Firefighting to fire prevention

Strong risk management and pragmatic incentives have left Japanese financial institutions better off than their peers in other developed economies. As a result, risk managers and policymakers attending Risk Japan 2009 are switching their attention from 'firefighting' to 'fire prevention'. Christopher Jeffery reports

Prudent regulation, less reliance on models and emphasis on innovation, and the inability of institutions to move to an originate-to-distribute model due to legacy non-performing loan problems have shielded Japan's financial sector from the worst of the financial crisis. Banks in the country have tended to employ stronger credit standards, used less leverage and often offered greater transparency than many of their peers in the West.

That's not to say there haven't been problems. Many issuers and investors relied too much on rating agencies, and regulators focused excessively on conventional risks such as value-at-risk and siloed risks in traditional buckets such as credit and market risks.

The economic crisis has had a detrimental effect on Asia's exporters that in turn has hit Japanese financial institutions. Rising credit costs and increasing impairment losses from the cross-shareholdings still held by banks have resulted in the authorities moving to set up a capital injection scheme that banks can tap to maintain a sufficient capital base to support their lending.

It was the subject of appropriate capital levels that Hirotaka Hideshima, a director of the Bank of Japan, chose for his opening address at Risk Japan 2009 on May 27. "As financial institutions have recognised more and more losses, concerns (have grown) about capital and the quality of capital," said Hideshima, who is also chairman of the definition of capital subgroup of the Basel Committee.

Many institutions have scrambled to raise capital, with most effort on share issues to shore up Tier 1 core capital. Indeed, some regulators have effectively said Tier 2 capital is irrelevant in a financial crisis.

Hideshima, however, presented delegates with a careful analysis on the subject, and said that he does not view Tier 2 capital as irrelevant. He also discussed the pros and cons of introducing self-capital buffers or raising minimum capital requirements in upturns and lowering them in downturns based on a range of potential criteria.

Bank of Japan deputy director-general for the financial examination and surveillance department Takashi Kozu, meanwhile, told delegates attending the event at the Mandarin Oriental hotel in Tokyo that 'firefighting' efforts are increasingly giving way to 'fire prevention' initiatives aimed so as "not to repeat the same type of crisis".

It was a theme taken up by Tsuyoshi Oyama, a director for risk and regulatory advisory at PricewaterhouseCoopers Arata, who argued that both macro and micro risk management needs to be dealt with at the same time to reinvent the mechanisms supporting a more secure financial system.

He said macro-prudential policies are needed to clarify the stresses that will be absorbed by banks and the authorities in times of crises and provide for cycle-smoothing. At a micro level, banks need to introduce stress-focused risk management frameworks and appropriate compensation systems.

These were some of the issues discussed by the risk management panel, which examined the lessons Japanese financial institutions must learn from the financial crisis. Panellists included Junko Nishioka, chief economist for Japan research and strategy at RBS Securities, Ken-ichi Hotto, senior manager for market risk in the corporate risk management division at Bank of Tokyo-Mitsubishi UFJ, Hiroaki Takahashi, senior economist in the treasury division at Shinkin Central Bank Research Institute, and Chris Matten, a partner at PricewaterhouseCoopers Singapore.

The final session for the day was a hedge funds panel discussion that looked at real hedge funds' due diligence. They concluded that one-of-a-kind strategies that appear to be 'too good to be true' are probably just that, since hedge fund trading strategy replication is the norm in the industry.