- Speeches and Material
Internationalization of Japan's Property Markets and the FSA's Better Market Initiative
Dr. Takafumi Sato
Commissioner, Financial Services Agency
Real Estate Investment Forum TOKYO
September 11, 2008
It is an honor to have this opportunity to speak at this forum, which exemplifies the globalization of real estate finance and the growing cross-border transactions in Japan's property market. I am also grateful to be invited today, since deepening dialogue with the representatives of the real estate securitization industry in various countries, as well as investors in this sector, is helpful in reinvigorating Japan's financial markets.
Before turning to the Better Market Initiative, which is the main topic of my speech today, I would like to touch briefly upon the structural changes in Japan's property market and the measures taken by the Financial Services Agency (FSA) in response to these changes.
I. Structural changes and recent developments in Japan's real estate market
By "structural changes" I mean a couple of related developments witnessed in Japan's market in recent years.
One of these developments is the changes that took place with respect to the pricing mechanism. At the time of the bubble economy in the late 1980s, real estate prices were usually estimated by referring to past transactions for similar properties. Given the large price increases at that time, the forecasts of real estate prices deviated from the economic realities as extreme optimism dominated. In contrast, the capitalization method has been widely used in recent years, particularly in estimating the value of large commercial properties. With this method, the value of real estate is estimated by calculating the net present value of the cash flow that it is expected to yield. Widespread use of this method has led to the standardization of the pricing process of real estate, thereby making it easier to compare real estate-related products with other financial products.
The other significant development is a shift from corporate to asset finance. In the past, a large proportion of commercial properties were bought by realtors and construction firms. Banks provided financing to these firms in the form of traditional corporate loans, based on their creditworthiness as corporations. These days, however, a significant portion of real estate is purchased by real estate funds, including J-REITs and private funds. In addition to equity raised from investors, these entities increase their leverage with non-recourse loans extended by banks. This second change stems partly from the first one: that is, the change in the way real estate is priced.
In a nutshell, real estate is now increasingly traded and treated as a type of financial product in Japan. So, what sort of trends have these structural changes brought to the country's property market? I think we can observe the following three.
The first is a strengthened linkage between the real estate market and the financial markets. As the pricing process becomes standardized under the capitalization method, investors can use a common metric to compare the return from investment in real estate with borrowing costs, or with the return from alternative investment products. Thus, a closer linkage allows arbitrage across these markets and contributes to the more active functioning of the pricing mechanism.
Another trend is the greater integration of domestic and overseas markets. With the increasing use of the capitalization method, the prices of Japanese real estate are now largely comparable to those of real estate in other countries. This means that more and more Japanese real estate has become eligible as an investment target for foreign investors. Indeed, the volume of cross-border transactions of Japanese real estate funds has grown rapidly.
A third trend is the growing inflow of risk money resulting from the widespread use of securitization such as commercial mortgage-backed securities, or CMBSs. Many REITs and private funds use trust schemes or SPCs (special purpose companies) to raise risk money. This can be seen as an improvement for Japan's market, since bank lending used to supply even the equity part of funding for property investment during the bubble period of the 1980s, exacerbating the banks' non-performing loan problems thereafter.
I think we can properly explain the current developments in the real estate market if we base our explanation on the assessment I have just mentioned. As Japan's real estate market underwent structural changes, the effect of the global financial market turmoil since the summer of 2007 has spilled over to this market as well. Having incurred huge losses outside of Japan, investment funds and financial firms, particularly foreign ones, accelerated their withdrawal of funds in order to cover their losses and hoard liquidity. Thus, changes in the conditions of the overseas financial markets have significantly changed the money flow in Japan's property market.
What has the FSA been doing in response to the structural changes and current developments in recent years?
First of all, we have been closely monitoring the situation of the real estate market, in light of the increased importance of market developments for financial stability.
Second, we have been encouraging market participants to ensure that due diligence is taken, adequate disclosure is made, and conflicts of interest are avoided. This will also contribute to the protection of retail investors, who have difficulty in accessing relevant information.
Third, we have been making efforts to verify the risk management practices of banks that have exposure to the real estate sector through various channels, including non-recourse loans and investment in the equity part of real estate funds.
Let me emphasize here that the FSA never instructs or urges financial firms to reduce or restrain their exposure to a specific sector. This is explicitly stated in our supervisory policies. There are rumors that the FSA is forcing banks to cut lending to the real estate sector, but these are totally groundless. What we have been asking financial firms to do is to provide funds and capital smoothly while ensuring the soundness of their own finances through proper risk management.
II. Better Market Initiative
Now, let me turn to the Better Market Initiative (BMI), the government's plan to strengthen the competitiveness of Japan's financial and capital markets.
Globalization is not confined to the real estate market. Financial markets have become increasingly integrated and global competition among markets has intensified. In order for Japan to sustain economic growth with its shrinking and rapidly aging population, I believe there is an urgent need to strengthen the competitiveness of our financial and capital markets. Japan's markets need to provide good investment opportunities for the huge financial assets held by the country's household sector. They should also supply companies with sufficient amounts of growth capital. Moreover, Japan's financial services industry needs to provide high quality services to its customers and contribute to the country's future economic growth by generating high value added.
Against this background, last December we embarked on the "Better Market Initiative" 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 the amendment of the Financial Instruments and Exchange Act, etc. last June.
Admittedly, Japan has a number of shortcomings as a financial center. In recent surveys comparing the competitiveness of financial centers throughout the world, Tokyo not only trailed behind London and New York, but was also lagging 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.
However, Japan also has many attractive aspects. Its economy is still the second largest in the world, and the financial assets of its household sector exceed 14 trillion U.S. dollars. Our country also enjoys the advantage of geographic proximity to the emerging market economies in Asia, the region expected to maintain the highest rate of economic growth in the world.
For many years after the early 1990s, Japan's financial sector was overwhelmed by the collapse of the bubble economy and the non-performing loan problem. During that period, Japan found itself left behind as international competition among financial centers intensified. Fortunately, those years of difficulties are now over and Japan's financial sector has entered a new stage. The direct impact of the ongoing global market turmoil on our financial system has been relatively limited. Now is therefore an excellent time for the country to close the gap with the global frontrunners.
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.
1. Reliable and vibrant markets
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 among 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.
At the same time, from this December we will introduce a new flexible framework for the exchange markets, the participants of which will include only so-called specified investors (tokutei toshika), who are more competent than ordinary retail investors.
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.
In addition, a couple of measures have been taken to promote the diversification of J-REITs. First, guidelines for the appraisal of overseas real estate have been issued by the Ministry of Land, Infrastructure and Transport in order to make it possible to incorporate overseas real estate in the assets of J-REITs. Second, the Tokyo Stock Exchange has amended its listing regulations with regard to the incorporation of overseas real estate in the assets of J-REITs.
2. Enhanced business environment
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 globalization 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 taken 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. Furthermore, the FSA has put forward a tax amendment request for the next fiscal year to address another PE risk. At present, an offshore investor could face the risk of double taxation if it invests in a fund established as a partnership in Japan. To address this problem, the FSA has proposed that such a partnership-type fund should not be deemed as a permanent establishment of the offshore investor.
3. Better Regulation
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, which 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 the interpretation of 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 forum 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 Instruments and Exchange Act, Banking Act and Insurance Business Act was completed by last June.
Third, the FSA issued 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.
4. Supportive Market Infrastructure
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 develop the urban infrastructure necessary for an international financial center and improve its functioning. To this end, the development plan for an international financial center was put together last April, and two areas in Tokyo were designated as priority areas. According to the plan, targeted policy actions will be taken in terms of (i) enhancement of the business environment, (ii) creating a suitable environment for foreign workers together with comfortable living and reliable education opportunities for their families, (iii) development of domestic human resources, and (iv) promotion and public relations activities for the areas.
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 fortunate for us that the direct impact of the global market turmoil on Japan's financial system has been relatively limited, and that we are in a position to be able to envisage how to develop Japan's financial markets in the future. The FSA is fully committed to promptly implementing the various measures envisaged in the BMI, so that we can continue to contribute to making our markets more attractive to investors and issuers, both domestically and overseas.
It is the private sector, however, that is expected to play the leading role in our collective efforts toward this end. By taking advantage of the policy measures implemented in accordance with the BMI, financial firms and exchanges will be able to improve their products and services further and better serve the needs of their customers. The role of invigorating the financial markets also falls in part on those who use financial services and the capital markets. We look forward to working with all of you to make Japan's financial markets better and more attractive, and to strengthen their international competitiveness.
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