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The ''Annual Policies for the Supervision of Major Banks, etc. for Administrative Year 2006'' released to the public in August 2006 specified the priorities in dealing with the diversification of asset management techniques. ''At major banks, etc., there is a trend to secure revenue through such new techniques as increasing, for example, ''(i) credit derivatives trading, (ii) loans targeted at real estate funds, and (iii) alternative investments. Whether or not the risks associated with such new trading patterns are being accurately identified and managed must be verified.''

The ''Annual Policies for the Supervision of Securities Companies, etc. for Administrative Year 2006'' also released to the public in August 2006 specified its priorities. For customer protection, ''investment trust businesses, investment corporations' asset management businesses and investment advisory businesses must continue to be strictly checked as to whether there are any breaches of the duty of loyalty or the duty of care of a good manager with respect to customers''; and for the development of an adequate business operations system, ''the importance of properly managing legal risks and rumor risks is deemed to be growing in line with the increase in potential conflict of interest, etc. due to the diversification and complexity of operations. Based on this reality, risk managements systems pertaining to securities companies, etc. must be examined through comprehensive interviews, etc.''

In consideration of these policies, the Financial Services Agency (FSA) conducted interviews with financial institutions between October and November 2006 for the purpose identifying the actual state of investments and loans geared towards real estate funds. Based on the interview findings, the FSA has decided to add the following notes to the corresponding Annual Policies as matters that require attention.

According to these Annual Policies, the FSA will endeavor to enhance collaboration with the inspection divisions and to conduct supervisory administration in a strict, effective and efficient manner.

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1. Introduction

On December 26, 2006, the Financial Services Agency (FSA) published a document entitled ''Financial Inspections Pursuant to the Implementation of Basel II''.

Basel II (a set of new capital adequacy requirements) is an accord that was reached in June 2004 by the Basel Committee on Banking Supervision following the revision of the existing capital adequacy requirements, whose objective is to achieve international harmonization of banking supervision in different countries. Specifically, it consists of three pillars: the first pillar relates to the minimum capital requirement, the second relates to self-supervision by financial institutions and supervisory review, and the third to market discipline. The aim thereof is to make financial institutions' risk management more sophisticated. The first pillar requires the refinement of capital adequacy ratio calculations. Specifically, this requires the refining of credit risk measurement and the re-introduction of operational risk measurement into the calculation of capital adequacy ratio. The second pillar requires financial institutions to properly identify and manage the risks to which they are exposed as a whole, including those not covered within the framework of the first pillar. The third pillar requires improved effectiveness of market discipline by way of enhancement of information disclosure. Basel II is scheduled for implementation as of the year ending on March 31, 2007.

The following is an overview of ''Financial Inspections Pursuant to the Implementation of Basel II''.

2. Overview of ''Financial Inspections Pursuant to the Implementation of Basel II''

(1) Purpose of Formulation

As the existing financial inspection manuals are not compatible with the aforementioned Basel II reforms, we have decided to put together inspection checklists compatible with Basel II.

(2) Background to Publication

In October 2006, the Study Group for the Revision of the Financial Inspection Manual, whose members include experts and professionals from the private sector, was established under the auspices of the Inspection Bureau of the FSA, and began conducting studies. The Study Group held discussions from a specialized and technical perspective, covering topics not limited to conformation to Basel II.

In consideration of the discussions that have taken place within the Study Group, we launched procedures to invite public comments on sections that need to be made to conform to Basel II before other revised sections, taking into account the high level of interest especially among associated parties, and received a broad range of opinions from the general public. In consideration of the opinions, etc. received, we have published the final draft.

(3) Published Contents

In the ''Financial Inspections Pursuant to the Implementation of Basel II'', we have specifically defined and published an inspection checklist with respect to the list of items to be verified regarding the standardized approach and the Internal-Ratings Based (IRB) Approach in: (1) integrated risk management systems; (2) capital management systems; (3) operational risk management systems; and (4) credit risk management systems. We have also formulated (5) our approach to the verification of integrated risk management systems as our future inspection policy for integrated risk management systems. These checklists, etc. are scheduled for introduction in inspections conducted as of April 2007.

The FSA is currently working on the revision of the totality of its financial inspection manuals, and as such the aforementioned checklists are due to constitute a part of the revision of all financial inspection manuals, together with other revisions sections.

The following is an explanation of the content of the checklists for the inspection of (1) integrated risk management systems; (2) capital management systems; and (3) operational risk management systems. ((4) The list of items to be verified regarding the standardized approach and the IRB approach and (5) the approach to verification of integrated risk management systems are omitted.)

3. Contents of Integrated Risk Management System Inspection Checklist

(1) What is Integrated Risk Management?

Integrated risk management involves the execution of self-controlled risk management by identifying risks faced by financial institutions that have been assessed with respect to each risk category (credit risk, market risk, operational risk, etc.) in a comprehensive manner, including risks that are not included in the calculation of the capital adequacy ratio (credit concentration risks, interest rate risks in banking records, etc.), and by comparing and contrasting these with the financial institution's fiscal status (capital).

(2) Main Inspection Items

- Has an adequate integrated risk management system commensurate with the scale, characteristics, risk profile, etc. of bank operations been developed?

- Is the integrated risk management process that determines, assesses, monitors and controls risks facing financial institutions functioning effectively?

- In cases where an ''integrated risk measurement technique'' for measuring various risks quantitatively, based on standardized scale, represents the integrated risk measurement system, is said system being managed properly?

(3) Matters Requiring Attention Upon Conducting Verification

The checklist states that when an inspector verifies an integrated risk management system, it is important that he/she verifies whether an adequate integrated risk management system has been developed commensurate with the level of complexity and sophistication of the risk assessment method adopted by the financial institution, in addition to its strategic goals, as well as the scale, characteristics and risk profile of its operations, while showing utmost respect for the voluntary efforts made to develop and establish an integrated risk management system by the financial institution in question.

4. Contents of Checklist for Inspection of Capital Management Systems

(1) What is Capital Management?

Capital management involves the implementation of capital enhancement measures, the assessment of the capital enhancement status and the calculation of the capital adequacy ratio.

(2) Main Inspection Items

- Are capital enhancement measures being implemented smoothly based on management plans, capital plans, etc.?

- Is the status of capital enhancement being properly assessed in consideration of the scale, characteristics and risk profile of operations of the institution in question?

- Is the capital adequacy ratio being calculated accurately as prescribed by decrees, etc.?

(3) Matters Requiring Attention Upon Conducting Verification

The checklist states that when an inspector verifies a capital management system, it is important that he/she verifies whether an adequate capital management system has been developed commensurate with the level of complexity and sophistication of the method of assessing the capital enhancement status adopted by the financial institution in question.

5. Contents of Checklist for Inspection of Operational Risk Management Systems

(1) Composition

The FSA is currently working on the revision of the totality of its financial inspection manuals. The overall composition of the checklist for the inspection of operational risk management systems is slated to consist of the following:

1. Comprehensive operational risk management system (this section has just been published.)

2. Operational risk management systems

(2) What is Operational Risk?

Operational risk refers to the risk of incurring losses due to inadequacies in a financial institution's operational processes, failures on the part of its executives/employees' activities or systems, or external phenomena (a portion of risks that is included in the calculation of capital adequacy ratio) as well as risks that are defined as ''operational risks'' by the financial institution itself (a portion of risks that is excluded from the calculation of the capital adequacy ratio).

Furthermore, comprehensive operational risk management refers to the determination, assessment, monitoring, control and reduction of operational risks in a comprehensive manner within the totality of the financial institution.

(3) Main Inspection Items

- Has an appropriate comprehensive operational risk management system commensurate with the scale, characteristics, risk profile, etc. of operations been developed?

- Is the system for the comprehensive management of operational risks functioning effectively in the financial institution as a whole?

- If an operational risk measurement technique is being used, is the risk measurement system being managed properly?

(4) Matters Requiring Attention Upon Conducting Verification

The checklist states that when an inspector verifies a comprehensive operational risk management system, it is important that he/she verifies whether an adequate comprehensive operational risk management system commensurate with the level of complexity and sophistication of the method of quantifying (measuring) operational risks adopted by the financial institution (including the Basic Indicator Approach (BIA) and the Standardized Approach (TSA)), as towel as the scale, characteristics and risk profile of the financial institution's operations has been developed.

6. Conclusion

These checklists are regarded purely as guidebooks for inspectors' use when inspecting financial institutions. Financial institutions are expected to make full use of their creativity and ingenuity in consideration of these checklists, etc., based on the principle of self-responsibility, and to take action in accordance with their scale, characteristics, etc.

Moreover, it is hoped that the sharing the checklists with financial institutions will lead to more efficient and effective inspections through two-way dialogues between financial institutions and inspectors during inspections, and will help improve the transparency of financial administration.

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1. Amendment of Insurance Business Law

Before the revised Insurance Business Law came into force in April 2006, insurance underwriters targeted at specific individuals without any legal restrictions (so-called unlicensed cooperatives) were outside the scope of the Insurance Business Law. This is because voluntary mutual assistance was deemed to be fundamental to so-called unlicensed cooperatives, and regulations to protect policyholders were basically regarded as unnecessary.

On the other hand, there have been an increasing number of disputes in recent years relating to ''members only'' insurance sold by so-called unlicensed cooperatives, due to the inadequate sales methods, poor financial foundations and the like. For this reason, the Insurance Business Law was amended and unlicensed cooperatives were brought under the scope of regulations by the Insurance Business Law for the purpose of protecting policyholders, etc.

As a general rule, unlicensed cooperatives have been subjected to supervision by the Financial Services Agency (FSA) as specific insurance businesses since April 2006.

2. Supervision of Specific Insurance Businesses

The FSA is required to supervise specific insurance businesses to enable policyholders to use insurance products with peace of mind, by making specific insurance businesses run their operations in a sound manner in compliance with laws and regulations, etc.

Firstly, specific insurance businesses were obliged to file a notice with the FSA before engaging in any specific insurance activities by the end of September 2006; 389 organizations filed a notice by the end of September 2006.

In view of the protection of policyholders, specific insurance businesses are subject to regulations such as measures relating to insurance solicitation and business operations, transactions with specific parties, etc.

As appropriate supervision is required in order to make such regulations effective, the FSA has once again instructed the Local Finance Bureaus that are commissioned to handle supervisory affairs concerning specific insurance businesses to take an appropriate approach as described below, based on the ''Supervisory Guideline for Small-claims and Short-term Insurance Businesses'', which is a supplementary issue of the Comprehensive Guideline for Supervision of Insurance Companies.

(1) Approach to Specific Insurance Businesses Operating Without Filing Notice

If an entity is found to have been engaging in insurance business without having filed a notice based on the complaints, tip-offs, inquiries from law enforcement authorities, newspaper advertisements, etc., Local Finance Bureaus must actively make fact-finding efforts, including investigating the nature of operations by such means as making inquiries to the police, consumer affairs bureaus, etc. and by directly confirming it with the entity by phone (unless it causes problems for the law enforcement authorities).

If the investigation results reveal that the entity has been carrying out insurance activities without having filed a notice, the entity will be given a warning in writing, contacted directly by phone or through interviews, etc. and urged to rectify the situation. Furthermore, Local Finance Bureaus must endeavor to collaborate with law enforcement authorities and other relevant authorities.

(2) Fact-Finding Activities targeted at Specific Insurance Businesses, etc.

Local Finance Bureaus must check the content of notices, etc. and verify whether there are any problems in the state of the approach taken by the entity based on legal provisions (measures related to business operations, prohibited acts relating to solicitation, management of personal information and outsourcing of operations), in addition to verifying whether or not there are any operational problems, etc., including checking its financial position and the terms and conditions of the insurance contract in view of protecting policyholders, etc.

Even after the content of the notice has been verified, Local Finance Bureaus must implement further fact-finding efforts with respect to business operations, etc., such as conducting interviews targeted at specific insurance businesses as necessary.

In the event that any problems based on the aforementioned fact-finding efforts are uncovered, local finance bureaus must request that a report be made under the Insurance Business Law as necessary, and must consider taking supervisory action if any serious problems are deemed to exist.

(3) Consideration for Smooth Transition of Specific Insurance Businesses

Specific insurance businesses are required to take such approaches as turning into small-claims and short-term insurance businesses (refer to ''Primer on Financial Literacy'') by the end of March 2008. Local Finance Bureaus must give advice, etc. according to the actual circumstances of each specific insurance business so that they could make the transition appropriately by the end of the transition period.

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The Financial Services Agency (FSA) has compiled a document entitled ''The State of the Distribution of Financial Inspection Rating Results'' concerning the Financial Inspection Rating System (FIRST) and disclosed it to the public on November 15 (available in Japanese only).

1. FIRST was institutionalized in July 2005. Having gone through a trial preparation period until December 2005, it was launched on a trial basis in January 2006.
2. The purpose of FIRST is to motivate financial institutions to make managerial improvements of their own accord by rating* the results of financial inspections, and bringing about more efficient and effective inspections, etc.
3. In light of FIRST's purpose as described above, it is sufficient for the rating results to be recognized only by the inspected financial institution, and it is deemed inappropriate to disclose them to outsiders on an individual basis due to the risk of rumors, etc.
4. However, the FSA has received many requests for the publication of the state of distribution of ratings from each type of business (financial institution) wanting to find out its own positioning.
5. In response to such requests, the FSA published the rating results of 137 financial institutions that had been notified of the rating and inspection results after being given advance notice (or being subject to the commencement of inspection in cases where no advance notice was given) in January 2006 or later and having finished the inspection by June 2006, such as the ratio of the number of areas in which they were given a rating of C or below in regards to each type of business and rating area.
6. The FSA intends to continue to accumulate data for ''The State of Distribution of Financial Inspection Rating Results'' in the future, and publish updates when a certain amount of data has been accumulated.

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Following the announcement of FY2006 interim financial results by the major banks, the Financial Services Agency (FSA) added up the figures etc. announced by the respective banks and released the results on Wednesday, November 22.

Below is a summary of the FY2006 interim financial results for the major banks.

1. Interim Financial Results of Major Banks

With 1.6 trillion yen in net income, income levels turned out to be roughly the same year on year. While their interest income, which represents earnings from lending, showed a downward trend, fees and commissions income from investment trust and insurance product sales increased. However, their performance in the bond business (government bonds etc.) went from profits to losses, and their net core business profits dropped. On the other hand, the overall level remained the same as last year, thanks presumably to profits generated as a result of the reversal of bad loan allowances, as had also been the case for the last term, and also to exceptional factors, including improved pension asset management due to the newly-introduced retirement benefit accounting and the revision of the estimate period for deferred tax asset calculation purposes.

Their capital ratio also rose slightly to 12.3%, a 0.1 percentage point increase from the FY ending March 2006.

2. Non-Performing Loan Status at Major Banks

Balances of non-performing loans (loans subject to disclosure under the Financial Reconstruction Law) stood at 3.9 trillion yen in total, a 15.7% decrease from the FY ending in March 2006. Those categorized as ''in danger of bankruptcy'' or worse stood at 2 trillion yen, a 15.1% decrease year on year, and those categorized as ''Needs special attention'' dropped by 16.5% year on year to 1.9 trillion yen.

The non-performing loan ratio fell to 1.5% from 2.9% from the FY ending in March 2005, a drop of 1.4 percentage points. This presumably reflects the fact that progress in the major banks' efforts to improve their asset portfolios remains an on-going process since the FY ending in March 2005, which was when they achieved their goal of halving the non-performing ratio.

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