8 April 1998
Inspection Department, Financial Supervisory Agency
Outline of the "Final Report" of the Working Group on Financial Inspection Manuals
In August 1998, the Financial Supervisory Agency established the Working Group on
Financial Inspection Manuals in the Inspection Department. This Group, which consisted of
lawyers, certified public accountants, and seasoned financial experts, was charged with
preparing manuals to be used by Agency inspectors when inspecting financial institutions.
The Group met a total of twenty-four times. On December 22 of last year, it published an "Interim Report" and invited
public comments on it. These comments were reviewed and considered, and where possible
incorporated into the "Final Report"
of the Working Group on Financial Inspection Manuals, which was published today.
I . Outline
(1) A change from regulator-led inspections to self-management-style inspections (focus on process examination to verify the appropriateness of internal control and external auditing on the assumption that financial institutions will themselves have strict internal controls and be subject to rigorous external audits by accounting auditors).
(2) A change in emphasis from assessment of asset quality to inspection of risk management.
In addition, the Report also considers, from the perspective of global standards, trends in financial inspection in other countries and discussions in the Basle Committee on Banking Supervision.
For compliance, the checklist gauges whether management1 has erected a set of corporate ethics based on the social responsibilities and public duties of financial institutions, and whether the institution has systems in place to ensure compliance with all applicable laws and ordinances.
For risk management, the checklists gauge whether, based on the principle of self-responsibility, the institution has clearly articulated the roles and responsibilities of the management (including auditors) and the accounting auditors, whether the management recognizes the importance of managing various risks, and whether the institution has formulated guidelines and established systems for risk management.
The Financial Inspection Manuals are designed to be used by inspectors when inspecting financial institutions. It is expected that, as part of their efforts to ensure sound and proper operations and in accordance with the principle of self-responsibility, individual financial institutions will fully exercise their creativity and innovation to voluntarily create their own detailed manuals. These institutional manuals should make note of the content of the Financial Inspection Manuals and be adapted to the size and nature of the institution.
The check points2 in the draft Financial Inspection Manual represent criteria to be used by inspectors in evaluating the risk management and other systems of financial institutions. They do not constitute direct statutory obligations to be achieved by institutions. Care must be taken that the Financial Inspection Manuals are not employed in a manner that is mechanical and unvarying. There may be cases in which the letter of the checklist description has not been fulfilled, but the institution has nonetheless taken measures that are, from the perspective of ensuring the soundness and appropriateness of its operations considered rational, and these measures are equivalent in their effects to the descriptions for the check point or are sufficient given the size and nature of the institution. In such cases, the institution’s measures would not be deemed inappropriate. Inspectors will therefore need to engage in adequate discussions and exchanges of opinion with financial institutions during their on-site inspections.
It should also be underscored that matters noted in inspections will not immediately lead to specific supervisory measures.
II . Outline of individual draft manuals
This checklist encourages financial institutions to serve the public good by clearly articulating the roles of their directors and auditors, clearly defining measures and programs to ensure compliance, fostering an awareness of compliance issues among directors and other top managers, and creating a corporate culture that emphasizes compliance.
(1) Risk management systems checklist (common items)
This checklist defines common check points for all of the many different kinds of risk management that will be engaged in by financial institutions. These points are defined with reference to "Framework for Internal Control Systems in Banking Organizations" published by the Basle Committee on Banking Supervision.
The items on this checklist represent the very basics of risk management that should obviously be employed by financial-institution managements, particularly those items that should be understood and practiced by the directors of the institution.
Specifically, this checklist encourages institutions to clearly define the awarenesses and roles of directors, the board of directors, the board of directors etc., auditors, and senior management, encourages the board of directors etc. to be aware of their role in risk management, and encourages institutions to put in place proper risk management systems.
(2) Credit Risk Management Checklist and Credit Risk Management Manual
This checklist emphasizes the importance of managing portfolios so as to eliminate excess concentration of credit, and encourages institutions to employ credit ratings and quantify their credit risks.
In light of the potential for a "credit contraction," the check list contains items asking, "Does the institution supply funds in a smooth manner?" and "Does the institution use the Financial Inspection Manuals as an excuse for refusing to supply funds or for the collection of funds etc.?"
The Credit Risk Management Manual bases its discussion of self-assessment inspections on the "Asset Quality Assessment" guidelines issued by the former Banking Inspection Division of the Ministry of Finance. From this base it seeks to further clarify the criteria by which borrowers are classified (in particular, it seeks to clarify the methods used to evaluate affiliated non-banks and others to whom financial assistance is provided). These criteria represent rough guidelines for the classification of borrowers; classification must be based on a general evaluation that takes account of the industry of the borrower, not just on quantitative measurements. The checklist also contains a clear statement that the classification of lending to smaller businesses must take into account the assets of the company's representative and others, not just the financial position of the company itself.
For inspections of adequacy of write-offs and reserves, the manual seeks to provide further clarification of write-off and reserve standards, with inspections focusing on the appropriateness of the methods used to calculate the rate of reserves against bad debts, etc., and the appropriateness of overall levels of actual write-off and reserves. In addition, for reserves against "need attention" borrowers, the manual encourages institutions to manage credits classified as "special attention" separately from other credits and asks inspectors to judge the appropriateness of those classifications.
Inspections will carefully consider the findings from inspections of self-assessments and write-offs and reserves in light of the impact of these items on capital adequacy ratios, etc.
(3) Market-related Risk Management Checklist
This checklist integrates the "Market-related Risk Management Checklist" and "Checklist for the Inspection of Foreign Offices" issued by the former Banking Inspection Division of the Ministry of Finance. Having done so, it seeks to improve the level of market-related risk management practiced by financial institutions as warranted by changes in the financial environment. The content of the checklist is further enhanced with the addition of new regulations on market risks as they impact capital adequacy ratios, and also the addition of new check points on trading accounts.
(4) Liquidity Risk Management Checklist
This checklist was created in such a way as to emphasize cash-flow risks in light of the extreme importance of liquidity management in today's financial markets.
Specifically, it defines management techniques to be used in accordance with the degree of cash-flow tightness, mandates integrated management of yen and foreign currency cash flow and domestic and foreign office cash flow, gauges the institution's fund-raising capabilities in terms of off-balance-sheet transactions, commitment lines, and diversification of lenders, and encourages institutions to establish appropriate systems for managing their liquidity risks.
Note that management of market liquidity risks is included in the Market Risk Management Checklist and inspected within that context.
(5) Operational Risk Management Checklist
Traditional practice for operational risks has been to use physical and on-site inspections as a means of checking general operational management systems. The purpose of this checklist, however, is to use inspections of the had office to evaluate the processes and checks that are in place for the institution’s operational risk management systems.
More specifically, the checklist seeks to encourage institutions to appropriately evaluate their operational risks (including quantification) and checks how institutions manage their operational risks by defining comprehensive management rules and regulations and by making clear provisions regarding the functions of internal audits. The checklist emphasizes full customer protection, and seeks particular rigor and prudence in the handling of financial information from borrowers and other information concerning individual companies.
(6) Computer System Risk Management Checklist
This checklist is based on the "Computer System and Contingency Plan Checklist" issued by the former Banking Inspection Division of the Ministry of Finance. Where the old checklist emphasized system safety measures and contingency plans, however, the new checklist makes use of the manuals provided by the Financial Information Systems Center (FISC) and emphasizes in regulatory inspections checks of system planning/development and management/operation organizations.
Specifically, the checklist asks institutions to clearly articulate computer system strategies and security policies and to confirm that auditing trails are available for internal audits. It also encourages institutions to take account of systemic risk when formulating contingency plans.
(1) Items defining "minimum standards" that, unless specifically noted, are to be adhered to by all financial institutions. These items generally are expressed in the form of questions such as "does the institution have" or "is the institution doing." Inspectors will, as they go through their checklists, need to fully verify the effectiveness of these items.
(2) Items that, unless specifically noted, constitute "best practice" for all financial institutions. These items are generally worded in the form of "it would be desirable that." Inspectors need only confirm these items.
(3) Items that are a combination of the two, representing minimum standards for internationally active banks (those financial institutions calculating their capital adequacy ratios according to the Basle standards), but serving only as best practices for the other financial institutions.