Asset Price Bubble and Banks: The Case of Japan

This paper analyses the behaviour of the Japanese banks at the outset of the asset price bubble in the late 1980s. The paper argues that with the advent of financial deregulations, the declining trend of profitability forced the banks to exhibit speculative behaviour during the asset price bubble period (mid-1980s) to increase short term profit. This has ultimately led to the banking crisis after the burst of the bubble in 1989. Our empirical results support this argument. The paper also attempts to provide a comprehensive description of a number of interrelated structural changes in the financial system of Japan during 1977-2003 that opens up the domain of possibility for rethinking the issues related to change in policies. The case of Japan in the context of the rise and burst of the asset price bubble and subsequent banking crisis could be instructive for many countries including Bangladesh that are facing the asset price bubble situation. Japanese experience suggests that monetary policy should respond to asset bubbles in a cautious and moderate manner in order to avoid economic distortions. The lessons that can be learned from the Japanese experience are: (i) central bank’s role to burst bubbles must depend on the degree of efficiency of the financial sector, and (ii) the speed to burst the bubble must be based on the overall economic situation