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Weekly UpdatesLoans on securities indicated that the real bills doctrine was being violated. That view was more potent in exercising the Federal Reserve Board than disapproval of the equity market boom. As it stated in February 1929 [Annual Report, 1929, p. 3]:
"The Federal Reserve Board neither assumes the right nor has it any disposition to set itself up as an arbiter of security speculation or values."
Response of the Authorities
In 1928 the Federal Reserve Board sought to curb speculative bank lending by restricting access to the discount window of the Federal Reserve Banks by banks that were liberal in extending loans on securities. The way the Board intended to achieve this end was that the Reserve Banks would apply direct pressure to offending banks by refusing to discount for them. The Board believed that direct pressure would succeed in reducing loans for speculative purposes without interfering with loans for productive purposes. It was unwilling to approve a rise in discount rates in order not to limit productive loans. The New York Reserve Bank as well as others opposed the Board's policy and instead advocated rises in discount rates or open market sales to curb speculation. They believed the Reserve Banks had no legal right to refuse to rediscount for member banks that held eligible paper, that, only if an individual member bank borrowed for protracted periods or far in excess of amounts borrowed by others, should it be den ied rediscounting facilities, and that correction of a member bank's portfolio was a matter of internal bank management, not the business of its Reserve Bank [F&S, 1963, p. 257].
The New York Reserve Bank directors repeatedly in 1929 voted to raise discount rates but not until August 1929 did the Federal Reserve Board approve. That month marked the cyclical peak. The following month the stock market crashed. It is ironic that neither outcome was the objective of the Federal Reserve. It did not intend to end the stock market boom and it did not seek to halt the business expansion.
Alternatives to the Authorities Response
Neither direct pressure nor discount rate rises dealt directly with the problem of bank portfolios with a growing proportion of collateralized loans at values set when equity prices were escalating. The position of the New York Reserve Bank was that it was a matter of internal bank management to correct a portfolio overloaded with equity collateral of uncertain future value. This condition could have been a concern of bank regulators and examiners not in order to spare the banks involved from the follies of their lending decisions, but to spare the economy from those consequences.
What measures could have been taken in advance to avoid a prospective crisis for the financial system after the asset boom collapsed? A deterrent to the distortion of bank portfolios would have been a capital requirement that increased with the growth of the proportion of collateralized loans. Authorities would have been required to monitor compliance by banks. If the banks were able to raise capital along with the growth of asset-backed loans as a proportion of their portfolios, they would not have been vulnerable when the value of the collateral they held dissipated. Had such a scheme been in place, the representation of collateral on bank balance sheets might not have grown to levels that became a problem when asset price inflation peaked, and the peak itself might have been lower.
Japan in the 1980s
The Upswing
Equity prices tripled and land prices doubled in the dramatic rise in asset prices in Japan in the second half of the 1980s. The Nikkei 225 stock price index rose from 13,000 in December 1985 to 26,000 in October 1987, when it declined briefly but then recovered to almost 39,000 at the end of 1989. Land prices in Japan rose at an annual rate of 13 percent between 1985 and mid-1990, rising more in than outside major cities, and commercial land increasing in value faster than residential land, with industrial land lagging both. Consumer price inflation remained relatively low. The general consumer price index rose from 87.4 in 1985 to 88.0 in 1987, to 90.7 in 1989.
Was the surge in asset prices a bubble? One analyst assigns a role also to fundamentals [Kahkonen 1995]: 25 percent growth of real GDP; 69 percent growth of corporate profits. However, easy monetary policy and declines in interest rates to historically low levels, and liberalization of financial markets as well as distortions of Japan's land tax system indicate a bubble.
Financial Institution Portfolios
To determine the extent of the exposure of the financial system to equity price inflation, for the U.S. case it is enough to check how much the loan portfolio of institutions shifted in favor of loans backed by equity collateral. For the Japanese case, that information must be supplemented with data on holdings of equity by financial institutions, a balance sheet asset denied U.S. banks.
The Bank of Japan collects data on both asset entries: corporate equities as well as loans outstanding of domestically licensed banks by kind of collateral [Economic Statistics Annual 1997, pp. 210, 55]. Domestically licensed banks include city banks, regional banks, regional banks II, trust banks, long-term credit banks, and other financial institutions. Some of the types of banks may not have been included in reports of early years of the asset price boom, so the numbers referred to here may distort the true shift in the equity holdings and the loan portfolios of domestically licensed banks. Although I confine discussion of asset price inflation to banks, Japanese life insurance companies were also significant purchasers of equities and hence vulnerable to sharp falls in their prices.
The value of equities held by domestically licensed banks more than doubled between 1985 and 1989, but there has been no downturn in this account since then until 1997, when holdings were 17 percent higher than in 1989. However, as a percent of total assets, equities were negligible, 3 percent in 1985, 4 percent in 1989, 6 percent in 1997. Nevertheless, as shown in what follows, holdings of corporate equity by the banks have been lethal to their soundness in the aftermath of the asset price boom.. If the valuation of equities were marked to market, the banks' capital would have been seriously impaired.
The two categories that reflect the impact of asset price inflation are loans secured by real estate and floating mortgages and loans secured by stocks and bonds. Major changes in these two categories occurred between the end of fiscal year 1985 and 1989, but loans secured by real estate and floating mortgages far surpassed loans secured by stocks and bonds. The former were 11 times the size of the latter in 1985 and not quite 10 times the size of the latter in 1989. Real estate collateral loans, however, did not peak until 1992, two years after real estate prices crashed, whereas the security collateral loans peaked in 1989. Both categories increased at about the same pace, despite the difference in their levels, security collateral loans in 1989 2 3/4 times higher than in 1985, real estate collateral loans in 1992 nearly 3 times higher than in 1985. While security collateral loans constituted only 1 or 2 percent of total bank assets, real estate collateral loans accounted for 14 percent of total bank asset s in 1985, 18 percent in 1989, and 20 percent in 1992.
Banks and nonbank lenders increased lending to the real estate sector in part to replace lending to large manufacturing corporations that were able to access international capital markets once controls on capital markets were dismantled after 1979. Deregulation of interest rates on deposits led banks to lend to small firms backed by property. Despite the increased risk of loan portfolios, easy monetary conditions in the second half of the 1980s kept interest rates from rising enough to compensate for the higher risk. Households also found credit easily available, deployed it in the stock market, and drove up equity prices.
Response of the Authorities
Japanese authorities resorted to moral suasion during the period of asset price inflation to restrain bank lending while maintaining monetary ease. From January 1986 to February 1987, the Bank of Japan lowered the discount rate five times, reaching a low of 2.5 percent. The second to the fifth discount rate declines were instituted in response to pressure from the industrialized countries for Japan to support international policy coordination in order to boost Japanese domestic demand and to contain yen appreciation. The discount rate was unchanged from February 1987 to May 1989. From the second quarter of 1987 the Bank began to urge commercial banks to be prudent lenders, with little effect. On 1 April 1989 a consumption tax was introduced and on 31 May 1989 the discount rate was raised to 3.25 percent. The Bank called on commercial banks to improve the quantity and quality of their lending. On four subsequent dates the discount rate was raised, reaching 6 percent on 30 August 1990.
Alternatives to the Authorities Response
Inflated land prices became the backing for an egregious expansion of bank credit, which continued past the second half of the 1980s. Bank authorities could foresee severe effects on the soundness of Japanese bank portfolios once land prices declined. Because of their limited share of total assets, equities that served as collateral for loans presaged less damaging effects of inflated corporate equity prices than property collateral on the quality of bank portfolios. A more serious issue that was not adequately weighed during the equity price boom was the role of equity that banks owned by taking stakes in the corporations with which they formed business relationships. A plunge in share prices would impose valuation losses that could breach minimum capital requirements.
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