Financial institutions ; Financial institutions - Japan

Thomas F. Cargill

English

Research Papers in Economics

FABSF WEEKLY LETTER
May 17, 1985
A Tale of Two Financial Reforms
The U.s. and japan are both in the process of
changing the structure oftheir financial institutions
and markets. In the U.S. the process is referred to
as "deregulation", while in japan the appropriate
term is "financial liberalization." Othercountries
also are undergoing financial reform, butthe U.S.
and japan deserve special attention because they
are the two largest economies in the free world in
termsofthe level oftheirGross Domestic Products
and because there exist important relationships
between theireconomies and the rest oftheworld
in the conduct of international trade and finance.
Financial systems prior to current reforms
The U.S. and japanese financial systems both be-
fore and during the current reform efforts differ in
terms ofthe structure of markets and institutions,
theextentofopen securities markets, theextentof
government-supplied credit in the total flow of
intermediation finance, and the structure and
objectivesoffinancial regu lation. Yet despite these
differences, both systems shared a common char-
acteristic prior to the current financial reform
period.
In both systems, avariety of regulations restricted
the portfolio choices of institutions and other
market participants, imposed interest rate ceilings
on deposits and loans, and attempted to allocate
credit by explicit and implicitcontrols. In japan's
case, financial regulations also restricted inter-
national capital movements and isolated the
domestic financial system from international
forces. These restrictions limited competition and
the role ofmarket forces in transferring funds be-
tween lenders and borrowers.
Among the differences between the two systems,
two stand out. First, financial regulation in japan
restricted market forces to a greater extent than in
the u.s. For example, almost all interest rates in
japan were regulated whereas in the U.S., interest
rate restrictions applied onlytodepositsand selec-
ted types of lending.
Second, financial regulation in each country did
not always share the same set ofobjectives. In the
U.S., much ofthe financial regulation emerged
from the Great Depression period and was de-
signed to limitwhat were perceived atthe time to
be unsound banking practices thoughtto encour-
age the adoption ofrisky loan and investment
strategies. In the view ofmany analysts, the effect
ofthese restrictions was to limit competition and
the influenceofmarketforces. In addition, regula-
tionwas also used as an instrumenttoencouragea
greater flowofcredit into housing in the hopeof
making homeownershippossibleforall American
households. In japan, financial regulation was
designed to encourage industrialization, export-
led economic growth, international isolation 9f
domestic finance, and a high household savings
rate.
During much ofthe post-WW II period, both fi-
nancial systems appeared tofunction in asatisfac-
tory manner and accommodated rapid economic
growth. Starting in the late 1960s and early 1970s,
however, the economic environmentchanged in
each country and rendered existing financial
arrangements inefficient. The basic problem
emerged from aconflictbetween afinancial struc-
ture that limited flexibility and a changing eco-
nomicenvironment thatdemanded greater flexi-
biIity. The newenvironmentwas characterized by
oil-price shocks, inflation, high and unstable
interestrates, changes in established flowoffunds
patterns, advances in computer and telecomn;1U-
nications technology, and a shift from a fixed to a
floating exchange rate system.
In response, both the market system and the regu-
lators inthe u.s. and japan embarked on aprocess
of reform designed to give marketforces more
freedom in allocating funds between lenders and
borrowers. The private marketin thetwocountries
played an important role in this process by inno-
vatingtocircumventthemorebindingconstraints,
thereby pressuring the regulators to change the
structure ofthe system and often indicatingthe
type offinancial reform thatwould most benefit
the publie. (The reader may wantto refer totwo
previous Letters on the U.s., March 22, 1985, and
japan,May10,1985,forbackground information.)
Catalyst for financial reform
In the U.s.,financial reform emerged as aresuItof
the conflict between the existing structure offi-FRBSF
nancial regulation and the failure to contain infla-
tionary pressures duringthe 1970s and especially
after 1978. Overly expansionary monetary policy
combined with oil and other commodity price
shocks during the 1970s produced successively
more serious bursts of inflation as the decade
progressed. Interest rates increased to historically
high levels as a resuItand made much ofthe
existing financial regulation, especially Regulation
Qdeposit ceilings, increasingly burdensome. At
the same time, high and volatile interest rates ex-
posed depository institutions, especially thrifts, to
new and unexpected risks that had not been pres-
ent in the low":inflation period.
By the late 1970s, the Federal Reserve had recog-
nized the need to restrain monetary growth to
bring inflation under control. Its task, however,
was complicated by the growth of money market
mutual funds and the new financial instruments
and services introduced by depository institutions
to circumvent binding regulation. These tensions
in themonetarysectorofthe economyconstituted
the catalyst for financial reform in the u.s.
In japan, the situation was quite different. The
primary catalyst for financial reform emerged in
the "real" sectorofthe economy. The sudden end
offasteconomic growth in 1973 with the first
oil-price shocks and the effect this had on the
market for credit were the principal causes. In
particular, the public sector began to run large
deficits after 1975. The ensuing large volumeof
governmentdebtcaused mounting market resis-
tance to the policy ofrequiring financial institu-
tionstoabsorb thedebtat below-marketyields. As
a result, the government was forced to make a
numberofconcessions and, increasingly, govern-
ment debt practices came to reflect marketforces.
At the same time, japanese banks became advo-
cates of new powers to restore their market share
in the financial system lost when corporations-
which had relied almost exclusively on banks for
funding-began to borrow less than before. In
addition, corporations urged that newtypes of
financial assets be created to provide them with
profit opportunities to replace those lost because
ofslowereconomic growth. Similarly, households,
which continued to provide a large volume of
savings, no longer were willing to invest those
savings in alimited set offinancial assets at below-
market regulated interest rates. Unlike the past,
fast real income growth no longer compensated
for the limited choice offinancial assets and
services.
Process of finandalreforrn
There are three differences between U.S. and
japanese regulatory responses to the forces of
financial reform. First, japan'sfinancial regulation
is defined and enforced by administrative decree
rather than by explicit laworthe codification of
regulations as is characteristic of U.s. financial
regulation. As such, japan has not embodied its
reforms in major legislative actions such as the
U.S. Deregulation and Monetary Control ~ctof
1980 and the Garn-StGermain Depository Institu-
tions Act of1982. japan's reform process is ad-
ministratively directed and conducted by the
Ministry of Finance and the Bank ofjapan. As a
result, it is much more difficultfor an outside
observer to determine the content ofthe reforms
compared to the situation in the U.S.
Second, significant regulatory reforms often occur
only in acrisisenvironmentwherethere is apress-
ingand obvious need forchange. A reviewofU.s.
financial historysuggests thatthis is especiallytrue
inthis country. Thetwomostsignificantperiodsof
reform in the U.S., the 1930s and the 1980s, fol-
lowedaperiod ofcrisis in thefinancial and mone-
tary structure. This crisis-reaction scenario does
noteasi Iy fitjapan's case. The one major instance
ofintense incompatibilitybetween the structureof
financial regulation and the economic environ-
ment in japan, caused by the high inflation rate of
1973-74, was overcome by slower monetary
growth. In the absence ofa crisis environment,
japanese liberalization has proceeded in a more
continuous and less dynamic form than U.s.
reform. It has allowed japan to adopt a gradual
approach that would be difficult to achieve in the
U.S. environment.
Thethird differencebetween the U.S. and japanese
processes of regulatory change concerns howthe
regulatory structure itself influences the type of
regulation, the type of regulator response to pres-
sures, and the degree ofmarket-regulator inter-action. The U.s. scene is characterized byamulti-
plicity of regulators at the federal level and a
dualistic regulatory structure in which depository
institutionsoperate undereitherastate ornational
charter. These characteristics widen the range for
financial innovation as market participants "shop"
for the most favorable set ofregulations.
Japan does not possess a multiplicityof regulators
nordoes itpossess adualistic regulatory structure.
Its more unified regulatory structure and its cul-
tural emphasis on group behavior make it less
likelythat market participants in Japan would be
willing to create financial assets and services that
circumventthe intentofregu lation. Onemightsay
that the market participant in the U.S. assumes an
action is permissible if it is not explicitly prohibited
by legislation, whereas the Japanese market par-
ticipantassumes the action is notpermitted unless
administratively authorized.
Constraints on reform
Reforms thatexposethe system to newcompetitive
forces threaten established groups that have
benefited from past regulations. Both Japan and
the U.S. face resistance to financial reform, but
from different groups.
In the U.S., the social commitment to encourage
mortgage lending has been weakened bydereg-
ulation but not broken. Although adjustable rate
mortgages are nowcommon and thrifts have been
given powers to diversify to enable them to be-
come less dependenton mortgages, maintaininga
largeflowoffunds into housingremains an impor-
tant policyobjective. Current regulationsforthrifts,
for example, restrict the amountof nonmortgage
loans they can hold in their portfolios, and tax
breaks provide a strong disincentive to diversify
away from real estate lending. Continuing such
credit allocation policies interferes with the de-
regulation efforts aimed at establishing a more
efficient, adaptable, and stable financial system.
In Japan, the large role ofgovernment financial
institutions in the lending and borrowing market
constrains the move toward a liberated system. In
1982, government financial institutions provided
29.2 percent ofthe total flow offunds to final
borrowers, and this involvement had been steadily
increasing throughout the 1970s. The increase in
governmentintermediation has been primariIythe
resuIt ofthe rapid growth ofthe Postal Savings
System (PSS) in Japan, one ofthe world's largest
financial institutionsbyany standard. In 1983, PSS
deposits represented over 30 percent oftotal
household deposits in Japan. Favorable regu lation
and tax treatment of interest income earned from
PSS depositscompared tootherdepository institu-
tions account for their rapid growth. The pressure
to maintain favorable treatment is strong since the
MinistryofFinance is the recipientofPSS funds for
lending operations conducted through its Trust
Fund Bureau, alarge numberofentitiesdepend on
funds from the Trust Fund Bureau, and the PSS has
anetworkofalmost 23,000 postoffices throughout
Japan that render the system politically powerful.
Conclusion
The U.S. and Japan share a unique historical,
cultural, and economic relationship, and they play
an important role in the world economy. Both
countries are restructuring their financial institu-
tions and markets to provide their financial
systems with the flexibility needed to adapttathe
economic environmentofthe 1980s. Theirexper-
iences differ as to the catalysts for reform, the
process of reform, and the constraints on reform.
However, both reform processes seem to be con-
verging on a newfinancial system that is more
flexible and more open to market forces.
Thomas F. Cargill
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthe managementof the Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybe addressed totheeditor(GregoryTong) ortotheauthor•...FreecopiesofFederal Reservepublications
can be obtainedfrom the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone(415) 974-2246.uo~6u!4S0m 4o~n U060JO 0POI\0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
05/01/85
change
from
04/24/85
Change from 05/02/84
Dollar Percent!
Loans, Leases and Investments1 2 190,767 1,186 10,748 5.9
Loans and Leases1 6 172,648 991 12,048 7.5
Commercial and Industrial 52,166 184 3,182 6.4
Real estate 62,854 39 2,812 4.6
Loans to Individuals 33,927 160 6,264 22.6
Leases 5,370 20 356 7.1
U.S. Treasury and Agency Securities2 11,181 176 - 886 - 7.3
Other Securities2 6,938 20 - 413 - 5.6
Total Deposits 195,979 2,743 8,568 4.5
Demand Deposits 48,020 3,954 2,241 4.8
Demand Deposits Adjusted3 29,897 - 251 787 2.7
OtherTransaction Balances4 13,199 - 384 936 7.6
Total Non-Transaction Balances6 134,760 - 827 5,391 4.1
MoneyMarket Deposit
Accounts-Total 42,866 - 444 3,558 9.0
Time Deposits in Amounts of
$100,000 or more 38,235 - 464 - 228 - 0.5
Other Liabilities for Borrowed MoneyS 23,361 407 1,552 7.1
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
04/22/85
88
24
64
Period ended
04/08/85
32
123
155
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.5. government and depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TI&Lnotes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percentchange

A tale of two financial reforms

http://www.frbsf.org/publications/economics/letter/1985/el85-20.pdf

A tale of two financial reforms

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