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

2009 International Monetary Conference
Session III “The Changing Regulatory Environment”
Kyoto, Japan, June 8, 2009

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

Introduction

Since the outbreak of the current market turmoil almost a couple of years ago, the world’s financial regulators have been working on two categories of policies at the same time. One is short-term crisis management measures to stabilize the financial markets. The other category is medium-term reforms to “re-design” the regulatory framework in order to prevent the recurrence of a similar kind of crises in the future.

These two categories may overlap to some extent, but today I wish to focus my discussion on the latter category of policies.

I. Broad directions of likely changes in financial regulation

As head of a national regulator and supervisor, I wish to make a small contribution by highlighting several key concepts that indicate the broad directions of likely changes in financial regulation. In my view, the following six concepts may be pointed out:

The first concept is enhancing risk management at financial firms.

A long period of benign macroeconomic conditions created complacency among market participants, which gave rise to an erosion of sound practices. The internal presence of risk management sections at financial firms was low, and their views were often suppressed by the drives for maximization of short-term profits. Also, the risk management systems of financial firms failed to capture the risks associated with their business models. On the regulatory side, the Basel II framework was certainly an improvement from Basel I in terms of risk sensitivity, but even this new capital regime did not pay sufficient attention to the complexities of risks regarding structured finance.

In view of the current market turmoil, risk management at financial firms needs to be upgraded and given higher priority in their organizations. Financial firms should strengthen risk capture and build a sufficient level of capital that is proportionate to the risks their business models entail. For their part, the regulators should revise the regulatory framework in a way that promotes such efforts by the industry.

The second concept is addressing misaligned incentives in business models.

Lack of transparency and conflicts of interest in the “originate-to- distribute” business model led to moral hazard in the securitization market. It took the form of poor underwriting standards by originators, insufficient risk information provided by arrangers or distributors, poor performance of credit rating agencies, and poor due diligence and blind reliance on credit ratings by investors. To address these issues, reviews on incentive structures have been proposed to encourage originators, arrangers, distributers and investors to carry out due diligence and transmit accurate information of underlying assets at each stage, in addition to new regulation on credit rating agencies.

Another example of misaligned incentives is financial firms’ compensation schemes. Prior to the current market turmoil, compensation practices at financial firms were giving excessive incentives that favored maximization of short-term profitability. They did not recognize explicitly the huge risks that could be materialized much later. In this context, more risk-adjusted compensation schemes have been advised.

The third concept is enhancing integrity and transparency of the market.

Increasingly complex, opaque financial products were widely traded among market participants, including off-balance-sheet entities, without sufficient disclosure of assets held by financial institutions. As a result, tremendous uncertainty was built up in the market regarding toxic exposures and future losses, which, in turn, increased the level of counterparty risk.

To prevent the recurrence of such a situation, the recommended measures are aimed at ensuring the integrity and transparency of the markets. They include improving the transparency of securitized products, strengthened disclosure by financial institutions, enhanced quality of accounting standards, regulatory framework for credit rating agencies, and more rigorous due diligence.

The fourth concept is broadening the regulatory scope with a view to systemic risk.

The current turmoil has highlighted the fact that the conditions of non-bank financial firms can have a significant impact on overall financial stability. Traditionally, the regulatory framework to deal with systemic risk has been mainly focused on the commercial banking sector, with a view to protecting bank deposits and the payment system. However, the current turmoil was triggered and deepened typically by troubles at large investment banks and a global insurance group. Large commercial banks had also expanded the scope of their business, for example, by using SIVs or ABCP conduits and by providing them with liquidity support. Furthermore, previously unregulated firms and markets are exerting increasing influence over the global financial system.

In view of these developments, the G20 leaders declared that the scope of regulation and supervision would be broadened to cover all systemically important institutions, products, and markets. The measures will include strengthening regulation on hedge funds and OTC derivatives.

The fifth concept is strengthening international cooperation among regulators.

Prior to the current market turmoil, risks had been scattered through the markets to a wide range of investors around the globe. Reflecting this increasingly cross-border character of financial transactions, the measures to tackle the current problem need to be internationally consistent. Thus, international institutions and groupings are playing a leading role in developing and coordinating policy response. They include the G7, the G20, and the Financial Stability Forum (FSF) that has now been re-established as the Financial Stability Board (FSB).

In addition, the international impact of the recent collapse of large, complex financial institutions has demonstrated that global systemic risk posed by such institutions needs to be dealt with by close cooperation among regulators. To this end, the world’s major regulators have established supervisory colleges for each of the global financial firms. At the FSF (FSB), the regulators have also agreed to the fundamental principles for cross-border cooperation on crisis management.

The sixth concept is macroprudential perspectives for supervision.

It is recognized that the preceding favorable macroeconomic and market environments contributed to breeding the current turmoil. They made financial firms eager to search for higher returns, which led to excessive leverage and reckless behavior.

As financial transactions become increasingly market-based, serious risks latent in the markets become common risk factors to many financial firms, which would materialize themselves once an individual firm runs into trouble. The effect could spread to the entire financial system through increased counterparty risk and behavioral changes at financial firms, with market liquidity dried up and the pricing function of the markets impaired. This in turn would threaten the soundness of financial firms.

Indeed, the current crisis demonstrated that macroeconomic and market developments are as important as idiosyncratic risks at individual firms. It is therefore essential that regulators strive to identify such common risk factors and make use of the analysis in supervision. To this end, traditional microprudential supervision focusing on the soundness of individual financial institutions will not be sufficient. Regulators will need to analyze more thoroughly the effect of macroeconomic or market developments on the soundness of the financial system and behavior of financial firms. In addition, the macroeconomic impact of the financial system or financial regulation should also be addressed. Addressing procyclicality of the capital adequacy requirements can be seen as one of these macroprudential approaches in this broader sense.

II. Points to be kept in mind by regulators

In my view, these six key concepts characterize well the broad directions of the “re-design” of financial regulation.

At the same time, however, I believe that there are some important points regulators should bear in mind in advancing these regulatory changes.

• The first is the recognition that the role of the financial sector in supporting the real economy is indispensable and remains unchanged. Well-functioning financial systems and financial markets are vital for the sustainable growth of the world economy. They are expected to provide good investment opportunities to investors and to supply fundraisers with adequate amount of growth capital.
• Second, regulators must avoid impeding the vigor of, and innovations in, financial markets by excessive regulation. They should be aware that good, genuine innovation increases economic welfare through promoting optimal allocation of resources. Financial regulation should therefore be designed to incentivize private sector efforts that would contribute to enhancing this public interest in our market economy.
• And third, regulators need to implement both short-term crisis management measures and medium-term regulatory reforms in a balanced manner. On the one hand, if the policies lean too much toward crisis management with extraordinary public support, it could cause moral hazard in the marketplace or distort the financial 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.

III. Implications for financial business in future

Finally, I would like to reflect on the likely implications of these changes for the future of the financial sector. I am aware that amid the times of high uncertainty such as now, one should refrain from making any decisive comments about what will happen. So, please take the following comments just as some food for thought.

• First, leverage in the financial system will be reduced significantly, as a result of more rigorous risk management and due diligence, as well as regulatory changes.
• Second, in financial firms’ decision-making process, chief risk officers or the risk management section will desirably play a more prominent role.
• Third, financial firms’ business models will be based more on risk-adjusted profitability. It will be further enhanced if compensation schemes are modified so as to restrict excessive incentives for short-term profit maximization.
• And finally, in a more transparency-oriented market environment, more standardization of financial products could proceed, and shift of transactions to exchanges out of OTC could take place.

Conclusion

The future of the financial services industry hinges on whether and how the industry can make creative efforts with wisdom and prudence, while adapting to the regulatory changes. I think a stable and prosperous financial system will result from the constructive interaction of private sector efforts and improved regulation.

Thank you.