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15 February 2010

Some reflections after my visit: Some devils leap out of the detail of implementing G20 recommendations in Japan

The recently-elected Japanese Government may be more forceful in G20 negotiations in areas of technical detail if Japan’s interests are divergent: bank capital adequacy, accounting standards and clearing of derivatives.

Letter from Tokyo[1]

The recently-elected Japanese Government may be more forceful in G20 negotiations in areas of technical detail if Japan’s interests are divergent: bank capital adequacy, accounting standards and clearing of derivatives.

Change of government:

In August 2009, the General Election produced a decisive change of government as the LDP lost power after an almost continuous half century in control. The winning Democratic Party of Japan (DPJ) is led by PM Hatoyama but there remains a big question about the actual power of the party Secretary-General Ichiro Ozawa. However his influence may well be dented by a campaign financing scandal even though only his past and present secretaries were formally charged. Public opinion polls suggest widespread disbelief that he knew nothing.  The honeymoon may be wearing thin already but a major electoral test will come in July when Upper House elections take place.

The new Parliamentarians are a younger, more technocratic generation and they are already challenging the power of the established bureaucrats – see box below. This is the fundamental challenge:  who takes decisions: bureaucrats or politicians? The answer now seems to be that the politicians are asserting their primacy. The potential significance of this change is largely un-reported in Europe. Already there are clear indications of the wind of change – ranging from the liquidation of JAL, to the serious debate about the future of US bases in Okinawa.

But that debate is still constrained by security concerns about North Korea and China. However, the Prime Minister is putting forward vague ideas of an East Asian community with a vocation for a degree of unification – loosely based on the role model of EU.  As part of those aspirations, in December Ozawa led a delegation to China that including 143 MPs – nearly half the DPJ’s MPs.

This is the new political climate in which Japan will negotiate at the G20. The politics of any agreements will have to be tested more rigorously against the needs of Japanese society, and its traditions of doing things in its own way.  Now that the G20 process is moving from lofty ambitions about resolving the financial crisis into the technical details of the necessary measures, there may not be as smooth a glide path to resolution as many fondly imagine. In part, any resistance may reflect the pithy analysis that this was not a global crisis but a North Atlantic one – even though quite a bit of debris did indeed wash up on the shores of Tokyo Bay.

Extracts from DPJ website: “In contrast to the LDP, which is almost entirely dependent on the bureaucracy for policy-making, the DPJ is a party dominated by young professionals, including bureaucrats, lawyers, doctors, aid workers, bankers, and journalists, who are able to draw on a wide variety of experience in formulating policy proposals… The party places a strong emphasis on the speedy implementation of across-the-board reform and the creation of a fairer and more inclusive social environment in Japan. The DPJ was instrumental in introducing the manifesto (party platform) to Japanese politics, marking the initiation of genuine policy debate... The DPJ places particular importance on shifting from a political system dominated by central-government bureaucrats to one in which politicians and local communities play a leading role.”


Japan is a key member of G20 so, in principle, is committed to implementing the detailed measures that will flow from the over-arching visions agreed at the Heads of State summits. These details are now being fleshed out by the FSB and it is already apparent that some of them may cause particular difficulties in Japan. Other details may cause difficulties in other countries but the range of discussions held during our visit suggests that the glide path into operation for the G20 proposals may yet have some bumps in it. But there can be no doubt about the wish for success.

We found three issues that cropped up and there may well be others that surface as the detailed policies are developed. So these may already be amongst the “devil is in the details” category.

      Bank capital adequacy: FSB members recently reaffirmed their commitment to raising the quality and level of capital and liquidity buffers in the banking system and recognised the importance of finalising the outstanding issues of the quality and definition of capital. They remain committed to “preserving a level playing field”. The BCBS proposal is that “For banks structured as joint stock companies the predominant form of Tier 1 capital must be common shares and retained earnings… all Tier 2 capital will need to meet the minimum standard of being subordinated to depositors and general creditors.” We were informed that, in light of the strict taxation regime for loss recognition, Japanese banks often have 1-2 percentage points of capital represented by deferred tax. Can that fulfil these requirements for inclusion?

That said, Japanese banks seem to have relatively low capital ratios anyway so the commitment to a “level playing field” would be the more onerous as it would imply an even sharper rise in capital ratios. But there may be macro-economic implications from the combination of a drive to have higher capital ratios and simultaneously raise holdings of liquid assets. That might have a particularly adverse impact on Japan and this could seem especially unfair when the global financial crisis can be described as a North Atlantic crisis and Japanese banks weathered the storm much better than their competitors. So Japan may have a distinctly different interest in the outcome of the BCBS calibration exercise later this year.

      Accounting standards: Japan now has a roadmap for the adoption of IFRS that calls for a final decision in 2012 with implementation in 2015. Indeed some companies are now permitted to use IFRS. But this is clearly a conditional process and is dependent on the final outcome of the ISASB’s deliberations. Last June, an IFRS Council was set up and the “Interim Report: Application of International Financial Reporting Standards (IFRSs) in Japan” also marked a key step forward for Japan moving towards adoption of IFRS: “The report sets out a number of milestones before deciding the application of IFRS”. Moreover a Strategic Committee was set up to deliberate “upon a strategy and specific actions as to how best to influence developments of major accounting standards.”  The Chairman of this IFRS Council pointed out that “Considering that Japanese GAAP has already converged well with IFRS, the transition to IFRS itself would not be a major problem…. We also need to work with the International Accounting Standards Board (IASB), a standard setter of IFRS, to better reflect views from Japanese constituents during its standards setting process.”

Asian-Oceanian Standard-Setters Group (AOSSG): In November 2009 this group held its first meeting in Malayasia – with 100 participants from 21 countries, ranging from Turkey, through Saudi Arabia, India, China, Korea and Singapore down to Australia/NZ and of course, Japan. They set themselves targets: promoting the adoption of and consistent convergence with IFRSs; Coordinating input to the IASB; and cooperating with governments and regulators. They also recognised the need to play a more active role in the technical activities the IASB given the fact that many of them have adopted IFRSs or have declared or intend to declare in the future.

They discussed four technical issues: (1) IAS 39 Financial Instruments: Recognition and Measurement and Impairment, (2) Revenue Recognition, (3) Fair Value Measurement and (4) Financial Statement Presentation. On IAS 39, the Group expressed support for the outcome of the classification and measurement part of the financial instruments project and urged the IASB to work actively with the FASB to achieve a converged global standard. But they stopped short of such support in other areas and “will be actively considering the forthcoming exposure draft on impairment of financial assets. The Group will be examining the conceptual basis for the expected loss model and its practical implications both for financial institutions …” So there is not a blank cheque from the region on some contentious issues.

These issues include: Impairment of loans and debt securities; post-retirement benefits; revenue recognition and leasing.

·         The key element in the impairment debate seems to be the use of an “expected loss model” in computing the P&L. The banking supervisors seem to be thinking of an expected loss that crystallises on a 12- month horizon whereas the IASB is thinking about losses over the entire life of the loan. For banks, this difference could potentially produce vastly different impacts on the P&L. The Japanese Banking Association is scheduled to publish its final views in April.

·         Accounting for post-retirement benefits is always a difficult subject for companies that sponsor Defined Benefit schemes. The UK has led the way in forcing companies to report to the shareholders the magnitude of the economic promise made to the workforce as there is a clear public policy interest in society being aware of the implications of these promises even if the unpalatable truth turns out to be that they cannot be afforded. Though that disclosure may come about via G20 pressure to adopt IFRS, a radical government may want its electors to be properly informed anyway.

      Derivatives and CCPs: The G20 Pittsburgh Summit stated “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.” So Japan has undertaken a commitment that it is now following through. Are there circumstances where that could be difficult as it might clash with its own social norms?

The Japanese FSA published a draft on December 17, 2009 - with a short deadline for response - and published the results in late January. Some relevant highlights are set out in the box below but the key elements seem to be that:

·         Clearing should ideally be concentrated in CCPs established in Japan ,

·         Mandatory CCP clearing through alliances between foreign CCPs and domestic CCPs or mandatory clearing at foreign CCPs, should also be admitted… given that they meet certain requirement and standards,

·         A system for the regulator to monitor to ensure that these requirements are being met continuously

·         However, whilst the international protocol which is typically employed by market participants should be respected, central clearing by domestic CCPs is required with respect to OTC derivative transactions for which the clearing criteria relates closely to the corporate bankruptcy criteria under the domestic law.


Much of the securities trading is already done through a CCP so the real debate is building one for CDS and other derivatives. Three bidders have come forward but it seems the actual dealers are not much interested and would prefer to use an existing EU or US one. Moreover, there is not that much derivative trading in Japan - the Japanese FSA quotes BIS data that 95% of the global total is done in US and EU. Moreover such trading is said to be dominated by foreigners – who appear to be shifting international operations to Hong Kong. Contracts issued under the ISDA master agreement provide for a committee of the affected firms to take the decisions to call an “event of default”.

An issue crystallised in December with CDSs on Aiful Corp as it used the socially-accepted norm of an Alternative Dispute Resolution (ADR). New York-based ISDA called a meeting of about 150 traders, lawyers and investors to discuss whether that ADR process was actually a so-called credit event. That led to the creation of a panel that may make recommendations to ISDA’s determinations committee in Japan (15 dealers and investors) that decides when payouts on credit swaps should be made.

If this problem occurred in the future with a major Japanese financial institution, what would the reaction be if a committee of foreigners overrode deep-seated cultural values and pushed the institution into bankruptcy, rather than use the ADR?  Would the committee even be sitting in Tokyo? What happens if the default is called in NY or the EU (London)? 

So the FSA’s draft is trying to square a delicate circle as it would prefer credit events that might have bankruptcy consequences to be decided in Japan. Yet it also recognises that much international business is transacted outside Japan and is controlled by the terms of the ISDA master agreement.  Full application of the apparent letter of the G20 statement could lead to major domestic economic events being imposed on Japan in certain, extreme circumstances. Will that be acceptable to the new Government?

There is an interesting parallel with the current EU debate on regulatory powers of the proposed European Supervisory Authorities (ESAs). The EU’s governments have been bound together into an “ever closer union” by the Treaty of Rome for half a century, and supervised by the European Court of Justice to ensure that the rules are obeyed. But those governments have just had a fierce argument to agree to give only limited powers to the new ESAs, and be constrained by the requirement that any decision should have no budgetary consequences. Japan does not have any corresponding Treaty arrangement with the other G20 members, yet it may be expected to cede powers to a private sector group of foreigners that could have massive budgetary consequences. This may be a highly technical issue, but we have all learnt that in a crisis these can become vital matters.

Extracts from Financial Services Agency: Development of Institutional Frameworks Pertaining to Financial and Capital Markets – 21 January 2010


      Scope of the mandatory CCP clearing, and the system of CCPs Clearing of OTC derivative transactions of a large trading volume (currently, “plain vanilla” interest rate swaps) needs to be subject to mandatory CCP clearing …. In order to reduce settlement risk in Japan’s markets promptly and effectively, clearing should ideally be concentrated in CCPs established in Japan (domestic CCPs). …At the same time, given that most Japanese financial institutions conduct international transactions, alternative options such as mandatory CCP clearing through alliances between foreign CCPs and domestic CCPs or mandatory clearing at foreign CCPs, given that they meet certain requirement standards, should also be admitted.


      If the entry of foreign CCPs based on alliances or by direct means are to be permitted, entry requirements equivalent to those required for domestic CCPs would need to be established, as well as introducing a system for the regulator to monitor to ensure that these requirements are being met continuously


      It is necessary to consolidate information of transactions such as information of Japanese financial institutions and their counterparties involved in the transactions into CCPs by means of mandatory CCP clearing. This enables CCPs to appropriately acquire information of transactions subject to mandatory CCP clearing and the authorities to grasp the full picture of Japan market by requiring information from CCPs. In addition, it is also necessary that the authorities publish part of acquired information in order to enhance transparency of the market of Japan


      However, whilst the international protocol which is typically employed by market participants should be respected, central clearing by domestic CCPs is required with respect to OTC derivative transactions for which the clearing criteria relates closely to the corporate bankruptcy criteria under the domestic law. For such transactions, domestic CCPs who have thorough understanding of the domestic legislations should be appropriately involved (see Note) in the determination of the necessity of clearing and maintain the right to voice opinions where necessary as contracting party of the transactions. (Note) At present, certain foreign CDS clearing houses provide under their operational regulations that where the trade participants do not undergo determination by themselves, they undertake the decision.


[1] is extending its activities to Japan and we are very grateful to the European Commission for providing an ETP scholarship to Stefan Brill to study in Tokyo and to the Japanese Securities Dealers Association (JSDA) for hosting Dr. Brill in Tokyo and all the help they have provided to us. This letter sets out my impressions from many conversations during my recent visit, and I am deeply grateful to all those who willingly shared their views.


© Graham Bishop

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