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Soundness of Financial Systems

Remarks by Deputy Governor Sakuya Fujiwara, Bank of Japan, at the International Conference on Central Banking Policies: Leading the Way towards Sustainable Economic Growth, on May 14, 1999

May 14, 1999
Bank of Japan

Introduction

Good afternoon, Ladies and Gentlemen.

I am pleased to have this opportunity to address the distinguished participants of the International Conference on Central Banking Policies.

Today, under the topic of "Soundness of Financial Systems," I will first discuss how the Bank of Japan has been dealing with the non-performing loan problem of Japanese banks. Then, I will discuss risk management and market mechanisms, making use of the lessons learned during the process of dealing with the non-performing loan problem. In so doing, I will outline directions for the establishment of an efficient and stable financial system for the 21st century. And lastly, I will say a few words about the Bank of Japan's responses.

As I will elaborate upon later, Japan is still in the process of overcoming its non-performing loan problem, and thus it might be premature to derive any final lessons from the process. Nevertheless, I believe that summarizing the lessons learned so far will provide significant clues for establishing a new financial system. I also hope that our experiences might somehow help other Asian countries in solving their own non-performing loan problems.

1. Current State of Japan's Non-performing Loan Problem

Let me first review the current situation regarding Japan's non-performing loan problem. In dealing with it, we have already incurred enormous costs, both in terms of time and financial resources. Time-wise, almost seven years have passed since the collapse of the "bubble" economy, which saw real estate prices start to fall, and deposit insurance first being applied to deal with a failed small regional financial institution.

The costs already add up to some 70 trillion yen, about 14 percent of GDP, and mostly cover the losses incurred by financial institutions in the process of disposing of non-performing loans. We expect to incur further costs, totaling several trillion yen, before the temporarily nationalized Long-Term Credit Bank of Japan and Nippon Credit Bank, both former international players, see their balance sheets cleaned up and are handed over to sound recipients.

Taking into account the long period of time and the enormous amount of financial resources used in dealing with the problem, it is quite regrettable that we have not yet seen the end of the problem. One reason for this is the continuing stagnant economy and decline in land prices, which led to additional losses in non-performing loans of financial institutions. Needless to say, in retrospect, more prompt measures to solve the problem would have been desirable.

With the financial industry becoming more globalized and increasingly relying on information technology, we recognize that there is a stronger linkage between domestic and international markets. But with this comes a greater contagion risk of financial instability in one part of the world spreading to other parts through such linkage.

In other words, we recognize that an early solution to Japan's non-performing loan problem is imperative, not only for Japan but also for other nations, especially our Asian neighbors. Our frequently repeated claim that we will never trigger international financial instability comes from this recognition.

Bearing in mind this recognition, the authorities in Japan have been exerting their best efforts to solve the problem. In particular, the legal framework to deal with the non-performing loan problem made progress last year with the enactment of two laws, one regarding reconstructing failed financial institutions and the other regarding strengthening weak financial institutions through capital injection.

With the institutional framework in place, we have now entered a phase where we can implement necessary measures to combat the non-performing loan problem with steadfast resolve.

The Bank of Japan has repeatedly emphasized the need for enhancing capital base, in the belief that the undercapitalized state of financial institutions is the main reason behind the diminishing market credibility of Japanese financial institutions and the financial system as a whole. In this regard, we welcome the considerable capital injection of public funds into the major banks at the end of March, and further welcome the possibility of injecting capital into regional banks.

However, capital injection alone will not solve the entire problem. Not only must banks themselves make every possible effort to remove non-performing loans from their balance sheets, but they must also revitalize their management under the trend toward consolidation.

The current comprehensive safety net will be effective until the end of March 2001. It includes a framework for capital injection using public funds, the full protection of deposits and other claims on banks, and a scheme to establish public bridge banks or temporarily nationalized banks. While these measures are absolutely necessary at the moment considering the current precarious state of Japan's financial system, financial institutions should never become complacent. It is important that they should become more self-reliant and disciplined.

In this context, discussions have already started regarding whether these measures should be extended beyond the March 2001 deadline. At the Bank of Japan, we consider it inappropriate to extend the present safety net measures beyond April 2001 too easily, because, if we did, it would increase the social cost, create moral hazard for depositors and financial institutions, and further delay final resolution of the non-performing loan problem. It is also incompatible with Japan's financial Big Bang principles of "free, fair, and global."

We will continue our efforts to establish an appropriate safety net after April 2001. But at the same time, as we move toward April 2001, it is important for individual financial institutions to improve their financial condition and strengthen their capital base, so that they do not have to rely on the safety net. And this takes me to the second subject of my talk, which is risk management.

2. Focus on Risk Management and Making Use of Market Mechanisms

As I just suggested, the safety net we have in mind for the 21st century would incur minimum social and economic costs, while at the same time being able to promptly solve any problems. This is not an easy thing, but in considering the question, let me express my views on what lessons can be derived from our experience of dealing with the non-performing loan problem.

The most basic lesson is that once a "bubble" economy has emerged, it will impose enormous economic costs on the public for a long time. Therefore, appropriate macroeconomic policy is important in preempting the formation of a bubble. Bearing in mind that the topic of this conference is "Soundness of Financial Systems," here I would like to point out that in order to ensure financial system stability under a rapidly changing environment, the focus must be on the risk management of financial institutions and the utilization of market mechanisms. I will say a few words about each.

First, risk management. During the "bubble" economy of the late 1980s, Japanese financial institutions tended to pursue a policy of quantitative expansion without appropriate risk management. In retrospect, insufficient scrutiny of the possibility of land price declines and the concentration of loan exposure to the real estate-related industry were manifestations of the absence of basic credit risk management.

During the same period, major financial institutions overseas made intensive efforts to improve their risk management techniques, covering not only credit risk but also market risk, which resulted in strengthening their competitiveness in the global market. In contrast, the loss of competitiveness of Japanese financial institutions after the collapse of the "bubble" economy highlighted their inadequate risk management.

Conclusions obtained from analyzing past failures only underline the need for Japanese financial institutions to focus more on risk management. Even without referring to the expansion of derivative transactions, financial transactions will certainly continue to change rapidly. For internationally active banks exposed to intense competition in international financial markets, risk management will never reach a point where they can say "enough." Instead, they must make continuous efforts to keep up with the pace of financial innovation. In addition, in deciding policy, management must thoroughly understand and make use of the information derived from their risk management systems.

The second focus I mentioned with respect to ensuring financial system stability was market mechanisms. Here I am reminded of the ineffectiveness of the market's checks and balances, or put another way, the deficiency of a system that should have encouraged the working of such mechanisms. One reason for this was the extremely cautious attitude of the parties concerned toward disclosure. For example, the dominant view used to be that "disclosing the amount of non-performing loans required careful consideration because it might induce disturbance in the financial system." In addition, the accounting systems and practices tended to obscure the real business condition of financial institutions. Such circumstances increased the lack of transparency with respect to the management of financial institutions, and, accordingly, accelerated the deterioration in the credibility of Japan's financial system as a whole.

By utilizing the checks and balances of the market, we need to devise ways to build a mechanism that ensures the stability of the financial system itself. This requires, above anything else, more transparency on the part of management of financial institutions by providing more information to the market.

In this regard, the accounting system needs to be improved. Recently, the criteria used to assess non-performing loans have been revised, as have the standards for loan write-offs and loan-loss provisioning. Vigorous preparations must also be undertaken for mark-to-market accounting, which is soon to be introduced. The new accounting system is expected to increase the transparency of financial institutions' balance sheets. Furthermore, it is expected to make financial institutions aware of the risks they are taking by helping them better understand their own financial condition.

For greater transparency of management, it is important to voluntarily expand the scope of disclosure, as the Bank of Japan has been stressing for some time. Enhanced disclosure may at times mean forcing financial institutions to reveal their unresolved problems. However, past experience has taught us that, in order to ensure the credibility of the market, it is more effective to honestly admit the existence of problems and explain how such problems will be solved, than it is to conceal such problems.

Financial institutions should consider disclosure not as a duty but as an opportunity to enhance their reputation with the public. Once a pioneering financial institution makes such disclosure, others will follow suit, or even improve the content of disclosure. This will unleash a dynamic competitive process.

Let us now turn to the policy response of the monetary authorities. I daresay we have not necessarily been able to successfully respond to the changes in the financial markets. In order to maintain the stability of the financial system, we used to rely on measures such as detailed, ex-ante regulations and one-on-one guidance to financial institutions. While it is true that such measures worked for a long period, it also seems we allowed financial institutions to be indifferent to risk management and their own responsibilities, thereby passively encouraging their "do as-everyone-else-does" attitude.

Under such a system, Japanese financial institutions offered very similar financial services. The regulatory system tended to prevent the innovator from profiting, as he deserved, if a financial institution developed a new product.

The conventional system might have remained viable had the financial industry remained static. However, innovation in financial technology has been dramatic. It is no longer possible for a fine-meshed net of regulations to keep up with rapidly evolving financial transactions and markets. Therefore, for financial system stability, we need to establish new principles based on self-responsibility and market mechanisms.

Making use of market mechanisms and increased sophistication of risk management will provide a means of detecting deterioration in the health of financial institutions. This would not only reduce the cost of regulating and supervising financial institutions, but also lessen the burden on the safety net by preventing failures.

3. Response of the Bank of Japan

The Bank of Japan believes that it has done its best to counter the non-performing loan problem within the existing institutional framework, among other things, by fulfilling its functions and executing measures, including its role as lender of last resort.

In providing funds to maintain the stability of the financial system, we apply four criteria. First, there must be a real threat of systemic risk materializing. Second, there is no alternative to the provision of central bank funds. Third, appropriate measures must be taken to prevent moral hazard. And fourth, the financial soundness of the Bank of Japan must not be impaired. Bearing in mind these criteria, it is necessary to take measures on a case-by-case basis when dealing with individual financial crises. Therefore, it is quite difficult to come up with one single answer for all situations. We must continue to unceasingly examine the role a central bank should play, and to take appropriate measures.

The Bank of Japan conducts on-site examinations and off-site monitoring of financial institutions holding current accounts with it. Because a central bank implements its policy through banking transactions, we believe that on-site examinations and off-site monitoring, through which a central bank accurately grasps the financial condition of individual counterparties, are important starting points for policy implementation. They are also essential for the Bank to accurately assess the "macro risk profile," that is, the existence of risks to the overall financial system and the possibility of their materializing, and thereby prevent disruption of the financial system.

In formulating and implementing policy, the Bank of Japan will also utilize the findings of its research and studies on the overall financial system, based on the information obtained through examinations and daily monitoring. Furthermore, we intend to publicize those findings, to the extent possible, in order to assist the advancement of financial institutions' risk management techniques.

From the viewpoint of financial system stability, we also have an important role to play in reducing settlement risk, which includes improving BOJ-NET, the Bank of Japan Financial Network System. In this context, we are currently restructuring BOJ-NET to make real-time gross settlement, or RTGS, the only settlement mode for fund transfers and for the settlement of Japanese government bonds, by abolishing the designated-time settlement mode. RTGS is one of the essential methods for preventing the failure of one participant from spreading throughout the whole system, in other words, preventing systemic risk. In addition, to reduce settlement risk in foreign exchange transactions, we will extend the operating hours of BOJ-NET's on-line services. This will be accomplished by the end of next year, when BOJ-NET is scheduled to shift to RTGS.

Of more immediacy is the Y2K problem, which we are also actively addressing. Through on-site examinations focusing specifically on the problem, and through three external tests conducted between BOJ-NET and financial institutions and private-sector payment and settlement systems since the end of last year, we have confirmed that Japanese financial institutions are successfully dealing with this problem. We plan to conduct three more external tests this year, including one this weekend. Since the associated risk may not be eliminated completely, we have tried to support Japanese financial institutions' crisis management efforts by publishing the "Guidance on Year 2000 Contingency Planning" report last November. We have also made public an outline of our own contingency plan. Needless to say, we will continue to take all possible measures to cope with the Y2K problem.

Concluding Remarks

As I mentioned at the beginning, Japan's financial system finds itself in a never-before experienced situation, which can be regarded as the painful process of the transformation of the financial sector from being heavily protected to being a competitive industry that generates innovation and profits.

The path of this transformation will not be smooth. However, emerging moves on the part of financial institutions to undertake decisive restructuring and consolidation, the fact that the monetary authorities have explicitly committed themselves to reconstructing the financial system, and household financial assets of 1,200 trillion yen, firmly convince me that it will not be too long before Japanese financial institutions recover their competitiveness. Should I have the opportunity to address you once again in the future, I hope the title of my speech will be "How Japanese financial institutions recovered."

Thank you for your attention.