Japanese Financial Market's Strategy in the Globalization Era

Consulting Fellow, RIETI

Transformation of financial institutions

In order to adapt to the economic globalization which accelerated after the 1980s, United States and European financial institutions have transformed the fundamental architecture of their financial business, - business models, organizational structures, human resource management, and information systems - to a global management style earlier than financial institutions in the rest of the world. At the same time, in order to avoid an ambiguous profit mechanism which has a negative effect caused by cross-border organizational structure, they have also taken up the challenge to clearly segregate between "profit center" and "cost center." Furthermore, they are now communicating on a real-time basis between their worldwide operation centers in New York, London, Tokyo, Hong Kong, Singapore, and Sydney by utilizing a global information network.

Front offices, as profit centers, are located in Wall Street in New York; the City or Canary Wharf in London; Otemachi, Marunouchi, Nihonbashi, Toranomon, or Roppongi in Tokyo; Hong Kong Island in Hong Kong; and Raffles Place or Suntec City in Singapore. On the other hand, because of increased competition in cost reduction through the use of information technology (IT) in and after the 1990s, many financial institutions have gradually outsourced their back offices, as cost centers, to offshore locations such as Singapore, and Mumbai or Bangalore in India. This combination model of, centralizing profit centers to specific attractive financial markets and outsourcing cost centers to offshore locations, enables the financial institutions to achieve two objectives: brand maintenance management and cost reduction.

History of financial markets

The history and transition of the financial markets worldwide is investigated in this section from a long-term view, a hundred-year scale. In the U.S., Philadelphia was a financial center until around 1830. From then until now, for nearly two centuries, New York has taken this position. In the history of European financial markets, however, it is very rare that the financial center has remained in one location for the long term. A financial market in the European region initially emerged in Italy in the 13th century. After this, the center of the financial market moved to Portugal and Spain in the 15th and 16th centuries, then to Paris and Amsterdam in the 17th century. Furthermore, the European financial center moved to London in the 18th century, mainly driven by two factors: increased demand of domestic financial services through growth of domestic economy after the Industrial Revolution, and large inflows of foreign capital caused by admitting land ownership to foreigners. In summary, the European financial center moved around every one or two centuries.

In Asia, Shanghai was the financial center until around 1940. After World War II, however, Tokyo became an Asian financial center through Japanese postwar reconstruction earlier than other Asian countries and Chinese political transformation to communism. In and after the 1980s, Hong Kong and Singapore emerged as new Asian financial markets. Tokyo, however, still maintains its status as an Asian financial center. This can be proved by the frequent usage of the term non-Japan Asia (NJA) in the international financial business and the majority of the Asian headquarters of multinational financial institutions being located in Tokyo. Consequently, the world's three major financial centers of Tokyo, London, and New York are firmly linked to each other. In addition, they independently play a role as the central hub of financial markets in Asia-Pacific, Europe, and North America. This mechanism, hub-and-spoke structures, is the core architecture of today's international financial market.

However, the long-term sustainability of the current "three-hub" financial market structure between Tokyo, London, and New York seems to be uncertain. An uncertain question is whether the Tokyo financial market will be able to continuously play a role as a financial hub in the Asian financial market, or whether other cities will be able to take the role and consequently the three-hub financial market structure will be drastically changed. From a long-term view, hundred-year scale, in reference to the European history discussed above, an answer for the question might fully depend on the Japanese political decision on the financial, economic and industrial aspects in the coming few years.

Types of financial markets

Based on the historical backgrounds and current roles, the financial markets can be categorized into three types. The first type is the "financial market constructed through domestic economic growth," which has frequently emerged in modern economic history. This type of financial market is developed and expanded through synergistic demand for domestic financial services in a) the primary development of the manufacturing sector and b) the secondary expansion of demand to related trades, transportation, telecommunications, and other service industries. The current Tokyo and New York markets belong to this type.

The second type is the "financial market developed with incoming foreign capital," of which Singapore is an example in recent years. This type of financial market is intentionally developed as part of a country's national strategy in order to become an attractive financial market to foreign capitals by constructing the necessary social infrastructure, both software and hardware, i.e. regulations, laws, taxation scheme, buildings, and information networks in a country with limited land-space and natural-resources. Dubai in recent years also belongs to this type.

The third type is the "financial market accumulating knowledge at a global level." London is a typical financial market of this model. The London financial market was constructed and expanded during the developing period of the domestic economy in the Industrial Revolution. Thus, in the emerging period, it was constructed as a financial market through domestic economic growth, as described above. However, even after the decline of the manufacturing sector in the United Kingdom, London has maintained its status as the European financial center by transforming itself into "a financial market accumulating knowledge at global level" by opening policies to foreign investors.

Financial market accumulating knowledge at global level: London

When the European Union introduced the euro as a new united currency in 1999, it was warned that London as the financial center of Europe might be replaced by Frankfurt, Paris, or Zurich. Apart from this negative prediction, London could continuously maintain and expand itself as a dominant hub for international finance in the European region. In spite of the UK's decision of nonparticipation in the Euro, "Conversion Procedure,"1 a booklet explaining conversion processes from the legacy currencies to the new currency, published by the Bank of England, has been widely referred to in the financial market. This seems to be a symbolic event to demonstrate that London continuously maintains its status as the center of the European financial market.

Regulatory structure in London is a principal base of its financial market. London organized its market accumulating knowledge at a global level through advantageously utilizing internationally used languages - English; a standard time zone in the Greenwich Mean Time (GMT); and valuable interaction with other industries surrounding finance, such as education, art, broadcasting, information, and software. In addition, in order to enable the smooth flow of people across borders, the strategic planning of city architecture, which contains five airports (Heathrow, Gatwick, Luton, Stansted, and City) in the center, north, south, west, and east sides of London, and the Eurostar network between London and Paris/Brussels, is effectively working. Consequently, London, as the financial market accumulating knowledge at a global level, has vigorously grown in recent years. It is not only as a base for European companies' financial investment activities, but also as a destination point for Middle Eastern oil money, and an absorber for excess funds from booming Russia. It is now said that London has exceeded New York in size.

Highly information-oriented society and "exchangeability"

The theme can be investigated more deeply by applying the concept of "exchangeability," which has recently come into wide usage in the field of information sociology. In short, exchangeability represents the possibility of exchanging a certain item for another one. It is said that this possibility is rapidly rising in modern society which has been transforming itself into a highly information-oriented and excessively liquidized structure. Under such circumstances, the characteristic of human relationships at home, school, or work offices has shifted from "few traditional, strong, and thick bonds" to "many modern, weak, and thin ties." The shift is occurring globally.

The value of an item, which is "highly exchangeable," in other words, can be easily exchanged, is drastically decreased. On the other hand, an item which has a "unique quality," a person who has a "unique ability" and a place that possesses a "unique attraction" have become the winners of the survival game in today's highly information-oriented society, because they are attractive with a specific value of low exchangeability.

In an initial phase of discussion concerning the phenomenon of a highly information-oriented society, there was a forecast that the existing global financial market could be accordingly declining, because the expansion of virtual financial markets enables releasing from specific local constraints in relation to financial transactions and moving financial markets to low-cost locations elsewhere in the world. However, an unexpected phenomenon has occurred. Many financial institutions have transformed their organizational structures; "front offices as profit center" and "back offices as cost center" move in opposite directions.

Back office operations have been transferred to low-cost locations through the mechanism of offshore outsourcing, because exchangeability of location in the back office, which performs a similar type and level of operational processes, is relatively high. This movement is very much in line with forecasts. However, front office operations have increasingly centralized in attractive financial markets, because the characteristics of their business, such as trading and marketing, create values in relation to low exchangeability, in other words, differentiation which others cannot perform.

Japanese financial market's strategy

Considering the phenomena demonstrated in the above, the Japanese financial market's strategy is investigated here from the perspective of Tokyo and local cities.

Financial market accumulating knowledge at global level + α: Tokyo
If Tokyo aims to maintain its status as the most attractive international financial market in the Asian region, it needs to follow the same path which London has taken. It is a transformation from a "financial market constructed through domestic economic growth" to a "financial market accumulating knowledge at a global level." However, it should be noted that Tokyo does not need to become a copy of London, although it does need to perform a transformation.

As mentioned, London was established based on its own attractive characteristics. In order to remain as an Asian financial hub, Tokyo needs to transform into an attractive "difficult-to-exchange financial market accumulating knowledge at a global level" for front offices. This means that it is necessary to establish "a financial market accumulating knowledge at global level + α" (utilizing unique characteristics of Tokyo).

Destination of back office operational processes: local cities
In 2004, a U.S. investment bank established a back office operation center in Glasgow. Glasgow was ultimately selected from several candidates, including Singapore and Bangalore, India. Currently, the center has approximately 800 employees who perform operational processes on behalf of other offices in the U.S. and Europe. However, the idea of establishing a back office operational center in local cities has not been discussed yet in Japan at any level.

Some Japanese local cities possess highly advanced academic institutions and highly educated human resources. If excellent managers could be hired, it would be possible for those cities to establish back office operations centers for financial institutions. Although it seems that a financial market strategy tends to focus on front office activities, the viewpoint of establishing a back office operation center in local cities will be becoming increasingly important in formulating the Japanese financial market's strategy.

September 25, 2007
  1. Bank of England (1996, 1997 and 1998), "Practical Issues Arising from the Introduction of the Euro"

September 25, 2007

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