Full steam ahead on FSA policy initiatives  

The Financial Services Agency ("FSA") remains firmly convinced that there is no need to make any significant alteration to its twin policies of Better Market Initiative1 and Better Regulation2. In a speech in Okinawa on 30 January 20093 Dr. Takafumi Sato, Commissioner of the FSA stated:  

"…some may wonder whether both initiatives now need fundamental overhaul in view of the ongoing financial crisis, as they include various elements of deregulation. Others might hastily conclude that they would have to be suspended or even scrapped.

Therefore, I would like to make it clear here that both the BMI and Better Regulation remain valid and the efforts in this direction will continue.  

…In view of the ongoing crisis, it will be important that we examine carefully whether there are any measures in the BMI that may require modifications, taking into account their consistency with the global trend of "re-regulation" or "re-design" of the regulatory framework. However, I do not think this will lead to fundamental changes to the entire initiative."

As the liberalisations offered by the BMI are quite limited, the more important change would be one that affected the tenor of the policy of Better Regulation which is based upon a more consultative approach to regulatory practice and policy goals. Change in that area would be significant indeed after the recent relaxation.  

Currently the senior ranks of the FSA have considerable latitude in setting policy as political leadership remains minimal as symbolized by the ignominious recent departure of Mr Shoichi Nakagawa, Finance Minister, who had responsibility for the FSA. His successor, Kaoru Yosano, seems burdened with other more urgent matters, although there are signs his attention has recently turned to the problem of bank capital adequacy.  

Three possible icebergs  

The FSA's confidence that the policy course can be maintained was based on the fact that Japan's financial services companies had relatively little sub-prime exposure4 and that the damage to capital resources and Basel ratios would therefore be limited. However, the FSA has now acknowledged to some extent that this optimistic outlook is being progressively undermined by the secondary effects of the global financial crisis. At least three icebergs are now looming into worrying focus:  

  1. Loans to SME5s: Commissioner Sato spoke in Okinawa of his grave concerns in this area. The sharp decline in economic activity is likely to cause a surge of domestic SME defaults that could affect many Japanese banks.
  2. Property sector: In a speech on 27 February 2009 to the Japan Real Estate Institute6, Commissioner Sato noted that the sector had changed greatly as a result of the involvement of REITs and foreign investors. He denied that the FSA had asked banks to reduce their exposure to the sector, but noted vigilance was necessary as the domestic real estate market went through a tough period.  
  3. Regional banks: In Okinawa Commissioner Sato told his audience that two Japanese regional banks had already expressed their interest in applying for a capital injection from the FSA, which has reviewed and strengthened its scheme for such financings.  

FSA's mix of counter-measures  

At this stage the FSA's largest concern appears to be the status of loans to SMEs. In Okinawa, Commissioner Sato noted that:  

"The FSA has revised its supervisory guidelines and inspection manuals to expand the cases where rescheduled loans to SMEs are not classified as non-performing loans. This is in light of the inherent nature of SMEs that the scope for restructuring is limited and it takes time to recover profitability or to return to solvency."  

The FSA may genuinely want to protect the economy in Japan's regions, but this statement sounds remarkably like a relaxation of regulatory policy that has two side-effects: helping maintain the capital bases of regional banks and protecting the FSA from political pressure and interference.  

Other recent initiatives to improve regulatory oversight include support for the measures taken by the Accounting Standards Board of Japan with regard to accounting standards for financial products and the consideration of a new framework for the regulation of credit rating agencies to prevent conflicts of interest and enhance disclosure. In this last measure the FSA hopes to coordinate with US and European regulatory authorities to supervise global credit rating agencies.  

Time to expect more visits and pressure on lenders

However, it is not just credit rating agencies that should now expect to see more FSA inspectors. All lending institutions in Japan are, once again, a source of systemic risk to Japan's domestic financial system by virtue of their exposures to domestic real estate or SME lending. The FSA's policy with respect to lenders is not yet clearly defined: increased vigilance is mentioned but there is also a willingness to be flexible on the classification of non-performing loans if SMEs are involved.  

Whilst the FSA seeks to reiterate that its twin policies of Better Market Initiative and Better Regulation have not changed, regulated institutions would seem to be facing a more uncertain regulatory environment as domestic economic and credit risks ratchet higher. Over the last two years the FSA has wanted to move to principles-based regulation and to engage cordially with regulated institutions. The next year will test that policy as deterioration in the quality of domestic financial assets requires the FSA to become more interventionist, particularly in the case of banks.