April 1999 By Katsushige Sawaki Almost every day on CNN or one of the other international news networks, you hear horror stories about Japan's financial problems. You cannot pick up a newspaper, it seems, without reading about a proposed merger or alliance between two or more of Japan's troubled financial institutions. Meanwhile, all we hear coming out of the United States is good news as the U.S. stock market soars to new records. After several years of these diametrically opposite financial reports, is it any wonder that confidence in the Japanese financial system is at a low ebb? The current situation brings to mind something that was said about a dozen years ago when Japan was at the peak of a booming economy while the U.S. market, with its "Black Monday," was suffering much like Japan is today. I can recall a catch phrase popular at the time: "Japan can do it; why can't the USA?" If we took the description of the U.S. economy then, we would probably have an accurate description of the state of the Japanese economy today. I would like to take this opportunity to explain what mistakes the Japanese financial business community has made, what problems it is facing, what it is trying to do to solve these problems, and, particularly, what OR/MS can do to solve these problems. Weakness of Japan's Financial Sector In my opinion, the weakening of Japan's financial business can be attributed to two things: 1. For many years it was protected from overseas competition by legal regulation, and 2. Because of the protection, none of its industries acquired or fostered the technology particular to that industry and the human capital to support that technology. So that you will understand the kind of regulation Japan's financial business was under, let me tell you an experience I had when I acted as academic advisor to an institutional investor — a fire and marine insurance company — with investments in excess of 5 billion yen. At the time (late 1980s), there was an annual increase of nearly 1 billion yen flowing into the company, and the fund manager was grappling with development of an efficient asset and liability management (ALM) system. He had systematized ALM as a large-scale mathematical programming problem by means of stochastic programming; the setting of the objective functions changed smoothly, including agreement on management risk. But as we listed the specific contents of the management environment, I recall being surprised at how many constraints there were. For example, the funds had to be managed account by account, and any transfer of assets between accounts had to be reported to the Ministry of Finance (MOF). Executive officers try to avoid such situations at all costs. For investment in domestic stocks, certain accounts had to be 30 percent of book value or less. Real estate investment had to be 20 percent or less. Overseas real estate could not be more than 30 percent. Loans could not exceed 55 percent. Financing of an overseas subsidiary was restricted to funds in a certain account, with a 3 percent upper limit on what could be used for that purpose. Altogether, more than 20 inequality constraints had to be added in. These constraints were not constraints due to policy judgements imposed on itself by the financial institution as an autonomous decision-making body; rather they were essentially artificial constraints imposed by the MOF in its exercise of guidance. I remember venting my frustration by making a sensitivity analysis of how much of a sacrifice these constraints imposed on management performance. There was, however, one good result of these constraints for the company: bad debts stemming from real estate investment were kept low. It is sad, in a way, that the large amounts of bad debt that life insurance companies have accrued are not the result of differences between them and fire and marine insurance companies in the abilities of managers to make good decisions, but differences in government regulation. As can be seen from the above case, Japan's financial institutions have many complex constraints from the point of view of ALM imposed on them: what can be invested in; what percentage can be invested; differences stemming from how interest, dividends and capital gain (loss) are handled accounting-wise; etc. From the standpoint of mathematical programming these constraints are no more than mathematical constraints, but as costs of asset management they are burdens not imposed on other financial investors around the world. On the other hand, administrative officials impose a heavy burden of responsibility on the investor in regard to securing a determinate income to guarantee the payment of debt. Under such complex constraints and payment responsibilities, applying asset management techniques used in pension funds in the past is inappropriate. The detailed accounting regulations prescribed not only asset allocation for the current period, but future asset allocations as well. They also generated large "political costs" (costs stemming from hanging on to politically correct stocks, for example, when common sense would dictate selling them). Finally, asset management with a long-term point of view of four to five years was unavoidable. Under today's financial conditions, forecasting interest rates, rates of return and volatility four or more years down the track is not only impossible, it is next to meaningless. And yet the institutional investor in Japan takes payment liabilities to its policyholders as its most important responsibility. For the asset management technique in Japan to be accepted within the organization everything depended on how well the three types of constraints — administrative regulations and the tax law, accounting rules, and payment liabilities — were incorporated into ALM. This is because if an improvement in management performance of 0.1 percent resulted, it would be linked with an enormous cash inflow. I do not want to go into detail about the decision-making process of Japanese institutional investors, but what I, as an outsider, found amazing was that the business section, which had collected the money, showed almost no interest in the results of how it was managed. The project taught me several things, such as: how it is possible for the institutional investor to lose long-term profits if the relationship between the book-value-base target and the purpose of the market-value-base asset plan is not made clear; how to develop software and a database; and how to establish a scenario approach. These regulations discouraged financial business in Japan from adopting and improving the technology in bank and insurance company operations then being developed in Europe and the United States. Look at the history of quality control after it was imported from the United States; it took root in Japan, and was improved. What was possible with QC was not duplicated in financial engineering. As a result, Japan missed the financial innovation boat that was traveling around the world throughout the 1980s. Having acquired abundant residual funds during the bubble economy of the second half of the 1980s, Japan's financial business marched into overseas markets in search of profits. But in the financial markets of New York and London, a continuous stream of innovative options and swaps and other financial derivatives was already being used as a means of high-risk management and speculation. Even U.S. and U.K. managers of institutional investments were making free use of high-powered mathematical engineering technologies, including portfolio insurance and program trading. Shocked to learn that traditional economics had retreated to the background and that the financial arena was now dominated by engineers well versed in high-level mathematical engineering and information technologies, Japan's financial institutions hustled to catch up. They began hiring engineers en mass. As a result, by the late 1980s and early 1990s, large numbers of graduates from science and engineering universities entered the Japanese business community, along with engineers drafted from the manufacturing sector. Unfortunately, most of the engineers from science and engineering schools did not know enough about financial business operations. And just when their efforts to learn were beginning to pay off, the bubble burst. The abrupt drop in asset values that began in 1990 deprived banks and securities firms of the ability to make new investments. While bad assets were being disposed of, financial technology was abandoned as unnecessary. Maybe someday there would be competition with overseas firms in the Japanese market, but not in the foreseeable future. With this attitude, managers cut investment in financial technology, and the engineers working in financial institutions were shifted to other posts or became the victims of restructuring. Against this background of worldwide financial innovation, deregulation in Japan became government policy. In 1993 barriers to entry into the business world were removed so that banks could enter the security business, and the latter could enter the banking business. But this went no further than competition among peer firms on the domestic scene. Japan's "Big Bang" (a series of major financial sector reforms) that will begin in April 2000, however, is an attempt to lead financial business into a completely different dimension: the world. The "Big Bang" will bring about large-scale competition under global standards. But given the state of Japan's financial business, which is so far behind in terms of high-tech applications compared with firms in the advanced nations of the West, there are grave fears that the Tokyo market will "tank." High tech in the financial business begins with technology for planning, instituting and assessing options, swaps and other derivatives; technology for the quantification and management of risk; technology for asset management on international markets; and technology for "securitizing" assets. In recent years it extends to what is called "Internet finance": asset procurement and management via the electronic media. Thus, financial business has changed its image during the past 10 years and has been transfigured into "techno-commerce business." Financial business has changed into an information-intensive, high-tech industry that cannot remain competitive unless it builds an information system that will produce creative and value-added information. The key to nurturing financial business for the 21st century is the advanced technology of financial software needed to realize high-level information systems. Because Japanese financial firms are lagging behind their U.S. and European counterparts in terms of human capital and software development, the fear that the Tokyo market will crash in the next few years cannot be easily dismissed. For this reason, a movement is under way, centering around OR researchers in Japan, to promote engineering approaches to finance and nurture educational and research organizations in this area. Coming to Grips with Financial Engineering by Means of OR/MS The Japanese are very good at taking an engineering approach equipped with mathematical modeling. In the case of quality control, we have demonstrated the ability to improve upon an existing financial engineering technique and modify it to suit Japan's investment environment. In response to the "high-teching" taking place in the financial arena, we will now need to mobilize such mathematical engineering methods and information technologies as applied stochastic processes and optimization methods, coding technology, artificial intelligence technology, and computer simulation. In the international financial market, where transactions are going on instantaneously via networking, computer transactions involving high-powered decision-support systems are an everyday occurrence. In this sort of environment, engineering methods that have to do with quantitative management of risk are indispensable. Despite these needs, there are very few science and engineering-type universities in Japan teaching an engineering approach to finance. The Tokyo Institute of Technology teaches the rudiments, and no more. The economic and commerce faculties simply did not handle it, and the science and engineering universities historically thought there was no need to teach it. Generally speaking, economics departments in Japan focus on qualitative and equilibrium analyses of economic phenomena; they do not attempt to cover the quantitative skills required for asset management and risk management, or they lack the knowledge to teach it in the first place. In commerce faculties, too, the focus of study is on financial management and accounting for recording and assessing the results of enterprise activities. The type of mathematical engineering analysis needed for optimization in asset management and for dealing with derivatives is generally a weak point with them. In short, despite the fact that the skills of operations research, mathematical engineering, computer sciences and the like are indispensable in the financial business of the new age, science and engineering universities are still not awake to the fact. In such a situation, financial businesses in Japan are groping along, using associations with companies and research organizations overseas in order to shore up shaky foundations. Unlike the U. S. financial structure that is built around direct financing, the core of the Japanese market is indirect financing that makes systematic asset allocation possible. Hence, technologies developed in the U.S. cannot be applied in Japan without change. This is the reason why technologies are needed that take into account the special characteristics of the Japanese market. Given the situation described above, there is strong demand for organizations to do the serious engineering research needed to support Japan's financial business in the 21st century. Acting on this demand, the Tokyo Institute of Technology will open a Center of Financial Engineering in April 1999. Directed by Professor Hiroshi Konno, the institution will be Japan's first research center for financial engineering. OR/MS researchers with an interest in this area are expected to help the fledgling program grow and to nurture the human capital that will guide Japan's financial business far into the future. For many decades Japan's educational system separated liberal arts and science. The system unwisely separated economics and business management from science and engineering. Japan's educational and research institutions for traditional engineering technology, such as the Tokyo Institute of Technology, are waking up to the problem. We thus look forward with keen anticipation to the activities of the Center for Financial Engineering, where Professor Konno and three associates (whom we have dubbed the Four Musketeers of Japan's financial engineering research) are aiming at joint research between industry and academia. The Japanese are known for taking a long time to become aware of mistakes and failures, but once we wake up to them we tend to rush full steam ahead in order to make up for lost time. The same holds true in regard to financial engineering. Now that we are aware of our mistakes, watch out, world, here we come! Katsushige Sawaki is a professor of Management Science, Faculty of Business Administration, Nanzan University in Japan. Table of Contents OR/MS Today Home Page OR/MS Today copyright © 1999 by the Institute for Operations Research and the Management Sciences. All rights reserved. Lionheart Publishing, Inc. 506 Roswell Street, Suite 220, Marietta, GA 30060, USA Phone: 770-431-0867 | Fax: 770-432-6969 E-mail: lpi@lionhrtpub.com URL: http://www.lionhrtpub.com Web Site © Copyright 1999 by Lionheart Publishing, Inc. All rights reserved.