[International Affairs]
The Fifth High-Level Bilateral Dialogue on Securities Markets was held on June 15 at the Financial Services Agency (FSA).
The High-Level Bilateral Dialogue on Securities Markets is a policy dialogue held regularly to conduct high-level discussions on issues common to the global securities markets. Dialogues have been held once a year since 2005, with the venue alternating between Japan and the United States.
The High-Level Bilateral Dialogue on Securities Markets was attended by high-level officials from the FSA and from the United States Securities and Exchange Commission (SEC), led respectively by Mr. Junichi Maruyama, Deputy Commissioner for International Affairs, and by Commissioner Kathleen Casey. At the meeting, participants discussed a wide range of policy issues, including regulatory issues such as credit rating agencies, short selling and credit default swaps, accounting standards, disclosure, and enforcement issues.
During the 12 months since last year's dialogue, we have witnessed turmoil in the global financial and capital markets. It is believed that we are in an age where, in order to respond to the global financial crisis, the regulatory authorities of each country must conduct serious discussions.
Amid ongoing globalization, it is important that Japan and the United States also join hands in boosting the cooperation of their supervisory authorities more than ever before. And as the turmoil of the world financial markets continues, it is considered extremely important that the SEC and the FSA also cooperate and collaborate closely in the area of enforcement.
Given these circumstances, officials from the two organizations deepened their mutual understanding through the dialogue and enhanced their cooperative relationship.
*For further details, please refer to FSA and U.S. SEC hold the fifth meeting of the High-Level Dialogue (June 15, 2009) in the “Press Releases” section of the FSA website.
[Explanations of Laws and Regulations]
Partial revision of the inspection manuals pertaining to the development of conflict of interest management systems
1. Introduction
On May 20, the Financial Services Agency (FSA) partially revised the Financial Inspection Manual, the Insurance Inspection Manual and the Inspection Manual for Financial Holding Companies, including establishing checkpoints relating to the development of conflict of interest management systems.
2. Background to the revisions
Under the Act for the Amendment of the Financial Instruments and Exchange Act, which was passed in June 2008, firewall regulations were reformed and requirements were introduced for the establishment of systems for managing conflicts of interest.
The aim of the amendment is to enable financial groups to provide a diverse range of high-quality services by relaxing the firewall regulations pertaining to the reciprocal entry of firms into other types of business, and by requiring firms to establish conflict of interest management systems in order to prevent their customers' interests from being unfairly harmed in association with trading by the firm itself or by a group company.
In response to the amendment, a decision was made to revise each of the inspection manuals from the perspective of customer protection, including establishing new checkpoints related to the development of conflict of interest management systems. The proposed revisions were referred to public comment between March 31 and April 30, 2009. On May 20, the FSA published their response to the comments received, and released the revised manuals incorporating consideration of these comments. The revisions will come into force on June 1, 2009, and shall apply to inspections conducted on or after this date.
3. Financial Inspection Manual
Below, we examine the outline and main checkpoints of the Financial Inspection Manual which were subject to revision.
1) Outline of revision
Regulations contained in the Financial Instruments and Exchange Act relating to conflict of interest management are not controls on conduct that prohibit “transactions involving conflicts of interest”; instead, from the perspective of protecting customers' interests, they require financial institutions to have arrangements and procedures for appropriately managing conflicts of interest.
Thus, in the revised Financial Inspection Manual, it was decided to include a conflict of interest management system alongside the customer explanation management system and customer support management system as an inspection point of the customer protection management system.
The Financial Inspection Manual states that, with regard to customer protection management, it is important for a financial institution to review its own business operations from the customer's viewpoint and to constantly review and improve the business operations. This means that this kind of approach is also important when managing conflicts of interest.
2) Main checkpoints
(1) What is conflict of interest management?
What specifically does “conflict of interest management” mean?
The Financial Inspection Manual describes it as:
Managing conflicts of interest in a way that prevents customers' interests from being unfairly harmed as a consequence of transactions conducted by a financial institution or an affiliated group company
With respect to the term “a financial institution or an affiliated group company,” in addition to the Bank, a bank agent for which the Bank serves as a principal bank, and a parent or subsidiary financial institution, etc. of the Bank (as prescribed in Article 13-3-2 (1) of the Banking Act ), the manual goes further to include:
- Any company for which the said financial institution has deemed conflict of interest management necessary for the protection of its customers.
Furthermore, the manual broadly states “customers” as the target of protection, unlike the Banking Act which limits protection to those “customers connected to banking-related business.”
Although inspecting thus whether a firm is managing conflicts of interest may be seen as going beyond the scope of the law, this checkpoint has not been included with that objective in mind.
The checkpoint has been included in keeping with the spirit that, in developing a conflict of interest management system regarding which transactions are at risk of harming the interests of which customers, because circumstances differ greatly between different financial groups, each financial institution should determine itself the scope of its applicable transactions and the scope of its customers to be protected based on laws and regulations and in accordance with such factors as the scale and characteristics of its own business.
(2) Organizational frameworks
With respect to conflict of interest management systems, the Financial Inspection Manual stipulates
1 Banks shall, pursuant to the provisions of a Cabinet Office Ordinance, appropriately manage information pertaining to the business conducted by the Bank, a bank agent for which the Bank serves as a principal bank, or a subsidiary financial institution, etc. of the Bank (limited to banking business, bank agency service and other business specified by a Cabinet Office Ordinance), and shall develop systems and implement other necessary measures for appropriately monitoring how the said business is being conducted, so that customers' interests pertaining to the said business are not unfairly harmed as a consequence of transactions conducted by the Bank, a bank agent for which the Bank serves as a principal bank, or a parent financial institution, etc. or subsidiary financial institution, etc. of the Bank.
the designation of a Conflict of Interest Manager as a checkpoint:
Has a manager in charge of the overall control of conflicts of interest (Conflict of Interest Manager) been established for the development and establishment of an appropriate system for controlling conflicts of interest? Has a system been provided that stipulates the responsibilities and authority and allocates appropriate roles to the Conflict of Interest Manager?
With respect to the development of a specific organizational framework in such cases as where a conflict of interest management division is established, this is left to the discretion of the financial institution. As long as conflict of interest management is effectively assured, the manual does not preclude an officer or employee of the compliance management division or another division from concurrently engaging in other duties including the management of conflicts of interest.
Furthermore, although a financial institution may of course designate more than one Conflict of Interest Manager to provide more detailed management, in such instances, it would need to clearly specify where responsibility lies, such as by designating the individual responsible for overall management.
(3) Ensuring independence from the sales division
The Financial Inspection Manual lists, as points to note when developing systems relating to conflicts of interest, having the Conflict of Interest Manager ensure independence from the sales division and developing a system under which a check-and-balance function can be performed over the sales division.
The aim of this is to prevent such instances as being unable to take necessary measures to manage conflicts of interest as a result of officers or employees from the sales division having interfered in the decisions related to conflict of interest management.
In the real business world, situations can be readily envisaged where “the sales division makes standard decisions in accordance with an operations manual prescribed by the Conflict of Interest Manager,” and as such, the Financial Inspection Manual does not entirely preclude sales division officers or employees from being involved in the conflict of interest management process.
Of course, since managing conflicts of interest does have a certain quality requiring decisions to be made that are contrary to the pursuit of commercial profit, consideration needs to be given so that a distinction is made between the scope within which decisions should be strictly made from a perspective of managing conflicts of interest and the scope within which the sales division can be involved.
(4) Implementation of conflict of interest management, and assessment and improvement activities
The Financial Inspection Manual also lists other checkpoints regarding measures implemented by individual financial institutions for the purpose of managing conflicts of interest, and checkpoints regarding activities for assessing and improving their conflict of interest management systems (corresponding to the “C” and “A” phases of the PDCA cycle), including:
- Is a system in place to properly specify transactions that have potential conflicts of interest?
- Is a system in place to select appropriate methods for managing conflicts of interest?
- Are records of conflict of interest management being compiled and kept?
4. Insurance Inspection Manual
Similar to the Financial Inspection Manual, new checkpoints regarding conflict of interest management systems were established in the checklist for customer protection management systems contained in the Insurance Inspection Manual.
Descriptions based on the PDCA cycle, like those in the Financial Inspection Manual, have not been fully clarified in the Insurance Inspection Manual, and although some terminology usage is also different to the Financial Inspection Manual, it is fair to regard the basic idea as being the same as the Financial Inspection Manual.
5. Inspection Manual for Financial Holding Companies
Checkpoints regarding conflict of interest management have been established in the Inspection Manual for Financial Holding Companies in both the checklists for bank holding companies and the checklists for insurance holding companies, as specific issues of particular note within the checklist for group business management (governance) systems.
The checkpoints here include: Do the directors of the financial holding company fully recognize the need for managing conflicts of interest for the group as a whole? Have the directors developed a system for centrally managing these conflicts of interest?
*For further details, please refer to Partial revision of the inspection manuals pertaining to the development of conflict of interest management systems (May 20, 2009)
in the “Press Releases” section of the FSA
The Financial Services Agency (FSA) invited opinions from the public regarding the draft partial revision of the Comprehensive Guidelines for Supervision of Insurance Companies from April 23 to May 25, 2009. On June 8, the FSA published the results of the public comment procedure and revised the guidelines accordingly. The revised guidelines have been applicable since this date.
The aim and the key points of the revision are as follows:
1. Aim
In part based on the report of the Financial Stability Forum (FSF) and the G20 action plan, revisions were made regarding viewpoints relating to risk management in the guidelines for the supervision of insurance companies.
2. Key points of the revisions
1) Integrated risk management [II-2-6-1 ]
Given that insurance companies generally face complex and large-scale risks, the revisions required them to establish systems for managing the various risks by integrating them. Specifically, the following supervisory viewpoints were prescribed:
(1) Has the insurance company established an integrated risk management policy in line with its overall management policy?
(2) Has the insurance company clearly defined the division to comprehensively manage risks?
(3) Has the insurance company quantified the risks using common standards, and is it applying those results to the execution of its business?
2) Stress tests [II-2-6-2 ]
Although the existing guidelines do mention stress tests, important points regarding the setting of stress scenarios, etc. were added so that the stress tests could be used in making specific decisions on risk management even in circumstances where the market is fluctuating widely. Specifically, the following supervisory viewpoints were added:
(1) Does the insurance company conduct analyses based not only on historical scenarios (using past major crises and maximum past losses) but also on simulated scenarios where multiple factors (stock prices, interest rates, exchange rates, etc.) fluctuate simultaneously?
(2) At such times, does the insurance company include in its examination situations where there is a break down in the price correlations between asset holdings that were anticipated in normal times?
(3) When setting the stress scenarios, does the insurance company include considerations from the perspective that they are faced with risks that cannot be identified using the quantification techniques of integrated risk management?
3) Risk management for credit investments such as securitized products [II-2-6-6-2(3) ]
The following supervisory viewpoints were added with regard to risk management relating to credit investments such as securitized products:
(1) Does the insurance company strive to understand the nature of products, etc., such as the details of collateral assets, senior-subordinated structures and the status of credit enhancement, and the details of credit events?
(2) When appraising values, in cases where there is frequent trading, does the insurance company use the market prices; and in other cases, does the insurance company make reasonable appraisals being mindful of the frequency of transactions and the differences in seller and buyer prices? And does it reflect these in its accounting treatment?
(3) Does the insurance company have in place systems for responding in a timely manner in cases where concerns over market liquidity have been recognized?
4) Risk management relating to financial guarantee insurance and CDS transactions [II-2-6-6-2(3), II-2-6-7-2 (2)
]The following supervisory viewpoints were added with regard to risk management relating to financial guarantee insurance and CDS transactions:
(1) Does the insurance company strive to understand the nature of products, etc., such as the details of obligations covered by financial guarantee insurance and reference obligations of CDSs, and the details of credit events?
(2) With respect to financial guarantee insurance, does the insurance company appropriately appraise the value of the associated liabilities, and where necessary, does it place additional funds into the policy reserves?
With respect to CDS transactions, when appraising values, in cases where there is frequent trading, does the insurance company use the market prices; and in other cases, does the insurance company make reasonable appraisals being mindful of the frequency of transactions and the differences in seller and buyer prices? And does it reflect these in its accounting treatment?
(3) With financial guarantee insurance and CDS transactions, etc., in cases where one of the terms is a requirement for collateral based on such factors as the rating of the insurance company and the degree of credit of the guarantee obligations or reference obligations, does the insurance company manage liquidity assuming the provision of the collateral?
(4) In conducting CDS transactions, from the perspective of improving the security of transactions, does the insurance company adopt appropriate trading practices while bearing in mind the efforts of relevant parties, such as the standardization of transactions and the use of a central settlement provider?
5) Treatment of policy reserves when insurance contracts are reinsured [II-2-1-4(8)
]In cases where an insurance contract is reinsured, although the guidelines allow the insurance company not to place an amount equivalent to the reinsured portion into the policy reserves, the guidelines made it clear that attention should be paid to the following points when deciding on this treatment:
(1) Is the reinsurance contract of the sort where risks will definitely be transferred in the future?
(2) Is there a high probability that the reinsurance amount pertaining to the reinsurance contract will be recovered?
*For further details, please refer to Results of the public comments on the proposed partial revision of the Comprehensive Guidelines for Supervision of Insurance Companies (June 8, 2009) in the “Press Releases” section of the FSA website.
