- Speeches and Material
Financial Innovation and Global Market Turmoil
∼ Preparing for the Post-Subprime World of Finance ∼
Keynote speech by Dr. Takafumi Sato
Commissioner, Financial Services Agency
FIA Asia Derivatives Conference
September 18, 2008
- Opening Remarks
Good morning. It is a great honor to be invited to this occasion, and to speak before futures traders, executives of exchanges, and representatives from supervisory authorities gathering here to share their insights on developments in futures markets.
As recent events exemplify, we are now experiencing a difficult correction phase, especially with respect to (i) highly geared leverage, (ii) incentive distortions toward short-term profits, and (iii) the multi-layered structure of complex financial products. In this process, we must promote and manage an orderly deleveraging in the financial system. Although the direct impact of the subprime loan crisis on the Japanese financial sector has been relatively limited compared with the U.S. and European ones, the Japan FSA is committed to taking necessary action against any spillovers in order to ensure the stability of Japan's financial system.
Furthermore, the effect of the crisis is not limited to the direct one. If you look at broader economic situations, the United States economy appears to be already experiencing a negative interaction between the financial sector adjustment and the real economy, where bad events in one induce pain in the other. Flight to quality disrupted the financial markets for equities, bonds, currencies and commodities across the globe, creating increased volatility in market prices. Meanwhile, a more imminent risk to Japan is its deteriorating economic condition caused by its worsening terms of trade due to rising commodity prices as well as the global economic downturn. This deterioration could drag down the condition of the Japanese financial system.
The unfolding financial turmoil is a reminder that supervisory authorities are never able to escape the fate of pursuing two possibly conflicting objectives at the same time. On the one hand, we must address current serious concerns arising from our day-to-day supervisory operations. On the other hand, we must proactively envision a direction for financial regulation over the longer term. Ten years ago, we drastically reformed our regulatory and supervisory framework while making continuous efforts to stabilize the financial system. The circumstances are little different this time, and I am lucky enough to be still in pursuit of such great dreams. As Commissioner of the Financial Services Agency, what I aim to achieve in parallel with countering the global financial upheaval is to improve the quality of financial regulation, or promote and encourage "Better Regulation," and also to strengthen the competitiveness of Japan's financial and capital markets by implementing the "Better Market Initiative."
- Global Market Turmoil and Policy Actions by Supervisors
Before going into the details of "Better Regulation" and the "Better Market Initiative," I would first like to offer some of my thoughts on the current global market turmoil so as to put those policy initiatives into the broader context of the current financial situation.
(1) Mechanism of the Subprime Loan Crisis
A significant and distinctive contributing factor to the outbreak of the current turmoil was the proliferation of the originate-to-distribute model (OTD model) based on the financial technology of securitization. The weakness of this model is that originators, arrangers of securitization, distributors and investment managers had insufficient incentives to generate and provide information on the quality and performance of underlying assets. There is an emerging consensus that misaligned incentives along the securitization chain thus caused moral hazard among the parties involved in the process.
(2) Subprime Loan Crisis and Market Turbulence
With that mechanism in mind, I would like to go through the typical problems along the securitization chain that were exacerbated by the exceptional boom in credit growth and leverage in the financial system.
A long period of benign macroeconomic conditions created complacency among market participants, which gave rise to an erosion of sound practices. This in turn led to (i) poor underwriting standards by originators and mortgage brokers, (ii) weak risk management at financial institutions, and (iii) poor due diligence and blind reliance on credit ratings by investors. If there had been appropriate incentives for checks and balances along the process, the deterioration of standards in market practices could have been prevented.
Poor performance by credit rating agencies (CRAs) with respect to structured products worsened the problem. It seems that the CRAs were overwhelmed by the sheer volume of the workload and failed to keep pace with the increasing complexities in structured products. The shortcomings among CRAs typically included (i) weaknesses in rating models and methodologies and (ii) inadequate due diligence regarding the quality of underlying assets.
Furthermore, weaknesses in public disclosures by financial institutions, which were not an issue as long as the benign environment hid the flaws in the securitization chain, damaged market confidence through amplifying anxiety among market participants once the crisis broke out. Their disclosures often failed to make clear the type and magnitude of risks associated with their on- and off-balance sheet exposures.
The consequences of the crisis have been devastating. A lack of transparency in risk transfer enabled by the securitization process blurred the overall and individual levels of risk exposure among market participants, thereby increasing counterparty risks. Moreover, the loss of confidence in credit ratings and prices of structured products led to an implosion in investor demand and the evaporation of market prices, raising uncertainty over incurring losses.
Although some pundits predict that the trend would reverse soon, I would like to draw your attention to a mixed picture containing both positive and negative aspects. The positive aspects include (i) prompt loss recognition and capital raising among large and complex financial institutions (LCFIs) in the United States and Europe, (ii) policy response by the relevant authorities to contain systemic risk, and (iii) recently subdued commodity prices.
On the other hand, the negative aspects are (i) prolonged weakness in the U.S. housing market, (ii) the lack of any sign of recovery in the structured product market, (iii) tightening lending attitudes, (iv) the deteriorating performance of the real economy, and (v) the concurrent risk of inflation. My view is that, while there continue to be positives and negatives in the market, it will take a decent time for the situation to return to normal.
(4) Policy Actions and Implications for Financial Innovation
In response to the current turmoil, the Financial Stability Forum's Working Group on Market and Institutional Resilience put together concrete recommendations last April. These include (i) strengthening prudential oversight, (ii) enhancing transparency, (iii) making changes in the role and uses of credit ratings, (iv) strengthening the authorities' responsiveness to risks, and (v) making robust arrangements for dealing with stress in the financial system.
Thus, an emerging global trend points to the direction of financial re-regulation, exemplified by (i) strengthened risk management and disclosure, (ii) due diligence in the securitization process, and (iii) strengthened supervision over CRAs. These are countermeasures against excessive leverage and the shortcomings of the OTD model. My sense is that implementing the FSF recommendations in this context might create a world of finance that is more firmly based on value-adding activities in the real economy.
In the case of Japan, the FSA responded quickly to the outbreak of the global market turmoil by directing its existing administrative resources to that matter in order to assess its impact on the Japanese financial system. In particular, the FSA's early release of the total exposure of the Japanese deposit-taking institutions to subprime-related products was very effective in removing uneasiness from the Japanese market.
Furthermore, the FSA took proactive action, prior to the FSF recommendations, to ensure traceability along the securitization chain so that distortions in the incentive structure among market participants were properly corrected. It is envisaged that this policy action will be complemented by self-regulation by the Japan Securities Dealers Association, setting a template for the disclosure of underlying assets.
It is not our intention, however, to stifle financial innovation by over-regulation. Innovation generally increases economic welfare through realizing optimal resource allocation by enhancing availability of finance or creating new combination of risks and returns. I recognize that, while individual financial institutions pursue innovation on profit-maximizing motivations, it often leads to increasing overall social benefits in the end. In this light, my aim is to keep financial regulations as market-friendly and innovation-friendly as possible, whereas fairness, transparency, and compliance in financial transactions are properly ensured so that the principle of self-responsibility will be upheld. It is in this context that the "Better Market Initiative" needs to be steadfastly implemented even against the background of the current turmoil.
- The "Better Market Initiative"
Now let me turn to the details of the Better Market Initiative. In order for Japan to sustain economic growth with its shrinking and rapidly aging population, I believe that there is an urgent need to strengthen the competitiveness of our financial and capital markets. Japan's financial services industry needs to provide high quality services to its customers and contribute to the country's future economic growth.
As a financial center, Japan has many attractive aspects. Its economy is currently the second largest in the world, and the financial assets of its household sector exceed 14 trillion US dollars. Our country also enjoys the advantage of geographical proximity to the emerging market economies in Asia, the region expected to maintain the highest rate of economic growth in the world.
On the other hand, Japan's financial markets do also have a number of shortcomings. In recent surveys comparing the competitiveness of financial centers throughout the world, Tokyo not only trailed behind London and New York, but also lagged behind regional rivals such as Hong Kong and Singapore.
We are aware of these weaknesses, and we are not standing idly by. Against this backdrop, we embarked last December on the "Better Market Initiative (BMI)" 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 amendment of the Financial Instruments and Exchange Act, etc. last June.
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 "Reliable and Vibrant Markets." The focus of these measures is to provide flexibility for transactions between 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). 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.
Other measures in the first pillar include:
- Diversification of ETFs (exchange-traded funds); and
- Establishment of a framework for alliances between a stock exchange and a commodity exchange so that a full line of products ranging from equities, bonds, and financial derivatives to commodity derivatives can be offered by a single group of exchanges.
(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, including with respect to interlocking officers and employees and the sharing of customer information within a financial group, provided that robust internal systems will be put in place for controlling conflicts of interest. 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. 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 internationalization of financial services. Specific measures include:
- Permitting sister companies of banks and insurance companies to provide new businesses, such as commodity spot trading,
- Permitting subsidiaries of banks and insurance companies to engage in Islamic finance; and
- Permitting banks and insurance companies to engage in emissions trading.
(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, and this 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 interpreting rules. Thus, more principle-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.
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.
Third, the FSA published 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, accounting, etc.; 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.
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 the private sector, however, that is expected to play the leading role in our collective efforts to this end. By taking advantage of the policy measures implemented in accordance with the BMI, financial firms and exchanges will be able to further improve their products and services and better serve the needs of their customers. The role of invigorating the financial markets also falls in part to those who use the financial services and capital markets.
- Concluding Remarks
For many years after the early 1990s, Japan's financial sector was overwhelmed by the collapse of the bubble economy and the nonperforming loan problem. During that period, Japan found itself left behind as international competition intensified among financial centers. However, those years of difficulties are now over for Japan's financial sector, and we have entered a new stage. Now is an excellent time for Japan to close the gap with the global frontrunners.
In this context, it is fortunate that Japan's financial markets have been relatively stable recently, in contrast with the U.S. and European ones. Here, the subprime loan crisis alone is unlikely to pose a serious threat to the country's financial system given limited exposure of its financial institutions to subprime-related products vis-à-vis the level of their Tier 1 capital and operating profits.
It seems to me that the Japanese market is uniquely positioned at the current juncture. As I mentioned earlier, an emerging global trend points to the direction of financial re-regulation, exemplified by countermeasures against excessive leverage and the shortcomings of the OTD model. At the same time, Japan is at the initial stage of implementing the BMI and aims to encourage private sector-driven initiatives through deregulation. Japan needs to manage these simultaneous processes of "re-regulation" and "deregulation" and to make balanced progress toward a post-subprime crisis world of finance.
As I said earlier, that financial world might be more firmly based on value-adding activities in the real economy. Therefore, there is a huge growth potential for financial markets in Asia, where a high rate of economic expansion is still maintained. Thus, the next challenge for financial institutions in Asia will be to exploit such an opportunity by strengthening the capability of financial intermediation ideally suited to serving that objective. I hope that Japan will be a center of financial innovation in that financial universe, building upon the policy outcomes stemming from the "Better Regulation" and "Better Market Initiative." I wish your institutions and the futures industry in Asia to be part of this endeavor in the near future.
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