ignorant about the situation he/she faces, his/her rational behavior can
be described as "maximin" optimization. In the maximin optimization, he/she is particularly sensitive to the
worst-case scenario. See, Nishimura, K. G., and H. Ozaki (2006), "An Axiomatic Approach to
εcontamination," Economic Theory, Vol. 27(2), pp. 333-340.
3
Also, the Fed expanded swap lines with other central banks to enable other central banks to provide further
dollar liquidity.
BIS Review 137/2009
A significantly longer duration of liquidity-provision operations helped to substantially reduce
financial institutions' fear over procuring longer-term liquidity. The expansion of
counterparties and collateral eligibility secured them new no-risk funding sources, that is,
central banks, to partly alleviate a lingering fear of counterparty risks in money markets. I
think no additional words are needed about their put-option characteristics of the asset
purchase programs.
Looking ahead: no free umbrella against plain old rain
Clearly, central banks' provision of catastrophe insurance measures has worked quite well,
together with various governmental measures of similar characteristics.4 Immediate dangers
have subsided, though we are still facing a possibly bumpy adjustment process after the
collapse of the "credit bubble".
In order to look ahead, the following two points should be kept in mind.
First, these catastrophe-insurance measures are in fact "free" insurance. Beneficiaries of
these measures do not pay fair, or, in many cases, any premium for these hedges. Rather,
central banks and governments implemented these measures against the "unusual and
exigent" circumstances of contagious confidence erosion. Thus, the measures were to be
temporary. A permanent provision of such free put-like options obviously distorts the market
mechanism and prompts undesirable risk taking or "moral hazard." To put it differently, free
shelters should be provided against a hurricane, but there should be no free umbrella against
plain old rain.
Second, central banks' ability of providing "catastrophe insurance" is not unlimited and
depends crucially on market participants' confidence in them. Some measures taken by
central banks impose financial and possibly reputational risks on themselves. An option
provider should make sure that it would not seriously undermine its capital base.
That being said, unconventional, catastrophe insurance-like measures should be explicitly
temporary and for some measures "self-fading" as market conditions improve. Currently, we
see in fact some measures winding down in the US and other places, including Japan, and
some other measures, such as the U.S. Treasury's Guarantee Program for Money Market
Funds, to have expired. The wind-down shall be carefully arranged, in some cases step by
step, to avoid possible transitional problems as much as possible.
Finally, I would like to add that as the immediate threat subsides and the hurricane shelters
are removed, nobody assumes that that is the end of public efforts to rebuild the devastated
community. This is exactly the same for central banks' unconventional measures. Although
the balance sheets of central banks may be reduced when these unconventional measures
are faded out, this is not a sign of a change in the stance of central banks. Rather, this is the
sign that central banks can now use conventional means more effectively to pursue current
monetary policy.