The Bank of Japan’s recent paper on macroprudential policy and its analysis of how macroprudential strategies are playing, and will play in the real world is quite a heartening document. The world needs Japan to find its way out of its lost decades and back to reasonable growth. This being so, there is no doubt that a confident and active BoJ, with a firm grip on the tiller as and when growth restarts, will be a very good thing. It is impossible to read the BoJ paper without feeling that many of the lessons of 2008 and the global crash have been understood and taken to heart.
One of the biggest lessons, which the BoJ has certainly grasped, is that microprudential policies alone won’t prevent the next bubble from building. As the BoJ paper points out, many of the most severe risks to economies come from the interrelationships between a number of players in various sectors. Focusing on the health of individual institutions will not show up these interactions. It is only by understanding the interactions of key players and key groups at the macro level, that regulators can hope to intervene meaningfully to maintain the stability of the global financial system.
The one odd note in the paper, however, and it is not a minor note but more of a major chord, is the astonishing degree of comfort the BoJ evinces in the idea of it being “a lender of last resort:”
“The Bank implements necessary measures in order to ensure stability when it detects risks threatening the stability of the entire financial system. Specifically, the Bank provides necessary liquidity as the lender of last resort, when shocks such as the failure of a financial institution could render the entire financial system unstable. Upon the need to prevent systemic risk from materializing, the Bank extends uncollateralized loans to the financial institution based on the so-called four principles for extending special loans…”
The “four principles” required for the BoJ to spring into action, bearing sacks of cash in each fist, are simply (a) there is a clear systemic risk, (b) without the BoJ the risk will materialize (i.e. the institution in question will fail because no one else will lend to it), (c) all relevant parties are to avoid moral hazard, and (d) acting will not blow the BoJ itself out the water (i.e. the institution’s debts do not overmass the BoJ itself – a near impossibility, since the BoJ can print however much cash it pleases).
As good as it sounds?
Let us pause a moment here and review the four principles upon which the BoJ is prepared to save financial institutions. First, what is it going to be saving them from? The only possible answer, based on the evidence of the 2008 global financial crash is that it will be stepping in to save the institution in question, whichever it is, from the consequences of its own folly. The BoJ manages to avoid saying this because it keeps its thinking at the helicopter level, where what it is dealing with, is the consequences of folly, namely the inability of the institution concerned to raise essential funding to continue its operations. The BoJ avoids admitting that the reason this situation develops in the real world is that no other funder is prepared to risk funding said institution because its debt position is so hideous.
If you take this view then where exactly does this leave the third point above, namely that all parties are to avoid moral hazard? The definition of moral hazard is to know that you can take any risk you please because the dear old BoJ is 100% committed to bailing you out. And here is the dear old BoJ setting its passionate devotion to the idea of being the source of last ditch bailouts in stone, even as it piously urges all concerned to avoid moral hazard.Japan was notorious for its reluctance to allow its “zombie banks” to go to the wall through the long years following its own crash in 1990, and here we have what looks like the same principle being enshrined in the BoJ’s new macroprudential operating principles. One can only hope that the BoJ gets its macroprudential regulatory act together and spots – and acts to deflate – any bubble-creating trading practices that emerge in Japan’s financial system, before they achieve the scale required to sink the institutions concerned. This is an extremely tough thing to do. Bubbles don’t look like bubbles when they are forming. They look like profitable trading “innovations.” They generate increased tax revenues for governments and a feeling of prosperity for the nation. In Japan’s case, a nascent bubble would look like heaven-sent growth at last after two decades of deflation. It will take a very special kind of regulator to step in and take that particular punch bowl away when the party’s just beginning to fire up. Would the BoJ be up to the job? I wouldn’t bet on it… Jumping on the toes of top CEOs is just not in its cultural DNA.
Further reading on asset bubbles and Asian economies:
- Asset bubbles, to act or not to act... , by Anthony Harrington
- IMF gives Hong Kong a lesson in deflating property bubbles, by Anthony Harrington
- Booms, Busts, and How to Navigate Troubled Waters, by Joachim Klement
Tags: asset bubble , bailout , Bank of Japan , BoJ , global crash , global financial system , global recession , Japan , Japan financial system , Japanese economy , lender of last resort , macroprudential , micro prudential , microprudential policies , zombie bank , zombie banks