Masaru Hayami: The impact of innovation in information and
communications technology on financial systems
Speech by Mr Masaru Hayami, Governor of the Bank of Japan, held at Kisaragi-kai, Tokyo, on
5 October 2000.
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It is an honor to be invited and given this opportunity to speak at Kisaragi-kai. Today, I would like to
share with you our thoughts on changes in Japan's financial system against the backdrop of the rapid
pace of innovation in information and communications technology, and how, under such
circumstances, we should continue improving both the stability and efficiency of the financial system.
The recent rapid evolution of information and communications technology, which is generally called
the "IT revolution", has been exerting a profound impact on economies and finance as a whole. In the
United States where such technological innovation has been one of the driving forces behind the
longest period of economic expansion in its history, there are views that a new economy that is totally
different from the old economy has been born. Some even claim it is comparable to the Industrial
Revolution of the 19th century. Though it will be a long time before economic historians can make an
objective assessment of innovation in information and communications technology, which is still
under way, there is no doubt that it has had a profound impact on economies and finance as a whole.
Indeed, I don't think I need tell you that technological innovation has brought about the speedy
processing and transmission of information enabling a substantial reduction in costs, wider
networking, and globalization on an unprecedented scale and scope. Moreover, it has affected a wide
range of industries, having a particularly dramatic impact on the financial services industry.
Man created an instrument called "money", which is a unit of account, a means of exchange and a
store of value, for the smooth execution of economic activity. The financial services industry is closely
related to this instrument we call money, and its core business is based on information processing and
networking. Therefore, the financial services industry has been a major user of information and
communications technology, and, significantly, it is an industry that can easily take advantage of
technological innovation. As we all know, computers and exclusive communications networks have
greatly contributed to improving the efficiency and safety of business, for example, in retail deposit
taking where an enormous amount of information must be processed and recorded as well as in fund
transfers and domestic and foreign exchange where extensive networks are required. Furthermore, the
recent rapid growth of derivatives and securitization has been made possible through downsizing and
the spread of computers.
Changes in the financial system stemming from the recent advance of information and
communications technology are not limited to improving the efficiency of traditional businesses and
enabling the development of new instruments in specific fields. Here, a good example is the
development of a new supply channel for financial services, namely the internet, which has made it
possible to establish extensive and low-cost financial networking. Traditionally, the provision of
financial services was very much dependent on the branch networks of financial institutions. But now,
information and communications technology has enabled the more diversified and convenient
provision of financial services, including via the internet and unmanned ATM networks.
The creation of a new supply channel for financial services has substantially reduced the cost of
financial transactions. For example, internet banking has greatly lowered the processing cost of
banking. According to research conducted in the United States, in some cases processing by the
internet is estimated to cost less than one hundredth what it does at a bank branch window.
Furthermore, the emergence of a new supply channel for financial services and the substantial
reduction in processing costs have brought forth changes in the composition of financial service
providers. One example is entry into financial services by non-financial business firms. While the
provision of financial services was traditionally via the branch networks of financial institutions
featuring vaults and lobbies, the emergence of new supply channels such as internet banking and
unmanned ATM networks has made it possible to convert without much difficulty networks used for
non-financial activities into ones that can provide financial services.
The reduction in processing costs of financial transactions and the easy conversion of non-financial
networks to financial ones have created a profitable opportunity for non-financial business firms to
enter the financial services industry by selecting such specialized areas as payment and settlement
without needing the synergies obtained from accepting deposits and extending loans. Because entry
into selected financial services has become possible, it appears that the initial entry cost has been
further reduced and the incentive for non-financial business firms to enter the sector further
strengthened.
Following revision of the Securities and Exchange Law in 1998 that permitted entry into the securities
field through simple registration instead of licensing, quite a few non-financial business firms began to
engage in securities activities. And recently, some non-financial business firms have announced plans
to start banking operations. Such active entry into banking has not been seen since 1993 when the
Financial System Reform Law was enacted and securities houses began entering the banking area
through subsidiaries. The reduction in entry costs, thanks to technological innovation in information
and communications, has enabled not only mutual entry into each other's field between banks and
securities houses within the financial services industry, but also new entry into the financial services
industry by non-financial business firms.
The advance of information and communications technology has not only strengthened the incentive
of non-financial business firms to engage in banking but also urged existing financial institutions to
review their management. Recently we have observed various forms of alliances and reorganization
among financial institutions, and particularly conspicuous is the movement of major financial
institutions toward M&A and consolidation among themselves. The main aim of the movement toward
mega-banks is for financial institutions with different niches to strengthen competitiveness by
complementing each other. Under the current situation where information and communications
systems might strongly affect competitiveness, it is indispensable that financial institutions effect huge
IT-related investments to strengthen their competitive position. Thus, it cannot be denied that the
incentive to rationalize IT-related investments in overlapping fields, thereby alleviating the financial
burden and making it possible to increase IT-related investments in strategic areas, has been a big
driving force behind financial consolidation.
While innovation in information and communications technology will bring about advances,
diversification and improved efficiency, thus eventually leading to better services for users, it is also
true that more information-oriented financial services and networking will give rise to greater and
more complex risks, the quicker transmission of such risks, and possibly new types of risks. For
example, the diversification and greater use of derivatives has resulted in more complex and bigger
risks. Moreover, financial globalization has further deepened the linkage of financial markets both at
home and abroad, thus significantly increasing risk of financial turbulence in one market being
transmitted to other markets overseas. The spread of financial networks has further exacerbated the
possibility of illegal entry into computer systems by hackers, leading to the diversification and
proliferation of operational risks.
What should be our basic attitude toward changes in the financial system generated by innovation in
information and communications technology? Given that innovation will further proceed in terms of
both transmission speed and scope, and since it is a major driving force promoting structural reform,
one of the most important agendas for the current Japanese economy, we have no alternative but to
embrace innovation and try to reap the maximum benefits.
Before I elucidate on this, let me summarize the main points of what follows. First, technological
innovation proceeds very rapidly, and it is not easy to foresee its impact on the financial system.
Under such circumstances, we should be positive and flexible in responding to changes in the financial
system. Second, it is not appropriate to maintain financial system stability through traditional ex ante
regulations since they would nip the seed of private sector innovation in the bud and weaken the
dynamism of financial markets. To realize both an active and stable financial system, we rather need
to emphasize risk management and market discipline.
There is a possibility that innovation will ultimately make the existing financial system obsolete,
threaten the status of financial institutions that have traditionally provided financial services, change
the nature of deposits at banks, and eventually the currency created by the central bank. In view of
accelerating technological innovation, those who are involved in the financial system, including the
central bank, should bear such possibilities in mind. But before that eventuality occurs, existing
financial institutions will most likely strive to improve the financial services they offer by taking
advantage of technological innovation. Thus, it can be anticipated that competition between existing
financial institutions and the new entrants will continue for a long time.
So far, changes in the financial system generated by innovation in information and communications
technology have been gradual with the existing framework being improved step by step. For example,
non-financial business firms, which intend to enter the payment area, will establish subsidiaries to
acquire banking licenses and accept deposits, which are the traditional medium of payment, rather than
establish firms that will introduce a new medium of payment. This suggests that, in such areas as
payment where the existing infrastructure can be utilized, at least for the time being traditional
institutions and transaction channels, like banks and deposits, will be more useful than otherwise. In
other words, technological innovation has progressed to the point where barriers to non-financial
business firms entering financial services have been lowered, but not to the extent where the existing
framework has been made completely obsolete.
It appears that rapid technological innovation and subsequent changes in the financial system have
thus far had little effect on the fundamental functions of finance, including the transfer of funds from
fund surplus to fund shortage sectors, the reallocation of risks, and payment and settlement.
To summarize so far, while it is true that technological innovation may significantly change the
financial system, there exists great uncertainty regarding the extent and speed of change. Therefore,
when responding to change, we should be positive and flexible while paying close attention to
uncertainty.
Then, what should we do to reconstruct an efficient and stable financial system under the rapid
advance of information and communications technology? In Japan we have traditionally emphasized
detailed ex ante regulations and specific guidelines for individual financial institutions as ways to
maintain financial system stability. It cannot be denied that such measures have, to some extent,
contributed to the stability of Japan's financial system characterized by the strict segmentation and
specialization of business areas. However, over-dependence on ex ante regulations and specific
guidelines will undermine the incentive for management to pursue differentiation because the
development of new instruments is not linked to initial rewards attaching to innovators, thereby
leading to the spread of a "keep up with the Joneses" mentality among financial institutions.
Furthermore, we might have to pay a huge price in terms of the weakened vitality of the financial
system as innovation and competition are hindered. Currently, the "Big Bang", which is based on the
basic principle of free, fair and global, is being promoted in Japan, and we have effected a wide range
of reforms, such as the diversification of financial instruments and services, the promotion of
competition in the financial services industry and the improvement of financial markets. These
reforms are much needed to invigorate financial markets and should be further effected as
expeditiously and steadily as possible.
The truth of the matter is that with the rapid advance of innovation in financial technology we can no
longer maintain financial system stability solely through traditional ex ante regulations. It has become
impossible for the authorities to foresee changes and the direction of financial markets and
transactions and to implement detailed regulations in advance.
When changes are dramatic and entail a lot of uncertainty, it is important to further emphasize risk
management and market discipline in order to maintain financial system stability without impairing its
efficiency. Though we cannot exclude uncertainty regarding the impact of the advance of information
and communications technology on the financial system, what is crystal clear is that financial
institutions will need a risk management ability corresponding to the advances in information and
communications technology. It is thus a prerequisite for financial institutions to improve risk
measurement methods so as to accurately grasp more complex risks and establish an appropriate
capital base in order to win amid intense competition. In the process of innovation, risk management is
also the object of innovation, and only those who succeed in risk management will be able lead the
world. Technological innovation has made traditional thinking that believes risk management is a cost
completely outmoded. Financial institution management must realize that risk management is a way to
maximize profits. While risk management has hitherto been primarily concerned with the management
of credit risk, in the future financial institutions will have to construct advanced risk management
systems covering operational risk and interest rate risk in banking accounts, and also establish a high
quality capital base consistent with the level of risks they carry.
To establish a more efficient and stable financial system, market discipline is important. It is necessary
that financial institutions constantly strive for sound management and higher profitability fully
realizing that their every move is being closely monitored by the market. From this viewpoint, it
becomes important for them to actively disclose their financial conditions according to appropriate
accounting methods. In this regard, we have received criticism from abroad that accounting methods
and disclosure standards in Japan need to be improved in a number of areas. In response, I have to say
that based on the lessons we learned from the bursting of the bubble we have been rapidly improving
the infrastructure related to disclosure, including improvement of the standards for write-off and the
provisioning of non-performing assets. Also, consolidated balance sheets have been refined and
markto-market accounting expanded from the viewpoint of international compatibility. In the area of
corporate information disclosure, markets have begun to positively evaluate those firms that see
legally required disclosure standards as minimum standards and which at their own initiative disclose
management strategy and financial conditions beyond such minimum standards. I hope these
movements will further prevail and take firm root in Japan.
How should the Bank of Japan respond to changes in the financial system as innovation in information
and communications technology progresses? Before examining this issue, let me begin by briefly
reviewing the role of the Bank of Japan in the context of the financial system and the payment system.
In general, banknotes issued by the central bank finalize the payment of transactions when handed
over to transaction counterparties. Similarly, current accounts with the central bank can also finalize
payment, a function which is supported by public confidence in the central bank. As such, settlements
through the liabilities of the central bank, namely banknotes and current accounts, possess "finality" in
the sense that they completely settle payment. Furthermore, various private sector clearing systems
eventually complete fund settlement as well as securities settlement by directly or indirectly making
use of the medium of settlement with finality conferred by the central bank. Thus, each payment
system is operated in a responsible manner by a respective steering body, and the central bank is
responsible for maintaining the smooth and safe operation of the nation's overall payment systems.
Article 1 of the Bank of Japan Law clearly stipulates that the Bank's mission is to maintain the smooth
and stable operation of Japan's payment and settlement systems: "The objective of the Bank of Japan,
... , is to issue banknotes and to carry out currency and monetary control. In addition ..., the Bank's
objective is to ensure the smooth settlement of funds among banks and other financial institutions,
thereby contributing to the maintenance of an orderly financial system."
To fulfill this mission, the Bank of Japan performs a variety of functions. First, it provides the medium
of settlement in the form of Bank of Japan notes and current account services, and constantly strives to
improve efficiency and safety. Its function to examine the authenticity of banknotes and prevent
counterfeiting while securing the efficient circulation of banknotes lays the foundation for public
confidence in banknotes. Furthermore, the Bank has been making various efforts to improve the
efficiency and safety of the settlement system for funds and government securities by providing online
services for current accounts through the BOJ-NET system.
In addition to such efforts, the Bank of Japan conducts on-site examinations and off-site monitoring of
financial institutions that hold current accounts with it, and obtains information regarding their
financial strength and risk management. If a financial institution faces a liquidity shortage that might
seriously impair the smooth operation of payment systems, the Bank of Japan will provide liquidity as
the lender of last resort, thereby preventing systemic risk from emerging.
With this preamble, let me turn to the role of the Bank of Japan in securing efficient and safe payment
systems, thereby maintaining financial system stability under innovation in information and
communications technology. Payment systems in Japan consist of those operated by the Bank of Japan
and private sector ones. In view of the fact that payment systems are a fundamental infrastructure for
economic activity, it is always important to maintain the safety of payment systems as a whole
regardless of whether technological innovation creates a new provider, a new channel or a new means
of payment. In this regard, all related parties, that is, financial institutions, the steering bodies of
private payment systems and the central bank, need to be in close contact and make efforts to
discharge their respective responsibilities.
The Bank of Japan provides a settlement service called BOJ-NET. BOJ-NET is the core settlement
system for yen funds and government securities and is participated in by major financial institutions
and private payment systems. We continue to make efforts to accurately grasp new waves of
innovation in information and communications technology and to make our settlement systems
support the advances of financial institutions and private payment systems.
The Bank of Japan is currently making preparations so that current account transactions and the
settlement of government securities will be executed by real-time gross settlement, RTGS, from the
beginning of next year. There are two current account settlement methods: fixed-time net settlement is
where settlement is finalized by paying net debit or credit balances among financial institutions at a
pre-designated time, and real-time gross settlement is where each settlement is finalized on a real-time
basis without calculating net debit or credit balances. Most settlements are presently fixed-time net
settlement though it has the serious drawback that if one of the participating financial institutions fails
to make a payment, then all settlements of all financial institutions will be disrupted. To overcome this
we will abolish, in principle, fixed-time net settlement and introduce real-time gross settlement from
January next year. It is recognized globally that real-time gross settlement is appropriate for large fund
settlements like interbank transactions since it reduces systemic risk, in which a chain reaction of
defaults arises.
There have recently been discussions in the securities industry that the settlement period between
contract and delivery should be shortened for transactions in equities and government securities. The
current practice is to settle such transactions within three days after the contract. Many argue that
settlement should be one day after the contract, which is basically the right direction from the
viewpoint of reducing the outstanding amount of unsettled transactions so as to enhance safety of the
settlement system. Such discussions have indeed been promoted by the rapid improvement of
information processing capabilities and communication speed under the advance of technological
innovation. We will constantly strive to improve the services we offer so that we will be able to
appropriately support future changes in settlement practices.
Moreover, in order for BOJ-NET to contribute to greater efficiency and enhanced safety of Japan's
payment systems as a whole, we must cooperate with the steering bodies of private payment systems.
For example, it is possible to conceive a situation in which we cannot easily enhance the safety of
payment systems when one system among various systems is deficient in terms of risk management
and settlements become concentrated on this one system. In particular, although technological
innovation enhances profitability and transaction convenience, it also creates new kinds of risks and
increases the degree of risk involved, thus making coordination with private payment systems all the
more important. In collaboration with other central banks, we have been working to establish
internationally agreed core principles that major private payment systems must comply with. In this
regard, Lamfalussy standards, which were established 10 years ago, are well known worldwide, and,
based on these standards, the drafting of new core principles is in progress. With these principles as a
guideline, we will continue to closely monitor private payment systems and ensure that they
continuously pursue greater efficiency and safety, which is often called "oversight" abroad.
Innovation in information and communications technology has raised a new issue about our
relationship with individual financial institutions. Since their financial strength and risk management
might have a big adverse impact on the efficiency and stability of the financial system as a whole, it is
an important issue for the central bank to evaluate its business relationship with individual financial
institutions. As I mentioned, we have recently begun to observe a new provider of payment services
such as institutions that specialize in internet banking. If a banking subsidiary of a non-financial
business firm requests to open an account with us, we will decide whether to enter into a business
relationship with it in light of the already published standards for account opening and by examining
such factors as its capital base in comparison with the intrinsic risks faced, the relationship with its
parent, and its contingency plans. The Bank of Japan has been paying close attention to how such
subsidiaries might develop payment operations because their activity might exert not a small influence
on the efficiency and safety of payment and settlement systems. If we establish a business relationship
with such subsidiaries, we will monitor them through on-site examination and off-sight monitoring.
Views are now divided as to how the move toward mega-banks will change risks in the financial
system. Some are concerned that the financial system might become more vulnerable to contagion
than before because such moves will bring about the concentration of risks. Others are more optimistic
and believe that the financial system as a whole will become more robust in terms of risk taking
because individual financial institutions will become stronger due to higher profitability and an
improved BIS capital ratio as financial consolidation progresses.
At the moment, non-financial business firms are expected to enter banking by first establishing a
subsidiary which will acquire a banking license. Amid the move toward mega-banks, many financial
groups will establish banking subsidiaries under their respective holding companies. The Bank of
Japan will naturally examine those banking subsidiaries that are direct current account holders.
However, if parent companies and holding companies have the power to make important management
decisions, such as business operation and risk management strategy, for subsidiaries that hold current
accounts with the Bank of Japan, then examination of subsidiaries alone might not be sufficient to
truly grasp their condition. In such a case, we will need to conduct a review of parent companies,
including on-site examinations, to the extent necessary.
Japan's financial system has been changing against the background of rapid innovation in information
and communications technology. And, as always, it is an important task for the Bank of Japan to
contribute to improving the functioning of the financial system by increasing the efficiency and safety
of payment and settlement systems. By responding to this task, we hope that the financial system will
function to appropriately reallocate the financial assets of the household sector, which amount to more
than 1,380 trillion yen. If such a reallocation mechanism works properly according to market
discipline, it will provide strong support, from the financial side, for the promotion of structural
reform, which is one of the major challenges Japan's economy faces.