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Principles for On-site Examinationand Off-site Monitoring for Fiscal 2000

March 28, 2000
Bank of Japan

I. On-site examination of financial institutions in fiscal 1999

A. Overview

In "Principles for On-site Examination and Off-site Monitoring for Fiscal 1999", the roles of on-site examination (conducted at individual financial institutions that hold accounts with the Bank of Japan <hereinafter referred to as "correspondent financial institutions">) and daily off-site monitoring were summarized as follows: (1) monitoring the business conditions and asset quality of individual correspondent financial institutions, (2) continuously monitoring potential risks in the overall financial system and analyzing the mechanisms by which such risks manifest themselves and are transferred, and (3) applying the above information to contribute to the overall activities of the Bank. In addition, the Bank determined that it would effectively integrate on-site examination and off-site monitoring.

Taking this into account, since April 1999 the Bank has conducted on-site examinations focusing on evaluating the financial strength of financial institutions and checking the conditions of their respective risk management systems related to credit, market, liquidity and other risks. Additionally, the Bank has conducted targeted examinations (focusing on specific business areas) related to the Year 2000 problem (which initially began in the fall of 1998), and also those focusing on settlement and liquidity risks at some financial institutions that have a large market presence.

> In conducting these examinations, while giving due consideration to alleviating the administrative burden incurred by the financial institutions subject to examination, the Bank made efforts to flexibly set schedules in accordance with the strength and risk management capability of each financial institution and to adjust the content of the examination in accordance with risk profiles.

Number of financial institutions examined by the Bank of Japan in fiscal 1999
Type of financial institution Number
Banks 41
Shinkin Banks 30
Others* 37
  • Includes securities companies and Japanese branches of foreign banks.

In addition, the Bank conducted on-site examinations at the overseas branches of Japanese banks in Shanghai, China, and targeted examinations at 12 banks including examinations focusing on the Year 2000 compliance.

With respect to off-site monitoring, the Bank endeavored to obtain an accurate picture of conditions at individual correspondent financial institutions and, by aggregating and analyzing the information thus acquired, tried to grasp the overall risk in the financial system (including influence on asset quality and the strength of financial institutions due to changes in the economy and market environment) and the risk that smooth funds settlement among financial institutions may be impaired. The Bank utilized such assessments in its analysis of current conditions, contributing to the implementation of appropriate measures.

In particular, from the latter half of last year until the beginning of this year, while bearing in mind the increased liquidity needs related to the Year 2000 problem as well as payment system risk, the Bank focused on ascertaining financial and liquidity conditions at correspondent financial institutions. Additionally, taking account of the fact that additional cost for disposal of nonperforming loans was causing persistent downside risk at financial institutions, the Bank tried to monitor nonperforming loans, including those of financial institutions not subject to on-site examination during fiscal 1999.

Moreover, in implementing off-site monitoring the Bank has endeavored to design an appropriate linkage with on-site examinations, including utilizing the information acquired through monitoring in selecting financial institutions for on-site examination and deciding the content of on-site examination, with the aim of reducing the administrative burden incurred by financial institutions subject to on-site examination.

B. Main findings regarding the focal points of the fiscal 1999 on-site examination plan

1. Strength of financial institutions and their credit risk management

While loan-loss provisionings and write-offs for nonperforming assets weakened the financial strength of financial institutions, a noticeable trend, primarily at banks, was the enhancement of capital through third-party share allocation. Examinations focused particularly on verifying that financial institutions were adequately implementing the self-assessment of assets and properly executing loan-loss provisionings and write-offs based on such self-assessment. Additionally, attention was paid as to whether these institutions would be sufficiently profitable, enabling them to hold an appropriate level of capital even if new nonperforming loans surface resulting in considerable losses.

  • Substantial progress is being made in establishing standards for the self-assessment of assets and loan-loss provisionings and write-offs, as well as overall improvement in the appropriateness of self-assessments. However, in some cases, certain aspects of the standards required further improvement, and in others, standards were not being correctly followed. The financial institutions concerned were asked to further improve standards, enhance their audit functions, etc.
  • Beginning in the year ended March 1999, a method that allows financial institutions to recognize deferred tax assets was introduced. Following this change, financial institutions are required to verify that these assets will serve to reduce tax liabilities in future periods through appropriate estimation of future taxable income. Some financial institutions have devoted insufficient attention to this issue.
  • Although progress has been made, primarily among major financial institutions, in instituting a credit rating system and in quantifying credit risk for the purposes of improving credit risk management, the Bank would like to see further efforts in such areas as data preparation and effective application to business operations.

2. Market/liquidity risk management

Examinations by the Bank focused on the capabilities of risk management systems in regard to market transactions and liquidity risk, as well as the implementation of contingency plans concerning the management of such risks.

  • Looking at liquidity risk management systems and their implementation, most correspondent financial institutions had systems in place which were properly managed. Some, however, did not have clearly defined contingency policies and had not adequately verified their ability to use funding sources in an emergency.
  • With respect to details and capabilities of market risk management systems, measures are increasingly being put in place to understand, control, and monitor risk from the standpoint of mark-to-market valuation by using VaR and other means, not only regarding the trading book but also the banking book. Meanwhile, there is still room for improvement in using stress tests and understanding the nature of market liquidity when evaluating risk, and in establishing systems to control market risk in comparison with the capital base.

3. Operational risk management

Following targeted examinations on ten institutions (a cumulative total of 54 institutions since fiscal 1998) focusing on the Year 2000 problem, in May 1999 the Bank announced compliance status and issued a checklist for financial institutions. Additionally, the Bank continued to survey compliance from the previous year and announced the results in August 1999. Furthermore, toward the end of the year, the Bank held discussions with financial institutions that were either large institutions with a major presence in settlement systems or that appeared to be relatively lagging in achieving compliance. The Bank encouraged these institutions to draft more complete contingency plans and to achieve more thorough compliance.

The Bank also checked the risk management systems pertaining to general business operations.

  • There were some cases of insufficient operational guidance and internal audit at business processing centers that carry out back-office and fund transfer activities.

4. Settlement risk management

From the perspective of ensuring stability of the payment and settlement system, the Bank conducted examinations related to the settlement risk management of each individual financial institution. Based on the results, the Bank released "Settlement Risk Management of Financial Institutions" (in Japanese) in February 2000, which lists items for financial institutions to take into consideration.

  • The Bank uncovered cases where risk management related to the intra-day overdrafts of customer deposit accounts was not being conducted properly. In response, the Bank requested the strengthening of risk management, including the assessment of customer creditworthiness when setting and managing overdraft limits and the involvement of head offices with business divisions.

5. International business operations

In addition to conducting on-site examinations at the principal overseas branches when examining major banks, the Bank conducted on-site examination of the branches of Japanese banks in Shanghai, China, to review the overall risk management practices including liquidity risk management.

  • The Bank uncovered cases where there was a need for a further enhancement of procedures related to risk management operations, including ensuring consistency and a deeper linkage between head offices and overseas branches.

II. Focal points of on-site examination in fiscal 2000

In looking at the situation surrounding Japanese financial institutions, since last year progress has been made in enhancing the capital base of banks, including the injection of public funds pursuant to the Law concerning Emergency Measures for the Revitalization of the Functions of the Financial System and by the procurement of private capital, such as through third-party share allocation. This led to the elimination of factors causing financial instability to a considerable degree. Additionally, progress was made in handling bank failures through such schemes as the introduction of financial reorganization administrators to manage financial institutions that had difficulty in restructuring on their own due to negative net worth or other reasons.

Until now, a large amount of loan-loss provisionings and write-offs for nonperforming loans caused by the bursting of the economic bubble has been carried out. However, work remains to be done in regard to the overall financial system, including the elimination of nonperforming loans from balance sheets. For this reason, there is a need to continue maximum efforts aimed at achieving a final solution to the nonperforming loan problem.

There is a growing trend, primarily among major financial institutions, toward the restructuring of business strategies using financial holding companies. Also evident is a trend toward the restructuring of existing businesses, as well as the development of new ones, including Internet banking. Efforts to improve profitability while properly managing the many diverse and complex risks have become a critical and urgent issue for Japanese financial institutions to raise their credibility both domestically and internationally and to ensure future development.

Taking into account the general conditions surrounding financial institutions as well as results of on-site examinations in fiscal 1999, the Bank will emphasize the following points in conducting on-site examinations in fiscal 2000. Concerning critical issues with respect to the content of on-site examinations, the Bank intends to prepare and publish checkpoints whenever the need arises.

A. Focal points of on-site examination

  1. The Bank will endeavor to accurately assess the financial strength (e.g., verification of capital adequacy that takes account of effects stemming from changes in accounting standards and the possibility of additional nonperforming loans) of financial institutions.
  2. The Bank will conduct "risk-focused" examinations that place emphasis on a preemptive approach to prevent the deterioration in financial institutions' strength based on the following points, while taking into consideration the specific situation at each correspondent financial institution.
  1. (a) Credit risk management
    • Given that financial institutions are establishing procedures with respect to self-assessment of assets and effecting loan-loss provisionings and write-offs based on such self-assessment, they are expected to properly fulfill their role as financial intermediaries and improve profitability, by improving credit risk management. Hence, in regard to the entire credit risk management process, the Bank will strive to check that the rules, organization, and procedures appropriate to extending credit and also other businesses have been properly adhered to and that appropriate management structures are in place.
    • Additionally, in checking credit risk management, the Bank will pay due attention to the degree to which a credit rating system, which is basic to this process, has been established and whether or not portfolio management effectively utilizes it (ensuring, for example, that excess concentration of credit in a specific industry is avoided).
    • Furthermore, depending on the level of sophistication of credit risk management at each financial institution, the Bank will pay attention to the developments in the quantification of credit risk, and whether lending is effected taking into account the credit risk of borrowers. In addition, the Bank will note whether the credit review function ensures a double-checking system so that the evaluation of debtor creditworthiness and overall management of the credit portfolio are not distorted.
  2. (b) Market/liquidity risk management
    • Also, given that appropriate liquidity management continues to be a critical issue, the Bank will strive to gain an understanding of systems in place and their operation in practice.
    • Given that suitable management of market risk will become even more important with the implementation of mark-to-market accounting for financial products beginning this fiscal year, the Bank is checking whether market risk and liquidity risk management systems, including the asset and liability management of loans and deposits, are consistent with the scope of business, and that they actually function effectively. In this regard, the Bank will note whether or not sufficient capital is ensured to respond to rapid changes in market conditions, how stress tests are implemented, and whether or not financial institutions take account of each product's market liquidity in their risk management systems.
  3. (c) Operational risk management
    • The Bank will focus its examinations on the degree to which risk management systems are in place in those departments where the Bank has deemed that the concentration of risk is relatively high, such as the head office and business processing centers.
    • Also, given the increased dependence on computer systems and the growing use of the Internet and other open systems for financial services, the management of system risk, particularly that related to information security, is becoming increasingly important. Therefore, the Bank will conduct examinations with emphasis on how such risk is dealt with.
  4. (d) Settlement risk management
    • From the perspective of ensuring smooth settlement between financial institutions, the Bank will check the status of risk management regarding the settlement risk that each financial institution has been exposed to, while giving due consideration to various points raised in "Settlement Risk Management of Financial Institutions", published in February 2000.
    • The Bank will also take into consideration the level of understanding of the impact on the business that will be brought by the conversion of the Bank of Japan Financial Network System (BOJ-NET) to RTGS planned for the end of the year 2000 and accompanying changes in market practices. Furthermore, the Bank will also pay attention to the progress made in establishing risk management systems required for project management, operations, computer systems, and other areas.
  5. (e) International business operations
    • Regarding overseas investments in Asia, on which Japanese banks place relatively high emphasis, the Bank will continue to verify whether or not these banks face any problems related to risk management and asset quality. Additionally, the Bank will check to see whether consideration is given to the characteristics and risks of the economies being invested in (including those in Asia), as well as linkages between such risks.
    • The Bank will check that the integration and separation of overseas offices and moves into new business areas and other activities, as a result of mergers and integrations of Japanese banks, and the restructuring of their international divisions are proceeding smoothly, including relations with the authorities in relevant countries.
  6. (f) The Bank will verify whether efforts are being made to put in place systems to control, in line with financial strength, a variety of risks, including interest rate risk in banking book and price fluctuation risk, in accordance with the complexity of activities at each financial institution.

B. Issues to be considered when implementing on-site examination

1. More flexibility in the scope and schedule of on-site examination

While flexibly managing the schedules of on-site examination in accordance with the financial strength and risk management capability of each financial institution, the Bank will also try to be flexible in terms of the scope of examination by focusing more closely on areas that require particular improvement. Since the year before last, we have been making such efforts from the standpoint of alleviating the administrative burden incurred by financial institutions and making examinations more efficient. In fiscal 2000, the Bank will strive to achieve more flexibility through such measures as the effective use of data obtained through off-site monitoring.

2. Further utilization of targeted examination

When deemed necessary to gain further insight into progress made in readiness for the introduction of RTGS to BOJ-NET as well as the risk management of specific risks such as settlement risk and information security risk, the Bank will conduct targeted on-site examinations of relevant sections as part of its flexible approach.

C. Reviewing parent companies of correspondent financial institutions

Recently, considerable changes have been observed in the management structure of financial institutions. For example, some financial groups have transferred a portion of their management function to financial holding companies, and some non-financial companies have announced entry into banking through financial subsidiaries.

The Bank will scrutinize each case with regard to what kind of function or business the parent companies (including financial holding companies) of correspondent financial institutions will conduct, with a view to accurately capturing conditions of those institutions. If it is thought that any parent companies play an important role in the management function (such as making key administrative and risk management decisions) with respect to their subsidiaries that are the Bank's correspondent financial institutions, then the Bank considers it necessary to conduct review of the companies concerned, including on-site visits to the extent needed to achieve the objectives of on-site examination for the correspondent financial institutions. The Bank will discuss with financial and other institutions regarding procedures for conducting such reviews.