Keynote speech by Dr. Takafumi Sato
Commissioner, Financial Services Agency
“Symposium on Building the Financial System of the 21st Century“
Co-organized by Program on International Financial Systems at Harvard Law School and International House of Japan
October 25, 2008
It is a great honor to be invited to this Symposium to speak before distinguished experts on finance from Japan and the United States. As this year’s Symposium is being held in the midst of a global financial crisis, I look forward to stimulating discussions among the participants, including those from academia, governments, and the private sectors.
In this speech, I would like to share with you my thoughts on how to resolve the ongoing global financial crisis, including from the standpoint of what sort of contribution Japan’s experience can make to that process. My speech mainly consists of four parts. I will start with comparing the world now with Japan in the 1990s and describe our bitter experience during that period. Then I will turn to the distinctive characteristics of the current crisis and the policy response to address them. Thirdly, I will explore how Japan can contribute to ensuring the global process of an orderly de-leveraging. Finally, I will briefly talk about present Japan’s unique position in terms of financial regulation.
I am sure the past couple of months will be long remembered as a historic period of the financial world. As you all know:
-- Two giant government-supported enterprises, or GSEs, have been intervened by the U.S. government;
-- The Federal Reserve engaged in extraordinary lending to an insurance company because it had grown systemically important;
-- As money markets have dried up, the world’s central banks have taken coordinated actions to provide financial institutions with broad access to liquidity;
-- Once-mighty investment banks have all disappeared as standalone entities by going bankrupt, by being acquired by commercial banks, or by transforming themselves into bank holding companies; and
-- U.S. and European authorities finally intervened in their financial institutions, in the form of nationalization, purchase of troubled assets, capital injection, blanket guarantee of bank deposits, and so on.
As financial regulators, these exceptional measures are the last actions we want to take. For one of Japan’s long-serving regulators like me, however, most of the measures taken by our fellow regulators seem to come under one or more categories of measures we took in the 1990s and the early 2000s. During that long period, we struggled to avoid a system-wide financial breakdown by taking most of the exceptional measures I just mentioned. Our experience clearly shows that taking these kinds of measures is critical in stabilizing the financial system. While they do not sit comfortably with the principles of market capitalism, we need to recognize that extraordinary situation requires extraordinary actions.
Why are the actions taken so similar? If you compare the current crisis with Japan’s crisis in the 1990s, you can find that the two crises evolved in a similar fashion.
-- First, irresponsible lending had been widespread prior to both crises, on the assumption that real estate prices would continue to go up.
-- Second, the financial market turmoil was triggered by the decline in real estate prices.
-- Third, the adverse effect of the market turmoil spilled over to the real economy.
-- And fourth, the turmoil resulted in a system-wide financial crisis, thereby necessitating public intervention by governments and central banks.
Of course, the current crisis differs significantly from Japan’s past crisis in some important aspects, as I will explain later. Particularly, the speed at which the authorities are forced to address the problem is much faster now. Also, the global nature of the current crisis demands cooperative action on a global basis.) Nevertheless, it seems to me that Japan’s bitter experience in the 1990s does offer some useful suggestions as to how the authorities around the world should tackle the problems they now face.
The first useful lesson is that prompt and accurate recognition of losses is essential. In the early 1990s, Japan did not have in place effective frameworks for disclosure and provisioning with respect to non-performing loans. This gave financial firms incentives to postpone the disposal of their non-performing loans, and the country plunged into a negative spiral of credit crunch and deterioration of the real economy. Based on this bitter experience, Japan improved disclosure requirements, clarified the rules on write-downs and provisioning, put in place a prompt corrective action scheme, and established an early warning system that enables the supervisors to conduct intense monitoring of banks before they become undercapitalized. In order for supervisors to act promptly, it is effective to have a regulatory framework in which they can make judgment in an objective manner.
From this standpoint, prompt disclosure by U.S. financial firms of the losses on financial instruments is encouraging. Challenges do remain, however, including the methodologies for valuation of financial instruments in cases where their market liquidity dries up, and the lack of data on exposure to complex financial products that are comparable across financial firms.
The second lesson is that toxic assets need to be taken off the balance sheet. This is crucial in order to break the negative spiral I mentioned earlier. If a financial firm is to make provisioning only and leave the assets on its balance sheet, it would be difficult to restore full market confidence as additional losses on those assets could be incurred later. In Japan’s case, the Resolution and Collection Corporation, or RCC, purchased the banks’ non-performing loans, while the Financial Services Agency, or FSA, strongly encouraged major banks to take their non-performing loans off balance sheet in a steady manner.
I believe that this lesson is relevant in tackling the current crisis, too. Market confidence may not be restored as long as a substantial amount of illiquid financial products remain on the balance sheets of financial firms. In this context, the role expected of U.S. Treasury’s Troubled Assets Relief Program to this end is crucial. Also, purchasing prices of those products by the Treasury will become important. If the prices are too high, this could lead to taxpayers’ burden. If the prices are too low, the banks would not use the program as they would be forced to incur larger losses by selling their assets. Thus the success of the program hinges on the highest expertise of the U.S. authorities.
Third, undercapitalization of financial firms needs to be addressed, by injecting public funds if necessary. Prompt and sufficient recapitalization is needed if a financial firm becomes undercapitalized as a result of the disposal of bad assets. In cases where a sufficient amount of capital cannot be raised on a market basis, recapitalization with public funds is effective as a final safety net. While capital injection does put taxpayers’ money at risk, it may end up with benefiting taxpayers if successful. In Japan, the government injected 12.4 trillion yen in 37 banks, of which 9.2 trillion yen has already been repaid, of which capital gains amount to 1.3 trillion yen. These are on top of a cumulative dividend income of 770 billion yen as of end-March 2008.
In this respect, I welcome the decision of the U.S. government to commit 250 billion dollars to recapitalize the financial firms. At the same time, the authorities should be flexible in responding to new, additional developments. Losses could grow further, because the adverse effect of the deteriorating real economy could hit financial firms if a substantial amount of bad assets remain on their balance sheets.
Fourth, exceptional measures, such as blanket guarantee of bank deposits and temporary nationalization of troubled banks, can be options in times of serious crises. Some European countries have already taken these steps. Japan also introduced full protection of bank deposits in the 1990s. This guarantee was lifted in two steps, in 2003 and 2005, after the financial system had been stabilized. In 2003, Japan introduced full protection of non-interest bearing deposits for settlement purposes as a permanent scheme. In fact, I was deeply involved in the preparation of the legislation necessary to introduce this measure. This protection looks similar to the provision of full coverage of non-interest bearing deposit accounts, which the U.S. authorities have announced recently.
The fifth and final lesson is that short-term measures and re-design of the regulatory framework in the medium-term need to be implemented simultaneously and in a balanced manner. While the work to extinguish the burning fire as soon as possible is of course necessary, it is also essential to put in place a framework to prevent the recurrence of the same kind of crisis. On one hand, if the policies lean too much toward crisis management, it could cause moral hazard or distort the system in the long run. On the other hand, hasty implementation of medium-term measures could rather exacerbate the situation and make crisis management even more difficult. It is therefore important to strike an appropriate balance between these two strands of policies.
Japan in the 1990s may not have been a perfect success story in this respect. However, while encouraging early recognition of non-performing loans and their removal from the banks’ balance sheet, as well as raising banks’ capital with public funds as an exceptional measure, we introduced, during the same period, the prompt corrective action scheme and asset evaluation rules, thereby reforming the regulatory framework from a longer-term perspective.
Probably, this experience has some relevance to the current situation, too. The keyword among the world’s major financial regulators today is “orderly de-leveraging.” I believe the word “orderly” signifies the issue of how to strike a good balance between short-term policies and medium-term reforms. Supervisors are never able to escape the fate of pursuing two possibly conflicting objectives at the same time.
As I have just explained, Japan’s experience in the past decade seems to provide some useful suggestions regarding the policy response necessary to resolve the current financial crisis. However, it is also true that the two crises do differ in some important aspects, which requires a different kind of measures in the current context.
The main differences between the two crises may be summarized in the following three points:
-- First, the current crisis can be characterized as a 21st century crisis, where risks were scattered through the markets to a wide range of investors by means of the financial technology of securitization. In contrast, in 1990s’ Japan, risks were concentrated in the commercial banking sector in the form of lending assets on their balance sheets.
-- Second, Western banks have been forced to write down securitized products promptly due to mark-to-market accounting. In the 1990s, Japanese banks were allowed to take time to dispose of their non-performing loans because their lending assets were largely not traded in the market. In addition, the banks had an incentive to keep the assets on balance sheet in the hope that the borrowers’ performance could be improved, including by the support from the lending banks.
-- Third, Japan’s financial crisis was contained within the border, and so were its impact on the real economy and the sharing of losses. However, the losses from the burst of the bubble this time have been dispersed globally because of the widespread use of securitization and the “originate-to-distribute” business model. This has caused severe slowdown of the global economy, impacting also Japan’s financial system through the decline in share prices and worsening of the broader economy.
Reflecting these differences, the measures being taken to tackle the current problem inevitably become more market-oriented and take on an international character.
Earlier this month, the G-7 Finance Ministers and Central Bank Governors agreed to a five-point Plan of Action and expressed their commitment to work together to stabilize the financial markets. In view of the nature of the crisis that is market-driven, the Plan highlights the importance of restarting the secondary markets for securitized assets, and the need for accurate valuation and transparent disclosure of assets.
For their part, the Financial Stability Forum, or FSF, which is a grouping of major national financial authorities and international bodies, put together last April a list of concrete recommendations for enhancing market and institutional resilience. Based on the recognition that distorted incentives along the securitization chain had caused moral hazard in the “originate-to-distribute” model, the FSF recommended the strengthening of prudential oversight, enhancing transparency including through more disclosure of securitized products, review of the role and uses of credit ratings. It also proposed the establishment of colleges of supervisors regarding supervision of the largest global financial firms. At the time of the October G-7 meeting, the FSF issued a follow-up report and announced that it would work on how to better integrate macroeconomic oversight and prudential supervision and reassess the scope of financial regulation. Work is also underway at international groupings of supervisors, including the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions, along with these FSF reports.
Let me now turn to the third issue of how Japan can contribute to getting the global financial markets back to normal.
It seems clear to me that the most important challenge faced by the world’s financial regulators right now is how to promote the process of orderly de-leveraging. A large amount of toxic assets accumulated as a result of excessive leverage need to be written off, and the recapitalization of financial firms is necessary. While this process was initially carried out by the private sector, the markets could become more unstable unless de-leveraging is undertaken in an orderly manner. The measures taken by the authorities such as recapitalization with public funds and purchase of troubled assets are part of the efforts toward this de-leveraging.
In this context, U.S. and European authorities have been taking exceptional actions, which I think will surely support the process of orderly de-leveraging. For our part, we should take appropriate measures to ensure financial stability in light of the situation of Japan’s markets and financial system. In any case, it is essential that the regulators in Japan, the U.S., and Europe take effective measures in a cooperative fashion.
Also, some interesting developments have been witnessed in Japan’s markets and in the behavior of Japanese financial firms. For example,
-- The market for samurai bonds has grown substantially. According to the Japan Securities Dealers Association, samurai issues in the first half of this year are at around 1.7 trillion yen, up 33 percent compared with the same period last year. Even though new issuance has stopped since the collapse of Lehman Brothers, many experts expect the market to bounce back.
-- The overseas loans extended to non-Japanese companies by Japanese megabanks were on an increasing trend until last summer, although marked developments have not been witnessed recently for the same reason I just mentioned.
-- Some Japanese financial firms are active in forming alliance with overseas firms and in acquiring businesses abroad. Mitsubishi UFJ entered into a capital alliance with Morgan Stanley, while Nomura acquired some of the business operations of Lehman Brothers in Asia, Europe and the Middle East. Although these actions are up to the business judgment of the individual firms, they are expected to alleviate disruptions in the global financial markets.
It is my view that these developments took place against the background of the relative stability of Japan’s financial system and may be making some contribution to orderly de-leveraging.
Finally, I would like to point out that Japan is uniquely positioned at the current juncture in terms of the direction of financial regulation.
As I mentioned earlier, the world’s financial regulators need to strike a good balance between short-term measures to cope with the ongoing crisis and medium-term policies to re-design the regulatory framework. Full implementation of the FSF recommendations is vital to this end, as endorsed by the G-7. These developments seem to indicate that the emerging global trend points to a direction of financial re-regulation, with a view to recreating a financial system that has less leverage and is immune from misaligned incentives witnessed in the “originate-to-distribute” model.
However, changes in Japan’s regulatory framework have yet another dimension. That is, the FSA aims to invigorate private sector activities and bring about prosperity to Japan’s markets through the implementation of “Better Regulation” and “Better Market Initiative”. "Better Regulation" refers to improving the quality of financial regulation by enhancing its effectiveness, efficiency, consistency and transparency. “Better Market Initiative” is a concrete policy package to strengthen the competitiveness of Japan’s financial markets by creating a reliable marketplace and enhancing the business environment of financial firms. Thus we need to manage the two medium-term processes of “re-regulation” and “deregulation” in a simultaneous manner. This is the reason why I say Japan’s current position is unique.
It is my sense that implementing the FSF recommendations could eventually lead to a world of finance more firmly based on value-adding activities in the real economy. This may favor countries like Japan that has a large real economy and a strong manufacture sector with advanced technologies. At the same time, implementation of “Better Regulation” and “Better Market Initiative” will broaden the opportunities in Japan’s financial markets for investors, fundraisers, and financial firms from all around the world. It is my hope that Japan will be able to emerge as one of the global financial centers in the post-subprime-crisis world of finance.