- Speeches and Material
Global Market Turmoil and Beyond
∼ Need for Longer-Term Perspectives ∼
Keynote Address by Dr. Takafumi Sato
Commissioner, Financial Services Agency
The Euromoney Japan Capital Markets Congress 2008
September 25, 2008
- Opening Remarks
Good Morning. It is a great honor to be invited to this Euromoney Congress and to speak before distinguished experts in the financial world gathering here to discuss how we can make Japanese capital work more.
For the past few weeks, we have been witnessing new heights of the global market turmoil, every moment of which will be long remembered in the history of finance. As you know well, those significant events include:
-- The United States government's actions with respect to the GSEs, including placement of these entities into conservatorship and preferred stock purchase agreements to inject capital;
-- The bankruptcy of Lehman Brothers, and Bank of America's acquisition of Merrill Lynch;
-- The New York Fed's bridge lending to AIG (American International Group) so that the company can sell its assets in an orderly manner;
-- An expansion of the Federal Reserve's currency swap arrangements with other major central banks, including the Bank of Japan, to support the provision of US dollar liquidity;
-- US Treasury's guaranty program for money market funds;
-- The Treasury's proposal to purchase troubled assets from financial institutions up to 700 billion US dollars;
-- Acquisition of the bank holding company status by Goldman Sachs and Morgan Stanley;
-- Nomura's acquisition of the Asia, Europe and Middle East business units of Lehman Brothers; and
-- Mitsubishi UFJ Financial Group's purchase of the stakes of Morgan Stanley.
If we take a step back from day-to-day operations, these recent events seem to indicate that 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, supervisory authorities are in a position to 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 US and European ones, the Japan FSA is committed to taking necessary action against spillovers in order to ensure the stability of Japan's financial system. At the same time, 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. 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 introducing you to an overview 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 of 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 US 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 US housing market, (ii) the lack of any sign of recovery in the structured product market, (iii) concerns over sustainability of some major LCFIs as their losses are mounting, (iv) tightening lending attitudes, (v) the deteriorating performance of the real economy, and (vi) the potential risk of inflation.
(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.
In this connection, the latest G-7 statement calls for whatever actions may be necessary to ensure the stability of the international financial system, and reiterates the commitment to full and rapid implementation of the FSF recommendations for the longer term solutions to root causes of the current turmoil.
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.
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"
(1) The Background of the "Better Market Initiative"
Now let me turn to 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.
It is true that Japan's financial markets have a number of shortcomings despite many attractive aspects. 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.
(2) Overview of the Better Market Initiative
Taking this opportunity, I would like to provide you with an overview of 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.
The first pillar of the BMI is to create "Reliable and Vibrant Markets." The focus under this pillar is to provide flexibility for transactions between professionals based on the principle of self-responsibility. I believe that the relevant 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.
The second pillar is to put in place an "Enhanced Business Environment." Deregulatory measures in this pillar are aimed at enabling banks and other financial services providers to make their business operations more efficient and to better serve the needs of their customers. A key measure under this pillar is the relaxation of firewall regulations.
The third pillar is "Better Regulation." 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. Under this pillar, we put together fourteen key principles last April and agreed to share them with the industry. Also, we are striving to enhance the transparency and predictability of our regulation and supervision. In addition, the FSA published the first progress report on its efforts toward the "Better Regulation" last May, and plans to release another progress report every six months.
The fourth pillar relates to "Supportive Market Infrastructures." This includes development of a pool of talent in such areas as finance, law, accounting, etc., as well as improvement of urban infrastructure for the financial business.
By taking these actions across the four pillars under the BMI, 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
If we put the recent events into perspective, we may be at the crossroads in the history of finance. In response to the ongoing financial turmoil, it is vital to implement the FSF recommendations steadily in order to enhance the resilience of the global financial system over the longer term. It is my sense that implementing the FSF recommendations could eventually lead to a world of finance more firmly based on value-adding activities related with the real economy. In this case, the next challenge for financial institutions would be to adapt to such a financial world by strengthening the capability of financial intermediation ideally suited to serving that objective.
At the same time, Japan is at an early stage of implementing the BMI and aims to encourage private sector-driven initiatives through deregulation. In this sense, Japan is uniquely positioned at the current juncture, since it needs to manage the processes of "re-regulation" and "deregulation" in a simultaneous manner. Building upon the policy outcomes stemming from the "Better Regulation" and "Better Market Initiative", I hope that Japan will be able to become a center of financial innovation in that financial world. Through that process, Japan could emerge as one of the global financial centers in the post-subprime-crisis world of finance. I wish your institutions will take part in this endeavor in the near future.
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