Japan FSA Endorses Obama Administration Call for Systemic Risk Regulation, Including Hedge Funds and Derivatives

A senior official of the Japanese Financial Services Agency has endorsed the Obama Administration’s call for systemic risk regulation and international consistency in the regulatory reform through the offices of the Financial Stability Board. In setting out the key principles for financial reform efforts at the International Bankers Association, Commissioner Takafumi Sato also agreed that the scope of regulation should be broadened to cover all systemically important institutions, products, and markets, including the regulation of hedge funds and OTC derivatives.

A key concept of reform is broadening the regulatory scope with a view to systemic risk. In his view, systemic risk regulation is imperative because the behavior of investment and other non-bank financial firms had a significant impact on overall financial stability. Traditionally, the regulatory framework to deal with systemic risk has been mainly focused on the commercial banking sector. However, the current turmoil was triggered and deepened by troubles at large investment banks, while the bailout of a global insurance group exposed the significant gap in the US regulatory framework.

Large commercial banks had also expanded the scope of their business, for example, by using structured investment vehicles and asset-based conduits and by providing them with liquidity support. Furthermore, previously unregulated firms and markets are exerting increasing influence over the global financial system. Thus, the FSA believes that the scope of regulation should be broadened to cover all systemically important institutions, products, and markets, including strengthening regulation on hedge funds and OTC derivatives.

An intertwined but no less important concept is the need for macro-prudential regulation. The current crisis has demonstrated that macro market developments are as important as idiosyncratic risk at individual firms, he said. Risk factors at an individual firm can spread to the entire financial system through increased counterparty risk and behavioral changes at financial firms, he noted, with market liquidity dried up and the pricing function of the markets impaired.

It is therefore essential that regulators identify common risk factors and make use of the analysis. To this end, he emphasized that traditional micro prudential supervision focusing on the soundness of individual financial firms will not be sufficient. Regulators will need to analyze more thoroughly the effect of macro market developments on the soundness of the financial system and the behavior of financial firms.

In Commissioner Sato’s view, addressing procyclicality of the capital adequacy requirements can be seen as one of these macro prudential approaches in this broader sense. Arguments have been raised that the capital regime has a procyclical effect. That is, when the economic situation gets worse, more capital is required but raising it is made more difficult. In such a situation, banks are tempted to squeeze lending, which in turn further worsen the real economy. On the other hand, when the economy is in good shape and their asset quality is improved, the banks may need less capital but capital increases without much effort.

Another key concept is the need for international cooperation among regulators. The international impact of the recent collapse of large, complex financial institutions demonstrated that global systemic risk posed by such institutions needs to be dealt with by close cooperation among regulators. To this end, the world’s major regulators must establish supervisory colleges for each of the global financial firms. As did the G-20 and the Obama Administration, the FSA official endorsed the Financial Stability Board as a key vehicle for monitoring national regulations so that agreement can be reached on the fundamental principles for cross-border cooperation on crisis management.

Another key concept is enhancing risk management. He recommended that risk management at financial firms be upgraded and given higher priority. Firms should strengthen risk capture and build a sufficient level of capital that is proportionate to the risks their business models entail. For their part, regulators should revise the regulatory framework in a way that promotes the efforts made by the industry to this end. The internal presence of risk management sections at financial firms has been low, and their views were often suppressed by the drives for maximization of short-term profits.

A related key concept is to align compensation incentives so that they do not favor the maximization of short-term profits. Compensation schemes must recognize explicitly the huge risks that materialize later. Legislation and regulation must put in place incentive structures that encourage originators, arrangers, distributors and investors to carry out due diligence and transmit accurate information of underlying assets at each stage; in addition to new regulation on credit rating agencies.

A final concept is enhancing integrity and transparency of the market. Complex, opaque financial products were widely traded among market participants, including off-balance-sheet entities, without adequate appreciation of risks, without transmission of accurate information, and without sufficient disclosure of assets held by financial institutions. As a result, tremendous uncertainty was built up in the market as to toxic exposures and future losses which, in turn, increased the level of counterparty risk. To prevent the recurrence of such a situation, the commissioner recommended improving the transparency of securitized products, strengthening disclosure by financial institutions, enhancing the quality of accounting standards, and more rigorous due diligence.