Comments on Chapters 2 and 3 of Financial Innovation in Japan

Prepared for the Tokyo Club-Brookings Financial Seminar 2006
Revised for publication

April 1, 2007

The author is grateful to Robert Litan for the invitation to participate in the Tokyo Club-Brookings Financial Seminar 2006.

The papers by Yasuyuki Fuchita and Yuta Seki are of extraordinary detail and include some very useful information in their figures and tables. Upon their publication in the latest volume by the Brookings Institution and the Nomura Institute of Capital Markets Research, I am confident that they will become references for all financial market observers. At the same time, it is worth calling attention to the very phenomenon that the authors themselves carefully establish in regard to exchange-traded funds (ETFs), real estate investment trusts (REITs), and mortgage securitization: the ongoing innovation in Japanese financial markets, and the ever wider adoption and use of sophisticated financial instruments by Japanese investors and issuers.

This is a particularly good time to call attention in the United States and elsewhere in the English-speaking world to such healthy developments. With the leadership transition in Japan from Junichiro Koizumi to the current Prime Minister Shinzo Abe, many Western observers have wondered out loud and in print whether the deregulation thrust that Koizumi supposedly began would continue. Such questions show how underappreciated the financial transformation in Japan to date has been. Although it is true that Koizumi and his then financial services minister Heizo Takenaka bravely cleaned up the banking crisis left to them by their predecessors' willful neglect, financial deregulation had been underway in Japan for 20 years.1 The "Big Bang" financial liberalization begun by Ryutaro Hashimoto in 1996 was largely completed by the time Koizumi took office in 2001, even though the full benefits could not be seen until the banking system had been recapitalized by Koizumi and Takenaka (and the Bank of Japan had supported the country's recovery from deflation).

This sustained period of liberalization and consolidation has completely transformed corporate finance in Japan as well as the structure and behavior of the Japanese financial system. This transformation has gone much too far to be reversed, and it has vastly narrowed the difference between the types of financial products offered and corporate financing behavior in Tokyo and such products and behavior in New York or London. Household investment behavior and corporate governance in Japan may still leave a lot to be desired from the point of view of the market or the economist, but that should not obscure what has taken place. So the excellent expositions of the long and steady progress of the new financial instruments outlined by Fuchita and Seki are important simply as documentation of this ongoing trend.

There is still plenty of room for political economy questions of what caused this broader trend of financial reform and how the rise of ETFs and mortgage securitization fits with standard models of reform politics. Some will immediately attribute both the trend and the introduction and advancement of these particular instruments to the competitive pressure experienced by Japanese financial firms. While that has certainly played a role, we all know that the existence of alternatives in financial markets do not immediately translate into convergence of financial behaviors across borders-otherwise Japan would have been here before the 1990s, and continental European financial markets would look very different today (and more like Japanese, US, and UK markets). Others might cite that the broader Japanese crisis provoked a response, but that explanation strikes me as disregarding the facts that, at the same time this deregulation trend was going on, Japanese bank supervisors and politicians were making the banking problems worse and that these advances in financial depth and liberalization only became evident and widespread after the crisis had passed. Questions about what brought about financial reforms in Japan go beyond the remit of these papers, but they do provide interesting material for future research into determinants of reform and their outcomes.

What is probably more relevant for this audience is to treat the adoption and spread of these financial instruments in Japan as the independent variable, rather than trying to explain where it came from. I would therefore like to address five topics on the kinds of changes that the development of these instruments may cause in Japan, three of which are raised directly in the papers and two of which arise out of my own focus in these matters: the impact of change in the financial market on macroeconomic outcomes.

First, will the supply of new financial instruments automatically create its own demand in Japan? While most economists are skeptical in the abstract about Say's Law, in practice one sometimes gets the sense that they are believers. If one reads about ETFs in Seki's paper or the development of ETFs in the United States in Broms and Gastineau's complementary paper in this volume, one finds that there is a strong case made that ETFs are an obviously better mousetrap and that it is only a matter of time before households and other savers wake up and start buying more of them. There certainly is some precedent for such responses to financial innovations, but there are also counterexamples.

All of the $1.5 trillion plus (dollars not yen) in low-yielding CDs held with the Japanese postal savings system and rolled over into similar but still lower-yielding instruments upon expiration from 1999 to 2001-and that was the overwhelming majority of those funds, as various US retail firms found to their regret-represented a decision by Japanese investors to pass up on some new savings instruments that were available to Japanese savers at that time. Let us remember that in the United States, when savers shifted into REITs and ETFs in recent years, and homeowners took out the mortgages that securitization made available, they were largely shifting out of one class of risk assets into another. For Japanese savers, large-scale adoption of such instruments would require shifting from cash and deposits into risk assets, which is something else.2

The shift to securitization of mortgages discussed by Fuchita is much larger, and is more persuasively inevitable, than the rise of REITs and ETFs, perhaps because it is being done by the financial firms themselves, as intermediaries trying to shift their risk. Put another way, the numbers on the growth of REITs given by Seki do not come close to the massive growth in securitized mortgages presented by Fuchita. It is not households that are buying even repackagings of these securities, at least not in large numbers.

It would be even better to build on what the authors have done and try to estimate some demand functions for these securities in a more formal manner. For example, how much has the demand for REITs been influenced by movements in the dividend yield in Japanese equities or by equity and real estate prices, or how well have the institutional investors packing the mortgages evaluated credit risk after years of the ZIRP (zero-interest rate policy) and declining real estate prices? The point is not that these instruments are unimportant or unlikely to last; the movement of even a few percentage points of Japanese household savings is sufficient to ensure their importance and continued existence (and it already has). The point is that it may not be enough to forecast their growth and then discuss their impact without some consideration of what drives their growth.

Second, what effect will these new instruments, particularly the ETFs, have on Japanese corporate governance? Seki as well as others have raised the issue of the governance of these funds themselves, and certainly the contemporaneous spread of ETFs in the US market has accompanied concerns about the behavior of mutual funds here. Fuchita raises the same point, by another means, when he discusses the difficulties everyone has had understanding, let alone tracking, the balance sheets of Fannie Mae and Freddie Mac, as an example of how not to design a government-sponsored enterprise (GSE). We can offer this wonderful product of securitized mortgages, but there is some limit to their acceptance (or what should be their acceptance) if the behavior of their main issuer (or issuers) is suspect.3

Undoubtedly, compared with the various investment vehicles previously available in Japan, these new instruments have many admirable attributes. As amply demonstrated in the 1980s and 1990s, even the management of insured savings account deposits at Japanese banks could well have used greater scrutiny, both from accountholders and regulators. Yet, if ETFs (and for that matter REITs and mortgage-backed securities) are inherently to display their putative benefits, the underlying corporate or real estate investments they are tied to must offer some transparency as well. Otherwise, the point of the governance of these instruments and their issuers is moot.

In other words, it is still the corporate governance of Japanese companies (and real estate developers) that is at issue, just as it has been for a long time. And the financial liberalization of the 1980s and 1990s has had insufficient impact on Japanese corporate transparency in my assessment. Japan is still a place where formal and informal interlocking of companies, insider deals, smoothing of earnings, and managerial entrenchment prevail, and shareholder rights are far from protected.4 There is still only a negligible number of contests for corporate control or turnovers of management for poor performance, and the environment remains hostile to such contests. The real estate sector is in many ways worse, beset by extensive underworld involvement (far beyond that of the kind seen during the construction cycle in New York City, for example) and offering little of the information about properties that is necessary to create a liquid market outside of the one for class A office space in Tokyo. In addition, accounting in both the corporate and real estate sectors is often literally not worth the paper it is printed upon..

So will the rise of these new financial instruments in Japan be limited by the failures of the underlying assets to be well governed? Or will these new instruments themselves lead to some improvements in Japanese corporate governance? So far, the demand for these instruments has been strong, and one can well understand why under such conditions mortgage-backed securities, used as a means to get real estate loans off of their balance sheets, could be an attractive defensive strategy, at least for the lending banks. Frankly, I am of two minds and would be interested in the authors' thoughts on this issue. On the one hand, I fear that a scandal arising from conflicts over ownership of properties or from buildings whose mortgages are securitized that do not meet earthquake or other codes could erode confidence in REITs and securitized mortgages-and one can easily come up with something similar in the corporate sector that would sour the Japanese savers on equities, and thus ETFs, just as they are starting to get back into that class of assets. On the other, depending upon how voting rights of ETF shareholders and the attraction of global real estate investors to repackaged mortgages proceed to develop, one could imagine institutional investors exercising greater scrutiny and discipline on Japanese companies and developers.

Third, is it possible to design a "good" GSE to securitize mortgages? Fuchita rightly identifies this theme as perhaps the critical issue in the future development of the mortgage-backed securities market in Japan. He also correctly points out that US "agencies" do not present an ideal model, while recognizing their strengths. Fuchita balances nicely the discussion of the ideal with the politically realistic, given historical and current conditions, something all of us writing to influence the public policy debate have to try to do. I expect that this paper (or its Japanese language equivalent) will have a significant influence on the discussion of these policies in Japan.

I would, however, encourage Fuchita to more explicitly address two aspects of the issue of designing a "good" GSE that are troubling in the current US situation and are relevant for this institution-building exercise in Japan. The first is such GSEs' balance sheets in general, and whether they should be allowed to keep mortgages and securities on them for investment purposes. Fannie and Freddie have been both great profitmakers and great sources of concern largely because they have retained holdings of mortgage assets, rather than simply getting off of their balance sheets everything that they securitize (except whatever mortgages are necessary to retain while the assembly, securitization, and sale are in process). Whatever was the original intent of providing a legal capacity for these two agencies to engage in such for-profit activities, it is clear that such speculative holdings of mortgages is unnecessary for them to fulfill their legislated function and provide benefits to American homeowners. Moreover, it is evident that the scale of these holdings is far too great and, partly as a result, far too opaquely reported to be justified and that such a combination makes them a source of systemic risk.5 In short, Japan would probably suffer from allowing this kind of behavior by its GSE, as I fear the United States may in the not-too-distant future.

The second aspect for Fuchita to address more directly is the question of what should be the nature of the government guarantee, if any, for a Japanese GSE securitizing mortgages. Right now, with respect to Freddie and Fannie, the United States is living with what all financial economists know to be the worst of all worlds: an implicit, open-ended, but widely believed to exist guarantee. This partly arises out of the way these agencies are seen as "too big to fail," which in turn, of course, feeds their speculative behavior, which then increases their size and systemic risk, and so on (a dynamic with which Japanese policymakers are all too familiar). And one can easily imagine that in the present declining US real estate market, few members of Congress would be brave enough to suggest that the federal government not step in if Fannie and Freddie had to start selling off assets in their portfolios during a down market-even though we know from Japanese experience in the 1990s among other examples that allowing such sales would be the right thing to do.6 It is unclear, however, why a government guarantee is necessary for a securitizing GSE to do its job, and why the expectations of investors would be all that different if such a guarantee were explicitly precluded from the start in Japan. Either the assets are worth buying, or they are not, and the new instrument (so to speak) of mortgage securitization should make these assets more attractive-and the market for them more liquid-irrespective of the creditworthiness of the intermediary.

This leads directly into my one real criticism of the Fuchita paper. Fuchita discusses at length the issue of how the GSE in Japan would establish a AAA bond rating for itself and assesses three proposals for how to do it. I wonder why this is necessary at all. Again, the virtue of the new financial instrument is in the securitization itself, not in the agency. Although there might be some risk at any given time for mortgages and deals in process at the agency, why is that any different than the risks of bookbuilding for an investment bank with a new offering or buying a derivative from a trading house? I do not mean to be disingenuous; of course, an agency seen as unlikely to make its payments or at risk of insolvency is not one from which an investor wants to purchase securities. Thus it would fail in its mission. But the risk specific to the GSE is surely only during the period of intermediation, with the asset's value and risk characteristics determined by the mortgages underlying it and the structure of the security.

Fourth, what difference would widespread adoption of these new instruments and practices make to the transmission of financial shocks in Japan? Underlying this question are two ideas: First, some of the miseries of the Japanese economy following the bursting of the asset price bubbles over the course 1990 to 1992 were compounded, if not created, by the structure of the financial sector. Second, financial innovation in recent years has increased the volatility of particular assets globally but arguably has diminished the volatility of the real economy by reducing the costs of reallocating risk. One way of considering this issue of financial structure and shock transmission is to compare the responses of the US and Japanese economies to similar equity price rises and collapses a decade apart. Around 1990, the transmission was far greater in Japan's bank-based and highly relationship-based (rather than securitized) financial system.7

The diminished transmission and persistence of financial shocks will be seen and felt much more in real estate assets than in equities, naturally. Even in Japan, equities inherently were far more liquid than properties with collateralized mortgages, which were held by individual banks and required specialized assessment of worth relative to local markets. Although REITs and securitization cannot make the entire difference between equities and real estate assets go away, they certainly can narrow it significantly.

In particular, just as theory would predict, US experience demonstrates that if real estate lenders manage to off-load properties from their balance sheets, and real estate investors buy into diversified portfolios, both the overhang of unsold properties and the impairment of bank capital following a real estate bust are lower. Thus there is a public policy interest from a macroeconomic stability point of view, as well as from those of financial stability and efficiency, in the healthy development of REITs and real estate securitization in Japan. The authors might do well to at least acknowledge the prior work done on the macroeconomic aspect of this topic as a way of buttressing their case for the virtues of recent developments.

Every responsible public policy analysis comes with the caveat that "X is not a panacea," with X being the policy change in question, and that holds as well here where X is securitization and REITs. A great deal of the benefits of securitization depend upon there being sufficient but not excessive consolidation in the mortgage market, particularly regionally, such that the major lenders and real estate investors are diversified across geographic markets. Such diversification reduces, if not rules out, local capital crunches for banks, of the sort that hit banks in New England from1989 to 1992 or in Texas and California in the mid-1980s. Another key condition is that the bank supervisors do not allow the legitimate easing of some of their concerns and duties, resulting from the existence of securitization, to absolve them and the banks they supervise from properly provisioning for loan losses. Yet, more than in most cases, one can make the case that the securitization of real estate lending (including both creating a GSE to promote securitization, and allowing for the creation of REITs) is a clear improvement in public welfare without apparent costs.8

Finally, what effect might the widespread adoption of these new financial instruments in Japan have on the growth of productivity? It has become increasingly well-established in recent research that development of the financial sector is crucial to the reallocation of capital between sectors and between specific firms within sectors, both of which are necessary for sustained productivity growth. From a Schumpeterian perspective, where entrepreneurial activity and innovation of all kinds are intertwined, financial firms have to be ready to support new entrants and new technologies. It is therefore worth going beyond the assessment of asking how, and by how much, new financial instruments might improve the efficiency of financial markets in Japan, which would raise growth temporarily through the productivity gain within the financial sector, to asking whether such changes might enhance the productivity growth of the entire economy in a sustained manner, by improving the allocation of capital.

As I have discovered in recent research, a large proportion of the differences in (productivity and GDP) growth rates among the OECD economies can be explained by differences in corporate governance that depend upon the ability of banks and markets to reallocate capital between firms and sectors.9 While the general consensus has emerged among researchers that there is no significant difference between financial systems that are bank-based or securities-based per se in their impact on productivity growth, I find that the closer that banks come to the classic model of relationship banking (for example, the Japan's former main bank system, the still extant Hausbank system in Germany, and so on), the less reallocation of capital and employment takes place between sectors. When banks pursue more national(ist) goals in more consolidated banking systems, along the lines of France's traditional model of Credit Mobilier and increasingly in the Japanese system in recent years, and thus are less captured by local interests and companies, the more willing they are to make the necessary reallocations for productivity growth. And, it appears that these more consolidated banking systems are also more willing to innovate than the more fragmented and politically influenced, and partially publicly held, systems as those in Germany and Italy.

But this takes us a very long way from ETFs, REITs, and securitization of mortgages. In other words, the readiness of a financial system to make its main contribution to growth in advanced countries-shifting the allocation of capital between businesses and sectors-depends primarily on the financial system's structure and political independence.10 Those products that increase the throughput of the financial system may contribute to stability and certainly will offer some cost savings to household investors, but they will not have a first-order effect on allocative efficiency. They do not directly change the incentives of the financial system to be less rent-seeking or less tolerant of relationship clients yielding low returns. This can be seen in the continued problems of the US financial system related to fraud, looting by corporate insiders in various forms, misstatements of earnings, and so on that persist despite the existence of a wealth of financial products available to households.

So it may be for Japan, too. That is why we should welcome these new instruments in Japan as being consistent with the overall development of the Japanese financial system, but we should also recognize that the already completed significant changes on the corporate financing side are the true source for ongoing productivity gains. It is a sign of the renewed health of the Japanese financial system, and of the economy more broadly, that we are able now to focus on these matters and that such innovations can take place.


1. Most would argue that it was partial but real deregulation in the 1980s that sowed the seeds of the 1990s banking crisis in Japan, as did mismanaged partial deregulation of the savings and loan institutions in the United States in the early 1980s. See Ryoichi Mikitani and Adam S. Posen, eds. 2000. Japan's Financial Crisis and Its Parallels to US Experience. Washington: Peterson Institute of International Economics.

2. Whether US small investors and mortgage borrowers fully understand the risks they are assuming, and had assumed in the past, is a matter open for discussion, but their situation and choices are not comparable with those of Japanese grandmothers with savings accounts at the local postal savings branch.

3. Something similar has been seen in 2005-06 with the sudden closures of REIT-like funds offered to German investors after sharp falls in their net asset values (NAVs). Whereas malfeasance is probably not at issue, the poor handling of how retail customers were informed about interruptions in access to their money has probably had lasting negative effects on the demand for these instruments in Germany.

4. This is not to say that there is still (or even was) a "Japan, Inc.," the fantastic keiretsu monster of some Americans' nightmares. The more accurate statement is that larger publicly listed companies, and banks in particular, have been subjected to greater market discipline, and some of the ties to smaller suppliers and to bank loans have loosened, but the vast majority of Japanese businesses (particularly those in domestic service sectors) retain unaccountable management that tends to overinvest.

5. I am oversimplifying here to some extent. Such issues as the smoothing of earnings and executive compensation at the agencies, the use of derivatives (not limited to Fannie and Freddie), and uncertain regulatory supervision all play roles in this situation. Yet the bottom line for Japan and other countries adopting some GSE-like institutional framework to enable the securitization of mortgages probably remains simply to preclude their counterparts to Fannie and Freddie from holding such assets on their balance sheets for the sole purpose of making profit.

6. In fact, this may well explain why efforts a few years ago to better regulate the US GSEs and clarify their nonguaranteed status have dried up in Congress of late.

7. See the US-Japan comparison in Adam S. Posen. 2003. It Takes More than a Bubble to Become Japan. In Asset Prices and Monetary Policy, ed. Anthony Richards and Tim Robinson. Sydney: Reserve Bank of Australia, Economic Group, pp. 203-49. The Federal Reserve Bank's response to the asset price bust was far more aggressive than that of the Bank of Japan and also played a key role, along with the structural differences.

8. One could go so far as to suggest that some dire predictions of a negative impact on the US economy from the fall of real estate prices at present are likely exaggerated, beyond the direct or "first-round" effects of such declines on consumption, given the combination of securitization, diversification of lenders across regions, ample capitalization, and strong supervision.

9. Adam Posen. Forthcoming. Reform and Growth in a Rich Country: Germany. Washington: Peterson Institute for International Economics.

10. Classically, the other main function of financial systems is to safely mobilize savings from households, but in advanced economies that may be taken for granted today.

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