Comments on “Procyclical Financial Behavior: What Can Be Done?”
- Stefan Gerlach, and Paul Gruenwald
- Published Date:
- July 2006
The issue of financial system procyclicality is tricky. In a way, central bankers like myself have mixed feelings on the procyclical nature of financial forces. We love it, because it is the very source of leverage of our monetary policy. We hate it, because it amplifies economic swings, sometimes triggering economic and financial crises. Lowe and Stevens are right when they caution us that the outgrowth of financial resources over real economic resources makes the well-known issue of procyclicality increasingly important for today’s policy considerations.
That said, let me start by asking again, what are the core issues for policy-makers, especially in the Asian context? When I say “in the Asian context,” I assume in the first place that rapidly growing Asia, as an emerging economy, is prone to relatively large economic swings between booms and busts. As such, there are some sources of procyclicality in the structure of the financial system in contrast with more mature economies. For example, Asian economies are more reliant on bank-based financial intermediation, are heavily dependent on mortgage collateral, have less expertise in risk assessment, and lack strong corporate governance and bank supervision.
Procyclical financial forces could be lethal. They could inflate a speculative bubble and then exacerbate distress in the unwinding process once the bubble bursts. Problems associated with the bursting of the bubble may be fundamentally different from those we know in our discussions on procyclicality associated with a normal business cycle. A huge bubble results in huge economic and social costs, both when it is created and when it bursts. This is exactly what we must bear in mind when we consider procyclicality in the Asian context.
We know it from our own experiences. We know such risks are more likely to materialize in an economy with a weak financial system. I shall focus on this point in my subsequent discussion.
What lessons can we glean from Japan’s case?
Let me start by revisiting our own episode, the speculative bubble in the late 1980s. It is a typical example. A financial system, comprising institutions without robust risk management, drove a speculative bubble in the real estate market, only to leave behind long-lasting balance sheet damage in banks as well as in non-bank corporations.
Looking back, we can identify a few policy questions. First is monetary policy. “Too little too late,” is the criticism we often receive. It may be so in retrospect, but I would argue that it was extremely difficult or almost politically impossible then to make a persuasive case for pre-emptive tightening when general price inflation was nowhere in sight. It was widely recognized by academics and others that asset prices cannot or should not be the target variables of monetary policy. The Bank did warn against the potential risk of inflation, but it went unheeded. Warnings were simply dwarfed by the euphoric sentiment of the day.
What would have happened if a reversal in monetary policy had come at an earlier time? It would have taken away a fraction of growth, but I doubt if it could have effectively contained the asset price bubble, because the collective euphoria of the day compressed risk premia significantly. Early signaling by monetary policy is no doubt important, but one cannot expect too much of its effect in containing an asset price bubble, once the bubble starts to unfold. I think I read a similar message in Chapter 4.
Such recognition naturally leads to an interesting question in the context of today’s bullish housing market in many economies. How should central banks targeting inflation respond to such asset price inflation in a disinflationary environment?
A second policy question is supervisory policy. There may be some promising policy options in this area, particularly in the Asian context. The basics of risk management are simple. Financial institutions must identify risks at an early stage and prepare for them under reasonably conservative assumptions. Supervisors are expected to help promote good risk management practices of financial institutions.
What we know from our own experience, however, is that that is easier said than done. Supervisors face enormous challenges in times of euphoria. During the boom, risks do not surface and actual charge-offs and credit costs decline notably. A number of exotic arguments kick in to justify the euphoria and people love them. In Japan’s case, banks’ search for new market opportunities was significantly accentuated by their fear of eroding franchise value resulting from the prospect of financial liberalization.
What can you do as supervisors in such a situation? I think the answer is to “return to the basics.” This means focusing on risk concentration arising from real estate related lending, performing stress tests based on commonsense assumptions, and persuading banks to carefully evaluate the results of such tests. For example, the collateral underlying real estate in a land development project is not very secure, because the collateral value of the land is closely tied up with the success (or failure) of the project itself.
We were not entirely unaware of these issues during the Japanese bubble. The problem was that we did not have a robust prudential platform which encouraged banks and supervisors to detect potential risks and to manage those risks rigorously. And for such a platform to be really workable, continuous and collective efforts by banks and supervisors are required especially during the less eventful period when risks start to develop. I think that this has particular importance in the Asian context.
Implications of Basel II for Asia
Now, Basel II is clearly in sight. Concerns have been voiced about the potential for the new arrangement to amplify economic cycles. The literature on this topic suggests that the issue is inconclusive. However, the good news in this respect is that Basel II includes mechanisms which mitigate potential procyclical effects. For instance, Basel II essentially accepts the idea of over-the-cycle provisioning and its Pillar II process encourages integrated risk management.
Concerns over procyclicality aside, I think that Basel II will motivate Asian economies to re-examine the quality of their banks’ risk management strategy and also the quality of supervision from a number of different angles. Such a process of re-examination has critical importance in taking the best advantage of the new framework.
Monetary policy and prudential policy
Before concluding, I would like briefly to touch upon my favorite topic: the integration of monetary and prudential policies. I do not want to place myself in the delicate terrain of who is responsible for what. Instead, I would like to emphasize that in this world of ever-increasing financial leverage, monetary policy must be accompanied by good prudential policy for the sake of attaining a stable economic environment, a prerequisite for healthy economic development.
A simple example is that monetary policy loses its power when the financial system becomes dysfunctional. This is not just a theoretical possibility, but the reality we have already encountered.
On top of that, I think that the objective of monetary policy, widely perceived as price stability, is also seriously challenged. I could say that the Bank of Japan was the perfect central bank in terms of its record on price stability. The average rate of CPI inflation in Japan over the past twenty years was around 1 percent and its volatility was extremely low. In spite of such an impressive record on price stability, the Bank does not enjoy a good reputation, because of the big economic swings that Japan experienced during that period and because of the weak financial system which allegedly amplified those swings.
Price stability is important because it is believed to pave the way for stable growth. However, our experience suggests that it may not be enough. Then what should we do? Perhaps we have to reflect on this fundamental question for years to come. What is evident, in my view, is that central banks must be more vigilant to the risks inherent in the financial system for the better conduct of monetary policy.
The institutional setting of supervisory authorities poses another difficult question. “It depends,” is my answer. However, regardless of the institutional setting, a modern central bank cannot fully discharge its responsibility without timely and relevant information on financial institutions and the financial system.
The Bank of Japan started purchasing corporate stocks from banks two years ago, and finished the operation only recently. (The amount we purchased was about 20 billion US dollars.) We did this with the intention of helping reduce banks’ exposure to the stock market, one of the serious sources of vulnerability of banks’ capital. This policy action was defined as a prudential policy, and therefore the decision was made not in our monetary policy meeting but in a regular board meeting, which is responsible for important decisions other than monetary policy decision.
Distinctions aside, such an unusual action by the Bank of Japan had multiple effects. First, it functioned as a wake-up call, and became a catalyst for more forceful supervisory actions from the government. Second, it facilitated banks’ efforts to reduce their stock holdings without causing serious dampening effects on the stock market, which was suffering from low liquidity. Third, all this triggered an acceleration of banks’ efforts in tackling their bad loan problems and in restructuring their management, because significant reduction of banks’ exposure to the stock market was functionally equivalent to the increase of banks’ economic capital.
Obviously, this “prudential action” had an important implication for monetary policy as well. When banks’ balance sheets were repaired, they could resume healthy risk taking and hence their function as financial intermediaries could be restored.
Why then did we not make a decision in our monetary policy meeting? First, this measure arose from our prudential concerns. Second, we wanted to avoid misleading the market that monetary policy went so far as to intervene in the stock market to boost its price.
This case indicates that the difference between monetary and prudential policies may become extremely ambiguous in time of financial stress. A similar argument applies to quantitative easing - our current monetary policy framework - the most identifiable effect of which is to maintain financial stability in times of stress by supplying more than ample liquidity.
In sum, I believe that central banks in this part of the world should assume responsibilities for ensuring financial stability for the good conduct of monetary policy.