Japan: Basel Core Principles for Effective Banking Supervision
Detailed Assessment of Compliance

This report focuses on the effectiveness of the Japanese Financial Supervisory Authority (FSA) and the Bank of Japan in supervising and regulating the Japanese financial system during the March 2011 earthquake. The report also highlights Japan’s compliance with the Basel Core Principles (BCPs) for Effective Banking Supervision. Japan has introduced various improvement measures to its regulatory framework and has an operational set-up that largely complies with the norms of the BCP's. In general, the mandates for supervision are structured and FSA given a free hand on supervisory responsibilities.

Abstract

This report focuses on the effectiveness of the Japanese Financial Supervisory Authority (FSA) and the Bank of Japan in supervising and regulating the Japanese financial system during the March 2011 earthquake. The report also highlights Japan’s compliance with the Basel Core Principles (BCPs) for Effective Banking Supervision. Japan has introduced various improvement measures to its regulatory framework and has an operational set-up that largely complies with the norms of the BCP's. In general, the mandates for supervision are structured and FSA given a free hand on supervisory responsibilities.

I. Context, Key Findings, and Recommendations

A. Introduction

1. This detailed assessment of Japan’s compliance with the Basel Core Principles for Effective Banking Supervision (BCP) was conducted from November 28–December 16, 2011. It follows the first assessment of the supervision framework conducted by the International Monetary Fund (IMF) in 2002.

2. The assessment focused on the banking regulatory and supervisory framework currently in place and the oversight by the Japanese Financial Supervisory Authority (FSA) and the Bank of Japan (BOJ). While the BOJ is not a regulatory authority per se as defined under the Banking Act, it conducts on-site examinations and off-site monitoring of banks with the objectives stipulated in the Bank of Japan Act.

3. The assessment was held in the months following the Great East Japan Earthquake in March 2011 that had severely tested the resilience of the Japanese financial system. Swift and decisive actions taken by the BOJ and the FSA helped maintain financial stability in Japan. Japan’s financial system had weathered well the initial shock of the earthquake and set in motion the process of gradual recovery.

4. Japan has introduced various improvements to their regulatory and supervisory framework since the 2003 FSAP. This included the FSA’s “better regulation” program that is focused on improving the quality of financial regulations. Amongst others, this program promotes a more risk-focused and forward-looking approach in new regulation. Both the BOJ and the FSA had also initiated improvements in supervisory practices following lessons learnt from the global financial crisis and the March 2011 earthquake.

5. In general, banking supervision framework in Japan is structurally sound, with a legislative and operational set-up that largely complies with the BCP.

B. Information and Methodology Used

6. This Detailed Assessment of Observance Report was prepared as part of the FSAP Update mission to Japan. It is Japan’s first full review under the BCPs that were revised in 2006. The assessment team1 reviewed the legal framework for banking supervision, held discussions with staff from the FSA, BOJ, the Japan Bankers Association, as well as private sector participants in the banking and financial sectors. The team examined the current practice for on-site and off-site supervision by the Japanese authorities. The assessment team enjoyed excellent cooperation with its counterparts, who provided extensive clarifications in the form of documents and oral explanations, and a comprehensive BCP self assessment.

7. The assessment is based on several sources: (i) the aforementioned self assessment received in October 2011; (ii) detailed interviews with staff from the FSA and BOJ; (iii) reading of laws, regulations, and other documentation on the supervisory framework; (iv) review of supervisory materials provided to the assessors during and after the FSAP mission; (v) meetings with other agencies and independent bodies, such as rating agencies, and audit firms; and (vi) meetings with the banking industry including the various banking associations, as well as with select individual institutions including city banks, regional banks, and foreign banks.

8. The assessors had the full cooperation of the Japanese authorities and received information necessary for conducting the assessment. The team extends its thanks to the management and staff of the various agencies and institutions for their openness and participation in the assessment process.

9. The assessment has been conducted in accordance with the guidelines laid down in the Core Principles (CP) Methodology (October 2006) by the Basel Committee on Banking Supervision (BCBS). It assessed compliance with both the “essential” and the “additional” criteria, but the ratings assigned were based on compliance with the “essential” criteria only. The methodology requires that the assessment be based on (i) the legal and other documentary evidence; (ii) the work of the supervisory authority; as well as (iii) the implementation in the banking sector. Full compliance requires that all these three prerequisites are met. The guidelines allow that a country may fulfill the compliance criteria in a different manner from the ones suggested as long as it can demonstrate that the overriding objectives of each CP are reached. Conversely, countries may sometimes be required to fulfill more than the minimum standards—e.g., due to structural weaknesses in that country. The methodology also states that the assessment is to be made on the factual situation of the date when the assessment is completed. However, where applicable, the assessors made note of regulatory initiatives such as the revised CP under consultation, that have yet to be completed or implemented.

10. To determine the level of compliance of each CP the FSAP assessment has made use of five rating categories: compliant; largely compliant; materially noncompliant; noncompliant; and non-applicable. An assessment of “compliant” is given when all essential criteria are met without any significant deficiencies, including instances where the relevant CP has been achieved by other means. A “largely compliant” assessment is given when there are only minor shortcomings, which do not raise serious concerns about the authorities’ ability to achieve the objective of the CP and there is clear intent to achieve full compliance with the CP within a prescribed period of time. A CP is considered to be “materially noncompliant” in case of severe shortcomings, despite the existence of formal rules and procedures and there is evidence that supervision has clearly not been effective, the practical implementation is weak or that the shortcomings are sufficient to raise doubts about the authority’s ability to achieve compliance. A CP is assessed “noncompliant” if it is not substantially implemented, several essential criteria are not complied with, or supervision is manifestly ineffective. Finally, a category of “non-applicable” is reserved (though not used in this assessment) for those cases where the criteria would not be relevant for the Japanese situation.

11. The assessment of compliance with the BCPs is not--and is not intended to be--an exact science; reaching conclusions require judgments by the assessment team. Banking systems differ from one country to another as do domestic circumstances. Also, banking activities are changing rapidly around the world after the crisis and theories, policies, and best practices are rapidly evolving. Nevertheless, by adhering to a common agreed methodology, the assessment should provide the Japanese authorities with an internationally consistent measure of the quality of their banking supervision in relation to the 2006 BCP which is an internationally recognized minimum standard.

12. For completeness, it should be noted that the ratings assigned during this assessment are not necessarily directly comparable to the ones assigned in terms of an FSAP performed using the pre-2006 BCP methodology. Differences may stem from the fact that the supervisory effectiveness standards were raised by the 2006 update of the BCP Methodology. The lessons drawn from the financial crisis also have a bearing on the expectations from the extant supervisory practices.

C. Institutional and Macroeconomic Setting, and Market Structure

13. Japan’s financial system remains the second largest in the world and is characterized by the “main bank system” comprising three megabanks and several smaller sized banks. The authorities have aimed to increase the economy’s reliance on capital markets since the launch of the Japanese “Big Bang” initiative in 1996. However, banks’ dominance in the system remains fundamental. Benefiting from strong deposit bases, banks remain the main source of lending, in particular for small-to medium-sized enterprises (SMEs).

14. The domestic market is fragmented with about 2,000 deposit-taking institutions. The three megabanks are large by global standards and internationally active. The smaller-size banks mainly service local businesses. Overseas expansion, thus far, has been limited to the larger city banks. Since the early 2000s, consolidation within the sector has been gradual and it is expected to remain so. The customary classification of domestic banks is as follows:

  • City banks (5) are large banks headquartered in major cities (three of them are “megabanks”). Their core business is traditional commercial banking. They have historically close ties with large industry groups and also substantial SME exposures. Overseas operations are limited but growing in the recent period.

  • Trust banks (16) generally focus on both commercial and trust banking activities, including asset management and real estate brokerage. Their main clients are large (often export-oriented) corporations. Most are subsidiaries of other banks (only one is independent).2

  • Regional banks (63) and second-tier regional banks (42) are generally small banks that operate within local prefectures with strong ties to the local economy.3 Many regional banks have to deal with the impact of declining local lending to SMEs and are cutting branch staff. Despite fierce competition and the large number of banks with limited market share, consolidation has progressed slowly for various reasons, including regional banks’ business and ownership structures.

  • Foreign banks (58) have a small market share. They are mostly involved in investment and private banking and lead financial derivatives trading.

  • Other banks (17) are mainly internet banks or banks backed by retail service companies (e.g., Aeon bank), with retail banking franchises and partly owned by major city banks.

  • Japan Post Bank (JPB)4 takes deposits and primarily invests in Japanese Government Bonds (JGBs) (¥146 trillion as of end-FY2010—i.e., 76 percent of total assets) and other local government and corporate bonds. Lending activities are limited (about 2 percent of total assets).

  • Cooperative style financial institutions (271 credit associations (Shinkin banks) and cooperatives (158) credit unions) must provide most (Shinkin banks) or all (credit unions) of their financial services to their members (i.e., SMEs or individuals). Notable institutions in this category are Shinkin Central Bank and Shinkumi Federation Bank.5 Agricultural and fisheries cooperatives play an active role in taking farmers’ deposits and providing credit, and the Central Cooperative Bank for Agriculture and Forestry (Norin-Chukin bank) is the central entity under the supervision of the Ministry of Agriculture and Fisheries (MoAF) as well as the FSA.

Key characteristics of the banking industry:

15. High concentration. JPB continues to hold a quarter of total deposits (about 40 percent of GDP), although this share has declined from about half of total deposits in the 1990s. City banks hold approximately forty percent of total deposits.

16. Low core profitability. Japanese banks suffer from weak profitability due, in particular, to low and declining net interest margin (NIM) amid sluggish borrowing demand of firms and households. In seeking new sources of profit, megabanks have tried to increasingly shift their lending and other activities abroad, particularly to Asia, including by accompanying Japanese corporations. However, this raises challenges related to their corporate governance (e.g., human resources, language, and information technology practices), local funding costs, and risk management (e.g., credit risk assessment, due to information barriers). While some megabanks have also tried to acquire global institutions for this purpose (e.g., parts of Morgan Stanley bought by Mitsubishi UFJ financial group (MUFJ)), some of the above obstacles remain. Overall, bank revenues come mostly from interest revenue (70 percent of gross revenue), while fee income accounts for about 20 percent and securities trading (including JGBs) for the rest. The decline in net interest margins reflects both the low interest rate environment and shrinking lending, and limits the banks’ capacity to build up capital, thereby limiting their future capacity to absorb losses.

17. Asset structure. Loans represent over half of total bank assets and securities about a quarter. In a context of limited credit demand and rising deposits, banks’ JGB holdings have increased in the past few years, which have increased the banks’ exposure to market risks.

18. Loan quality challenges ahead. Loan composition across sectors has not changed significantly in recent years, except for a general decline of retail mortgages. SME lending has been declining due to weak credit demand. Loan quality improved significantly since the early 2000s, but concerns regarding loan quality going forward remain due to weak growth and rising bankruptcy, in particular for regional banks.6

19. Securities holdings and market risks. Banks hold large JGB and equity portfolios. JGB exposures in the banking system have continued to grow in the recent period, increasing bank exposures to interest rate risk. According to BOJ estimates, a 1 percent rise in yields would increase the value of interest rate risk at major and regional banks by about ¥6 trillion, corresponding to 10 percent of major banks’ Tier 1 capital and more than 30 percent of regional banks’ Tier 1 capital respectively. Equity holdings are mainly held to support long-term relationships (and related businesses) with large corporations, and account for more than half of city banks’ Tier 1 capital. Since the early 2000s, banks have gradually reduced such exposures, including with government help. Banks generally have limited exposures to derivative markets.

20. Favorable liquidity situation. Banks benefit from a relatively large and stable deposit base (about 60 percent of household savings are held in deposits). As such, they have a strong liquidity position, with small dependence on short-term wholesale market funding except for their overseas operations. Loan-to-deposits ratios are at historic lows (less than 70 percent). Liquidity pressures appeared in the interbank market at the peak of the Lehman crisis, but have since disappeared.

21. Bank capital. Basel II was implemented in FY 2007. Capital requirements for internationally active banks are 8 percent of risk-weighted assets (RWA). For banks without foreign branches, the standard is 4 percent of RWA. Reflecting market pressures and expectations of Basel III, major banks have raised around 4½ trillion yen of capital in 2009–10, of which a portion remains as hybrid capital, particularly for the mega banks.

22. At the time of the mission, the financial system had stabilized following the March 2011 earthquake due partly also to the policy measures taken by the government to support financial intermediation. However, the banking sector remains exposed to important vulnerabilities including the large concentration to JGB exposures, quality of capital at megabanks and adequacy of capital at the non-megabanks in the face of low profitability and reducing loan demands. Operational, funding, and governance risks faced by banks expanding overseas are also areas of concern.

D. Preconditions for Effective Banking Supervision

Sound and sustainable macroeconomic policies

23. The institutional framework supporting the conduct of sound macroeconomic policies in Japan follows the integrated approach. A single universal regulator (the FSA)7 conducts both safety and soundness oversight and conduct-of-business regulation for all the sectors of financial services, while the BOJ8 conducts on-site examinations and off-site monitoring of its counterparty financial institutions. The Ministry of Finance (MOF)9 also retains an important role. The Deposit Insurance Corporation of Japan (DICJ)10 is responsible for implementing measures such as the reimbursement of insured deposits and financial assistance to reorganize failed banks. The reform of the previous supervisory system that established an integrated system in the late 1990s was a response to perceived weaknesses in the traditional inspection and supervisory practices of the MOF, which emphasized consultation and administrative guidance.

24. Close domestic coordination among the above agencies is required for effective macro prudential policy making. As the FSA, MOF, and BOJ frequently exchange information at multiple levels and there are also several councils covering various aspects of financial system policies, the lack of MOUs is not a major obstacle to effective cooperation.

25. As regards crisis management, the Financial System Management Council (FSMC) is activated when government intervention in a troubled financial institution is necessary. The FSMC consists of the Prime Minister (PM) (chair), the Chief Cabinet Secretary, Minister for Financial Services, the Minister of Finance, the Commissioner of Financial Services, and the Governor of the BOJ. It is convened by the PM to deal with financial institutions that face serious liquidity or solvency pressures. Since its creation, the FSMC has been used only twice, and since the blanket guarantee was lifted, the general bank resolution measure of providing partial depositor protection has only been used once. As stipulated in Article 38 of the Bank of Japan Act, the Prime Minister, and the Minister of Finance may request BOJ to take actions, when they find it especially necessary for the maintenance of stability of the financial system. When the request has been made, BOJ may undertake the necessary actions, including the provision of uncollateralized loans.

26. As regards the financial system as a whole, BOJ analyzes and assesses risks in the entire financial system and releases its findings in the Financial System Report (FSR) semi-annually. The FSR aims to gauge risks in and challenges for Japan's financial system and to share recognition of the risks with a broad range of concerned parties, including financial institutions, so as to ensure stability of the financial system. BOJ's analysis and assessment of the financial system from the macro prudential perspective are reflected in its on-site examinations and off-site monitoring, seminars of BOJ's Center for Advanced Financial Technology, and international discussions.

27. Separately, general advice regarding the financial system is provided via the Financial System Council (FSC) within the FSA. The FSC, which comprises different sectional committees and subcommittees in the FSA, conducts wide-ranging deliberations on the financial system in response to requests from the Prime Minister, the Commissioner of the FSA, or the Minister of Finance. The FSC has conducted deliberations on matters that call for improvements of the financial system involving legislative measures, and has presented reports on the financial system from medium- and long-term perspectives (including disclosures and accounting issues).

Well developed infrastructure

28. Overall, the infrastructure supporting effective banking supervision in Japan is well-developed. The accounting standards in Japan have been extensively developed over the last 10–15 years. Banks are subject to the Japanese generally accepted accounting principles (GAAP) for regulatory reporting. Movements towards convergence between Japanese GAAP and international financial reporting standards (IFRS) started in March 2005. Under the August 2007 “Tokyo Agreement,” Japan established the timeline of end 2008 to eliminate the 26 major differences between Japanese GAAP and IFRS, with the remaining differences being removed by June 2011. Industry opinion is that Japan is at the final stages of convergence to IFRS. At the moment, Japanese GAAP allows for certain assets and liabilities to be reported as historical cost while the application of fair value accounting requires the reporting at the lower of historical cost or fair value under certain circumstances.

29. The legislative framework for external audit requires external auditors to be independent in both fact and appearance. The existing independence requirements are further bolstered by the establishment of the CPAAOB within the FSA that is in charge of overseeing the quality review work performed by the JIPCA. The CPA Act also imposes specific requirements on mandatory rotation from audit engagements of listed companies within a maximum period of seven years from the date of appointment with a two-year cooling off period. In addition, the CPA Act also requires larger audit corporations auditing 100 or more listed companies to follow a five-year rotation rule. The judicial system is relatively well-developed.

30. The payment and settlement system is reliable and efficient. There have been several structural improvements for the past decade with the implementation of Real Time Gross Settlement (RTGS) for all large-value payments, the introduction of liquidity saving features in the RTGS, and the development of delivery-versus-payment (DVP) for all types of securities resulting in the reduction of risks in clearing and settlement of JGBs. Japan is the only jurisdiction, apart from the United States, that had adopted legislation mandating central clearing of standardized over the counter (OTC) derivatives by the end of 2012.

Effective market discipline

31. Legislation in Japan contains several safeguards for disclosure and transparency. The Banking Act requires a bank to publicly disclose an annual report both on solo and consolidated basis that details the banks’ business and financial condition. Corporate law stipulates information disclosure for shareholders and the Financial Instruments and Exchange Act specifies the information disclosure requirements for listed companies. Listed companies are also required to publicly disclose and submit to the FSA, annual financial statements, as set forth in Article 435 of the Companies Act, which had been audited by external auditors in accordance with the Companies Act and Financial Instruments and Exchange Act. The financial statements should be accompanied by explanatory documents on the business and property and be made available to the public by placing them in branches. Securities Exchanges and Japan Securities Dealers Association (JSDA) have also required listed companies to timely disclose information on their performance information. The information on decision making in management such as capital raising, merger and acquisition and events such as disaster and lawsuits is made public through TDnet, the securities exchanges’ online system. The reliability of financial disclosures is ensured by the legislative framework governing the external auditing function. Corporate governance requirements are also spelled out in the FSA’ Supervisory Guidelines and Inspection Manuals, which, while they are not legally binding, are explicit expectations to be complied with by the banks, failing which, administrative actions could be taken by the FSA.

Public safety nets

32. The Deposit Insurance Act defines the deposits that are protected in the case of a bank failure. “Payment and Settlement deposits,” namely current deposits or non-interest bearing ordinary deposits that satisfy the three conditions of (i) bearing no interest; (ii) being redeemable on demand; and (iii) providing normally required payment and settlement services, are fully protected. The other remaining deposits, such as time deposits, are protected up to a maximum principle of ¥10 million including interest, per depositor, per financial institution.

33. The Deposit Insurance Corporation of Japan (DICJ) contributes to financial stability by managing the deposit insurance system and resolving failed banks. In cases when a bank fails, the DICJ will make payouts to insurable deposits, inject capital in solvent banks (funded by government guaranteed borrowings from the market), and at the same time, take resolution actions and facilitate the collection of claims acquired from failed banks in coordination with the Resolution and Collection Corporation (RCC). Since 2008, capital injections have been based on the Financial Functions Strengthening Act. As of March 2010, the DICJ has injected capital under this Act in 13 banks, for a total amount of public funds of about ¥350 billion.

34. The Deposit Guarantee Scheme is funded ex ante by periodical contribution from banks. Insurance premium is determined as a flat rate to insured deposits. In addition, the DICJ has the powers to make borrowings and issue bonds in markets under the approval of the FSA and MOF, and the State may provide guarantee on the DICJ’s financing. Currently, ¥51 trillion of guarantee lines are provided to the DICJ by the annual State budget. The DICJ is also allowed to ask the BOJ for temporary liquidity support guaranteed by the government.

Legal framework

35. The legal framework for banking supervision in Japan is formulated on four levels. The first level is the Banking Act that has been approved by the Cabinet and passed by the Diet. The second level is the Orders for Enforcement of the Banking Act that have been approved and issued by the Cabinet. The third level is the Ordinances for Enforcement of the Banking Act, which is issued by the FSA. The FSA is substantially involved in the drafting of laws, orders, and ordinances. As a fourth level, in order to implement and reinforce the legal framework, the FSA has developed and published supervisory guidelines and inspection manuals. In practice, the supervisory guidelines are mostly being used in the assessment of off-site activities of the FSA staff, whereas the inspection manuals are being used as guiding practice for the onsite activities of the FSA during their inspections. Financial institutions are expected to establish internal control system in reference to Supervisory Guidelines and the Inspection manuals which are public. Supervisory Guidelines and Inspection manuals are frequently updated to take into account developments in the banking industry and improvements in supervisory practices and focus.

Supervisory approach

36. Both the BOJ and the FSA conduct day to day supervision of banks using both onsite inspections and off-site monitoring, and regular interactions with officials of the supervised entities. Formally, and based upon Article 44 of the Bank of Japan Act, the FSA may request BOJ to submit the inspections reports describing the results of the onsite examinations and other related materials with respect to concerned financial institutions. With regard to off-site analyses and at senior management level, there exists more regular information exchange between the FSA and BOJ. Staff exchanges between the FSA and BOJ also take place regularly. Since 2007, the FSA has undertaken a “Better Regulation” program which sets out goals such as enhancing dialogues with financial institutions, strengthening cooperation with foreign supervisors, enhancing research function, and improving quality of employees. To that end, every year the FSA has published how it has achieved the goals listed in this program on its website. The FSA also publishes on an annual basis its objectives with respect to banking supervision. A distinction has been made in objectives for off-site and onsite. The objectives provide a general orientation for the execution of supervision. Concerning onsite supervision, the policy also indicates the planned number of examinations and their focus areas reflecting the issues recognized in the past examinations and risk awareness. Both BOJ and the FSA determine the frequency, scope, and the number of examiners, using the “risk-based” framework for on-site examinations. BOJ announces its on-site examination policy on an annual basis, including the key issues in the conduct of on-site examinations and major findings in the previous year.

37. Under Pillar II of the Basel II framework—the Supervisory Review Process (SRP)—banking supervisors are tasked with assessing the quality of banks’ internal governance, risk management, and internal control processes, taking due regard to each institution’s specific circumstances. In accordance with this, the supervisory framework in Japan requires licensed institutions to establish internal control processes to identify all material risks and to ensure these risks are sufficiently managed—i.e., to identify, assess, mitigate, monitor, and communicate these risks. Checks are conducted through on-site and off-site activities in a manner commensurate the size, risk and complexity of the institution, and activities conducted.

E. Main Findings

Objectives, independence, powers, transparency, and cooperation (CP 1)

38. The assessors concluded that in general the mandates for supervision are sufficiently clear and unambiguous. However, the supervisory arrangements for some cooperative style institutions could be clarified. The FSA is the integrated supervisory authority for banking, insurance, and securities sector. City banks, regional banks, and shinkin banks are directly supervised by the FSA. The day-to-day supervision of the regional and shinkin banks is delegated to Local Finance Bureaus of the Ministry of Finance (MOF). Some cooperative style institutions are co-supervised by the FSA and the Ministry of Agriculture respectively the Ministry of Labor, based upon different arrangements. Co-supervision by the FSA and a Ministry on supervisory matters may lead to less clear decision making processes. It is therefore recommended to clarify and make transparent based upon which procedures the decision making process takes place between the FSA and the other ministries, whereby these decision making procedures should be structured in such a manner that the FSAs supervisory responsibilities would not be jeopardized. Further, agricultural and fishery cooperatives are supervised under the Agricultural Cooperatives Act and the Fishery Cooperatives Act under which they are allowed to take deposits, whereby daily supervision is conducted by local state government. Given (i) the limited size and the nature of their main business; (ii) the fact that the FSA together with the responsible Ministry of Agriculture has developed supervisory guidelines for these cooperatives; and (iii) the FSA could, upon request, undertake on-site examinations, we view that in general a sufficient basis for prudential supervision exists for these cooperatives. BOJ also conducts on-site examinations and off-site monitoring with regard to its counterparties (banks, major securities firms, and other financial institutions) in the context of its central banking function. Its supervisory activities are based upon contracts formulated in accordance with Articles 1 and 44 of the Bank of Japan Act.

39. The institutional framework for supervision in Japan provides sufficient safeguards for the supervisor’s independence in its day-to-day supervision. Nonetheless, in order to enhance the independence in decision-making by the FSA concerning some cooperative style institutions, the FSA is asked to clarify in detail and be transparent on the way co-decision effectively takes place on labor cooperatives and Norin-Chukin, which should not jeopardize FSAs supervisory responsibilities, as mentioned above. The FSA could also consider strengthening the governance arrangements towards the Ministry of Finance’s Local Finance Bureaus, to which the day-to-day supervision of regional and shinkin banks has been delegated by the FSA, by increasing the staff to oversee these activities and by improving the review processes

40. The Japanese legal framework provides for clear provisions on the authorization of banking establishments. It also provides for adequate information powers, as well as sufficient provisions for the supervisor to set prudential regulations via standards, guidelines and inspection manuals. The supervisor has in general sufficient powers to undertake remedial action. The ultimate responsibilities to revoke the banking license or issue an order to suspend whole or part of the banking business are delegated to the Minister for Financial Services, assigned by the PM, and has not been delegated to the FSA. As a consequence, while guidelines for assessing the application are developed by the FSA and proposals for those actions are prepared by the FSA, they would need approval by the Minister for Financial Services.

41. Also the legal framework, especially the Banking Act, includes sufficient powers to address compliance with laws as well as safety and soundness concerns and the legal protection for banking supervisors is adequately safeguarded.

42. Predominantly informal arrangements exist for the cooperation between the FSA and BOJ and with foreign supervisory authorities. The cooperation between the Japanese authorities should further be intensified. Given the bank’s strategies to extend rather than reduce their overseas business, the arrangements with foreign authorities could be further enhanced as well.

Licensing and structure (CPs 2–5)

43. In Japan, the permissible activities of institutions that are licensed and subject to supervision are clearly defined. Also appropriate provisions for the licensing of banks are in place. The FSA might consider to more proactively engaging in monitoring of the credit markets, enforcing that only licensed institutions operate as a bank.

44. The FSA has adequate powers in approving a transfer of a significant ownership in a bank to another party. Every shareholder of a bank that would acquire 20 percent or more of shares needs to be approved as a major shareholder. Subsequent changes in the shareholding need to be reported but not approved unless the FSA exercises the power to impose the condition on the approval of the major shareholder that a possible future majority holding by the major shareholder should be subject to a pre-approval by the FSA. The FSA should consider strengthening its approval process for cases whereby the transfer would lead to a controlling interest by exercising the power above, given the consequences this might have for the business model and governance structure of the bank.

45. The FSA does not require an ex ante approval of investments by a bank in another bank, in an ancillary business or a related banking business, although a prior notification of such investments is necessary. Acquisitions would need prior approval, except when it would be in an ancillary business. Investments in non-banking activities are limited by law and may not lead to a significant ownership or a controlling interest of the bank in question.

Prudential regulation and requirements (CPs 6–18)

46. The FSA requires all institutions to calculate and maintain a minimum capital adequacy ratio (CAR). It also has the power to impose higher capital requirements above the minimum on individual banks. However, the FSA’s implementation of Pillar 2 of Basel II does not provide for setting extra capital charges in case the supervisory review process would indicate that not all material risks would have been captured. Also for domestic and internationally active banks different minimum capital levels and a different definition of capital are used, although a similar capital adequacy framework applies. Moreover, triggers for early intervention measures due to a shortfall in minimum capital levels, are set at a too low level, especially for domestic banks. In addition, we have noticed some (temporary) measures taken by the Japanese government end-2008, which include a partial relaxation of the capital adequacy requirement for banks. The assessors recommend to enhance the standards for capital adequacy and to streamline the rules applicable for domestically and internationally operating banks.

47. The Japanese authorities have a sufficient regulatory framework for identifying and evaluating bank’s risk management systems and processes. In the assessors’ views, there are sufficient on-site inspections and off-site monitoring carried out by the FSA and the BOJ to assess the adequacy of the risk management systems at banks. However, the role of the external audit function should be strengthened, and further focus should be put on bank’s stress testing practices, bank’s integrated risk management and bank’s governance arrangements.

48. Since the last decade, the FSA and BOJ have enhanced their onsite and off-site supervision of banks’ credit risk management processes. The banks the assessors visited had adequate processes and policies in place, with different levels of sophistication. Also the policies and practices of banks with regard to problem assets have improved considerably over the last ten years. In the assessor’s view, problem loans are adequately identified and classified. However, in the subsequent evaluation for extra provisions and reserves, banks are expected to take a prudent stance in taking into account government measures that are aimed at providing enhanced financing and support to their clients, including the restructuring of their loans. The FSA should inspect this more intrusively.

49. The large exposure and concentration limits applied to banks should be more rigorous. It should have a higher impact on lending and investment levels to individual counterparts or groups of connected counterparties. Also, the systems observed at banks for managing concentration risks should be further developed, for instance by taking into account more detailed exposures to industries, geographical areas, etc.

50. The Japanese regulations contain the basic provisions with regard to “exposures to related parties,” including that these should be subject to the arms’ length rule. However, the FSA does not actively enforce these provisions via regular off-site monitoring in combination with focused on-site inspections.

51. The FSA had stepped up on its reporting requirement for banks in terms of individual country exposures on both frequency and granularity to better monitor country and transfer risks and exposures. More consideration could be given on the actual quality of the country exposures, due to a possible materialization of the country risks identified, and having in place a more forward-looking approach to the evaluation of these risks and provisions where necessary.

52. The current supervisory framework with regard to liquidity risk complies with the criteria of the relevant CP. Nonetheless, continued focus by both the BOJ and the FSA on the foreign currency funding profile of banks expanding overseas would be important given the banks’ reliance on wholesale funding in these markets and higher costs of funding overseas compared to their domestic funding profiles.

53. The FSA has acknowledged the key risks arising from IT systems obsolescence or changes in IT systems as a result of mergers among entities within bank groups. It has also intensified its supervision over the adequacy of integrated risk management for banks expanding overseas. A continued focus on these areas by the FSA would be paramount to ensure that banks’ IT systems and risk management processes are able to deal with the risks arising from changes in the banks’ risk profiles.

54. The current supervisory framework with regard to interest rate risk in the banking book complies with the criteria of the relevant CP. Nonetheless, the assessors support the envisaged change of the FSA’s internal policy to undertake a more intrusive, capital adequacy management for “outlier” banks following the results of the predefined (potential) parallel interest rate shift stress tests.

55. While the framework for internal audit and control is largely in-line with the CP, corporate governance functions at individual banks could be further improved through strengthening the independence of the internal audit function and Board of Company Auditors.

56. The report of the 2008 Financial Action Task Force (FATF) Mutual Evaluation of Japan concluded that the anti-money laundering/combating the financing of terrorism (AML/CFT) framework prevailing at the time of the evaluation was not fully in-line with the FATF’s recommendations. The assessors understand that the Japanese authorities are in the process of addressing the weaknesses identified in the evaluation. The Japanese are recommended to review their AML/CFT frameworks and bring them in-line with the FATF recommendations as soon as possible.

Methods of ongoing banking supervision (CPs 19-21)

57. The FSA’s current bottom up supervisory approach of having supervisory teams responsible for highlighting and following up on supervisory issues and concerns facing financial institutions under their charge enables the FSA to promptly identify and deal with issues facing institutions with the highlighted supervisory concerns. However, the FSA should have a more formalized, analytical risk framework that might be used to assess the risk profile of an institution on a holistic basis. In addition, it is recommended to define more formalized criteria for the identification of systemically important financial institutions taking into consideration the probability and potential impact of a financial institution on the financial system that would allow the FSA to better prioritize its supervisory resources and intensity.

Accounting and disclosure (CP 22)

58. While the accounting and disclosure practices in Japan comply with the relevant CP to a large extent, there is a risk that temporary government measures in place could lead to valuation practices differing from international standards. These government measures could also result in some differing accounting and disclosure practices from international standards. The supervisory authorities may want to take steps to promote the prompt standardization of valuation, accounting and disclosure standards with international standards in all areas. The FSA may also wish to strengthen its authority over external auditors.

Corrective and remedial powers of supervisors (CP 23)

59. The FSA has a range of supervisory tools and powers to take measures against banks which are in violation of laws, regulations or are engaging in unsafe or unsound business practices. However, the FSA may also wish to consider reviewing its current Prompt Corrective Action (PCA) system with a view to increasing its effectiveness. Intervention efforts of the FSA could be further enhanced through the greater use of more direct supervisory tools such as penalties, immediate corrective actions, etc.

Consolidated supervision and cross-border banking supervision (CPs 24–25)

60. The FSA has the general powers to effectively supervise banking groups on a consolidated basis. However, it should continuously enhance the effectiveness of its cross-border supervision, including strengthening potential resolution tools as more banks expand overseas in the search for yield and undertake more diverse legal forms that could complicate crisis management or potential resolution.

61. Progress in the cooperation and information sharing between the FSA and other home and host supervisors had been observed. This has been achieved through various channels such as the Exchange of Letters (EOL) with overseas supervisors and the holding of regular supervisory colleges for the major bank groups. The FSA should continue to further strengthen home/host cooperation through engaging in more proactive cooperation with foreign supervisors by ensuring that relevant information is shared swiftly and effectively to strengthen the FSA’s ability to anticipate and deal with crisis situations and potentially any bank resolution situations.

Table 1.

Japan: Summary Compliance with the Basel Core Principles—Detailed Assessments

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Table 2.

Japan: Recommended Action Plan to Improve Compliance with the Basel Core Principles

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Authorities’ response to the assessment

62. The Japanese authorities wish to express their sincere appreciation to the IMF and its experienced assessors for the dedication, time and resources committed to this assessment. It provided the authorities with an opportunity to comprehensively review their regulatory and supervisory framework through their self-assessments and dialogue with the IMF.

63. The authorities welcome the overall assessment by the IMF that they have achieved a high level of compliance with the BCP. They also appreciate the IMF’s assessment that significant progress has been made since the last FSAP. The recommendations made by the IMF to further improve regulation and supervision in accordance with the BCPs are well received. While some initiatives towards reform are already taken since the time of the assessment, the authorities will thoroughly take into account these recommendations in their continuous efforts to strengthen their capacities for better regulation and supervision.

64. In two areas where the authorities have received unfavorable grades, initiatives are already underway.

65. Concerning CP 6, on March 30, 2012, the FSA published the final capital adequacy rules for internationally active banks based on Basel III after a one month public consultation period. The FSA will implement the new rules as from March 31, 2013, which is the end of the fiscal year 2012. The FSA is also now considering new capital adequacy rules for non-internationally active banks (domestic banks). The FSA expects the IMF to understand that non-internationally active banks engage in community based businesses and thus their minimum capital ratios should be set to balance the two objectives of facilitating their financial intermediary function in respective regions and ensuring safety and soundness of those banks.

66. Concerning CP10, the Financial System Council, which has been established as an advisory body to the Prime Minister, the Commissioner of the FSA and Finance Minister, is now requested to review the large exposure regime in Japan.

67. Finally, the authorities strongly support the role the FSAP plays in promoting the soundness of the global financial system and financial stability in member countries through improving regulatory and supervisory practices around the world.

II. Detailed Assessment of Various CPS

Table 3.

Japan: Detailed Assessment of Compliance with the Basel Core Principles

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