FSA Newsletter May 2006

The Financial Services Agency (FSA) was entitled to inspect contractors for financial institutions, etc. (banks, insurance companies, etc. set forth in the Banking Law, Insurance Business Law, etc.) under the Banking Law, Insurance Business Law, etc. on April 1, 2006. With this in mind, FSA published on March 31, 2006 the Inspections to Contractors of Financial Institutions, etc., which clarifies the approach to basic procedures, etc. for the inspections in consideration of public comments, with the aim of ensuring the effectiveness and transparency of inspections. The content is outlined below. As contractors for financial institutions, etc. are wide-ranging, the FSA will properly determine the contractors that are actually subject to inspections by taking various factors into consideration, such as the nature and scale of the operations outsourced from financial institutions, etc., in accordance with the spirit of laws and regulations.

1. Basic Approach
Inspections targeted at contractors may be conducted to the extent required when deemed especially necessary in the event of setting foot in, asking a question or inspecting a financial institution, etc. under the provisions of the Banking Law, etc. Accordingly, for example, in cases where a financial institution, etc. is to be inspected, the FSA will inspect a contractor if inadequacies in clerical processes, system failure, etc. on the part of the contractor have the potential to undermine the appropriateness of the operations of the financial institution, etc., and in turn, the interest of the users, when the actual status is difficult to be identified by an on-site inspection of the financial institution, etc. Inspections targeted at contractors will be conducted in accordance with the Financial Inspection Basic Guidelines (July 1, 2005) (Note) (hereinafter referred to as "FIBG").

2. Inspection Procedures
An inspection targeted at a contractor will be conducted as part of an inspection targeted at a financial institution, etc. (the outsourcer) in accordance with site investigation procedures, etc. under FIBG. However, the contractor will be treated as follows, in consideration of the fact that its characteristics are different from those of the financial institution's branch and other factors.

(1) Inspections Conducted with or without Prior Notification
In principle, site investigations must be conducted without giving prior notification according to FIBG. The FSA will determine whether or not to give prior notification when inspecting a contractor on a case-by-case basis, by comparing and examining the efficiency and effectiveness of inspections, taking into account a wide range of factors in a comprehensive manner, including the scope of verification and the matters of interest in inspections, as well as the burden on contractors.
(2) Prior Explanation of Important Matters to Contractors, etc.
In order to ensure the transparency of inspection procedures, etc., the FSA will provide a prior explanation of important matters, etc. to contractors and give presentations on inspection orders, etc. in accordance with FIBG. The explanation of the important matters will be comparable to the explanation given to the financial institutions, etc. regarding the matters referred to in the appendix to FIBG titled List of Matters to be Explained, etc., such as the scope of verification.
(3) Treatment of Inspection-related Information
Inspection-related information will also be treated in accordance with FIBG. In cases where a contractor wishes to disclose inspection-related information to a third party, the contractor will be required to obtain approval from the FSA.

3. Treatment of Inspection Monitoring and Inspection Results Notice
As an inspection targeted at a contractor will be conducted as part of an inspection targeted at a financial institution, etc., inspection monitoring will be conducted and the inspection results notice will be issued with respect to the financial institution, etc. that outsources the operations, not the contractor.

4. Other
Other basic approaches, implementation procedures, etc. for inspections targeted at contractors will be executed in accordance with FIBG.

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[Featured]

Overview of Basel II (the New Capital Adequacy Framework)

As a part of the framework that is to be applied as from the end of March 2007, the Financial Services Agency (FSA) published the draft rule text on the third pillar (market discipline) for public consultation at the end of March 2006. With the published ordinance on the first pillar (minimum capital requirements) and the supervisory guidelines on the second pillar (supervisory review process), it constructs the overall implementation framework of Basel II in Japan.
This article outlines the first and third pillars, and briefly explains about some of the reference materials published at the end of March 2006: (i) the preliminary results of mapping between the ratings assigned by eligible external credit assessment institutions (ECAIs) and their corresponding risk weights prescribed in the ordinance; (ii) "Publication Items of Eligible Ratings to Securitization Transactions in Japan" (draft); and (iii) the frequently-asked-questions (FAQs) on the new framework. For information on the second pillar, please refer to the January edition of the FSA Newsletter.

1. The First Pillar
The first pillar sets forth the minimum capital requirements. Its most distinctive feature is that it further improves the precision of measurement of risks (as a denominator) in the calculation of the capital adequacy ratio compared to the existing ordinance (i.e. Basel I).
Specifically, it newly introduced the measurement of operational risk into the calculation of the capital adequacy ratio, in addition to improving the precision of credit risk measurement. (There is no considerable difference from the existing ordinance in terms of market risk).

(1) Credit Risk
There are three approaches to measuring credit risk: the standardized approach, the Foundation Internal Ratings-Based Approach (FIRB) and the Advanced Internal Ratings-Based Approach (AIRB). Financial institutions are now able to choose one from the three approaches.
(Note) The FIRB and the AIRB are subject to the approval of the FSA.
The standardized approach is the simplest approach, which is a modified version of the existing framework. Major points of such modification are as follows:
(i) The risk weight for exposures to small- and medium-sized enterprises and individuals is reduced from 100% (in the existing framework) to 75% in consideration of the diversification of risk into small accounts. The risk weight for housing loans is reduced from 50% (in the existing framework) to 35%.
(ii) The risk weight for past due loans, which is past due for more than 3 months, is higher than non-past due loans, and could be decreased according to the provisioning rate.
(iii) For exposures to corporations, appropriate risk weights can be used according to their creditworthiness. (Risk weights are from 20% to 150% according to the ratings given by eligible ECAIs. However, banks can choose to apply a 100% risk weight to all exposures without using the ECAIs.
On the other hand, the IRB approaches are approaches in which financial institutions with advanced risk management system calculate the required capital using risk parameters such as the probability of default (PD) estimated by themselves. In FIRB approach, the financial institution only estimates the PD and uses the internationally-prescribed values for the loss given default (LGD) and the exposure at default (EAD). In AIRB approach, the financial institutions estimate PD, LGD and EAD, and calculate the required capital based on these estimates.
In such a framework that allows financial institutions to choose one from the three approaches, financial institutions will be prompted to choose one from various alternatives and advance their risk management system on their own initiative.

(2) Operational Risk
Operational risk refers to the risk of losses resulting from a failure in internal processes and systems, misconduct, etc.
Three options are given to financial institutions for measuring operational risk: the Basic Indicator Approach (BIA), the Standardized Approach (TSA) and the Advanced Measurement Approaches (AMA).
(Note) TSA and AMA are subject to the approval of the FSA.
In the BIA and TSA, gross income shall be used as an indicator of operational risk, and the required capital shall be calculated by multiplying gross income by a certain factor. In AMA, financial institutions shall calculate the amount of risk through their own measurement approaches based on the experienced losses, etc. and decide the required capital based on the risk amount.

2. The Third Pillar
Basel II prescribes the disclosure of the capital adequacy ratio, its breakdown, the calculation methods of each type of risk and other quantitative information, in order to improve the effectiveness of market discipline through the enhancement of disclosure.
The draft rule text on the third pillar prescribes the disclosure items and requires the disclosure of information on these items at least twice a year (once a year in the case of small financial institutions other than banks) pursuant to the disclosure requirements under the Banking Law, etc. In addition, it emphasizes financial institutions' efforts toward more frequent (e.g. quarterly) disclosures for encouraging them to disclose their actual circumstances. Moreover, banks adopting the IRB (credit risk) and/or the AMA (operational risk) approaches will need to implement the semi-annual and/or quarterly disclosures in an appropriate manner as a part of the requirements for the approval of such approaches. The same requirement will also apply to internationally-active financial institutions.

3. Eligible External Credit Assessment Institutions (ECAIs) and the Mapping
The mapping between the ratings assigned by eligible ECAIs and the risk weights prescribed in the ordinance is a process to determine what risk weights should correspond to the individual rating grades set by each eligible ECAI whose ratings can be used in the standardized approach for credit risk.
The mapping, with respect to ECAIs that wish to be eligible, is determined by six qualitative criteria on appropriateness (i.e., objectivity, independency, transparency, disclosure, human resources/organizational structure, and credibility) and other quantitative criteria such as the default rate, which are presented in the "Eligibility of External Credit Assessment Institutions Usable in Basel II" published on March 31, 2005. (For further information on eligible ECAIs and the mapping, please refer to the website of the FSA.)
The mapping may be revised, when it is necessary, before the implementation of Basel II at the end of March 2007, for the existing mapping was tentatively published to be in time of the parallel run period which commences at the end of March 2006.

4. "Publication Items of Eligible Ratings to Securitization Transactions in Japan" (Draft)
Risk profiles of securitization transactions are apt to be more complicated and various than that of ordinary exposures to corporations. As risk weights on securitization exposure shall be calculated with the ratings by eligible ECAIs in Basel II, such risk weights will vary significantly according to the applied ratings. In the circumstances, it is deemed extremely important to ensure the appropriateness of the ratings that can be used for securitization exposures.
However, individual ratings could not be checked thoroughly by the market as it is difficult for third parties to identify the individual securitization transactions in detail. In addition, due to limited historical default data, it is difficult to test the statistical significance of the default rate that is observed in each rating by the experienced default value (for example, three-year cumulative default rate). With such characteristics in mind, Basel II requires that "a rating must be published in an accessible form and included in the ECAI's transition matrix "), for that the appropriateness of ratings to securitization exposures should be ensured through market discipline.
The FSA considers that to satisfy the need of publication, it is necessary to make information, of which the extent is that third parties (not stake holders) can assess the appropriateness of external credit assessments, accessible easily to market participants by such means as the website and reports of the eligible ECAIs. Based on the view, the FSA published the individual publication items for public consultation on March 31, 2006.

5. FAQs
The FSA summarizes its current approach to facilitate the implementation of Basel II and foster a further advancement of risk management system at each financial institution. The FSA intends to have dialogue actively with financial institutions advancing their risk management system and prompts further advancement of risk management system. In the process, the FSA plans to continue reviewing FAQs and revise, when it is necessary, with the purpose above in mind.

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