Hirohide Yamaguchi: Some remarks on the financial crisis over the past
year
Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at the 4th Annual
Euromoney Japan Capital Markets Congress, Tokyo, 18 September 2009.
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Introduction
I am honored to be invited to speak today at the fourth annual Euromoney Japan capital
markets congress.
The collapse of Lehman Brothers one year ago triggered unprecedented disruptions in the
global financial markets. Fortunately, financial conditions have improved recently to a great
extent, but they have not yet fully recovered from the crisis. Today, by looking back on the
financial and economic developments in the past year, I will provide some of my impressions
of those developments.
I. Economic and financial developments after the collapse of Lehman Brothers
The global financial markets changed drastically after the collapse of Lehman Brothers in
September 2008. Market participants became increasingly cautious about taking
counterparty risk, causing trading volume to decrease sharply and market liquidity to decline
significantly. Credit spreads widened and the prices of financial products, including
securitized products, plunged. Consequently, financial institutions experienced business
difficulties or failed one after another in many countries, thereby aggravating financial system
concern. Credit provisions from financial institutions to firms and households declined
markedly, leading to a global credit contraction. Confidence, which is the most crucial
element in the financial system and markets to function smoothly, was virtually lost.
Meanwhile, economic conditions deteriorated simultaneously and rapidly around the globe.
Final demand - namely, housing investment, private consumption, and business fixed
investment - plunged, leading to large-scale adjustments in inventory and production. This
deterioration in economic conditions, together with a spread of anxiety among firms and
households, exacerbated the malfunctioning of the financial system, and in turn deteriorated
economic conditions further, causing a downward spiral - the emergence of the so-called
adverse feedback loop between financial and economic conditions.
Also in Japan, the functioning of commercial paper and corporate bond markets was
impaired, and strains in Japan's short-term money markets increased as reflected in a rapid
expansion of the LIBOR-OIS spreads. Nevertheless, the stress imposed on financial markets
and the financial system in Japan after the collapse of Lehman Brothers was low relative to
that in the United States and Europe because financial institutions in Japan had little
exposure to securitized products. However, the slowdown in economic growth was rapid in
Japan, compared with that in the United States and Europe. Against a backdrop of a global
accumulation of inventories of durable and capital goods and the ensuing large-scale
reduction in production to adjust the level of inventories, exports of automobiles, electrical
machinery, and general machinery - industries in which Japan excels - declined in an
unprecedented manner. Accordingly, production declined considerably.
The factor behind the sudden contraction of financial and economic activities on a global
basis, including Japan, was an accumulation of various excesses during the mid-2000s,
particularly in the United States and Europe, and the adjustments of the balance sheets of
firms and households emerged in the process of the unwinding of excesses. During the
mid2000s, the world economy constantly registered unprecedented high levels of growth at
around five percent. Despite this high growth rate, prices continued to be generally stable,
and accommodative financial conditions continued for a long time around the world. The
continued benign environment of high growth, low inflation, and accommodative financial
conditions led to the prevalence of optimism for the future (which in retrospect is hard to
believe). Meanwhile, overconfidence also spread in the sophistication of financial
technologies that were developing remarkably at the time. In those circumstances,
imbalances such as the increase in credit and leverage as well as the rise in asset prices
accumulated worldwide. Developments since last autumn can be described as essentially
the adjustment of the accumulated imbalances; in other words, the bursting of a global credit
bubble.
Nevertheless, world economic conditions have been showing signs of leveling-out since the
spring of this year. That is because the global financial markets have gradually started to
stabilize because the provision of ample liquidity by central banks around the world, the
aggressive public capital infusion and debt guarantees by the governments for U.S. and
European financial institutions, have dissipated market participants' extreme anxiety. The
progress with inventory adjustments on a global basis due to large reduction in production,
and the manifestation of the effects of large-scale economic stimulus measures implemented
around the globe have also contributed. Thanks to such developments, a positive trend has
been emerging in Japan's economy. Exports and production have been recovering,
especially in the automotive and electronic parts industries. Fiscal measures including public
investment have also been underpinning economic activity.
As for the economic outlook, the upward momentum in the world economy is likely to
continue for a while. The recent clear recovery of emerging economies is a reassuring factor.
Against this background, Japan's economy is expected to start recovering from the second
half of Japanese fiscal 2009. Of course, as I have previously mentioned, the world's firms
and households are now in the process of balance sheet adjustments. Therefore, the
momentum for recovery in the world economy greatly depends on how the balance-sheet
adjustments evolve, and Japan will not be immune from the influence of such developments.
Consequently, there still will be considerable uncertainty about the outlook. The Bank of
Japan, paying due attention to various risk factors, will continue to monitor carefully financial
and economic developments both at home and abroad.
II. Some remarks
After confirming the current financial crisis and large swings in economic activity, I have
come up with several impressions or questions. First, how effective is the advancement of
financial technologies in controlling risk? Second, how to solve the issue that prolonged
benign market conditions can actually encourage economic entities and market participants
to engage in excessive action, and thus might just lead to future large swings in the
economy. Third, is it possible to maintain high market liquidity even under any type of shock?
And fourth, how market participants' extreme anxiety can be controlled? All of those
questions are difficult to answer. Today, I will outline my thoughts on the first two
interconnected questions as a basis for your discussion.
Financial technology advancement and risk control - the importance of "self
discipline"
To begin with, let us consider if the advancement of financial technologies is effective in
controlling risk, or has the experience of the current financial crisis proven it to be ineffective.
Financial engineering, which has evolved rapidly in recent years, was first developed as a
technique to control risks, that is, to break down and manage risks associated with financial
products. Indeed, the advancement of financial technologies has made it possible to design a
variety of financial products according to the specific risk preference of various investors,
and, as a result, financial markets have become broader and more versatile.
Securitized products, which triggered the current financial crisis, included various innovations
to control the risks associated with normal lending and securities investment. For example,
the bankruptcy remoteness of cash flows obtained from underlying assets as well as the
creation of a risk buffer by setting multiple tranches enhanced the safety of investments and
facilitated credit risk transfers. In addition, credit default swap transactions also allowed easy
credit risk transfers. These methods were believed to be capable of controlling accurately the
risks associated with securitized products.
However, the reality was different. As turmoil actually occurred, massive risks surfaced, and
it became clear that the methodology of risk control initially envisaged did not work.
Importantly, the root of the problem in fact lay in the loose assessment of simple risk factors,
rather than the complex technology of securitization itself. Specifically, the basic standards of
risk management, such as the credit risk of the original debtor, risk monitoring, liquidity risk of
investment vehicles, and the degree of correlation between the risk factors, were neglected.
In addition, we should not forget that there was a lack of preparedness for the tail risks that
occurred when great stress was imposed on the financial markets. If we consider the
foregoing, the heart of the problem can be attributable to two elements: lax risk assessment
due to a behavioral pattern of market participants who put the pursuit of profit first, and the
so-called agency problem based on information asymmetry.
Of course, the resolution of the problem is not easy. Strengthening of regulations and
introduction of further advanced financial technology cannot control all the risks nor
completely resolve the agency problem. In addition, as long as the pursuit of profit is a basic
incentive for market participants, lax risk assessment under certain market conditions might
result from human nature.
While I do not deny the importance of enhancing risk management through the advancement
of financial technology, it is perhaps difficult to control human nature and psychology with
financial technology. What is of the utmost importance is for market participants to avoid a
deep sense of complacency in relying on financial technology for risk management, and to
remain vigilant in maintaining the crucial risk awareness, that is known as "self-discipline". In
my view, the unsolved part of uncontrollable risks and agency problems might be somewhat
solved by this "self-discipline". We need to recognize again that regulations and advanced
financial technology are not a substitute for "self-discipline". In that regard, future financial
supervision and regulation that are currently being discussed on a global basis, should be
carefully crafted from the viewpoint of whether they would function to strengthen the internal
"self-discipline" of market participants, rather than merely being an externally imposed
compliance regime.
Preempting excessive behavior of market participants - the sharing of "common
sense"
I will now turn to the issue of whether there are ways to preempt the excessive behavior of
economic entities and market participants.
As previously mentioned, the current financial crisis grew out of the need for an adjustment
of the imbalances that accumulated through the mid-2000s. The creation of financial and
economic excesses and their eventual adjustment is a cycle that has been repeated over
and over around the world. In each of those cases, the causes and preventive measures
were seriously discussed, and necessary improvements were made in terms of system and
regulation. Despite those efforts, we have allowed again the accumulation of imbalances and
the occurrence of a financial crisis.
Why excessive financial and economic activities recur? It might be true that humans by
nature cannot learn from history. It seems that each time a state of benign economy
continued for a long time, plausible logic appeared to explain that "this time was different".
The examples include: "Tokyo is becoming a global financial center" used during the
Japanese bubble of the 1990s, and the "advent of a new economy" used in the case of the
dot com bubble in the US; those examples go on and on. Each time it was extremely difficult
to counter the new logic by merely relying on the lessons from history. Nonetheless, it would
also be excessive to lay the onus solely on uncontrollable human nature.
To come closer to the heart of the problem, we need to focus on the market participants'
incentives under a capitalist economic system. Market participants pursue their own profits
as their number one priority, and are not usually interested in how their actions influence the
performance of the market as a whole and eventually the performance of the economy as a
whole. Even if those actions result in an accumulation of excesses in the economy and
cause considerable economic fluctuations when the excesses are eventually adjusted, those
actions are deemed rational, at least in the short term, as long as the individual market
participants make profits. On the other hand, for the authorities in charge of setting policy,
they do not arrest individual market participants' pursuit of profit. Their main incentive is to
improve the performance of the economy as a whole.
The incentives of individual market participants and those of the policy authorities may
conflict in the short run, but should be compatible over a longer period. Therefore, what
becomes important is how to align the incentives on both sides over a longer perspective and
to have this alignment reflected in the actions of both the actual market participants and the
policy authorities.
Here again, it is not easy to give a correct answer. Nevertheless, in my view, if the lessons
learned from the past financial crises could be shared broadly between the policy authorities
and market participants as one form of "common sense", it might change the nature of
incentives and could reduce the excessive actions of market participants. When I say "the
lessons", they are not such dramatic ones. It can be as simple as "when benign financial and
economic conditions continue for a long time, there is a possibility that various excesses will
accumulate, resulting in extremely large economic fluctuations." Of course, it is easy to
anticipate that there will be difficulties in utilizing the lessons, or "common sense", in actual
policy responses. However, whether such "common sense" is shared broadly or not could
make a big difference in the economic outcome.
Recently, the idea of macro-prudence has been discussed as a methodology for crisis
prevention. While specific system designing is a future challenge, I believe that the sharing of
"common sense" between the policy authorities and the market participants could be a
starting point for the discussion of establishing a macro-prudence system. By occasionally
reminding ourselves of the lessons from the financial crises and sharing the lessons as
"common sense" with many people, we will ensure the flexibility of policy management and
minimize the possibility of a future financial crisis.
The Bank of Japan's measures to facilitate corporate financing
In closing, turning to a different issue, I will briefly touch on the specific steps the Bank has
taken since last year to facilitate corporate financing. In response to the substantial
deterioration in corporate financing since the autumn of last year, the Bank has been taking a
series of steps such as outright purchases of commercial paper and corporate bonds and
special funds-supplying operations to facilitate corporate financing. While those measures
were extraordinary as a central bank's policy measures, we judged it appropriate as
temporary measures in light of the severe economic and financial conditions. As for how to
treat those temporary measures, the Bank will decide by thoroughly examining the state of
corporate financing and financial markets and considering the degree of their improvements.
In doing so, a risk that the prolonged usage of temporary measures might impair an
autonomous recovery in market functioning and result in a distortion of resource allocation,
will also be taken into account. If the Bank can share such a risk as "common sense" with
market participants, the Bank can conduct its policies in a timely manner. In addition, the
incentives of the market participants and those of the policy authorities could be aligned in
the context of achieving stable economic and financial conditions from a longer term
perspective.
Thank you.