FSA Newsletter May 2006

Foreword
The Financial Services Agency (FSA) amended parts of the "Comprehensive Guideline for Supervision of Major Banks, etc.," the "Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions", and the "Comprehensive Guideline for Supervision of Insurance Companies" on March 31, 2006.
The amendments relate to: (1) the clarification of the specific perspectives of the provisions on the qualities of directors of financial institutions (Fit and Proper principle); (2) the implementation of the second pillar of Basel II; (3) the supervision of bank agents; and (4) the revision associated with amendments to the Banking Law (excluding (3)). The nature of the amendments is outlined below.

1. Provisions on Qualities of Directors, etc. of Financial Institutions (Fit and Proper Principle) (Amendments to the "Comprehensive Guideline for Supervision of Major Banks, etc.," the "Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions", and the "Comprehensive Guideline for Supervision of Insurance Companies")
Provisions on the aptitude of directors and operating officers of banks and insurance companies were newly established when the Banking Law and the Insurance Business Law were amended in 2001. As a supervisory authority, the FSA has been conducting supervision properly with respect to the qualities of directors of banks and insurance companies pursuant to the said provisions.
In response to the revelation of scandals, etc. attributable to the responsibility of the management of financial institutions and the occurrence of incidents developing into social problems in recent years, the Program for Further Financial Reform announced in December 2004 declared to clarify the specific perspectives of the provisions on the qualities of directors of financial institutions (Fit and Proper principle) as a policy measure.
With this in mind, the FSA decided to clarify the specific perspectives and the supervision techniques in relation to the provisions on the aptitude of directors of banks and insurance companies, in order to improve the predictability of the parties concerned and to enhance the governance of financial institutions. Specifically, the FSA clearly defined knowledge and experience to execute governance in a precise, fair and efficient manner and sufficient social credibility as qualities that a financial institution should specifically look for when determining the aptitude of directors in the resolution process for the election of directors of the financial institution.
Examples of what banks should specifically look for in terms of knowledge and experience to execute governance in a precise, fair and efficient manner include: sufficient knowledge and experience to understand and implement the perspectives of governance under the regulations related to the Banking Law, etc. and supervisory guidelines; sufficient knowledge of and experience in compliance and risk management; sufficient knowledge of and experience in compliance and risk management required for the sound and proper administration of bank operations; and knowledge and experience required to properly execute other operations within the bank's capacity.
Examples of what banks should specifically look for in terms of sufficient social credibility include: whether or not the directors have ever engaged in antisocial behavior; whether or not the directors have ever been fined (including punishment equivalent to a fine under foreign laws and regulations) for violating the provisions of financial laws and regulations in Japan such as the Securities and Exchange Law or similar foreign laws and regulations, or for committing a crime under the Criminal Code or the Law concerning Punishment of Physical Violence and Others; and whether or not the directors have belonged or belong to a companies subjected to administrative action by a financial supervisory authority in relation to compliance - such as a Business Improvement Order, Business Suspension Order, or revocation of license, registration or approval - and allowed the facts which led to the said action to arise, either intentionally or by gross negligence (due to exceptionally severe carelessness, despite acknowledging a certain outcome and being able to avert it), while being a party to the conduct or being in the position to give directions and orders to the wrongdoer.
The perspectives of the provisions on the qualities of directors are examples of matters to be checked by the FSA in regards to whether or not the aptitude of directors is properly determined in the process of electing directors in each financial institution, on the basis of voluntary efforts made in such a process. They are not to be applied to specific matters for the purpose of making a snap judgment on their aptitude.
Accordingly, it is important for the financial institutions themselves to consider and properly figure out the qualities of directors and other individuals at a particular point in time in a comprehensive manner, under the principle of self-responsibility, taking into account the aforementioned perspectives.

2.

Implementation of the Second Pillar of Basel II (Amendments to the "Comprehensive Guideline for Supervision of Major Banks, etc." and the "Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions")
The amendments are as follows:
(1) The perspectives of the comprehensive risk management system have added to the "Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions"; and
(2) The guidelines on the Early Warning System^*1 including monitoring the interest rate risk in the banking book in the "Comprehensive Guideline for Supervision of Major Banks, etc." and the "Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions" have revised.
They were included in the "Implementation Framework of the Second Pillar of Basel II^*2 " published in November 2005 and, this time, have been incorporated into the supervisory guidelines.
The purpose of the amendments is to clear the FSA's approach based on that: the second pillar emphasizes that financial institutions should fulfill their self-responsibility for appropriately assessing and managing various risks they face, and maintaining sufficient capital; 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.
In terms of the evaluation of the comprehensive risk management system, 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. For these reasons, the FSA will assess financial institutions' preparedness in terms of the comprehensive risk management system as well as the capital adequacy assessment process.
As for the revised guidelines on 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. 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 has incorporated its supervisory measures for these 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.
More specifically, in reviewing the interest rate risk in the banking book, an "outlier" level^*3 has been set and appropriately monitored within the framework of the "Stability Improvement Measures" in the Early Warning System.
The FSA will conduct appropriate monitoring of credit concentration risk within the framework of the "Credit Risk Improvement Measures" in the Early Warning System. To achieve this end, certain thresholds have been set in terms of credit concentrations on a particular industry, and the capital adequacy ratio assuming^*4 that a risk to a specific large borrower had become apparent.
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.

3.
Supervision of Bank Agents (Amendments to the "Comprehensive Guideline for Supervision of Major Banks, etc." and the "Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions")
In principle, the existing capital requirements and multi-operations restrictions have allowed a bank's subsidiary to act as a bank agent provided that it specialized in bank agency operations. A new bank agency business system has been established pursuant to the Law for Partial Amendments to the Banking Law, etc. enforced on April 1, 2006.
The new system is expected to ensure and improve users' access to financial services and make financial institutions efficiently utilize their diverse sales channels, partly by allowing ordinary businesses to enter into the bank agency business. On the other hand, the FSA decided to ensure the sound and proper operation of bank agency businesses, in order to prevent unfair trading based on the exploitation of business relationships as ordinary businesses.
For the supervision of bank agents, it is necessary to supervise bank agents and the banks with which they are affiliated ("affiliate banks") so as to ensure that bank agency businesses are executed in an appropriate and steady fashion, considering that under the new system, entry into the bank agency business is subject to approval and agents who wish to engage in non-bank agency operations on the side are subject to authorization on an individual basis.
Especially in cases where a bank agent wishes to engage in non-bank agency operations on the side (e.g., cases where an existing ordinary business enters into the bank agency business), it is necessary to bear in mind that the bank agent is strongly required to be well-prepared in terms of operations structure in order to prevent tie-in sales (loans), loans extended by favoritism, diversion and other inappropriate handling of customer information.
On the other hand, considering that the affiliate bank is held responsible for taking measures to ensure the sound and proper operation of the bank agent's bank agency business, it is necessary to focus on the supervision of the affiliate bank when supervising the agent: the affiliate bank must be supervised first, so that operations related to the bank agent's bank agency business would be executed in a sound and proper fashion.

4.
Amendments to Provisions Unrelated to Supervision of Bank Agents (Amendments to the "Comprehensive Guideline for Supervision of Major Banks, etc." and the "Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions")
In conjunction with the latest amendments to the Banking Law, provisions other than those related to the supervision of bank agents were amended to clarify the perspectives of supervision, including preventing inappropriate transactions from occurring in the event of M&A financing, etc.

Afterword
The latest amendments are as outlined above. The amended provisions have been applied from April 1, 2006 onwards (a part of Basel II relating to the "outlier" level will be applicable from April 2007). The FSA is committed to smoothly reflecting them in the actual supervision process.


1		The Early Warning System is 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. It 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. (return to ^*1)
2		"The International Convergence of Capital Measurement and Capital Standards: a Revised Framework" issued by the Basel Committee on Banking Supervision (June 2004) (return to ^*2)
3		It is whether the interest rate risk amount in the banking book (i.e. a decline of the economic value of the overall positions of an financial institution, which is calculated as a result of either (1) an upward and downward 200 basis point parallel rate shock, (2) or 1st and 99th percentile of observed interest rate changes using a 1 year (240 working days) holding period and a minimum of 5 years of observations) exceeds 20% of the sum of Tier 1 and Tier 2 capital. (return to ^*3)
4		An assumption in which a certain amount of the unsecured portion of claims (net of loan-loss provisions)to large borrowers who are classified as “need special attention” or below was recognized as a loss. (return to ^*4)

The Study Team on Insurance Product Sales and Solicitation (Chair: Professor Shuya Nomura, CHUO UNIVERSITY Faculty of Law), which is organized under the auspices of the Financial Services Agency (FSA), recently (March 1, 2006) put together and released to the public a document entitled "Interim Summary of Issues on Sales and Solicitation of Insurance Products in accordance with Suitability Rule."

1. Background to Study
In consideration of suggestions that there are still a large number of complaints about sales and solicitation activities in the insurance industry and that product features have become difficult for consumers to understand due to more diversified and complicated product lineups, the Study Team on Insurance Product Sales and Solicitation is being convened, with members including experts and service users, and is conducting studies for the purpose of tackling such suggestions in a professional and practice-oriented fashion, in order to improve user protection and user convenience. The Team recently compiled an interim summary of issues as described below, based on the results of studies conducted since September 2005, focusing on compliance with the suitability rule in insurance agreements.
2. Overview of Interim Summary of Issues
(1) Whereabouts of Problems: Perception Gap between Agents, etc. and Consumers during Sales and Solicitation for Insurance Products It is important for consumers to properly choose and purchase insurance products that meet their needs. However, the Team made the following suggestions as to whether that is actually possible.
	(i) Due to the complexity, etc. of insurance products, consumers' understanding of product features is limited. (ii) Consumers who have no immediate need to take out insurance have difficulty in properly identifying their own needs. (iii) Unless the consumer has collected and understands information on other options such as alternative insurance products and optional extras, it is difficult for the consumer to make the final judgment as to whether the insurance product he/she is about to buy truly meets his/her needs.
On the other hand, the reality of insurance sales is that agents, etc. make customized proposals by narrowing down and designing insurance products demanded by the customer, in consideration of the customer's attributes and needs. In such cases, agents, etc. and customers are deemed to be making a collaborative effort: for example, the customer provides certain information to the agent, etc., based on which the agent, etc. narrows down the insurance products that meet the customer's needs and makes a proposal. However, the Team suggested that there is a perception gap between the agent, etc. and customers with respect to the aforementioned collaborative effort, as described below.
[Perception of Agent, etc.]
	The agent, etc. recognizes that there is a limit to providing an insurance product that best suits the customer's needs, as the collaborative effort is made purely as a service to the customer.
[Customers' Perception]
	Customers expect the agent, etc. to give advice based on his/her expertise and recommend an insurance product that meets customers' needs. Due to such expectations, there are cases in which the customer passively purchases the recommended product without confirming whether or not it truly meets his/her needs.
The Team looked into effective measures to eliminate such a perception gap and ensure smooth collaborative efforts, so that customers can purchase insurance products that meet their needs.
(2) Role of Agents, etc. and Consumers to Eliminate Perception Gap The approach presented by the Team is to require the agent, etc. and the consumer to perform the following roles, assuming that the process from solicitation to purchase of insurance products is a collaborative effort between them.
[Role of Agent, etc.]
	(i) The agent, etc. must properly collect information on the customer's needs, and recommend an insurance product based on that information. (ii) The agent, etc. must make efforts so that the explanation is not misunderstood by the customer in the solicitation process, and if any lack of understanding or misunderstanding has been identified on the part of the customer, provide a more intelligible explanation or clear up the misunderstanding.
[Role of Consumer]
	(i) The customer must properly provide the agent, etc. with information on his/her needs. (ii) The customer must NOT purchase an insurance product recommended by an agent, etc. straight away; he/she must confirm that the features of the recommended product meet his/her needs and determine whether or not to purchase it based on the principle of self-responsibility.
The Team suggested that in order to crystallize such an approach, it would be effective to establish the following framework, by referring to the so-called suitability rule and foreign legal systems.
(3) Details of Framework: Intention Confirmation Form To make sure that the customer has the opportunity to make a final confirmation as to whether or not the insurance product he/she is about to purchase meets his/her needs before signing the agreement, the Team suggested that it would be effective to prepare, issue and store a form designed to collect information on the customer's needs and confirm that the insurance product meets his/her needs (hereinafter referred to as "Intention Confirmation Form"). The Team pointed out the following merits of the Intention Confirmation Form:
	(i) The customer will be able to confirm his/her needs and whether or not the insurance product meets his/her needs before signing the agreement, and will be able reconsider whether or not to sign the agreement. (ii) The agent, etc. will confirm whether or not the insurance product meets the customer's needs in the process of preparing the Intention Confirmation Form, and will be able to reconsider whether the recommendation is appropriate or not. (ii) Both parties will be able to confirm the purchase process afterwards. It will help prevent and solve problems, etc. that might arise afterwards.
a. Details of Intention Confirmation Form The Team stated its views that the following information should be written on the Intention Confirmation Form.
	(i) Information on the customer's needs learned by the agent, etc. (ii) Main reasons why the recommended insurance product is deemed to meet the customer's needs. (iii) Customer's needs that cannot be met, if any, and other matters that are worth noting, if any.
The agent, etc. needs to be provided with information on the customer's needs in order to determine his/her needs. The Team has made the following suggestions on this matter. - Information on needs may vary widely, ranging from the type of coverage required for insurance against death, etc. to the exact amount of insurance premiums and other particulars of the main policy and each optional extra. - It would be appropriate for the Intention Confirmation Form to cover information on needs that would at least be required as exemplified below.
	(i) What kind of cover is sought? (Coverage for bereaved family compensation in the event of death, medical coverage for cancer and three major diseases, etc.) (ii) Is a savings component required? (iii) Are market risks tolerated? (iv) Period of coverage sought, requests concerning insurance premium, amount insured, priority items, etc., if any.
- In addition to the above, as the needs relating to the particulars of the insurance policy (such as the exact amount insured and the exact amount of insurance premium for the main policy and each optional extra) are also important, it would be appropriate to require the agent, etc. to reconfirm whether or not the customer's needs are met with respect to important items in the ultimate insurance policy, by such means as questioning.
The Team considers that it would be appropriate to confirm with the customer any information on needs provided by him/her in the Intention Confirmation Form, and to allow the customer to request the correction of any information that contradicts with facts.
For the purpose of clarifying the person who prepared and issued the Intention Confirmation Form, the Team considers that it would be appropriate to expressly state the name of the agent, etc. when preparing and issuing the Form.
As for the media format in which the Intention Confirmation Form should be provided, the Team considers that it would be appropriate to provide it in document format, as it is necessary to store it to enable the customer to confirm the purchase process afterwards. While it may be possible to provide the Form by email or in other electronic media format if the customer consents to it, the Team considers that it would be appropriate to make it storable (e.g., printable) for customers.
b. Scope of Application of Intention Confirmation Form
The Team stated in its view that it would be appropriate to apply the Intention Confirmation Form to the following cases where solicitation involves the agent, etc. and the customer making a collaborative effort based on the exchange of information, etc. between each other and customer protection requirements are high due to the type of the product.
	(i) Products with investment attributes (ii) In the case of protection-oriented products, the Intention Confirmation Form should be applied in cases where the disadvantage incurred by the customer as a result of the product not meeting his/her needs is substantial, such as those with a long insurance period. (iii) Policy exchange and conversion
(4) Approach to Cases in which Intention Confirmation Form is Inapplicable Even in cases where there is no need to prepare or issue the Intention Confirmation Form, the Team considers that it would be appropriate to store documents, etc. which checks important matters regarding the customer's needs that must be confirmed carefully. In regards to what kind of information on the customer should be collected in each stage of the sales and solicitation process, and how to provide an explanation to the customer when the insurance product is found to not meet his/her needs, the Team considers that it would be appropriate to require insurance companies, etc. to develop a proper system based on their own judgment. It is necessary to develop a system that can verify the appropriateness of sales and solicitation activities afterwards. Such a system should be established with respect to each product characteristic, such as the length of the insurance period. For example, storage of questionnaires and documents outlining the negotiation process has been suggested as a possibility.
(5) Other Activities Required among Agents, etc. Other activities required among agents, etc. pointed out by the Team are as follows. (i) Provide an explanation according to the customer's level of understanding and eliminate misunderstanding. - In the event that an agent, etc. discovers that the customer does not understand or misunderstands his/her explanation, the agent, etc. must strive to provide a more intelligible explanation and eliminate misunderstandings. (ii) Expressly state the positioning of the agent, etc. - Upon solicitation, it would be appropriate for the agent, etc. to expressly state the range of insurance companies that he/she can deal with (whether or not the agent, etc. is exclusive or nonexclusive; if nonexclusive, the number of insurance companies he/she can deal with and other such information should be expressly stated). - If the customer is about to make a declaration, it would be appropriate for the agent, etc. to expressly state the existence of the right to receive the declaration.
(6) Positioning under Laws and Regulations As for the positioning under laws and regulations, the Team has pointed out that for example, the Intention Confirmation Form could be positioned as the duty of developing a system under Article 53 (7) of the Enforcement Regulations of the Insurance Business Law being fulfilled in concrete terms, and the rules could be clearly defined in the supervisory guidelines.

Kaoru Yosano (Minister of State for Economic & Fiscal Policy and Financial Services) delivers an address at a meeting of Directors of Local Financial Bureaus (April 27).		Yoshitaka Sakurada (Senior Vice Minister for Financial Services) delivers an address at a meeting of Subcommittee on Certified Public Accountants System, Financial System Council (April 26).
Table of Contents