FSA Newsletter October 2006

The Financial Services Agency (FSA) released to the public the ''Annual Policies for the Supervision of Securities Companies, etc. for Administrative Year 2006'' on August 30, 2006. The Supervisory Policies indicate the key areas to be examined during annual supervision separately from the Supervisory Guidelines, for the purpose of improving administrative transparency and the predictability of audited securities companies. This is the second set of the Supervisory Policies, following the first set formulated and published last year (Administrative Year 2005).

Basic Approach

Understanding of Current Status of Securities Businesses, etc.
While various measures have been taken to invigorate the securities market since the reform of the financial system, the previous administrative year-which was marked by the settlement of the non-performing loans (NPL) problem at major banks and balanced economic recovery-may be regarded as the beginning of a full-fledged transition phase in which the shift ''from savings to investments'' accelerates.
However, the previous year was also marred by various problems in the Japanese securities market, such as a huge erroneous buy order for stocks, a system failure at a securities company and unfair trading by investors.

Basic Approach
Based on such an understanding of the current status of securities businesses, etc., we will expand our scope from securities companies to ''securities companies, etc.'', a category which will also include investment trust management companies, investment corporations, investment advisory businesses and financial futures dealers, in order to promote voluntary efforts that cut across industries and strictly enforce customer protection before the full-fledged enforcement of the Financial Instruments and Exchange Law in the next administrative year. We will take strict and proper action with respect to these businesses focusing on the following three priorities:
(1) Customer protection;
(2) Establishment of appropriate business operation systems; and
(3) Proper demonstration of market intermediation functions, etc. of securities companies.

. Priorities

1. Customer Protection
(1) Establishment of Solicitation and Explanation Systems
Securities companies, etc. need to establish appropriate solicitation and explanation systems considering the characteristics of securities transactions in recent years, as exemplified by the rapid increase in individual investors, the increasing complexity and diversification of financial instruments, and the diversification of sales channels. For this purpose, the FSA will examine the systems of securities companies, etc. for compliance with laws and regulations related to solicitation and explanation as well as their frameworks for screening advertisements, and take strict supervisory action in the event that any problems arise.

(2) Proper Response to Inquiries and Complaints
As operations of securities companies, etc. are unsustainable without customers' support and trust, it is their vital and inevasible responsibility to deal sincerely with inquiries and complaints from customers. From this perspective, we will examine their framework for dealing with inquiries and complaints.

(3) Establishment of Customer Information Management System
As it is important to build a system to properly manage customer information including both personal information and corporate information, we will take strict supervisory action in the event that any problems arise in relation to customer information management systems of securities companies, etc.

(4) Strict Enforcement of Segregated Custody
It is indispensable that securities companies, etc. hold customers' assets separately from their own assets in order for customers to perform securities transactions with a sense of security. In the event that any problems arise in the framework of segregated custody at securities companies, etc., we will promptly request that the situation be rectified.

(5) Protecting Customers from Asset Management Businesses, etc.
We will continue to conduct strict checks as to whether there are any breaches of duty in regards to loyalty or managerial competence on the part of investment trust management companies, investment corporations' asset management businesses and investment advisory businesses with respect to customers, and check the appropriateness of their advertisements, etc.

(6) Protecting Customers from Financial Futures Dealers
We will take strict supervisory action in the event that foreign exchange margin trading businesses are found to have problems in observing the codes of practice concerning the prohibition of unsolicited calls, advertising regulations, etc.

2. Establishment of Appropriate Business Operation Systems
(1) Governance Systems of Securities Companies, etc.
It is important that governance is properly exercised in order for the market to make sound progress based on the strict enforcement of compliance and risk management among securities companies, etc.
From such a perspective, we will examine the representative director's awareness of and efforts towards compliance and risk management, and whether the management checking functions of the board of directors, etc. and internal audit functions are being properly demonstrated, especially in consideration of the recent problems regarding the inappropriate business operations by the executive committee of investment corporations and other such incidents.

(2) Development of Sophisticated and Robust Compliance and Risk Management Systems
It is important that the compliance department and the risk management department play their respective roles in an appropriate manner, in addition to improving the management team's awareness of and proactive involvement in compliance. With this in mind, we will examine the management team's awareness of compliance, the appropriateness of compliance and risk management systems, the functions of the internal audit department, etc. when an application for registration is filed by securities companies, etc. and on other such occasions.

(3) Dealing with Governance of Financial Conglomerates
In consideration of the problems that came to light in the previous year and other such incidents, we will examine the management system of financial conglomerates and the concurrent postal system between securities companies, etc. and other financial institutions.

(4) Ensuring Financial Soundness
We will monitor the regulatory capital ratio, examine the risk management system of security company groups that are expanding principal investment businesses, and examine the capital adequacy, etc. of financial conglomerates on a group-wide scale.

(5) Prevention of Conflict of Interest, etc. at Registered Financial Institutions and Securities Brokers
We will examine registered financial institutions as to what they are doing to prevent conflict of interest arising between their securities operations and other operations such as banking operations and to prevent their dominant positions from being abused, etc. We will also examine securities brokers as to whether they are properly identifying the solicitation systems, etc. of affiliated securities companies, etc.

3. Proper Demonstration of Market Intermediation Functions, etc.
(1) Improvement of Reliability of Operations
We will make the following efforts in addition to following up on the ''Summary of Issues by the Round Table Conference on the Financial Market Intermediation Function of Securities Companies'' (hereinafter referred to as ''Summary of Issues''):

1) Prevention of Recurrence of Erroneous Buy/Sell Orders
In consideration of the industry-wide inspections conducted by the FSA and the establishment of self-imposed regulations by the Japan Securities Dealers' Association (JSDA), we will examine measures, etc. to prevent erroneous buy/sell orders by securities companies and prompt them to make proper improvements if there are any problems. We will also endeavor to identify how position limits and risk limits should be set by each security company by conducting interviews, etc.

2) Collateral Margin in Margin Transactions
In consideration of the self-imposed regulations established by the JSDA in response to an incident in which the margin for collateral securities was set at zero with no advance notice, etc. provided, we will keep a close eye on securities companies' responses.

3) Suitable Long-Term Computer System Management Systems
In consideration of the increase in securities transactions involving the use of computer systems in recent years as well as the state of system failures occurring in securities companies lately, we will intensively examine the computer system management operations of securities companies and take strict action if there are any problems, including taking administrative action.
We will also examine systems built for identifying the progress made in providing new services, etc. and examining Business Continuity Plans (BCPs) of securities companies.

(2) Demonstration of Checking Functions Targeted at Issuers
In consideration of the problems that have occurred in the issue market in recent years and the fact that underwriting services will now be subject to a registration system under the Financial Instruments and Exchange Law, we will endeavor to identity the actual state of underwriting and other such operations of securities companies, in addition to following up on the ''Summary of Issues''. In doing so, we will prompt them on appropriate improvements if any problems or structural inadequacies are found.

(3) Demonstration of Checking Functions Targeted at Investors
In consideration of the recent incidents involving market manipulation, insider trading, etc. resulting in punitive action, we will examine the effectiveness, etc. of trading management and screening systems of securities companies, in addition to following up on the ''Summary of Issues'', and take strict supervisory action if any problems are found.
In regards to preliminary hearings, we will examine the system development status of securities companies in consideration of the revision of cabinet orders, etc.

(4) Maintenance of Market Player Self-Discipline
As the environment is changing as exemplified by the expansion of the scope of activities of securities companies, attention needs to be given to conflict of interest between functions as a market intermediary and functions as a market player in an increasing number of cases. It is therefore important to build an appropriate internal control system.
Accordingly, we will examine the development of ''Chinese Walls'' in securities companies and the extent to which they comply with various laws and regulations, in addition to following up on the ''Summary of Issues'', and we will take strict supervisory action if any problems are found.
Furthermore, we will examine the extent to which securities companies to have endeavored demonstrate self-discipline, beyond the scope of compliance.

I. Supervisory Methods

1. Ensuring Proper Collaboration with Inspection and Surveillance Departments
We will collaborate with the Supervisory Bureau, the Executive Bureau of the Securities and Exchange Surveillance Commission (SESC), etc., such as exchanging useful information and sharing awareness of problems in accordance with the proper division of roles.

2. Ensuring Collaboration with Self-regulatory Organizations
We will properly collaborate with self-regulatory organizations in each industry, including following up on the ''Summary of Issues''. In particular, we will encourage self-regulatory organizations to enhance and demonstrate their functions, including conducting audits and taking punitive action.

3. Relationship with Securities Companies, etc.
Supervisory authorities will give due consideration to respecting the voluntary efforts made by securities companies, etc. relating to their business operations, etc. and endeavor to ensure sufficient communication with securities companies, etc.

4. Enhancement of Collaboration with Overseas Supervisory Authorities, etc.
In consideration of the increasing number of financial conglomerates and the growth in cross-border securities transactions, we will strive to further enhance collaboration with overseas supervisory authorities, etc. through the exchange of information and opinions.

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Annual Policies for the Supervision of Major Banks

The Financial Services Agency (FSA) drew up its ''Annual Policies for the Supervision of Major Banks for Administrative Year 2006'' (hereinafter referred to as ''Supervisory Policies'') based on the Comprehensive Guideline for the Supervision of Major Banks, etc. established in October 2005 (hereinafter referred to as ''Supervisory Guideline'') and released them to the public on August 9, 2006. The outline of the Supervisory Policies is as follows.
(Note) Administrative Year 2006: From July 1, 2006 to June 30, 2007

1. Background, etc.
The FSA decided to draw up ''Annual Policies for the Supervision of Major Banks'' and release them to the public in response to the Supervisory Guideline, which set forth that ''at the beginning of each administrative year, the FSA will draw up supervisory policies for the administrative year and release them to the public in order to clarify the supervisory priorities''.
Upon supervising major banks, etc. in Administrative Year 2006, we will conduct offsite monitoring comprising various interviews including ''comprehensive interviews'' and ''risk management interviews'' in accordance with the Supervisory Policies.

2. Composition
The Supervisory Policies start with the presentation of the ''Basic Approach'' to fulfilling the basic objectives of financial administration, and then set forth three supervisory priorities for Administrative Year 2006, namely, ''strict enforcement of customer protection rules and improvement of convenience'', ''sophistication of risk management, etc.'', and ''responses to financial globalization, etc.''

3. Basic Approach
The ''Basic Approach'' section briefly explains the events leading up to the development of the Supervisory Policies and then describes our understanding of the current state of major banks, etc. and our basic approach to the three priorities mentioned above.

	(1	) Circumstances Surrounding Major Banks, etc. and Their Expected Roles
	This section first describes the following changes in the circumstances surrounding major banks, etc.
		1) Introduction of the bank agency system under the revised Banking Law (April 2006) and the improvement and enhancement of provisions for customer protection pursuant to the revised Banking Law and the Financial Instruments and Exchange Law established during the ordinary Diet session this year 2) Enhancement of measures to prevent financial crime such as the enforcement of the so-called ''Counterfeited and Stolen Credit Cards and Depositor Protection Law'' (February 2006) and the convocation of the Study Group on Information Security (March through June 2006) 3) Recent termination of the zero-interest-rate policy by the Bank of Japan 4) Implementation of Basel II (new capital adequacy requirements) for the year ending on March 31, 2007
	In addition, it addresses the fact that under such circumstances, financial institutions are in general required to provide a wide range of high-quality financial products and services that meet customers' needs by taking advantage of their respective strengths. In particular, it states that major banks, etc. are expected to contribute to Japan's economic progress and help improve people's lives by providing services of the highest level in the world and play a crucial role in the global financial market, as they have a huge influence on the Japanese economy due to their large size, and engage in financial activities on an international scale in many cases. (2) Basic Approach to Priorities Please refer to each item in ''4. Priorities'' below.

Priorities
In consideration of the circumstances surrounding major banks, etc. and the expectations placed on them referred to in (1) above, we will continue to make efforts to enhance collaboration with inspection divisions upon supervising major banks, etc. in Administrative Year 2006, in addition to executing supervisory administration in a strict, effective and efficient manner by giving priority to the following three areas:

(1) Enforcement of Customer Protection Rules and Improvement of Convenience
Major banks, etc. are implementing a wide range of efforts, including diversifying the financial instruments they deal in and expanding their fee-charging businesses. We will carry out supervision intensively so as to make sure that customer protection and convenience are not disregarded in such efforts. Specifically, we will conduct supervision by focusing on the following matters, while actively utilizing information from the Counseling Office for Financial Services Users, etc. in addition to reports from financial institutions and inspection results.

1) Improvement and enhancement of explanation systems and consultation and complaints handling functions
2) Enhancement and strict enforcement of measures to prevent financial crime, etc.
3) Ensuring the appropriateness of computer system risk management systems
4) Strict enforcement of compliance with relevant laws and regulations such as the Anti-Monopoly Law in business operations
5) Development of screening and loan management systems according to borrowers' needs
6) Ensuring appropriate business operations by bank agents
7) Ensuring the appropriateness of portfolio/sales-related operations for structured bonds, etc.

(2) Sophistication of Risk Management, etc.
In order for financial institutions to ensure financial soundness based on their own voluntary and sustainable efforts, it is important that they perform risk management in an appropriate manner. Therefore, we will conduct supervision by focusing on the following matters, as to whether efforts are being made towards the implementation of Basel II and whether efforts are being made to advance risk management to adapt to the diversification of risks associated with the expansion of operations of major banks, etc. Specifically, we will conduct supervision with respect to:

1) Dealing with Basel II
2) Dealing with the diversification of risks through such means as diversification of invested assets
3) Improving the quality of capital

(3) Response to Financial Globalization, etc.
In response to the globalization of the financial sector and other such changes, major banks, etc. are becoming increasingly conglomeratized and are expanding their overseas operations. Considering that such efforts are leading to increased revenue but are at the risk of giving rise to poor operational control, we will conduct supervision by focusing on the following matters, including whether an appropriate operational control framework is developed:

1) Supervision of financial conglomerates
2) Operational control concerning overseas operations

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Annual Policies for the Supervision of Small- and Medium-Sized and Regional Financial Institutions

Since Administrative Year 2004, the Financial Services Agency (FSA) has been drawing up supervisory policies and releasing them to the public at the beginning of each administrative year, in order to clarify its supervisory priorities upon conducting the supervision of small-and medium-sized and regional financial institutions (RFIs) in the administrative year.
For this administrative year, the FSA released ''Annual Policies for the Supervision of Small-and Medium-sized and Regional Financial Institutions for Administrative Year 2006'' (hereinafter referred to as ''Supervisory Policies 2006'') on August 9. The Supervisory Policies 2006 introduce the FSA's basic standpoint in conducting supervision and its supervisory priorities, as outlined below.

(Note) Administrative Year 2006: From July 1, 2006 to June 30, 2007

1. Basic Standpoint
The Supervisory Policies 2006 starts with the presentation of the ''Basic Standpoint'', in which the circumstances surrounding RFIs are explained, especially in regards to recent changes in the environment. The basic approach to conducting efficient and effective supervision is also explained.

(1) Current Circumstances Surrounding RFIs
Specific changes in the environment stated explicitly in this section are as follows.

1) Firstly, efforts in region-based relationship banking have been made by RFIs. Since the formulation of the Action Program in April 2003, RFIs have been making efforts to promote region-based relationship banking, which are generally making steady progress. However, their customers rated efforts to ''facilitate business revitalization and small and medium-sized enterprise (SME) financing'' such as the provision of loans without excessively relying on collateral and guarantees as well as business revitalization and efforts to ''enhance convenience for regional customers'' as inefficient. It is thus necessary to continue efforts to promote region-based relationship banking with consideration to the aforementioned area.
2) Secondly, there is a growing need to improve customer protection in financial transactions and to enhance measures to prevent financial crime, as exemplified by the enactment of the Financial Instruments and Exchange Law and the introduction of the law that protects depositors having their credit cards counterfeited or stolen.
3) Thirdly, there are new interest-rate and market environments stemming from the termination of the zero-interest-rate policy by the Bank of Japan. Also, the New Basel Capital Accord (Basel II) will be implemented in March, 2007.

(2) Basic Approach to Supervision Process
Based on aforementioned charges of the current circumstances surrounding RFIs, the FSA will carry out supervisory administration in an effective and efficient manner in Administrative Year 2006, so as to ensure the following:

1) Respect for voluntary efforts made by financial institutions in their business operation
2) Ensuring sufficient communication with financial institutions
3) Continued coordination with inspection divisions
4) Further enhancement of coordination between regional financial bureaus and the FSA

2. Priorities
In consideration of the changes in the environment referred to in 1 (1) above, the Supervisory Policies 2006 set forth the following three priorities: (1) ''adherence to customer protection rules and improvement of convenience in the region'', (2) ''facilitation of business revitalization and SME financing'' and (3) ''further sophistication of risk management.''
The FSA takes the view that the internal control systems need to be enhanced by the management's leadership under the current circumstances where there are a wide range of issues to be addressed by financial institutions. Based on this view, the Supervisory Policies 2006 explicitly state that special attention will be given to the appropriateness of governance when taking supervisory actions with respect to the following three priorities.

(1) Adherence to Customer Protection Rules and Improvement of Convenience in the Region
The top priority set forth by the Supervisory Policies 2006 is the ''adherence to customer protection rules and improvement of convenience in the region''. This was the second priority last year-the top priority last year being ''further promotion of region-based relationship banking''. Considering that the improvement of convenience for customers in the region had been a major factor in the new action program for region-based relationship banking and that convenience was deemed insufficient according to customer surveys, it was given top priority so as to reaffirm the trends in financial administration to giving utmost importance to customers' viewpoints.
Moreover, in consideration of the need to provide an appropriate explanation to customers and borrowers due to changes in the financial climate as exemplified by the recent diversification of financial instruments and the interest rate rise associated with the termination of the zero-interest-rate policy by the Bank of Japan, as well as the frequent misconduct financial institutions' employees and institutions' poor awareness of abuse in dominant position, the FSA will conduct supervision by focusing on:

1) Strengthening of explanation systems and of consultation and complaints handling functions
2) Compliance with laws and regulations
3) Enhancement and strict enforcement of measures to prevent financial crimes
4) Establishment of customer information management systems
5) Ensuring appropriate management of computer systems

(2) Facilitation of Business Revitalization and SME Financing
The second priority is ''facilitation of business revitalization and SME financing'', bearing in mind that among the region-based relationship banking efforts, ''business revitalization efforts'' and ''provision of loans without excessively relying on collateral and loans'' are still rated as insufficient.
The FSA will continue to follow up on the progress of region-based relationship banking efforts, and conduct supervision by focusing especially on:

1) Business revitalization efforts; and
2) Provision of loans without excessively relying on collateral and guarantees.

(3) Further Sophistication of Risk Management
The third priority is ''further sophistication of risk management'', as it was last year. The FSA will look into the financial institutions' development of appropriate risk management systems, especially in consideration of recent securitization efforts, the trend of expansion of asset management with complex risk profiles as exemplified by real estate funds and other various fund products, and new interest-rate and market environments due to the termination of the zero-interest-rate policy by the Bank of Japan.
This includes perspectives that take into account the implementation of Basel II (new capital adequacy requirements) in March, 2007, specifically, whether or not financial institutions are properly calculating and managing their capital adequacy ratios in accordance with the First Pillar (minimum capital requirement), and whether or not their capital mainly consists of Tier 1 capital, considering that the disclosure of the basic elements of capital (Tier 1) is required under the Third Pillar (market discipline).

1) Ensuring reliability of asset appraisal and credit risk management
2) Development of market risk management systems
3) Preparation for Basel II