FSA Newsletter January 2006

Implementation Framework of the Second Pillar of Basel II

The Financial Services Agency (FSA) has announced the implementation framework of the second pillar (supervisory review process) of Basel II (the new capital adequacy framework, which is due to be carried out from the end of March, 2007).

Key Features of the Second Pillar of Basel II

The second pillar - supervisory review process emphasizes that financial institutions should fulfill their self-responsibility for appropriately assessing and managing various risks they face, and maintaining sufficient capital according to such risks including those not covered within the first pillar (minimum capital requirements). It also mentions that supervisors should review and evaluate risk management methods which are adopted by individual financial institutions on their own initiative and take appropriate supervisory actions as necessary.

(Reference)

Basel II (the new capital adequacy framework) establishes the following four key principles in the second pillar.

Principle 1:

Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

Principle 2:

Supervisors should review and evaluate banks' internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate action if they are not satisfied with the result of this process.

Principle 3:

Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Principle 4:

Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

*	Basel Committee on Banking Supervision, ''International Convergence of Capital Measurement and Capital Standards: A Revised Framework'', June 2004.

The approach of the FSA to the second pillar of Basel II is the implementation of three-tier supervision below.

(1)		Communicate the supervisory expectations and induce efforts of individual financial institutions to achieve the comprehensive risk management (in response to Principle 1).
(2)		Review the effectiveness of the comprehensive risk management system (in response to Principle 2).
(3)		Establish early warning thresholds for individual risks (in response to Principles 3 and 4).

The ultimate objective of the financial administration, in light of the second pillar of Basel II, is that each financial institution maintains and improves its soundness by advancing its own risk management function that is commensurate with its scale and risk profile, etc. Promoting these efforts, together with those for the third pillar of Basel II (market discipline) described in the later section, is consistent with the principles of financial supervision in Japan, where the principle of self-responsibility and market discipline form the foundation which is supplemented by supervisors.

Relationship with the First Pillar (Minimum Capital Requirements)

Basel II consists of he first pillar (which seeks to improve the accuracy of the calculation method of capital adequacy ratio which is an important indicator of a financial institution's soundness), the second pillar (which seeks to promote self-disciplined risk management by financial institutions and enforce review by supervisors), and the third pillar (which seeks to enhance market discipline). The three pillars complement each other for the purpose of ensuring the soundness of financial institutions.
The first pillar aims to improve the accuracy of risk measurements and advance risk management function, in order to overcome the limitations and problems in the existing capital adequacy requirements (Basel I).

(Note)

The FSA has released a draft of the new capital adequacy requirements for public comment from interested parties three times: (1) October 28, 2004, (2) March 31, 2005 and (3) December 28 2005.

The second pillar emphasizes that financial institutions should appropriately assess and manage the entire risks including those risks which are not covered in the calculation of the minimum capital requirement under the first pillar system, in light of their scale and risk profile, etc. It also mentions that supervisors should review and evaluate risk management methods of individual financial institutions and take such appropriate supervisory actions as periodic reporting and interviews as necessary, while assigning maximum respect to efforts to be made by each financial institution on its own initiative. The second pillar thereby aims to complement the first pillar and encourage financial institutions to achieve a more appropriate self-disciplined risk management.

Evaluation of Comprehensive Risk Management System

Based on this approach, the supervisory perspectives to review a comprehensive risk management system will be included in supervisory guidelines summarizing the FSA's basic approach to the supervision process so as to encourage each financial institution, having considered these perspectives, to build an appropriate and comprehensive risk management system in accordance with the scale of its business and risk profile, etc, and to build a process for assessing its capital adequacy in relation to its own risk.
The FSA will assess, review and evaluate the effectiveness of a comprehensive risk management system established by each financial institution via such means as periodic reporting and interviews with the management of each institution, while assigning maximum respect to efforts to be made by each financial institution on its own initiative. The FSA will conduct its supervisory reviews and evaluations in accordance with the ''Evaluation of Comprehensive Risk Management System'' that will be described below.
Evaluation of Comprehensive Risk Management System
Risk-taking is an essential element in financial intermediation. As the financial institutions' operations continue to diversify, it is becoming increasingly important for the management of financial institutions to gain a comprehensive understanding of various risks and to prepare appropriate management systems on its own initiative to deal with such risks. When reviewing risk management systems of financial institutions, the fundamental role of the FSA is to supplement their own efforts to manage risks. Pursuant to this approach, the FSA will, in implementing the second pillar of Basel II, review whether each financial institution appropriately assesses and manages the entire risks including those risks which are not covered in the calculation of the minimum capital requirement under the first pillar.

(Reference)

Examples of risks mentioned in ''The International Convergence of capital Measurement and Capital Standards: a Revised Framework'' issued by the Basel Committee on Banking Supervision (June 2004). (This list is not exclusive.)
Credit risk, operational risk, market risk, interest rate risk in the banking book, liquidity risk and other risks (reputational risk, strategic risk, etc.)

Financial institutions need to establish a clear risk management policy that is commensurate with the size, characteristics and complexity of their businesses, and assess the various risks inherent in each business department aggregately and quantitatively. It is also necessary to maintain sufficient level of capital both in terms of quality and quantity in comparison with such aggregated risks. ^(Note)

(Note)

It has been recognized as the best practice to quantify the volume of risks in each business department to the extent possible, and allocate capital accordingly to each department within the range of the institution's overall level of capital. By doing so, the volume of risks taken by individual institutions can be limited within the scope of their capital. At the same time, financial institutions are expected to conduct an appropriate management of risks and returns in relation to their business plans, using, for instance, quantitative indicators such as risk-adjusted profit of each business department.

For the reasons, the FSA will revise the ''Comprehensive Guideline for Supervision of Small- and Medium-sized and Regional Financial Institutions,'' in line with the perspectives clarified in the recently-published ''Comprehensive Guideline for Supervision of Major Banks, etc.,'' in order to assess financial institutions' preparedness in terms of the comprehensive risk management systems as well as the capital adequacy assessment process. However, as the scale and the risk profile of each financial institution could vary significantly, due care must be paid to avoid uniform and inflexible application of regulations. Rather, it is important to ensure that the FSA's review will be implemented in a manner that is in line with the actual development status of the risk management system at each financial institution. In doing so, the FSA will respect the internal management system and quantification method assumed by each financial institution to the maximum extent in accordance with the actual development status, and where necessary, it will foster a further advancement of risk management system at each institution.

Enhancement of the Early Warning System

On the other hand, an appropriate mechanism for supervisory intervention on individual risk categories needs to be established in order to supplement the above-mentioned supervisory reviews/evaluations of the comprehensive risk management system based on self-responsibility of each financial institution. For example, in order to avoid situations where an unsatisfactory management system of key individual risks affects the soundness of the financial institution, those financial institutions with a high probability of materializing such risks need to be observed with focused attention.
The FSA introduced an Early Warning System in 2002, as a framework whereby remedial actions are prompted to financial institutions with capital adequacy ratios above the required minimum (not subject to prompt corrective actions) at an early stage. The Early Warning System is a tool that enables the FSA to monitor such aspects of each financial institution as profitability, credit risk, market risk, and liquidity risk, and in accordance with the results of such monitoring, the FSA requests individual institutions to submit reports or order operational improvement as necessary if those financial institutions could not satisfy certain thresholds that are pre-determined for each of these risks commonly for each institution.
In light of such a characteristic and method of the Early Warning System, it would be effective and efficient to utilize the existing early warning thresholds that focus on specific indicators for individual risks, as a tool to implement the second pillar of Basel II, together with the aforementioned FSA's approach to encourage each financial institution to make its own efforts to build a comprehensive risk management system, and to review its effectiveness. Such a combination of supervisory approaches would be desirable in terms of the compliance costs paid by financial institutions, and of the continuity of the financial administration.

With regards to the ''interest rate risk in the banking book'' and ''credit concentration risk'' which are explicitly regarded as important risks to be covered under the second pillar, the FSA will incorporate its supervisory measures for those two risks into the framework of the Early Warning System, so as to ensure that these risks are managed in an appropriate manner on an individual basis.

(Note)

For more information on the ''interest rate risk in the banking book'' and ''credit concentration risk'', please refer to the press release titled ''Implementation Framework of the Second Pillar of Basel II'' (November 22, 2005).

In the framework of the Early Warning System, the FSA conducts interviews in order to analyze the cause, review the appropriateness of the risk management and remedial actions taken by financial institutions which fall below the pre-determined level. Also as necessary, the FSA requests a written report in accordance with Article 24 of the Banking Law, or issue a business improvement order in accordance with Article 26 of the Banking Law when the necessity is acknowledged to deliver a successful implementation of a business improvement plan.
In such a framework, supervisory actions such as interviews have to be taken as a part of the ''Stability Improvement Measure'' concerning the interest rate risk in the banking book, or of the ''Credit Risk Improvement Measure'' concerning the credit concentration risk of the financial institutions that fall below the above-mentioned threshold. Even in such circumstances, however, it does not mean that the management of the financial institutions concerned is automatically regarded as unsound, and thus, the FSA does not necessarily make an immediate request for improvement of the management.
Furthermore, even in the case where an improvement is needed in individual institutions, special attentions should be paid to appropriately select the method and the timing of the improvement plan in order to contain potential influences of the improvement actions on the financial market and financial intermediaries for small- and medium-sized enterprises.
If a need is recognized after the implementation of this supervisory framework, the FSA will flexibly review the framework as well as its implementation method.

Supervisory Approach for Small- and Medium-Sized and Regional Financial Institutions

The above framework also applies to small- and medium-sized and regional financial institutions. The fundamental approach of the FSA is to utilize the framework to review and evaluate the system for a comprehensive management of various risks at each financial institution, in tandem with the Early Warning System including those for the ''interest rate risk in the banking book'' and the ''credit concentration risk''.
It must be noted, however, that the comprehensive risk management is basically intended to apply for financial institutions with large-scale and complicated risks in order for them to assess and manage a wide range of risks as a whole. On the other hand, there exist some small- and medium-sized and regional financial institutions for which it may not be appropriate to immediately require a highly sophisticated comprehensive risk management system, in light of their scale and risk profile. Therefore, the Early Warning System will form the basis for the supervision of these financial institutions, and in the course of conducting interviews and requesting reports based on the Early Warning System, the FSA may encourage individual institutions – where necessary, to establish a desirable level of system for comprehensively managing various risks, commensurate with the scale and risk profile of each institution.

The Third Pillar

Basel II seeks to improve the effectiveness of market discipline by enhancing disclosure, and requires financial institutions to disclose the capital adequacy ratio, its breakdown, the volume of risks by each risk type held by individual financial institutions, the calculation methods of each risk and so forth.
The draft of the third pillar (the FSA has already released the proposed disclosure items for public comments from interested parties, in conjunction with the draft of the first pillar. For more information, please refer to FSA's official website aforementioned.) shows the disclosure items in compliance with Basel II, and requires financial institutions to disclose information relating to these items at least once a year (twice a year in the case of banks), based on financial institutions' duty of disclosure set forth in the Banking Law, etc. It also has provisions for financial institutions to make efforts to disclose such information on a semiannual and quarterly basis, depending on the actual status of each financial institution. Moreover, banks that adopt Internal Ratings-Based Approach (credit risk) or Advanced Measurement Approaches (operational risk) need to properly disclose information on a semiannual and quarterly basis as well, and such disclosure policy is defined in the requirements for the approval of each approach. International standard banks are also due to be treated in the same manner because of their characteristics.

For more information, please refer the ''Implementation Framework of the Second Pillar of Basel II'' (November 22, 2005) of the ''Press Releases'' section on the FSA's website.

The major banks' financial results for the first half ending September 30, 2005 are outlined below.
1.	Profit and Loss Status

	Operating profits from core business of all the major banks combined amounted to 2.0 trillion yen in the first half ending September 30, 2005, which was similar to the level in the first half ending September 30, 2004 (1.8 trillion yen). In the first half ending September 30, 2005, the net income of all the major banks combined substantially increased to 1.6 trillion yen, and at the same time, all the major banks recorded positive net income. This can be largely attributable to extraordinary factors: losses from the disposal of non-performing loans (NPLs), which had amounted to 1.1 trillion yen in the first half ending September 30, 2004, reversed a gain of 0.2 trillion yen, as the reversal of the allowance for credit losses increased, while write-offs of loans and provisions for the allowance for credit losses decreased.
2.	Status of Capital Adequacy Ratio

	The capital adequacy ratio of major banks (based on non-consolidated weighted average) was 11.6%, which turned out to be exactly the same as in the fiscal year ended March 31, 2005.
3.	Status of NPLs

	The balance of NPLs (loans disclosed under the Financial Reconstruction Law) decreased by 1.3 trillion yen to 6.1 trillion yen overall from the fiscal year ended March 31, 2005 (7.4 trillion yen). The percentage of NPLs decreased by about 0.5 percentage points to 2.4% from the fiscal year ended March 31, 2005 (2.9%). The percentage of NPLs decreased at all major banks, so the banks are deemed to be steadily improving the soundness of their assets.

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Masazumi Gotoda (Parliamentary Secretary) giving keynote speech at symposium on how to use money and thoughts on local communities (December 17)		Kaoru Yosano (Minister of State for Economic & Fiscal Policy and Financial Services) making an address at conference on facilitating small- and medium-sized enterprises (SME) financing (December 13)
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