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On Financial Stability

(Excerpt from the Outline of Business Operations for Fiscal 1998)

May 28, 1999
Bank of Japan

1. Financial Stability and the Role of the Bank of Japan

One of the objectives of the Bank of Japan, as stipulated in Article 1 of the Bank of Japan Law, is "to ensure the smooth settlement of funds among banks and other financial institutions, thereby contributing to the maintenance of an orderly financial system." Financial system stability is an important task of the Bank of Japan because: (a) it is necessary for achieving, through monetary policy, price stability, the most important mission of the Bank of Japan; and (b) in actually securing financial system stability, the Bank of Japan, as the sole issuer of legal tender, is in a position to provide payment with finality (banknotes and Bank of Japan current accounts) and exercise the lender of last resort function.

In order to develop and maintain stability and efficiency of the financial system, the Bank of Japan has been active in the following areas.

From the viewpoint of preventing systemic risk, the Bank of Japan has taken steps to improve efficiency, stability, and international consistency of the payment and settlement system, an essential infrastructure supporting the financial system, and is always prepared to appropriately exercise its lender of last resort function in a timely fashion.

In order to secure proper working of Bank of Japan operations including the lender of last resort function, the Bank conducts on-site examinations (under Article 44 of the Bank of Japan Law) and off-site monitoring (the analysis of financial data collected from banks and information obtained from bank management through interviews) to grasp the business and financial conditions of individual financial institutions which hold accounts with the Bank.

In line with the trend toward the internationalization and globalization of finance, the Bank of Japan closely cooperates with foreign central banks and supervisory authorities to maintain financial system stability. These cooperative efforts vary, ranging from discussions on bank supervisory-related issues at the Basle Committee on Banking Supervision to discussions on improvement of payment and settlement systems at the Bank for International Settlements.

2. Four Principles in Conducting Business Necessary to Maintain Financial Stability

(1) Overview

When conducting "business necessary to maintain an orderly financial system, including the provision of loans," as stipulated under Article 38 (hereafter "special loans"), the Bank of Japan has made decisions in view of the following four principles:

  1. 1) there must be a strong likelihood that systemic risk may materialize;
  2. 2) there must be no alternative to the provision of central bank funds;
  3. 3) all responsible parties are required to take clear responsibility to avoid moral hazard; and
  4. 4) the financial soundness of the Bank of Japan should not be impaired.

The Bank has taken efforts to disseminate information on these principles so that the public understands the rationale behind its operations in dealing with failed financial institutions.

Since the provision of special loans is one of the countermeasures to avoid a financial crisis (hereafter "safety net"), it should be reviewed in light of the changes in the overall framework of the safety net including deposit insurance. In particular, when applying the four principles in determining whether special loans should be extended, careful attention should be paid to the fact that other components of the safety net have been greatly strengthened in recent years.

The Bank of Japan intends to improve the transparency of its policy decisions by reaffirming its posture with respect to application of the four principles under the current safety net framework.

In providing special loans, the Bank of Japan must make sure that the four principles are deemed to be duly satisfied. In order to come to such a judgement, the Bank must continuously monitor financial markets at home and abroad as well as the whole financial system, and their relationship with the real economy. In addition, it is equally important to obtain the latest information on the business and financial conditions of individual financial institutions through daily monitoring and flexible on-site examinations.

In March 2001, the current special treatment of the deposit insurance scheme is scheduled to terminate. The Bank of Japan will re-examine how it will provide special loans under a new safety net framework to be established after April 2001.

(2) Explanation and Application of the Four Principles

Principle 1: There must be a strong likelihood that systemic risk may materialize.

Financial institutions perform various functions. One of the most fundamental is the provision of a payment and settlement system in the form of deposits. Equally fundamental is the credit creation and credit intermediation function, namely accepting highly liquid short-term liabilities like deposits and investing them in such illiquid assets as medium- to long-term loans.

Most daily economic transactions are settled through fund settlement systems among financial institutions, and hence the soundness of such systems should be maintained. In addition, the provision of money and credit necessary for economic activity is provided through such fund settlement systems in which financial institutions play a key role. As such, fund settlement systems are a fundamental infrastructure supporting the nation's economic activity, thus it is essential to maintain financial system stability for sustainable economic growth.

However, it should be noted that there is inherent risk in the financial system, namely systemic risk. Financial institutions daily process a huge amount of fund transactions with customers and other financial institutions. Except for those settled in cash, most transactions are settled through deposit accounts held at financial institutions. Eventually, such settlement is finalized by way of the current deposit accounts of financial institutions held with the Bank of Japan. Since financial institutions are mutually connected like a web through various transactions and networks, the default of one financial institution could be contagious and easily affect other institutions through markets and fund settlement systems. The recent development of telecommunication technology and innovative financial products as seen in the increase in derivative transactions have made daily financial transactions massive, more complicated, and more globally linked. In addition, since such new transactions as derivatives have deepened linkage among financial products as well as between markets at home and abroad, there is a greater possibility than ever before that turmoil in one market might rapidly spread to other markets. If such turmoil arises, not only credit intermediation and fund settlement systems but also the market function itself would be paralyzed. In some cases, there is risk that effects could instantaneously spread abroad.

The deposit and loan activities of financial institutions and the settlement services provided by them are built upon the trust of depositors. Since financial institutions invest most deposits in such assets as loans, once their soundness is brought into question and depositors decide to withdraw their deposits simultaneously, even a sound financial institution would find it difficult to meet such demand. As such, financial institutions are quite vulnerable to any diminution of their credibility. In particular, under current financial uncertainty against the background of the non-performing loan problem, there would appear to be considerable contagion risk in that the failure of one financial institution could induce the withdrawal of deposits from other financial institutions, resulting in multiple bank failures.

The so-called Promisel Report, published in 1992 by the BIS Euro-Currency Standing Committee, defined systemic risk as "the risk that a disruption (at a firm, in a market segment, to a settlement system etc.) causes widespread difficulties at other firms, in other market segments or in the financial system as a whole." Once systemic risk materializes, credit intermediation and settlement functions come to a halt, eventually inducing turmoil in the whole economy and jeopardizing its stability.

If a financial crisis is caused by liquidity drying up due to the default of a financial institution or the disruption of market functions, the central bank is the ultimate body that can deal with it. This is when the lender of last resort function of a central bank comes into play to prevent systemic risk from materializing by providing liquidity as needed. In this regard, the first principle is the most important and fundamental among the four. It should be emphasized that a decision to effect the lender of last resort function is not based on an intention to protect or rescue an individual financial institution, but whether the suspension of deposit withdrawals or defaults at an individual financial institution could adversely affect the overall financial system.

Application

The first principle is deemed to be satisfied in such situations as the following:

  1. (a) Judging from the circumstances surrounding the financial system, there is concern that the suspension of deposit withdrawal at one bank will intensify depositor uncertainty, thereby inducing runs on other banks.
  2. (b) In view of the linkage of transactions among financial institutions, there is concern that the default of one bank will make it difficult for other banks to meet payments, thereby inducing a chain of defaults.
  3. (c) As a result of transactions in various markets not being performed because of the default of a financial institution, there is concern that markets at home and abroad will be in turmoil and market functions significantly disrupted, leading to a chain of defaults at large.

Principle 2: There must be no alternative to the provision of central bank funds.

Under the current framework, in dealing with a failed bank, all its liabilities, including deposits, are protected with the losses of the failed institution fully covered by the deposit insurance system and through such measures as the transfer of its business to an assuming bank. The deposit insurance system protects depositors by covering the losses of a failed bank in the form of financial assistance or by paying off deposits in its stead, thereby seeking to maintain an orderly financial system through ensuring trust in the safety of deposits.

On the other hand, the lender of last resort function of a central bank aims at preventing systemic risk from materializing, as explained under Principle 1, by providing temporary liquidity to financial institutions experiencing a liquidity shortage, given that there is no alternative to central bank funds, thereby securing deposit withdrawal and ensuring the execution of existing transactions. In the framework of dealing with failed financial institutions, special loans of the Bank of Japan are provided as bridging finance until failed financial institutions obtain financial assistance under the deposit insurance system on transferring their business to other financial institutions. As such, the lender of last resort function basically refers to the temporary provision of liquidity, and is, in this regard, different in nature from funds intended to cover existing losses.

However, if operations under the safety net are easily invoked, moral hazard with respect to depositors and bank management will become more pronounced. When financial system uncertainty lingers, as is the present case in Japan, it may be unavoidable to adopt a flexible approach in protecting depositors for a limited time. Since central bank funds should be provided literally as the lender of last resort, every possible solution must be explored before central bank funds are used. The provision of central bank loans should only be effected when there is no alternative, and the amount should be restricted to the minimum necessary. This may be justified also from the viewpoint of containing moral hazard. Furthermore, interest rates on such loans should be higher than those on regular loans collateralized by sound assets.

Application

The second principle is satisfied when all of the following conditions are met:

  1. (a) Despite all efforts, a financial institution faces the prospect of a fund shortage.
  2. (b) It is difficult to cope with the situation within the private sector framework, such as through support from other financial institutions.
  3. (c) It is difficult to cope with the situation within the public sector framework, such as through loans from the Deposit Insurance Corporation.

Principle 3: All responsible parties are required to take clear responsibility to avoid moral hazard.

A safety net is indispensable to prevent systemic risk from materializing and to ensure financial system stability. However, if it is known that safety net is being enhanced, the more it becomes likely that bank management and shareholders will not effect self-discipline as rigorously as would otherwise be the case. This is called the moral hazard problem. Therefore, in effecting a safety net, due attention should be paid to maintaining discipline on the part of related parties.

When related parties are subject to criminal and civil liability, they are dealt with according to the law. In addition, in past cases of financial institution failure, management was required to take responsibility for failure and resign. Stockholders and subscribers are required to share the burden of losses.

The degree and content of management responsibility may differ. Since the failure of a financial institution is dealt with by administrative procedures, with management responsibility investigated during the process, it is not necessarily deemed appropriate for a central bank to investigate such responsibility on its own. Still, in order to avoid moral hazard, in exercising the lender of last resort function it is important for a central bank to ascertain whether bank management as well as shareholders and subscribers are likely to take clear responsibility.

Application

The third principle is satisfied when the following conditions are expected to be fulfilled:

  1. (a) Management responsibility for failure is expected to be acknowledged through such measures as the resignation of bank management.
  2. (b) The responsibility of shareholders and subscribers is expected to be acknowledged by such measures as their taking losses on capital and subscription.

Principle 4: The financial soundness of the Bank of Japan should not be impaired.

As stated before, the lender of last resort function of a central bank basically refers to the temporary provision of liquidity. It is not the role of the central bank to cover losses in such cases as clearly non-collectable ones. In coping with financial system uncertainty in the past, the Bank of Japan provided not only temporary liquidity but also risk capital such as capital subscription as a special and exceptional measure. The latter was necessary to avoid systemic risk given the then underdeveloped safety net system. The provision of risk capital goes fundamentally beyond the role of a central bank, and should be dealt with under other frameworks such as the deposit insurance system.

In addition, central bank special loans are normally provided to troubled financial institutions on a non-collateral basis, and thus involve greater uncertainty compared with regular credit provisions collateralized by safe assets.

On the other hand, as the nation's central bank, the Bank of Japan is required to conduct policies giving due consideration to maintaining its own financial soundness. This is because once a central bank loses public trust, not only does policy implementation become difficult, but also the credibility of the whole nation is impaired through diminishing trust in the currency which the central bank issues, thus significantly affecting both corporate and household sector activity.

Therefore, the Bank of Japan must fulfill its role as the lender of last resort by taking due account of both "the possibility of systemic risk materializing and its spillover effects" and "the magnitude of risk accompanying the provision of credit and the likely effect on financial soundness of the Bank if such risk should materialize." In addition, when exercising the lender of last resort function, the Bank of Japan must try to maintain its financial soundness by taking every possible measure such as adequate provisioning according to the risk entailed.

It should be emphasized that the amount of loans provided under the lender of last resort function should be confined to the absolute minimum as necessary. Interest rates on such loans should be higher than those on regular loans collateralized by safe assets.

Application

The fourth principle requires that the following be duly taken into account:

  1. (a) There must be reason to believe that special loans are collectable. The loans should not be provided to cover the loss in a clearly non-collectable situation.
  2. (b) In principle, liquidity should be provided, not risk capital.
  3. (c) In order to prepare for possible losses, provisions should be set aside, as needed, for each individual case, thereby maintaining financial soundness to underpin the credibility of the central bank.