New Financial Instruments and Institutions: Opportunities and Policy Challenges

Chapter 1: Introduction

1 Introduction 1 One of the most important characteristics of financial markets and institutions is change. The industry, and the products and services it offers, is constantly evolving in response to financial innovations developed by entrepreneurs within existing and new institutions and the ever-changing needs of users and suppliers of funds. This book is about some of the recent innovations—especially new financial instruments —and new institutions that are changing the financial sectors in the United States and Japan. It contains the papers presented, and the formal remarks of discussants, at the third annual conference of financial issues of mutual interest to the two countries held at the Brookings Institution on September 12, 2006, and cosponsored by Brookings and the Tokyo Club Foundation for Global Studies.1 As in the volume produced for the second annual conference, which focused on the “financial gatekeepers,” the third annual conference highlighted some interesting contrasts and commonalities in finance in the two countries.2 For one thing, it will be clear from reading the papers on Japanese finance that financial innovation in Japan has taken its cue from the United States and is proceeding more rapidly than many in America (and possibly in other countries) may realize. yasuyuki fuchita robert e. litan 1. The Tokyo Club Foundation for Global Studies was established by Nomura Securities Co., Ltd., in 1987 as a nonprofit organization for promoting studies in the management of the global economy. 2. Fuchita and Litan (2006). For another, in at least one important market—the secondary market for residential mortgages—Japan shows evidence of learning from the United States, specifically what features are best to adopt and those that are best to avoid. As for the U.S. financial market, this volume focuses on the growth of two relatively new, and in some circles controversial, financial institutions: hedge funds and private equity funds. The two main financial instruments of interest are structured products—investment vehicles whose performance depends on the performance of some other underlying instrument (and thus are analogous to derivatives )—and exchange-traded funds, or EFTs, increasingly popular means of asset diversification that are alternatives to mutual funds. All of these institutions and products illustrate the seemingly never-ending ingenuity of the financial services industry to come up with new methods for financing or hedging risks—but at the same time each raises novel legal and policy issues, or in some cases, risks. If Japan’s history in adapting U.S. institutions and financial instruments continues to repeat itself, then surely at some future conference we will be considering how Japan has adapted and refined the more innovative U.S. institutions and instruments that we feature here. Meanwhile, we believe the chapters that follow provide an excellent overview and introduction to some of the more innovative developments in finance today—for the benefit of investors, policymakers, and regulators who may not have the time to keep up with the seemingly dizzying pace of change in the financial markets. This volume begins with two chapters analyzing recent innovations in the Japanese financial market. Chapter 2, by Yuta Seki, addresses the development and increased use of two types of financial securities first introduced in the United States: exchange-traded funds (ETFs) and real estate investment trusts (REITs). Both securities are collective investment vehicles, offered to both retail and institutional investors. Both are also relatively recent in Japan, having been introduced in that market in 2001, although each had a very different history. In reviewing the history of investment trusts in Japan, Seki notes that collective investment vehicles of all types (beginning with mutual funds) always have accounted for a much lower share of household financial assets in Japan than in the United States (the same is true of stockholdings). Japanese consumers have been more comfortable with lower-risk investments in bank accounts, especially at the country’s Postal Savings Banks. Stocks grew in popularity during the boom of the 1980s, but growth halted after the stock market bubble burst in 1989. In an effort to boost the flagging stock market in the mid-1990s, the Japanese government eased several restrictions aiming to encourage the growth of mutual funds. In 2001 defined contribution pension plans were first introduced in the 2 yasuyuki fuchita and robert e. litan country, which also encouraged demand for mutual funds. An additional boost came in 2005, when Postal Savings Banks...