, if any, to debt repayment rather than to capital investment. such moves are reflected in the declining growth rate of money supply ( m2 + cds ). money supply posted 3 - 4 percent growth last year, but it has now slowed down to around 2 percent. a reason for this slowdown is probably a reaction to the rapid fund shift that was seen two years ago, but it is a fact that the current situation does not warrant high growth for the time being. money supply is the sum of deposits and cash held by firms and individuals, and deposits, which occupy a large part of it, drive its movement. since deposits are liabilities of a bank, they are determined as a result of financial intermediary activity on the part of banks and demand for funds on the part of firms. a substantial increase in money supply growth means a large expansion of banks'balance sheets. but, banks'balance sheets do not expand when it is rather difficult to expect an immediate increase in bank lending in the current situation where firms are repaying excess debt, which in itself is a necessary adjustment in the immediate future. in this context, the challenges facing the policymakers, including the bank regulators, are how to activate the financial intermediary function of banks and, simultaneously, how to enhance financial intermediation other than through banks. significance of capital market development when there are constraints on the credit creation activity of the banking sector, which shoulders the nonperforming loan problem, the use of capital markets, which are alternative channels for financial intermediation, might give an important clue for seeing japan's economy return to a sustainable growth path. banks and capital markets ought to complement each other to support a nation's financial system. i believe that the advantage of capital markets lies in their price discovery function in order to realize efficient fund allocation. as the economic environment is constantly changing, such a function is particularly important at the present juncture where the swift reallocation of productive resources is needed and there are increasing public expectations for nurturing and organizing capital markets in which various market participants become engaged in price formation. japan's capital markets are quite small compared with those of the united states ( chart 3 ). in terms of corporate sector funding, while the outstanding loan amount extended by commercial banks is some 300 trillion yen, the outstanding balance of corporate bonds and cp issued remains at some 80 trillion yen ( chart 4 ). furthermore, japan's capital markets are not matured and not

those investors had intended. the result was a change in the value of existing contracts and a period of market adjustment as new restructuring clauses were developed and implemented. of course, we should not want to prevent rapid price changes or changes in investment flows, as such changes may be appropriate as new information about fundamentals emerges. and the occurrence of glitches in new markets and institutions need not reflect policy failures or provide evidence that an innovation is undesirable. preventing all such occurrences would probably require us to stop all innovation. but neither is it desirable that growing pains in one market or at a few institutions spill over so strongly that the financial system as a whole could be destabilized. a middle way in regulation policymakers have a range of strategies available for dealing with innovation. at one extreme, in theory we could take a completely hands - off approach, allowing new financial markets and instruments to develop without restrictions and indeed without any scrutiny, trusting private market participants to do everything necessary for stability and efficiency. at the other extreme, policymakers theoretically might be quite heavy - handed, either imposing regulations on virtually every market and instrument to stop any innovations that, in their judgment, could cause harm or, conversely, actively fostering or subsidizing innovations seen as desirable. obviously, these are extreme positions, and i do not know of any practicing policymaker who seriously wants to pursue either extreme course. today i wish to argue for a middle ground in which markets are allowed to work and develop and in which policymakers work hard to understand new developments and to help market participants see the need for improvements where appropriate. in my view, regulations should be imposed only when market participants do not have the incentive or the capability to effectively manage the risks created by financial innovation. for example, explicit or implicit subsidies of some institutions could limit market discipline of their risk - taking, leading to a concentration of risk so large that even the most sophisticated institutions would find it next to impossible to manage the risk under stressful circumstances. or policymakers may be concerned that some potential parties to innovative contracts, especially in the retail arena, are insufficiently knowledgeable to understand or manage the associated risks. i believe such instances are rare. making a case for early regulatory intervention is particularly difficult when the private parties involved in an innovation are sophisticated because, in many cases, they will be the first to recognize possible problems and will have strong incentives to fix them and also to protect themselves against fraud or unfair dealing. so how should