Progress in the FSA's Efforts toward "Better Regulation"

26 June 2008
At the International Bankers Association

Takafumi Sato
Commissioner
Financial Services Agency

Good afternoon. It is my great pleasure to have this opportunity to speak before the distinguished members of the International Bankers Association (IBA). My speech at the IBA meeting last September was about our "better regulation" initiative, which was announced just after my appointment as FSA Commissioner last July. Today, I am delighted to report back to you on the progress we have made since then.

"Better regulation" refers to improving the quality of financial regulation and supervision in order to enhance its effectiveness, efficiency, consistency and transparency. We place this as an overarching theme for the FSA's work in the coming years. Let me first briefly reiterate the outline of the initiative.

The initiative centres on four pillars, namely,

1. Optimal combination of rules-based and principles-based supervisory approaches,
2. Timely recognition of priority issues and effective response,
3. Encouraging voluntary efforts by financial firms and placing greater emphasis on designing proper incentives, and
4. Improving the transparency and predictability of regulatory actions.

Under these four pillars, we have laid out five specific areas requiring immediate focus. These are:

1. Enhancing dialogue with financial institutions,
2. Disseminating information more widely and effectively,
3. Strengthening cooperation with our fellow authorities abroad,
4. Enhancing research functions so as to better understand market developments, and
5. Strengthening human resource development within the FSA.

My speech today is based on our first progress report on the implementation of the "better regulation" initiative published last month. The full report in Japanese and its summary in English are available on our website. It covers the various steps forward that we have taken during the first ten months of the initiative. Today I will present to you some of its highlights, focusing on those of great interest to today's audience. Our progress in terms of the four pillars of the initiative will be presented first, followed by the progress in the initiative's five areas of focus. Lastly, I will present to you the key results of the survey that we conducted along with the progress report.

Progress in terms of the four pillars of the "better regulation" initiative

Pillar I: Optimal combination of rules-based and principles-based supervisory approaches

With regards to the first pillar of the initiative, namely, optimal combination of rules-based and principles-based supervisory approaches, a big step forward is the agreement on key principles reached between the financial services industry and the FSA. We have held a series of consultation meetings with industry representatives since last December. We thought it was important to work together, share common values and reach agreement between the regulator and regulated financial firms, rather than imposing the authority's views on them unilaterally. I appreciate Chairman Kuo for his attendance at these consultation meetings representing the IBA to provide useful and insightful comments. The FSA and the industry reached agreement on fourteen key principles in April, and they were published under the title "The Principles in the Financial Services Industry."

If we try to categorise these fourteen principles, Principles 1 and 2 are the most fundamental ones arising from the public nature of financial business. Principles 3 to 7 deal with customer protection issues. Principles 8, 9, 11 and 12 are about sound business operations, such as governance, disclosure, financial soundness and risk management. Principles 10 and 13 can be categorised as safeguards against external factors. The last principle, Principle 14, concerns the relationship between financial firms and the FSA.

It may be interesting to compare our principles with those by the UK Financial Services Authority (FSA). UK FSA's "Principles for Business" have been in place since 2001. It should be noted that there are certain differences between the two FSAs in the way they take a principles-based approach. The UK FSA has been substantially shifting its regulatory framework to a more principles-based one, whereas what we are trying to achieve at the Japan FSA is an optimal combination of rules-based and principles-based approaches. Nevertheless, the two sets of principles share many common features [as this slide indicates]. On the other hand, there are some additional elements included in our principles such as Principles 1, 5, 9, 10 and 13. This may reflect differences in regulatory needs of Japan and the U.K., as well as differences in the timing of the principles' introduction in the two countries.

The establishment of the principles in Japan is expected to have a positive impact on customers, financial firms and the FSA. For financial firms in particular, the principles should play a guiding role in developing best practices on their own initiative. Along with the announcement of the principles, the FSA has made it clear that we will not take any official administrative actions nor impose sanctions even if a firm does not sufficiently meet the principles as long as it does not violate laws and rules. We have also made it clear that we will give due consideration and may reduce the sanctions in administrative actions if a firm has been making sufficient efforts to meet the principles. By way of these combined announcements, financial firms are encouraged to meet the principles in a positive way and develop best practices on their own initiative.

Another important step forward along these lines is our ongoing efforts to provide interpretations of rules in light of principles. Specifically, we published "Our Answers to Your Questions about the Financial Instruments and Exchange Act" in February and "Eleven Misunderstandings about the Internal Control Report System" in March. These publications are intended to mitigate some of the excessive concerns in reaction to the new requirements for explanation to customers and internal control reporting. These two documents provide clear written interpretations in light of the original purpose and intention of the laws and rules, or in other words "principles."

Pillar II: Timely recognition of priority issues and effective response

Let me now turn to the progress on the second pillar of the initiative. The major challenge we have been facing in relation to this pillar has been the ongoing global financial market turmoil triggered by the subprime loan problem in the U.S. This global turmoil has deepened considerably since last summer. It has presented us with a real test for our implementation of better regulation, particularly in light of this second pillar.

The FSA has devoted significant resources to this new challenge in a proactive manner, and has taken a series of actions to respond to it:

• The FSA has been vigilantly assessing the impact of the global turmoil on Japan's financial system, and has been closely monitoring risk management practices at financial firms since last summer. We have made public from time to time our assessment of the situation through press conferences and other occasions.
• We have been releasing aggregate data on Japanese banks' exposures to subprime-related products on a quarterly basis since last November. I believe that, so far, the FSA is the only major supervisor in the world to publish such data. These announcements should have helped to alleviate uncertainties in the market.
• We set up a new office in February, called the Market Analysis Office, with the purpose of enhancing our research and analysis functions on financial market developments.
• We are maintaining close cooperation with our fellow authorities abroad in tackling this global challenge. In particular, we have been actively contributing to the work at the Financial Stability Forum (FSF) and its high-level working group, which was set up to work out policy recommendations aimed at enhancing market and institutional resilience. I myself have been taking part in the FSF's working group, representing Japan, though often having to send my deputy, Junichi Maruyama, on my behalf.

Other steps forward include measures to promote a forward-looking, risk-focused approach in our supervision and on-site inspections. For instance, when we develop our annual inspection and supervision policies at the start of the programme year, we analyse and identify priority issues in a forward-looking manner and incorporate them into the annual policies in the coming year. We have positioned the upgrading of risk management at financial firms as one of the priority issues for the current programme year, in light of their growing exposures to investment funds and securitised products.

Another example is a more focused approach in our inspections. The annual inspection policies for banks and insurance companies for the current programme year specify that we intend to take a more focused approach in inspections. For instance, we intend to increase the number of "targeted inspections" for major banks, which focus on specific risks and themes with smaller scale and shorter length.

Pillar III: Encouraging voluntary efforts by financial institutions and placing greater emphasis on designing proper incentives

For the third pillar, a major step forward is the full introduction of the Financial Inspection Rating System in January. Rating results are to be reflected in the frequency, scope and depth of future inspections. In this way, the rating system is expected to provide financial firms with greater incentives to improve their business operations.

Another major step under this pillar is the full implementation of Basel II in Japan, ahead of other major countries. The Basel II framework incorporates various incentive-compatible mechanisms, such as the availability of the Internal Ratings-Based (IRB) approach, greater accuracy in risk measurement, banks' self-disciplined risk management and supervisory review process (Pillar 2), and market discipline through enhanced public disclosure (Pillar 3). Comments from market participants suggest that the implementation of Basel II in Japan has had a positive impact on risk management practices at financial firms, and that it may have contributed to limiting the negative impact of the recent global turmoil on our financial system.

Pillar IV: Improving the transparency and predictability of regulatory actions

With regard to the fourth pillar, the FSA has been continuing its efforts to improve the transparency and predictability of regulatory actions. Our efforts include the publication of Supervisory Guidelines and Inspection Manuals, as well as other important documents such as "Administrative Action in the Financial Sector," which clarifies the criteria for our decisions on administrative actions. We have also published on our website two useful sets of case studies; one on the problems pointed out in past inspections and the other on past administrative actions. We improved our no-action letter system last summer, and have been accumulating various Q&A materials for clearer interpretation of rules. We are conducting public consultation processes in due manner. We recently conducted two public consultations in English as well, that is, one on the notification requirement for foreign audit firms, and the other on the English-language disclosure system.

Progress in the five areas of immediate focus

Now, let me turn to the progress we have made in the five areas of immediate focus laid out in the "better regulation" initiative.

1. Enhancing dialogue with financial institutions and other relevant parties

As you know, the FSA established a regular dialogue with the IBA in April last year. This is our first attempt to engage in such regular meetings with a body representing foreign financial institutions. The FSA-IBA dialogue has been held on a regular basis ever since, and we just had our fourth meeting earlier this month. This offers us the excellent opportunity to exchange views on timely issues directly with CEOs of IBA member firms.

We have extended the use of such regular dialogues to other relevant parties in the financial services community. In addition, we intend to increase the frequency of dialogues with individual firms at the management level. The number of meetings with the management of foreign financial firms has increased by more than 10% from the previous year. Actually, more than 30 CEOs and equivalent executives coming from overseas headquarters have kindly visited me since my appointment as Commissioner, and we have had meaningful exchanges of views.

2. Disseminating information more widely and effectively

We have made progress in this regard through active use of public speeches, press interviews and articles, in English as well as in Japanese. We have also made efforts to utilise press releases more effectively in order to provide timely information on our regulation and supervision. The FSA website was upgraded twice, in August and December of last year, so as to ensure easier viewing and a more systematic structure. Our English website has become richer in content and is being updated more frequently. We initiated an email alert service in English in January, and have received positive feedback from foreign firms and embassy attachés on this service.

3. Strengthening cooperation with foreign authorities

As I mentioned earlier, the recent global financial market turmoil has tested supervisors and central banks around the world on how effectively we can cooperate among ourselves to tackle this global challenge. The FSF's working group that I referred to earlier has been undertaking a leading role in formulating recommendations on how to enhance market and institutional resilience in light of the lessons learnt from the global turmoil. We have been deeply engaged in the FSF's work in compiling its interim report submitted to the February G7 meeting in Tokyo, and its final report submitted to the April G7 meeting in Washington, D.C. We will continue to contribute to the work at the FSF and other international bodies such as the Basel Committee on Banking Supervision and IOSCO (International Organization of Securities Commissions) in implementing the FSF recommendations and monitoring progress.

Another important achievement on the international cooperation front was the success of the IOSCO Tokyo Conference last November. I would like to take this opportunity to thank the IBA and its members for your invaluable support for that wonderful event. With more than 400 participants from around the world, the conference offered us an excellent opportunity to showcase Tokyo as an international financial centre. In addition, the conference enabled us to hold a series of bilateral meetings with heads of securities regulators from around the world.

Subsequently, the FSA became a signatory to IOSCO's multilateral MOU (Memorandum of Understanding) framework in February. This has enabled us to exchange information with foreign securities regulators on a world-wide basis in an efficient and effective manner. The IOSCO's multilateral MOU framework and recent bilateral supervisory arrangements with the Chinese and Dubai authorities are major steps forward toward enhancing our international cooperation.

4. Enhancing research functions so as to better understand market developments

As I mentioned earlier, we have established a new Market Analysis Office so as to intensively collect and analyse market information. This action was taken in light of the growing impact of global economic and financial market developments on our financial system. The results of this analysis are shared within the FSA with a view to helping identify important risks arising in the financial system, and are utilised in our supervision and on-site inspections.

5. Strengthening human resource development within the FSA

This year the FSA began conducting a survey among its staff members about the expertise they intend to develop, such as risk management, compliance, information systems, accounting and financial engineering. The aim of this survey is twofold:  to raise self-awareness among our staff members about their own expertise, and to help us ascertain the expertise of individual staff members. We intend to implement personnel policies with a greater emphasis on the expertise of individual staff members.

Other efforts initiated for the purpose of bolstering human resources include: 1) improving our internal training programmes, 2) sending our staff to overseas graduate schools and external training programmes hosted by foreign regulators, and 3) seconding our staff to foreign regulatory bodies, international organisations, and Japanese embassies abroad. We also intend to continue active recruitment of personnel from the private sector, including lawyers, accountants and individuals with experience at private financial firms.

Highlights of the survey results on our progress toward better regulation

Given the progress we have made as I just described, we are confident that the "better regulation" initiative has had some positive impact. However, we should never become complacent. To assess the actual progress, the FSA conducted a survey in March. Specifically, we asked the respondents if they considered the FSA to have improved since the announcement of the initiative last July in terms of 1) transparency and predictability, 2) dialogue with industry, and 3) dissemination of information. The questionnaire was sent to about 1,500 individuals at regulated firms, and nearly 70% returned responses. Questionnaires were sent to three layers of industry people with different job positions, that is, presidents and CEOs as the first group, board directors, executive officers and general managers as the second group, and division managers as the third group.

The results are in general encouraging. With regard to transparency and predictability, the total percentage of respondents who stated that the FSA had "improved" or "somehow improved" was nearly 80%. The percentage is similar across different sectors, between Japanese and non-Japanese firms, and across different job classes.

As for our dialogue with industry, nearly 60% of respondents replied that the FSA had "improved" or "somehow improved." If we compare the results across firms, the percentage is even higher among non-Japanese firms. It is worth noting that the percentage is higher among higher ranking personnel. Nearly 70% of presidents and CEOs returned positive responses whereas the percentage was below 50% for division managers. Comments from respondents suggest that we should enhance our dialogue with industry at the working levels.

With regard to our dissemination of information, the percentage of respondents replying "improved" or "somehow improved" amounted to nearly 80%. The survey also asked respondents at non-Japanese financial firms specifically how they rated our dissemination of information in English. About two-thirds of respondents said we had "improved" or "somehow improved." This result is encouraging, but we are aware that we need to make further efforts in this area as the percentage of positive responses is somewhat lower than that of information dissemination in general. Comments from respondents suggest that we should make further improvements particularly to the content of our English website.

All in all, the results of the survey that I have just presented can be interpreted as confirming that we have made a certain degree of progress in our efforts toward better regulation. On the other hand, the survey results and the accompanying comments from respondents also suggest that some specific areas require further improvement. First, we should ensure that every FSA staff member fully understands the concept of better regulation. Second, we need to improve dialogue and increase opportunities for frank exchange of views with industry at the working levels. Third, we should improve our dissemination of information, by way of, for instance, increasing the number of briefing sessions and making our website more user-friendly. We have taken these suggestions on board, and the FSA is committed to continuing to make efforts toward better regulation.

Concluding remarks

Our efforts toward better regulation constitute an integral part of our broader agenda to strengthen the competitiveness of our markets. As you are well aware, we announced a "Plan for Strengthening the Competitiveness of Japan's Financial and Capital Markets" back in December. A journal article published in English described the plan as "inelegantly" titled, and I think this is a fair comment. The title is so long that I got tongue-tied quite often when saying it. Therefore we have decided to use a new, short nickname for the plan, and from now on we will call it "Better Market Initiative (BMI)." We believe that "better market" and "better regulation" can be good twin concepts. It may not be a flashy and impressive naming, but, as you know, understatement and euphemism is one of traditional virtues of Japanese culture. So, from now on, please use this new name as frequently as you can in order to make it popular.

In terms of the implementation of this BMI initiative, we took a great stride forward earlier this month with the passage of the bill that will enable various measures envisaged in the initiative to be realised. This legislation includes such important items as 1) creation of new, deregulated exchange markets exclusively for professional investors, 2) diversification of ETFs (exchange-traded funds), 3) revamp of the firewall regulations, and 4) broadening of the scope of businesses permitted to banking and insurance groups, such as emissions trading and commodity spot trading. Going forward, it is critically important that financial firms themselves redouble their efforts to take full advantage of the new legislation and regulatory reforms on their own initiative, and compete with each other to provide better financial services.

On our side, the FSA needs to continue improving the quality of regulation and supervision. As I have often said on various occasions, the quality of regulation is a crucial determinant of the competitiveness of the financial markets to which it is applied. Realising better regulation is easier said than done. It requires continuous effort on our side at every level. The FSA is committed to continue educating its staff in order to ensure that every FSA staff member possesses the right mind-set for better regulation. We plan to continue publishing progress reports on the "better regulation" initiative every six months, so that our efforts can be assessed on a regular basis.

Thank you.