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Financial innovations should preserve market discipline and trust

by Takashi Kitazume

The country’s reforms in the financial sector have had mixed results so far, with progress on the domestic front lagging behind Japan’s growing contribution to Asian financial stability, according to Charles Calomiris, a Columbia Business School professor.

Speaking at the June 3 Keizai Koho Center symposium, Calomiris said Japan has resolved the challenges of its “lost decade” and is embarking on a path of positive growth, rising employment, stabilized prices and improved bank conditions.

But, he asked, “Will it become a global leader in financial affairs, as it must become in order to maintain productivity growth and to establish its rightful position in world affairs?”

Such an effort will be multidimentional, the professor said:

First, Japan must become a leader in global financial policymaking, particularly for emerging markets and in designing effective assistance for countries hit by financial crises and promoting their reforms, Calomiris said,

Second, Japan needs to turn itself into a leading nation in financial services, capable of providing a full range of modern financial services to consumers and firms, he said.

Third, its financial sector has to take on the role of a promoter of corporate managerial efficiency through effective financial policies that encourage good corporate governance, and “create a contestable market for corporate control” such as mergers and acquisitions and hostile takeovers.

Calomiris lauded Japan for taking a leadership role in a new Asian initiative to pool liquidity across countries in the region, which he said will create a counterbalancing force to the International Monetary Fund.

“This will not only help Asia, especially given the likelihood that emerging-market crises could (again) occur in Asia, but it may more generally help to reform the IMF based on competitive pressure, forcing it to make liquidity protection rules more explicit and less political,” he noted.

However, developments on the domestic fronts are less promising, he said.

True, certain progress has been made — such as the unwinding of cross shareholdings between banks and industrial corporations; creation of more rational bank lending policies; and improved public attitudes toward foreign ownership, Calomiris said.

However, he noted that further progress is hampered by problems in the structure and rules of the financial system. He also pointed to risks of making a “wrong turn” in corporate governance and takeover laws under consideration.

“The common problem is the remaining absence of credible market discipline — both over banks and nonbank firms — which economc research shows is the only reliable force for ensuring stable, lasting growth in both the financial sector and the broader economy,” he observed.

As Japan’s experience in the post-bubble doldrums illustrates, the whole economy depends on the financial sector as the gatekeeper that ensures efficient allocation of resources, he said.

Calomiris warned that Japan should not imitate U.S. models of rules and regulations in market discipline.

“Japan needs to innovate to provide new mechanisms that go beyond the American or European rules and regulations. . . . The formalistic American approach to corporate governance rules, the American emphasis on independent directors as a salvation to corporate governance, and American takeover protection laws are all inadequate and not worthy of imitation by Japan,” he told the audience.

Calomiris expressed concern that the high-profile takeover battle between Livedoor Co. and the Fujisankei media conglomerate earlier this year “has created an unfortunate backlash against hostile takeovers.”

“Part of the backlash reflects the Japanese view that hostile takeovers in the U.S. have promoted short-termism and destruction of long-term corporate value,” he noted.

However, hostile takeovers are “strongly supported” in the U.S. academic community of finance experts “as a crucial ingredient of discipline,” he emphasized, adding that takeover defenses such as the so-called poison pills are “inimical to desirable competition for corporate control.”

The professor also lashed out against guidelines proposed recently by the Economy, Trade and Industry Ministry (METI) which, while apparently trying to find a balance between excessive regulations and no limitations on hostile takeovers, seek to allow poison pills.

“That is a mistake and a missed opportunity. Japan should not permit poison pills. There are far better ways” of achieving what METI wants to do, he said.

Calomiris suggested that the Japanese government should enact a law, rather than just formulate guidelines, that clearly establish guidelines that encourage takeovers.

Such a law should focus on empowering institutional investors — such as pension funds — by “clearly delineating rules for takeover offers and stockholder proxy fights to ensure that these informed investors have the information they need and the time they need to make choices,” he said.

The focus should be on slowing down the takeover process — for a few months — to ensure that all bidders have a chance to participate, though not stopping or prolonging the process indefinitely, he added.

On banking sector reform, Calomiris observed that there remains “significant unfinished business for re-establishing a healthy banking sector founded on the central principle of market discipline.”

“Unfortunately, the market and the banks have learned from experience that the government is unwilling to allow depositor losses in large banks,” the professor said.

The removal of blanket deposit insurance — finally implemented in April after being postponed — is “more formal than real becasue of the continuing unlimited protection provided to the so-called settlement accounts,” he noted.

While opposition lingers even within the ruling Liberal Democratic Party to Prime Minister Junichiro Koizumi’s proposed legislation to privatize the state-run postal services, Calomiris said privatization of the “yucho” postal savings is important for “both its economic effects and its crucial symbolic effects.”

Privatization, the professor said, will enhance competition in retail banking and reduce diversion of funds for support of “unnecessary and inefficient government-directed credit programs, which are no longer needed in Japan.”

Implementing postal privatization “would be a crucial signal of Japan’s political maturity and commitment to modernization and reform that the market would immediately react in the form of substantially increased foreign direct investment in Japan and increased stock prices,” he noted.