Luncheon Address
Akira Watanabe
General Manager & Regional Executive of Singapore
The Bank of Tokyo-Mitsubishi, Ltd.

1Introduction

I am very pleased to be here for this important conference on risk management
and systemic risk. It is a great honor to have been asked to make this luncheon
address. I do thank the Bank of Japan for organizing this event and also for inviting me.
Today, I have been asked firstly, to make some comments on the papers
prepared for the conference and thereafter, share some thoughts on the major
systemic risk issues we are facing in the global financial markets from a practitioner’s point of view.
Before I move on, I should like to touch briefly on my personal background. I
have been involved in derivatives since the early eighties. As a board member of
ISDA as well as a working group member of G-30 Global Derivatives representing Japanese financial institutions, I have participated in the development of theframework on capital rules, risk management method, legal netting and market
information survey for derivatives in collaboration with various supervisors,particularly the Bank of Japan and BIS.
Over the last four years, I was in charge of capital markets operations inLondon and recently in July, I moved to Singapore where I am now responsible
for banking in this region. Like anybody else in the financial markets, I had
experienced many financial crises in both the capital markets and commercial
banking sector during the last eighteen months. I would like to talk on these later.

2Comments on research papers

First of all, let me briefly touch on the research papers presented at our conference this time. An overall impression I have is that the topics covered by thepapers are very well-diversified. They range from statistical analysis on market
data, quantitative measurement of risks, model analysis of market behavior topolicy discussion on supervisory framework. The role of central banks as lendersof last resort was also addressed.
Also, if we compare this year’s research agenda with that of the previous
conference in 1995, we can see a noticeable difference between the two. The 1995

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research agenda focused more on the risk management side while the focus thisyear is on the systemic risk side; the key word for the 1995 conference being“value-at-risk” while the key word for this year is “contagion.”
More specifically, in 1995, many papers discussed various techniques on how
to quantify risks, both market and credit, and how to manage them using models.
Evaluation of effectiveness of these models was also performed based on empirical analysis. In 1998, the priority of market analysis shifted towards that of amarket movement under stressful conditions in one market and its contagious
effect on the other markets. The concept of systemic risk has also been reviewed
in the context of a contagion effect and detailed analysis on how contagion will
emerge in various sectors of the financial system has been conducted.
What is the reason for such a difference? In 1995, liquidity was growing in
the market through financial innovation and globalization. Those days, we saw arapid and significant growth of new derivatives, securitization and emerging
markets. Also, cross-market trading by hedge funds provided a lot of liquidity inthe markets. Therefore, the needs for more accurate and effective pricing, risk
management and risk/return analysis using advanced models were urgent at thattime.
In 1998, however, the picture of financial markets changed completely. Several major market disruptions have taken place over the last eighteen months andglobal financial markets today are threatened by potential systemic crises. Also,
excess liquidity has turned into a shortage which is beginning to cause either amarket malfunction or dislocation of credit.
When I read the research papers against this background, I found them allvery useful and informative. The following papers were particularly intriguing tome.
· De Bandt and Hartman’s paper titled “What is Systemic Risk Today” thatprovides a comprehensive overview of systemic risk in banking markets,securities markets and payment systems.
· Kodres and Pritsker’s paper titled “A Rational Expectations Model ofFinancial Contagion” which presents an extensive model analysis of a contagion process.
· Shimizu and Ui’s paper titled “Contagious Expectations and Malfunctionsof Markets” that explains the current liquidity crisis situation of Japanesefinancial markets through model analysis on the contagious effects of expectation.
· Yoshifuji and Demizu’s paper titled “A Study of the Mechanism ofStress/Shock Movements in Financial Markets” that attempts an innovative
approach derived from complexity theory to produce a market behavioralmodel.

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Recent financial crises

Next, I would like to review three recent financial crises in the context of systemic risk; namely the Asian currency and debt crisis, the collapse of Long-Term
Capital Management and the non-performing loan problems of Japanese banks.

3.1

Asian currency and debt crisis

The Asian currency and debt crisis which began with the devaluation of the Thai
Baht in June 1997, spreading over to the other countries in the region, was unprecedented in terms of gravity and velocity.
The sharp drop in prices of currencies and equities and the ensuing soaring
interest rates caused negative impact on the real economy. This was followed by
the breakdown of the financial system and the occurrence of corporate failures inmost countries hit by the crisis. We also witnessed a severe drain of liquidity
which created a credit crunch. Contagion was another characteristic of the crisis.
It spread out quickly not only to the other countries in the region but also to suchother emerging markets as Russia and Latin America.
Excess liquidity is regarded as a primary cause of the crisis. It created a“bubble” in both the real economy and the financial markets, destined to burst.
The crisis was also exacerbated by poor currency and debt management; i.e. overvaluation of currency and heavy dependence on short-term foreign capital. A
weak banking system and political instability in some of the countries worsened
the crisis further. The contagion was thought to have occurred due to a swiftchange of market expectation towards emerging markets. Investors moved
quickly to liquidate their investment portfolios and arbitragers created shortpositions in currencies, equities and debts using mostly derivatives in thoseemerging market countries with similarly weak fundamentals. In a globalized
capital market where capital and information flow very fast, contagion is unavoidable.
One of the by-products of the Asian currency and debt crisis was the threat tothe payment system for off-shore Malaysian ringgit which arose from a sudden
imposition of capital controls by the Malaysian government. On September 1, theMalaysian government announced a new rule which effectively banned the holding of Malaysian ringgit by non-residents. It also required the transfer of all
ringgit accounts from off-shore to on-shore as well as early settlements of allexisting foreign exchange contracts involving ringgit within a very short period oftime. Depositors and exporters and importers in Singapore where a majority ofoff-shore ringgit had been traded went into a panic because all the off-shore
ringgit accounts and contracts would become either worthless or invalid after thedeadline. Potentially, that could have caused a systemic risk as the amount of offshore ringgit outstanding was equivalent to tens of billions of US dollars. However, due to very diligent work and close cooperation amongst banks and between
banks and MAS, a swift decision was reached to settle all the ringgit contracts in30

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US dollars at a suggested exchange rate as a guideline. Eventually, most of thedeposits and foreign exchange contracts were either paid out or cash settled in US
dollars in an orderly manner.
Except for Mr. Soros who praised the prompt solution in his testimony before
the US Congress, this incident did not attract much attention from the world
financial market. However, it did prove that close cooperation between banks andthe central bank and quick action taken by them were the keys to preventing a
potential systemic failure from occurring.

3.2

Collapse of long-term capital management

Long-Term Capital Management, a prominent hedge fund, collapsed due to losses
arising from huge positions accumulated through the so-called leverage play.
The collapse could have caused a serious market disruption, politically a systemic
risk, since it was a dominant market player and a sole liquidity provider in somemarkets. Any large-scale liquidation of its positions or additional losses from firesales would have resulted in significant losses to banks who had loans or counterparty exposures even though most of them were collateralized. Also, as manybanks had copy-cat positions on their own books, such liquidation would havefurther aggravated the lack of liquidity in the markets. In other words, LTCM was
too big to liquidate.
The Fed eventually intervened by organizing a consortium of banks which
injected new capital into LTCM, thus preventing a major market disruption. The
purpose of this intervention by the Fed was, I believe, not to rescue LTCM, but tolighten the problem by allowing for ordinary liquidation of its huge positions overtime. Again, I regard the prompt action based on close cooperation between banks
and the central bank as a key to preventing the occurrence of a systemic failure.
There are a number of implications for systemic risk which can be derived
from this incident; inadequate disclosure by unregulated financial institutions,correlation risk in the market place by commonality of positions, lack of liquidity
due to the disappearance of a dominant market player and difficulty in obtaining
reliable price information in an extremely volatile and illiquid market.

3.3

Non-performing loan problem of Japanese banks

The non-performing loan problems of Japanese banks have posed an increasing
threat to the stability of the Japanese financial system. We have already seen a
few major failures over the last eighteen months. The current level of provisions
for non-performing loans is regarded as insufficient and uncertainty remains withrespect to true financial condition due to the lack of disclosure and arbitrary
accounting. As such, major international credit rating agencies have successively
downgraded Japanese banks, making Japanese banks’ foreign currency funding
operations in the international money markets more difficult and expensive. In themeantime, efforts by Japanese banks to increase capital adequacy ratios by scaling down on lending to corporations have caused a severe credit crunch.

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In order to remove this uncertainty surrounding them, Japanese banks must
resolve their non-performing loan problem once and for all. They should not be
hesitant to accept public funds to reinforce capital after taking sufficient provisions for non-performing loans. Otherwise, this credit crunch will continue,
choking up corporate activities essential for the recovery of the real economy
which, in turn, will deteriorate the banks’ balance sheets further.

4Systemic risk in today’s financial market and proposed
initiatives

I have just reviewed three major financial crises which we have seen over the lasteighteen months. Among the causes for the crises, be it the severe economic
slump, the hang-over from large unliquidated positions or credit deterioration due
to non-performing loans, the common feature of systemic risk which we face inthe global financial markets today is the contraction of liquidity.
A bank’s role as a financial intermediary is to provide liquidity to corporations as a lender or to the market as a market-maker by taking credit and market
risks. However, the risk-taking capabilities of banks, particularly those of Japanese banks, have been curtailed sharply and liquidity in the market place has also
reduced significantly.
In order to cope with such a shortage of liquidity, Japanese banks must remove this uncertainty by taking adequate provisions for non-performing loans,restore capital using public funds and upgrade their credit rating by adopting
more transparent disclosure and international accounting standards.
Needless to say, proactive risk-taking activities of banks must be supported bystrong risk management infrastructure; both systems and practices. In this respect,taking lessons from the recent crises into account, a very robust stress testing forrisk management purpose is important. Also, in collaboration with central banks
and BIS, banks should work towards re-modeling the current capital rules so as toreflect credit risk, market risk and liquidity risk more accurately.
Concentration risk in terms of a liquidity provider has also been highlighted in
the LTCM case. As we have seen an increasing concentration of market-making
activities for derivatives and securities trading into a small number of financial
institutions, notably a few commercial banks and investment banks in the U.S.,
further research work to study its impact on systemic risk will be necessary.