The financial crisis in Japan during the 1990s: how the Bank of Japan responded and the lessons learnt

In the 1990s, Japan experienced a financial crisis after the bursting of a bubble. Although outside the scope of this paper, the seeds of the crisis might have been sown during the financial deregulation in the 1980s before the formation of asset bubbles. When the gap between competitive pressures in the financial markets and a "convoy" style of banking supervision and regulation that, in effect, ensured the viability of the weakest banks became unsustainable, the crisis erupted. In this regard, it may be argued that the crisis was accentuated by the formation and bursting of the bubble. It was an unprecedented crisis in terms of severity. Though essentially a domestic problem, with the authorities' primary concerns focused on its impact on the domestic financial system and economy, in an increasingly integrated global economy and finance there was a latent, potential risk that a mishandling of the crisis could trigger a cross-border financial crisis. Most of the seven years I spent at the Financial System Division of the Bank of Japan (1993 to 2000) were devoted to crisis management in an attempt to prevent the crisis from getting out of control. Throughout this period the Division remained totally committed to the policy objective of the central bank as stipulated in the Bank of Japan Law, namely, the maintenance of financial system stability. Nonetheless, the efforts to overcome the crisis turned out to be a very lengthy process and also very costly. This is the main point of the criticism blaming policymakers for "the lost decade" in which the financial intermediary function was severely undermined, contributing to an extended recession. The purpose of this paper is to focus on the policies of the financial authorities from the time the bubble burst until early 2000, when a more systematic approach to deal with troubled banks became available. It aims to shed light on the policy responses of the authorities with a particular focus on the central bank's crisis management to address financial instability. Therefore, macroeconomic developments or monetary policy, which also had a significant influence in shaping the financial crisis of 1990s are outside the scope of this paper. Similarly, policy responses after 2000 are not covered in this paper. They may have to be examined separately in the light of what happened subsequently. The paper first traces in Section 1 the chronology of events and the policy responses by the authorities and describes the evolutionary way in which the safety net in Japan was reinforced. Section 2 tries to identify factors that explain why it has taken so long to bring the crisis under control. Section 3 focuses on the central bank's lender of last resort function because this was one of the key policy tools in addressing the crisis. By categorising various types of emergency fund provision by the central bank, the paper explores whether the responsibility of the central bank might have been overstretched during the earlier part of the crisis. Section 4 refers to some comparative aspects in an attempt to identify key features of Japan's experience that stand out relative to other countries that have undergone banking crises. Section 5 asks whether any information or indices could effectively warn the authorities of build-up of risks in the financial system. Section 6 outlines the new safety net that became effective in April 2001 and highlights the key features incorporated in the new framework following lessons learned in the crisis management during the 1990s. Finally, Section 7 sets out some of the future challenges for the central bank and the Japanese banking industry. I am conscious of the limitations of the paper in that it is based on my personal experience as a chief manager of the central bank who led the team on the front line dealing with the crisis. Thus, the views expressed in the paper are my own and do not necessarily reflect the official views of the BIS or the Bank of Japan. I am also conscious that the problem that Japan has faced is not over yet. Indeed, further developments in Japan's financial system may yield more implications and lessons. Still, despite some idiosyncratic aspects, it is my belief that the financial crisis we faced was in many ways not a unique Japanese experience. There are many universal aspects and lessons that can be relevant for other countries that might experience similar problems in the future. Moreover, given the persistent vulnerability of Japan's financial system as of 2001, the experience thus far would provide Japan's policymakers with guideposts for the way forward to finish off the problem that overshadowed Japan's financial system and economy for more than a decade. In this regard, the paper is intended to benefit both the domestic and the international community as a basis for further discussions concerning effective crisis prevention and management to address potential financial disturbances.