Japans financial regulatory responses to the global financial crisis

Description
This paper aims to understand Japan’s financial regulatory responses after the global
financial crisis and recession. Japan’s post-crisis reactions show two seemingly opposing trends:
collaboration with international organizations to strengthen the regulation to maintain financial
stability, and regulatory forbearance for the banks with troubled small and medium enterprise
[SME] borrowers. The paper evaluates the responses by the Japanese financial regulators in five
areas (Basel III, stress tests, over-the-counter [OTC] derivatives regulation, recovery and resolution
planning and banking policy for SME lending) and concludes that the effectiveness of the new
regulations for financial stability critically depends on the willingness of the regulators to use the
new tools.

Journal of Financial Economic Policy
Japan’s financial regulatory responses to the global financial crisis
Kimie Harada Takeo Hoshi Masami Imai Satoshi Koibuchi Ayako Yasuda
Article information:
To cite this document:
Kimie Harada Takeo Hoshi Masami Imai Satoshi Koibuchi Ayako Yasuda , (2015),"J apan’s financial
regulatory responses to the global financial crisis", J ournal of Financial Economic Policy, Vol. 7 Iss 1
pp. 51 - 67
Permanent link to this document:http://dx.doi.org/10.1108/J FEP-12-2014-0077
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Santiago Carbó-Valverde, Harald A. Benink, Tom Berglund, Clas Wihlborg, (2015),"Regulatory
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Economic Policy, Vol. 7 Iss 1 pp. 29-50http://dx.doi.org/10.1108/J FEP-11-2014-0071
Robert A. Eisenbeis, Richard J . Herring, (2015),"Playing for time: the Fed’s attempt to mange the
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Japan’s fnancial regulatory
responses to the global
fnancial crisis
Kimie Harada
Faculty of Commerce, Chuo University, Tokyo, Japan and
Tokyo Center for Economic Research (TCER), Tokyo, Japan
Takeo Hoshi
Asia Pacifc Research Center, Stanford University, Stanford,
California, USA, National Bureau of Economic Research (NBER),
Cambridge, Massachusetts, USA and
Asian Bureau of Finance and Economic Research (ABFER), Singapore
Masami Imai
Wesleyan University, Middletown, Connecticut, USA
Satoshi Koibuchi
Faculty of Commerce, Chuo University, Tokyo, Japan and
Tokyo Center for Economic Research (TCER), Tokyo, Japan, and
Ayako Yasuda
Graduate School of Management, University of California, Davis,
California, USA
Abstract
Purpose – This paper aims to understand Japan’s fnancial regulatory responses after the global
fnancial crisis and recession. Japan’s post-crisis reactions show two seemingly opposing trends:
collaboration with international organizations to strengthen the regulation to maintain fnancial
stability, and regulatory forbearance for the banks with troubled small and medium enterprise
[SME] borrowers. The paper evaluates the responses by the Japanese fnancial regulators in fve
areas (Basel III, stress tests, over-the-counter [OTC] derivatives regulation, recovery and resolution
planning and banking policy for SME lending) and concludes that the effectiveness of the new
regulations for fnancial stability critically depends on the willingness of the regulators to use the
new tools.
Design/methodology/approach – This report evaluates the post-crisis responses by the Japanese
fnancial authorities in fve dimensions (Basel III, stress tests, OTC derivatives regulations, recovery
and resolution planning and bank supervision).
Findings – The effectiveness of the new regulations for fnancial stability critically depends on the
willingness of the regulators to use the new tools.
Originality/value – The paper is the frst attempt to evaluate the fnancial regulatory trends in Japan
after the global fnancial crisis.
Keywords Financial markets, Government policy and regulation, Financial institutions and services
Paper type Research paper
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
Japan’s
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responses
51
Received9 December 2014
Revised9 December 2014
Accepted9 December 2014
Journal of Financial Economic
Policy
Vol. 7 No. 1, 2015
pp. 51-67
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-12-2014-0077
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1. Introduction
The Japanese fnancial system did not suffer directly from the global fnancial crisis of
2007-2009. As Harada et al. (2011) argues, one important factor that reduced the exposure of
Japanese fnancial institutions to the risks realized in the global fnancial crisis was Japan’s
(micro) prudential regulationregime that hadbeensignifcantlyimprovedfollowingJapan’s
own fnancial crisis in the 1990s. The Japanese regulators had fnally forced the banks to
recognize and deal with non-performing loans, created the framework to deal with troubled
but systemically important banks, recapitalized the banks using public funds when
necessaryandestablishedthe systemof supervisionthat stresses safetyandsoundness. The
process was slow, but all the major ingredients for the improvedregulatoryregime hadbeen
established by the mid-2000s. When the global fnancial crisis hit the major fnancial
institutions around the world, Japan’s fnancial institutions had little exposure to the
securitized fnancial products that were at the epicenter of the crisis. Hence, although the
ensuing global recession hurt the Japanese economy (especially through its export-oriented
frms, whichsufferedfromthe decline of global trades), its fnancial sector remainedhealthy,
compared to those of the USAand European counterparts.
Japan’s fnancial regulatory responses to the global fnancial crisis and recession
show two seemingly opposing directions. On the one hand, Japan eagerly cooperated
with the regulators of other major countries to strengthen the fnancial regulation,
trying to avoid another global fnancial meltdown. On the other hand, Japan’s regulators
relaxed the soundness standard for the bank regulation to protect the borrowers that
suffered from the global recession.
This report describes the responses that Japanese fnancial regulators have taken
since the global fnancial crisis, and evaluates them. The next four sections (Sections 2,
3, 4 and 5) examine the regulatory changes in Japan that have been adopted in
coordination with the rest of the world to strengthen the existing regulation and to
expand the scope of the fnancial regulation. Section 6 describes how Japanese
regulators relaxed the bank supervision to help the troubled borrowers after the crisis.
Section 7 offers concluding comments.
2. Basel III
Japanwas one of the earliest adopters of Basel II framework, whichwas consideredto be the
improved version of the international accord on bank capital regulation known as Basel I.
Thus, when the Basel Committee on Banking Supervision (BCBS) started to examine the
need to revamp the capital regulation in light of the global fnancial crisis, not surprisingly,
Japan embraced the idea again. Table I shows the dates of implementations of Basel
frameworks for Japan. By the end of 2013, the domestic rule-making process toward the full
implementation of Basel III rules was largely complete.
Soon after the global fnancial crisis, the BCBS started to coordinate the international
efforts to revise the bank capital regulation framework to address a variety of challenges
presented by the global fnancial crisis. The frst outcome of the rule-making efforts
appeared as Basel 2.5 of July 2009. Basel 2.5 was positioned as an enhancement of the
Basel II, which was already implemented in many European countries and Japan (but
not in the USA) before the global fnancial crisis.
The contents of Basel 2.5 are found in BCBS (2009b), BCBS (2009a) and BCBS
(2009c)[1]. In addition to the risks considered in Basel II, Basel 2.5 introduced capital
charges for banks’ securitization tranche positions held in their trading books and
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off-balance sheet vehicles (e.g. asset-backed commercial paper conduits). In addition,
substantially higher-risk weights for resecuritizations compared to securitization
tranches were introduced[2]. The new standard also introduced a leverage ratio as a
backstop to the Basel II capital ratio.
The enhancement of Basel II to address such new “market” risks was a direct
response to the global fnancial crisis. Many banks in the USA and Europe built up
signifcant exposures to off-balance conduits. They also accumulated massive losses in
their trading books.
Although many Japanese banks did not have much exposure to these market risks,
the Financial Services Agency of Japan (JFSA) duly implemented Basel 2.5. The
resecuritization exposure regulation rule introduced in March 2011 requires banks to
hold higher capital for “resecuritized” products, which are collateralized debt
obligations (CDOs) that packaged together asset-backed securities and other CDOs. In
response to banks’ requests to clarify the range of securitized products that are
considered to be resecuritized, the JFSA published the list of securitized products that
are not considered to be resecuritized.
Enhancement of Basel II framework, however, was considered insuffcient to address
major problems that were revealed by the global fnancial crisis. The BCBS developed a
more fundamental reform of the capital regulation, which was termed Basel III. The
Basel III rules were published in December 2010. They are detailed in the following two
documents:
(1) Basel III: A global regulatory framework for more resilient banks and banking
systems.
(2) Basel III: International framework for liquidity risk measurement, standards and
monitoring.
The former presents the details of the Basel III framework, including defnition of
capital, risk coverage, capital conservation buffer and countercyclical capital buffer.
Table I.
Dates of
implementations of
Basel frameworks
Regulation Basel guideline Japan
Basel 2 Finalized in June 2004 Fully implemented by March
2007
Basel 2.5 Finalized in July 2009 Fully implemented by
December 2011
Basel 3: minimum common
equity capital ratio (4.5%)
Full implementation by 2019 Full implementation by
January 2015
Basel 3: capital conservation
buffer (2.5%)
Full implementation by 2019 Implementation starts at
0.625% in 2016
Gradually raised to 2.5% by
2019
Basel 3: liquidity coverage ratio Partial implementation starting
in 2015
Full implementation by 2019
Start implementation in 2015
(60% of the full
implementation)
Basel 3: net stable funding ratio Finalized by 2018 Start implementation in 2018
Sources: Basel Committee on Banking Supervision (2010b) and Financial Services Agency of Japan
(2013b)
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The defnition of risk-weighted assets was expanded to cover exposures to off-balance
sheet conduits. Basel III also introduces the minimumamount of liquidity that banks are
required to hold. The banks are required to satisfy two minimum liquidity ratios:
(1) The liquidity coverage ratio.
(2) The net stable funding ratio.
The national implementation of Basel III in Japan started in January 2013, but the fnal
implementation is not expected until as late as 2022. In Basel III, banks are required to
satisfy several levels of minimumcapital ratios. Initially, the core capital must be higher
than 3.5 per cent of the risk-weighted assets, Tier 1 capital must be higher than 4.5 per
cent of the risk-weighted assets, and the total capital must be higher than 4.5 per cent of
the risk-weighted assets. The minimum capital ratios will be increased gradually over
time. By 2019, the banks will be required to hold core capital that exceeds 4.5 per cent of
the risk-weighted asset, Tier 1 capital higher than 6 per cent of the risk-weighted capital
and total capital larger than 8 per cent of the risk-weighted assets.
Basel III proposes to add two conservation buffers over and above these minimum
capital ratios, starting in 2016. The capital conservation buffer increases gradually to 2.5
per cent by 2019. The countercyclical buffer, which goes up to 2.5 per cent during a
boom, aims at mitigating the problem of pro-cyclical nature of the capital regulation.
The largest and most connected banks in the world whose failure might trigger a
fnancial crisis, called global systemically important fnancial institutions (G-SIFIs), are
required to hold additional capital ranging from1 to 3.5 per cent of risk-weighted assets,
depending on the level of systemic importance. The list of G-SIFIs will be updated
annually and published by the Financial Stability Board each November. As of
November 2013, 28 banks and one insurance company are designated as G-SIFIs[3].
In Japan, the Basel III requirement is imposed only on 16 major banks that are
internationally active[4]. Three of these major banks, Mitsubishi-UFJ Financial Group,
Mizuho Financial Group and Sumitomo Mitsui Financial Group, are G-SIFIs and, thus,
required to hold additional capital. For the domestic banks other than the 16 major
banks, the required minimum (total) capital remains at 4 per cent of the risk-weighted
assets, although the defnition of capital has been slightly changed under Basel III.
Thus, the gap between international banks and domestic banks has expanded with the
introduction of Basel III.
3. Stress tests
The traditional approachtobankcapital regulationrepresentedbythe Basel regulations has
oftenproventobe inadequate. Time andagain, fnancial institutions that hadmet regulatory
capital requirements failed shortly thereafter. The problem was observed in the global
fnancial crisis again. As adramatic example, the Financial Services Authority(FSA) judged
Northern Rock Bank to be well-capitalized and allowed the bank to increase its dividends
shortly before its failure in February 2008. With this background, some regulators,
especially the US Federal Reserve Board (FRB), advocated stress tests to ensure that
individual banks hold suffcient capital in an ongoing basis in the face of potential adverse
conditions as a complementary regulatory tool.
One of the earliest examples of stress tests is the Supervisory Capital Assessment
Program (SCAP), which was conducted by the FRB in 2009 on the 19 largest bank
holding companies (BHCs) in the USA[5]. The SCAP brought about a large-scale
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recapitalization of BHCs and helped restore confdence in the US fnancial
system.
The stress test is now an integral part of the regulation of major BHCs in the USA.
The Comprehensive Capital Analysis and Review mandates that large BHCs must
submit to the FRB their capital distribution plans, along with internal evaluations of
how they will maintain capital ratios in adverse economic scenarios, some of which are
supplied by the FRB. For an FRBstress scenario, the FRBconducts a stress test using its
own models, instead of BHC’s models, and evaluates the capital plan. Based on its
assessment, the FRB can object to BHCs’ capital plans and ask them to resubmit the
plans. The Dodd-Frank Act also requires major banks to run stress tests and publish the
results periodically.
The frst wave of stress tests in Japan actually happened well before the global
fnancial crisis during Japan’s own banking crisis in the late 1990s. As the FRBdid in the
SCAP, the Bank of Japan (BOJ) and the Ministry of Finance (MOF) examined each major
bank in early 1999 to determine how much additional capital it needed to withstand
stressful scenarios. If a bank was deemed to be undercapitalized, it was forced to
recapitalize by accepting public funds.
The stress test is now an integral part of bank regulation in Japan (Financial
Service Agency of Japan, 2014a). The JFSA mandates in its “Inspection Manual for
Deposit-Taking Institutions (Financial Service Agency of Japan, 2014b)” that banks
must undertake stress tests using their own stress scenarios and submit a report
that details the method and the result of stress tests to the JFSA every quarter. This
is important because stress scenarios and statistical models that are appropriate for
each bank are highly heterogeneous. Upon the receipts of the report from the banks,
the JFSA examines the appropriateness of stress scenarios and statistical models,
and more importantly, if the test indicates that the banks cannot withstand stressful
scenarios, the JFSA mandates that banks must raise capital and improve their risk
management.
In addition to the aforementioned micro-stress tests that have been implemented by
individual banks as a risk management tool, the BOJ has also performed macro-stress
test by setting up a fnancial-macro econometric model and assessing the vulnerability
of banking system as a whole to stress scenarios. The frst implementation of such test
took place in 2011-2012, when the BOJ, jointly with the JFSA and the (International
Monetary Fund (IMF) (2012), undertook macro-stress tests of Japanese banks as a part of
IMF’s Financial Sector Assessment Program. In this test, four stress scenarios were
considered:
(1) A global double-dip mild recession with a one standard deviation shock to real
gross domestic product (GDP) growth.
(2) A global double-dip severe recession with a two standard deviations shock to
real GDP growth.
(3) A protracted growth slowdown over the medium- to long-term with further
defationary pressures.
(4) A global double-dip mild scenario combined with a 100 bps parallel shift of the
yield curve, which represents a moderate market yield shock in line with Japan’s
experience in the past 15 years.
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The results of the test indicated that the fnancial institutions in Japan were in aggregate
resilient to all of the above adverse scenarios. Although Japanese banks were projected
to experience a sizable decline in capital ratios under some of the stress scenarios, they
were judged to have enough capital to withstand those shocks and continue their normal
operations. Nonetheless, the report pointed out some areas of concern as well. First,
stress scenario 4 was deemed to pose the largest risk to the Japanese fnancial system
and was the only scenario with some systemic implications. Second, stress scenario 4
put regional banks at a greater risk than major banks, given that the former had lower
capital ratios, larger credit risk and larger holdings of the Japanese Government Bonds.
Namely, in stress scenario 4, the report found that regional banks’ Tier 1 ratio would
decline by 1 percentage point from 10 to 9 per cent. Even though the required ratio for
regional banks in Japan was 4 per cent, it was pointed out as an area of concern.
To date, the BOJ has continued to undertake its own macro-stress tests and report its
results in the semiannual publication of Financial System Report (FSR). The 2014 FSR
reported that Japan’s fnancial systemis well-capitalized and its fnancial conditions are
improving in part as a result of favorable economic conditions (Bank of Japan, 2014). As
was the case with the results of the frst macro-stress test of 2011-2012, the report shows
that the fnancial system will be resilient to global recession or a moderate rise in the
market yield (2 percentage points), while it warns that some banks, in particular regional
banks, will be under-capitalized under a scenario in which both global recession and
rising yield affect the balance sheet of fnancial institutions.
The stress test is a relatively newregulatory tool in Japan and elsewhere. The method
is still evolving and can beneft fromefforts to improve it. There are three issues that are
important to examine, concerning stress tests in general. The frst is a classical question
of how stressful stress scenarios should be. For example, the BOJ considers a 200 bps
market yield shock based on historical volatility in its stress tests of Japanese banks in
the most recent macro-stress test. This may not be stressful enough. Similarly, stress
tests of European banks conducted by European Banking Authority were repeatedly
criticized to be insuffciently stressful. It is important to consider a scenario that seems
unlikely and yet can pose catastrophic outcomes. Second, fnancial macro-econometric
models used for macro-stress tests are still evolving and undergoing refnements. The
feedback effects through the real sector are complex and might be diffcult to capture,
given the uncertainty about how fnancial institutions de-leverage in response to
negative shocks. Third, the experiences of different countries have varied dramatically
in terms of the extent of information disclosure; for example, the Fed makes the results
of stress tests on individual banks publicly available, whereas the BOJ only reports the
aggregate results. The academic literature has yet to reach any consensus on whether or
not authorities should disclose all information pertaining to stress tests, as there might
be an important trade-off between market discipline and run (Goldstein and Leitner,
2013; Schuermann, 2013).
4. Regulating over-the-counter derivatives
Another area of concern highlighted by the global fnancial crisis was the OTC
(over-the-counter) transactions of fnancial derivatives. The highly interconnected yet
opaque nature of the OTCderivative transactions was believed to be an important factor
that intensifed the crisis. Japan’s regulatory reform in this area has been following the
lead of the G20 (the Group of Twenty).
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Since the onset of the global fnancial crisis, the G20 has taken a leadership role in
coordinating international fnancial regulatory reforms and implementations. It held the
frst summit in Washington, D.C., in November 2008 and held four more summits in
2009 and 2010. Since 2011, the summit has been held annually.
At the Pittsburg summit, held in September 2009, the G20 agreed that by the end of
2012:
• Standardized OTC derivatives should be traded on exchanges or ETPs.
• Standardized derivatives transactions should be cleared through central clearing
parties (CCPs).
• Data relating to OTC derivatives transactions should be reported to trade
repositories (TRs).
This G20 agreement has set in motion a series of regulatory changes that affects how
OTC derivatives are transacted, recorded and reported in Japan. Following the
agreement, the Financial Instruments and Exchange Act of Japan (Act No. 25 of 1948, as
amended; the “FIEA”) was amended in May 2010 (the “2010” Amendment) and came
into effect on November 1, 2012. The 2010 Amendment of the FIEA addressed items (2)
and (3) of the Pittsburg agreement, namely, it required clearing of certain standardized
OTC derivatives transactions through a CCP and reporting of certain data relating to
certain OTC derivatives transactions to the JFSA. The details and scope of the
mandatory clearing and reporting requirements are laid out in the Cabinet Offce
Ordinance (COO). Below we describe how the amendment of the FIEA addressed
clearing and reporting of OTC derivatives that the Pittsburgh agreement required[6].
4.1 Clearing
All fnancial instruments business operators (FIBOs) and registered fnancial
institutions (RFIs) registered under the FIEA are required to clear certain OTC
derivatives through a CCP. FIBOs include securities frms, investment advisors and
investment managers registered in Japan under the FIEA. Thus, foreign entities are not
included unless they are registered in Japan. RFIs include banks, insurance companies
and certain other fnancial institutions that are licensed and registered in Japan to
operate certain securities business or derivatives business under the FIEA. Again,
foreign banks and other institutions not licensed in Japan are not included[7].
Just two categories of OTC derivatives transactions were initially covered by the
FIEA. First, credit default swap (CDS) transactions on the iTraxx Japan index, of which
reference entities are 50 or fewer domestic corporations, must be cleared through CCPs.
An existing product that meets these criteria includes iTraxx Japan 50. Second,
yen-denominated plain vanilla interest swaps on three- or six-month Japanese yen
London interbank offered rate (LIBOR) interest rate also must be cleared through CCPs.
As of June 2011, nearly three-quarters of the outstanding notional amount of domestic
OTC derivatives contracts in Japan were in the interest swap category; among the OTC
interest rate swaps, about 30 per cent had remaining maturities of one year or less (Bank
of Japan, 2013b). No other types of OTC derivatives are included in the initial phase of
the FIEA. Thus, even if transactions involve FIBOs and RFIs, if they fall into other
product categories (e.g. dollar-denominated interest rate swaps), then they are currently
not required to clear through CCPs.
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CDS transactions on the iTraxx Japan index can only be cleared through licensed
Japanese CCPs, whereas interest swap transactions can be cleared through any of
licensed Japanese CCPs, licensed foreign CCPs and foreign CCPs with approved linkage
arrangements with licensed domestic CCPs. In November 2012, when the 2010
Amendment went into effect, only one CCP, the Japan Securities Clearing Corporation
(JSCC), was in operation as a licensed CCP, and no other CCPs, foreign or domestic, had
been licensed or approved. JSCC started providing clearing services for CDS iTraxx
Japan transactions in July 2011, and interest rate swap transactions in October 2012.
The 2010 Amendment allowed broad exemptions to the mandatory clearing
requirement, thus further limiting the scope of the OTC derivatives regulation in Japan
to a narrow set of counterparties and transactions at least in the initial phase. The
contracts that already existed as of November 1, 2012 were exempt from the clearing
requirement. Moreover, transactions where any of the parties are neither a FIBO nor an
RFI were exempt. This implied that unless all parties of the contract were FIBOs or RFIs,
the contract did not have to be cleared through CCPs. Transactions booked in trust
accounts and intra-group transactions were also exempt from the requirement. Finally,
transactions in which either of the parties (or any of their group companies), with
reasonable grounds, is not a clearing member of a CCPwere exempt. This last exemption
was especially troubling because it left ambiguity as to who can be considered, with
reasonable grounds, not a clearing member of a CCP.
4.2 Reporting
Information relating to every type of OTC derivative transaction regulated under the
FIEA must be reported to the government. These product types include:
• forward transactions and index forward, where the settlement date comes three or
more business days after the trade date;
• option transactions and index option transactions, where the exercise date comes
three or more business days after the trade date;
• swap (e.g. interest swap and currency swap) transactions; and
• credit derivatives transactions, where the trigger event is in relation to credit
condition changes to a reference entity (e.g. CDS).
Notable exceptions here are weather- and earthquake-related derivatives transactions.
Who is required to store and report the information depends on whether the
transactions are cleared through a CCP or not. If transactions are cleared through a CCP,
the CCP is obligated to keep the trade information and report it to the JFSA. This
includes both transactions that are required to be cleared through a CCP and those that
are voluntarily cleared through the CCP. If transactions are not cleared through a CCP,
any party to the transactions that is a Type 1 FIBO or RFI must either store and report
the trade information to the government itself or provide information to a designated
TR. Reporting Type 1 FIBOs or RFIs, if reporting themselves, must keep the trade
information for fve years, and submit information about trades executed during a given
week within the frst three business days of the following week. If instead the trade
information is provided to a local TR, the TRmust report the information to the Japanese
Government. If the trade information is provided to a foreign TR, reporting to JFSA is
not currently required. In the future, the JFSA plans to establish a system to exchange
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information internationally with the supervisory agencies of other countries and
expects to collect the trade data by Type 1 FIBOs and RFIs that are provided to foreign
TRs via such arrangements.
In March 2013, the JFSAapproved Depository Trust &Clearing Corporation (DTCC)
Data Repository Japan (DDRJ) to be the frst TRto operate in the Japanese market. DDRJ
is a subsidiary of DTCC (Bannister, 2013). The data storage and reporting obligation
under the 2010 Amendment was enforced starting on April 1, 2013.
Similar to the clearing requirement, some transactions are exempt fromthe recording
requirement. First, the contracts that already existed as of November 1, 2012 were
exempt. The transactions with governments, central banks or other international
authorities specifed by the JFSA are also exempt. Certain intra-group transactions
(between parents and subsidiaries or between subsidiaries of common parent
companies) do not have to be recorded either.
4.3 The 2012 amendment
Another bill was passed on September 12, 2012 to address the frst point raised by the
G20 Pittsburg agreement. This introduced provisions regarding the mandatory use of
electronic trading platforms (ETPs). It was scheduled to take effect within three years,
i.e. by 2015. Details and scope of the ETP use requirement are yet to be fnalized and
implemented as of this writing, but we can observe some discussions on this issue in the
FSA’s OTCDerivatives Regulation ReviewPanel report released in December 2011 (The
Financial Services Agency of Japan, 2011).
In JFSA’s implementation proposal as of this writing (August 2014), large FIBOs and
RFIs (with derivative contracts exceeding ¥6 trillion or US$59 billion) will be required to
use ETPs by September 2015 when they enter into yen-denominated plain vanilla
interest swap contracts. This threshold is expected to cover 10-20 of the largest dealers.
Then, the JFSA will consider expanding this requirement to CDS transactions on the
iTraxx Japan index after monitoring the market liquidity of these transactions.
During the G20 St. Petersburg summit in September 2013, the BCBS and the
International Organization of Securities Commissions (IOSCO) released the fnal
framework for margin requirements for non-centrally cleared derivatives (Bank for
International Settlements, 2013). Under this globally agreed standard, all fnancial frms
and systemically important non-fnancial entities that engage in non-centrally cleared
derivatives will have to exchange initial and variation margins commensurate with the
counterparty risks arising from such transactions starting in December 2015. The new
framework has been designed to reduce systemic risks related to OTC derivatives
markets, as well as to provide frms with appropriate incentives for central clearing.
Though details are yet to be fnalized, this new standard will further push fnancial
institutions towards more voluntary clearing through CCPs. Implementing this new
standard on margin requirements will also necessitate further regulatory deliberations
and decisions on issues such as margin segregation and re-hypothecation rules.
Financial regulators in Japan and other advanced economies have been gradually
building a newregulatory framework for derivative transactions in each country, but an
important issue of international coordination remains. For example, considerable
complications may arise when the Japanese derivative regulation is applied to
cross-border derivatives transactions involving Japanese counterparties. For example,
if a FIBOor RFI (a domestic regulated entity) acts as an agent or an intermediary for an
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overseas branch of the same institution in a transaction of a kind that is subject to
central clearing requirements, it may trigger the central clearing obligation for the
FIBO/RFI. Such a transaction may be simultaneously subject to a clearing obligation
under a foreign law, thus resulting in overlaps. There is no clear rule under the current
Japanese law that indicates how to deal with overlapping regulations. Resolving these
implementation issues require international cooperation between supervisory agencies
so as to avoid both opportunities for “regulatory arbitrage” and extraterritorial
overreach[8].
On that note, the European Securities and Markets Authority (ESMA)’s proposed
recognition of Japanese derivatives regulation in September 2013 seems to be a
signifcant step forward. In particular, ESMA has proposed to recognize as equivalent
the rules drawn up by the USA and Japan, including rules pertaining to the use of
clearing houses and TRs (Stafford, 2013). The ESMA recommendation must frst be
approved by the European Commission before it comes into effect.
Other major implementation issues include potential expansion of the scope of the
clearing rules on both counterparties and transaction types. For example, the
JFSA is considering expansion of the central clearing requirements to dollar- or
euro-denominated plain-vanilla interest rate swaps, yen-denominated interest swaps on
the Japanese yen Tokyo Interbank Offered Rate (TIBOR) interest rate, single-name CDS
transactions referring to a Japanese entity and single-name CDS transactions referring
to a European or North American entity, or CDS transactions referring to an indexes
consisting of European or North American entities. The JFSAalso considers expanding
the mandatory use of CCPs to transactions between a FIBO/RFI and a foreign dealer
acting outside Japan (i.e. cross-border transactions with a foreign dealer) or a
non-fnancial entity.
5. Recovery and resolution planning
One problem that the Japanese fnancial regulators faced when the banking crisis was
becoming more serious in 1999 was the lack of a framework to deal with insolvent
banks, especially those which can have systemic implications. Thus, when two large,
internationally connected banks (Long-term Credit Bank of Japan [LTCB] and Nippon
Credit Bank [NCB]) appeared to be insolvent in the mid-1999, the government worked to
create a mechanism to contain the problem without hurting the fnancial system as a
whole, both domestic and global. As Chapter 8 of Hoshi and Kashyap (2001) documents,
the government (after prolonged negotiation and compromise with the opposition party)
passed two laws in the fall of 1999:
(1) The Act on Emergency Measures for the Revitalization of Financial Functions.
(2) The Act on Emergency Measures for Early Strengthening of Financial
Functions.
The frst law, known as the Financial Revitalization Act provided a framework to
restructure insolvent banks, and the second law, known as the Early Strengthening Act,
provided a framework to inject public capitals into solvent but troubled systemically
important banks. Japan used the Financial Revitalization Act to nationalize and
restructure LTCBand NCBin late 1998, and the Early Strengthening Act to inject public
funds into other large banks in March 1999.
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As the names suggest, these two laws were emergency measures that were to expire
in fve years. Thus, the Deposit Insurance Corporation (DIC) Act was revised in 2001 to
make these frameworks permanent. Chapters 5 and 6 of the revised DIC Act specifed
the procedures for insolvent banks that are non-systematic. When a bank is deemed
insolvent, the DIC takes over the management of the bank as the fnancial administrator
and transfers the business operations to an assuming fnancial institution (Chapter 5).
This is essentially the same as the process of resolution by purchase and assumption
(P&A) by Federal Deposit Insurance Corporation (FDIC). If no assuming fnancial
institution comes forward immediately, the business operations are transferred to a
bridge bank operated by DICJ (Chapter 6).
Chapter 7 specifes how to handle a systemic bank that is in trouble. If the bank is
solvent, DICJ injects capital and forces the bank to restructure (Chapter 7 Section 102-1).
If the bank is insolvent, DICJ nationalizes the bank and restructure the claims (Chapter
7 Section 102-3). Recapitalization under Section 102-1 was applied to Resona Bank in
2003, and restructuring under Section 102-3 was applied to Ashikaga Bank in 2003.
Thus, Japan had a reasonable resolution mechanism for banks, including systemic
ones before the global fnancial crisis. Similar to the USA, however, Japan still lacked
regulatory tools to deal with systemic non-bank fnancial institutions that may be
insolvent. The revision of the DIC Act in 2013 addressed this shortfall by adding
Chapter 7-2 to expand the resolution system to cover non-bank fnancial institutions,
including fnancial holding companies, insurance companies and securities companies.
In the Chapter 7-2 procedure, the process starts with a recommendation from the
Financial Crisis Response Council to the Prime Minister to designate that a systemically
important fnancial institution goes through the orderly resolution process. If the
fnancial institution is deemed solvent, it is put under special oversight by the DICJ and
receives liquidity assistance (Type I measures). If the fnancial institution is insolvent,
DICJ takes it over, transfers the claims that are essential for fnancial stability to a bridge
bank and provides fnancial assistance (Type II measures). The DIC Act Chapter 7-2
process has not been tested by an actual case, but Japan now has a framework to deal
with a failing systemically important fnancial institution, at least in theory.
The DIC Act Chapter 7-2 process has not been tested by an actual case, but the
Chapter 6 procedure was applied to resolve a mid-size bank successfully in Japan after
the global fnancial crisis. The Incubator Bank of Japan was established in 2003 to
specialize in SME(small and mediumenterprise) lending. The bank attracted depositors
by offering high-interest rates and grew to have ¥647 billion of total assets by March
2010. JFSA’s inspection in the mid-2010 revealed the bank had a large amount of
non-performing loans unreported to the regulator. Massive withdrawals by the
depositors followed, and the bank notifed the JFSA Commissioner that it “had
insuffcient assets to fully discharge its claims” on Friday, September 10, 2010. The FSA
applied the Chapter 6 procedure to the bank and ordered the DICJ to act as the fnancial
administrator (DICJ, 2013). It became the frst case of bank resolution in Japan under the
limited coverage, in which the insured deposits of only up to ¥10 million per depositor in
principal and interest payable (as of the day of failure) were protected[9]. Over the
weekend, the Incubator Bank of Japan concluded the basic agreement with the Second
Bridge Bank of Japan, the bank fled with the Tokyo District Court for the
commencement of civil rehabilitation proceedings, and policy board meeting of the DICJ
was held and decided to provide loans for repayment of deposit and other liabilities. The
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DICJ then identifed insured and uninsured portions of deposits by aggregating deposits
by name[10]. On Monday, September 13, 16 branches of the Incubator Bank of Japan
reopened for business. The DICJ provided loans to the bank for the repayment of
deposits and other liabilities. The frst repayment on uninsured portion of deposits
started on December 13, 2010, three months after the failure[11]. On December 26, 2011,
all outstanding shares in the Incubator Bank held by the Second Bridge Bank were
transferred to AEON Bank (DICJ, 2013).
There are two notable features in the resolution of the Incubator Bank of Japan. First,
the limited coverage scheme forced uninsured depositors and other liability holders to
share the cost for the frst time in the post-war Japan. This bail-in of large creditors is
considered to have mitigated the collective action problem. Second, the DICJ closed a
bank by applying the limited coverage scheme. Skillful implementation of bank
resolution under the limited coverage scheme by the Japanese authority may make the
commitment on no bail-out more credible by reducing the administrative cost of bank
resolution[12].
6. Relaxation of bank supervision
Since the global fnancial crisis, the Japanese regulators have been tightening and
expanding regulation along with their counterparts in other advanced countries. At the
same time, however, the Japanese authority has also encouraged banks to lend to
troubled SMEs. To support the banks’ efforts to help the troubled borrowers, the JFSA
relaxed the supervision standard, so that the banks do not have to reveal how much
these efforts added to their non-performing loans.
As Harada et al. (2011) discuss, the relaxation started with the November 2008
announcement by the JFSA on the “Measures to encourage loan restructuring for
SMEs”. The announced policy allowed the banks to not disclose restructured loans to
SMEs as non-performing if the restructurings were accompanied with recovery plans to
make loans performing in fve years. In December 2009, the encouragement given
to banks to roll over loans to troubled SME borrowers was formalized as the SME
Financing Smoothing Act. With this act, the JFSA relaxed the supervisory manual
again, so that the banks can exclude the restructured SME loans from non-performing
loans if they plan to come up with restructuring plans that are expected to make the
loans performing in fve years from the time they specify the plan. The law was set to
expire at the end of March 2011, but it was extended twice before fnally allowed to
expire at the end of March 2013.
Although the SME Financing Smoothing Act expired at the end of March 2013, the
JFSA has not reversed the rule that allows banks to classify the restructured loans to
SMEs as “normal”. Moreover, the JFSAhas changed the supervisory manual once again,
this time to give an extra credit for banks’ efforts to help SME borrowers. As a result,
troubled SMEs continue to ask for loan restructuring, and banks continue to grant loan
restructuring for almost all who ask. Figure 1 shows the number of requests by SMEs to
restructure their loans and the number of those that were accepted by banks during each
of the six-month periods since the start of the SME Financing Smoothing Act. Both the
number of requests and the number of approvals declined by only about 10 per cent after
the expiration of the SME Financing Smoothing Act. Moreover, the approval rate in the
post-expiration period was 98 per cent, compared to the average of 95 per cent during the
period in which the law was in effect. Thus, the (troubled) SME loan restructurings by
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Japanese banks have not declined very much, even after the law that formally
encouraged them expired.
7. Conclusion
In general, Japan has not been a laggard in the post-crisis global push toward
implementing stricter and (one hopes) safer bank capital regulation. In the areas of
adopting Basel III, integrating bank stress tests into the monitoring operations by bank
regulators and centralizing OTC derivative clearing/reporting functions, Japan has
made substantive progress on par with or sometimes ahead of other developed
economies.
The question is whether the new regulation has real teeth. The answer critically
depends on the willingness of the regulator to use the new regulatory tools to enhance
the stability of fnancial system. Although it is too early to make any conclusive
statements about this important question, there is one area of concerns. As discussed in
Section 6, the fnancial authority has encouraged the banks to renew non-performing
loans to SMEs as long as they are nominally under restructuring plans, and allowed the
banks not to report these as non-performing loans. It remains vital that the new bank
regulation not be defanged by such politically expedient policy, and that it press
forward for further feshing-out of reforms yet to be implemented.
Notes
1. BCBS (2009b) was revised and published as BCBS (2010a). BCBS (2009a) and BCBS (2009c)
were implemented at the end of December 2011.
2. “Enhancement to the Basel II Framework” defnes resecuritization exposure as “a securitization
exposure in which the risk associated with an underlying pool of exposures is tranched, and at
least one of the underlying exposures is a securitization exposure. In addition, an exposure to one
or more resecuritization exposures is a resecuritization exposure” (p. 2).
645,854
688,933
645,116
629,671
610,241
673,987
586,195
573,356
622,548
641,659
626,431
593,972
586,844
638,536
580,961
554,104
- 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000
Apr. 2010 - Sept. 2010
Oct. 2010 - Mar. 2011
Apr. 2011 - Sept. 2011
Oct. 2011 - Mar. 2012
Apr. 2012 - Sept. 2012
Oct. 2012 - Mar. 2013
Apr. 2013 - Sept. 2013
Oct. 2013 - Mar. 2014
Accepted Requests
Note: This figure shows the number of requests by SMEs to restructure their loans
and the number of those that were accepted by banks during each of the six-month
periods
Source: Financial Services Agency of Japan (2014b)
Figure 1.
Number of loan
restructurings to
SMEs: April 2010 –
March 2014
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3. The detail is released in “Globally Systematically Important Banks: Assessment
Methodology and the Additional Loss Absorbency Requirement Rule Text and Cover Note”
(November 2011).
4. See BCBS (2012).
5. In SCAP, the adverse scenario assumed 2.8 per cent decline in GDP, an increase in
unemployment rate to 10.3, and 29 per cent decline in housing prices. The test revealed that 10
of the 19 fnancial institutions did not have suffcient capital to withstand the adverse
scenarios, and the Federal Reserve required them to raise US$75 billion in capital.
6. The information here is taken fromthe fnal version of the COOreleased by Financial Services
Agency of Japan in July 11, 2012 (Financial Stability Board, 2012).
7. Clearing mandates are to be phased in multiple stages. As of this writing (August 2014), large
fnancial institutions – mostly banks and securities frms – with outstanding notional amount
exceeding¥1 trillion(about US$9.8 billion) are requiredto complybyDecember 2014. The second
phase, planned for December 2015, captures smaller fnancial institutions with outstanding
notional amount of ¥300 billion or more. Insurance companies, pension funds and other buy-side
investors have not been included in the two compliance phases announced so far.
8. In July 2012, the Commodity Futures Trading Commission proposed that its transaction-level
rules on clearing, execution and reporting should apply to all trades involving a US person,
regardless of the location of the counterparties. In April 2013, the Japanese fnance minister,
along with the EC commissioner for internal market and services and seven other fnance
ministers from UK, France, Germany, Brazil, Russia, South Africa and Switzerland, sent a
letter to US Treasury Secretary, Jack Lew. In the letter, the fnance ministers warned that “[a]n
approach in which jurisdictions require that their own domestic regulatory rules be applied to
their frms’ derivatives transactions taking place in broadly equivalent regulatory regimes
abroad is not sustainable” and advocated that “mutual recognition, substituted compliance,
exemptions, or a combinationof these wouldall be a validapproach, andcareful consideration
should be given with respect to registration requirements for frms operating across borders”
(Financial Services Agency of Japan, 2013a, 2013b).
9. Although Japan experienced 181 cases of bank failure for 17 years from 1991 to 2008, all
liabilities of failed banks were protected under the emergency measures of bank resolution,
despite the transition from the full coverage scheme to the limited coverage scheme
implemented in April 2005 (Endo et al., 2013).
10. As a result of name-based aggregation of deposits, ¥11 billion of deposits (2.7 per cent in
terms of the number of depositors and 1.9 per cent in terms of principal of deposits) were
identifed as uninsured portion (Endo et al., 2013).
11. First repayment rate on uninsured deposits was 39 per cent.
12. The Deposit Insurance Act was also revised in 2013 based on the experiences from the
resolution of the Incubator Bank of Japan. See page 47 of DICJ (2013) for the detail of 2013
revision.
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Regulatory Committees fromAround the World, FIC Press, Wharton Financial Institutions
Center, Philadelphia, PA, pp. 193-227.
Hoshi, T. and Kashyap, A. (2001), Corporate Financing and Governance in Japan: The Road to the
Future, MIT Press, Cambridge, MA.
International Monetary Fund (2012), “Japan: fnancial sector stability assessment update”, IMF
Country Report No. 12/210, available at: www.imf.org/external/pubs/ft/scr/2012/cr12210.
pdf (accessed 8 September 2014).
Schuermann, T. (2013), “Stress testing banks”, Mimeo, available at:http://fc.wharton.upenn.edu/
fc/papers/12/12-08.pdf (accessed 8 September 2014).
Stafford, P. (2013), “Europe recognizes US and Japan derivative rules”, Financial Times, 3
September 3, available at: www.ft.com/cms/s/0/5911a004-14b1-11e3-a2df-00144feabdc0.
html#axzz3CkSopPnT (accessed 8 September 2014).
Further reading
Bank of Japan (2013a), “Financial systemreport”, available at: www.boj.or.jp/en/research/brp/fsr/
data/fsr130417a.pdf (accessed 5 September 2014).
Bank of Japan (2013b), “Results of the regular derivatives market statistics in Japan (End-June
2013)”, available at: www.boj.or.jp/en/statistics/bis/yoshi/index.htm/ (accessed 5
September 2014).
Bank of Japan (2014), “Financial system report”, available at: www.boj.or.jp/en/research/brp/fsr/
fsr140423.htm/ (accessed 5 September 2014).
Basel Committee on Banking Supervision (2010c), “Basel III: international framework for liquidity
riskmeasurement, standards andmonitoring”, available at: www.bis.org/publ/bcbs188.pdf
(accessed 5 September 2014).
Basel Committee on Banking Supervision (2011), “Globally systematically important banks:
assessment methodology and the additional loss absorbency requirement rule text and
cover note”, available at: www.bis.org/publ/bcbs207cn.pdf (accessed 5 September 2014).
Devorak, P. (2013), “Japanese banks urged to lend in fght against defation”, Wall Street Journal
(Japan Real Time), 2 May, available at:http://blogs.wsj.com/japanrealtime/2013/05/02/
japanese-banks-urged-to-lend-in-fght-against-defation/ (accessed 8 September 2014).
Financial Stability Board (2011), “Policy measures to address systematically important fnancial
institutions”, available at: www.fnancialstabilityboard.org/publications/r_111104bb.pdf
(accessed 5 September 2014).
About the authors
Kimie Harada is a Professor at Chuo University. Harada’s career includes membership in numerous
government committees. She currently serves as a member of the Financial Services Agency’s
Financial System Council, member of the Fiscal Investment and Loan Program Subcommittee of the
MOF’s Fiscal System Council, member of the MOF’s Independent Administrative Institution
Evaluation Committee and the acting chairperson of Agriculture, Forestry and Fisheries Credit
Foundations. Additionally, she is a public board member of the Self-regulation Board of Japan
Securities Dealers Association. Harada has published in academic journals such as Journal of Money,
Credit and Banking andJournal of the Japanese and International Economies. She is a ResearchFellow
at the Tokyo Center for Economic Research and at Japan Securities Research Institute, and a member
of editorial board of Japan’s Securities Analysts Journal. She holds a Wine Expert appellation
qualifcation of the Japan Sommelier Association and conducts research centering on the fnancial
feld, as well as wine. She has received two BA degrees from Osaka University and an MA and PhD
degree in Economics fromthe University of Tokyo.
JFEP
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Takeo Hoshi is Henri and Tomoye Takahashi Senior Fellowat the Freeman Spogli Institute for
International Studies, Professor of Finance (by courtesy) at the Graduate School of Business and
Director of the Japan Program at the Walter H. Shorenstein Asia-Pacifc Research Center, all at
Stanford University. Hoshi is also a Visiting Scholar at the Federal Reserve Bank of San Francisco,
a Research Associate at the National Bureau of Economic Research and at the Tokyo Center for
Economic Research and a Senior Fellow at the Asian Bureau of Finance and Economic Research.
His main research interest includes corporate fnance, banking, monetary policy and the Japanese
economy. He received 2006 Enjoji Jiro Memorial Prize of Nihon Keizai Shimbun-sha and 2005
Japan Economic Association Nakahara Prize. His book Corporate Financing and Governance in
Japan: The Road to the Future, which he co-authored with Anil Kashyap, received the Nikkei
Award for the Best Economics Books in 2002. He received a BA degree from the University of
Tokyo (1983) and PhD in Economics from the Massachusetts Institute of Technology (1988).
Takeo Hoshi is the corresponding author and can be contacted at: [email protected]
Masami Imai is a Professor of Economics at Wesleyan University in Middletown, Connecticut.
He teaches Money, Banking and Financial Markets, Quantitative Methods in Economics and
Economy of Japan. He has a PhD in Economics from the University of California-Davis and a BA
in Economics from the University of Wisconsin-Eau Claire. He received support from Center for
Financial Research at Federal Deposit Insurance Corporation in 2008 and was awarded the most
signifcant paper published in 2012 in the Journal of Financial Intermediation. He is a member of
the Japanese Shadow Financial Regulatory Committee and also a Research Fellow at Tokyo
Center for Economics Research. His research focuses on banking and has been published in
American Economic Journal: Macroeconomics, Journal of Money, Credit, and Banking, Journal of
Financial Intermediation, Journal of Law and Economics, Journal of Public Economics, Journal of
Development Economics and Journal of Banking and Finance as well as other scholarly journals.
Satoshi Koibuchi is an Associate Professor of Finance at Chuo University in Tokyo. His areas
of focus are corporate fnance, fnancial system and macroeconomics. Koibuchi received his MA
and PhD in Economics from The University of Tokyo, and BA in Economics from Waseda
University. Before joining Chuo, he was an Assistant Professor at Chiba University of Commerce
and a Visiting Scholar at School of International Relations and Pacifc Studies, University of
California, San Diego. He has published in the academic journals such as Japanese Economic
Review, International Journal of Finance and Economics and Pacifc Basin Finance Journal. He and
his coauthors are currently writing a book titled Managing Currency Risk: Currency Invoicing and
Production Network of Japanese Firms. He is also a Research Fellow and a board member of
Tokyo Center of Economic Research.
Ayako Yasuda is an Associate Professor of Finance at the Graduate School of Management,
University of California, Davis. She was previously a faculty member in the fnance department at
the Wharton School of the University of Pennsylvania. Dr Yasuda received a BA and PhD in
Economics from Stanford University. She has received numerous professional awards and has
published in leading academic journals such as the Journal of Finance, Journal of Financial
Economics and the Review of Financial Studies. Her research has also been featured in leading
media outlets such as The Financial Times, The Economist, The New York Times and The Wall
Street Journal. She co-authored an MBA course textbook Venture Capital and the Finance of
Innovation, which has been adopted at many of the world’s top universities, including Chicago,
Duke, Harvard, NewYork University, University of California (multiple campuses), University of
Southern California, University of Pennsylvania (Wharton) and Yale. She is a Fellow of the
Wharton Financial Institutions Center at University of Pennsylvania.
For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
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