Review of On-site Examination Policy in Fiscal 2002 and Plans for Fiscal 2003

March 28, 2003
Bank of Japan

1. Review of On-site Examination of Financial Institutions in Fiscal 2002

(1) Overview

In fiscal 2002, the Bank of Japan (the Bank) conducted on-site examinations at 115 financial institutions: 35 banks, 67 shinkin banks, and 13 other institutions (securities companies, Japanese branches of foreign banks, etc.) ^*

• The Bank continued to conduct shortened examinations of just over a week with a view to improving the efficiency of examinations, focusing on financial strength, credit risk, and market risk, and such account for 41 of the examinations at shinkin banks. At three financial institutions, the Bank's on-site examinations also focused on a review of the project management systems for computer system integration.

The Bank additionally conducted examinations at the premises of four financial holding companies in order to supplement the above on-site examinations.

(2) Issues related on the management of financial institutions

Issues found through on-site examinations in fiscal 2002 are as follows.

Overview

Many financial institutions have already dealt with a substantial amount of non-performing loans. Amid structural adjustment of the Japanese economy and the stagnation of regional economies, however, new non-performing loans continue to emerge in more diversified sectors of the economy. Under these circumstances, substantial improvements in the asset quality and financial strength of financial institutions have not been seen thus far. Credit costs (write-offs and provisions for non-performing loans) may remain high in the years ahead.

Against the above background, financial institutions need to further intensify their efforts to overcome the non-performing loan problem. They should also enhance their earning power by (i) further improving efficiency through cost reductions, (ii) pursuing a new lending strategy backed by appropriate credit risk evaluation, and (iii) providing new financial services to increase fee income.

Credit risk

As a result of on-site examinations during fiscal 2002, the Bank found many financial institutions where credit risk management could be improved. For example, there were not a few cases where methods for assessing borrowers' business conditions and measuring expected loan losses and the disposable value of pledged real estate were found inadequate.

An increasing number of financial institutions made efforts to introduce a systematic way of rehabilitating financially troubled firms, which the Bank reviewed in light of their effectiveness and resultant improvement in loan quality. It explored ways to strengthen such efforts.

The Bank has discussed with major banks how they should evaluate the economic value of their loans using the discounted cash flow (DCF) method, with the result that they have come to share an understanding of the importance of loan valuation based on future cash flows. The Bank confirmed that major banks would move toward further developing more precise evaluation method and detailed database to ensure reliability of the DCF method.

Market risk

With interest rates at historically low levels, the Bank reviewed the interest rate risk management of financial institutions, for example their stress testing in the event of interest rate fluctuation. In addition, it confirmed that major banks had been aggressively reducing their shareholdings by various means, including via the equity purchase facility offered by the Bank. This reflected the strong intention of these banks to manage market risk attaching to shareholdings.

Some regional financial institutions purchased hybrid financial products seeking high yields. Examination of these cases indicates the need for these institutions to improve market risk management by, for example, strengthening their capability to evaluate various underlying complex risks.

Operational risk

In light of financial institutions intensifying their efforts to streamline and relocate branches and human resources while expanding new product lineups, the Bank observed that some needed to improve operational risk management. In fiscal 2002, the problem mainly related to the risk management of computer systems arose, as evidenced by large-scale malfunctioning among major banks as a result of lack of appropriate preparations for system integration. The Bank identified various risks inherent in system integration for bank mergers as well as outsourcing and the sharing of both system development and operation. It held discussions regarding possible measures to improve the management of such risks.

2. On-site Examination Policy for Fiscal 2003

(1) Basic viewpoint

Japanese financial institutions still face the difficult challenge of resolving non-performing loan problems. This is all the more true as the non-performing loan problem is increasingly characterized as not only the "negative legacy from the bursting of asset price bubbles" but also as the "adverse effect from structural changes in the economy".

In October, 2002, the Bank published "Japan's Non-performing Loan Problem," which argued that, in order to resolve the non-performing loan problem a comprehensive approach should center on "the appropriate evaluation of the economic value of non-performing loans and their quick disposal" and "improving the earning power of both banks and firms". As the Bank highlighted in this publication, appropriate provisioning based on an adequate evaluation of the impaired value of loans and the introduction of new lending strategy based on such evaluation should be a starting point for restoring the soundness and earning power of financial institutions as well as for maintaining the stability and efficiency of the financial system. The Bank believes that the strengthening of the financial intermediary function through these measures, both at an individual institution level and the financial system as a whole, will contribute to promoting corporate rehabilitation and creating new businesses, which will in the end lead to the revitalization of Japan's economy.

Thus, in fiscal 2003 the Bank will conduct on-site examinations, with a focus on the following five points:

1. Disposal of non-performing loans and corporate rehabilitation

The Bank will examine if financial institutions correctly assess the actual financial conditions of borrowers and effect appropriate provisioning against non-performing loans based on such evaluation. The Bank will also encourage financial institutions to examine the feasibility of rehabilitation plans for financially troubled firms more strictly and, if necessary, to restructure loans at an early stage of a firm's credit deterioration.

2. Seeking new business opportunities

Through assessing banks' earning power, the Bank will encourage financial institutions to seek new business opportunities as well as enhance efficiency. In particular, the Bank regards the following measures as being critically important: 1) the appropriate allocation of capital for strategically important areas to improve profitability, 2) the introduction of new lending strategy focusing on cash flow, and 3) cultivating new lending markets capitalizing on structural changes in the macroeconomy. The Bank will have in-depth discussions with financial institutions to urge that their efforts are aligned with improving the financial intermediary function.

3. Management of diversified and complex risks

With the advent of new financial products made possible by advanced information technology, risk has become diversified and more complex. Simultaneously, employing new technologies requires financial institutions introduce sophisticated computer systems, which also generate another kind of complex risk. Under these circumstances, the Bank will examine if proper institutional frameworks for business operation and risk control are in place and effective. The Bank will also examine whether financial institutions undergoing business consolidation and restructuring have prepared appropriate measures and contingency plans to ensure smooth integration of their computer systems and to resolve any system failure.

4. Business continuity management

It is an important task for financial institutions to establish contingency plans for situations should important operations be disrupted or halted. In this context, the Bank will discuss business continuity, recovery plans, and strengthened concerted action with the Bank.

5. Preventing systemic risk from materializing

The Bank is determined to take appropriate measures to provide sufficient liquidity to safeguard market stability should signs of systemic risk emerge. To pursue this goal successfully, the Bank will continue to gather information in linkage with financial institutions and other settlement chains so as to have a better grasp of risk profile.

The Bank has been making efforts to review the financial conditions and business activities of individual financial institutions through its on-site examinations and off-site monitoring. It has also carried out intensive analyses of the relationship between the financial system and the real economy with the help of information obtained through central banking activities. The Bank continues to utilize the information obtained through on-site examinations for financial stability policy and monetary policy, thereby contributing to the stability of the financial system and the revitalization of the Japanese economy.

(2) Focal points

Financial strength

The Bank will continue to examine the financial strength of financial institutions by reviewing capital adequacy and earning power. It will also verify the amount of write-offs, provisioning, and deferred tax assets. In particular, with regard to the DCF method, which will be introduced at major banks, the Bank will examine necessary elements such as method for gauging economic value of loans such as probability of default and loss given default, and expected cash flow.

The Bank will continue to discuss with financial institutions various measures to enhance their earning power and to adapt to possible changes in accounting principles.

Credit risk

The Bank will examine the accuracy of the assessment of borrower conditions by financial institutions. In particular, with respect to large exposures, the Bank will examine whether financial institutions accurately grasp the impact of the possible bankruptcy of such debtors so that they can manage such risk properly.

The Bank will examine more critically whether financial institutions have established policies for distressed borrowers and, in particular whether loan-loss protection measures as well as advice given borrowers are effective so as to contribute to improving loan quality. The Bank will also review the feasibility of the restructuring plans of corporations.

In addition, the Bank will evaluate whether financial institutions properly calculate the expected disposable value of pledged real estate, considering borrowers' conditions.

With regard to the risk management of an overall loan portfolio, the Bank will examine the accuracy of credit cost obtained by internal credit rating systems and their application to loan management. In addition, the Bank will analyze borrower financial data collectively and hold discuss with financial institutions based on such analysis with the aim of improving loan management.

Market risk

The Bank will continue to review the policies of major banks to control interest rate risk and to reduce market risk arising from shareholdings.

As for regional financial institutions, the Bank will closely examine whether they appropriately grasp risks attaching to hybrid financial products and whether they adopt appropriate risk management measures.

The Bank will also attempt to accurately grasp possible risks arising from market transactions between financial institutions when a shock occurs in any sector of the financial system. The Bank will encourage improvements, if necessary, in business operations and market practices.

Settlement and liquidity risks

The Bank will continue to examine liquidity risk management and the emergency measures of financial institutions in the event of funding difficulties.

The Bank will discuss with financial institutions settlement operations and risk management so as to maintain smooth and reliable settlement operations.

Discussion will be held regarding the effectiveness of financial institutions' business continuity and recovery plans, and concerted action with the Bank in the event of emergencies such as material damage to a bank's head office or computer center, a large scale disaster, or the disruption of telecommunications.

Various rules and procedures for ensuring smooth settlement within private settlement systems are prepared and ready to be activated immediately if some financial institutions become unable to execute settlement functions. The Bank will review process management at financial institutions in accordance with such rules. The Bank will also review the settlement profiles of funds and securities among financial institutions.

Operational risk

An increasing number of financial institutions are concentrating and outsourcing business processing as well as streamlining and relocating branches and human resources. The Bank will review whether financial institutions grasp the risks incurred by such changes and have established appropriate risk management.

Financial institutions are engaged in new business fields, such as providing new financial products and services, including Internet banking and loan securitized products, in order to satisfy customer needs and create new business opportunities. Hence, the Bank will examine whether financial institutions have an appropriate business infrastructure and risk management system in place concerning such new business endeavors.

Compilation of statistical data for business operations and enhancement of analytical ability is necessary for quantifying operational risk, which is a prerequisite for appropriately managing such risk. The Bank will review whether financial institutions, especially top management, appropriately recognize the necessity of such prerequisites so that they can take proper measures.

Computer system risk

The Bank will examine measures effected by financial institutions to strengthen their system risk management in order to maintain the security, stability, and integrity of their systems.

In reviewing computer system integration project management, the Bank will ascertain if the various risks involved are recognized by top management, as well as if measures to ensure smooth system transition and a practical contingency plan are in place.

Risk management systems pertaining to outsourcing and sharing computer system development/management and preparing for measures to enhance functions after system transition will also be reviewed.

Integrated risk management

Financial institutions, mainly major banks, are implementing integrated risk management under which various risks are measured by a common yardstick and controlled within risk limit and loss cut rules. Here, the Bank will review the appropriateness of the scope of risks and the sophistication of measurement tools, as well as whether this framework is effectively utilized for the allocation of economic capital, profitability analysis, and the provision of incentives for each business line.

In accordance with changes in business and management systems, the importance of the 'internal audit' function is increasing. The Bank will continue to discuss with financial institutions various measures to strengthen functions such as introduction of risk-based audit, the monitoring of business units, and the proper involvement of management.

(3) On conducting on-site examinations

The Bank's examinations seek to ensure the soundness of financial institutions, enhance the stability of the financial system, and strengthen the function of financial intermediaries. During on-site examinations, the Bank tries to form a consensus with financial institutions so as to ensure that findings lead to proper and active management. The Bank also holds comprehensive discussions with financial institutions and, if necessary, external auditors, regarding accounting practices.

The Bank effects on-site examinations at flexible frequency, scope and terms considering the size of risks and risk control measures in place. Further, when the Bank deems it necessary to assess specific risk categories, it makes active use of shortened on-site examinations.

Due to rapid changes in financial and business conditions, financial institutions could suffer sudden and significant changes in financial position and business. Under such conditions, the Bank is determined to review responses to such changes seamlessly and accurately through on-site examinations and off-site monitoring.