Kiyohiko G Nishimura: The importance of financial infrastructure in
seeking a more resilient financial system - from an Asian regional
perspective
Keynote speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the
Bank of Korea International Conference 2011, Seoul, 26 May 2011.
* * *
1. Introduction: resiliency of the financial system
Governor Kim, distinguished guests, ladies and gentlemen, I am delighted and honored to
have the opportunity to deliver this keynote speech at the Bank of Korea International
Conference.
The theme of this 2011 conference, "Future of the International Financial Architecture," is
timely and very important, because it points us directly to the lessons we should draw from
the recent crises, including the collapse of Lehman Brothers, the sovereign debt problems in
some European nations, and even the Great East Japan Earthquake and its massive
tsunami in March this year. I am delighted to be able to participate in this conference, and
hope to contribute to it, representing the Bank of Japan.
Before proceeding with my speech, let me first express my sincere gratitude, on behalf of the
Bank of Japan and the Japanese people, to all the people around the world who have given
their generous support to the severely damaged area of East Japan. We are deeply grateful
for all the prompt and compassionate physical assistance and financial donations we
received from so many overseas jurisdictions.
The disaster reminded me once again of the utmost importance of a resilient financial market
and system, in which a central bank plays an essential part. In spite of the magnitude 9
earthquake, the Japanese financial system maintained its soundness, although some
regional financial institutions were severely affected. Our payment and settlement systems
have functioned effectively and without serious disruption in delivering necessary cash
across the entire nation, including the disaster-hit areas. Although significant volatility was
temporarily observed in the week following the disaster on March 11, the Japanese stock
market has recovered its value since then, and the foreign exchange market has regained its
stability.
We must bear in mind, however, that such financial stability was not necessarily achieved in
the case of past disasters. The San Francisco earthquake of 1906 is a case in point. That
earthquake destroyed San Francisco, which was then the financial center of the West of the
United States. Huge demand for cash was generated in the West for its reconstruction and
insurance payments, at a time when the United States had no central bank system.1 Market
participants then tried to address this urgent situation by transmitting money to the West from
New York City, but ironically, their action resulted in a significant shortage of liquidity in the
nation's financial center. In consequence, short-term interest rates increased rapidly, and the
New York money market lost its functionality. The contagious impact was also observed in
overseas financial markets such as London.2
In this speech, I will focus on the determinants of the resiliency of a financial system, and the
role of regional cooperation in seeking a more stable and resilient system. Here, I argue that
it is of utmost importance to build a liberalized, transparent, and deep financial market and
system, without arbitrary intervention, whether formal or informal. In particular, from an Asian
regional perspective, I would like to emphasize the need to improve the region's financial
infrastructure, including its payment and settlement systems, so that financial markets can
maintain their functionality even during a crisis.
In the following, I will first review a variety of policy efforts introduced in the region since the
Asian currency crisis to address the risks related mainly to massive capital outflows. This is
followed by my views on how to cope with harmful volatility in the financial market and
system. Finally, I will conclude by emphasizing the importance of improving payment and
settlements systems in the region.
2. Successful efforts since the Asian currency crisis: but don't be too
complacent
The more than ten years since the Asian currency crisis has literally been a period of reform
for Asian financial markets. Bearing the important lessons in mind, Asian authorities have
made a variety of policy efforts to strengthen the resilience of their economies and financial
markets, including the self-insurance of accumulating foreign reserves, multilateral swap
agreements under the "Chiang Mai Initiative",3 and reduction of their dependency on
off-shore short-term funding. They have also endeavored to and succeeded in improving
their fiscal positions. Coupled with the high growth potential of Asian economies, these policy
efforts have proved effective in helping Asia steer through the global financial crisis, often
called the "financial tsunami", which followed the collapse of Lehman Brothers in September
2008.
Such a success story would, however, be short-lived, if Asian economies were too
complacent to address the challenges that capital flows and domestic inflation bring. Owing
to their high growth potential, Asian economies have again experienced large capital inflows,
creating an environment that is likely to increase volatility, particularly in asset prices
(Slide 1). In addition, the recent surge and increasing volatility in commodity prices, which is
in part explained by financial factors, may accelerate existing domestic inflation risks in
emerging Asia (Slide 2).
The challenge now is how to cope with the short-term, harmful volatility that disruptive capital
flows may cause, while at the same time maintaining and enhancing the long-term
welfare-improving efficiency that steady capital flows bring about. Capital flows are beneficial
for the Asian region, where there is large potential demand for public and private
infrastructure. Thus, they are absolutely necessary for the further development of Asian
financial markets, as well as for further growth in Asian economies.
Volatile capital flows are often said to be beyond the control of regional authorities. I believe
this is true to a great extent because Asian financial markets are still lacking in depth and
liberalization. Their ability to cope with large-scale external shocks through, for example, the
modulation of capital flows, therefore remains far from sufficient.
3. Short-term measures to cope with financial instability: don't forget their
longterm consequences
Recently, many Asian economies have again experienced a surge in capital inflows.
Large-scale capital inflows are said to have brought three major problems. First, they have
caused rapid currency appreciation in a short period of time, which is undermining the
competitiveness of export industries and dampening corporate confidence. This is especially
detrimental to Asian emerging economies with their relatively high dependence on exports.
Second, these massive capital inflows, together with their favorable economic expansion,
have pushed stock prices to historical peaks and brought about a rapid increase in property
prices. Such developments, if continued for an extended period without appropriate policy
actions, would increase the unwelcome risk of asset price bubbles. Third, increases in asset
prices and bank lending are stimulating excessive consumer spending and business
investment through wealth effects, leading to the risk of an overheating economy and
accelerating inflation. Indeed, inflationary pressures and inflation expectations have been
rising in many Asian emerging economies, fueled also by the recent surge in commodity
prices.
In response to these challenges, many Asian economies have adopted short-term policy
responses, such as restrictions on capital inflows and macro-prudential policy measures, as
well as foreign exchange market intervention. Since last year, they have introduced a variety
of quantitative regulations and tax measures to mitigate the risks that excessive capital
inflows may cause. Moreover, in an effort to curb overheated property investment, they have
strengthened regulations and taxation on property transactions, lowered the required
loan-to-value ratio for financial institutions, and imposed tighter limitations on bank loan
volumes. These specifically targeted policy actions have indeed begun to take effect. For
example, the upward pressure on property prices seems to have eased somewhat in several
economies.
However, such favorable effects may be the exception, and these policies may have
unintended adverse effects on the economy if they are in place for longer than necessary,
such as distorting optimal credit allocation and impeding necessary structural reforms.
Moreover, temporary success in these short-term measures may tempt policy makers into
postponing measures necessary to cope with real and fundamental problems.
In particular, monetary and other macroeconomic policy actions must not fall behind the
curve. Although the increase in interest rates may attract further capital inflows, we should
not rely too much on the above-mentioned short-term regulatory and macro-prudential
measures. As was evident from Japan's experience of the past bubble, delayed monetary
and macroeconomic policy responses may bring about an accumulation of "excesses" in
employment, business capacity, and debt under an inflexible labor market or high investment
irreversibility. Such accumulated excesses may persist for an extended period, and may
hamper economic growth in the years following. After all, regulatory and macro-prudential
measures are supplementary to, but not substitutive for traditional or conventional policy
measures.
Let me move on to the longer-term issues associated with vulnerability to unanticipated
external shocks. As I mentioned earlier, steady capital inflows are beneficial in bringing about
welfare-improving efficiency in the long run. In order to ensure their benefits, I would like to
emphasize the importance, here in Asia, of long-term policy efforts to develop more
liberalized, deep, and well-balanced financial markets, or I may say, a better financial
infrastructure or architecture. Deep and well-balanced financial markets, side-by-side with
free and stable capital flows, enhance the effectiveness of resource allocation. It should be
emphasized that liberalized and deep financial markets also strengthen the effectiveness of
macroeconomic policies, through improvements in the monetary transmission mechanism.
The Asian authorities are together in having recognized this long-term perspective, and they
have been making collaborative efforts over the past decade to develop their financial
markets, particularly their bond markets. Examples of such efforts include the Asian Bond
Fund (ABF) initiatives launched by the EMEAP,4 in which the Bank of Japan also takes part,
and the Asian Bond Markets Initiative (ABMI) of the ASEAN+3 process.5
Asian financial markets have developed remarkably in recent years thanks to these policy
efforts (Slide 3). Nevertheless, they are still much smaller and less liquid than their
counterparts in advanced economies, magnifying the impact of short-term volatility of capital
flows on their stock and bond prices, and accordingly on their foreign exchange rates. In
particular, the secondary and repo markets as well as the primary markets for corporate
bonds remain relatively underdeveloped in the region, compared with the expanding primary
markets for government bonds. This situation needs to be addressed through more
cooperative and collaborative efforts among Asian economies, including Japan.
Moreover, in a broader sense of the infrastructure issue, there is still an excess of regulations
on cross-border transactions, including those applied to foreign exchange, overseas
remittances, and foreign inward investments, as well as an over-complex taxation system.
The lack of transparency is often criticized, as well as the seeming arbitrariness found
sometimes in the enforcement of such regulations. They remain an impediment to the
promotion of transactions and to the development of liberalized and deep financial markets in
this region.
4. Improving payment and settlement systems in Asia: respect free markets
I would like to emphasize the utmost importance of improving the post-trade infrastructure of
securities markets in Asia. This would enhance the resilience of the financial system as
Asia's financial markets continue to develop. As I mentioned earlier, Japan's payment and
settlement systems were not disrupted by the Great East Japan Earthquake, and have
continued to function effectively, helping to ensure financial and social stability.
The role of payment and settlement systems is to settle claims and obligations arising from
transactions. While the infrastructure making financial contracts straightforward and smooth
could be compared to arteries pumping out blood into the body of the economy, the payment
and settlement system would then be the veins carrying the blood back to the heart (Slide 4).
Both of them are absolutely necessary for the proper functioning of the financial system,
especially for cross-border transactions. The international financial system would stall if the
veins, or the payment and settlement system, became choked with blood clots. In this
respect, it is extremely important to ensure the safety and efficiency of the payment and
settlement system, as well as its stable operation, even in times of crisis.
From the cross-border perspective, however, I recognize at least two problems in the
post-trade infrastructure for cross-border securities trading in the Asian region.6
4
The EMEAP was established in 1991, and consists of eleven central banks and monetary authorities in the
Asia and Pacific region, namely Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New
Zealand, Philippines, Singapore, and Thailand.
5
Under the ABF initiatives, EMEAP member central banks invest a portion of their foreign reserves in sovereign
and quasi-sovereign bonds of eight EMEAP jurisdictions. The ABF initiatives have promoted the recognition of
local currency-denominated bonds issued in Asia, and acted as a catalyst to accelerate and harmonize legal,
regulatory, and tax reforms related to bond investments in the region. The ABMI has also made a variety of
efforts and achievements, including providing technical assistances and credit guarantees, as well as
enhancing information disclosure for investors, aiming at improving the issuance and investment environment
on government and corporate bonds in the region.
6
There have been relative improvements in domestic payment and settlement systems in Asia. Online
securities payment and settlement systems have been constructed, and delivery-versus-payment settlement
has been achieved. Many jurisdictions have also already realized settlement cycles of T+2 to T+3. Further
improvements may still be needed in some jurisdictions to establish legislation on settlement finality.
First, settlement risks associated with cross-border securities trading remain, and sufficient
measures have not yet been introduced to manage them. For example, the U.S. dollar is
usually employed as the intermediary for obtaining the investment currency. However, in
many cases in Asia, the settlement between the local currency and the U.S. dollar is not
made through payment-versus-payment settlement. In addition, since invested securities are
held or settled through a multi-tiered system involving central securities depositories and
sub- and global custodian banks, custody risks are inherent across the tiers.
Second, as operational procedures often need to be adjusted individually in order to meet the
regulatory and system requirements of each jurisdiction, operational costs are quite high for
intermediaries between issuers and investors, such as central securities depositories,
sub- and global custodians, and international central securities depositories. This in turn
increases the costs for investors.7
In order to support strong and sustainable economic growth in Asia, it is important to develop
deep and liquid bond markets, as well as to build the infrastructures supporting such
markets. In this respect, the Asian economies must endeavor to rectify these and other
problems, not only individually, but also on a collaborative basis by recognizing the whole
Asian region as one single market. As for the direction of the action to be taken, we should in
particular build an infrastructure for ensuring efficient and safe cross-border payment and
settlements, and expand measures to maintain market liquidity even in times of crisis.8
There are two conceptual issues to be considered when designing Asia's future cross-border
payment and settlement system. One is to what extent the system should be integrated,
while the other is to what extent the public sector should be involved in the function.
As for the degree of integration desirable, the more integrated the infrastructure, the easier it
becomes to adopt better functions. However, it would then be more costly and difficult to
reach agreement on the location for its installation. As for public sector involvement,
generally speaking, the more the public sector is involved, the safer the infrastructure
becomes. However, it is then likely that the scope of the services would be limited, while
raising private sector suspicion of possible state interference. Since the involvement of the
public sector in payment and settlement systems is traditionally high in Asia, it might be
realistic for us to consider the above-mentioned issue not as a choice between two mutually
exclusive options, but as a decision on how to combine the efforts of both the public and the
private sectors.
In attempting to strike a better balance in such trade-offs, we should follow three basic
principles. The first is to respect the choices of market participants using the payment and
settlement systems and ensure good governance. The second is to enhance the use of
central bank money in payments and settlements as a means of reducing settlement risks.
The third is to adopt a gradual approach that takes into account the differences in the degree
of market liberalization among Asian economies.
The use of cross-border collateral arrangements by central banks could be one of the
measures used to maintain market liquidity in times of crisis. If we have an infrastructure in
which central banks can be flexible in providing their local currencies against highly liquid
foreign assets as collateral, this would contribute to the smooth funding of locally active
financial institutions, and thereby enhance the stability of domestic financial markets.
Japan has made substantial improvements in the post-trade infrastructure for Japanese
government bonds, which have the largest market volume in Asia. Improvements have been
made, for example, in aspects of the payment and settlement system, the legislation
governing securities settlement, and the tax system for non-residents. I believe that our
experience will also be helpful in promoting the development and stability of financial markets
across the Asian region. Working in close cooperation with the relevant institutions, the Bank
of Japan hopes to be able to contribute to the development of financial infrastructures in both
Japan and the Asian region by sharing the knowledge obtained from our experience.
Now, let me wrap up. Motivated by the lessons of the Asian currency crisis, Asia is the most
active region in terms of policy cooperation and coordination aimed at building robust
financial markets and systems. However, to be honest, the policy goal has not yet been fully
achieved, as the markets and systems are still under-developed. We Asian policymakers
need to make more cooperative and coordinated efforts to construct better systems (both in
terms of hard and soft aspects) that are sufficiently resilient against large unanticipated
shocks, including sudden capital outflows and natural disasters, even though, realistically
speaking, there may be no perfect design.
Thank you for your kind attention.
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