Bank of Japan : On-Site Examination Policy for Fiscal 2021

March 30, 2021

Bank of Japan

On-Site Examination Policy for Fiscal 2021

1. On-Site Examination by the Bank of Japan

The Bank of Japan (hereafter, the Bank) formulates the on-site examination policy every fiscal year based on the decision of the Policy Board.1

With a view to preventing the spread of COVID-19 and reducing the operational burden on examinee institutions striving to provide financing support to firms and households, the Bank temporarily ceased its on-site examinations in fiscal 2020 and instead conducted intensive interviews with examinee institutions using remote methods, such as web and telephone conferencing, in place of such examinations (hereafter referred to as "remote intensive interviews"). Based on the risk profiles of examinee institutions, the Bank focused on examining how COVID-19 affected their business, such as in terms of providing financing support to firms and households and management of credit and market risk.2 In doing so, the Bank gave sufficient consideration to the operational burden on examinee institutions to help them focus on their financing support.

This document, "On-Site Examination Policy for Fiscal 2021," briefly reviews remote intensive interviews conducted in fiscal 2020 and, in light of the recent situation of the spread of COVID-19 and of the examinee institutions' provision of financing support, outlines the basic approach and key issues in the conduct of examinations of financial institutions in fiscal 2021, which will be resumed using remote methods. The Bank will conduct on-site examinations in fiscal 2021 on the basis of this document.

1 The Bank of Japan Act stipulates that "the content of a contract concerning on-site examinations" and "important matters concerning the implementation of on-site examinations for each business year" shall be determined by the Policy Board (Article 15, paragraph 2, item v).

2

See "Guideline for Conducting On-Site Examinations in Response to COVID-19" released on June 30, 2020.

2. Remote Intensive Interviews in Fiscal 2020 and General Observations

(1) Remote Intensive Interviews in Fiscal 2020

The Bank conducted remote intensive interviews with 37 financial institutions: 18 domestically licensed banks, 14 shinkin banks, and 5 other institutions, including securities companies as well as Japanese branches and subsidiaries of foreign banks.3

Number of Financial Institutions Examined/Interviewed

(number of entities)

On-site examinations	Remote intensive interviews
Fiscal 2018	Fiscal 2019	Fiscal 2020
Domestically licensed banks	29	34	18
Shinkin banks	54	43	14
Other institutions	8	8	5
Total	91	85	37

(2) Issues Identified in Remote Intensive Interviews

In response to the spread of COVID-19, financial institutions have been actively providing financing support for firms and households under the large-scale fiscal and monetary policy measures and flexible regulatory and supervisory actions taken by the government and the

Bank. These institutions have smoothly provided such support, despite the restrictions on movement and face-to-face services to prevent the spread of COVID-19, partly due to the increased flexibility of branch operations, including working arrangements, and the widespread adoption of remote work through the enhancement of IT infrastructures.

On the other hand, credit costs have been increasing. This mainly is because a growing number of financial institutions have increased loan-loss provisions, as there is uncertainty over the business prospects of borrowers who have suffered significant declines in their

3 "Securities companies" in this document refers to firms that conduct securities-related business activities among those classified as Type I Financial Instruments Business in Article 28 of the Financial Instruments and Exchange Act.

business due to the impact of COVID-19, thereby causing concern over their repayment capacity. Credit costs could increase considerably given the prolonged spread of COVID-19, although such costs will greatly depend on the future course of the infection and economic activity. Regarding credit risk management, some financial institutions did not fully ascertain the changes in the risk of their credit portfolios in terms of borrowers' repayment capacity. Moreover, there continued to be cases where financial institutions had an insufficient understanding of the financial condition of borrowers; for example, loans were downgraded from normal to "de facto bankrupt" or below due to the detection of window-dressing.

In terms of market risk management, there were quite a few cases where the losses on securities holdings breached the thresholds set in the loss-cut rule and the triggers for consultation in March 2020, when market conditions faced a sudden change due to the

COVID-19 outbreak. However, at many financial institutions, the respective boards of directors and senior management were involved in an appropriate manner in decisions on whether to continue to hold securities. There were also cases where some financial institutions, although increasing investments in risky products amid the continued redemptions of bonds with higher coupon rates than those of recently issued bonds, did not manage market risk sufficiently based on the risk characteristics of these products.

With regard to foreign currency liquidity risk management, major financial institutions, which have been expanding their overseas activities, saw a sharp increase in foreign currency-denominated lending due to the drawdown of committed lines in March 2020 triggered by the COVID-19 outbreak, while funding such as through the CD and CP markets temporarily deteriorated. However, there were no major disruptions to foreign currency funding, partly due to the swift expansions of U.S. dollar liquidity swap line arrangements by six central banks and of the U.S. dollar funds-supplying operations by the Bank. This experience showed once again that it is extremely important for financial institutions to continue to strengthen stable foreign currency funding bases and increase the sophistication of their foreign currency liquidity risk management.

Financial institutions' capital levels are adequate relative to the amounts of various types of risk taken on, and they have sufficient capacity to absorb losses. In addition, even though the real economy has been under severe downward pressure due to the spread of COVID-19, the smooth functioning of financial intermediation has been maintained on the back of the implementation of large-scale fiscal and monetary policy measures.

However, the capital adequacy ratios of regional financial institutions are likely to continue to follow a downtrend, reflecting the decline in their core profitability. Against this background, to increase business efficiency, a growing number of financial institutions have been working to reengineer business processes through, for example, substantial consolidation of their branch networks, reviews of their ATM networks and staff allocation, and active use of digital technology. There has been an increase in capital and business alliances among financial institutions and with firms from other industries in order to further enhance their financial services and improve business efficiency.

3. On-Site Examination Policy for Fiscal 2021

(1) Resumption of On-Site Examinations and Strengthening of Coordination with the

Inspections by the Financial Services Agency (FSA)

The Bank conducted remote intensive interviews in place of on-site examinations in fiscal

2020. Meanwhile, examinee institutions' operational burden for providing financing support has been reduced, given that the number of loan guarantees approved by credit guarantee corporations peaked in mid-2020 and has been on a downtrend since then, and that the growth of domestic lending by financial institutions has slowed down recently. Therefore, the Bank will resume on-site examinations in fiscal 2021.

When they resume, in order to prevent the spread of COVID-19, the Bank will continue to make active use of remote methods such as web and telephone conferencing. Once resumed, the Bank will assess whether it is appropriate to conduct examinations, mainly in light of

COVID-19 trends and examinee institutions' operational burden, and will give the utmost consideration to the situation faced by these institutions by, for example, adjusting schedules as necessary. Moreover, as in previous fiscal years, the Bank will conduct on-site examinations in a flexible and efficient manner in accordance with financial institutions' risk situation, profitability, and financial soundness.

In addition, in order to further enhance the efficiency and effectiveness of on-site examinations, the Bank will strengthen its coordination with the FSA through the Joint