Masaaki Shirakawa: The Central Bank from the viewpoint of "law and
economics"
Lecture by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Faculty of Law,
University of Tokyo, Tokyo, 21 October 2009.
* * *
I. Introduction
I am happy to be speaking to you from this podium at the law faculty today. I feel that I have
made something of a long detour in life before reaching this classroom. I entered the
University of Tokyo in 1968 to advance to the faculty of law, but my interests led me instead
to the faculty of economics, so I never stepped inside a law faculty classroom during my
undergraduate days. So I am now filled with an inexpressible feeling as I stand here finally
after 40 years.
Nevertheless, I have felt a sense of familiarity with the world of law for a long time. While you
might imagine that work at the Bank of Japan frequently employs knowledge of economics,
there are also many tasks that require knowledge of law or the so-called legal mind. During
some 34 years of service at the Bank before I assumed my current position, I carried out a
variety of responsibilities related to monetary policy, research and studies, financial markets
and the payment and settlement system, and the disposal of failed financial institutions. In
those days, I keenly felt the importance of having knowledge not only of economics but also
of law. Today, therefore, I will talk about the role of a central bank from the viewpoint of "law
and economics."
First, I will briefly explain the mission and role of the Bank. The Bank of Japan is the nation's
only central bank. If I were to express the mission of a central bank in one sentence, it would
be "to issue money, or currency, and to ensure that people can use it with confidence." The
money most close to you is likely to be banknotes, namely "Bank of Japan notes," and the
Bank of Japan is the organization that issues those banknotes (Chart 1). The face values of
"Bank of Japan notes" significantly exceed their production costs.1 Nevertheless, nobody
worries about whether a 10,000 yen banknote in your wallet will turn into a mere sheet of
paper, or that it might not be accepted by the stores. While banknotes are the most typical
form of money, what is greater in terms of value is what you deposit at banks, namely, bank
deposits (Chart 1). Deposits are based on a private law contract between depositors and
banks. You need not worry that those deposits will not return to you as stipulated in the
contract or that they will become valueless. "Money" such as cash and deposits is vital for
economic activity. Economic activity cannot proceed stably if people worry that currency
might not be accepted or become valueless. To ensure that people can use money with
confidence, thereby contributing to economic growth; this is the most fundamental mission of
a central bank.
II. Experience of the global financial crisis
Let me explain the work of a central bank more specifically. Here, I will take up the global
financial and economic crisis after the failure of Lehman Brothers in September of last year.
From the autumn of last year2, global economic activity plummeted and global trade also
contracted rapidly (Chart 2). This situation was the first such experience in 70 years. Quite
recently, economic activity has been picking up, although the current level of economic
activity is still significantly lower than that of last year.
What circumstances were behind this? Up to the mid-2000s, the global economy had been
enjoying a long period of benign economic conditions of high growth, low inflation rates, and
low interest rates. As a result, people became bullish about the future, and willingly took risks
and invested in various sectors such as real estate. This was the so-called bubble. What is
happening now is the unwinding of the "excesses," namely, the bursting process of the
"bubble."
In the United States, housing prices peaked in the second quarter of 2006 after rising
steadily for a long period. Then, people who took out mortgages on the prospects for rising
house prices became unable to repay their mortgages. Banks did not hold all the mortgages
on their balance sheets, but aggregated them in pools so that new securities could be issued
by the pools and sold to other financial institutions and investors. These were called
"securitized products" (Chart 3). Because of issuance in several tranches according to the
order of interest received from a pool of loans or principal repayments, the senior tranche in
the securitized products obtained high ratings. However, as house prices plunged and a
larger-than-expected number of mortgages turned delinquent, the prices of securitized
products including highly rated ones dropped significantly. Thus, financial institutions holding
a large amount of the securitized products also incurred huge losses. In these
circumstances, leading financial institutions faced a management crisis and Lehman
Brothers filed for insolvency in September 2008.
Financial institutions mutually make various transactions, and thus many debts and credits
are mingled together. Since financial institutions other than Lehman Brothers incurred losses,
albeit to different degrees, they began to worry that their trading counterparts might go
bankrupt. In such a situation, financial institutions became reluctant to lend to or borrow
money from each other in the market. In addition, even when financial institutions lent to their
counterparties, they charged high interest rates on the loans (Chart 4).
As a result, financial institutions started to worry that they might not be able to borrow
required funds in the market, and became cautious about lending to firms and individuals.
For example, commercial paper (CP) that firms issue to raise short-term funds faced a
decline in the amount issued and a rise in the issue rate since financial institutions stopped
buying the CP (Chart 5). Among the buyers of the CP were mutual funds such as money
market funds (MMFs) that invested in various products including securitized products. In
preparation for investors' withdrawal, the mutual funds held back investments in the CP. That
was also a blow to the CP market. The securitized products, which were the epicenter of the
current crisis, had no buyer in the sagging market and, as a result of the limited room for risk
taking on the part of financial institutions, the products faced a significant decline in trading
volume and extremely high issue rates (Chart 6).
To put this phenomenon more concisely, it was a "collapse of confidence." Financial
transactions are based on confidence. Even a simple sales contract entails various kinds of
risks. First, there is credit risk as to whether a trading counterparty has sound financial
conditions and is immune from default. Second, there is liquidity risk as to whether a buyer
can secure funds necessary for payment. Third, there is payment and settlement risk as to
whether products or payments are delivered as stipulated in the contract, namely, whether
payment and settlement are smoothly carried out without the risk of not receiving money or
products. If these risks are deemed significant then one cannot make a contract, out of fear.
In particular, since financial transactions are large in amount and complex in contents,
financial transactions will not be carried out in the usual manner if financial institutions are
extremely sensitive to the risks. If financial transactions cease, funds necessary for economic
activity will not be distributed and economic activity will stagnate further.
As such, in the current global financial and economic crisis, confidence, which is the most
important element in finance, collapsed during the process of the unwinding of the
"excesses." Consequently, the flow of funds stopped and the economy deteriorated further,
aggravating the crisis.
III. Measures taken by the Bank of Japan
Since financial institutions are globally linked through various transactions and economies
are also globalized through trade and investments, the crisis that started in the United States
spread quickly around the world. Although Japanese financial institutions did not hold many
securitized products, Japan's economy was affected significantly because of the global
economic and financial mutual relationship. In facing this global crisis, the Bank has taken a
number of measures. I will now explain the four particularly important ones.3
Reductions in the policy interest rate
First, there was a reduction in the interbank interest rate to a low level of 0.1 percent. With a
view to achieving stable economic activity and prices from a longer-term perspective, a
central bank raises or reduces the short-term interest rate based on the future assessment.
This is what is referred to as monetary policy in the orthodox definition of textbooks.4 This
time, in response to the global economic slowdown, central banks around the world reduced
short-term interest rates to a level expressed as the "zero interest rate" (Chart 7).
Provision of ample liquidity
Second, the Bank provided ample liquidity in order to ensure stability in financial markets and
financial systems. As mentioned earlier, when mutual confidence in financial institutions
declines and concern arises that funding in financial markets might be impaired, this
constrains financial institutions from lending to firms and individuals. In such a situation, the
Bank provided the market with ample liquidity to preempt such concern.
It is no surprise that central banks provide funds in their home currency in a crisis. This time,
however, central banks of not only the United States but also other countries coordinated to
arrange for a framework of U.S. dollar-funds provision. Specifically, the Bank of Japan and
other European central banks made swap arrangements, received the supply of dollars from
the central bank of the United States, the Federal Reserve, and supplied them to financial
institutions in their own countries (Chart 8). This made dollar funding of financial institutions
in each country easier.
Both the Bank of Japan and all other central banks require collateral when providing liquidity.
In the case of the Bank, Japanese government bonds, bills, and bonds normally are
accepted as eligible collateral (Chart 9). In the current phase, the Bank made it possible to
provide the yen or the dollars against foreign government bonds as eligible collateral. This
framework is called cross-border collateral arrangement. Other central banks have
introduced or have been trying to introduce a similar framework. Since internationally active
financial institutions diversify assets located around the world denominated in various
currencies, the adoption of such a framework by central banks enables the financial
institutions to borrow funds from central banks by using effectively assets located in various
countries.
Support to malfunctioning capital markets
While the second measure I have just explained is a measure to indirectly support financial
institutions' lending to firms by providing financial institutions with ample liquidity, the Bank
has also implemented more direct measures, given that this time firms were unable to raise
funds in the capital market. One of these measures was the outright purchases of CP. The
Bank has been providing financial institutions with loans against CP as collateral, or
purchasing CP from financial institutions on the condition of selling back in the future. In
these cases, the risk of incurring losses when a firm issuing the CP goes bankrupt, namely,
credit risk, is primarily assumed by financial institutions. If the Bank purchases CP without
the condition of selling back, however, the Bank bears the credit risk (Chart 10).
It is a principle that under normal circumstances a central bank provides liquidity to the
financial market as a whole, and private financial institutions and investors that know a
borrowers' conditions well will carry out individual fund allocation. In this regard, it is an
exceptional step, as in the current crisis, for central banks to themselves directly bear credit
risk for individual private firms and provide liquidity. When the functioning of financial markets
declined markedly, leading to tightening in most areas of corporate finance, the Bank
decided to implement outright purchases of CP and corporate bonds as temporary
measures. The Bank judged that these measures would be necessary to fulfill the mission of
the central bank, that is, to distribute funds necessary for economic activity to every corner of
the economy by maintaining stability in the economy, prices, and the financial system.
Risk reduction measures in the payment and settlement system
As the fourth measure, I will explain that, in coping with a financial crisis, it is important to
always prepare for a crisis with down-to-earth efforts to establish systems. As an example, I
will discuss the foreign exchange payment system such as yen-dollar transactions. From the
autumn of last year, it became extremely difficult to raise funds in the U.S. dollar funds
market due to the collapse of confidence. The difficulty in dollar funding was a particularly
grave problem for foreign financial institutions that did not have dollar deposits in Japan, in
other words, that lacked a relatively stable funding source. What was used in these
circumstances was a "swap transaction," which exchanges the yen and the euro for the
dollar for a certain period of time (Chart 11). Since this was dollar funding using the yen and
the euro as collateral, or vice versa, it was relatively safer than uncollateralized funds
transactions. The swap market accounts for almost half of the entire foreign exchange
market, and is a large market with a trading volume of 1.7 trillion U.S. dollars per day in the
world.
There is a time-zone difference between the delivery of the yen, which is made in Japan, and
the delivery of the dollars, which is made in the United States. Suppose that a financial
institution delivers the yen first to a counterpart financial institution and receives the dollars
later; this financial institution faces the risk of not receiving dollars in the event the
counterpart financial institution goes bankrupt before the New York market opens. While
such time-lag risk is not recognized in normal times, it becomes critical in a crisis. To prepare
for such a situation, central banks had long been encouraging private financial institutions
around the world to establish a simultaneous settlement method among major currencies
including the yen and the dollar; it is called payment versus payment (PVP). As a result, the
Continuous Linked Settlement (CLS) system was established in 2002, with financial
contributions from private financial institutions around the world (Chart 12). If the current
global financial crisis had taken place in the absence of such a system as CLS, foreign
currency funding by financial institutions might have faced more difficulties and the crisis
might have worsened further.
IV. The role of the Central Bank
I have so far been explaining the role of a central bank by using the example of the current
global financial and economic crisis and central banks' responses. Here, I will explain in a
more general way the central bank's role to "ensure that people can use money with
confidence," which I mentioned at the outset.5
As a lecture in the faculty of law should do, I will start with an article of law. In the Bank of
Japan Act, there is an article that stipulates, "The banknotes issued by the Bank of Japan
(hereinafter referred to as "Bank of Japan notes") as prescribed in the preceding paragraph
shall be legal tender and hence shall be used for payment without limits" (Article 46, Section
2) (Chart 13). Because of this stipulation, transfer of a banknote will be "the performance
actually consistent with the purpose of the obligation" that you have learned in the class on
civil law. If a borrower tenders the Bank's banknote as a tender of performance, the creditor
must accept it. In this regard, this article is quite important.
Even with such an article, Bank of Japan notes might not be used in the actual transactions.
Under the principle of the freedom of contract, an individual is free to either make or forgo a
contract. If a seller does not want to sell the product in exchange for the Bank of Japan note,
the sales contract will not go through to start with, and thus the Bank of Japan note will not
be used for transactions. While such a case might not occur in major countries, many of you
might have an experience in which a seller does not sell the product in the home currency or
asks to use dollars for the purchase. In these cases, while the home currency might be legal
tender, it might be a currency that people cannot receive with a sense of security, because of
various factors. For example, there might be too many counterfeit notes to engender
confidence, there might be high inflation and a risk that the value of banknotes will decline
tomorrow, or the country might be experiencing a financial crisis and people cannot deposit
their money with a sense of security.
The mission of a central bank is to avert these things. Put more specifically, a central bank's
mission is to achieve "stability of the value of money." In detail, first, a central bank's most
intrinsic task is to issue banknotes and faithfully manage them so that counterfeits or dirty
banknotes do not circulate. The second task is to stabilize prices. Since fluctuations in prices
will make rational economic calculation difficult and impair the efficiency of resource
allocation, they will hamper economic growth and, to start with, threaten social stability. The
third task is to maintain financial system stability. Bank runs and the absence of trade in the
financial markets occur when financial system stability is eroded, and its grave effects are
what I explained earlier. A central bank's mission is to ensure that money necessary for
economic activity can be circulated to every corner of the world through the tasks I have just
described. In a nutshell, the mission is to "ensure that people can use money with
confidence," namely, to achieve "stability of the value of money." While it goes without saying
that this state cannot be achieved solely by a central bank, and the regulatory and
supervisory authorities as well as private financial institutions also play important roles, the
role played by the central bank is extremely important.
While you may have read about this in a textbook or have some prior knowledge about this
mission of a central bank, let me emphasize two things for thorough and accurate
understanding of the mission of a central bank.
First is the importance of credibility in a central bank. A central bank's ability to control
interest rates and to supply ample funds derives from the fact that nobody will refuse
acceptance of money issued by the central bank, namely, banknotes and the central bank's
current account deposits. Through experience, modern nations have recognized the
importance of credibility, established an organization that crystallizes this credibility, and
entrusted the issue of money to that organization. In other words, even if an organization
called a central bank has been established, a central bank will not be able to control money
properly if its credibility is insufficient, and thus the central bank itself must strive to win such
confidence.
Second, when a central bank tries to pursue its public purpose of the stability of money, it will
do so not by law or administrative order but through transactions in the market. Earlier I
explained the Bank's measures taken in response to the global financial and economic crisis,
and all these measures were not forced by law and administrative order but were carried out
in the form of market transactions. Be it control over interest rates or provision of funds, they
were conducted mainly by purchasing government bonds from the market or lending to
financial institutions. As for CP, the Bank purchases it from financial institutions by
conducting auctions. Because of this, a central bank is called the "bank of banks" or the
entity "in the market."
V. The role of Law
How and in what form are law and the legal mind useful for the Bank to carry on its mission?
I will discuss three points.
Democracy and central bank independence: issues from the viewpoint of public law
The first point is from the viewpoint of public law: the issue of "democracy and central bank
independence." "Independence" means "to decide on one's own with a decision that is not
reversed by others" (Chart 14). Now, why is a central bank granted independence in a
democracy? In general, monetary policy affects economic activity and prices after a time-lag.
Against such a backdrop, if monetary policy is conducted, based only on judgments about
short-term economic and financial conditions, it will likely lead to a situation in which
economic stability is impaired, as experienced during the previous inflations and the bubble.
One major cause of the current global credit bubble was the prolonged low interest rates.
When the problem started to grow in 2003 through 2004, the focus of many policy authorities
and economists in the United States and Europe was on neither inflation nor the bubble but
rather how to stave off global deflation. While people are weak in that they are likely to be
influenced by short-term interests, they are also equipped with wisdom that allows them to
establish a system in advance to avoid a situation that is undesirable from a medium- to
long-term perspective. This is the conception of central bank independence, which entrusts
the conduct of monetary policy to an organization that makes judgments based on expertise
from a medium- to long-term perspective.6 Of course, there is no all-encompassing
independence. The objectives of a central bank are clearly stipulated in the central bank act,
and the governor and other central bank executives are appointed according to democratic
procedure. Moreover, it is required by law to disclose the policy decision process of a central
bank (Chart 14).7
In the current crisis, central banks around the world including the Bank of Japan have acted
extremely vigorously, including taking extraordinary measures in rapid sequence. A series of
measures have been substantially effective in stabilizing the crisis. The prompt
implementation of these measures in response to the changes in financial market conditions
was only made possible because each central bank expeditiously decided policies according
to its own judgment and the temporary measures could be terminated when they became
unnecessary.
The independence of a central bank is rarely questioned when it conducts policy using
orthodox measures and operations. However, when a central bank had to take extraordinary
measures in the current crisis, it was quite difficult for the central bank to decide what
measures to take and to what extent based on what rationale.
Taking the outright purchase of CP, for example, the point of contention was whether a
central bank should go beyond the territory of liquidity provision to the financial markets as a
whole and bear credit risk for individual firms. If the CP-issuing firm goes bankrupt, the Bank
of Japan will incur losses, which results in a burden on taxpayers. A question naturally arises
whether such a measure should be carried out as a fiscal policy measure by the Diet and the
government in line with the decision-making process in a democracy. We had repeated
serious discussions on that point. As explained earlier, as for the right or wrong of carrying
out the measures, we decided that the extraordinary measures would be necessary to fulfill
the mission of a central bank under an extraordinary situation of extreme malfunctioning of
the capital market. On this basis, we paid due attention to the system design so as to
minimize the side effects (Chart 15). For example, in purchasing the CP, we set conditions
so that the incentives of financial institutions to sell CP to the Bank would decline as the
functioning of the market recovered. Moreover, we limited the purchases to the CP issued by
firms whose ratings were above a certain threshold. Credit risk was of course not zero, but
we judged that it was necessary to be borne in order to achieve the purpose and effects of
the policy.
While it is important that a central bank respond flexibly according to economic and financial
conditions in light of the objectives stipulated in law, it becomes quite difficult for a central
bank to draw a clear line between what it "should do" and "should not do," given that it is
granted the capability of issuing currency unlimitedly. This is important as an issue of
decision making in a democracy. Our task is to fulfill our mission by utilizing the resource of
"confidence" as effectively as possible, while being cognizant of the mission of a central bank
and the position of a central bank in a democracy, and thus it is associated with difficult
judgments.8
Innovation in central banking business: issues from the viewpoint of private law
From a slightly different angle, I will talk about the second legal point at issue. I have
mentioned that a central bank achieves its public objective of currency stability through
transactions in the market. In doing so, the services provided by the central bank must be
attractive. Therefore, the central bank has been trying various measures in accordance with
the changes in the economic and financial environment, and I will explain the role law has
been playing in that respect, mainly focusing on private law.
Earlier I explained the introduction of a scheme to provide funds against foreign government
bonds as eligible collateral - a cross-border collateral arrangement. In order to put the
scheme into practice, there were numerous legal issues to be cleared. First, a question of
private international law: which country's law would be applied in creating the security
interest over foreign government bonds physically located in foreign countries. Second, a
question of the legal framework for collateral in foreign countries: how to create the security
interest and how to exercise the security interest in case of default. Third, a question of
international financial business practices: what kind of contract should be concluded with a
counterparty. While it is a difficult job to examine each country's legal system and hammer
out responses, it is nevertheless worth challenging and it is fascinating.
I just mentioned "foreign government bonds physically located in foreign countries", but in
fact government bonds of Japan and other major countries are dematerialized and transfers
and pledges of these bonds are made by making entries into securities accounts. In the Bank
of Japan's cross-border collateral arrangement, with the transfer of a country's government
bond to a securities account held with the country's central bank, the security interest will be
created based on the country's law. While details vary by country, such a scheme has
enabled financial institutions to efficiently use securities, wherever they are physically
located, as collateral to borrow necessary funds from various central banks around the world.
Such innovations are necessary not only in the area of legal knowledge but also in the areas
of the payment and settlement system and computer system. The Bank runs a system called
the Bank of Japan Financial Network System (BOJ-NET), and transactions between financial
institutions are settled in that system. When the BOJ-NET is used to settle the sale and
purchase of securities, there is a scheme to simultaneously carry out the delivery of the
securities and payment of funds; it is called delivery versus payment (DVP). Through DVP,
default risk associated with the time difference between delivery of securities and funds can
be mitigated. Building on the idea of DVP, extending the operating time of the BOJ-NET and,
for example, creating a time zone that overlaps with the operating time of other central banks'
system would facilitate simultaneous settlement between the yen and the U.S. dollar and
make it possible to meet other various settlement needs. Recognizing these possibilities, the
Bank has started to consider building a new system.
As such, to make the flow of funds efficient and safe by improving the fund provisioning
framework and payment system is an important job for a central bank. By way of these
innovations, the central bank has always been striving to make its services more usable and
attractive. Such efforts to improve services are essential for maintaining confidence in a
central bank. From the viewpoint of a central bank, the progress in globalization means that
central banks are entering competition in terms of providing high-quality services.
Financial system stability and international legal issues
Lastly I will take up as the legal point at issue the role that law is playing in financial system
stability, especially in an international aspect. Safeguarding the stability of the financial
system is not the same as preventing individual financial institutions from going bankrupt. In
the market economy, the principle is that financial institutions, like other firms, will also
undergo selection if they fail in their management. If there is an overly high sense of security
that the government and the central bank will bail out financial institutions even if they fail in
their management, financial institutions' self-discipline will be lost and they will pursue
excessive risks, thereby destabilizing the financial system. This is the so-called moral hazard
problem. What is important, even if individual financial institutions go bankrupt, is to minimize
the effects on other financial institutions and maintain the stability of the financial system as a
whole.
Let me take up again the case of Lehman Brothers as an example (Chart 16). In order to
smoothly pursue the insolvency proceeding of an internationally active financial institution
like Lehman Brothers, it is essential to have coordination between central banks and the
supervisory authorities. To begin with, if insolvency during operating hours, namely "intraday
insolvency," occurs amid the existence of a time difference, the effects will be grave. In order
to avoid this, it becomes necessary to set a proper timing for insolvency. In addition, so as
not to complicate the relationship of debts and claims due to new transactions, a business
suspension order might become necessary. In the case of Lehman Brothers, in response to
the U.S. headquarters' filing for Chapter 11 on September 15, 2008, the Financial Services
Agency issued a partial business suspension order to its Japan affiliate. September 15 was a
national holiday in Japan. On the ensuing first business day, September 16, Lehman
Brothers' Japan affiliate applied to the Tokyo District Court for the civil rehabilitation
procedure, and the court decided on the start of the procedure on September 19. The Bank
of Japan implemented measures as a central bank to secure financial system stability. Since
the Bank was also a creditor of Lehman Brothers, the Bank needed to carry out the
measures by gaining the understanding of the court. Moreover, on the settlement front,
onesided default risk was mitigated through the yen-dollar PVP by the CLS and securities DVP
by the BOJ-NET. Furthermore, settlement proceedings and loss-share rules in case of
insolvency were agreed in advance among market participants, and these functioned well.
Because of these various responses, payment and settlement of domestic transactions were
conducted generally smoothly in Japan. While it might sound unusual, it is of critical
importance that bankruptcy be conducted skillfully without causing any trouble to the financial
system as a whole.
In the current financial crisis, Lehman Brothers filed for insolvency, while many financial
institutions in the United States and Europe were nationalized or received public capital
infusion. In response to this situation, the reflection emerged that a framework for orderly
disposal of a financial institution with a significant impact on the financial system was
insufficient.9
Since the framework for disposal was insufficient, a case occurred such as
Lehman Brothers - which could not be disposed of while maintaining important operations
and which was forced to liquidate - or, adversely, cases occurred in which the authorities
judged part of financial institutions as "too big to fail," and eventually many taxpayers had to
bear t