Identifying the security lending channel in a central bank’s asset purchase program: a case of Bank of Japan’s ETF purchases

The Bank of Japan (BOJ) introduced the ETF purchasing program in 2010 in order to stimulate the economy after the GFC. Since then, continuous and massive purchases of equity index-tracking ETFs (i.e., TOPIX and Nikkei 225 tracking types are two majors) have provoked discussions among economists and researchers on the BOJ’s impact on the stock market. In particular, one of the most frequently asked questions is, to what extent does it affect stock prices? To answer this question, it is worth taking a closer look at the structure of the program.

Two observations are made: First, the BOJ’s ETF purchases increase the creation of ETFs. As the market-tracking ETFs that the BOJ has been purchasing are non-synthetic, ETFs need to hold a market basket to follow its mandate of minimizing tracking errors from the market returns. Therefore, the BOJ’s ETF purchases inevitably result in increases in demand for individual stocks that constitute the indexes, thus tightening supply–demand conditions in the stock market and possibly leading to increases in stock prices or liquidity shortages of individual stocks.

Second, ETF managers can lend out their holding stocks that constitute ETFs purchased by the BOJ. In the balance sheet of an ETF managed by ETF fund managers, the liability side includes principals obtained by issuing beneficiary certificates. Under the BOJ’s massive ETF purchase program, most of the certificates are held by the BOJ. On the asset side, the ETF holds the corresponding amounts of individual stocks to minimize tracking errors. This implies that the direct holder of the stocks is not the BOJ but ETF mangers. Under this framework, ETF fund managers have strong incentives to earn lending fees by supplying stocks in ETFs to the stock lending market. It is particularly true for ETFs held by the BOJ, given that the BOJ does not have plans to sell its ETF holdings and is considered a long-term ETF holder. Figure 1 shows that the upper limits of the stock lending ratios, defined as the number of lending stocks to the total number of stocks in ETFs, have been raised as the purchase program expands.

Sources: ETF balance sheets, EDINET.

 

Based on those observations, consider the following channel through which the ETF purchase program can influence on stock returns.

Step 1: ETF purchases directly exert upward pressure on stock prices.

Step 2: Stocks purchased by BOJ are supplied in the lending market.

Step 3: Increases in lendable stocks lower lending fees.

Step 4: Stock borrowing transactions (= short sells) increase.

Step 5: Downward pressure is exerted on stock prices.

While existing research on the effects of the program on stock returns mainly focuses on Step 1, Katagiri, Shino and Takahashi (2023) investigate whether Step 1 through Step 5 affect stock returns as a whole. Here it should be noted that, in order for the whole mechanics (especially Step 3) to effectively work, lending fees of some stocks should have substantial room to be lowered. That is, for some stocks, there should not be excess supply in the lending market so that lending fee is sufficiently high. Following existing literature of stock lending markets such as Blocher, Reed and Van Wesep (2013), we call such stocks with high lending fees “special stocks,” otherwise “non-special stocks.”

Specifically, Katagiri, Shino, and Takahashi show evidence of the two channels through which the ETF purchase program affects stock markets: the direct channel and the security lending channel. First, they find that the ETF program has a positive effect on stock returns by shifting upward the demand curve in the stock market, which we call the “direct channel,” corresponding to Step 1 above. Next and more intriguingly, they show that, over longer periods, the BOJ’s accumulated purchases have lowered lending fees in the stock lending market (Step 3) and thus exerted downward pressures on stock returns (Step 5), particularly for “special stocks” (See Figure 2 and Figure 3 below). This suggests that the accumulated purchases by the BOJ increased the supply of lendable shares in the stock lending market, and the rightward shift of the supply curve in the lending market is a “security lending channel.” These results indicate that the intended effects of the BOJ’s ETF purchase program on stock returns can be offset by the increased supply of lendable shares in the stock lending market through the response of ETF managers.

Note: Based on the estimation results in Katagiri, Shino and Takahashi (2023), the blue and black solid lines indicate the median and mean of the marginal effects of an ETF purchase on weekly stock returns for non-special stocks, respectively, while the dotted blue lines indicate their 10th and 90th percentiles. Similarly, the green and red solid lines indicate the median and mean of the marginal effects of the purchase on stock returns for special stocks, respectively, while the dotted green lines indicate their 10th and 90th percentiles. It shows that the average marginal effects for special stocks have declined over time, while those for non-special stocks have remained almost unchanged. Sources: Estimation results in Katagiri, Shino and Takahashi (2023).

Policy Insights

Our analysis has shown that the security lending channel should be considered in evaluating the effect of an asset purchase program on asset prices, especially when the assets purchased by a central bank can be lent out subsequently in the associated lending market. For instance, suppose that, as the BOJ is retaining the large scale ETF purchase program, the supply of lendable stocks is expected to increase, i.e., the supply curve in the lending market shifts rightward. Based on our results, the rightward shift exerts downward pressure on lending fees for special stocks, which offsets the intended policy effects generated by the direct channel.

On the other hand, there is also a possibility that this program can be evaluated positively in terms of helping the stock lending market operate more effectively. Specifically, when the BOJ’s ETF purchases help increase the supply of lendable stocks in the lending market, it helps investors borrow overvalued stocks and sell them in the spot market, which exerts downward pressure on overvalued stock prices and thus corrects price distortions among individual stocks. In other words, if such effects exist, the BOJ should consider the possibility that an exit from their ETF purchase program may cause a sudden deterioration in the availability of lendable stocks and induce unintended consequences.