masaaki shirakawa : the role of central banks in the new financial environment remarks by mr masaaki shirakawa, governor of the bank of japan, at the international monetary conference, kyoto, 9 june 2009. * * * introduction let me first thank the hosts for inviting me to the international monetary conference. the imc has a very long history of providing not only its private sector members, but also the public sector with an excellent opportunity to frankly discuss a broad range of issues regarding financial institutions, financial markets and the financial system. we are unfortunately still in the midst of an unprecedented financial crisis, although hopefully the worst is behind us. the topic the organizers have given to us central bankers, " the role of central banks in the new financial environment ", is clearly a very timely one, something which is on our minds everyday. the fundamental role of a central bank remains unchanged, but its functions have gradually changed with the passing of time. in the case of the bank of japan, on - site examinations of financial institutions were introduced in 1928 based on the experience of the financial crisis after world war i. the bank of japan act was revised in 1998 to strengthen the independence of monetary policy. this reflects, among others, the lessons learned regarding the conduct of monetary policy during the bubble period of the latter half of the 1980s. at that time, our on - site bank examination was also given a clear legal backing. how will the role of the central banks around the world change in light of the current global financial crisis? in considering this issue, i would like to first pose two questions to the top executives that are here with us today. first, in the years heading up to the crisis, especially the five year period between 2003 and 2007, did you recognize that risks were building up in your institution and / or in the financial system? second - this is a question about the now famous quote regarding dancing with the music - if we were in the future to experience a similar benign economic period of high growth, low inflation, low interest rates and low market volatility, would you choose a different business strategy? if you were to choose a different strategy, what would be your expectations on the path that senior executives of your rival institutions would choose? while you are responsible for making your bank both profitable and resilient to shocks, the role of the central banks is to assure that your endeavors lead to a sound financial system conducive to economic prosperity. what we central

banks need to understand is that the behavior of market participants will be influenced by human nature and competitive pressures in the markets. without trying to paint a complete picture, let me raise a number of issues with respect to the role of central banks which i believe are important in the new financial environment. role of central banks assessing risks on a system - wide basis first, central banks need to assess risks on a system - wide basis taking into consideration the linkages between the real economy and financial markets as well as among financial institutions. such assessment will be the basis for policy actions regarding financial system stability. of course, this is a typical example of something that is easier said than done. before the current crisis, central banks issued warnings regarding the build - up of risks through financial system reports. however, issuing warnings are not so difficult. senior bank executives and other market participants themselves, to some extent, recognize such risks. if we seriously wish to reduce such risks, remedial action is required. but in order to go beyond analysis and take remedial actions, a proper assessment, a strong will, together with a robust legal framework which enables effective action, are all necessary. in any event, without a system - wide assessment, no actions are possible. i believe central banks are in a natural position to take up such an assessment role. as the entity responsible for monetary policy, central banks focus on macro economic conditions, have close contacts with financial market participants, and our institutional culture emphasizes the importance of research. reconsidering the conduct of monetary policy second, we need to reconsider the conduct of monetary policy. when one looks at market participants and senior bank management collectively, their incentives are also influenced by macro economic and financial conditions. the most typical example would be the search for yield witnessed during the so - called great moderation. this incentive issue evolves into a difficult challenge for monetary policy when asset bubbles emerge. the problem is often debated simply as whether monetary policy should lean against the wind or excessive asset price increases. however, i believe that such a formulation of the issue confuses the discussions on monetary policy. no central banker believes that bubbles can or should be prevented just through monetary policy. a more practical formulation of the issue for central banks would be, " how should monetary policy be conducted in an environment where asset prices are rising, credit and leverage are increasing and the economy is growing, strongly signaling a need for policy tightening, while only general prices remain stable? " in such