Financial Services Agency

JFSA’s supervisory approaches
Replacing checklists with engagement

June 20180This document, published on June 29, 2018,is the translation of the report in Japanese(Kin’yuu kensa kantoku no kangae-kata tosusume-kata – Kensa kantoku kihon houshin)published on the same day. Both thistranslation and the Japanese original areavailable at the JFSA’s website (English:
https://www.fsa.go.jp/en/wp/wp_revised.html,
Japanese:https://www.fsa.go.jp/news/30/wp/wp_revised.
html).

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Contents
I.

Introduction ...................................................................................... 4II.

Why to regulate financial institutions ............................................ 6
1. Regulatory goals ........................................................................................ 6
2. Market failures and roles of regulators ....................................................... 8
3. Government failures ................................................................................... 9
4. Substantive, forward-looking and holistic analysis and judgment............. 10

III.

Supervisory approaches ............................................................... 13

1. Three pillars of new supervisory approaches ........................................... 13
2. New environment, new issues and new priorities ..................................... 15
3. The first pillar: Enforcement ..................................................................... 17
4. The second pillar: Dynamic supervision ................................................... 19
5. The third pillar: Disclosure and engagement ............................................ 25
6. Reforms common to the three pillars ....................................................... 30

IV. Enhancing the JFSA’s readiness for new supervisory
approaches ............................................................................. 33
1. JFSA’s governance .................................................................................. 33
2. Quality control .......................................................................................... 34
3. Communications on supervisory policies ................................................. 35
4. Internal organization, human resource development and information
infrastructure .............................................................................................. 432

Key principles•

Make supervisory approaches consistent with the ultimate goal of regulation,
which is:⁃Enhancing national welfare by contributing to the sustainable growth ofthe economy and national wealth⁃by attaining both financial stability and effective intermediation, bothconsumer protection and better services, and both market integrity andvigor.
•
Minimize the sum of market and government failures so as to make market
mechanisms function best.
•
Shift from rule-based compliance checks to balanced use of rules andprinciples.

Transforming supervisory approaches•

Expand the scope of its supervisory approaches from a backward-looking,element-by-element compliance check to substantive, forward-looking andholistic analysis and judgment. More specifically, Focus the enforcement activities on the assessment of the overall
effectiveness rather than on item-by-item compliance check, Conduct dynamic supervision based on forward-looking analysis, and Promote disclosure and engage with firms to support the pursuit of bestpractices.
•
Focus on issues of firm-wide priority rather than try to check each and every
items on common checklists.
•
Shift from periodic on-site inspection to continuous and seamless monitoring
and further the coordination between on-site and off-site activities.
•
Accumulate in-depth knowledge on each firm and specialized analytical skills.
Engage with a broader range of stakeholders.

Transforming the JFSA•

Enhance the Agency’s own governance, quality control of supervision andmake effective use of feedback from outside the Agency.
•
Use theme-specific discussion papers for deeper engagement.
•
Repeal the Inspection Manuals after the end of fiscal year 2018. Do not denyfirms’ established business practices but support firms’ initiatives to innovate.
•
Restructure the JFSA’s internal organization, human resource policy andinformation infrastructure so that the Agency will be able to successfully
implement the new supervisory approaches.
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I. Introduction
This report aims to present how the Financial Services Agency (JFSA), Japan’s
integrated regulator of banks, insurance companies and capital markets, intends
to transform its supervisory approaches so that both the Agency and the industry
could continuously benefit from the interaction between them and reform andinnovate themselves, for the Agency to upgrade the quality of its supervisory
activities, for the industry to enhance its performance, and for both to better
contribute to the unleashing of the unrealized potential of the Japanese
economy.
The existing supervisory approaches which rely on the elaborate system ofchecklists may lead supervisors and financial institutions to split hairs while
ignoring the elephant in the room. Rigorous loan by loan review conducted by
the Agency contributed to the resolution of the non-performing loan problems,
but might not be effective in preventing the next crisis. Compliance checks
repeated year after year by the Agency have made firms improve their internal
control, but may also have worked to stifle their initiative to innovate.
A panel of experts commissioned by the JFSA, the Advisory Group on
Supervisory Approaches, submitted a report “Transforming the JFSA's
supervisory approaches” to the Agency in March 2017, and recommended the
Agency to recast its existing supervisory approaches, which focus on
backward-looking, element-by-element check on the compliance with formal
requirements, into those based on substantive, forward-looking and holistic
analysis and judgment. The panel also recommended the Agency to review if its
approaches are consistent with the ultimate goal of financial regulation. The
current report is the JFSA’s response to the panel’s report and describes how it
intends to operationalize the panel’s recommendations.
The public consultation period on this report was closed on February 14, 2018.
The Agency received various comments and published an outline of thecomments as well as the response of the JFSA on its website(https://www.fsa.go.jp/en/wp/wp_revised.html). Additionally, during the public
consultation period, the Agency held dialogue with financial institutions and theirexternal auditors in eleven cities across Japan, and published a summary of theopinions
obtainedinthedialogueonits
website(https://www.fsa.go.jp/news/30/wp/dialogues.html). The Agency intends tocontinuously engage in dialogue with consumers, financial institutions, market
participants and other stakeholders and to continuously update this report andenhance its supervisory approaches.

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The JFSA will also work to enhance its own readiness for the new supervisory
approaches. The Agency intends to learn by doing and to reflect lessons learnedin future revisions to this report.
This report describes approaches commonly applicable to supervision offinancial institutions subject to JFSA regulations. The new supervisory
approaches based on this report should be implemented commensurate with thesize and characteristics of financial institutions and should not require
small-scale financial institutions to engage in unduly complicated discussions.
The Agency will supplement it with separate reports on approaches to more
specific aspects of supervision.

Why do we need new approaches?
Because we want to see that both the JFSA and the industry continuously reform and innovatethemselves, for the Agency to upgrade the quality of its supervisory activities, for the industry toenhance its performance, and for both to better contribute to the unleashing of the unrealized potentialof the Japanese economy.

Current approaches
 The elaborate system of checklists
help avoid overlooking minor flaws,
but may deter us from focusing onpriority issues.
 Rigorous loan by loan review shouldhave contributed to resolving nonperforming loan problems, but might
not be effective in preventing the nextcrisis.
 Compliance checks repeated year
after year may have improved firms’internal control, but may have worked
to stifle their initiative to innovate.

New supervisory
approaches
 Enforcement
Profile firms throughcontinuous monitoring andfocus on priority issues ofsubstance.
 Dynamic supervision
Analyze if firms can sustain
their safety and soundness
and engage with them on
forward-looking remedial
measures, if needed.
 Disclosure and engagement
Motivate firms and support
their initiatives to innovate.

5

 Repeal theInspection
Manuals Enhance theAgency’s own
governance andquality controlof supervision.
Make effective
use of feedback
from the outside.

II. Why to regulate financial institutions
1. Regulatory goals
The ultimate goal of financial regulation is to contribute to the maximization ofnational welfare. Financial regulation can contribute to the nation’s economic
welfare both by enhancing flows, or promoting sustainable economic growth,and by enhancing stocks, or increasing national wealth.
Upon its establishment, the JFSA set three missions for itself: ensuring financial
stability, promoting consumer protection, and maintaining market integrity andtransparency. These missions corresponded to the priority issues of the time: theAgency had to restore trust in the Japanese financial system and markets, which
had been undermined by the persistent growth of non-performing loans, a seriesof bank failures and incidents of serious misconduct.
The three goals – financial stability, consumer protection and market integrity –still remain critical today. They themselves, however, are not the ultimate goals.
They are means to achieve the ultimate goal described above, and are
indispensable but not sufficient in achieving it. Three goals had better be seen inperspective.
Ensuring financial stability is indeed an essential goal, but if regulators pursue
financial stability as if it is the only overarching goal, financial institutions may
become overly risk averse and refrain from discharging their intermediation
functions, restraining economic growth, although sound economy is a key
precondition for financial stability. Regulators should strike the right balance
between ensuring financial stability and securing effective financial
intermediation. We should aim at a virtuous cycle where sound banks support
economy and sound economy makes banks sound.
Similarly, regulators should secure firms’ compliance with consumer protection
rules, but compliance will only assure that they do no harm, not necessarily thatthey bring benefit. If financial institutions consider that compliance with rules is
all that is expected of them and would not make efforts to improve their products
or services to best suit the interests of customers, financial industry’s
contribution to the growth in national wealth will be much limited. We need toensure that financial institutions abide by rules as a matter of course but should
also expect that they creatively and innovatively strive for better services.
Lastly, market integrity and transparency is a precondition for the proper
functioning of the market. However, should the Japanese market stay stagnant
6while markets across the world compete with each other vigorously, it cannot
make enough contributions to efficient corporate financing or growth inhousehold assets. We need a market which attracts critical information andplayers from around the world and provides a variety of opportunities forfinancing and investment. We should aim at having both integrity and vigor in ourmarket.
The three goals of financial stability, consumer protection and market integrity
should thus be balanced with the other three goals of effective intermediation,better services and market vigor. To achieve the ultimate goal of enhancing
national welfare by contributing to the sustainable growth of the economy andnational wealth, the JFSA aims to attain i) both financial stability and effective
intermediation, ii) both consumer protection and better services, and iii) bothmarket integrity and vigor, all in a balanced manner. This report calls the threebalances as the basic goals of regulation, which are intermediate goals in ourefforts to attain the ultimate goal.

Redefining regulatory goals: from “stability” to “stability and growth”
 The JFSA in its earlier days defined its
mission as securing financial stability,
promoting consumer protection, andmaintaining market integrity andtransparency.

 The JFSA will aim to:•

Strike the right balance i) between financial stability andeffective financial intermediation, ii) between consumer
protection and better services and iii) market integrity and vigor,
and•Make its supervisory approaches consistent with the ultimate
goal of regulation
Maximizing national
welfareUltimategoal

By promoting sustainable growth of theeconomy and national wealth

Consistency with the ultimate goal

Financialstability

Consumerprotection

Marketintegrity

Basic
goals

Financialstability

Effective
financialintermediation

Balance7

Consumerprotection

Betterservices

Balance

Marketintegrity

Marketvigor

Balance2. Market failures and the role of regulators
It goes without saying that the protagonists in financial markets are customers,
market participants and financial institutions, not regulators. It would be better if
the goals described above are achieved through free competition and market
forces founded on rational choices made by customers, market participants andshareholders of financial institutions.
However, in reality, various forms of market failures prevent the protagonists
from behaving in a manner which would maximize the national welfare. For
example:- Individual financial institutions optimize their behavior without incorporating
negative or positive effects their behaviors have on the financial system or
the macro-economy (negative or positive externality).
- Financial institutions have only a small part of information their customers
have, and vice versa (information asymmetry).
- Even if multiple equilibria exist and efficiency gain can be attained by shifting
to a better equilibrium, sometimes no financial institutions change theirstrategies as the first mover may become prey to other firms (the prisoner's
dilemma).
- Limitations in cognitive capability or in knowledge and experience often
prevent individuals from making a fully rational judgment (bounded
rationality).
- Employees or management, when provided with incentives not fully aligned
to the interests of shareholders or the financial institution, may prioritize theirprivate short-term interests (the agency problem).
The role of supervisory authorities is to address market failures so that market
forces would fully work and the governance mechanism of financial institutions
properly functions. That is needed to attain each of the six elements in the basic
goals of regulation, as described in the following:-

Financial stability: To attain financial stability, regulators need to address
vulnerabilities in the financial system arising from negative externalities (Abank’s failure may have domino effects on other banks due to theinterconnectedness, but the management of the bank may not take thepotential spillover into their consideration.) and information asymmetries(Depositors who do not have enough information to distinguish good banksfrom bad banks may run on good banks.).

-

Effective intermediation: Also, to promote effective financial intermediation,
regulators need to address market failures arising from positive externalities(A bank’s contribution to the local economy benefits competing banks as
well.), the prisoner’s dilemma (No bank exits from the strategy focusing on
lending volume as the first mover may lose market share.) and information
asymmetry (Difference in service quality among banks may not be well
8

recognized by customers.).
-

Consumer protection: Regulators must protect consumers of financial
services against disadvantages stemming from information asymmetry andfrom limited means available for them to handle stress events.

-

Better services: Also, market force may not work well to foster competition
towards better services, as the differences in financial institutions’ asset
management capabilities or in their dedication to customers’ best interest
may not be properly appreciated by customers due to information
asymmetries and bounded rationality, and thus may not lead to differentiatedgrowth of firms. Regulators can address this by promoting disclosure byfinancial institutions and enhancing customers’ financial literacy.

-

Market integrity: Regulators enforce capital market rules to maintain market
integrity and transparency, without which large information asymmetry both
between securities issuers and investors and among investors themselves
would stay and deprive a majority of investors the opportunities to makeinformed investment decisions.

-Market vigor: To promote market vigor, regulators should work to eliminate
obstacles and provide necessary conditions for market agglomeration tohappen, as the benefit of agglomeration is enjoyed throughout the market(positive externality) and individual market participants are not sufficiently
incentivized to make decisions which would result in agglomeration.

3. Government failures
As in other areas of government intervention, financial regulators can incurcases of government failures in trying to address market failures. Once certain
measures prove to be effective in rectifying market failures, regulators tend to
apply them mechanically year after year, but that would increase the risk ofunintended consequences and government failures.
Government failures may occur in cases like the following:- Regulators may make excessive intervention and cause undue market
distortions.
- Regulators may impose overly prescriptive regulations and stifle innovations.
- Supervisors may exercise large discretion and damage predictability inbusiness environment.
- Supervisors may lack sufficient information, knowledge or expertise and failto make appropriate or timely judgments.
- Supervisors may pursue their narrow goals so single-mindedly that they end
up in harming the overall national welfare.
- Regulation and supervision may be implemented in such a way to unduly
increase compliance costs incurred to financial institutions.
9Regulators and supervisors should aim to minimize the sum of market failuresand government failures so that market mechanisms would function mosteffectively.
4. Substantive, forward-looking and holistic analysis and judgment
How can the JFSA minimize government failures while addressing market
failures effectively so that the ultimate goal of regulation can be best achieved?
In the late 1990s and early 2000s, the JFSA developed supervisory approaches
based on compliance checks and asset quality reviews. Though the approaches
proved effective a decade and a half ago, mechanical and repetitive applicationof them can lead supervisors and firms to be obsessed with the compliance withthe letters of the rules (focus on form), backward-looking review of the evidenceof the past (focus on the past) and analysis of details and elements (focus onelements).
Focus on form: If supervisors examine a firm in the light of forms, not substance,
firms may be induced to focus on having simple and objective evidence toprotect them. Bankers would find it easier to defend lending decisions byreferring to collaterals and guarantees than by presenting bankers’ own views on
borrowers’ future business prospects. Brokers may spend more time for creating
evidence of compliance with product sales rules than for listening to customers’
life plans and needs.
Focus on the past: Supervisors may satisfy themselves just by examining banks’balance sheets, which represent the consequences of their past activities, while
complacent on the sustainability of banks’ business models in the future.
Supervisors may spend most of their time criticizing specific past incidents of
misconduct but may fail to discuss whether firms meet the changing needs of thecustomers.
Focus on elements: Supervisors may focus on loan-by-loan classification while
overlooking key risks to the banks’ sustainability. They may also focus on a
specific incident of non-compliance, while failing to identify root causes andreform needed to address them.
Analysis of the substance, the future, and the holistic conditions need to befounded on analysis of the form, the past and elements. If, however, supervisors
stop at the analysis of form, the past and elements and would not proceed toform their views on substance, the future, and holistic conditions, they may
create government failures as described above while not effectively addressing
market failures. A supervisor’s focus on the form, the past and elements tends to
induce financial institutions to allocate their resources on issues of the form, thepast and elements as well.
To better attain the ultimate goal of regulation, the JFSA will transform its
10

supervisory approaches from those focused on the form, the past, and elements
to those that emphasize the substance, the future, and the holistic analysis, as
follows:-

From form to substance: The JFSA will expand its focus of reviews from form
to substance, for example from compliance with the formal requirements tothe quality of services provided and the effectiveness of risk management.

-

From the past to the future: The Agency will not satisfy itself just by
backward-looking analysis (for example, verification of safety andsoundness at a certain point in time of the past) and augmentforward-looking analysis (for example, review on the sustainability of thesafety and soundness in the future).

-

From element-by-element to holistic analysis: The JFSA will work to identify
and address priority issues which have firm-wide implications, rather thanfocusing on firms’ handling of specific incidents.

Making substantive, forward-looking and holistic judgment is harder to do thanjudging on the form, the past and elements. Action or inaction based on
substantive, forward-looking and holistic judgment increases the risk thatsupervisors are accused of their misjudgment. In all aspects of financial
regulation and supervision, as a natural tendency of bureaucracy, those who arein charge are tempted to rely on excuses based on the form, the past andelements. The JFSA should continue to ensure that it is not yielding to such
temptations.
Substantive, forward-looking and holistic judgment can properly be made only ifsupervisors are competent enough to do so. The JFSA will systematically carryout reforms in its governance, quality control processes, manuals and guidelines,
organizational structure, human resources development and information
infrastructure.

11

Expanding the scope:
Towards substantive, forward-looking and holistic analysis and judgment
The Form

The Substance- Supervisors and firms focus on thequestions if a loan is with collaterals orguarantees and if the evidence ofcompliance can be produced.

- Supervisors and firms focus on the effective
risk management and quality of service
provided.

The Past- Supervisors and firms focus on thebalance-sheet figure in the past andpast incidents of misconducts.

The future

Expandingthe focus of - Supervisors and firms focus on thesustainability of firms’ safety and soundness.
review

Element by element analysis

Holistic analysis- Supervisors and firms focus on loanby-loan classification and on specificincident of misconducts.

⁃ Supervisors and firms analyze and identify
priority issues and focus on addressing them.

12III. Supervisory approaches
1. Three pillars of the new supervisory approaches
This chapter describes how the JFSA intends to expand the scope of its
supervisory approaches from a backward-looking, element-by-element
compliance check with formal requirements to substantive, forward-looking andholistic analysis and judgment so that the Agency will better contribute to theultimate goal of regulation by attaining basic goals in a balanced manner. The
new supervisory approaches have the following three pillars.
The first pillar is the enforcement of minimum standards. The JFSA will continue
to enforce minimum standards it sets to attain financial stability, consumer
protection and market integrity and transparency. In the past, however, theAgency’s enforcement activities may have had the tendency to overly focus on abackward-looking, element-by-element check on the compliance with formal
requirements, and to split hairs while ignoring the elephant in the room. Goingforward, they will be guided more by substantive, forward-looking and holistic
analysis and judgment.
The second pillar is the dynamic supervision. Compliance with minimum
standards at present does not guarantee that regulatory goals will be satisfied in
the future. Given that the breach of minimum standards incurs large costs to
consumers, financial institutions and regulators, the JFSA will assess thelikelihood that financial institutions breach standards in the future and calibrate
its supervisory actions according to the likelihood and the significance of thepossible breach.
The third pillar is the promotion of disclosure and engagement with financial
institutions aimed to encourage financial institutions’ pursuit of best practices.
Given the rapid evolution of financial businesses, financial institutions’ practices
will quickly become outdated if they are designed just to satisfy minimum
standards. Their business models and risk management practices should be
renovated day by day. Also, better financial intermediation, better services andmore vibrant markets can be attained only through firms’ diverse initiatives toinnovate themselves. The JFSA will encourage financial institutions’ efforts topursue best practices by promoting disclosure and by engaging with a financial
institution with the aim to explore solutions fitted to the firm’s own conditions andcircumstances.
These three pillars provide a conceptual framework which shows a spectrum ofavailable supervisory approaches. In the actual supervisory activities, the focus
13will naturally change as the discussion between the authority and the financial
institution evolves. Therefore, it is not useful to label each and every supervisory
activity as the exercise of one of the three categories. Besides, each of the threepillars above will be applied with gradations depending on the situation and they
form a continuous spectrum. They are not totally distinctive from each other.
In addition, the three pillars above will be applied in accordance with respective
circumstances, rather than mechanistically applied to all financial institutions.
For example, in certain areas where many financial institutions need toaccelerate improvement, the JFSA might specifically indicate the minimum levelof standards needed to be satisfied and focus on the enforcement of suchminimum standards. Also, for financial institutions which have fundamental
issues in safety and soundness or compliance control, the JFSA will carry out
rigorous enforcement of the minimum standards and make clear the necessary
remedial actions. On the other hand, when a financial institution apparently
meets the minimum standards at present but does not catch up with the changes
in the business environment or expectations from the general public, the JFSA
might focus on the promotion of disclosure and engagement.
The goal of financial regulation cannot be achieved if the Agency engages in
dialogue with a financial institution only to encourage its pursuit of best practices
at a time when rigorous enforcement of the minimum standards is the priority forsaid institution. Nor can it be achieved if the Agency focuses on enforcing theminimum standards when engagement to encourage the pursuit of bestpractices is more needed. The JFSA will conduct accurate profiling of thefinancial institutions on a day-to-day basis and identify, based on the facts, whichissues warrant further discussions and which supervisory measure isappropriate to address them.
Notably, even after a specific supervisory process has proceeded for a certain
financial institution, if previously unknown facts are recognized, the JFSA will
incorporate them in its profiling and analyze if the current supervisory approach
is appropriate. In addition, the JFSA will carefully communicate with the financial
institutions on the background as well as the purpose of discussions in thecourse of its supervision.
Basel III, the international framework for prudential supervision of banks, also
adopts three pillar approach, calling the minimum capital requirements as Pillar
One, the supervisory review of the adequacy of the buffer above minimum
requirements as Pillar Two and the disclosure requirements to make market
discipline to function as Pillar Three. The three pillars of the JFSA’s new
supervisory approaches and Basel’s three pillars share some common
elements.
The rest of this report focuses on supervision of regulated financial institutions. It
does not discuss issues related to the design of regulations. Neither does it
cover market surveillance, which deals with a broader range of market
14

participants including unregulated entities and largely focuses on enforcement ofrules.
2. New environment, new issues and new priorities
The ultimate and basic goals of regulation do not change over time, but thepriority issues the JFSA need to address do. The Agency will stay vigilant on the
gap between the goals and the reality and on any imbalance among the degrees
basic goals are attained.
As a new environment and issues emerge, the JFSA will continue to update bothsupervisory programs for individual financial institutions and the Agency-widebusiness plans through the PDCA (plan, do, check, action) cycle, identifying
priority issues in a forward-looking and holistic manner.
As described below, the priorities for the JFSA have evolved with regard to all of
the basic goals of regulations.
(Balancing financial stability and effective intermediation)
Until the early 2000s, resolving banks’ non-performing loan problem had been
the Agency’s top priority, and it focused on reviews on the quality of individualloans and verifications of banks’ compliance with the minimum capitalrequirements.
Over time, however, most financial institutions have satisfied the required
minimum standards. Meanwhile, the business environment for financial
institutions is becoming increasingly challenging due to aging and declining
population, shrinking domestic market, persistent global low interest rates, andcompetition intensified by the rise of new technologies including FinTech. Under
this unfavorable business environment, avoiding to take excessive risks alone is
not enough for financial institutions to maintain sustainable profitability andsoundness. The JFSA will not limit itself to enforcing the minimum standards but
will engage in dynamic supervision, based on forward-looking analysis of thesustainability of financial institutions’ business models and safety andsoundness.
One possible way for a financial institution to survive in the unfavorable businessenvironment described above is to grow with its customers and the regional
economy by providing better financial intermediation and creating value sharedwith them. The JFSA, on its part, will do what it can do to prepare an
environment which facilitates the pursuit of best business practices by financial
institutions.
In addition, as the form and the locus of risks for financial institutions
metamorphose exceedingly quickly, it is becoming more important for them tohave the ability to assess and address emerging risks. Financial institutions
should therefore update their risk management practices day by day in view of15their own risk profiles and the changing business environment, not being
satisfied with achieving common benchmarks established by the Agency. The
JFSA will improve its approaches to encourage firms to pursue better risk
management practices.
(Balancing consumer protection and better services)
Similarly, the priority issues have shifted in attaining consumer protection andbetter services. In the first half of the 2000s, recurrence of serious consumer
protection incidents called the Agency to thoroughly probe breaches using thechecklists and demand financial institutions to establish a minimum level ofcompliance controls. Over time, however, most financial institutions havedeveloped their own basic rules and procedures for consumer protection.
Minimum level of consumer protection, however, does not guarantee provision of
better services. Rigorous compliance with the letter of laws and regulations can
co-exist with business practices which pay little attention to the interest ofcustomers. Often, much less time is spent for identifying customer needs thanfor creating evidence of compliance. Complex products, fully compliant with laws
and regulations, are designed to churn greater fees.
In 2017, the JFSA published the Principles for Customer-Oriented BusinessConduct. The Agency engages with financial institutions referring to the
Principles to promote better services. It also promotes disclosure by the financial
institutions on their policy and the products and services they provide so that
consumers can make an informed choice.
(Balancing market integrity and market vigor)
In addition, the Agency is embarking on new measures in its efforts to enhancemarket integrity and market vigor.
The Agency envisages a virtuous cycle which would transform the flow of funds
and create a vibrant capital market. In the envisaged cycle, financial institutions
involved in each step in the investment chain would strive to serve the bestinterests of customers and compete with each other to be more creative inoffering better quality products and services. This would in turn enhance trustfrom customers in the market, augment flow of funds in the capital market, andresult in the accumulation of information and expertise in the Japanese market.
The JFSA will support the development of the environment which facilitatescompetition and the pursuit of best business practices by financial institutions.
As the market continues to experience transformational changes, ensuringmarket integrity and transparency would also require the JFSA to adopt new
approaches and methods. To identify emerging risks for market integrity at an
early stage, the JFSA will keep an eye on the developments in the Japanese andglobal economies, enhance its market intelligence, and conduct forward-looking
analysis. The JFSA’s own system of collecting and analyzing market information
should be transformed to fit the changing market environment.
16

3. The first pillar: Enforcement(1)

Enforcing minimum standards

The first pillar of the JFSA’s supervisory approaches is the enforcement ofminimum standards, or checking compliance with common minimum standards
and requesting remedial actions where deficiencies exist. The minimum
standards have been established to ensure that financial institutions attain theminimum necessary level of financial safety and soundness, consumer
protection, and market integrity and transparency. Examples of the minimum
standards include accounting standards on loan classification, loan write-offs
and loan loss provisioning, capital adequacy requirements, rules and regulations
on consumer protection and market integrity, as well as the minimum levels ofinternal control as a precondition for adequate business management, customer
protection and risk management.
At the time the JFSA was established, its top priority was the enforcement ofminimum standards. Today, its significance remains unchanged as maintaining
safety and soundness of financial institutions, protecting consumers andensuring market integrity and transparency remain important goals.
(2)

Potential side effects of the past approaches

Though enforcement of minimum standards is indispensable, the JFSA’s pastmethodology of periodic and exhaustive inspection of financial institutions using
the prescribed checklists could lead to the risk of focusing excessively on theform, the past and elements.
(Excessive focus on elements)
Without having the holistic view of the financial institutions, the regulators could
be easily obsessed with revealing individual flaws and incidents. Suchsupervisory practices may incur unnecessary compliance costs to financial
institutions. More importantly, financial institutions may be distracted away fromtrue challenges for them.
(Excessive focus on the form)
If the regulators focus too much on verifying whether financial institutions havedeveloped and implemented their internal rules and have established theinternal control systems as prescribed by the checklists, they may not focus onwhether in fact these internal rules and controls are effective in attaining
compliance. Regulators may end up in allocating a large part of their resources
for the tasks which should be carried out by financial institutions themselves.
(Excessive focus on the past)
Sometimes the regulators, financial institutions and the general public may
become excessively obsessed with the past incidents of misconducts and17particularly with consequent regulatory sanctions, paying limited attention to theefforts to analyze the root causes of the incidents, such as governance andinstitutional cultures, and to take necessary remedial actions.
Should the regulators focus on the form, the past and elements, it has a negative
spillover effect on financial institutions. They may concentrate on creating theevidence of compliance or on developing internal rules and internal controls
precisely corresponding to the letter of the checklists. Once fixed, internal rules
may not be changed flexibly and that may harm firms’ innovative thinking.
(3)

Principles for the first pillar

In order to attain the ultimate goals of regulation through the enforcement ofminimum standards, the JFSA should shift from the approach which focused on
the form, the past and elements to the one which emphasize the substance, thefuture and the holistic analysis and judgment.
Specifically, the JFSA will review its excessive reliance on a comprehensive setof prescriptive checklists and replace them with principles and engagement as
the foundation of its supervision. In addition to the general reforms in the
supervisory processes and in the use of checklists, which are described in III. 6
and in IV.3, respectively, the Agency will transform its approaches to theenforcement of the minimum standards according to the following principles:-

The objective of the Agency’s enforcement activities is the evaluation of theeffectiveness of firms’ overall governance, institutional culture and internal
control systems, not the assessment of the compliance with each and every
item on the checklist.

-

The JFSA will defer to financial institutions themselves matters of theirprimary responsibilities such as the verification of the internal rules andprocedures and their implementation.

-

The JFSA will make sure that the past communications from the supervisor
would not result in an unchangeable de-facto rule for the financial institutions.
An explicit process should be established which would enable firms tomodify their business improvement plans submitted to the supervisor in thepast. The JFSA will also review and improve the utility of its no action letter
framework and the process to publish questions and answers.

-

The regulator’s action should also be calibrated according to the significanceof the incident in question, rather than uniformly requiring the similar
remedial actions in response to each and every incident. It should beassessed by analyzing whether it was an inevitable and exceptional
derogation or it had deeper root-causes such as weak governance andinadequate institutional culture. In analyzing the potential root causes, theAgency will gather relevant facts, engage with financial institutions based on18

the facts, and make efforts to have a thorough view on the structure of the
problems before reaching the conclusions.
-

Rather than focusing solely on preventing the recurrence of similar incidents,
the FSA should attach more importance to preventing issues which may bestemming from the same root causes. The JFSA should also engage withthe sanctioned financial institutions on effective and forward-looking
remedies and follow up on the implementation of planned remedies.

-

The purpose and objectives as manifested in the overall structure of therelevant laws and regulations should guide the applications of specific legal
provisions to an incident. The regulator should identify the interest therelevant law protects and act proportionate to the degree the interest iscompromised.

4. The second pillar: Dynamic supervision(1)

Dynamic supervision to secure continued soundness

The second pillar of the JFSA’s supervisory approaches is dynamic supervision,or an approach whereby supervisors i) analyze the future business environment
and the likely developments in the financial institution in question, ii) assess thelikelihood that the firm breaches minimum standards in the future, and iii) sharesupervisors’ assessments with the firm and, if needed, engage with it to explore
remedial measures to reduce the likelihood.
A firm’s current compliance with the minimum standards does not guarantee that
it will satisfy them in the future. The breach of minimum standards, once
happens, incurs large costs to consumers, financial institutions, regulators andthe society as a whole. In addition, a recovery from a breach is much moredifficult financially and reputation-wise than prevention at an early stage.
Regulators should be justified to take a preemptive approach to engage withfirms with higher breach likelihood on possible remedies, even if they comply
with the standards at the moment.
At its inauguration, the JFSA championed a rule-based approach and ex post
enforcement and tried to exclude discretional judgment and ex ante guidance asmuch as possible. Naturally it tended to refrain from supervisory intervention
based on uncertain future prospects. However, analysis of emerging risks andengagement on measures to avoid future problems are among the corecomponents of supervision in many other parts of the world. The need for
dynamic supervision is particularly acute in the current environment where
financial institutions cannot maintain their safety and soundness withouttransforming their business model to meet the challenges of changing customer
needs, greater squeeze on their profitability and rapid metamorphosis in thenature and locus of risks they face.
19

Dynamic supervision entails significant risk of government failure as it is basedon the assessment of an uncertain future and is conducted at a stage when
there is no breach of minimum standards. To minimize the risk, the JFSA willcontinuously enhance its ability to form views on the future by gathering
information widely and timely and conducting in-depth and holistic analysis. It
will also avoid imposing a one-size-fits-all solution across the industry andcontinue its efforts to develop approaches to engage in constructive two-way
dialogue with an individual financial institution to explore possible solutions
tailored to its own circumstances. Such approaches should be distinct fromthose for enforcement.
(2)

Forward-looking analysis

Even if a financial institution currently satisfies the minimum requirements, thelikelihood of its breaching them in the future may be high in such cases asfollows:- The firm is exposed to excessive amount of risks which are not captured by
the existing standards.
- The firm’s profitability and business model is not expected to be sustainable
under future environments.
- The firm’s governance or corporate culture is not effective enough to preventor rectify reckless management.
Similarly, changes in their business models and strategies, changes in the social,economic and regulatory environment, as well as a higher level of expectations
from the general public, may raise the likelihood of future breach of conduct
rules by a financial institution, even when a clear incident of misconduct does notappear to exist at present.
To properly assess the likelihood of future breach of minimum standards, the
JFSA will keep track of market, economic and social developments domesticallyand internationally and assess various channels through which thedevelopments may affect the business of financial institutions. When a problem
which might lead to future breach does exist but is hidden because of afavorable business environment, a stress test can be an effective tool in
identifying such problem (see the Box on the next page).
The analysis on the future breach likelihood will be conducted withmacro-prudential, or system-wide and through-the-cycle, perspectives. In manyof the past financial crises, even though individual financial institutions executed
risk-hedging transactions rational for each of them, those transactions weremade in the same direction and collectively augmented unexpected volatilities inmarket prices and amplified credit cycles (fallacy of composition). Such
possibilities need be duly accounted for.

20

<Box> Examples of analysis for dynamic supervision of safety
and soundness
Below are the examples of forward-looking analysis to assess thesustainability of financial institutions’ safety and soundness:(Risks not fully captured by the existing minimum standards)
In many past financial crises unfolded in Japan and elsewhere,
financial institutions satisfied the minimum capital adequacy
requirement, a key benchmark of financial institutions’ soundness, ofthe time. Nevertheless, they were exposed to an excessive amount ofrisks which the regulatory benchmark did not capture. For example:- Though firms lent to quite diverse borrowers, many of the loans
were commonly exposed to the significant risk of real estate pricefluctuation, due to the nature of the borrowers’ business or the useof real estate as collateral. The credit risk correlation among loan
exposures was much higher than the capital adequacy standards
assumed.
- Through firms had engaged in transactions assuming that they hadborn only limited risks, they had to step-in and bear substantial
costs afterwards as there were no explicit ex-ante agreements on
risk-sharing.
- Firms engaged in transactions designed for regulatory arbitrage.
- The amount of risks, which was calculated based on the past
performance of loans and the past market volatilities, was anunderestimation due to long-lasted favorable economic conditions.
Although the degree of risk concentration and the quality of risk
management much affect the volatilities in firms’ earnings, they are notnecessarily parameters in the calculation of the regulatory capital
adequacy ratio. The above and other elements should be considered inassessing a firm’s risk profile.
(Sustainability of financial institutions’ profitability and business models)As the business environment for financial institutions becomesincreasingly challenging, it is difficult for the financial institutions tomaintain sustainable soundness unless they carefully take risks withreasonable returns. Thus curbing firms’ risk-taking excessive to theircapital adequacy level alone cannot secure financial stability anymore.
The JFSA needs to pay more attention to firms’ sustainable profitability.
Even if a firm records decent current earnings, it may cease to be
profitable and impair their capital base in the future, if its businessmodel is not sustainable, for example, in the following manner:- Long-term loans and debentures the firm acquired under the pasthigh interest rate environment will be gradually replaced withlow-yielding assets.
21

-

-

While shrinking population in the region is expected to lead todecrease in lending opportunities, the firm is wedded to a volumeoriented strategy and has not found an alternative business model
which enables it to grow together with its customers and the local
community.
The firm is profitable by churning fees from investors, but thepractice may erode customers’ trust in it over time.
The accounting profit is realized by selling securities with capitalgains while those with latent capital losses are kept on the books.

Sustainability of business model would require special attention in suchcases as mentioned above.
(Stress test)
A stress test is a methodology to perform a series of simulations underhypothetical adverse stress scenarios in order to assess how afinancial institution or the financial system is affected under eachscenario. It is a type of forward-looking analysis which can help
regulators and firms identify problems which may not be revealed bystatistical analysis of historical data.
A stress test by a financial institution, if designed and tailored to fit to its
own circumstances and risk-profile, can usefully provide insights onchannels of possible risk contagion and help it prepare for possible
changes in the business environment.
On the other hand, if the supervisors specify common stress scenarios
as a means to make pass-or-fail judgments on firms’ capital adequacy,
an inappropriate choice of the scenarios could result in an unintended
distortion in the financial institutions’ portfolio allocation. Further, if
common scenarios are not supplemented by firm specific ones, the test
can create a false sense of complacency as idiosyncratic vulnerabilityof each financial institution may stay unidentified.
The JFSA, with due regard to the possible negative consequences
mentioned above, will explore how better to use supervisory stresstests using common scenarios (universal tests), as they can bring in
benefits as shown below:- During an extended period of boom and bubbles, firms attaincontinued earnings growth and stronger capital base. Bullish
sentiments may prevail and make firms underestimate the risk theirbusiness entails. They may then be led to a euphoric view on thestrength of their capital base and the sustainability of their businessmodels. A stress test may reveal how the current perception on
their soundness is dependent on the boom and bubbles.
- If many banks operate on the assumption that a flattening of theyield curve would be short-lived, a test with a scenario of continued
22

-

(3)

flat yield curve may reveal potential vulnerabilities. On the other
hand, if banks build their business models assuming that thecurrent low interest rate and abundant liquidity will stay, a scenario
of tightened monetary policy may be useful.
A universal stress test may be effective in evaluating the soundnessof the financial system as a whole.
A universal stress test may be effective in comparing simulation
methods used across financial institutions.

Flexible and effective supervisory responses

If the forward-looking analysis identifies firms’ significant likelihood to breachminimum standards in the future, the JFSA will share the assessments with thefirm and engage with it to explore possible remedial measures.
As the business environment for the financial industry is becoming increasingly
challenging, firms may not be able to sustain their soundness merely by curbing
excessive risk-taking, reducing cost and increasing business volume throughaggressive marketing. In such cases, no simple mechanical rules can guide
firms to sustainable solutions. Supervisory response therefore has to be flexibly
tailored to firms’ unique conditions and circumstances.
If the significant likelihood of breach in the future is not properly addressed,
however, financial stability, consumer protection or market integrity would becompromised at some stage. Supervisory responses thus need be effective.
Flexibility will be used to choose and apply most effective supervisory responses
and does not mean tolerating forbearance.
To be both flexible and effective,- The JFSA will analyze economic conditions and demographic changes in themarket, the firm’s business models, lending and investment policies and risk
profiles, and other relevant factors, and form hypotheses on the root causesof the firm’s weak performance.
- It will engage with firms to arrive at a common understanding on the issues
and causes. The Agency will respect and pay much attention to the firm’s
own views, without unilaterally imposing the viewpoint of the authority, andwill be ready to modify or discard its initial hypothesis as appropriate. If a
common understanding cannot be reached, the Agency will clarify thedifference and continue the dialogue.
- It will request financial institutions to develop specific preemptive measures
based on the shared views and follow up on the implementation of themeasures.
For the firms to plan and for the authority to follow-up on remedial measures,
both sides should base their judgments on the facts, analyze and understand thecurrent circumstances and identify the issues which truly need to be dealt with.
23

The remedial measures should squarely address those issues; they should not
be superficial or pretending solutions.
These activities should be calibrated according to the likelihood of future breach,the importance of the minimum standards in question and the problems
underlying the likelihood. When excessive risk-taking is simply the underlying
problem, for example, the Agency will request the firm to establish andimplement a remedial plan with a specific deadline. If the likelihood is very high,the supervisory approach will become very close to the first pillar approach, orthe enforcement of the minimum standards.
Meanwhile, when the key issue is the concern on the sustainability of thebusiness model under the changing future business environment and the firm’s
management is fully aware of the need to address the concern, the supervisory
approach will become very close to the third pillar one, or the exploratory
engagement.
There can be a wide spectrum of intensities in the second pillar approaches andthe boundaries with other two pillars become blurred in marginal cases. Also, as
mentioned in Section III 1. above, the three pillars will be applied in accordancewith the current conditions of respective financial institutions. Even after a
specific supervisory process has proceeded for a certain financial institution, if
previously unknown facts are recognized, the JFSA will incorporate them to its
profiling and analyze if the current supervisory approach is appropriate.
The JFSA’s existing early warning mechanism use common thresholds
predetermined for several key indicators and not based on substantive,
forward-looking or holistic assessment. If a threshold is reached, supervisors
would react by conducting interviews with firms and requesting reports fromthem. The JFSA will review the analysis and response the mechanism specifies
and make it aligned to the process described above.

24

The second pillar: Dynamic supervision

Compliance with minimum
standards

Issues tobereviewed

Likelihoodofbreachingminimum
standards
in thefutureIn breach ofminimum
standards

Risks notcovered bystandards
but taken by
the firm

The size of buffer above regulatory minimum.

lowFirms will breachminimum standards if
risks taken but notcovered by standards
are materialized.

Sustainabilityof theprofitability
and business
modelSupervisory approaches

low

The degree the buffer above
regulatory minimum protects thefirm against risks taken but notcovered by standards.

Profitability andbusiness model may
not be sustained andmay breach minimum
standards in future.

First pillar:
Enforcement

Second pillar:
Dynamic supervision (Engagement on
forward-looking remedial measures)low

Sustainability

high

high

Third pillar:
Engagement towards bestpractices

5. The third pillar: Disclosure and engagement(1)
Disclosure to visualize differences and engagement to explore bestpractices
The third pillar of the JFSA’s supervisory approaches is composed of i) the
promotion of disclosure which visualize the differences in firms’ practices, ii)
engagement with firms to explore best practices, and iii) provision of support toindustry initiatives. The third pillar aims to promote an environment where firms
compete with each other to more promptly adapt to future business environment
and to excel in business practices.
The role of regulators under the third pillar stems from the three reasons: i)limited effectiveness of minimum standards in an environment of rapid change,ii) limited competition due to market and government failures, and iii) existenceof unrealized potential in attaining virtuous cycle.
The first reason for regulators’ third pillar activities is the limited effectiveness ofminimum standards in an environment of rapid change. Most minimum
standards are based on past regulatory experience and can quickly become
25

high

obsolete under an environment of rapid change. Even if a firm satisfy all the
relevant existing minimum standards, if its practices are weaker than its peers, it
can easily become a pray to those who look for firms which buy products withhidden and uncompensated risks, have weaker defense against cyber-attacks,
or are more likely to overlook transactions with money laundering or terrorist
finance risks. To ensure that the objectives of the minimum standards are
attained in fact, the regulators should encourage firms not to be satisfied withcompliance with minimum standards but to proactively strive towards bestpractices.
The second reason for the third pillar is the limited competition due to market
and government failures. Market mechanism, if it functions effectively, drives
financial institutions to innovate towards practices better than their competitors.
However, in reality, this may fail to happen as a result of the combined effects ofmarket and government failures, as shown below:- Regulation, in addition to stipulating the minimum level to be attained,
sometimes unnecessarily prescribes how it should be attained and stifles
innovations.
- Better products or services do not enjoy greater demand as users lackaccess to necessary information or financial literacy to interpret the
information.
- Moral hazard created by safety net allows firms’ management to staycomplacent and maintain inward-looking corporate culture andfollow-the-others style strategies.
- The first mover breaking away from the prevalent inefficient business model
can become disadvantaged against its competitors at least for certain periodof time.
- Benefits of a firm’s contribution to the revitalization of the local economy andmarkets are shared with firms which have made no contribution (externality).
The JFSA will try to reduce undue restraints on firms’ initiative, creativity andinnovation by shifting away from the supervisory regime based on checklists (asdiscussed in IV. 3). In addition, it will implement the third pillar of its supervisory
approaches to restore any weakened incentive to pursue best practices.
The third reason is the desirability to realize potential to attain virtuous cycle. At
present, most financial institutions clear minimum standards and for them thelikelihood of future breach is relatively limited. However, there should be further
scope for a virtuous cycle to work between better financial stability and better
financial intermediation, between better consumer protection and better services,and between market integrity and market vigor, and if the potential is exploited,
the ultimate goal of supervision should be much better served.
A key to establishing this virtuous cycle is the creation of shared value between
financial institutions and customers. In their 2011 article Creating Shared Value,
Michael E. Porter and Mark R. Kramer argued that companies can find newmarkets and achieve a competitive advantage by creating shared value with26

customers, the community, and the society in their core businesses. By providing
high-quality products and services that meet customer needs and contribute tocustomers’ growth, companies can solidify the foundations of their businesses
and increase their corporate value, according to their argument.
For example, if banks provide financial intermediary services that contribute tosustainable economic growth and asset management products and services that
contribute to the formation of national wealth, they can grow with their customers
and share value with them, and thereby more solidly sustain their businessmodels. If a quick fix alone does not allow a bank to sustain its safety andsoundness, it will have to find a business model with which it can grow with its
customers.
Similarly, if market intermediaries pursue best practices in securing market
integrity and transparency, asset managers enhance their asset management
skills, and both of them better produce information, the securities industry will beable to grow with the capital market.
Whether or not such possibilities will be explored and realized successfully
would have a significant impact on the achievement of the ultimate goal of
regulation.
In short, the third pillar aims to support firms’ efforts to meet the new challenges
in changing environment, to mitigate market and government failures, and tobetter attain the ultimate goal of regulation by creating a virtuous cycle. However,
it is not sufficient that financial institutions just wait for the authority to show an
example of best practices and strive to achieve them. The best practices should
be discussed and pursued within the financial institutions in light of their own
circumstances. The third pillar approaches are in an early stage of development
and there is no established methodologies yet. The JFSA will continue to explore
how the pillar, particularly the three elements discussed below, can be improved.
(2)

Disclosure to visualize differences

Effective disclosure will play a critical role in mitigating market failures and inpromoting competition among firms to unleash their creative thinking andinnovation. For example, information asymmetry can be effectively mitigated if
third-party private companies develop criteria to assess products and services
and publish their assessment. Better disclosure by firms on their products andservices will also enable customers to make better choice. In addition, thesupervisory authority can supplement consumers’ financial literacy by publishing
the summary of information it gathered and findings gained through its activities.
The JFSA has taken the following initiatives in recent years so that voluntary
disclosure by firms would more effectively help customers and otherstakeholders compare firms’ products, services and policies:- To help investors choose better asset management services, the JFSA
27

-published the “Principles for Customer-Oriented Business Conduct” andrecommended firms to disclose if they subscribe to the Principles, and, if so,comply or explain about each principle. The JFSA has also embarked upon
the development of common comparable performance indicators in thisarea.
To help customers choose better banks and promote competition for better
services, the Agency has established a range of common indicators on the
degree banks contribute to the increase in customers’ corporate values andon other performance. It has also recommended banks to choose anddisclose performance indicators most relevant to their business and policies.
The Agency will continue to improve the utility of the indicators.

In addition, the JFSA has tried to assist consumers’ informed decisions by
publishing its findings on the difference among financial institutions in the natureand quality of their products and services in its annual “Progress andAssessment of the Strategic Directions and Priorities” reports and otherpublications. The JFSA will continue to promote disclosure of information
valuable for customers.
If consumers’ financial literacy improves as a consequence of the disclosure aswell as financial education programs, the incentive will also grow for financial
institutions to actively pursue best business practices. When the financial
institutions which provide better products and services are chosen by thecustomers and become successful, it would in turn reinforce the functioning of
the financial system.
Disclosure of financial institutions’ policies and actions can also help
shareholders engage with them more effectively. Through corporate governancemechanism, financial institutions will be better incentivized to pursue bestpractices.
(3)

Engagement to explore best practices

In addition to reforming its first and second pillars of supervisory approaches toeliminate undue constraints on firms’ initiatives to transform themselves, the
JFSA will engage with firms to explore diverse range of good practices without
presupposing specific answers or conclusions. The engagement may work tonudge firms away from the embedded culture of behaving as others do and ofprioritizing firms’ internal peace.
The JFSA has access to diverse range of practices in the industry through its
horizontal review of firms. It also surveys by interviews and questionnaires how
customers view the firms and their products and services. It also exchanges
views with overseas counterparts and learn about industry best practices inother countries.
The Agency thus should be in a position to provide insights which it has
28

accumulated but is not readily available to individual firms, with due regard tosensitivities of business information. It can thereby support firms which
proactively engage in new initiatives and provide stimulus for change to firms
which have a tendency to follow industry trends and not open to new ideas. The
engagement with a firm can be made particularly fruitful if the JFSA conducts
comparative analysis of the firm vis-à-vis its peers.
Further, the Agency, by developing principles on best practices, can make its
engagement with firms more focused on key questions and provide firms with
opportunities to review their own business practices by examining whether or not
to adopt such principles, which principles to comply with and which principles to
explain the reason for non-compliance.
The pursuit of best business practices is matter for each financial institution tofind its own way fitted to its own condition and circumstances and there is nocommon solutions or thresholds to satisfy. Needless to say, the JFSA must
distance itself from unduly biasing firms’ business judgments by imposing what
the JFSA believes to be the best practice. The JFSA’s regulatory power overfinancial institutions enhances the risk that the Agency’s communication is
misconstrued as a pressure or a request, and particular care needs to be taken
to mitigate such risk.
Another important risk is that the JFSA engages with a firm without sufficient
grasp of its conditions and circumstances, the firm invents several cases of newpractices just to show them to the Agency, and both the Agency and the firm end
up in wasting their precious time and resources. To minimize the risk, the Agency
will try to acquire in-depth knowledge on firms’ business environment andchallenges they face through the monitoring and risk-profiling activities and to
ask as relevant questions as possible without a presumption on the rightanswers.
(4)

Industry initiatives

When the pursuit of best practices by individual firms alone does not deliver the
expected outcomes, such as an increase in customers’ trust in the industry andthe revitalization of the market, voluntary industry guidelines and otherindustry-wide initiatives may work as an effective solution.
For example, promoting disclosure based on an industry-wide format and theprovision of comparable information by an industry association may be usefulwhen disclosure by individual firms alone is not sufficient for customers tocompare and choose products and services.
The JFSA will support such industry-wide initiatives where appropriate, forexample by participating in discussions at industry associations as an observer.

29

6. Reforms common to the three pillars
So as to better focus on substantive, forward-looking and holistic analysis andjudgment, in addition to institutional reforms to be discussed in the next chapter,
the JFSA will reform its supervisory processes common to the three pillars as
follows.
(Fact-based supervision)
Accurate profiling based on relevant facts constitutes the cornerstone of the
JFSA’s new supervisory approaches. The Agency will make sure that facts drive
all its judgments and activities; supervisors need to start from the facts, refer tothe facts all throughout the supervisory process, and prioritize the facts overhypothesis or beliefs. The Agency will also conduct self-review of its profilingcapability, as well as establish a mechanism to gather necessary information,with due consideration to the burden on the financial institutions.
(Focus on priority issues)
Previously, the JFSA’s on-site inspection programs were not fully tailored to thechallenges each specific firm faces and its nature of business, location, size andrisk profiles, and the Agency repeated a comprehensive examination using thecommon checklist provided by the Inspection Manuals to most of the firms.
Mechanical repetition of the same inspection programs year after year could
promote a tendency on the part of the JFSA to focus more and more on minor
flaws while failing to address more fundamental issues. The firms may also beforced to allocate resources to address trivial irregularities.
To avoid obsession to details, the JFSA will i) gather data, conduct interviews,
identify changes in the firm’s business environment, and analyze the firm’s
overall condition, ii) identify priority issues to be examined, and iii) depending on
the nature of issues, choose between on-site inspection and off-site monitoring
and between firm-specific reviews and horizontal (i.e., theme-specific andindustry-wide) reviews.
Under the previous method of periodic on-site inspection, examiners were
expected to identify at least some problems which can be included in the Noticeof Inspection Results, the report to be handed to the inspected firm at theconclusion of the inspection. It was also assumed that only problems on which
both examiners and the firms reached common views through a process using
the Confirmation Table can be included in the Notice of Inspection Results.
Concerns were raised that this method could give examiners skewed incentives
to focus on issues which appear relatively easy to reach consensus. In response,at present, examiners have options to use means other than Notice of Inspection
Results to give feedback to the inspected firms. Examiners may choose toconfirm where the two sides disagreed and continue discussion. The JFSA willcontinue to explore how best to monitor firms so that the process will be a
productive and focused on priority issues.
30

(Continuous and seamless monitoring)
Previously, the JFSA deployed periodic on-site inspection and identified theareas for improvement based on the firms’ snap-shot conditions. Depending on
the nature of issues, off-site teams requested firms to submit remedial plans,followed up on the implementation of the plans, and depending on the nature of
problems, issued formal Business Improvement Orders. However, this approachcannot make timely responses to changes in the business environment or newissues that may arise during the interval of periodic inspections. Also, due to theorganizational separation of on-site and off-site teams and resultant silo effect,
there was a risk that information on individual financial institutions obtained
through on-site inspection may not be fully utilized in the off-site follow-up
process.
To address these concerns, the JFSA is shifting towards a seamless monitoring
approach. The new monitoring consists of risk-profiling of individual financial
institutions based on continuous information gathering, flexible use of on-site
inspection and off-site monitoring depending on the nature of the issues inquestion, and seamless monitoring of progress made by firms. Going forward,
the JFSA will further the coordination between its on-site and off-site supervisory
activities.
(Integrated assessment of firms’ processes and conditions)
In the past, a division of labor between on-site and off-site teams was assumed.
On-site inspectors were expected to be responsible to check whether certain
process prescribed in the checklists are in place, while off-site supervisors were
supposed to monitor the actual conditions of the financial institutions. Due to theassumption, even when the inspection teams identified problems in the firms’
actual conditions, the description in Inspection Report focused mainly on
deficiency in the process. On the other hand, off-site teams often lacked timeand resources to deep dive into specific issues in firms’ actual conditions. The
Agency considers that previously assumed division of labor cannot be justified
as the processes and actual conditions are causes and results and are notindependent from each other. It will examine and analyze both of them in theoverall cycle of monitoring activities.
(Accumulation of expert knowledge and skills)
In order to effectively engage with financial institutions, JFSA staff should
maintain in-depth knowledge on individual financial institutions. The JFSA
should also be able to conduct specialized issue-specific analyses such as thoseon business models, financial performance, governance, risk management andasset management.
To that end, the JFSA has already taken measures such as designating an
Examiner in Charge for each of the largest banking groups in Japan, as well as
forming examination teams specialized in individual risk categories. Goingforward, the Agency will work to enhance its staff’s expertise by reforming its
31

supervisory processes, organization and human resource policies. Emphasis will
also be placed on understanding the conditions of customers of financial
institutions, particularly the industry characteristics of borrower companies.
(Wider engagement)
Until recently, most supervisory interactions were made with firms’ specificsections responsible for managing relations with the authorities. However, as thefocus of supervisory activities shift from technical compliance with each item of
the checklists to firm-wide priority issues and firms’ governance and institutional
cultures, the JFSA will need to engage with firms’ outside directors, external
auditors, and top management as well as with customers and other stakeholders
outside the firms.
With respect to the supervision of internationally active financial institutions, the
JFSA will continue to enhance cooperation with its overseas counterparts
through supervisory colleges and other means.

32IV. Enhancing the JFSA’s readiness for new supervisory approaches

The last Chapter of this report describes how the JFSA will transform itself tobetter carry out its new supervisory approaches. The new approaches will rely
more on substantive, forward-looking and holistic analysis and judgment, andthus require the Agency to augment its capability to make sound judgments. The
JFSA will systematically implement reforms to improve its governance, quality
control, communications, organizational structure, human resource development
and information infrastructure.
1. JFSA’s governanceAt the start of each business year, the JFSA publicly announces its priority
issues in its “Strategic Directions and Priorities” report. After the business year,
the Agency publishes a summary of its activities during the year in its “Progress
and Assessment of the Strategic Directions and Priorities” report.
Work-in-progress and newly identified priority issues will be presented in thenext year’s “Strategic Directions and Priorities” report. Through this PDCA cycle,
the JFSA reviews its supervisory processes and reflects the lessons learned in
its next supervisory programs.
The JFSA will use the above mentioned reports to have in depth engagementwith stakeholders outside the Agency, including financial institutions, consumers
and subject-matter experts, and input feedback from stakeholders into the PDCA
cycle to improve its practices.
The Agency’s initiative for better governance includes expanding the role of the
Policy Evaluation Advisory Group, which is composed of independent external
experts and was originally commissioned to conduct annual evaluation of JFSA’s
policies and activities. Referring to good practices of private companies whichhave effective governance mechanisms and whose outside directors play
important roles, the Agency will further commission the Advisory Group to review
the whole areas of the Agency’s responsibilities more frequently and to advise
how the Agency should identify and address new priority issues.
The JFSA will ensure similar mechanisms exist for more specific themes ofsupervision. Suggestions from external experts discussed at theme-specificadvisory groups will also be reflected in the Agency’s supervisory programs.
In order to maintain a high level of supervision comparable to international bestpractices, the JFSA will use insights gained through reviews conducted byinternational organizations (e.g., Financial Sector Assessment Program by theInternational Monetary Fund and peer review by the Financial Stability Board)33

and through dialogue with overseas counterparts in its efforts to improve its
supervisory practices, while taking due consideration of Japan’s own conditionand circumstances.
2. Quality control
In the past, the overarching objective of the Agency’s supervisory activities wasto confirm that financial institutions abide by the minimum standards prescribedin the Agency’s checklists. Under the new supervisory approaches, the role ofsubstantive, forward-looking and holistic analysis and judgment will grow and it
will become more critical for the Agency to develop and maintain control
processes to secure and review the quality of supervisory activities and of
judgments it makes in discharging its responsibilities.
(Internal quality control)
The Agency will institutionalize its internal quality control processes so that
relevant decisions are not left to field officers alone but properly escalated tosenior officials and that the following points are properly reviewed:- Whether the Agency requests financial institutions to take necessary
remedial measures without undue forbearance;- Whether the Agency focuses on priority issues and avoid spending time ontrivial matters;- Whether the Agency poses relevant and material questions; and- Whether the Agency avoids unduly interfering with firms’ business judgment.
The Agency will have a process to incorporate organization-wide perspectives in
deciding the supervisory approaches to be taken and key messages to bedelivered to financial institutions so as not to allow individual supervisor’s
preoccupations to drive the process or an engagement to result in a provision ofa disguised form of administrative guidance without organizational oversight.
The JFSA will also review the quality of reporting requirements it sets. It will
examine if the requirements are sufficient but not excessive in view of the
purpose of the requests and if the costs incurred to financial institutions arecommensurate with the need. It will enhance internal coordination to eliminate
duplication of requests. When making requests, it will provide sufficient
explanation on the background and purpose of the request. After analyzing thereported information, it will feedback the outcome to reporting firms as much as
possible.
(Feedback from stakeholders)
Feedback from regulated firms, their customers and other stakeholders has a
key role in the Agency’s quality control process. The Agency already has aprocess for inspected firms to challenge inspectors’ views and have them
reviewed by a panel (the Inspection Challenge Process). It dispatches its senior
officials to conduct interviews with inspected firms’ senior executives and staff
members during or after on-site inspections and also send questionnaires to34

inspected firms after Notice of Inspection Results are handed to them (theInspection Monitor Process). In addition, any interested parties are invited tosubmit their comments, proposals and criticism on all aspects of the Agency’s
activities and policies either directly to the Agency (the Contact Desk forComments) or to the third-party experts commissioned by the JFSA (the FSA
Monitors), who recommend the Agency remedial actions where necessary.
To minimize the risks that the Agency is swept by misguided ideas and use its
discretional power improperly and to secure that the Agency take timely andadequate actions in line with the new supervisory approaches, in addition to themeasures to strengthen its governance, the JFSA will reinforce its processes so
as to be able to receive unfettered and candid comments, as follows:- The Agency will continuously invite insights from the Advisory Group on
Supervisory Approaches to improve its supervisory approaches.
- The Agency will more actively invite interested parties to use the above
mentioned FSA Monitors process.
- The Agency will commission consultants to have them interview firms and
JFSA staff and review the quality of supervision.
- The Agency will expand the current challenge process for on-site inspections
to include off-site monitoring.
- The Agency will improve its response to enquiries from firms oninterpretation of laws and regulations and on other matters. It will also
improve the process to publish responses which are likely to be useful forother as well.
The Agency will request the Advisory Group on Supervisory Approaches, thepanel of experts which recommended the JFSA to transform its supervisory
approaches, to regularly review the adequacy of the Agency’s responses tocomments and criticisms it receives from outside, and will reflect the Group’s
recommendations in the way the Agency conducts its business.
3. Communications on supervisory policies
To date, the JFSA expressed its supervisory policy through both the Inspection
Manuals and the Supervisory Guidelines. The Supervisory Guidelines provide
how laws and regulations should be applied in particular circumstances and how
the procedures for licensing and regulatory sanctions should be operated. On
the other hand, the Inspections Manuals take the form of a comprehensive
checklist intended to show the JFSA’s inspectors which aspects of the financial
institutions they should look at when conducting on-site inspections.
The Manuals, however, simply show what firms should do and do notnecessarily provide how the checklist is related to the ultimate and basic goals of
regulation. Consequently, the Manuals promoted a tendency to focus onformalistic, backward-looking and item by item checks. To shift towards
substantive, forward-looking and holistic analysis and judgment, the JFSA needs
to make clear the underlying concepts, approaches and principles of supervision35

so that its supervisory activities and decisions will be properly guided by theultimate and basic goals of regulation.
To attain these objectives, the JFSA intends to restructure the set ofcommunications it makes on its supervisory policies. It will repeal the Inspection
Manuals at a timing after the end of accounting year 2018 (after April 1, 2019). It
will enhance its communications on underlying concepts, approaches andprinciples by issuing Discussion Papers on specific areas of supervision. To
enhance transparency, principles will be illustrated by publications of casestudies. Further, to adapt to changes in the regulatory environment and in itspriorities, the JFSA will flexibly use its annual “Strategic Directions and Priorities”
reports, ad-hoc circulars to financial institutions and summaries of JFSA officials’
remarks at meetings with financial institutions, as measures to convey its
messages.
(1)

Inspection Manuals

The Inspection Manuals were intended to show the JFSA’s inspectors whichaspects of the financial institutions they should look at when they conduct onsite
inspection. It was also expected that the Manuals were used as a reference byfinancial institutions when they develop their internal rules and policies.
The Manuals takes the form of a checklist and lists what firms should do without
explicitly indicating why. They do not specify the level of effectiveness of firms’internal control but prescribe which specific internal rules and institutionalarrangements should be in place.
During and after the financial crisis in Japan, the Inspection Manuals played a
key role in bringing firms’ internal control on asset quality reviews, risk
management, compliance and customer protection to a minimum required level.
However, as Manual-based comprehensive inspections are repeated year afteryear, the following concerns have emerged. In recent inspections, therefore, theinspectors no longer refer to the Manuals.
- Checklist tends to make JFSA’s inspectors to split hairs to criticize
non-substantive trivial irregularities while losing sight of more important
issues.
- Firms are induced to focus on letters rather than spirit of the checklist andinternal control and risk management are pursued as a compliance exercise
rather than for their effects and functions.
- Corporate culture which prioritizes satisfying minimum standards and does
not aspire for better practices are fostered.
- Past comments by inspectors are construed as an implicit rule which should
be followed even after the changes in circumstances.
- Elaborate internal rules developed by financial institutions in line with theInspection Manuals were regarded as golden rules that should be abided byat any cost, hindering firms’ initiatives for innovations and sometimes being
used inside firms as an excuse to avoid necessary reforms.
36

(Tables on loan asset review and the role they played)
The tables attached to the Inspection Manuals, which are also formulated as achecklist, specifically deal with classification of loan assets, loan write-offs, andloan loss provisioning (the Tables).
Following the repeal in 1998 of the Ministry of Finance’s directive that governed
the accounting of banks, the accounting standards applicable to non-financial
companies started to be applicable to financial institutions as well. Around thesame time, procedures for loan write-offs went through changes. Previously,banks had to obtain prior approval from the authorities when writing off bad loans,but the change enabled them to write-off loans on their own judgment based on
their self-review of loan assets.
The Tables of the Manuals, which were published originally in 1999, provided,
among others, methodologies to classify loans into four categories, from Type I
to Type IV, based on pro-forma criteria such as presence of payment arrears,
modification of the lending terms and the availability of collateral and guarantee.
This simple method of classification was adopted at the time when a moresophisticated approach would have been difficult in the absence of sufficient
data on the part of financial institutions.
The Tables, coupled with then-conducted “special inspections”, which werecharacterized by a rigorous loan-by-loan review, have played a role inestablishing a consistent, minimum level of practices among the financial
institutions.
(Evolution in global practices)
However, global practices on asset quality reviews have evolved since then. For
example, in the U.S., the Federal Reserve Board issued “Determining an
Adequate Level for the Allowance for Loan and Lease Losses” in 2002 anddefined the regulators’ role as follows (emphases in original):- To evaluate the methodology and process that management employs incompiling an overall estimate of the allowance for loan and lease losses(ALLL);- To understand and evaluate the nature of the external and internal lending
environment and how they might influence management’s estimate of the
ALLL;- To determine the accuracy and reasonableness of management’s estimateof the overall ALLL; and- To evaluate the quality of the bank holding company’s systems andmanagement performance in identifying, monitoring, and resolving
asset-quality problems.
In addition, new accounting standards which require banks to reflect reasonable
and supportable forecasts in the provisioning will start to be applied in 2018 in
the case of the International Financial Reporting Standards and in 2020 for firms
37adopting the U.S. accounting standards. Meanwhile, the Basel Committee on
Banking Supervision is reviewing the relationship between the amount of
expected losses under the capital adequacy standards and the amount of loan
loss write-offs and provisions under the accounting standards.
(Measures taken so far in Japan)
In Japan, measures have been taken to supplement the pro-forma criteria
specified by the Tables of the Inspection Manuals. The Supplement to the
Manuals concerning Loans to Small and Medium-sized Enterprises published in
2002 confirms that borrower companies’ overall conditions, including elements
not specified in the Tables, should be reflected in asset quality reviews andillustrates the principle by example cases. In furtherance of the approaches
taken by the Supplement, the JFSA emphasizes the importance of looking
closely at borrower companies’ growth potential and their business model
sustainability.
Also as a recent initiative of the JFSA, in its “Financial Monitoring Policy for
2014-2015”, the Agency announced that in its supervisory process, “the Agency
in principle relies on asset quality review by the financial institutions in terms ofsmall-sized loan assets, as long as the financial institutions’ system of loan asset
management is considered well established and effective.” The JFSA further
announced that “Except on large-sized loan assets with the potential to impact
the safety and soundness of the financial institutions, the Agency will respect
their judgments provided that they have sound internal control and effective risk
management processes.”(Need for a further reform)
Despite these measures taken, some financial institutions still believe that they
are mandated to follow the pro-forma criteria exactly as provided in the Tables.
Some firms may believe that blind reliance on historical data and the availabilityof collaterals and guarantees would best protect them against inspectors’
criticism while estimation of future losses based on borrowers’ businessprospects may entail the risk of going out of the safe harbor provided by the
Tables. In spite of the accumulation of decades of experience and data under the
self-review regime, progress and improvements in loan classification, write-off
and provisioning practices have been rather limited, and the Tables may havecontributed to this.
The situation should not be left unaddressed, since financial institutions cannot
properly assess its own safety and soundness without appropriate loanclassification, write off and provisioning. In addition, firms with adequate loan
loss reserves and write off can flexibly take actions in a timely manner even intimes of stress, choosing from a broad range of options including assisting
borrowers’ business turnaround or supporting a wind-down of businesses. In
other words, sufficient loan write-off and loan loss provisioning are thepreconditions for the financial system to perform its intermediation function in a
resilient manner.
38

The supervisory approach focusing on the uniform, loan-by-loan quality review
process relying on specified loan characteristics and historical data should bemade more effective and flexible and reformulated to allow better practices. The
new approach needs not assume that the Agency and the firm should agree on
the classifications of each specific individual borrower. Nor should it assume thatthe firm should abide by the letter of each item of the Tables. Rather, the Agency
should focus on the overall level of provisioning and on whether financial
institutions have a well-functioning process fitted to the firms’ business andborrowers’ characteristics and which can properly assess the overall level offuture losses according to the relevant accounting standards.
In addition, though the current approach tend to equate loan quality review withthe prudential supervision, loan by loan classification alone is not enough toprevent the next formation of bad loans or ensure the overall soundness offinancial institutions. It should be a part of substantive, forward-looking andholistic assessment of overall soundness of financial institutions and needs to besupplemented by the monitoring of the financial institutions’ risk concentrationsin their asset portfolio mix and the accumulation of other potential vulnerabilities
in the ever-changing business environment.
More importantly, a bank’s practices on loan classification, write off andprovisioning should form a part of the overall design of its business and should
be consistent with its underwriting and risk management practices. It is not
appropriate if the Tables, by imposing a uniform practices, constrain firms’ efforts
to design business models fitted to its condition and circumstances.
For example, if a bank is to shift from a business model of minimizing the risk ofcreating a non-performing loan to a business model of controlled risk taking toremain profitable while staying sound, they will need a better capability to assess
future losses. Then the bank should look at broader aspects of borrowers’
business than the Tables typically presume. It may also want to look at future
cash flows in wider cases than the Tables require.
Complex methodologies of estimating the loan loss probability and otherparameters will not be necessary for financial institutions with a simple businessmodel or a simple risk profile. Nor changing established business practices
should be done in a hasty manner. Nevertheless, firms who want to do bettershould not be unduly constrained by the Tables.
(Repeal of the Inspection Manuals, including the Tables)
Accordingly, the JFSA intends to repeal the Inspection Manuals, including theTables, at a timing after the end of accounting year 2018 (after April 1, 2019).
Purpose of the repeal is not to deny established business practices of financial
institutions but to support their own initiatives and creativity building on theircurrent business practices. Although the Agency’s intention should be clear, inorder to avoid any potential misunderstandings, puzzles or concerns, the timing39

of the actual repeal is set at a later date, as described above.
In the coming period, the JFSA intends to take the following steps, so that both
the JFSA and financial institutions will be ready for the repeal:- The JFSA will issue Discussion Papers on prudential policy and compliancerisk management, use them as a basis of dialogue, and try to develop acommon understanding on the new supervisory approaches between the
Agency and financial institutions (see IV. 3. (3)).
- The JFSA will organize a study group comprised of financial institutions,external auditors and other experts, issue a Discussion Paper on loanclassification, loan write-offs and loan-loss provisioning, and continuously
advance dialogue with stakeholders.
- In possible cases of the repeal creating uncertainty over the application andinterpretation of relevant laws and regulations, the JFSA will address such
issues by revising the Supervisory Guidelines or through other means.1(2)

Supervisory guidelines

The Supervisory Guidelines provide guidance to JFSA staff how laws andregulations should be applied and how the procedures for licensing and otherregulatory actions should be operated. As such, they contribute to transparency
and predictability in JFSA’s operations, and should continue to stay even after
the repeal of the Inspection Manuals. Sections which overlap with the current
Inspection Manuals, however, should be streamlined, and any clauses withexcessive prescriptiveness should be rectified so as not to hinder financial
institutions’ initiatives for innovation.
(3)

Reports on area/issue specific approaches

The contents of this report, which presents JFSA’s common supervisory
approaches applicable to all regulated financial institutions, are limited tohigh-level principles and would need to be supplemented by reports on
approaches to more specific issues and areas under supervision.
The additional reports, though they may be more detailed than this report,
should not aim to eliminate the need for judgment. Their objective should be tosupport JFSA staff make judgments by providing underlying concepts, principles
and the link between the goals of regulation and specific issues of supervision.
The JFSA will produce them according to the following principles:
1

With respect to the disclosure requirements on non-performing loans under the Banking
Act and the Financial Revitalization Act, the standards of disclosure and the definitions ofloan categories are prescribed by laws and regulations. However, the details concerning theapplication of the standards are specified by the Supervisory Guidelines and Inspection
Manuals respectively. If the repeal of the Inspection Manuals should create uncertainty over
the application and interpretation of rules under the Financial Revitalization Act, the JFSA
will consider amending the Supervisory Guidelines as necessary.

40First, the reports should not aim to provide quick and easy answers to complex
questions and should not be written in a way to let the JFSA resort to thelanguages of the reports to cut short necessary dialogue with financial
institutions. Rather, they should provide viewpoints which would facilitate thedialogue between the JFSA and financial institutions and help them think deeper
and analyze the issue in question by referring back to principles and goals of
regulation.
Second, the JFSA will not aim to create a comprehensive body of reports, andthe reports will not aim to provide an answer to each and every possible question.
Reports dealing with priority areas and issues will be published first, and a reportfocusing on a very narrow issue may be issued before reports covering wider
areas. Topics may include general ones such as prudential policies, compliancerisk management and effective financial intermediation, industry specific ones
such as supervision of insurance companies, and more specific issues such as
the use of stress testing, IT governance, and asset quality reviews.
Third, each report will tailor its contents so that they can be applied in a manner
proportionate to the size and complexity of the financial institutions. It will also
clearly indicate that the JFSA will not request smaller financial institutions toengage in unduly complex dialogue.
Fourth, when the approaches discussed by a theme specific report is not mature
enough, the report will be issued as a Discussion Paper, with clear indicationthat it is issued to facilitate dialogue between the JFSA and stakeholders. A
Discussion Paper may be recast as Principles if the approaches described havebeen well tested and proved.
Reports dealing with priority areas and issues will be published to serve as abasis for the engagement with the financial institutions to promote the pursuit of
their best practices. It is not the Agency’s intention to request the firms to modify
practices or internal rules each time such report is published. Needless to say,the Agency no longer intends to apply the reports formalistically and use them ina box-ticking style exercise.
In addition to theme-specific reports, the JFSA may publish the outcomes of its
horizontal supervisory reviews on specific issues. For example, after monitoringclosely on specific consumer protection issue and accumulating sufficient
observations on the issue, the Agency may publish the outcome of such review,areas for improvements, and supervisory viewpoints.
Further, the JFSA may, in certain areas, publish concrete standards together
with the high-level principle. For example, if a wide range of the financial
institutions are facing the common challenges for improvement, or if there is alimit for an individual institution’s learning by doing, it may be helpful for theauthority to show such concrete standards. Moreover, the Agency will continue
to review and improve the reports and standards even after the publication, so
41

that it can continuously support the financial institutions’ efforts to pursue bestpractices.
(4)

Periodic and occasional communications

In addition to the Supervisory Guidelines and reports on supervisory approaches,
the JFSA will use periodic and occasional communications so that the agency’s
messages are delivered in a timely manner. The Agency’s periodic
communications include annual “Strategic Directions and Priorities” reports(issued since business year 2015), and summaries of JFSA remarks at monthly
meetings with financial institutions (issued since 2017). Its occasional
communications include issue-specific circulars to industry.
(5)

New set of communications: Not canons but means for dialogue

The new set of communications, as described above and shown in the chart
below, does not form a part of the system of laws and ordinances. It will not
attain its objective if it is considered as a body of canons which supervisors andfirms can blindly rely on. It should be used as a means for dialogue which helps
both to think deeper and better and innovate themselves. During the supervisory
processes, the JFSA will take due consideration of the differences in the purposeand objective of both its new and old policy documents and will provide thoroughexplanations to the financial institutions.
Scholastic body of detailed interpretation of words and phrases of the Inspection
Manuals has been accumulated over the last two decades. Both the JFSA andthe industry should refrain from starting anew a similar process with regard to thereports on supervisory approaches, principles or summaries of remarks.

42Current and new set of communications
Body of rules and checklists showing
what to do→

Body of principles and concepts showing
why and how

Inspection Manuals

To be repealed after the end of fiscal year 2018 (after April 2019)

Comprehensive and detailed checklist.

Not to deny firms’ established business practices but to support firms’ initiative to innovate.

Supervisory Guidelines

Supervisory Guidelines

Guidance on the application of laws and regulations to
specific circumstances and on the regulatory procedures.

Any clauses with excessive prescriptiveness should be rectified.

JFSA’s Supervisory Approaches report (This report)
Presents underlying concepts, approaches and principles of supervision without providing
checklist.

Principles
e.g. Principles for Customer-Oriented Business Conduct (2017-)

Theme specific reports→

Presents theme specific approaches. If the approaches is not mature enough, the report will
be issued as a Discussion Paper to facilitate dialogue between the JFSA and stakeholders.
In addition to the theme specific reports, the JFSA may publish the outcomes of its
horizontal supervisory reviews on specific issues.
Themes could include:✓ Prudential policy✓ Compliance risk management✓ Better financial intermediation ✓ IT governance✓ Loan classification, write-offs and loan loss provisioning.
Further, the JFSA may, in certain areas, publish concrete standards together with the highlevel principles.

Annual Inspection Policies and Annual
Supervisory Policies
Issued at the beginning of a business year.

Issue specific circulars to the industry
Issued occasionally to communicate the Agency’s viewson specific issues and to give alert to the industry.

Annual Strategic Directions and Priorities report (2015-)
Issued at the start of a business. The progress during the year is reviewed at the end of thebusiness year in the Progress and Assessment of the Strategic Directions and Priorities
report and reflected in the next year’s “Strategic Directions and Priorities” report.

Issue specific circulars to the Industry
Summaries of JFSA remarks at monthly meetings with financial
institutions (2017-)

4. Internal organization, human resource development and information
infrastructure(1)

JFSA’s internal organization

The new supervisory approaches require continuous review and identification ofpriorities in the light of the changing domestic and global conditions. The JFSA
should enhance its strategic planning and coordination function covering its
whole areas of responsibilities.
As the supervisory program shifts from checklist-based, uniform andcomprehensive review to monitoring focused on priority supervisory issues, theneed for supervisors to possess insights on domestic and global market
developments, expertise on risk management, business analysis skills, andother specialized knowledge will become even greater. Horizontal review acrossthe whole financial system or the whole industry will also be needed. The JFSA
will therefore strengthen its specialized teams of supervisors.
Insights on individual institutions and continuous engagement with them areindispensable if the JFSA is to effectively support the pursuit of best practices or
to ensure sustainable safety and soundness. Until recently, however, on-site andoff-site supervisory activities have been conducted independently, with on-siteteams working at the Inspection Bureau and off-site teams at the Supervisory
43

Bureau of the JFSA, limiting the accumulation of shared knowledge. These
operations need to be integrated.
To meet the challenges of FinTech and other technological development, and toattain more vibrant capital markets, the Agency needs to enhance its capability
to design and propose a more robust legal framework.
In addition to the above, the Agency will enhance coordination between theheadquarters and the Local Financial Bureaus so that staff at the latter will also
fully embody the new supervisory approaches.
(2)

Human resource development

In 2012, the JFSA staff members set out three goals: for them all to work towards
the national interest; for each staff member to develop his/her unique strength tocontribute to the national interest; and for the Agency to become a workplace
which helps staff members’ development.
The new supervisory approaches require JFSA staff not to limit themselves inmechanical application of the rules but to make a sound judgment in light of theultimate and basic goals of regulation. This means that the three goals above
are all the more important.
Also, to advance the new supervisory approaches, the JFSA needs diverse
viewpoints, expert knowledge and skills, and the ability to transform itself flexibly,
and thus should have appropriate diversity in its staff. Managers should enhancetheir skills to set forth goals and achieve them, rather than just to manage theprocess to repeat the previous year’s routines. Its top management should
demonstrate change leadership, creating a vision for the Agency and driving the
Agency to make the vision a reality.
The JFSA wants to be a place where each individual staff member will find theirown unique and diverse ways to grow and will be empowered to exercise theirindividual strength and skill sets to contribute to the goals of regulation.
The Agency therefore will:- Appraise its staff based on merits (e.g., professional skills and capabilities)
and achievements (e.g., initiatives taken to advance national interests),- Clarify the job description of each position at the Agency, specifying tasks to
be achieved and skills and experience required;- Assign the right person in the right place based on the job description rather
than on seniority, and actively recruit experts from outside;- Develop longer-term staff rotation to improve skills and knowledge in
specialized fields;- Have its human resource division engage with members of the staff on theirindividual professional career developments;- Provide professional training opportunities outside the JFSA, and enhance
44

-

(3)

internal training opportunities, for example, by adding case-study styleprograms designed to foster one’s ability to make judgments in a situation
where clear-cut answers cannot be found;Support research by staff and the publication of the results;
Continuously eliminate sources of inefficiencies and rationalize its businessprocesses; andCreate an environment which accommodates diverse working styles and isconductive to creative thinking and interactions which would foster
innovations.
Information infrastructure

Better supervision needs to be backed by better data and analysis and use
thereof. Enhancing information infrastructure is an important strategic goal of the
Agency. The Agency will identify priority needs for analysis under the newsupervisory approaches and build necessary information infrastructure. In
developing the IT infrastructure, the JFSA will establish a governancemechanism which facilitates the intra-agency coordination among those whogather, cleanse, analyze, and use data and design and run IT systems.
Low priority reporting requirements should be reviewed and streamlined, withdue considerations to the possibility that ad hoc requests or frequent changes inrequirements increase reporting burdens and limit the use of data for time-series
analyses.
The Agency will study how it can deploy information technologies to attainefficient, real-time and in-depth monitoring, with developments in RegTech on
the part of reporting financial institutions in mind.
(4)

Cooperation with the Bank of JapanThe JFSA has a strong cooperative relationship with the Bank of Japan (BOJ) ina number of areas at various levels, including through periodic meetings chairedby a BOJ Deputy Governor and the JFSA Commissioner. The knowledge andexperience gained by the BOJ through discussions among central banks aroundthe world, its analysis of financial markets and economies, on-site examinationof financial institutions, and the production of the Financial System Reports arevaluable inputs to the JFSA’s supervisory activities. Similarly, the JFSA will shareuseful findings gained through its supervisory activities with the BOJ.
The JFSA and the BOJ have a framework for joint analysis on the need toactivate the countercyclical-buffer requirements under the capital adequacy
regulation for banks. The JFSA and the BOJ will also explore other possibilities
for cooperation, including that related to information infrastructure.
(5)

Domestic policy formation and the global regulatory reforms
45

Japan’s regulatory policy cannot be independent from international regulatory
standards. However, in the past, the international section of the JFSA tended tonegotiate in international fora to minimize the burden of adopting international
standards, while the domestic sections independently addressed domestic
issues. The international and domestic sections of the JFSA tended to discharge
their responsibilities within a narrowly defined scope.
There are many commonalities between the problems that global regulatory
reforms intend to address and the challenges that Japanese regulators face.
The JFSA’s domestic and international sections will work together so that Japan
contributes to the global regulatory community with constructive suggestions
based on the experience in Japan and uses the accumulated wealth ofinternational discussions to resolve its own domestic issues.

46

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