Mr Hayami reports on recent monetary and economic conditions in Japan and elucidates progress toward the reconstruction of Japan's financial system
Speech by the Governor of the Bank of Japan, Mr Masaru Hayami, at the Research Institute of in Tokyo on 18 March 1999.
## I. Introduction 1
It is a great honor to be invited to the Research Institute of Japan and have the opportuni you.
I will begin with a brief outline of recent monetary policy management and then give my tho today's topic, the progress toward the revitalization of Japan's financial system.
## II. Recent Monetary Policy Management
## Monetary Easing in February 1999
On February 12, the Bank of Japan decided to conduct a further monetary easing. The new gu for the Bank's money market operations is to 'encourage the uncollateralized overnight ca move as low as possible' while giving due consideration to avoiding excessive volatilit markets.
Let me review the economic situation at the time of the decision. The pace of economic dete had been moderating since last autumn, supported by the increase in public investment. H economic activities in the private sector remained sluggish, and business and consumer sent persistently weak. Moreover, the rise in long-term interest rates and the appreciation against the U.S. dollar since the end of last year had added to the downside risk to the eco was concern that, if these trends continued, the economic deterioration would not come t possibly accelerating once again in the future. In light of these developments, the Bank ju would be appropriate to give maximum support to economic activity through monetary policy.
There have been some changes in the financial market since the monetary easing. The overni rate has fallen, recently to close to zero percent, reflecting the Bank's provision of ampl market. Money market interest rates on instruments with relatively long maturities, such as and three months, have also declined considerably. In addition, long-term interest rates ha clear decline, although the monetary easing was probably not the only factor involved. Th generally followed a downward trend. Stock prices, as measured by the Nikkei 225 Stock Av have recovered to around \16,000. We believe that, if these trends in the financial market they will influence the economy positively through an improvement in returns on invest further alleviation of the fund-raising conditions of financial institutions and firms, and business and household confidence.
Concurrently, measures such as the injection of public funds into major banks are likely advance the reconstruction of Japan's financial system. Also, the effects of the emergency package are expected to come out more fully. I strongly hope that the Bank's latest moneta combined with these policy measures, will give substantial support to economic activity.
Given the recent drop in the overnight call rate to close to zero, some market participant to think that the Bank of Japan has decided to employ an approach different from past easi called quantitative monetary expansion. What I would like to emphasize is that interest quantity of money are like two sides of the same coin. It is only natural for the Bank t
1 This article is excerpted and translated from the speech given in Japanese.
latest monetary easing to lead to an increase in money stock and other monetary aggregates thro changes in the behavior of financial institutions and in demand for funds. And this is nothing than the normal transmission that the Bank expected with any interest rate cut in the past.
The Bank's intention has merely been to carry out money market operations in accordance with t current monetary policy guideline decided by the Policy Board, which states that the Bank sho encourage the uncollateralized overnight call rate to 'move as low as possible.' Of course, the will continue to closely study other possible ways of managing monetary policy. I would like emphasize, however, that at present the target of policy management is, as it has always been overnight call rate, and that the Bank's aim now is to bring this rate down to as low a le possible.
In inducing declines in the overnight call rate, the Bank is giving, and will continue to gi consideration to the maintenance of market functions. The recent decline in the overnight call r encouraged institutional investors to shift part of their funds to ordinary deposits at banks, causing an approximately 20 percent decrease in the outstanding transaction volume of the call mo market. Fortunately, this contraction of the call money market has not hindered smooth settlemen funds. However, considering the recent big changes in the flow of funds, it will be necessary f Bank to carefully monitor market developments to make sure that they do not impair the prop functioning of the money market.
## Problems Associated with Government Bond Operations by a Central Bank - Underwriting and Increasing of Outright Purchases
A number of people have suggested that the Bank underwrite Japanese government bonds (JGBs) or increase its outright purchase of JGBs in easing monetary policy. As I have repeatedly sta however, it is totally unacceptable for a central bank to adopt measures that could lead to un financing of the fiscal deficit or ones that could be interpreted as such.
As you know, the Bank's basic stance on the outright purchase of JGBs is to keep the amount operations roughly in line with the long-term trend in increase in banknotes. At present, operations are carried out twice a month, each in the amount of \200 billion.
If the Bank were to change its stance and expand the outright purchase of JGBs without limit, it very well result in the loss of fiscal discipline, just as could happen with the Bank's underwr JGBs.
If a central bank made unlimited purchases of JGBs, the government would of course have no difficulty in funding its fiscal deficit no matter how massive. This would encourage both the and private sectors to rely on greater-than-necessary stimulative measures financed by a large issuance of JGBs even at the slightest sign of weakness in the economic outlook. Should such mass JGB issuance continue, Japan's economy would only end up having a massive fiscal deficit and a extremely weak supply side in the private sector.
Various shocks are inherent in an economy. Even though there is no need at the moment to consid the risk of inflation, we cannot rule out the possibility of some kind of a 'demand shock' occ over the longer term, such as a plunge of the yen and a tightening of global market conditions. a shock hits the economy when the supply side of the economy is feeble, firms will be apt to desperately the few skilled workers capable of handling new technology, rush to secure rare mater or race to invest in plants and equipment in order to seize suddenly appearing business opportun Supply shortage, by fueling such a nervous psychology, might intensify inflationary pressure before economic conditions improve noticeably. To contain such inflationary pressure, it would necessary to drastically tighten monetary policy. As a result, the economy would be forced t through severe adjustments.
The risk of inflation causing a wide swing of the economy can only materialize in the dist but the Bank of Japan, being responsible for maintaining price stability, must always be fu such a risk. It is this strong commitment to maintaining price stability over time that mak policy that could lead to the loss of fiscal discipline unacceptable.
It may be argued that the Bank should disregard the possibility of future inflation at such Japan's economy is plagued by the risk of deflation. On this point, I would like to stress of Japan shares the view that inflation is not at all an immediate threat. We are fully awar priority for Japan's economy at present is to dispel the deflationary psychology. It is pre purpose that the Bank further relaxed its monetary policy in February, and the Bank believes now it has taken all necessary measures. The Bank is also determined to maintain an easy policy stance until the economy gets back on a steady recovery path.
In doing so, the Bank of Japan will avoid employing monetary policy measures that might enc unwarranted expansion of the fiscal deficit, with unwelcome results of some kind in th Instead, the Bank will underpin economic activity on the monetary front while maintain discipline of a central bank at all times. The reason independence is essential to a centra it is expected to act constantly with a view to stabilizing even the future value of mone swayed by short-sighted concerns. The Bank believes that what it should do now is to pro market with ample funds and, at the same time, take great care to avoid the risk of future i
## The Importance of Structural Reform
What needs to be done for Japan's economy today is to strengthen the supply side of the eco restoring the productivity of the private sector, which declined after the collapse of the should be achieved while monetary and fiscal policies are underpinning the economy, which that the time limit may not be so far away. If policies to stimulate aggregate demand cont implemented without any progress in structural reforms that should renew the private secto economy would become increasingly inefficient and its productivity would decline further. economy would be vulnerable to shocks that could lead to vicious inflation. In order t sustainable economic growth without people anticipating inflation, the private sector continually revitalized through innovations and expansion of business frontiers. One obviou of this is the U.S. economy, which has enjoyed eight years of uninterrupted expansion.
Firms in various industries are becoming increasingly decisive in disposing of the 'negativ inherited from the 'bubble' economy in their accounting-year-end settlement in March 1999. moves can be taken as indicating firms' determination to launch drastic restructuring, and considers them as a necessary step for reviving the economy. If these efforts to part from accompanied by moves to enhance future activity, it should lead to the ideal picture, in structural adjustment of industry and an overall economic recovery are achieved smoothly.
The problem, as things stand today, is the persistence of the risk that the rapid disposal legacies' will proceed in the absence of sufficient constructive moves, strengthening the d tone of the economy. However, various efforts are starting to be made by firms and the go toward structural reform, and I hope such efforts will gradually bear fruit.
The dynamic process of divesting the economy of its old systems and giving birth to ne unavoidably involves great uncertainties. Therefore, it is also essential to reconstruct Jap system as promptly as possible to support the activities of firms facing this dynamic proces
Bearing in mind the significance of financial system reconstruction, I would now like to tal Bank's thoughts on this issue.
## III. Progress Toward the Reconstruction of Japan's Financial System
## A. The Current Condition of Japan's Financial System
It has been approximately nine years since Japanese stock prices peaked in late 1989 a approximately seven years since land prices began to fall. Meanwhile, a vast amount of money h been used to tackle the nonperforming-loan problem of financial institutions. It is truly regrett this problem has not been completely resolved as yet.
Today, the linkage between financial markets in Japan and abroad has strengthened significantly to the unprecedentedly rapid globalization and computerization of financial services. Therefore, a shock arises in one market, there is very serious risk that it will infect other markets. precisely why not only Japan but also other countries desire an early solution of Jap nonperforming-loan problem and the restoration of the credibility of Japan's financial system.
Needless to say, the parties concerned have made very great efforts to resolve the problem. In with the enactment of the Financial Function Reconstruction Law and the Financial Function Ear Strengthening Law of 1998, great progress has been made in establishing an institutional framewo The stage is now set for the actual task of unflinchingly cleaning up the nonperforming loans.
I have repeatedly stressed the need for enhancing the capital base of Japanese financial insti based on my thinking that the fundamental issue behind the deterioration in the credibilit individual institutions and the financial system as a whole is insufficient capital. In this reg appreciate the government's decision to inject large amounts of public funds into major banks significant step toward restoring the credibility of financial institutions. This alone, howeve enough to solve the problem. The Bank strongly hopes and expects that financial institutions continue to do their utmost to remove nonperforming loans from their balance sheets and also restructure their businesses within the context of the restructuring of the entire financial sect
In the past several years, the United States and Europe have witnessed large-scale mergers business tie-ups of financial institutions, which illustrate the dynamic competition in the financial market. There have been mergers and alliances across business and national boundaries efforts to respond to European unification or to enter new business areas. Meanwhile, similar m in Japan have been limited. However, the very recent trend toward diverse alliances a reorganizations, which was in part triggered by the injection of public funds, merits attentio clear that financial services are becoming greatly diversified driven by deregulation and innova information technology. Under these circumstances, the management of financial institutions required more than ever to establish effective strategies for selection of areas in which they comparative advantage and invest management resources, and for efficient supplementation of the weak business areas. In order to achieve corporate objectives, it may be more effective in c instances not to limit alliance partners to Japanese institutions. These considerations, in m should lead to still greater reorganization of the global financial community.
## B. Lessons Learned from Experience
One of the most important issues for Japan today is how to establish an efficient and stable fi system that can fully perform financial intermediation as well as other functions required in t century. Japan is still in the process of resolving the nonperforming-loan problem. Therefore lessons that will ultimately be learned from it is not yet known. Nevertheless, I believe meaningful to go over the lessons we have learned to date from our experiences in order successfully build a new financial system.
In my view, we have learned that Japan should have reviewed its principles to place emphasi management and should have utilized the market mechanism much sooner than it actually di response to the changes in the conditions surrounding financial industry. Now, in order t with the rest of the world, Japan needs to accelerate this review of principles.
The first concrete factor behind the delay in the review of principles was the inadequacy management systems of Japanese financial institutions. During the 'bubble' economy in t 1980s, Japanese financial institutions expanded their lending in pursuit of larger prof satisfactory risk management systems. In retrospect, the insufficient scrutiny of the possi price declines and concentration of loan exposure to the real estate-related indu manifestations of the absence of basic credit risk management. During this period, major institutions overseas were in fierce competition to improve their risk management technique for credit risk but also for market risk. The great damage Japanese financial institutions the collapse of the 'bubble' economy merely exposed their inadequate risk management.
The second factor was the ineffectiveness of the market's checks and balances, or put ano the deficiency of a system that should encourage the working of this mechanism. One reason was the extremely cautious stance of the parties concerned toward disclosure. For exam prevalent view until not so long ago was that disclosing the amount of nonperforming loans careful consideration because it might destabilize the financial system. The accounting s accounting practices have also tended to obscure the actual business condition of institutions. These increased the opaqueness of management of financial institutions and, the expectations of the parties concerned, spurred the deterioration in the credibilit financial system as a whole.
The third factor was the monetary authorities' insufficient response to the changes in t markets. We had historically relied on detailed regulations and one-on-one guidance to institutions in maintaining the stability of the financial system. It is true that thes worked for a long time. However, it also seems that they allowed Japanese financial institu indifferent to risk management and to their own responsibilities, and encouraged thei everyone-else-does' philosophy.
Under this so-called 'convoy system,' Japanese financial institutions offered very simila services. It is a fact that there was little incentive to differentiate themselves from th was no competition, and even if a financial institution developed a new product, the regulat tended to prevent the innovator profiting as he deserved.
The conventional principles might have remained viable, had the financial industry r static. However, innovation in financial technologies has been dramatic. It is no longer po fine-meshed net of regulations to keep up with the rapidly evolving financial transac markets, and to ensure unaided the soundness of financial institutions. This is why it is establish new principles based on self-responsibility and on the market mechanism.
## C. Establishment of New Principles
## 1. Issues toward April 2001
At present, the Japanese government provides a comprehensive safety net to the financial effective until March 31, 2001. The safely net is composed of (1) a framework to rec financial institutions with public funds; (2) full protection of deposits and other financ liabilities; and (3) a scheme to establish bridge banks or temporarily nationalize troubled
measures are essential given the current severe situation of the Japanese financial system. How we believe that unnecessary prolongation of these measures will be inappropriate, because they the potential of causing (1) an increase in social cost, including the amount of public funds u moral hazard on the part of depositors and financial institutions; and (3) further delays in so nonperforming-loan problem. Moreover, they are totally incompatible with the principles of Japa financial 'Big Bang,' which are 'free, fair, and global.'
I do not mean to say that from April 1, 2001 onward resolution of financial institution failures in every case involve execution of the so-called 'payoff,' that is, payment of deposit insu benefits. What is important as we move toward April 2001 is for individual financial instituti improve the quality of their balance sheets and strengthen their capital base. At the same ti must design and build a safety net based on the new principles of financial business, which I discuss in more detail later, and also on the lessons learned from past examples of financial ins failures. The scheme should incur the minimum social and economic costs, be able to promptly sol problems, and fit the financial system of the 21st century.
## 2. Emphasis on risk management
The foremost among the new principles is to place emphasis on risk management. As suggested by th expansion of derivatives transactions, financial transactions are sure to continue to undergo changes. Especially for major banks that are exposed to keen competition in international fina markets, adequate risk management will require constant efforts to keep up with financial innova Needless to say, the management of financial institutions needs to fully understand the substanc nature of the information derived from the risk management system, and effectively use t information in making its management decisions.
## 3. Utilization of the market mechanism
The second is to utilize the checks and balances of the market and to build into the financial s mechanism that ensures the system's stability. A prerequisite for this is disclosure of information to the market, which means more transparent financial institution management.
In this regard, it is most important to revise the accounting system. Assessment criteri nonperforming loans and standards for loan write-offs and loan-loss provisioning are now und review. At the same time, vigorous preparations must also be made for mark-to-market accountin which is soon to be introduced. The new accounting system is expected to increase the transpare of the balance sheet of financial institutions. Furthermore, it is expected to make financial in aware of the risks they are taking by helping them better understand their own financial conditio
For greater transparency of financial institution management, as the Bank has been stressing for time now, voluntary expansion of the scope of disclosure of an institution's financial condition important. Enhanced disclosure may at times mean forcing financial institutions to reveal t unsolved problems. Even so, past experiences teach us that it is more effective in securing the the market to honestly admit the existence of problems and declare how such problems will be sol than to conceal such information. It is also important for the management to explain in its own the management policy in order to win the trust of the market. Financial institutions should co disclosure not as a duty but as an opportunity to earn a good reputation with the public, and active use of such opportunities. Once a pioneering financial institution makes such disclosure, will follow suit or even improve the content of the disclosure. This will unleash a dyn competitive process.
Utilization of the market mechanism and increased sophistication of risk management will provid means of detecting a deterioration in the health of financial institutions. It will therefore
reduce the cost of regulating and supervising financial institutions but should also lesse on the safety net by preventing failures.
## D. Response of the Bank of Japan
The Bank of Japan believes that it has done its best to counter financial institutions' no loan problem within the existing institutional frameworks by, among other things, fulfillin the lender of last resort. However, the Bank needs to continue to examine unceasingly t central bank should play based on its experiences in battling the present financial crisis.
## 1. The failure of Nippon Credit Bank
From this perspective, the first incident we should examine carefully, I believe, is the ca Credit Bank. The temporary nationalization of this failed bank is likely to cause the Bank lose the \80 billion it subscribed to the bank's capital through the New Financial Stabili In April 1997, when Nippon Credit Bank drew up its restructuring plan, there was no safety which to deal with its management problems. Nor was there a consensus that bank debentures be protected by the deposit insurance system. Accordingly, there was a strong concern th bank failed, it would seriously disrupt the financial system at home and abroad. The Bank therefore made a difficult decision to use the New Financial Stabilization Fund. I believe the only choice the Bank had to safeguard the financial system. Unfortunately, sub developments have made it quite probable that the money subscribed by the Bank of Japan co lost. The Bank regards this as a grave situation.
Based on this experience, the Bank believes that it has to further clarify its policy on th funds for the purpose of maintaining an orderly financial system. Specifically, the Bank w define in more detail the criteria for assessing the fulfilment of the existing four condi provision: (1) there is a threat of systemic risk materializing; (2) there is no alte provision of central bank funds; (3) appropriate measures will be taken to prevent moral h (4) the financial soundness of the Bank of Japan will not be impaired. Now that a safety net a scheme to enhance the capital base of institutions with public funds, is in place, the B should be even more discreet in its capital subscription, or the provision of risk capital. learned valuable lessons from the disturbances in the financial system associated with th collapse of the 'bubble' economy and from its own responses to the disturbances, includ failure of Nippon Credit Bank. These lessons will always be remembered by the Bank of Jap referred to in making decisions in the future. I believe this is a responsibility assigne new Bank of Japan Law, which came into effect in April 1998.
## 2. Review of the Bank's on-site examination and off-site monitoring of financial institutio
Given the changing environment surrounding the financial industry and the Bank's experie dealing with financial institution failures, the Bank recognizes the need to review examination and off-site monitoring of financial institutions from a broad perspective. I denied that examinations and monitoring by the Bank during the 'bubble' period were not successful in accurately grasping the financial condition of financial institutions or, b findings, in prompting the Bank to take necessary steps to warn other parties of the situati
A central bank implements its policy through banking transactions. Therefore, its examinations and off-site monitoring, which are designed to accurately grasp the financial of individual transaction counterparties, are important starting points for execution of it are also essential in order for the Bank to accurately identify the risks in the overall f and the possibility of their materialization, and thereby prevent disruptions in the financi
In conducting on-site examinations, we will continue to place emphasis on the assessment of financial strength and risk management systems of institutions. In addition, with a view to adap the changing environment surrounding financial institution management, the Bank will become more flexible in determining the frequency of examinations and will carry out 'targeted examinati which focuses on specific areas of business and management. The Bank also intends to follow t condition of financial institutions on a continuous basis through a closer integration of examinations and daily off-site monitoring. The Bank believes that the integration should also r the regulatory burden on financial institutions.
The Bank will also make public as far as possible the findings of its research and studies overall financial system based on the information obtained through examinations and dail monitoring. By doing so, we hope to assist the advancement of financial institutions' risk manage techniques.
## 3. Loans to the Deposit Insurance Corporation
Now, I would like to add a word on the Bank of Japan's lending to the Deposit Insurance Corporat (DIC). The Bank's lending to the DIC has increased significantly reflecting the massive funding n of the DIC in proceeding with the resolution of the nonperforming-loan problem of financi institutions. Moreover, it has become very likely that this loan exposure will be fixed for an e period of time. The very function of a central bank is to implement monetary policy through purchase and sale of short-term, liquid financial assets. A sizable increase in fixed assets m only cause concern about a deterioration in the central bank's assets but also become a g impediment to the execution of monetary policy and money market operations. The Bank therefore regards the problem to be a very serious one. It is extremely unusual by international standard central bank to provide funds to facilitate the operation of the deposit insurance system. In fa has been no such case in the major industrialized countries. Therefore, the Bank of Japan believe the DIC, in raising funds, should first turn to the private sector and, for example, issue bonds its borrowing from the Bank of Japan to a bare minimum.
Needless to say, given the present condition of the Japanese financial system, the Bank of Japa not hesitate to provide short-term funds necessary for the smooth operation of the DIC. However, the reasons I have just described, I wish to stress that the DIC should first seek to raise fund means other than Bank of Japan loans, and make it clear that central bank money can be used only temporary bridge funds. In order to avoid taking on long-term fixed assets, the Bank of Japa deliberating whether to review the lending rate applied to the DIC, which to date has been the sa the official discount rate, to reflect the lending rates charged by private financial institution
## Conclusion
The Japanese financial system has been in an unprecedented crisis. This can be viewed as a pai process of transformation of the financial sector from a heavily protected to a competitive in that generates new know-how and income.
The path of this transformation will not be smooth. However, emerging moves on the part of financ institutions to undertake decisive restructuring and reorganization, and the fact that these in still possess sufficient potential in terms of management resources, including human resources, convince me that it will not be too long before they revive as a fully competitive industry, in quality rather than quantity, and driven by foresight rather than hindsight.