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PRESS RELEASE

22 December 1998
Financial Supervisory Agency

"Interim Report" of the Working Group on Financial Inspection Manuals

As part of its efforts under the "Comprehensive Plan for Financial Revitalization" (2nd Report; July 2), the Financial Supervisory Agency has established the Working Group on Financial Inspection Manuals in its Inspection Department. The Group has met fourteen times since August to lay the groundwork for the drafting of Financial Inspection Manuals and Checklists. The “Interim Report” released today includes a draft of manuals and checklists.

The basic concept underlying the "Interim Report" is that financial institutions should be run on the principle of self-responsibility, with financial inspection serving a means of supplementing this. Based on this concept, the report advocates: 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), and 2) a change in emphasis from assessment of asset quality to inspection of risk management. The Report also considers, from the perspective of global standards, trends in financial inspection in other countries and discussions in the Basel Committee on Banking Supervision.

The Agency will be soliciting public comments on the "Interim Report" and will continue to flesh out its content with the eventual objective of establishing and publishing Financial Inspection Manuals.

For further information contact:

Mr. Kurosawa Ex. 3269

Mr. Sekiguchi Ex. 3270

Evaluation Division, Inspection Department

Financial Supervisory Agency 03-3506-6000

22 December 1998
Inspection Department, Financial Supervisory Agency

Outline of the "Interim Report" of the Financial Inspection Manual Study Group

In August, 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 Study Group has continued to meet in the months since, and has prepared for publication today an "Interim Report" that represents the results of those meetings and a rough draft of the manuals.

I. Outline

In order to stabilize the Japanese financial system and restore confidence in it both in Japan and abroad, defaulted loans must be written off, businesses rebuilt and restructured, and greater information disclosure provided for. Along with this, Japan will also need to enhance its inspection and regulatory regime by, among other things, creating appropriate inspection manuals (the Comprehensive Plan for Financial Revitalization, the Emergency Economic Stimulus Plan). The creation of Financial Inspection Manuals and Checklists will improve the inspection and oversight functions of regulatory authorities, and its publication will encourage financial institutions to base their management on the principle of self-responsibility. This in turn can be expected to establish confidence in the financial regulatory regime as a whole.

The basic principle underlying the creation of the Financial Inspection Manual is that financial institutions should be run on the principle of self-responsibility, with financial inspection serving a means of supplementing this. Based on this, the Working Group advocates:

	(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 Basel Committee on Banking Supervision.

This draft of the Financial Inspection Manuals contains manuals and checklists that define check points for inspectors as they review the institution's compliance with applicable laws and ordinances and risk management systems.
As for compliance, the checklist gauges whether management 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, in regulatory inspections, recognizes the importance of managing risks, and whether the institution has formulated guidelines and established systems for risk management.
Regarding the relationship between financial inspection and supervisory sanctions, the Interim Report notes the need to articulate the process from financial inspection to supervisory sanctions (including the provision of opportunities for the inspected financial institution to defend its conduct) and the need for enhancements to the monitoring system.

Current plans are for the draft Financial Inspection Manuals to cover all deposit-taking institutions, including the foreign offices of Japanese institutions and the Japan offices of foreign banks.

The check points in the draft Financial Inspection Manual are divided into three categories:

	(1)	Items defining "minimum standards" to be adhered to by all financial institutions.
	(2)	Items that are minimum standards for those financial institutions calculating their capital adequacy ratios according to the Basle standards, but are only "important issues to be dealt with" by other financial institutions.
	(3)	Items that constitute "best practices" for all financial institutions.

II. Outline of individual draft manuals

Compliance Checklist
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.

Risk Management Checklists

	(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 Basel 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, auditors, and senior management, encourages directors and others 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 encourages institutions to employ credit ratings, to emphasize the importance of managing their portfolios so as to eliminate excess concentration of credit, and to quantify their credit risks. 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). Additionally, it clearly defines the relationship between credit classifications as used for inspection and assessment purposes and credit classifications as used for the purposes of the Law Concerning Emergency Measures to Restore Financial Functions. 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. 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 ratio as well as 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 head 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 and checks how institutions manage their operational risks by defining management rules and regulations and by making clear provisions regarding the functions of internal audits.
	(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.

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