Asset Price Bubbles and Macroeconomic Policy

Even now, almost two years after the so-called Lehman Shock, no definitive picture of finances in the future has yet emerged from the private sector or government. This paper discusses the future developments of the financial businesses and financial system in the context of risk management practices and regulatory policy on capital adequacy, the issues on which the author has been engaged in for many years. This paper is developed to definitively explore any issues inherent in risk management and financial regulation to date, and to encourage any correction of the vectors to be followed if any are wrongly directed. As such, the perspective of this paper exceeds the scope of enhancement of control alone. The paper begins with an analysis of the fundamental structures of Japanese banks as a preliminary survey. The "structure of risk concentration" at Japanese banks is discovered in the flow of funds such as deposits. Then, turning to the relationship between this structure and the Japanese economy, the "vulnerability of the credit grant structure" can clearly be identified. While Japanese banks' performance is designated by the "low income-generating structure, their corporate governance and social responsibility can be characterized by the "diluted-shareholder-right structure" and the "public-interest-biased structure" as the opposite side of the strong influence of the regulatory authorities. Next, this paper reviews anecdotal evidences of risk management practices and banking regulations for the past two decades. In fact, since the latest financial crisis has somewhat been rooted in these practices and regulations, it is important to re-examine them in providing insights into future developments. Specifically, in this paper we analyze a host of issues such as the following: "BIS regulations and credit grant contraction," "financial engineering and loss of flexibility in market risk management," "fair value accounting and no control of remuneration packages" "Basel II and credit risk management running into mere formality," "the outlier-regulation and loss of effectiveness of interest risk management," "examination by regulatory authorities and discretionary risk management," and "less substantive framework for the risk management of policy-based strategic equity holding." Securitization businesses grew dramatically in the mid 2000s. In time, their rising prominence resulted in the infiltration of flaws on many aspects growing from scattered small holes into a big crack, eventually precipitating the collapse. Such infiltration was one of the main forces behind the latest financial crisis and gave rise to a landscape totally different from the previous crisis. It was a completely new crisis triggered by interactions among the flaws, a crisis unexplainable based merely on the analysis of individual flaws. The mechanism can be analyzed in the context of the chain risks inherent in market-type finance and the cyclical risks embodied in the risk contagion among commercial banks. We can identify the characteristics of the explosive expansion of risks in the present financial network. Through these analyses I propose five agenda in the section entitled "For Future Development of Finance." I begin with addressing the need to respond to new risks and discussing the discovery and management of the macro risks now rapidly growing. Second, I explore the need for international financial supervision and system to prevent these macro risks from exploding all at once. In doing so, I propose an approach to shut out the risks by segregating the financial institutions with public interest-oriented characteristics from others pursuing efficiency. I attempt to do so in the context of the Volcker rules of the Obama Administration announced in January. Third, I present issues inherent in the banking regulation, in particular the rules on capital adequacy ratio of banks. While many argue, in considering the latest financial crisis, that strengthened regulation is clearly imperative, I take a few paragraphs to reexamine the adequacy of this approach. If regulation accelerates any negative spiral, we should preemptively redesign the system to eliminate the negative spiral and attain a more proactive regulatory approach. Forth, as banks' stronger dependence on the regulatory authorities is seen in Japan, I argue that Japan needs multilayer stakeholders as a means of promoting responsibility and accountability in bank management. Finally, 1 describe the current landscape of the Japanese economy where no development of financial businesses contributing to the economic growth has been witnessed during the ''two lost decades" since the dilution of the fund-providing function of banks that once served to finance Japan's industrial reconstruction after World War II. In conclusion, I point out the requirements for finance going forward. I analyze the substance of the current financial landscape that becomes divergent from the economy mainly because Japan has been tilted towards low-risk assets, mainly government bonds, while finance in Europe and the U.S. has been tilted sharply towards high-risk assets since the beginning of the 21 SI century, and discuss the need for asset allocation by financial institutions between the emerging economies and developed economies.