Financial December2,1996　Akiyoshi Horiuchi　 　The Japanese financial system has been substantially liberalized since the ear-ly 1980s. The market mechanism has been gradually, but steadily penetrating intovarious parts of the financial system. Despite the apparent advance in deregula-tion, however, many people are dissatisfied with the present state of financial system. Some argue that Japanese financial markets are not sufficiently effi- cient so that the "hollowing" phenomenon has been observed. Other people point out that the long-lasting bad loan problem in the banking sector is closely re- lated to specific processes of financial deregulation in Japan. What are wrong with the Japanese financial deregulation? I woukd like to discuss this problem shortly in this paper. 　1.Groups of vested interests:Hindrance to drastic deregulation 　The Japanese financial system was heavily regulated during the postwar period until the late 1970s. Financial businesses were segregated from each other through the compartmentalization regulation so that financial institutions or intermediaries in a specific field were not allowed to engage in businesses in the other fields. For example, the banking, the securities business and the in- surance business were separated form each other. In each field, the government controlled market mechanisms to suppress full-scale competition. The deposit in-terest rates were controlled by the Temporary Law of Interest Rates Adjustment instituted in 1947. The fee of stock brokerage was been controlled by the cartelamong securities companies authorized by the Ministry of Finance(MOF). The Law of Foreign Exchange Control prevented Japanese residents and non-residents from engaging in free financial transactions, so that domestic financial markets wereseparated from foreign markets. These regulations conferred handsome rents on existing financial institutions and intermediaries. The rents not only contributed to stabilizing Japanese fi- nancial system, but also kept inefficient financial institutions viable. The ex-sisting financial institutions were interested in keeping the status quo in the financial system. The financial regulations during the postwar period brought forth powerful groups of vested interests who resisted deregulation and finan- cial innovation that were expected to force them to abandon the way of business familiar to them. The monetary authorities had to cope with resistance from the vested interests against financial deregulation. At the same time, authorities believed that drastic deregulation would destabilize the Japanese financial sys-tem. Thus, the existence of the groups of vested interests has influenced the process of financial deregulation in Japan. First, the government adopted the policy of gradual deregulation("gradualism"). Secondly, the pressure from abroadwas quite important in promoting domestic deregulation. 2.The "gradualism" adopted by the MOF 　An important feature characteristic of Japanese financial deregulation has been"the gradualism" in the sense that the authorities were extremely cautious and sometimes too timid with liberalizing financial markets. Their primary concern was to avoid strong disturbances on the existing financial institutions. Thus, the deregulation has been almost always half-baked. for example. the liberaliza-tion of deposit interest rates was started in 1979 by introduction of negotiablecertificates in a restricted form deposit. However, the liberalization took fif-teen years before interest rates on time deposits were fully liberalized in 1994. The Laws of Financial Reforms instituted in 1992 made a window hole in the tra-ditional compartmentalization by allowing financial institutions to engage in activities which use to be outside of their territories through newly estab- lished subsidiaries. For example, banks are permitted to enter into securities business through their subsidiaries of securities companies. The securituies companies can engage in banking business by establishing bank subsidiaries. Al- though the purpose of this liberalization was to make each area of financial business more contestable, obviously it is half-baked because the MOF has for- bidden new subsidiaries engaging in some important businesses specific to the territories. Those businesses are to be reserved for the financial institutions staying in the territories long before. For example, a securities subsidiary established by a bank is not allowed to engage in stock brokerage which is stilla lucrative business for existing securities companies. This is also a sort of the "gradualism," which is sometimes called "the policy of avoiding sudden changes in financial markets." 3.Importance of pressures from abroad 　The pressure from abroad was an important promoters of financial deregulation in Japan. The Yen/Dollar Ad Hoc Commitee the Reagan administration forced the Japanese government to institute in 1983 produced a plan of liberalizing the Euro-yen market and specific time schedules of liberalizing interest rates in domestic markets. The development of the Euro-yen markets, accompanied with the amendment of the Foreign Exchange Law in 1980, exerted strong pressures on the domestic money markets through flexible arbitrage between domestic and Euro merkets. The Japanese major companies obtained access to cheaper means of fund- raising than the domestic corporate bond market which was notorious for its closed nature. Because many Japanese firms started to issue corporate bonds in the Euro-maket in the early 1980s, the Japanese securities companies and banks recognized the necessity of liberalizing domestic corporate bond market. The relationship between the development of the Euro-yen market and the deregu-lation in somestic corporate bond market was, although quite conspicuous, just an example showing the importance of the pressures from abroad with respect to promoting financial deregulation in Japan. It is noteworthy that the government did not determine some important aspects of financial deregulation on its own initiative, but was forced to decide specific process of deregulation. This was mainly because it was difficult for the government to deregulate financial sys- tem in the face of stiff resistance from the existing groups of vested interests. 　4.What we learn from Japan's experience 　In spite of apparent progress of financial deregulation in the Japanese finan- cial system, many people are dissatisfied with its current situation. They find that the Japanese financial system continues to be outstripped by foreign mar- kets in introducing financial innovation. They also find that the Japanese fi- nancial markets are experiencing "hollowing" in the sense that a substantial part of financial transactions between Japan's residents have been intermediatednot by the domestic markets, but by the foreign markets. At the same time, the Japanese financial system appears to have become more fragile than before since thelate 1980s as a consequence of the financial deregulation. At present, these dissatisfaction with respect to the financial system are an important challenge to the Japanese government. I will briefly discuss what lessons about financial deregulation can be derived from Japan's experience of financial deregulation. (1)Was "grudualism" the best policy? 　A lesson we learn from the Japanese experience of the financial regulation is that the management of deregulation process does matter. The MOF has recognized that the efficiency of financial system had to be improved through financial de-regulation lest it should be hollowed out by the globalization of Japanese fi- nancial markets. However, the MOF has continued to manage the process of deregu-lation to keep the equilibrium between the vested interests produced during the postwar period by means of the "gradualism." Through the gradualism, the MOF hastried to achieve two goals of increasing efficiency in the financial system and to keep the traditional (and relatively inefficient) financial institutions vi- able in the process of financial deregulation. However, the MOF seems to have fallen between two stools. The gradualism seems to have deprived the Japanese financial system of both vi-tality and flexibility in accommodating itself to structural changes in demand for financial services. As the foreign financial markets have quickly developed paricularly by active introduction of financial innovations, the gradualism in Japan has rather hindered improvement in efficiency of the domestic financial system. For example, Japan's major companies are increasing their dependence on the internal funds reducing the sise of external fund-raising, particularly borrowing from banks. On the other hand, most venture businesses are reportedly suffering from a shortage of capital because the traditional regulation on secu-rities markets has prevented financial intermediation mechanism for small-scale enterprises from developing its effciency. These are just a few sample of show- ing the failure of Japan's "gradualism." 　(2)How to keep financial stability in the process of deregulation 　Another lesson from the Japanese experience is the importance of balancing pru-dential regulations with the effective market discipline to stabilize the finan-cial system in the face of the liberalization of competitive restricting regu- lations. I have emphasized the gradual process of deregulation in Japan. Never- theless, the deregulation has undermine profitability of the traditional finan- cial businesses, because the demand for financial services shifted either from domestic to foreign financial markets or from external to internal (self-suffi- cient) finance. It is well known that the reduction in profitability induces financial institu-tions to engage in moral hazard like behavior under the safety net system mainlyconsisting of the MOF's policy of bailing out financially distressed institu- tions. Thus, we have to prevent financial institutions from taking excessive risk by the prudential regulations such as the capital adequacy requirement. However, to implement the prudential regulations perfectly is very costly be- cause a large number of staff would be required to precisely monitor financial institutions' everyday business. The market mechanism should take a substantial part of responsibility of monitoring and disciplining financial institutions to prevent their excessive risk-taking. In order that the market mechanism works efficiently, we need an effective system of disclosing information about indi- vidual institutions' management. The MOF should be blamed for neglecting the im-portance of disclosure system to strengthen the market discipline. 　(3)The public financial system:A remaining issue 　There remains an troublesome issue of how to deal with the system of public fi-nancial institutions in the process of deregulation. The presence of public fi- nancial institutions has become more and more important in the Japanese finan- cial system. This reflects the fact that the Japanese private financial institu-tions have been unsuccessful in efficiently responding to the diversified socialdemand for financial services mainly because of the gradualism implemented by the MOF. Thus, this is another evidence indicating failure of the MOF's gradual-ism. However, the public financial institutions are inconsistent with the deve- lopment of market mechanism in the financial system. How to accommodate the pub-lic financial institutions to the financial markets and how to reduce their pre-sence in the Japanese financial system will be an urgent policy issue in the near future.

　Table 1 : Structure of finance for the major companies

(Averages over five year period: %)

Period	Internal Fund	Borrowing	Bonds	Stocks	Trade
credit
1960-64	22.9	33.8	6.8	10.8	16.2
1965-69	37.5	36.9	5.2	3.8	22.7
1970-74	35.1	41.6	5.1	3.2	21.9
1975-79	45.8	26.5	10.6	8	17.7
1980-84	55.3	16.4	8.5	10.4	9.6
1985-89	45.2	6.4	17.4	15.8	5
1990-94	87.3	5.2	11.1	4.6	-7.1

(Source) Bank of Japan.