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On-site Examination Policy in Fiscal 2002

(Tentative translation)

April 8, 2002
Bank of Japan

I On-site Examination of Financial Institutions in Fiscal 2001

In fiscal 2001, the Bank of Japan conducted on-site examinations at 120 financial institutions: 31 banks, 78 shinkin banks, and 11 other institutions (securities companies, Japanese branches of foreign banks, etc.). Although on-site examinations usually take two to three weeks, the Bank conducted shortened examinations of just over a week at 19 shinkin banks among those which were recognized as not having any particular problem in terms of management conditions and so tended to have their examination cycles longer than usual. This was aimed at enhancing the efficiency of on-site examinations by focusing on financial strength, credit risk, and market risk. As a result, more financial institutions were examined in comparison with the prior year (see the table below).

In addition, taking into account the increasing dependence of financial businesses on information technology (IT), three targeted examinations were conducted, focusing on the integrity and stability of computer systems.

To alleviate the administrative burden on examined institutions, the Bank reduced the number of samples in checking the quality of assets while maintaining overall effectiveness by putting as much emphasis as possible on the coverage ratio of credit risk volume in light of the extent of utilization of an internal credit rating system.

Financial Institutions Examined in Recent Years
  FY1999 FY2000 FY2001
Banks 41 31 31
Shinkin banks 30 59 78
Others (including securities
companies and Japanese branches of
foreign banks)
37 21 11
Total 108 111 120

The main findings and points to be considered based on the above on-site examinations are as follows:

  1. Many financial institutions have not yet been able to halt the deterioration in loan quality, and continue to shoulder a heavy burden of non-performing loan disposal. Thus, on the whole, it is still difficult for many to enhance financial strength through the accumulation of profits in a fiscal period.
  2. With respect to credit risk management, there was considerable progress at most financial institutions, including small and medium-sized institutions, in terms of the adoption of self-assessment and establishment of risk control frameworks including internal credit rating systems. Some financial institutions need to make further improvements in such areas as the assessment of actual conditions at borrowers and detailed financial analyses, the timely review of internal credit ratings and their application to business management, and the appropriate evaluation of real estate pledged as collateral.
  3. Both market risk management systems and their applications have become more sophisticated at major banks, which have tried to quickly reduce risks related to stocks cross-held for the purpose of long-term investment. Meanwhile, regional financial institutions have been establishing systems to measure and monitor risk indicators, but, among the more active securities investments against the background of sluggish lending activity and extremely low interest rates, there are examples of regional institutions making investments without adequately evaluating the risks. Thus the Bank recognized the need for the further improvement of risk analysis and segregation of duties.
  4. Followed by mergers and acquisitions mainly involving the major financial groups, and increasing dependence on IT, financial institutions have put more emphasis on the integrity and stability of computer systems. Against the background of increased outsourcing and sharing of computer system divisions, issues remain with regard to the establishment of appropriate risk management systems. In terms of settlement risk, the Bank found that financial institutions better understood what was needed regarding the back-office response to the introduction in January 2001 of RTGS (real-time gross settlement) to BOJ-NET, the Bank's online system for the settlement of funds and Japanese government securities.

II Focal Points for Fiscal 2002 On-site Examinations

Basic viewpoint

With little progress in the improvement of asset quality, it is a challenging issue for Japan's financial institutions to properly manage various risks and to strengthen their earnings base to be able to absorb such risks, which are expected to become more diverse and complex following mergers and acquisitions and the launch of new businesses. This fiscal year, with the partial removal of the blanket protection of deposits, etc.*, it will be more important than before to maintain confidence among depositors and market participants.

At the same time, should any serious problem arise with respect to the management of a financial institution, the Bank would be required to form a judgment and respond in a timely and appropriate manner so that such an occurrence would not disrupt overall financial system stability. * Protection of the full amount of time deposits, etc., ceased at end-March 2002. Ordinary deposits, current deposits, and miscellaneous deposits will continue to be fully protected until end-March 2003.

With the above in mind in fiscal 2002, the Bank will conduct on-site examinations placing emphasis on the following:

  1. The Bank will examine whether financial institutions properly assess their financial strength, asset quality and necessity for loan-loss provisions and write-offs based on their assessment, and prospect toward strengthening future profitability, and whether they respond appropriately to each managerial issue.
  2. The Bank will assess whether financial institutions are establishing, expanding, or improving the effectiveness of control systems in response to the various risks which have become more diverse and complex. In particular, with regard to those financial groups involved in the reorganization of corporate structure, including mergers and acquisitions, it will examine to what extent they have established risk management systems reflecting such reorganization and how such systems work. It will also examine whether they have taken appropriate measures so as not to cause anything unexpected in the process of integration or sharing of computer systems.
  3. The Bank will identify as accurately as possible inter-bank transactions and the chain of settlement, as well as related risks. It will also collect related information so that it is prepared to provide liquidity in a timely and appropriate manner in the event of any shock impacting the financial markets and system.

Focal points of financial strength and each risk category

1. Financial strength

The Bank will review capital adequacy and profitability at a given point in time, taking into account the latest situation of non-performing loans. The Bank will carefully examine financial institutions' self-assessment of borrowers and the adequacy of loan-loss provisions and write-offs reflecting such assessment. In the case of major banks, etc., the Bank will also apply analytical methods of quantifying credit risk (see below) in order to examine the adequacy of loan-loss provisions and write-offs from different points of view.

In addition, in light of their future managerial stability and risk management, the Bank will promote discussions with financial institutions regarding various measures to strengthen profitability, such as achieving a better return on assets after the deduction of credit costs and also re-allocation plans of resources based on risk and return.

2. Credit risk

The Bank will continue to promote further discussions with financial institutions regarding the identification and management of credit risk, taking into account their business conditions and credit risk profiles.

First, with respect to the management of entire credit portfolios at financial institutions, the Bank will focus, when necessary, on their methods of quantifying credit risk, including their assessment of credit risk using such frameworks as internal credit rating systems, and cash flow analysis related to loan assets. It will review the effectiveness of risk management frameworks and their utilization in credit policy and the management of credits.

Second, with respect to the management of individual loans, the Bank will focus on whether various measures related to borrowers whose situation has deteriorated, including managerial advice for a business recovery and the enhanced preservation of assets, function effectively to achieve a steady improvement of the asset quality. It will also carefully review whether the valuation of real estate pledged as collateral is appropriate in light of the actual situation.

Third, through examining checking functions including credit risk management sections, the Bank will recommend the adoption of appropriate measures to strengthen internal control systems.

3. Market risk

Against the background of more active securities investment (mainly by regional financial institutions) reflecting sluggish lending activity and extremely low interest rates, the Bank will need to continue to carefully review market risk management and its effectiveness. Since investment in complex structured bonds seeking higher yields has been noticeable, the Bank will examine whether portfolio management systems have been established so as to properly analyze the complex risks inherent in these bonds and whether checks on investment sections by senior management and market risk management sections function effectively. Furthermore, regarding interest rate risk arising from mismatching between investment and funding related to deposits and loans, the Bank will examine the adequacy of identification, monitoring, and control of risk, calling attention to particular points if necessary. Since there is increasing recognition of the urgency for major banks to reduce risks inherent in stocks cross-held for the purpose of long-term investment, the Bank will review progress and risk awareness.

In this situation, in preparation for any propagation of risks through market transactions given the business operations of market participants and market trading practices, the Bank will examine, if necessary, how any shock occurring in one part of the financial system could have a contagion effect, and utilize the obtained information to ensure market stability.

4. Settlement and liquidity risks

Following the partial removal of the blanket protection of deposits, etc., depositors and market participants will have a greater influence on the funding operations of financial institutions than before. With this in mind, the Bank will continue to assess the adequacy of routine liquidity risk management and emergency measures in the event of extreme pressures on funding.

Discussions will continue with financial institutions regarding settlement practices in the interest of the maintenance of smooth and stable settlement operations. Specifically, considering the increasing complexity of managing funds and securities balances following the introduction of RTGS to BOJ-NET and increasing dependence on computer systems, the Bank will underline the importance of reliable settlement operations.

The Bank will also examine to what extent financial institutions have put in place emergency measures in case of system failure. The examinations will focus in particular on continuity plans for payment and settlement operations, should computer centers and office functions be lost (in case operating sites are hit by a disaster).

Since various arrangements have been incorporated into private payment systems in recent years for smooth settlement on the same day even if a participant becomes insolvent, the Bank will examine the readiness of financial institutions for such a situation based on these arrangements.

In addition, the Bank will examine, if necessary, the inter-bank settlement of funds and securities (settlement profiles).

5. Operational risk

As financial institutions in Japan are targeting further business efficiencies through mergers and acquisitions, business alliances, etc., the trend to streamline the allocation of personnel and concentration/outsourcing of business processing has accelerated. Under these circumstances, the Bank will focus on whether financial institutions adequately recognize and manage the risks inherent in back-office operations, including centralized or outsourced operations, and whether the segregation of duties works properly.

With respect to risks related to computer systems, the Bank will continue to assess the integrity, stability, and reliability of computer systems. This includes whether any information security violation or system breakdown would hinder the appropriate provision of financial services, and whether the functions and information provided by computer systems are appropriate to business requirements. Particular attention will be paid to whether appropriate measures have been taken to prevent unexpected events when systems are integrated or shared following mergers and acquisitions and business alliances, and whether adequate risk management is effected in response to changes in system infrastructure accompanying IT innovation.

In response to more complex operational risk, the necessity to improve management efficiency, and progress toward completion of the new Basel Capital Accord, a growing number of financial institutions have tried to enhance risk management by applying methods used to quantify operational risk to business management. The Bank will promote further discussions with financial institutions, focusing on a desirable management approach to operational risk in the future.

6. Integrated risk management and other

Internal management systems under which various risks are recognized from a common point of view and capital is allocated to each business unit to cover these risks are becoming common at major banks. Some regional financial institutions have also begun to make efforts toward introducing such systems. However, there remain many issues to be considered, including the scope of risks, methods of quantifying risks, and the frameworks of capital allocation and assessment of profit which are linked to incentives for appropriate business operations. From this standpoint, the Bank intends to promote further discussions with financial institutions regarding the sophistication of management techniques and their applications to business management.

In the case of major banks, the Bank will assess the current situation of new risk management systems reflecting the reorganization of corporate structures, their consistency with business practices, and their functions.

In order to support efforts by financial institutions to expand and improve internal audits, the Bank will place emphasis on monitoring the establishment of internal audit systems, including the degree of management involvement in internal audits, introduction of risk-based audit methods, and adjustments to the frequency and content of audits according to the risks of each business unit. It will also encourage further discussions regarding improvements to be made.

Measures in examination operations

The Bank intends to maintain and/or improve confidence in its on-site examination by continuing to conduct rigid examinations and ensuring that examined institutions fully understand the results of examinations. In this regard, the Bank has so far had a close exchange of views with examined institutions and their external auditors during on-site examinations, and has made efforts to listen to any opinions of examined institutions through off-site monitoring after on-site examinations. In addition to these arrangements, from this fiscal year, the Bank will introduce a new arrangement* by which an examined institution will be able to submit its opinion to the Director of the Bank Examination and Surveillance Department of the Bank after on-site examination in case a difference of opinion arises during the examination between the examined institution and the Bank's examination team.

The Bank will continue to endeavor to alleviate the administrative burden on examined institutions and conduct on-site examinations efficiently. When it is deemed necessary to assess the situation related to specific risks, the Bank intends to continue making active use of targeted on-site examinations. Moreover, regarding the selection of institutions to be examined, the Bank will determine the cycles, scope, and schedules of examinations flexibly in response to their risk size and their specific problems.

  • Under this new arrangement, an examined institution will be able to submit its opinion concerning matters where its opinion differs from that of the head of the Bank's examination team in writing to the Director of the Bank Examination and Surveillance Department, together with a letter of explanation, external auditor's written opinion, etc., within three working days after on-site examination.