Japan struggles with pillar 2

The Japanese banking sector seems, in recent years, to have shed its image as an industry mired in scandals, widespread bad loans and poor risk management. As part of the government's effort on structural reforms, Japan has promoted the principle of self-responsibility and market discipline in banks since the establishment of the Financial Supervisory Agency (FSA) in June 1998 as an integrated financial sector regulator.

Before that, banks had been supervised by the Ministry of Finance (MoF). At that time, the MoF took a strong initiative in deciding on the kinds of risks banks should bear and the methods to manage those risks. The establishment of the FSA began the shift towards risk-based supervision, whereby the regulator checks each bank's individual risk management process. That is also in line with Basel II's global pillar 2 practices.

Japan set the Basel II implementation deadline at the end of March 2007 and introduced final pillar 2 guidelines in March 2006. The FSA will assess financial firms' pillar 2 readiness based on the comprehensive risk management systems and the capital adequacy assessment (Icaap) process. It will employ a three-tier supervisory approach in governing pillar 2: communicate its expectations and induce financial institutions to achieve comprehensive risk management; continually review the comprehensive risk management system; and establish early-warning thresholds for individual risks.

The FSA's core plan for pillar 2 is the comprehensive risk management system, which will encourage each financial institution to build an appropriate and comprehensive risk management system in accordance with the scale of its business and risk profile, and to build a process for assessing its capital adequacy in relation to its own risk.

Banks, say the regulator, are expected to improve their own risk management systems to comprehensively understand and manage all material risks, including those not covered under pillar 1. The FSA will assess the effectiveness of the comprehensive risk management system established by each bank through periodic reporting and interviews with the management of each institution.

The FSA has highlighted two risks that will be covered under pillar 2: interest rate risk in the banking book (IRRBB) and credit concentration risk. IRRBB is defined as a potential loss resulting from a 200bp parallel shift of the yield curve or an economic loss caused by interest rate fluctuation beyond one percentile or 99 percentile points of an observation period of not less than five years for a one-year holding period. Such banking interest rate risk should not exceed 20% of total tier I and tier II capital. "I expect all major banks to clear this hurdle," says Toshio Koike, head of risk and control services, financial services department, Ernst & Young Shin Nihon.

The FSA defines credit concentration risk as an exposure of more than 10% of tier I capital. "We gather data from banks on credit concentration risk, which includes ratios of large exposures to the total exposure amount, and data regarding credit concentration on, for example, a particular industry," says an FSA official. "We would also require banks to conduct a kind of stress testing, in which hypothetical changes in the capital adequacy ratio will be assessed by assuming that a risk to a specific large borrower had become apparent." This is an assumption in which a certain amount of the unsecured portion of claims to large borrowers who are classified as 'need special attention' or below was recognised as a loss.

Yet even with benefit of the guidelines, credit concentration risk remains subjective and requires banks to make their own provisions. "Pillar 1 assumes there is no concentration of risk in any particular area, but that may not be entirely true in reality and therefore concentration needs to be measured and managed," says Koike. "The FSA has published guidelines, for example, stating that banks should measure potential credit losses based on an assumption that a portion of unsecured exposures to large debtors could not be collected. However, the regulator expects banks to develop their own processes taking their own risk profile into consideration."

Early warning

As part of the pillar 2 process, the FSA will also enhance its early-warning system by incorporating credit concentration risk and IRRBB. The early-warning system was first introduced in 2002 for the regulator to monitor the profitability, credit risk, market risk and liquidity risk of financial institutions. It allowed the regulator to take appropriate pre-emptive measures, such as conducting interviews, requesting reports or ordering operational improvements, at an early stage if necessary. The FSA conducts interviews to analyse the cause and review the appropriateness of the risk management approach and of any remedial actions taken by banks that fail to meet its requirements.

As it is, March 2007 is just around the corner, and Japanese banks are visibly struggling to meet pillar 2 requirements. Hajime Yasui, a partner at PricewaterhouseCoopers Aarata, says: "It seems that most banks, including regional ones, still have much work to do. Most banks have already calculated the IRRBB and unexpected loss under credit risks and are trying to make their approach more sophisticated. Banks also have to take into account the capital needed for other risks not covered under pillar 1, such as legal risk, reputation risk and liquidity risk. Banks might have to allocate 5-10% of regulatory capital to these, aside from that allocated to credit, market and operational risk."

Ongoing process

Major banks already have the basic infrastructure required under pillar 2 and can calculate credit value at risk, credit stress testing and various other risks. Banks have also been making efforts to improve the effectiveness of the capital allocation process, says Koike. The FSA official says the regulator expects banks to meet the deadline, but also understands that improvements to the risk management system are an ongoing process. "Those banks have, so far, been making good progress," adds the official. "Each of the banks has voluntarily put in a lot of effort to think about what it should do."

Banks looking to move towards the advanced internal ratings-based or advanced measurement approaches should not only improve their credit risk and operational risk management, but also their comprehensive risk management and internal control functions, says the official. However, the major banks in Japan do not necessarily have a long history of such quantitative risk management systems, he adds, and improvements to their comprehensive risk management systems will be an everlasting process.

While the FSA encourages banks to enhance voluntarily their own risk management to capture all material risks, small and medium-sized regional banks will come under varying degrees of supervision. "What is different (for the regional banks) is the extent to which they should quantitatively assess their volume of risks and internal integrated risk management," says the FSA official. "We do not necessarily require them to assess how much risk they are taking in that quantitative manner. Rather, we are concerned about what they should develop, in light of risk, size and risk profiles, and what is the best way to comprehensively understand what kinds of risks they're taking or how they should manage them."

Yet regional banks are falling further behind in pillar 2, which is a concern for the Japanese regulator, says Koike. "Under pillar 2, these banks are required to maintain adequate capital not only from a capital ratio perspective, but also from an integrated risk management perspective, in relation to banking account interest rate risks, credit concentration risks and other risks not captured by the pillar 1," he says. "The regulators are very serious about improving risk management at these regional banks, so these firms will come under close inspections and monitoring so as to push them to implement an integrated risk management infrastructure."