Chapter 5: The Legal Framework for Central Banking in a Crisis: Japan’s Experiences
- International Monetary Fund. Legal Dept.
- Published Date:
- February 2013
In a financial crisis, a central bank is often required to take various “unconventional” policy measures as well as to provide liquidity as a “lender of last resort (LLR).” Some unconventional policy measures inherently involve the risk of credit losses, which will ultimately be covered by taxpayers. Also, a central bank’s LLR functions, although necessary for maintaining financial stability, cannot escape from counterparty credit risks. In these respects, many of a central bank’s policy measures in a financial crisis may become closer to “quasi-fiscal” policies.
Consequently, in a financial crisis a central bank inevitably faces difficult challenges: It has to take necessary policy measures in a swift manner so as to tackle an immediate crisis, while being accountable to taxpayers. In this regard, the legal framework for a central bank plays an extremely important role in facilitating its crisis management, since it is the relevant laws that determine what policy tools a central bank has, and how flexibly it can make use of them.
This paper will focus on the experiences of the Bank of Japan (BOJ) in Japan’s financial crisis since the 1990s. The first half of this paper illustrates how the legal framework for BOJ strikes a delicate balance between flexibility and accountability, and how it actually enabled the BOJ to take necessary actions during the Japan’s financial crisis. Then, the second half of the paper broadly describes the remaining issues associated with the resolution of financial institutions, with particular attention to Japan’s experiences.
Legal Aspects of Central Banking in a Financial Crisis—Unconventional Easing, LLR, and Macroprudential Measures
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.
The BOJ’s Policy Measures During Japan’s Financial Crisis
In Japan’s financial crisis since the 1990s, the BOJ actually took widely-ranged policy measures, as described below:
(a) Massive liquidity provision
The BOJ provided a massive amount of liquidity for longer periods, to a wider scope of counterparties, while taking a wider range of collateral, in order to alleviate liquidity concerns.
(b) Unconventional monetary easing
Since 1999, the BOJ adopted measures known as Zero Interest Rate Policy (ZIRP) and Quantitative Easing Policy (QEP). As parts of QEP, the BOJ purchased asset-backed securities (ABS) and asset-backed commercial paper (ABCP) on an outright basis.
(c) Macroprudential policy measures
In the autumn of 2002, the BOJ introduced the stock purchasing program and purchased stocks held by banks so as to restore the risk-taking capacity of the banking sector that faced non-performing loan problems.1, 2
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
|Article||Article 15(1)||Article 43(1)|
|Procedure||Solely by BOJ’s decision||Authorization from PM and FM is needed.|
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.
Legal Aspects of the BOJ’s Provision of Loans to Individual Financial Institutions
A central bank’s LLR function for individual financial institutions also has to strike the right balance among financial stability, democratic decision-making processes and accountability to taxpayers. In general, if a central bank provides loans to financial institutions on a collateralized basis, risks of credit losses are relatively small. On the other hand, if its LLR functions must be executed on an uncollateralized basis, a central bank should face far more stringent accountability requirements due to larger credit risks. The fact that a central bank has to make uncollateralized loans to a financial institution means that the institution is in severe financial trouble so that it does not have sufficient eligible collateral. Thus, the credit risks associated with such loans can be substantial. In an economic sense, a central bank’s credit losses mean unintended income transfers from taxpayers to stakeholders of the borrower financial institution.
|Article 15(1)||The following matters concerning currency and monetary control shall be decided by the Board:|
(i) Determining or altering the basic discount rate and other discount rates pertaining to the discounting of negotiable instruments set forth in Article 33, paragraph 1, item (i), as well as the types and conditions of negotiable instruments pertaining to the said discounting;
(ii) Determining or altering the basic loan rate and other loan rates pertaining to the loans set forth in Article 33, paragraph 1, item (ii), as well as the types, conditions, and value of collateral pertaining to the said loans;
(iii) Determining, altering, or abolishing reserve requirement ratios, the base date, and other matters prescribed in Article 4, paragraph 1 of the Act on Reserve Deposit Requirement System (Act No. 135 of 1957);
(iv) Determining or altering the guidelines for financial market control (currency and monetary control conducted through financial markets [including open market operations]) through such measures as the buying and selling of negotiable instruments, bonds, or electronically recorded claims (electronically recorded claims prescribed in Article 2, paragraph 1 of the Electronically Recorded Claims Act [Act No. 102 of 2007]; hereinafter the same shall apply in this item and Article 33, paragraph 1) prescribed in Article 33, paragraph 1, item (iii), as well as determining or altering the types, conditions, and other matters of negotiable instruments, bonds, or electronically recorded claims pertaining to the said financial market control;
(v) Determining or altering other guidelines for currency and monetary control;
(vi) Determining or altering the Bank of Japan’s view on currency and monetary control, including its basic view on economic and monetary conditions which provides the basis for matters listed in the preceding items.
|Article 43(1)||The Bank of Japan may not conduct any business other than that specified by this Act as the business of the Bank; provided, however, that this shall not apply to the case where such business is necessary to achieve the Bank’s purpose specified by this Act and the Bank has obtained authorization from the Minister of Finance and the Prime Minister.|
From a legal perspective, BOJ’s loan provision to individual financial institutions can also be categorized as below:
(a) Article 33(1) of the Bank of Japan Act empowers the BOJ to provide loans to financial institutions on a collateralized basis, as its “regular business,” on its own decision (see Table 3).
(b) On the other hand, Article 38 of the Bank of Japan Act requires the a “request” to the Prime Minister and the Finance Minister in order that the BOJ could provide uncollateralized loans to financial institutions. In this regard, the Prime Minister and the Finance Minister are also responsible for the BOJ’s decision to extend uncollateralized loans (see Table 4). Moreover, the Act requires that the Prime Minister and the Finance Minister should find such uncollateralized loans “especially necessary for the maintenance of stability of the financial system.”
|Article||Article 33(1)||Article 38|
|Procedure||Solely by BOJ’s decision||Request from PM and FM is needed.|
|Article 33(1)||In order to achieve the purpose prescribed in Article 1, the Bank of Japan may conduct the following business:|
(i) Discounting of commercial bills and other negotiable instruments;
(ii) Making loans against collateral in the form of negotiable instruments, national government securities and other securities, or electronically recorded claims;
(iii) Buying and selling of commercial bills and other negotiable instruments (including those drawn by the Bank of Japan in this item), national government securities and other bonds, or electronically recorded claims;
(iv) Lending and borrowing of national government securities and other bonds against cash collateral;
(v) Taking deposits;
(vi) Conducting domestic funds transfers;
(vii) Taking safe custody of securities and other instruments pertaining to property rights, or certificates;
(viii) Buying and selling gold and silver bullion and carrying out business related to business set forth in the preceding items.
|Article 38||(1) The Prime Minister and the Minister of Finance may, when they find it especially necessary for the maintenance of stability of the financial system, such as in the case where they find that serious problems may arise in the maintenance of stability of the financial system based on the consultation pursuant to Article 57-5 of the Banking Act (Act No. 59 of 1981) or other laws and regulations, request the Bank of Japan to conduct the business necessary to maintain stability of the financial system, such as to provide loans to the financial institution pertaining to the said consultation.|
(2) When a request has been made from the Prime Minister and the Minister of Finance as prescribed in the preceding paragraph, the Bank of Japan may conduct the business necessary to maintain stability of the financial system, including the provision of loans under special conditions, responding to the said request, in addition to the business prescribed in Article 33, paragraph 1.
A central bank’s provision of uncollateralized loans constitutes extremely difficult challenges to policymakers. Immediately after the outbreak of trouble at Yamaichi Securities Co. in November 1997, the financial authorities and the BOJ determined to provide an uncollateralized emergency loan to Yamaichi, on the assumption that its net worth was still positive. Undoubtedly, the uncollateralized loan to Yamaichi, one of “top 4” securities firms in Japan then, contributed to containing cross-border spillovers of Japan’s financial crisis. Nonetheless, Yamaichi turned out to be insolvent later, and BOJ’s uncollateralized loan to Yamaichi inflicted credit losses. Such an experience illustrates the most difficult aspect of financial crisis management, which is to be focused on in the next section.
Remaining Issues—Especially in the Resolution of Troubled Financial Institutions
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.
Generally speaking, the legal frameworks for central banking, such as the Bank of Japan Act, have tried to satisfy both the need for effective crisis management and the accountability requirement, and have facilitated the central bank’s crisis management. Indeed, such legal frameworks have so far effectively supported the central bank’s policy actions, especially against “liquidity-type” crisis and the malfunctioning of financial markets.
Nonetheless, there remains a lot of work to be done, especially in the nexus of micro- and macroprudential policies. How can the authorities execute “early intervention” so as to maintain overall financial stability, while achieving a fair distribution of losses among various stakeholders? How can the authorities in each jurisdiction maximize the interest of stakeholders of a troubled financial institution, while minimizing the impact on global financial systems? In order to resolve these challenging questions, more collaborative work by lawyers and economists would be strongly needed.
The BOJ’s purchases of stocks held by banks liberated the capital banks held against the market risks associated with their stock holdings, and thus improved their risk-taking capacity. In this regard, the BOJ’s stock purchasing was akin to a counter-cyclical capital buffer now being discussed in the international fora as a possible macroprudential policy option.
In February 2009, shortly after the Lehman Shock, the BOJ reinstituted the stock purchasing program as a temporary measure. Three months later, the BOJ adopted another temporary facility to provide subordinated loans to banks.
Article 61-2 of the Bank of Japan Act states that “(t)he Prime Minister shall delegate the authority under this Act (excluding Article 19) to the Commissioner of the Financial Services Agency except for those prescribed by a Cabinet Order.”
Thus, if an ordinary liquidation procedure is always applied to financial institutions in trouble, no public money injection in needed. The need for public money injection is needed because the authorities may want to maintain a part of the functions of troubled institutions, or to bail-out a part of the stakeholders so as to maintain financial stability.