Putting the current financial crisis in perspective

Introduction

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

Since starting my current position at the Financial Services Agency (FSA) in July 2007, one of the issues I have focused on is “Better Regulation,” an initiative aimed at improving the quality of financial regulation. At its initial stage, I was anxious to promote this initiative at speeches and media interviews as an overarching theme of the FSA’s work in the coming years. Soon after the start of the initiative, we found ourselves in the center of media and public attention. It was indeed an opportune timing, but there was one slight problem. That is, our public relations efforts for Better Regulation were wiped out by the global financial market turmoil that erupted that summer. As a result, Better Regulation has not had as high a profile as I initially hoped.

However, it is important for regulators to be flexible enough to respond to rapid developments in the financial industry and markets. As I will explain to you later, risk-focused approach is one of the essential elements of Better Regulation. In that sense, it looks as if the current financial difficulties have been testing our resolve to achieve Better Regulation from the beginning.

Thus the topic of my speech today is inevitably how to deal with the current financial crisis. On this issue, various discussions have already been made as to how the current global crisis can be compared with Japan’s financial crisis in the 1990s, and what kind of policy lessons can be learned from Japan’s experience. I myself delivered a few speeches from this viewpoint, which are posted on the FSA’s website, including one in English. I will therefore refrain from repeating this discussion today.

Rather, it may be interesting to look at how Japan’s current situation can be compared with its own financial crisis in the 1990s. This will constitute the first part of my speech. Then I will move on to describe the policy response by our fellow authorities abroad to address the current crisis, and the measures taken by the FSA in recent months. Finally, I will briefly talk about Japan’s unique position in terms of financial regulation.

1. Comparing Japan’s current situation with its experience in the 1990s

Now let me start by discussing Japan’s situation now and that in the 1990s.

As the financial market turmoil has intensified since the collapse of Lehman Brothers last September, it seems that the word “once-in-a-century” has become the most familiar adjective to describe the extent of the current global crisis. I understand this word has been widely cited since former Federal Reserve Board Chairman Alan Greenspan mentioned in a testimony to United States Congress, in which he compared the current financial crisis to a great tsunami.

Certainly, the period since last September will surely be long remembered as a historic period of the financial world. As you all know, once-mighty American investment banks have all disappeared as standalone entities. The world’s central banks have taken extraordinary actions to provide liquidity of an unprecedented scale, while U.S. and European authorities have intervened heavily in their financial institutions in the form of capital injection, nationalization, full protection of bank deposits, and credit guarantee.

The effect of the market turmoil has spilled over to the real sector, and the world may already have plunged into a negative spiral of financial instability and deterioration of the real economy. This kind of spillover effect had been observed also in similar crises in the past, including the Asian crisis in the late 1990s. The current crisis seems to be much more serious, however, because the epicenter of the crisis is the world’s largest economy. It therefore looks as if the rest of the world economy is being dragged down by the crisis on Wall Street.

Needless to say, Japan cannot be immune from the effect of this downturn. On Thursday last week, the Bank of Japan revised down its forecast for the country’s real GDP growth for Fiscal Year 2009 to minus 2 percent. This is the worst since the end of the Second World War. The Bank also says that Japan's economic conditions are likely to continue deteriorating for the time being as domestic and overseas demand is expected to decline. No one doubts the seriousness of the current economic downturn, and that is why the Japanese government has been taking various measures with a sense of urgency.

It is also true that the global economic slowdown and market volatility have hit Japan’s financial sector as well. The financial results of Japanese banks at recent quarters have reflected significantly reduced profits, due to rising credit costs and sharp declines in share prices. Those of brokerage firms have also been poor following reduced transactions and valuation losses on securities. This week or next week, many of Japan’s major financial firms are due to report their financial results for the period from October to December 2008.

Given the seriousness of the impact it has had on the global economy, it is not without reason that the current financial crisis has been labeled as “once-in-a-century.” As you all know, however, it was not so long ago that Japan experienced the last serious crisis. Remembering my own experience in the financial regulatory authority ten or so years ago, my feeling is rather that the current financial stress is the “second-in-a-decade" in my country.

On the other hand, the current stress seems to differ significantly from the difficulties we faced in the 1990s. I think the following three points can be pointed out as the main sources of the difference. While the first two are comforting in the current context, the last point makes us rather more pessimistic:

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 the real economy is not expected to recover rapidly for some time. At the same time, Japan’s financial system has so far maintained its relative soundness. Japan’s financial sector is therefore increasingly relied upon in supporting the real economy and preventing its further deterioration.

2. Policy response to the current crisis, here and abroad

Now let me turn to the issue of how the authorities in Japan and abroad have been responding to the current global financial crisis. As I mentioned earlier, Japan’s current financial situation differs somewhat from what we faced in the 1990s. On the contrary, the current situation in the U.S. and the U.K. rather has some similarities to Japan in the 1990s in that the root causes of the crisis is endogenous in their markets. This has been reflected in the policy measures taken so far by the authorities to deal with the problems.

Policy response in the United States and Europe

In the U.S. and Europe, the authorities have been taking a number of exceptional measures, including capital injection with public funds, nationalization of banks, and full protection of bank deposits. As financial regulators, these exceptional measures are the last actions we want to take. For one of Japan’s long-serving regulators like me, however, most of the measures taken by our fellow regulators seem to come under one or more categories of measures we took in the 1990s and the early 2000s.

Of course, the current crisis differs significantly from Japan’s past crisis in some important aspects.

• In the current crisis, risks were scattered through the markets to a wide range of investors by means of securitization;
• Western banks have been forced to write down securitized products promptly due to mark-to-market accounting;
• The losses have been dispersed globally through the use of the “originate-to-distribute” business model, causing severe slowdown of the global economy; and
• Since the securitized products are traded on the markets, the current crisis has a strong cross-border character.

Reflecting these differences, the measures being taken to tackle the current problem inevitably become more market-oriented, and international institutions and groupings, such as the Group of Seven, the Group of Twenty, and the Financial Stability Forum (FSF), are playing a leading role in developing and coordinating policy response.

That said, our experience in the 1990s and the policy response by the U.S. and European authorities this time clearly show that taking these kinds of exceptional measures is critical in avoiding a system-wide financial breakdown. It may be arguable whether Japan in the 1990s was a success story in dealing with a system-wide crisis. It seems to me, however, that Japan’s past experience has provided useful suggestions as to how our fellow regulators should respond to the current financial crisis.

I am not going to repeat this discussion since I have already summarized my views on the lessons learned in other speeches, including the one in English I delivered on October 25th last year. Here, I would like to highlight just a couple of points. One of the lessons relevant in the current context is the need for prompt and accurate recognition of losses stemming from toxic assets. It seems that U.S. and European firms and authorities are faced with significant difficulties in this respect. Certainly, the financial firms have made prompt disclosure of their exposure to, and losses on, complex financial instruments. However, substantial uncertainties do remain with regard to valuation of financial assets when market liquidity for these assets has dried up. In addition, firms do not have an incentive to take these toxic assets off balance sheet, as it would result in further huge losses. In such a situation, it may be difficult to dispel the concerns of market participants as long as the firms hold these assets. It could therefore take a considerable amount of time until market confidence in the financial system is fully restored.

Another relevant suggestion from Japan’s experience is the need to implement short-term measures and medium-term re-design of the regulatory framework in a simultaneous and balanced manner. While the work to extinguish the burning fire as soon as possible is of course necessary, it is also essential to put in place a framework to prevent the recurrence of the same kind of crisis. On the one hand, if the policies lean too much toward crisis management, it could cause moral hazard or distort the system in the longer run. On the other hand, hasty implementation of medium-term measures could rather exacerbate the situation and make crisis management even more difficult.

I think the relevance of this suggestion is reflected in the keyword among the world’s major financial regulators today, which is “orderly de-leveraging.” Substantial de-leveraging in the global financial system is unavoidable and necessary, following the excessive risk-taking in the credit boom and the accommodative financial environment. At the same time, there is a clear need to maintain financial intermediary functions, particularly financing to the corporate sector, in view of the current severe macroeconomic conditions. This is why the authorities around the world have taken exceptional measures to intervene in financial institutions, while advancing on their efforts to put in place a more robust regulatory framework. The latter strand of policies has been put forth in the recommendations made by the FSF in April last year. Regulators are never able to escape the fate of pursuing two possibly conflicting objectives at the same time.

Measures taken in Japan

Compared with the U.S. and Europe, I think Japan’s financial system itself is still in a less severe condition. In terms of the losses incurred and the exposure to securitized products, the direct impact of the financial market turmoil on Japan’s financial system remains relatively small. Yet the global financial crisis has had a significant adverse effect on Japan’s financial sector as the country’s real economy has deteriorated and share prices have declined sharply. In particular, we have grave concerns about the severe environment surrounding small- and medium-sized enterprises (SMEs) and local economies, including their financing. It is therefore important that we remain on heightened alert and take measures necessary for stabilizing the financial system in a swift and effective manner.

From this standpoint, the FSA has implemented or supported several measures aimed at alleviating the adverse effect on Japan’s real economy of excessive volatility of market prices caused by the global financial market turmoil.

In parallel with these short-term measures, the FSA is also advancing on strengthening the regulatory framework from a longer-term perspective. This work is in line with the recommendations put forth by the FSF and is even ahead of them on some issues. For example,

3. Japan’s unique position in financial regulation

Thus like our fellow regulators abroad, the FSA is also pursuing two possibly conflicting objectives at the same time. That is, we have been taking short-term measures to contain the adverse effect of the ongoing crisis, and working on medium-term re-design of the regulatory framework in a simultaneous manner. In Japan’s case, however, the re-design of the regulatory framework has yet another dimension. Namely, the FSA is working on a couple of medium-term and proactive policy challenges. One is Better Market Initiative, and the other is Better Regulation. This is the reason why I say Japan’s current position is unique.

“Better Market Initiative (BMI)” is a concrete policy package to strengthen the competitiveness of Japan’s financial markets by creating a reliable marketplace and enhancing the business environment of financial firms. The measures include diversification of ETFs (exchange-traded funds), reform of the firewall regulations, and expanding the scope of business for banking and insurance groups. The implementation of the BMI is well on track. The necessary legislation has already been enacted and most parts of it took effect last December, while the deregulation on firewalls will take effect in June.

I mentioned Better Regulation at the beginning of this speech. It refers to improving the quality of financial regulation by enhancing its effectiveness, efficiency, consistency and transparency. Better Regulation centers 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 incentivizing voluntary efforts by the private sector; and
• Improved transparency and predictability of supervision.

Good progress has been made in these efforts, as summarized in the two progress reports issued last May and December. It includes the agreement with financial firms and other relevant parties on the fourteen guiding principles for the financial industry, effective allocation of administrative resources to deal with the current financial market turmoil, planned introduction of a new regulatory framework that promotes self-discipline of financial groups to prevent conflicts of interest, as well as a wide range of publications of supervisory guidelines and interpretation of rules.

In this connection, some may wonder whether both initiatives now need fundamental overhaul in view of the ongoing financial crisis, as they include various elements of deregulation. Others might hastily conclude that they would have to be suspended or even scrapped.

Therefore, I would like to make it clear here that both the BMI and Better Regulation remain valid and the efforts in this direction will continue.

The need for internationally competitive markets is clear in order for Japan to sustain economic growth with the aging and shrinking population. While the BMI certainly aims, in some aspects, to pull Japan’s markets up to level with London and New York, this does not mean that we are trying to imitate them completely. In view of the ongoing crisis, it will be important that we examine carefully whether there are any measures in the BMI that may require modifications, taking into account their consistency with 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.

With regard to Better Regulation, it does not contradict the current trend of “re-design” of the financial regulatory structure as represented in the FSF recommendations. While streamlining outdated provisions and taking care to avoid excessive regulation that could stifle innovation, Better Regulation aims to enhance the efficiency and effectiveness of the regulation that is truly needed. I would rather say that Better Regulation was even ahead of the current trend in terms of its focus on strengthening international cooperation, close monitoring of market developments, enhancing dialogue with the financial industry, and risk-based approach. The FSA will continue to make efforts to consolidate and further advance the initiative toward Better Regulation.

Concluding remarks

Finally, I would like to point out that the financial business may be in a process of change.

Having experienced the current crisis, the global financial markets are clearly in need of substantial adjustment, including correction of excessive leverage, misaligned incentives favoring short-term profit-raising, and excessive reliance on credit ratings. In order to prevent the recurrence of a similar crisis, financial regulators around the world need to re-design the regulatory framework, as indicated in the FSF recommendations.

It seems to me that implementing these recommendations could eventually lead to a financial world more firmly based on value-adding activities in the real economy. This trend may favor countries like Japan that has a large real economy and a strong manufacturing sector with advanced technologies. Its geographical proximity to the Asian region could also become another advantage to Japan’s financial markets, because a relatively high economic growth can be expected of the region over the long run.

At the same time, implementation of “Better Regulation” and “Better Market Initiative” will broaden the opportunities in Japan’s financial markets for investors, fundraisers, and financial firms from all around the world, once the current crisis is behind us. While I cannot predict with confidence what the financial world would be like post-crisis, it is my hope that Japan’s presence as an international financial center will be significant in that financial world. The FSA is determined to continue our efforts to this end. At the same time, it is also essential that the financial industry and other actors in the private sector also take necessary actions. I expect them to share our goal and to make their own efforts to raise the attractiveness of Japan’s economy and financial markets.

Thank you.