20 years on: Japan’s financial administration reaches turning point

November 17, 2017

Tokyo- With the problem of nonperforming loans that plagued Japanese banks winding down, the role of financial administration in Japan is undergoing a drastic change.

In summer 2018, the Financial Services Agency plans to scrap the Inspection Bureau, which struck fear into banks by rigorous checks on their operations. The tight scrutiny was a symbol of the regulator's break with the "convoy system" of financial industry supervision and regulation, which had long prevented any bank failures and buttressed industry growth.

The bureau will be integrated into the Supervisory Bureau, which oversees banks' day-to-day operations. Also, the FSA plans to revise its style of bank inspections, shifting emphasis from guidance to "dialogue."

The FSA emerged from the Financial Supervisory Agency, which was created in June 1998 through the separation of the former Finance Ministry's inspection department after the banking industry's excessive wining and dining of senior ministry officials to induce them to pull punches in bank inspections came under sharp public criticism.

The regulator's cozy relations with banks came to light only months after the high-profile failures of a major bank and a large securities company in November 1997 set off a financial crisis in Japan.

"At long last, the time has come that (the FSA) can reform its organizational structure," former FSA Commissioner Hirofumi Gomi, said. "This means that financial administration has earned trust," said Gomi, who played a central role in bringing transparency to financial administration when the predecessor agency was launched.

At the FSA, the Inspection Bureau and the Supervisory Bureau deal with each bank separately. With banks having to respond to the two bureaus simultaneously and the bureaus needing to communicate with each other frequently, this organizational arrangement has been criticized as inefficient.

The structure has still been maintained due to public distrust in the former ministry's financial administration, which was accused of being nontransparent, as exemplified by the revelation in 1998 that ministry personnel had given banks inside tips on inspection schedules in exchange for being entertained lavishly.

The ministry "was accused of neglecting to use information gained in bank inspections and take quick action, allowing the (bad loan) problem to become increasingly serious," Gomi recalled.

The 1998 scandal, which implicated many elite bureaucrats and led to the arrest of some, drained public confidence in the ministry, resulting in the dismantlement of an organization that once wielded huge authority over the full range of fiscal and financial affairs.

The Financial Supervisory Agency took over the financial inspection role of the ministry and put it on par with the supervisory department in order to ensure the independence of bank inspections.

The inefficient organizational setup can be taken as a cost of restoring public confidence in financial supervision and regulation, analysts say.

Even after the agency was transformed into the FSA in July 2000, the Inspection Bureau played a leading role at the new agency in urging banks to speed up bad loan disposal by conducting strict evaluations of bank assets.

As a result, major banks passed through the worst of the bad loan mess. The share of nonperforming loans in total lending at major banks fell to 2.9 pct in the fiscal year to March 2005, less than half of the 8.4 percent three years before.

The FSA revised its approach to bank inspections from around 2013, when the regulator and industry faced the new challenge of shoring up banks' reduced earnings capacity against the backdrop of a falling population and protracted low interest rates in Japan.

While leaving the administration of individual assets to the respective banks, the FSA started putting weight on reviews of banks' earnings outlooks, management plans and risk management against financial market swings.

In the coming reorganization, the Inspection Bureau's integration into the Supervisory Bureau is designed to improve regulatory efficiency. At the same time, the FSA plans to create independent groups specializing in specific areas, including market analysis and corporate governance, under the Planning and Coordination Bureau, in an effort to strengthen the risk management of the whole financial industry.

But the agency has been slow to secure or develop adequate human resources to operate under the new structure. Also, it has yet to decide a specific mechanism of interaction between the Supervisory Bureau and each of the specialized groups.

In addition, there is persistent concern that bank asset evaluations may be undermined by the abolition of the Inspection Bureau. "Signs of inappropriate business practices by banks can be detected in individual loan contracts. An insight into them is important," a former official of the Bank of Japan said.

Takahiro Mitani, former BOJ executive director, wonders if it is right to reduce the number of inspectors who evaluate assets at banks.

"If know-how on asset evaluations is lost, it (the FSA) will find it difficult to carry out adequate checks on risks (in lending)," Mitani said. "If economic conditions worsen and bad loans grow again in the future, financial regulators may not be able to address the problem appropriately."

The FSA "experienced success" with the Inspection Bureau, a senior official said. The agency has now decided to move forward from the experience and is feeling its way to becoming an organization capable of tackling new challenges. Jiji Press