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-- Financial Crisis and Heightening of Global Recessionary Pressures
-- Developments in Domestic Financial Markets in the Second Half of 2008: Deterioration in Market Functioning and Large Fluctuations in Asset Prices
-- Policy Responses of Central Banks and Governments to the Financial Crisis
-- Issues Regarding the Functioning of Financial Markets and the Bank of Japan's Actions in 2008
March 31, 2009
Bank of Japan
The current financial turmoil, triggered by the U.S. subprime mortgage problem, developed into a global financial crisis from autumn 2008. This crisis was caused by the adjustment pressure from the so-called "financial imbalances" that had accumulated during the global credit boom from around 2002 to the first half of 2007. The considerable adjustment pressure was exerted because U.S. and European financial institutions expanded their businesses as intermediaries of international capital flow while taking on higher liquidity risk, and these international banking activity became excessive relative to the real economy.
Although central banks in major economies had increased their liquidity provisions to address the turmoil since summer 2007, financial markets suffered markedly heightened strain in September 2008, triggered by the failure of Lehman Brothers, a major U.S. investment bank. Financial institutions deepened concerns over counterparty risk in the interbank markets, and liquidity dried up particularly for term funding. Tensions in the interbank markets made banks' lending policies more stringent for the nonfinancial sector, which led to the deterioration in funding conditions for investors, households, and companies and made them risk averse. As a result, the market functioning declined not only in interbank markets but also in financial and capital markets overall. Under these circumstances, the adverse feedback loop between the financial sector the real economy intensified, as economic conditions significantly deteriorated, instigating a rapid increase in uncertainty about the economic outlook and financial asset valuations.
The effects of the adverse feedback loop between the financial and real sectors became evident in both the developed and developing economies, which had been relatively robust to that point. Because the expansion of international capital flow between developed and developing economies had amplified the global credit boom until 2007, once the trend in capital flow started to reverse, the subsequent negative effects spread instantly around the world.
Domestic financial markets in the first half of 2008 were relatively stable although they were influenced by the turmoil in global financial markets. However, in the second half of 2008, domestic markets started to be strongly impacted by the turmoil, and their functioning declined.
In money markets, after the failure of Lehman Brothers, interest rates came under upward pressure, reflecting the rise in concerns over counterparty risk and the decrease in market liquidity. Market liquidity of Japanese government bonds (JGBs), which had already started to decline in the first half of 2008, decreased further after September. Arbitrage transactions became inactive and the price discovery function of the JGB market was impaired, as overseas investors such as hedge funds were forced to unwind their positions as they faced funding liquidity constraints. Against the background of sharp deterioration in the economic outlook and overseas investors' deleveraging, stock prices plunged, which led to a decline in the risk-taking capacity of domestic investors. This widened credit spreads in CP and corporate bond markets. The impaired functioning of long- and short-term credit markets caused companies to increase their reliance on bank borrowings. As a result, banks became increasingly active in funding through money markets while taking a cautious stance on investing funds, all of which exerted upward pressure on interbank rates.
In the foreign exchange (FX) markets, liquidity declined and FX rates fluctuated to a considerable degree as market participants became increasingly risk averse. Because of the rise in FX volatility, carry trade positions were unwound and the yen appreciated significantly, while also reflecting economic outlook and interest rate differentials between Japan and overseas. The sharp appreciation of the yen triggered not only substantial downward revisions of corporate profit forecasts in particular for manufacturing companies which had driven the Japanese economy's expansion until 2007, but also a further plunge in stock prices, leading to a decline in domestic investors' risk-taking capacity.
Against the backdrop of deterioration in economic conditions triggered by the financial crisis, central banks in major economies reduced policy interest rates significantly, and also expanded liquidity provisions to financial institutions by implementing various market operations in order to address the situation in which the impaired functioning of interbank markets lessened the effectiveness of monetary policy. In the early phase of the market turmoil, U.S. and European governments had conducted supportive measures against problems at their financial institutions on a case-by-case basis. However, as concerns over financial system instability spread globally, authorities in major economies began to implement more comprehensive initiatives in the form of guarantees on bank debt and capital injections. Furthermore, as the deterioration in the functioning of financial markets led to tighter funding conditions for all economic agents, including companies and households, central banks and governments in some countries implemented several unconventional measures such as purchases of private-sector assets to restore liquidity to the markets whose functioning had deteriorated noticeably.
The series of measures taken by public authorities in major countries were effective in containing further instability of global financial markets for a period of time. Nevertheless, tensions in global financial markets remained at a heightened level, further downward revisions were made in the outlook for the global economy, and uncertainty about the depth and span of the global recession remained quite high. Although adjustments to reduce the "financial imbalances" that have accumulated in the past credit boom are essential to normalizing economic conditions, downward pressures tend to be exerted on economic activity in an adjustment phase. For example, the size of the balance sheets of financial institutions that have increased their leverage comes under inevitable pressure to decrease, leading to more stringent lending policies toward companies and households. However, it is important to underpin the funding environment for the nonfinancial sector, in order to facilitate progress of the adjustment process while averting protracted and substantial deterioration in the real economy. Therefore, public authorities need to implement appropriate policies to alleviate burdens on the nonfinancial sector, while stabilizing the financial system.
Many countries continued to face downward pressure stemming from the adverse feedback loop between the financial sector and the real economy. There remained a concern that the shock-absorbing mechanisms available in the current financial system and policy frameworks might not be sufficient to buffer the materialization of imminent risks, and this was one factor that hampered the lifting of uncertainty over the economic outlook. Meanwhile, market participants increasingly seemed to expect further fiscal support by governments, so as to reduce uncertainty over the macroeconomic outlook and strengthen financial and economic conditions. However, at the same time, it should be noted that new sources of uncertainty might have arisen in connection with the deterioration in governments' fiscal conditions associated with the transfer of risk to the public sector, as evidenced by the widening of sovereign credit default swap (CDS) premiums.
With a view to supporting improvement in the functioning and efficiency of financial markets in Japan, the Bank addressed the following issues concerning the market infrastructure in 2008.
In 2008, the Bank enabled financial institutions to outsource transfers of Japanese government securities pledged to/returned from the Bank as eligible collateral. The Bank was also engaged in improving the statistics of interest rates on newly issued CP. In addition, the Bank carried out the Tokyo Money Market Survey, a comprehensive study of trends in money market transactions and changes in market participants' activities in August, in order to identify the challenges and developments related to the functioning of the money markets. The Bank published a report that includes data from the survey, as well as the findings regarding the impact of the failure of Lehman Brothers on the functioning of money markets, particularly on repo markets.
In response to the subprime mortgage problem, the Working Group on Distributions of Securitized Products under the Japan Securities Dealers Association held discussions on enhancing the transparency of transactions of securitized products by ensuring traceability to the underlying assets. Regarding over-the-counter derivatives markets, market participants discussed the needs for a central counterparty and other measures to improve the infrastructure, taking into account the developments in the United States and Europe.
With regard to the business continuity plan (BCP) in financial markets, ensuring that necessary transactions can be conducted even in emergency situations such as earthquakes or terrorist attacks is in the interest of each individual market participant, and contributes to maintaining the stability of the financial markets and the economy as a whole. In 2008, significant progress was made in the BCP, as market-wide exercises were conducted in money markets (call markets), FX markets, and securities markets.
The Bank will continue to support the initiatives by market participants related to improving market practices and infrastructure in financial markets.
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Financial Markets Department, Bank of Japan
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