The Global Financial Market Turmoil and its Policy Implications

Takafumi Sato
Commissioner, Financial Services Agency

At the EU Financial Counsellors Meeting, Tokyo
6 December, 2007

Good morning. It is my great pleasure to be invited here today to share my thoughts with financial counsellors and attachés of the European embassies here in Tokyo. Given the close economic and financial relationships between the EU and Japan, cooperation with our fellow authorities in the EU member states is very important to the Japan FSA. In taking this opportunity, let me first express my sincere gratitude for your help in this regard.

Financial markets around the world have become truly globalised. It is no wonder that the financial turmoil triggered by the U.S. subprime mortgage problem has been affecting financial markets on a global scale. Active discussion on this topic has been taking place both on national and international levels. I hope my speech here today can offer you some additional perspective to the ongoing international debate on this issue.

Backgrounds and Causes of the Global Market Turmoil

Last week, an advisory group to Minister Watanabe, called the Financial Markets Strategy Team, released its initial report. The report analyses the backgrounds and causes of the global market turmoil and put forth policy recommendations. It points out that there appear to have been various problems in terms of information transmission and risk control in the process of securitisation of subprime loans. I wish to speak today on this issue in line with this report.

The so-called ''originate-to-distribute'' business model involves a chain of stages with different counterparties transferring risks between them. At the outset of the chain, a mortgage company provides a housing loan to a borrower, categorised as ''sub-prime'' due to their less creditworthiness. Then, the lender, or the originator of the mortgage loan, sells it to commercial banks and investment banks, which then bundle different loans together to form securitised products such as mortgage-backed securities (MBS) and collaterised loan obligations (CDOs). In this process, these arrangers of securitised products deal with credit rating agencies to obtain ratings from them. In the final phase of the process, these securitised products are sold to end-investors through distributors, typically large investment banks. At each stage of this process, credit risk is transferred from one party to its counterparty. Supposedly, accurate information on the risk should also be transferred from one party to another in due manner in this process.

In reality, however, this may not have been the case. Rather, there is a possibility that in many cases information was transmitted in a distorted manner and accurate information was not transmitted between counterparties. For a party who was going to transfer credit risk by selling its claims to the counterparty, there might have been little incentive to carefully examine the quality of the credit due to be sold. Moreover, there may have been disincentives for the party in question to disclose accurate information to its counterparty. Thus in many cases, end-investors, and probably arrangers and distributors as well, may not have been adequately informed of, and may not have fully understood, the true nature of the risks they were bearing.

Securitisation offers lots of advantages, but it also has potential side effects. As I just described, there appear to be embedded vulnerabilities in the securitisation process, due in part to moral hazard and asymmetric information. These vulnerabilities were materialising as the external economic and financial conditions got worse. A large number of rating downgrades last summer on subprime-related securitised products caused a serious loss of confidence in the relevant markets. The retreat by investors from these products led to the inability of the markets to value these products, as the sellers could not find any investors who were willing to purchase them at an agreeable price.

As well as this ''pricing uncertainty'', the markets have also been plagued by what we may call ''risk proliferation uncertainty''. As financial innovations led by securitisation have scattered the risks of underlying assets over various parties around the world, it has become increasingly difficult to identify the location and the magnitude of risks in the financial system. Another type of uncertainty can be characterised as ''liquidity uncertainty''. The maturity mismatch between assets and liabilities of various off-balance sheet vehicles investing in subprime-related products, such as structured investment vehicles (SIVs) and asset-backed commercial paper (ABCP) conduits, were transformed into liquidity risk of the banks providing liquidity support facilities to these vehicles. These three types of uncertainties have become intertwined with each other, making the situation more complex and opaque.

Strengthening the Global Financial Markets

When our house is on fire, the first thing we should do is to put out the fire, rather than thinking about installing a fire alarm for future prevention. Thus, priority should be accorded to helping the markets back to normal as early as possible. The efforts undertaken by our central bank colleagues in major markets to this end, including their large-scale injections of liquidity, have been encouraging.

At the same time, however, financial supervisors and other authorities around the world must give serious consideration to how future turmoil of this sort can be prevented and how the global financial markets can be strengthened in the medium term. This exercise should also help restore market confidence in the near term.

Given the nature of the problems in the securitisation chain that I mentioned earlier, remedies aimed at correcting distorted incentives should be considered. If we can develop some sort of framework that will induce lenders to maintain strict lending standards, and persuade arrangers to be vigilant in regard to the quality of the credit they are bundling, this would help the situation improve considerably. For instance, it might be desirable for originators to keep a certain portion of the underlying assets, and for arrangers to keep a certain tranche of the structured products, as incentives for them to examine and monitor more carefully the quality of the credits and securitised products they are producing. An idea worth to consider could be rules or voluntary codes of conduct requesting the disclosure of information on the portion kept by originators and arrangers so that credit rating agencies can take such information into account in their ratings. The securitised products with some portion kept by originators or arrangers might deserve higher ratings, as the quality of credit for the underlying assets of these products is supposed to be more carefully examined and monitored by the originators and arrangers themselves.

Similarly, it would be desirable that distributors explain their complex structured products to investors in sufficient detail, including information on underlying assets and particular risk profiles. Some rules or voluntary codes of conduct for distributors could be established in this regard.

For their part, end-investors should be encouraged to make sound investment decisions with proper risk management, especially in cases where banks are investing in these complex products. For this, I would like to emphasise the usefulness of Basel II, the revised capital adequacy framework for banks. From our experience in fully implementing Basel II last March, I am confident that our early implementation of this framework must have contributed to better risk management at banks and enhanced market discipline.

To begin with Pillar 1 of Basel II, that is, minimum capital requirements, banks are now required to calculate the minimum amount of capital in a more risk-sensitive manner than under the old Basel I framework. A typical example is the so-called ''look through'' approach with regard to banks' fund investments. We have rigorously applied this approach within our Basel II framework, and banks are now required to keep larger amount of capital for their fund investments if the components of the fund cannot be identified. Therefore, banks are encouraged to ''look through'' the components of their fund investments. It has been reported that some banks have reduced their positions in funds for which detailed information cannot be obtained and also that some funds have improved their disclosure practices in response to the requests from Japanese banks. As these examples show, it is fair to say that Japanese banks have in general become more prudent and selective in choosing their portfolio.

As for the treatment of securitisation exposures in Basel II, we have added some extra value to the original framework. In Basel II, banks are allowed to use external ratings in computing their capital charge for securitisation exposures. We paid attention to the fact that market discipline works less effectively for ratings of securitisation products than those for conventional corporate bonds, as securitisation ratings are difficult to be validated, given very few actual default experiences for securitised products in Japan. We arrived at a market-based solution. In order for the securitisation ratings to be eligible, we have required that credit rating agencies publish, free of charge, not only general information such as rating criteria, but also detailed transaction-specific information such as the type of underlying assets. This must have contributed to improving market transparency as well as supporting banks' risk management.

With regard to disclosure and transparency, Pillar 3 of the Basel II framework requires banks to improve their disclosure of information on the risks they are taking. For example, banks must disclose information on their securitisation exposures, including breakdowns by type of underlying asset and by risk weight. We have received positive responses from market participants, indicating that the Pillar 3 disclosure requirements have helped a great deal in better understanding the magnitude of Japanese banks' involvement in the securitisation business, leading to more transparency and contributing to calming down market concerns during a time of global market turbulence.

Impact on the Japanese Financial System

Let me now turn to the domestic situation in Japan at present. The impact of this global financial turmoil on the Japanese financial system has not been insignificant, but so far the turmoil has not had a serious impact on our financial system. Of course, I should not make a predicative statement about future situations and we should remain vigilant in view of further market developments. Nevertheless, there are some reasons for this relative confidence.

First of all, Japanese financial institutions' exposures to subprime-related securitised products such as MBS and CDOs have been quite limited as a whole. The FSA published its survey results last week*, indicating that the total exposure of Japanese deposit-taking institutions to subprime-related products amounted to ¥1.4 trillion, or €8.8 billion ($13 billion), as of the end of last September. It is fair to say that this number is quite small from a global perspective, given that the size of the U.S. subprime mortgage market is estimated about $1.3 to $1.5 trillion (¥140 to ¥170 trillion, or €1.9 to €2.2 trillion).

If we look at the level of soundness of these deposit-taking institutions, their aggregate annual profits from banking businesses amounted to ¥6.7 trillion, or €42 billion ($61 billion) last year and their aggregate Tier 1 capital exceeded ¥49 trillion, or €300 billion ($440 billion) as of last March. Thus, their exposures to subprime-related products can be regarded as limited compared with these numbers as well.

In addition, the soundness of the Japanese financial system has improved substantially over the last decade. After more than a decade of suffering from the non-performing loan (NPL) problem, the NPL ratio of Japanese financial institutions has declined to a comfortable level and they are well capitalised on the whole. Their soundness is supported by improved risk management. Japanese banks have been working hard to put in place reliable risk management systems, in parallel with their efforts to resolve the non-performing loan problem. Moreover, the full implementation of the Basel II framework last March should have a positive impact in this regard as I mentioned earlier.

One distinct characteristic of the present situation here in Japan is that our money and credit markets have been relatively stable. This might be due in part to the fact that the use of off-balance sheet vehicles frequently cited in relation to the subprime turmoil, such as SIVs and ABCP conduits, has been relatively limited among Japanese financial firms. While some of the major banks are sponsoring ABCP programs, the underlying assets of these programs consist mainly of domestic, short-maturity ones such as account receivables and credit card receivables.

Only a few large Japanese financial firms have been engaged in the subprime-related securitisation business through their overseas subsidiaries. They have reported some realised losses and valuation losses on these business operations, but the size of their losses has been limited in comparison with their fundamentals.

In sum, the impact on our financial system has so far been limited, but we should continue to be vigilant to further market developments.

Strengthening the International Competitiveness of our Financial and Capital Markets

In the remainder of my speech, I would like to touch on our efforts to strengthen the competitiveness of our markets.

Our financial markets have been regarded by many critics as lagging behind in terms of competitiveness, compared with not only global financial centres such as London and New York but also our regional competitors in Asia such as Hong Kong and Singapore. As our population is aging rapidly, it is critical for us to have a stronger financial service industry in order to maintain our standard of living in the future. Strengthening the international competitiveness of our financial and capital markets is one of the top policy priorities for the current administration, and the FSA has been directed by the Prime Minister to compile a comprehensive plan by the end of this month.

The ongoing discussions on this issue at the Financial System Council, an official advisory body to the Prime Minister, have emphasised the following four areas for instance:
i)   Diversification of products tradable at exchanges,
ii)   Fostering more vibrant transactions among professional players,
iii)   Reviewing firewall regulations between banking and securities businesses, and
iv)   Making administrative civil money penalties against market misconduct more effective.

As for the diversification of products tradable at exchanges, the majority of Council members are in favour of allowing financial exchanges to list commodity-related ETFs (exchange-traded funds). Also, they are showing their support for allowing financial and commodity exchanges to form alliances, offering a full line of listed products ranging from stocks, bonds, and financial derivatives to commodity derivatives within a group.

With regard to fostering more vibrant transactions among professionals, a broad consensus has been reached at the Council on developing a framework where professionals can make transactions more efficiently with reduced disclosure requirements at their own risk. Ideas currently being discussed include a more flexible wholesale market to facilitate financing for both domestic and foreign companies while fostering financial innovations through competition among participants in the market.

Active discussion has been going on in regard to the issue of firewall regulations. There are opinions that firewall regulations should be re-examined in terms of customer convenience. For instance, corporate customers would benefit from being offered a wider range of financing options at one time. It would also help financial institutions make their business operations more efficient by consolidating internal control within a financial group. On the other hand, we should pay attention to the need to prevent conflicts of interest and abuse of dominant bargaining positions. It should be noted that banks have traditionally been in a relatively strong position in Japan. We should also pay attention to the increasing awareness for the protection of personal information of individuals. The Council has been discussing this matter in a spirit of satisfying all these elements. The main agenda items to review include the restriction on the exchange of undisclosed customers' information within a financial group, and the prohibition of interlocking officers and employees between banking and securities businesses.

As for administrative civil money penalties against market misconduct, specific issues currently being discussed include increasing the amount of the financial penalties for insider trading and false disclosure, and broadening the coverage of penalised misconduct.

The comprehensive plan will be compiled by the end of this month, and some measures would require amendments to the existing laws. In this case, necessary bills would be submitted to the ordinary session of the Diet next year.

In addition to the legal structures, the quality of the financial regulation as a whole is a crucial determinant of the competitiveness of financial markets to which it is applied. As you may know, ''better regulation'' is an overarching theme for the FSA's work in the coming years. We are currently working hard to implement various measures set out in my earlier speeches. Please visit our website and read my speech in English in September for further details on this topic.

Concluding Remarks

Let me close my speech by stressing that the ongoing global financial turmoil highlights the importance of closer cooperation among regulators, policymakers and central bankers around the world. Japan FSA will continue to work together with our colleagues in both the EU member states and other countries for global financial stability. We will continue to support and contribute to the works undertaken by various international bodies, including the Financial Stability Forum, the IOSCO, and the Basel Committee on Banking Supervision, to this end.

Thank you.