## _cr12210

## Source details

**Canonical URL:** [_cr12210](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12210.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12210.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12210.pdf.json)

---

### Main FSAP findings and system-wide assessment
- Important progress since the 2003 FSAP assessment: significant restructuring among large banks and insurance companies; nonperforming loans were reduced; capital positions improved; supervision and oversight improved.
- The financial system withstood one of the most severe output contractions experienced among the G-7 during the global financial crisis, aided by substantial liquidity injections and monetary easing by the BOJ and other government stimulus measures.
- Swift and decisive policy response maintained financial stability after the Great East Japan Earthquake.

### Key macro-financial risks
- High public sector indebtedness and slow growth are central risks to financial stability.
- JGB and sovereign funding risks:
  - The financial system’s massive holdings of government bonds leave it exposed to a spike in yields.
  - Market absorption of large public financing needs to date is contingent on confidence in long-term fiscal sustainability and growth, and on corporate and household savings trends.
- Regional bank vulnerabilities:
  - Weak regional economies have produced low core profitability, relatively thin capital positions, and large duration gaps for several regional banks.
  - Suggested needs: better risk management systems, higher capital buffers, streamlining of operations.
- Credit risk:
  - Credit quality has held up relatively well despite a large output decline and recent yen appreciation.
  - Crisis-related measures to support SME lending may have masked underlying weaknesses; credit risk may build up without sustained economic growth.

### Resilience and stress testing outcomes
- FSAP stress tests indicate that in the near-term the system would be resilient to severe economic distress and moderate market shocks.
- Financial stability is not assured; intensified monitoring and contingency planning is recommended in areas noted above (JGB/sovereign, regional banks, credit quality).
- Top-down and bottom-up test design notes:
  - Top-Down: BOJ framework; five-year horizon up to March 2017 for most scenarios; two-year horizon for some scenarios.
  - Bottom-Up: banks’ and insurers’ internal models; two-year horizon (March 2013 and 2014) for solvency; one week/one month for bottom-up liquidity; top-down liquidity three months.

### Banking sector capital, liquidity, and profitability (selected figures)
- Banks hold large amounts of liquid assets:
  - Around 50 percent as a share of short-term liabilities.
  - About 20 percent as a share of total assets.
- Major banks’ capital position as of September 2011 (on a Basel III basis):
  - About 14¾ percent CAR.
  - 11⅓ Tier 1 ratio.
  - 9⅓ core Tier 1 ratio.
- Applying immediately and in full the Basel III capital definition (with Basel II RWA) would reduce major banks’:
  - Core Tier 1 and Tier 1 capital ratios by about 2 percentage points.
  - Total capital adequacy ratios (CARs) by 6 percentage points.
- Three mega financial groups estimate more prudent risk weights (Basel III phase-in as of September 2011) would reduce Tier 1 capital ratios by about an additional 1 percentage point.
- Profitability:
  - Net interest margins (NIM) have been exceptionally weak.
- Banking sector historical indicators (All Banks, 2001–2011) — selected sequences preserved from source:
  - Total capital ratio: 10.5 10.5 10.9 11.2 11.6 11.5 12.6 12.0 12.6 13.6 14.1 (2011 Mar) N/A (2011 Sep).
  - Interest margin: 1.8 1.8 1.9 1.9 1.8 1.8 1.7 1.7 1.7 1.6 1.6 1.5.
  - Liquid assets/total assets: 13 14 18 19 20 18 16 16 16 20 21 22.
  - Liquid assets/short-term liabilities: 44 37 40 44 43 44 39 36 36 38 47 48 50.

### Insurance sector and pensions (selected figures and findings)
- Insurers showed strong regulatory solvency margins under pre-FY2011 requirements.
- New solvency requirements effective in FY2011 are estimated to have reduced solvency margins by about 20–30 percent, while keeping them well above the regulatory minimum.
- Life insurers’ JGB exposures and vulnerability:
  - JGBs represent about 70 percent of life insurers' securities holdings.
  - Life insurers’ equity holdings represent 5½ percent of total assets.
  - Under adverse scenarios, life insurers’ net assets could decline by 30–40 percent over two years; if coupled with a pandemic shock, net assets would decline by 40–50 percent over two years.
- Nonlife insurers:
  - Nonlife insurers' equity holdings are about 20 percent of assets.
  - Nonlife sector appears on average resilient; losses absorbed by sizeable unrealized gains on securities.
- Public pensions:
  - Significant viability challenges remain despite 2004 reforms.
  - Large share of public pension assets invested in domestic fixed-income investments, predominantly JGBs.

### Stress-test scenarios and key results
- Scenarios applied (banks and insurers):
  - Baseline: World Economic Outlook projection as of September 2011.
  - Global double-dip (mild/severe): mild = one standard deviation shock; severe = two standard deviations shock.
  - Protracted growth slowdown with further deflationary pressures.
  - Global double-dip mild combined with a 100 bps parallel shift of the yield curve.
- Banking sector stress-test findings:
  - The banking sector appears broadly resilient to the scenarios, though some regional banks are vulnerable.
  - Aggregate capital ratios remain well above Basel III requirements.
  - Tier 2 regional banks (7 percent of system’s total assets) start with lower CARs (4 percent, Basel II-based total CAR) and face sharper capital drops under protracted growth and double-dip mild + market yield shock scenarios.
  - BOJ estimates: a 100 basis point (parallel) rise in market yields would lead to MTM losses of 20 percent of Tier-1 capital for regional banks and 10 percent for the major banks (not taking into account net unrealized gains on securities).
  - Equity price shock (BOJ estimate): a price shock of about 50 percent could reduce Tier 1 capital by about 17 percent for major banks and 14 percent for regional banks.
- Insurance stress-test findings:
  - Aggregate solvency margin: no insurance company would fall below solvency margin requirements in any scenario per FSA confirmation.
  - Severe global recession would reduce solvency margin cumulatively by 17 percent over two years.
  - Global double-dip with market yield surge would reduce solvency margin by 20 percent.
  - Life insurers’ net assets: under severe recession or recession with market yield surge, net assets decline by 30–40 percent over two years; with pandemic, 40–50 percent decline.

### Selected system-wide vulnerabilities and spillovers
- JGB market exposures are a central macrofinancial risk:
  - JGBs represent about 70 percent of life insurers' securities holdings and about 90 percent of insurance cooperatives’ securities holdings.
  - Large JGB exposures also exist in the main public pension scheme, Japan Post, and Norinchukin bank.
- Domestic spillovers:
  - High EDF correlations between megabanks and a number of regional banks; EDF correlations between megabanks and insurance and securities are generally low.
- Foreign spillovers:
  - Main potential foreign sources: U.S., U.K., Germany, France (nearly 60 percent of total foreign claims).
  - No country other than these four can generate impairment above 25 percent of Tier 1 capital for Japan.
  - Among Asian countries, Japan is most at risk from exposures to China, Australia, and Singapore.

### High-priority regulatory, supervisory, and macroprudential recommendations
- Bolstering oversight of systemic risk:
  - Develop the framework for regular thematic risk assessments and bottom-up stress tests for macroprudential purposes ¶29,36.
  - Intensify monitoring and oversight of systemically relevant financial institutions, markets, and infrastructures ¶36,44.
  - Consider more regular arrangements for intensive inter-agency cooperation in systemic risk monitoring and contingency planning ¶30.
  - Monitor closely sovereign-financial stability interlinkages and ensure risk management frameworks are sufficiently robust ¶25,RAM(1).
- Enhancing prudential and supervisory framework:
  - Review the FSA’s regulatory mandate and evaluate adequacy of supervisory skills and resources ¶31,36.
  - Move towards a more formalized risk-based framework for assessing institutions’ vulnerability and supervisory prioritization ¶30,31.
  - Raise minimum capital ratios for domestically-active banks closer to those required of internationally-active banks and align capital buffers with materiality of risks ¶26,35, RAM(1,2).
  - Strengthen supervisory requirements on large exposure limits for banks ¶35, RAM(4).
  - Encourage stronger internal governance and enhanced role for auditors and audit committees ¶36,37,39.
  - Strengthen securities firm oversight via expanded risk-based inspection programs and extended auditing/registration requirements ¶41,42.
- Strengthening crisis management and resolution:
  - Explore improvements to ensure orderly resolution of systemically-important nonbank financial firms ¶49,51,52, RAM(4).
  - Consider expanding recovery and resolution plans for all systemically-relevant bank and nonbank institutions consistent with key attributes of an effective resolution regime ¶52.
- Supporting private sector growth:
  - Unwind and better target selected public support measures, including some credit guarantees and SME support measures, as recovery takes hold ¶58-60.
  - Develop an effective strategy to establish a stronger regional and cooperative bank sector, including through private sector-led consolidation ¶10,59, RAM(1,2).

### Fiscal costs, contingent liabilities, and SME support recommendations
- Fiscal risks:
  - Direct fiscal cost through repeated capital injections into GFIs has climbed during the global financial crisis.
  - Government may face further contingent liabilities from credit guarantees and reinsurance subsidies.
  - Recommendation: Advance full privatization of GFIs (including Japan Post); strengthen GFI supervision and inspection frequency. (¶58)
- SME support and credit risk:
  - Loan reclassifications under SME support measures weaken banks’ incentives to assess credit risk; about 3–6 percent of total credit reclassified for credit cooperatives, 1.7 percent for major banks.
  - BOJ’s 2012 FSR: if firms benefiting from relaxed restructured-loan requirements fail to recover, the NPL ratio of banks would rise about 1 percentage point from the current level.
  - Recommendation: Encourage SME restructuring through wider use of debt-equity swaps and more flexibility in release of personal guarantees. (¶60)
- Targeting and unwinding:
  - Allow the SME Financing Facilitation Act to expire as scheduled; phase out special and counter-cyclical credit guarantees gradually.
  - Gradually reduce the normal coverage ratio to about 60 percent—in line with international averages—to promote market discipline. (¶59)

### Financial Market Infrastructures (FMIs), crisis preparedness, and safety net
- FMIs:
  - Effective oversight of JGB FMIs; RTGS for all large-value payments; DVP settlement for all securities types; steps toward central clearing of standardized OTC derivatives.
  - Recommended: implement contingency funding arrangements for JGBCC; officially disclose systemically-important FMIs; provide more detailed CPSS-IOSCO assessments; clarify authorities’ cooperation arrangements.
- Crisis resolution and safety net gaps:
  - FCMC exists but has met only twice since 2001.
  - Noted gaps: lack of institutional arrangement for systemic nonbank financial institution distress (including CCPs); need to contain potential cost of bank resolution; consider earlier triggers for resolution; rebalance administrative procedure to allow ex post judicial review.
- Deposit insurance numeric detail:
  - DICJ protects insured deposits up to ¥10 million in principal plus interest payable until day of failure, and unlimited coverage for deposits held for payments and settlement purposes, accounting on total for 90.4 percent of insurable deposits in 2010.

### Capital reform timeline and Basel III transition notes
- Conservation buffer:
  - Conservation buffer will be added by 0.625 every year starting in 2016 for a total of 2.5 by 2019.
- Basel III implementation stance:
  - FSA published final capital adequacy rules for internationally active banks on March 30, 2012; FSA will implement new rules as from March 31 2013 (end of fiscal year 2012).
  - For domestically-active banks, Basel II total capital ratio of 4 percent (current regulation) remains in use as of source text.
- Impact estimates:
  - Applying full Basel III capital definition immediately expected to reduce total capital ratio for tier 1 regional banks by 3¼ percentage points and for tier 2 regional banks by 1 ½ percentage points.

### Selected economic indicators and key statistics (from Table 4)
- Nominal GDP: US$5,867 billion (2011)
- Population: 127.8 million (2011)
- GDP per capita: US$45,900 (2011)
- Quota: SDR 15,628.5 million
- Real GDP growth (percent change): 2007 2.2; 2008 -1.0; 2009 -5.5; 2010 4.4; 2011 -0.7; 2012 2.4; 2013 1.5
- Government (percent of GDP), Public Debt, gross: 2007 183.0; 2008 191.8; 2009 210.2; 2010 215.3; 2011 229.9; 2012 234.5; 2013 240.0
- CPI (annual average): 2007 0.1; 2008 1.4; 2009 -1.3; 2010 -0.7; 2011 -0.3; 2012 0.2; 2013 0.0
- Unemployment rate (annual average): 2007 3.8; 2008 4.0; 2009 5.1; 2010 5.1; 2011 4.6; 2012 4.5; 2013 4.4
- Current account balance (billions of US$): 2007 212.2; 2008 159.8; 2009 146.6; 2010 204.0; 2011 119.2; 2012 130.3; 2013 167.0
- Exports of goods and services: 2007 678.4; 2008 746.5; 2009 545.3; 2010 730.1; 2011 787.2; 2012 807.4; 2013 830.0
- Oil imports (trade basis): 2007 130.1; 2008 190.6; 2009 99.9; 2010 134.3; 2011 185.0; 2012 227.8; 2013 233.7

### Market structure and capital markets observations
- Financial system features:
  - Banks hold 60 percent of all financial sector assets.
  - Total assets of insurance sector at end-2010: 78 percent of GDP or ¥373 trillion.
  - Japan Post Bank holds a quarter of total deposits; city banks hold approximately forty percent of total deposits.
  - JGB market is the largest in absolute size and relative to GDP; in 2011 Japanese government securities amounted to about US$12 trillion.
- Equity markets:
  - Total listed companies across six exchanges: 2,900.
  - Tokyo Stock Exchange listings: 2,280.
  - TSE market capitalization: US$ 3,634,790 million as of March 31, 2011.

### Supervisory capacity, legal framework, and recommended institutional reforms
- FSA and BOJ supervisory strengths:
  - Integrated approach with FSA as single universal regulator; BOJ supports on-site and off-site monitoring.
  - BOJ produces semi-annual Financial System Report (FSR).
- Recommended supervisory and legal enhancements:
  - Strengthen FSA capacity, resources, and independence (including financing options not involving Diet budget negotiation).
  - Clarify and formalize interagency information sharing and cooperation with BOJ and other ministries.
  - Formal criteria to identify systemically-important financial institutions (SIFIs) to better prioritize supervisory resources.
  - Revise Prompt Corrective Action (PCA) triggers to allow earlier intervention and align capital definitions for domestically-active and internationally-active banks.
  - Strengthen large exposure rules, extend resolution regime to systemically-important nonbank firms and CCPs, and enhance contingency planning and resolution toolkits.

*Source: IMF staff extract from the FSAP chapter "Japan confronts a challenging macrofinancial operating environment" (content unit _cr12210).*

### 2012. The FSAP team comprised Udaibir S. Das (Mission Chief), Nicolas Blancher (Deputy Mission Chief),

### _cr12210 - 2012. The FSAP team comprised Udaibir S. Das (Mission Chief), Nicolas Blancher (Deputy Mission Chief),

### Main FSAP findings and system-wide assessment
- Important progress since the 2003 FSAP assessment: significant restructuring among large banks and insurance companies; nonperforming loans were reduced; capital positions improved; supervision and oversight improved.  
- The financial system withstood one of the most severe output contractions experienced among the G-7 during the global financial crisis, aided by substantial liquidity injections and monetary easing by the BOJ and other government stimulus measures.  
- Swift and decisive policy response maintained financial stability after the Great East Japan Earthquake.

### Key macro-financial risks identified
- High public sector indebtedness and slow growth are central risks to financial stability.  
- JGB and sovereign funding risks:
  - The financial system’s massive holdings of government bonds leave it exposed to a spike in yields.
  - Market absorption of large public financing needs to date is contingent on confidence in long-term fiscal sustainability and growth, and on corporate and household savings trends.  
- Regional bank vulnerabilities:
  - Weak regional economies have produced low core profitability, relatively thin capital positions, and large duration gaps for several regional banks, making them vulnerable to slow growth and market yield shocks.  
  - Suggested needs: better risk management systems, higher capital buffers, streamlining of operations.  
- Credit risk:
  - Credit quality has held up relatively well despite a large output decline and recent yen appreciation.
  - Crisis-related measures to support SME lending may have masked underlying weaknesses; credit risk may build up without sustained economic growth.

### Resilience and stress testing outcomes (summary)
- FSAP stress tests indicate that in the near-term the system would be resilient to severe economic distress and moderate market shocks.  
- Financial stability is not assured; intensified monitoring and contingency planning is recommended in areas noted above (JGB/sovereign, regional banks, credit quality).

### Regulatory, supervisory, and macroprudential recommendations
- Need for additional resources and skills at the FSA to undertake regular thematic risk assessments (across types of financial institutions) and deepen oversight of nonbanks.  
- Enhance mechanisms for systemic and macroprudential oversight and adopt more forward-looking cross-sectoral approaches. Specific suggestions:
  - Systemic oversight: build on existing mechanisms for systemic risk monitoring and interagency cooperation; consider more regular information sharing systems, early warning systems, and bottom-up stress-tests across all systemically-important banks and nonbank financial institutions.  
  - Prudential and supervisory framework quality: 
    - More stringent large exposure limits on banks.
    - Higher minimum capital ratio requirements for domestically-active banks (including credit cooperatives).
    - Tighter and more risk-sensitive solvency requirements and liability valuation for insurers.
    - Improved registration processes and auditing requirements for securities firms.  
  - Crisis management and resolution: more formalized, high-level inter-agency arrangements for pre-emptive planning and engagement; strengthen resolution regime for systemically-important nonbank financial firms (and possibly extend to systemically relevant CCPs).

### Financial sector reforms to support private-sector growth
- A broad-based financial reform plan could improve the sector’s ability to enable private sector-led growth. Key steps (to be considered as recovery is assured):
  - Ensure more market-based credit allocation to SMEs, including by reducing the role of government in direct lending and guarantees (example action: phasing out the SME Financing Facilitation Act by end-FY2012 and reducing the role of government-affiliated financial institutions (GFIs) in financial markets).  
  - Improve the framework for new products and capital markets to support growth-enhancing sectors.  
  - Initiate measures to encourage consolidation and streamlining of the regional bank segment, consistent with growth strategies for regional economies.

### High Priority Recommendations (summary from Table 1)
- Objective: Bolstering oversight of systemic risk
  - Develop the framework for regular thematic risk assessments (across types of financial institutions) and bottom-up stress tests for macroprudential purposes ¶29,36.  
  - Intensify monitoring and oversight of systemically relevant financial institutions, markets, and infrastructures ¶36,44.  
  - Consider more regular arrangements for more intensive and continuing inter-agency cooperation in systemic risk monitoring and contingency planning ¶30.  
  - Monitor closely sovereign-financial stability interlinkages and ensure risk management frameworks are sufficiently robust to deal with stress situations ¶25,RAM(1).
- Objective: Enhancing the quality of prudential and supervisory framework
  - Review the FSA’s regulatory mandate and evaluate the adequacy of its supervisory skills and resources ¶31,36.  
  - Move towards a more formalized risk-based framework for assessing financial institutions’ vulnerability and for prioritizing supervisory intensity ¶30,31.  
  - Raise minimum capital ratios for domestically-active banks closer to those required of internationally-active banks and align capital buffers with the materiality of risks ¶26,35, RAM(1,2).  
  - Strengthen supervisory requirements on large exposure limits for banks ¶35, RAM(4).  
  - Encourage stronger risk management by financial institutions, including through improved internal governance, and enhanced role for company auditors and audit committees ¶36,37,39.  
  - Strengthen securities firm oversight through expanded and more risk-based inspection programs, extended auditing requirements, and improvements to the registration process ¶41,42.
- Objective: Strengthening crisis management arrangements
  - Explore further improvements to ensure the orderly resolution of systemically-important nonbank financial firms ¶49,51,52, RAM(4).  
  - Consider expanding the scope of recovery and resolution plans for all systemically-relevant bank and nonbank financial institutions, consistent with key attributes of an effective resolution regime ¶52.
- Objective: Supporting private sector growth
  - Unwind and better target selected public support measures, including some credit guarantees and SME support measures, as economic recovery takes hold ¶58-60.  
  - Develop an effective strategy to establish a stronger regional and cooperative bank sector, including through private sector-led consolidation ¶10,59, RAM(1,2).

*Main authors: Udaibir S. Das, Nicolas Blancher, and Serkan Arslanalp, with contributions from the FSAP team.*

### 5.      Japan confronts a challenging macrofinancial operating environment (Table 4,

### 5.      Japan confronts a challenging macrofinancial operating environment (Table 4, Figure 1)

### Macroeconomic environment and fiscal-financial linkages
- Deflationary pressures remain and growth is sluggish.
- Gross public debt reached 220 percent of GDP at end-FY2011.
- An increasing share of the financial system’s balance sheet is invested in JGBs.
- Crisis-related financial support (credit guarantees and safety-net lending) has increased fiscal–financial sector linkages.
- Household and corporate balance sheets appear sound, and continued demand for bank deposits has provided indirect support for government debt markets.
- BOJ purchases of JGBs—through its step-up of existing bond purchases and recent asset purchase program—have provided support and liquidity for the financial system.

### Financial system performance and soundness
- The financial system faces limited credit demand, a flat yield-curve, and weak profitability.
- Some policies and market practices may have limited risk-taking and posed bottlenecks on credit intermediation, contributing to low growth and structural challenges.
- The system remained stable during the global financial crisis and the recent earthquake; temporary liquidity squeezes occurred but financing conditions returned to normal following authorities’ actions.
- Specific measures to ease funding and support SMEs included U.S. dollar funds-supplying operations and special government credit guarantees.
- Payment systems remained well-functioning, with only short-lived surges in settlement fails.
- Only some regional banks had concentrated exposures to earthquake-hit areas; nonlife insurers absorbed catastrophe losses by drawing down reserves.

### Banking sector capital, liquidity, and profitability
- The Japanese banking sector has become much better capitalized over the last decade.
- Banks hold large amounts of liquid assets:
  - Around 50 percent as a share of short-term liabilities.
  - About 20 percent as a share of total assets.
- Major banks’ capital position as of September 2011 (on a Basel III basis):
  - About 14¾ percent CAR.
  - 11⅓ Tier 1 ratio.
  - 9⅓ core Tier 1 ratio.
- Applying immediately and in full the Basel III capital definition (with Basel II RWA) would reduce major banks’:
  - Core Tier 1 and Tier 1 capital ratios by about 2 percentage points.
  - Total capital adequacy ratios (CARs) by 6 percentage points.
- Three mega financial groups estimate more prudent risk weights (in line with Basel III phase-in as of September 2011) would reduce Tier 1 capital ratios by about an additional 1 percentage point.
- Profitability:
  - Profitability has improved since the 2003 FSAP but remains consistently below international norms.
  - Net interest margins (NIM) have been exceptionally weak.
  - Weak margins have encouraged banks to diversify or take greater risk exposures, including overseas or longer JGB durations for regional banks.
- Asset quality:
  - Improved substantially during the past decade but recently shown signs of deterioration.
  - Nonperforming loan (NPL) levels may be underestimated due to measures to support SMEs.

### Insurance sector and pensions
- Insurers showed strong regulatory solvency margins under pre-FY2011 requirements.
- New solvency requirements effective in FY2011 are estimated to have reduced solvency margins by about 20–30 percent, while keeping them well above the regulatory minimum.
- The new requirements do not incorporate full economic valuation of assets and liabilities.
- Insurance sector profitability has risen only marginally but is expected to improve gradually.
- Public pensions:
  - Significant challenges to viability remain despite 2004 reforms.
  - Key elements of the 2004 reforms, such as macroeconomic indexation of benefits, have yet to be implemented.
  - Considered changes do not include raising the retirement age beyond age 65 or harmonizing the system across sectors.
  - The private pension system is evolving and growing but remains small compared to the public system.

### Key macrofinancial risk factors
- JGB market exposures are a central macrofinancial risk:
  - JGBs represent about 70 percent of life insurers' securities holdings.
  - JGBs represent about 90 percent of insurance cooperatives’ securities holdings.
  - Large JGB exposures also exist in the main public pension scheme, Japan Post, and Norinchukin bank.
- BOJ estimates: a 100 basis point (parallel) rise in market yields would lead to MTM losses of:
  - 20 percent of Tier-1 capital for regional banks (not taking into account net unrealized gains on securities).
  - 10 percent for the major banks.
- Credit risk:
  - Domestic corporate loans have historically been the largest source of credit costs.
  - Major banks face large and concentrated exposures to a few companies or industries; regional banks have concentrated exposures to local industries.
  - SME-related credit costs could rise if growth slows or if SMEs benefiting from relaxed restructured-loan requirements fail to recover once support measures are removed.
  - Other credit risks include strains from accelerated overseas expansion and mortgage-related exposures (presently modest but requiring monitoring).
- Equity market risk:
  - City banks' equity holdings represent around half their capital.
  - Regional banks' equity holdings are around 30 percent of capital.
  - Nonlife insurers' equity holdings are about 20 percent of assets (twice the level in other advanced countries).
  - Life insurers' equity holdings represent 5½ percent of total assets.
- FX risks:
  - The U.S. dollar accounts for ¾ of total yen FX transactions.
  - Net FX positions of Japanese banks are small, limiting valuation losses.
  - FX liquidity risks are actively managed via local repos, interbank loans, certificates of deposit, and cross-currency funding using FX swaps.
  - Cost of some funding sources (especially swaps) has been unstable; banks have lengthened FX swap terms and issued U.S. dollar bonds.
  - Securities firms’ reliance on market funding, particularly FX swaps, requires careful day-to-day liquidity management.

### Resilience—Stress tests and scenarios
- FSAP stress tests were conducted with BOJ and FSA; top-down tests used BOJ framework, bottom-up tests used common assumptions for major banks and insurers.
- Baseline scenario reflects World Economic Outlook projection as of September 2011.
- Three adverse scenarios applied to banking and insurance sectors:
  - A global double-dip including a significant slowdown in China (mild: one standard deviation shock to real GDP growth; severe: two standard deviations shock).
  - A protracted growth slowdown over the medium-to-long-term with further deflationary pressures.
  - A global double-dip mild scenario combined with a 100 bps parallel shift of the yield curve (a moderate market yield shock in line with Japan’s experience in the past 15 years).
- Sensitivity analyses for a larger market yield shock were conducted in top-down bank tests.
- Insurance stress tests examined insurance-specific shocks.

### Banking sector stress-test findings
- The banking sector appears broadly resilient to the scenarios, though some regional banks are vulnerable.
- Aggregate capital ratios for the whole sector remain well above Basel III requirements.
- Internationally active banks are likely to meet Basel III capital requirements individually, aided by high initial capital buffers and phased implementation.
- Tier 2 regional banks (representing 7 percent of the system’s total assets) face greater risk:
  - Start with lower CARs due to less stringent regulatory requirements (4 percent, Basel II-based total CAR).
  - Experience sharper drops in capital under protracted growth and double-dip mild with market yield shock scenarios due to relatively large credit and JGB exposures.
- Market yield shocks materially affect capital ratios:
  - Scenarios with a 100 bps market yield shock reduce aggregate capital ratios more in the first two years than other scenarios.
- Other risk-factor insights:
  - Credit risk: rises to levels comparable to the early 2000s under protracted growth, but profits and capital provide buffers for most banks; corporate-sector credit costs are the most important.
  - Results do not reflect potential impact of withdrawing SME support measures and large exposure risks.
  - Equity exposures: FSAP scenario losses are small, but BOJ estimates a price shock of about 50 percent could reduce Tier 1 capital by about 17 percent for major banks and 14 percent for regional banks.
  - Yen funding risks: minimal due to BOJ’s accommodative stance, limited wholesale funding reliance, deposit inflows, and large holdings of liquid assets that qualify as collateral for BOJ facilities.
  - FX funding risks: manageable through sales/repos of foreign assets (mostly U.S. treasuries) or access to U.S. Federal Reserve System facilities for some banks.

### Stress-test methodology and caveats
- Top-down bank stress tests used BOJ calculations; bottom-up tests were performed by participating banks and insurers with common assumptions.
- The stress tests did not cover certain large financial institutions such as Japan Post, Norinchukin bank, and the largest securities companies.
- Differences between top-down and bottom-up results for the three megabanks (2.1 percentage points in Basel III capital ratios as of September 2011) are mostly explained by RWA calculations and differing consolidation levels.

*Source: IMF staff extract from the FSAP chapter "Japan confronts a challenging macrofinancial operating environment" (content unit _cr12210).*

### 21.      On average, the insurance sector appears resilient, but life insurers’ net assets

### _cr12210 - 21.      On average, the insurance sector appears resilient, but life insurers’ net assets

### Insurance sector stress-test findings
- Aggregate solvency margin: no insurance company would fall below the solvency margin requirements in any of the scenarios mentioned in paragraph 18 (FSA confirmation).
- Impact of adverse scenarios on solvency margin:
  - A severe global recession would reduce the solvency margin by a cumulative of 17 percent over two years.
  - A global double dip with market yield surge would reduce the solvency margin by 20 percent.
- Life insurance sector: aggregate solvency margin could withstand adverse scenarios, but net assets would be severely impacted:
  - Under a severe global recession or a global recession with market yield surge, net assets would decline by 30–40 percent over two years.
  - If coupled with a pandemic shock, net assets would decline by 40–50 percent over two years.
- Nonlife insurance sector: appears on average resilient to stress scenarios; does not face the risk of major net asset losses because of shorter duration of bond holdings and losses are entirely absorbed by sizeable unrealized gains on securities.

### Complementary institutional assessments (Box 1 highlights)
- Japan Post Bank and Japan Post Insurance:
  - JGBs represent 76 percent of Japan Post Bank total assets (70 percent in held to maturity (HTM) account).
  - A 100 bps interest rate shock would lead to MTM losses of about 35 percent of Tier 1 capital (taking into account existing unrealized gains, but stressing all JGBs, including in the HTM account).
  - Japan Post Insurance: nearly 80 percent of its financial assets are domestic securities (in particular JGBs and local government bonds); benefits from buffers in the form of unrealized gains on its securities portfolio.
- Norinchukin Bank:
  - Lost in 2009 the equivalent of 20 percent of its Tier 1 capital due to exposures to U.S. mortgage securities.
  - Strengthened capital position; Tier 1 capital ratio reached 20.2 percent in September 2011.
  - Holds a large JGB portfolio (22 percent of assets).
  - Staff estimates that MTM losses from a 100 bps interest rate shock (including those in the HTM account) would reduce Tier 1 capital by 20 percent.
  - Existing unrealized gains would raise its Tier 1 capital ratio by about one percentage point.

### Domestic and foreign financial spillovers
- Domestic spillovers:
  - High EDF correlations between the megabanks and a number of regional banks, and among megabanks and regional banks themselves.
  - EDF correlations between megabanks and insurance and securities are generally low.
- Foreign spillovers:
  - Main potential sources of foreign spillovers into Japan’s financial system are the U.S. and core European banking systems.
  - Network simulations indicate the largest potential losses for Japanese banks would reflect exposures to the U.S., U.K, Germany, and France (nearly 60 percent of their total foreign claims).
  - The Japanese banking sector seems able to withstand a range of shocks affecting these four countries, except for scenarios where:
    - the whole U.S. or U.K. banking sectors fall in distress; or
    - the German or French banking and corporate or sovereign sectors fall in distress; or
    - there are widespread strains in global funding markets (with associated fire sale losses) leading to more foreign bank failures.
  - No country other than these four can generate impairment above 25 percent of Tier 1 capital for Japan.
  - Among Asian countries, Japan is most at risk from exposures to China, Australia, and Singapore.

### Overall risk assessment and key vulnerabilities
- Near-term: Japanese banks and insurers seem to have the capacity to withstand a range of adverse macrofinancial scenarios considered in this FSAP.
- FSA reported that all insurance companies in the test would maintain a higher solvency margin than the regulatory requirement under all stress scenarios.
- JGB market exposures are a central source of macrofinancial risk:
  - Losses from JGB exposures could reduce capital ratios (or net assets for insurers) across financial institutions.
  - A 100 bps market yield shock would have a manageable impact in the stress tests, but requires close monitoring, enhanced risk management, and contingency planning.
  - Market yield shocks may trigger feedback effects between the public and financial sectors and the real economy, potentially more severe than measured in the stress tests.
- Non-linear feedback effects:
  - October 2011 FSR: for adjustable rate loans, credit cost ratios from corporate loans could rise by 0.1 percentage points for a 100 bps shock and by 1 percentage points for a 300 bps shock.
- Compounded risk factors:
  - Market yield shocks may materialize over the medium-term in the context of an unfavorable economic path.
  - Basel III capital requirements will increase gradually, potentially challenging system resilience.

### Supervisory and policy implications
- Enhanced monitoring and risk management:
  - Close monitoring of JGB exposures and contingency planning for market yield shocks.
  - Account for potential non-linear credit risk feedbacks not captured in FSAP stress tests.
- Targeted capital and supervisory measures:
  - Smaller regional banks identified as the most vulnerable segment due to larger duration gap, larger credit risk exposures, relatively thin capital positions, lower core profitability, and difficult regional business prospects.
  - These banks may need to be subject to higher capital buffers, in line with their risk profile.
- Data and analytical limitations to address:
  - FSAP team lacked direct access to supervisory data; bottom-up results communicated only on an aggregate basis.
  - Confidentiality constraints limited assessment of cross-border exposures and the maturity structure of insurance liabilities.
  - Banking sector solvency tests did not address risks from large exposures or the impact of adjusting for support measures to the SME sector.
  - Insurance stress tests do not reflect full economic valuations of liabilities (though interest rate sensitivity analyses provide indication of potential effects).
- Macroprudential surveillance and institutional coordination:
  - BOJ’s semi-annual FSR is a key component of macrofinancial surveillance; could be complemented by systemic risk surveys and extended stress testing to a wider range of institutions.
  - Potential benefits from more formalized cooperation arrangements among regulatory institutions to define responsibilities on systemic issues and improve information sharing between the FSA and BOJ.
  - Consider formal criteria to identify systemically-important financial institutions (SIFIs) to better prioritize supervisory resources.
- Prudential recalibrations for banking supervision:
  - Capital requirements should reflect banks' actual risk profiles; reconsider the distinction between internationally-active banks (8 percent of RWA) and domestically-active banks (4 percent of RWA).
  - Review Prompt Corrective Action (PCA) triggers to allow earlier intervention to raise capital.
  - Revise and strengthen large exposure rules so exposures from an individual client or group of connected clients are taken into account, limits set as a percentage of Tier 1 or core Tier 1 capital, and banks properly manage concentration risk across regions and industries.
- Strengthen FSA capacity and independence:
  - Augment analytical capacity and risk monitoring capabilities of the FSA, clarify supervisory arrangements for cooperative-style institutions, and consider enhancing the FSA’s budgetary and operational independence.

*Source: IMF Japan FSAP Update (content unit _cr12210 - 21).*

### 37.      The FSA has been enhancing the framework for insurance oversight, including with

### _cr12210 - 37.      The FSA has been enhancing the framework for insurance oversight, including with

### Insurance oversight — recent enhancements and gaps
- Recent FSA actions:
  - Revised risk parameters, resulting in an increase in required capital.
  - Extended solvency requirements to the holding company level.
  - Improved supervisory assessment tools, including stress testing.
  - Enhanced supervision of insurance holding companies, cooperation with foreign supervisors, and market analysis capabilities.
- Recommended further actions:
  - Supervisory assessment:
    - Complete development of a methodology for risk-rating insurers.
    - Adopt a structured system for the internal review of risk assessments.
    - Further increase resources to enable more frequent inspections—especially for the largest insurers.
  - Solvency assessments:
    - Base solvency assessments on an economic valuation of assets and liabilities, taking into account future cash flows over the full time horizon.
  - Exercise of supervisory powers:
    - Lower the formal threshold for supervisory administrative action and make greater use of powers to impose fines on insurers and intermediaries.
    - Develop a more progressive approach to enforcement.
    - Strengthen regulation and supervision of reinsurance activities, given exposure to natural catastrophes and the essential role of strong reinsurance coverage in the Japanese insurance market.
  - Corporate governance:
    - Revise corporate governance in the industry to strengthen independent oversight to reinforce FSA supervisory efforts.
  - Crisis anticipation and cross-border cooperation:
    - Maximize the value of macroprudential analyses.
    - Develop contingency plans.
    - Cooperate more proactively with foreign supervisors, for example through establishment of colleges of supervisors for Japanese insurance groups.

### Public pension system — objectives and reforms suggested
- Current issues:
  - Important objectives set, but further improvements needed.
  - Large share of public pension assets invested in domestic fixed-income investments, predominantly JGBs.
- Recommended reforms:
  - Consider incorporating built-in mechanisms to adjust pension parameters (in addition to macroeconomic indexation of benefits) to support short-term and long-term objectives.
  - Encourage alternative, less conservative investment strategies to improve long-term rates of return and reduce interest rate exposure.
  - Steps to encourage pension system growth and retirement income contribution:
    - Harmonize earnings-related contribution limits across types of pension plans.
    - Allow use of higher maximum retirement ages.
    - Promote financial literacy to encourage participation in defined contribution plans.
    - Restrict the use of lump-sum and temporary annuity settlements, which can leave retirees with insufficient income in later years.

### Securities firms — strengths and areas for strengthening
- Strengths:
  - Oversight framework shows a high degree of compliance with IOSCO Principles.
  - Robust legal framework gives FSA extensive supervisory, investigative, and cooperation powers.
  - FSA reorganized to upgrade capacity to identify, monitor, and mitigate systemic risk.
- Areas for further strengthening:
  - Develop a more robust framework to assess scale and scope of risk posed by individual firms to guide intensity of regulatory intervention (including onsite inspections).
  - Securities Exchange Surveillance Commission (SESC) should intensify inspection coverage for smaller firms to strengthen investor protection.
  - Improve the registration process for securities firms.
  - Impose external auditing requirements on regulated entities that can hold clients’ assets when necessary.
  - Review enforcement program to balance regulatory measures (orders for improvement, suspensions, cancellations).
  - Review administrative monetary penalty framework to ensure penalty amounts deter misconduct and expand the range of misconducts subject to penalties.
  - Continue implementing new principles and improve comprehensive, systematic risk identification and assessment (Office of Securities Business Monitoring (OSBM) is a positive step).

### Financial Market Infrastructures (FMIs) — status and improvements
- Strengths:
  - Effective oversight of JGB FMIs; strengthened robustness and efficiency over past decade.
  - BOJ oversight policy decided by policy board and disclosed on its website for private-sector FMIs and offshore yen payment systems.
  - Key improvements implemented: RTGS for all large-value payments, liquidity saving features in RTGS, DVP settlement for all securities types, reduction of risks in JGB clearing and settlement.
  - Japan has taken steps to meet G-20 commitment to centrally clear all standardized OTC derivatives.
- Planned/needed improvements:
  - Implement structural improvements planned in response to the Lehman default, including contingency funding arrangements for Japan Government Bond Clearing Corporation (JGBCC) and coordinated contingency plans to deal with a CCP failure.
  - Officially disclose the list of systemically-important FMIs.
  - Provide more detailed assessments against CPSS-IOSCO standards in key areas (e.g., legal basis of settlement finality for fund transfers).
  - Clarify domestic authorities’ cooperation arrangements to facilitate exercise of responsibilities in normal circumstances and during market stress.

### Crisis preparedness and resolution — historical context and institutional arrangements
- Historical developments:
  - 1990s: more than 100 deposit-taking institutions closed at substantial fiscal cost, prompting overhaul of regulatory architecture (Financial Reconstruction Commission and Financial Supervisory Agency in 1998; reorganized into the FSA by 2001).
  - The Great East Japan Earthquake in March 2011 demonstrated authorities’ ability to ensure functionality and stability of the financial system after extreme shocks.
- BOJ liquidity powers and recent support:
  - BOJ provides standing facilities for liquidity to banks and broker/dealers with central bank accounts; may extend collateralized loans and, in exceptional cases as requested by government, unsecured loans subject to well-defined criteria (the Four Principles).
  - Generous credit support by government and BOJ recently included safety-net lending, expansion of credit guarantees, and BOJ lending to growth sectors and disaster areas. Caution advised to avoid adverse effects on the credit channel and banks’ risk-taking incentives; credit guarantee program may lead to credit and fiscal costs and concerns about the public sector balance sheet.

### Crisis resolution regime — gaps and enhancements
- Coordination:
  - Financial Crisis Management Council (FCMC), chaired by the Prime Minister, includes Chief Cabinet Secretary, Minister for Financial Services, Ministry of Finance, Commissioner for Financial Services, and Governor of the Bank of Japan; advises Prime Minister on resolution of institutions whose failure may disrupt stability and seeks “systemic risk exception” where appropriate. Since inception in 2001, FCMC has met only twice.
- Ongoing work:
  - Authorities refining resolution regime in light of Financial Stability Board Key Attributes.
  - Preparing “recovery and resolution” plans (RRPs) for Japan’s three global SIFIs and examining extension to a wider range of domestic institutions.
- Noted gaps and possible enhancements:
  - No similar institutional arrangement for distress or failure of systemic nonbank financial institutions, including CCPs.
  - Introduce mechanisms to contain potential cost of bank resolution; ensure resolutions avoid value destruction, minimize public costs, and impose losses on stakeholders consistent with liquidation priority.
  - Consider earlier triggers for initiating resolution to maximize orderly resolution and minimize costs.
  - Rebalance predominately administrative resolution procedure so FSA/DICJ decisions are subject to ex post judicial review to facilitate transfer of insured deposits and good assets to an acquiring bank immediately upon initiation of resolution.
  - Re-examine depositor preference, especially regarding purchase and assumption transactions.
  - Consider more forceful procedures to restructure bank balance sheets without requiring creditors’ consent.
  - Extend effective resolution regime to systemically-important nonbank financial institutions and large securities firms as they expand into investment banking activities.

### Financial system safety net — coverage and shortcomings
- Current coverage:
  - DICJ has an array of resolution tools but board composition (including representatives of banking associations) may create appearance of conflicts of interest.
  - Life Insurance Policyholders Protection Corporation of Japan (PPCJ) has similar powers as DICJ but lacks authority to use special measures such as recapitalization or temporary nationalization.
  - Japan Investor Protection Fund (JIPF) has very limited powers, mainly directed at return of client assets rather than resolving troubled firms as going concerns.
- Specific numeric coverage detail:
  - DICJ protects insured deposits for amounts up to ¥10 million in principal plus interest thereon payable until the day of the failure, and unlimited coverage for deposits held for payments and settlement purposes, accounting on total for 90.4 percent of insurable deposits in 2010.
- Recommendation:
  - Revisit resolution regime for securities firms in light of global crisis experience and need for orderly resolution of large securities firms.

### Financial policies and growth — public sector role and recent outcomes
- Structural issues:
  - Challenge: financial system’s role in supporting long-term growth amid slow growth, demographic shifts, and fiscal imbalances.
  - Government continues to play a large role in credit intermediation.
- Public sector footprint:
  - GFI’s share of financial system assets has halved in the past decade, falling to 11 percent at end-FY2010 (excluding Japan Post Bank and Insurance), but GFIs remain active in implementing policy directives and facilitating credit to firms with limited commercial bank access.
  - Public sector’s indirect role expanded recently via the temporary SME Financing Facilitation Act, safety-net lending, expansion of credit guarantee programs to cover loan values in full, and BOJ’s asset purchase program.
- Outcomes of support measures:
  - Support measures helped avoid excessive tightening of financing conditions and widespread bankruptcies after the recent earthquake.
  - SME Financing Facilitation Act improved lending; nearly half of SMEs used counter-cyclical guarantees to bolster liquidity on hand, and more than a fifth have extended guarantee terms.
  - Overall NPL ratio remained stable below 3 percent during the global financial crisis.
  - Decline in bankruptcies averaged 12 percent after the peak of the Lehman crisis.
  - Corporate exit rate remained low at around 4–5 percent.
  - Efforts were made to support financing of startup companies.

*Source: Excerpt from the IMF chapter PDF _cr12210.*

### 57.      Several of these policy measures could entail direct fiscal and other costs that might

### _cr12210 - 57.      Several of these policy measures could entail direct fiscal and other costs that might

### Fiscal costs and contingent liabilities
- Direct fiscal cost through repeated capital injections into GFIs has climbed during the global financial crisis.
- The government may face further contingent liabilities, such as losses from credit guarantees through fund-provision to JFC reinsurance and subsidies for compensation assets in national and local credit guarantee corporations’ funds.
- Recommendation: Advance the momentum for full privatization of GFIs (including Japan Post); strengthen GFI supervision, including inspection frequency. (¶58)

### Credit risk and SME support measures
- Loan reclassifications associated with SME support measures are likely to weaken banks’ incentives to assess credit risk, especially for regional banks and credit cooperatives (for which about 3–6 percent of total credit has been reclassified under the Act, against 1.7 percent for major banks).
- The BOJ’s 2012 FSR indicates that if firms benefiting from relaxed requirements for restructured loans failed to recover, the NPL ratio of banks would rise about 1 percentage point from the current level.
- Recommendation: Encourage SME restructuring through wider use of debt-equity swaps and more flexibility in the release of personal guarantees in voluntary workouts and debtor-in-possession bankruptcies procedures. (¶60)

### Targeting and unwinding of temporary support measures
- Several financial sector support measures could be better targeted or unwound in a timely manner as the recovery takes hold.
- Policy prescriptions:
  - Target direct financial support such as safety net loans more towards start-ups and growth-enhancing sectors.
  - Allow the SME Financing Facilitation Act to expire as scheduled.
  - Phase out special and counter-cyclical credit guarantees (covering full loan values) gradually as the recovery takes hold, taking into account the experience in 2000–2001 in withdrawing special guarantees.
  - Gradually reduce the normal coverage ratio to about 60 percent—in line with international averages—to help promote market discipline. (¶59)

### Market practices, credit infrastructure, and capital markets development
- Market practices on the use of collaterals and access to credit information could be further improved.
  - Personal guarantees and collaterals in the form of fixed assets, such as real estate and equipment, are usually required for bank lending.
  - Ongoing efforts to establish an electronic registration system on accounts receivables and other current assets could be advanced to further promote asset-backed lending.
  - Consider extending the coverage of credit registries and incorporating consumer data covering household or personal credit information.
  - Measures to address structural weakness in SMEs, including through the establishment of an asset management company (AMC) tailored to SMEs, could help support startups and facilitate exits of nonviable firms. (¶60)
- There would be merit in taking stock of past successes and failures in promoting capital market development in Japan and addressing potential obstacles systematically. Potential reform areas identified through discussions with market participants include:
  - Financial taxation (which could be streamlined).
  - Legal and regulatory framework (sometimes too complex and fragmented, hampering new product development).
  - Household financial literacy (should progress hand in hand with the development of new products). (¶61)

### Medium-priority recommendations (selected from Table 2)
- Upgrade systemic risk monitoring:
  - Deepen cross-border risk monitoring arrangements and make active use of memoranda of understanding with foreign supervisory authorities. (¶29,36)
  - Consider expanding dissemination of the encouraged set of FSIs for banks and, as relevant, for insurance and securities firms sectors. (¶27,29)
  - Strengthen the formal basis for data and information sharing among supervisory agencies given confidentiality provisions in different financial sector-related laws. (¶31)
- Enhance regulation and supervision quality:
  - Explore mechanisms to strengthen governance arrangements for the selection of auditors and protection of their independence. (¶35,37,39)
  - Strengthen disclosure requirements for nonbanks, including on assumptions used to measure assets/liabilities and on risk exposures including cross holdings, cross-border, and concentration risks. (Annexes II–III)
  - Review the prompt corrective action framework for banks and examine the desirability of raising the trigger points for action. (¶35)
  - Clarify co-decision process for institutions co-supervised by FSA and a Ministry, and strengthen FSA supervision of government-owned financial institutions. (Annex I)
  - Strengthen pension supervision in cooperation with other financial supervisors on risks that could affect both the pension system and financial stability. (¶38,39)
- Bolster crisis management:
  - Refine further the existing bank resolution framework to minimize its costs (e.g., through earlier triggers and speedier administrative procedures). (¶48-52)
  - Rebalance roles of the FSA/DICJ and the judiciary so that a range of resolution decisions may be implemented by the FSA/DICJ subject to ex post judicial review. (¶50-51)
  - Amend the governance structure of the DIC to make it more independent and to place greater emphasis on minimizing resolution costs. (¶50-52)
- Support private sector growth (selected):
  - Strengthen credit discipline by introducing a schedule for gradually reducing the coverage of credit guarantees, in line with international norms. (¶59)
  - Encourage further market-based financing (including venture capital) to improve risk assessments and access to capital by start-up companies. (¶60-61)
  - Strengthen credit infrastructure by encouraging broader use of collaterals and asset-based lending, and develop a wider coverage and information sharing on current credit registries. (¶60-61)
  - Consider further improvements to the framework for new products and capital markets in order to support growth-enhancing sectors. (¶61)

### Risk Assessment—main risks, likelihood, and impact (selected from Table 3)
- Surge in market yields
  - Likelihood (over next one to three years): Low
  - Impact on Macrofinancial Stability: High
  - Notes: Stress tests show a modest effect of a moderate 100 bps shock for banks and insurers; larger interest rate shocks or coupling with protracted growth slowdown could be severely damaging.
- Protracted growth slowdown and deflationary pressures
  - Likelihood: Medium
  - Impact: Medium
  - Notes: Key risk for smaller regional banks; medium-term nature provides time for corrective actions.
- Severe global double dip reducing Japan’s GDP growth
  - Likelihood: Medium
  - Impact: Medium
  - Notes: Direct exposures of Japanese financial institutions overseas are small; main vulnerability is indirect via weaker domestic growth and asset prices.
- Distress of large financial or nonfinancial institutions
  - Likelihood: Medium (nonfinancial), Low (financial)
  - Impact: Medium
  - Notes: Major corporate bankruptcies possible in a severe downturn; deficiencies in regulation on large exposures raise concerns about concentrated credit risk exposures.

### Selected economic indicators and key statistics (from Table 4)
- Nominal GDP: US$5,867 billion (2011)
- Population: 127.8 million (2011)
- GDP per capita: US$45,900 (2011)
- Quota: SDR 15,628.5 million
- Real GDP growth (percent change): 2007 2.2; 2008 -1.0; 2009 -5.5; 2010 4.4; 2011 -0.7; 2012 2.4; 2013 1.5
- Government (percent of GDP), Public Debt, gross: 2007 183.0; 2008 191.8; 2009 210.2; 2010 215.3; 2011 229.9; 2012 234.5; 2013 240.0
- CPI (annual average): 2007 0.1; 2008 1.4; 2009 -1.3; 2010 -0.7; 2011 -0.3; 2012 0.2; 2013 0.0
- Unemployment rate (annual average): 2007 3.8; 2008 4.0; 2009 5.1; 2010 5.1; 2011 4.6; 2012 4.5; 2013 4.4
- Current account balance (billions of US$): 2007 212.2; 2008 159.8; 2009 146.6; 2010 204.0; 2011 119.2; 2012 130.3; 2013 167.0
- Exports of goods and services: 2007 678.4; 2008 746.5; 2009 545.3; 2010 730.1; 2011 787.2; 2012 807.4; 2013 830.0
- Oil imports (trade basis): 2007 130.1; 2008 190.6; 2009 99.9; 2010 134.3; 2011 185.0; 2012 227.8; 2013 233.7

*Sources: Global Insight, Nomura database; IMF, Competitiveness Indicators System; and Fund staff estimates and projections, as of February 21, 2012.*

### Introduction of USD funds-supplying operations.

### _cr12210 - Introduction of USD funds-supplying operations.

### BOJ policy measures and timeline
- Oct-08: Extension of the security lending facility; suspension of selling stocks held by the BOJ. Expansion of the JGB purchases with repo agreements.
- Oct-08: Introduction of the complementary deposit facility.
- Dec-08 to Jan 09: Introduction of special funds-supplying operations to facilitate corporate financing.
- Feb-09: Introduction of outright purchases of JGBs and CP, and corporate bonds.
- Mar-09: Resumption of stock purchases held by financial institutions.
- Dec-09: Provision of subordinated loans to banks. Enhancement of Easy Monetary Conditions.
- May-10: Introduction of fixed rate funds supplying operations against pooled collateral.
- Jun-10: Reestablishment of U.S. dollar funds-supplying operations.
- Aug-10: Funds provisioning measure to support strengthening the foundations for economic growth. Enhancement of Easy Monetary Conditions. Expansion of fixed rate operation (with a new six month term and expand the size).
- Oct-10: Comprehensive Monetary Easing.
- Apr-11: Virtually zero interest rate policy (VZIRP), clarification of the policy time horizon on medium-term price stability and introduction of asset purchase program.
- Jun-11: Provision of funds-supplying operation to support financial institutions in the disaster areas.
- Jun-11: Special rules for equity investments and asset-based lending to enhance fund-provisioning measure.
- Additional measures involve the relaxation of collateral requirements to include asset-backed CPs, coverage of corporate debts, debt issued by real estate investment corporations, government guaranteed CP, loans on deeds to the public sector, selected foreign government bonds, and standards of corporate debt in disaster areas such as eligible collaterals.  
- Source: BOJ.

### Banking sector soundness: selected indicators (All Banks, 2001–2011)
- Capital adequacy
  - Total capital ratio: 10.5 (2001), 10.5 (2002), 10.9 (2003), 11.2 (2004), 11.6 (2005), 11.5 (2006), 12.6 (2007), 12.0 (2008), 12.6 (2009), 13.6 (2010), 14.1 (2011 Mar). N/A (2011 Sep).
  - NPL net of provisions/capital: 2/4 15 14 3 3 3 2 4 1 8 17 16 16 16 16 N/A (format preserved from source).
- Asset quality
  - NPL ratio: 2/6.7 8.7 7.8 6.3 4.6 3.5 3.1 2.9 2.8 2.9 2.9 N/A (years aligned as in source).
- Earnings and profitability
  - ROA: 0.0 -0.6 -0.6 -0.1 0.2 0.5 0.4 0.2 -0.2 0.2 0.3 0.3 (preserved sequence).
  - ROE: -0.8 -12.1 -13.9 -2.1 4.6 13.1 10.1 5.8 -5.2 5.0 6.3 6.7 (preserved sequence).
  - Interest margin: 1.8 1.8 1.9 1.9 1.8 1.8 1.7 1.7 1.7 1.6 1.6 1.5.
  - NII/gross income: 73 103 111 37 67 70 70 75 97 76 73 72.
  - Noninterest expenses/gross income: 59 80 90 61 62 56 59 64 84 65 65 65.
- Liquidity
  - Liquid assets/total assets: 13 14 18 19 20 18 16 16 16 20 21 22.
  - Liquid assets/short-term liabilities: 44 37 40 44 43 44 39 36 36 38 47 48 50.
  - Loan/deposit: 71 64 64 66 66 63 64 66 69 69 70.
- Other indicators
  - Capital/total assets: 4/4.6 4.2 4.3 4.2 4.4 4.3 4.6 4.2 3.6 4.4 4.7 4.7.
  - RWA/total assets: 44 40 39 38 38 37 35 29 32 33 N/A.
  - Equity exposures/Capital: 4/105 100 77 83 75 79 75 65 56 49 42 38.
  - Gross derivative asset/capital: 35 36 44 34 34 29 28 28 59 95 61 53 60.
  - Gross derivative liability/capital: 33 34 41 30 26 28 28 53 88 56 49 54.

(Note: Tables in source include further split by bank type — city, regional, shinkin — and additional balance sheet components and percentages; preserved number sequences are summarized here following source structure.)

### Japan FSAP — Stress Test Matrix (STeM) for the Banking Sector: Solvency Risk
- Institutions included
  - Bottom-Up by Banks: Three mega-banks (Mizuho financial group, Mitsubishi UFJ financial group, Sumitomo Mitsui financial group). All major and regional banks (111), 16 internationally active banks (56 percent), 95 domestically-active banks (44. percent).
  - Top-Down by the BOJ: 11 major banks (63 percent); 63 tier 1 regional banks (30 percent), 37 tier 2 regional banks (7 percent). Share in system by assets in parentheses.
- Market share
  - Bottom-Up: 53 percent of commercial banks; 41 percent of the narrow system and 34 percent of the broad system by assets. 1/2/
  - Top-Down: Almost 100 percent of commercial banks; 77 percent of the narrow system and 64 percent of the broad system by assets. 1/
- Data and baseline date
  - Bottom-Up: Banks internal data as of September 2011. Financial group consolidated, including nonbank subsidiaries.
  - Top-Down: Bank-by-bank public data and BOJ’s internal data as of September 2011. Bank consolidated, excluding nonbank subsidiaries of a financial group.
- Methodology
  - Bottom-Up: Banks’ internal models.
  - Top-Down: BOJ’s internal model (built on those used for FSR) modified to include additional exposures.
- Stress test horizon
  - Bottom-Up: Two years (March 2013 and 2014).
  - Top-Down: Five years up to March 2017 (two years for global double-dip +100 bps market yield surge scenario and instantaneous for sensitivity test).
- Scenarios (Scenario analysis — macro scenarios stressing asset prices and macroeconomic variables, same as insurance sector scenarios)
  - Baseline: September 2011 WEO, real GDP growth rate for the first two years is 4.2 ppt.
  - Global double-dip (mild/severe): For the first two years, two-year cumulative GDP growth rate shock of 1 standard deviation (-4½ ppts) for mild scenario and two standard deviation (-9 ppts) for severe scenario based on 1980-2010 data. Differentiated yield shocks on major European sovereigns.
  - Protracted slowdown: Real GDP deviating from baseline by 6¾ ppt over five years (about worst 10 percentile shock based on five year cumulative growth rate between 1980 and 2010).
  - Global double-dip with surge in market yield: 100 bps (parallel shift) shock (historical record shock since late 1990s) on market yields is added to global double dip mild scenario.
- Sensitivity Analysis (Single factor)
  - Market yield surge: instantaneous impact of a larger shock.
- Risks/factors assessed
  - Credit risk from domestic corporate and retail (housing and consumer loans), and overseas loan exposures.
  - Market risks with domestic securities (equity, bonds, incl. own sovereign bonds) in trading, and AFS accounts (excluding HTM (6 percent of total exposures)).
  - Market risks with overseas securities in trading, and AFS accounts (excl. HTM (6 percent of total exposures)).
  - Exchange rate.
  - Credit risk with domestic corporate and housing, and overseas loans.
  - Market risks with domestic securities (equity, bonds, incl. own sovereign bonds) in trading, AFS, and HTM accounts.
- Calibration of risk parameters
  - Domestic/overseas credit risk is estimated based on internal rating transition model (linked to macroeconomic variables). Point in time probability of default (PD) and loss-given default (LGD) are calculated to estimate expected loss and unexpected loss for credit risk.
  - Domestic corporate credit cost is estimated based on rating (regulatory loan classification categories) transition model (linked to GDP). Quantile regression model (with 90 percentile estimates) is used for estimation to capture tail-end sensitivity.
  - Equity risk is estimated based on individual stock basis.
  - Interest risk is estimated using Basis Point Value and interest rate scenario by region/countries.
  - Credit cost from housing loan: PD is projected based on empirical relationship between PD and debt service (linked to disposable income projection). LGD = max loan-to-value ratio (reduced to account for property price declines)-100, 0). Once a loan becomes default, 100 percent provisions are set aside for covering LGD.
  - Overseas loan credit cost is estimated by linking credit cost ratio to global GDP growth rate.
- Bank behavior assumptions
  - Bottom-Up: Constant exposures and no management actions (change in RWA in line with PD and LGD changes of existing portfolio). Assuming fixed dividend amount (across scenarios in line with recent dividend policy of each bank).
  - Top-Down: Constant RWA and funding. Latest actual data for dividend payout ratio and tax rate (bank by bank). Interest rate passes through upon maturity following bank’s historical patterns except for global double-dip + market yield surge scenario, where following is assumed: 100 percent for term deposit, 74 (68) percent for time deposit, 23 (17) percent for loans of major (regional) banks.
- Assessment criteria
  - Hurdle rate: Basel III ratios including conservation buffer but excluding SIFI charges. Core Tier 1 (Tier 1) requirement without conservation buffer will increase from 3.5 (4.5) percent in 2011 to 4.5 (6) percent in (source text cuts off).

*Source: Japanese authorities and IMF staff calculations (as presented in the source PDF)._

### 2017. Conservation buffer will be added

### _cr12210 - 2017. Conservation buffer will be added

### Capital requirements and conservation buffer
- Conservation buffer will be added by 0.625 every year starting in 2016 for a total of 2.5 by 2019.
- For internationally active banks: same as bottom-up.
- For domestically-active banks: Basel II total capital ratio of 4 percent (current regulation).

### Capital definition (methodology used in tests)
- Basel III capital definitions estimated by banks as per gradual phase in and out schedule following draft national regulation (February 2012).
- Basel III capital definition estimated by BOJ for all banks for impact analysis (Figure 9, 10, 12, and 13). Gradual phase in following draft national regulation (February 2012).
- Basel II capital definition for domestically-active banks when judging pass/fail (Figure 11).

### Risk-weighted assets (RWA) assumptions
- September 2011 RWAs incorporates Basel 2.5 and Basel III factors are gradually phased in following draft national regulation (February 2012).
- Basel II (actual as of September 2011) RWA.

### Reporting format to the FSAP team
- Aggregate data.
- Aggregate for the total sector and by groups (major, Tier 1 regional, and Tier 2 regional).
- Distribution of capital ratios by number and by share in the sector/subgroups by assets.

### Sample coverage notes
- The narrow banking system includes city, trust, regional (tier 1 and 2), foreign, bridge and internet banks, Shinkin bank and credit cooperatives.
- The broader system additionally includes J-Post and Norinchukin bank.
- The relative size of the bottom-up sample are measured by the size of their banking entities in each financial group (overlapping with top-down sample). Actual assets covered by bottom-up exercises are larger as financial group consolidation includes exposures held by nonbank entities in a group (including securities firms and consumer finance companies).
- Assets (RWA) of three mega banks covered in top-down amount to 88 (96) percent of the bottom-up data for the three mega financial groups.

### Banking sector liquidity stress test (STeM) — design summary
- Institutions included (bottom-up): Three mega-banks (Mizuho Corporate Bank, Bank of Tokyo Mitsubishi UFJ, Sumitomo Mitsui Bank).
- Institutions included (top-down): All major and regional banks (111) — 11 major banks (63 percent); 63 tier 1 regional banks (30 percent), 37 tier 2 regional banks (7 percent).
- Market share: About 50 percent of top-down sample (near 40 percent of the narrow system and 30 percent of the broad system) by assets. Top-down covers 77 percent of the narrow system and 62 percent of the broad system by assets.
- Data and baseline date: Banks internal, data as of September 2011; BOJ data as of September 2011. Bank consolidated.
- Risk factors: US$ funding (withdrawal and market freeze) risk (uniform shock across banks, independent of solvency tests); focus on access to funding (quantity), rather than funding cost. Top-down uses ¥ funding risk (uniform shock) and focus on access to funding.
- Test horizon: Bottom-up: One week and one month. Top-down: Three month.
- Methodology (bottom-up): Cash flow based analysis. Shocks on liability side: withdrawal rates applied for interbank funding (including commercial paper, certificate of deposits, deposits by banks and central banks), deposits by nonbanks, repos (using United States Treasuries, T-bonds, and government guaranteed agency bonds only), yen-US$ cross-currency funding, and committed credit lines. Mitigating actions: selling unencumbered securities (with haircut according Fed requirements), using Fed excess reserve deposits, Fed Discount Window (amount determined by value of unremunerated eligible collateral), etc. US$ funding through FX spot purchases and BOJ’s US$ funds supplying operations are excluded from additional funding tools.
- Methodology (top-down): Liquidity ratio based analysis. Compute post stress liquid asset ratio when (i) wholesale markets freeze; and (ii) deposit are withdrawn. No haircut applied for liquidity value of JGB.
- Shocks (bottom-up): Stress scenario: withdrawal upon maturity — interbank funding (30 percent), deposit (20 percent), repos (5 percent). No additional cross-currency funding using swaps beyond the amount they already have. 100 percent of committed asset back commercial paper and 5 percent of other committed credit facilities are incorporated as cash outflows. Extreme stress scenario: interbank funding (40 percent), deposit (20 percent), repos (5 percent). Cross-currency funding using swaps is reduced by 20 percent upon maturity. 100 percent of committed asset back commercial paper and 5 percent of other committed credit facilities are incorporated as cash outflows.
- Shocks (top-down): Market freeze scenario: wholesale funding market completely freezes for three months (Liquid asset ratio with 0 runoff rate for deposits). Deposit withdrawal scenario: in addition to wholesale market freeze, maturing and liquid deposits will be withdrawn by 5 and 10 percent (runoff rate).
- Assessment criteria: Bottom-up: A bank is considered liquid if it can maintain positive net cash inflow position after taking mitigating actions to generate liquidity. Top-down: Liquid asset ratio of 100 percent (analytical, not regulatory, criteria). Liquid asset ratio = (deposits with the BOJ+cash+JGB)/(net market funding matured within three months+runoff of deposits with a renewal time within three months).

### Insurance sector stress testing (STeM) — life and nonlife (bottom-up)
- Institutions included (life): Four major life insurance companies: Meiji Yasuda life insurance, Dai-ichi life insurance, Sumitomo life insurance, and Nippon life insurance.
- Institutions included (nonlife): Five major nonlife insurance companies: Tokio Marine & Nichido Fire Insurance, Sompo Japan Insurance, Nipponkoa Insurance, Mitsui Sumitomo Insurance, Aioi Nissay Dowa Insurance.
- Market share: Life: 43 percent as of FY2010 by life premium. Nonlife: 82 percent as of FY2010 by nonlife premium.
- Balance sheet data cutoff date: Data as of end-September 2011 for all analysis, except for life insurer’s interest rate sensitivity analysis using March 2010 data.
- Methodology: Life insurance internal models; Nonlife insurance internal models.
- Stress test horizon: Two years (one-time, cumulative shock applied).
- Scenarios (same as bank solvency test, accounting based valuation):
  - Baseline: September 2011 WEO, real GDP growth rate for the first two years is 4.2 ppt.
  - Global double-dip (mild/severe): For the first two years, two-year cumulative GDP growth rate shock of 1 standard deviation (-4½ ppt) for mild and 2 standard deviation (-9 ppts) for severe scenario based on 1980–2010 data. Differentiated yield shocks on major European sovereigns.
  - Protracted slowdown: Real GDP deviating from baseline by 6¾ ppt over five years (about worst 10 percentile shock based on five year cumulative growth rate between 1980 and 2010).
  - Global double-dip with surge in market yield: 100 bps (parallel shift) shock on market yields is added to global double dip mild scenario.
- Sensitivity (single factor) analysis:
  - Interest rate sensitivity analysis: shocks correspond to the two-year cumulative change in each scenario; provides indication of potential effects if an economic-based valuation was adopted.
  - Pandemic shock for life: shock on mortality rate is set at 0.13 percent provided by the authorities based on the study by the Ministry of Labor, Health and Welfare.
  - Moderate reinsurance failure on nonlife: set as 80–90 percent failures.
  - No further catastrophic shock is considered given the nonlife insurance sector faced an actual shock from the Great East Japan Earthquake.
- Risks/factors assessed:
  - Market risk: Losses/gains from securities holdings, including JGBs, domestic and foreign equities, and holdings of corporate and local government bonds. Securities investments such as equities, real estate, and fixed income assets in AFS account are subject to shocks, but debt securities earmarked for policy reserves and held to maturity (about two-thirds of bond holdings) is not subject to a markdown under the accounting basis.
  - Interest rate risk: Interest rate sensitivity includes JGBs in HTM account and account earmarked for policy reserves amounting to about 2/3 of JGBs.
  - Pandemic shocks and reinsurance failures: assessed for impact on solvency margin, various reserves position, and change in net assets.
- Reporting basis of results: All results reported using the accounting basis, except for interest rate sensitivity which provided an indication under economic-based valuation. Results were reported to FSAP team on an aggregate basis.
- Assessment criteria: Impact on solvency assessed using sector aggregate solvency margin (separate for life and nonlife) and net assets (including unrealized gains and losses).

*Source: _cr12210 - 2017. Conservation buffer will be added*

### 2017. A conservation buffer of 0.625 ppt per year will be added starting in 2016, for a total of 2.5 ppt by 2019.

### _cr12210 - 2017. A conservation buffer of 0.625 ppt per year will be added starting in 2016, for a total of 2.5 ppt by 2019.

### Top-down Bank Solvency: Distribution and Scenarios
- Figures present distributions of Basel II Core Tier 1 and Total capital ratios for:
  - internationally active banks (assets share), domestically-active banks (95 banks holding 44 percent of the system by asset), and three mega banks (three mega banks hold 54 percent of the system’s assets).  
- Stress scenarios shown:
  - Baseline
  - Double dip mild
  - Double dip severe
  - Protracted growth
  - Global double dip + 100 bps surge in market yields
- Key technical notes:
  - As of June 2012, no decision was made on the application of Basel III for domestically-active banks; capital adequacy under stress for this group is shown using their current requirement of 4 percent total minimum capital requirement based on Basel II capital definition.
  - Applying full Basel III capital definition immediately is expected to reduce total capital ratio for tier 1 regional banks by 3¼ percentage points and for tier 2 regional banks by 1 ½ percentage points.
  - Bond portfolio losses are first absorbed by existing buffers in the form of unrealized gains on securities portfolio (mostly JGB related), which amount to 4.3 percent of Tier 1 capital (raising Tier 1 ratio for the whole banking sector by 1/2 percentage points).

### Top-down Bank Solvency: Cumulative Impact and Key Contributors
- System composition:
  - 11 major banks with 63 percent of the system’s assets.
  - 100 regional banks with 37 percent of the system’s assets (including 63 tier 1 regional (30 percent by assets) and 37 tier 2 regional banks (7 percent of the system)).
- Factors contributing to changes in Basel III core tier 1 ratio (changes reported in charts as percentage points):
  - Gross profit
  - Credit costs (negative contributions)
  - Equity gain
  - Bond gain
  - Others (include tax, dividend drawdown of existing unrealized gains, and Basel III transitory effects)
- Example numeric values from scenario bars (in percent of latest actual risk weighted assets):
  - Baseline: 0.7, 0.6, 0.7, 1.8, 1.6, 2.1
  - Double-dip mild: -0.2, -0.4, 0.1, 1.0, 0.6, 1.6
  - Double-dip severe: -0.8, -1.2, -0.3, 0.5, -0.1, 1.3
  - Protracted growth: -0.1, -0.3, 0.1, 0.0, -0.5, 0.7
  - Global double dip mild with 100 bps surge in market yields: -1.1, -1.0, -1.3

### Three Mega Banks: Bottom-up and Top-down Comparison
- Sources: Bank of Japan (Top-down) and 3-mega banks and FSA (bottom-up), and IMF staff calculations.
- Notes and findings:
  - The 2.1 percentage points difference of the initial capital ratio mainly reflects the difference between Basel III RWA (for bottom-up) and Basel II RWA (for top-down), explaining 2/3 of the difference.
  - Other differences arise from varying extent of consolidation.
  - Assuming constant RWA tends to underestimate overall impact in top-down tests but is broadly compensated by larger estimated credit costs because the top-down model picks up more extreme reactions using quantile regressions.
  - Overall, the top-down credit cost estimate is comparable to bottom-up estimates for the overall Tier 1 impact from credit quality deterioration (credit costs plus deterioration in RWA).

### Aggregate Stress Test Results — Insurance Sector
- Life insurance companies:
  - Scenarios presented: Mild double dip, Severe double dip, Protracted growth, Global double-dip mild + 100 bps surge in market yields.
  - Metrics shown: Change in net assets; Interest rate sensitivity.
  - Solvency margin notes:
    - Solvency margin are 1/ Before tax.
    - Unrealized gain/loss expect land indicates 90 percent of profits and 100 percent of loss.
    - Unrealized gain/loss of land indicates 85 percent of profits and 100 percent of loss.
- Nonlife insurance companies:
  - Same four scenarios presented.
  - Metrics shown: Change in Net Assets; Interest rate sensitivity.
  - Solvency margin notes:
    - Solvency margin are 1/ Before tax.
    - Unrealized gain/loss expect land indicates 90 percent of profits and 100 percent of loss.
    - Unrealized gain/loss of land indicates 85 percent of profits and 100 percent of loss.
    - Reinsurance failures are assumed to have recoverable rate of 90 percent in mild double dip and JGB shock scenarios, 80 percent in severe double dip scenario, and 100 percent in protracted growth scenario.

### Financial System Supervisory Architecture
- Figures depict:
  - Core Financial System Supervisory Architecture.
  - Expanded Financial System Supervisory Architecture showing interactions among:
    - BOJ, MOF, FSAMETI MAFF MIAC MLI TMHLW (governmental ministries), DBJ, JFC, DIC, Securities, Insurance, Bank, Credit Guarantee Corporations, Shoko Chukin, JP Bank, JP Insurance, Norinchukin, Federations of Agricultural/Fishery Cooperatives, Pension Fund, JHF, Labor banks.
  - The ministries supervise the institutions.
  - The institutions have current accounts of the BOJ.
  - The DIC protects the institutions by its deposit insurance.

### Government Credit Support to the Financial System
- Observations:
  - While GFIs’ presence declined over the past decade, they still play an active intermediation role.
  - Following the global financial crisis, the government substantially extended support measures to SMEs.
  - Public support in the form of guarantees appears larger than in other advanced countries.
  - The SME Financing Facilitation Act has helped improve lending attitudes by financial institutions, although this is not fully perceived by the SMEs.
  - Sizeable SME guarantees help limit NPL ratios but a shift towards special guarantees is underway.
  - The SME Financing Facilitation Act could also affect banks’ credit risk assessment.

### Firm Dynamics: Entry, Exit, and Venture Capital
- Key findings:
  - Start-ups rely predominantly on self-finance, and venture capital funds are uncommon.
  - Business transfers are low, possibly hindered by wide uses of personal guarantees.
  - Firm dynamics are lackluster:
    - Business entry rates and exit rates are much lower than in other advanced countries.
  - Venture capital investment is limited, partly due to limited exit venues such as IPOs, mergers and acquisitions.
- Data graphics referenced:
  - Business Entry Rate (In percent) and Business Exit Rates (In percent) series for years 1990–2008 comparing Japan, United States, United Kingdom (sources: SME Agency, METI, 2011).
  - Selected Advanced Economies: Venture Capital Investment (In percent of GDP) including Israel, United Kingdom, United States, OECD (27), France, Italy, Canada, Germany, Japan (Source: OECD (2008)).

### Annex: Assessment of Basel Core Principles for Effective Banking Supervision
- Overview:
  - The Annex summarizes Japan’s observance of international standards and codes based on detailed assessments carried out as part of the 2012 FSAP Update:
    - Basel Core Principles for Effective Banking Supervision (Assessors: Serene Chow and Arnoud Vossen)
    - IAIS Insurance Core Principles (Assessors: Michael Hafeman and Rodolfo Wehrhahn)
    - IOSCO Objectives and Principles of Securities Regulation (Assessors: Ana Carvajal and Martin Kinsky)
  - Summaries identify strengths and suggest areas for further strengthening and reform.
- Assessment of Basel Core Principles — key points:
  - Japan has made several improvements to its financial regulatory and supervisory framework and practices since the 2003 FSAP, enabling successful management of the global financial crisis and business continuity after natural catastrophes (including the March 2011 tsunami and earthquake).
  - The legislative and operational framework for banking supervision largely conforms to the Basel Core Principles (BCPs).
  - Methodology:
    - Assessment based on Basel Committee methodology and judgment of assessment team; review included legal and institutional framework, discussions with FSA, BOJ, Japan Bankers Association, industry representatives, and examination of onsite/off-site practices and recent reforms.
    - The detailed BCP assessment was conducted during November 28–December 16, 2011.
  - Institutional and market structure observations:
    - Japan’s financial system remains the second largest in the world and bank-dominated.
    - The domestic banking market includes about 2,000 deposit-taking institutions.
    - High concentration: Japan Post Bank holds a quarter of total deposits; city banks hold approximately forty percent of total deposits.
    - Low core profitability due to low and declining net interest margins.
    - Asset structure: Loans represent over half of total bank assets and securities about a quarter; JGB holdings have increased.
    - Loan quality improved since the early 2000s but concerns remain for regional banks.
    - Favorable liquidity situation due to large and stable corporate and household deposit base.
    - Bank capital: major banks raised around ¥4½ trillion of capital in 2009–10, with a portion as hybrid capital.
    - Vulnerabilities include concentration to JGB exposures, quality of capital at megabanks, adequacy of capital at non-megabanks, and operational/funding/governance risks for banks expanding overseas.
  - Preconditions for effective supervision:
    - Japan follows an integrated approach with the FSA as a single universal regulator; BOJ conducts on-site examinations and off-site monitoring of counterparties.
    - The Deposit Insurance Corporation of Japan (DICJ) implements reimbursement of insured deposits and financial assistance to reorganize failed banks.
    - The Financial System Management Council (FSMC) is activated for government intervention; FSMC composition and convening rules described.
    - BOJ produces the Financial System Report (FSR) semi-annually to assess system-wide risks and inform supervisory work.
    - Accounting standards: Japanese GAAP used for regulatory reporting; movements towards convergence with IFRS started in March 2005.
    - Payment and settlement improvements include Real Time Gross Settlement (RTGS), liquidity saving features, and delivery-versus-payment (DVP) for all types of securities; Japan adopted legislation mandating central clearing of standardized OTC derivatives by the end of 2012 (Japan and U.S. noted as jurisdictions doing so).

*Sources: The Bank of Japan and staff calculation; Bank of Japan; FSA; IMF staff calculations; FSA and staff calculations; SME Agency, METI, 2011; OECD (2008).*

### 13.      The Deposit Insurance Act defines the deposits that are protected in the case of a

### _cr12210 - 13.      The Deposit Insurance Act defines the deposits that are protected in the case of a

### Deposit insurance scope
- “Payment and Settlement deposits,” defined as current deposits or non-interest bearing ordinary deposits that satisfy the three conditions of (1) bearing no interest; (2) being redeemable on demand; and (3) providing normally required payment and settlement services, are fully protected.
- Other deposits, such as time deposits, are protected up to a maximum principle of ¥10 million including interest, per depositor, per financial institution.

### Main findings — Objectives, independence, powers, transparency, and cooperation (CP 1)
- Mandates for banking supervision are generally clear and unambiguous; the FSA is the integrated supervisory authority for banking, insurance, and securities.
- City banks, regional banks, and shinkin banks are directly supervised by the FSA; day-to-day supervision of regional and shinkin banks is delegated to Local Finance Bureaus of the Ministry of Finance (MOF).
- Some cooperative-style institutions are co-supervised by the FSA and the Ministry of Agriculture or the Ministry of Labor under different arrangements; co-supervision may lead to less clear decision-making processes.
- Agricultural and fishery cooperatives are supervised under the Agricultural Cooperatives Act and the Fishery Cooperatives Act; daily supervision is conducted by local state government. The FSA and the responsible Ministry of Agriculture have developed supervisory guidelines and the FSA could, upon request, undertake on-site examinations.
- BOJ conducts on-site examinations and off-site monitoring of counterparties (banks, major securities firms, and other financial institutions) under Articles 1 and 44 of the Bank of Japan Act.
- Institutional safeguards exist for supervisor independence in day-to-day supervision, but:
  - The FSA could clarify and be transparent on co-decision processes for labor cooperatives and Nurin-Chukin.
  - The FSA could consider strengthening governance arrangements vis-à-vis the MOF’s Local Finance Bureaus by increasing staff and improving review processes.
- Ultimate authority to revoke banking licenses or suspend banking business is delegated to the Minister for Financial Services (to whom the FSA reports) and not delegated to the Commissioner of the FSA; FSA prepares proposals that require Ministerial approval.
- Legal framework (Banking Act) includes sufficient powers to address compliance, safety, and soundness; legal protection for supervisors is adequate.
- Predominantly informal arrangements exist for cooperation between the FSA and BOJ and with foreign supervisory authorities; a more formalized and systematic basis for interagency information exchange and decision making should be intensified, and arrangements with foreign authorities should be enhanced.

### Licensing and structure (CPs 2–5)
- Permissible activities for licensed institutions are clearly defined; appropriate licensing provisions are in place.
- The FSA might more proactively monitor credit markets and strictly enforce that only licensed institutions operate as banks.
- The FSA has adequate powers to approve a transfer of significant ownership: any shareholder acquiring 20 percent or more of shares needs approval as a major shareholder.
  - Subsequent changes in shareholding must be reported but are not subject to approval unless the FSA imposes a pre-approval condition for future majority holdings.
  - The FSA should consider strengthening its approval process where transfers could lead to a controlling interest.
- The FSA does not require ex ante approval of investments by a bank in another bank, in an ancillary business, or in a related banking business; prior notification is required. Acquisitions generally need prior approval except when in an ancillary business. Investments in non-banking activities are limited by law and may not lead to significant ownership or control.

### Prudential regulation and requirements (CPs 6–18)
- The FSA requires all institutions to calculate and maintain a minimum capital adequacy ratio and can impose higher capital requirements on individual banks.
- FSA’s implementation of Pillar 2 of Basel II does not provide for setting extra capital charges when the supervisory review indicates material risks are not fully captured.
- Different minimum capital levels and different definitions of capital are used for domestic and internationally active banks despite a similar capital adequacy framework.
- Triggers for early intervention measures due to a shortfall in minimum capital levels are set at a too low level, especially for domestic banks.
- Noted temporary measures taken by the Japanese government towards the end of 2008 include a partial relaxation of the capital adequacy requirement for banks.
- Authorities should enhance standards for capital adequacy and streamline rules applicable to domestically and internationally operating banks.
- Regulatory framework for identifying and evaluating banks’ risk management systems is adequate; sufficient on-site inspections and off-site monitoring are carried out by the FSA and the BOJ.
  - The external audit function should be strengthened.
  - Further focus is needed on banks’ stress testing practices, integrated risk management, and governance arrangements.
- Credit risk management supervision has been enhanced since the last decade; problem assets are better identified and classified, though FSA should more intrusively inspect banks’ evaluations for extra provisions and reserves given government support measures.
- Large exposure and concentration limits should be more rigorous and better aligned to lending and investment levels to individual counterparts or groups of connected counterparties; systems for managing concentration risks should incorporate exposures by industry and geography.
- Regulations contain basic provisions on exposures to related parties and arms’ length rules; FSA should ensure enforcement via regular off-site monitoring and focused on-site inspections.
- FSA increased reporting requirements for banks on individual country exposures (frequency and granularity); further consideration on the quality of monitoring and a more forward-looking approach is recommended.
- Supervisory framework for liquidity risk complies with relevant core principle criteria; continued focus on foreign currency funding profiles for banks expanding overseas is important given reliance on wholesale funding and higher overseas funding costs.
- FSA recognizes IT systems obsolescence and merger-related IT risks and has intensified supervision of integrated risk management for overseas expansion; continued focus is paramount.
- Supervisory framework for interest rate risk in the banking book complies with relevant criteria; assessors support FSA’s envisaged change to undertake more intrusive capital adequacy management for “outlier” banks following predefined parallel interest rate shift stress tests.
- Internal audit and control framework largely in line with CP, but corporate governance could be improved by strengthening independence of internal audit and Board of Company Auditors.
- The 2008 FATF Mutual Evaluation concluded Japan’s AML/CFT framework then was not fully in line with FATF recommendations; authorities are addressing weaknesses and should bring the framework in-line with FATF recommendations as soon as possible.

### Methods of ongoing banking supervision (CPs 19–21)
- FSA’s bottom-up supervisory approach with supervisory teams enables prompt identification and follow-up of supervisory issues.
- FSA should develop a more formalized, analytical risk framework to assess institution risk profiles holistically.
- A formalized criterion for identifying systemically important financial institutions is recommended, taking into account probability and potential impact, to better prioritize supervisory resources and intensity.

### Accounting and disclosure (CP 22)
- Accounting and disclosure practices generally comply with the relevant CP, but temporary government measures could lead to valuation practices differing from international standards.
- Supervisory authorities may want to promote prompt standardization of valuation, accounting and disclosure with international standards.
- The FSA may wish to strengthen its authority over external auditors.

### Corrective and remedial powers of supervisors (CP 23)
- The FSA has a range of supervisory tools and powers to act against banks violating laws or engaging in unsafe or unsound practices.
- FSA should consider reviewing its Prompt Corrective Action (PCA) system to increase effectiveness and use more direct supervisory tools such as penalties and immediate corrective actions.

### Consolidated supervision and cross-border banking supervision (CPs 24–25)
- FSA has general powers to supervise banking groups on a consolidated basis.
- FSA should continuously enhance cross-border supervision effectiveness, including strengthening potential resolution tools as banks expand overseas and adopt diverse legal forms that could complicate crisis management or resolution.
- Progress has been made in cooperation and information sharing with home and host supervisors (Exchange of Letters, supervisory colleges); FSA should further strengthen home/host cooperation to ensure swift and effective information sharing for anticipating and managing crises and resolutions.

### Summary observations from Table A1 (selected)
- Co-supervision arrangements with Ministries and local governments create areas needing greater clarity and transparency in decision making.
- Independence protections exist but major decisions remain formally taken by the Minister for Financial Services rather than being fully delegated to the FSA.
- Capital adequacy framework issues of note:
  - Domestic banks may include deferred tax assets without a cap as part of capital; internationally active banks have a cap at 20 percent.
  - Temporary measures at end-2008 partially relaxed capital adequacy requirements.
  - Triggers for early intervention are set too low for domestic banks.
- Accounting practices could lead to late recognition of losses, affecting capital adequacy.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 7. Risk management process The FSA and BOJ have sufficient frameworks for

### _cr12210 - 7. Risk management process The FSA and BOJ have sufficient frameworks for

### Risk management process (CP 7) — main findings
- The FSA and BOJ have sufficient frameworks for identifying and evaluating bank’s risk management systems and processes and for requiring remedial actions.
- They perform sufficient inspections and monitoring to assess the processes at banks.
- Weaknesses identified:
  - The role of the external audit function should be strengthened.
  - Further focus needed on banks’ stress testing practices and banks’ integrated risk management.
  - Governance arrangements at banks should be strengthened to promote:
    - a more independent risk management and internal control function;
    - an audit committee or a board of company auditors that can act independently from the board of directors, in both ‘form’ and ‘substance’;
    - direct information flows on implementation of risk management systems, actual risks run, and identified breaches from internal and external audit or compliance;
    - separation of responsibilities between business and internal control functions.

### Credit risk (CP 8)
- The comprehensive work by the FSA (on- and off-site) and BOJ provides a sound basis for supervision of credit risks.
- Banks visited generally had a sufficient credit risk management system in place.

### Problem assets, provisions, and reserves (CP 9)
- Policies and practices regarding problem assets have improved considerably over the last ten years.
- Problem loans are adequately identified and classified.
- Recommended improvement: banks are expected to take a more prudent stance in evaluating the need for extra provisions and reserves, taking into account factors such as possible changes in their business environment and government measures aimed at providing enhanced financing and support to clients, including loan restructuring.

### Large exposure limits (CP 10)
- Current large exposure rules are not sufficient:
  - The current group concept does not sufficiently capture groups of related counterparties with similar counterparty risk.
  - Not all exposures on a single counterparty or group of related counterparties are taken into account in exposure calculations.
  - Domestic banks face the same large exposure limits as internationally active banks while their minimum level of capital is half that of an internationally active bank.
  - Reliance solely on risk weighted exposures or exclusion of certain exposures may be inappropriate, especially under current global market conditions.
  - Limits should ensure that after an event occurs, a sufficient level of capital remains to absorb losses on a going concern basis; this may be challenging for domestically operating banks.
- Assessors heard of differing systems at banks to manage risk concentrations which could be further strengthened.

### Exposures to related parties (CP 11)
- The law includes basic provisions on exposures to related parties, including arms’ length requirements.
- The FSA does not actively enforce these provisions via regular off-site monitoring combined with focused onsite inspections.

### Country and transfer risks (CP 12)
- The FSA’s approach is largely in-line with the criterion.
- More consideration should be given to the actual quality of country exposures and to adopting a more forward looking approach to asset evaluation and provisions.

### Market risks (CP 13)
- Megabanks are the more active trading participants.
- The FSA has adequate market risk specialists and carries out on-site inspections in this area.
- Risk limits for trading activities were usually low with real time monitoring and daily escalations.

### Liquidity risk (CP 14)
- Liquidity risk supervision is performed by both BOJ and the FSA with coordinated onsite inspections and off-site monitoring.

### Operational risk (CP 15)
- Operational risk and crisis management framework is well established and in compliance with this Principle.
- Continued focus needed on key areas such as information technology and adequacy of integrated risk management for banks expanding overseas.

### Interest rate risk in the banking book (CP 16)
- Awareness, measurement, monitoring, and stress testing tools are in place to qualify for compliant grading.
- The FSA should note comments on valuation and capital impact as further discussed under CP 22 and CP 6.

### Internal control and audit (CP 17)
- Corporate governance functions at banks should be improved by strengthening independence of the internal audit function and fit-and-proper requirements for the company auditors.

### Abuse of financial services (CP 18)
- Weaknesses identified by the 2008 FATF evaluation have still not been addressed by changes to banking laws in Japan.

### Supervisory approach (CP 19)
- Supervisory resources are not fully allocated according to bank risk assessments because there is no formalized, analytical risk framework for assessing the overall risk profile of an institution, except for regional banks.
- SIBs have been allocated more resources than other banks.
- There was no formalized definition of systemically important banks factoring probability and potential impact analysis from financial stability and consumer protection dimensions.

### Supervisory techniques (CP 20)
- Off-site and onsite supervisory processes are generally in compliance with this Principle.

### Supervisory reporting (CP 21)
- The FSA can collect, review, and analyze financial institutions’ prudential returns on both a solo and consolidated basis.

### Accounting and disclosure (CP 22)
- The FSA does not have power to reject or rescind the appointment of an external auditor (EC 6).
- Temporary government measures (including measures to facilitate financing for SMEs and relaxing capital adequacy where MTM on “available for sale securities” in the banking book are required to be realized only when a loss of 50 percent was suffered) would affect accounting representations, loan classifications, provisioning, valuations and capital adequacy.

### Corrective and remedial powers of supervisors (CP 23)
- Trigger levels for the PCA system are set too low (EC 5).
- Intervention procedures of the FSA could be strengthened to ensure remedial actions are taken promptly by banks.

### Consolidated supervision (CP 24)
- Legal uncertainty under Articles 24-3, 52-31(3), 25-5 and 52-32(5) of the Banking Act allows subsidiaries of the bank and banking holding company to refuse to submit reports or materials requested by the FSA, which might impede effective supervision.

### Home-host relationships (CP 25)
- Cooperation with foreign regulators can be further strengthened through proactive engagement and coordinated, effective, and timely sharing of relevant information.

### Recommended Action Plan — selected recommendations by principle (extract)
- Responsibilities and objectives (CP 1.1): Clarify and make transparent co-supervision arrangements where licensed institutions are co-supervised with the FSA.
- Independence, Accountability, transparency (CP 1.2): Consider strengthening governance arrangements for Local Finance Bureaus and deploy additional staff resources to oversee day-to-day supervisory activities.
- Cooperation (CP 1.6): FSA and BOJ should intensify cooperation, knowledge sharing, joint activities, and share supervisory findings more regularly; authorities should engage in bilateral and/or multilateral MOUs with relevant foreign supervisory authorities.
- Permissible activities (CP 2): FSA could more proactively monitor credit markets to ensure only licensed institutions undertake banking business.
- Licensing (CP 3): Fit-and-proper regulations should reflect substance, excluding individuals with criminal records or adverse regulatory judgments from senior positions.
- Transfer of significant ownerships (CP 4): Regulations should provide explicit supervisory approval of changes in ownership that would result in a controlling interest; FSA could condition approvals on future pre-approval.
- Major acquisitions (CP 5): Regulations should provide explicit supervisory approval of major investments and consider inclusion of ancillary business acquisitions.
- Capital adequacy (CP 6):
  - FSA should use powers to set higher capital levels than the minimum depending on actual risk profile.
  - Capital standards for domestically operating banks should be aligned with those for internationally active banks.
  - Triggers for early intervention should be set at higher levels and aligned for domestic banks to enable earlier intrusive measures.
  - If a bank falls below its minimum level, it should not be allowed to pay dividends or executive compensation.
  - Elements of capital and deductions for domestic banks should be aligned with internationally active banks as far as possible.
  - Authorities should ensure capital adequacy standards do not discourage use of internal models and improved risk management.
- Risk management process (CP 7):
  - FSA should have arrangements with external auditors for regular exchange of information and direct notification of exceptions for unusual transactions.
  - FSA and BOJ should focus inspections on improving governance structures, risk management, internal audit, and the substantive independence of company auditors and possibly an audit committee.
  - Encourage separation between business line and control functions at senior levels commensurate with size and complexity.
  - Maintain focus on quality of enterprise risk management and stress testing as regular risk assessment tools.
- Credit risk (CP 8): Increase supervisory attention to integration of concentration risk rules and counterparty credit risk of securities and related derivatives.
- Problem assets, provisions and reserves (CP 9): FSA should investigate evaluation of need for extra provisions and reserves and ensure more prudent stances regarding government measures.
- Large exposure limits (CP 10):
  - Extend group concept of connected counterparties.
  - Change exposure definition to include all exposures from an individual client or connected group.
  - Set large exposure limits commensurate with minimum capital adequacy ratio and expected buffer capital.
  - Consider setting limits as a percentage of Tier 1 or core Tier 1 capital rather than percentage of bank capital.
  - Encourage FSA to examine banks’ risk management systems to increase management of risk concentrations by region and industry.
- Exposures to related parties (CP 11): Enforce provisions more vigorously by introducing regular off-site monitoring and focused onsite inspections.
- Liquidity risk (CP 14): Further enhance consistency of risk assessment standards between FSA and BOJ.
- Operational risk (CP 15): Continue focus on IT system risks and adequacy of integrated risk management.
- Interest rate risk in the banking book (CP 16): Adopt intensified capital adequacy management for “outlier” banks following parallel interest rate shift stress tests and standardize valuation rules with international standards for supervisory purposes.
- Internal control and audit (CP 17): Strengthen independence and effectiveness of independent oversight functions within banks.
- Abuse of Financial Services (CP 18): Expedite remediation of weaknesses from the 2008 FATF Mutual Evaluation.
- Supervisory Approach (CP 19): Develop a holistic risk rating assessment framework and define criteria for identifying systemically important financial institutions to guide resource allocation and supervisory intensity.
- Supervisory reporting (CP 21): Consider requiring external auditors to opine on filing accuracy and to immediately report material shortcomings directly to the FSA.
- Accounting and Disclosure (CP 22): Empower the FSA to reject or rescind appointment of an external auditor and promote prompt alignment with international standards.
- Supervisors’ Corrective and Remedial Powers (CP 23): Rectify PCA framework deficiencies and use a wider range of intervention tools to avoid remedial action delays.
- Consolidated Supervision (CP 24): Ensure supervisory powers are not constrained by legal provisions and enhance cross-border supervision and potential resolution tools.
- Home-Host relationships (CP 25): Engage proactively in coordinated, timely information sharing with foreign supervisors and continue signing formalized arrangements.

### Authorities’ response to the assessment
- Paragraph 41–42: Authorities express appreciation to the IMF and assessors; welcome IMF assessment that they have achieved a high level of compliance and that significant progress has been made since the last FSAP; will take recommendations into account.
- Paragraph 43 — initiatives underway in two areas:
  - CP 6: On March 30, 2012, the FSA published final capital adequacy rules for internationally active banks based on Basel III after a one month public consultation period. The FSA will implement the new rules as from March 31 2013, which is the end of the fiscal year 2012. The FSA is also considering new capital adequacy rules for non-internationally active banks (domestic banks). The FSA expects the IMF to understand that non-internationally active banks engage in community based businesses and thus their minimum capital ratios should be set to balance facilitating their financial intermediary function in respective regions and ensuring safety and soundness.
  - CP 10: The Financial System Council is now requested to review the large exposure regime in Japan.
- Paragraph 44: Authorities strongly support the role the FSAP plays in promoting soundness of the global financial system and financial stability through improving regulatory and supervisory practices.

*Source: _cr12210 - 7. Risk management process The FSA and BOJ have sufficient frameworks for identifying and evaluating bank’s risk management systems and processes and for requiring remedial actions.*

### 2.      Regulation and supervision of the insurance industry in Japan is largely the

### _cr12210 - 2.      Regulation and supervision of the insurance industry in Japan is largely the

### Institutional framework and supervisory scope
- The Financial Services Agency (FSA) is responsible for regulation and supervision of the insurance business; it is an external organ of the Cabinet Office, headed by a Commissioner, and accountable to the Minister for Financial Services.
- The assessment is based solely on laws, regulations, and supervisory requirements and practices in place at the time of assessment and was informed by a complete self-assessment and a detailed questionnaire provided by the FSA.
- The Insurance Business Act (IBA) is the primary legislation regulating insurance business; some activities are outside its scope and not supervised by the FSA, including captives, certain closed-group business (e.g., labor unions with their members), and insurance activities of cooperatives (Kyosai) which are supervised by the relevant government ministries.
- Japan was the first jurisdiction assessed under the 2011 version of the ICPs.

### Market size, structure, and concentration
- Total assets of the insurance sector at end-2010: 78 percent of GDP or ¥373 trillion.
- Life sector assets: around ¥291 trillion, of which:
  - ¥96 trillion correspond to JPI;
  - ¥46 trillion relates to the Zenkyoren;
  - ¥36 trillion to the nonlife sector.
- Aggregate insurance premiums in 2010: 13 percent or ¥41.5 trillion of global premiums:
  - around 17.5 percent of the global life insurance premium;
  - around 6.5 percent of the global nonlife insurance premium.
- Number of firms:
  - Life insurers: 47 companies.
  - Nonlife insurers: 52 insurers.
  - Cooperatives: 6,921 cooperatives offering life and nonlife insurance.
- Market concentration:
  - JPI accounts for 21 percent of the life premium; the next four largest life insurers account for another 43 percent.
  - Three groups control over 90 percent of the nonlife market; four companies over 65 percent of the life market (excluding JPI).
  - The five largest nonlife insurers (belonging to three groups) account for 82 percent of the nonlife premium.
- Foreign participation:
  - About one-half of insurers operating in Japan are now foreign-owned.
  - Foreign-owned share: 20 percent in the life sector; less than 10 percent in the nonlife sector.
- Premium trends: Premiums in both the life and nonlife sectors have stagnated in recent years.

### Products, distribution, and reinsurance
- Life products: mainly traditional individual endowments, whole life, and term insurance.
  - Simple life protection and saving products account for 87 percent of sales via large agent sales forces.
  - Financial institutions (particularly banks) distribute around 13 percent of individual life products.
  - Every third policy sold in 2010 related to the “third sector” (private medical, hospitalization, disability, cancer, long-term care).
- Nonlife product mix:
  - Motor insurance (voluntary and mandatory) accounts for 64 percent of the market (down from 68 percent in 2002).
  - Fire insurance: 17 percent share.
  - Brokers place less than 5 percent of the premium.
- Reinsurance (fiscal year 2010):
  - International reinsurance ceded: ¥310 billion.
  - Inwards reinsurance: ¥200 billion (about the same level as in previous three years).

### Crisis response: Great East Japan Earthquake (2011)
- Insurer actions: Life, nonlife, and cooperative insurers set up disaster response headquarters within hours; agents and employees deployed for claims identification and payment.
- Regulatory facilitation: Earthquake exclusion clause waived; with FSA agreement, formal payment requirements relaxed.
- Claims handling: Close collaboration with police enabled fast settlement of life benefits; the standard earthquake homeowners policy’s simple form allowed 80 percent of claims paid within 10 weeks.
- Homeowners’ earthquake insurance payouts as of September 2011: ¥1,145 billion.

### Financial performance and solvency
- Life sector profitability:
  - Fully recovered from the 2008 global financial crisis and showed two years of record profits.
  - Recovery aided by portfolio mix with significant JGB and local equity holdings.
  - Expected further improvement as negative spread in several portfolios is reduced.
- Life sector solvency:
  - Current solvency margin ratios: 500 percent or more for the life insurance sector.
  - Regulatory action threshold: 200 percent.
  - Under newly-established solvency requirements (taking effect at end of the current fiscal year), a reduction of 20 to 30 percent in the margin is expected.
- Nonlife sector effects and performance:
  - FY2008 equity exposure led to a 150 percent loss for nonlife insurers in FY2008.
  - Great East Japan Earthquake (end of FY2011) resulted in additional commercial earthquake insurance claims in the order of ¥600 billion, of which reinsurance is expected to assume ¥400 billion; losses to life insurers are modest.
  - Expected profits for the nonlife sector during coming years are moderately positive.
  - Motor insurance rate increases planned to accelerate recovery.
  - International expansion has increased exposure to global natural catastrophes; presence in over 50 countries.
  - Combined ratio exceeded 100 percent for three consecutive years, increasing pressure to reduce expenses while maintaining service and regulatory compliance.
  - Mega mergers are a response to these conditions.
- Nonlife solvency and financial indicators:
  - 43 nonlife insurers have solvency margin ratios of 500 percent or more; industry remains above the 200 percent solvency control level.
  - Risk ratio (net premium written to capital and surplus): 234.6 percent.
  - Capital and surplus of 10 percent of total assets are within international norms.
  - Foreign currency assets: less than 100 percent of capital and surplus and largely hedged.
  - Equity holdings affect liquidity, but overall liquidity remains at a reasonable level.
- Valuation note: Absence of economic valuation of liabilities is less important for nonlife than life insurers, but return-of-premium nonlife business liabilities would be affected by adoption of such valuation; quantitative impact analysis is necessary.

### Main findings and policy recommendations
- Overall compliance: High degree of compliance with the IAIS Core Principles.
- Areas needing strengthening:
  - ICPs on the supervisor.
  - Valuation.
  - Macroprudential surveillance and insurance supervision.
  - Cross-border cooperation and coordination on crisis management.
- Supervisory capacity and resources:
  - FSA has strengthened solvency requirements, revised risk parameters (increasing required capital), extended solvency requirements to holding company level, and improved supervisory assessment tools (including stress testing).
  - Recommended actions for the FSA:
    - Complete development of a methodology for risk-rating insurers.
    - Adopt a structured system for internal review of risk assessments.
    - Further increase resource levels to enable more frequent inspections, particularly for the largest insurers.
- Macroprudential and group supervision:
  - FSA has developed a good foundation for group-wide and macroprudential issues, including supervision of Japanese insurance holding companies, cooperation with foreign supervisors, and market analysis.
  - Recommended actions for the FSA:
    - Continue improving ability to anticipate and deal with crisis situations.
    - Maximize value of macroprudential analyses.
    - Develop contingency plans.
    - Cooperate more proactively with foreign supervisors, including establishing colleges of supervisors for Japanese insurance groups.
- Independence and funding of the FSA:
  - No indications of political or undue interference in supervision currently, but legal framework contains elements that could undermine independence and capacity.
  - Annual FSA budget must be approved by the Diet after approval by the Minister for Financial Services and the Ministry of Finance; Diet-approved budgets have sometimes been less than requested.
  - Recommendation: Consider financing the FSA in a manner not involving negotiation of its budget (e.g., through legally-enforceable levies) to strengthen independence and resources.
- Valuation methodology:
  - Solvency assessment should be based on a transparent economic valuation of assets and liabilities, taking into account future cash flows over the full time horizon.
  - Current methods of valuing insurance liabilities do not meet these criteria and risk under-recognition of liabilities.
  - Recommendation: FSA should revise valuation approach to take fuller account of emerging experience and anticipated future experience.

*Source: _cr12210 - 2.      Regulation and supervision of the insurance industry in Japan is largely the*

### 23.      A few additional areas where improvement would be particularly desirable are

### _cr12210 - 23.      A few additional areas where improvement would be particularly desirable are

### FSA intervention, enforcement, and preventive/corrective measures
- Findings:
  - The FSA requires insurers to take steps to deal with identified weaknesses, but its intervention efforts could be enhanced.
  - The FSA prefers to deal with minor regulatory violations through dialogue and moral suasion.
  - Minor sanctions are not being applied.
  - The formal supervisory administrative action threshold appears to be high, based on the limited number of such actions taken in the last 10 years.
- Recommendations:
  - The FSA should make greater use of the tools available to it, such as the power to impose fines on insurers and intermediaries, to develop a more progressive approach to enforcement.
  - The FSA might consider the applicability of administrative monetary penalties in Japan and, if appropriate, the legislation should be revised accordingly.
  - The adoption of a risk-rating system (see ICP 2) and the revision of solvency margin control levels (see ICP 17) would support the FSA’s ability to take early preventive and corrective measures.

### Corporate governance and suitability of persons
- Findings:
  - Corporate governance has made improvements but independence remains weak.
  - A few insurers have a board structure with a clear segregation between board members and senior management; the majority maintain a traditional board largely comprised of senior management overseen by an audit board.
  - The board of corporate auditors has limited powers; for example, it cannot dismiss directors or call for a shareholders meeting.
  - The board of corporate auditors’ work is largely performed by full-time members who were previously part of management.
  - Fit and proper requirements under the IBA do not apply to corporate auditors and apply only to a limited extent to part-time directors.
- Recommendations:
  - The corporate governance and suitability requirements should be revised to strengthen independent oversight, which will reinforce the supervisory efforts of the FSA.
  - As indicated under ICP 2, the FSA should consider making some of its expectations regarding corporate governance into legally-binding requirements under the IBA or secondary legislation.
  - The legislation should be revised to extend the application of suitability requirements to part-time directors, corporate auditors, and all executive officers.
  - The FSA should consider seeking an amendment to legislation to strengthen its ability to disqualify persons who have been convicted of financial crimes from holding key roles in the governance and operation of an insurer.

### Reinsurance and natural catastrophe exposure
- Findings:
  - Exposure to natural catastrophes makes strong reinsurance coverage essential to the Japanese insurance market and overall economy.
  - The FSA reviews the reinsurance strategies and programs of insurers, but the regulation and supervision of reinsurance could be strengthened.
  - The exclusion of the cooperatives’ insurance programs from the national earthquake pool might be reconsidered, as it could affect the solvency of those cooperatives in case of a major event or the failure of reinsurers.
- Recommendations:
  - The FSA should consider measures such as stronger documentation requirements (including the prohibition of side letters) and a more formal assessment of the manner in which foreign reinsurers are supervised.
  - The exclusion of the cooperatives’ insurance programs from the national earthquake pool should be reconsidered due to potential solvency implications.

### Stress testing, valuation, and capital adequacy
- Findings:
  - Stress testing is at an early stage of use and sophistication.
  - The FSA performs top-down stress testing of the insurance sector each quarter with respect to equity-price, exchange-rate, and credit risks.
  - Insurers are expected to perform stress tests and they generally submit the results to the FSA; however, the FSA does not prescribe specific stress scenarios that insurers are required to test.
  - Solvency assessment should be based on a transparent economic valuation of assets and liabilities, which takes into account future cash flows over the full time horizon.
  - The current methods of valuing insurance liabilities do not meet these criteria (standards 14.8 and 14.9).
  - Although future cash flows over the full time horizon are taken into account in the initial valuation of liabilities, subsequent testing of their sufficiency requires consideration of only cash flows during the next 10 years.
  - The absence of an explicit valuation of some options and guarantees creates the possibility that liabilities might be understated.
  - The FSA is considering moving to a valuation approach more closely related to economic value and considering that costs regarding options and guarantees will be taken into account when insurance liabilities are calculated.
- Findings on capital adequacy and supervisory calibration:
  - For the most recent revisions, the risk parameters were calculated by the FSA, based on historical experience.
  - It has been at least 10 years since any insurer has fallen below the 200 percent solvency control level—including an insurer that failed.
  - Even with recent strengthening of the risk weights, most insurers are likely to remain well above the control levels.
  - The FSA does not impose variations to the solvency margin requirements on individual insurers.
  - Very few insurers are using internal models for solvency margin calculations, though requests to do so are likely to increase.
- Recommendations:
  - The FSA should complete the development of a methodology for risk-rating insurers and adopt a structured system for the internal review of risk assessments.
  - Solvency control levels should be revised so the highest solvency control level is closer to the level insurers typically maintain.
  - The FSA should consider allowing—or require—greater use of internal models where appropriate and consider variations to solvency margin requirements to account for insurer-specific risk characteristics.
  - The FSA is considering changes to investment regulations, including eliminating the quantitative limit on equity investments.

### Supervisory review, reporting, inspections, and public disclosure
- Findings:
  - The FSA has been strengthening its insurance regulatory framework and is improving the tools used for supervisory assessment.
  - The FSA expects industry participants to act in accordance with guidance provided by both the Supervisory Guideline and the Inspection Manuals; however, the manner in which expectations are expressed could affect enforceability and transparency.
  - It would be better for the public to obtain both industry-wide and entity-specific information from a single, reliable, and consistent source.
  - The positive response to specific requests from foreign supervisors could be enhanced by a more proactive exchange of information.
  - The exchange of information with a foreign supervisor could be delayed if the FSA has not previously checked the confidentiality regime of the foreign jurisdiction.
  - The time between inspections is longer than it should be.
  - Currently, few insurers are using internal models to calculate the solvency requirements for catastrophe risks, and those that do are not required to disclose information about such models.
  - Insurers disclose exposures to reinsurers by ratings category, but this does not enable users to assess the possible effects of reinsurance concentrations.
- Recommendations:
  - The FSA should make information about the industry, individual insurers, insurance groups, and intermediaries available on its website.
  - The FSA should consider publishing information regarding the classes of insurance each insurer has been approved to underwrite.
  - The legislation should be amended to require foreign branches to submit audited financial information.
  - The arrangements for communication with external auditors should be enhanced, including meeting regularly with external auditors and revising the legal framework to enable greater reliance on their work.
  - The FSA should increase the frequency of its inspections (example targets provided: inspect all large insurers at least once every two years, high-risk insurers at least annually, and other insurers at least once every three years).

### Other ICP observations and specific recommendations (selected)
- Group-wide and macroprudential issues:
  - Group-wide solvency requirements have been adopted, which insurance holding companies must meet by March 2012 (the end of the fiscal year).
  - The IAIS and other international organizations are considering how to define and deal with global systemically-important financial institutions; these considerations are relevant to Japan in light of the size and concentration of its insurance sector.
  - The FSA serves as the group-wide supervisor of Japanese insurance groups, but in some cases does not regularly communicate with foreign host supervisors.
  - Cross-border cooperation and coordination specifically related to crisis management of Japanese insurers is in its initial stages.
- Intermediaries, conduct of business, AML/CFT, and fraud:
  - Onsite inspection is an important tool in supervision of insurers and insurance intermediaries.
  - Some supervisors have created units responsible for customer protection; such an approach helps ensure timely identification and resolution of consumer issues.
  - Fraud in insurance has not been a significant problem in Japan; relatively few cases have been reported, but there are no statistics on the extent or cost of fraud.
  - The AML/CFT efforts of insurers and intermediaries should be inspected regularly.
- Select recommendations from Table A4:
  - Consider centralizing insurance supervision with the FSA or establishing a process to facilitate regular exchange of views on supervisory objectives among the FSA and responsible ministries.
  - Consider financing the FSA in a manner that does not involve negotiation of its budget, such as by legally-enforceable levies on the industry.
  - Consider using outside experts to supplement FSA staff resources.
  - The FSA should consider expanding its distribution list of relevant supervisors and proactively checking confidentiality regimes of relevant home and host jurisdictions.

*Source: IMF staff summary from the Japan insurance sector assessment (content unit _cr12210 - 23).*

### 24.      The exclusion of the cooperatives’ insurance

### _cr12210 - 24.      The exclusion of the cooperatives’ insurance

### Key supervisory findings and recommendations (selected items 14–26)
- 14 - Valuation
  - The FSA should revise its valuation approach to take fuller account of emerging experience and anticipated future experience.
- 15 - Investment
  - The FSA might consider whether the inclusion of a prudent person requirement in the IBA would be useful in Japan.
- 16 - Enterprise Risk Management for Solvency Purposes
  - The FSA should enhance its guidance on enterprise risk management to indicate that insurers should explicitly describe the relationship between their risk tolerance limits, regulatory capital requirements, economic capital, and the processes and methods for monitoring risk.
  - The FSA should provide more explicit guidance regarding the performance of own risk and solvency assessment.
  - The FSA should encourage insurers to include the target asset mix as part of their investment policies.
  - The FSA should consider incorporating basic requirements to perform enterprise risk management in the legislation, and communicate more specific expectations through the Supervisory Guideline.
  - The FSA should actively supervise the efforts of insurers in this area, to help ensure that their capabilities are evolving at an appropriate pace.
- 17 - Capital Adequacy
  - The required solvency margin should include risk margins for any mismatching of assets and liabilities, not just a risk margin for interest-rate risk.
  - The required solvency margin should also be enhanced to consider the ratings of reinsurers in the risk weights applied to reinsurance credit exposures.
  - The FSA should consider enhancing the process of revising solvency requirements by asking insurers to model risk scenarios and making detailed comparisons to the solvency regimes of other jurisdictions.
  - The FSA should consider increasing the solvency control levels.
  - The FSA should consider imposing variations to the solvency margin requirements in cases where the risk characteristics of individual insurers are not fully captured by the standardized formulas.
  - The FSA should update its model approval standards to conform to current best practices.
- 18 - Intermediaries
  - The FSA should perform periodic onsite inspections of brokers, even though they account for a small share of the market in Japan.
  - Consideration should be given to making it a legal requirement that all insurance intermediaries pass examinations as a condition of registration.
- 19 - Conduct of Business
  - The FSA might consider creating a customer protection unit.
- 20 - Public Disclosure
  - The disclosure requirements should be revised to require the public disclosure of information about the internal models used to calculate the solvency requirements for catastrophe risks.
  - The FSA should enhance the requirements to include the disclosure of information such as:
    - the level of sensitivity of investment values to market variables;
    - the methodology used and the key assumptions employed in measuring assets and liabilities for ALM purposes;
    - a quantitative analysis of sources of earnings;
    - quantitative information about material risk exposures, including concentrations; and
    - the nature of stress testing being performed.
  - The FSA should consider requiring the disclosure of reinsurance premium concentration ratios.
- 21 - Countering Fraud in Insurance
  - The FSA should encourage the industry associations to maintain industry-wide data bases to help detect fraud.
- 22 - Anti-Money Laundering and Combating the Financing of Terrorism
  - The FSA should reinforce its supervision of AML/CFT through more frequent onsite inspections of insurers and intermediaries (see ICPs 9 and 18).
- 23 - Group-wide Supervision
  - None.
- 24 - Macroprudential Surveillance and Insurance Supervision
  - The FSA should remain actively engaged in the international discussions, and deal with the issue of systemically-important insurers for its own market.
  - Steps should be taken to enhance the macroprudential value of the information currently being prepared by the FSA.
  - The FSA should develop a comprehensive process for: bringing together various pieces of information; identifying issues of possible macroprudential importance to the insurance sector (and the financial sector more broadly); formulating adverse scenarios for further consideration; and communicating the results of this analysis internally and with other Japanese supervisory authorities.
  - The effects of adverse scenarios should be assessed quantitatively, through either top-down stress testing by the FSA or bottom-up stress testing of prescribed scenarios by the insurers.
  - The FSA should contribute to the ability of others to analyze the industry by making market data publicly available.
- 25 - Supervisory Cooperation and Coordination
  - The FSA should establish supervisory colleges for Japanese insurers with material foreign operations, supported by adequate staff and financial resources, and use the colleges to enhance cooperation and coordination.
- 26 - Cross-border Cooperation and Coordination on Crisis Management
  - The FSA should develop comprehensive plans for dealing with insurers in crisis and ensure that it has the tools needed to carry out such plans.
  - The FSA should ensure that the plans are internationally-coordinated by working with foreign supervisors, for example, through supervisory colleges.
  - Insurers should be required to prepare contingency plans, which should include specific procedures for use in a gone-concern situation.
- Cooperatives’ earthquake insurance
  - The exclusion of the cooperatives’ insurance programs from the national earthquake pool might be reconsidered, as it could affect the solvency of those cooperatives in case of a major event or the failure of reinsurers.

### Authorities’ response to the assessment
- The Japanese authorities:
  - Welcome being the first jurisdiction assessed under the newly revised version of the Insurance Core Principles (ICPs), published in October 2011.
  - Express appreciation to the IMF and assessors for the assessment opportunity and dialogue.
  - Welcome the IMF’s overall assessment that they have achieved a high level of compliance with the ICPs, and generally well receive the IMF recommendations.
  - Note that some initiatives towards reform have already been taken since the time of the assessment and that recommendations will be thoroughly taken into account in continuous efforts to strengthen regulatory and supervisory capacities.
- Differences of view and broader points
  - The authorities note differences in interpreting the 2011 version of the ICPs (example: ICP 14’s broader interpretation of “economic valuation” amid developing accounting standards such as IFRS 4).
  - The authorities observe that full and immediate compliance with newly developed standards is a major challenge for all jurisdictions (example: ICP 24 on macroprudential surveillance).
  - The authorities emphasize their “better regulation” approach: creating incentives for enhancing effective management by insurers, using close monitoring and communication rather than primarily relying on a rules-based approach with strict penalties. They view fines and penalties as complementary rather than primary tools.

### IOSCO assessment summary (Introduction, scope, methodology, and institutional framework)
- Introduction and overall view
  - The legal and regulatory framework for the securities market in Japan exhibits a high level of implementation of the IOSCO Principles.
  - The FSA has robust powers to supervise regulated entities, investigate breaches of securities laws and regulations, and cooperate domestically and internationally.
  - The FSA has made organizational changes to upgrade capacity to identify, monitor and mitigate systemic risk.
- Supervisory strengthening suggested
  - The FSA should develop a more robust framework to identify and assess the scale and scope of risk posed by individual firms to determine regulatory intervention intensity (including on-site inspections).
  - The SESC should intensify inspection coverage for smaller firms; conduct additional institution-based inspections, thematic reviews and/or random inspections.
  - The FSA should consider reviewing its enforcement program to ensure proper balance among orders for improvement, suspensions and cancellations of registration.
  - The authorities should consider reviewing the current framework for money penalties to ensure deterrence and to expand the types of misconduct subject to administrative money penalties.
  - FSA governance arrangements and resources should continue to be strengthened, including mechanisms to hire and retain expert staff and reviewing the salary scale.
  - The FSA should review whether current resources are sufficient to ensure robustness of its supervisory program and explore ways to enhance FSA legal independence.
  - Efforts to implement new IOSCO principles should continue, particularly in identifying emerging and systemic risk; the creation of OSBM is noted as a step in the right direction.
- Scope and methodology
  - The assessment was conducted based on the IOSCO Principles and Objectives of Securities Regulation approved in 2010 and the Methodology adopted in 2011.
  - Principle 38 was not assessed due to a separate standard for securities settlement systems.
  - The assessment did not cover commodities derivatives exchanges or other derivatives exchanges where the underlying asset is not a security.
  - Assessors reviewed legal/regulatory framework and implementation in practice, including inspection programs, cycle, scope, quality and follow-up on findings and enforcement use.
  - Assessors relied on: (i) a self-assessment by the FSA; (ii) review of relevant laws and reports in English; (iii) meetings with FSA, SESC, CPAAOB, and BoJ staff; and (iv) meetings with market participants. Limited English information posed challenges.
- Institutional and market structure
  - Regulation and supervision responsibilities rest with the Financial Services Agency (FSA), the Securities Exchange Surveillance Commission (SESC), and the CPAAOB.
  - The FSA is an agency within the Cabinet; the SESC and CPAAOB are boards within the FSA with a high degree of independence under the FIEA.
  - The FIEA assigns regulation and supervision responsibility to the Prime Minister and delegates authority to the FSA, except functions excluded by Cabinet Ordinance (exceptions limited mainly to licensing of exchanges and authorization of associations).
  - The FIEA delegates authority to the SESC to request reports and conduct on-site inspections and investigations. The CPA Act delegates oversight of auditors to the CPAAOB.
  - Operational responsibilities:
    - FSA: policy, off-site monitoring, imposition of enforcement actions.
    - SESC: onsite inspections and investigations; may recommend enforcement actions to the FSA.
    - CPAAOB: oversees JICPA quality control program, carries out auditor inspections, may recommend enforcement actions to the FSA.
  - Local finance bureaus receive delegated monitoring and inspection functions for certain tasks; off-site monitoring and on-site inspections of FIBOs with capital less than ¥1 billion are entrusted to local finance bureaus.
  - Self-regulatory organizations (SROs) coexist: exchanges, associations and SROs (constituted by exchanges). Active SROs include The Tokyo Stock Exchange SRO, the JSDA and the ITAJ. Additional associations: JSIAA and the Type II FIA (Type II FIA is of recent creation and not covered in the assessment).
- Basic legal framework for market participants
  - Main laws: Financial Instruments Exchange Act (FIEA) and the Investment Trust and Investment Corporations Act (ITIC).
  - Issuers of securities offered to the public:
    - Required to notify the FSA and file a registration statement.
    - Required to submit an annual report, and either a quarterly report (for listed issuers) or a semiannual report (for non-listed issuers).
    - Required to notify a list of corporate events to the FSA.
    - TSE requires timely disclosure of corporate actions that could materially affect investors’ decisions.
  - Collective Investment Schemes (CIS) offered to the public:
    - Required to file offering documents with the FSA.
    - May be trusts or corporations; law requires management by a registered financial instruments business operator (FIBO) as an investment management business operator (IMBO).
  - Types of FIBOs:
    - Type I: broker dealer trading a wide array of securities including stocks, bonds, shares of CIS, derivatives.
    - Type II: broker-dealer trading a limited category of securities (illiquid securities).
    - IMBO: asset manager.
    - Investment advisory firm: provides investment advisory services.
    - Registered financial institutions (banks, cooperatives, insurance companies) can provide limited securities services to retail investors, mainly distribution of government debt and CIS.
  - The FSA has a consolidated supervision system for securities firms with assets equal or above ¥1 trillion.
  - Market trading venues:
    - Exchanges require a license granted by the MoFS on behalf of the PM.
    - Proprietary trading facilities (PTS) must be registered as a Type I FIBO.
    - A trading volume limit of 10 percent is set on PTS (Article 1 of the Cabinet Order for Enforcement of the FIEA).

*Source: IMF assessment content provided in the supplied PDF excerpt.*

### 18.      A total of 2,900 companies are listed on any of the six exchanges that operate in

### 18.      A total of 2,900 companies are listed on any of the six exchanges that operate in

### Equity markets and listings
- Total listed companies across six exchanges: 2,900.
- Tokyo Stock Exchange (TSE) listings: 2,280.
- TSE market capitalization: US$ 3,634,790 million as of March 31, 2011.
- Sector composition: publicly listed companies dominated by industrial (including telecommunication and services) and consumer goods companies.
- Large caps account for 85 percent of market capitalization, though they amount to only one third of the number of listed companies.
- Foreign companies listed in Japan: 12.
- New listings and delistings on TSE in 2010: 26 new companies listed; 68 delisted.
- Breakdown by exchange (as presented):
  - Tokyo: Listed companies 2,280; Listed in one exchange 1,552; Listed in multiple exchanges 728; Five stock exchanges 24; Four stock exchanges 12; Three stock exchanges 81; Two stock exchanges 611.
  - Osaka: Listed companies 1,745; Listed in one exchange 1,188; Listed in multiple exchanges 557; Five stock exchanges 24; Four stock exchanges 12; Three stock exchanges 78; Two stock exchanges 443.
  - Nagoya: Listed companies 341; Listed in one exchange 101; Listed in multiple exchanges 240; Five stock exchanges 24; Four stock exchanges 11; Three stock exchanges 62; Two stock exchanges 143.
  - Fukuoka: Listed companies 129; Listed in one exchange 38; Listed in multiple exchanges 91; Five stock exchanges 24; Four stock exchanges 10; Three stock exchanges 17; Two stock exchanges 40.
  - Sapporo: Listed companies 76; Listed in one exchange 21; Listed in multiple exchanges 55; Five stock exchanges 24; Four stock exchanges 3; Three stock exchanges 5; Two stock exchanges 23.
  - Total (table): Listed companies 3,647; Listed in one exchange 2,900; Listed in multiple exchanges 747; Five stock exchanges 24; Four stock exchanges 12; Three stock exchanges 81; Two stock exchanges 630.

### Alternative and growth markets
- TSE and London Stock Exchange joint venture: Tokyo AIM — a Tokyo equity based market for growing companies only open to professional investors; market at an early stage.
- Tokyo AIM considering a debt securities market for professional investors only.
- Note: The TSE plans to integrate TOKYO AIM into the Tokyo Stock Exchange effective July 1, 2012, and re-brand the TOKYO AIM market as ‘TOKYO PRO Market.’

### Bond markets and debt trading
- Total bond issuance for 2010: 198,439 billion yen.
  - Corporate bonds: 4.8 percent of issuance.
  - Municipal bonds: 3.9 percent of issuance.
  - Japanese Government Bonds (JGBs): 83.6 percent of issuance.
- Debt trading: mostly conducted in over the counter (OTC) markets.
- TSE role: main securities exchange outside OTC; number of companies with listed debt is small compared to equities.
- Straight bonds: no straight bonds listed on the TSE, except for certain government debt bonds.
- Convertible bonds (as of November 30, 2010): number of issuers 37; number of listed securities 39; total amount ¥1,239 billion.

### Collective investment schemes (CIS)
- Assets under management (AUM) by investment trusts as of end 2010: ¥98 trillion.
  - Publicly offered investment trusts: ¥63 trillion.
  - Real estate investment trusts: roughly ¥4 trillion.
  - Privately placed investment trusts: ¥31 trillion.
- Of publicly offered investment trusts:
  - Stock investment trusts: ¥52 trillion.
  - Bond investment trusts: ¥9 trillion.
  - MMF: ¥2 trillion.
- Major securities firms and most major banks are the largest CIS managers.
- Custody and valuation:
  - Assets must be entrusted to a separate custodian; no obligation that custodian be independent, but custodians (trust banks) are subject to regulation and supervision by the FSA.
  - Assets must be valued at fair value.
  - ITAJ has developed guidance on valuation of assets, including illiquid assets.
  - Conditions of suspensions of redemptions must be disclosed in offering documents; suspensions of redemptions are notified to the FSA.

### Securities intermediaries and trading platforms
- Type I FIBOs operating in Japan: 322, of which 22 are foreign firms (not incorporated).
  - Majority are small, retail-oriented firms; a few large firms have complex business models.
  - Securities companies subject to consolidated supervision: 16.
  - Subgroup with more intense monitoring assigned to OSBM.
  - Firms with overseas presence: 19 (main overseas cities: New York, London, Singapore, Hong Kong).
- Other intermediaries (as of November 2011):
  - Type II: 1,293.
  - Investment Advisory and Agency Business: 1,122.
  - IMBOs: 322.
- Trading platforms:
  - Six exchanges operating: TSE, Osaka Stock Exchange (OSE), Nagoya Stock Exchange, Fukuoka Stock Exchange, Sapporo Stock Exchange, Tokyo AIM.
  - Significant trading volumes mainly at TSE and OSE.
  - On the cash side, TSE accounts for roughly 90 percent of trading volumes.
  - OSE is the main market for derivatives.
  - A merger between TSE and OSE has been agreed, with completion expected by 2013.
  - Five PTS trade equity, government debt, and corporate debt; their trading volumes are not significant.

### Preconditions for effective securities regulation
- Need to strengthen corporate governance through additional independent directors and independent oversight bodies (e.g., system of committees).
- Foreign issuers and investors:
  - Foreign issuers can tap markets under similar conditions to domestic issuers.
  - Foreign corporations can register as financial instruments business operators with the same requirements as domestic corporations.
  - No barriers for foreign investors to invest in the domestic market.
- Company law and insolvency:
  - Company law is modern; incorporation typically takes less than a week.
  - Insolvency framework includes rehabilitation procedures; out-of-court proceedings and guidelines exist.
  - Judiciary perceived as impartial; prosecution office has specialized offices in Tokyo and Osaka to deal with financial crime, but courts might lack expertise.
- Accounting and auditing standards: do not have major differences from international standards.

### Main findings and supervisory observations
- Regulatory responsibilities:
  - Responsibilities for supervision of securities markets lie with the FSA, the SESC and the CPAAOB.
  - Certain legal features raise concerns about independence, but no evidence of day-to-day government interference.
  - FSA cannot impose money penalties except in connection with a limited number of misconducts.
  - FSA has strengthened capacity to identify and monitor emerging and systemic risk.
- Self-regulatory organizations (SROs):
  - Multiple long-established SROs subject to “authorization” and FSA oversight.
  - FSA developed oversight tailored to each SRO that appears to be working well.
- Enforcement and supervision gaps:
  - FSA has not developed a framework to identify and determine scale and scope of risks of individual firms to set intensity of regulatory intervention (including on-site inspections).
  - Coverage of on-site inspection program is limited, especially for smaller Type I and IMBOs, Type II, and investment advisors — most of which are inspected only by cause.
  - FSA increasing use of stronger measures such as suspensions in addition to orders for improvement; periodic review of enforcement strategy is important.
  - Criminal convictions secured, but commuted sentences can limit deterrence.
- Issuers and disclosure:
  - Issuers of public offerings subject to disclosure obligations at registration and on a periodic and on-going basis in line with IOSCO Principles.
  - FSA and SESC review offering documents and periodic reports.
  - Shareholder rights are embedded in company law; FIEA provides additional protections (e.g., mandatory tender offer under certain conditions).
  - Notification obligations for substantial holdings exist; holdings of insiders must be included in disclosure documents but a system of timely notification of transactions by insiders is not in place.
  - Financial statements must be prepared according to local GAAPs, broadly consistent with IFRS.
- Auditors and information providers:
  - Quality control system for auditors involves reviews by JICPA under CPAAOB oversight, complemented by direct CPAAOB examinations.
  - Auditors required to be independent; issuers’ mechanisms to monitor auditors’ independence require strengthening.
  - Credit rating agencies are registered by the FSA and subject to ongoing supervision through reporting and on-site inspections.
  - Framework for sell-side analysts to address conflicts of interest is based on disclosure.
- Collective investment schemes supervision:
  - Managers and distributors of CIS required to register with the FSA; managers must register as IMBOs with capital, fit and proper, and organizational requirements or deposits for operation.
  - SESC does not have a policy to inspect newly registered CIS managers within a short timeframe after registration.
  - Current risk-based approach ensures regular on-site inspections for CIS managers, but SESC should further strengthen inspection program for CIS managers, especially if the managed CIS is offered to the public.
- Securities intermediaries supervision:
  - Financial instruments business may only be carried on in Japan by entities registered by the FSA and complying with registration requirements (minimum capital, fit and proper, organizational requirements).
  - SESC does not have a policy to inspect newly registered FIBOs within a short timeframe after registration.
  - Ongoing capital requirements apply only to Type I FIBOs, which must comply and report a capital ratio similar to Basel II.
  - Reporting requirements are extensive for Type I FIBOs.
  - Smaller intermediaries are not necessarily subject to external audit.
  - Risk-based approach ensures regular inspection of larger Type I FIBOs and IMBOs by the FSA, complemented by JSDA/TSE and ITAJ inspections.
  - Longer inspection cycles apply to smaller Type I and IMBOs; Type II and investment advisors are inspected mainly by cause.
  - FSA has not developed a plan to deal with the failure of a securities firm, but experiences of past failures have been documented.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12210.pdf*

### 35.      Principles for secondary markets: Exchanges and PTS are the only secondary

### _cr12210 - 35.      Principles for secondary markets: Exchanges and PTS are the only secondary

### Market structure and responsibilities
- Exchanges and PTS are the only secondary markets that can trade securities and each must comply with criteria set down by FSA.
- The SROs are responsible for ensuring orderly trading.
- The SESC is responsible for market surveillance for purposes of detecting unfair trading practices—in such function it is supported by the exchanges.
- There has been active enforcement of the requirements prohibiting unfair trading practices.

### Clearing, default management, and market safeguards
- CCPs manage exposures on a daily basis and have powers to request members to post additional margin.
- Default procedures are known to members.
- Price limits apply in both the cash and derivatives and circuit breakers apply to derivatives trading if there is excessive volatility.
- Naked short selling is prohibited.

### Transparency and trading reporting
- Bids, offers, and trade information are made publicly available for exchanges (95 percent of all trading) and PTS.
- Electronic platforms for dark pools do not appear to be a cause of concern.
- Internalization and block trades are permitted and must be reported to exchanges.

### Surveillance, enforcement and penalties
- Administrative and criminal penalties apply for unfair trading practices, including market manipulation, false rumors and insider dealing.
- There is active market surveillance by the SESC and the exchanges.
- Administrative penalties have been imposed and criminal convictions have been secured.
- Enforcement in connection with unfair trading practices appears to be active, as money penalties have been imposed. Criminal convictions have been secured, but commuted sentences are common.

### Key findings related to systemic risk and large exposures
- Exposures of the larger complex firms are under intense monitoring by the OSBM.
- The CCPs monitor clearing members’ positions on a daily basis.
- If a participant’s exposure becomes a concern, the CCP has the power to request additional collateral; further transactions will be prohibited and outstanding positions will be closed out if this does not occur.
- There are clear procedures in the event of default which are available to members.

### Selected recommended actions (from Table A6)
- Principle 35: The FSA should consider the development of regulations concerning the treatment of dark pools.
- Principle 37: The FSA should consider the introduction of a large traders report.

*Source: _cr12210 - 35.      Principles for secondary markets: Exchanges and PTS are the only secondary (IMF).*

### 36.      The Japanese authorities welcome the opportunity to be assessed as the first

### _cr12210 - 36.      The Japanese authorities welcome the opportunity to be assessed as the first

### Authorities’ response to IOSCO/IMF assessment
- Japanese authorities welcomed being assessed as the first jurisdiction under the new IOSCO Principles and Objectives published in 2010 and the Methodologies published in September 2011.
- Authorities expressed appreciation to the IMF and its assessors for their dedication, time and resources.
- The assessment provided an opportunity for a comprehensive review through self-assessments and dialogue with the IMF.
- The authorities welcome the IMF’s overall finding of a high level of compliance with the IOSCO Principles.
- The IMF recommendations are generally well received; some reforms have already been initiated since the assessment.
- Authorities will thoroughly take into account the IMF recommendations in continuous efforts to strengthen regulatory and supervisory capacities.
- Authorities consider Methodologies need improvement to enable more risk-based assessments with emphasis on outcomes rather than form of policy action.
  - Concern: Methodologies currently provide a single set of policy actions for compliance with each principle, irrespective of country risk profile or differences in policy effectiveness.
  - Example: Full compliance with Principle 30 would require all market intermediaries holding client assets to be subject to external audit, regardless of risk profile.
  - Authorities’ view: While external audit is useful, other measures could achieve the same objectives; excessive emphasis on form could lead to box-ticking that does not enhance market integrity, efficient markets, or financial stability.
- Authorities will continue to work with IOSCO and the IMF to improve the Methodologies.

### Financial system structure — key features and statistics
- The financial system remains predominantly bank-oriented.
  - Banks hold 60 percent of all financial sector assets.
  - Relative to GDP, the banking sector is larger than other G-7 countries, except for France and the U.K.
- Japan is the second largest insurance market in the world in terms of aggregate insurance premiums.
- Market concentration and institution counts:
  - About 2,000 deposit-taking institutions exist, but a few banks dominate.
  - The six city banks are large commercial banks, four of which belong to the three major banking groups (“megabanks”), holding about 51 percent of Japan's banking sector assets.
  - Six trust banks focus on commercial and trust banking including asset management for large corporations.
  - Regional banks fund mainly local enterprises and governments.
  - Since the early 2000s, consolidation within the sector has been limited.
- Foreign banks and Japan Post:
  - Foreign banks’ share of industry assets fell to 3.5 percent in FY2010 from 7 percent in FY2006.
  - Japan Post Bank represents 12 percent of all deposit taking institutions’ assets and is the largest deposit-taker in the world.
- Insurance sector:
  - As of end-2010, total assets of the insurance sector represented 78 percent of GDP.
  - Close to 80 percent of insurance assets are in the life insurance sector.
  - About one-third of life insurance assets are held by Japan Post Insurance, the largest life insurer in the world.
  - The nonlife sector is dominated by motor insurance (nearly two-thirds of the market).
  - About 6 percent of nonlife business and less than 2 percent of the life business is reinsured, primarily in the local market.
  - Less than 1 percent of insurance business is reinsured abroad and less than 1 percent of premiums of Japanese insurers relate to reinsurance of foreign risks.
- Government involvement:
  - Government retains full ownership of key government-affiliated financial institutions, including, through a holding company, Japan Post Bank (JPB) and Insurance (JPI).
  - Public credit guarantees outstanding amount is equivalent to about 8 percent of GDP.

### Market structure evolution and international expansion
- Overseas expansion of Japanese financial institutions:
  - Consolidated foreign claims of Japanese banks doubled from US$1.3 trillion to US$2.7 trillion between 2004 and 2010.
  - The U.S. remains the main destination; Asia’s share has grown to about 15 percent of overseas exposures.
  - Continued yen appreciation and weak domestic activity could spur further overseas expansion, increasing interconnectedness to global and regional markets.
- Cross-share holdings:
  - Cross-share holdings between financial groups, except among insurance companies, are declining.
  - Insurance companies collectively held about 8 percent of bank shares in FY01; they hold about 2 percent now.
  - Exception: increase in cross-share holdings among insurance companies.
- Securities firms:
  - The securities firms sector is relatively small; low profitability has led to consolidation.
  - Japanese securities firms pursue conservative business models; about 70 percent of net operating revenue stems from commissions rather than proprietary trading.
  - For non-Japanese global investment banks, trading income represents 46–60 percent or more of total income.
  - Retail financial innovation has progressed but has room for further development.
- Financial market infrastructure (FMIs) relevance:
  - BOJ-NET Funds Transfer System (BOJ-NET FTS) settles about 22 percent of GDP daily and ranks among top four large value payment systems worldwide.
  - BOJ-NET JGB Services had daily transaction equivalent to about 16 percent of GDP in 2010 and ranks among top five securities settlement systems globally.
  - Japan Government Bond Clearing Corporation is a CCP with daily transactions of about 8 percent of GDP in 2010 and ranks among the top 10 CCPs in the world.
- Pension sector:
  - Public and private pensions are important; pension funds hold total assets of about ¥287 trillion as of end-2011, including significant investments in JGBs.
- Capital markets:
  - Apart from the JGB market, capital markets are small compared to other G-7 countries.
  - Japan’s public debt market is the largest in the world in absolute size and relative to GDP.
  - In 2011, Japanese government securities amounted to about US$12 trillion, exceeding total domestic bank credit.
  - Yen-denominated international bond financing declined from 6 percent of global bond financing in 2001 to 2½ percent in 2011.
  - Equity market capitalization has remained broadly unchanged since the early 1990s.

### Basel III implementation readiness for internationally active Japanese banks
- Timeline and domestic approach:
  - The Basel III framework will begin to enter into force at end-March 2013.
  - New regulations in Japan were finalized and issued in March 2012 after a consultation in early 2012.
  - Japan’s implementation strategy: finalize different parts of the Basel III framework by 2019, typically one year ahead of internationally agreed dates.
  - The first part introduced includes changes in the definition of capital and risk coverage under Basel III.
  - Next amendments planned on the capital conservation buffer and on the liquidity coverage ratio (LCR); exact timeline depends on international discussions.
- Scope of application:
  - As of end-2011, Basel II.5 applied only to internationally active banks.
  - Whether Basel III will also have the same limited application was still under discussion; if applied to other banks it might be in whole or only in part.
- Regulatory stance:
  - Authorities intend to implement Basel III with the same level of detail as agreed internationally; extra guidance only where national discretion is allowed or text is unclear.
  - The FSA does not intend to introduce gold plating or super-equivalent rules.
  - The BOJ is preparing for Basel III and plans to adapt its reporting framework, including on liquidity, to Basel III concepts.
- Banks’ preparedness and potential constraints:
  - Banks have prepared, focusing mainly on new capital requirements.
  - Banks covered by Basel II.5 indicated they would be able to meet revised capital requirements according to the Basel III timetable.
  - FSAP stress tests indicate major banks can achieve medium-term levels of higher required capital under adverse scenarios, including a slow medium-term growth scenario.
  - Major banks appear well positioned to meet new capital requirements because of:
    - Already issued equity capital in 2008–2010,
    - Scope to rely on retained earnings,
    - Ability to access other sources (such as mandatory conversion of preferred stocks into equity capital).
  - Banks indicated no expected difficulties in meeting LCR and Net Stable Funding Ratio (NSFR), scheduled to be introduced in 2015 and 2018 respectively.
  - Monitoring needed for ability to meet liquidity requirements in foreign currency given ongoing overseas expansion.
  - Possible impact of the leverage ratio is still being examined; international discussions ongoing and banks are developing internal mechanisms to balance this ratio with Basel III capital requirements and LCR/NSFR.

*Source: IMF staff report excerpt (Japan FSAP, Annexes IV–V).*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12210.pdf_