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Toward Further Development of Capital Markets

To Support Smooth Corporate Finance
Masaru Hayami, Governor, Bank of Japan, at the Capital Markets Research Institute on December 9, 2002

December 9, 2002
Bank of Japan


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  1. It is my great pleasure to address the Capital Markets Research Institute today.
  2. I would like to share my thoughts with you on the challenges in regard to the development of Japan's capital markets and the role of market participants.
  3. Since adopting the so-called quantitative easing framework in March 2001, the Bank of Japan has substantially increased its liquidity provision to the market. To illustrate the extent of fund provision by the Bank, let me quote some figures with respect to the size of the Bank's assets. As shown in Figure 1 in the handout, they were 139 trillion yen as of end-fiscal 2001. In comparison, in yen terms the assets of the European Central Bank were 95 trillion yen, and those of the US Federal Reserve System 86 trillion yen. In terms of asset size, the Bank of Japan is the largest central bank in the world. Of note is that the ratio of the Bank of Japan's assets to nominal GDP increased substantially from 16% at end-fiscal 1998 to 28% at end-fiscal 2001.
  4. While fund provision from the Bank has increased dramatically, commercial bank lending has been declining since 1997, showing a year-on-year decline of 3% adjusting for special factors such as write-offs.
  5. At present, firms still carry excess debt, and they are pursuing such debt restructuring as allotting improved cash flows to repaying borrowings from banks. On the other hand, banks need to promote the disposal of non-performing loans (NPLs) and improve their earning power. In the process, there will be forces holding down bank lending from both banks themselves and firms. Banks will view corporate fund demand as being low while firms for their part will feel that the lending attitude of banks is severe.
  6. What is important here is whether other developed channels of fund raising are available. If such channels are in place, firms can satisfy their needs by obtaining funding through them, thus leading to economic development. The capital markets are one such fund-raising channel.
  7. Let me start by giving an overview of Japan's financial and capital markets using Figures 2 and 3 in the handout.
  8. As shown in Figure 2, in Japan the most rapidly developing financial and capital market is the primary market for Japanese government bonds (JGBs), whose issue amount outstanding already exceeds 500 trillion yen. While we will have to tackle the difficult problem of reimbursing the massive increase in government bonds in the future, the JGB markets, including the primary and secondary markets, as well as payment and settlement system, have developed substantially.
  9. In terms of corporate sector funding shown in Figure 3, 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 80 trillion yen. The size of the corporate bond and CP markets relative to the loan market is quite small in Japan compared with the US. In addition, unlike the US where even BBB-rated firms actively issue corporate bonds, only firms with a relatively high credit rating can issue bonds and thus it cannot be denied that the market lacks depth in Japan. Although not shown in the handout, the outstanding balance of securitized products, such as asset-backed securities (ABS), is also small in Japan, being a little below 20 trillion yen in Japan, compared with more than 600 trillion yen, in yen terms, in the US.
  10. Since financial and capital markets reflect the history and economic structure of an individual country, Japanese markets do not necessarily need to have the same structure as those of US markets. Given the current financial and economic situation in Japan where the NPL problem is a big burden, it is important to effectively utilize the capital markets, which are an alternative credit intermediary channel.
  11. There are two types of capital markets: stock markets (equity markets) and the markets which deal with such corporate debt obligations as corporate bonds and CP, the so-called debt markets. While both markets are equally important, I have the impression that, except among experts such as today's audience, stock markets tend to attract more discussion relative to debt markets, and also that there seems to be substantial room for improving debt markets.
  12. The following is the outline of my speech with particular emphasis on debt markets: first, why it is important to develop capital markets; second, what are the necessary conditions for capital market development; third, what are the recent changes in capital markets; and fourth, how the Bank of Japan is trying to improve capital markets.

I Significance of capital market development

  1. Let me start with the significance of capital markets.
  2. Arguably, the role of a capital market is to link the funding needs of firms and households with the needs of investors, and thus realize efficient fund allocation. While I used the term 'efficient fund allocation,' it is by no means the mere process of quantitative allocation. Interest rates, which are the price of funds, are determined by supply and demand in the market. As a market expands, various participants enter and the market and prices are formed more efficiently, resulting in more efficient fund allocation. Through such a process is the basis for economic development formed. This is the significance of developing capital markets.
  3. In the household sector, the accumulation of financial assets and aging have led to an increase in assets such as pension and insurance funds, and the demands of institutional investors for long-term investment vehicles have been increasing. A challenge for the capital markets is thus to provide various long-term financial products in response to such heightened needs.
  4. In the meantime, many firms have actively been making efforts to innovate their management style under a rapidly changing industrial structure. In the process, firms have come to face increasingly complicated and diversified risks. One role for the capital markets is to provide a variety of risk-hedge methods against such diversified risks as price volatility pertaining to interest rates, foreign exchange rates, stock prices, and property prices.
  5. Banks should naturally also play a role in efficient fund allocation. As we all know, they play a financial intermediary function between fund-raisers and depositors by accepting deposits and extending loans, in other words, taking certain risks themselves using their own balance sheets.
  6. There is no point in discussing the relative importance of banks and capital markets, as they ought to complement each other to support a nation's financial and economic system. In fact, there have been several instances in the US when capital markets substituted for the flow of funds through banks when they were in trouble, and, to the contrary, banks expanded fund provision to firms instead of the capital markets when they contracted due to certain shocks. For example, when the large hedge-fund Long-term Capital Management collapsed in autumn 1998, capital markets contracted rapidly and corporate bond issuance declined. However, smooth fund provision to firms was preserved thanks to a substantial increase in bank lending, successfully replacing fund provision via capital markets.
  7. As such, it is desirable to see banks and capital markets develop together by being closely connected and influencing each other, and supporting Japan's economy from the financial front.

The roles of capital markets have increasingly gained significance as banks have strengthened management style

  1. Since banks are currently saddled with non-performing loans, NPLs, the role of capital markets has become especially important.
  2. A report entitled "Japan's Non-performing Loan Problem," published by the Bank of Japan in October, advocated comprehensive measures were inevitable in order to overcome the NPL problem, including a prompt grasp of the economic value of such loans, the promotion of their prompt disposal, and improvement in the earning power of both borrowing firms and banks. Subsequently, the Financial Services Agency formulated its Program for Financial Revival and, on November 29, announced a timetable. Taking into account such developments with respect to the NPL problem, banks have been vigorously striving to strengthen their management base by focusing on the prompt disposal of NPLs and an improvement in earning power.
  3. Under such an environment, the significance of developing capital markets is manifold. Firstly, it is important to take advantage of capital market functions in order to maintain smooth corporate finance.
  4. In the process of banks pursuing ways to strengthen themselves, it is likely they will aim at adjusting the composition of their portfolio to strike an appropriate balance with their net worth while reducing their assets to some extent. While this might be seen as implying a reduction in new loans, the reality is that banks have so far adjusted their portfolios through measures such as the securitization of existing loan assets, a reduction in foreign assets, and selling their securities holdings. In the long run, such moves are necessary if an efficient financial intermediary function is to be restored on the part of banks, but we have to be vigilant as to what effect it will have on corporate financing.
  5. In order to ensure smooth corporate financing, firms need to devise ways from various angles. One such angle is utilization of the capital market.
  6. As previously mentioned, banks and capital markets are complementary, and capital markets are expected to substitute for the role of banks in the event banks are faced with problems. In fact, in addition to direct funding measures such as corporate debentures and CP, recent developments in financial technology have facilitated the securitization and liquidation of loan assets into forms in line with investor needs. These developments cannot resolve all problems attaching to corporate finance, but I believe that, in order to ensure smooth corporate finance, firms should not leave the capital market function unutilized.
  7. Secondly, and from a slightly different perspective, it can be pointed out that the more efficient pricing in capital markets becomes, the more favorable effects will emerge with respect to the disposal of NPLs and an improvement in earning power.
  8. In disposing of NPLs, banks are required to make efforts to remove such loans from their balance sheets upon setting aside appropriate provisions. Such off-balancing could be realized through the secondary market for loan assets, and, the mere existence of a market with various investors makes it easier for banks to find investors who have a strong willingness and know-how for reviving troubled firms, and thus the path for business revival might become more visible. In addition, through such a process, prices for securitized loan assets will be formed at levels which are acceptable or borrowers and lenders have no choice but to accept, and banks would be able to more smoothly promote the disposal of NPLs by making reference to those prices in the secondary market. In the future, when the disposal of NPLs and corporate rehabilitation is conducted through the Resolution and Collection Corporation and the Corporate Rehabilitation Organization, if there is a secondary market for loan assets, and market prices are formed transparently for various loan assets, such prices could be used effectively as a clue to evaluate individual corporate value.
  9. In addition, from the viewpoint of strengthening earning power, banks have to endeavor to set more appropriate lending rates which correspond to the risks. In so doing, if there are developed secondary markets for loan assets, then banks can judge the appropriateness of their lending rates by using such market prices as a reference together with their own risk evaluation methods.
  10. As such, the process of strengthening bank management encourages the expansion of capital markets, and banks can strengthen their own management if capital markets function effectively.
  11. Strengthening bank management can trigger the development of capital markets, and efforts should be made to this end.

II Conditions necessary for the development of capital markets

Improvement in infrastructure which underpins capital markets

  1. Let me move on to point out four conditions which are common to capital market development.
  2. The first is to always check the institutional infrastructure such as legal, taxation, and accounting systems, and to improve them as the environment changes.
  3. Until the mid-1990s, there were strict criteria for firms which could issue bonds and stocks domestically, and it was difficult for firms which were regarded as not being very creditworthy to enter capital markets. In addition, the range of securities in which institutional investors could invest was also limited to those with a relatively high credit rating. While such a system aimed at protecting investors by depending heavily on ex-ante restrictions, it had the aspect of suppressing the most important function of capital markets, which is 'to attract various investors by handling various risks and realizing efficient fund allocation.' However, such a side-effect has been alleviated considerably following the abolition of qualification standards for bond issuance and the expansion of institutional investors' investment range parallel with enhanced disclosure.
  4. However, under current circumstances in which both the financial and economic structure rapidly change and financial technology continues to advance, an institutional framework is likely to quickly become obsolete. A framework which is effective today might become a hindrance tomorrow.
  5. From such a viewpoint, what has troubled us recently is that while new financial products based on new financial technology are continuously created, there are not a few cases where the tax and accounting treatment of such products is not necessarily clear. In fact, when we talk to market players, we often hear that they have been refraining from engaging in new kinds of transactions because the tax and accounting treatment is not clear.
  6. If tax and accounting treatment is not clear, including actual application, the evaluation of risks of individual products becomes difficult. If such treatment continues to be vague, we might not be able to effectively use technologies which meet market demands. Transactions in ever evolving new financial products, based on new technologies, often face a problem in terms of legal treatment since many such products have not previously been envisioned. As you may recall, in the early days of derivative transactions in Japan, there was discussion that such transactions might violate gambling laws. Even recently, it seems to be a challenge to bring new financial products, such as asset-backed securities and syndicated loans, in line with the legal system.
  7. While it is understandable that such treatments are difficult to determine because the products are new, I think it has become important to learn from the wisdom of related parties to practically improve the situation by utilizing methods such as 'no-action letters'.

Utilization of rapidly evolving innovation in information technology

  1. The second necessary condition for capital market development is to aggressively incorporate innovation in information technology.
  2. The development and prevalence of computer and Internet technology have promoted efficiency and diversification in every area of the economy. The financial area is no exception.
  3. The rapid progress in calculation techniques by computers has enabled a massive amount of statistical data to be handled instantaneously. For example, calculations to obtain default probability and various risks, which are critical when dealing with financial products, are now done in a very short period of time. In addition, due to the progress in telecommunication technology, including the Internet, massive data collection has become far easier than in the past.
  4. So-called derivative transactions isolate risks intrinsic to underlying assets and enable trading in these risks separately. Such highly abstract transactions were made possible by the remarkable progress of computer calculation technology. These derivative transactions have enabled and facilitated the unbundling and re-bundling of risks to generate combinations of risks and returns different from those of underlying assets.
  5. Some asset-backed securities, for example ABCP backed by the receivables of small to medium-sized firms and mortgage-backed securities, aim at diversifying risks by bundling numerous small-lot assets into one security. It is impossible to have these products in the absence of massive data collection and expeditious calculation.
  6. For the capital market to aim at more efficient fund allocation, it is important to make the best use of new technologies and respond to market needs appropriately.

Clarifying the roles of public financial institutions

  1. The third condition is to clarify the policy objectives and roles of public institutions in financial markets.
  2. The share of public finance in Japan's financial markets is remarkably high compared with other countries. Public finance has played an important role historically, including during the post-war recovery period. And, when bank lending declined rapidly as in 1997-98, public financial institutions played a complementary function. In this sense, I have no intention to deny the general role of public financial institutions. However, given that anything has effects and side-effects, I believe it necessary to keep our eyes on the side-effects.
  3. As the economic environment is ever changing, the risk and return profile of corporate business also changes. One function of financial and capital markets is to factor such changing risks into market prices on a real-time basis, and realize more efficient fund allocation. However, if the size of public financial institutions becomes too big, the risk-and-return relationship in the economy as a whole is distorted, resulting in the market economy pricing mechanism (where price changes trigger management innovation on the part of firms and investors) failing to penetrate the economy as a whole.
  4. Public financial institutions account for a high proportion of overall financial intermediation in such industrialized countries as Japan and Germany. It might not be a mere coincidence that in both countries the earning power of commercial banks is weak and capital markets are not well-developed. As long as public financial institutions are not able to shoulder financial intermediation for the nation as a whole, it becomes necessary after all to consider how funds collected by private financial institutions can be efficiently channeled to firms and individuals, and, in order to realize this, to clarify the role and functions to be exercised by public financial institutions. For example, public financial institutions' direct lending in areas which compete with private financial institutions warrants review from a long-term viewpoint.
  5. Having said that, I do not believe that the role of public financial institutions will totally disappear. In my opinion, there is a definite role which public financial institutions should play, and I sincerely hope that they fulfill such responsibilities. Over time, the main role of public financial institutions might come to be restricted to providing credit enhancement measures in limited areas where there is a policy need. At an early stage of securitization, such as ABCP backed by the receivables of small to medium-sized firms and mortgage-backed securities, there might be some ways to support market expansion through credit enhancement measures provided by public financial institutions.
  6. The provision of credit enhancement measures by public financial institutions entails the risk of weakening the recognition of risks, thereby distorting the risk-and-return relationship. If this materializes, it will be important to devise ways of providing credit enhancement measures in such a way as not to hamper market mechanisms in the overall economy.

Acceptance of a 'credit culture'

  1. As the fourth condition for capital market development, I would like to point out the establishment of 'credit culture.'
  2. The term 'credit culture' might be unfamiliar, but it suggests the essence of capital markets where investors accurately evaluate risks and returns and pursue investment and financing based on calculations derived from such evaluation.
  3. Capital markets are markets in which investors invest in the credit risks of firms and banks and expect returns, and hence in this sense it is quite natural to say they thoroughly evaluate the risks and invest appropriately. Nevertheless, the reason why I mention this is that, despite various institutional reforms, in my opinion, debt markets have not developed at the pace initially envisaged. I cannot help feeling that the root cause of such a slow tempo lies in the issue of 'credit culture.'
  4. For example, institutional investors seek the optimum combination of risks and returns by diversifying their investment. Until the mid-1990s, it was not easy to pursue such investment diversification due to the institutional constraints. However, since then, the constraints have largely disappeared. Against this background, to what extent have we seen the expansion of investment choices and pursuit of returns by way of investment diversification? Granted that severe economic conditions continue, but I think it unfortunate that the number of firms which can issue bonds remains so small.
  5. With the strong influence of the main bank system, firms have also been generally reluctant to expand their funding sources, which might result in weakening the relationship with banks. This also leads to the recent situation where firms tend to be reluctant to give 'permission' when banks try to securitize loans to them. Of course, there would be no problem if firms judged it advantageous to do so. However, there are various choices for funding in a rapidly changing financial environment. The relationship between firms and main banks will not continue to be the same as in the past. To this end, it is important for firms to take into account all these changes and select what they judge as the most advantageous way to obtain funding.
  6. To avoid misunderstanding, let me add that, by saying 'credit culture,' I am not referring to 'character' or 'courage' on the part of firms and investors. What is necessary for risk-and-return calculation is not 'courage' but experience as an expert and 'technique' which supports such experience. Having advanced techniques to evaluate risk-and-return and being able to realize returns by controlling the risks are indeed the source of profits and justify the raison dêtre of banks and institutional investors.
  7. The relationship between the development of capital markets and entrenchment of credit culture is a chicken-and-egg question. One can say that the development of debt markets has been delayed because a credit culture is not entrenched, and vice versa that a credit culture has not become entrenched because the debt markets are not sufficiently developed. I hope that, taking the current opportunity when capital markets are entering a period of change, a posture to effect objective evaluations and follow the results will take root in Japan.

III Noteworthy developments toward capital market improvement

Development of the ABS market: Securitization of receivables of small to medium-sized firms

  1. Now, let me introduce what the Bank of Japan sees as some noticeable developments toward the further development of capital markets.
  2. One is the generation of asset-backed securities (ABS). There are already many types of ABS issued, with assets which serve as collateral ranging from lease credits to real estate, and which were held by firms of various size.
  3. I will take up two types of ABS: ABCP backed by the receivables of small to medium-sized firms, and ABS backed by mortgage loans.
  4. Previously, the receivables of small to medium-sized firms against big firms and other counter parties were not used as funding collateral because they were not in the form of securities or bills and the amount was relatively small. These days, however, there are examples of banks extending loans using receivables as collateral, and subsequently converting such loan assets to securitized products and selling them to investors. Such a scheme is being well received in the market as it supports the funding of small and medium-sized firms.
  5. By taking advantage of such a technique, in the future we might see a scheme which securitizes assets via arrangements and intermediation by banks and factoring firms, and sales are made directly to investors. If such schemes increase, it would facilitate the financing of small and medium-sized firms.
  6. For such schemes to be successful, firms should make efforts to attract investor money. The strict management of their own transactions and aggressive disclosure of their financial data are examples. While the issuance of ABCP backed by the receivables of small to medium-sized firms is still in its infancy, it is an area which deserves further consideration as a device to ensure smooth corporate financing.

Development of the ABS market: Securitization of mortgage loans

  1. The securitization of mortgage loans is another area which has growth prospects. While each mortgage loan is a small amount and thus difficult to securitize directly, one can make a securitized product which satisfies the demands of investors by bundling similar loan assets. In the US, the market for mortgage-backed securities has rapidly expanded since the 1980s and its size now exceeds that of Treasury securities.
  2. In Japan, there is only a small market, on the scale of about 1 trillion yen, for mortgage-backed securities, centering on bonds issued by the Government Housing Loan Corporation. However, institutional investors such as pension funds and life insurance companies have strong demand for long-term assets to match their long-term liabilities. Mortgage loans are likely to be increasingly provided by commercial banks upon abolition of the Government Housing Loan Corporation. In this regard, the secondary market for mortgage loan assets should increasingly gain in significance for commercial banks as a place to manage their interest rate and prepayment risks. Such expansion of market activity will contribute to stable provision of mortgage loans. I hope that the work to nurture such a market conducted by the wide range of parties concerned including banks, participants in securities markets, and public agencies, will take further shape and bear fruit in due course.

Expansion of the syndicated loan market

  1. Those then are the recent moves related to the ABS market. In parallel with such moves, syndicated loans for major firms have been gradually increasing in addition to the expansion of the secondary market for loan assets.
  2. A syndicated loan is, in general, a loan, extended to a firm by multiple banks based on a single contract under the arrangement of a managing bank.
  3. Syndicated loans have been increasing because major banks, in their efforts to strengthen themselves, have started to earn profits by playing the role of a managing bank while reducing loan concentration risk. Regional banks and institutional investors who participate in syndicated loans consider that such loans give an opportunity to extend loans to major firms, which used to be difficult to approach individually, and thus broaden the chance of earning profits and controlling credit risks. In fact, we increasingly find names of institutional investors, in addition to banks, as initial fund providers of syndicated loans these days, and thus such loans can be regarded as a variant of the capital markets.
  4. Such syndicated loans and the secondary market for loan assets have increased rapidly in the US since the mid-1990s. The size of syndicated loans in Japan remains at 4% of new loans and they have been characterized as a variable of joint financing and thus different from US-type syndicated loans where underwriters sell securities. In this sense, the market for syndicated loans in Japan is expected to show full-fledged growth from now on, and market participants are already making efforts to improve transaction practices and to accumulate and publish information with respect to loan prices.
  5. If transactions in the syndicated loan market and secondary market for loan assets become active, such markets will contribute to maintaining smooth corporate financing even when banks try to reduce their assets. I hope efforts of related parties bear fruit and lead to further expansion of the markets.

IV Efforts by the Bank of Japan

  1. Lastly, let me touch on the Bank of Japan's efforts with respect to capital market development.
  2. The Bank of Japan has a close relationship with capital markets through its central banking operations. The Bank effects daily money market operations such as the purchase and sale of bonds using the capital markets as one of the venues. In terms of payment and settlement system, the Bank runs the government bond settlement system through BOJ-NET.
  3. Financial and capital markets serve as an important vehicle transmitting monetary policy effects to economic activity as a whole. If the financial and capital markets do not function sufficiently, policy effects might be dampened. Therefore, the Bank has also been trying to support them from various aspects to enhance their market function.
  4. Let me introduce some recent examples. On the money market operation front, in November we started to see a new type of government bond repo operation replacing the conventional borrowing of JGBs against cash collateral and short-term government bond repo operations. Such a shift was based on our judgement that it is desirable to adopt a new type of operation which is safer and more convenient taking into account the recent improvement in trading practices in the market. In addition, considering that preparations for computerizing CP transactions are well under way, the Bank plans to, upon commencement of a computerized CP book-entry system scheduled for spring next year, make such computerized CP eligible as collateral.
  5. I would like to elaborate on our eligible collateral. As collateral for bill operations and the Lombard-type lending facility, the Bank selects eligible collateral based mainly on creditworthiness and marketability. Bearing in mind that such selection of eligible collateral contributes indirectly to the expansion of markets, the Bank has been making efforts to actively adopt even new financial products as eligible collateral. For example, the Bank already accepts ABS and ABCP which satisfy certain conditions as eligible collateral. CP, which is backed by small to medium-sized firms' receivables, and mortgage loan backed securities have also been accepted as eligible collateral if they satisfy certain conditions. While the amount of securitized products used as collateral is not that large so far, we believe there has been some favorable impact on market development through the provision of liquidity by our making them eligible as collateral.
  6. In addition, on the payment and settlement front, the Bank introduced in January last year real-time-gross-settlement (RTGS) to BOJ-NET from the viewpoint of further improving the security of fund settlement and government bond settlement. Since then, the RTGS system has been smoothly functioning and seems to have been completely accepted. The government bond settlement system is also being modified to be consistent with a new law concerning central depository systems which is scheduled to be effected in January 2003. We are also making preparations on the system front for the anticipated issuance of personal government bonds and strips bonds. Based on such improvement in payment and settlement systems, we need to further tackle such issues as developing new repo transactions with same day (T+0) settlement.
  7. Concurrently, we have recently been conducting various studies in collaboration with parties concerned. With respect to ABCP backed by the receivables of small to medium-sized firms, we have held discussions with a wide range of participants from public agencies, banks, securities firms, and venture capital firms, and published the results. We have also been actively participating in many venues to examine various topics and making a contribution in our own way.
  8. The Bank of Japan intends to promote studies, together with parties concerned, which will contribute to the further development of capital markets.
  9. I would like to conclude by reiterating that there are great expectations capital markets will help Japan overcome the current problems.
  10. Thank you for your attention.