Asian Perspectives on Financial Sector Reforms and Regulation

7. Macroprudential Lessons from the Financial Crises: A Practitioner's View

180 In this chapter, I focus on the issues of financial stability and central bank policies based on two episodes of financial crisis: one dating from twenty years ago in Japan and the other from three years ago in the United States. I first present one stylized account from a macroprudential perspective of the buildup in financial imbalances that led eventually to the financial crisis in the late 1980s in Japan. Then I illustrate the startling similarities between the recent U.S. subprimetriggered experience and that of Japan in the 1980s. Examining these two crises, I draw four implications for macroprudential policy, which are likely to be universally relevant, particularly for emerging economies. The message is simple and straightforward: Beware. So-called macroprudential measures may not always be sufficient. For example, if investors are excessively optimistic, a modest increase in capital requirements and leverage restraints may not be effective to curb such unwarranted optimism. This leads to the final topic, the role of monetary policy during the buildup of financial imbalances, a role that I would argue is, in a word, crucial. Letting financial imbalances balloon and then collapse may be too costly to bear, if such imbalances lead to wasteful irreversible investment. Moreover, there remains substantial uncertainty about the effectiveness of regulatory reforms and other macroprudential measures in the real world. It is therefore wise to use monetary policy to address the issue of financial imbalances in tandem with macroprudential measures, if, first, substantial imbalances are building up and, second, regulatory policies have proved to be insufficient. Macroprudential Lessons from the Financial Crises: A Practitioner’s View kiyohiko g. nishimura 7 12689-08_CH07-rev2.qxd 10/5/11 12:30 PM Page 180 macroprudential lessons from the financial crises 181 Financial Imbalances in 1980s Japan: A Stylized Account This account, of the buildup to financial imbalances in Japan in the late 1980s, is from a macroprudential perspective.1 It is intended to be descriptive and schematic in the way that macroprudential issues are highlighted. It is admittedly simplistic, but I believe this is a good starting point for discussion. Deregulation-Induced Financial Innovations and Financial Anomalies A number of financial innovations introduced as a result of deregulation appear to have played a role in the late 1980s bubble in Japan. Under the designation of financial liberalization, deregulation sparked the arrival of new products such as commercial paper (CP) and large time deposits with unregulated rates, which nourished the atmosphere of profit seeking through these “financial technology” products.2 Financial liberalization was a gradual process; it started in the late 1970s and spanned twenty years. Around 1986 signs of financial anomalies emerged, brought about by innovations associated with financial liberalization. The most notable anomaly was the apparent no-risk arbitrage opportunity for large nonfinancial corporations . In 1985 banks were allowed to offer large time deposits with no regulation on their rates. Banks then offered short-term, large, time deposits to major nonfinancial corporations with rates higher than the corresponding term CP rates. Thus large nonfinancial corporations could profit from raising funds by issuing CPs and depositing them in these unregulated, large, time deposits.3 By a similar token, three-to-six-month unregulated time deposit rates were substantially higher than short-term prime lending rates (figure 7-1). These anomalies were often explained as banks’ investment in customer capital in large nonfinancial corporations. These large nonfinancial corporations, which were once good customers of the banks, had gained increasingly good access to capital markets through deregulation. If the banks could obtain and keep longterm customer relations with these corporations, the banks could profit from their clients’ increased financial and other activities through increased fees and commissions . This was not mere wishful thinking at that time, since the banks themselves were being gradually deregulated and allowed to expand their business into securities markets and other activities, in order to accommodate the various financial needs of these large nonfinancial corporations. Favorable Capital Market Conditions and Looser Lending Standards At the same time, banks’ profits surged and their capital positions strengthened, as shown in figure 7-2. Banks tapped capital markets to raise capital easily, and 1. This account is partly based on Hattori, Shin, and Takahashi (2009). 2. These technologies were known at the time as zai-teku in Japanese. 3. Bank of Japan (1989). 12689-08_CH07-rev2.qxd 10/5/11 12:30 PM Page 181 182 kiyohiko g. nishimura...