Fed following path that didn't help Japan in crisis

TOKYO (Reuters) - If Japan's experience is any guide, the Federal Reserve's plans to accept equity as collateral for loans will have little impact on the credit crisis and may even erode the U.S. central bank's influence over markets.

While the Bank of Japan tinkered with its collateral policy, the government spent public funds to replenish the capital of debt-laden banks and that is what ultimately helped pull Japan out of its crisis, analysts said.

The United States, by contrast, has so far withheld public funding from troubled institutions until they were on the brink of collapse.

In one of a series of emergency policy responses to the spiraling credit crisis, the Fed said this week it would add equities to the types of collateral for emergency loans through one of its credit facilities. It had previously accepted only investment-grade debt securities.

The move, unprecedented in the U.S. central bank's nearly 95-year history, stirs memories in Japan, which suffered a decade of deflation after an asset bubble collapsed in the 1990s in the much the same way as the U.S. housing market imploded last year.

"Broadly speaking, what the Bank of Japan did and what the Fed's doing is the same in that they are expanding eligible collateral," said Izuru Kato, chief economist at Totan Research, a research arm of Japanese money broker Totan.

The Fed agreed to lend against stocks as investment bank Lehman Brothers LEH.N collapsed, becoming a casualty of the crisis triggered by U.S. mortgage defaults that has wiped over $400 billion from the balance sheets of the world's banks.

It then saved American International Group (AIG.N), once the world's largest insurer, from a similar fate by pledging a loan of up to $85 billion. ID:nN14461974

CREDIT CRUNCH

Although there are differences in the circumstances, the Fed's measures bear some resemblance to BOJ policies during the Japanese financial crisis.

The BOJ also expanded the definition of collateral to corporate bonds and asset-backed securities to allow companies to raise funds during a domestic credit crunch.

That may have helped Japan cope with the crisis, but in the end did nothing to solve the problem until banks were able to raise fresh capital.

"I don't think they were an essential part of the solution," said Mitsuru Saito, chief economist at Tokai Tokyo Securities.

"Those measures will not cure solvency problems. If banks suffer losses, they need to raise capital."

Japan spent more than 12 trillion yen ($114 billion) of public funds to bolster banks' capital and then pushed lenders to raise cash of their own.

The BOJ has also been more cautious than the Fed about stepping outside the boundaries of the traditional central banking and never went as far as to accept equities as collateral.

With deflation persisting it did take the unprecedented step of buying Japanese shares to free up cash at banks.

CREDIBILITY ON THE LINE

Between 2002 and 2004, the BOJ bought 2 trillion yen of stock, and said it would sell them back in the market over 10 years from October 2007.

As it turned out the BOJ has so far made something of a profit because the Japanese share market bottomed out in 2003. It has not given details of its holdings.

Still, the BOJ, central bank of the world's second largest economy, put its credibility on the line and ultimately lost some of its influence on markets.

In 2003, when the BOJ was flooding the money market with cash and effectively guiding short-term rates around zero, some foreign banks were reluctant to put too much money on deposit at the BOJ because they were worried about the central bank's balance sheet.

These banks preferred to place those funds with other banks with high credit ratings at negative interest rates -- effectively paying them to take the deposit. As a result overnight call money rate regularly fell below zero and below the BOJ's target.

"I think the BOJ's credibility was hanging almost by a thread at that stage. The BOJ clearly went through a risky phase then," said Kato of Totan Research.

With the credit crisis threatening to rupture the entire financial system, the Fed may not have much choice but to follow in the Bank of Japan's footsteps and put its credibility on the line.