The financial crisis in Japan: causes and policy reactions by the Bank of Japan.

• Author: Vollmer, Uwe
• Position: Report

1. Introduction

   Japan is currently experiencing its second major financial crisis of the last two decades. While the first crisis of the 1990s was entirely home-made and had effects that were largely confined to Japan, the recent crisis originated outside Japan--mainly in the US and UK--and was transmitted not only to Japan, but to all other major economies worldwide. (3) The Bank of Japan (BoJ) and other Japanese government agencies, such as the Financial Services Agency (FSA), started to react to the financial crisis in September 2008, taking into account the experiences of the first financial crisis. Compared to measures undertaken in other countries, especially in the USA, but also in Europe, monetary policy reaction in Japan was quantitatively rather modest and only temporary. (4) This modest reaction may be due not only to the fact that Japan was hit less hard by the recent crisis, but also because the authorities had learnt from experiences acquired during the 1990s financial crisis.

   In this paper, we describe the propagation of the recent financial crisis to Japan, analyze the reactions of the BoJ and compare them with those in the European Monetary Union (EMU), the UK, and the US. Although the recent financial crisis was a global phenomenon, the Japanese case is of particular interest for the following three reasons. Firstly, during the 1990s financial crisis, the BoJ already had to act as a lender of last resort and provided financial assistance to individual financial institutions and to financial markets, so as to prevent a meltdown of the financial system. Differences between policy reactions then and now help us to understand what form of financial assistance is appropriate during a financial crisis in order to regain financial stability. (5) Secondly, all major central banks have significantly reduced interest rates and almost shifted towards a zero interest rate policy (ZIRP) and one of quantitative/qualitative easing (QEP). While this is new territory for most central banks, the Bank of Japan had already pursued such a policy until 2006. Hence, the monetary policy measures undertaken by the BoJ in the late 1990s may serve as a blueprint for ZIRP and QEP in other countries during a financial crisis. Finally, as with some other major central banks, the BoJ has augmented its monetary policy framework and, for example, introduced a deposit facility which did not exist in Japan during the first financial crisis. Thus, the Japanese case enables us to understand the functions of such a deposit facility and why some central banks started to adjust their monetary policy toolkits.

   To date, the literature offers only a few analyses of the impact of the recent world financial crisis on Japan and of the actions taken by BoJ. Kamezaki (2009) is a notable exception, providing a short chronological overview of reactions by the BoJ after the collapse of Lehman Brothers in September 2008, but without comparing them with reactions in other countries. Another is Sato (2009), who describes the current state of Japan's financial system and analyses FSA's recent responses. Borio and Nelson (2008), Chailloux et al. (2008), Committee on the Global Financial System Report (2008), Bank of Japan (2009a, 2009b), and Bank for International Settlements (2009a, 2009b) analyze rescue programs that were adopted in several countries, after the Lehman Brothers default, in order to support banks and other financial institutions. None of these papers, however, relates the recent policy measures in Japan since 2008 to the experiences of the first financial crisis, but rather treat the recent financial crisis as a historically unique event. (6) They fail to explain the lessons that were learnt in Japan from the financial crisis during the 1990s. Therefore, these studies do not enable policymakers to determine appropriate reactions to a financial crisis.

   In this paper, we bridge this gap and compare the policy reactions in Japan during the recent crisis with those in Japan during the 1990s, and with recent actions in the member countries of the EMU, the UK, and the US. Our objective is to determine how severely Japan was affected by the recent financial crisis and whether the Japanese authorities reacted differently to the recent crisis, than during the 1990s or to the actions of authorities in other countries. We consider the extent to which the recent reactions by the Japanese authorities can be traced back to experiences during the first financial crisis and what lessons have been learnt. Our research reveals that Japanese banks were barely involved in the production and distribution of subprime-related products and explains how the financial crisis was transmitted to Japan through capital outflows. We argue that the Japanese authorities reacted differently to the recent financial crisis than other central banks, not because Japan was hit less severely by the current crisis, but because Japan had indeed learned from its experiences during the first crisis.

   Since the purpose of this paper is to analyze and compare monetary policy reactions to financial crises, we concentrate on the time period between 2008 and 2010 and do not address in detail the reactions to the great earthquake and tsunami in East Japan on March 11, 2011. The Bank of Japan reacted immediately to this catastrophe and injected 15 trillion Yen into the interbank market (far more than after the collapse of Lehman Brothers). In consequence, the financial markets remained resilient and there was no serious interruption to the payments system after the Earthquake. (7)

   The paper is organized as follows: Section 2 reviews the theoretical and empirical literature on the origins and propagation of a financial crisis in general. In Section 3, we turn to the Japanese case and analyse the origins of the recent crisis, as well as the reactions by the BoJ. In Section 4, we compare these policy measures with the crisis of the 1990s and with recent policy reactions in other countries. Section 5 provides some concluding remarks.

2. Origins and propagation of a financial crisis: Recent literature

   The recent literature on financial crises attempts to address three interrelated questions. Firstly, what causes a financial crisis? Secondly, what makes it spread throughout a national banking industry, across borders and into the real economy? Thirdly, what are the appropriate policy responses to a financial crisis?

   With respect to the first question, there is general consensus that a financial crisis is characterized by a crisis of the national banking industry. (8) Banks are fragile institutions that simultaneously grant loans and issue demandable deposits. Thus, they create liquidity but are simultaneously exposed to the risk of a bank run, i.e. a situation in which all depositors, even without actually facing liquidity needs, wish to withdraw their deposits. Such a run may result from a coordination failure among depositors, i.e., depositors withdraw deposits because they believe that other depositors will also do so (Diamond and Dybvig, 1983). Alternatively, a bank run may be triggered by changing fundamentals and by expectations that a bank's capital cushion will be depleted when assets devaluate (Jacklin and Bhattacharya, 1988; Diamond and Rajan, 2000).

   Regarding the devaluation of assets, especially with regard to real estate and securitized financial products, the literature offers three major strands of explanation. One argues that swings in asset prices are due to monetary policy changes and that bank failures stem mainly from a less accommodative monetary policy, resulting in a collapse of the housing market and of the securitization market. (Taylor, 2007: 8-10). (9) A second strand blames the increased diffusion of the 'originate-and-distribute-business' in banking and the massive increase in the size of markets for credit risks, as causing the banking crisis. 'Originate-and-distribute-business' refers to a bank not holding a loan on its balance sheet but, either selling it directly or buying a synthetic product--such as a credit default swap (CDS)--that effectively insures the bank against non-performance. (10) Both direct loan sales and the use of CDS allow a separation of credit risks from loans. This strengthens bank ability to manage risk, because credit risks can be valued more accurately and more easily be diversified (Deutsche Bundesbank, 2004: 36). On the other hand, however, asymmetric information may cause efficiency problems, due to adverse selection and moral hazard (Parlour and Winton, 2008; Heyde and Neyer, 2010).

   Finally, the third strand accuses the decrease in asset prices of bursting an asset bubble, i.e., to the sudden reversal of a speculative price increase (see, e.g., Kindleberger, 1978). An asset bubble is a situation in which market participants buy assets in expectation of a further increase in asset prices. This increase in asset demand is financed by loans which are expected to be repaid by gains from asset price increases. In such a case, the expectation of rising asset prices can be self-fulfilling. However, if asset prices reach a certain ceiling, the process reverses and asset prices start to fall. According to this explanation, housing prices in the US increased merely because market participants expected further future price increases, and started to fall in 2004, when housing prices reached unsustainable levels relative to borrowers' income.

   The literature quoted above offers explanations as to why banks with large exposures in the housing and subprime markets may get into trouble and ultimately originate a financial crisis. We now explore the literature explaining how the financial crisis is propagated i.e. why other banks, with no housing and subprime market exposure, also got into difficulties. Such financial contagion may be caused by imperfections in the interbank markets which channel liquidity from banks with excess...