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Principles for On-site Examination and Off-site Monitoring for Fiscal 1999*

  • Tentative translation by the Bank Supervision Department

March 30, 1999
Bank of Japan

On-site examination by the Bank of Japan (the Bank) is stipulated in Article 44 of the amended Bank of Japan Law (the BOJ Law). As part of the organizational reform that took place in April 1998, some functions of the Credit and Market Management Department were transferred to the Bank Supervision Department, bringing both on-site examination and off-site monitoring under the same department. Almost one year has passed since the new Bank Supervision Department began operating under this new institutional and organizational framework.

In this paper, the Bank's principles for on-site examination and off-site monitoring for fiscal 1999 are developed. In so doing, (i) the functions of the Bank Supervision Department are reviewed by building upon the lessons learned during the past years, and the role of on-site examination is clarified; (ii) the results of the Bank's on-site examinations conducted throughout fiscal 1998 are reviewed; and (iii) focal points for on-site examination in fiscal 1999 are set out.

I. The Bank's on-site examination to achieve policy goals through its banking business

The Bank of Japan implements its policies through its banking activities as the central bank. On-site examination and off-site monitoring to evaluate the business conditions and asset quality of individual financial institutions that hold accounts with the Bank (hereinafter referred to as "correspondent financial institutions"), therefore, provide a basis for execution of the Bank's policy. On this point, Article 44 of the BOJ Law stipulates that on-site examination is conducted "for the purpose of appropriately conducting or preparing to conduct business prescribed by Articles 37 through 39."

The roles of on-site examination and off-site monitoring can be summarized in the following three points, all of which the Bank considers indispensable to achieve its goals in a responsible manner.

  1. i) Contribute to maintaining the stability of the financial system, by monitoring the business conditions and asset quality of individual correspondent financial institutions, and feeding the Bank's findings back to these institutions, to require them to take necessary steps.
  2. ii) Building upon i) above, continuously monitor potential risks (including types, magnitude and distribution among correspondent financial institutions) and analyze the mechanisms by which such risks manifest themselves and are transferred within the financial system with a particular emphasis on the fund settlement systems, taking appropriate actions to other parties to prevent materialization of such risks where necessary.
  3. iii) Contribute to the overall activities of the Bank, by making the above-mentioned information available to the Bank's credit extension to correspondent financial institutions (including the activation of the "lender of last resort" role), and for smoother and more stable functioning of the payment and settlement systems which the Bank either operates or participates in.

Daily off-site monitoring and on-site examination that enables the Bank to grasp the conditions of financial institutions more deeply, both of which are closely linked to the fact that the Bank is the provider of the fund settlement system services with finality, are indispensable in gaining an understanding of the business conditions and asset quality of individual correspondent financial institutions. For the sake of efficiency, it is appropriate to integrate and harmonize both activities, so that the Bank will appropriately and effectively apply information acquired through daily off-site monitoring to the conduct of on-site examination.

Integrating on-site examination and off-site monitoring will contribute to a better and seamless understanding of the business conditions and asset quality of the correspondent financial institutions, thus serving to lessen the burden incurred by the institutions. The Bank Supervision Department is determined to make every effort to reduce the burden incurred by the correspondent financial institutions as stipulated in the BOJ Law. Accordingly, the Bank revised and simplified the contents of the materials to be submitted to the Bank prior to on-site examination last year. In addition, the revision of regular reports for off-site monitoring is proceeding, and the correspondent financial institutions will be notified of the new reporting format when the revision is completed.

Since financial institutions are generally required to manage themselves on their own responsibility, on-site examination and off-site monitoring should also be conducted to encourage their self-management to the highest degree, by means such as their initiatives to develop and upgrade methodologies for internal risk management. In this connection, the Bank intends to make some of the research papers on the overall financial systems available to the public that have been developed through on-site examination and off-site monitoring process, to the extent possible.

II. On-site examination of financial institutions in fiscal 1998

A. Overview

Based on the focal points of the fiscal 1998 plan, which was released on March 31, 1998, the Bank Supervision Department conducted on-site examination of financial institutions to review their financial strength, as well as their ability to manage credit risk, market/liquidity risk and operational risk in fiscal 1998. Additionally, "targeted examination" (i.e., on-site examination focused on specific business areas) was conducted to assess activities of overseas branches of Japanese financial institutions located in the United States and Asia and to evaluate Year 2000 compliance. The Bank also conducted intensive on-site examination in collaboration with the Financial Supervisory Agency from August 1998, in accordance with the second report on the "Comprehensive Plan for Financial Revitalization," or the so-called Total Plan (released by the ruling Liberal Democratic Party of Japan and the government in July 1998), since it was considered that the status of non-performing loans of the Japanese financial institutions must be addressed with highest priority and urgency. In order to review the accuracy of the self-assessments of assets of the institutions and the adequacy of their loan-loss provisioning and write-offs based on self-assessments, the Bank's examiners visited five of city banks and trust banks, and forty-three of regional banks and member banks of the Second Association of Regional Banks (regional banks II), to conduct intensive on-site examination in fiscal 1998. Among the focal points of the plan released at the beginning of the fiscal 1998, this resulted in placing more emphasis on the assessment of the strength of financial institutions and the adequacy of their credit risk management.

Number of financial institutions examined by the Bank of Japan in fiscal 1998
Type of financial institution Number
Banks 62 (48)*1
Shinkin Banks 65
Others*2 12

In addition to the above numbers, the Bank has conducted on-site examination of overseas branches of Japanese banks in two countries (Thailand and the United States), and targeted examination of Year 2000 compliance at 44 banks.

  • *1Number in brackets denotes banks examined through intensive examination in collaboration with the Financial Supervisory Agency.
  • *2Includes securities companies and Japanese branches of foreign banks.

B. Main findings regarding the focal points of the fiscal 1998 on-site examination plan

(a) Strength of financial institutions and their credit risk management

Considering the weakening of strength that many financial institutions experienced through the bursting of the "bubble" and the economic deterioration that followed, together with the introduction of the self-assessment of assets under the Prompt Corrective Action framework, the Bank carefully reviewed the self-assessment of assets and adequacy of loan-loss provisioning and write-offs through on-site examination and off-site monitoring.

  • Financial institutions had established their own standards for self-assessment of assets and policies and procedures for loan-loss provisioning and write-offs, but in some cases such standards required improvement, and/or were not being adequately implemented. In such cases, the establishment of appropriate standards together with their stricter application was required, and organizational/systematic improvement to ensure adequate application of the standards was encouraged.
  • Financial institutions were improving their credit risk management, but there seemed to be a need for further improvement.

(b) Market/liquidity risk management

With regard to the weakening strength of financial institutions and increasing importance of liquidity risk management in the market, the Bank has placed an emphasis on evaluating whether the institutions had established adequate liquidity risk management systems and whether such systems have worked effectively. Special attention was given to a review of the implementability of contingency plans for liquidity management.

  • Although an increasing number of financial institutions had established market/liquidity risk management systems, in some cases the management did not fully utilize information obtained from such systems in its decision-making process.
  • For institutions engaging in a high volume of transactions or taking complex risks, risk management methodologies based on internal models were reviewed where necessary, and some improvements were requested.

(c) Operational risk management

Due to the short period of time left before the year 2000, the Year 2000 preparedness of financial institutions was closely examined and monitored.

  • To address the Year 2000 problem, the Bank Supervision Department conducted a survey to assess Year 2000 compliance of financial institutions, in collaboration with relevant departments and offices within the Bank. The results of the survey were released in August 1998. Taking into account the results, the Bank conducted targeted examinations focused on Year 2000 compliance, and strongly urged financial institutions to prepare promptly and carefully upgrade their preparedness. In the meantime, "Guidance on Cooperation with Service Providers and Vendors in Addressing the Year 2000 Problem" and "Guidance on Year 2000 Contingency Planning" were released in November 1998, requiring financial institutions to establish contingency plans to meet emergency situations.
  • The "Checklist for Risk Management" was revised and published in June 1998. The revised checklist reflected the recent financial environment and international discussions regarding risk management, and items such as those relating to legal compliance were largely expanded.
  • A checklist was released in November 1998 for preparation for the launch of the euro in January 1999.

(d) On-site examination of the branches of Japanese financial institutions in Asia

In the light of the instability of financial and capital markets in Asia, off-site monitoring of financial institutions was strengthened. At the same time, the adequacy of the credit management of the branches of Japanese banks in Thailand was examined.

  • Targeted examinations focusing on the credit management were conducted to branches of the Japanese banks in Thailand. Self-assessment of assets at the overseas branches was carefully examined, and banks were required to increase the frequency of evaluation of borrowers' financial condition, if necessary.

III. Focal points for on-site examination in fiscal 1999

The general conditions surrounding Japanese financial institutions that need attention can be summarized as follows:

  1. i) In order to maintain financial stability in Japan, it is urgent and essential to resolve issues surrounding non-performing loans held by financial institutions. In March 1999, the Financial Reconstruction Commission decided to enhance the capital base of Japanese banks, such as city banks, by injecting public funds. This was done pursuant to the Law concerning Emergency Measures for the Revitalization of the Functions of the Financial System. It is also possible that public funds will be injected into other regional financial institutions. Meanwhile, it is expected that special treatment with respect to financial assistance based on the Deposit Insurance Law will be abolished at the end of March 2001.
  2. ii) Under these conditions, it is becoming increasingly important for financial institutions to restructure their managerial strategy and improve their earnings. Faced with changes such as the Japanese "Big Bang", the introduction of financial holding companies, and wider application of consolidated accounting principles, the institutions need to drastically reform their management. Therefore, it is expected that they will significantly restructure and improve their managerial policies and their risk management systems and techniques.

In conducting on-site examination in fiscal 1999, we will emphasize the following points, considering the aforementioned role that the Bank Supervision Department should play and the achievement of on-site examination in fiscal 1998, as well as general conditions surrounding financial institutions.

A. Focal points of on-site examination

  1. (a) The Bank will grasp the strength of financial institutions and other institutions, such as assessment of the institutions' capital adequacy, the possibility of additional non-performing loans, the adequacy of their self-assessments of assets, and the adequacy of their write-offs and provisions.
  2. (b) The Bank will conduct "risk-focused" examination focusing on the following points, emphasizing a preemptive approach to prevent deterioration of financial institutions' strength, while paying due attention to the differences among such institutions.
  1. i) Credit risk management
    • Financial institutions are expected to function properly as financial intermediaries and improve their profitability, and accordingly, they would take appropriate credit risks, thereby increasing their earnings. At the same time, as a prerequisite, the institutions must thoroughly manage their credit risks. Consequently, the Bank will check the extent to which they have put credit risk management systems in place and how they use such systems (e.g., the consistency of their risk-taking activities and their risk management systems, together with their risk management procedures).
    • In assessing financial institutions' credit risk management systems, the Bank will check the following points: Do the credit rating systems include an appropriate assessment of the profitability of individual counterparties? Have credit review systems been established, including systems for evaluating results of self-assessment of assets and verifying credit-rating processes? Are overall credit portfolios properly managed? For example, do financial institutions avoid excessive concentration of credit in specific industries and geographic areas?
    • The Bank will strengthen its efforts to monitor financial institutions' management of credit risks that accompany market transactions, and also review credit risks accompanying new financial products, including credit derivatives.
    • Since financial institutions (mainly large institutions) will likely develop and/or improve models for the measurement of credit risks and establish more efficient and effective credit risk management systems, the Bank will monitor the extent to which these institutions bring their models into practical use.
  2. ii) Market/liquidity risk management
    • Since market/liquidity risk management continues to be an important task for financial institutions, the Bank will monitor how the institutions manage liquidity risks and use liquidity risk management systems.
    • The Bank will assess whether financial institutions' market risk management systems (including asset and liability management of their portfolios) and liquidity risk management systems are consistent with their risk-taking policies and whether such systems function effectively, to meet market fluctuations such as interest rate changes. At the same time, the Bank will check whether the institutions' capital is sufficient to absorb the losses from sudden changes in market conditions, whether stress tests are adequately carried out, and whether risk management systems take account of individual products' market liquidity.
  3. iii) Operational risk management
    • Towards late 1999, the Bank will evaluate the Year 2000 preparedness of financial institutions, particularly focusing on contingency planning.
  4. iv) Risks related to payment and settlement systems
    • The Bank will review the settlement risk management of financial institutions in order to contribute to the maintenance of the stability of the payment and settlement systems, and examine whether the institutions have established reliable systems to manage such risks.
    • When conducting such reviews, the Bank will pay special attention to modification of settlement risk management (in areas such as liquidity arrangements and collateral management) of Foreign Exchange Yen Clearing System at the end of 1998 and the Zengin Data Telecommunication System in the near future. At the same time, the Bank will closely monitor the financial institutions' preparedness for the transformation of the Bank of Japan Financial Network System (BOJ-NET) to introduce real-time gross settlement, which is expected to be completed by the end of the year 2000.
  5. v) International business operations
    • Regarding overseas lending, the Bank will examine whether financial institutions have clear understanding of the correlation among various types of risks, which include the possibility of country risks spreading to other countries. Such correlation effects, known as "contagion," have attracted attention during events such as the turmoil in the financial and capital markets of Asian countries in recent years.
    • The Bank will conduct on-site examination of overseas branches of financial institutions in major financial markets such as New York, London and Hong Kong, paying attention to the recent restructuring of their overseas networks (branches/subsidiaries). On such occasions, the Bank will review operational risks arising from such business restructuring as the consolidation of overseas branches and subsidiaries.
  6. vi) The overall risk management system of financial institutions' group with regard to the wider application of consolidated accounting principles
    • Since consolidated accounting principles will be widely applied to financial institutions, the Bank will review the risk-taking behavior and risk management system of financial institutions' group as a whole and their influence on each institution. The Bank will also review the effects of other changes on the accounting principles.

B. Issues to be considered when implementing on-site examination

1. More flexibility in the frequency and the scope of on-site examination

The Bank intends to gain more flexibility in the frequency and the scope of on-site examination. The frequency will be determined in accordance with the financial strength and risk management capability of each financial institution, while on-site examination will focus more closely on areas that require particular improvement.

2. Further utilization of targeted examination

When it is necessary to review the details of risk management systems of specific risk factors, such as the Year 2000 preparedness or settlement risk management, the Bank will conduct targeted examinations focusing on such areas. In addition, the Bank will conduct on-site examination focused on the evaluation of the financial strength of financial institutions, if necessary.

C. Other issues

It is anticipated that the institutional framework of financial institutions will change significantly owing to the establishment of financial holding companies and the wider application of consolidated accounting principles. Therefore, it will be necessary for the Bank to review financial conditions of parent institutions (including financial holding companies) in order to accurately grasp the conditions of the correspondent financial institutions that have accounts with the Bank. The Bank will continue its effort to better analyze the changes that are taking place in the financial industry, and aims to establish adequate review procedures through necessary discussions with financial institutions.