Policy exhaustion over the summer

After the surge of activity required to ensure passage of the amendments to the Financial Instruments and Exchange Act ("FIEL") in early June (see our July newsletter) it was inevitable that there would be an even more subdued summer lull than normal in regulatory matters. Whilst the bureaucratic impetus for new policy has been exhausted by the passage of FIEL and its amendments, high level political turmoil has undermined ministerial leadership. The capable Mr Yoshimi Watanabe was replaced as Minister for Financial Affairs with effect from 1 August as a result of Prime Minster Fukuda's first (and, now it seems, last) cabinet reshuffle. His replacement, Mr Toshimitsu Moteki, active in foreign affairs and a former employee of Marubeni, Yomiuri Newspapers and McKinsey, appears an interesting choice, although his position is already uncertain as a result of Mr Fukuda's recent decision to resign. In this environment it seems reasonable to expect that there will be relatively little new legislation in the field of financial sector regulation. Bureaucratic attention will move to implementation: indeed the shift was already apparent in Financial Services Agency ("FSA") Commissioner Sato's speech to the IBA on 26 June 20081. This newsletter, therefore, also turns away from policy issues and focuses on implementation strategy at the FSA and Securities and Exchange Surveillance Commission ("SESC").

SESC plans fewer, but better, inspections in period July 2008 to June 2009

The SESC issued its Basic Inspection Guidelines and Plan for 2008-9 on 25 July 20082. Citing the the "dynamic" state of the world financial system and the need for "better regulation", the SESC aims to deliver more efficient and productive inspections that reflect the requirements of market participants and make better use of the efforts that regulated companies already make themselves. There will also be a greater focus on general principles (as opposed to fine rules) and specific risk. This assertion of "quality over quantity" is expected to result in fewer inspections for mainline FIEL Category 13 financial instruments businesses in the coming year with inspections declining from an actual 171 companies last year to a projected 130 this year4. Inspections of fund management companies and fund advisors or intermediaries are, by contrast, expected to rise from an actual level last year of 57 to 70 this year. Category 2 intermediaries and self-regulatory organizations will only be inspected as necessary. The rebalancing of the SESC's inspection effort suggests a declining interest in the external enforcement of detailed trading rules (which can in part be entrusted to Category 1 businesses themselves) and a growing interest in consumer protection for those dealing with fund managers. This pattern fits recent announcements made by regulators.

FSA also expects to conduct fewer inspections for Program year 2008

The FSA issued its Basic Policy and Plan for Financial Inspections in Program Year5 (PY) 2008 on 19 August 20086. Overall, in line with the policy of better regulation and targeted inspection, the FSA expects to oversee fewer inspections of other financial institutions, such as non-banks. However, inspections of major deposit-taking financial institutions and insurers will be maintained at current levels, on the assumption that "important risks" (to use the FSA's words) are concentrated in these sectors. Simplified inspections of small financial institutions with a limited range of operations (such as small branches of foreign banks or domestic credit associations operating exclusively among particular occupations or business sectors) are also to be introduced to facilitate better regulation.

To see FSA Basic Policy and Plan for Financial Inspections in Program Year 2008 view original document.

As at August 2008, four major inspection priorities were noted by the FSA: 

  1. establishment of appropriate risk management systems corresponding to the risks inherent in various types of loans and financial products; 
  1. improvement of control system (i.e. oversight) at internationally active (primarily Japanese) banks; 
  1. promotion of customer protection and improvement of user convenience (i.e. explanation of risk to customers, timely response to complaints, security of transactions, avoidance of system failures); and, 
  1. smooth financing of small and medium-sized enterprises and regional industries.

These, unsurprisingly, are broadly based on the (14) Principles in the Financial Services Industry that were published on 18 April 20087.

Quality remains elusive, but FSA and SESC do want to improve

More interesting is the additional evidence that the senior managers of the FSA still feel very frustrated by continuing poor quality inspection. The foreword to the Basic Policy notes:

"In the current program year, it is the most important issue for the FSA to further disseminate and ingrain the concept of "better regulation" with the Inspection Bureau (part of the FSA!) and the Ministry of Finance's Local Finance Bureaus."

A section entitled "Enhancement of Effectiveness of Inspections" highlights the need for improved cooperation between all domestic financial regulators (and implicitly, less territorial thinking, even with the FSA). The FSA plans to promote joint training and cross inspections (e.g. participation of inspectors from Local Finance Bureaus in inspections conducted by the FSA) and "proactively (to) employ outside professionals (experts in computer systems, market risks, etc.) as part of efforts to enhance its inspection capacity."

The battle to deliver a higher quality, principles-based system of financial sector regulation in Japanese financial markets, therefore, continues to rage between the various bureaus of the FSA, the SESC and the Local Finance Bureaus.

The good news for those outside these struggles is that the SESC in particular is more willing than ever to listen to the entities they it regulates and has been proactive in arranging meetings in recent months with companies, lawyers (both Japanese and foreign) to obtain feedback on the inspection process and regulations generally. We encourage all of our clients to engage actively in this process. It is a real opportunity to improve the regulatory landscape in Japan.