Finance Reform and Its Impact on Growth

Interviewed two years ago in his plush Tokyo office, Nomura Securities Chairman Yoshihisa Tabuchi--an intense man with considerable physical presence--professed great admiration for Joseph Schumpeter, the eloquent economist laureate of innovation. Tabuchi was particularly taken with Schumpeter’s description of innovation as a process of “creative destruction.”

Today, Tabuchi-san and Nomura stand disgraced--less victims of “creative destruction” than of self-destruction. Japan’s largest and most profitable securities house confessed to having surreptitiously covered the stock market losses of some of its biggest customers. What’s more, Nomura apparently manipulated stocks for a notorious yakuza , a member of the Japanese Mafia. The scandal required Tabuchi to resign and prompted louder than usual cries--at home and abroad--for Japan to dramatically overhaul its Byzantine financial services system.

Although the ultimate impact of Nomuragate is uncertain, the call for fundamental reform--a creative destruction of the financial status quo--is not limited to Japan. From the Europe 1992 economic confederation to the banking bills percolating in Washington, policy-makers are struggling to redefine the institutions that allocate credit and capital. The issue goes far beyond the basic integrity and soundness of a country’s financial system and into the critical challenges surrounding economic competitiveness. Twiddle with a nation’s financial institutions and you can radically--and unintentionally--alter the flow of industrial investment, as the S&L; deregulatory debacle has painfully demonstrated.

We had a $200-billion industrial policy for shopping mall construction, asserts one acerbic economist. As any Eastern European will tell you, a nation’s financial structure plays a critical role in shaping its economic development.

Unfortunately, this is a relationship we don’t understand very well. The investment ecology of financial institutions, innovation and regulatory policy lies beyond explanations proffered by macro- and microeconomic models. A decade ago, the rise of venture capital transformed America’s corporate landscape. So did the rise (and fall) of junk bonds.

In Germany, the universal banks are at the center of that country’s industrial strength.

The nature of financial institutions can be as important as the availability of capital itself. Many prominent observers argue that much of Japan’s postwar economic success can be traced to its keiretsu-- the giant industrial groups that invariably have a bank or securities house at their core. Mitsubishi, Mitsui, Nomura, Sumitomo and other keiretsu have done a superb job during the past 40 years of providing access to cheap capital and managing high-risk, capital-intensive investments in technology development.

Any effort to fundamentally change Japan’s financial system would inevitably affect the keiretsu. Indeed, Shoichi Royama, the dean of Osaka University’s economics department, told a Japan Society conference on restructuring financial services in Japan and the United States that keiretsu will disappear as Japan deregulates its financial services sector.

Royama argued that this would make Japan’s markets more efficient and effective. However, Yoshio Suzuki, chief counselor of the Nomura Research Institute and a 34-year veteran with the Bank of Japan, insisted that the keiretsu will actually grow in importance and that other countries should emulate this hybrid financial-industrial structure.

If financial deregulation undermines the competitive cohesiveness of keiretsu, just how far will Japan be prepared to push reform? Can one meaningfully divorce fundamental reform in finance from its potential impact on industrial competitiveness? These are the questions that lie at the heart of economic growth.

A Nomuragate isn’t just a story of corruption; it’s an insight into the web of traditional relationships that have enabled Japanese industry and investors to effectively manage financial risk. Redesign those relationships, and Japan’s risk/reward ratios are forever changed.

In America, the financial reform debate has been almost totally decoupled from issues of industrial competitiveness. According to McKinsey & Co.’s Lowell L. Bryan, who oversees the consulting firm’s banking practice, financial reform here is motivated by the crises facing the S&L; industry, the commercial banks and the insurance industry.

At stake is the fundamental soundness of the banking system. Of course, one can have a financial system that’s as sound as a dollar but so conservative that it inhibits necessary capital formation and essential credit expansion for industry. What’s the appropriate balance? Remember, financial markets are supposed to be a means to an end--creating a framework for the fair and effective allocation of capital and credit to stimulate appropriate economic growth--not an end in themselves.

The real question to address isn’t just the credibility of our financial institutions in a global market but which role these financial institutions should play in assuring domestic national growth.

It’s highly improbable that global financial markets will crash and burn, taking their national economies down with them. What’s more likely is that, as policy-makers fiddle and twiddle with today’s markets to mitigate these financial scandals and crises, a sense of balance will be lost. These reforms will be more destructive than creative.