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Japanese Economy Update

Can We Do Without a Macro-Prudential Policy Framework?

  Senior Research Fellow


The unprecedented monetary easing

Central banks today are engaged in unconventional monetary policies in pursuit of unprecedented monetary easing. Their impact can be witnessed in the extraordinary expansion of the balance sheets of the central banks. The policies have been invaluable in countering the rapid and steep decline in economic activity in the aftermath of the financial crisis, the risk of falling into deflation, and the delay of the improvement in the labor market.

Monetary easing as a cradle for bubbles

However, the fact that a prolonged monetary easing tend to lead to an asset bubble is an important lesson we have learned the hard way. Such was the case in Japan, in the late 1980s, and in USA and Europe, in mid-2000s. The possibility of bubbles seem to intensify when deregulation of financial system and innovation in financial technology also take place. Under any circumstances, we must be sensitive to the risk of creating bubbles since we have suffered greatly from the devastating damage caused by their burst in the past.

Growing importance of macro-prudential policy

The lessons learned have led the USA and Europe to establish a framework for macro-prudential policy, in addition to the micro-prudential policy framework already in place; policy framework that monitors risks in the financial system, manages the risks which may harm the financial stability and addresses the problem when the risk actually materializes.

The main pillars of macro-prudential policy adopted in these economies consist of; (a) collecting information regarding risks in the financial system; (b) analyzing and assessing the collected information; (c) designing and preparing institutional arrangement and policy framework to manage the risks; and (d) establishing institutions and implementing policy to address the risks and the consequences. Attention is also paid to information-sharing, and cooperation and coordination among the agencies, in designing institutional arrangement and implementing policies that become vital in smooth accomplishment of the responsibility.

Macro-prudential policy framework adopted in other countries and regions

In view of these considerations, countries and regions have established a comprehensive framework to implement macro-prudential polices.

For example, the USA has established the Financial Stability Oversight Council (FSOC). Under the chairpersonship of the Secretary of the Treasury, the Council consists of the chairman of the FRB, heads of the federal financial regulators, and an independent member with insurance expertise (above ten members have voting rights), with the Director of Office of Financial Research, the Director of the Federal Insurance Office, and representatives of state regulators (these five members have no voting rights). The Office of Financial Research (OFR) has been established as an organization within the Department of the Treasury to be responsible for collecting and analyzing information for the FSOC. The mandate of the FRB has also been strengthened to be given the right to supervise and regulate the Systemically Important Financial Institutions (SIFIs).

In the UK, the Financial Services Agency (FSA), which was solely responsible for the micro-prudential policy, has been abolished, and a tripartite structure consisting of the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA), and the Financial Conduct Authority (FCA) has been established instead. FPC, which is responsible for macro-prudential policy, is a committee within the BOE but its members consists of the Governor and Deputy Governors of the BOE, the executive director of the BOE for Financial Stability, the chief executive of the FCA, and the four external members appointed by the Chancellor (these ten members have voting rights)、with a representative of the Treasury (having no voting rights). The Executive Director of the BOE for Markets also attends the meetings. The Treasury can also make recommendations to the FPC in exercising its functions. The organizational structure is such that would assure cooperation between the BOE and the Treasury.

EU has established the European Systemic Risk Board (ESRB). It has been established as an organization in charge of macro prudential policy, in addition to the European Supervisory Authorities (ESAs), which is responsible for micro prudential policy. The General Board of the ESRB consists of the President and the Vice-President of the ECB, the Governors of the national central banks of the member states, a member of the European Commission, the Chairpersons of the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA), the Chair and the two Vice-Chairs of the Advisory Scientific Committee, and the Chair of the Advisory Technical Committee (ATC) (the above all have voting rights). It also includes a representative per member state of the national supervisory authorities, and the President of the Economic and Financial Committee (EFC) (they have no voting rights). The organizational structure aims to address the difficulties the EU faces of having to coordinate between the member states as well as between the financial sectors.

Japan lagging behind

Compared to the progress made in other countries and regions, setting up a macro-prudential framework in Japan is undeniably lagging behind. At present, macro-prudential policy is segmented, and is in effect left to the hands of the BOJ, which publishes the Financial System Report annually.

However, leaving macro-prudential policy only to the hand of the BOJ is not sufficient, as can be witnessed by the comprehensive organization structure that other countries and regions have adopted. Relying only on the BOJ has the following problems.

First is the problem in collecting information on the financial system. The monitoring by the BOJ is limited to the financial institutions subject to on-sight examination and off-sight monitoring by the BOJ. However, we have a wide spectrum of financial institutions ranging from city banks, local banks, trust banks, Postal Savings Bank, foreign banks, to shinkin banks, credit unions, agriculture and fishery cooperatives, and workers’ credit union. Since even the government has not been able, to this date, to put them under a unique regulator, there should be a great limitation in relying only to the BOJ for collecting sufficient information.

Second is the problem in building capacity to analyze and to assess the risk in the financial system and the impact they may have on the economic activity. The BOJ, no doubt, has researchers and specialists fit for the task. However, when it comes to analyzing the impact of financial risks on macroeconomic activities and industries, the Cabinet Office, the Ministry of Finance, and Ministry of Economy, Trade, and Industries, also have human resources that may be valuable. Sufficient functioning of macro prudential policy should require full mobilization of these available talents.

Third is the problem in designing and implementing institutional arrangements and policies to manage and containing financial risks. In order to counter systemic risks, it does not suffice to rely only on policies conducted by the BOJ. Policies by the Financial Services Agency and the Ministry of Finance should also have to be implemented at the time of financial pressure. In order to insure appropriate policy response to financial risks, sufficient information-sharing and coordination needs to be made among the relevant bodies.

Urgent need for setting up a framework

Japanese economic activity suffered significantly from the impact of the financial crisis of 2007-2008. The impact on the financial sector, on the other hand, was almost negligible. The fact was undeniably fortunate for the Japanese economy. However, it is also a fact that, because of the relative soundness of the financial system, Japan is lagging behind in terms of setting up a macro prudence policy framework that other countries and region has promptly established.

Japanese economy has reached a stage where the end of deflation, which we have suffered for the past twenty years, is finally in sight. A risk of a bubble may yet seem to be remote. However, it is important for us to establish a macro-prudential policy framework at this stage so that we can prepare for the risk that could emerge in the future. We should never forget the harm that bubbles do on the economy.