Toward More Competitive Tokyo Market: Deepening Market-based Indirect Financing

Kazuhito IKEO (Professor, Keio University)

Governance Effect of Financial Services Industry

Since Japan's manufacturing, especially export-oriented manufacturing, is highly competitive in the world market, there is still a dominant view in Japan that we should continue focusing on the production of manufactured goods to sustain the economy in the future. However, export-based manufacturing is now forced to globalize its activity with less employment within Japan, except some R&D activity which seems to be returning home in recent years. Furthermore domestically oriented manufacturing is facing direct competition with China and other newly industrializing economies, thus reducing its industrial base in Japan.

As a result, manufacturing employment in Japan has been declining for the last 15 years, although it seems to remain steady this year due to the current economic recovery. In other words, from the viewpoint of securing employment and tax revenue, no one could escape the conclusion that we would need to rely on non-manufacturing activity in the future.

On the other hand, there is a problem with Japan's non-manufacturing sector, whose productivity level is much lower and productivity growth is much slower than export-oriented manufacturing. Although there may be no alternative for Japan, this productivity problem should be resolved in order to improve future prospects for the economy as a whole.

In this regard, strengthening Japan's financial services industry is quite important on the following two grounds. First, the financial services industry itself is one of the major non-manufacturing industries. Second, productivity improvements in other industries would be facilitated if there is more effective application of the governance function which is one of the basic functions of the financial industry.

Based on this recognition, there have recently been renewed discussions about how to strengthen the competitiveness of the financial and capital markets in Japan, leading to the official approval of "Basic Policies for Economic and Fiscal Reform in 2007" in June, when a Cabinet decision was made on a "Plan to Strengthen Financial and Capital Markets" to be prepared by the Financial Services Agency by the end of 2007 and to be actively promoted by the government as a whole.

Complete Channel in Multi-Layered Market

Two key policy measures are urged to be included in this "Plan," that is, strengthening the competitiveness of securities and commodities exchanges and reviewing firewall regulations concerning banking and securities. These points are actually being focused on in official discussions at the Financial System Council, which is in charge of preparing the Plan.

Especially important is the point about the competitive strength of exchanges, because creating "multi-layered market structure" is considered indispensable for improving the competitiveness of the financial services industry as well as financial and capital markets. In other words, the development of financial and capital markets generally requires more complex structure than simple one-step intermediation either through banks or through securities markets. For that purpose, financial activities should be expanded in the form of what might be called "market-based indirect financing," which means the type of financial intermediation connecting firms or households on one hand and markets on the other.

There are two types of market-based indirect financing. The first type is to connect fund providers and markets, and the second type is to connect markets and fund raisers. The first type is represented by various funds such as investment trusts (mutual funds) and pension funds, and the second type is related to such financial activities as securitization. If these two types of financing are connected through the market, a complete channel from fund providers to fund raisers will be opened with multi-layered market structure, in which more efficient transformation and sharing of risks will be made possible.

In this process, the division of labor among financial institutions is to take place and co-evolution between markets and financial institutions is to be promoted. As a result, the financial services industry will be strengthened, and financial and capital markets will be developed further. In fact, there exist quite a few layers of financial institutions throughout the market channel in such financially competitive countries as the US and the UK.

More Self-Discipline and Less Regulation

It should be pointed out that promoting the formation of such multi-layered market structure is the main purpose of current discussions on "product diversification of securities exchanges" and "promotion of transactions in professional markets" at the Financial System Council. If ETFs, which invest in commodity futures, are traded in the exchange as a step toward product diversification, individual investors would in effect have access to various opportunities for commodity futures markets, even though they themselves could not directly participate in such markets.

While it is needless to say that there should be some markets for individual investors, it would be desirable to have multi-layered structure including those markets that are formed solely by professionals. This is because with professionals as sole market participants it is possible to promote free economic activities with minimal regulations under the principle of self responsibility, in contrast to more general markets including individual investors, where strict investor protection and other regulations may be required to limit risks in market transactions. Therefore, professional-only markets are more appropriate for such transactions as commodity futures and start-up companies' shares, which require a high level of information gathering and analytical abilities.

As all these relationships are developed and market-based indirect financing is deepened, there will be multi-layered agency relations involving financial institutions and their clients. Therefore, it is important that financial institutions act for the benefit of their clients such as individual investors and fund raisers. If financial institutions behave only in their own interest or solely for one of their clients with a conflict of interests, then the foundations of market-based indirect financing will collapse. Another discussion point at the Financial System Council, that is, "reviewing firewall regulations concerning banking and securities," should be understood in this context.

As is well known, firewall regulations have been adopted for the purpose of avoiding negative effects of a conflict of interests and abuses of banks' dominant positions. Reviewing such regulations does not mean abandoning these purposes, but rather strengthening the self-discipline of financial institutions to achieve those objectives.

From now on, financial institutions will be required to establish an internal control system to resolve such problems as a conflict of interests, and its effectiveness will be checked through monitoring procedures by regulatory agencies. This means that the regulatory framework will become more of the ex-post checking type. In this framework financial institutions are expected to exercise their own self-discipline in the process of deregulation and overcome such challenges for success in the future.

(The original Japanese article appeared in the December 20, 2007 issue of Nihon Keizai Shimbun)