RIETI Policy Debate

Round 2: BOJ Plan to Purchase Bank-held Shares: Second Best Option to Banking Crisis—Preferable to Liquidity Provision; the Government Should Take Initiative

Fellow, RIETI

An unrestrained supply of liquidity in the money market and deposit guarantees at the time of a banking crisis will increase the ultimate burden on taxpayers. The Bank of Japan's plan to purchase shares directly from banks is tantamount to the injection of public funds into the banks, a task that should have been taken by the government. The measure initiated by the central bank surely comes with negative side effects, but it deserves credits as a second best option to the banking crisis.

Continuing Insolvency is the Substance of a Banking Crisis

The BOJ stunned the world when it unveiled its stock purchasing plan during an unscheduled policy board meeting on September 18. The announcement was meant to demonstrate the BOJ's determination to revamp banks' capital bases with an effective infusion of public funds, effectively declaring that the nation's banking system is once again in a crisis. In this article, I would like to evaluate the BOJ's latest policy, introducing some empirical studies on policy responses during past banking crises.

TA banking crisis initially refers to a panic situation in which depositors make a run on banks. This is how a banking crisis has been generally perceived in Japan and as we do not observe such a panic situation in Japan at this moment, some people insist that the Japanese financial system is not in a critical condition.

Within a circle of researchers, however, recognition is now spreading that a bank panic is just one symptom of a banking crisis and that the fundamental question is whether or not the banking system as a whole is in a state of insolvency. Based on this perspective, it is highly probable that the Japanese financial system is actually in the state of an effective "crisis."

The World Bank perceives the substance of a banking crisis to be insolvency, a situation in which liabilities exceed assets, and considers Japan to have been in a crisis for more than a decade based on this perspective.

Policy responses to a banking crisis are largely divided into the following five categories:

[Unlimited Support of Liquidity]
In order to prevent the spread of panic, the central bank provides unlimited liquidity to the money market. Primarily, a central bank should be providing liquidity only to sound banks. But, as it is difficult to distinguish sound banks from those which are unsound and insolvent, liquidity is often given to troubled banks, consequently prolonging their lives. Excessive monetary easing and BOJ emergency loans under the Article 25 of the Bank of Japan Law are examples of such policies.

[Unlimited Guarantee of Bank Deposits]
To prevent disturbances among the general public, a government often extends full protection to bank deposits. Japan, too, introduced such unlimited protection in 1996 by freezing a payoff scheme, a limited protection plan that guarantees the repayment of principal worth up to ¥10 million and interest. The freeze on the payoff scheme has yet to be fully lifted.

[Regulatory Forbearance]
One typical policy measure is to allow insolvent banks to adopt easier accounting standards to enable them to continue operations. In the 1980s, the United States resorted to this measure to bail out major U.S. banks which were then suffering under mounting bad loans to Central and South America. This scheme has been generally perceived to be a success.

[Capital Augmentation through Public Funds]
Capital injections are indispensable to restore the financial stability of insolvent banks. The direct injection of public funds, however, is not the only way to accomplish this policy measure. When a government or central bank purchases banks' bad loans and other risk assets including their held shares at higher-than-market prices, it is also considered to be a capital augmentation measure in a broad sense.

[Establishment of a Resolution and Collection Corporation]
In coping with a banking crisis, massive amounts of problem loans must be disposed of. The disposal of bad loans, however, is a task which is completely different from banks' ordinary operations. And it is said that specialized agents, rather than banks themselves, can carry out this task more efficiently. Indeed, many countries, in tackling their respective banking crises, established public resolution and collection corporations and let them promote bad loans disposal.

Capital Augmentation does not Increase Fiscal Costs

A group of researchers led by Patrick Honohan, an economist at the World Bank, has conducted an empirical analysis on the effects of the aforementioned policy measures, using data from the latest 40 cases of banking crises.

Concerning the impact of policy measures on fiscal costs that are necessary to defuse a crisis, they found: (1) the first three measures—liquidity support, deposit guarantees and regulatory forbearance—have a significant effect on the boosting of fiscal costs, while (2) the later two measures—capital augmentation and a public debt collection entity—do not have any significant effect on absolute fiscal costs.

Liquidity support, deposit guarantees and regulatory forbearance are measures that help insolvent banks continue operations, and many economists have been warning that such life-extending measures may foster a moral hazard. Empirical evidence described in (1) has confirmed such concerns.

The finding that capital augmentation and the establishment of a resolution and collection corporation would not increase fiscal costs is quite noteworthy. These measures are meant to fill the "hole" of excessive liabilities and, thus, require direct fiscal expenditures. However, the empirical study has shown that the overall costs required for the solution of a banking crisis would not increase by implementing these measures.

This provides counterevidence to those opposing bank recapitalization with public funds and other aggressive bad loan disposal measures based on the ground that such schemes would boost fiscal costs. The "hole (of fiscal costs)" has not been created by measures to fill the hole of excessive liabilities. The "hole" would have been there long before the measures were implemented.

As to the influence of these measures on the real economy's recovery, it was found that liquidity support has a significant effect in impairing economic growth, while the other measures have no significant impact. That is, unlimited liquidity support by a central bank at a time of a banking crisis would increase fiscal costs required to solve the crisis and impair economic growth.

Also, case studies by the International Monetary Fund show that it takes policies of a totally different nature from those necessary to supervise banks in ordinary times to revive a banking system which as a whole is in a state of insolvency. Thus, it is said to be more efficient to let a new organization—rather than the financial supervising authorities and central bank that have a range of day-to-day operations—play a leading role in mapping out and implementing measures to cope with a banking crisis. It is especially noted that reviving banks under the initiative of a central bank is costly because its money supply function often conflicts with the task of restoring banks (which involves consolidations and liquidation of specific banks).

For instance, Chile, where the central bank took initiatives in restoring banks, fell into a situation in which tasks ranging from the disposal of bad loans to extending credits to corporate borrowers were managed by the central bank, resulting in a massive burden on taxpayers. In successful cases as seen in Sweden, Spain and the U.S., a special, temporary entity was established to play a leading role.

Concerns over Aggravating Moral Hazard

Should the recognition that Japan's banking system is now in crisis be correct, the required policies would be to establish a highly independent entity, reassess banks' assets and dispose of soured assets in a strict manner under the initiatives of that entity, inject public funds to revamp banks' capital bases, then, introduce the payoff system and bring liquidity support to the normal level.

The BOJ's purchase of shares from banks is not a measure to provide greater liquidity support. Instead, it is in effect a publicly-implemented capital augmentation measure in which the central bank takes over stock price fluctuation risks from banks. This is, by nature, not the task of a central bank but of a government. Also, a series of cases in other countries point to the tendency of a greater public burden when a central bank takes initiatives in restoring banks.

Furthermore, there exist concerns over aggravating moral hazard on the part of banks' management because management responsibility would not be fully pursued under the BOJ's stock-purchasing scheme, unlike under the case of directly injecting public funds. Thus, there is a possibility that the BOJ's scheme will result in great burdens on taxpayers in the future. Yet, it must be noted that taxpayers' burden would not be alleviated either by the BOJ's inaction.

Provided that Japan is in a banking crisis, the BOJ's scheme would surely be more costly than measures implemented under the government's initiatives, but an even greater burden would be incurred if both the government and the central bank remained inactive, in which case liquidity support and deposit guarantees would be further expanded instead of replenishing banks' capital.

Having recognized the current situation as a crisis, the BOJ should abandon the second and third measures, for instance through the implementation of stricter standards for the BOJ's inspections of banks, to finally put an end to banks' bad debt problem and restore banks' assets. Despite expected negative side effects, the BOJ should proceed with its scheme because it provides a chance to make the nation's economy better than it is today.

* reprinted from NIKKEI Shimbun (September 26, 2002)

October 15, 2002

October 15, 2002

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