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Prudential regulation

i Relationship with the prudential regulator

Most banks have a close relationship with the regulators. We understand that the officials of the supervisory division of the FSA and local finance bureaus are each assigned to monitor specific banks.

The regulators tend to focus their attention principally on appropriate management of banking businesses, maintenance of sufficient financial conditions, including satisfaction of capital adequacy requirements and protection of customers, and the maintenance of robust internal control systems to ensure that a bank is always in compliance with the applicable laws. It is fairly common that a bank will consult regulators in advance on occasions when it expects to receive particular attention from the regulators: for instance, if it launches a new business that is not covered clearly by existing legislation, or an issue has arisen that may affect the bank's financial condition.

ii Management of banks

Under the Banking Act, a local entity bank must have a board of directors and accounting auditors, as well as a board of corporate auditors or a subcommittee of the board of directors (comprising either an audit and supervisory committee or an audit committee, remuneration committee and appointment committee), pursuant to the Companies Act. Directors and executive officers engaging in the ordinary business of a local entity bank must have the knowledge and experience to be able to manage and control the bank appropriately, fairly and efficiently, and must have sufficient social credibility (the Banking Act requires a bank to appoint directors who are trusted within society; however, what precisely is meant by this criterion is ambiguous). For local entity banks that have a board of corporate auditors, the representative director shall:

  1. take command of the establishment and maintenance of the internal compliance framework;
  2. make risk management a primary concern;
  3. establish a sufficient internal control framework to properly disclose the bank's corporate information to the public; and
  4. ensure that appropriate internal audits are performed.

The board of directors must:

  1. proactively oversee the representative directors;
  2. establish and review business management plans in line with the bank's business objectives;
  3. establish a clear risk management policy by taking these objectives into consideration; and
  4. ensure appropriate performance and review of internal audits.

For foreign bank branches, although there is no required specific corporate governance structure such as that for local entity banks, a branch manager must also have the knowledge and experience to manage and control the branch appropriately, fairly and efficiently, and must also have sufficient social credibility (as referred to above). In addition, officers with sufficient knowledge and experience must be appointed to manage the branch, and the proper authority to do so must be delegated to those officers by the overseas head office. Of course, the head office is likely to want to oversee the management of the branch, and it is permissible for it to offer supervision and guidance. Therefore, it may be advisable to introduce appropriate systems for oversight and approvals; for example, that any problematic issues occurring within the branch should immediately be reported to the head office as well as to the regulatory authority.

In addition, however, it must be borne in mind that oversight by the overseas branch or holding company must not undermine the governance framework, and the management responsibility for such, which must be established within the local entity bank or foreign bank branch to manage its business properly as a licensed financial institution. Administrative action (in the form of an order to suspend part of the business or to improve part of the business) taken against a local entity bank subsidiary of a US-based bank group illustrates the FSA's position on how each financial institution within the same group should be managed. An FSA press release dated 27 January 2006 regarding its action states that the US parent appointed a person who had no directorship of the local entity bank but was given the title of 'Representative in Japan', and gave that person the primary management and control of the businesses of the local entity bank. This thereby undermined the authority and responsibility of each director of the local entity bank (despite the fact that such authority and responsibility is required under Japanese corporation law and the Banking Act). The FSA ordered the creation and development of independent governance and internal control systems, and the establishment of a clear system of responsibility within the local entity bank, predicated upon a fundamental re-evaluation of the current state of managerial involvement and monitoring of the bank by the US parent.

There is no express provision under the Banking Act that directly restricts the amount, form and manner of remuneration paid to the management or employees of banks or their affiliates. However, the regulators have been placing greater emphasis on ensuring appropriate remuneration in light of the need to avoid excessive risk-taking and to conform with the consensus of the Financial Stability Board. More specifically, as part of general prudential regulations, banks are expected to:

  1. have an independent committee or other type of organisation to sufficiently monitor the remuneration of management and employees;
  2. ensure financial sufficiency, appropriate risk control, consistency between incentive bonuses and actual performance (i.e., the level of incentive bonuses should substantially decrease in the event of poor financial performance), and the contribution to long-term profits in determining remuneration structures; and
  3. disclose important matters regarding remuneration.
iii Regulatory capital and liquidity

The framework for regulating local entity banks' capital adequacy under the Banking Act has been amended in line with the implementation of Basel II. By March 2008, the regulatory framework of Basel II was fully introduced into Japanese banking laws through amendments of the FSA administrative notice, including, inter alia, the internal ratings-based approach and the advanced measurement approach. Basel III is also being introduced into Japanese banking laws.

The status of the capital adequacy of banks, including the risk-adjusted capital ratio, must be reported and disclosed on a semi-annual basis. If a bank's capital ratio falls short of the minimum requirement, the FSA may require the bank to prepare and implement a capital reform plan. In extreme cases, it may reduce the bank's assets, restrict the increase of its assets, prohibit the acceptance of deposits or take any other measures it deems necessary.

Effective from April 2014, foreign bank branches, in principle, are required to maintain assets in Japan (in the form designated by a cabinet order) equal to or more than ¥2 billion at all times, which is equal to the required minimum capital amount of the local entity banks.

On occasion, a large transaction with any one bank may be restricted as a result of the large lending limit regulation. Pursuant to this regulation, aggregate exposure of a local entity bank to a single person (including that person's group companies) by means of extending loans or purchasing debt instruments or equity investments shall not exceed, in principle, 25 per cent of the amount of non-consolidated regulatory capital (with certain adjustments) of the local entity bank.

The Banking Act does not contain an express provision that directly regulates banks' liquidity or any quantitative standards of liquidity, but the FSA Supervisory Guidelines provide some guidance on this point from a regulatory monitoring perspective. These guidelines require a bank, inter alia, to:

  1. establish an internal framework to appropriately control liquidity risk (e.g., by separating the treasury division from the liquidity risk control division);
  2. maintain control methods as well as internal reporting procedures regarding the bank's liquidity that are subject to the approval of the board of directors; and
  3. monitor the status of its liquidity and be prepared for emergency circumstances.

The Inspection Manual for Deposit-taking Institutions, prepared by the FSA for use by its inspectors, also includes detailed checklists for self-regulation by banks as part of the framework for managing liquidity risk. These requirements apply to both local entity banks and foreign bank branches. For the latter, however, it is understood that there will be broad variations as to what constitutes acceptable levels of, and procedures for, liquidity risk management, given that the business of foreign bank branches varies greatly. After April 2019, the FSA will repeal the Inspection Manual. In June 2018, the FSA announced the creation of a Supervisory Approaches Report that would provide underlying concepts, approaches and principles of supervision, without providing checklists.

iv Recovery and resolution

The Deposit Insurance Act provides certain measures in cases where serious problems arise in maintaining the stability of the financial systems in Japan or in regions where a bank operates its business. These measures, which include capital injection, full deposit protection and temporary nationalisation, may be initiated subject to deliberation by the Financial System Management Council.

Capital injection is designed to allow a bank with positive net worth to increase the amount of its capital by way of having its shares subscribed to by the Deposit Insurance Corporation of Japan. Full deposit protection is designed for banks with negative net worth, or that suspend or may suspend the repayment of deposits. Temporary nationalisation is intended for banks with negative net worth that suspend or may suspend the repayment of deposits.

In addition, since March 2014, other measures have been provided by the Deposit Insurance Act in the event of significant turmoil in financial systems, including the following:

  1. special oversight;
  2. capital injection;
  3. providing liquidity and debt guarantees for banks with positive net worth; and
  4. special oversight and financial assistance for banks with negative net worth, or that suspend or may suspend the repayment of deposits.

These measures may also be initiated subject to a deliberation by the Financial System Management Council.

The provisions for bail-in, which were also implemented in March 2014, stipulate that, in the cases mentioned above, the Prime Minister will decide the treatment of certain types of subordinated bonds, or subordinated loans and preferred shares issued by banks with negative net worth, or that suspend or may suspend the repayment of deposits.