Hiroshi Nakaso Financial Markets Department Bank of Japan Banking Crisis Resolution (Japan's case and the role of central banks)

1 1. Overview of Japan’s Crisis in Late 1990’s

2 Number of Failed Depository Institution Number of Failed Depository Institutions (FY FY 2004) Banks 20 Credit unions 27 Credit-cooperatives 134 TOTAL 181

3 Magnitude of Non-Performing Loans NPLs / Nominal GDP

4 NPL Ratios NPL / GDPASSET / GDPNPL / ASSET USA (1991) 2.9%63.3%4.5% Sweden (1992) 13.2%130.1%10.1% Japan (1999) 7.8%217.4%3.6% Notes: NPL / GDP= Asset / GDP × NPL / Asset NPL : Forthe US,past due loans, loans innon-accrual status,andrestructured loans. For Sweden, gross problem loans. For Japan, risk management loans. Asset: Forthe US, assets held by commercial banks, saving banks, and S&Ls. For Sweden, assets held by large banks. For Japan, assets held by all deposit taking institutions.

5 Cost of Disposal Notes: 1)Losses include those arising from debt-forgiveness and loan restructuring. 2)For FY92-94, figures are for City Banks, Long-term Credit Banks and Trust Banks. Source: FSA, DIC.

6 Use of Public Funds USA  Expenditure to RTC 1  Expenditure to liquidate FSLIC 2  Interest payment for bonds issued by REFCORP 3 $$$$$$ billion Total$200.8billion( 3%) Sweden  Capital injection and loans 4 SEK 65.0billion( 4%) Norway  Capital injection 5 NOK 24.9billion( 3%) Finland  Capital injection 6 FIM 82.7billion(17%) Japan 7  Guarantees  Cashable bonds 8 ¥¥¥¥ trillion Total¥70trillion(14%) Notes: 1. Resolution Trust Corporation 2. Federal Savings and Loan Insurance Corporation 3. Resolution Financing Cooperation 4. Total expenditure until July Total expenditure until Dec Total expenditure until Dec Japan’s figures are for FY Assigned for loss coverage ( ) ratio to nominal GDP

7 Crisis of Autumn 1997 Oct. 14 Failure of Kyoto Kyoei Bank Nov. 3 Sanyo Securities files application for corporate rehabilitation Nov. 17 Failure of Hokkaido Takushoku Bank Nov. 24 Yamaichi Securities announces suspension of operations Nov. 26 Failure of Tokuyo City Bank

8 Profile of Long-Term Credit Bank of Japan Failure announced October 1998 Financial data (consolidated basis, as of March 1998, in \ billion) Total assets : 26,565 Capital : 390 Debentures : 12,268 Deposits : 5,955 Derivatives : 50,000 (notional principal basis) Branches : 39 (24 domestic, 15 overseas) Employees : 3,346 Crisis of Autumn 1998

9 Safety Net Framework (after April 2002) Purchase and Assumption (P&A) Failed bank Systemic Risk Exception Assuming institution(s) Capital injection Full loss coverage Temporary nationalisation

10 Credit Premiums for Banks Spread of 5-year Bank Bonds Yield over 5-year JGB yield

11 Banknotes in Circulation

12 2. “Lender of Last Resort” – Japan’s Case

13 Types of Lender of Last Resort Function Emergency liquidity assistance to a failed deposit taking institution Provision of liquidity to interbank markets Emergency liquidity assistance to a failed non-bank financial institution Provision of risk capital to a financial institution Emergency liquidity assistance to a temporarily illiquid financial institution Type 1 : Type 2 : Type 3 : Type 4 : Type 5 :

14 Outstanding of the LoLR Fund Provision

15 Loss Experience from the LoLR Function Note*: Subsequently covered by MOF.

16 3. Questions Out of Japan’s Experience

17 (1) Solvency or Liquidity?

18 Solvency or Liquidity? General principle: LoLR assists solvent but illiquid financial institutions Differentiation of solvency from liquidity does not make much sense in a real crisis Many banks went under in what might be called a vicious cycle to insolvency, triggered by funding difficulties

19 Vicious Cycle to Insolvency A troubled bank faces deposit withdrawal due to deterioration of credit standing (e.g. down grading). In order to meet the imminent funding requirement, the bank sells sound assets. The sales of sound assets results in deterioration of asset quality. This leads to further loss of confidence in the bank, triggering another round of deposit outflow. The bank runs out of sound assets and NPLs erodes capital leading to an eventual insolvency.

20 (2) What Should be the Scope of the LoLR Function?

21 Case of Large and Complex Financial Institution Yamaichi Securities Creditors Bank of Japan flow of funds LoLR support Bank in GB Bank in CH Bank in DE Bank in NL Ring fencing

22 Bank A Case of Cross-Border Banking (eg. Asian Crisis) Home country’s Central Bank Bank B Branch Bank C Bank D Bank E Bank F Tokyo Interbank Market Bank of Japan flow of funds

23 (3) Is “ Constructive Ambiguity ” Constructive?

24 Four Principles in the Actual Provision of LoLR Assistance (a) There must be strong likelihood that systematic risk will materialize. (b) There must be no alternative to the provision of central bank funds. (c) All parties involved are required to take clear responsibility to avoid moral hazard. (d) The financial soundness of the Bank of Japan should not be impaired.

25 (4) Will Private Sector Solutions Always Work?

26 Will Private Sectors Solutions Always Work? A scheme orchestrated by private firms based on commercial interests (without the use of public funds) Supervisory agency or the central bank may be involved as honest broker (e.g. LTCM in 1998) Prisoners’ dilemma for the related private sector participants

27 Risks to a Private Sector Solution Related parties are diverse and the exposure is unforeseeable but could potentially be large Legal risks for the related parties Legal or reputation risks for the public sector Could only be successful when the case is an isolated event

28 (5) Any Role for Monetary Policy to Address Financial Crises?

29 Quantitative Monetary Easing Current account targeting

30 Intended Policy Effects Support economic recovery --- encourage bank lending and facilitate corporate financing Maintain financial system stability --- ensure banks’ liquidity positions

31 Sign of Economic Recovery Real GDP growth

32 Underbidding

33 Market Function -1

34 Market Function -2 Outstanding of Uncollateralized Call Market

35 Outright Purchase Scheme for Asset-Backed Securities (1) Types of eligible assets ・ Asset-backed securities (publicly-offered) ・ Synthetic-type securities (publicly-offered credit-link notes) ・ Asset-backed commercial paper (including dematerialized commercial paper) (2) Underlying assets ・ 50 % or more of the total value or the total number of individual assets in underlying assets shall be composed of assets related to small and medium-sized enterprises.

36 ABS Purchased by BOJ