Lessons of Japan and America Bubble burst to China

1. Lessons of Japan and America Bubble burst to China A study of Bank capital adequacy, Basel Accord, and Chinese housing bubble.

2. Fundamentals • 1988 Basel Accord I: The 1988 Basel Capital Adequacy Accord was a milestone in the approach to bank regulation. Agreement was reached between the member countries of the Basel Committee that a minimum capital requirement of 8% would be required of internationally active banks. The impetus behind this move was widespread concern about declining levels of capital held generally. Since that time the Accord has been adopted by more than 100 countries.

3. Basel I • capital (= Tier I + Tier II)/risk weighted assets> 8% • Problem: “Regulatory Arbitrage” • Bank’s obligation always the same, “8%”, banks off-balance sheet activities always replace low risk by high risk investment or loan • Change proportion of loan/asset structure: e.g. replace G-bond with resident mortgage.

4. Basel II • Basel I + individual credit rating • Capital adequacy or BIS rate rise to 10% • Problems with Basel II internal credit risk models (which relate to the fact such banks’ internal credit risk models were overly sensitive in their implementation for the calculation of regulatory capital, and generated pro cyclical effects) were realized during the recent Financial Crisis

5. Problems Although the criticisms of the 1988 Accord have come from more than one source, it seems that it is the pressure applied by the internationally active banks that have led to the proposals in the New Accord. As Moody's point out the, the New Accord is very much geared towards the small number of large internationally active banks.2 Hence, the major thrust of the proposals aim to increase the risk-sensitivity of capital requirements and thereby more closely align these requirements with actual risks. To this end, a major proposal is to move towards ever-greater use of banks' own internal risk management systems. However, although the focus of the proposals are aimed towards the needs of major banks from the G-10, it is likely that the New Accord, when implemented, will have significant, and broadly negative, repercussions for the developing world, both internationally and domestically.

6. Basel at developing countries The Basel Committee does not have the right to impose its own Accord on others, and has never, at least explicitly, sought to do so. Nevertheless, more than 100 countries have implemented the Basel Accord in some form. There are several possible explanations: it is cheaper to pick one off the shelf than to start from scratch; financial markets reward governments and banks in developing countries where a Basel regime is implemented; the international official community (including the Basel Committee and the international financial institutions) encourages them to do so; and financial institutions from countries not complying with Basel standards find it difficult to enter important financial centres such as London and New York. Developing country regulators may feel that they have little choice. If so, the Accord has the status, if not the form, of customary international law, and those designing it bear the responsibilities of international law-makers.

7. Basel III? BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed upon by the members of the Basel Committee on Banking Supervision.1 The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.

8. Basel III Changes: Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

9. Problem Basel III cannot address the problems caused by regulatory arbitrage: to attract banks and to create viable financial centers, national governments can choose not to implement these international risk-based capital standards. And as regulations become more onerous, the incentives increase to instantaneously move capital from countries with oppressive supervision to countries with a more relaxed approach to financial regulation.

10. Japan’s case • The world during 2007-2010 resembles Japan in the 1990s-the early 2000s. • Property and other asset price bubbles and their collapse with serious effects on the financial system. • The bubbles turned on too easy macroeconomic environment and regulatory failure to reign in excessive speculation. • After the burst of the bubble, monetary policy rates were lowered aggressively from fairly high levels, reaching eventually near zero levels. • Central banks in 2007-09 acted more rapidly than in Japan in the early to mid 1990s. • Policies to address financial system problems were also adopted more quickly in the current episode. • In Japan, it was possible to hide bad loan problems for a while due to the bank centered nature of the financial system unlike in the current case. • If the world fails to avoid deflation or a near zero inflation rate, however, it may look like Japan 1999-2006 for years to come. • The world is also following Japan with regard to the heavy burden on fiscal authorities.

11. America’s case: Fear of deflation led the Fed to adopt ultra easy policy in 2003-04 • a substantial fall in inflation at this stage has the potential to interfere with the ongoing U.S. recovery, and that in conceivable--though remote--circumstances, a serious deflation could do significant economic harm. Thus, avoiding a further substantial fall in inflation should be a priority of monetary policy. (B. Bernanke, July 2003) • "the Committee believes that policy accommodation can be maintained for a considerable period." …. Today inflation is at the lower end of the range consistent with optimum economic performance, and soft labor markets and excess capacity create a further downward risk to inflation. As a result, I believe that increased economic growth may not elicit the same response from the Fed that it has sometimes elicited in the past. (B. Bernanke, September 2003)

12. Japan 17 of the 25 world’s largest financial institutions were Japanese as of 1989. US The U.S. economy has conquered the business cycle. (R. Dornbusch, R. Lucas.) The U.S. economy has become very flexible and resilient. (A. Greenspan.) Japan and US’s eagle

13. Japan Deregulation in the bond market. But banks were not allowed to move into securities businesses, unlike in the US. Banks increased property related lending. Also, through Jusen. Neither banks nor regulators were equipped with risk management techniques to look at the entire bank loan portfolios. US BIS capital regulation, financial innovation and some deregulation encouraged the formation of the shadow banking system, which was not policed well by regulators. BIS regulation on security trading was effectively eased in 1996. The SEC policy change toward investment banks in2004. SEC policy toward rating agencies. Derivatives. Government’s housing policy. Compensation. Distorted Incentives leading up to the Bubble:regulatory failure

14. Lesson • Ultra easy--say, easier than the Taylor rule--monetary policy sometimes generates major financial imbalances. • In both Japan and China the ultra easy monetary policy came from the fear of deflationary effects of stronger currency. • Financial imbalances are exacerbated when financial regulation does not catch up with financial innovation or when pace of deregulation is uneven across sectors. • Bubbles lead to systemic events if financial intermediaries are at the heart of their formation. • People learn from others’ mistakes, but not always. • The world is not out of the woods yet. • Large budget deficits and buildup of government debt • Disinflation is continuing.

15. Conclusion: • Even though Basel Accord is self-improving according to changing world banking circumstances, and it is the best available, and most commonly recognized “guild line” so far, but concerns about how well it will fits developing countries is still in question. • China’s housing bubble situation need to learn from Japan and America’s mistake.

16. References • http://ssrn.com/abstract_id=348461 • http://ssrn.com/abstract=1680886 • WORKING PAPER NO. 04 THE NEW BASEL ACCORD AND DEVELOPING COUNTRIES: PROBLEMS AND ALTERNATIVES Jonathan Ward • http://en.wikipedia.org/wiki/Basel_III • Japan’s bubble and America’s bubble: some implications for China By: Kazuo Ueda, Professor of Economics University of Tokyo. • Will the proposed new Basel Capital Accord have a net negative effect on developing countries? By: S Griffith-Jones & S Spratt Institute of Development Studies University of Sussex Brighton BN1 9RE • http://ssrn.com/abstract=1693622