Toshihiko Fukui: Toward strengthening competitiveness of Japan's
financial system
Summary of a speech given by Toshihiko Fukui, Governor of the Bank of Japan, at the
Center for Financial Industry Information Systems, Tokyo, 30 November 2007.
* * *
Introduction
I am deeply honored to be given the opportunity to speak before many distinguished guests
in the financial sector on the theme of strengthening the competitiveness of Japan's financial
system.
The financial system and financial markets not only allocate funds from the overfunded
sector to the underfunded sector but also they sort out firms with high profitability and growth
potential. The efficient and competitive financial system and financial markets are therefore
vital to a country's economic growth. First I will explain the changes surrounding Japan's
financial institutions, and then assess their competitiveness and profitability. I will then
address the steps toward strengthening their competitiveness. Finally I will touch upon the
lessons learned from the subprime mortgage problems.
1. Changes in the environment surrounding financial institutions
Changes in firm activity
Since the 1990s, the world economy and financial markets have undergone substantial
changes. Behind that are various factors, among which globalization and information
technology (IT) innovation are particularly important.
The economic globalization has enabled diverse goods and services to move across the
border, thereby enhanced the division of labor between the countries and the convergence of
prices and wages. Advances in IT raised the efficiency of information processing and
communication at a remarkable pace, which in turn eased time and geographical constraints,
and led to a large cutback on the cost of remote business transactions. Against such a
background, notable changes emerged in firms' international activities. Firms have been
relocating their production sites overseas at a faster pace and global M&A activity has been
actively taking place. Accordingly, the division of labor between the firms has also
progressed. For example, in the area of software development and data processing,
outsourcing has been taking place across the border. More recently, an open source
approach - i.e. releasing an idea for new products and inviting other firms which are in the
possession of competitive technology for possible joint production - has gained popularity.
Arguably, the global IT network has underpinned the information flows behind the
abovementioned processes.
Changes in financial activity
With the remarkable changes in firm activities, financial transactions have also gone through
significant changes.
First, in terms of financial instruments, the derivatives market has grown considerably with
the help of finance theory and IT development. Transactions have expanded at a rapid pace:
not only those dealing with assets such as government bonds and foreign exchange whose
market prices are readily available, but also those dealing with credit risk whose price is
derived from theoretical models. With regard to M&A finance and real estate finance, a new
financial approach that attaches greater importance to cash flow has been widely accepted.
In addition, progress in the securitization method has created a variety of securitized
products.
Second, in terms of market participants, now many types of investors are playing the market.
Most notably, hedge funds and private equity funds have begun to play an important role in
the global financial system. Such funds' strong demand for investment opportunities appears
to have been the driving force in creating a variety of investment products including real
estate financing and M&A activity.
Due to such development of financial transactions and an increasing prominence of various
investment funds, risk money with a diverse risk appetite is racing around the global financial
markets. The current subprime mortgage problems clearly indicate that this is an era where
the risks in a certain sector of a country will be distributed and be held widely by financial
institutions and investors worldwide.
Changes in financial institutions' business model
Under such circumstances, the business model for developed countries' financial institutions,
which form the centerpiece of the global financial system, has gone through substantial
changes. In particular, innovative financial institutions in Europe and in the United States
have increasingly relied on the so-called "originate and distribute" business model, where
credit risk inherent in lending is transferred to investors via securitization. Such an increase
in securitization business stems from the fact that it has become difficult to generate profits
from the traditional wholesale transactions such as lending to large firms in light of the
development of capital markets. In addition, it reflects a diversified risk appetite of various
investment funds. Against such a background, financial institutions overseas are striving to
gain higher returns on capital, taking account of stockholders' demand while securing enough
capital to maintain high credit ratings.
Financial institutions in Japan
Japan has been making efforts to overcome the nonperforming loan problem for more than
ten years since the 1990s. Financial institutions disposed of nonperforming loans,
streamlined the workforce, closed down domestic and overseas branches, postponed IT
investment, and refrained from strategically allocating new management resources. Such
efforts paid off. Around 2005, the nonperforming loan problem was largely cleared up. Since
then, they have been stepping up their efforts into more forward-looking resource allocation
such as recruiting new employees, investing in new businesses and re-expanding their
overseas sections.
Meanwhile, the last ten years also witnessed the structure of Japan's economy and its
financial system facing major changes, due to globalization and IT innovation. For example,
Japanese firms including medium sized firms have been actively expanding their business
overseas, and the number of M&As involving Japanese firms has been on the rise. While the
corporate sector, on the whole, has become the overfunded sector, the savings rate of the
household sector has been on a downward trend, due to the declining birthrate and the aging
population. Therefore, it is uncertain whether the traditional financial intermediation -
collecting funds from the household sector and lending them to the corporate sector - will
provide plenty of profit opportunity. Moreover, the easing of regulations has allowed
nonfinancial industries to enter financial businesses.
It is good news that Japan's financial institutions are sound again and are able to once again
implement a forward looking strategy, and I commend the efforts of those concerned.
Nevertheless, it should be noted that the circumstances and conditions facing competition
have changed drastically during those periods, and the business strategies need to be
refined accordingly.
2. Profitability of financial institutions in Japan
Competitiveness of financial institutions
One may ask what is the best way to gauge the ability of financial institutions to add values,
when the financial sector's competitiveness is assessed with the amount of added value
stemming from financial transactions. Added value means creating value that exceeds the
investment cost and it cannot be assessed simply by comparing the quantity of funds and the
size of assets. It needs to be assessed in light of profitability. In this regard, highly profitable
banks can be seen as those that have gained support of many customers, who are satisfied
with the products and services as well as the banks' pricing strategy. I now go on to review
the profitability of financial institutions in Japan and discuss how to enhance their profitability.
The current assessment of profitability
In fiscal 2005, both major banks and regional banks posted an all time high net profit, and
maintained almost the same profit level in fiscal 2006 as well. The capital adequacy rate at
the end of fiscal 2006 registered 12% for major banks and 10% for regional banks.
Meanwhile, out of 12 trillion yen, the amount of the public funds injected since 1998, 9 trillion
yen, which accounts for three quarters of the total money injected, has already been paid
back. In sum, profit and capital levels of financial institutions have been recovering
significantly in recent years.
Such recovery of profits has been brought about, because credit costs have been kept at
extremely low levels since provisions for loan losses, which increased drastically in the
process of disposing of nonperforming loans, have become no longer necessary in light of
improved business conditions and progress in corporate revitalization. Indeed, net interest
income and income from fees and commissions have been either decreasing or showing a
sluggish growth and thus the core profitability in the banking sector has not necessarily
improved.
Financial System Report
The Bank of Japan releases the biannually, presenting a
comprehensive analysis of Japan's financial system. The latest edition released in
September this year analyzed the long-term profitability of the overall banking sector (i.e. the
shinkin
major, the regional and the banks) since the early 1980s, and the following results
came up. First, returns on assets (ROAs) were at around 0.5% even if the periods were
excluded when ROAs continued to register below zero, due to large losses incurred by the
disposal of nonperforming loans. Looking at the composition of ROAs, the net interest
income rate and the general and administrative expense rate have been stable at around
1.3% and 1.0% respectively. That means that net asset profitability was only around 0.3%,
and it could only remain positive if the credit cost was kept exceptionally low, for example,
due to the reversals of allowances for loan losses. There is a risk that asset profitability will
become negative, should the allowances for loan losses return to normal and credit costs
rise.
The low profitability of Japan's banking sector is highlighted, compared with other countries.
For example, the rate of banking assets to nominal GDP in Japan is 150%, while it is only
50% in the United States. By contrast, the ROA of the U.S. banking sector has been at about
1.5% on average since the early 1980s, reaching nearly 2.0% in recent years, whereas it has
been at around 0.5% in Japan, even if the years with negative ROAs are excluded from the
sample. In terms of general and administrative expenses, Japan's banking sector has a
considerable advantage, but the narrow interest margins from assets as well as the low non
interest income ratio have been pushing down the ROAs of Japan's banking sector. In sum,
while financial institutions in Japan hold more assets than its U.S. counterparts, their assets
have lower added values. Moreover, contributions from profitable products and services that
do not rely on the volume of assets remain meager.
Factors behind the low profitability
Let us now discuss why the profitability of Japan's financial sector remains low.
First, as a business model, many financial institutions still rely heavily on traditional deposit
taking and lending, which can be provided by any financial institution, as a source of profits.
In general, it is difficult to sharpen the competitive edge of those products unless their pricing
is constantly being reviewed. Moreover, while Japanese firms, having learned the lessons
from the bursting of the bubble economy, have become less inclined to borrow even in the
midst of favorable business conditions, bank loans still account for more than 50% of the
total assets of Japan's financial institutions. With sluggish demand for loans, any attempt to
increase its volume will inevitably lead to narrower profit margins.
It is interesting to note that there is a clear difference between Japan and the United States
when the number of financial institutions from which small and medium sized enterprises
(SMEs) borrow funds are compared. In the United States, 80% of SMEs borrow funds from
only one financial institution, whereas in Japan a majority of SMEs borrow from more than
three financial institutions. That illustrates how severe competition is in Japan's loan market
and it implies that Japan's financial institutions are yet to build mutual trust between them
and their customers by offering unique customer-oriented financial services.
Second, in terms of governance, it appears that most stakeholders, shareholders in
particular, have been tolerant of the low profitability that has continued for a long time in
Japan's banking sector. Indeed, cross-shareholdings between financial institutions and firms
used to be prominent. Under such relationship, firms acted both as a shareholder and a
valued customer for banks. Hence, corporate governance, in its pursuit of higher profitability,
did not function well: on the one hand firms called for improvement in shareholders' value; on
the other hand they pursued favorable terms and conditions on loans. Recently,
crossshareholdings have dissipated and shareholdings by foreigners and investment funds, to
whom maximizing shareholders' value is a priority, have been on an increasing trend. And
legislative efforts to strengthen internal control are being taken. Nevertheless, looking at
Japan's financial sector as a whole, initiatives that are intended to improve banks' profitability
through stronger governance by shareholders and market participants as well as corporate
governance within the bank still appear to be limited.
Problems regarding prolonged low profitability
I know other views, too. One might say that a narrow interest margin is a result of the
reimbursement of profits to customers and many stakeholders are still tolerant of the low
profitability. That view suggests that even if the profitability of financial institutions remains
low, it may not pose a problem for the time being, and moreover that the low profitability of
financial institutions may support Japan's economy through low borrowing costs. However,
should the low profitability of Japan's overall financial institutions continue, it could raise
concern in the following two respects.
First, the future vitality of Japan's economy remains concern. The low profitability holds true
not only for the financial institutions but also for many other firms in Japan. Currently,
however, it is becoming increasingly difficult for businesses that only provide low
valueadded products and services to survive in the global economy. For a country's economic
development, the sectors with high productivity and potential for growth need to play an
active role. And it is essential that risk money is channeled to such sectors without
hindrance, and for that purpose, the limited resources on the part of financial intermediaries
should be allocated efficiently and concentrated in the areas with highly added value.
Therefore, if financial institutions do not reinforce the provision of higher value-added
financial services and support firms exploring new business opportunities, the economy's
future may look grim. Of course, while active overseas financial institutions could play a
complementary role in reinforcing the intermediary function, they might not be able to
participate aggressively in areas such as SME financing where the extent of disclosure is
relatively limited.
Second, securing Japan's financial stability over a longer period also is an issue. Periodical
earnings are the fundamental source of strengthening a bank's capital base. Raising
additional funds from the capital market is, of course, an option, but such funding can be
done only if the profitability and the potential of the business are attractive to investors.
Therefore, should the low profitability continue, there may not be sufficient capital in the
medium to the long term to counter an increase in credit costs in case of an economic
downturn, and accordingly the stability of the financial system may be put in jeopardy.
3. Measures to enhance the profitability of financial institutions
Enhancing the profitability of financial institutions is particularly important in ensuring financial
system stability and economic growth. Next, I discuss the measures towards enhancing
profitability.
Objective assessment of risk and return balances
First, financial institutions should further improve the methods of assessing risk-return
balances. In order to improve profitability, they must first assess the nature and the size of
the risks inherent in financial products and services as well as the risks with the related asset
holdings and financial transactions. Without the accurate assessment of its risk-return
balances, specific action plans that contribute to enhancing profitability cannot be taken.
It has been pointed out that investment banking and overseas business activities need to be
reinforced at major banks, which currently have a hard time improving profitability via their
domestic commercial banking business. Looking at the risk taking behavior of major banks
from the perspective of integrated risk management, both credit risk and the risks associated
with long-term stockholdings have increased. As such, overall risks including interest rate
risk and operational risk are already reaching an amount equivalent to their core capital. That
is, most of the core capital has already been used to cover the risks associated with the
current financial products and services. Therefore, be it investment banking or overseas
business activities, banks need to scrape together capital by assessing the current
operations' risk-return balances and scale down those with low risk-return balances in order
to explore new risk taking opportunities through new business operations with a higher
additional value. Efforts are being made among major banks where the so-called "credit
portfolio management" is used to reduce concentrated credit exposure, enhancing the
efficiency of loan portfolios. Further efforts on this front to improve returns are called for.
Regional banks allegedly have a mission to provide long-term support to regional customers'
economic activity. For example, one might say that in dealing with a regional customer, a
long term business relationship is more important than short term profits and the bank has to
give support to the firm which might face a temporary downturn of its business. If regional
banks are to take the risks associated with long term commitment to their respective regions,
it is essential that they have the capability to assess such risks. For example, if the duration
of loans to a local firm has become long, then it is necessary to quantify the risk by taking
account of the period of loans extended. Moreover, if part of the loan is constantly rolled
over, its associated risk should be treated in line with the risk of equity investments. Once the
risks associated with regional commitment are assessed, there is a possibility that the
amount of risks increases. Under such circumstances, it is necessary to secure
corresponding capital. Many regional banks have already built up capital well exceeding the
amount of risks they have calculated. That may suggest that those banks have implicitly
prepared for the risks associated with regional commitment. However, if the risks remain
vague, the improvement in returns cannot be hoped for. Clear recognition of the risks
associated with regional commitment would in turn allow regional banks to take measures
with respect to returns. For example, to the firms with poor business performance, early
support for business revitalization can be made, which could improve their cash flow and
lead to higher net interest income for regional banks. For loans that have become
"pseudocapital", regional banks can act as an intermediary to invite external risk money and thus
earn fee income.
Selection and concentration of business operations
Second, financial institutions should check whether the services they provide have a
comparative advantage and need to limit the extent and to adjust the method of resource
allocation accordingly. As I explained earlier, in the case of financial products and services
that are commonly provided by many entities, it is difficult for the entities to pull out from
unprofitable price competition. The comparative advantage of each financial product and
service should be assessed, based on the non-price factors such as the ability for banks to
reinforce brand potential, to offer solutions to customers, to collect non-public information,
and to judge the growth potential of each product line. It is also necessary to check whether
the combination of prices and the quality of financial services could be refined and moreover
to address the most appropriate channel for providing such services. Having done that,
financial institutions need to draw the line between the operations where more resources
should be allocated and those that should be scaled down or should be done with higher
efficiency. They then need to come up with a specific action plan to carry out such
management decisions.
It is not easy to specify the business areas that have a big comparative advantage since
different financial institutions face different business environments and have different
characteristics. In general, however, it is effective to explore the possibility of the added
value by focusing on the nature of management resources.
For major banks, for example, comparative advantages may arguably lie in a wide branch
network, a large network of payment and settlement systems, a solid customer base
centering on large firms, the diversity of affiliate companies and personnel, the strength to
build large portfolios with diversified risks, and its business strength in the Asian region. In
response to various needs such as overseas business activities of firms including M&A,
demand for new risk hedge measures, the utilization of intellectual property, and product
development according to various life stages of the household sector, each bank should seek
the areas of great advantage. Providing adequate products and solutions to satisfy such
needs, banks will secure profits for themselves as well. Also banks are expected to bridge
the gap between the investment needs of domestic investors and the growth challenges
faced by Asian firms. There is, however, a limit to banks' capital, and in conducting overseas
operations, market participants will scrutinize credit ratings and ROEs. Banks therefore need
to further streamline the areas that do not have a comparative advantage while strengthening
those with greater advantages. Part of the risks should be taken by banks themselves but it
is also important to accommodate various types of domestic and overseas risk money.
As for regional banks, most of the customers are small and medium sized firms. Lending to
SMEs which provide little information and have limited capability to pledge collateral would
be a difficult business task for banks. It is hard to assess the creditworthiness and potential
of SMEs through financial disclosures alone, and thus the ability to obtain unpublicized
information -- such as firms' actual business conditions and the qualities of the managements
-- is all the more important. In that respect, regional financial institutions have an advantage
in that they could make daily and close contact with regional customers. For example,
information on the blueprint of new businesses top executives draw up, concern over
financial and accounting matters, successor related issues, can be obtained through a close
liaison while having acute awareness of a business opportunity. Such information might lead
to increased profitability of the regional financial institutions if they could make a proposal to
improve such firms' cash flow with whatever special skills they have.
It is also important to share, and not to store away, such "live" information within the
organization and to construct a database that enables concerned parties to use the
information from various perspectives. It requires certain costs to maintain a framework that
collects non-disclosed information based on close contact with customers and therefore,
measures to further enhance the efficiency need to be taken, such as the use of outsourcing,
with respect to the number and the distribution method of products and services with a small
competitive advantage.
Merits and pitfalls of mergers and consolidations
So far, I have described that general financial services offered by a number of financial
institutions are difficult to differentiate and that it does not necessarily lead to enhanced
profitability. One might argue that the profitability of such businesses could be enhanced by
mergers and consolidations of financial institutions. Economic theory shows that the scale
economy can take place and indeed some empirical analysis confirms that the efficiency of
general and administrative expenses could be improved, while another analysis suggests
that a mere increase in asset size would push down lending rates, offsetting the
improvement in general and administrative expenses.
Since many analyses on mergers and integrations cover the period when financial
institutions struggled with the non performing loan problem, the picture may turn out to be
different when financial institutions engage in M&A activity as part of a forward-looking
business strategy. As I mentioned in the beginning, various types of M&As are currently
taking place in the non-financial industries. Japan's financial industry will naturally engage in
M&A activities in their pursuit of raising their corporate value. For example, acquiring
business operations that bring a greater synergy with the current operations, or selling
business operations with a small competitive advantage are a few means of enhancing their
corporate value. With respect to cross-border M&As, the recent revision of Japanese
corporate law enabled overseas firms to conduct a forward triangular merger through the
exchange of shares. In fact, the first case took place in the financial industry, where a large
U.S. banking group acquired a major securities firm in Japan. In summary, while mergers
and integrations that simply increase the asset size do not necessarily lead to enhanced
profitability, M&As could be an effective tool for improving profitability if they are used to
strengthen and streamline business operations that have a comparative advantage.
Measures for legal and accounting infrastructure
So far I have outlined the measures taken and challenges faced by financial institutions
themselves. Improvement in its infrastructure is also imperative in enhancing the profitability
and competitiveness of Japan's financial system. Now I mention a few issues that require
improvement with respect to legal and accounting infrastructure.
First, the transparency and reliability of financial accounting information should be enhanced.
In order for financial institutions and investors alike to adequately assess the risks when
extending credit or making an investment decision, further disclosure of firms' financial
information is necessary. In that respect, the Financial Instruments and Exchange Law
enacted in September 2007 introduced mandatory quarterly releases of financial information
to listed companies. And to secure the reliability of the released information, the law obliges
companies to submit certification of an annual report and an internal control report. Still for
SMEs the scope of financial statements subject to external auditing is relatively limited in
Japan, compared with other countries and further improvement in raising the reliability of
disclosed information is called for.
Second, the reform of Japan's financial system should enable financial institutions to provide
flexible financial services in response to diversified needs of the corporate and household
sectors. More specifically, consideration should be given to easing the firewall regulations
between banking and securities business, which are somewhat stricter than other developed
countries. From the financial institutions' perspective, that has an effect of facilitating more
synergy within a financial group. The major premise behind such regulation easing is to
ensure that prevention rules of unfair transactions such as prohibition of insider trading and
rules to protect retail investors be firmly put in place.
Third, the reform of the public financial sector should be carried out without delay. Japan
Post has already begun its business and preparations for integrating public sector financial
institutions are currently underway. Financial institutions due to be privatized are to build
robust risk management and operational systems and are expected to take part in a sound
and fair competition with other private financial institutions. As for government sponsored
financial institutions fulfilling government policy objectives, if the areas of overlap with private
entities are large, it may prevent private financial institutions from adjusting risk-return
balances. The operations of public institutions should be based on the principle that they are
complementary to the private sector.
Consideration from overall economy
So far, I have talked about the measures taken by financial institutions and the reform
strategy of the financial system towards enhancing the profitability of financial institutions.
However, low profitability relative to asset size and capital is also applicable to many
Japanese firms with the exception of large firms facing severe competition in the global
market. In terms of risk taking towards new businesses, the amount of cash and deposit
against the total asset outstanding in Japan's manufacturing industry is two times as high as
that of the U.S. counterpart. That may suggest that Japanese companies are more cautious
about taking new business risks. Put it another way, if companies hold excess liquidity at
hand against future investment opportunities, that may suggest that financial services
intending to provide funding in a flexible manner are not functioning well.
For the future of Japan's economy, it is essential that both the ability of firms to take new
risks in creating higher value-added products and the capacity of financial institutions to
provide risk money and business solutions should develop hand in hand together.
Fortunately, Japan has the manufacturing industry with strong international competitiveness
and moreover it has the world's largest accumulation of financial assets. The IT infrastructure
such as high-speed telecommunications wire networks is as much developed as in Europe
and the United States. It is strongly hoped that both the industrial sector and the financial
sector, taking advantage of their comparative superiority both in stock and flow measures,
create further added values through technology and knowledge in order to vitalize Japan's
economy.
4. Closing remarks
In closing, let me give a few remarks on the recent turbulence in global financial markets
triggered by the subprime mortgage problems.
As the subprime mortgage problems have worsened and spread more widely in financial
markets abroad, the impact on Japan's financial institutions has been felt at a pace faster
than expected. For instance, some financial institutions registered losses as a result of a
decline in the market value of investment products, and others posted losses from
revaluation on the unsold products arranged as part of their securitization businesses
overseas. However, since Japan's financial institutions' exposure to the U.S. credit markets is
relatively low, it appears that so far each financial institution/group has been able to absorb
the losses within its annual earnings or its capital base. While further developments in the
U.S. and European financial markets need to be monitored closely, it seems unlikely that this
particular problem will pose a significant threat to the stability of Japan's financial system.
Based on the experience pertaining to the subprime mortgage problems, several lessons
could be drawn for the management of financial institutions and the functioning of financial
markets. And two lessons seem particularly noteworthy.
The first lesson stems from the difficulty of both transferring and disconnecting the risks from
financial institutions. Subprime mortgage loans are, indeed, riskier than normal housing
loans, and most of the risk was believed to be transferred from financial institutions to
investors vi