- Speeches and Material
“Financial business environment in Japan: current progress and future change”
Speech by Dr. Takafumi Sato
Commissioner, Financial Services Agency (FSA)
The International Bankers Association
Tokyo, 22 June 2009
Good afternoon. It is my pleasure to be back here again to speak before the distinguished members of the International Bankers Association.
Today, I would like to discuss the changing financial business environment in Japan. This speech consists of two parts. In the first part, I would like to talk about the progress made in our efforts on the initiatives of “Better Regulation” and “Better Market Initiative (BMI).” You may recall that my previous two speeches at the IBA were about Better Regulation. To my deep regret, it is scarcely taken up in public discussions these days. It is all because of the ongoing global market turmoil. However, our commitment to Better Regulation has not changed at all. I would therefore like to talk about this initiative as a follow-up to my previous two addresses. I also wish to touch upon the BMI since its progress should have significant implications for the business environment surrounding financial firms operating in Japan.
In the second part of the speech, I would like to discuss the changing regulatory environment from a broader, global perspective. Since the outbreak of the current turmoil, the world’s financial regulators have been working on a “re-design” of the regulatory framework in the medium term, in addition to short-term crisis management measures. I would like to discuss the broad directions of likely changes in financial regulation, and reflect on their implications for the financial services industry in the future.
I. Progress in Better Regulation and Better Market Initiative
Following the ongoing global market turmoil, regulators have been working on short-term measures to stabilise the markets and medium-term reforms of financial regulation at the same time.
Japan is no exception. The FSA has implemented several stabilisation measures aimed at maintaining the functioning of financial intermediation, including the provision of a new capital injection scheme. In parallel with these measures, the FSA has also introduced other measures to prevent the recurrence of a similar kind of turmoil in the future. They include a new regulatory framework for credit rating agencies, strengthening the disclosure requirements for financial firms with respect to their exposure to the securitisation market, and establishing the supervisory colleges for each of Japan’s three megabanks and for Nomura.
However, neither Better Regulation nor the BMI falls nicely into either of these two categories. Both of them are medium-term policy initiatives but more proactive than “re-design” of financial regulation that was initiated in reaction to the global market turmoil. This is the reason why I think these two initiatives are characteristic of Japan’s situation in financial regulation. It is my view that Better Regulation and the BMI, as well as the global trend of regulatory “re-design,” will constitute an overarching theme that will shape the financial business in Japan in the longer term.
1. Better Regulation
Let me first talk about the progress made in the implementation of Better Regulation. As I hope you are fully aware, 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 are committed to preparing progress reports on Better Regulation on a regular basis, and intend to issue the third progress report probably in a month’s time. Although we are still working on the details of the forthcoming report, I would like to highlight some areas where the most tangible progress has been witnessed.
Better Regulation at financial inspections
One of such areas is financial inspections. While there are still many issues to be addressed, the concept of Better Regulation is taking root in the operations of our financial inspections. The overarching philosophy of the inspection manual, which was revised to incorporate the spirit of Better Regulation, can be summarised as “Focus on material issues”, “Incentivise voluntary improvement”, and “Obtain a sense of acceptance and appreciation on the part of financial firms”.
If we take stock of the progress made in this area, we feel that good relationship with financial institutions has emerged as a result of the initiative, which enables us to conduct frank and productive dialogue with them. The mindset of inspectors has changed considerably and they are now keen to bring forward the agenda of Better Regulation in their daily operations.
We are firmly committed to taking this initiative further ahead. Especially, we still see room for improvement in our efforts to achieve “more usefulness and relatedness” of our inspections with financial institutions’ efforts to realise a higher level of compliance and risk management. For this purpose, we have developed a new roadmap, “Action Plan II for Better Regulation at Financial Inspections,” which emphasises our capacity enhancements at both organisational and individual levels.
In this connection, let me add that your cooperation is vital to make further progress in this initiative since inspections are collective work between inspectors and financial institutions to share a vision of the ideal financial sector activities and to find ways to move closer to those ideals.
Risk-focused approach and international cooperation
Another area of good progress is related to the second pillar of Better Regulation, which is a risk-focused and forward-looking approach. It means promptly identifying the areas where huge risks could be latent that might materialise themselves in the future. In this sense, the ongoing global market turmoil presented us with a real test for our implementation of Better Regulation.
In this regard, we have been rewarded from our risk-focused and forward-looking approach and our policy of placing greater emphasis on close monitoring of market developments. As the current turmoil in Japan was triggered by an exogenous shock stemming mainly from the collapse of the financial markets in other countries, we acted accordingly by taking a high and constant vigilance against external events and their developments. In this context, we have been releasing aggregate data on Japanese banks' exposure to subprime-related products on a quarterly basis since November 2007, and securitised products more broadly in line with the leading practices agreed at the Financial Stability Forum (FSF). I believe that these announcements have been helpful in alleviating uncertainties about Japan’s financial markets. Also, short-term regulatory measures were designed to ensure that the “external injury” for the Japanese economy would not turn into a serious disease of its internal organs.
Furthermore, we have strengthened international cooperation with financial regulators around the globe, not only through establishing supervisory colleges but also through enhancing the dialogue in terms of its frequencies and substance. In tackling an exogenous shock, it is critical to keep close contact with respective financial authorities for ensuring our preparedness for a crisis well in advance. I believe that the authority’s capability to respond to crises is integral part of the financial business environment. We are determined to make further efforts towards this direction.
Effects of global “re-design” on Better Regulation?
Then, a question might arise as to the relationship between Better Regulation and the current global trend of “re-design” of financial regulation. Will this trend affect Better Regulation?
Better Regulation does not contradict the global trend of regulatory “re-design.” 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 in light of recent developments, the importance of Better Regulation is even increasing.
2. Better Market Initiative
Let me now turn to the 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) 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. Furthermore, the bill including the provisions for enabling alliance between stock exchanges and commodity exchanges was approved by the Diet last week.
Some may wonder whether the BMI needs major revisions, as they include various elements of deregulation but the global trend seems to point to “re-regulation.” However, I believe the BMI remains valid in spite of the global market turmoil, and our efforts in this direction will continue.
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. 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-design” of the regulatory framework. However, I do not think this will lead to fundamental changes to the entire initiative of the BMI.
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 particular case 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.
II. Broad directions of likely changes in financial regulation
Now, let me move on to the second part of the speech, and let us broaden the perspective to look at recent developments in financial regulation taking place globally.
1. Six key concepts of regulatory reform
As I mentioned earlier, the world’s financial regulators, including Japan FSA, have been working on medium-term reforms to “re-design” the regulatory framework. Discussions on the regulatory reform are still ongoing but, by reading the wind carefully, 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, distributors and investors to carry out due diligence and transmit accurate information of underlying assets 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, increased the level of 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 (structured investment vehicles) or ABCP (asset-based commercial paper) 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.
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 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.
2. 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.
3. 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. I am aware that, amid the times of high uncertainty such as now, one should refrain from making any decisive comments about what will happen. So, please take the following comments just as some food for thought.
- 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 off OTC and on to exchanges could be another related development.
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 its part, the FSA will continue the efforts to advance Better Regulation and increase Japan’s attractiveness as an international financial centre. I sincerely hope that such collaboration between the industry and the FSA will shape Japan’s financial business environment that firmly supports value-adding activities of the real economy, and will lead to a better future for Japan’s standing as one of the major financial centres in the world.
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