The opening lines of the Japan Financial Services Agency's (JFSA) homepage state that the top priority for its recent regulatory policies has been "better market initiative" and "better regulation".
One of the pillars of the JFSA's Better Market Initiative has been to lower the firewall between securities business and banking/insurance. At the same time that the firewall initiative was progressing throughout 2008 and 2009, other countries' regulators were reviewing the wisdom of their own deregulation. In the US in particular, there is growing support for the view that dismantling Glass-Steagall materially assisted large financial institutions in taking too much risk, which ultimately led to the recent turmoil in the international financial markets.
We aim to review the business imperative for deregulation in Japan and assess how the firewall has been lowered and the resulting benefits. This is deliberately a practical analysis, rather than an intellectual critique. But as the JFSA proclaims that it has its eyes clearly focused on the needs of "the Street", it is from this vantage point that the recent developments should be assessed.
The imperative for change
Twenty years ago, at the peak of its bubble economy, Japan was regarded as the world's most successful high-income country. Today, conventional wisdom is that Japan is on a long slide. During this period the economy has grown at an average annual rate of 1.1%. More shockingly, in real terms, the Nikkei stock market index is a quarter of what it was two decades ago and general government gross debt is generally forecast at around 200% of GDP for 2010.
Japan's policy makers have reason to be concerned. Two years ago, Japan's target for accumulated foreign direct investment (FDI) was a comparatively low 5% of nominal GDP. In 2010 the figure is expected to be 2-3%, far less than the international average of around 20% for similarly developed economies. Of the FDI that Japan does attract, roughly 60% goes into the finance and insurance sectors so effective deregulation in these fields can bring immediate and material gains. As emerging economies strive to catch the eye of foreign investors, Japan – which has a serious excess of production capacity – must lose no time in lowering investment hurdles. The JFSA's initiatives to support investment are therefore essential and timely. But are they enough?
When the Securities and Exchange Law of Japan was originally promulgated in 1948, it adopted a policy of strict separation of banking and securities business modelled on the Glass-Steagall Law of the US. As a result Japan's financial industry was sub-categorised into commercial banks, commercial banks with trust business licenses, securities companies and insurance companies. Banks were prohibited from engaging in securities business. The purposes of such separation was to (i) maintain the sound financial conditions of banks, (ii) avoid conflicts of interests of depositors and investors, and (iii) prevent the abuse of dominant positions by banks. Sixty years later these are still topical concerns. However, such separation also protected each business sector from competition from other sectors. It is worth remembering that the financial Big Bang in the UK in the late 1980s largely removed the viability of standalone securities companies.
The view from "the Street"
Japan's firewall structure is based on the concept that non-public customer information cannot be transmitted across corporate lines unless the customer has given specific consent to do so. The resulting compartmentalisation of information within a financial group was originally seen as preventing all powerful banks from abusing their so-called dominant position at the expense of their hapless customers. However, an inevitable, and negative, consequence of the firewall was that it not only ring-fenced customer information but led to group entities developing unique cultures and stand alone businesses. The firewall promoted and reinforced silo mentality on a massive scale. It also led to duplicated standalone management structures and a parochial view of financial products. The banker analysed his clients' needs by considering what products the Banking Law allowed him to offer and his colleagues in the securities company saw life from the more quixotic terrain of the securities industry. The field of insurance was equally alien to both.
However, the increasing complexity of financial products had two very obvious consequences that would rock the foundations of silo-bound financial industry in Japan: Clients realised that they needed a more holistic view of financial products. And groups providing financial services to sophisticated clients needed to fully understand all the risks that their major clients were exposing them to.
The firewall was designed to severely restrict all levels of management from seeing their clients' activities undertaken in other group entities. A country manager in Japan of a group of entities typically covering banking, securities and asset management businesses was in fact country manager of the primary entity only.
A plethora of group company CEOs emerged, each responsible for their own entity. The rigorousness of the JFSA's policing the firewall and publicly exposing transgressors meant that it was a brave country manager who tried to get a real handle on all the entities for which his overseas bosses deemed he was responsible.
In responding to increasing industry calls for a review of the firewall, the JFSA has consistently made clear that its aim was not to introduce universal banking. Consequently, throughout the stages of the deregulation project, the goal has been to lower, rather than flatten the firewall.
During the 1970s and 1980s the level of interest deposit banks could offer was gradually liberalised, reflecting product innovation. The scope of business banks could engage in was gradually increased, reflecting market changes and US financial de-regulation initiatives. More recently de-regulation has brought changes such as (i) allowing banks to sell government bonds to investors, (ii) permitting banks and securities firms to enter into securities business and banking business with each other through their affiliate companies, (iii) the commencement of sales of certificates of mutual funds to investors by banks; and (iv) permitting banks to engage in securities intermediary business.
In the late 1990s the Liberal Democratic Party administration took various initiatives to stabilise the financial system and revitalise the national economy. Japan's own Big Bang was intended to restore Tokyo's position as a financial centre on a par with New York and London by 2001. However, while 'double-hatting' for control functions was introduced the firewall concept largely survived the new initiatives and continued to provide an impenetrable barrier for management of banking and securities businesses, seriously limiting the sharing of client information among group companies and preventing management from developing a broader perspective on increasingly complex financial products. A growing perception emerged that the firewall was putting market players in Japan at a serious disadvantage when compared with competitors in US and Europe who had embraced the universal banking model.
Following the JFSA's "Programme for Further Financial Reform – Japan's challenge:
Moving toward a Financial Services Nation" launched in 2004, the groundbreaking Financial Instruments and Exchange Law (FIEL) was implemented in 2007, overhauling the post-war Securities and Exchange Law. The FIEL takes a much broader approach to the financial industry, but also seeks to protect customers and enable experienced investors to have easier access to more complex financial products. And similar rules of customer protection were imported into the Banking Law in relation to 'riskier' deposits, such as foreign currency deposits and structured deposits.
Discussions about firewall deregulation were held in 2007 at the 'Council on Economic and Fiscal Policy' and at the governments 'Financial System Council'. As a result, the new firewall rules were realised in the amendment of FIEL and other related laws, which were passed by the Diet on June 6 2008. The present firewall regulations were made effective on June 1 2009. During this process there was an unprecedented level of dialogue between the JFSA and the financial industry, including foreign financial institutions in Japan.
Are the benefits tangible?
The doctrine that non-public customer information can only be shared across entity lines if the customer agrees remains unchanged. However, in the case of corporate customers only, the new regulations have introduced an opt-out system for information sharing, whereby non-public customer information can be shared across entity lines if the corporate customer does not object to such sharing after having received a so-called "opt-out letter" informing the customer of its right to object to such disclosure. The new mechanism was heralded as a significant step forward in enabling customer information to be shared amongst a financial group's entities. In practice, however, it has been of limited effect.
Indications are that for those financial groups who broadly distributed opt-out letters to their corporate clients, they received rejections from around 10-15% of their customers. A non-response from a corporate customer is a deemed consent to information sharing, so the higher the non-response rate the better. But with 10-15% negative response levels, financial groups have in effect been prevented from integrating customer data bases and having cross-entity management meetings where customer data is shared amongst interested executives. It is too cumbersome to keep track of which customers have obligingly remained silent and which ones are in the vociferous 10-15% category. The situation is complicated further, because silent customers may subsequently elect to opt-out at any time so systems need to cater for such change.
The real lowering of the firewall has been achieved through 'interlocking', brought in by FIEL which has replaced its predecessors 'double-hating' or "multi-hating' involving time consuming approval procedures. As a result, internal control functions can now oversee securities companies, banks and other regulated entities without going through protracted FSA application procedures. Crucially, as discussed below, certain senior management roles can now also be interlocked for the first time.
Interlocking control function roles allows certain roles to be mirrored across several entities. For instance, the HSBC Japan general counsel role technically comprises separate general counsel roles for each regulated legal entity in Japan. By assuming concurrent roles exist in each regulated entity, the role is allowed access to customer data of each entity without customer data needing to cross corporate entity lines (other than in the mind of the interlocked employee). From the perspective of entity-level organisational charts, interlocking has, visually, resulted in a multiplication of certain positions.
The new interlocking mechanism also extends to directors of securities companies who, until the FIEL amendment, had been prohibited from having a management position in a bank or other group company. If the CEO or Japan representative of a securities company wants to have a management role in respect of the affiliated banking operation, this now only requires an notification to the JFSA. The position is slightly more complicated in respect of a bank CEO or bank representative because amendments to FIEL were not mirrored by similar changes to the Banking Law. As a result, the bank CEO or representative still needs to formally apply to the FSA for permission for this interlocking.
The regulations do raise one practical difficulty. As mentioned earlier, even after the opt-out scheme for corporate customers is introduced, the customer information of individual (private) customers and corporate customers which have opted out cannot be shared across entities except for "internal control or management purposes".
This restriction on information sharing will have little impact on how control function staff go about their daily activities, because they are not involved in business promotion or sales activities.
However, for country managers or interlocked business heads, who supervise and receive reports from control functions but also engage in high-level business activities, the lines become blurred. Unlike the control function staff, such business executives are deemed to have a so-called 'home base' entity from which they are interlocked into other entities. In the absence of customer consent, they can only access customer data held in non-home base entities if they need it for management purposes. It is not allowed for sales or business promotion reasons.
While all new interlocking management structures will need to be discussed with the FSA, the changes are a dramatic improvement and enable effective country-level management and control across entity lines in Japan. Country managers can now hold board or similar, positions in respect of all group entities. Although the country manager may have to hold a mixture of executive and non-executive roles to do so, it is still a significant improvement.
To ensure that lowering the firewall does not prejudice customers, on June 1 2009 conflict of interest management regulations were strengthened, which now require financial groups to implement comprehensive conflict management processes. In addition, increased record keeping and training obligations are key aspects of the new regime.
Better governance
The opt-out mechanism has been undermined by significant numbers of clients seemingly rejecting information sharing and opting-out. So cross-entity governance meetings need to be constructed and operated in ways that avoid accidental disclosure of client data to executives who may not have access to it. And as mentioned, interlocking senior management roles with sales responsibilities alongside more formal management duties, present challenges.
But despite these problems, the lowering of the firewall in Japan is a clear step in the right direction. Although it is too early to appraise the whole process of deregulation since most groups only completed interlocking formalities at the end of 2009, the new governance and control structures will help to ensure more effective management control and will go some way towards alleviating concerns of foreign financial institutions in Japan that country heads cannot assess all the risks of their businesses.
Other improvements are being discussed with the JFSA. But the increasingly conservative international regulatory climate and the JFSA's desire to assess the results of the recent deregulation in Japan mean that additional reform of the firewall structure is unlikely in the near future. However, at the time of writing this article Standard &Poor's warned that it might cut its sovereign debt rating on Japan for the first time since 2002. So if the new Democratic Party of Japan is serious about restoring the financial health of the world's second largest economy, there is no room for complacency.