Impetus for change

Author: | Published: 1 Oct 2007
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

In Japan, "the lost decade" is the term used to describe Japan's economy after the economic bubble's collapse in the early 1990s. All the causes of this economic stagnation have not been identified; however, non-performing loans held by Japanese banks, a reported ¥38.7 trillion ($330 billion) in March 1999, are recognized as one of the main causes.

In November 1996, Japanese Prime Minister Hashimoto announced plans to promote financial reform by introducing "free, fair, global" markets to Japan. The plan was named the "Financial Big Bang" after the 1986 Big Bang in financial markets in the UK. In April 2001, the government of Prime Minister Koizumi issued the Bold Policy, which identified correcting the non-performing loan problem as the first step towards financial revitalization. Since then, bank regulation in Japan has been consistently changed in accordance with the policy of financial reform.

Bank regulators

From 1891 to 1998, the Ministry of Finance (MOF), as the sole bank regulator in Japan, had exclusive authority over bank supervision and inspection. After the collapse of the bubble economy in the early 1990s, the Diet decided that the MOF should be restructured. In 1998, the Financial Supervisory Agency (Kinyu Kantokucho) and the Financial Reconstruction Commission (Kinyu Saisei Iinkai) (FRC) were established, and bank supervision was transferred primarily to the Financial Supervisory Agency from the MOF. In January 2001, the Financial Supervisory Agency was reformed as the Financial Services Agency (Kinyucho) (FSA), as an outside organization of the Cabinet Office. At the same time, the FRC was integrated into the FSA.

Since January 2001, the FSA has been the sole bank administrative authority regulating banks, trust banks, credit unions (shinyo-kinko), credit cooperatives (shinyo-kumiai), labour credit unions (rodo-kinko), as well as insurance companies, securities companies, financial holding companies, non-banks and other forms of financial institutions. All business activities of a bank are continuously monitored through offsite and onsite monitoring systems constructed by the FSA under the Banking Law. Onsite monitoring functions belong to the Bank Inspection Division of the FSA, offsite monitoring and administrative action functions belong to the Bank Supervision Division, and the General Planning Division is responsible for planning financial regulations.

Under the Banking Law and the Securities and Exchange Law (the SEL), banks are generally prohibited from conducting any activities related to the securities business unless the bank registers as a registered financial institution with the Prime Minister. All activities relating to the securities business conducted by a registered financial institution are regulated by the FSA and the Securities Exchange Surveillance Committee (SESC) under the Banking Law and the SEL (soon to be replaced by the Financial Instruments and Exchange Law (FIEL)). The SESC has the authority to inspect registered financial institutions and securities companies, and the FSA has the authority to accept registrations and to supervise these companies.

Depository institutions, other than banks, may be subject to the authority of more than one regulator. For example, labour credit unions are regulated by the Ministry of Health, Labour and Welfare as well as the FSA.

Changing regulatory landscape

In July 1999, the Financial Supervisory Agency issued the Bank Inspection Manual, which disclosed the expected minimum standards for management of a bank, including a standard for evaluating loans mainly covered by personal guarantee and real estate. The MOF had long used bank inspection as an effective tool for controlling bank activities and ensuring their sound operation, however, the inspection process and criteria used in the evaluation had never been disclosed before. The Financial Supervisory Agency began conducting bank inspections mainly focused on non-performing loans and legal compliance under the Bank Inspection Manual. In 2001, the FSA started special inspections of the main banks. The special inspections became known for stricter evaluation of credit risk management systems of banks and the self-assessment system with regard to bank credit extension. The aim of the special inspections is to ensure appropriate borrower classification as well as a sufficient level of write-offs and provisioning on a timely basis, reflecting the borrowers' business conditions and market signals against them.

In December 2004, the FSA issued the Programme for Further Financial Reform; Japan's Challenge: Moving toward a Financial Services Nation. In this programme, the FSA officially announced that the government had moved past adopting emergency measures to resolve the non-performing loan problem and the economic stagnation of the lost decade, and was entering a new forward-looking phase aimed at establishing a desirable financial system for the future by adopting the following basic principles: (i) thorough adoption by the FSA of a role of regulator that complements market discipline; (ii) establishment of a code of conduct for financial administration along with a full review of regulation and repeal of unnecessary regulations; and (iii) development and thorough implementation of consumer protection rules so that consumers do not suffer unexpected losses. These basic principles for financial administration, introduced for the purpose of revitalizing the Japanese economy, resulted in big regulatory reform mainly in banking. Some of the consequent proactive changes made to bank regulations include permitting, since December 1998, banks to sell investment funds after implementation of firewall regulations and introduction of the Law for Punishment of Organized Crimes, Control of Crime Proceeds and Other Matters (the Anti-Organized Crime Law) in April 2001. Also, banks may now sell certain types of insurance policies and the list of permitted types has gradually expanded. Firewall regulations regarding solicitation of insurance policies were introduced at the same time. The Trust Business Law was totally revised in 2004, to promote businesses relating to trusts. Lastly, the SEL will be revised and promulgated as the FIEL on September 30 2007.

The Banking Law

The banking business licence

Article 4 of the Banking Law stipulates that no one can engage in banking business unless licensed by the Prime Minister of Japan. Banking business is defined as: (1) acceptance of deposits and/or instalment savings (teiki-tsumikin), together with lending money and/or discounting bills; or (2) exchange business (including fund transfer transactions business) (kawase torihiki). On March 12 2001, the Japanese Supreme Court defined exchange business under the Banking Law to mean the acceptance and/or execution of a request from a customer to transfer certain funds to another person without physically delivering the funds. Accordingly, a company without a banking business licence must be cognizant of relevant laws and regulations if the company wishes to act as the paying agent in a syndicated loan transaction, or engage in the transferring fund business, or settlement of payments or other fund transfer activities. Even if the company uses an existing bank account in Japan, it must consider whether a proposed transaction falls under the definition of exchange business, because the Supreme Court decision defines the exchange business quite broadly. In addition, Article 3 of the Banking Law stipulates that any business that merely accepts deposits or instalment of savings is deemed a banking business and is subject to the Banking Law.

To qualify for a banking business licence, the applicant must meet the standards stipulated in Article 4(2) of the Banking Law, that is, have adequate capital and capacity to carry out banking business activities properly, including adequate knowledge and experience with banking activities in Japan, as well as having adopted the fit and proper rules applicable to the management of the applicant as provided in Article 7-2 of the Banking Law. The following requirements must also be met.

  • A bank must have at least ¥2 billion in capital. If a bank wishes to decrease the capital amount, it must obtain the prior permission of the Prime Minister. On the other hand, before increase of its capital amount, the bank is required to notify the Prime Minister but not to obtain permission.
  • For Japanese banks, a bank must be a joint-stock corporation (kabushiki kaisha) that has a board of directors, a board of statutory auditors or statutory auditor's committee, and an auditor.

Foreign banks – branch licence

To enter banking business in Japan, foreign banks may, as an alternative to establishing a joint-stock company as a subsidiary and obtaining a banking business licence for it, obtain a banking business licence for a bank branch in Japan. Article 47 of the Banking Law provides that a foreign bank may establish a branch or agency that is the main office for its banking activities in Japan and obtain a branch licence for it. In that case, the applicant must meet the standards in Article 4 of the Banking Law, excluding the minimum capital requirements and organizational structure described above and some other entry rules. In examining applications, the reciprocity of treatment between the home country of the foreign bank and Japan will be taken into account. Almost all foreign banks obtain a bank branch licence, except for trust banks. If a foreign bank wishes to establish a new sub-branch, change the type of, or close an existing branch, permission must be obtained.

Scope of a bank's business

In Japan, banks may only perform the types of business permitted by the Banking Law or other laws (Article 12 of the Banking Law). There are two main reasons for this. First, the public policy that banks should concentrate only on the banking business. Second, the protection of banks from losses that arise from engaging in non-banking businesses to prevent damage to the soundness of their banking business. So the types of businesses that a bank may perform are limited to: typical banking business; ancillary businesses; limited securities business; and other business permitted by other laws as further described below.

  • Typical banking business. Article 10(1) of the Banking Law provides that a bank may: (1) accept deposits and/or instalment savings; (2) lend money and/or discount bills; and (3) engage in exchange business (including fund transfer transactions). These three categories are collectively called principal banking business.
  • Ancillary business. Article 10(2) of the Banking Law provides that a bank may engage in businesses ancillary to the typical banking business described above. This section lists 20 categories of ancillary businesses as examples, including acquiring and assigning monetary claims, handling private placement of securities, and securities lending. As well as these 20 categories of ancillary businesses, some other businesses might be permitted as being ancillary to the banking business. Article 10(2) of the Banking Law stipulates that a bank may conduct "other businesses associated with the banking business". Administrative guidelines provide interpretations of the standards and elements to be considered in determining when a business is ancillary; however, these interpretations do not fully resolve the complicated and ambiguous nature of these standards and elements. Accordingly, a bank wishing to engage in a business not expressly listed in Article 10(2) of the Banking Law should consult a lawyer regarding whether or not the business meets these standards and elements.
  • Securities business. A unique feature of bank regulation in Japan is that it maintains the segregation rule between banking and securities activities, and the banking and trust business. A bank is generally prohibited from engaging in the securities related business under Article 33 of the FIEL. A bank must register with the Prime Minister as a registered financial institution under Article 33-2(1) of the FIEL if it wished to engage in: (a) delivering customers' written orders relating to securities; (b) a certain securities activities set out in Article 33(2) of the FIEL; (c) specified derivatives transactions, excluding securities related derivatives; (d) handling private placements or public offering of securities set out in Article 2(8), item 7 of the FIEL; (e) investment advisory or agency business; and (f) operation business for management of securities and/or money. Registered financial institutions are subject to regulations prescribed in the FIEL, including: (i) required delivery of written documents before execution of a financial instrument transaction; (ii) required delivery of written documents at the time of execution; and (iii) suitability rules.
  • Other business. A bank may conduct other businesses if law permits. For example, the business conducted by trust banks under the Law concerning Trust Business as Concurrent Business of Financial Institutions as well as the trust business under the Secured Bond Trust Law. Separate registrations or approvals are required in some instances.

Credit limit for a single borrower

To avoid excessive concentration of credit extension by a bank or its group companies to a certain borrower or borrower's group companies, and so ensure the soundness of bank operations and fairness of distribution of bank credit, Article 13 of the Banking Law sets out the upper credit limit that may be extended to one person. For the purpose of calculation, the credit limit for a borrower's group is 40% of the net worth of the bank, and for a single borrower is 25% of the net worth of the bank.

Arm's length rule

Article 13-2 of the Banking Law prohibits transactions between a bank and specified related companies or customers, terms and conditions of which are adverse to the bank or a specific related company or customer in comparison to normal terms and conditions. This is the arm's length rule. Specified related companies include bank subsidiaries, affiliated companies, bank holding companies and its subsidiaries, broadly defined.

Capital adequacy rule

Japanese banks are subject to capital adequacy rules; that is, banks employing international standards are required to maintain a capital adequacy ratio of 8% or higher, and banks employing domestic standards must maintain a ratio 4% or higher. For foreign bank branches, this rule is not applicable under the Banking Law. In March 2007, the FSA introduced new regulations conforming to the Basel II Accord, and issued a wholly amended Bank Inspection Manual, corresponding to the sophisticated risk management system prescribed and expected in the Basel II Accord, covering the operational risk management system of new concepts advocated in Basel II.

Shareholders and bank holding companies

In March 1998, the Banking Law was amended so that a company could become a bank holding company. If a company falling under the definition of holding company under the Anti-monopoly Laws wishes to hold a bank as a subsidiary, it must obtain permission to be a bank holding company from the Prime Minister. A bank holding company, and its subsidiaries, may not hold more than 15% in total of the issued shares of a company that is engaged in a business not permitted by a bank subsidiary.

If a shareholder is to hold 20% or more of a bank's shareholder voting rights, the shareholder must obtain permission in advance from the Prime Minister.

Other laws applicable to banks

Business activities conducted by a bank are subject to various laws and regulations, including the Banking Law, the SEL (to be replaced by the FIEL), the Law Concerning the Identification of Customers by Financial Institutions and the Prevention of the Unlawful Use of Bank Accounts, the Law Concerning Financial Products, the Anti-Organizational Crime Law, the Anti-Monopoly Laws, the Usury Law, and the Foreign Exchange and Foreign Trade Law. In addition, the orders and the ordinances of the Banking Law must also be observed as well as the guidelines promulgated under these laws by the FSA, such as the Guidelines for Supervision of the Major Banks, the Guidelines for Middle-to-Small-Sized or Regional Financial Institutions, and the Bank Inspection Manual. The FSA discloses its interpretation of some laws, orders, ordinances and guidelines through its "answer to public comments" during the amendment process for the same and through no-action letters, and frequently asked questions accessible on the FSA's website. In addition, self-regulatory organizations, such as the Japanese Bankers Association, the All Banks Fair Trade Council, and the Japan Securities Dealers Association, issue relevant internal rules and codes of conduct for their members.

The Financial Instruments and Exchange Law

On September 30, 2007, the SEL will be wholly revised and promulgated as the FIEL.

The purpose of the FIEL can be divided into the following four basic elements:

  1. Development of cross-sectoral regulation of financial instruments to protect investors;
  2. Enhancement of the disclosure system;
  3. Reinforcement of the self-regulatory functions of stock exchanges; and
  4. Strict enforcement of prohibitions and penalties related to unfair trading, etc.

The characteristics of the FIEL include:

  1. Expansion of the scope of regulated products;
  2. Regulated cross-sectoral operations;
  3. Relaxation of restrictions on market entry according to nature of operations;
  4. Reorganizing regulation on conduct of the financial instruments business;
  5. Rules of Conduct relating to "Sales and Solicitation";
  6. Flexible Regulation according to Customer Categories; and
  7. Development of Other Systems for Customer Protection.

More specifically, the FIEL will introduce many new rules for protecting retail customers, such as the so-called professional-amateur rule, advertising regulations, the obligation to deliver statutorily mandated documents prior to, and at the time of the sale and purchase of a financial product, suitability rules, and other detailed restrictions concerning solicitation of financial products. The FIEL is applicable to certain high-risk financial products; such as foreign currency deposits and derivative deposits, and high-risk insurance products (i.e., foreign currency insurance, individual variable annuity) as well as investment funds that a bank, as a registered financial institution, may deal to its customer.

Steps forward

After enacting numerous changes to help emerge from the Lost Decade, the government and regulators have focused their attention on designing and implementing bank regulations that will help create a strong and vibrant financial services industry that will revitalize the Japanese economy. The most recent result of these efforts is the FIEL, and the inevitable process of interpretation and adjustment that will follow, for both regulators and the finance sector, as Japan moves further along the road to economic reform and revitalization.

Author biography

Taku Umezawa

Nagashima Ohno & Tsunematsu

Taku Umezawa is a senior associate of Nagashima Ohno & Tsunematsu. He provides legal advice on laws and regulations relating to bank institutions, securities companies, insurance companies, asset management and other financial institutions, as well as legal compliance issues and corporate governance of companies.

He was admitted to the Bar in Japan in 1999. He received his BA from the University of Tokyo in 1997 and an LLM from University of the Pennsylvania Law School in 2004. He has also worked at the New York office of Simpson Thacher & Bartlett, as an international associate, and worked as a government official (special financial inspector) in the Financial Services Agency (FSA), Inspection Bureau, and Securities and Exchange Surveillance Commission (SESC) of Japan, from 2005 to 2007. When he was in the FSA, he engaged in drafting Revised Bank Inspection Manual, Trust Bank Inspection Manual, and Insurance Inspection Manual. He has authored and co-authored a number of publications in both English and Japanese, all in the areas of financial regulation and corporate governance.