Dr. Takafumi Sato
Commissioner, Financial Services Agency
IIF Asian CEO Summit
September 11, 2008
It is a great honor to be invited to this occasion, and to speak before the CEOs of Asian financial institutions gathering here to share their insights on the current issues surrounding the global financial markets.
The unfolding financial turmoil reminds me that supervisory authorities are never able to escape the fate of pursuing two possibly conflicting objectives at the same time. On the one hand, we must address current serious concerns arising from our day-to-day supervisory operations. On the other hand, we must proactively envision a direction for financial regulation over the longer term. Ten years ago, we drastically reformed our regulatory and supervisory framework while making unceasing efforts to stabilize the financial system. The circumstances are little different this time, and I am lucky enough to be still in pursuit of such great dreams. As Commissioner of the Financial Services Agency, what I aim to achieve in parallel with countering the global financial upheaval is to improve the quality of financial regulation, or promote and encourage "Better Regulation," and to strengthen the competitiveness of Japan's financial and capital markets through implementing the "Better Market Initiative."
Before going into the details of "Better Regulation" and the "Better Market Initiative," I would first like to offer some of my thoughts on the current global market turmoil, so that the FSA's position will be clear to you in respect of the related policy actions taken against the global market upheaval triggered by the subprime loan crisis.
A significant and distinctive contributing factor to the outbreak of the current turmoil was the proliferation of the originate-to-distribute model (OTD model) based on the financial technology of securitization. The weakness of this model is that originators, arrangers of securitization, distributors and investment managers had insufficient incentives to generate and provide initial and ongoing information on the quality and performance of underlying assets. There is an emerging consensus that misaligned incentives along the securitization chain thus caused moral hazard among the parties involved in the process.
Underlying Causes and Weaknesses behind the Crisis
With that mechanism in mind, I would like to go through the typical problems along the securitization chain that were exacerbated by the exceptional boom in credit growth and leverage in the financial system.
Complacency among market participants, created by a long period of benign macroeconomic conditions, gave rise to an erosion of sound practices. This in turn led to problems such as (i) poor underwriting standards by originators and mortgage brokers, (ii) weak risk management at financial institutions, particularly with respect to off-balance sheet exposures, and (iii) poor due diligence and blind reliance on credit ratings by investors. If there had been appropriate incentives for checks and balances along the process, the deterioration of standards in market practices could have been prevented.
Poor performance by credit rating agencies (CRAs) with respect to structured products worsened the problem, since investor dependence on credit ratings grew as complacency became widespread. It seems that the CRAs were overwhelmed by the sheer volume of the workload and failed to keep pace with the increasing complexities in structured products. The shortcomings among CRAs typically included (i) weaknesses in rating models and methodologies and (ii) inadequate due diligence regarding the quality of underlying assets.
Furthermore, weaknesses in public disclosures by financial institutions, which were not an issue as long as the benign environment hid the flaws in the securitization chain, damaged market confidence through amplifying anxiety among market participants once the crisis broke out. Their disclosures often failed to make clear the type and magnitude of risks associated with their on- and off-balance sheet exposures.
Thus, the consequences of the crisis have been devastating.
A lack of transparency in risk transfer enabled by the securitization process blurred the overall and individual levels of risk exposure among market participants, thereby increasing counterparty risks. Moreover, the loss of confidence in credit ratings and prices of structured products led to an implosion in investor demand and the evaporation of market prices, raising uncertainty over incurring losses.
A shock wave extended further to the U.S. and European money markets, taking the form of reluctance to provide term money in inter-bank markets. As a result, those markets have become largely dependent upon the liquidity facilities offered by central banks. Meanwhile, a flight to quality also disrupted the financial markets for equities, bonds, currencies and commodities across the globe, creating increased volatility in market prices.
Although some pundits predict that the trend would reverse soon, I would like to draw your attention to a mixed picture containing both positive and negative aspects. The positive aspects include (i) prompt loss recognition and capital raising among large and complex financial institutions (LCFIs) in the United States and Europe, (ii) policy response by the relevant authorities to contain systemic risk, and (iii) recently subdued commodity prices.
On the other hand, the negative aspects are (i) prolonged weakness in the U.S. housing market, (ii) the lack of any sign of recovery in the structured product market, (iii) tightening lending attitudes, (iv) the deteriorating performance of the real economy, and (v) the concurrent risk of inflation. My view is that, while there continue to be positives and negatives in the market, it will take a decent time for the situation to return to normal.
I have focused so far on the global picture of the ongoing turmoil, especially in the U.S. and Europe. I would now like to turn to the situation in Japan.
The latest figure shows that Japanese deposit-taking institutions hold 958 billion yen, or approximately 9 billion U.S. dollars of subprime-related products and the aggregate of their realized and valuation losses amounts to 896 billion yen, or about 8.5 billion U.S. dollars. Furthermore, disclosure based on the leading practices summarized in a report by the Financial Stability Forum (FSF) reveals that the total exposure of deposit-taking institutions in Japan to securitized products is 23.5 trillion yen, or about 220 billion U.S. dollars. Accordingly, their realized and valuation losses have been limited to 2.6 trillion yen, or about 24 billion U.S. dollars.
I conclude, therefore, that the direct impact of the subprime loan crisis on the Japanese financial sector has so far been relatively small compared to the U.S. and European ones. In view of the level of Tier 1 capital and operating profits, the subprime loan crisis alone is unlikely to pose a serious threat to Japan's financial system. Rather, a more imminent risk to the country is its deteriorating economic condition caused by worsening terms of trade due to rising commodity prices. This deterioration could drag down the condition of the Japanese financial system.
In response to the current turmoil, the FSF's Working Group on Market and Institutional Resilience put together concrete recommendations for enhancing market and institutional resilience last April. These include (i) strengthening prudential oversight, (ii) enhancing transparency, (iii) making changes in the role and uses of credit ratings, (iv) strengthening the authorities' responsiveness to risks, and (v) making robust arrangements for dealing with stress in the financial system.
In the case of Japan, the FSA responded quickly to the outbreak of the global market turmoil by directing its existing administrative resources to that matter in order to assess its impact on the Japanese financial system. In particular, the FSA's early release of the total exposure of Japanese deposit-taking institutions to subprime-related products was very effective in removing uneasiness from the Japanese market.
Furthermore, the FSA took proactive action, prior to the FSF recommendations, to ensure traceability along the securitization chain so that distortions in the incentive structure among market participants were properly corrected. It is envisaged that this policy action will be complemented by regulation by the Japan Securities Dealers Association, setting a template for the disclosure of underlying assets.
Last but not least, I would like to briefly share my views on why the current financial upheaval has had a comparatively small and indirect impact on Japan's financial sector. One of the possible reasons is the early implementation of the Basel II framework in Japan. Under this framework, rigorous risk management is required when investing in structured products. In particular, we can point out the effect of Japan's original rules, under which disclosure by credit rating agencies of the subordination ratio in the securitization process is made a prerequisite for the use of external credit ratings in computing capital requirements. Thus, the lesson learned from this episode is, I believe, the value of a forward-looking approach in regulation and supervision.
Now let me turn to the FSA's Better Market Initiative. In addition to taking necessary actions in response to the ongoing global turmoil, Japan has another task to accomplish. In order for Japan to sustain economic growth with its shrinking and rapidly aging population, I believe that there is an urgent need to strengthen the competitiveness of our financial and capital markets. Japan's financial services industry needs to provide high quality services to its customers and contribute to the country's future economic growth.
As a financial center, Japan has many attractive aspects. Its economy is currently the second largest in the world, and the financial assets of its household sector exceed 14 trillion US dollars. Our country also enjoys the advantage of geographical proximity to the emerging market economies in Asia, the region expected to maintain the highest rate of economic growth in the world.
On the other hand, Japan's financial markets do also have a number of shortcomings. In recent surveys comparing the competitiveness of financial centers throughout the world, Tokyo not only trailed behind global centers such as London and New York, but also lagged behind regional rivals such as Hong Kong and Singapore. The reasons for this are probably better known to the members of the audience, who are actually engaged in business.
We are aware of these weaknesses, and we are not standing idly by. For many years after the early 1990s, Japan's financial sector was overwhelmed by the collapse of the bubble economy and the nonperforming loan problem. During that period, Japan found itself left behind as international competition between financial centers intensified. Fortunately, those years of difficulties are now over for Japan's financial sector, and we have entered a new stage. The direct negative impact of the ongoing global market turmoil on our financial system has been relatively limited. Now is therefore an excellent time for the nation to close the gap with the global frontrunners.
Against this backdrop, last December we embarked on the "Better Market Initiative (BMI)" to strengthen the competitiveness of Japan's financial and capital markets. We have made significant progress so far, including the passage of our milestone bill for amendment of the Financial Instruments and Exchange Act, etc. last June.
Taking this opportunity, I would like to tell you about some of the progress made in implementing the BMI that might be of interest to you. I will explain some of the main items, following the four pillars of the BMI in turn.
The first set of measures is categorized under the pillar of "Creating Reliable and Vibrant Markets." The focus of these measures is to provide flexibility for transactions between professionals based on the principle of self-responsibility, drawing upon the experiences of the AIM (Alternative Investment Market) in the United Kingdom and the markets under Rule 144A of the U.S. Securities and Exchange Commission (SEC).
The revised framework for transactions among professionals provides opportunities four times a year to acquire the status of qualified institutional investors (tekikaku kikan toshika), who can make private offerings without being subject to public disclosure requirements.
In addition, last June we expanded the scope of securities for which disclosure in English is permitted to any type of securities issued by foreign issuers, including foreign governments and foreign funds. This measure is expected to greatly reduce the administrative burden on foreign issuers raising funds in Japanese markets.
I believe that these measures will broaden the opportunities for both Japanese and non-Japanese issuers to raise funds in our markets, and will also promote financial innovation through competition among professional players.
Other measures in the first pillar include:
- Diversification of ETFs (exchange-traded funds); and
- Establishment of a framework for alliances between stock and commodity exchanges so that a full line of products ranging from equities, bonds, and financial derivatives to commodity derivatives can be offered by a single group of exchanges.
The second set of measures is aimed at vitalizing the financial services industry and promoting competition.
First among the measures in this pillar is the relaxation of firewall regulations. Specifically, the ban on interlocking officers and employees among banking, securities and insurance businesses in a financial group will be lifted, and restrictions on the sharing of undisclosed corporate customer information between banking and securities businesses will be relaxed. These steps should enable financial groups to better serve their customers by allowing them to propose a wide range of alternatives at one time, and will facilitate integrated risk management within a financial group. At the same time, financial firms will be required to put internal systems in place for controlling conflicts of interest. This relaxation will take place by June next year.
Second, the scope of business permitted for banking and insurance groups will be broadened by this December. This is a policy response in light of the growing diversification, sophistication and internationalization of financial services. Specific measures include:
- Permitting subsidiaries of banks and insurance companies to engage in Islamic finance; and
- Permitting banks and insurance companies to engage in emissions trading.
Good news for the fund management business is the measures to minimize the PE risk, the risk of double taxation that offshore funds could face if they engage in transactions in Japan through domestic fund managers. In order to facilitate the domestic fund managers' business with offshore funds, these funds are now regarded as not having a permanent establishment (PE) in Japan as long as their fund managers in Japan are seen as being sufficiently independent of them.
The third pillar of the initiative is "Better Regulation." I believe that the quality of regulation is a crucial determinant of the competitiveness of financial markets. In a better regulatory environment, financial institutions will be encouraged to develop creative ideas at their own initiative, and this will lead to better financial services.
There are several areas that we are currently focusing on for this purpose. First, we put together fourteen key principles last April and agreed to share them with the industry. The principles are expected to play a guiding role for financial firms in exercising best practices and to serve as a basis for interpreting rules. Thus, more principles-based regulation will help to ensure maximum flexibility in business operations for financial firms. This will also improve the effectiveness of our supervision by encouraging voluntary efforts by financial firms. In order to share a deeper understanding of the principles, we will enhance our dialogue with the industry and relevant parties through various channels. In this context, I believe the opportunity that I have been given at this occasion today is a valuable one.
Second, we are striving to enhance the transparency and predictability of our regulation and supervision. In July 2007, the FSA revised the No Action Letter system to facilitate the processing of letters of inquiry. In addition, in response to inquiries often received from financial firms on the interpretation of rules, we continue to compile our views in the form of FAQs (Frequently Asked Questions) and post them on our website. We are also speeding up our efforts to translate financial laws and regulations as well as relevant policy documents and materials into English. The translation of major acts such as the Financial Instrument and Exchange Act, Banking Act and Insurance Business Act was completed by last June.
Third, the FSA published the first progress report on its efforts toward "Better Regulation" in May, and plans to release another progress report every six months. This demonstrates the FSA's strong commitment to improving the quality of financial regulation in Japan.
The fourth and final pillar relates to improving the broader environment surrounding the markets. The measures we have in mind are: developing and accumulating internationally competitive human resources in the areas of finance, law and accounting; and enhancing urban functions to levels suitable for an international financial center. Tokyo scores well in terms of infrastructure in my opinion. But we need strategic and long-term efforts, both in terms of infrastructure and in terms of human resources.
In this regard, it is critical to expand the pool of talent with financial knowledge and skills befitting an international financial center and ensuring a shared sense of compliance among personnel engaged in regulation and in business. For this purpose, a study group on financial experts was established last November. After intensive discussions on the required abilities, practical work experience, and follow-up education, the study group released for public comments a summary of issues regarding the basic concept concerning financial experts last April. We will continue this study with a view to completing the final version of the concept.
By taking these actions across the four pillars, we intend to enhance the overall attractiveness and quality of Japan's financial and capital markets, and thereby to attract and accumulate funds, information and human resources in our markets, from both domestic and international sources.
It is the private sector, however, that is expected to play the leading role in our collective efforts to this end. By taking advantage of the policy measures implemented in accordance with the BMI, financial firms and exchanges will be able to further improve their products and services and better serve the needs of their customers. The role of invigorating the financial markets also falls in part to those who use the financial services and capital markets.
While the Asian financial markets have been relatively stable recently, in contrast with the U.S. and European ones, the Japanese market is uniquely positioned in this context.
On the one hand, the emerging global trend points to a direction of financial re-regulation, exemplified by (i) strengthened risk management and disclosure, (ii) due diligence in the securitization process, and (iii) strengthened supervision over CRAs. These are countermeasures against excessive leverage and the shortcomings of the OTD model. On the other hand, Japan is at the initial stage of implementing the BMI and aims to encourage private sector-driven initiatives through deregulation. Japan needs to manage these simultaneous processes and to make balanced progress toward a post-subprime crisis world.
We are now experiencing a phase of correction of excesses in finance, especially with respect to (i) highly geared leverage, (ii) incentive distortions toward short-term profits, and (iii) the multi-layered structure of complex financial products. My sense is that implementing the FSF recommendations in this context might create a financial universe where we can discover a new model of financial business, one that is more firmly based on value-adding activities in the real economy.
In this regard, there is a huge growth potential for financial markets in Asia, where a high rate of economic expansion is still maintained through the creation of real value. Thus, the next challenge for financial institutions in Asia will be to exploit such an opportunity by strengthening the capability of financial intermediation ideally suited to serving that objective in the future. I hope that Japan will be a center of financial innovation in that financial universe, led by many of your institutions.