Exploring the Global Financial Information Superhighway

Vol. 8: Construction Period of Offshoring and Outsourcing in the Investment Banking Industry (part one)

Consulting Fellow, RIETI

In this volume, we look at the characteristics of the "construction period" from 1995-1999, which followed the "initial period" from 1970-1989 and the "dawn period" from 1990-1994. One economist singled out 1995 as the year in which the mechanism of contemporary capitalism began to change dramatically as a result of the IT revolution and globalization. Likewise, in this series, I consider 1995 to be the year in which a dramatic paradigm shift got underway, in the direction of global information system management in the investment banking industry. This paradigm shift took different courses in Japan, the United States, and Europe. With this in mind, in this series we look at the financial and telecommunications deregulation in the U.S. that drove the paradigm shift, as well as changes that took place in Japanese financial administration and financial institutions over the same period.

Paradigm shift in U.S. financial administration

The economist Kazuo Mizuno published Why Do People Misread the Essence of the Global Economy? (Note 1) (in Japanese) in March 2007. In his book, the author views 1995 as the year in which the relationship between nations and capital began to change dramatically, pointing to two triggers: the IT revolution and globalization. The Clinton government laid the groundwork for this change. Following its inauguration in January 1993, the Clinton administration positioned finance and IT at the core of its economic policies. In doing so, it encouraged a paradigm shift from the old economy to the new economy.

As 2001 Nobel laureate in economics Joseph E. Stiglitz pointed out in his book The Roaring Nineties (Note 2), deregulation in telecommunications and finance were the central reforms under the Clinton administration that brought about a paradigm shift to the new economy. First, the Telecommunications Act was revised for the first time in roughly 60 years in February 1996. The revision allowed the government to advance universal service policies covering not only conventional telephone services but also Internet connections and other advanced telecommunications services (Note 3). Then, the Gramm-Leach-Bliley Act (GLB Act) was enacted in November 1999. The Act dropped the barrier between commercial and investment banking that had been in place for more than 60 years under the Glass-Steagall Act of June 1933.

Restrictions under the Glass-Steagall Act can be traced to the Great Depression in the 1930s, which started with the Wall Street crash on October 24, 1929. Many banks went under. In response, the Roosevelt administration instituted a number of reforms, including the Glass-Steagall Act, which set boundaries for commercial banks primarily operating savings and lending businesses, and investment banks offering services focused on the issuing of securities such as bonds and shares. Barred from commercial banking under the Glass-Steagall Act, investment banks went on to establish operations centering on investment advisory services for companies. In the 1940s, Morgan Stanley, First Boston, Dillon Read, and Kuhn Loeb emerged as the big four investment banks and began to expand their market shares.

In the 1960s, it became difficult for commercial banks to increase profits with their traditional business model of relying on savings and lending alone. The banks thus attempted to move into investment banking. In the 1970s, the case of First National City Bank (forerunner of today's Citibank), a commercial bank that was a pioneer in this respect, divided opinions among the Office of the Comptroller of the Currency, Investment Company Institute, and the courts. In a series of rulings in the 1980s, however, U.S. courts backed the Federal Reserve Board (Fed) in approving the start of investment banking by commercial banks. The consequence was that decision-making was increasingly left to the discretion of the Fed in practice, and the restrictions under the Glass-Steagall Act gradually began to ease. Since the late-1980s, deregulation had been the subject of continued discussion, which became more intense as several bills were submitted to amend or abolish the Glass-Steagall Act. Then, with the enactment of the GLB Act in November 1999, commercial banks were at last free to advance into investment banking (Note 4).

Paradigm shift in Japanese financial administration

In a period of several years centered around 1995, a major switch took place in Japanese politics. In this period, the so-called 1955 system, in which politics was dominated by two major political parties - the ruling Liberal Democratic Party (LDP) and the opposition Japan Socialist Party - was replaced by a framework in which governments were formed by a multi-party coalition. The LDP temporarily went into opposition during the governments of Morihiro Hosokawa, inaugurated in August 1993, and Tsutomu Hata, formed in April 1994. The LDP returned to power in June 1994, when it formed a coalition with its traditional ideological rival the Japan Socialist Party, and New Party Sakigake, and formed a government under Tomiichi Murayama.

The LDP went on to control the government by joining hands with various coalition partners through the process that led to the inauguration of the Hashimoto cabinet in January 1996, Obuchi cabinet in July 1998, Mori cabinet in April 2000, Koizumi cabinet in April 2001, Abe cabinet in September 2006, and finally the Fukuda cabinet in September 2007. Throughout this period, finance had been considered one of the most important issues in national politics. The government of Ryutaro Hashimoto that took office in 1996 advanced the Japanese version of Big Bang financial reforms, modeled after the Big Bang reforms instituted by Margaret Thatcher in the United Kingdom, under the three principles of "free, fair, and global" for revitalizing Japanese financial markets.

Meanwhile, in terms of public administration, the Ministry of Finance had controlled national fiscal and financial administration from the period after the Meiji Restoration in 1868, in which the framework for modern Japan began to develop, until the 1990s. During this long period, spanning more than 100 years, the Ministry of Finance had overseen financial service providers in Japan, including city banks, provincial banks, credit associations, trust banks, securities companies, life insurance companies, and general insurance companies, in the so-called convoy system.

Separation of fiscal administration and financial administration emerged as a political issue, as the collusion of private financial institutions and the Ministry of Finance was cited as one of the factors behind the slow pace of nonperforming loan disposal through the course of cleanup efforts starting 1990 that followed the collapse of the economic bubble. In 1998, the year in which the Obuchi cabinet took over from the Hashimoto cabinet, a historic paradigm shift in Japanese financial administration, from the convoy system led by the Ministry of Finance to the introduction of the principle of competition under the leadership of the Financial Services Agency, finally got underway.

As a result of this shift, the Financial Supervisory Agency was established in June 1998 as an administrative organ affiliated with the Prime Minister's Office, charged with the task of inspecting and supervising private financial institutions, and monitoring securities and other transactions. Jurisdiction over the Financial Supervisory Agency moved to the Financial Reconstruction Commission when it was established in December 1998. In July 2000, the Financial Supervisory Agency took over financial system planning and drafting operations from the Ministry of Finance, and reorganized itself to become the Financial Services Agency. In January 2001, the Financial Services Agency became affiliated with the Cabinet Office, following the abolishment of the Financial Reconstruction Commission and the restructuring of central government ministries and agencies. Meanwhile, the Ministry of Finance changed its Japanese name from okura-sho to zaimu-sho to reflect its reorganization, establishing the present framework for fiscal and financial administration (Note 5).

Bankruptcy, downsizing, and merger of Japanese financial institutions

The dissolution of the Japanese banking industry by the General Headquarters of the Allied Forces (GHQ) during the U.S. occupation, which ran for approximately seven years following the end of World War II, was minor compared with the dissolution of the trading sector and other industries. As a result, banks affiliated with prewar family-run conglomerates survived the waves of dissolutions of zaibatsu (groups of companies) carried out by the GHQ. To encourage postwar reconstruction, the Japanese government protected the financial industry, and established government-affiliated financial institutions, including the Bank of Tokyo and Long-Term Credit Bank of Japan. Through the course of high economic growth, zaibatsu came back to life. At the same time, cross-shareholding alliances began to develop among companies belonging to the same corporate groups.

Under the financial protection policies of the Japanese government, financial sector players such as banks, life insurance companies, general insurance companies, and securities companies bolstered their capital strength by taking advantage of the mechanism that enabled them to earn fixed commissions. At the same time, the financial sector operators became leading shareholders in Japanese companies, protecting Japanese industry from hostile takeovers by foreigners. Japanese city banks affiliated with the zaibatsu in particular stood at the top of the organizations of affiliated companies, because of their position as principal shareholders in such affiliates. They played leadership roles within their zaibatsu. Thanks to the sustained growth enjoyed by the Japanese economy during the postwar period, and the financial capital accumulated in domestic markets, Japanese banking remained a stable sector capable of earning high profits until the late-1980s.

However, Japanese financial institutions were about to experience a period of turbulent change. The turning point was 1995. The changes can probably be summed up in three words: bankruptcy, downsizing, and merger. When the asset-inflated economy burst in the early-1990s, Japanese financial institutions were forced to make previously unthinkable decisions. The banking industry in particular choked on the disposal of a huge amount of bad loans. Securities firms watched their profitability disappear with the slump in share prices. As a result, several traditional long-term credit banks, city banks, and securities companies walked the plank toward bankruptcy.

In November 1997, Hokkaido Takushoku Bank and Sanyo Securities went under. Yamaichi Securities closed voluntarily. The Obuchi cabinet held extraordinary Diet sessions - dubbed financial sessions - that ran for approximately three months following its inauguration in July 1998. The government enacted the Financial Revitalization Law in October of the same year. Under this legislation, the Long-Term Credit Bank of Japan was placed under special governmental control, and temporarily nationalized in October 1998. The same steps were taken for Nippon Credit Bank two months later, in December 1998. The weaker city banks and securities companies downsized or closed their less profitable departments under new reconstruction plans. In some cases, the concerned companies pulled out of overseas markets, closing offices in locations such as New York, London, Brussels, Frankfurt, Zurich, Hong Kong, Singapore, and Sydney.

The merger of financial institutions picked up speed in bursts following the April 1996 creation of the Bank of Tokyo-Mitsubishi through the merger of Mitsubishi Bank, a city bank at the core of the Mitsubishi zaibatsu, and the Bank of Tokyo, a specialist foreign exchange bank. With the establishment of Mizuho Holdings, the Dai-Ichi Kangyo Bank, Fuji Bank, and Industrial Bank of Japan merged in September 2000. Then, in April 2001, Sumitomo Mitsui Banking Corporation was created out of the merger of Mitsui Bank and Sumitomo Bank, which had been core city banks in the Mitsui and Sumitomo zaibatsu, respectively. These mergers created the basic structure of the current three major financial groups, each of which controls three businesses: commercial banking, trust banking, and securities transactions.

Differences in direction between Japanese and Western information system strategies

When the Clinton administration was inaugurated in 1993, it sought to engineer a shift to a new economy focused on finance and IT, adopting a policy switch that substantially relaxed the traditional regulations in telecommunications and finance established in the 1930s in the aftermath of the Great Depression. This was the first step in this direction in approximately 60 years. In U.S. business circles, this switch facilitated exchange between Wall Street, in the financial center of New York, and California's Silicon Valley, the epicenter of the IT revolution. In U.S. academic circles, the move generated collaboration between the financial expertise on the East Coast and the IT skills on the West Coast2. The new knowledge generated by using IT in finance was not limited to research on derivatives trading techniques in financial engineering. It encompassed broad areas of research, including global financial business models, matrix organizational structures, intercultural management, business process reengineering, IT project management, offshoring, and outsourcing. U.S. investment banks saw global information system strategies as critical, and went on to develop telecommunications networks to connect their operations in the Americas, Europe, and Asia. European investment banks followed suit.

Meanwhile, "system integration required by mergers" and "system changes in response to financial system reforms" began to drain the information system departments of Japanese financial groups of human resources in 1995, in the angry waves of nonperforming loan disposal, a shift from the convoy-type administration led by the Ministry of Finance to administration based on the principle of competition led by the Financial Services Agency, withdrawal from overseas markets, and financial restructuring. This loss of manpower meant that Japanese financial groups missed their chance to expand their information system networks to overseas offices. As a result, they ended up playing second fiddle to European and U.S. investment banks in the field of global information system strategies. Japan then found itself confronting another financial crisis in 2003 as its financial institutions began to struggle.

In the next volume, we look at examples of the global information system strategies European and U.S. investment banks embraced in the construction period for offshoring and outsourcing operations starting 1995.

April 16, 2008
  1. Mizuno, Kazuo (2007) Why Do People Misread the Essence of the Global Economy? (in Japanese), Nikkei Publishing Inc.
  2. Stiglitz, Joseph E. (2003) The Roaring Nineties: A New History of the World's Most Prosperous Decade (Japanese translation by Chikara Suzuki, Tokuma Shoten, November 25, 2003, ISBN: 4198617619
  3. Kiyohara, Seiko. (2003) "Political Process for U.S. Telecommunications Policies in Recent Years - Focusing on the Mechanism for Public Interest Expression," (in Japanese) Research on Telecommunications from the Perspective of International Relations: The Telecommunications Advancement Foundation Research Report Vol. 20:5, pp. 224-231
  4. Hayashi, Hiromi. (2000) "Discussion of the Gramm-Leach-Bliley Act of the United States," Chiteki Shisan Sozo, March 2000, pp. 36-47
  5. Financial Services Agency (2008) "Financial Services Agency Pamphlet," Financial Services Agency website

April 16, 2008

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