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“Current situation of Japan’s financial system and FSA’s policy response ”
Speech by Dr. Takafumi Sato
Commissioner, Financial Services Agency
The Foreign Correspondents’ Club of Japan
Tokyo, June 17, 2009
Good afternoon. It is my pleasure to be here to speak about the policy challenges faced by us, the Financial Services Agency (FSA).
I am delighted to be given this opportunity to speak directly to Japan correspondents from the foreign media. As part of our initiative toward “Better Regulation,” Japan FSA attaches great importance to disseminating information on our policies and activities. For the past couple of years in particular, we have been striving to make more information about us available in the English language, making full use of our limited capacities.
Today, I would like to talk about our view on the current situation of Japan’s financial system and our response to the current global financial market turmoil. In order to highlight the commonalities and differences, I will try to compare the current situation in Japan with that in the United States and Europe, or with Japan’s situation in the 1990s.
1. Current situation in Japan
As you all know, the global financial markets are still under a severe stress. The global financial landscape has clearly changed from a period of ample liquidity and high risk appetite only a few years ago to scarce transactions and de-leveraging. In response, the world’s governments and central banks have taken extraordinary actions on an unprecedented scale in fiscal, monetary, and financial policies. Even though the markets have got a little calm compared with some months ago, significant downside risks remain in many corners and regulators around the world still need to remain on a heightened state of alert in monitoring developments in the markets.
Needless to say, Japan is not immune from this global market turmoil. The financial system was severely affected by the deterioration of the real economy and high volatility of the financial markets. However, one can fairly say that the financial system itself is relatively sound compared with those in the United States and Europe. This stems from the fact that the losses Japan’s financial sector incurred from complex securitized products are relatively small, which are one digit smaller than those of the American and European financial sectors.
Accordingly, the impact of these losses on capital is less severe in this country. The exposure of Japan’s financial sector to opaque, toxic assets is also significantly smaller. This implies that future additional losses from these assets will be limited as well. This is the bright side of the story for Japan.
There may be a few reasons for this relative soundness.
- Admittedly, it is partly because Japan’s financial firms were not strongly innovation-oriented, as some critics have pointed out.
- But it is also because they were giving priorities to improving their financial soundness rather than enhancing their profitability in the last several years. When the so-called “originate-to-distribute” business model became widespread, it happened that Japan’s financial firms were at the final stage of resolving the non-performing loan problems.
- In addition, it is significant that risk management practices of Japan’s financial firms were improving in the course of the period I just mentioned. Firms became more cautious than before about investing in financial products with uncertainty on their underlying assets or associated risks. Early implementation of the Basel II framework in Japan has also contributed to ensuring these practices.
Let me turn to the dark side of the story. Japan’s financial system does have considerable risks in other areas, and they are materializing. There are two main sources of risk. The one is rising credit costs caused by the weakening of the real economy. The other is valuation losses and impairment on shares held by financial firms, particularly banks. Against this background, many of Japanese banks posted final losses at their annual financial results as of end-March 2009.
In this connection, it has been argued that banks’ shareholdings should be further restricted by regulation. As you may know, shareholding by a bank is currently regulated to not exceed the value of its Tier 1 capital. At this point in time, we do not think it is necessary to further tighten these restrictions by outright regulation. Yet I hope that Japanese banks have drawn a good lesson from their bitter experience over the last twelve months or so. They have been made aware that shareholding entails significant risk, which could adversely affect the banks’ financial soundness. Therefore, I expect each bank to enhance the robustness of its risk management so that its capital buffer is sufficient and proportionate to the level of its shareholdings. For the time being, the FSA intends to follow up on banks’ efforts with strong interest.
2. “Once-in-a-century” or “second-in-a-decade”?
Now, I would like to talk about the degree of seriousness of the current financial stress in Japan by comparing with our own experience in the 1990s.
For a while, the scale of the current global crisis was characterized as “once-in-a-century.” This word gained popularity after former U.S. Federal Reserve Board Chairman Alan Greenspan used it when comparing the current crisis to a great tsunami. Since the impact of the market turmoil has been serious globally, it is not without reason that the current difficulties are labelled in this manner.
Yet it was not so long ago that Japan experienced the last serious crisis, as you probably know well. Remembering my own experience in the financial regulatory authority ten or so years ago, my feeling is rather that the current stress is the “second-in-a-decade" in terms of the magnitude of problems in the financial sector.
These divergent views on Japan’s current situation probably reflect the fact that the current stress differs significantly from the difficulties we faced in the 1990s, and that some of the difference are comforting in the current context but others make us more pessimistic.
I think the following three can be pointed out as the main sources of the difference:
- First, the current turmoil in Japan was triggered by an exogenous shock, whereas the root causes of the last crisis were located within the country. By “exogenous shock” I mean that the current crisis stems mainly from the collapse of the housing market and the securitization market in the United States and the United Kingdom. In contrast, the crisis in the 1990s was the result of an endogenous shock, since Japanese financial firms had been deeply involved in the creation of the bubble in the domestic property market. Accordingly, their exposure to problem loans was much greater in the 1990s, while the direct impact of the current market turmoil on Japan’s financial system itself is not as severe as the last crisis.
- Second, the regulatory framework and financial safety net have now been significantly improved in Japan. In the early 1990s, we had in place neither sufficient effective frameworks for disclosure or provisioning with respect to non-performing loans, nor sufficiently robust schemes for deposit protection and resolution of failed banks. The lack of these frameworks provided incentives for banks to postpone the disposal of their non-performing loans, and for authorities to avoid bank resolution at all costs. This prolonged financial distress and the economic slump. Based on this bitter experience, we have improved disclosure requirements, clarified the rules on write-downs and provisioning, put in place a prompt corrective action scheme, and established an early warning system that enables the supervisors to conduct intense monitoring of banks before they become undercapitalized. The deposit insurance scheme has also been strengthened, and a robust framework to deal with systemic risk has been put in place.
- The third point of difference is that the current market turmoil has resulted in a rapid worsening of the entire global economy. In the April World Economic Outlook, the International Monetary Fund forecasts the World’s real GDP growth for 2009 as minus 1.3 percent, which would represent the deepest global recession since the Second World War. The global recession has led to a serious weakening of Japan’s real economy through severe contraction of external demand. As you know, Japan’s GDP recorded a negative growth of 14.2 percent on an annualized basis in the first quarter of 2009. In comparison, the effect of Japan’s financial crisis in the 1990s was largely contained within the border. Even combined with the Asian crisis and the turbulence of the global markets that followed, the world economy sustained a positive growth as a whole, and recovered quickly and strongly.
As I have just explained, we are now in a better condition in some aspects and in a worse condition in others than we were in the 1990s. The majority view on the economic outlook is that Japan’s real economy is not expected to recover rapidly. Meanwhile, Japan’s financial system has so far maintained its relative soundness. Therefore, Japan’s financial sector is increasingly relied upon in supporting the real economy and preventing its further deterioration.
3. Policy response to the current crisis
Now let me move on to describe our response to the current financial turmoil and economic difficulties. Like our fellow regulators abroad, the FSA has been working on two categories of policies since the outbreak of the turmoil. One is short-term crisis management measures to stabilize 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.
Crisis management measures
I wish to talk about short-term crisis management measures first. Under this category, the features of the measures seem to differ considerably between Japan on the one hand, and the U.S. and Europe on the other.
As I mentioned earlier, the U.S. and European authorities have taken a number of extraordinary actions to stabilize the financial system. They include large-scale capital injection with public funds, temporary bank nationalization, and credit guarantees by governments, as well as massive liquidity provisioning by central banks.
Meanwhile, most of these extreme actions have not been taken in Japan in response to the current turmoil. This difference stems from the different nature of shocks that have affected respective countries. Namely, the shock Japan has suffered in the current turmoil is exogenous, but the root causes of the current crisis, typically in the U.S. and the U.K., are endogenous.
Indeed, the manner in which the current crisis evolved in these two countries has commonalities to what happened in Japan in the 1990s. That is:
- First, irresponsible lending had been widespread prior to the crisis, on the assumption that real estate prices would continue to go up;
- Second, the financial market turmoil was triggered by the decline in real estate prices;
- Third, the adverse effect of the market turmoil spilled over to the real economy; and
- Fourth, the turmoil resulted in a system-wide financial crisis.
In contrast, Japan’s financial system has not been affected this time as severely as it was in the 1990s. Put it another way, it has suffered from external injury but not from a disease of internal organs. Therefore, most of the short-term policies in Japan are aimed at preventing the external injury from turning into a serious internal disease. They are more focused on maintaining the functioning of financial intermediation in order to support activities in the real economy. They include:
- Providing the capital injection scheme, which can be used by banks on their own business judgment to maintain a sufficient capital base and sustain their lending; and
- Intensive supervisory review of banks’ lending practices to ensure that their financial intermediary functions work properly.
“Re-design” of regulatory framework
In parallel with these short-term measures, the FSA is also advancing medium-term reforms to strengthen financial regulation. Discussions are underway globally regarding capital adequacy of banks, procyclicality in the financial system, market integrity and transparency, and international cooperation among regulators. They are in line with the recommendations put forth by the Financial Stability Forum in April 2008, which were endorsed at the subsequent meetings of the G7 and the G20 leaders.
Recent developments in Japan include the following:
- First, the FSA strengthened the disclosure requirements for financial firms with respect to their exposure to the securitization market. It also made sure that the underlying assets of securitized products were traceable along the chains of origination and distribution;
- Second, a bill has been submitted to the current session of the Diet to introduce a legal framework for regulating credit rating agencies, which is consistent with the developments in the United States and Europe. As I understand, the bill was just approved by the Upper House earlier today and enacted; and
- Third, given the need to supervise systemically important financial firms on a global basis, supervisory colleges have been established for each of these firms. Japan FSA has established the colleges for Japan’s three megabanks and Nomura. We are also member of the colleges for several foreign firms with significant influence over Japan’s financial markets.
These two categories of policies are common to the financial regulators in major countries, and all of us are facing the challenge of how to strike the right balance between the two. On the one hand, if the policies lean too much toward crisis management with large-scale public support, it could cause moral hazard in the marketplace or distort the 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.
4. Revisiting Japan’s experience in the 1990s
Here, I would like to emphasize that we already learned this lesson from our own experience more than a decade ago. When Japan was in the midst of a serious financial crisis in the late 1990s, the authorities needed to resort to exceptional measures in an effort to stabilize the financial system. At the same time, however, the authorities were also working on measures to strengthen the institutional framework, including in accounting, financial regulation, and bank resolution. This laid the foundation for the FSA’s stronger position in dealing with financial instability, market transparency, and risk management at financial firms.
In the course of the current global market turmoil, we have argued that Japan’s experience in the 1990s provides useful suggestions as to how our fellow regulators should respond to the ongoing difficulties. In addition to the point I have just mentioned, there are four other major lessons.
- First, prompt and accurate recognition of losses is essential. Lack of it would give financial firms incentives to postpone the disposal of their non-performing assets, which could cause a negative spiral of credit crunch and the weakening economy.
- Second, toxic assets need to be taken off the balance sheet. Otherwise it would be difficult to restore full market confidence as additional losses on those assets could be incurred later.
- Third, undercapitalization of financial firms needs to be addressed by injecting public funds if necessary. Prompt and sufficient recapitalization is needed if a financial firm becomes undercapitalized as a result of the disposal of bad assets.
- Fourth, exceptional measures can be options in times of serious crises. In the 1990s, Japan introduced full protection of bank deposits and nationalized a couple of banks on a temporary basis.
Recent developments in the U.S. and Europe show that these lessons have been relevant in the context of the current global crisis. For example, the Capital Assistance Program of the U.S. is aimed at assessing potential future losses by stress tests in order to determine the additional capital required, with the option of recapitalizing banks with public funds. This program bears certain similarities to the FSA’s intensive inspections into banks’ balance sheets, followed by capital injection with public funds in 1999.
Meanwhile, the objective of the Public-Private Investment Program is to take what is called “legacy assets” off balance sheet. European countries also seem to be taking similar routes, with some of them introducing full protection of bank deposits and temporary bank nationalization.
Until recently, most observers saw Japan’s response to its last crisis as a failure. Measures taken by Japan were regarded as being too slow, too little, too late, and were unfavorably compared with more drastic solutions taken by small economies, which are theoretically appealing. These days, however, quite a few experts have started to say that Japan in the 1990s was not as bad as previously argued.
It may be because the U.S. and European authorities are facing difficulties as we did in putting through tough actions or in persuading taxpayers on the need for public intervention into the troubled banks. These policies are inevitably met by fierce resistance both from the industry and the public, making further actions more difficult. In Japan, the bailout of housing loan companies in 1996 triggered public outrage. This contributed to the delayed introduction of a robust bank resolution framework, which was necessary for a fundamental solution to the non-performing loan problem. In this respect, the important thing is to stress to the public that taxpayers’ money is injected not to rescue individual financial firms but to save the entire financial system and the national economy.
Also, many Japanese observers say somewhat masochistically that the U.S. authorities have been moving swiftly this time, whereas the Japanese did not in the 1990s. However, these comments are superficial in my view because they tend to overlook the significant differences that exist between the current crisis and Japan’s past crisis. Particularly, as financial transactions have become more market-based, Western banks are now forced to write down toxic assets promptly due to mark-to-market accounting. Accordingly, the speed at which the authorities are forced to address the problem is much faster now. In contrast, in 1990s’ Japan, risks were concentrated in the commercial banking sector in the form of lending assets on their balance sheets. Because their lending assets were largely not traded in the market, Japanese banks were allowed to take time to dispose of their non-performing loans.
To conclude, significant differences exist between crises that occur in different places or at different times. It is therefore natural that the manner in which the authorities respond differs from one crisis to another. Yet one can also identify significant commonalities in these crises and the policy measures taken by the authorities. Anyway, achieving internationally consistent regulatory frameworks and closer cooperation among regulators have become crucial as financial transactions take on an increasingly cross-border character.
At the same time, regulators and the financial services industry should recognize that the role of the financial sector in supporting the real economy is indispensable and remains unchanged. Regulators also must avoid impeding the vigor of the financial sector and innovations in financial markets by excessive regulation. We should keep these points in mind in advancing regulatory changes.
Financial stability is a global public good. In the absence of a stable financial system, sustained growth of the world economy is untenable. It is important that the objectives of financial “re-regulation” be understood in this broad perspective. We wish to make active contribution to the global efforts to achieve this objective in a forward-looking manner.
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