Financial system deregulation and international competitive pressure have drastically changed the banking sector in Japan. The International Monetary Fund's (IMF) 2005 Article IV Consultation report states that heightened supervisory efforts of the Financial Services Agency (FSA) have contributed to improvements in the banking system. The FSA notably improved recognition and provisioning for non-performing loans, strengthened bank capital, and reduced the role of government financial institutions. Furthermore, policies in the banking system, which were enhanced through the FSA's 2002 Program for Financial Revival, are broadly in line with the recommendations of the IMF's 2003 Financial System Stability Assessment. However, extensive cross-shareholding remains within the financial sector and between financial and non-financial institutions. At the time of a 2005 IMF report, the FSA had adopted a Program for Further Financial Reform and was in the process of elaborating more detailed policies. While the Program improves significantly the health of major banks, the IMF advocates bolder reforms and policies, which include raising profitability in the banking system, reducing reliance on real estate collateral, and improving risk management systems. These measures should help prepare Japanese banks for the adoption of Basel II. As of March 31, 2007, according to a 2007 Global Survey by the Institute of International Bankers, capital adequacy standards, based on the new capital adequacy framework (Basel II), apply to all depository financial institutions in Japan. Despite the above descriptive information, none of the available sources directly address Japan's overall compliance with the Basel Core Principles.

General Overview

Until the creation of the Financial Supervisory Agency, established under the Financial Reconstruction Commission (FRC), banking and insurance supervision was carried out by the Banking Bureau of the Ministry of Finance (MoF). Similarly, securities firms were supervised by the Securities Bureau. The functions of the Banking Bureau and the Securities Bureau were transferred to the Financial Supervisory Agency in June 1998, and the Agency was subsequently renamed as the Financial Services Agency (FSA) in July 2000. The FRC merged into the FSA in January 2001. The Bank of Japan (BoJ) also examines banks and other major financial institutions. The legal framework for banking supervision is mainly based on the 1998 Act for the Establishment of the FSA No. 130, the 1981 Banking Act No. 59, Cabinet Ordinances, Cabinet Office/Ministerial Ordinances, and Administrative Guidelines issued pursuant to the Banking Act.

In 2003, the International Monetary Fund's (IMF) published its Financial System Stability Assessment (FSSA), which assesses Japan's observance of the Basel Core Principles (BCPs) for Effective Banking Supervision. The 2003 FSSA, although informative, does not provide an explicit statement as to Japan's compliance with the BCPs. According to the report, substantial improvements have been made in the supervisory process since the FSA was set up as the regulatory body in Japan. The implementation of the recommended financial reforms by the FSA is expected to expedite the pace of consolidation, and improve profitability of the banking system in Japan. However, it is unclear whether the authorities are in a position to enforce the requirements fully, especially with regard to the valuation of assets and the quality of capital. The IMF's 2003 FSSA notes that the MoF has effective management control over the FSA, which further lacks a board with outside members. This institutional structure creates scope for the FSA to be subject to political pressures.

At the time of the 2003 FSSA, the Japan Post, which offers deposits, a payment system, and life insurance products, benefited from an explicit government guarantee. The government financial institutions (GFIs), which offer long-term loans with low fixed interest rates, also benefited from subsidies. Furthermore, the Japan Post and most GFIs were subject to limited prudential supervision. The long-term involvement of the public sector in financial intermediation has impeded the development of the financial system, reducing competition in the private banking sector. The IMF report recommended reducing the involvement of the government in financial intermediation, by restricting the activities of the GFIs, as well as postal savings and insurance schemes. As of October 1, 2007, according to the IMF's 2008 Selected Issues report, efforts of the government to privatize the Japan Post have resulted in the creation of a single holding company with four separate businesses, namely the Japan Post Service, Japan Post Network, Japan Post Bank (JPB) and Japan Post Insurance (JPI). Under this new structure, the JPB and JPI are subject to similar regulatory and supervisory requirements as other private institutions.

The IMF's 2005 Article IV Consultation states that heightened supervisory efforts have contributed to improvements in the banking system. The FSA notably improved recognition and provisioning of non-performing loans (NPLs), strengthened bank capital, and reduced the role of GFIs. Furthermore, policies in the banking system, which were enhanced through the FSA's 2002 Program for Financial Revival, are broadly in line with the 2003 FSSA recommendations. However, regional banks continue to lag, and bank profitability remains low. It is recommended that Japan strengthen supervision and regulation in an expeditious manner to resolve banking sector weaknesses, including those identified in the context of the 2003 FSSA. While the FSA's 2004 Program for Financial Revival improved significantly the health of major banks, the IMF advocates bolder reforms, and policies shifted toward promoting the revitalization of the banking system. Key priorities include raising profitability in the banking system, reducing reliance on real estate collateral, and improving risk management systems. These measures should help prepare Japanese banks for the adoption of Basel II. At the time of the IMF's 2005 report, the FSA adopted a Program for Further Financial Reform, and was in the process of elaborating more detailed policies. As of March 31, 2007, according to a 2007 Global Survey by the Institute of International Bankers (IIB), capital adequacy standards, based on the new capital adequacy framework (Basel II), apply to all depository financial institutions in Japan.

The Japanese banking sector is comprised of 12 major and internationally-oriented banks, and more than a hundred smaller regional banks, according to a 2008 study by Elena Loukoianova and published by the IMF. Major banks are divided into two segments: city banks and trust banks. City banks operate as commercial banks, offering banking services mainly to large corporate customers, whereas trust banks specialize in asset and wealth management. Conversely, regional banks focus their business mainly on retail banking in specific geographical areas. The 2008 study by Loukoianova reports that more than 80 percent of the regional banks' customers are local small and medium size enterprises (SMEs), with individual deposits accounting for approximately 70 percent of total deposits. City banks have the largest share of the market in terms of deposits and loans, respectively 33 percent and 35 percent of total loans and total deposits of private financial institutions. The study further highlights that the share of NPLs for regional banks has been declining, although it tends to be higher than that of major banks because of their higher proportionate exposure to SMEs. As of the end of March 2007, according to the FSA's 2007 Newsletter, the total amount of NPLs for all Japanese banks reached 12 trillion yen, a 10.5 percent decrease from the previous year. Furthermore, the NPL ratio declined for both major banks and regional banks, dropping to the lowest levels since the 1999 requirement of NPL disclosure under the Financial Reconstruction Act.

According to the U.S. Department of Commerce's 2008 Country Commercial Guide, while financial system deregulation and international competitive pressure has drastically changed the banking sector in Japan, including the consolidation of 19 banks into four major banks, much corporate banking business is rooted in either keiretsu (i.e conglomeration of companies organized around a single bank) or regional relationships. Furthermore, banks are often large shareholders in publicly traded corporations, and have close relationships with both local governments and national regulatory agencies. The IMF's 2003 FSSA highlights that while there were no direct ownership linkages between banks and insurance companies, extensive cross-shareholding takes place between the banking and insurance sector in terms of capital and capital-like instruments. In particular, banks hold foundation funds (i.e. form of capital for mutual companies), and subordinated debt issued by insurance companies. Conversely, insurers hold shares, preferred shares and subordinated debt issued by banks.

Regarding the further development of capital markets, as stated in the IMF's 2007 Article IV Consultation, Japanese authorities seek to enhance Tokyo's appeal as an international financial center. Initiatives include relaxing barriers between banks and securities firms, and consolidating financial exchanges. The IMF report notes that there is potential for banks to diversify into new business lines and for attracting more foreign investment. In October 2007, as reported in the IMF's 2008 Selected Issues report, the G7 finance ministers and central bank governors asked the Financial Stability Forum (FSF) to analyze the causes and weaknesses of the market turmoil, and to set out recommendations for increasing the resilience of markets and institutions going forward. The IMF report notes that most of the FSF recommendations are relevant to Japan, and in line with recommendations of the Financial Markets Strategy Team--an advisory group established by the Japanese Minister for Financial Services--to study the implications of the subprime crisis for Japan. The IMF report highlights that Japan's relatively low exposure to the subprime crisis can be explained by its more traditional banking system, as well as the stricter treatment of structured holdings under Basel II.

The Principles

1. (1) Clear responsibilities and objectives for each supervisory agency.

II

Until the creation of the Financial Supervisory Agency, established under the FRC, banking and insurance supervision was carried out by the Banking Bureau of the MoF. Conversely, securities firms were supervised by the Securities Bureau. The functions of the Banking Bureau and the Securities Bureau were transferred to the Financial Supervisory Agency in 1998, and the Agency was subsequently renamed to the FSA in 2000. The BoJ also examines banks and other major financial institutions. The IMF's 2003 FSSA stated that the FSA's mandate should be limited to the prudential supervision of financial institutions. Responsibility for auditing standards should further be undertaken by a body outside the FSA. However, the available sources do not directly address Japan's compliance with this principle.

1.(2) Operational independence and adequate resources.

II

The IMF's 2003 FSSA reports that the FSA is funded from the central government budget, hence, lacks budgetary independence. Furthermore, the FSA operates with minimal supervisory staff levels. The removal of supervisory responsibility from the MoF, and the setting up of the FSA in 2000 were major steps forward, as stated in the IMF's 2003 FSSA. However, there appears to be a lack of operational independence due to the MoF's remaining control over the operations of the FSA, creating scope for political pressures. It is recommended that the FSA be given full operational autonomy, and that the FSA's mandate be limited to the prudential supervision of financial institutions. It is further advised to provide additional resources to the FSA, including human capital. The FSA is encouraged to set up a board to help ensure visible autonomy and accountability. In order to guarantee the FSA's budgetary independence, it is also recommended that the supervised institutions be charged by the FSA for the cost of supervision. However, the available sources do not directly address Japan's compliance with this principle.

1.(3) A suitable legal framework for authorization and ongoing supervision.

II

The legal framework for banking supervision is mainly based on the Act for the Establishment of the FSA, the Banking Act, Cabinet Ordinances, Cabinet Office/Ministerial Ordinances, and Administrative Guidelines issued pursuant to the Banking Act. However, the available sources do not address Japan's compliance with this principle.

1.(4) A suitable legal framework to address compliance with laws as well as safety and soundness concerns.

II

See Principle 1.(3).

1.(5) Legal protection for supervisors.

II

The IMF's 2003 FSSA highlights that banks which receive public funds require new leadership. Furthermore, the establishment of a public governance framework is needed to protect management from outside pressures and give a clear mandate to restructure the banks' operations in light of privatization efforts. However, the available sources do not directly address Japan's compliance with this principle.

1.(6) Arrangement for sharing of information between supervisors and protection of confidentiality of shared information.

II

The IMF's 2003 FSSA reports that there is generally no formal procedures in place for the regular exchange of information between the BoJ and the FSA, although such exchanges take place on an ad hoc basis. The exchange of information with foreign banking supervisory authorities, including on-site visits, is generally based on informal arrangements. In this regard, it is recommended that the arrangements for the exchange of information with the BoJ and other regulatory bodies be formalized. It is further advised to require by law that external auditors inform the supervisory authority of any material findings. However, the available sources do not directly address Japan's compliance with this principle.

2. Clearly defined permissible activities for banks and control of the use of the word 'bank'.

II

The IMF's 2003 FSSA reports that while the Banking Act clearly defines the term "bank" and the permissible activities of banks, it does not deal with the GFIs. The Commissioner of the FSA is the sole authority for granting banking licenses. It is recommended that supervisory authority of the FSA be extended to GFIs. However, the available sources do not directly address Japan's compliance with this principle.

3. Criteria for structure, directors, operating plan, controls, financial condition and capital base.

II

The IMF's 2003 FSSA recommends that banks adopt corporate governance reforms consistent with the Basel Committee's guidelines, including outside directors and a board audit committee. Furthermore, the establishment of a public governance framework is needed to protect management from outside pressures and give a clear mandate to restructure the banks' operations in light of privatization efforts. The FSA's 2004 Program for Further Financial Reform was aimed at enhancing governance of financial institutions by clarifying criteria to evaluate the qualifications for directors of financial institutions. However, the available sources do not directly address Japan's compliance with this principle.

4. Authority to review and reject transfer of ownership.

II

Under the Banking Act, according to the IMF's 2003 FSSA, the FSA has the authority to grant authorization for acquisitions or an increase in qualifying holdings. The FSA is further entitled to revoke the approval if requirements are not met. The Banking Act clearly defines significant ownership "which requires approval and provides for immediate notification in the case of an increase in a qualifying holding to more than 20 percent" (p. 38). In this context, it is advised that the FSA approve an increase in a significant holding. However, the available sources do not directly address Japan's compliance with this principle.

5. Authority to review major acquisitions and investments.

II

Pursuant to the Banking Act, as stated in the IMF's 2003 FSSA, the FSA has authority to grant authorization for acquisitions or an increase in qualifying holdings. However, the types of permissible investments are only defined in very general terms under the law and regulations. Supervisory approval is not required for investments within the limit, which corresponds to 5 percent of the total number of outstanding shares of a domestic corporation with voting rights. Furthermore, investments in other companies that are neither banks nor financial institutions are not restricted in terms of the proportion of the bank's own capital, although such investments are subject to the large exposure limits. In this regard, it is recommended that the FSA approve the amount of investments in relation to the bank's capital. Nevertheless, the available sources do not directly address Japan's compliance with this principle.

6. Minimum capital adequacy requirements (meet Basle Capital Accord for internationally active banks).

II

The IMF's 2003 FSSA reports that the Banking Act provides the supervisor with the authority to set capital adequacy standards. At the time of the 2003 FSSA, the banking system's capital position was weak and required rapid strengthening. In this regard, banks were called on to meet capital requirements in line with stricter treatment of deferred tax assets and provisioning. It was recommended that the minimum capital requirement for domestic banks be raised to 8 percent. The IMF's 2005 report states that capital quality has since improved, with the capital adequacy ratio rising to 11.6 percent. The improvement at regional banks has, however, been more gradual. As of March 31, 2007, according to the 2007 Global Survey by the IIB, the new capital adequacy standards, based on Basel II, apply to all depository financial institutions in Japan. Under Basel II, banks' minimum capital requirements are established by the administrative notification based on the provisions in the Banking Act. Nevertheless, the available sources do not directly address Japan's compliance with this principle.

In October 2007, as reported in the IMF's 2008 Selected Issues report, the G7 finance ministers and central bank governors asked the FSF to analyze the causes and weaknesses of the market turmoil, and to set out recommendations for increasing the resilience of markets and institutions going forward. Recommendations include strengthening the prudential oversight of capital, liquidity and risk management by, inter alia, raising Basel II capital requirements for complex structured products.

7. A method exists for the evaluation of procedures related to loans, investments and portfolio management.

II

The IMF's 2003 FSSA suggests that loans be valued on the basis of net present value of expected recoveries. The IMF's 2005 report states that the FSA has improved recognition and provisioning of bad loans, with NPLs declining sharply. Additionally, the FSA has broadened the application of forward-looking discounted cash flow analysis in assessing loan quality. Heightened scrutiny of loan books has also led to better bad loan recognition and more appropriate provisioning. As of the end of March 2007, according to the FSA's 2007 Newsletter, the total amount of NPLs for all Japanese banks reached 12 trillion yen, a 10.5 percent decrease from the previous year. Furthermore, the NPL ratio declined for both major banks and regional banks, dropping to the lowest levels since the 1999 requirement of NPL disclosure under the Financial Reconstruction Act. However, the available sources do not directly address Japan's compliance with this principle.

8. Policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and reserves.

II

The IMF's 2003 FSSA states that provisioning requirements in Japan are based on accounting standards and guidelines issued by the Japanese Institute of Certified Public Accountants (JICPA). Banks are required to conduct frequent assessments of their portfolio, and ensure that provisioning requirements were in line with the FSA guidance. The predominance of NPLs and the lack of underlying profitability in the banking system contribute to significant credit and market risks. The IMF report highlights that "better treatment of impaired bank assets and stronger provisioning requirements would help clarify banks' capital positions and improve incentives" (p. 8). Banks should strengthen provisioning for NPLs, including by making more extensive use of forward-looking expected loss estimates. However, the available sources do not directly address Japan's compliance with this principle.

9. Prudential limits and management information system on concentration of exposure.

II

The IMF's 2003 FSSA states that regulations and on-site inspections provide adequate guidance on large loan exposure. It is recommended that prudential limits on concentration of exposure be reduced. However, the available sources do not directly address Japan's compliance with this principle.

10. Arm's length rule and monitoring for connected lending.

II

The IMF's 2003 FSSA states that "connected lending is also carefully monitored and requires, in many cases, a supermajority of the bank's board to approve such lending" (p. 39). The IMF, therefore, does not issue any specific recommendation for this principle. However, the available sources do not directly address Japan's compliance with this principle.

11. Policies and procedures for country risk and transfer risk.

II

The IMF's 2003 FSSA states that country and transfer risks are not regularly reported and hence recommended that country risk be regularly reported and supervised. However, the available sources do not directly address Japan's compliance with this principle.

12. Measuring and monitoring market risk. Limit and/or specific capital charge on market risk exposure.

II

The IMF's 2003 FSSA states that market, interest rate, operational, and other risks are adequately monitored during on-site inspections and prudential reports are required on a frequent basis. Nevertheless, the report highlights that the banking system remains exposed to significant credit and market risks. However, the available sources do not directly address Japan's compliance with this principle.

13. Comprehensive risk management processes.

II

The IMF's 2003 FSSA states that the FSA has implemented "a policy of more continuous supervision of major banks, and this is an important step forward" (p. 38-39). Staff has also been specifically allocated to improve supervision in areas such as market risk, internal controls, and information technology. The IMF report further notes that a prompt corrective action scheme is in place and observed by the supervisory authorities. The FSA's 2004 Program for Further Financial Reform was aimed at enhancing governance of financial institutions, and promoting highly-developed risk management processes through an early warning system framework and early recognition and treatment of NPLs. The IMF's 2005 report notes that the Program put forward a wide range of policy measures to improve the soundness and efficiency of Japan's financial system, including an enhanced focus on risk management. However, the available sources do not directly address Japan's compliance with this principle.

In October 2007, as reported in the IMF's 2008 Selected Issues report, the G7 finance ministers and central bank governors asked the FSF to analyze the causes and weaknesses of the market turmoil, and to set out recommendations for increasing the resilience of markets and institutions going forward. Recommendations include strengthening the prudential oversight of capital, liquidity and risk management by, inter alia, strengthening supervision of liquidity management across a wide range of liquidity risks, and enhancing supervision of risk management for firm-wide risks.

14. Adequate internal controls.

II

The IMF's 2003 FSSA states that while "internal controls in individual banks are checked routinely during the on-site inspection process" (p. 39), the supervisory process does not take into account collaboration with auditors. The role of statutory auditors, which were traditionally part of the management of the bank in the past, is to ensure that "management carries out its responsibilities in an acceptable manner" (p. 39). In addition, "the oversight of the routine audit function is the direct responsibility of the board, and the audit function sometimes reports directly to the chief executive officer or chief operating officer" (p. 39). The IMF report underlines that the independence of the audit function might be affected by this process. However, the available sources do not directly address Japan's compliance with this principle.

15. Strict "know-your-customer" rules and high ethical and professional standards.

II

The IMF's 2003 FSSA documents that on-site inspections are carried out to review banks' policies, practices, and procedures regarding anti-money laundering (AML) initiatives. It is recommended that the customer identification law be applied more effectively. According to the U.S. Department of State's 2008 International Narcotics Control Strategy Report, there have been a large number of investigations into underground banking networks, which violate the Banking Act. Reportedly, substantial illicit proceeds have been transferred abroad, particularly to China, North and South Korea, and Peru. In November 2004, the Diet approved legislation banning the sale of bank accounts, in a bid to prevent the use of purchased accounts for fraud or money laundering. On March 13, 2007, as stated in the 2007 Global Survey by the IIB, the FSA partially revised the comprehensive supervisory guidelines for major banks and regional banks in the area of AML and combating the financing of terrorism. However, the available sources do not directly address Japan's compliance with this principle.

16. Effective supervisory system consisting of on-site and off-site supervision.

II

According to the IMF's 2003 FSSA, the FSA conducts on-site and offsite supervision to verify that adequate and reliable systems and controls are in place. It also reviews and monitors banks' financial conditions with the information and data required of banks. The IMF report further notes that "staff is adequately trained and, in most observed cases, experienced" (p. 38). However, the available sources do not directly address Japan's compliance with this principle.

17. Regular contact with bank management and understanding of bank's operations.

II

The IMF's 2003 FSSA notes that supervisors hold regular meetings with banks' management in the course of monitoring and inspection. The IMF staff advised that meetings with external auditors with the participation of bank management take place on a regular basis. The IMF report highlights that "the FSA does not have the authority to appoint or oppose the appointment of an external auditor" (p. 40). However, the available sources do not directly address Japan's compliance with this principle.

18. Analytical reports and statistical returns on solo and consolidated basis.

II

There is insufficient publicly available information to address Japan's compliance with this principle.

19. Independent validation of supervisory information through on-site examination or external auditors.

II

There is insufficient publicly available information to address Japan's compliance with this principle.

20. Ability to supervise on a consolidated basis.

II

According to the IMF's 2003 FSSA, "the FSA supervises banks on a consolidated basis including the enforcement of prudential regulations such as capital adequacy and single lending limits" (p. 40). In addition, the FSA is responsible for the supervision of subsidiaries, and non-bank financial institutions. However, the available sources do not directly address Japan's compliance with this principle.

21. Consistent accounting policies and practices that provide a true and fair view of the financial condition of the bank.

II

Accounting standards have significantly been improved, and are generally in line with international standards, as stated in the IMF's 2003 FSSA. Auditing and disclosure standards have also been revised and improved. It is advised that the FSA be given the authority to revoke the license of an external auditor. In January 2005, according to the 2005 update available from the Deloitte & Touche IAS Plus website, the International Accounting Standards Board (IASB) and the Accounting Standards Board of Japan (ASBJ) launched a joint project to reduce differences between the International Financial Reporting Standards (IFRSs) and Japanese accounting standards. The ASBJ was established in July 2001 as a private sector organization, under the authority of the FSA. Per the April 2008 update, the IASB met with representatives of the ASBJ in Tokyo from 8-9 April 2008. This was their second meeting in Tokyo since the announcement of the initiative to accelerate convergence between Japanese GAAP and IFRSs in August 2007. However, the available sources do not directly address Japan's compliance with this principle.

22. Adequate supervisory measures to ensure timely corrective action.

II

According to the IMF's 2003 FSSA, "the FSA is authorized to take an appropriate range of actions against a bank that requires remedial measures" (p. 40). Furthermore, a prompt corrective action scheme is in place and observed by the supervisory authorities. Actions range from submission of business improvement plans to revocation of the license. Per the same report, sanctions also apply to the board of directors, auditors and managers for violation of the Banking Act. However, the available sources do not directly address Japan's compliance with this principle.

23. Banking supervisors must practice global consolidated supervision over their internationally-active banking organizations.

II

The IMF's 2003 FSSA reports that the FSA has the authority to supervise the overseas branches of locally incorporated banking institutions. However, per the same report, "the current regulatory and supervisory framework does not have specific provisions relating to global consolidated supervision" (p. 40). Nevertheless, the available sources do not directly address Japan's compliance with this principle.

24. International exchange of information with other supervisors.

II

The IMF's 2003 FSSA reports that there are no legal provisions for the sharing of information with other supervisors. It is advised that the informal information-sharing arrangements with foreign supervisors be formalized. There is also a need for recognition in the law of the rights of supervisors to exchange information. Nevertheless, the available sources do not directly address Japan's compliance with this principle.

25. Supervision of local operation of foreign banks and information sharing with home country supervisors.

II

The IMF's 2003 FSSA notes that "the current legal provisions give the FSA powers to access any information in a subsidiary of a foreign banking institution" (p. 41). The IMF report recommends introducing more formalized arrangements for the exchange of information with foreign supervisors. Nevertheless, the available sources do not directly address Japan's compliance with this principle.