Japanese Deregulation Term Paper

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Former Prime Minister Ryutaro Hashimoto announced that government would undertake an extensive deregulation of Japan's financial system by 2001 a proposal likened by senior officials to the "Big Bang" financial deregulation in the United Kingdom more than a decade ago. The exact nature of these reforms, the timetable for implementation, and indeed whether the reforms will be as sweeping as promised, is still uncertain. The fundamental changes proposed, even were they to greatly benefit the Japanese economy as a whole, would necessarily entail losers as well as winners. And the potential losers, at present protected (by regulation) from market competition in Japan's compartmentalized financial-services industry, are likely to vigorously oppose change. Financial deregulation in Japan has been on the agenda for many years, proceeding only gradually, and some skeptics argue that a sense of d j vu surrounds the present push for deregulation as well.

Japan's financial system, however, is at a juncture today which is not comparable to any other episode during the past 45 years. Stress in the Japanese financial system, especially failure to quickly resolve the non-performing loan problem, continues to hold back the economy and has stagnated a large part of the real estate market. And the shortcomings of the existing regulatory and supervisory structure, pit against vastly different financial institutions (and markets) than just 15 years ago, is readily apparent. Market forces and competition among financial institutions make the existing financial structure incompatible with Japan's regulatory and supervisory structure. For these conflicts to be resolved, reform is necessary. Hence, economic as well as political pressure for fundamental reform will continue even if the present wave of popular opinion against Japan's financial institutions and regulators, especially the Ministry of Finance, wanes.

Although there is conflict between the existing financial system and regulatory structure, changes in regulatory and supervisory policy would likely help resolve this conflict. One proposal on the table at this writing is to form a new agency to inspect and supervise banks and other financial institutions, taking this responsibility in large part from the Ministry of Finance. Whatever the ultimate division of responsibilities among the Japanese government bureaucracy, however, our research suggests that a central element to any successful reform is the introduction of a new policy approach to deal with the problems of regulatory delays, moral hazard and inadequate funding to deal with insolvent financial institutions burdened with non-performing loans. A new approach should be based on a more explicit and transparent accounting, supervisory and regulatory framework. A new institution handling regulatory and supervisory responsibilities may facilitate introducing and implementing a new policy, but the process itself as opposed to the specific institution taking responsibility for it is most important for a successful reform.

A review of the contribution of financial liberalization, greater market competition and changes in the flows of funds to the asset-price bubble in Japan illustrates the basic conflict between Japan's financial system and its current regulatory and supervisory structure. These fundamental changes in the financial system occurred in the 1970s and 1980s without corresponding changes in regulatory and supervisory policy. The burst of the bubble in the 1990s, resulting non-performing loan problem, and inadequate response by the regulatory authorities, highlight why financial distress in Japan became so pronounced and has had such detrimental effects on the economy. Regulatory reform is necessary since the alternative reversing past liberalization moves, re-regulating the economy, and maintaining tight administrative guidance over a highly segmented financial system is not compatible with Japan's integration into increasingly open international financial markets.

Financial Deregulation and the Bubble Economy

In the second half of the 1980s, asset inflation was evident in many countries, though not of the same order of magnitude as in Japan. Indices of real asset prices for 13 industrialized countries consisting of equity, residential real-estate, and commercial-real-estate components, illustrate a broad-based process of asset inflation in the second half of the 1980s (Borio, Kennedy, and Prowse, 1994).

The international character of asset inflation suggests common explanatory factors. The coincidence of financial liberalization and asset inflation and deflation has led a number of observers to argue liberalization played a major role in the financial disruptions of the 1980s and in the problems that the 1990s inherited from the boom-and-bust period. This view is rooted in the traditional argument that unregulated and competitive banking is inherently unstable in the absence of government supervision. In the context of liberalization in the 1980s, the removal of binding portfolio constraints permitted banks and other depositories to adopt more riskier investment and loan portfolios, including the adoption of high loan-to-value ratios.

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