Remarks by Dr. Takafumi Sato
Commissioner, Financial Services Agency (FSA)

“The Financial and Economic Futures of Japan and the U.S.”
Conference organized by Center on Japanese Economy and
Business, Columbia Business School
Tokyo, May 14, 2009

Thank you. It is my pleasure to join this panel discussion.

I would like to comment briefly on two things. One is the FSA’s view on the current situation of Japan’s financial system. And the other is the policy challenges we shall be facing in the period ahead.

With regard to the first issue, Japan’s financial system itself is still relatively sound compared with those in the United States and Europe. Yet the system is increasingly affected by the deterioration of the real economy and high volatility of the financial markets.

The relative soundness of Japan’s financial sector stems from the fact that its losses incurred from complex securitized products are relatively small. These figures are one digit larger at the American and European financial sectors, and the impact of the losses on capital is far less severe in this country. The exposure of Japan’s financial sector to opaque, toxic assets is also significantly smaller. This implies that future additional losses from the exposure will be limited.

There may be a few reasons for this relative soundness.

• Admittedly, it is partly because Japan’s financial firms were not strongly innovation-oriented.
• But it is also because they were giving priorities to improving their financial soundness rather than enhancing their profitability in the recent several years. When the so-called “originate-to-distribute” business model became widespread, it happened that many of Japan’s financial firms were at the final stage of resolving the non-performing loan problems.
• In addition, it is significant that risk management practices of Japan’s financial firms were improving in the course of the period I just mentioned. Firms became more cautious than before about investing in financial products with uncertainty on their underlying assets or associated risks. Early implementation of the Basel II framework in Japan has also contributed to ensuring these practices.

Having said that, Japan’s financial system does have considerable risks in other areas, and they are materializing. There are two main sources of risk, one of which is rising credit costs caused by the weakening of the real economy, and the other is valuation losses and impairment on shares held by banks. Against this background, the annual financial results of many Japanese financial firms at end-March 2009 are expected to post final losses. Given these materializing risks, the FSA will remain on a heightened state of alert in monitoring developments in Japan’s financial sector.

In this connection, it has been argued that banks’ shareholdings should be further restricted by regulation. As you may know, shareholding by a bank is currently regulated to not exceed the value of its Tier 1 capital. At this point in time, we do not think it is necessary to further tighten these restrictions by outright regulation. Yet I hope that Japanese banks have drawn a good lesson from what they have experienced over the last twelve months or so. They have bitterly learned that shareholding entails significant risk, which could adversely affect the banks’ financial soundness. Therefore, I expect each bank to enhance the robustness of its risk management so that its capital buffer is sufficient and proportionate to the level of its shareholdings.

Now let me move on to talk about the FSA’s policy challenges in the period ahead. Like our fellow regulators abroad, Japan FSA is working on two categories of policies at the same time.

The first category is short-term crisis management to cope with the ongoing financial turmoil and economic difficulties. In Japan, these policies are more focused on maintaining the functioning of financial intermediation in a severely worsening real economy. They include:

• Providing the capital injection scheme, which can be used by banks that wish to maintain a sufficient capital base in order to sustain their lending; and
• Intensive supervisory review of banks’ lending practices to ensure that their financial intermediary functions work properly.

Given its relative soundness, Japan’s financial sector is increasingly relied upon in supporting the real economy and preventing its further deterioration.

The second category consists of medium-term reforms to “re-design” the regulatory framework in order to prevent the recurrence of a similar kind of crises in the future. Discussions are underway globally regarding capital adequacy of banks, procyclicality in the financial system, market integrity and transparency, and international cooperation among regulators. They are in line with the recommendations put forth by the Financial Stability Forum in April 2008, which were endorsed at the subsequent meetings of the G7 and the G20 leaders. Recent developments in Japan include the following:

• First, the FSA strengthened the disclosure requirements for financial firms with respect to their exposure to the securitization market. It also made sure that the underlying assets of securitized products were traceable along the chains of origination and distribution. Thus we are encouraging firms to examine the contents of underlying assets and to strengthen their risk management;
• Second, a bill has been submitted to the current session of the Diet to introduce a legal framework for regulating credit rating agencies, which is consistent with the developments in the United States and Europe;
• Third, given the need to supervise systemically important financial firms on a global basis, supervisory colleges have been established for each of these firms. Japan FSA has established the colleges for Japan’s three megabanks and Nomura. We are also member of the colleges for several foreign firms with significant influence over Japan’s financial markets.

These two categories of policies are common to the financial regulators in major countries, and all of us are facing the challenge of how to strike the right balance between the two. On the one hand, if the policies lean too much toward crisis management, it could cause moral hazard in the marketplace or distort the system in the longer run. On the other hand, too hasty implementation of medium-term measures could rather exacerbate the current situation and make crisis management even more difficult.

In Japan’s case, however, the FSA is working on yet another category of policies, which is characteristic of Japan’s situation in the area of financial regulation. They are a couple of proactive policy initiatives called the “Better Market Initiative (BMI)” and “Better Regulation”.

• The BMI is a concrete policy package to create a reliable and attractive marketplace for investors, fund-raisers and financial intermediaries. The implementation of the BMI is well on track.
• “Better Regulation” refers to improving the quality and effectiveness of Japan’s financial regulation, which includes:
  • The optimal combination of rules-based and principles-based supervision;
  • A risk-focused and forward-looking approach; and others.

• Substantial progress has been made so far in various areas.

In spite of the ongoing financial crisis, we will continue our efforts in these initiatives.

• The fact that dysfunction of the financial system has caused the current economic mess does not deny the fundamental roles the financial sector should play in supporting the real economy. Based on this recognition, strengthening Japan’s financial markets continues to be an important policy challenge to us.
• Better Regulation does not contradict the global trend of “re-regulation”, either. While streamlining outdated provisions and avoiding excessive regulation that could stifle financial innovation, Better Regulation aims to enhance the efficiency and effectiveness of the regulation that is truly needed. In this sense, Better Regulation is a continuous policy initiative that should not be affected by financial situations or market developments in the short term.