Central Bank as the “Market-Maker of the Last Resort”

In my blog last week titled “Jusen,” I described how the financial regulators in Japan delayed the process of cleaning up the housing loan companies (jusen) after the fall of land prices (early 1990s) and ended up worsening the problem. I appreciate the comments, which I find right on the mark and prompted me to write this blog. The title comes from a phrase in London Banker’s comment, which seems very apt in describing the expanding role of the Federal Reserve Bank and other central banks.

Many commentators argued that the Federal Reserve Bank’s (and the Bank of England’s) provision of credit to banks with sometimes questionable collateral (mortgage, for example) may play the same role as a “rescue fund.” This is a legitimate concern and an important one.

Such an action by the central bank may allow banks to postpone full resolution of losses they incurred, which will further increase the eventual cost of resolution. If such assistance from the central banks is somehow designed to encourage the banks to clean up the SIVs and other problem assets once and for all, however, that could be a useful part of the policy package. The general principle here is indeed the same as the one that Nouriel Roubini argues in his March 19^th blog “The Worst Financial Crisis Since the Great Depression is Getting Worse…and the Need for Radical Policy Solutions to the Crisis” on government intervention in mortgage contacts. The government intervention should “not be aimed to prevent the necessary adjustment of asset prices.” It should be “aimed at ensuring that the necessary adjustment is not disorderly.” The same can be said for the central bank intervention.

The issue for the central bank, however, is further complicated by the fact that the central bank is responsible for monetary policy as well. Sometimes the goal of maintaining price stability may contradict prudential regulation of financial institutions. This is a general problem when the central bank is both monetary authority and financial regulator, as it is the case for the Federal Reserve System. If the central bank puts too much weight on its role as a financial regulator, the central bank may have an incentive to loosen the monetary policy too much to avoid financial instability. If the central bank is primarily concerned with price stability, it may end up assisting the financial institutions too much to be consistent with prudential regulation.

Japanese case in the late 1990s to the early 2000s provides us with an interesting example in considering the relation between bank regulation and monetary policy. The Bank of Japan was not a primary bank regulator in Japan, but it emphasized the importance for Japanese banks to resolve their non-performing loans. The BOJ stressed the importance of restructuring banking sector so much that it held monetary policy too tight (even though their monetary policy was extremely loose by conventional measure with overnight interbank rate at zero percent). For example, the BOJ (temporarily it turned out) stopped the zero interest policy in August 2000 when the inflation rate was still negative. They were also reluctant in trying non-traditional monetary expansion (such as buying up non-performing loans) that many foreign observers advocated back then.

When the BOJ started the zero interest rate policy in 1999, the BOJ already believed that restructuring of banking sector is at least as important as the monetary expansion. So the BOJ announced:

In order to bring Japanese economy back to a solid recovery path, it is important not only to provide support from monetary and fiscal sides but also to steadily promote financial system revitalization and structural reforms. (“Change of the Guideline for Money Market Operations,” February 12, 1999.)

The restructuring of the Japanese banks, however, did not proceed as quickly as the BOJ hoped. The BOJ’s suspension of the zero interest rate policy in August 2000 can be even seen as a result of its frustration on the slow progress of banking reform and its attempt to force the restructuring. The following announcement, which was issued right before the BOJ started the “quantitative easing,” shows that the BOJ was still frustrated and believed that the resolution of non-performing loans and other structural reform is more important than the monetary expansion.

To realize the full permeation of the effects of strong monetary easing, it is essential to strengthen a financial system and ensure its stability by making a swift move to resolve the non-performing loan problem. It is also vital to make progress in structural reform on the economic and industrial fronts through tax reform, streamlining of public financial institutions, and deregulation. The Bank strongly hopes that both the Government and the private sector, in particular financial institutions, will take more determined and effective steps in this regard. (“On Today’s Decision at the Monetary Policy Meeting,” February 28, 2002)

Thus, the experience of the BOJ suggests that the concern for prudential regulation may have discouraged the central bank from experimenting with non-traditional monetary expansion. The current situation in the U.S. is very different. At the positive (and maybe increasing) inflation rate, the real federal funds rate is probably already negative. So, the potential problem is the monetary policy being rather too loose. Nonetheless, the Japanese case suggests an important conflict between monetary policy and prudential regulation. This issue will become even more important as we discuss the possibility of expanding the regulatory role of the Federal Reserve.