FSA Newsletter May 2006

Review of the "Core Principles for Effective Banking Supervision" (The Basel Core Principles)

On 6 April 2006, the Basel Committee on Banking Supervision (hereafter, "the Basel Committee") issued, for public consultation, updated versions of the "Core Principles for Effective Banking Supervision" (or better-known as the "Basel Core Principles") and the "Core Principles Methodology", whose original versions were issued in September 1997 and October 1999, respectively.

Much like their original versions, the Basel Committee prepared the updated documents in collaboration with banking supervisors in non-G10 jurisdictions as well as the International Monetary Fund (IMF) and the World Bank. The FSA, together with the Bank of Japan, has been deeply involved in this review process and has made positive contributions to it.

The Basel Core Principles are the "minimum requirements" applicable to banking supervisors in all countries. They have been used by national supervisors as a benchmark for assessing the quality of their supervisory systems and for identifying future works needed to ensure sound supervisory practices. The Basel Core Principles and its Methodology have also been used by the IMF/World Bank in the context of the Financial Sector Assessment Program (FSAP).

Although the Basel Core Principles and its Methodology have worked quite well in the enhancement of supervisory practices around the world, changes have occurred in banking regulations and supervisory techniques over the years, and much experience has been gained through implementing the Core Principles in individual countries. Therefore, updating the Core Principles to reflect these changes and experiences will ensure their continued validity and usefulness, while keeping such changes to a minimum in order to maintain their continued relevance as flexible, globally applicable standards. The review does not in any way call into question the validity of previous work already conducted, especially country assessments and reform agendas based on the 1997 Principles.

The revised Basel Core Principles stress the importance of the independence, accountability, and transparency of banking supervisors (Principle 1). A new "umbrella" Principle 7 that recommends banks to have integrated risk management systems, and the enhanced principles and criteria for interest rate, liquidity, and operational risks, are also good examples of improvements that are to be achieved in the revised documents. In addition, the updated Principle 6 on capital adequacy requirements also clarifies that the assessment of compliance with this principle will not be based on whether or not a country has implemented Basel II - a new capital adequacy framework for internationally active banks in G10 countries. Instead, such assessment will be made against the capital standard chosen by the country, consistent with the recognition of the Basel Committee that Basel II may not be the first priority for all non-G10 supervisors in terms of what is needed to strengthen their supervisory systems.

The Basel Committee invites comments on the revised Basel Core Principles and the Core Principles Methodology by 23 June 2006. For further details, please visit the following BIS website: http://www.bis.org/press/p060406.htm

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[Primer on Financial Literacy]

Supervisory Guidelines and Administrative Guidelines

Administrative Guidelines refer to guidebooks for staff in administrative divisions compiled before the launch of the Financial Supervisory Agency in June 1998. At the time, the Ministry of Finance conducted a sweeping review and carried out the radical abolition of financial notices, etc. and switched to ministerial ordinances, announcements, etc. in order to improve administrative transparency, as part of its efforts to shift towards transparent and fair financial administration based on rules. As part of this, the Administrative Guidelines regarding the interpretation of laws and regulations aimed at standardized administrative management, procedures in administrative divisions and financial soundness, operational appropriateness and other focuses of financial institutions were formulated and released to the general public.
On the other hand, Supervisory Guidelines basically refer to all-in-one guidebooks for staff in administrative divisions that are packed with necessary information, providing a structured overview of the basic approach to the supervision process, evaluation items in supervision and matters to consider in administrative processes in consideration of the content of the existing Administrative Guidelines, for the purpose of building a comprehensive supervision system based on more multifaceted evaluations. In other words, Supervisory Guidelines may be regarded as Administrative Guidelines that have been progressively deconstructed and newly formulated. Due to increased recognition that it is necessary to build a comprehensive supervision system based on more multifaceted evaluations in order to carry out supervisory operations more appropriately in accordance with the characteristics of each type of business since the formulation of the Administrative Guidelines, progress was made in the formulation of Supervisory Guidelines for each type of business, triggered by the formulation of the Comprehensive Guidelines for Supervision of Small- and Medium-Sized and Regional Financial Institutions.

1. Comprehensive Guidelines for Supervision of Small- and Medium-Sized and Regional Financial Institutions
The report entitled "Enhancement of Relationship Banking Functions" released to the public by the Second Subcommittee, Sectional Committee on Financial System of the Financial System Council on March 27, 2003 pointed out the need to look into policies to build a comprehensive supervision system based on more multifaceted evaluations by taking into account the impact, etc. of corporate governance, management quality and commitment to local communities and client companies (local contributions) on profitability and financial soundness without being limited to the areas provided for in the existing Administrative Guidelines, on the grounds that (1) small- and medium-sized and regional financial institutions (RFIs) are basically characterized by their operations in limited service areas and their services that are closely tied to certain areas and business types, and (2) RFIs tend to go unchecked by the market, and have the possibility of exercising relatively weak governance.
With this in mind, the formulation of the Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions was explicitly stated in the Action Program concerning Enhancement of Relationship Banking Functions, which was formulated in March 2003 with the aim to revitalize small- and medium-sized enterprises (SMEs) and invigorate the regional economy, and at the same time, resolve the non-performing loan (NPL) problem of RFIs. In response, the Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions was formulated and released to the public in May 2004 as a structured overview of the basic approach to the supervision process, evaluation items in supervision and matters to consider in administrative processes for RFIs, in consideration of the content of the existing Administrative Guidelines.
In conjunction with the formulation of the Comprehensive Guideline for Supervision of Small- and Medium- Sized and Regional Financial Institutions, RFI-related items in the Administrative Guidelines (Volume I: Deposit-handling Financial Institutions) were deleted.

2. Formulation of Comprehensive Guideline for Supervision of Major Banks, etc.
On the other hand, with respect to major banks, efforts were being made at the time when the Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions was formulated, in order to fulfill the target of reducing the NPL ratio to about a half of the ratio in the year ended March 31, 2002 (8.4%) by March 31, 2005 based on the Program for Financial Revival (October 2002), etc. Accordingly, it was deemed appropriate to formulate comprehensive Guideline for the supervision of major banks once the NPL problem was resolved.
Subsequently, the NPL ratio at major banks in the year ended March 31, 2005 fell to 2.9%. In response to the resolution of the NPL problem at major banks, the Comprehensive Guideline for Supervision of Major Banks, etc. was formulated and released to the public in October 2005. Its formulation was aimed at establishing a comprehensive supervision system focusing on sophisticated risk management, appropriate governance, etc. required by major banks, etc. that are deemed to be expected to provide world-class financial services and contribute to Japan's economic progress and improvement in people's lives, in consideration of the significance of the Comprehensive Guideline for Supervision of Small- and Medium-Sized and Regional Financial Institutions, etc.
In conjunction with the formulation of the Comprehensive Guideline for Supervision of Major Banks, etc., the Administrative Guidelines (Volume I: Deposit-handling Financial Institutions) were abolished.

3. Formulation of Supervisory Guidelines for Other Types of Businesses, etc.
With respect to other types of businesses, Supervisory Guidelines were formulated one after the other as a structured overview of the basic approach to the supervision process, evaluation items in supervision and matters to consider in administrative processes in order to carry out supervisory operations more appropriately according to the characteristics of each type of business, in consideration of the content of the existing Administrative Guidelines (June 2005: Comprehensive Guideline for Supervision of Financial Futures Dealers, July 2005: Comprehensive Guideline for Supervision of Securities Companies, August 2005: Comprehensive Guideline for Supervision of Insurance Companies, March 2006: Comprehensive Guideline for Supervision of Small-claims and Short-term Insurance Businesses). In conjunction with the formulation of the Supervisory Guidelines for each type of business, the related sections of the corresponding Administrative Guidelines were abolished.
Furthermore, in order to add new points to consider following the revision of laws and to clarify the focus of supervision to deal with new trends in the financial sector, progress was made in the formulation of Supervisory Guidelines outside the framework of Administrative Guidelines (December 2004: Comprehensive Guideline for Supervision of Trust Companies, etc., June 2005: Guideline for Supervision of Financial Conglomerates).

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