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If Yogi Berra were analyzing the state of play in todayÆs world financial markets, he might conclude that its dTja vu all over again. The Asian financial crisis in 1997, which started in Thailand, spread quickly to many of the countries in the region. In 2007, the subprime loan crisis in the United States threatens credit markets around the world. But the architecture of the global financial system is quite different today.
I have recently returned to Japan to take up my law practice at White & Case following the completion of my term as general counsel of the Asian Development Bank. Moving from Manila to Tokyo has also given me the opportunity to consider how both the US and Japan have changed in the intervening years.
Ten years ago, the Harvard Law School convened a symposium on ôBuilding the Financial System for the 21st Centuryö. Senior government officials from both Tokyo and Washington, bankers and lawyers gathered to assess the situation. The air was thick with tension because the Long-term Credit Bank of Japan, in effect, had gone bust many years before but few in Japan were willing to acknowledge that reality. The effects of too much lending, bad credit practices, lax regulation and negative impacts on the economy beyond the financial system began to take its toll.
One of the books I read at the time was titled æJapan: The most misunderstood countryÆ by Kaoru Kobayashi. It was an explanation of why the Japanese system û main banks, lifetime employment and the symbiotic relationship between government bureaucrats and the business community would see Japan through. Looking back, we can see that the æJapanese systemÆ he envisioned has not survived intact.
The corrosive practices I have just described do not fit our image of Japan today. In fact, they might more accurately describe the subprime mortgage market in the US today. According to the New York Times, more than two million US homeowners are now headed to default. It is pertinent to ask why there was such a regulatory failure in the U.S. system, one that is thought to be the most advanced?
It seems certain that there will be calls for more regulation of hedge and private equity funds and the rating agencies as well. This will happen in the US, Europe and Japan. But what type of regulation will it be? Can government regulators do a better job of evaluating risk than the private sector? Since I acted as a government regulator of sorts for almost five years, I can confirm that governments cannot do a better job in that area. So what is the right type of regulation?
A crisis in confidence and a contraction in liquidity in the financial system can become the self-fulfilling prophesy that causes actual damage to the real economy. Surely, more transparency concerning lending practices would go a long way to help all participants understand the true dynamics of the current credit markets. But transparency is only a general principle. It must be given substance by a broad agreement among investors concerning how to value complex financial instruments, even in times when markets are stagnant.
There is no doubt that the financial ôBig Bangö, which promised to make JapanÆs capital markets free, fair and global, was a major part of the structural reforms that took place in the early part of the decade. Today, there is far more certainty and less bureaucratic guidance for business than ever before. But the Big BangÆs promise to put JapanÆs capital markets in a position on par with New York and London has only been partly fulfilled. Today, the TokyoÆs markets are, by any measure, more free and fair than 10 years before but they are not global because there is no consensus among Japanese policymakers concerning whether Tokyo should remain as a strong local player, take on a regional role or compete with other capital markets on a worldwide basis. That decision, when it is made, will have profound effects on the flow of funds in Tokyo and the region as well as the structure of business in the Asian landscape.
Japan has a new prime minister but it is far from clear that the momentum for reform seen in the Koizumi years will return. As the banks have cleaned up their balance sheets and resumed lending, Japanese corporations have lost interest in (and incentives for) enhancing shareholder value. Poison-pills and other defense techniques as well as share-buybacks and increased dividends have put off a reckoning for the moment but how will Japanese companies fare against competition from China and India if they fail to increase productivity?
In times of crisis, the public looks to the government to correct market failures. Ten years ago, it was quite easy to figure out whom to call. In todayÆs environment, no one government or regulator has a handle on all of the factors that are likely to affect its financial system. Now we must seriously ask whether the current framework is sufficient for the financial system of the 21st century? We are already hearing calls for the creation of new supranational or regional regulatory bodies. Personally I am not sure that this would be a good solution but more of the same type of coordination between national regulators that exists today is not likely to do the trick either. And if there is to be more regulation, how can we be sure that it is the right type of regulation: rules that protect investors but to not unreasonably inhibit financial innovation?
Can the public be spared unbearable pain without bailing out the financial professionals who took unreasonable risks? And what about permanent damage to the financial system and the economy as a whole? As the situation evolves, it seems likely that a few more hedge funds will go bust and a bank or two may collapse. While neither Japan nor the US is in danger of financial collapse at this point, it may useful to keep in mind what Jared Diamond said about why some societies make disastrous decisions. They involve:
* the failure to anticipate problems
* the failure to perceive risks
* rational but bad behavior
* unsuccessful solutions
The world today is unpredictable, chaotic and full of risk. As it turns out, many of the models that have been used failed to help us understand our current reality. The fact that our financial systems are connected in fundamental ways that were not even possible 10 years ago means that we all have a stake in insuring that the risks are well understood and managed properly.
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