September 14, 2007
HP-665

Symposium on Building the Financial System of the 21st Century
An Agenda for Japan and the United States
Harvard Law School, Cambridge, MA September 14, 2007, 6:15 pm

Thank you very much to Hal Scott and the organizers of this great event for the invitation to speak with you today.

I'm proud that the U.S. Treasury Department has been a significant participant in these discussions over these ten years. In fact, many of my former bosses – Larry Summers, Ken Dam, Tim Geithner, John Taylor, and Glen Hubbard - while not technically my boss, it felt that way – have been contributors. All of these men were quite demanding so I'm sure they would not have signed off on my remarks tonight.

I am also honored to share the podium this evening with a good friend and extraordinarily capable colleague from the Ministry of Finance, Naoyuki Shinohara.

This is the tenth anniversary of both this symposium and the Asian Financial Crisis. I will leave it to others to flesh out lessons learned and progress made over the course of this conference. But let me suggest that one of the key lessons from ten years ago is one that we are discovering again today, and I would further suggest, will be one that we will be drawing on ten years hence. That is, we cannot take market stability for granted and that volatility can occur abruptly and unexpectedly.

As the Asian Financial Crisis showed and recent events reinforced, market conditions can change unpredictably. For policy and regulatory officials, it is critical to bear in mind that, despite our best wishes, we cannot entirely eliminate the potential for risk from the markets, nor should we try to do so.

Rather, our goal should be to establish a regulatory regime that fosters deep, liquid, and transparent markets; markets that are robust and resilient enough to withstand the inevitable volatility that investors face from time to time.

The difficulty of such an objective – I would assert – is that it can never be reached. Financial markets continually evolve and innovate, and at an accelerating pace in this era of globalization. It is therefore imperative that financial regulation keep pace so that our markets remain transparent, robust and internationally competitive.

The greatest danger we face – in the U.S. and Japan – as policy makers and regulators is to think we've reached our goal. In short, complacency is our enemy; never being satisfied is our friend.

This a theme I'll return to but first, let me detour a bit to try to address a question that's been on many of our minds over the past month: what exactly has been going on in the markets?

Let's start with one of the triggers. More defaults than expected in subprime mortgages underlying mortgage-backed securities created uncertainty regarding the future prospects of these securities. This compelled investors to reassess the risk and reprice these securities accordingly. This reappraisal has spread across the credit market spectrum, first affecting residential-mortgage backed securities and then spreading to other asset classes and, in particular, securitized products.

In early August, uncertainty began to spread to the asset-backed commercial paper market. For instance, faced with a sharp drop in demand for their commercial paper, structured investment vehicles – off balance sheet entities created by commercial banks to purchase their loans - exercised credit guarantees from their parent banks and invoked infrequently-used extension clauses for their outstanding paper. Banks' demand for precautionary balances surged, while at the same time, the fear of a credit dislocation - real or feared - sharply raised perceived counterparty risk.

Overall liquidity became more of a concern, and the U.S. Federal Reserve Board took action by adding liquidity to the credit markets. The Federal Reserve also lowered the discount rate and encouraged banks to use the discount window. These actions have helped stabilize the markets to some degree. Nonetheless, we remain vigilant for other potential sources of stress in the system.

As the recent turmoil sharply reminds us, capital markets are becoming increasingly internationalized. This has contributed to the significant global economic growth over the past decade, especially in the emerging market economies. At the same time, an event in one country's market may impact the rest of the world.

Markets in Japan, the United States, and globally continue to go through a period of adjustment, as market participants work through the repricing of risk. Reassuringly, the depth of the markets in Japan and the United States, and elsewhere, and the ability and willingness of our financial authorities to take appropriate action, has contributed to the continued functioning of markets. The global economy as a whole also appears to be robust – quite the contrary to 1997-1998 during the Asian Crisis.

As we assess recent market events, it is critical that we do not rush to judgment as events continue to unfold, but take the necessary time to ask the right questions and fully understand the issues.

As you might expect, we have been in regular communication with other U.S. regulators, including the other members of the President's Working Group on Financial Markets (PWG). The PWG is comprised of the Treasury, Federal Reserve, SEC and CFTC.

On August 31, President Bush announced several steps to examine some of the broader market issues underlying the recent mortgage problems, help homeowners in need of assistance avoid foreclosure, and help ensure that the problems now disrupting the housing industry do not happen again.

The U.S. is also communicating with our G-7 colleagues to determine the root causes of recent market events and to take timely and appropriate action. The G-7 will ask the Financial Stability Forum (FSF) to review recent events, with input from the relevant standard setters and international experts, and recommend an appropriate response. The FSF report will provide input for the G-7 Finance Ministers at their October meeting.

Recent events underscore the importance of policymakers' constantly reassessing. Rather than making policy changes only in response to emergencies, effective regulation needs to be a constant iterative process between regulators and market participants. Such a process can feed a steady evolution of the regulatory environment conducive to building and maintaining capital markets that foster innovation and fuel the business growth that creates jobs and drives our economy.

I'd like now to talk about the efforts underway in the United States and Japan to energize our regulatory frameworks and avoid complacency.

U.S. Capital Markets Initiative

Let me first address the efforts underway in the United States. Let me be clear - U.S. capital markets are the deepest, most efficient, and most transparent in the world, and are the lifeblood of the U.S. economy. To promote the conditions for American prosperity and economic growth, it is essential that we maintain the competitiveness of our capital markets.

To energize this process, Secretary Paulson launched a Capital Markets Competitiveness Initiative, to assess the state of U.S. capital markets, and to assess, and, if necessary, recalibrate our approach to the balancing of investor protection, market integrity, and systemic risk. We've reached out to academics, investors, the business world, and government officials.

The first set of capital markets initiatives was unveiled in May. These focused on enhancing investor protection by strengthening financial reporting and seeking a more sustainable and transparent auditing profession. As part of these measures, we have established a public federal advisory committee, led by former SEC Chairman Arthur Levitt and former SEC Chief Accountant Donald Nicolaisen, that will develop proposals for creating a stronger, sustainable auditing profession,.

In June, Secretary Paulson unveiled the second stage of the capital markets initiative, which includes releasing a blueprint of structural regulatory reforms to improve oversight, increase efficiency, and reduce regulatory overlap of the financial services industry. In addition, the PWG will work with asset managers of private pools of capital and investors to help these two groups define separate sets of best practices that address investor protection, enhance market discipline, and mitigate systemic risk.

Further steps will be announced in the near future, as we continue to strive to enhance the competitiveness of U.S. capital markets.

Turning to Japan, starting with Japan's financial "Big Bang" in 1996, it has made significant strides in reforming and liberalizing its financial markets. Japan is also strengthening its financial regulatory regime, moving toward striking an appropriate balance between transparency and investor protection on the one hand, and allowing innovation on the other.

Japan reformed and liberalized its financial system in one of the most difficult environments possible – the middle of a non-performing loan crisis. But Japan pushed forward with reforms. And, with the creation of the Financial Supervision Agency in 1998 - later renamed as the Financial Services Agency - and subsequent steps like the passage of the Financial Instruments and Exchange Law in 2006, Japan has shown its commitment to building a stronger financial system.

FSA Commissioner Sato, as he started his term this summer, increased communication and consultation with market participants, a step we in the United States have found is critical to maintaining our competitiveness. In fact, I believe many of you in this room are already part of the process, and share my appreciation for the renewed efforts of the FSA in trying to promote Japan as an international financial center.

So what is needed? Key issues have been identified by a number of observers, including the American Chamber of Commerce in Japan, the International Bankers Association, and others. Some of the steps that we see as most beneficial include:

• Improving the consistency, transparency and predictability of regulation and supervision through expanding the body of written interpretation of laws and regulations, adopting safe harbor rules.
• Rationalizing regulation of financial conglomerates so that firewall restrictions do not hinder risk management, innovation and market development.
• Implementing cost-benefit analyses for proposed and existing regulations, including those implementing the Financial Instruments and Exchange Law.
• Expanding financial education, both at the professional level and for the general public.

I should add that an important indicator of Japan's commitment to becoming an international financial center that is being watched closely is the privatization of Japan Post. With two of the world's largest financial entities poised to enter the competitive financial market, we look forward to the FSA's regulating these entities in the same manner as their competitors. We hope that a fully level playing field will be established in a given market, and that risk management capabilities will be developed, before Japan Post offers new products.

While I'm sure Naoyuki could suggest an even more robust action plan, these are some concrete steps to make Tokyo a premier international financial center.

In closing, my caution to Japanese officials and to U.S. officials is a major lesson of the previous ten years – as well as the previous ten weeks – our work is never done in fostering deep, liquid, transparent markets that are robust and resilient. Complacency is our enemy, and never being satisfied is our greatest friend.

Thank you.