Home > About the Bank > Speeches and Statements > Speeches 1996–2010 > Speeches 2007 > Excerpts of a Speech Given by Atsushi Mizuno, Member of the Policy Board, at a Meeting with Business Leaders in Yamanashi on August 30, 2007 (The Recent Turbulence in Financial Markets and Its Implications)
The Recent Turbulence in Financial Markets and Its Implications
Excerpts of a Speech Given by Atsushi Mizuno, Member of the Policy Board, at a Meeting with Business Leaders in Yamanashi on August 30, 2007
October 19, 2007
Bank of Japan
Contents
- I. Globalization and Issues Faced by Central Banks
- II. The Globalization of the Tokyo Financial Market
I. Globalization and Issues Faced by Central Banks
Together with economic globalization, global financial integration has intensified in recent years. The recent turbulence in financial markets, triggered by a deterioration in the U.S. subprime mortgage market, may be dealt with in the context of an advance in globalization.
A. Global Financial Integration and the Rise of Investment Funds
1. Global financial integration
As the global economy continues to expand, with momentum being gained across a wide range of economies, firms are more than ever crossing borders in their manufacturing and commercial activities. Institutional investors, for their part, have been searching for better investment opportunities against the background of an environment of persistently low interest rates. As a result of these developments, the demand for cross-border financial transactions has been growing and financial institutions have responded accordingly.
This trend is evident in the changes in the business models of, and products offered by, European and U.S. financial institutions. The business model at major financial institutions in industrialized countries has shifted from one of "originate and hold," where credit and interest rate risks were held until maturity, to one of "originate and distribute," in which financial institutions, by using their global networks and providing their products, bring together firms requiring funds and investors looking for investment opportunities and thereby contribute to an efficient allocation of risks and returns. Consequently, the main source of earnings of such financial institutions no longer lies in traditional lending and deposit taking, but in originating and distributing structured products, supplying leveraged loans -- the pillar of M&A financing -- and providing complex asset-backed securities and credit derivatives.
As a result of this trend, debtor risks are no longer confined solely to the financial institutions located in the country of origin, but are spread widely throughout the world. In this way, financial globalization is resulting in increased interdependence of international markets and in greater global financial integration.
2. The rise of investment funds
Increased economic globalization and global financial integration have entailed a diversification in investor behavior, which has given rise to new financial products and markets. The growth of various types of investment funds has been remarkable.
In the United States and Europe, the term "fund capitalism" is widely used to indicate the prominence of giant funds, such as private equity, business regeneration, and real estate funds, which have become the main players in acquiring risky assets. In Japan, too, the presence and investment volume of such funds are increasing. In addition, in the area of corporate financing, their involvement as shareholders in the delisting of stocks is also noticeable. An example is the involvement of funds in management buyouts (MBOs). The term "MBO" is now widely recognized in Japan. A fund involved in an MBO typically purchases the stock of a firm jointly with its management from other shareholders with a view to delisting it. Such delisting is intended to avoid stock price fluctuations and the costs incurred by listed firms, such as those for disclosure, to enable the management to pursue long-term business strategies. These transactions allow participating funds, as major shareholders, to exercise more direct corporate control to improve corporate value and to provide outside management expertise. Managers of these funds, for their part, are accountable to their own investors and are therefore under pressure to ensure that the firms in question implement measures to increase corporate value within a specific period of time.
In principle, the increased presence of investment funds encourages the formation of fair market prices, including the valuation of firms, in line with economic fundamentals. No doubt, if an investment fund with a dominant market position behaved erratically, this could throw the market into confusion. The global integration of financial markets, however, is making it increasingly difficult for any single investment fund to hold a large market share. In any case, any investment that ignored fundamentals would, in the long term, result in losses. There are various types of investment funds in the market, and although their degree of risk preference may vary, they are all invariably looking for investments with a favorable risk-reward relationship and investments that help diversify risk.
The rise of investment funds has also led to an expansion in the private placement market. However, this does not diminish the role of the traditional public offering market, where funds are raised from the public in general; rather, price formation in the private placement market coexists with efficient price formation in the public offering market and the two interact with each other in a way that should contribute to the appropriate allocation of resources.1
- 1For more details, please refer to my speech titled "Economic and Financial Globalization, and Challenges Facing the Central Bank," given in Miyagi on February 28, 2007 (available on the Bank of Japan's web site).
B. The Subprime Mortgage Problem and the Recent Turbulence in Financial Markets
1. Subprime mortgage loans provided in the United States and structured products
In the United States, it is common practice to move a number of times during one's lifetime in response to changes in family circumstances or the level of annual income. In accordance with this practice, various tax measures have been designed to assist house purchases. The high level of immigration has also worked to keep up housing demand. As a result, the size of the secondary housing market is about five times as large as that of the market for new houses.
Against this background of vigorous housing demand, various types of mortgages are on offer to cater to various family budgets. In the case of subprime mortgage loans, the terms take into account borrowers' low income levels. For example, interest rates are kept low for the first two or three years. In more recent years, intense competition among financial institutions, including mortgage banks, has resulted in easier lending terms for borrowers. For example, 30-year mortgage loans that do not require strict screening of annual and regular income levels nor any down payment have become available.
In line with the shift to the "originate and distribute" model mentioned earlier, these lenders of mortgages have proceeded to securitize and distribute their loans rather than hold on to them until maturity. They have packaged a number of mortgage loans together to create mortgage-backed securities. These products are designed to meet the needs of investors by providing different classes of securities with different rights to the cash flow generated by the underlying loans. Since these products are sold to investors worldwide, house purchases in the United States are being financed by financial institutions and other institutional investors, such as pension funds and life insurance companies, all over the world, and not just by U.S. financial institutions. In other words, the credit risks of mortgage loans are dispersed worldwide.
2. The rise of the subprime mortgage problem
Against this background, the rate of delinquencies and foreclosures among U.S. subprime mortgage borrowers started to increase during the second half of 2006. In some regions, house prices started to fall, bringing down the value of mortgages. A string of failures among subprime mortgage lenders followed. Prices of securitized products backed by subprime mortgage loans and of bonds with complex structures incorporating these securitized products started to fall. Furthermore, prices of securitized products tumbled further in a vicious circle triggered by doubts as to the validity of modeled prices (theoretical prices) and credit ratings of such products. In July, funds owned by a major U.S. financial institution suffered substantial losses. In August, the announcement by a major European financial institution that it had suspended withdrawals by investors from investment funds under its control sent short-term interest rates in the euro zone surging, making it difficult for European financial institutions to procure U.S. dollars. The liquidity shortage prompted the European Central Bank to make an emergency liquidity provision to the money market.
As a result of these events, doubts over the credibility of financial products relating to U.S. subprime mortgage loans spread throughout the world. In my view, the ensuing confusion was far in excess of a rational repricing process. The confusion extended to the whole credit market. It damaged the proper functioning of the markets for collateralized debt obligations (CDOs) -- asset-backed securities with bonds and loans as the underlying collateral -- and collateralized loan obligations (CLOs) -- asset-backed securities with loans as the underlying collateral. It also made funds procurement in the leveraged loan market difficult, while tightening liquidity in the asset-backed commercial paper (ABCP) market. In the foreign exchange market, carry trade positions were dissolved, leading to a sharp rise in volatility.
3. Assessment of the subprime mortgage problem
Over the past 20 years, the world's financial markets have experienced turbulence every three years or so. In 1987, for example, there was "Black Monday," then concerns arose about a credit crunch following the savings and loan crisis in 1990. In 1994, there was the Mexican peso crisis, then the Russian crisis and the Long-Term Capital Management (LTCM) shock in 1998. Market confusion followed the bursting of the IT bubble in 2000 and the 9/11 terrorist attacks in 2001, and concerns regarding deflation heightened during 2002 and 2003.
Turning to the present situation, stock and credit markets worldwide have been on a bull run since the second half of 2003, and this created a "credit bubble." My long experience in financial markets tells me that after three years of a bull market, a period of adjustment is almost a matter of course. The episode of global risk reduction in May 2006 and the worldwide stock price correction in February 2007 were most probably forewarnings of the current turbulence in financial markets.
I believe that the current market turbulence was caused by the spread of growing anxiety felt by market participants, who rushed to secure liquidity. The anxiety was furthered by the fact that the securitization market had not previously undergone any major adjustment -- it was an untested market. When the markets will stabilize is anybody's guess. In the short term, it is likely that the number of M&As will decrease. However, one can also take the view that the markets will head toward recovery once the market hysteria dissipates. An exemplary course of action to restore orderly conditions was taken by the U.S. Federal Reserve in August. On August 17, the Fed lowered the primary credit rate to 5.75 percent from 6.25 percent. This move, while aiming to calm panicky market sentiment, made clear the Fed's willingness to supply much-needed liquidity to the market.
It is my view that the main factor behind the subprime mortgage problem was overinvestment against the background of excessive liquidity in global financial markets. Various factors were intertwined in a complex way with regard to the cause of global excessive liquidity: (1) consumer prices had been stable worldwide amid the ongoing economic globalization; (2) the distribution of international investment had widened, especially distribution of investment by pension funds of major economies and of increased foreign exchange reserves of Asian and oil-producing economies; (3) excessive optimism regarding investment in credit products had been generated partly due to continuing accommodative financial conditions worldwide; and (4) the Bank of Japan had continued its low interest rate policy. It cannot be denied that Japan's low interest rate policy is likely to have been one of the underlying causes for the subprime mortgage problem and the consequent large swings of the yen. In other words, the recent turbulence in financial markets has proved that maintaining interest rates at levels inconsistent with economic fundamentals entails the risk of causing instability in financial markets.
Therefore, I believe that a gradual reduction in excessive liquidity and the appropriate repricing of credit products are key for restoring stability in financial markets in the end. Regarding the former, we can observe that central banks around the world have gradually been taking measures to reduce excessive liquidity in accordance with economic and financial fundamentals in their respective economies. As for the latter, as investors have been searching for fair value since the outbreak of the turbulence in financial markets, I expect that the repricing will be completed some time in the near future.
With regard to the possible impact of the recent deterioration in subprime mortgage loans, the bottom line is (1) whether it will lead to systemic risks and (2) whether it will damage economic activity significantly.
Regarding these points, I believe that once the current problem of a shortage in liquidity is resolved, the process of repricing in financial markets, with major financial institutions absorbing any losses, will progress, given that (1) the global economy is strong; (2) the financial condition of blue-chip companies in Japan, the United States, and Europe is very sound; and (3) major financial institutions in Europe and the United States are highly profitable and their capital bases are solid as never before.
It is worth noting that emerging economies, many of which have a current account surplus, are diversifying the ways in which their foreign exchange reserves are managed, meaning that there are abundant funds invested globally. The presence of such funds, in addition to pension funds and sovereign wealth funds, is preventing asset prices from declining significantly.
My assessment of the subprime mortgage problem I have described is based on the assumption that the policy action taken by the Fed has been appropriate. That is to say, if the financial environment is such that a preemptive rate cut by the Fed to avoid liquidity risks and the risk of a credit crunch is sufficient and that no further policy actions are necessary, I expect global financial markets to stabilize in due course. However, the premise of this line of argument no longer holds if the Fed is forced to reduce interest rates because of an unexpected downturn in the economy. Thus, the key for forecasting the Fed's policy action, I believe, is developments in employment. This is because, if there is going to be an unexpected economic downturn, I think it will come as a result of a drop in consumption triggered by the weak employment situation.
C. The Subprime Mortgage Problem and Its Possible Effects on Japan's Economy
Compared with their U.S. and European counterparts, Japanese financial institutions have lagged in dealing with credit products and securitized products. In the case of products with a senior/subordinate structure, Japanese banks have invested mainly in high-rated tranches, such as those with the highest AAA rating. Furthermore, the share of such structured products in their bond portfolios has been limited. Given this situation, the effects of the U.S. subprime mortgage problem on Japanese financial markets seem to be limited.
The subprime mortgage problem could conceivably affect economic activity in Japan. It is probable that the pace of U.S. economic growth will be somewhat slower than previously expected, but as I mentioned earlier, I believe that the global economy as a whole is probably strong enough to absorb the adverse effects of the deceleration in the U.S. economy.
D. Lessons Central Banks Have Drawn from the Subprime Mortgage Problem
The subprime mortgage problem has already raised some issues for market participants, financial regulators, and central banks. An increasing number of economic entities are involved in financial markets reflecting the following trends: (1) the rapid expansion of the securitization market; (2) the diversification of ways to raise and invest funds; (3) the growing sophistication of risk-hedging methods using credit derivatives; and (4) the broadening of the distribution of international investment. In this situation, an important issue for central banks is the need to understand the risks stemming from a broadly defined financial system -- specifically, the risk that the impairment of financial assets held by economic entities or a decline in the financial intermediation function may trigger economic destabilization.
Therefore, to maintain the soundness of the financial system, central banks should establish a new monitoring system since monitoring of financial intermediaries has so far been focused on financial institutions that conduct traditional banking operations. In the United Kingdom and the United States, where financial systems have developed beyond a narrowly defined financial system and comprise, for example, an advanced securitization market, the Bank of England and the Fed, especially the Federal Reserve Bank of New York, have allocated large numbers of their staff to the monitoring of market developments.
Considering the abundance of funds invested globally, what central banks need to do is mitigate liquidity risks and anxiety about the stability of the financial system through market operations with the aim of avoiding a credit crunch. However, they should leave the repricing of financial assets to the market.
Another important point that I would like to emphasize is that central banks should not discourage the rise of investment funds and financial innovation. The recent turbulence in financial markets was not the result of the increased presence of investment funds or the expansion of asset-backed securities markets, but due to inappropriate pricing in financial markets. Very favorable market conditions had led to excessive risk taking by investors. When taking risks, investors should have checked, through stress tests or other measures, whether such actions were appropriate in view of their capital bases.
It is my opinion that the increased role of the nonbank financial sector, including investment funds, and the accompanying expansion of the private placement market are inevitable outcomes of the global integration of financial markets. Therefore, I do not think we should find fault with such phenomena. Rather, we should aim to promote the well-balanced development of financial intermediary functions by, for example, examining whether the public offering market is sufficiently efficient or whether regulations are fair and unbiased and are not excessively controlling some particular areas of business.
II. The Globalization of the Tokyo Financial Market2
Recently, the globalization of the Tokyo financial market has been actively rediscussed at various meetings of, for example, the Council on Economic and Fiscal Policy, chaired by the Prime Minister, and the Financial System Council.
I believe that, with regard to such discussions, the following issues are pertinent: (1) how to encourage the provision of risk capital -- which is invested, from a long-term perspective, to achieve higher returns through risk taking -- in Japan as in Europe and the United States, where huge investment funds act as the main providers of risk capital; (2) how to strengthen efforts to encourage foreign risk-capital providers and financial professionals (fund managers, international lawyers, and consultants), who contribute to an increase in investment opportunities, to come to Japan; (3) how to raise awareness in Japan that the country is lagging in responding to globalization of the economies and financial markets; (4) how to promote a deeper understanding of the fact that development of the financial services industry will lead to a more efficient allocation of resources in Japan and to a rise in Japan's overall services sector; (5) how to achieve a public consensus on the importance of making Tokyo an international financial center; and (6) how to improve financial and English education so as to provide the right training for people to work in financial services and to enhance financial literacy of the public.
However, it would be unrealistic to blindly follow examples of successful international financial centers with different historical, cultural, and geographical circumstances from Japan's.
The points I have highlighted indicate that many issues remain to be addressed in order to make Japan into a country with a stronger financial sector, but solutions are at hand.
The issue of globalization was also raised in the "Asian Gateway Initiative" released by the government in May 2007. There it was stated that, as a response to globalization, it is important for Japan to identify its position and, if necessary, effectively express its opinions.
Large investment funds from Europe and the United States see a depreciation of the yen as an opportunity to invest in real estate in metropolitan areas in Japan and to acquire prominent Japanese firms. However, strict regulations should not be imposed on investment funds, because they would contradict the government's objective of realizing an open economy and society. Instead, a much better response is to take advantage of the strengths and distinctive features of Japanese industry to create risk capital that is distinctive to Japan. An example of the business model of risk-capital provision worth examining is large investment funds investing in Asia that are established not solely by banks but through tie-ups between banks and (1) firms that are considering investment and possess superior information in specific areas or (2) manufacturers that have the leading edge in safety, environmental, or energy-saving technologies.
Hong Kong and Singapore have been strengthening their role as financial centers with a view to keeping up with London. I therefore think that for Tokyo to compete, it is necessary to drastically reform the legal framework including regulations and the tax system. Another important element is to improve the infrastructure of metropolitan areas. I think there is significant potential demand for large office space with high resistance to earthquakes. An airport with fast access to central Tokyo that acts as a hub is also crucial, and Haneda Airport should ideally be expanded at an early stage and become a truly international airport that will act as a hub 24 hours a day.
Financial services industries in the major advanced countries have been flourishing, reflecting thriving global financial transactions. Countries have been competing with each other to develop their financial markets, and I am concerned that Japan may have been left behind in that competition. According to "Economic and Fiscal Reform 2007" released by the government in June 2007, the Financial Services Agency intends to finalize its plan for enhancing the competitiveness of financial markets in Japan in 2007, which will then be implemented by the government as a whole. I hope that the importance of making Japan into a country with a stronger financial sector will be actively discussed not only within the government but among the wider public as well.
- 2For further details, please see my written contribution to The Nihon Keizai Shimbun on July 31, 2007 (available only in Japanese).