FROM THE OFFICE OF PUBLIC AFFAIRS

I’d like to thank Hal Scott for inviting me to speak with you again.  It’s a great pleasure for me to be making a repeat engagement at what has become a premier policy gathering.  Since its creation in 1998, this symposium has addressed a variety of issues critical to both the U.S. and Japanese financial sectors.  This year’s focus on auditor independence and the flow of information to capital markets is no exception.

Since we last met in Gotemba, a number of important developments have taken place in the United States, as you know.  We have witnessed a series of corporate scandals that have touched the integrity of U.S. accounting standards, corporate governance and transparency.  These developments have taken a toll on equity markets in the U.S.  They have dampened investor confidence in our corporate leaders.  But rather than outline the costs, I’d like to focus on the process of response.  Our leaders, including the President, the SEC and the Congress – and even the private sector itself – have taken swift corrective actions.  I believe important lessons can be drawn from their responses.   

President Bush was the first to act.  On March 7th of this year, he announced a ten-point plan for restoring corporate accountability.  Three core principles drove the plan.  The President made clear that corporations would be forced to provide better information to investors; second, corporate officers would be held better accountable to shareholders; and third, a stronger, more independent accounting and auditing system would be developed.  Just six months later, much of that plan is now in place.

Following the President’s lead, came the Securities and Exchange Commission, which moved swiftly to propose a rule that would require CEOs and CFOs to certify the completeness and accuracy of quarterly and annual reports.

Then, SEC Chairman Pitt ordered the CEOs and CFOs of nearly 1000 of the largest corporations to certify personally the accuracy and completeness of their disclosures through the prior fiscal year.  To date, the overwhelming majority of companies due to certify have done so.  The Bush Administration has even created an interagency Corporate Fraud Task Force, led by the Deputy Attorney General, which will direct investigations and prosecutions of corporate criminal activity.

Congress also helped.  They passed legislation, later signed by the President, creating a new Public Company Accounting Oversight Board.  The Sarbanes-Oxley Act, as it is called, increases penalties for corporate wrongdoing like shredding documents, and it fortifies the independence of auditing firms and securities analysts.

The private sector, too, fashioned its own response.  Organizations like the New York Stock Exchange and the National Association of Securities Dealers have taken action to strengthen operating rules for their members.  Both the NYSE and NASD, for example, have proposed rules which require that the majority of any member’s board be comprised of independent directors.

Therefore, despite systemic weaknesses exposed this year in the U.S. accounting and auditing professions, and in corporate governance, the lesson to be drawn is that the Bush Administration, along with the Congress, the regulatory community, and the private sector have worked together to address the problems directly and expeditiously.  What I like to call the “self-healing” feature of American capitalism, has been work.  This “self-healing” quality is part of the reason our capital markets remain the deepest and most efficient in the world.  Leadership requires responsibility.  When there are problems, leaders must be willing to face them quickly and head-on. 

This is a lesson Japanese policymakers also understand.  Our two countries depend on each other’s leadership, in fact.  We are the world’s two largest economies.  Japanese businessmen, investors, and policymakers are intensely interested in how the U.S. economy is doing, just as Americans are in the Japanese economy.  Professor Patrick’s background paper for this symposium has nicely set out the extent of the transformations that are now underway in Japan.  I don’t want to understate the difficulty of the challenges that Japan faces. But nor do I want to understate the stake that we all have in Japan’s success.  One figure from Professor Patrick’s paper illustrates this point:  If Japan had grown at its 1980s average growth rate over the past 11 years – 3.7% per year instead of the actual 0.7% – Japanese real GDP would be 43% higher than it is today.  Returning Japan to its full growth potential is of the utmost importance to Japan in order to assure employment, income security, and fiscal sustainability.   The U.S. has a huge stake in Japan’s return to robust, long-term growth.  A healthy Japan would add another powerful engine of growth to the world economy.

The U.S. stands behind Prime Minister Koizumi’s resolve to deal with what we view as the four key challenges that Japan faces.  The first challenge is restoring the health and effectiveness of the banking system, so that it can efficiently channel capital to the most productive and profitable, uses. 

The Prime Minister underscored that goal in his meeting last week with the President, and pledged to accelerate bad debt disposal.  This pledge was particularly welcome, since overcoming the bad debt problem is critical to Japanese recovery and growth. 

The hobbled banking system has been a severe obstacle to Japanese growth.  Clearing this obstacle requires removing NPLs and troubled loans from the books of the banks, and recasting the banks as more effective judges of risk and profitability.  But it also means dealing with the distressed borrowers – restructuring where possible, liquidating if not – and moving the underlying assets on to more productive uses.

Solving the banking problem also means dealing with troubled loans – loans that are performing, but owed by firms that are barely able to keep afloat.  These firms may be able to scrape together their interest payments, but at the expense of investment, and with little hope of long term survival.  Dealing with these firms, restructuring their operations and obligations, before they become NPLs and while there is still value that can be salvaged, is the key issue.  And it is one that is made more complicated by the second challenge that Japan faces.

That challenge is overcoming deflation.  Deflation wreaks havoc with business balance sheets; it discourages investment and leads households to postpone expenditures.  Although Japanese deflation has been modest each year, it’s also persistent, and now firmly embedded in expectations. 

And, in combination with Japan’s banking and bad loan problem, deflation is particularly damaging.   This is because deflation skews incentives strongly toward postponement.  With very low interest rates, many firms can meet their interest obligations, and the loan remains performing for another year.  But in deflation, the real value of the debt obligation increases steadily year after year.     Firms and banks that would face critical decisions at a much earlier stage in a more normal price environment, struggle on under deflation.  As a result, failure, liquidation, and unemployment are a much more likely eventual result.

Last year the Bank of Japan committed to expand liquidity until price stability was achieved, and BoJ actions have led to a significant increase in the monetary base.  But Japanese deflation remains firmly entrenched, and experience with deflation in other countries suggests that larger, sustained increases in the money supply are needed to break deflation’s grip.

The third challenge is one that Prime Minister Koizumi has stated most clearly – “no growth without structural reforms.”  Structural reforms and deregulation -- to increase competition, open up new business opportunities, and spur productivity growth -- are vital in bringing Japan to its full growth potential.  Financial sector reforms are obviously a key component of structural reforms to enhance growth. 

The final challenge that Japan faces is also one that the Prime Minister has clearly identified – developing a credible medium-term fiscal consolidation program.  Cutting fiscal deficits requires hard choices.  But a transparent, credible medium term plan, one that increases household and investor confidence, can do much to assure that consolidation enhances growth rather than holding it back. 

There is lively, and very important, discussion going on now in Japan about tax reform.  Tax policy is a central part of a credible fiscal plan, and also a powerful tool for shaping incentives and actions.  Our own experience in the United States bears this out – tax systems that are non-distortionary, broad-based, and have relatively low maximum marginal tax rates encourage growth. 

Bad debt workout, deflation, structural reform and fiscal sustainability are difficult challenges.  And, as I have tried to emphasize, they are intertwined – progress on each supports the others.  For example, deflation can be overcome by determined actions of the Bank of Japan.   But the effectiveness of monetary policy is blunted by the weaknesses of the banking sector if banks do not expand their lending when the central bank provides more liquidity.  And overcoming deflation alone will not remove the other obstacles to Japanese recovery.   Progress on all of these fronts will be self-reinforcing; progress on any of them will be dragged down by inaction on the others.  Although the focus of my remarks today is on the banking sector, this by no means diminishes the importance of the other challenges.

The banking sector may be the most daunting of the four challenges, given its sheer size, complexity, and its lengthy history.  The authorities have faced much criticism for the persistence of the banking problem.  But it would be wrong to ignore the fact that much of the infrastructure needed to resolve the problem is now in place.   Improvements in supervision and inspection, legislation to allow securitization and special purpose companies, the new Civil Rehabilitation Law, and efforts to facilitate corporate restructuring are all key elements of the ultimate solution to the banking problem.

I believe that the legal and institutional plumbing is now largely in place.  What is missing is the flow of water – the large scale use of this infrastructure to finally resolve the bad debt problem.  Although bad loan claims have been written off, and increasingly removed from banks’ books, the volume of actual final resolution of loan claims through restructuring, liquidation, or sale has simply been too small relative to the scale of the problem.

Stepping up the pace requires changing the incentives that banks, borrowers, and government institutions face to encourage more rapid disposal.  The most frequently cited obstacle to bank resolution of problem loans is that almost always face additional losses, beyond what they had provisioned for, when they resolve a loan.  Increasing provision requirements to better reflect marketable values of troubled loans would greatly increase the incentives that banks have to act.

More favorable tax treatment of losses incurred in resolving bad loans would also speed up disposal.  There are many critics of Japanese banks’ extensive use of deferred tax assets as part of their regulatory capital, and I think these criticisms are sound.  But at the same time, the ability of Japanese banks to charge loan-loss reserves against taxable income once the loss is realized is subject to far greater restriction than in the United States or European countries.  The FSA proposal to extend the loan-loss carryforward period in Japan would provide greater incentive for banks to dispose of NPLs, rather than continue to carry them on their books.

Another action that could speed up NPL disposal is the separation of the responsibility for workouts from the responsibility for originating bank business.    The ability of banks to separate themselves from the past and act to cut losses is critical to making loan resolution decisions.  A separate workout unit inside a bank, with a clear mandate to obtain best value in reasonable time, has proven to be highly successful in a number of countries that have tried to deal with bank workouts, including my own.

With Japan’s NPL problem as large as it is, increasing incentives for disposal is just part of the answer.  As learned in the United States during the S&L crisis, a cleanup of this magnitude requires a lot of creativity and experimentation, as well as a willingness to draw on market participants and market solutions wherever possible.  Americans often describe the RTC experience as a simple, clear-cut result, but that is far from the truth.  There was considerable experimentation with types of sales, types of loan-packaging, as well as loss-sharing arrangements over the RTC’s 6 year history.   The RTC also relied heavily on private contractors to assist in managing and disposing of assets – signing almost 200 different agreements with 91 different contractors.  Amendments and shifts of emphasis were made constantly, based on what worked.

As I pointed out when we met last December, Japan can certainly benefit from the experiences of the United States, Sweden, Korea, and other countries in dealing with banking crises.  However, with banking sector problems, as with most things, there’s no substitute for learning-by-doing.   An RCC with the latitude and courage to experiment and a mandate to act would be a valuable tool in revitalizing Japan’s banks. 

Ultimately, the biggest factor in speeding the resolution of bad loans and the restructuring of distressed borrowers is the political and public acceptance of the need to finally and decisively overcome the bad debt problem and move on.

 The recognition of huge losses, much of which must be covered by taxpayers; unemployment resulting from bankruptcies; the passage of companies from one set of owners to another; sales of assets at a fraction of original values; purchases by foreign interests; and complaints about national assets and landmarks moving into foreign hands, are all highly charged issues wherever they occur.

We in the United States understand.  I’m talking about the late 1980’s – when it was our skyscrapers and golf courses, and the buyers were often Japanese.    Book titles of the period – “Selling Out...,” and “Yen! Japan’s New Financial Empire.” – reflected and exacerbated the fear. 

The purchasing of Pebble Beach and Rockefeller Center by Japanese investors sounded alarm bells, just as the purchase of ailing Japanese firms by U.S. investors today causes some to decry the return of the Black Ships.

Concerns about foreigners benefiting from distress color rational views on corporate restructuring.  It’s true that the initial interest in distressed debt purchases and corporate workouts in Japan was from foreign firms – many of them American – drawing on the experience they had accumulated in other countries.  But today there are many Japanese institutions in this market.  Nomura, Tokyo-Mitsubishi and Sumitomo-Mitsui, and the Development Bank of Japan all have formed corporate restructuring groups.  Other Japanese companies, like Jusco in retailing, have expanded through purchases of troubled small companies.

Corporate restructuring is not about nationality, nor is it about instant profit.   Corporate restructuring is fundamentally about trying to identify and salvage viable businesses out of distressed borrowers – preserving valuable assets and employment.   A good example of what is possible is Victoria Sportswear.  Jafco, Nomura’s private equity group, organized a leveraged buyout with the help of Deutsche Bank to rescue a profitable ski and sportswear operation from a company that had failed under a load of over $1 billion in property-related debt.   Corporate restructuring is also about accepting risk; just like new businesses, restructuring efforts fail as well as to succeed.

When a country is forced to deal with banking sector problems and has to put distressed assets up for sale, a nationalist reaction is understandable.  But it is also one that quickly fades.  Cries that the Japanese were taking over America now appear quaint.  So does the worry that many had five years ago about a Japanese “Wimbledon Effect” in Big Bang financial liberalization – a fear that, once competition was opened up to foreigners, no domestic participants would remain.  While foreign entrants and foreign investment provide new ideas and new competition, domestic institutions will always have advantages and will always have a role.

In a similar way, Japanese institutions will respond to the demands and opportunities of corporate restructuring and distressed debt resolution, once that process begins in earnest. 

The success of this process will play a critical role in determining how fast Japan returns to a path of sustainable long-term growth.  Restoring Japan to its full growth potential is a matter of enormous consequence, not just to Japan, but to the world economy as a whole.