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Keynote speech (Summary) by Mr. Kenji Tamura
Parliamentary Secretary of Cabinet Office for Financial Services
The Economist Conference “The Bellwether Series: Japan”

Tokyo, May 19, 2010

Introduction

It is my great pleasure to be invited to this Conference to speak before distinguished guests from Japan's financial markets. I hope that such a gathering will be held regularly in this country in order to facilitate the understanding of the ever changing financial environments in Japan and all over the world.

I heard that the topic of this session is “The regulator: Help or hindrance?”

My response to the topic of this session is that the FSA can be either help or hindrance to the financial services industry, depending on the industry's behavior towards the FSA's policy objectives.

The primary objectives of the FSA are maintaining financial stability, protecting users of financial services, and ensuring integrity of financial markets. Protecting and developing the financial sector is not the Agency's goal. Therefore, if the industry shares these objectives, we will feel comfortable to help such an industry. However, if the financial sector's behaviour threatens the stability of the financial system or the interests of depositors, investors, or other users of financial services, it is rather the responsibility of the FSA to hinder and obstruct such behaviour.

Today, I would like to share with you my thoughts on Japan's financial system and the direction of global financial regulatory reform. My speech largely consists of four parts. First, I will discuss how Japan's financial system was affected by the recent global financial crisis. Second, I would like to share my thoughts on Basel II. Third, I will present my view on reform of financial regulation, which is being discussed globally. Finally, I would like to talk about what I think as the challenges faced by Japan's financial sector.

The global financial crisis and Japan's financial system

As you know well, Japan was not immune from the global financial crisis. The global economics downturn led to a serious weakening to Japan real economy. Japan's GDP recorded a negative growth of 8.9 percents on an annualized basis in the first quarter of 2009. In fact, Japan was one of the countries that were most severely affected by the crisis in terms of its impact on the real economy.

Nevertheless, we can fairly say that Japan's financial system itself remains relatively sound compared with those in the United States and Europe. I would emphasize this since this recognition is not shared widely. For example, there were neither any financial institutions that failed nor those that received capital injection from the government due to undercapitalization. The losses Japan's financial banking sector incurred from complex securitized products were one digit smaller than those of the American and European financial sectors. Certainly, the global market turmoil did hit Japan's financial sector through a sharp decline of share prices. Credit costs were elevated, and Japan's financial markets became turbulent temporarily. However, we can say that the magnitude of these effects was manageable and overall stability of the financial system was maintained. Namely, I think we can say Japan's financial system was not that affected.

Some thoughts on Basel II

Let me now move on to talk about my thoughts on Basel II. There are divergent views on the effectiveness of Basel II. Some see it as significant improvement from Basel I that became out of date. Others are skeptical about Basel II because they think it relies too much on the risk management practices of financial firms, which proved to be flawed following the recent crisis.

With the benefit of hindsight, we must say that there was certainly ample room for improving Basel II. It is for this reason that the Basel Committee on Banking Supervision has decided to strengthen the capital requirements for trading book and re-securitization, which were the flashpoints of the recent crisis. The Committee is also examining the possible measures to contain the pro-cyclical effects of capital regulation, because it is alleged to amplify the economic cycle by imposing lax capital requirements at good times and stringent requirements at bad times.

I would highlight the fact that Basel II was based on the philosophy that banks will carry out risk management in their own interest and the regulators have only to complement the banks' risk management. Although I would not say that this philosophy is completely wrong, I tend to think that this view may have been too naïve. Financial firms are private sector companies. Their primary objective is to raise profits and increase its own economic value, while they do not have incentives to give consideration to social welfare costs due to failures of their management. On the other hand, some have pointed out the issue of whether the regulators have the capability to fully understand the firms' risk management, and verify the robustness of their internal rating systems or loss estimates. In the public consultation document issued last December, the Basel Committee made proposals also in response to these concerns.

As such, Basel II was not a perfect product. However, returning to Basel I will not solve any problems. In the first place, one of regulators' motivations to develop Basel II was the need to enhance risk capture with respect to securitization exposures, where regulatory arbitrage was prevalent under Basel I. It should be stressed that the root cause of the recent global financial crisis was lack of adequate risk capture by financial firms and regulators with regard to complex financial products and the “originate-to-distribute” business model. The fundamental philosophy of Basel II is that capital adequacy requirements should promote robust risk measurement and management of financial firms. This philosophy continues to be valid.

We should also note that Basel II had not been implemented in major jurisdictions prior to the beginning of the recent crisis. The notable exception is Japan, whereas Basel II is still to be implemented in the United States, the epicenter of the crisis.

Developments towards financial regulatory reform

As you may well know, these discussions are taking place at international meetings and standard-setting bodies, such as the Group of Twenty (G20), the Financial Stability Board (FSB), the Basel Committee on Banking Supervision, the Internal Organization of Securities Commissions (IOSCO), and others. As member of these meetings and bodies, the Japan FSA has been actively engaged in the efforts towards effective regulatory reform with a view to preventing the same kind of crises from occurring again.

Following the recent global financial crisis, it is now widely recognized internationally that a certain degree of public intervention is necessary to ensure financial stability, and relying solely on voluntary efforts of the financial sector is not sufficient. In this sense, it is correct to say that regulatory reform is geared towards “re-regulation” at least in part. The Japan FSA broadly shares the objectives of global reform of financial regulation with authorities in other major countries. These include correcting the misaligned incentives in the financial markets; protecting market integrity and reducing risks through further development of financial infrastructure; and requiring that financial firms maintain the level and quality of capital proportionate to the risks associated with their business. Indeed, we submitted for consideration by the National Diet a bill for amending the Financial Instruments and Exchange Act and other acts, with a view to further improving Japan's financial markets and the Diet approved it.

On the other hand, we firmly believe that we must avoid ending up introducing excessive regulation in a hasty manner, for the sake of taking advantage of political momentum currently still available. It is absolutely essential that the measures proposed by standard setters be reviewed carefully in order to ensure that they will not rather damage financial stability and will not adversely affect the real economy. In this context, it is also crucial that the comprehensive reform package address the root causes of the recent global financial crisis, and structural elements of financial instability.

For example, I do think that enhanced capital adequacy continues to be an important challenge for Japan's financial firms in light of the experience of not only the recent stress but also the last banking crisis in the 1990s. However, what is required here is an enhancement of capital adequacy that is commensurate to the level of risk associated with the business conducted by the financial firm in question. In contrast, simply raising the required capital ratio may be politically easy to understand, but has serious side effects in terms of incentivising firms to strengthen risk management. Furthermore, such a blunt measure could unduly constrain traditional commercial banking business. Although its profitability is low, this type of business is low-risk, stable, and vital to recovery of the real economy. In addition, a substantial length of the transition period is necessary in view of the nascent and still uncertain economic recovery.

Challenges faced by Japan's financial sector

Sometimes, the discussions about Japan's financial regulation in future are made as if “re-regulation” in response to the recent financial crisis and further “de-regulation” to spur economic growth were mutually exclusive. I believe such dichotomy would yield little value. What is important from the regulator's perspective is to continue our efforts towards “better and quality regulation”, which necessary to achieve financial stability, protection of users of financial service and market integrity, but make the benefit to the economy. To this end, it is crucial that the regulator deepen its understanding of financial markets and operations of financial firms, and the regulator must not lose sight of the regulatory objectives as part of public policy, and strive to be transparent and accountable for the need and reason for specific regulations and supervisory actions.

Thank you

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