I would like to talk about recent developments in financial regulation in Japan, focusing on two aspects: the recent changes in the Financial Instruments and Exchange Law and the adoption of the "Plan for Strengthening the Competitiveness of Japan's Financial and Capital Markets".

I.     Financial Instruments and Exchange Law

1.         The Bill to amend the old Securities and Exchange Law was approved in the Diet2 in June 2006.  As a result, the title of the law was changed to the Financial Instruments and Exchange Law, and it became fully effective as of end-September last year.  The law aims to enhance investor protection, fairness and transparency of the market and thereby to increase the attractiveness of the Japanese capital market.  Contents of the amendment are very comprehensive and include various technical aspects, but in this talk I would like to give you some of the highlights of the revisions.

2.         First, the new law has established a cross-sectional framework for a wide range of financial instruments and services.  With the advancement of financial techniques, we have seen the emergence of various types of financial products, notably various types of investment funds which solicit investment from the general public.  In some cases, these funds were not covered by the old Securities and Exchange Law or other laws, and their failure in the past has caused serious financial damage to their investors.  Also the new law has expanded the scope of "securities" which are subject to various regulations for investor protection, such as regulations on advertisement or obligations to deliver written documents before and at the time of contract.

3.         For example, investors' rights in a "collective investment scheme", which is a broad concept to include various types of funds, are now regarded as "securities" under the new law.  Also, the new law has expanded the scope of "derivative transactions" to include, for example, currency and interest rate swaps or weather derivatives, which were not covered by the old law.  It has also broadened the scope of financial instruments firms to include different types of investment related firms, including securities firms, investment advisory firms and financial futures trading firms, and made them subject in principle to the same regulations.

4.         Second, the new law has enhanced disclosure requirements.  This change was made after some cases which related to unlawful or inappropriate disclosure practices came to light in Japan several years ago.  The new law has introduced a statutory quarterly reporting system for listed companies as a result, and this new system will start from the current quarter of April to June 2008 for most companies.  It has also enhanced internal control over financial reporting.  Listed companies must submit "internal control reports" which provide an evaluation of the validity of internal control of financial reporting, and make them subject to audit by certified public accountants or other auditing firms.  Listed companies must also submit "certification" by management stating that descriptions in financial statements are appropriate and in compliance with laws and regulations.  These new regulations, which are sometimes called "J-SOX", following the US SOX or Sarbanes-Oxley Act, will start at the end of this current fiscal year (in March 2009 for many companies). 

5.         Third, the new law has increased the maximum criminal penalties against various market frauds to strengthen investor protection; for example, the maximum prison sentences have been raised for unfair trading, spreading of false rumours, market manipulation and the submission of false annual reports (from five to ten years), whilst that for insider trading has been increased from three to five years.  The maximum fines for various fraudulent activities have also been increased.

6.         Fourth, the new law has provided organisational structures for self-regulatory functions for exchanges; as a result, for example, the Tokyo Stock Exchange Regulation was created last year as a self-regulatory regime under the umbrella of TSE Inc.

7.         These are the highlights of the new Financial Instruments and Exchange Law.  Today, I would like to go further, as this new law is once again expected to be amended in the current Diet session which started at the beginning of this year. 

II.    The Plan for Strengthening the Competitiveness of Japan's Financial and Capital Markets

8.         Last December, the Japanese Government adopted its "Plan for Strengthening the Competitiveness of Japan's Financial and Capital Markets", after a broad consultation with the private sector and with academics.  Basic philosophies of the plan are summarized as "Four Pillars", i.e. (I) bolstering the confidence and vigour of the markets, (II) encouraging a business environment that vitalizes the financial services industry and promotes competition, (III) Improving the regulatory environment (i.e. better regulation) and (IV) improving the broader environment surrounding the markets.  Under these pillars, the government put forward various measures to strengthen the markets and improve regulations.  The government also submitted a Bill to amend the Financial Instruments and Exchange Law and related laws to the Diet in March of this year.

9.         I would now like to give some specific examples of measures contained in the Plan.

10.     First, under the heading of "1. Diversification of products tradeable at exchanges" "(i) Diversification of exchange-traded funds (ETFs)", it is proposed that the regulations on ETFs be amended to make it possible to invest in a wide range of products, including financial and commodity derivatives.  ETFs are mutual funds or investment trusts which are traded in exchanges and their values are often linked to market indexes, e.g. the Dow Jones Industrial Average or the Nikkei 225. 

11.     With such features as low cost and the availability of continuous pricing, the number of ETFs listed on the world's major stock exchanges has increased remarkably in recent years, and their coverage is being broadened to include not only stock indexes but also indexes of bonds and commodity futures.  In Japan, ETFs currently traded in exchanges are largely confined to stock indexes, but the Bill, once approved, will enable ETFs to be linked to bond indexes or commodities, such as gold, and commodity futures.  This represents an example of further diversification of financial products in Japan.

12.     Moreover, as the next paragraph explains, the plan envisages "(ii) Alliance between financial and commodity exchanges", so that these exchanges as a group will be able to offer a full line of products from equities, bonds, financial derivatives to commodity derivatives in the future.   

13.     The next item I would like to explain is "2. Fostering vibrant transactions among professionals".  Here it is proposed to amend "the current legal framework to further broaden the scope of the framework for markets among professionals".  In other words, the Government is preparing for the creation of markets for professional investors.  This proposes to establish markets with a high degree of freedom, notably with an exemption for professional investors, from the current disclosure regulations, following examples abroad, such as the US market based on Rule 144A made by the Securities and Exchange Commission. 

14.     The new markets are expected to enhance financing opportunities for foreign companies such as those from Asia and start-up companies in Japan, and promoting financial innovation through competition among professional investors.  In this regard, I am pleased to mention that, last year, the Tokyo Stock Exchange and the London Stock Exchange announced their intention to establish a new market for emerging companies both from abroad and in Japan, building on the successful experience of the AIM.  The TSE and LSE are now working on designing this new market for professional investors.

15.     The next item I would like to mention is "Relaxing the firewall regulation among banking, securities, and insurance businesses".  Here, I would like to focus on the relation between banking and securities businesses, which is one of the frequently debated topics in Japan's system of financial regulation.  In Japan, the Financial Instrument and Exchange Law provides for the separation of banking and securities businesses, like the Glass Steagal Act of the United States.  However, this regulation has been gradually relaxed in line with the developments abroad; in 1993, Japanese banks and securities firms were allowed to enter into each other's business areas through subsidiaries, while the laws and regulations have maintained firewalls between the two businesses in certain areas. 

16.     Today there remain views from domestic as well as foreign financial institutions that compliance with current Japanese firewalls is costly.  Notably, the ban on interlocking or concurrent posts in banking and securities affiliates within the same financial group and the restrictions on the sharing of undisclosed customer information are often cited as examples of costly regulations.  The United States has already effectively repealed these restrictions during the last ten years. 

17.     Then, after the deliberations within the Government and consultations with the private sector, the Government has decided to amend the law and related regulations so that the ban on concurrent posts within the same financial group is to be lifted, and the restriction on the sharing of corporate customer information is to be relaxed, while requiring the financial groups themselves to establish an internal system for managing conflicts of interest between their banking, securities and insurance arms. 

18.     The next item I would like to mention is on "III. Improving the regulatory environment" or "better regulation".  A better legal framework must, of course, be accompanied by a better regulation by the regulatory authorities.  The Japanese FSA is trying to improve its regulation following the practice of UK FSA in many respects.  Here various changes are proposed for implementation, such as "Enhanced dialogue with the industry", "Optimal combination of rules-based and principles-based supervisory approaches". 

19.     On the issue of the rules-based vis-à-vis principles-based approach, in the past, the Japanese FSA's emphasis has been on rules-based regulation, as this enhances predictability and avoids the discretionary applications of laws.  The rules-based approach is still important in certain areas, notably in enforcement.  However, there are other areas that are better left to the judgment and internal control of financial institutions themselves, for example in the case of handling new financial products and techniques.  In this way, the Japanese FSA has been seeking to achieve an optimal combination of both the rules-based and principles-based approaches.

20.     Last but not least, a competitive financial market cannot be realised only by the improvement in financial legal and regulatory framework, but it also has to be approached within a broader context.  The Government is therefore promoting "Developing and accumulating internationally competitive human resources specialising in finance, law, and accounting", and "Enhancing urban functions as an international financial centre".

21.     This last point of "Enhancing urban functions as an international financial centre" takes Canary Wharf as one of the main models in its design.  Of course, the FSA does not itself have expertise on urban development and, therefore, another office under the Cabinet Secretariat is now working on developing this approach.

Kazuhiko Koguchi

Minister (Finance)

Embassy of Japan, London