Overview

In a financial crisis, central banks are often required to take credit risks through unconventional monetary policy measures (e.g., “credit easing”) as well as through micro- and macroprudential measures, due to the following circumstances:

(a) Market anomalies

A financial crisis usually damages the functioning of credit markets through market participants’ strong anxiety for liquidity as well as their extreme averseness to risk. Although a central bank is generally expected to refrain from influencing market views on credit risks, in such extreme circumstances as described above a central bank’s intervention in credit markets can be justified as a necessary action to normalize market functions.

(b) Zero bound of nominal interest rates

A central bank may face “zero bound” of interest rates especially when a financial crisis brings about strong deflationary pressures on the economy. Under zero bound, since there is virtually no room for further reduction in short-term risk-free interest rates, a central bank has to adopt unconventional measures so as to reduce credit risk premiums or interest rates on longer maturities in order to realize further easing effects.

(c) Need for prudential policy measures

A financial crisis often leads a central bank to take micro- and macroprudential policy measures so as to avoid the collapse of the financial system and to restore banks’ risk-taking capacity. Many of these policy measures inherently accompany risk taking by a central bank.

Legal Aspects of BOJ’s Policy Measures in Japan’s Financial Crisis

When a central bank, whose decision making is basically independent from the government, takes more risks, it should satisfy more stringent accountability requirements because of larger risks of ultimate taxpayers’ losses. Nonetheless, there is an inherent trade-off between stringent accountability and policy flexibility.

From a legal perspective, the policy measures undertaken by the BOJ during Japan’s financial crisis can be divided into the following categories:

• (a) Measures that the Bank of Japan Act empowers BOJ to execute solely by its own decision:

  • Massive liquidity provision (through widening the range of eligible collateral, widening the range of counterparties, extending the period of liquidity provision, etc.)

  • Outright purchases of ABS and ABCP in the secondary market

  • Outright purchases of government securities in the secondary market

• (b) Measures that the Bank of Japan Act requires the BOJ to have the authorization from the Minister of Finance and the Prime Minister:³

  • Purchases of stocks held by banks

  • Provision of subordinated loans to banks

^{Table 1.}

Legal Aspects of BOJ’s Policy Measures

^{Table 1.}

Legal Aspects of BOJ’s Policy Measures

Article	Article 15(1)	Article 43(1)
Procedure	Solely by BOJ’s decision	Authorization from PM and FM is needed.
Policy measures	Massive liquidity provision Outright purchase of ABS and ABCP in the secondary market Outright purchase of government securities in the secondary market	Purchase of stocks held by banks Provision of subordinated loans to banks

View Table

^{Table 1.}

Legal Aspects of BOJ’s Policy Measures

Article	Article 15(1)	Article 43(1)
Procedure	Solely by BOJ’s decision	Authorization from PM and FM is needed.
Policy measures	Massive liquidity provision Outright purchase of ABS and ABCP in the secondary market Outright purchase of government securities in the secondary market	Purchase of stocks held by banks Provision of subordinated loans to banks

The legal basis for the BOJ’s policy tools referred to above are found in Articles 15(1) and 43(1) of the Bank of Japan Act. Article 15(1) empowers the BOJ to provide liquidity on a collateralized basis, and to buy and sell “negotiable instruments, bonds or electronically recorded claims” for monetary control solely by the decision of the Policy Board. Besides, Article 43 (1) allows the BOJ to take an almost infinite range of policy actions, on the condition that BOJ obtains authorization from the Minister of Finance and the Prime Minister, and as long as such policy actions are necessary to achieve price stability or financial stability.

As indicated above, Article 15(1) of the Bank of Japan Act empowers the BOJ to take widely-ranged policy tools for monetary control and ordinary liquidity provision, such as purchases and sales of debt instruments, solely by its own decision. Such a legal framework enables the BOJ to provide abundant liquidity and intervene in credit markets in an extremely swift and flexible manner so as to tackle any sudden deterioration in financial market conditions.

Article 43(1) of the Bank of Japan Act also empowers the BOJ to adopt widely-ranged policy tools so as to achieve price stability and financial stability, on the condition that BOJ obtains authorization from the Prime Minister and the Finance Minister. In this regard, the Article 43(1) strikes a delicate balance between the BOJ’s policy discretion and its accountability to taxpayers. Moreover, this Article enables BOJ to take any necessary actions without any new legislation, which usually takes a long time to enact.

Overview

In theory, a central bank can create infinite liquidity. Thus, as long as crisis management remains in a sphere of liquidity management, a central bank generally has sufficient scope for policy maneuvers to normalize market conditions. On the other hand, a central bank may face extremely difficult challenges in the overlapping area of liquidity risks and credit risks, as shown in the case of Yamaichi in November 1997. Indeed, in a financial crisis, it is not always easy to distinguish liquidity risks from credit risks.

Early Intervention, Transparency, and Stakeholders’ Interests

In an ordinary bankruptcy procedure, the shareholders’ return shall be zero because the net worth of the bankrupt firm has already been negative, and the remaining losses shall be allocated to creditors on a pro-rata basis.⁴

In cases of the resolution of financial institutions, however, the situations can be much more complicated. In general, legal frameworks in many countries allow regulatory and supervisory authorities to intervene in financial institutions at an earlier stage than in the case of bankruptcies of business corporations. Needless to say, such an “early intervention” reflects the importance of the stability of the financial systems as a whole. The authorities try to intervene in a troubled financial institution while its net worth remains positive, so as to maintain its core financial function, prevent systemic spillovers and maintain the stability of the whole financial system.

Nonetheless, such an early intervention inherently accompanies the “trade-off” relationship with transparency, because it may not escape from some discretion in the choice of the timing of intervention. Since the net worth value of corporations always fluctuate, the timing of early intervention may affect the interests of the stakeholders. For example, shareholders may not welcome the authorities’ early intervention if they must completely lose all the possible upside return in the future and bear the losses fixed at the timing of intervention. Moreover, since the authorities’ early intervention is executed while the intervened financial institution’s net worth is believed to remain positive, the creditors are unlikely to expect any losses, and the shareholders might also expect some positive returns.

Furthermore, it is extremely difficult to estimate the actual net worth of a troubled financial institution at the time of intervention, since its ongoing concern value may substantially differ from its liquidation value. It may be possible to calculate the approximate value of financial assets held by the troubled institution by applying the market prices observed then. Nonetheless, market prices always fluctuate, and the volatility of these prices are extremely large in a financial crisis. Consequently, these assets are very likely to be sold only at substantially lower prices than estimated. The case of Yamaichi, whose net worth became negative, clearly evidenced such difficulties. Thus, it may not be an easy job for authorities to determine the amount of fair returns and losses of various stakeholders such as shareholders, collateralized creditors and general creditors.

Cross-Border Issues and Ring-Fencing

The problems regarding the resolution of a troubled financial institution may become far more complicated if it has cross-border aspects. In general, the authorities in each jurisdiction have a duty to maximize creditors’ interests in bankruptcy proceedings. Thus, in the resolution of a global financial institution, the authorities of each jurisdiction are very likely to compare (a) the amount of claims of domestic and overseas creditors, and (b) the value of the assets of the institution within the border and outside the border. If the authorities see that the aggregate amount of domestic creditor’s claims is relatively large while the aggregate value of the assets within the border is relatively small, they would prefer participating in universal-type resolution procedures. On the other hand, if they see that there are sufficient amount of the assets within the border to cover the claim of domestic creditors, they would prefer “ring-fencing,” so as to maximize domestic creditors’ interests. In this regard, “ring-fencing” usually occurs because the authorities of each jurisdiction are loyal to their own duties, which are also in line with the incentives of creditors.

In addition, under the globalization of financial services, it may not always be easy to determine the location of assets. For example, it is a very common practice that securitized products, based on original mortgage assets in Country A, are created as shares of an investment vehicle incorporated in “tax haven” Country B, and possessed by an investor in Country C through a custodian in Country D as a nominee.

Principle of Corporate Laws and “Too Complex to Fail” Issues

Global financial institutions usually have hundreds of affiliates and subsidiaries, and some may well argue that such structural complexities constitute “too-complex-to-fail” (TCTF) problems, which we should continue paying attention to.

Nonetheless, corporate laws provide for corporations with limited liabilities so as to facilitate the development of commercial businesses. Insulating risks and returns through the scheme of corporations with limited liabilities usually makes investment judgment easier, since the profiles of risks and returns should be more visible. In addition, from the viewpoint of regulation and supervision, corporate laws can create the entities that are suitable to the current regulatory frameworks. For example, a bank subsidiary of a holding company is to be regulated by bank regulators, and an insurance subsidiary is to be regulated by insurance regulators, while another subsidiary might operate as a non-bank business firm. If all of these businesses were to be operated in a single, extremely big entity, it might be difficult for investors to evaluate the profiles of risks and returns, and for the financial authorities to enforce regulation and supervision in an effective manner.

Moreover, creating overseas subsidiaries may give the regulators of host countries more room to maneuver in regulation and supervision. For example, if all the businesses of a global financial institution are operated by a single entity and a part of the businesses are in trouble, it may be difficult for regulators to shut down the troubled businesses while maintaining other operations of the institution. Indeed, the courts in the United States and Japan sometimes “pierce the corporate veil,” but only on very limited occasions. In the debates of financial regulation, more efforts may be needed to strike the right balance between the benefits of corporate systems and TCTF problems.