## _cr03287 - Appendix Tables ## Source details **Canonical URL:** [_cr03287 - Appendix Tables](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03287.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03287.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03287.pdf.json) --- ### Overall stability assessment — financial stability and structural change in a deflationary environment - More than a decade has passed since the bursting of the asset price bubble in Japan; major financial sector weaknesses remain. - Root causes of vulnerability: - Absence of a sustained economic recovery and high corporate sector leverage. - Weak capital position and profitability of banks and life insurers. - Nonperforming loans (NPLs), although declining, remain high. - Significant market and credit risks across financial institutions. - Consequences: - Financial sector weakness has held back prospects for a sustained recovery. - Low growth and continued deflation have: - Constrained bank profitability and exacerbated the bad loan problem. - Added to real debt burdens, raised corporate bankruptcies, and eroded collateral values. - Made it easier for banks to delay recognizing problem loans due to ample liquidity and low interest rates. - Authorities’ actions taken (selected): - Establishment of the Financial Services Agency (FSA). - Government recapitalization of major banks in 1998/99. - Enhancement of the safety net and adoption of a Program for Financial Revival (PFR). - Banks have attempted to improve capital adequacy, raise provisioning, and accelerate NPL disposal. - Systemic risk and policy imperative: - In the short run a systemic crisis seems unlikely given a strong external position and effective government safety nets. - If credibility of government support were questioned, liquidity problems could emerge because of reliance on sizeable short-term domestic funding at very low costs. - Staff view: government intervention is required to address causes (stock and flow problems) and restore health and profitability of the financial sector; staff’s key recommendations summarized in Box 2. ### Key financial system reforms (1996–2003) — selected chronology - 1996: “Big Bang” — removal of legal barriers between banks, trust banks, securities firms, and insurance companies; removal of ban on holding companies; temporary comprehensive deposit insurance. - 1997/98: Crisis resolution — three large weak banks resolved; Resolution and Collection Bank (RCB) functions as asset management/realization company. - 1998: Banking law reform — PCA procedures; Financial Supervisory Agency under FRC; inspection manual and self-assessment process; BoJ law establishing an independent central bank. - 1998–99: Bank recapitalization with performance conditions. - 1999: Insolvency law reform under Civil Rehabilitation Law; improved disclosure; RCC created. - 2000–2003: Safety net, accounting, supervisory, deposit insurance, and market-structure changes including the Program for Financial Revival (PFR), special inspections, IRCJ set up, and Securities and Exchange Law changes. ### Key policy recommendations — selected (Box 2, verbatim) - Asset quality and bank capital - Further strengthen banks’ provisioning for NPLs, including by extending the use of forward-looking expected loss estimates. - Limit the use of deferred tax assets in calculating bank capital. - Bank recapitalization - Encourage banks to raise from the markets the additional capital needed to meet requirements due to the stricter treatment of deferred tax assets and provisioning. - Recapitalize those systemically important banks that are unable to raise sufficient capital in the market to at least 8 percent. - Require recapitalized banks to bring in new management. - Raise the minimum capital requirement for domestic banks to at least 8 percent. - Bank governance - Require banks to adopt corporate governance reforms consistent with the Basel Committee’s guidelines, including outside directors and a board audit committee. - Corporate restructuring - Encourage banks to set up subsidiary “work-out” companies. - Develop further the market for distressed debt by having the RCC and the IRCJ serve as a catalyst for transferring impaired assets from the banks to the private sector. - Supervision - Reform the governance of the supervisory process to give the FSA full operational autonomy and confine its responsibilities to supervision. - Provide additional resources to the FSA and continue to enhance its human capital. - Government involvement in the financial sector - Reduce government involvement in the financial sector by restricting the activities of the postal savings and insurance schemes and the government lending agencies. - Staff recommendation summary: - Decisively address both the “stock” problem (weak capital base and poor asset quality) and the “flow” problem (low profitability). - Tackle the stock problem via recapitalization, bad loan restructuring, and tighter supervision. - Address the flow problem by reducing government role in financial intermediation, strengthening corporate governance, and promoting further consolidation. - Cost–benefit view: - Staff believes long-run benefits of reform exceed short-run costs (including possible short-run adverse impact on the economy and use of public funds). ### Banking sector — findings and recommended actions - Asset quality and provisioning - Banks should make more extensive use of forward-looking expected loss estimates rather than rely on historical loss experience. - Low nominal interest rates have eased financing constraints on inherently unprofitable borrowers and complicated borrower viability assessment. - Underprovisioning has hampered transfer of bad assets to the RCC and to the private sector. - Tax authorities should allow provisions required by supervisors to be recognized as a cost for tax purposes (the Tax Commission has proposed examining this issue further). - Capital adequacy - The banking system’s capital cushion has been run down to minimal levels. - Most new capital raised has been in the form of preferred securities and other interest-bearing paper not building stronger balance sheets. - Deferred tax assets now account for more than half of the Tier-1 capital in major banks; their value depends on resumption of taxable profits. - FSA should limit the use of deferred tax assets as regulatory capital. - After limiting deferred tax assets and strengthening provisioning, any systemically important banks unable to raise additional private capital should be recapitalized with public funds to at least 8 percent. - Non-viable banks should be wound down or merged to promote further consolidation. - The minimum capital requirement for domestically-active banks should be progressively raised to 8 percent. - Governance and corporate control - Require banks to adopt corporate governance reforms consistent with the Basel Committee’s guidelines, including appointment of qualified outside directors and a board audit committee with a majority of outside directors for major banks. - For banks receiving public funds, require new leadership and a public governance framework to protect management from outside pressures and give a clear mandate for restructuring and reprivatization. - Competition and government involvement - Japan Post and government financial institutions reduce private banks’ ability to compete; they benefit from subsidies and limited prudential supervision. - Government should gradually run down involvement in financial intermediation by restricting activities of postal savings and insurance schemes and government lending/guarantee agencies. - Consolidation prospects - Despite many exits, more than 100 regional banks and many cooperative institutions remain. - Slow consolidation reflects adherence to existing business models, relative financial weakness, cross-holdings, and limited value of deposit franchises in a zero interest rate environment. - Comprehensive reforms are expected to accelerate consolidation and improve profitability. ### Life insurance sector — vulnerabilities and supervisory actions - Stress drivers: - Declines in investment income and stock prices have weakened insurers’ capital bases. - Large decline in equity prices has lowered solvency margins for a number of life insurers, though all still remain above the regulatory minimum. - “Negative spread” problem: investment returns below guaranteed yields to policyholders, producing losses offset so far by expected gains from lower mortality and expenses. - Recommended actions: - Require life insurers and their actuaries to revalue policy liabilities to account for currently lower investment returns. - Require insurers to set aside deficiency reserves against known losses on investment returns. - FSA should strengthen solvency margin calculations, taking into account internal risk-based formulae used by life insurance companies. ### Corporate sector financial structure and systemic implications - Corporate sector is highly leveraged; deflation has increased the real burden of debt. - The share of Japanese corporate financing provided by banks exceeds that of most G-7 countries. - The relatively small corporate bond market and still high degree of cross-shareholding deter structural change. - Further development of capital markets and healthy banks would: - promote investor activism; - enhance discipline; and - strengthen the position of creditors in the corporate restructuring process. - Corporate governance developments: accounting and auditing improvements and April 2003 Commercial Code revision giving option of governance with a majority of outside directors; remaining weaknesses include low shareholder activism and few outside directors. ### Macroeconomic environment and links to financial stability - Growth and labor/firm outcomes: - During 1991–2002, growth rates averaged only 1 percent per annum, compared to 4 percent per annum in the 1980s. - Unemployment and corporate bankruptcies have reached post-war record highs. - Deflation continues; equity prices and land values remain weak. - In 2002 Japan recovered from its deepest recession in four decades, but growth slowed during the year and the economy is expected to remain broadly flat in 2003. - Policy effectiveness and fiscal concerns: - Increases in base money have not fed into broader monetary aggregates or stopped the five year decline in bank lending. - Continued fiscal deficits have fed a rapidly growing government debt which is now the highest among industrial countries. - External position: - Official reserves at around US$530 billion (as of May 2003). - Japan is a major net external creditor and enjoys sizable current account surpluses. - Financial structure characteristics: - Bank-centered system; major banks, including trust banks, account for about one quarter of total financial system assets. - Public sector plays a larger role in financial intermediation than in other major OECD countries; Japan Post and GFIs have large market shares. - Insurance reserves amount to 38 percent of GDP; roughly 95 percent of households have life insurance policies. ### Macroeconomic links to liquidity, NPLs, and credit flow — selected quantitative indicators - Banks have disposed of more than ¥90 trillion in nonperforming loans (16 percent of GDP) since 1992. - Official NPLs, gross of provisions, still account for over 8 percent of outstanding loans (as of September 2002). - Major banks raised about ¥2 trillion, mainly in preferred shares, early in 2003. - Official reserves at around US$530 billion (as of May 2003). - Nonperforming loans and other indicator series are presented in tables and charts within the source (1997–2002 series, solvency ratios, growth rates, ROE/ROA comparisons, and time series for bank lending 1990–2002). ### Asset resolution, work-outs, and NPL targets - Finding: Banks have lacked incentives to dispose of problem assets once provisioned; reluctance to sell collateral partly because funding costs are so low. - Government action: Authorities have begun to exert pressure on banks to “dispose” of these assets via insolvency proceedings, restructuring, or selling written down claims to the market or to the RCC. - Progress: FY 2002 results of major banks indicate they are on track to meet the target of halving NPL ratios by end-March 2005. - Recommendation: Bank work-out subsidiaries staffed with appropriate expertise could improve asset quality and enhance corporate restructuring. ### Provisioning and loan valuation - FSA recommends loan valuation based on the cash flow borrowers will generate (the cash flow approach) with provisioning down to net present value where appropriate. - BoJ reported in 2002 that some banks were beginning to recognize deterioration sooner; special inspections raised provisioning for “needs special attention” borrowers in FY 2002. - BoJ research suggests provisions and write-offs are likely to continue to average some one percent of risk assets a year. - BoJ noted "the current amount of provisioning is unlikely to cover the reduced economic value of NPL." ### Equity holdings and market valuation risk - Banks required to reduce equity holdings to no more than Tier-1 capital by September 2004. - BoJ program to buy up to ¥3 trillion of these holdings at market prices, but off the market, supports meeting required limits. - Major banks on average have reached the target level already; residual exposure to equity market remains unusually large for banks. ### Deferred tax assets (DTAs) and capital composition - Deferred tax assets now represent about half of major banks’ Tier-1 capital. - DTAs usable only to the extent the bank makes profits and are not available to meet losses in event of failure. - Staff recommends limits on inclusion of DTAs in regulatory bank capital—proposes adopting an approach similar to the United States (limit DTAs to the lesser of 10 percent of Tier-1 capital or one year’s profits). - Banks have issued preferred securities and other interest-bearing instruments treated as Tier-1 rather than ordinary shareholders' funds. - Provisions in respect of category II loans should not be included in Tier-2 capital; current practice not consistent with the Basel Capital Accord. ### Stress test results and vulnerabilities — IMF staff summary - Sample: 7 city bank financial groups, 21 regional banks, 2 central banks of credit cooperative financial institutions, and 10 life insurance companies; represents 56 percent of total bank/cooperative assets and 86 percent of life insurance assets. Data used: end-March 2002 annual report data and end-March 2003 updates. - Market-risk shock parameters: - Equity stress: 20 percent decline in equity prices. - Interest rate stress: 100 basis points increase in yields. - Credit-risk shock parameters: - Banks: 3 percent credit loss on loan book. - Life insurers: 1.5 percent credit loss on loan book. - Group-average reported impacts (selected, as presented): - Equity stress (20% decline in prices): - city banks: 44% - cooperative central banks: 3% - regional banks: 9% - life insurance: 45% - Interest rate stress (100 bps increase in yields): - city banks: 33% - cooperative central banks: 72% - regional banks: 22% - life insurance: 38% - Credit risk stress (3% credit loss on loan book; 1.5% for life insurers): - city banks: 94% - cooperative central banks: 35% - regional banks: 45% - life insurance: 10% - Key stress-test conclusions: - A combination of interest rate and equity stresses could challenge risk-bearing capacity in many institutions. - Credit risk is significant for weakly capitalized institutions under a scenario mirroring recent loan loss experience. - Measured by loss-bearing capacity of shareholders’ equity, the Japanese banking system is undercapitalized relative to interest rate, equity price, and credit risks. - Measures of risk-bearing capacity worsen when the limited loss-bearing capacity of DTAs is recognized. - DTAs on average exceed 86 percent of city banks’ shareholder equity in March 2003. - Caveats: Public annual report data limit measurement of off-balance sheet, FX, and derivatives exposures; tests are static and do not model dynamic management responses or safety-net actions. ### Need for recapitalization: rationale and proposed framework - Finding: Once banks are fully provisioned and recommended adjustments to capital are made, many banks would not meet minimum requirements. - Illustration: If deferred tax assets were to be deducted from capital for major banks, then their average Tier-1 ratio as of March 2003 would fall from 5 percent to around 2 percent. - Staff recommendation: - Government should develop a plan to recapitalize the banking sector expeditiously despite possible short-run economic costs and use of public funds. - Plan should be publicly announced and on offer to all systemically important banks whose capital ratios fall below 8 percent. - Systemically important banks unable to raise sufficient capital in the market within a prescribed time should be recapitalized with public funds to at least 8 percent. - If Tier-1 capital is below 4 percent, the government would convert existing preferred shares into equity and subscribe additional equity to bring Tier-1 ratio up to 4 percent; additional injections to bring total ratio to at least 8 percent could take the form of Tier-2 capital. - Scheme should mandate establishment of asset management companies by banks that have not already done so and extend prompt corrective action where banks cannot access private markets. - Conditionality and governance: - Recapitalization should include profitability targets, require corporate governance reforms consistent with Basel guidelines, and provide a governance framework for DIC and RCC in exercising shareholder roles. ### Case example: Resona Bank rescue (Box 5) - On May 17, 2003, the government announced a recapitalization of the Resona Group by the Deposit Insurance Corporation (DIC) under Article 102 of the Deposit Insurance Law. - Triggers: - Auditors refused to sign off on initial accounts, insisting DTA was overstated. - Revised accounts reduced group capital ratio to 3.8 percent (below the minimum of 4 percent); in September 2002 the ratio had been 7.8 percent. - Measures and outcomes: - DIC recapitalization aimed to bring capital adequacy well in excess of 10 percent. - BoJ agreed to provide liquidity support if needed; proved unnecessary. - Resona submitted a business revitalization plan with salary cuts and departure of about 70 senior management. - New capital (mainly voting preference shares but also including ¥0.3 trillion of ordinary shares) amounts to approximately ¥2 trillion and gives the government more than 70 percent of the votes. - Group must publish new business plans and make periodic progress reports. ### Bank governance and capital adequacy — supervisory stance and recommendations - Avoid imposing recapitalization conditions that reduce profitability (example: compulsory lending quotas to SMEs). - Board and audit governance recommendations: - Require appointment of well-qualified outside directors. - Require board audit committee to consist solely or majority of outside directors with chairman drawn from that group. - Internal auditor should report to the audit committee. - Capital adequacy recommendation: - Staff view: all banks should be subject to the 8 percent minimum capital requirement. - Current regime: “domestic banks” subject to a capital adequacy ratio of 4 percent; “internationally active” banks subject to 8 percent. - Staff proposal: raise minimum capital requirement for domestic banks to 8 percent, with phased implementation over a period of years. ### Public sector financial intermediation and Japan Post - Long-term public sector involvement has held back financial system development by undermining market competition through special privileges. - Japan Post: - Offers deposits, a payment system, and life insurance products. - Does not participate in the deposit insurance system and benefits from an explicit government guarantee. - Network: more than 24,000 offices, accounting for 37 percent of all outlets in Japan providing banking services. - Postal savings represent almost 25 percent of total deposits in Japan. - Postal insurance total assets related to its insurance business of ¥126.6 trillion. - GFIs: - Ten GFIs exist, nine are specialized lending institutions; GHLC has a 30–40 percent market share in mortgage loans. - FILP assets totaled ¥432 trillion (86 percent of GDP) as of March 2002. - Reform recommendation for Japan Post: - Gradually downsize operations and subject Japan Post to same regulatory and tax treatment as private financial institutions; options include refocus or privatize. ### Insurance, pensions, securities, and other institutions — selected recommendations - Life insurers: - Require revaluation of policy liabilities and set aside deficiency reserves where negative spread risks exist. - FSA should strengthen solvency margin calculations and consider risk-based adjustments. - Limit insurer participation in derivatives and enforce exposure limits until internal risk-management systems are developed. - Nonlife insurers: - Monitor heavy concentration in domestic property and prepare for natural disaster risk. - Pension funds: - Public pensions funded only about 20–25 percent; non-payment of contributions to national pension scheme about 25 percent and rising. - Recommendations: review funding, evaluate liabilities using a range of discount rates, introduce checks to remove undue political influence, and consider an independent professional body to develop investment policy for public pension assets. - Securities firms and markets: - Risks of a systemic crisis from the securities sector appear limited; recommended greater formalization of MOUs and fit-and-proper tests (introduced in 2003). ### Payment systems and BoJ oversight — CPSS assessment summary - BoJ-NET FTS is the core system, accounting for around 65 percent of aggregate value settled by the four systemically important systems. - Zengin System: clears about 94 percent of aggregate payment volume but only about 9 percent of the value. - TCH-BCCS (bills and checks) has notable operational weaknesses and contingency plans that are inadequately tested. - Main findings: - Both modes of BoJ-NET FTS and RTGS mode of FXYCS accord closely with CPSS Core Principles; deferred gross settlement mode of BoJ-NET FTS and deferred net settlement modes of private systems show deviations. - Recommended actions include migrating remaining deferred gross settlement payments to RTGS, legal protections for pledged collateral, and improved contingency testing and oversight for TCH-BCCS. - BoJ largely satisfies transparency and disclosure practices for monetary policy; observance of the MFP Transparency Code meets a high standard. ### Basel Core Principles, FSA assessment and recommended action plan — key findings - Assessment basis: Core Principles Methodology of October 1999; FSAP mission October 2002. - Independence concerns: - Lack of operational independence; ministerial control creates scope for political pressure. - FSA has no budgetary independence and is funded from central government budget. - Information sharing: - No formal regular exchange procedures between BoJ and FSA; exchanges occur ad hoc. - Licensing and supervision: - FSA is sole authority for granting banking licenses; some GFIs not supervised by FSA. - Consolidated supervision practiced; FSA can inspect subsidiaries and major shareholders. - Prudential regulation and supervision: - Composition of capital overly reliant on DTAs and preference shares. - Provisioning and NPL classification: focus on categories including “in danger of bankruptcy” and below as essentially worthless; major banks encouraged to remove existing loans from balance sheets by March 2004. - Recommended actions (selected by reference principle): - CP 1.2 Independence: consider setting up a board for the FSA and charge supervised institutions for supervision costs to guarantee budgetary independence. - CP 6 Capital adequacy: change definition of capital to limit inclusion of DTA; general provisions for Category II assets should not be in Tier-2; capital adequacy ratio for domestic banks should be at least 8 percent. - CP 8 Loan evaluation: loans should be valued on the basis of the net present value of expected recoveries. - CP 19 Validation of supervisory information: grant FSA authority to appoint, or oppose the appointment of, an external auditor. - CP 24 Host country supervision: recognize rights of supervisors to exchange information in law; formalize arrangements with foreign supervisors. ### Public financial backstops and safety nets - Government committed ¥15 trillion for support of banks in the event of a threat to the system; market interprets this as implying the five largest banking groups are “too big to fail.” - BoJ equity purchases: program to buy up to ¥3 trillion of bank equity holdings at market prices, off the market. - Deposit Insurance Corporation (DIC) deficit: ¥3.4 trillion as at the end of FY 2002; staff believes credibility of deposit insurance would be enhanced if DIC’s deficit were written off by the government. - Deposit insurance premium rates (with effect from April 2003): 0.09 percent for “specific deposits” and 0.08 percent for other deposits. ### Selected quantitative tables and indicators (preserved as presented) - Banks have disposed of more than ¥90 trillion in nonperforming loans (16 percent of GDP) since 1992. - Official NPLs, gross of provisions, still account for over 8 percent of outstanding loans (as of September 2002). - Major banks raised about ¥2 trillion, mainly in preferred shares, early in 2003. - Official reserves at around US$530 billion (as of May 2003). - Government committed ¥15 trillion for bank support. - BoJ program to buy up to ¥3 trillion of bank equity holdings. - DIC deficit: ¥3.4 trillion (end of FY 2002). - DTAs on average exceed 86 percent of city banks’ shareholder equity in March 2003. - Stress-test group-average impacts (selected): - Equity stress (20% decline): city banks 44%; life insurance 45%. - Interest rate stress (100 bps increase): cooperative central banks 72%; life insurance 38%. - Credit risk stress (3% loss on loan book): city banks 94%; regional banks 45%. - Household sector indicators (Disposable income, net percentage change 1997–2001): 2.0 1.0 -0.6 -1.5 -2.9. - Household liabilities ratios (1997–2001): - Liabilities as percent of gross disposable income: 118.3 117.7 117.8 118.6 120.1. - Liabilities as percent of net worth: 17.2 17.6 17.0 17.1 17.6. - Savings rate: 7.8 9.6 9.3 8.2 5.3. - Corporate sector: aggregate debt-equity ratio reported as 175 percent for Japan (1998–2002 tables); total corporate debt to GDP series and debt-equity by firm size preserved in source tables. *Source: _cr03287 - Appendix Tables — https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03287.pdf* ### Appendix Tables ### _cr03287 - Appendix Tables ### Overall stability assessment — financial stability and structural change in a deflationary environment - More than a decade has passed since the bursting of the asset price bubble in Japan; major financial sector weaknesses remain. - Root causes of vulnerability: - Absence of a sustained economic recovery and high corporate sector leverage. - Weak capital position and profitability of banks and life insurers. - Nonperforming loans (NPLs), although declining, remain high. - Significant market and credit risks across financial institutions. - Consequences: - Financial sector weakness has held back prospects for a sustained recovery. - Low growth and continued deflation have: - Constrained bank profitability and exacerbated the bad loan problem. - Added to real debt burdens, raised corporate bankruptcies, and eroded collateral values. - Made it easier for banks to delay recognizing problem loans due to ample liquidity and low interest rates. - Authorities’ actions taken (selected): - Establishment of the Financial Services Agency (FSA). - Government recapitalization of major banks in 1998/99. - Enhancement of the safety net and adoption of a Program for Financial Revival (PFR). - Banks have attempted to improve capital adequacy, raise provisioning, and accelerate NPL disposal. - Systemic risk and policy imperative: - In the short run a systemic crisis seems unlikely given a strong external position and effective government safety nets. - If credibility of government support were questioned, liquidity problems could emerge because of reliance on sizeable short-term domestic funding at very low costs. - Staff view: government intervention is required to address causes (stock and flow problems) and restore health and profitability of the financial sector; staff’s key recommendations summarized in Box 2. ### Key financial system reforms (1996–2003) — Box 1 (selected chronology) - 1996: The “Big Bang” — removal of legal barriers between banks, trust banks, securities firms, and insurance companies; removal of ban on holding companies; temporary comprehensive deposit insurance. - 1997/98: Crisis resolution — three large weak banks resolved; Resolution and Collection Bank (RCB) functions as asset management/realization company. - 1998: Banking law reform — PCA procedures; Financial Supervisory Agency under FRC; inspection manual and self-assessment process; BoJ law establishing an independent central bank. - 1998–99: Bank recapitalization — additional large banks recapitalized and subjected to performance conditions. - 1999: Insolvency law reform under Civil Rehabilitation Law; improved disclosure; RCC created. - 2000: Safety net enhanced; new deposit insurance law; accounting reforms including consolidated accounting and mandatory use of market values for securities; Financial Supervisory Agency renamed FSA. - 2001: FSA takes over FRC functions; Minister for Financial Services established; Accounting Standards Board of Japan created; FILP reforms enacted; special inspections by FSA. - 2002: Comprehensive deposit insurance withdrawn; large time deposits no longer insured; schemes for purchasing bank equity holdings established; Program for Financial Revival published with measures including: (i) new inspection of major banks’ loan classification and provisioning; (ii) introducing discounted cash flow (DCF) methodology for provisioning loans to large “special attention” borrowers; (iii) harmonizing loan classification for large borrowers across banks; (iv) disclosing the gap between major banks’ self-assessment of problem loans and FSA assessment; and (v) external auditing of capital adequacy ratios, starting in FY2003. - 2003: Industrial Revitalization Corporation of Japan (IRCJ) set up; another round of special inspections leading banks to raise external capital and set up asset resolution companies; Japan Post incorporated; Securities and Exchange Law changes introducing a "fit and proper" test on principal shareholders of securities companies and related entities. ### Key policy recommendations — Box 2 (selected, verbatim) - Asset quality and bank capital - Further strengthen banks’ provisioning for NPLs, including by extending the use of forward-looking expected loss estimates. - Limit the use of deferred tax assets in calculating bank capital. - Bank recapitalization - Encourage banks to raise from the markets the additional capital needed to meet requirements due to the stricter treatment of deferred tax assets and provisioning. - Recapitalize those systemically important banks that are unable to raise sufficient capital in the market to at least 8 percent. - Require recapitalized banks to bring in new management. - Raise the minimum capital requirement for domestic banks to at least 8 percent. - Bank governance - Require banks to adopt corporate governance reforms consistent with the Basel Committee’s guidelines, including outside directors and a board audit committee. - Corporate restructuring - Encourage banks to set up subsidiary “work-out” companies. - Develop further the market for distressed debt by having the Resolution and Collection Corporation (RCC) and the Industrial Revitalization Corporation of Japan (IRCJ) serve as a catalyst for transferring impaired assets from the banks to the private sector. - Supervision - Reform the governance of the supervisory process to give the FSA full operational autonomy and confine its responsibilities to supervision. - Provide additional resources to the FSA and continue to enhance its human capital. - Government involvement in the financial sector - Reduce government involvement in the financial sector by restricting the activities of the postal savings and insurance schemes and the government lending agencies. - Staff recommendation summary: - Decisively address both the “stock” problem (weak capital base and poor asset quality) and the “flow” problem (low profitability). - Tackle the stock problem via recapitalization, bad loan restructuring, and tighter supervision. - Address the flow problem by reducing government role in financial intermediation, strengthening corporate governance, and promoting further consolidation. - Cost–benefit view: - Staff believes long-run benefits of reform exceed short-run costs (including possible short-run adverse impact on the economy and use of public funds). ### Banking sector — findings and recommended actions - Asset quality and provisioning - Banks should make more extensive use of forward-looking expected loss estimates rather than rely on historical loss experience. - Low nominal interest rates have eased financing constraints on inherently unprofitable borrowers and complicated borrower viability assessment. - Underprovisioning has hampered transfer of bad assets to the RCC and to the private sector. - Tax authorities should allow provisions required by supervisors to be recognized as a cost for tax purposes (the Tax Commission has proposed examining this issue further). - Capital adequacy - The banking system’s capital cushion has been run down to minimal levels. - Most new capital raised has been in the form of preferred securities and other interest-bearing paper not building stronger balance sheets. - Deferred tax assets now account for more than half of the Tier-1 capital in major banks; their value depends on resumption of taxable profits. - FSA should limit the use of deferred tax assets as regulatory capital. - After limiting deferred tax assets and strengthening provisioning, any systemically important banks unable to raise additional private capital should be recapitalized with public funds to at least 8 percent. - Non-viable banks should be wound down or merged to promote further consolidation. - The minimum capital requirement for domestically-active banks should be progressively raised to 8 percent. - Governance and corporate control - Banks should adopt corporate governance reforms consistent with the Basel Committee’s guidelines, including appointment of qualified outside directors and a board audit committee with a majority of outside directors for major banks. - For banks receiving public funds, require new leadership and a public governance framework to protect management from outside pressures and give a clear mandate for restructuring and reprivatization. - Improvements in governance would develop the market for contested takeovers and facilitate consolidation; government actions in the Resona case to adopt the new committee system are encouraging. - Competition and government involvement - Japan Post (the largest deposit taker in the world) and government financial institutions reduce private banks’ ability to compete; they benefit from subsidies and limited prudential supervision. - Government should gradually run down involvement in financial intermediation by restricting activities of postal savings and insurance schemes and government lending/guarantee agencies. - Consolidation prospects - Despite exit of many banks, there remain more than 100 regional banks and many cooperative institutions. - Slow consolidation reflects adherence to existing business models, relative financial weakness, cross-holdings, and limited value of deposit franchises in a zero interest rate environment. - Comprehensive reforms are expected to accelerate consolidation and improve profitability. ### Life insurance sector — vulnerabilities and supervisory actions - Stress drivers: - Declines in investment income and stock prices have weakened insurers’ capital bases. - Large decline in equity prices has lowered solvency margins for a number of life insurers, though all still remain above the regulatory minimum. - “Negative spread” problem: investment returns below guaranteed yields to policyholders, producing losses offset so far by expected gains from lower mortality and expenses. - Recommended actions: - Require life insurers and their actuaries to revalue policy liabilities to account for currently lower investment returns. - Require insurers to set aside deficiency reserves against known losses on investment returns. - FSA should strengthen solvency margin calculations, taking into account internal risk-based formulae used by life insurance companies. *Source: _cr03287 - Appendix Tables — https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03287.pdf* ### 13. The financial structure of the corporate sector in Japan has potential systemic ### 13. The financial structure of the corporate sector in Japan has potential systemic implications not present in other G-7 countries ### Corporate sector financial structure and systemic implications - The corporate sector is highly leveraged, and deflation has increased the real burden of debt. - The share of Japanese corporate financing provided by banks exceeds that of most G-7 countries. - As a result, the financial sector is more directly exposed to weaknesses in the corporate sector. - The relatively small corporate bond market and still high degree of cross-shareholding deter structural change. - Further development of capital markets and healthy banks would: - promote investor activism; - enhance discipline; and - strengthen the position of creditors in the corporate restructuring process. ### Corporate governance developments and remaining weaknesses - Recent improvements: - raising Japanese standards for accounting to near international best practices; - strengthening of the accounting and auditing framework; - revision to the Commercial Code in April 2003 giving corporations the option of a governance structure with a majority of outside directors. - Remaining issues: - low level of shareholder activism; - few outside directors; - need for greater transparency. - Policy implication: - Further development of capital markets would help promote investor activism; healthy banks would enhance creditor discipline in restructuring. ### Supervisory, transparency, and market-integrity framework - Establishment of the FSA in July 2000 was a key organizational step in strengthening and integrating financial sector supervision. - Remaining desirable improvements: - The lack of a board creates scope for the FSA to be subject to political and industry pressures. - The FSA staff is relatively small and needs to strengthen experience in some areas, in particular in insurance. - The FSA, operating an inspection-based system, should make greater use of external auditors of financial institutions given pressure on its resources. - Formalization of arrangements for exchange of information between the FSA and the Bank of Japan (BoJ) and other regulatory bodies would increase efficient use of specialist skills. - Deposit insurance: - Staff agrees with the authorities’ decision to defer for two years the complete withdrawal of the remaining component of the blanket guarantee earlier scheduled for April 2003. - The decision envisages an indefinite unlimited guarantee of a subset of demand deposits. - Lender-of-last-resort and crisis management: - The BoJ’s lender of last resort facilities appear to work well. - Cooperation on crisis management between the BoJ and the FSA is satisfactory. - Noted uncertainty whether modifications to the framework are necessary under the new partial deposit insurance regime effective in April 2002, where confidence factors and demands for emergency liquidity might arise more frequently and quickly. - Other elements: - Payment, clearing, and settlement arrangements strengthened, including implementation of a real-time gross settlement mode in the main system. - Overall transparency with respect to monetary and financial policies is in line with international good practice. - A preliminary and partial review of the AML/CFT framework did not reveal major issues; a full AML/CFT assessment planned for the fall of 2003. - Public debt management practices are consistent with existing international practices, though there is some room to strengthen the risk management framework. ### Macroeconomic environment: recent developments and implications for financial stability - Growth and labor/firm outcomes: - Since the bursting of the asset price bubble in 1990/91, the economy has entered a prolonged slowdown. - During 1991–2002, growth rates averaged only 1 percent per annum, compared to 4 percent per annum in the 1980s. - Unemployment and corporate bankruptcies have reached post-war record highs. - Deflation continues unabated; equity prices and land values remain weak. - In 2002, Japan recovered from its deepest recession in four decades, but growth slowed during the year and the economy is expected to remain broadly flat in 2003. - Policy effectiveness and fiscal concerns: - Despite a series of fiscal stimulus packages, unprecedented monetary easing, and deregulation initiatives, the economy has failed to break out of its slump. - Increases in base money have not fed into broader monetary aggregates or stopped the five year decline in bank lending. - Continued fiscal deficits have fed a rapidly growing government debt which is now the highest among industrial countries and have raised concerns over the sustainability of fiscal policy. - External position: - Official reserves at around US$530 billion (as of May 2003). - Japan is a major net external creditor and enjoys sizable current account surpluses. - Financial structure characteristics: - The Japanese financial system is bank centered; the banking sector is fragmented and profitability is low. - Major banks, including the trust banks, account for about one quarter of total financial system assets. - Extensive cross-shareholding and relationship-based shareholding within the financial sector and between financial and nonfinancial institutions. - The public sector plays a larger role in financial intermediation than in other major OECD countries. - The Japan Post (largest deposit taker in the world) takes deposits, offers payment services and life insurance products, and channels funds via the Fiscal Investment and Loan Program (FILP). - Other government financial institutions have a market share of 20–40 percent in various lending markets. - Insurance sector: - Japanese insurance companies historically funneled household savings to the industry sector and the government; roughly 95 percent of households have life insurance policies. - Postal Insurance System (“Kampo”) is one of the largest insurance businesses, controlled by the Japan Post. - The insurance industry has been shrinking for two decades reflecting reductions in investment income, sharp fall in securities values, and demographic trends. ### Macroeconomic links to financial stability: liquidity, NPLs, and credit flow - Banking system impact: - Prolonged slowdown has weakened the banking system, constrained profitability, and exacerbated the bad loan problem. - Although banks have disposed of more than ¥90 trillion in nonperforming loans (16 percent of GDP) since 1992, official NPLs, gross of provisions, still account for over 8 percent of outstanding loans (as of September 2002) as new problem loans continue to emerge. - Major banks raised about ¥2 trillion, mainly in preferred shares, early in 2003. - Effects of abundant liquidity and low nominal interest rates: - Low nominal interest rates have made it easier for banks to delay recognizing problem loans. - BoJ quantitative easing and continued deflation pushed down rates along the yield curve to near-historic lows, flattening the yield curve and making maturity transformation less profitable. - Abundance of liquidity and low funding costs have allowed many weak banks to continue operating, holding back profitability and consolidation. - Bank behavior and macro transmission: - Banks have limited capacity to accept risk, curtail loans, and switch to risk-free assets such as JGBs and cash reserves. - Impaired banking system and corporate debt overhang have undermined the effectiveness of monetary policy; despite expanding liquidity bank lending continues to decline. - Corporate restructuring impediments: - Banks lack capital to write-down problem loans and thus face little incentive to liquidate nonviable firms or enter into workout agreements. - Nonviable firms remain with banks and prolong excess capacity and deflationary pressures, delaying recovery. ### Banking: fragility, profitability, and asset quality - Sources of fragility: - Continuing asset quality problems including large NPLs, weak capital base, exposure to the stock market ("the stock problem"). - Lack of underlying profitability ("the flow problem") preventing banks from dealing with asset quality issues and eroding the capital base. - Market indicators and ratings: - Bank liabilities may have relatively high ratings (long-term deposits are, on average, rated by Moody's at A3-Baa1) largely attributable to the safety net. - The average of Moody's financial strength ratings for Japanese banks is between D- and E+, while other G-7 banking systems have average ratings in the A- to C+ range. - Bank profitability and rate of return on equity are considerably lower than in other G-7 countries. - Persistence of unprofitability: - Low profitability likely to persist while the economy remains stagnant due to weak corporate sector, small net interest margins, competition from the public sector, many competing institutions, and governance weaknesses. - Some banks improved return on equity by shifting to personal lending, but systemic improvement requires sustainable growth. - Asset quality recognition and supervisory actions: - Asset quality deterioration is not yet fully recognized in banks’ assessment process, per FSA examinations. - FSA has been harmonizing classification of large borrowers across banks in 2003 and introduced the discounted cash flow approach to “special attention” loans to large borrowers in March 2003. - Room for further improvements in NPL recognition, particularly among smaller banks. - Debt-service delinquencies and provisioning: - Low nominal interest rates allow nearly insolvent borrowers to service debt, weakening the effectiveness of debt service delinquencies as early-warning indicators. - BoJ research suggests provisions and write-offs are likely to continue to average some one percent of risk assets a year. - The BoJ noted that "the current amount of provisioning is unlikely to cover the reduced economic value of NPL." - Quantitative indicators cited in text (preserve exactly as presented): - Banks have disposed of more than ¥90 trillion in nonperforming loans (16 percent of GDP) since 1992. - Official NPLs, gross of provisions, still account for over 8 percent of outstanding loans (as of September 2002). - Major banks raised about ¥2 trillion, mainly in preferred shares, early in 2003. - Official reserves at around US$530 billion (as of May 2003). - Nonperforming loans and other indicator series are presented in tables and charts within the source (1997–2002 series, solvency ratios, growth rates, ROE/ROA comparisons, and time series for bank lending 1990–2002). ### Policy implications and recommended focuses - Strengthen FSA capacity and governance: - Consider board governance to reduce susceptibility to political and industry pressures. - Expand staff experience, notably in insurance supervision. - Make greater use of external auditors given limited FSA resources. - Formalize information exchange arrangements between FSA, BoJ, and other regulators. - Deposit insurance and crisis preparedness: - Monitor effects of deferred withdrawal of blanket guarantee components and indefinite unlimited guarantee of a subset of demand deposits. - Assess whether modifications to lender-of-last-resort and crisis frameworks are needed under partial deposit insurance regime effective April 2002. - Improve NPL recognition and bank balance-sheet repair: - Continue harmonization of loan classification and extend the discounted cash flow approach for large borrowers. - Encourage provisioning and capital strengthening to enable meaningful corporate restructuring. - Promote capital-market development and corporate governance: - Develop corporate bond markets and reduce cross-shareholding to foster investor activism and better pricing of risk. - Address macro-financial linkages: - Recognize that sustained economic growth is central to improving bank profitability and enabling consolidation and restructuring. *Source: _cr03287 - 13. The financial structure of the corporate sector in Japan has potential systemic implications not present in other G-7 countries* ### 34. An additional problem has been the lack of incentives for banks to deal with ### _cr03287 - 34. An additional problem has been the lack of incentives for banks to deal with ### Asset resolution, work-outs, and NPL targets - Finding: Banks have lacked incentives to dispose of problem assets once provisioned; reluctance to sell collateral partly because funding costs are so low. - Government action: Authorities have begun to exert pressure on banks to “dispose” of these assets by putting borrowers into insolvency proceedings, restructuring them, or selling written down claims to the market or to the RCC. - Progress: The FY 2002 results of major banks indicate that they are on track to meet the target of halving NPL ratios by end-March 2005. - Recommendation: Bank work-out subsidiaries staffed with appropriate expertise could improve asset quality and enhance corporate restructuring; such subsidiaries could be sold, merged, or have shares issued to bank shareholders. Some major banks have already established such units, sometimes as joint ventures. ### Provisioning and loan valuation - Policy change: The FSA now recommends that banks base loan valuation on the cash flow borrowers will generate (the cash flow approach). - Mechanism: Banks must establish what the borrower could pay (the economic value as the BoJ puts it), agree a new contract, and provision down to its net present value. - Effects observed: The BoJ reported in 2002 that some banks were beginning to recognize deterioration sooner; the “special inspection” process has helped, reflected in higher provisioning levels for “needs special attention” borrowers of major banks in FY 2002. - Recommendation: More aggressive provisioning would improve balance-sheet quality and accelerate corporate restructuring. ### Equity holdings and market valuation risk - Finding: A large share of quoted equity securities on bank balance sheets made up a cushion when market value exceeded book value; that has ceased to be the case and marked-to-market declines flow straight through to equity. - Regulatory action and support: - Banks are required to reduce equity holdings to no more than Tier-1 capital by September 2004. - The BoJ’s program to buy up to ¥3 trillion of these holdings at market prices, but off the market, is helping banks meet the FSA’s required limits, though it will only marginally reduce total exposure to the equity market. - Progress: Major banks have used these arrangements and market sales to make substantial progress; on average the major banks have now reached the target level already. - Residual concern: Even at target levels, exposure to the equity market remains unusually large for banks. ### Deferred tax assets (DTAs) and bank capital - Finding: Deferred tax assets now represent about half of the major banks’ Tier-1 capital. - Nature of DTAs: Deferred tax assets are credits against taxes on future taxable income; much of outstanding DTAs are due to losses carried forward because banks have paid little taxes on income for several years. - Limitations: DTAs are usable only to the extent the bank makes profits and are not available to meet losses in the event of bank failure. - Recommendation: Staff recommends limits on the inclusion of deferred tax assets in regulatory bank capital—proposes adopting an approach similar to the United States where regulators limit DTAs to the lesser of 10 percent of Tier-1 capital or one year’s profits. ### Composition of capital and provisioning treatment - Finding: Banks have largely issued preferred securities and other interest-bearing instruments treated as Tier-1 capital rather than ordinary shareholders' funds; this does not generate wider ownership of bank equity. - Capital accounting concern: Specific and general provisioning regulations overstate bank capital. Provisions in respect of category II loans (“needs attention” and “needs special attention”), treated as general provisions, should not be included in Tier-2 capital because they are largely raised in respect of specific assets. - View: This practice is not consistent with the Basel Capital Accord. ### Stress test results and vulnerabilities (summary of IMF staff stress tests) - Sample: 7 city bank financial groups, 21 regional banks, 2 central banks of credit cooperative financial institutions, and 10 life insurance companies; represents 56 percent of total bank/cooperative assets and 86 percent of life insurance assets. Data used: end-March 2002 annual report data. - Market-risk shock parameters: - Equity stress: 20 percent decline in equity prices. - Interest rate stress: 100 basis points increase in yields. - Credit-risk shock parameters: - Banks: 3 percent credit loss on loan book. - Life insurers: 1.5 percent credit loss on loan book. - Measurement: Loss-bearing capacities measured against shareholder equity value gross and net of DTAs; for insurers measured against shareholder equity and selected reserve account balances. - Findings: - A combination of interest rate and equity stresses could challenge risk-bearing capacity in many institutions. - Credit risk is significant for weakly capitalized institutions under a scenario mirroring recent loan loss experience. - Regional banks are better capitalized relative to combined market risk stresses but remain highly exposed to credit risks. - Measured by loss-bearing capacity of shareholders’ equity, the Japanese banking system is undercapitalized relative to interest rate, equity price, and credit risks. - Measures of risk-bearing capacity worsen when the limited loss-bearing capacity of DTAs is recognized. - Results highlight the importance of government safety nets and the need to strengthen bank capital bases. - Group-average stress-test summary table (as presented): - equity stress: 20% decline in prices - interest rate stress: 100 bps increase in yields - credit risk stress: 3% credit loss on loan book (1.5% for life insurers) ### Need for recapitalization: rationale and proposed framework - Finding: Once banks are fully provisioned and recommended adjustments to capital are made, minimum requirements would not be met in many cases. - Illustration: If deferred tax assets were to be deducted from capital for major banks, then their average Tier-1 ratio as of March 2003 would fall from 5 percent to around 2 percent. - Recommendation (staff): - Government should develop a plan to recapitalize the banking sector expeditiously despite possible short-run economic costs and use of public funds. - The plan should be publicly announced and be on offer to all systemically important banks whose capital ratios fall below 8 percent. - All elements should be fully transparent to preclude vested interests. - As a result of actions to increase provisions and to limit DTAs, systemically important banks unable to raise sufficient capital in the market within a prescribed time should be recapitalized with public funds to at least 8 percent. - If Tier-1 capital is below 4 percent, the government would convert its existing holdings of preferred shares into equity and subscribe additional equity to bring the banks' Tier-1 ratio up to 4 percent, thereby diluting existing shareholders’ stake. - Additional injections to bring the total ratio to at least 8 percent could take the form of Tier-2 capital. - The scheme should mandate establishment of asset management companies by banks that have not already done so. - The plan would extend the prompt corrective action framework where banks cannot access private markets. - Conditionality and governance: - Government recapitalization should include profitability targets to hold management accountable. - Conditionality could require adoption of corporate governance reforms consistent with Basel Committee guidelines. - A governance framework should allow the DIC and the RCC to exercise the government’s role as principal shareholder transparently and effectively, including selection of directors based on shareholding (the government might hold a majority). - Bank management should be given a clear mandate to restructure operations in preparation for reprivatization, be protected from outside pressures, and be held accountable. ### Case example: Government rescue of Resona Bank (Box 5) - Dates and legal basis: - On May 17, 2003, the government announced a recapitalization of the Resona Group by the Deposit Insurance Corporation (DIC) under Article 102 of the Deposit Insurance Law. - Triggers: - Auditors refused to sign off on initial accounts, insisting DTA was overstated. - Revised accounts reduced group capital ratio to 3.8 percent (below the minimum of 4 percent); in September 2002 the ratio had been 7.8 percent. - Measures and outcomes: - The DIC recapitalization was aimed to bring capital adequacy ratio well in excess of 10 percent. - The BoJ agreed to provide liquidity support if funding difficulties arose; this proved unnecessary. - Resona submitted a business revitalization plan with salary cuts and departure of about 70 senior management. - Shareholders approved a capital reduction to cover losses and substantial board changes: new independent chairman and non-executive directors forming a majority of the board. - New capital (mainly voting preference shares but also including ¥0.3 trillion of ordinary shares) amounts to approximately ¥2 trillion and gives the government more than 70 percent of the votes. - The group must publish new business plans and make periodic progress reports; the new Board commissioned a separate audit firm to reassess assets to update business plans. *Source: IMF staff report (content unit _cr03287).* ### 47. It is advisable not to include conditions which are not conducive to increasing ### 47. It is advisable not to include conditions which are not conducive to increasing ### D. Bank Governance and Capital Adequacy - Recommendation: Avoid imposing conditions on recapitalized banks that reduce their profitability (example: compulsory lending quotas to SMEs can: - Put pressure on banks’ margins, - Increase banks’ risk profile, - Distort credit allocation). - Board and audit governance recommendations: - Require banks to appoint well-qualified outside directors. - Require the board audit committee to consist solely of outside directors, or at least have a majority of outside directors with the chairman drawn from that group. - Audit committee responsibility: recommend appointment of the external auditor or independent accounting firm. - Internal auditor should report to the audit committee. - Capital adequacy recommendation: - Staff view: all banks should be subject to the 8 percent minimum capital requirement. - Current regime: “domestic banks” subject to a capital adequacy ratio of 4 percent; “internationally active” banks subject to 8 percent. - Authorities’ position: Basel Capital Accord considered to apply only to internationally active banks (term not defined); average capital ratios across bank groups exceed 8 percent though some banks fall below it. - Staff proposal: raise minimum capital requirement for domestic banks to 8 percent, with phased implementation over a period of years to minimize disruption. - Numeric values preserved: "8 percent" and "4 percent". ### E. The Market for Distressed Debt - Role for RCC (Resolution and Collection Company): - Purchase impaired assets from banks and transfer them quickly to the private sector. - Facilitate transfers by purchasing company debt from various creditors and repackaging for quick sales (auctions or securitized assets). - RCC mandate: purchase NPLs at realistic and fair market prices to promote transparency and create incentives for restructuring or bankruptcy procedures. - Caution: RCC should avoid crowding out the private sector in purchasing NPLs. - Reasons for constrained supply of distressed debt: - Underprovisioning by banks (leading to pricing gaps). - Insufficient capital to absorb further losses. - Banks’ close relationships with borrowers. - Creditor coordination difficulties. - Low carry costs with the fall in interest rates. - IRCJ (Industrial Revitalization Corporation of Japan): - Began operations in June 2003. - Plans: purchase distressed loans from non-main banks and, with the main bank, help companies restructure. - Purchase policy: buy loans at fair market value taking into account assessment of the company’s rehabilitation program. - Governance safeguards recommended: - Operate free from political interference aimed at keeping nonviable firms alive. - Limit the period between purchase and sale of loans as much as possible. - Be subject to strict transparency rules, including reporting progress in recovering public funds. ### IV. PUBLIC SECTOR FINANCIAL INTERMEDIATION AND OTHER FINANCIAL INSTITUTIONS A. Public Sector Financial Institutions - Assessment: Long-term public sector involvement has held back financial system development by undermining market competition through special privileges. - Examples and effects: - Japan Post: - Offers deposits, a payment system, and life insurance products. - Does not participate in the deposit insurance system and benefits from an explicit government guarantee. - Subject to a social obligation to maintain a nationwide network (including unprofitable areas). - Not required to earn a return on capital employed; postal savings account suffered substantial losses in recent years. - Government Financial Institutions (GFIs): - Offer long-term loans with low fixed interest rates. - Benefit from explicit and implicit government guarantees and favorable regulatory and tax regimes. - Most GFIs are not subject to key prudential regulations as in the private sector, do not pay dividends to the government, and are exempt from most taxes. - Securities market impact: - Direct lending by the Government Housing Loan Corporation (GHLC) has impeded development of a mortgage-backed securities market. - Development Bank of Japan and JBIC extend loans to listed large companies able to raise funds from the corporate bond market. - Reform recommendation for Japan Post: - Gradually downsize operations to minimize disruption by phasing in a reduction of maximum limits on its products and subjecting Japan Post to the same regulatory and tax treatment as private financial institutions. - Post-downsizing options: - Refocus: stop accepting new accounts in local areas where it competes with the private sector; limit to basic services for small depositors in underserved local areas; offer branch network services to the private sector for a fee. - Or privatize. B. Insurance Sector - Life insurance: - Recommendation: life insurance companies and actuaries should establish appropriate policy reserves for all policies taking into account current investment returns and other conditions. - FSA should not permit discounting policy reserves using interest assumptions that exceed current actual investment returns. - Insurers should be encouraged to revalue policy liabilities to account for lower current investment returns. - Require insurers to set aside deficiency reserves against known losses on investment returns. - Legislation note: recent legislation provides an out-of-court mechanism to permit insurers to reduce guaranteed yields with approval of a high percentage of policyholders before bankruptcy; combining restructuring flexibility with tightened solvency standards is desirable. - Risk exposures and solvency: - Quantitative analyses: many life insurers have large exposures to equity market risk and, to a lesser extent, interest rate risk relative to their capital. - A number of life insurance companies would have difficulties absorbing a combination of market stresses with available core capital and reserve accounts. - DTAs (deferred tax assets) in many life insurers compromise loss-bearing capacity. - FSA solvency tests shortcomings: - Solvency ratios using FSA-prescribed tests do not convey accurate financial health. - Companies’ internal assessments show they do not possess the substantial margins indicated by the FSA formula. - FSA should review its formula, including risk weights used to calculate risk amounts and liabilities that qualify as solvency margin. - Derivative markets: - FSA should limit insurance company participation in derivatives to prevent speculative risk-taking; enforce exposure limits until insurers’ internal risk control and management systems are adequately developed. - Nonlife insurance: - Heavy concentration in domestic property requires careful monitoring. - Risk of a serious natural disaster or a string of disasters could cause considerable industry damage through claims and asset value losses. - FSA should monitor risk management and use experienced (re)insurance experts. C. Pension Funds - Funding status and concerns: - Public pensions are now funded only about 20–25 percent, implying a major intergenerational transfer from current working population to retirees. - Non-payment of contributions to the national pension scheme has reached about 25 percent and is rising. - Recommendations to restore confidence: - Keep funding under review and evaluate liabilities alongside assets using a range of discount rates. - Introduce additional checks and balances to remove undue political influence over investment policy. - Set up an independent professional body to develop an investment policy for public pension fund assets. - GPIF (Government Pensions Investment Fund): - Displays a high degree of transparency and has contributed to corporate governance through commitment to shareholder rights. - Recommendation: clarify GPIF’s future status and strengthen operations, including hiring more staff with investment experience. D. Securities Firms - Assessment: - Risks of a systemic crisis from the securities sector appear limited based on available data and supervisory improvements. - Contributing factors to limited systemic risk: - Small share of financial assets held by the securities industry (around 3 percent). - Industry accustomed to large turnover over the past 5 years. - Improvements to payment and settlement systems and expansion of the investor safety net. - Enhanced supervision by the FSA, the SESC, and self-regulatory organizations; crisis management framework in place. - Caveat: assessment does not include off-balance sheet liabilities. - Authorities’ point: introduction in FY 2003 of an external audit requirement on separation of clients' assets and a principle-based approach to off-balance sheet transactions reduces risk of unexpected large off-balance sheet liabilities. ### V. FINANCIAL MARKETS, HOUSEHOLD AND CORPORATE SECTORS A. Financial Markets — key issues and vulnerabilities - Market stress drivers: weak economy, 1997–98 financial crisis, ongoing structural changes in corporate and financial sectors. - Key concerns: - Low short-term interest rates have sharply dampened activity in the interbank call market, making early signs of distress harder to observe and increasing the need to monitor participants and reactivate the market. - Relatively small markets for direct financing (corporate bonds, syndicated lending) leave banking system exposed to corporate sector weaknesses and vice versa; improvements in corporate governance would help develop these markets and shift away from relationship-based lending. - Ownership of JGBs is relatively concentrated; market concerned over possible sharp increase in JGB yields, relying more on BoJ and other large public holders to preserve stability. - Structural change implications: - Continued effects from the Big Bang (started in 1996) likely to pressure banks on lending (as corporates use direct financing) and on deposits (as investors’ risk appetite recovers). - Positive effects: improved credit risk pricing as high-risk lending markets expand and new risk-management instruments develop. B. Household Sector — condition and vulnerabilities - Overall assessment: Japanese household indebtedness appears in line with ability to pay. - Trends: - Total household wealth declined sharply during the 1990s due to the bursting of the land price bubble and declining personal savings. - Compared to other G-7 countries, Japanese households’ financial assets remain large. - Households now have more than half of financial wealth in currency and deposits; high liquidity reduces household vulnerability, shifting private sector vulnerability mainly to corporations and banks. - As Japan becomes more capital-market oriented, households will likely shift assets away from deposits in search of higher risk-adjusted returns. - Selected Financial Soundness Indicators for the Household Sector, 1997–2001 (In billions of yen, end-December, unless otherwise indicated) — selected items preserved exactly as presented: - Disposable income, net (percentage change): 2.0 1.0 -0.6 -1.5 -2.9 - Liabilities as percent of gross disposable income: 118.3 117.7 117.8 118.6 120.1 - Liabilities as percent of net worth: 17.2 17.6 17.0 17.1 17.6 - Liabilities as percent of financial assets: 29.8 29.9 27.7 27.5 27.6 - Savings rate: 7.8 9.6 9.3 8.2 5.3 - Sources: Nomura Research Institute and staff calculations. C. Corporate Sector — distress and leverage - Core vulnerability: corporate distress is central to systemic vulnerabilities due to linkage between corporate distress and bank NPLs — restructuring of one requires restructuring of the other. - Progress and remaining issues: - Important progress made in reducing corporate leverage in recent years, largely via deleveraging of medium and large firms. - Small firms, with the weakest earnings, remain more highly leveraged than larger firms. - Comparative statistics and observations: - The nonfinancial corporate sector aggregate debt-equity ratio reported as 175 percent for Japan (almost double that of the next highest country, Germany). - Corporate bank borrowings to GDP are much higher in Japan compared to other G-7 countries, increasing risk to real activity. - Financial sector size: ratio of financial intermediary assets to GDP is the highest of G-7 countries except the U.K., implying financial sector stress has important real-sector implications. Italic: IMF staff report content as provided in the source document. ### 66. The traditional corporate governance system in Japan impeded restructuring ### _cr03287 - 66. The traditional corporate governance system in Japan impeded restructuring ### Corporate governance and restructuring - Findings: - Shareholders had substantial power over boards of directors on paper, but did not have effective control due to obstacles to their involvement. - Boards combined the executive and shareholder functions but were often ineffective owing to dominance by insiders. - This structure slows the pace of restructuring, prevents amelioration of systemic risk, and impedes efficient resource allocation. - Enhanced market incentives for corporate management to improve governance need to be introduced for legal and regulatory measures to have full effect. - Developments and measures: - Corporate ownership structure is becoming more balanced with less bank control and cross ownership and a bigger share of individual and foreign ownership. - Shareholder rights are assuming greater importance and growing institutional shareholder activism is a positive development. - Boards still include relatively few outside directors, but the revision to the Commercial Code which took effect in April 2003 gives corporations the option of a specific governance structure with a majority of outside directors and could be an important step forward. - Standards for accounting have been brought toward international best practices and the accounting and auditing infrastructure is being enhanced. - Recommended further measures: - Development of takeover markets. - Steps to promote greater shareholder activism. ### Legal framework for corporate insolvency - Findings: - The Japanese authorities’ initiative in reforming the insolvency laws is commendable; the system now generally works quite well. - Despite recent legal reforms the framework remains complex and invites noncooperative behavior by debtors and creditors. - Further developments are warranted to expand tools for alleviating over-indebtedness in the corporate sector and to serve prospective needs of the economy. - Recommendation: - Amend insolvency laws to foster a more active role for creditors in resolving corporate debt problems. - Specifically, provide that the costs incurred by creditors’ committees shall be borne by the debtor as an administrative expense of the proceeding. - Observed creditor behavior: - Creditors typically defer to the debtor company’s management and the “main bank” during deterioration and then rely on the court-appointed administrator after insolvency proceedings are initiated. ### Japan: Selected Financial Soundness Indicators for the Nonfinancial Corporate Sector, 1998-2002 - (In percentage, end-March, unless otherwise indicated) - Capital Structure (1998 1999 2000 2001 2002): - Debt-equity ratio4.04.23.52.93.0 - Large-size firms (capital > 1 billion yen)2.42.32.22.02.1 - Medium-size firms (1 billion yen > capital>10 million yen)6.36.65.03.84.1 - Small-size firms (capital < 10 million yen)9.010.210.49.311.4 - Total corporate debt to GDP 108.6112.4100.994.494.5 - Share of short-term debt in total 43.139.941.841.242.3 - Profitability (1998 1999 2000 2001 2002): - Return on asset (pre-tax) 2.11.62.12.82.3 - Return on equity (pre-tax) 10.78.39.510.98.9 - Market-based indicators (1998 1999 2000 2001 2002): - # of bankruptcies per year17,439 17,49716,88718,92620,052 - Bankruptcies liabilities (% of total corporate liabilities)1.41.41.12.7... ### Supervision and the Financial Services Agency (FSA) - Progress and capacity: - The FSA has made immense strides since establishment a few years ago; resources expanded and new skills recruited; ability to assess risk management increased significantly. - Issues requiring early attention / recommendations: - Enhance FSA autonomy: establish a board with outside members to whom the Commissioner could be accountable; legal clarity that neither the Prime Minister nor the Minister for Financial Services should decide on individual supervised institutions except where public money is involved. - Modify frequent rotation system to enhance specialization and recruit those with private sector experience. - Increase supervisory/inspection staff including actuaries and reinsurance specialists; noted that first three actuaries and a reinsurance expert have joined since the FSAP mission. - Give greater statutory force to corporate governance requirements currently in guidelines and inspection manuals. - Require banks and insurance companies to establish audit functions with at least half of members drawn from independent persons (use government actions with respect to Resona as a model). - Limit FSA responsibilities to prudential supervision; devolve responsibility for auditing standards to a body outside the FSA with private sector participation. - Make greater use of external auditors; authorize auditors to communicate findings to supervisors and report on internal controls. - Provide legal authority in the insurance sector for the FSA to delegate on-site inspection functions totally or partly to third parties (independent actuaries, auditors). - Formalize arrangements for exchange of information with the BoJ and other regulatory bodies to avoid duplication and increase use of specialist skills. ### Insurance sector and investment limits - Recent liberalization: - Marketing of insurance products now requires only notification to the FSA rather than approval. - Insurers free to set premium rates and distribution channels liberalized so life and non-life insurers can compete and banks can sell some insurance products. - Policy form approvals streamlined; companies file new policy form proposals but FSA will not insist on approval before policies are sold. - Recommendations: - Impose limits on certain investments in the insurance sector. - Limit use of derivatives to hedging purposes. - Impose limits on a single exposure (e.g., a specific real estate project) and on aggregate counter-party exposures. ### Safety nets, deposit insurance, and lender-of-last-resort - Findings and policy stance: - Safety net arrangements are well-developed and broadly appropriate. - Postponement of full implementation of the limited deposit insurance scheme from April 2003 reflects continuing fragility of the banking system. - Deferral of withdrawal of the remaining component of the deposit insurance blanket guarantee in April 2003 buys time and envisages a permanent unlimited guarantee of a subset of demand deposits. - Insurance premia expected to be higher on deposits with unlimited coverage; full coverage effectively becomes voluntary. - Staff believes credibility of deposit insurance would be enhanced if the DIC’s deficit (¥3.4 trillion as at the end of FY 2002) were to be written off by the government. - Lender-of-last-resort and crisis management: - BoJ’s last resort facilities appear to work well; cooperation between BoJ and FSA satisfactory. - Resona case handled effectively. - Further modification of facilities may be necessary given the new deposit insurance regime initiated in April 2002 whereby depositors can incur losses. - Bank resolution framework: - Refined several times; recommendation for more formal arrangements for enhanced exchange of information at the pre-crisis stage among the FSA, BoJ, and DIC. ### Payment system and securities settlement - Reforms and improvements: - Implementation of real-time gross settlement in the BoJ-NET Funds Transfer System. - BoJ established the Payment System Forum and enhanced public communication of systemically important payment systems and BoJ roles. - New Law concerning Book-Entry Transfer of Corporate and Other Debt Securities went into effect January 2003, enhancing uniformity for debt securities. - Japan Securities Clearing Corporation took over as central counterparty from the stock exchanges in January 2003. - Remaining risks and recommendations: - Apply a uniform legal framework to stocks as well as debt securities. - If shift to dematerialization is slow, actions may be necessary to avoid risks and costs from coexistence of different custodian practices and paper-based settlements. - Encourage extensive use of planned DVP facilities to cover possibly all kinds of assets and transactions. - Increase ongoing oversight and more effective daily monitoring of private securities settlement systems and market practices of major custody and liquidity providers. ### Public debt management - Findings: - Public debt management practices are consistent with existing international practices. - Coordination is well established; authority to borrow rests on a clear legal base; institutional framework provides clear roles; MoF manages debt in a transparent and predictable manner. - Recommendations: - Expand risk management framework: employ quantitative models for calculating risk in the debt portfolio and analyze trade-offs between risks and expected costs. - Use specialized risk analysis based on modern portfolio theory to inform alternative debt strategies. - Allocate adequate resources and technical infrastructure for risk analysis. - Closely monitor risk exposure implicit in government guarantees. ### Transparency - Findings: - BoJ’s observance of the IMF Code of Good Practices on Transparency in Monetary and Financial Policies meets a very high standard. - BoJ uses multiple disclosure means (Japanese and English): outlines of discussion of Monetary Policy Meetings, transcripts later, semi-annual reports to the Diet, Annual Review (in English), annual Outline of Business Operations (in Japanese), press releases, press conferences, public consultations, speeches, and a user-friendly website. - The respective Japanese authorities broadly observe the financial policy section of the Transparency Code; statutes are modern and state objectives/responsibilities clearly. - FSA and BoJ produce substantive annual reports and regular documentation and describe activities through frequent press conferences and speeches; senior officials account frequently to the Diet. - DIC has explained the deposit insurance scheme and depositor protection extent extensively. ### Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) - Review and recent developments: - A partial review of legal and institutional framework for AML/CFT was conducted; a full assessment culminating in a ROSC will be undertaken in fall of 2003. - Positive developments: money laundering related to drug offences criminalized in 1992 via Narcotics Special Law; POCL (February 2000) broadened predicate offences; financing of terrorism criminalized in 2002; terrorist financing added to predicate offences. - Law on Customer Identification and Record Retention (January 2003) established customer identification and record keeping for financial institutions. - Reporting and JAFIO: - Banks, foreign exchange dealers, insurance and securities companies report directly to the Japan Financial Intelligence Office (JAFIO); other institutions report suspicious transactions to primary regulators who forward reports to JAFIO—this indirect process impedes timely reporting and further streamlining is recommended. - JAFIO analyzes suspicious transaction reports and disseminates to law enforcement. - JAFIO has routine access to information from the FSA; access to administrative and law enforcement information is limited. - Recommendations: - Grant JAFIO greater access to administrative and law enforcement information to support analytical capabilities. - Increase staffing for JAFIO. *Source: _cr03287 - 66. The traditional corporate governance system in Japan impeded restructuring* ### 1. This assessment of observance of the Basel Core Principles for Effective Banking ### This assessment of observance of the Basel Core Principles for Effective Banking Supervision ### Assessment basis and process - Conducted on the basis of the Core Principles Methodology of October 1999. - The assessment examined the degree of observance of each of the essential criteria and the additional criteria where the assessors judged that necessary. - Assessment team: William Ryback, Federal Reserve Board; Stefan Spamer, Deutsche Bundesbank; Tarisa Watanagase, Bank of Thailand (October 2002). - The Financial Services Agency (FSA) and the Bank of Japan (BoJ) cooperated fully and provided documents and oral explanation. - Discussions were held with commercial bankers, bankers’ association representatives, accountants, and other market participants. ### Institutional and macroprudential setting: market structure overview - The Japanese financial system is bank centered, with segmentation among different types of financial institutions and structural cross-shareholdings. - Trust banks provide asset management services as well as conventional bank functions; some commercial and foreign banks have de novo trust bank subsidiaries. - Post-bubble developments: - Real estate and equity bubbles burst in the early 1990s, leading to declining capital positions and rapid rise in nonperforming assets due to exposure to real estate. - Authorities responded with an explicit guarantee of bank liabilities (in practice extended to subordinated debt liabilities). - Consolidation and market composition: - Following mergers in the 1990s, major banks are down to five groups and two independent trust banks. - Large group of regional banks; takeovers by city banks of regional banks have been rare. - Regional banks benefit from a lower minimum capital requirement of 4 percent for “domestic” banks versus 8 percent for “internationally active” banks. - Foreign banks hold a relatively small market share of about 3 percent of total assets. - Numerous local shinkin banks, credit cooperatives, agricultural cooperatives; central institution Norinchukin Bank manages liquidity and is a very large player in the JGB market. - Licensing and supervision: - All banks and deposit-taking institutions described are licensed under the Banking Law or other relevant laws and supervised by the FSA except agricultural credit cooperatives and Norinchukin Bank (supervised jointly by the FSA and respective government departments). - Several specialized Government Financial Institutions (GFIs) are not licensed under the Banking Law and hence are not supervised by the FSA; the FSA is scheduled to inspect risk management in the GFIs with action by the sponsoring minister as required. - Profitability and capital adequacy: - Japanese banks' operating profits have been low for the past decade. - Capital adequacy disclosed by internationally active banks (mostly city banks and a few regional banks) remain above 8 percent. - Capital adequacy ratios disclosed by domestic-oriented banks are, for the most part, above 8 percent and all are above the 4 percent minimum. ### General preconditions for effective banking supervision - The FSA was created in July 2000 by integrating the Financial Supervisory Agency and the Financial Planning Bureau of the Ministry of Finance. - In January 2001, with abolition of the Financial Reconstruction Commission, the FSA was established as an external agency of the Cabinet Office. - The FSA Law (FSAL) and implementing ordinance provide for establishment of other supervisory and deliberative bodies (including SESC, Financial System Council, Compulsory Automotive Liability Insurance Council, Certified Public Accountant Examination and Investigation Board, Business Accounting Council). - At the end of fiscal 2002, the FSA employed a total of 981 staff. - Under Art. 11 of the Law Establishing Cabinet Ministries, a Special Minister for Financial Services (MFS) was established to provide overall leadership regarding matters under the jurisdiction of the FSA. ### Summary of Basel Core Principles assessment (major findings) - CP 1 (Preconditions): Basic legal framework in FSAL, Banking Law, Cabinet Ordinances, Cabinet Office/Ministerial Ordinances, and Administrative Guidelines; FSA not responsible for supervision of GFIs. - Independence concerns: - Lack of operational independence; constitutional framework with a minister effectively controlling operations creates scope for political pressure. - FSA has no budgetary independence and is funded from the central government budget. - FSA operates with minimal supervisory staff levels; additional staff may be needed for asset quality problems and pending revised Basel Capital Accord implementation. - Information sharing: - No formal regular exchange procedures between BoJ and FSA; exchanges occur ad hoc. - Requests for information could be rejected on legal and confidentiality grounds. - Exchange with foreign supervisors, including on-site visits, generally based on informal arrangements. - Licensing and structure (CPs 2–5): - Banking Law clearly defines “bank” and permissible activities but does not deal with GFIs and Japan Post. - License required from the Prime Minister (normally delegated to the Commissioner of the FSA); FSA is sole authority for granting banking licenses. - FSA authority to grant authorization for acquisitions or increase in qualifying holdings; definition of “significant” ownership requires approval and immediate notification for increase to more than 20 percent. - FSA can obtain information from and inspect a “major shareholder” and can revoke approval if conditions cease to be met. - Permissible investments: - Laws/regulations define permissible investments only in general terms; Banking Law upper limit: 5 percent of the total number of outstanding shares of a domestic corporation with voting rights (no supervisory approval required within limit). - Investments in non-financial companies are not restricted in proportion to the bank’s own capital but are subject to large exposure limits. - Prudential regulation and supervision (CPs 6–15): - FSA conducts on-site inspections and off-site analysis; inspection manual is thorough and covers major risks. - Staff is adequately trained and experienced in most observed cases. - Policy of more continuous supervision of major banks implemented; dedicated staff for market risk, internal controls, and information technology. - FSA has power to require corrective or remedial actions; a prompt corrective action scheme is in place and observed. - Capital adequacy: - Banking law provides authority to set capital adequacy standards; capital assessed during on-site inspections. - Composition of capital for major banks over reliant on deferred tax assets (DTA) and preference shares (much subscribed by government). - Major banking groups are weakly capitalized. - Capital levels for non-internationally active banks are set at a lower level without apparent justification based on relative risk profiles. - Provisioning and NPLs: - Current provisioning requirements based on accounting standards and JICPA guidelines. - Banks required to conduct frequent portfolio assessments and align provisioning with FSA guidance; on-site inspections check observance. - Focus on category “nonperforming loans (NPLs)” which includes loans requiring special attention, in danger of bankruptcy, de facto bankruptcy, and bankrupt. - Loans in categories “in danger of bankruptcy” and below are essentially worthless; major banks encouraged to remove existing loans from balance sheets by March 2004, and newly emerging ones within three years of classification. - Risk monitoring: - Large loan exposure guidance adequate and checked during on-site inspections. - Connected lending carefully monitored with board supermajority approval required in many cases. - Market, interest rate, operational, and other risks adequately monitored during on-site inspection. - Country and transfer risk is not regularly reported; inspectors check internal procedures but improvement is necessary. - Internal controls and governance: - Internal controls checked routinely; inspection manual comprehensive. - Special review of certain large borrowers involved tri-partite discussions with auditors, but routine discussion with auditors is not standard practice. - Outside directors are not yet numerous on most bank boards. - Oversight conducted through statutory auditors traditionally part of management; audit function sometimes reports directly to CEO or COO, which may not provide desired independence. - Anti-money laundering (CP 15): - On-site inspections review AML policies, practices, and procedures; inspection manual comprehensive. - FSA has power to require correction of deficiencies. - Strengthening customer identification procedures in process; planned implementation of a new law effective from the beginning of 2003. - On-site and off-site supervision (CPs 16–19): - FSA conducts on-site and off-site supervision, reviews and monitors banks’ financial conditions with required information. - Sanctions apply for failure to submit required information timely. - Inspection cycles vary by risk, type, and size of banks. - Supervision focus shifting from regulator-led to bank self-assessment and from observance-based to risk-based. - Inspectors use work of internal and external auditors but meetings with external auditors involving bank management should be regular. - FSA does not have authority to appoint or oppose appointment of an external auditor. - Consolidated supervision (CP 20): - FSA supervises on a consolidated basis, enforcing prudential regulations such as capital adequacy and single lending limits. - Supervision of non-bank financial institutions integrated within the same agency. - FSA has authority to request information from a bank subsidiary and to conduct on-site inspection of a subsidiary. - Accounting standards (CP 21): - Accounting standards have significantly improved and are generally in line with international standards; auditing and disclosure standards revised and improved. - Remedial measures (CP 22): - FSA authorized to take a range of actions against banks requiring remedial measures, from business improvement plans to revocation of license. - Sanctions apply to board, auditors, and managers for violations of the Banking Law, including failure to observe corrective orders. - Cross-border banking (CPs 23–25): - Regulatory framework lacks specific provisions for global consolidated supervision. - Banks under the Banking Law must notify FSA for approval before establishing a subsidiary, branch, or agency. - FSA has authority to supervise overseas branches of locally incorporated banks, e.g., through direct inspections. - No legal provisions for formal information sharing with other supervisors; current informal arrangements should be formalized to avoid confidentiality restrictions and facilitate on-site visits. - Informal arrangements have seldom impaired FSA’s ability to practice consolidated supervision, including on-site inspections if necessary. - Foreign banks in Japan subject to similar regulatory requirements, with approval needed for each additional branch; FSA has powers to access information in a subsidiary of a foreign banking institution. - No written/legal requirement for host country supervisor to share information on local operations of foreign banks with home country supervisors due to confidentiality protections. ### Recommended Action Plan (selected recommendations by Reference Principle) - CP 1.2 Independence - Consider setting up a board for the FSA (as with the SESC) to help ensure visible autonomy and accountability. - To guarantee budgetary independence, the supervised institutions should be charged by the FSA for the costs of supervision. - CP 1.6 Information sharing - Formalize arrangements for regular exchange of information with the Bank of Japan. - An obligation for external auditors to inform the supervisor of any material finding should be embodied in law. - CP 2 Permissible activities - Extend full supervisory authority of the FSA to GFIs. - CP 4 Control of banks - Need for FSA approval of an increase in a significant holding. - CP 5 Investments by banks - Need for FSA approval of amount of investments in relation to the bank’s capital. - CP 6 Capital adequacy - Change definition of capital to limit inclusion of DTA. - General provisions for Category II assets should not be in Tier-2. - The capital adequacy ratio for domestic banks should be at least 8 percent. - CP 8 Loan evaluation and loan-loss provisioning - Loans should be valued on the basis of the net present value of expected recoveries. - CP 9 Large exposure limits - Limits should be reduced. - CP 11 Country risk - Country risk should be regularly reported and supervised. - CP 15 Money laundering - New customer identification law will need to be applied effectively. - CP 19 Validation of supervisory information - Need for the FSA to have the authority to appoint, or oppose the appointment of, an external auditor. - CP 21 Accounting standards - Need for the FSA to have the right to revoke the license of an external auditor. - CP 24 Host country supervision - Need for recognition in the law of the rights of supervisors to exchange information. - CP 25 Supervision over foreign banks’ establishments - Introduce more formalized arrangements for the exchange of information with foreign supervisors. ### Authorities’ response - Japanese authorities consider the FSAP mission’s findings and recommendations valuable and many improvements are already underway. - Examples: - CP 15: The Law on Customer Identification and Record Retention has been in effect since January 2003. - CP 8: Major banks started applying a discounted cash flow approach to evaluate loans of large borrowers categorized as “Need special attention” and “In danger of bankruptcy.” - On capital adequacy: an advisory body to the FSA is studying the treatment of deferred tax assets and other relevant issues. - Authorities note some recommendations warrant further consideration as their presumed benefits may not surpass those of current regimes (e.g., extending full FSA supervisory authority to GFIs versus ministry-led supervision tied to policy objectives). *Source: This assessment of observance of the Basel Core Principles for Effective Banking Supervision (FSAP mission, October 2002).* ### 29. This section provides summary findings from the assessment of implementation of ### _cr03287 - 29. This section provides summary findings from the assessment of implementation of ### Institutional and Macro Prudential Setting - The principal regulator of securities markets in Japan is the Financial Services Agency (FSA) and its associated agency, the Securities Exchange Surveillance Commission (SESC). - Main information sources for the assessment included: a self-assessment prepared by the FSA; documents furnished by the FSA, such as its Annual Report, and the Law to Establish the FSA (FSAL); material from the FSA’s website, press releases and speeches by senior FSA officials, and from self regulatory organizations; the Securities and Exchange Law (SEL), and the textbook Securities Market in Japan 2002, published September 2002; interviews organized through the FSA with self regulatory organizations, market participants, industry groups, and others; and lengthy discussions with senior staff of the FSA. - The principal assessor with respect to securities regulation was Alan Cameron; the assessment with respect to clearing and settlement systems was conducted by Ms. Daniela Russo of the European Central Bank. The assessments were carried out in October 2002. - The FSA was established in July 2000 as the successor to the Financial Supervisory Agency and the Financial Planning Bureau in the Ministry of Finance. The SESC had been created in July 1992 under the Ministry of Finance, but was transferred to the Financial Supervisory Agency when that was established in June 1998. Both are now governed by the FSAL. - Trading of securities in Japan is conducted on securities exchanges, alternative trading systems, and in the over-the-counter (OTC) market. - Of the five stock exchanges in Japan, the largest is the Tokyo Stock Exchange (TSE) with a market capitalization of about ¥232 trillion in March 2003. - In addition to the exchanges, stock trading is done in the JASDAQ market (an OTC market managed by the Japan Securities Dealers Association (JSDA)), over a proprietary trading system, and in off-exchange trading sites for listed stocks. - Historically, Japan’s dramatic post-1945 growth to become the world's second largest economy was financed mainly by bank-based finance. - IOSCO’s three objectives are identified as: (a) the protection of investors; (b) ensuring that markets are fair, efficient and transparent; and (c) the reduction of systemic risk. The Japanese regulatory system is broadly designed to address each objective. The system has traditionally favored a compliance approach, though the FSA's Inspection Manual now provides for assessment of internal controls as part of its procedures. ### Summary assessment - Regulator (Principles 1–5) - Assessed as fully or broadly implemented. - The FSA’s mandate: to assure the stable and efficient functioning of the Japanese financial system, and to protect depositors, policyholders, securities investors, and similar persons. - The SESC is responsible for administration of specified provisions of the SEL, the Law for Foreign Securities Firms and the Financial Futures Trading Law. - General division: FSA responsible for policy making, supervision and inspection; SESC responsible for investigation and enforcement. - Subsequent to the assessment the SESC acquired responsibility for administering some aspects of the Law on Customer Identification that came into force in January 2003. - The FSA is "an administrative agency within the Cabinet Office". The head of the FSA is the Commissioner, appointed by and capable of removal by the Prime Minister. The Minister for Financial Services provides guidance and coordination but does not direct the FSA; the Commissioner reports to the Prime Minister. - The organizational structure does not give the FSA the appearance of independence that would best assure its ability to perform and be seen to perform all responsibilities with independence. - The SESC is to "exercise independent authority" (article 9 of the FSAL); commissioners appointed by the Prime Minister subject to approval by both houses of the national legislature; commissioners to be apolitical and removable by the Prime Minister only under limited conditions. - Staff of both agencies are civil servants and subject to general rules on duties, removal for cause, transfer and rotation. Specific protection beyond the National Civil Service Law would be desirable. - Funding: FSA and SESC are funded as part of the government budget; operational independence should be established by more secure funding so it does not depend on the annual government budget. - Staffing: Despite general public sector reductions, the FSA and the SESC were permitted to recruit significantly in FY 2002, and are budgeted to increase in total to about 1,000 staff. Market participants reported perceptions that staff is overworked and responses take too long. Rotation among unrelated agencies makes building industry knowledge and expertise difficult and aggravates staff shortages. - Self-Regulatory Organizations (Principles 6 and 7) - Japan makes extensive and effective use of self regulation; principles both fully implemented. - Concerns: potential overlap among many regulators (FSA, SESC, stock exchanges, JSDA, Bank of Japan) leading to multiple inspections and possible duplicate penalties; some SROs face conflicting roles as SROs, industry bodies and market operators. - Enforcement (Principles 8–10) - The FSA and the SESC between them have comprehensive inspection, investigation, surveillance and enforcement powers. - A Financial System Council Report (Overview of the Medium-term Vision for the Future of the Japanese Financial System, September 2002) noted the need to boost public confidence in market players; enforcement outcomes of the FSA and the SESC may need to increase in number and focus on substantial wrongdoing. - Cooperation (Principles 11–13) - The FSA believes it has authority to share public and non-public information with domestic counterparts pursuant to the FSAL and the National Civil Service Law when public interest in sharing outweighs maintaining confidence; and with a foreign authority if it considers it reasonable to respond to a request. - The Law does not permit cooperation if the foreign regulator would not respond to a similar request from Japan, or where action might "exert a serious influence to the detriment of the capital market of Japan or undermine other interests of Japan," or where any report might be used for other purposes. The authority to share information on an unsolicited basis is somewhat tenuous. - Recommendations in this area: express domestic authority to share information more clearly; limit the ability to decline cooperation with foreign regulators' requests to specific grounds, with the presumption in favor of cooperation; review laws fundamentally to encourage exchange of supervisory and enforcement information domestically and internationally; encourage agencies to enter into agreements laying down clear expectations. - The FSA has a small number of formal MOUs. Negotiation of when, what and how information will be exchanged among government agencies and with SROs provides opportunity to increase regulatory effectiveness and minimize gaps. The SESC and FSA efforts to formalize more such arrangements should continue. Provisions for cooperation with foreign counterparts should be reviewed and strengthened, and are in some respects better developed than domestic equivalents. - Issuers (Principles 14–16) - Principles requiring full, accurate and timely disclosure are regarded as fully implemented. - Japan intends to enhance continuous disclosure by taking measures to require disclosure of risk information, management discussion and analysis, and governance information, by March 2003; and to develop guidelines within the exchanges and the JSDA on quarterly disclosure of financial and business performance. - Commercial Code provisions designed to ensure holders of securities in a company are treated in a fair and equitable manner. - Accounting and auditing standards: broadly implemented. Important changes in the past five years have brought standards closer to international practices. The business combination (mergers and acquisition) standard remains to be changed. Increasing need to focus on implementation of accounting and auditing standards. Number of CPAs is significantly small compared with U.S. and U.K., but not so out of line with other G-7 countries. - Collective Investment Schemes (Principles 17–20) - Principle requiring regulatory standards for eligibility and regulation of those who market or operate a collective investment scheme is broadly implemented. - Introduction of a "fit and proper" test on persons who control such a company will mean full implementation; the proposed introduction in 2003 was necessary and "This law has now been passed." (see Recommended Actions). - Principles relating to legal form and structure, segregation and protection of client assets, disclosure (as for issuers), proper and disclosed basis for asset valuation and pricing and redemption of units are fully implemented. - Market Intermediaries (Principles 21–24) - Minimum entry standards for market intermediaries laid down under the SEL: capital requirements, fit and proper test for directors, and registration with the FSA. - Law concerning the Regulation of Investment Advisers provides minimum entry standards. Neither it nor the SEL provided a fit and proper test for those who own or control such businesses until amendment. - The law was amended in May 2003 to require a “fit and proper” test on principal shareholders of securities companies and investment advisers. - SEL provides standards for internal organization and operational conduct, prohibits business without fulfilling standards, and provides procedures for dealing with failure of a market intermediary to minimize investor damage and contain systemic risk. These principles are fully implemented. - Secondary Market (Principles 25–30) - Assessed as fully implemented. - FSA licenses markets on application and examines applications to determine conformity of articles of incorporation and business regulations with laws and adequacy to ensure fairness and investor protection. - Ongoing regulatory supervision of exchanges and trading systems is required under the law. - Transparency promoted by the SEL and by the Fair Business Practice Regulations of the JSDA. - SEL prohibits insider trading, market manipulation, and spreading of rumors, and prescribes criminal sanctions. - An Ordinance prescribes matters necessary for investor protection including restrictions on trading by securities companies for own account or trading of excessive volume as the FSA deems detrimental. ### Recommended Actions - The FSA should be given more structural independence to better assure its ability to autonomously perform and be seen to perform all of its responsibilities. - The agencies’ operational independence should be established by more secure funding. - The leadership and staff of the FSA and the SESC should be protected by statute when acting bona fide in the course of their duties. - The FSA and SESC need to build up industry knowledge and expertise and also alleviate current shortages of specialized staff. - The efforts of the SESC and the FSA to formalize MOUs with other supervisory agencies should continue. - While important changes in the accounting and auditing standards during the past five years have brought them closer to international practices, the business combination (mergers and acquisition) standard remains to be changed. Further there is now a need to focus on implementation of standards rather than improving standards. - The proposed introduction in 2003 of a "fit and proper" test on persons who control managers of collective investment vehicles was necessary to ensure that these vehicles are not controlled by inappropriate persons. This law has now been passed. - The proposed introduction in 2003 of a "fit and proper" test on principal shareholders of securities companies and investment advisers was necessary to ensure that securities companies are not controlled by inappropriate persons. This law has now been passed. ### Authorities’ Response - The FSA considers that the FSAP assessment is valuable and clearly demonstrates Japan’s very high degree of compliance with the IOSCO principles. The FSA and other relevant authorities have announced and carried out many reforms and programs in the areas of securities issues, securities markets, and corporate governance in recent years. - The staff notes the appearance of political interference in the FSA’s work, but the authorities respond that some relationship between administration and politics is normal in a democratic country. The authorities consider Japan not so different from other developed countries. Roles of the Commissioner and the Minister for Financial Services are clearly stipulated and divided by law to secure the autonomy of the FSA; supervision and inspection authorities are delegated to the Commissioner directly by the Prime Minister. The Commissioner has the power of appointing staff. - The leadership and staff of the FSA and the SESC are currently protected by statute when acting bona fide in the course of their duties. Based on Article 78 and 82 of the National Public Services Law, national public servants including officials in the FSA, may not be dismissed against their will except in cases where they have been adjudicated bankrupt or for other legally defined reasons. - Funding by the government’s annual budget is considered secure. The FY 2003 budget of the FSA is up 15.3 percent from the FY 2002 budget. - The FSA has been developing staff experience as integrated regulators through training and recruiting experienced staff, greatly increasing the number of specialized staff such as former employees of securities firms, lawyers, and CPAs in recent years. - The FSA has been making efforts to conclude bilateral MOUs with major foreign securities regulatory authorities. - The Business Accounting Council (BAC), an advisory body established within the FSA, is considering the comprehensive accounting standard for business combinations. - From the viewpoint of focusing on implementation of standards, the Diet passed a bill on May 30, 2003 for comprehensive revision of the Certified Public Accountants Law. The revised law includes measures to enhance auditor oversight and auditor independence, and to review CPA examinations for increasing the number of CPAs and enhancing the quality of CPAs. - Revisions of the Securities and Exchange Law, the Law for Investment Trusts and Investment Companies and the Law for Investment Advisers passed the Diet on May 23, 2003. The revised laws include measures for introducing a “fit and proper” test of principal shareholders of securities companies, investment trust management companies and discretionary investment advisers. *Source: Assessment of implementation of the IOSCO Objectives and Principles of Securities Regulation (excerpt).* ### 57. The assessment was performed using the Core Principles Methodology adopted by ### _cr03287 - 57. The assessment was performed using the Core Principles Methodology adopted by ### Methodology and scope - The assessment was performed using the Core Principles Methodology adopted by the International Association of Insurance Supervisors (IAIS) at its meeting in October 2000. - Main objectives: - Determine levels of observance of the IAIS principles. - Suggest areas where further development may be appropriate. - Assessment basis: - Review of the legal framework. - Extensive discussions with supervisory authorities and market participants. - Focus on work of the various insurance units within the Financial Services Agency (FSA). - Footnote: The assessment was prepared by Mr. Donald McIsaac and Dr. Helmut Müller in October 2002. ### Data disclosure and statistical reporting - The FSA does not assemble and publish its own statistical report for insurance business. - Extensive disclosure by companies is required, including results of the solvency test and component details used in performing the test. - Widely available sources of company data include the journal “Insurance” (Insurance Institute of Japan), Life Insurance Association of Japan, and Marine and Fire Insurance Association of Japan. ### Market structure and systemic importance - Japan has the second largest insurance market in the world with a relatively small number of licensed companies: - 43 life insurance companies at end of FY 2001, of which 25 were locally-owned. - 59 non-life insurers at end of FY 2001, of which 28 were locally-owned. - Locally-owned companies are dominant in both markets. - Market concentration: - Market share of top ten companies exceeds 80 percent in both life and nonlife sectors. - The 10 largest companies collected 85 percent of life insurance premiums in Japan in 2000. - For nonlife business, the 10 largest companies collected 80 percent of total premiums in 2000. - Ninety-five percent of their revenues arise in Japan even though largest companies have international operations. - Balance-sheet significance: - Reserves held by insurance companies amount to 38 percent of GDP, equivalent to approximately 25 percent of retail deposits with banks. - Interconnections: - No direct ownership linkages between insurance companies and banks. - Significant cross-holdings in capital and capital-like instruments: - Insurance companies hold shares, preferred shares and subordinated debt issued by banks. - Banks hold “foundation funds” for mutual companies and subordinated debt issued by insurance companies. ### Financial pressures in the life insurance sector - Drivers of stress: - Decline in interest rates and decline in stock market prices. - Older, larger mutual companies hold substantial portfolios with heavy savings elements and guaranteed rates of return on policyholders’ “asset share.” - Negative spread: - Investment income on life insurance reserve funds has not been sufficient to cover guaranteed policyholder returns. - The “negative spread” is the aggregate shortfall between investment income earned and the amount presumed credited to policy liabilities. - FY2001 total loss from interest rate deficiency: ¥1.3 trillion. - Offsetting items: Gains from low mortality and low costs resulted in ¥2.2 trillion of profits from basic insurance business operations in FY2001. - Reserving practice: - Actuaries project cash-flow for the next five years based on several conservative scenarios approved by the FSA. - If losses from negative spread are unlikely to be covered over the next five years, a deficiency provision for that period must be included in policy liabilities. - One life insurance company established such a deficiency provision in FY2001. ### Nonlife insurance sector - Performance: - Nonlife sector continues to be profitable and companies have established substantial capital margins. - Risk concentration: - Asset concentration in Japan exposes firms to the risk of simultaneous losses on both sides of the balance sheet (e.g., natural disaster plus asset value fall from same cause). - Some companies are considering regional diversification. - Market practices: - Until recently, prices of insurance products were controlled with an emphasis on premium adequacy rather than competitiveness. ### Preconditions for effective supervision - Deregulation trends: - Gradual deregulation over the last decade; rating bureaus still quote “reference” rates but companies may depart from them. - Policy form approvals have been streamlined; FSA allows filing of new policy forms without insisting on pre-sale approval. - Deregulation increases supervisory challenges; supervisors must identify financial problems in time to take corrective action. - FSA supervisory approach and capacity: - Movement toward risk-focused supervision linking off-site supervision with on-site inspection. - On-site work reviews company risk management systems and assesses effectiveness and remedial actions. - Capacity gaps: - Insufficient numbers of personnel with extensive industry experience. - Lack of expertise in actuarial and reinsurance areas, despite inspections being conducted by staff with long supervision experience. - Since assessment completion, FSA has recruited several actuaries and an expert in reinsurance. - Auditor role: - Auditors are not formal partners with supervisors; they have a special monitoring position but less integrated than in some other countries. - Actuarial standards and reporting: - Institute of Actuaries of Japan has issued standards of practice strongly endorsed by the FSA. - Company actuaries report regularly to Boards of Directors and must report to management and, if required, to the FSA when issues threaten long-term survival. - FSA currently has few qualified actuaries on staff and lacks authority to obtain these services through outsourcing. ### Main findings (supervisory gaps and concerns) - Organization of Insurance Supervision (CP 1): - FSA staff should be strengthened with experts in actuarial science, reinsurance and risk management. - Very few qualified actuaries on FSA staff; inspection resources should be increased for more frequent inspections. - Corporate Governance and Internal Controls (CPs 4–5): - FSA guidelines reflect commendable practices but are not statutory instruments. - Preferable to enshrine these rules in statute or formal regulation. - Prudential Rules (CPs 6–10): - FSA reluctant to impose investment limits; focuses instead on risk management and disclosure. - Recommended prudential enhancements include: - Limits on transactions with related parties. - Limit on maximum exposure to any single risk. - Aggregate limit on exposure to derivatives and prudential limits on derivatives not used for hedging until firm risk-assessment capacities are developed. - Concerns over aggressive derivative trading aimed at improving returns rather than hedging, exposing policyholders’ savings. - Negative spread under guaranteed long-term life policies requires companies to establish deficiency reserves when future premiums and investment income are insufficient to meet policy promises. - Recommendation to improve recognition of reinsurance in calculating technical provisions for primary insurers. - Monitoring, Inspection, and Sanctions (CPs 12–14): - Enhance cooperation with auditors and actuaries in the supervisory process. - Cross-Border Operations, Supervisory Coordination and Cooperation, and Confidentiality (CPs 15–17): - Closer cooperation with foreign supervisors is recommended, using means such as Memoranda of Understanding (MOUs), while respecting confidentiality. - Organizational summary recommendation (excerpt from Action Plan): - CP 1: Increase insurance supervisory/inspection staff, including experienced actuaries and reinsurance specialists; consider better use of third parties (independent actuaries, auditors). - CPs 2–3: Complete implementation of new rules concerning controls over ownership transfers. - CPs 4–5: Consider enshrining corporate governance/internal control guidelines in statute or formal regulation. - CPs 6–10: Impose limits on related-party investments, limit derivatives exposure (especially non-hedging), require accumulation of extra mathematical reserves for negative spread, and improve reinsurance recognition methodology. - CPs 12–14: Enhance cooperation with auditors and actuaries. - CPs 15–17: Pursue closer cooperation with foreign supervisors (MOUs), respecting confidentiality. ### Authorities’ response and actions taken or planned - Staffing and expertise (paragraphs 73 and 74): - FSA has significantly increased staff for off-site monitoring and on-site inspection since its establishment and will continue to do so. - FSA provides training and has employed staff with insurance industry experience or actuarial qualifications; plans to employ more. - New rules on change in control became effective in April 2002 and are to be completely implemented in April 2004 when the transitional period expires. - Corporate governance and enforcement (paragraph 75): - Insurance Business Law, Commercial Code, and Special law of Commercial Code set basic corporate governance requirements. - Administrative guidelines and inspection manual describe practical application and on-site check-points. - FSA can request reports and issue orders for infringements; will introduce new regulations when necessary. - Investment limits and risk-focused supervision (paragraph 76): - FSA sets individual investment limits only when absolutely necessary; focuses supervision on risk management and disclosure. - FSA routinely receives extensive insurer reports on market, liquidity, and credit risks and monitors them; conducts detailed checks in on-site inspections and orders corrective measures as necessary. - Insurers are required to publicly disclose detailed information on investment activities and risk management. - FSA considers introduction of the specific individual limits recommended (aggregate limits on derivatives, restrictions to hedging, related-party limits, single-exposure limits) to be inappropriate. - Deficiency provisioning and negative spread (paragraph 77): - Actuaries project cash-flows for the next five years under conservative scenarios approved by the FSA. - If negative spread losses are unlikely to be covered over five years, a deficiency provision must be included in policy liabilities. - FSA recognizes the serious impact of low interest rates and will remain vigilant about establishing deficiency provisions. - Reinsurance recognition and reinsurer soundness (paragraph 78): - FSA is considering changing the recognition method of reinsurance from netting-out to gross. - FSA is reviewing methodology to assess soundness of reinsurers who are counterparties of insurers. - Cross-border cooperation (paragraph 79): - FSA has cooperated closely with foreign supervisors via mutual visits and communications. - Exchanges have covered financial strengths of insurers, administrative actions, and fit-and-properness of managers. - In recent cases, FSA notifies foreign supervisors of proposed administrative actions against Japanese establishments of foreign insurers at an earlier stage than before. - FSA intends to further enhance cooperation with foreign supervisors. - Relations with auditors and actuaries (paragraph 80): - FSA receives and relies primarily on reports by internal and external auditors and actuaries’ opinions on provisioning, dividends and future cash flow analysis. - FSA holds meetings with auditors and actuaries, frequently exchanges views with the Institute of Actuaries of Japan, and will strengthen these relations. ### Payment systems—context note - The document continues to review CPSS Core Principles for systemically important payment systems and notes that four Japanese systems were assessed: BoJ-NET Funds Transfer System (real-time gross settlement and deferred gross settlement modes), Foreign Exchange Yen Clearing System (real-time gross settlement and deferred net settlement modes), Domestic Funds Transfer (Zengin) System, and Tokyo Clearing House’s Bill and Check Clearing System (TCH-BCCS). - Detailed questionnaire responses from the Bank of Japan, private system operators, and other agencies informed the assessment. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03287.pdf* ### 82. The BoJ-NET FTS, which is operated by the Bank of Japan, is the core system, ### The BoJ-NET FTS, which is operated by the Bank of Japan, is the core system, ### System structure and roles - BoJ-NET FTS - Accounts for around 65 percent of the aggregate value settled by the four systemically important systems. - Other three private systems settle their net obligations over the BoJ-NET FTS. - Cash leg of a range of securities transactions (notably JGB and non-JGB debt instruments) and derivative transactions in the Tokyo International Financial Futures Exchange also settle over the BoJ-NET FTS. - Majority of payments processed and settled through BoJ-NET FTS’ real-time gross settlement mode. - Only a few specific payment types (e.g., settlement of non-JGB transactions or the Bank of Japan as counterparty) use the deferred gross settlement mode. - FXYCS - Owned by the Tokyo Bankers Association; operated under agreement by the Bank of Japan. - Clears and settles the yen leg of foreign exchange transactions. - Most volume and value cleared via deferred net settlement mode. - RTGS mode used when deferred net settlement is unavailable and for settlement of yen payments involving CLS Bank. - In RTGS mode, individual payment obligations are passed straight through to the BoJ-NET FTS for settlement. - Zengin System - Essentially a retail payment system. - Clears and settles about 94 percent of the aggregate payment volume through the four systems but only about 9 percent of the value. - Deferred net settlement system owned and operated by the Tokyo Bankers Association. - Majority are small-value credit transfers; system also handles some individual large-value payments. - TCH-BCCS (Tokyo Clearing House - Bills and Checks Clearing System) - Debit-pull system clearing and settling due bills of exchange and checks (used almost exclusively for business-to-business payments). - Of 540 clearing houses in Japan, the Tokyo Clearing House is the largest and is automated and operated by the Tokyo Bankers Association. - Handles intra-regional payment items but clears and settles about three-quarters of the total value of bills and checks used in Japan. - That value accounts for only about 5 percent of the aggregate volume of payments cleared and settled by the four principal systems; share declining in recent years. - Inter-regional collection of bill and check payments is settled over the Zengin System. ### Oversight and institutional arrangements - Bank of Japan (BoJ) - Solely responsible for oversight of payment systems in Japan. - No discretionary regulatory powers over private systems; uses contractual agreements and access to settlement and credit facilities to support "moral suasion" as principal oversight tool. - Participates in network of advisory councils and working groups organized by various Ministries influencing payment services. - Operators and transparency - Operators provide public documentation on roles and organization of systemically important systems. - Tokyo Bankers Association made access and participation criteria public: TCH-BCCS earlier; FXYCS in December 2002; Zengin System in February 2003. ### Main findings on observance of CPSS Core Principles (summary) - General - Both modes of BoJ-NET FTS and RTGS mode of FXYCS accord closely with the CPSIPS. - Deferred gross settlement mode of BoJ-NET FTS does not fully observe Core Principles regarding effective management of settlement risks and certainty of prompt and final settlement, but deviations have no significant systemic implications. - Deferred net settlement mode of FXYCS and other private systems have deviations from some CPSS Core Principles that may have notable systemic implications. - Unless otherwise stated, Core Principles are observed in the assessed payment systems. - BoJ largely satisfies its responsibilities in applying the Core Principles within its mandate. ### Legal foundation (CP I) - Assessment: partly observed for deferred net settlement mode of FXYCS and the Zengin System. - Key issue: - Collateral is pledged by participants to cover potential systemic risks from a default by the participant with the largest net debt position. - Under corporate reorganization laws for financial institutions, stays of execution could be imposed on liquidation of pledged collateral. - Under such stays, risk containment arrangements would be vulnerable to failure with a default by the systems’ largest net debtor. ### Understanding and management of risks (CPs II–III) - Core Principle III assessment: - Broadly observed in deferred gross settlement mode of BoJ-NET FTS. - Partly observed in TCH-BCCS. - Specific deficiencies: - No controls to cover liquidity risks to surviving participants from a default of a counterparty in the cash leg of a non-JGB transaction settled in deferred gross settlement mode of BoJ-NET FTS. - Aggregate value of these transactions is relatively small. - Surviving participants can obtain intra-day credit from the Bank of Japan using non-JGB securities from the failed transaction as collateral; thus no significant systemic implications. - No settlement risk controls in TCH-BCCS. - In event of participant default, payments would be unwound, leaving surviving participants exposed to liquidity and possibly credit risk. - Could have systemic consequences if defaulting participant were a large net debtor due to unwinds of large-value inter-corporate payments and absence of securities collateral. ### Settlement (CPs IV–VI) - Findings: - TCH-BCCS: CP IV (prompt and final settlement) and CP V (certainty of settlement of a deferred multilateral net settlement system in event of default by participant with largest obligation) are non-observed because of inadequate risk controls. - BoJ-NET FTS deferred gross settlement mode: CP IV not fully observed because cash leg of non-JGB transactions can be cancelled in event of participant default. - However, associated collateral available to surviving participants allows ready access to intra-day credit; no systemic consequences expected from recalculation and settlement delays. - All systems settle on BoJ current accounts, satisfying CP VI requirement for a virtually riskless settlement asset. ### Security and operational reliability and contingency arrangements (CP VII) - Findings: - All systems have adequate back-up arrangements in primary and remote sites. - All systems except TCH-BCCS have effective business continuity arrangements. - TCH-BCCS: - Has contingency plan for switching to an off-site manual-entry PC system if primary and back-up at primary site fail. - Contingency plans not adequately tested. - Primary and back-up on-site and off-site systems not independently audited. ### Efficiency and practicality (CP VIII) - Findings: - All systems except TCH-BCCS are efficient and practical for systemically important payment systems. - TCH-BCCS: - Practical for participants serving business customers preferring bills and checks. - Relatively cost-inefficient and impractical for large-value and time-sensitive payments compared to Zengin System. - Low aggregate volume and value, and ability to transfer business payments to Zengin System, limit broad consequences of inefficiency. ### Criteria for participation (CP IX) and Governance (CP X) - CP IX: - Access and participation criteria are objective and publicly disclosed by all systems. - CP X: - Governance arrangements in all systems accord with Core Principle X (effective, accountable and transparent governance). - Operators have effective communications and accountability with participants and provide public documentation. - BoJ reports publicly on operational services and policy initiatives and supports consultation mechanisms. - Recommendation: private system operators might consider greater public transparency regarding governance and operating initiatives. ### Central Bank responsibilities in applying the CPs - BoJ largely meets responsibilities in applying Core Principles to systems it operates and oversees. - Notable deviation: broadly observed assessment of CPs III and IV for deferred gross settlement mode of BoJ-NET FTS. - BoJ practices: - Objectives, roles and policies publicly disclosed through various media. - Cooperates with other central banks, private operators, principal participants and public agencies via consultative and advisory networks. - Monitors and promotes compliance by private operators within statutory mandate. - Continues to develop oversight function and mechanisms. - Suggested to be more proactive in promoting safety and efficiency objectives inherent to the CPs, using available instruments with appropriate public agencies and private owners/operators to redress deviations. ### Recommended actions to improve observance of CPSS Core Principles and BoJ responsibilities — SIPS - Legal foundation (CP I) - The Bank of Japan should initiate discussions with relevant parties and ministries regarding legal changes necessary to protect collateral pledged to central counterparties of systemically important payment systems from stays on execution. - Understanding and management of risks (CP III) - In consultation with the Bank of Japan, the Tokyo Bankers Association should develop effective strategies in the TCH-BCCS to limit settlement risks to surviving participants in the event of a default by another participant. - Mechanisms to consider: an enhanced settlement fund, a loss-sharing arrangement and a value cap on individual payment items accepted for clearing and settlement. - Settlement (CP IV) - The Bank of Japan should finalize the schedule for migrating remaining types of payments processed through the deferred gross settlement mode of BoJ-NET FTS (which has inadequate risk controls for ensuring prompt and final settlement of some payment types) to its RTGS mode and implement it according to schedule. - Security and operational reliability and contingency arrangements (CP VII) - The Tokyo Bankers Association, in consultation with the Bank of Japan, should design an effective testing program for the primary site and PC-based back-up systems for the TCH-BCCS and institute periodic independent audits of the systems. ### Authorities’ response - Legal foundation (CP I) - BoJ: risk control arrangements in Zengin System and FXYCS already introduced so legal risk would be effectively contained and mitigated even if default by participant with largest net debit position occurs. - Rules of both systems define loss-sharing and procedures to be followed if collateral liquidation by system operator is delayed under reorganization-type insolvency proceedings. - Prompt repayment from the Tokyo Bankers Association to liquidity-provider banks will be ensured per these rules. - Understanding and management of risks (CP III) - BoJ: no practical way for TCH-BCCS (as a debit transfer system) to satisfy CP III. - FSAP-recommended actions are viewed as too costly or impractical. - Volume and value of bills and checks exchanged through TCH-BCCS have been decreasing significantly and constantly throughout the decade; probability of participant default causing systemic disruption is now small. - Bank does not believe current risk control arrangements should be changed. - Settlement (CP IV) - BoJ will continue to migrate remaining types of payments processed through deferred gross settlement mode of BoJ-NET FTS to RTGS mode, in accordance with schedules such as the one published in April 2001. - BoJ does not intend to migrate all payments settled over current accounts at the Bank to RTGS mode. - For certain payment types made to/from the Bank, deferred gross settlement mode is more suited operationally and does not pose additional risk to participants. ### Transparency of Monetary Policies — BoJ assessment (MFP Transparency Code) - Assessment basis: - Self assessment by BoJ staff and responses to 1999 questionnaire. - Review of BoJ Law and BoJ publications (Annual Review, Bank of Japan Quarterly Bulletin, Monetary and Economic Studies), public statements, statistical releases. - Review of information on BoJ website (http://www.boj.or.jp). - Discussions with BoJ officials (including a Deputy Governor and an Executive Director). - Discussions with private sector professionals (five from financial institutions and three financial journalists). - Main findings summary: - Observance by BoJ with respect to transparency practices in conduct of monetary policies meets a high standard. - New Bank of Japan Law provisions require transparency by, and accountability of, the BoJ and serve as operational and directional guide. - BoJ officials at Policy Board level supportive of transparency as an ongoing process and receptive to new initiatives. - BoJ uses multiple means to disclose and explain information (in Japanese and English): outlines of discussion of Monetary Policy Meetings [minutes] and transcripts at a later date, semi-annual reports to the Diet, Annual Review, annual “Outline of Business Operations” (in Japanese), press releases, press conferences, public consultations, speeches, and website. - Internet has dramatically widened scope for disseminating information; BoJ has made good use of this mechanism and is consciously working to build on progress. *Source: IMF assessment text (FSAP appendix).* ### 103. Meetings with financial journalists and market participants on how the public ### Meetings with financial journalists and market participants on how the public perceives the BoJ’s practice and implementation of transparency ### Perceptions of BoJ transparency and communication - Private sector professionals confirmed the BoJ was taking the implementation of transparency practices seriously and were on the whole positive about the BoJ’s efforts and results. - Uniform praise for the content and quality of the BoJ’s website. - Given the unique economic circumstances of deflation, professionals stressed the BoJ’s policy stance requires clear exposition and periodic restatement. ### Clarity of roles, responsibilities, and objectives - Considerable good transparency practiced by the BoJ regarding roles, responsibilities, and objectives of monetary policies. - Most aspects concerning the BoJ are specified in the BoJ Law that took effect in 1998 and are further disclosed in BoJ reports, publications, and speeches, many of which are posted on the BoJ’s website. ### Open process for formulating and reporting monetary policy - The advance meeting schedule of the Policy Board for the bi-monthly Monetary Policy Meetings is publicly disclosed. - The BoJ announces and posts all monetary policy decisions by the Policy Board immediately after each of the two monthly Monetary Policy Meetings (even when there is no change in policy). - When there is a monetary policy change, the Bank issues a statement explaining the decision and holds a special press conference the same day. - Regular press conferences are held by the Governor after the first of the bi-monthly Monetary Policy Meetings. - The BoJ publishes minutes of its Monetary Policy Meetings approximately one month after such meetings and releases transcripts of these meetings ten years later. - Reasons for monetary policy decisions are offered in BoJ publications, speeches, and reports to the Diet; periodic reports cover progress toward policy objectives and evolving macroeconomic conditions and implications. ### Public availability of monetary policy information and publications - The BoJ observes practices of the Code with regard to public availability of information on monetary policies. - Japan subscribes to the IMF’s Special Data Dissemination Standards (SDDS). - Information about foreign exchange reserve assets, liabilities and commitments by monetary authorities are disclosed on a pre-announced schedule consistent with the IMF’s Data Dissemination Standards. - The BoJ’s website contains Japanese and English material; it is described as well-structured, user friendly, and well-maintained, with an organized publications program and increasing English-language material. - The BoJ issues reports required by the BoJ Law, including a semi-annual report on the Policy Board’s decisions relating to currency and monetary control. - The BoJ issues primers and operates a public education program; texts of speeches and regulations are publicly posted. - The BoJ issues its balance sheet on a pre-announced schedule and publicly discloses aggregate market transactions. - On the day the BoJ decides to make Article 38 loans (“special loans”), the Bank issues a public statement containing the name of the institution; aggregate information on such loans is provided in published financial statements and the two annual reports (one Japanese, one English) contain further information. ### Accountability and assurances of integrity - BoJ officials make numerous appearances before Diet committees and members to report on monetary policy conduct, objectives, performance, and to exchange views on the economy and financial system. - The BoJ releases appropriately prepared financial statements on a scheduled basis and discloses information on operating expenses and standards for personal financial conduct of officials and staff. ### Assessment and recommended action - The BoJ observes or broadly observes the practices of the MFP Transparency Code; the assessment does not call for a recommended action plan to address shortcomings in transparency. - Given transparency is mandated in the BoJ Law and endorsed at the Policy Board level, BoJ officials should build on achievements and introduce additional transparency measures over time where appropriate. ### Authorities’ response on BoJ transparency - The BoJ found the IMF process constructive and welcomed the positive assessment. - The BoJ emphasized transparency implementation is evolutionary and ongoing and noted further efforts since the assessment, including publication of its self-assessment report on transparency practices for monetary policy (both in Japanese and in English) in August 2002. ### Transparency of financial policies — institutional scope - The role of “financial agency” for this assessment comprises the Financial Services Agency (FSA) and the Deposit Insurance Corporation (DIC); the assessment also covers part of the BoJ’s activities. - The FSA’s legal powers stem mainly from the FSA Law (FSAL) and other laws regulating authorization of financial institutions; the DIC is governed by the Deposit Insurance Law (DIL). - The BoJ Law provides the BoJ with power to provide payment services, responsibility to oversee their provision, and authorization to enter into contracts permitting examinations (Article 44). ### Main findings on financial policy transparency - Both the FSA and the BoJ demonstrate a high degree of transparency; this also applies to the DIC and its subsidiary, the RCC. - Statutes are modern, kept up to date, and state clearly objectives and responsibilities. - The FSA and BoJ produce substantive annual reports and regular documentation, and senior officials frequently account to the Diet. - The DIC has worked to explain the deposit insurance scheme and depositor protections. ### Identified transparency deficiencies and institutional concerns - The division of responsibilities between the Commissioner of the FSA and the Minister for Financial Services is complicated and not fully transparent. - The Minister is a Cabinet member serving at the Prime Minister’s pleasure; the Commissioner, while protected from dismissal by civil service rules, can be transferred to other duties at the government’s wishes without reasons normally given, creating an appearance of political interference. - The FSA’s role includes non-prudential functions; as a government agency this raises risks that actions could be driven by non-prudential policies. - From April 2003 the FSA assumed inspection of risk management systems for the Japan Post and certain government-owned financial institutions, while responsibility for consequent action lies with the relevant government department. - Statutory barriers and confidentiality obligations can impede the exchange of supervisory information between the FSA and the BoJ; it is not clear whether these barriers are always effectively surmounted. ### Authorities’ response on financial policy transparency - The authorities state the roles of the Commissioner and the Minister are clarified in their respective laws and transparency is fully secured. - They argue that apparent political relationships are inherent in democratic administration and not exceptional to Japan. - The Commissioner’s delegated supervisory authority and appointment powers are cited as safeguards of FSA autonomy. - The authorities assert the FSA observes the IMF transparency code and that delegation to inspect risk management for GFIs clarifies roles and secures transparency. - They maintain the FSA and BoJ effectively share necessary information subject to confidentiality obligations and that statutory barriers do not prevent effective information exchange. ### Financial system overview — banking system structure and key statistics - The bank-centered Japanese financial system remains large relative to the economy; the public sector plays a much larger role in financial intermediation than in any other major OECD country. - Bank profitability is low; Japanese banks rely significantly on collateral, primarily real estate. - The major banks, including trust banks, account for about 27 percent of total financial system assets, or one-third if government owned financial institutions are excluded. - As of end-March 2002, financial institutions and non-financial corporations were the two largest shareholders for the major financial groups. - By March 2003, the major banks had, on average, reduced their equity holdings close to 100 percent of Tier-1 capital compared to 150 percent in March 2002. - Following 1990s mergers, major banks are down to five banking groups, with two independent trust banks. - Many regional banks remain; major banks’ market share is relatively small compared with other industrial countries due to regional bank prevalence. - Most regional banks benefit from a 4 percent minimum capital requirement for domestically-oriented banks versus an 8 percent requirement for internationally active banks. - Loans to small- and medium-sized enterprises still account for about half of total bank lending, though this share has fallen steadily since 1997; lending to individuals and large corporations has increased. - Lending to four troubled sectors (construction, wholesale and retail, real estate, and other financial institutions) represents about 40 percent of total loans. - Nonperforming loans rose during 1997–2001 but declined in the latter half of 2002 for some deposit-taking institutions. - At end-September 2002, city banks’ outstanding nonperforming loans, after provisions, amounted to 54 percent of their total capital and exceeded their level of Tier-1 capital. - The major banks’ gross nonperforming loan ratio declined and in the year ending March 2003 fell to 7.2 percent of total loans. *Source: IMF staff report excerpts contained in the provided content unit.* ### 7. Although Japanese banks' operating profits have been low for the past decade, ### _cr03287 - 7. Although Japanese banks' operating profits have been low for the past decade, ### Banking sector performance - Operating profits have been low for the past decade, but reported capital adequacy remains above the regulatory minimum (Tables 4 and 5). - After taking account of increases in loan losses and provisions, Japanese banks recorded a loss of ¥6.5 trillion for the year ending March 2002. - For the subset of major banks in the year ending March 2003, net losses amounted to around ¥4.4 trillion (on a non-consolidated basis). - Interest income remained the main contribution to gross income, while the share of fee and trading income has increased somewhat. - Despite deregulation and pressure to increase lending spreads to cover loan losses, spreads remain largely unchanged. - Capital adequacy as of end-September 2002 disclosed by the 20 internationally active banks remained above 8 percent. - Capital adequacy ratios for domestic-oriented banks were well above the 4 percent minimum, with the majority above 8 percent. - At end March 2003, the capital ratio for Resona Bank fell short of the minimum, triggering prudential intervention. ### Public sector financial intermediation - The public financial sector, including the Japan Post, plays a significant role in financial intermediation in Japan. - The Postal Services Agency (PSA) was reorganized into the Japan Post in April 2003 and is expected to continue providing existing financial services without major changes. - Japan Post: the largest deposit-taker in the world, offering deposits, payment services, and life insurance products in addition to mail services. - Japan Post network: more than 24,000 offices, accounting for 37 percent of all outlets in Japan providing banking services. - Postal savings represent almost 25 percent of total deposits in Japan. - Postal insurance sells about 15 percent of all life insurance products held by individuals. - Government Financial Institutions (GFIs): - Ten GFIs exist, fully state-owned with one exception (the Shoko Chukin Bank); nine are specialized lending institutions. - The Government Housing Loan Corporation (GHLC) has a 30–40 percent market share in mortgage loans. - Two GFIs together have 19 percent share in loans to large companies. - Three GFIs provide loans to small-and-medium-sized enterprises (SMEs). - The Japan Small and Medium Enterprise Corporation reinsures guarantees of SME loans originated by private sector financial institutions. - When direct lending and guarantees to private lending are combined, the public sector accounts for about 20 percent of all loans to SMEs. - Fiscal Investment and Loan Program (FILP): - Traditionally channels funds collected by the PSA and other sources to public agencies on a long-term basis. - FILP assets totaled ¥432 trillion (86 percent of GDP) as of March 2002. - Users include GFIs, special public corporations, and local governments. - FILP reform in April 2001 abolished the compulsory transfer from the PSA; successor Japan Post still holds about 80 percent of its assets in domestic bonds, expected to fall only gradually. - Interest rate mismatch exposure: - Until April 2001, postal savings system deposited most funds with the Trust Fund Bureau Fund (TFBF) for seven years at a fixed rate set around the 10-year JGB rate. - Liabilities include teigaku deposits offering a fixed deposit rate for up to 10 years with a free option of withdrawing after 6 months, allowing depositors to benefit from higher rates when interest rates rise. - Reforms and supervision: - Plans under way to reform the Japan Post, the FILP and the GFIs and introduce a new role for the FSA. - GHLC to be reorganized by FY 2006 into an independent administrative agency securitizing housing loans originated by private sector lenders. - Reform of the remaining eight GFIs has been delayed. - Public sector financial institutions are not regulated by the FSA; Japan Post regulated by the Ministry of Public Management, Home Affairs, and Posts and Telecommunications; GFIs regulated by the MoF and other ministries. - Legal amendments in May 2002 enabled supervisory ministries of the GFIs to delegate inspection of risk management of the GFIs to the FSA from April 2003. ### Insurance sector and pensions - Insurance sector: - Insurance company reserves amount to 38 percent of GDP and equal 25 percent of retail deposits with the banks. - This is the second largest insurance sector in the world (after the United States). - Insurance purchases in Japan exceed those in the United States in terms of premiums per capita and premiums as a percentage of GDP. - Roughly 95 percent of households have life insurance policies. - Postal insurance system (“Kampo”) conducted by the Japan Post: total assets related to its insurance business of ¥126.6 trillion. - Combined assets for all private Japanese life insurance companies aggregate ¥143.6 trillion. - Industry trends: - The industry is shrinking slowly over the past two decades. - Profit margins have narrowed, particularly for life insurance companies, leading to reductions in dividends to policyholders. - Decline attributable mainly to reductions in investment income and the sharp fall in the values of securities, weakening capitalization. - Demographic trends may accelerate the shrinking process. - Pensions: - Including the introduction of 401k-style plans, the Japanese pension system has all three pillars recommended as protection against the risks of poverty in old age. - A modest basic national pension is available to all citizens who maintain contributions. - Company workers and civil servants also contribute to a public earnings-related program, which in many cases is supplemented by a company add-on scheme. - Although a market for private pension plans exists, it is small. ### Securities firms and markets - Securities firms: - Since 1990, number of securities firms has remained around 290; 112 companies left the market (mergers or discontinuation) and 114 new companies were established. - Deregulation under the mid-1990s “Big Bang” initiative promoted new market entry and removed restrictions on business scope and organization. - Major domestic banks, foreign financial institutions, and Internet-based securities firms entered the market and gained market share. - Ability of Japanese securities firms to compete internationally constrained by decline in profitability of domestic business; none of Japan’s big three securities firms ranks in the top 15 in underwriting outside of Japan. - Money and bond markets: - Short-term money market comprises mainly the call market, euroyen market, and foreign exchange swap market. - Low interest rates under the BoJ’s quantitative easing program have sharply dampened market activity; banks have preferred holding current account balances as excess reserves at the BoJ and in some cases lent at negative interest rates. - Interbank market has become thin; BoJ emerged as one of the main suppliers of liquidity. - In September 2002, outstanding volume of Japanese government securities, including JGBs, reached ¥467 trillion, accounting for around 30 percent of government securities issued by OECD countries. - JGB market concentration: government holds 37 percent and private financial institutions hold 43 percent of JGBs. - Corporate bond market outstanding (excluding asset-backed securities) reached ¥58 trillion in September 2002, compared with ¥430 trillion in outstanding bank loans and ¥467 trillion in government securities. - Reasons for small corporate bond market include main banking system model and strong presence of GFIs in long-term corporate lending. - Foreign exchange and equity markets: - Activity in foreign exchange markets has increased, reflecting the rise in FX swaps as a channel for investing and raising short-term funds. - Japanese banks increasingly use FX swaps to fund FX assets; foreign financial institutions use FX swaps for yen funding. - Of the five stock exchanges, the Tokyo Stock Exchange (TSE) market capitalization was about ¥232 trillion as of end-March 2003. - Stock trading also occurs in JASDAQ, over proprietary trading systems, and off-exchange trading sites. - Following mid-1990s deregulation, foreign ownership and activity have risen sharply. - Household investor share has remained around 20 percent; ownership by financial institutions and corporations has fallen due to unwinding of cross-shareholdings and marking-to-market of equity holdings. - Real estate: - Land prices fell by an average of 6.4 percent in 2002—its 12th straight year of decline. - Extensive use of land as collateral has negatively impacted bank and corporate balance sheets. - Some urban areas (central Tokyo) show signs of recovery, but concerns exist over the “2003 office problem” as a large supply of redeveloped commercial property enters the market. ### Infrastructure: payment, securities systems, and market plumbing - Payment systems: - Four main inter-bank clearing and settlement systems form the non-cash payments infrastructure. - BoJ-NET Funds Transfer System (BoJ-NET FTS), operated by the BoJ, accounts for around 65 percent of aggregate value settled. - Domestic Funds Transfer (Zengin) System, owned and operated by the Tokyo Bankers Association (TBA), settles about 9 percent of aggregate value but accounts for 94 percent of payment volume over the four systems. - Foreign Exchange Yen Clearing System (FXYCS), operated by the BoJ under contractual arrangement with the TBA, accounts for about 24 percent of aggregate settlement value. - Tokyo Clearing House Bill and Check Clearing System (TCH-BCCS), operated by the TBA, settles due bills of exchange and checks. - Real-time gross settlement (RTGS) is now the principal settlement mode for funds transfers over the BoJ’s current accounts, though some payments still settle on a deferred gross basis in BoJ-NET FTS. - Securities settlement: - Central securities depositories (CSDs) exist for JGBs and other securities and stocks. - JGB transactions settled on a real-time delivery-versus-payment (DVP) basis through the BoJ-NET JGB Services. - Stock transactions in JASDEC are settled on a book-entry basis; DVP available for stocks traded through exchanges. - Non-JGB bonds (corporate and municipal) are registered and transferred on books of registration agencies (generally banks); settlement processed on a DVP basis. - In March 2003, JASDEC introduced a book-entry system including dematerialization, online settlement processing, and DVP for commercial paper transactions. - A unified central counterparty for exchange and JASDAQ stock market transactions started operations as of January 2003. ### Safety nets, crisis management, and lender-of-last-resort - Lender of last resort: - BoJ law amended in 1997 to clarify BoJ’s “lender of last resort” (LOLR) function; Article 1 specifies the “last resort” function as a BoJ objective. - Article 38: “The Prime Minister and the Minister of Finance may request that the Bank of Japan conduct the business necessary to maintain an orderly financial system, including provision of loans, when it is believed to be especially necessary for the maintenance of an orderly financial system.” - Since the 1990s financial crisis, the BoJ has advanced money to a number of failing institutions. - Deposit insurance: - Japan has a deposit insurance scheme under the Deposit Insurance Law, administered by the DIC (established July 1971) and subject to oversight by the MoF and the FSA. - Coverage: ¥10 million per depositor per institution for specified liabilities of deposit-taking institutions, except agricultural and related cooperatives and the postal savings deposits of the Japan Post and deposits of the Shoko Chukin Bank. - 1996 amendment temporarily covered all deposits irrespective of amount for five years; in March 2001 coverage for time deposits extended by one year and coverage for current and demand accounts extended by two years. - In 2003, coverage of demand deposits extended for a further two years, with coverage of non-interest bearing deposits in specific “settlement” accounts continuing indefinitely. - The scheme is running a deficit: the deficit has reached some ¥3.4 trillion. - Any DIC operation involves increased borrowing in the form of government guaranteed loans from the BoJ or financial institutions or by issuance of government guaranteed bonds. - Premium rates (with effect from April 2003): 0.09 percent for “specific deposits” (those still covered by the full guarantee) and 0.08 percent for other deposits (e.g., time deposits insured up to ¥10 million per depositor). - Procedures for failing banks: - A set of procedures administered by the FSA involves the DIC, the RCC (a subsidiary of the DIC), the Bridge Bank of Japan, and the BoJ. - Failed institutions in 1997/98 and thereafter were often resolved via purchase and assumption transactions, with “good” assets acquired by other institutions and remaining assets transferred to the RCC. - May 2000 amendment to the Deposit Insurance Law authorized the Commissioner of the FSA to appoint a financial administrator with full powers to deal with the business of a failed bank pending final resolution. - Financial crisis management framework: - May 2000 amendment established an explicit crisis management framework and the “systemic risk exception.” - If the potential failure of a financial institution poses a serious threat to stability, the Prime Minister can summon the Financial Crisis Council chaired by the Prime Minister. - The Council consists of the Chief Cabinet Secretary, the Minister of Finance, the Minister for Financial Services, the Commissioner of the FSA, and the Governor of the BoJ. - On the Council’s advice, the Prime Minister can authorize the DIC to: (i) inject capital into one or more financial institutions; (ii) provide financial assistance in excess of that mandated under the deposit insurance scheme; or (iii) take over control and acquire the share capital of a financial institution. *Source: _cr03287 - 7. Although Japanese banks' operating profits have been low for the past decade,* ### 31. To back up these arrangements the government has committed ¥15 trillion for ### _cr03287 - 31. To back up these arrangements the government has committed ¥15 trillion for ### Support facility and market implications - The government has committed ¥15 trillion for the support of banks in the event of a threat to the system. - The facility, together with the advance commitment of funds, has been taken by the market to mean that the five largest banking groups can be regarded as “too big to fail”. - The arrangement was tested in the recent Resona case, which demonstrated that, in close coordination with the BoJ, the arrangements were effective. - The authorities believe the amount available is sufficient to ensure the stability of the financial system. - The Financial System Council is reportedly considering a new system that would allow for preventive injection of public funds, even in cases where banks meet minimum regulatory capital requirements. ### BoJ equity purchases - A recently established BoJ equity purchases scheme is intended to contribute to financial stability. - The BoJ offers to purchase, off the market, some of the equity holdings that banks will have to sell to meet the limits that will be imposed from October 2004. - These purchases supplement arrangements for purchases by a government scheme for which the conditions proved too restrictive for much use to be made of them. ### Institutional aspects of supervision - The supervisory framework has recently been substantially changed with the setting up of the FSA. - The FSA law provides for on-site and off-site supervision of all authorized financial institutions by the FSA. - Legislation provides for a minister for financial services, who is a member of the cabinet and has effective authority over the FSA. - The FSA law authorizes the FSA to prescribe prudential rules and to apply sanctions where the rules are not complied with, or where an authorized institution is regarded as unsafe or unsound. - While the FSA has inherited the function of the MoF as statutory regulator, most major financial institutions are also subject to supervision by the BoJ under contractual arrangements with each intermediary. - The BoJ is not the statutory regulator and has no formal powers to require implementation of its examiners’ findings, but the BoJ law, as amended in 1997, contains a provision enabling the BoJ to require financial intermediaries with whom it deals to enter into such a contract. - The BoJ also has oversight responsibility for payment systems. ### Prudential rules and capital composition - Minimum capital requirements are designed to conform with the Basel Accord. - The FSA has no freedom to vary minimum capital requirements in accordance with its relative risk assessment but in 2002 introduced an early warning mechanism providing for intensive monitoring for banks that are above the required minimum capital but exhibit particular risk characteristics. - The composition of capital, while built upon the Basel framework, is over-reliant on preferred shares and deferred tax assets, and several large groups lack sufficient ordinary shareholders’ funds. - The FSA has established new procedures for the classification of borrowers and of assets: each claim is classified in two dimensions, by borrower and by type of claim (principally the type of collateral). - Provisions are raised against uncollateralized loans. Provisions can be deducted from income for corporate tax purposes to a limited extent only. - None of deferred tax assets are deducted from capital for capital adequacy purposes, but the Financial System Council is considering the appropriate treatment. ### Large exposure and shareholder limits - Large exposures are limited to 25 percent of capital per customer. - To a group of related customers, exposure can reach up to 40 percent. - Exposures to shareholders are restricted to 15 percent of capital and to shareholders and related parties to 25 percent of capital. - The large exposure limits are somewhat higher than those suggested by the Basel Committee. ### Supervision practice, staffing, and organizational history - Both FSA and BoJ do on-site examinations; supervisors also make some use of external audit reports. - Inspections take place once a year for major banks; in practice smaller banks have been inspected twice in the years the FSA has been in existence. - For major banks, the FSA in 2002 introduced an arrangement whereby inspectors are continuously assigned to major banks throughout the year. - Consolidated supervision is practiced; the FSA has powers to examine holding companies, and also shareholders who hold more than 20 percent of a supervised institution. - The FSA works closely together with a bank’s external auditor, but the auditor has no obligation to inform the FSA of problems he comes across during audit work. - Historical and staffing details: - When first established in 1998, the Financial Supervisory Agency worked in conjunction with the MoF Financial Policy Bureau and the Financial Reconstruction Commission. - As a second stage, when the Financial Supervisory Agency was renamed Financial Services Agency (FSA), the Commission was abolished in January 2001 and residual functions were transferred to the FSA. - The FSA staff has grown dramatically and has now reached about 1,000, with a further 1400 in LFBs of the MoF working on supervision. - About 800 staff are involved in off-site supervision, of which some 640 are in LFBs. - Staff turnover is low. Salaries are competitive with salaries in banks. Public servants are not allowed to work for institutions with which they have had a regulatory relationship for two years after leaving the service. - Since April 2003, the FSA has been delegated certain powers to inspect the risk management processes of some government financial institutions and agricultural credit cooperatives (which are not subject to the supervision of the FSA but by their sponsoring ministry). *Source: _cr03287 - 31.* ### 38. The FSA has powers to revoke a banking license and the law provides a ### _cr03287 - 38. The FSA has powers to revoke a banking license and the law provides a ### Supervisory powers and enforcement - The FSA has powers to revoke a banking license and the law provides a mandatory “prompt corrective action procedure” where banks fail to meet minimum capital requirements. - The FSA can prevent a bank from paying dividends and has powers over the appointment of managers and directors. - Shareholders who acquire more than 5 percent of a bank’s equity must notify the FSA and the acquisition of more than 20 percent requires FSA approval. - The FSA has powers to share information with foreign supervisory authorities for supervisory purposes. - Note on prompt corrective action procedures: “Prompt corrective action procedures,” first established in the U.S. and now used in several other countries, are legal requirements that force the supervisor to take specified actions when trigger thresholds are reached. These requirements are intended to limit opportunities for supervisory forbearance. ### Financial system structure (Table 1, end-March 2002 / Fiscal 2001) - Total financial system (excl. Bank of Japan): - Institutions: 30,766 - Branches: 74,287 - Employees: 1,154,251 - Total assets: 1,960 (trill. yen) — 100.0 percent of Total — 391.4 percent of GDP - Deposits outstanding: 1,105 (trill. yen) — 100.0 percent of Total - Loans and disc. outstanding: 862 (trill. yen) — 100.0 percent of Total - Private depository institutions — Banks (selected): - City banks (consolidated): 7 institutions; Branches 2,853; Employees 104,847; Total assets 410 (trill. yen) — 20.9 percent of Total — 81.9 percent of GDP; Deposits 260 (trill. yen) — 23.5 percent of Total; Loans 238 (trill. yen) — 27.6 percent of Total - Long-term credit banks: 3 institutions; Branches 39; Employees 4,131; Total assets 53 (trill. yen) — 2.7 percent of Total — 10.6 percent of GDP; Deposits 10 (trill. yen) — 0.9 percent of Total; Loans 27 (trill. yen) — 3.1 percent of Total - Trust banks: 29 institutions; Branches 405; Employees 28,266; Total assets 67 (trill. yen) — 3.4 percent of Total — 13.4 percent of GDP; Deposits 33 (trill. yen) — 3.0 percent of Total; Loans 41 (trill. yen) — 4.8 percent of Total - Regional banks: 64 institutions; Branches 7,788; Employees 141,237; Total assets 206 (trill. yen) — 10.5 percent of Total — 41.1 percent of GDP; Deposits 181 (trill. yen) — 16.4 percent of Total; Loans 136 (trill. yen) — 15.8 percent of Total - Regional banks II: 53 institutions; Branches 3,873; Employees 59,830; Total assets 60 (trill. yen) — 3.1 percent of Total — 12.0 percent of GDP; Deposits 55 (trill. yen) — 5.0 percent of Total; Loans 43 (trill. yen) — 5.0 percent of Total - Foreign banks: 73 institutions; Branches 112; Employees 4,993; Total assets 50 (trill. yen) — 2.6 percent of Total — 10.0 percent of GDP; Deposits 10 (trill. yen) — 0.9 percent of Total; Loans 12 (trill. yen) — 1.4 percent of Total - Others: 5 institutions; Branches 4; Employees 303; Total assets 0.4 (trill. yen) — 0.0 percent of Total — 0.1 percent of GDP; Deposits 0.2 (trill. yen) — 0.0 percent of Total; Loans 0.0 (trill. yen) — 0.0 percent of Total - Cooperative financial institutions (selected): - Shinkin banks and Shinkin Central Bank: 350 institutions; Branches 8,416; Employees 131,401; Total assets 137 (trill. yen) — 7.0 percent of Total — 27.4 percent of GDP; Deposits 120 (trill. yen) — 10.9 percent of Total; Loans 74 (trill. yen) — 8.6 percent of Total - Credit cooperatives and National Federation: 205 institutions; Branches 1,950; Employees 23,234; Total assets 19 (trill. yen) — 1.0 percent of Total — 3.8 percent of GDP; Deposits 16 (trill. yen) — 1.4 percent of Total; Loans 10 (trill. yen) — 1.2 percent of Total - Labor credit associations and Rokinren Bank: 22 institutions; Branches 689; Employees 11,439; Total assets 17 (trill. yen) — 0.9 percent of Total — 3.4 percent of GDP; Deposits 15 (trill. yen) — 1.4 percent of Total; Loans 8 (trill. yen) — 0.9 percent of Total - Agricultural cooperatives and Credit federations: 1,227 institutions; Total assets 147 (trill. yen) — 7.5 percent of Total — 29.4 percent of GDP; Deposits 123 (trill. yen) — 11.1 percent of Total; Loans 26 (trill. yen) — 3.0 percent of Total - Fishery cooperatives and Credit federations: 638 institutions; Total assets 4 (trill. yen) — 0.2 percent of Total — 0.8 percent of GDP; Deposits 3 (trill. yen) — 0.3 percent of Total; Loans 1 (trill. yen) — 0.1 percent of Total - Others: 2 institutions; Branches 142; Employees 7,635; Total assets 70 (trill. yen) — 3.6 percent of Total — 14.0 percent of GDP; Deposits 40 (trill. yen) — 3.6 percent of Total; Loans 35 (trill. yen) — 4.1 percent of Total - Non-depository financial institutions (selected): - Life insurance companies: 43 institutions; Branches 15,807; Employees 380,864; Total assets 184 (trill. yen) — 9.4 percent of Total — 36.7 percent of GDP; Loans item replaced by “...” for deposits/loans columns; Loans 47 — 5.5 (format in source) - Nonlife insurance: 59 institutions; Total assets 33 (trill. yen) — 1.7 percent of Total — 6.6 percent of GDP; Loans 4 — 0.5 (format in source) - Securities companies: 290 institutions; Branches 2,249; Employees 94,464; Total assets 65 (trill. yen) — 3.3 percent of Total — 13.0 percent of GDP - Money market dealers: 3 institutions; Branches 7; Employees 434; Total assets 30 (trill. yen) — 1.5 percent of Total — 6.0 percent of GDP - Others: 27,684 institutions; (other fields not filled in source) - Public financial institutions: - Postal savings: Institutions 1; Branches 24,773; Employees 62,422; Total assets 242 (trill. yen) — 12.3 percent of Total — 48.3 percent of GDP; Deposits 239 (trill. yen) — 21.6 percent of Total; Loans 0.7 and 0.1 (trill. yen) entries in source - Development Bank of Japan: 1 institution; Branches 25; Employees 1,390; Total assets 18 (trill. yen) — 0.9 percent of Total — 3.6 percent of GDP; Loans 17 — 2.0 (format in source) - Japan Bank for International Cooperation: 1 institution; Branches 29; Employees 893; Total assets 23 (trill. yen) — 1.2 percent of Total — 4.6 percent of GDP; Loans 22 — 2.6 (format in source) - Finance corporations: 6 institutions; Branches 257; Employees 8,967; Total assets 125 (trill. yen) — 6.4 percent of Total — 25.0 percent of GDP; Loans 120 — 13.9 (format in source) ### Ownership structures (Table 2, end-March 2002 / Fiscal 2001) - Major financial groups (ownership share in percent): Local and Central Government 0.1; Financial Institutions 37.3; Securities Firms 1.7; Non-financial Corp. 41.1; Foreign Corp. and Individuals 8.6; Other Individuals 11.3 - Selected group breakdowns (percent ownership shares): - Mizuho Holdings: Local and Central Government 0.1; Financial Institutions 49.1; Securities Firms 1.2; Non-financial Corp. 33.1; Foreign Corp. and Individuals 6.5; Other Individuals 10.0 - MTFG: Local and Central Government 0.1; Financial Institutions 45.9; Securities Firms 0.8; Non-financial Corp. 34.1; Foreign Corp. and Individuals 12.7; Other Individuals 7.1 - SMBC: Local and Central Government 0.1; Financial Institutions 38.8; Securities Firms 1.7; Non-financial Corp. 38.4; Foreign Corp. and Individuals 11.3; Other Individuals 9.8 - UFJ: Local and Central Government 0.0; Financial Institutions 39.2; Securities Firms 1.8; Non-financial Corp. 43.2; Foreign Corp. and Individuals 5.9; Other Individuals 9.9 - Resona: Local and Central Government 0.2; Financial Institutions 27.6; Securities Firms 2.1; Non-financial Corp. 42.5; Foreign Corp. and Individuals 5.5; Other Individuals 22.2 - Mitsui Trust Holdings: Local and Central Government 0.0; Financial Institutions 23.9; Securities Firms 2.9; Non-financial Corp. 56.3; Foreign Corp. and Individuals 1.9; Other Individuals 15.1 - Sumitomo Trust: Local and Central Government 0.0; Financial Institutions 36.8; Securities Firms 1.3; Non-financial Corp. 40.5; Foreign Corp. and Individuals 16.6; Other Individuals 4.8 - Major life insurers: Daido: Local and Central Government 0.0; Financial Institutions 18.2; Securities Firms 0.6; Non-financial Corp. 60.8; Foreign Corp. and Individuals 7.9; Other Individuals 12.5 - Major non-life insurers (selected): - Tokio Marine & Fire: Local and Central Government 0.0; Financial Institutions 46.4; Securities Firms 1.3; Non-financial Corp. 9.9; Foreign Corp. and Individuals 23.6; Other Individuals 18.7 - Yasuda Fire & Marine: Local and Central Government 0.0; Financial Institutions 49.0; Securities Firms 0.7; Non-financial Corp. 11.1; Foreign Corp. and Individuals 22.5; Other Individuals 16.7 - Mitsui Sumitomo: Local and Central Government 0.0; Financial Institutions 33.9; Securities Firms 0.6; Non-financial Corp. 18.0; Foreign Corp. and Individuals 32.3; Other Individuals 15.3 - Nissay Dowa: Local and Central Government 0.0; Financial Institutions 72.8; Securities Firms 0.6; Non-financial Corp. 11.7; Foreign Corp. and Individuals 5.5; Other Individuals 9.5 - Major clearing houses and market makers: - Tokyo Stock Exchange 3/: Local and Central Government 0.0; Financial Institutions 0.0; Securities Firms 100.0; Non-financial Corp. 0.0; Foreign Corp. and Individuals 0.0; Other Individuals 0.0 - Nomura Holdings: Local and Central Government 0.0; Financial Institutions 42.2; Securities Firms 0.6; Non-financial Corp. 9.5; Foreign Corp. and Individuals 28.3; Other Individuals 19.4 - Nikko Holdings: Local and Central Government 0.0; Financial Institutions 28.2; Securities Firms 0.9; Non-financial Corp. 6.8; Foreign Corp. and Individuals 49.8; Other Individuals 14.4 - Daiwa Securities Group: Local and Central Government 0.0; Financial Institutions 47.2; Securities Firms 0.6; Non-financial Corp. 7.0; Foreign Corp. and Individuals 29.4; Other Individuals 15.9 ### Asset composition and quality, domestic banks (Table 3, 1997–2002; end of March unless indicated) - Total loans and discounts outstanding (in trillions of yen) 1/: 1997 512; 1998 514; 1999 503; 2000 493; 2001 475; 2002 447; Sept. 2002 429 - Sectoral distribution of loans to total loans 1/ (selected entries): - Individuals: 1997 17.4; 1998 17.8; 1999 18.5; 2000 19.1; 2001 20.2; 2002 22.2; Sept. 2002 23.4 - Local governments: 1.4; 1.6; 1.9; 1.8; 1.8; 2.2; 2.2 - Manufacturing: 14.3; 13.8; 14.1; 14.8; 14.6; 14.2; 13.9 - Non-manufacturing: 65.6; 65.3; 64.2; 63.3; 62.4; 60.2; 59.6 - Construction: 6.2; 6.2; 6.4; 6.3; 6.1; 5.7; 5.4 - Wholesale, retail, and restaurants: 15.4; 15.2; 15.2; 15.2; 15.0; 14.2; 13.9 - Finance and insurance: 10.1; 10.0; 9.5; 9.1; 8.8; 8.8; 8.5 - Real estate: 12.4; 12.7; 12.9; 12.6; 12.5; 12.4; 12.3 - Memorandum item: - Small and medium enterprises (incl. finance and insurance): 1997 51.4; 1998 50.5; 1999 49.3; 2000 46.8; 2001 49.4; 2002 48.2; Sept. 2002 46.5 - Total external claims as a percent of total assets: 11.3; 12.1; 11.2; 9.1; 10.0; 10.2... - Geographical distribution of external claims (selected): - Developed countries: 34.8; 40.9; 52.0; ...; 55.7; 62.8; 63.0... - Developing countries: 8.0; 6.0; 5.3; 5.3; 4.0; 3.9... - Asia pacific: 7.3; 5.2; 4.4; 4.7; 3.3; 3.2... - Off-shore financial centers: 55.9; 51.9; 41.8; ...; 37.8; 32.4; 31.5... - FX-denominated loans to total loans 2/: -21.7; 15.2; ...; 11.0; 10.6; 9.7... - Sources: FSA website and internal data, and "Financial and Economic Statistics" by the BoJ. - Notes: - 1/ For 1997–2001, the data refer to end-Dec. 1996–end Dec. 2000 respectively. - 2/ This is the ratio of loans extended via overseas branches to total loans. ### Profitability, liquidity, and spreads, domestic private banks (Table 4, 1997–2002; end-March unless indicated) - Earnings and profitability (selected series): - ROA (pre-tax): 1997 0.0; 1998 -0.6; 1999 -0.9; 2000 0.3; 2001 0.1; 2002 -0.7; Sept. 2002 0.0 - ROE (pre-tax): 1997 0.2; 1998 -20.0; 1999 -25.1; 2000 6.8; 2001 1.2; 2002 -19.5; Sept. 2002 0.4 - Interest margin to gross income: 1997 47.4; 1998 51.7; 1999 53.6; 2000 46.7; 2001 61.3; 2002 63.4; Sept. 2002 62.7 - Non-interest expenses to gross income: 1997 78.5; 1998 80.3; 1999 86.2; 2000 88.5; 2001 83.2; 2002 91.3; Sept. 2002 93.2 - Personnel expenses to non-interest expenses: 1997 49.7; 1998 49.5; 1999 48.3; 2000 48.1; 2001 47.2; 2002 46.7; Sept. 2002 ... - Trading and fee income to total income: 1997 7.6; 1998 7.7; 1999 8.4; 2000 7.8; 2001 11.6; 2002 13.6; Sept. 2002 15.5 - Spread between average lending and deposit rates (by bank type): - City banks (7): 1.7; 1.7; 1.8; 1.8; 1.8; 1.8; 1.8 - Trust banks (5): 1.7; 1.6; 1.6; 1.7; 1.7; 1.7; 1.6 - Long-term credit banks (3): 1.0; 0.8; 0.8; 1.0; 1.1; 1.1; 1.2 - Regional banks (64): 0.8; 0.7; 0.8; 0.8; 0.8; 0.7; 1.5 - Regional banks II (54): 2.6; 2.0; 2.1; 2.1; 2.1; 2.1; 2.1 - Liquidity: - Liquid assets to total assets 2/: 1997 25.2; 1998 26.6; 1999 24.9; 2000 28.0; 2001 32.1; 2002 31.2; Sept. 2002 32.7 - Liquid assets to total short-term liabilities 3/: 1997 31.3; 1998 34.0; 1999 31.6; 2000 34.9; 2001 40.2; 2002 37.6; Sept. 2002 39.0 - Liquid assets to total (non-interbank) loans: 1997 38.4; 1998 41.9; 1999 38.6; 2000 43.4; 2001 54.3; 2002 51.8; Sept. 2002 55.3 - Average bid-ask spread in the securities market (in bps): .........1.6; 1.2; 0.9... - Average bid-ask spread in the FX market (in bps): ...6.5; 7.9; 9.9; 3.2; 5.9... - Amount of outstanding guarantees (in trillions of yen) 4/: 1997 30.9; 1998 33.2; 1999 30.4; 2000 27.5; 2001 25.7; 2002 24.3; Sept. 2002 23.0 - Notes: - 1/ Figures in parentheses in the first column are the number of institutions as of the end of September 2002. - 2/ Liquid assets include cash and due from banks, call loans, receivables under resale agreements, bills bought, monetary claims bought, trading assets, trading account securities, money held in trust, and investment securities. - 3/ Short-term liabilities include deposits, negotiable certificates of deposit, debentures, call money, payables under repurchase agreements, bills sold, commercial papers, and trading liabilities. - 4/ Sum of acceptance and guarantees extended by total banks. End of previous calendar year for 1997–2000. ### Capital adequacy, domestic private banks (Table 5, 1997–2002; end-March unless indicated) - Regulatory capital (tier-1 capital) to risk-weighted assets (selected series and categories): - All banks — International active (18): 1997 9.0 (4.7); 1998 9.6 (4.9); 1999 11.9 (6.9); 2000 12.2 (7.1); 2001 11.7 (7.0); 2002 10.9 (6.2); Sept. 2002 10.8 (6.1) - All banks — Not internationally active (114) 2/: 1997 4.4(...); 1998 7.7 (6.0); 1999 7.2 (5.3); 2000 9.7 (7.0); 2001 10.0 (7.0); 2002 9.4 (6.5); Sept. 2002 9.0 (6.3) - Regulatory capital (tier-1 capital) to risk-weighted assets (selected bank groups): - City banks — International active (5) 1/: 1997 9.0 (4.6); 1998 9.3 (4.7); 1999 11.9 (6.6); 2000 12.4 (6.9); 2001 11.7 (6.7); 2002 11.1 (6.0); Sept. 2002 10.9 (5.8) - City banks — Not internationally active (2): values include 12.7 (2000?) and 12.0 (8.4) etc., with later entries 8.7 (4.4) and 7.8 (4.0) - Trust banks — International active (2): 1997 9.6 (5.5); 1998 10.8 (6.1); 1999 13.1 (7.7); 2000 11.4 (7.0); 2001 11.7 (6.7); 2002 10.9 (6.2); Sept. 2002 11.6 (6.6) - Regional banks — Not internationally active (53): 1997 4.2 (3.1); 1998 9.0 (7.0); 1999 8.3 (6.2); 2000 9.5 (7.1); 2001 9.5 (7.2); 2002 9.2 (6.9); Sept. 2002 9.4 (7.1) - Regional banks II — Not internationally active (54): 1997 4.4(...); 1998 6.1 (5.1); 1999 5.0 (3.9); 2000 8.1 (6.3); 2001 8.1 (6.5); 2002 8.1 (6.3); Sept. 2002 8.6 (6.8) - Average capital-assets ratio (selected): - City banks (7): 3.1; 2.4; 4.6; 4.8; 4.2; ...; 3.4; 3.0 (format in source) - Trust banks (5): 3.3; 3.1; 5.6; 5.9; 5.2; ...; 4.0; 3.8 - Long-term credit banks (2): 2.8; 2.8; 3.9; 4.4; 4.6; ...; 4.1; 8.2 - Regional banks (64): 4.1; 3.8; 4.2; 4.6; 5.2; ...; 4.7; 4.7 - Regional banks II (54): 3.4; 2.5; 3.5; 4.2; 4.3; ...; 4.0; 4.3 - Memorandum item — Major banks 3/: - Internationally active (8): 1997 9.0 (4.7); 1998 9.6 (4.9); 1999 12.1 (6.7); 2000 12.3 (6.9); 2001 11.7 (6.7); 2002 11.0 (5.9); Sept. 2002 10.9 (5.9) - Not internationally active (5): entries include 13.5; (12.9)8.2 (7.6)12.0 (7.7)11.5 (7.1) 9.4 (5.0) 8.7 (4.6) - Sources: FSA, Japanese Bankers Association "Analysis of Financial Statements of all banks." - Notes: - 1/ Figures in parentheses in the first column are the number of institutions included as of the end of September, 2002. - 2/ The definition changed as of end-March 1998. As for end-March 1997, the ratio is capital to total assets. - 3/ Composed of the following 13 major banks: Mizuho (DKB, Fuji, IBJ, Yasuda Trust), MTFG (Tokyo-Mitsubishi, Mitsubishi Trust), UFJ (UFJ Bank, UFJ Trust), SMBC, Resona (Asahi, Daiwa), Chuo-Mitsui Trust, and Sumitomo Trust. *Italic: Source — _cr03287 - 38. The FSA has powers to revoke a banking license and the law provides a; Appendix II and III tables and notes as provided in the source content.* ### 1. Stress test estimates are based on data published in English versions of institutions’ ### _cr03287 - 1. Stress test estimates are based on data published in English versions of institutions’ 2002 annual reports and other public websites. ### Data sources and sample - Stress test estimates are based on data published in English versions of institutions’ 2002 annual reports and other public websites. - Public data availability limited the scope of analysis; authorities did not provide supervisory data or exposure estimates. - Sample includes: - 7 city bank financial groups - 21 regional banks - 2 central banks of credit cooperative financial institutions - 10 life insurance companies - The sample represents 56 percent of the total assets of banks and cooperative financial institutions and 86 percent of the assets of the life insurance industry. - For insurance companies, balance-sheet data was compiled by Fitch Ratings in a special report on “Japan’s Major Life companies in 2001/02: Mid-sized Players Squeezed.” ### Methodology and key assumptions - Market risk shocks: - Equity prices: 20 percent decline in equity prices (single market shock). - Interest rates: 100 basis points increase in yields. - Shock sizes represent about a two-standard deviation movement in the underlying risk factors over a three-month horizon (sample period 1970–2000). - Credit risk shocks: - Banks: 3 percent credit loss on the book value of loan portfolios. - Life insurers: 1.5 percent credit loss (reflecting higher quality credit portfolios). - Interest rate shock treatment: - Data limitations required foreign bonds to be included with domestic positions. - All bond positions repriced using the same price change estimates implied by a 100 basis point increase in domestic yields. - Japanese banks and insurance companies report only summary maturity structure information and do not differentiate fixed vs. floating rate debt; analysis assumes all fixed income portfolio positions are fixed rate. - Equity and bond portfolio treatment: - City banks rebalanced portfolios away from equities toward bonds, increasing potential losses from higher interest rates while reducing those from lower equity prices; reduction in equity losses was more than offset by fall in shareholder equity. - Measurement of loss-bearing capacity: - Losses compared to book shareholders’ equity in banks. - For insurers, losses compared to shareholder equity plus a subset of reserve account items included in insurers’ prudential solvency margin calculations and that would qualify as Tier-1 capital equivalents under banking rules. - Alternative measure: adjusted shareholders’ equity = shareholders’ equity less an institution’s deferred tax assets (DTAs). - DTAs cannot absorb losses; DTAs on average exceed 86 percent of city banks’ shareholder equity in March 2003 (used to correct measures of risk-bearing capacity). - The analysis does not measure effects on banks’ regulatory capital adequacy ratios (CARs) because Tier-1 and Tier-2 capital positions are not disclosed in English annual reports of many (primarily regional) banks. ### Key stress shock calibrations and historical context - Market moves in 2002: - Japanese equity prices fell by more than 20 percent (intra year). - Long term interest yields declined by nearly 100 basis points in 2002. - Stress shocks are not sized to capture all crisis scenarios where interest rates rise and equity prices decline; they may be undersized but provide useful information about exposures. - Historical calibration note: shocks represent about a two-standard deviation movement over a three-month horizon (sample period 1970–2000). ### Main findings from the updated stress tests (end-March 2003 data) - Overall conclusion: - Latest data support earlier FSSA conclusions regarding weaknesses in risk-bearing capacities and the need to strengthen the capital base of the banking sector. - Sector-level results and vulnerabilities: - City banks and cooperative central banks have the largest equity exposures relative to core capital. - Cooperative central banks have the largest interest rate risk exposures. - Regional banks are less vulnerable to the combined market stresses than city banks. - Life insurance companies show significant exposures to equity and interest rate risk relative to their capital and reserve assets; credit risks are less important for life insurers. - Group-average stress test results (selected figures as reported): - Equity stress (20% decline in prices) — reported group average impacts: - city banks: 44% - cooperative central banks: 3% - regional banks: 9% - life insurance: 45% - Interest rate stress (100 bps increase in yields) — reported group average impacts: - city banks: 33% - cooperative central banks: 72% - regional banks: 22% - life insurance: 38% - Credit risk stress (3% credit loss on loan book) — reported group average impacts: - city banks: 94% - cooperative central banks: 35% - regional banks: 45% - life insurance: 10% - Combined market stress scenario (20% equity decline and 100 bps yield increase): - Distributional results indicate a combination of market stresses may challenge the risk-bearing capacity of many institutions. - Correcting for DTAs further diminishes measures of risk-bearing capacity. - A combination of market risk stresses alone could deplete book shareholder equity in a number of banking institutions and test solvency margin buffers of some insurers. - Additional reported metrics and data points: - DTAs on average exceed 86 percent of city banks’ shareholder equity in March 2003. - One average excludes two institutions in which DTAs exceed shareholder equity. - One average excludes one institution in which DTAs and Tier 1 capital equivalents are approximately equal. ### Caveats, data limitations, and omitted considerations - Public annual report data lack sufficient detail to ensure all exposures are accurately measured; limitations include: - Inability to quantify foreign exchange risk or risks from off-balance sheet positions including derivatives. - Foreign exchange risks are reported to be modest for most Japanese banks and insurance companies, but this cannot be confirmed with public data. - Reports of derivative positions being used to increase bank exposures to interest rate risk could not be verified. - The stress tests are static and do not account for: - Loss-minimizing responses by banks and insurers. - The impact of shocks on insurers’ liabilities. - The effects of government support mechanisms or the availability of safety nets. - Contagion/spillover effects arising from interconnections (cross institution share and subordinated debt holdings) in the financial sector; such contagion risks were not quantified. - The tests reflect vulnerabilities as of end-March 2003; subsequent events noted include government recapitalization of Resona Bank, an increase in equity prices, and falling bond prices. ### Policy implications and recommendations (as implied by findings) - Strengthen the capital base of the banking sector given weakened risk-bearing capacities, particularly for city banks. - Recognize the importance of government safety nets in sustaining depositors’ and policy holders’ confidence, given that market shocks could deplete book shareholder equity and test insurers’ solvency margins. - Improve data collection and reporting (including disclosure of Tier-1 and Tier-2 capital, breakdowns of fixed vs. floating rate positions, and off-balance sheet exposures) to allow more comprehensive and accurate stress testing. *Prepared by the Monetary and Financial Systems and Asia and Pacific Departments; approved by Stefan Ingves and David Burton; August 14, 2003.* ### 4. The authorities provided end-March 2003 data (FY 2002) for selected indicators ### _cr03287 - 4. The authorities provided end-March 2003 data (FY 2002) for selected indicators ### Key developments in FY 2002 - Total bank and credit cooperative assets have declined accompanied by reductions in the number of branches and employees. - The shares of bank lending to four troubled sectors (construction, wholesale/retail, finance and insurance, and real estate) and to small and medium enterprises declined but still account for over 40 percent of total loans. - Bank profitability remains weak as the sector as a whole posted losses for the second consecutive year. - Lending-deposit spreads are broadly unchanged and liquidity ratios rose. - Banks’ average capital adequacy ratios (CARs) declined but remain above minimum requirements; loan losses eroded capital in many banks but reductions in risk assets and the issuance of preferred shares helped to attenuate CAR declines. - The quality of bank capital remains poor with deferred tax assets (DTAs) accounting for an even larger share of Tier-1 capital. - Life insurers face pressures from equity exposures and high guaranteed yields; solvency margin ratios declined due to valuation losses on marketable securities and shrinking gross premium income but remain above the prudential minimum requirement. - Progress in dealing with problem loans was mixed: major banks charged off more loans, reducing NPLs to below 8 percent for the sector as a whole, while NPL ratios for regional banks remain unchanged. ### Financial system structure (Table 1) — selected figures, end-March 2003 (Fiscal 2002) - Total financial system (excl. Bank of Japan): Amount 1,098,419 (trill. yen), 1,884 (100.0 percent of total), 377.6 (percent of GDP); deposits outstanding 1,092 (100.0); loans and discounts outstanding 797 (100.0). - City banks (consolidated): Institutions 72, Branches 655, Employees 95,422, Total assets Amount 407 (trill. yen) (21.6 percent of total) (81.6 percent of GDP?), Deposits 248 (22.7 percent of total), Loans 223 (28.0 percent of total). - Long-term credit banks: Institutions 2, Branches 46, Employees 3,062, Total assets 13 (0.7 percent of total) (2.6 percent of GDP), Deposits 40 (4.04?), Loans 70.9 (values as in table). - Trust banks: Institutions 27, Branches 325, Employees 21,303, Total assets 61 (3.2 percent of total) (12.2 percent of GDP), Deposits 34 (3.1 percent), Loans 31 (3.9 percent). - Regional banks: Institutions 64, Branches 7,600, Employees 124,970, Total assets 204 (10.8 percent of total) (40.9 percent of GDP), Deposits 181 (16.6 percent), Loans 136 (17.1 percent). - Shinkin banks and Shinkin Central Bank: Institutions 327, Branches 8,015, Employees 126,179, Total assets 139 (7.4 percent of total) (27.9 percent of GDP), Deposits 120 (11.0 percent), Loans 72 (9.0 percent). - Life insurance companies: Institutions 43, Employees 15,807, Total assets 380,864 (179 (9.5 percent of total) (35.9 percent of GDP)), Loans n.a.; Loans/Deposits entries: Deposits n.a., Loans 47 (5.9 percent). - Memorandum: City banks' international operations Amount 5,126 (11,849?) (35 (1.9 percent of total) (7.0 percent of GDP)), Deposits 12 (1.1 percent), Loans 16 (2.0 percent). (Note: Table 1 contains many institution-specific values; above are selected entries preserved as in the source table.) ### Ownership structures of major institutions (Table 2), ownership share in percent, end-March 2003/Fiscal 2002 — selected entries - Mizuho Holdings: Local and Central Government 0.1, Financial Institutions 47.0, Securities Firms 1.1, Non-financial Corp. 32.1, Foreign Corp. and Individuals 5.7, Other Individuals 14.0. - MTFG: 0.0, 42.6, 1.1, 30.7, 14.1, 11.5. - SMBC: 0.1, 36.4, 2.5, 37.8, 9.3, 13.9. - UFJ: 0.0, 32.1, 2.5, 39.4, 10.7, 15.3. - Resona: 0.1, 28.8, 1.9, 42.3, 3.8, 23.1. - Major life insurer (Daido): Local and Central Government 0.0, Financial Institutions 27.5, Securities Firms 1.4, Non-financial Corp. 58.6, Foreign Corp. and Individuals 5.6, Other Individuals 7.0. - Selected major nonlife insurers (Aioi, Sompo Japan Insurance, Nisshin Fire & Marine, Nissey Dowa General Insurance, Nipponkoa Insurance, Fuji Fire and Marine, Mitsui Sumitomo Insurance, Millea Holdings) — ownership shares listed in table (preserved verbatim in source). ### Asset composition, domestic private banks (Table 3), 1998–2003 (end-March) - Total loans and discounts outstanding (in trillions of yen) 1998: 514; 1999: 503; 2000: 493; 2001: 475; 2002: 447; 2003: 432. - Sectoral distribution of loans to total loans (percent): - Individuals: 1998: 17.8, 1999: 18.5, 2000: 19.1, 2001: 20.2, 2002: 22.2, 2003: 23.7. - Local governments: 1.6, 1.9, 1.8, 1.8, 2.2, 2.6. - Manufacturing: 13.8, 14.1, 14.8, 14.6, 14.2, 14.1. - Non-manufacturing: 65.3, 64.2, 63.3, 62.4, 60.2, 59.3. - Construction: 6.2, 6.4, 6.3, 6.1, 5.7, 5.4. - Wholesale, retail, and restaurants: 15.2, 15.2, 15.2, 15.0, 14.2, 13.8. - Finance and insurance: 10.0, 9.5, 9.1, 8.8, 8.8, 8.7. - Real estate: 12.7, 12.9, 12.6, 12.5, 12.4, 12.3. - Memorandum: Small and medium enterprises (incl. finance and insurance): 50.5, 49.3, 46.8, 49.4, 48.2, 45.5. - Total external claims as a percent of total assets: 12.1, 11.2, 9.1, 10.0, 10.2, 8.6. - Geographical distribution of external claims (percent): Developed countries 40.9, 52.0, 55.7, 62.8, 63.0, 64.9; Developing countries 6.0, 5.3, 5.3, 4.0, 3.9, 4.5; Asia pacific 5.2, 4.4, 4.7, 3.3, 3.2, 3.7; Off-shore financial centers 51.9, 41.8, 37.8, 32.4, 31.5, 28.4. - FX-denominated loans to total loans 2/: 21.7, 15.2, 11.0, 10.6, 9.7, ... ### Profitability, liquidity, and spreads, domestic private banks (Table 4), 1998–2003 (end-March) - Earnings and profitability: - ROA (pre-tax): 1998: -0.6, 1999: -0.9, 2000: 0.3, 2001: 0.1, 2002: -0.7, 2003: -0.6. - ROE (pre-tax): -20.0, -25.1, 6.8, 1.2, -19.5, -19.4. - Interest margin to gross income: 51.7, 53.6, 46.7, 61.3, 63.4, 60.0. - Non-interest expenses to gross income: 80.3, 86.2, 88.5, 83.2, 91.3, ... - Personnel expenses to non-interest expenses: 49.5, 48.3, 48.1, 47.2, 46.7, 46.3. - Trading and fee income to total income: 7.7, 8.4, 7.8, 11.6, 13.6, 16.6. - Spread between average lending and deposit rates (percent): - City banks: 1.6, 1.6, 1.7, 1.7, 1.7, 1.6. - Trust banks: 0.8, 0.8, 1.0, 1.1, 1.1, 1.2. - Long-term credit banks: 0.7, 0.8, 0.8, 0.8, 0.7, 1.5. - Regional banks: 2.0, 2.1, 2.1, 2.1, 2.12.1 (table formatting artifact). - Regional banks II: 2.4, 2.3, 2.4, 2.5, 2.5, 2.5. - Liquidity ratios (percent): - Liquid assets to total assets 1/: 26.6, 24.9, 28.0, 32.1, 31.2, 34.9. - Liquid assets to total short-term liabilities 2/: 34.0, 31.6, 34.9, 40.2, 37.6, 41.0. - Liquid assets to total (non-interbank) loans: 41.9, 38.6, 43.4, 54.3, 51.8, 56.9. - Average bid-ask spread in securities market (in bps): ..., ..., 1.6, 1.2, 0.9, ... - Average bid-ask spread in FX market (in bps): 6.5, 7.9, 9.9, 3.2, 5.9, ... - Amount of outstanding guarantees (in trillions of yen) 3/: 33.2, 30.4, 27.5, 25.7, 24.3, 19.8. ### Capital adequacy, domestic private banks (Table 5), 1998–2003 (end-March) - Regulatory capital (tier 1 capital) to risk-weighted assets (percent), selected series: - City banks, International active (5): 1998: 9.3 (4.7), 1999: 11.9 (6.6), 2000: 12.4 (6.9), 2001: 11.7 (6.7), 2002: 11.1 (6.0), 2003: 10.3 (5.3). - City banks, Not internationally active (2): ..., ..., 12.7 (8.7), 12.0 (8.4), 8.7 (4.4), 6.7 (3.5). - Trust banks, International active (2): 10.8 (6.1), 13.1 (7.7), 11.4 (7.0), 11.7 (6.7), 10.9 (6.2), 11.0 (6.1). - Regional banks, International active (10): 10.7 (7.6), 10.6 (7.6), 11.5 (8.1), 11.3 (8.1), 10.9 (8.0), 10.7 (8.0). - All banks, International active (18): 9.6 (4.9), 11.9 (6.9), 12.2 (7.1), 11.7 (7.0), 10.9 (6.2), 10.4 (5.7). - All banks, Not internationally active (114): 7.7 (6.0), 7.2 (5.3), 9.7 (7.0), 10.0 (7.0), 9.4 (6.5), 8.5 (5.9). - Average capital-assets ratio (percent), selected groups: - City banks (7): 2.4, 4.6, 4.8, 4.2, 3.4, 2.1. - Trust banks (5): 3.1, 5.6, 5.9, 5.2, 4.0, 3.4. - Regional banks (64): 3.8, 4.2, 4.6, 5.2, 4.7, 4.5. - Regional banks II (53): 2.5, 3.5, 4.2, 4.3, 4.0, 4.0. - Memorandum: Major banks (internationally active (7)): 9.6 (4.9), 12.1 (6.7), 12.3 (6.9), 11.7 (6.7), 11.0 (5.9), 10.4 (5.4). ### Insurance sector and nonperforming loans (Text tables from FSSA) - Japan: Financial Soundness Indicators for the Insurance Sector, 1998–2003 (percent, end-March): - Solvency ratio: - Life insurance companies: 705.9, 692.8, 819.0, 712.8, 671.9, 631.1 (1998–2003). - Non-life insurance companies: 908.1, 1,385.7, 1,290.8, 999.9, 934.6, 790.9. - Nominal growth rate of gross premium income: - Life insurance companies: 3.4, -5.0, -4.3, -2.4, -2.8, -1.7. - Non-life insurance companies: -1.3, -4.8, -0.7, 0.6, 0.0, ... - Net pre-tax earning as percent of total assets: - Life insurance companies: 0.8, 0.1, 0.5, 0.3, 0.2, 0.2. - Non-life insurance companies: 1.2, 0.9, 0.5, 0.5, -0.8, ... - Japan: Nonperforming Loans, 1998–2003 (percent, end-March): - Nonperforming loans to total loans 1/: 1998: 5.4, 1999: 5.8, 2000: 6.1, 2001: 6.6, 2002: 8.9, 2003: 7.8. - City banks: 4.8, 5.2, 5.0, 5.4, 9.4, 7.8. - Trust banks: 8.4, 11.0, 8.7, 7.5, 9.5, 7.5. - Long-term credit banks: 10.0, 9.1, 9.0, 10.0, 9.6, 6.2. - Regional banks: 3.7, 4.9, 5.6, 7.0, 7.7, 7.7. - Regional banks II: 5.3, 5.5, 6.7, 8.2, 9.0, 8.9. *Source: FSA, MOF, Japanese Bankers Association "Analysis of Financial Statements of all banks," Japan Post, Shoko Chukin Bank, BoJ, Life Insurance Association of Japan (data as presented in the provided FSSA update for end-March 2003/FY 2002).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03287.pdf_