Toward Better Regulation

Speech by Dr Takafumi Sato, Commissioner, Financial Services Agency (FSA)
at meetings of the International Bankers Association, September 25, 2007
and of the American Chamber of Commerce in Japan, September 26, 2007.

It is a great honor for me to be invited here today to this gathering of distinguished members. Today, I would like to talk about the FSA's efforts toward ''better regulation''.

My speech consists of three parts. First, I would like to start with the background as to why better regulation is now called for. Then, I will turn to the major pillars of better regulation. Finally, I will present you with some specific areas to focus on in our efforts toward better regulation.

What is Better Regulation?

Better regulation refers to improving the quality of financial regulation and supervision in order to enhance its effectiveness, efficiency, consistency and transparency. It is my intention to make this an overarching theme for the FSA's work in the coming years. Why is better regulation now called for? In my view, the need for it can be drawn from the following two broad contexts.

First, better regulation is highly relevant to one of Japan's current policy priorities, namely making Japan's financial markets more vibrant and more competitive internationally. Given that we are entering an era of shrinking and aging population, the Japanese economy would not be able to achieve sustainable development without a stronger financial sector. The Japanese people should be able to enjoy the benefits of financial services, by which their financial assets and pensions can be invested efficiently and safely. The financial services industry should play a core role in the Japanese economy by generating high value added. Japanese financial markets should endeavor to become more attractive to both domestic and overseas issuers and investors, and more user-friendly to customers. I believe that the quality of regulation is a crucial determinant of the competitiveness of financial markets to which it is applied. Therefore, we hope that our efforts toward better regulation contribute to making our financial markets more vibrant and to strengthening their international competitiveness.

The other context is that our regulatory and supervisory approach must correspond to the changes in phases in terms of the situation of the Japanese financial sector.

Financial regulation and supervision has three ultimate objectives, which are ensuring stability of the financial system, protecting the interest of the customers, and ensuring fairness and transparency in financial markets. These three objectives are widely shared among major financial regulators around the world, and will not be changed easily. Ben Bernanke, the Chairman of the U.S. Federal Reserve Board, expressed a similar view in his recent speech, stating, ''As public policymakers, we have three principal objectives in the financial sphere, objectives that have remained essentially unchanged over many decades even as the pace of financial innovation has accelerated. These objectives are financial stability, investor protection, and market integrity.'' ^*

As the situation of the Japanese financial sector is moving into a new phase, however, the policy environment in which we are pursuing these three objectives has changed considerably. As far as financial system stability is concerned, 1997--exactly a decade ago--was a year of serious concern for the Japanese financial system itself after the failures of major financial institutions. Even after overcoming this crisis by conducting rigorous inspections and supervision, injecting capital and carrying out resolution of failed institutions, the non-performing loans (NPL) problem remained the most urgent issue for some time. Now that substantial progress has been made in terms of disposing non-performing loans, the NPL ratio of Japan's major banks has declined to a level comparable to that of their foreign counterparts.

Subsequently, we saw a surge in the number of cases where financial firms posed various problems in their business operations from the viewpoint of customer protection. In response, the FSA improved customer protection rules and undertook individual supervisory actions. Problems arose in the securities markets as well, including unfair trading and inappropriate conduct regarding disclosure. We addressed them both at the legislative level and the enforcement level. Thanks to efforts by both public and private sectors, significant progress has been made in improving the regulatory framework and the actual practices by financial firms.

Taking all this history into account, the Japanese financial sector, in my view, is now in a phase where the lessons learnt from past experience should be firmly incorporated and further deepened. In doing so, it is crucial for each financial institution to tackle various issues based on its own efforts and responsibility. Taking risk management as an example, financial institutions are expected to upgrade their risk management systems to a level proportionate to their individual size and business characteristics. This perspective is incorporated into the Basel II framework that was implemented in Japan last spring. In the area of customer protection, a major challenge for financial institutions is to put strong ownership in place in building effective systems and cross-checking structures in advance to prevent problems from arising. In the securities markets, each financial firm is expected to operate its business with a strong compliance culture. In this process, our regulatory approach should correspond properly to the changes in situation and should place a greater emphasis on self-responsibility and voluntary efforts by financial institutions.

In addition, we have been observing rapid change in recent years in that financial transactions are becoming increasingly globalized and financial instruments and sales channels are becoming more diversified. Corporate structures at financial institutions are becoming more varied across the industry and conglomeration is an ongoing trend. Another new development is a greater presence of investment funds in financial markets. To respond effectively to such new developments, it is essential to make efforts toward better regulation and improve our supervisory approach corresponding to new challenges of each epoch.

Four Pillars of Better Regulation

What then does better regulation consist of? We have set out four pillars of better regulation. This can be regarded as a kind of mindset of the FSA officials, or the direction to take for further evolution of our supervisory approach.

The first pillar is the optimal combination of rules-based and principles-based supervisory approaches. The rules-based approach involves establishing detailed rules and applying them to individual cases. The advantage of this approach is that it ensures predictability and eliminates arbitrariness in regulatory actions from the viewpoint of financial institutions. On the other hand, the principles-based approach is a framework where several key principles are explicitly stated so as to encourage voluntary efforts by financial institutions in line with such principles. Its advantage is that it ensures the maximum freedom of business management for financial institutions.

The rules-based approach is supposed to be effective in cases where common rules need to be applied to market participants including a large number of unspecified parties, or in cases where administrative sanctions are imposed under regulatory authority. The principles-based approach is supposed to be effective in cases where financial institutions are encouraged to develop their own systems and controls for governance, risk management and legal compliance, since voluntary efforts by financial institutions are essential in these areas. The existence of principles may also play a significant role to resolve a case in which there is a gap between rules because of newly introduced products, services and sales methods, as it is impossible to set up comprehensive rules in advance that cover every future situation.

For the effective functioning of the principles-based approach, self-discipline on the part of financial firms is critical. It is vital to have a culture in place where financial firms do not engage in undesirable acts even if such acts do not directly violate laws and regulations. They should make a clear departure from a culture where financial firms feel free to do anything so long as they do not directly violate laws and regulations. Ethical norms and self-control on the part of financial firms are essential in this regard, and there is a role to be played by self-regulatory organizations as well in establishing these norms at the industry level.

Now, rules-based and principles-based approaches are mutually complementary, rather than exclusive against each other. It is therefore important for us to ensure the effectiveness of the entire regulatory framework through an optimal combination of these two approaches. To find out how to combine these two approaches, various efforts have been made in other countries as well. The U.K. Financial Services Authority, for instance, has published eleven principles that should be respected by financial institutions, and expressed its intention to shift its supervision toward a more principles-based one. Given that the rulebook published by the UK FSA is very detailed, totaling as many as 8,500 pages, it may be fair to say that they have learnt some lessons from it and that they are now in the phase of shifting the balance to a more principles-based approach. In Japan, principles have been scattered in existing laws and regulations, supervisory guidelines and other documents. We are open to discussion with financial institutions and other relevant parties as to whether these principles should become more systematized and what the best way would be to combine rules and principles, considering Japan's legal system and other factors.

The second pillar is prompt and effective responses to high-priority issues. This is partly based on a keen awareness of how we could utilize our limited resources most efficiently. This pillar corresponds to what is often called a ''risk-focused, forward-looking'' approach in the U.S. and the U.K. It means promptly foreseeing and identifying the areas where serious problems could be hidden and where huge risks might materialize in the future, and effectively allocating our resources to these areas so as to address such significant issues. I believe that by taking such a proactive approach, the range of policy options available to respond to such risks will be broader. This approach also means that we should not be obsessed with minor issues that are given low priority in light of our objectives.

In order to promptly recognize potential risks in the financial system, it is necessary to monitor economies and markets on a global basis and to understand as accurately as possible the strategies and activities of financial institutions. I feel that, in addition to intensive communications with financial institutions, we also need to improve our direct and indirect communications with various market participants like investment funds that are increasingly influential on a global scale.

The third pillar is to encourage voluntary efforts by financial institutions, and to place greater emphasis on incentives for them. This incentive-compatible approach has already been incorporated in our Financial Inspection Rating System and the Basel II framework, creating incentives for financial institutions to improve the systems and controls in business operations and risk management. Another example is our Relationship Banking framework for regional banks, which has been modified into a new permanent framework beginning this financial year with a view to placing greater emphasis on the initiatives each financial institution. As these examples show, our approach toward more incentive-compatibility and greater emphasis on voluntary efforts has already been incorporated to a significant extent in our regulatory framework. As I stated earlier, voluntary efforts are becoming more crucial as the financial sector is shifting into a new phase, where financial institutions satisfying the minimum standard are now expected to compete in implementing best practices. It is my intention to pay continuous attention to the effectiveness of such incentive-compatible frameworks.

Lastly, the fourth pillar is to improve the transparency and predictability of regulatory actions. Since the inauguration of the FSA's predecessor, the Financial Supervisory Agency, in 1998, one of the principles of conduct has been to pursue fair and transparent financial regulation and supervision. Based on this principle, the FSA has compiled and published its inspection manuals and supervisory guidelines to clarify checkpoints in inspection and supervision and workflow of administrative actions. Annual inspection and supervisory policies are also published for each operational year. Our latest efforts during the past twelve months include the publication of criteria for our administrative actions and upgrading our No Action Letter System to make it more user-friendly. We also posted the answers to more than 100 questions from financial institutions and others concerning the interpretation of rules under Basel II on the FSA website in the form of Q&As. Thus we have taken various measures to improve the transparency and predictability of our actions. We intend to continue our efforts and examine whether there is any room for further improvement by listening to the opinions of interested parties.

Areas to Focus on for Better Regulation

Let me now turn to raise some specific areas we intend to focus on in order to advance in line with the four pillars of better regulation I just described.

The first is enhanced dialogue with financial institutions and other relevant parties. In order to make better regulation effective, it is necessary for financial institutions and the FSA to have more opportunities to engage in dialogue with each other and build mutual trust so as to enable a frank exchange of views. Such enhanced dialogue would not only help financial institutions to obtain greater predictability about administrative actions, but also help us in promptly identifying what is happening and what is forthcoming in financial markets. Regulation itself is by no means the purpose of regulatory authority. We hope to establish a relationship in which financial institutions can consult with us on various challenges they face, and in turn we can offer them clues to possible solutions. Dialogue is also important in establishing common understanding of the principles I mentioned earlier, and in cooperating with each other in seeking solutions to the problems for the financial system as a whole.

The second area to focus on is effective dissemination of information. We have been trying to deliver our views accurately to interested parties, both domestic and abroad, through various channels such as speeches by senior officials, the FSA website, and various documents both in Japanese and in English. We will continue to make efforts to utilize various platforms and disseminate information more widely and more effectively. We would like to bring about an environment where people can easily access basic information and data on FSA's regulation and our views on current issues. To this end, we intend, for instance, to participate actively in symposiums and other public events both at home and abroad.

The third area is further cooperation with fellow authorities abroad. To respond to acceleration in cross-border activities by financial institutions and globalization of financial transactions, it is urgent for supervisory authorities in different jurisdictions to enhance cooperation among them. In doing so, it is important to pay attention to international harmonization of regulations and supervision. We should avoid the situation where inconsistency in regulation and supervision would lead to exodus of financial transactions into jurisdictions with extremely lax regulations, or to unfair trading conducted in such jurisdictions inflicting damages on investors in other jurisdictions. Moreover, the sharing of information with foreign authorities is indispensable in grasping global market situations. Thus, we would like to strengthen cooperation with our counterparts abroad and international organizations, for instance, in identifying the activities of investment funds and monitoring risks for the global financial system stability.

The fourth area is enhanced research functions for the purpose of prompt recognition of market developments. The FSA is in a position to analyze and assess the impacts of macroeconomic and market events on the business of financial institutions and the stability of the entire financial system. And these analyses and assessments should be reflected on appropriate actions on the supervisory front. For these purposes, it is our intention to enhance our research functions on financial markets and the broader economy. In addition, we will strengthen our communication and cooperation with relevant parties, including major market participants, the Bank of Japan, and our counterparts abroad.

Last and the fifth area is to redouble our efforts in human resource development. In order to upgrade our efforts in each specific area I have raised, it is imperative that we improve the quality of our staff without lagging behind in terms of financial technology and financial market development. As we know, the financial sector is a field which requires high degree of professionalism. This requirement applies to FSA staff members without exception. We will therefore put forth our best efforts to improve the expertise and specialist capabilities of our staff. Ideas to be considered in this regard would include improving our training programs, developing incentive-inspiring approaches in our personnel system, and personnel exchanges with the private sector.

I have just presented you our approach toward better regulation. I believe that if the FSA fulfills its role in achieving the three ultimate objectives of financial regulation I mentioned earlier, it will contribute to strengthening the competitiveness of Japan's financial markets and improving the quality of financial services, ultimately leading to sound development of the national economy. As the situation of the financial sector is continuously changing, our task is becoming increasingly complex and sophisticated. In this context, the FSA intends to make its utmost efforts to improve the quality of our regulatory framework to meet the demand of the times. To this end, we are anxious to listen to the voices of the public and users of financial services, and, above all, the voices of those who are directly engaged in the financial sector. I would like to conclude my remarks by asking all of you to help us achieve our objectives.

Thank you.

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^* http://www.federalreserve.gov/newsevents/speech/bernanke20070515a.htm