• Speeches and Material

“Global reform of financial regulation and its implications”

Keynote speech by Dr. Takafumi Sato
Commissioner, Financial Services Agency (FSA)
The 4th Annual Japan Investment Forum organised by
Institutional Investor Conferences
Tokyo, 10 June 2009


Good morning. It is my pleasure to be here to speak before such distinguished experts from the investment community, financial industry, and public sector.

In today’s speech, I would like to discuss the broad directions of likely changes in financial regulation following the ongoing global market turmoil, and reflect on their implications for the financial services industry in the future.

You may say I am too brave as a regulator to forecast future developments. It is now well known that regulators are no good forecasters, generally speaking. Because if they were, the current turmoil must have been well prevented in the first place. I myself am not endowed with sufficient capabilities to predict with confidence what the financial world may be like post-crisis. I am also aware that amid the times of high uncertainty such as now, one should refrain from making any decisive comments about what will happen.

It is nevertheless worth trying to be proactive and look forward. Even though significant downside risks remain in many corners, the markets have got a little calm compared with some months ago. Some people say that there are signs that the current turmoil is moving into a new phase. If that is the case, the focus of regulatory response will shift accordingly. Therefore, I wish to make a small contribution to the success of this forum by providing you with the following comments as some food for thought.

I. Two categories of policies

Since the outbreak of the current turmoil almost a couple of years ago, the world’s financial regulators have been working on two categories of policies. One is short-term crisis management measures to stabilise 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.

Admittedly, it is the crisis management measures that have attracted much attention so far. This may be inevitable because, if fire strikes, priority is naturally given to putting it out immediately rather than establishing a fire-proof building to prevent another emergency.

It may also be because these measures are sometimes extraordinary in terms of massive public support that is unthinkable in normal times. They include those measures currently witnessed in the United States and Europe, such as large-scale capital injection with public funds, temporary bank nationalisation, credit guarantee by governments and massive liquidity provisioning by central banks. Although many of these extreme actions have not been taken in Japan in response to the current turmoil, a number of regulatory measures have been introduced to maintain the functioning of financial intermediation in order to cope with difficulties in the real economy. They should also be included in the category of short-term measures.

However, I would like to emphasise that we have been working on medium-term reforms of financial regulation at the same time. Discussions are underway globally regarding capital adequacy of banks, procyclicality in the financial system, market integrity and transparency, and international cooperation among regulators. A number of measures in this category have already been planned or implemented. They include strengthened disclosure requirements with respect to the securitisation market, establishment of supervisory colleges for each of the global financial firms, and internationally consistent frameworks for regulating credit rating agencies.

II. Broad directions of likely changes in financial regulation

Since I will be talking about the changes in the regulatory environment over the medium term, I will focus my discussion today on the latter category of policies. In my view, the following six points may be highlighted as the key concepts that indicate the broad directions of likely changes in financial regulation.

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 maximisation 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 the first place, Basel II had not been implemented in major jurisdictions before 2007, with the notable exception of Japan.

In view of the current market turmoil, risk management at financial firms needs to be upgraded and given higher priority in their organisations. 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 the efforts made by the industry to this end.

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 securitisation 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 of incentive structures have been proposed to encourage originators, arrangers, distributers and investors to carry out due diligence and transmit accurate information of underlying assets etc. 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 favoured maximisation of short-term profitability. They did not recognise explicitly the huge risks that could be materialised 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 adequate appreciation of risks, without transmission of accurate information, and without sufficient disclosure of assets held by financial institutions. As a result, tremendous uncertainty was built up in the market as to toxic exposures and future losses, which, in turn, expanded 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 securitised 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 behaviour 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, while the bailout of a global insurance group has exposed the significant gap in the US regulatory framework. 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, and discussions are underway at both national and international levels.

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.

Historically low interest rates, the favourable macroeconomic environment, and global imbalances contributed to breeding the current turmoil. They made financial firms eager to search for higher returns, which led to excessive leverage and reckless behaviour.

As financial transactions become increasingly market-based, serious risks latent in the markets have become common risk factors to many financial firms, which would materialise themselves once an individual firm runs into trouble. The effect could spread to the entire financial system through increased counterparty risk and behavioural 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 has demonstrated that macroeconomic and market developments are as important as idiosyncratic risk 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 firms will not be sufficient. Regulators will need to analyse more thoroughly the effect of macroeconomic or market developments on the soundness of the financial system and behaviour of financial firms.

In addition, the macroeconomic impact of the financial system or financial regulation should also be analysed. Addressing procyclicality of the capital adequacy requirements can be seen as one of these macroprudential approaches in this broader sense. Arguments have been raised that the capital regime has a procyclical effect. That is, when the economic situation gets worse, more capital is required but raising it is made more difficult. In such a situation, banks are tempted to squeeze lending, which in turn further worsen the real economy. On the other hand, when the economy is in good shape and their asset quality is improved, the banks may need less capital but capital increases without much effort.

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

III. Points to be kept in mind by regulators

At the same time, however, I believe that there are a few 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 vigour of financial business 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 incentivise 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.

IV. Implications for financial business in future

Now I would like to reflect on the likely implications of these changes for the future of the financial sector. Again, please treat my following comments as starting points for further discussion rather than firm predictions.

  • 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, with more emphasis placed on risk management, financial firms’ decision-making process may be affected accordingly. This may mean that chief risk officers or the risk management section will play a more prominent role in decision-making. As a result, internal management costs may also be increased.
  • 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 to maximise short-term profits.
  • And finally, a more transparency-oriented market environment could promote more standardisation of financial products. This may be induced also by less investor appetite to opaque, complex financial products due also to the concerns about their market liquidity. A shift of transactions out of OTC to exchanges could be another related development.

V. Global regulatory “re-design” and Japan’s unique position

As I mentioned earlier, the world’s financial regulators have been working on short-term measures and medium-term reforms at the same time. Japan is no exception, though the nature of the measures, particularly short-term measures, differs somewhat in accordance with the differing economic and financial circumstances.

In Japan’s case, however, the FSA is working on yet another category of policies, which is characteristic of Japan’s situation in financial regulation. As you may know, they are a couple of proactive policy initiatives called “Better Regulation” and the “Better Market Initiative” .

1. Better Regulation

Better Regulation refers to improving the quality of financial regulation by enhancing its effectiveness, efficiency, consistency and transparency. Better Regulation centres upon the four pillars of:

  • The optimal combination of rules-based and principles-based supervision;
  • A risk-focused and forward-looking approach;
  • Regulation aimed at incentivising voluntary efforts by the private sector; and
  • Improved transparency and predictability of supervision.

Substantial progress has been made in various areas, as summarised in the two progress reports issued May and December 2008. It includes the agreement with financial firms on the fourteen guiding principles for the financial industry, effective allocation of administrative resources to deal with the current financial market turmoil, and publication of supervisory guidelines and interpretation of rules. We intend to issue the third progress report in a month or so.

Then, will the current global trend of “re-design” of financial regulation affect Better Regulation?

Better Regulation does not contradict the global trend of “re-regulation”. I would rather say that Better Regulation was even ahead of this trend in terms of its focus on strengthening international cooperation, close monitoring of market developments, enhancing dialogue with the financial industry and, above all, risk-focused approach. While streamlining outdated provisions and avoiding excessive regulation that could stifle financial innovation, Better Regulation aims to enhance the efficiency and effectiveness of the regulation that is truly needed. In this sense, Better Regulation is a continuous policy initiative that should not be affected by the financial situation of the time, and its importance is increasing.

2. Better Market Initiative

Let me now turn to the Better Market Initiative (BMI), which is a concrete policy package to strengthen the competitiveness of Japan’s financial markets. The measures incorporated in the BMI are aimed at creating a reliable and attractive marketplace for investors and fund-raisers, and enhancing the business environment of financial intermediaries. They include diversification of ETFs (exchange-traded funds), reform of the firewall regulations, and broadening the scope of business for banking and insurance groups.

The implementation of the BMI is well on track. Most of the necessary legislation has already been completed and put into implementation. On the first of June, the provisions related to the reform of firewall regulations took effect. An exchange market for professional investors with streamlined disclosure requirements, TOKYO AIM, started its operations on the same day.

The fact that dysfunction of the financial system has caused the current economic mess does not deny the fundamental roles the financial sector should play in supporting the real economy. Based on this recognition, strengthening Japan’s financial markets continues to be an important policy challenge to us. Given the prospects of the aging and shrinking population, strengthened markets are essential for the sustainable growth of Japan’s economy. In view of the ongoing crisis, it will be important for us to examine carefully whether there are areas where modifications will be required, taking into account the global trend of “re-regulation” or “re-design” of the regulatory framework. However, I do not think this will lead to fundamental changes to the entire initiative of the BMI.

3. Reform of firewall regulations

In this context, the reform of firewall regulations is one of the major items of the BMI, and a measure in which the spirit of the first pillar of Better Regulation, optimal combination of rules-based and principles based approach, is crucial.

Proper implementation of this reform will lead to improvements in the quality of financial services and benefit both users and providers of these services. Removing firewalls will contribute to increased benefits to users, as they will become able to receive a comprehensive set of services from a single financial group and will be given a variety of options. From the standpoint of financial services providers, the reform of firewall regulations is expected to pull out synergies within financial groups in the provision of financial services and increased efficiency in group-wide business control.

Needless to say, these benefits are predicated upon proper management and control of conflicts of interest by each financial group, and effective prevention of abuse of their dominant positions. However, given the diversity of financial transactions, it is natural that the manner in which a conflict of interest occurs and such a conflict is managed differs from one group to another. This is the reason why financial groups are obligated to put in place an effective mechanism to address these problems, but the provision is principles-based in that the details of the required mechanism is not legally prescribed. Thus, I expect each financial group to have in-depth understanding of this new framework and aim for achieving best practice. That will promote increased user convenience, improved efficiency in business operations, and increased effectiveness of regulation.


To conclude, 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 have explained. I think a stable and prosperous financial system will result from this constructive interaction of private sector efforts and improved regulation. For our part, the FSA will continue our efforts to advance Better Regulation and increase Japan’s attractiveness as an international financial centre.

Thank you.

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