of problems. technological innovation in the capital market made the services offered by banks less attractive, and pressure from abroad for financial deregulation intensified. as a result, banks became strongly aware of the decline in their franchise value, which gave them a strong incentive to pursue risk - taking activities to maintain and improve their earnings. furthermore, deregulation of the traditional segmentation of business areas and banking organization proceeded only gradually, thus making it difficult for banks to develop businesses that might open up new opportunities for profits. the result was excessive risk taking in lending which was their traditional business. furthermore, financial institutions can temporarily prevent a fundamental deterioration in profitability from surfacing through aggressive lending. this kind of behavior and a rapid rise in asset prices during the emergence of the bubble that accelerated credit expansion, worked together to amplify the excess in the business cycle. during the bursting of the bubble in the 1990s, japanese banks simultaneously faced two problems : the non - performing asset problem and a further rise in pressure stemming from global competition. the interaction of these two problems further delayed improvements in financial system functions, and was a significant factor behind the stagnation of japan ’ s economy in the following years. major japanese banks found it difficult to make sufficient high - tech related investments due to capital constraints, and had to divest themselves of profitable overseas subsidiaries. this had a significant adverse impact on the competitiveness of investment banking, which has tended to yield the highest returns, and perhaps further delayed reconstruction of the medium - term profitability of banks. furthermore, economic globalization promoted the convergence of factor prices, including property prices, and made reconstruction of the financial system more difficult by amplifying pressure stemming from asset deflation. what lessons can the central bank learn from recent changes in the financial system and the experience of financial crises? first of all, innovations in information technology and globalization are ongoing phenomena and will likely continue to change each country ’ s economy as well as its financial system at a rapid pace. for a central bank, this leads to increased uncertainty in the environment surrounding the conduct of monetary policy. a case in point is the argument that i made earlier on “ overbanked ” market. such an argument is often made regarding the financial system in countries like japan and germany. if this argument is correct, it is envisaged that these countries would witness the rapid reduction of both deposits and loans, and the increase in such instruments as mmfs. in japan, we hear conflicting views on the issue :

many countries have experienced the fluctuation of asset prices, which is one example of uncertainty. here, one issue is the difficulty of identifying whether such fluctuation reflects the arrival of a new era or the emergence of a bubble, and also how monetary policy should be conducted under such circumstances. allow me to elucidate a little on these issues, which i think important, though they are not directly related to the problem of changes in the financial system. a key question for a central bank is whether excessive swings in economic activity can be avoided only if price stability is maintained by appropriate monetary policy. while this question requires careful examination, by looking at the experience in japan, my preliminary answer is, to my regret, “ no ”. in fact, japan ’ s bubble emerged in the midst of favorable macroeconomic performance where high growth and price stability had co - existed for several years. the yen ’ s appreciation resulting from the outlook for higher growth potential coupled with contained inflationary expectations brought about notable price stability during the period when asset prices rose rapidly, which made it difficult for the bank of japan to preemptively raise interest rates citing the future risk of inflation. during periods of euphoria when overheating of the economy is not reflected in price forecasts, and the central bank tolerates continued monetary easing despite uneasiness that leads to a delay in taking preemptive measures, the result will almost inevitably be an excess in asset prices and economic activity. in this regard, ironic as it may sound, favorable macroeconomic performance and price stability seem to be necessary conditions for the emergence of an asset price bubble. this seeming paradox poses a serious challenge to the central bank. if favorable economic performance and price stability that could be perceived as the arrival of a new era in fact turns out to be just euphoria, high asset prices will not last long, and the subsequent correction of asset prices will have a serious adverse impact on both financial and macroeconomic aspects of the economy. such concern, however, is not convincing enough to persuade those who believe in the arrival of a new era to restrain ambitious investments. in many cases, the arrival of a new era and euphoria are both triggered by such changes in the environment as technological innovation, and it is never an easy task for anybody to judge whether the change witnessed in the middle of euphoria is simply more euphoria or if a new era is being ushered in. technological innovation significantly raises such uncertainty. generally