Masaaki Shirakawa: International policy response to financial crises
Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Federal Reserve
Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming, 21 August
2009.
* * *
Introduction
I will explore the future of international coordination between central banks in the wake of the
current financial crisis. Here, I mean by coordination between central banks that they attempt
to respond to and stave off a global crisis effectively in an organized way without any outside
pressure.
The current crisis has posed enormous challenges on many fronts to policymakers. As the
starting point for discussing those challenges, I think it is important to highlight three facts.
First, the global economy has encountered a crisis more frequently in the past 20 years than
before. Second, the current crisis has grown literally into a global crisis. The global economy
has contracted sharply since the fall of 2008, as often described as falling off a cliff. By
contrast, the prior crises such as Japan's post-bubble period and the East Asian crisis still
remained local, even though they exerted significant adverse effects on the domestic or
regional economy.1 Third, the soundness of financial institutions before the crisis differed
significantly between those countries in question. Asian financial institutions, including
Japanese institutions, as well as Canadian and Australian ones, had smaller exposure to
complicated structured products, compared with U.S. and European institutions. Those three
points provide a sound basis for considering how to forestall a crisis.
Causes for global financial crisis
Here, I will try to summarize some stylized facts about the unfolding of crises, including the
current one. During a pre-crisis period, benign economic conditions, just like the "Great
Moderation" prior to the current crisis, usually prevail for some time, and the risk-taking
attitude of economic agents becomes aggressive. In economic analysis, economic agents'
preferences are assumed to remain unchanged over time. But, in reality, risk perception
becomes optimistic and risk tolerance is elevated under benign economic conditions.
Unfortunately, our knowledge of a mechanism of such endogenous changes in the
risktaking attitude, or risk-taking channel, is quite limited. Institutional arrangements, such as
regulation, valuation, and compensation, shape incentives at a micro level. Given institutional
arrangements, an actual implication of such incentives is importantly influenced by the
financial and economic environment at a macro level. In that respect, low inflation and high
growth coupled with low volatility of the two certainly play an important role in fostering
bullish sentiment. In addition, a sense of unlimited availability of liquidity transforms such
bullish sentiment into excessive risk-taking.
In the process of risk-taking, financial imbalances are being accumulated in various forms,
such as expansion of credit and leverage, an increase in maturity mismatches, and a surge
in asset prices. The build-up of financial imbalances is hardly sustainable over time and a
balance sheet adjustment eventually takes place. The adjustment initially proceeds in a
gradual pace. Then a crisis comes to the surface in the form of a severe liquidity shortage
triggered by some shocks, and it deepens when confidence among financial market
participants collapses. Market liquidity declines in wide-ranging markets and an adverse
feedback mechanism starts working between the financial system and the real economy.
Capital shortages at financial institutions become apparent, although the very distinction
between a liquidity shortage and a capital shortage becomes blurred in a crisis.
Then, what made the current crisis truly a globalized one, in contrast to the aftermath of
Japan's bubble burst and the East Asian crisis?
First, during the pre-crisis period, excess liquidity prevailed on a worldwide basis, and thus,
the financial imbalances expanded massively and spread out over a wide range of regions
around the globe. A variety of factors worked in a complicated manner behind the scenes,
and expectations for the continuation of low interest rates among industrial countries
certainly played an important role in expanding financial imbalances by generating a false
sense of abundant liquidity.
By contrast, in the case of Japan's bubble, the outstanding performance in terms of both
inflation and growth was to a large extent an isolated phenomenon. Headline CPI for Japan
remained already at a low level, just below 1 percent on average between 1985 and 1989,
whereas that for G-7 excluding Japan and Germany still remained around 5 percent. The
overall picture of inflation performance remained almost unchanged when using the core
measures, like excluding food and energy prices. Thus, there was virtually no
synchronization in expectations for prolonged low interest rates on a worldwide basis.
Second, the increased interconnection between financial institutions made the adjustment in
the current crisis more acute and globally synchronized. Financial institutions had become
highly interconnected on a worldwide basis before the crisis. A case in point is a surge in
cross-border lending. Cross-border lending by banks in industrial countries toward emerging
economies continued to increase over time, and has accelerated since 2003. Lending toward
Central and Eastern Europe by euro area banks was more conspicuous. That process
inevitably involved the expansion of a dual mismatch, that is, a currency and maturity
mismatch, which was supported by a sense of abundant liquidity in both domestic and
foreign currencies. In the wake of the crisis, fragility stemming from the dual mismatch
abruptly exerted severe funding pressures, further deepening the crisis in many countries,
including emerging economies.
By contrast, during Japan's bubble era in the late 1980s, the increase in cross-border lending
was not globally observed and mostly limited to Japanese financial institutions.
As a related issue, "the global savings glut" is often pointed as one of the causes for the
global credit bubble, but I am a little skeptical about that line of argument. It is true that
savings by emerging economies are one of its determinants, since global real interest rates
are determined so as to equate the savings and investment in the global economy. To
understand the phenomenon of the global credit bubble, however, gross capital flows are far
more important than net capital flows. The gross capital flows do not necessarily correspond
to the savings-investment balances at a national and regional level. In fact, it was euro area
banks that strikingly expanded cross-border lending, while the euro area as a whole did not
register a current account surplus.
International coordination: assessment on the current crisis responses
To the extent that a crisis becomes increasingly globalized, greater cooperation among
policymakers will be called for. How should policy responses so far be assessed from the
viewpoint of international coordination?
I will start with positive developments. First, governments and central banks in many
countries have carried out aggressive macroeconomic policy responses to stave off a
significant deterioration in economic activity. Second, many countries have provided public
capital to financial institutions and instituted government guarantees on their liabilities. Third,
coordination between central banks in conducting money market operations has advanced
significantly. A case in point is the U.S. dollar funds-supplying operations at many central
banks, backed by the U.S. dollar swap arrangements with the U.S. Federal Reserve. Fourth,
the prior collaborative efforts by central banks and private financial institutions in reducing
settlement risk have proven effective. The functioning of currency swap markets, which plays
a key role in linking interbank markets in many countries, crucially depends on perceived
settlement risk. In that regard, the continuous linked settlement (CLS) mechanism, which
started in 2002, proved quite effective. Without such a payment-versus-payment service for
foreign exchange transactions, the global financial system would have been in deeper turmoil
through the amplification of counterparty risk due to further risks associated with time zone
differences.
Of course, it is a hard fact that various limits exist in international coordination. First,
measures to stabilize the financial system in each country have hastily been introduced
without necessary harmonization between the countries. That has created some gaps in the
range of government guarantees for depositors and creditors between the countries, thereby
triggering sudden international shifts in deposits. Second, financial institutions have been
increasingly asked to serve for the domestic "interests" and sort of "financial nationalism"
seems to have emerged. Third, in some countries, the aggregated balance-sheet size of
domestic financial institutions expanded far beyond nominal GDP, thus making it increasingly
difficult to take necessary policy actions, including public capital injections.
The observations I have just mentioned indicate the limitations in international coordination,
in the sense that the global or world-wide optimum has not necessarily been chosen. Like it
or not, that is a reality and such limitations do arise for a couple of reasons. First, with public
money injections, a government is in a position to pay more attention to taxpayers' interests,
and naturally has incentives for ring-fencing interests of its own country. Second, bankruptcy
legislation for financial institutions differs between countries. As the Bank of England
Governor Mervyn King put it, "global banking institutions are global in life, but national in
death."2
Challenging conventional wisdom
The limitations I have just mentioned are, for the most part, sort of a coordination failure due
to the very existence of sovereign nations. We cannot deny the importance of making efforts
to avoid a coordination failure, but it seems more productive for each policymaker around the
globe to address the common factors causing crises. In that regard, we should take seriously
the fact that the frequency of crises has increased in the last 20 years, and the crises have
also become increasingly globalized. For those reasons, it seems natural to reflect on the
relationship between that fact and conventional wisdom underpinning monetary policy, and
financial regulation and supervision.
Put it simply, the prevailing philosophy among central banks and other policy authorities rests
on three forms of "pre-established harmony," if you please. First, macroeconomic stability
can be achieved by monetary policy, which pursues low and stable inflation. Macroeconomic
stability is complementary to financial stability. Second, financial stability can be achieved by
pursuing a microprudential approach. To that end, the authorities need to properly regulate
and supervise individual financial institutions. As a key tool, capital adequacy regulation has
become increasingly sophisticated to calibrate risk involved in a specific activity. Third,
financial institutions with a sufficient capital position can easily raise liquidity in financial
markets. Thus, liquidity consideration has been assigned only an ancillary role in regulation
and supervision.
Way of thinking about monetary policy management
It is a good time to review the prevailing philosophy in light of the current crisis.
On the first form of the pre-established harmony on macroeconomic stability, monetary policy
aimed at low and stable inflation was so successful in the past two decades. Oddly, such
success of monetary policy also turned out to be a part of the problem. Given human
psychology and institutional arrangements, the unfounded expectations for the continuation
of low interest rates were responsible for creating perverse incentives under benign
economic conditions. Such perverse incentives in turn induced the process of accumulation
and manifestation of financial imbalances, thereby destabilizing the economy in the longer
term.3
The issue we are facing is sometimes inappropriately described as an intra-temporal
tradeoff between price stability and financial stability. The actual trade-off here is an inter-temporal
trade-off between the current and the future economic stability. Lively debate on the possible
role of monetary policy is going on. Monetary policy alone cannot or should not stave off a
bubble. Indeed, it bears a more modest but important task. Monetary policy should avoid
accelerating a bubble through creating unfounded expectations for the continuation of low
interest rates, since incentives are underpinned ultimately by the financial and economic
environment at a macro level.4
Capital adequacy regulation and incentives
The second form of pre-established harmony on microprudential policy also needs to be
reexamined. A macroprudential perspective is definitely needed in assessing risks as well as
in designing regulations.
The very fundamental problem is how to stem intrinsic moral hazard due to the limited liability
of stockholders. In the past 20 years, the financial regulatory and supervisory authorities
have attempted to tighten capital adequacy regulation. With low leverage, however, financial
institutions faced difficulty in achieving sufficiently high return-on-equity to satisfy bank
stockholders, which then induced the expansion of "shadow banking."5 An alternative
business strategy was to raise return-on-asset, but the franchise value of financial institutions
tended to be declining over time due to financial deregulation and intensified competition.
The declined profitability put pressure on some financial institutions to take an excessively
high risk.6
The regulatory and supervisory authorities count on self-discipline at private financial
institutions as well, because the authorities are well aware that they are unable to monitor
every detail of business activity at private financial institutions. At the same time, as the
authorities hardly count solely on such private initiatives, they impose regulations on private
financial institutions to avoid the manifestation of systemic risk. Central to the issue is how to
balance public regulation and self-discipline at private financial institutions as well as capital
adequacy regulation and other forms of public regulation.7
Given the limited liability of stockholders, strengthening capital adequacy regulation alone will
not be effective enough to constrain the short-sighted behavior of stockholders and business
executives. In any event, the most important challenge to ensure financial stability is how we
can strengthen credit underwriting discipline and liquidity management, which, after all,
provide the most reliable protection for the sound financial system.8
In that regard, it should be noted that the pendulum has swung back and forth in the
discussion of models for financial regulation and supervision. Simply put, the Asian model
was downgraded after the Asian crisis, and the Anglo-Saxon model was also downgraded
this time, although the exact meaning of those models has remained vague. It should be also
noted that the soundness of financial institutions before the crisis differed between the
countries. With that observation, I do not intend to suggest that one model is superior to the
other. Rather, that seems to suggest the importance of versatility of financial regulatory and
supervisory models.9 In view of the situation in each country, we need to think over what kind
of combination of public regulation and self-discipline is desirable, and what kind of
combination of capital adequacy regulation and other forms of public regulation is desirable.
For example, even in the age of globalization, the factors influencing incentives, such as
executive compensations, differ considerably between the countries.
Liquidity transfer
Turning to the third form of pre-established harmony on the availability of liquidity, as shown
by the experience of the current crisis, counterparty risk, whether actual or perceived, plays a
crucial role in aggravating a crisis. Even a well-capitalized financial institution cannot easily
raise liquidity in financial markets in a crisis. Thus, we should put more emphasis on building
financial infrastructure less vulnerable to shocks. One of the key actions here is to ensure
smooth liquidity transfer across currencies, time zones and regions. The payoff of such
efforts will be more solid and substantial, even though it does not make the headlines.
Necessity of cooperation and coordination between central banks
In relation to the three challenges above, I will next explain the necessary efforts in the area
of cooperation and coordination between central banks.
First, regarding monetary policy, each country should make every effort to put its own house
in order. Central banks also need to put more collaborative efforts into making an analysis of
global financial conditions and enhancing further information sharing. I find it increasingly
important to monitor the international dimension of the risk-taking channels with regard to the
transmission mechanism of monetary policy. That dimension is typically observed as the
common lender channel, by which I mean internationally active financial institutions playing a
role in transmitting monetary policy effects, and global investors taking carry-trade positions
in various forms.
Next, in terms of financial regulation and supervision, putting its house in order in each
country is again the most important principle for ensuring financial stability. The experience
following the collapse of Lehman Brothers shows its importance succinctly. On top of that, it
is crucial to make further effort to redesign the regulatory framework to stave off a future
crisis. In that regard, we are working definitely in the right direction to embrace a
macroprudential perspective. As we are charged with so many tasks in our agenda, some
caution should be needed not to lose a holistic view. G20 and Financial Stability Board (FSB)
have correctly proposed to review the capital adequacy standards, with a reservation of
implementing most of the new rules once recovery is assured.10 Such a policy direction
seems relevant in light of the amount of risk actually taken by internationally active financial
institutions in recent years. In implementing the policy, however, we also need to pay
attention to the endogenous changes in financial institutions' risk-taking stemming from
strengthened capital regulation.
Finally, coordination between central banks is required in the area of money market
operations, and, more generally, banking policy. A crisis is likely to be amplified by concern
over funding liquidity. That underscores the importance of the efforts to transfer liquidity
smoothly on a global basis.
U.S. dollar funds-supplying operations, carried out under coordination between major central
banks, have been highly effective under such conditions. In that case, other central banks
than the Fed have an incentive to implement operations to secure the stability of domestic
financial markets and domestic financial institutions. The Fed also has a natural incentive to
secure the stability in U.S. dollar denominated financial markets. As a result, U.S. dollar
funds-supplying operations are mutually beneficial for both the Fed and other central banks.
That point is markedly different from "international policy coordination" in monetary policy,
easily placing strain on bilateral relations in key variables, such as foreign exchange rates
and the balance of payments.
Through the current crisis, we have reconfirmed that it is important to make currency swap,
repo, and other collateralized markets more robust, and that central banks need to promote
private initiatives in that direction. From that perspective, central banks need to make further
coordination in providing liquidity, accepting cross-border collateral, and extending operating
hours for the payment and settlement systems provided by central banks.
Concluding remarks
In closing, I emphasize the importance of promoting human interaction in further developing
coordination between central banks.
Since the summer of 2007, central banks have communicated with each other intensively at
various levels, from top central bankers to mid-class staffers using various tools, such as
emails, conference calls, and face-to-face conversations. Such efforts have contributed to
preventing the crisis from worsening further.
Financial markets are inevitably incomplete in economists' terminology, and it is professional
judgment that fills the gap inherent in the incomplete contracts. In that sense, the deepened
mutual trust, the accumulated practical and operational know-how, and the strong network of
central banks, which have been established during the process of crisis management,
provide a basis for substantive cooperation. A new international financial system, if that in
fact comes true, will emerge from the wealth of human network.
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