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Credit Risk Credit Risk Credit Risk Credit Risk Management System Management System Management System Management System Checklist and ManualChecklist and ManualChecklist and ManualChecklist and Manual

Credit risk is the risk that a financial institution will incur losses because the financial position of a borrower has deteriorated to the point that the valueof an asset (including off-balance-sheet assets) is reduced or extinguished. Among credit risks, the risk that the financial institution will incur losses because ofpolitical or economic conditions in the country of a foreign borrower is referred to as “country risk.”

Inspectors will verify and inspect the credit risk management systems of financial institutions using the Risk Management Systems Checklists (CommonItems) and this checklist. They will also inspect the self-assessments on asset quality, write offs and reserves, and capital adequacy ratios etc. of the financialinstitution using the “Credit Risk Inspection Manual.”

This checklist applies to all deposit-taking financial institutions, including the foreign offices of Japanese banks (foreign branch offices, foreignsubsidiaries, and foreign liaison offices, etc., though whether or not to include these offices in the inspection will be determined in light of applicable laws andordinances, including applicable foreign-country laws and ordinances) and the Japan offices of foreign banks. In inspections of cooperative financialinstitutions, inspectors should be aware that cooperative financial institutions are only required to select external auditors in limited cases.

Notes on the use of this manual in inspectionsNotes on the use of this manual in inspectionsNotes on the use of this manual in inspectionsNotes on the use of this manual in inspections

This manual is only a handbook to be used by inspectors in the inspection of financial institutions. It is expected that, as part of their efforts to ensuresound and proper operations and in accordance with the principle of self-responsibility, individual financial institutions will fully exercise their creativity andinnovation to voluntarily create their own detailed manuals. These institutional manuals should make note of the content of this manual and be adapted to thesize and nature of the institution.

The check points in this manual represent criteria to be used by inspectors in evaluating the risk management systems of financial institutions. They donot constitute direct statutory obligations to be achieved by institutions. Care must be taken that the manual is not employed in a manner that is mechanicaland unvarying. There may be cases in which the letter of the checklist description has not been fulfilled, but the institution has nonetheless taken measuresthat are, from the perspective of ensuring the soundness and appropriateness of its operations, rational, and these measures are equivalent in their effects tothe descriptions for the check point or are sufficient given the size and nature of the institution. In such cases, the institution’s measures should not be deemedinappropriate.

Inspectors will therefore need to engage in full discussion of relevant points with financial institutions during on-site inspections.

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Explanation of check pointsExplanation of check pointsExplanation of check pointsExplanation of check points

1. Unless explicitly stated otherwise, items expressed in the question form such as “does the institution” or “is the institution” are minimum standards thatare expected of all financial institutions. Inspectors, as they go through their checklists, need to fully verify the effectiveness of these items.

2. Unless explicitly stated otherwise, items worded in the form of “it would be desirable that” constitute “best practice” for all financial institutions.Inspectors need only confirm these items.

3. Items that are a combination of the two represent minimum standards for internationally active banks (those financial institutions calculating theircapital adequacy ratios according to the Basle standards) but serve only as best practices for other financial institutions (those calculating their capitaladequacy ratios according to domestic standards).

Distinction between Distinction between Distinction between Distinction between ““““board of directorsboard of directorsboard of directorsboard of directors”””” and and and and ““““board of directors etc.board of directors etc.board of directors etc.board of directors etc.””””

1. Items that are defined as roles of the “board of directors” are items for which the board of directors itself needs to determine all essential matters. Thisdoes not, however, preclude the board of directors from delegating consideration of draft documents to the management committee or similar bodies.

2. The phrase “board of directors etc.” includes the board of directors, the management committee, the business steering committee, and similar bodies.Items that are defined as roles of the “board of directors etc.” would ideally be determined by the board of directors itself, but may be delegated to themanagement committee etc. provided that there has been a clear delegation of this authority from the board of directors, the management committee etc. haskept minutes of its proceedings and other materials that would allow after-the-fact confirmation, and there are adequate internal controls in place, e.g., theresults are reported to the board of directors, and auditors are allowed to participate in the management committee etc.

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Credit Risk Management System ChecklistCredit Risk Management System ChecklistCredit Risk Management System ChecklistCredit Risk Management System Checklist

ItemItemItemItem Risk Management System Check PointRisk Management System Check PointRisk Management System Check PointRisk Management System Check Point Explanation of Risk Management Check PointsExplanation of Risk Management Check PointsExplanation of Risk Management Check PointsExplanation of Risk Management Check Points RemarksRemarksRemarksRemarks

I.I.I.I. Awareness of risk managementAwareness of risk managementAwareness of risk managementAwareness of risk managementetc.etc.etc.etc.

1. Awareness of directors and roleof board of directors

(1) Articulation of strategic goals in linewith management philosophies etc.

(1) Does the institution set clearly strategic goals for the lending divisions etc. in line with managementphilosophies etc. for the financial institution as awhole?

Are the strategic goals for the lending divisions etc.appropriate from the perspective of riskmanagement that results? For example, do theyeliminate a concentration of credit risks from effortsto achieve short-term profits by lending to specificindustries or groups?

(2) Directors’ understanding andawareness etc. of risk management

(2) Do directors understand the need, from the perspective of credit risk management, of integratedmanagement of not only lending but all assets andoff-balance-sheet items for which there are creditrisks (including the credit risks associated withmarket transactions) at the financial institutionand, to the extent permitted under applicable lawsand ordinances, its consolidated subsidiaries andsubsidiaries falling under the equity method?

Do directors understand credit risk managementtechniques (including the content of credit ratingsand portfolio management) and monitoringtechniques? Are they aware of the need, from theperspective of credit risk management, for creditratings, portfolio management, and self-assessmentson asset quality? Do directors in charge of these andrelated areas have deep understandings andawarenesses of these issues?

Does the board of directors verify that write-offs andreserves are at levels commensurate to credit risks?

If the board of directors uses quantifications of creditrisk in the management of the institution, does itunderstand quantification techniques, dataavailability issues, the relationship between creditrisk exposure and capital adequacy, and other issuesin the use of this information?

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(3) Establishment of credit riskmanagement guidelines

(3) Does the board of directors articulate credit riskmanagement policies in light of strategic goals?

Does the institution have a set credit policy thatcontributes to credit risk management? This wouldinclude the scope of lending, credit rating standards,portfolio management guidelines (for example,prevention of concentrations of lending by settinglending ceilings for specific industries and groups),and decision-making authority.

(4) Establishment of organizations for riskmanagement

(4) Has the board of directors provided for appropriatemanagement of credit risk by, for example, erectingan appropriate screening and management systemthat separates the business promotion divisionsfrom the screening and management division so thatthe screening and management division is notinfluenced by the business promotion divisions, or byerecting an appropriate credit management systemwith the establishment of a credit auditing divisionand risk management division?

(5) Reporting on risk status to the board ofdirectors etc. and use of riskinformation in decision-making for theorganization as a whole

(5) Does the board of directors etc. receive regularreports on credit risks (including the status ofconcentrated lending to specific industries orgroups)? Does it verify adherence to credit riskmanagement policies based on measured riskinformation?

Does the board of directors receive reports on creditrisks at other times as necessary in addition toregular reports? Does the board of directors makenecessary decisions according to predeterminedpolicies, issue instructions to reduce credit riskexposure by diversifying risks, or otherwise makeuse of risk information in risk management?

Note:

① “Business promotiondivisions” refers to branchoffices and business divisionswithin the head office.

② “Screening and managementdivision” refers to a divisionthat screens proposedlending and manages credits.

③ “Credit auditing division”refers to a division that isindependent of the businesspromotion divisions (forexample, the credit screeningoffice or inspectionsdepartment) and thescreening and managementdivision, and which carriesout audits of self-assessments etc. and ofcredit management andcredit management status.

④ “Risk management division”refers to a division thatmanages overall credit risks,including off-balance-sheetassets.

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2. Awareness and roles of seniormanagement

(1) Establishment of rules for riskmanagement

(1) Does senior management establish rules for creditrisk management in accordance with credit riskmanagement policies and with the approval of theboard of directors etc? Does it review these rules asnecessary?

Do rules for credit risk management include thescope of lending, credit ratios, portfoliomanagement, decision-making authority, screeningguidelines, credit audit methods and other relevantmatters?

Note: “Senior management”refers to branch office managersand persons in senior managerialpositions (including directors)with equivalent levels ofresponsibility, and so throughout.

(2) Appropriate risk management practice (2) Does senior management practice effective creditrisk management in individual divisions inaccordance with risk management policies and riskmanagement rules, and does it bear theresponsibility for risk management?

It is desirable that internal models etc. based oncredit ratings be used to quantify credit risks forcredit risk management purposes, and that theinstitution set credit risk limits commensurate toappropriate profitability, allocations of managerialresources, and capital adequacy.

It is also desirable that such systems have adequatecomputer system support.

II.II.II.II. Establishment of appropriateEstablishment of appropriateEstablishment of appropriateEstablishment of appropriaterisk management systemsrisk management systemsrisk management systemsrisk management systems

1. Awareness and evaluation ofrisk

(1) Establishment of integrated riskmanagement systems

(1) Does the institution practice integrated credit riskmanagement that includes, to the extent permittedunder applicable laws and ordinances, itsconsolidated subsidiaries and subsidiaries fallingunder the equity method?

Does the institution practice integratedmanagement that covers not only lending but allassets and off-balance-sheet items for which thereare credit risks including the credit risks associatedwith market transactions)?

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(2) Evaluation of new products andactivities

(2) When introducing new products and activities, doesthe risk management division evaluate the locus etc.of credit risk, seek opinions from the legal affairsdivision and inspections division etc. whennecessary, report to the board of directors etc. on itsrisk evaluation findings, and seek the approval ofthe board of directors etc. for the introduction of newproducts and activities?

2. Screening and management (1) Establishment of screening andmanagement system

(1) Is the screening and management division insulatedfrom the influence of the business promotiondivisions, for example, by being independent of thebusiness promotion divisions and not havingdirectors concurrently overseeing both the screeningand management division and the businesspromotion divisions?

If the screening and management division is notindependent of the business promotion divisions or ifa director concurrently oversees both the screeningand management division and the businesspromotion divisions, has the institution provided forchecking functions to ensure that screening andmanagement is appropriate?

(2) Role of screening and managementdivision

(2) Does the screening and management divisionprovide appropriate screening and management ofloans, for example, by accurately measuring theborrower’s financial position, the use to which thefunds will be put, and the resources from which theloan will be repaid, and utilizing this information toverify the accuracy of credit ratings?

Does the screening and management division etc.check that business promotion divisions areappropriately following its instructions, that theyhave sound lending stances (providing a smooth flowof funding to borrowers engaged in soundbusinesses, especially medium, small, and microbusinesses etc., banning speculative real estatelending and lending for excessively speculativefinancial schemes, and refusing to supply funds toantisocial elements), and that they are not engagedin inappropriate collections of funds?

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Does the screening and management divisioncommunicate to business promotion divisions thatthe Financial Inspection Manuals created by theauthorities are not to be used as an excuse forrefusing to lend to borrowers engaged in soundbusinesses, for recalling funds from such borrowers,or for other inappropriate handling? Does it check toensure that the business promotion divisions are notengaged in inappropriate handling?

3. Credit management (1) Establishment of credit managementdivision

(1) Do the business promotion divisions and screeningand management division have systems in place forintegrated management of credits (for example, thestatus of business conditions in the borrower’sindustry) that covers, to the extent permitted underapplicable laws and ordinances, the financialinstitution, its consolidated subsidiaries, and itssubsidiaries falling under the equity method?

Is a specific division assigned to verify the levels ofwrite-offs and reserves? Does this division very thatthe levels of write-offs and reserves arecommensurate to credit risks, and does it report theamount of write-offs and reserves accurately to theboard of directors?

Is a specific division assigned to manage portfoliostatus (including the concentration of lending inspecific industries and groups)? Does this divisionengage in appropriate portfolio management anddoes it report regularly on the status of the portfolioto the board of directors?

(2) Roles of credit auditing division (2) Does the institution have a credit auditing divisionthat verifies the accuracy of credit ratings, thestatus of borrower credit management, and otherrelevant information? Does this division verify theappropriateness of credit management and report itsfindings to the board of directors etc? If a businesspromotion division or a screening and managementdivision manages the portfolio, does the creditauditing division verify the appropriateness ofportfolio management?

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Do financial institutions calculating their capitaladequacy ratios according to the Basle standardshave specialized systems for their crediting auditing(including systems in which the risk managementdivision performs credit audits)?

It would also be desirable for financial institutionscalculating their capital adequacy ratios according todomestic standards to have specialized systems fortheir credit auditing divisions.

(3) Roles of risk management division (3) Does the institution have a risk managementdivision that provides integrated management ofassets with credit risk exposure and off-balance-sheet items? Does it practice integrated credit riskmanagement?

Do financial institutions calculating their capitaladequacy ratios according to the Basle standardshave specialized systems for their risk managementdivision (including systems in which the riskmanagement division performs credit audits)?

It would also be desirable for financial institutionscalculating their capital adequacy ratios according todomestic standards to have specialized systems fortheir risk management divisions.

4. Management of problem credits (1) Establishment of management systemfor problem credits

(1) Is there a specific division assigned to manage andcollect problem credits? Does it appropriatelymanage problem credits?

Does the institution specify the range of credits thatparticularly require management as problemcredits?

Do financial institutions calculating their capitaladequacy ratios according to the Basle standardshave specialized divisions for managing andcollecting problem credits? It would also be desirablefor financial institutions calculating their capitaladequacy ratios according to domestic standards tohave specialized systems for managing andcollecting problem credits.

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(2) Role of problem credit managementdivision

(2) Does the division responsible for managing andcollecting problem credits articulate clear guidelinesfor working with problem borrowers and manage thebusiness conditions etc. at problem borrowersaccordingly?

Are problem borrowers given appropriate guidancein rebuilding, or are they liquidated or collected,based on the guidelines for working with problemborrowers?

5. Self-assessments on assetquality

See “Credit Risk Inspection Manual.”

6. Write-offs and reserves See “Credit Risk Inspection Manual.”

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Credit Risk Management ManualCredit Risk Management ManualCredit Risk Management ManualCredit Risk Management ManualTable of ContentsTable of ContentsTable of ContentsTable of Contents

• Inspections of self-assessments on asset qualityI. Purpose of inspections of self-assessments.......... 3II. Method of inspecting self-assessment standards. 3III. Verification of the institution’s self-assessment

systems................................................................. 41. Formulation of self-assessment standards.......... 42. Status of self-assessment systems....................... 43. Reporting of self-assessment results to the board of

directors ............................................................... 54. Auditing by auditors and external auditors of self-

assessment systems ............................................. 5IV. Verification of the appropriateness of self-

assessment standards.......................................... 51. Definition of terms ............................................... 52. Categories used in self-assessment standards .... 5

V. Verification of the appropriateness of self-assessment results............................................... 6

1. Base date.............................................................. 62. Sampling standards............................................. 73. Specific inspection methods etc. .......................... 74. Self-assessment accuracy standards ................... 8

Attachment1. Credit classification method ................................ 10

(1) Basic concepts ...................................................... 10(2) Credit ratings....................................................... 11(3) Borrower classifications....................................... 11

1) “Normal”............................................................. 122) “Needs attention” ............................................... 123) “In danger of bankruptcy”.................................. 144) “Effectively bankrupt”........................................ 165) “Bankrupt” ......................................................... 17

(4) Adjustment for collateral ..................................... 171) Superior collateral ............................................. 172) Ordinary collateral............................................. 183) Appraised collateral value ................................ 184) Estimated disposal value ................................... 19

(5) Adjustment for guarantees etc. .......................... 201) Superior guarantees etc. .................................... 222) Ordinary guarantees.......................................... 223) Guarantee reservation and management

supervision pledges ............................................ 22(6) Credits not subject to classification..................... 22

(7) Credit categorization standards ......................... 241) “Normal” credits ................................................. 242) “Need attention” credits ..................................... 243) “In danger of bankruptcy” credits ...................... 264) “Effectively bankrupt” and “bankrupt” credits .. 27

(8) Credits to foreign governments etc. ..................... 28(9) Credits to foreign private companies and to

Japanese companies abroad................................. 29(10) Interest receivable similar to loans ..................... 29(11) Relationship with credit categories under the Law

Regarding Emergency Measures to RevitalizeFinancial Functions ............................................. 30

1) “Non-classified” credits ...................................... 302) “Special attention” credits.................................. 313) “Risk” credits ...................................................... 314) “Unrecoverable or valueless” credits.................. 31

(12) Credits to consolidated subsidiaries .................... 312. Securities categorization method......................... 32

(1) Basic concepts ...................................................... 32(2) Bonds.................................................................... 32

1) Bonds not subject to classification ..................... 322) Bond classification method ................................ 33

(3) Equities ................................................................ 341) Equities not subject to classification ................. 342) Equity categorization method ........................... 34

(4) Foreign securities ................................................ 351) Foreign securities not subject to classification .. 352) Foreign security classification method .............. 36

(5) Other securities.................................................... 363. Method of categorization for other assets (i.e.,

assets other than credits and securities) ............. 37(1) Suspense payments.............................................. 37(2) Chattels and real estate....................................... 37(3) Golf club memberships......................................... 38(4) Miscellaneous assets ............................................ 38

• Inspections of Write-offs and ReservesI. Purpose of inspectors of write-offs and reserves.. 40II. Method of inspecting write-offs and reserves ...... 40III. Verification of the institutions’ write-off and reserve

systems ................................................................. 411. Formulation of write-off and reserve standards .. 412. Status of write-off and reserve systems ............... 413. Reporting of write-off and reserve results to the

board of directors.................................................. 424. Auditing by auditors and external auditors of write-

off and reserve systems ........................................ 42IV. Verification of the appropriateness of write-off and

reserve standards ................................................. 42V. Verification of the appropriateness of write-off and

reserve results ...................................................... 421. Base date .............................................................. 432. Specific inspection methods etc............................ 433. Standards for judging the appropriateness of write-

offs and reserves................................................... 43

Attachment1. Default reserves ................................................... 44

(1) General default reserves ..................................... 441) Default reserves for credits to “normal” borrowers

............................................................................ 472) Default reserves for credits to “needs attention”

borrowers ............................................................ 48(2) Specific default reserves and direct write-offs ..... 49

1) Specific default reserves for credits to “in danger ofbankruptcy” borrowers ....................................... 49

2) Specific default reserves and direct write-offs for“effectively bankrupt” and “bankrupt” borrowers............................................................................ 52

3) Reserves against specific foreign credits............ 524) Verification of the appropriateness of the total

value of default reserves ..................................... 532. Reserves other than default reserves................... 53

(1) Reserves against losses from the sale of credits .. 53(2) Reserves against support for specific borrowers.. 54(3) Other reserves against contingency losses .......... 55

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3. Securities appraisal ............................................. 56(1) Bond appraisal ..................................................... 56(2) Equity appraisal ................................................. 56(3) Foreign security appraisal ................................... 57(4) Securities investment trust beneficiary certificate

appraisal..................................................................... 574. Appraisal of other assets ..................................... 57

(1) Suspense payment appraisal ............................... 57(2) Chattel and real estate appraisal ........................ 57(3) Golf club membership appraisal.......................... 58(4) Miscellaneous assets appraisal ........................... 58

• Inspections of capital adequacy ratiosI. Inspections of the accuracy of capital adequacy

ratios .................................................................... 59II. Verification of the effect of write-off and reserve

inspection results on capital adequacy ratios...... 591. Study write-off and reserve levels ...................... 602. Calculation of additional required write-off and

reserve values ...................................................... 60III. Monitoring of the financial institution’s response to

declines in the capital adequacy ratio ................. 60

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Inspections of Credit RiskInspections of Credit RiskInspections of Credit RiskInspections of Credit Risk

The prompt corrective actions are based on capital adequacy ratios, and because of this, capital adequacy ratios must be calculated from accuratefinancial statements. The creation of accurate financial statements will entail appropriate write-off and reserve allocations and also appropriate self-assessments on asset quality, since self-assessments form the preparatory stage for write-off and reserve allocations.

Therefore, in inspections of credit risk, inspectors will need to go beyond confirmations of appropriateness of self-assessment standards and verificationsof the accuracy of self-assessment results to verify the total amount of write-offs and reserves that the institution is claiming and the appropriateness of thoselevels. They must place particular emphasis on verifying that the institution’s total write-offs and reserves are at levels commensurate to credit risks.

• Inspections of self-assessments on asset quality

I.I.I.I. Purpose of inspections of self-assessments Purpose of inspections of self-assessments Purpose of inspections of self-assessments Purpose of inspections of self-assessments on asset qualityon asset qualityon asset qualityon asset quality

Asset quality assessments consider the assets held by the financial institution separately and individually in order to classify them according to theircollection risk and price-decline risk. This serves as a measure of the safety and the certainty of the assets that stand behind the deposits of depositorsor, in other words, the degree of risk to which deposits are exposed because of the potential, for example, for assets to be defaulted on. When the financialinstitution performs this assessment on its own, it is referred to as a “self-assessment.”

Self-assessments are a tool that financial institutions can use to manage their credit risks, and they also serve as the preparatory stage forappropriate write-offs and reserves. Similarly, external auditors can refer to self-assessments in their audits of financial statements to evaluate theeffectiveness of the financial institution’s self-assessments and other internal controls.

When inspecting self-assessments, inspectors should assume that financial institutions have indeed performed self-assessments and that these self-assessments have been audited by external auditors. Based on these assumptions, inspectors should verify the status of the systems that the institutionhas put in place for self-assessments, the appropriateness of its self-assessment standards, and the accuracy of its self-assessment results, and shouldthen determine if the institution’s self-assessment standards, which are the preparatory stage for write-offs and reserves, are rational and whether theself-assessment results appropriately reflect the asset quality of the financial institution under inspection.

In inspections of cooperative financial institutions, inspectors should be aware that cooperative financial institutions are only required to selectexternal auditors in a limited number of cases.

II.II.II.II. Method of inspecting self-assessment standardsMethod of inspecting self-assessment standardsMethod of inspecting self-assessment standardsMethod of inspecting self-assessment standards

Inspectors shall begin by performing “process examination.” That is, they will first verify the status of the systems that the institution has put inplace for self-assessments and the appropriateness of the institution’s self-assessment standards. Having done this, they will then verify the results ofself-assessments, in principle by means of sampling.

Should there be problems identified during inspectors, the inspectors shall endeavor to exchange opinions with the financial institution. For example,inspectors shall provide the financial institution under inspection with the viewpoints of the authorities, shall fully recognize the thinking of thefinancial institution in this regard, and shall directly confirm the viewpoint of the external auditors in the presence of the financial institution.

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III.III.III.III. Verification of the institutionVerification of the institutionVerification of the institutionVerification of the institution’’’’s self-assessment systemss self-assessment systemss self-assessment systemss self-assessment systems

Inspectors shall verify the status of the systems that the institution has put in place for self-assessments by checking the items listed below.

1. Formulation of self-assessment standards

Do self-assessment standards conform to all applicable laws and ordinances and to the framework set forth in the inspection manual?

Have formal bank procedures been followed by the board of directors in determining and codifying self-assessment standards?

Do self-assessment standards specify the scope of assets subject to self-assessment, the divisions responsible for performing self-assessments(sales-related divisions (business offices, head-office sales divisions, head office loan approval divisions (loan management division, loan reviewdivision etc.) or asset auditing divisions) and auditing divisions (credit auditing office, inspection division etc.)), and the lines of responsibility for self-assessment standards and their formulation?

Are the opinions of the auditing division and compliance management divisions sought in the formulation and revision of self-assessmentstandards, not just the opinions of divisions performing self-assessment standards?

Have self-assessment manuals been formulated and codified for the use of business offices etc. in appropriately performing self-assessments?

2. Status of self-assessment systems

Are there sufficient checks on sales-related divisions in self-assessment standards? For example, 1) a system in which the businesses office andhead-office sales divisions perform primary assessments, the head office loan approval division performs secondary assessments, and then an assetauditing division independent of the sales-related divisions audits the results, or 2) a system in which self-assessments are performed with thecooperation of the sales-related divisions by an asset assessment division that is independent of the sales-related divisions. Is the system able toaccurately perform self-assessments?

Are personnel versed in self-assessments assigned to the divisions performing self-assessments and the auditing divisions?

Do asset auditing divisions and asset assessment divisions provide needed training and supervision to sales-related divisions?

Is the auditing division independent of the sales-related divisions? Do directors in charge of sales-related divisions have concurrent responsibilitiesfor auditing divisions? If directors in charge of auditing divisions are also in charge of sales-related divisions, are there sufficient checks in place toensure that audits are appropriate?

Does the auditing division verify that self-assessments are performed appropriately and in accordance with the self-assessment standards andself-assessment manual?

It is desirable that the auditing division does not just verify the accuracy of self-assessment results but also verifies the accuracy of credit ratingsand credit follow-up and management.

Does the financial institution keep sufficient records and documents in its divisions that government inspectors, auditors and others are able toverify the performance of self-assessments after-the-fact?

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3. Reporting of self-assessment results to the board of directors

Are self-assessment results reported regularly and appropriately to the board of directors?

Does the board of directors receive timely reports on the status of self-assessment systems (changes in divisions performing or auditing self-assessments etc.)?

4. Auditing by auditors and external auditors of self-assessment systems

Do auditors and external auditors who are not subject to the influence of the directors appropriately audit the status of self-assessment system asdescribed in 1-3 above?

IV.IV.IV.IV. Verification of the appropriateness of self-asseVerification of the appropriateness of self-asseVerification of the appropriateness of self-asseVerification of the appropriateness of self-assessment standardsssment standardsssment standardsssment standards

Inspectors shall check whether the self-assessment standards formulated by the financial institution are clear and appropriate and whether theirframework is in line with the framework described in the Attachment. If the financial institution uses an original framework for its self-assessmentstandards, inspectors shall verify the relationship between the institution’s framework and the model framework in the Attachment, and shall determinewhether individual rules within the institution’s self-assessment standards are rational (for example, the collateral appraisal rules, or simplifiedsecurities appraisal rule).

1. Definition of terms

(1) Credit rating: A rating of the borrower’s degree of credit risk. Credit ratings are essential to credit risk management and form the basis foraccurate self-assessments and appropriate write-offs and reserves. Credit ratings must also be consistent with borrower classifications.

(2) Borrower classifications: A judgement of the borrower’s ability to repay the obligation as determined from the borrower’ financial position, cashflow, profitability and other considerations. Depending on results, the borrower is classified as “normal”, “needs attention”, “in danger ofbankruptcy”, “effectively bankrupt”, or “bankrupt”.

(3) The assignment of assets to Categories II, III, or IV during self-assessment standards is referred to as “classification”, and asset that have beenassigned to Categories II, III, or IV are referred to as “classified assets.” Not assigning assets to Categories II, III, or IV is referred to as “non-classified,” and all assets other than classified assets (i.e., all Category I assets) are referred to as “non-classified assets”.

(4) “Credit categories” are as defined in the asset assessment standards set forth in the “Law Regarding Emergency Measures to RevitalizeFinancial Functions” (Law No. 132 of 1998; “Emergency Revitalization Law” hereinafter) Article 6:2 and the “Concomitant Ordinances for theLaw Regarding Emergency Measures to Revitalize Financial Functions” (Prime Minister’s Office Ordinance No. 65 of 1998; “EmergencyRevitalization Law Ordinances” hereinafter) Article 4. Credit categories are based on the financial position and the business results of theborrower, and consist of “Non-classified credits,” “special attention credits”, “risk credits”, “unrecoverable/valueless credits”, categories.

2. Categories used in self-assessment standards

Self-assessment standards shall classify assets in four groups according to the repayment risk and the loss of value risk: I, II, III, IV.

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(1) Category I (unclassified assets) consists of assets not assigned to Category II, Category III, or Category IV. These are assets with no problems interms of repayment risk or loss of value risk.

(2) Category II consists of “assets deemed to include a higher than normal repayment risk because conditions for ensuring the integrity of the credithave not been fully met or because there are questions regarding the creditworthiness of the borrower.” Category II may include both assetssecured with collateral and guarantees, and unsecured assets.

(3) Category III consists of “assets for which there are serious doubts about final collection or value and therefore a high risk of losses but for whichthe amount of loss is difficult to rationally estimate.” However, it is not entirely impossible for financial institutions to estimate a loss amountand it is appropriate that institutions do estimate losses according to their own rules and a detailed consideration of the status of the individualasset.

(4) Category IV consists of “assets that are deemed uncollectable or without value.” Category IV assets are not, however, assets that are absolutelyuncollectable or without value. Partial collection may indeed be possible at some point in the future, but the asset is uncollectable or withoutvalue on the assessment base date.

V.V.V.V. Verification of the appropriateness of self-assessment resultsVerification of the appropriateness of self-assessment resultsVerification of the appropriateness of self-assessment resultsVerification of the appropriateness of self-assessment results

Inspectors shall use the methods described in the attachment to verify that self-assessments are being performed appropriately and in accordancewith the self-assessment standards. This verification process should endeavor to form an accurate picture of the institution’s systems for self-assessments, reporting of self-assessment results to the board of directors, and internal and external auditing of self-assessment systems.

Therefore, when inspectors deem self-assessment results to be inappropriate, they shall endeavor to fully confirm and accurately identify the causestherefor (because of self-assessment standards or because of the way in which self-assessments are performed) and future improvements to be made bythe financial institution under inspection.

1. Base date

The day that serves as the base for verification of the accuracy of self-assessment results (the “base date” hereinafter) shall in principle be the lastday of the accounting period (including mid-term accounting periods and so throughout) directly prior to the accounting period in which the inspectionis performed (or the “advance notice date” for inspections made with advance notice). However, if the inspection date is prior to a board of directorsmeeting to determine final accounts for the preceding accounting period, the base date shall be the final day of the second preceding accountingperiod.

(1) The determination of the base date shall take into account the nature of the assets held by the financial institution under inspection, theinspection period and other relevant matters. If it is likely that there will be a board of directors meeting held to review final accounts during theinspection period and if the nature of the assets held by the financial institution under inspection would warrant the inspection of the accuracy ofthe self-assessment results from the accounting period immediately prior, then the base date shall be the last day of the accounting periodimmediately prior to the inspection.

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(2) All financial institutions are required to perform self-assessments as of the last day of the accounting period, but there may be cases in which, forconvenience in processing, the institution establishes a provisional base date for its self-assessments. In these cases, inspectors should verify thatthe provisional base date is in principle within three months of the last day of the accounting period. Note that, from the perspective of creditrisk management, it is desirable that the institution engage in credit management. This management should consist of on-going monitoring ofthe financial position of the borrower, the status of the collateral and guarantee, and other relevant information, and the institution shouldreview credit ratings, credit categories, and classifications as warranted by changes in conditions at the borrower. When the financial institutionunder inspection handles credits in this manner without establishing provisional base dates, then inspectors should verify that credit ratingreviews and the like are performed in an appropriate and timely manner.

2. Sampling standards

The chief inspector shall determine sampling standards according to the size of the financial institution under inspection, the nature of its assets,the results from the last inspection, the number of inspectors assigned to the institution, the period of the inspection, and other relevant information.The chief inspector may change sampling standards after an on-site inspection has begun as necessary to ensure the effectiveness of the inspection.

The chief inspector shall endeavor to improve the efficiency of inspections. For example, if no particular problems are found in the nature of theassets held by the financial institution under inspection and the results from the last inspection were good, the chief inspector may reduce thesampling rate.

3. Specific inspection methods etc.

The following methods shall be used to verify the accuracy of self-assessment results.

(1) Scope of verification

The scope of accuracy verifications shall be assets on the base date sampled according to the sampling standards described in Item 2 above.Priority attention shall be given to verification of the accuracy of self-assessments for assets from borrowers classified as other than “normal” inthe self-assessments performed by the financial institution under inspection. Should the results of verifications of the self-assessment standardsof the financial institution under inspection indicate problems in the sampling standards of the financial institution under inspection, andshould there be the potential for non-“normal” borrowers to have been classified as “normal”, the inspection shall also place priority on verifyingthe accuracy of self-assessments of credits from borrowers classified as “normal”.

(2) Specific verification methods

Inspectors shall use the materials (worksheets etc.) employed by the financial institution under inspection in its self-assessments to verify theaccuracy of self-assessments according to the self-assessment standards of the financial institution under inspection, paying particular attentionto borrowers classified as other than “normal”. More concretely, inspectors shall verify the accuracy of borrower classifications and creditcategories, and classified amounts.

1) When the financial institution under inspection uses provisional base dates to perform its self-assessments, inspectors shall use materialsfrom the provisional base date to verify the accuracy of borrower classifications, credit categories, and classified amounts as at the provisionalbase date. They shall next verify that the institution has clear standards for revisions between the provisional base date and the actual base

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date, and that these standards are rational. Finally, they shall verify that necessary revisions are made to self-assessment results betweenthe provisional and actual base dates.

Should the provisional base date not be within three months of the last day of the accounting period, inspectors shall verify that necessaryrevisions are performed in an appropriate manner when there are changes in conditions between the provisional base date and the final dayof the accounting period.

In determining whether the standards for revisions between the provisional base date and the actual base date are rational, inspectorsshall make a general judgement that considers the size of the assets held by the financial institution under inspection, the businesses inwhich it is engaged, and the impact on write-offs and reserves.

2) For developments that occur after the final day of the accounting period, inspectors shall use the sampling standards described in Item 2above to sample assets that meet set standards, shall study the assets in detail and shall verify that changes have been reflected in thecurrent accounting period. When verifying developments after the final day of the accounting period, inspectors shall note the need to verifythat the institution has rational standards for initiating reviews because of subsequent developments, as was the case in Paragraph 1 above.

Serious subsequent developments (primary developments) need to be reflected in the current accounting period. Should inspectors discoverthat subsequent developments have occurred that are potentially serious given the size of the asset held by the financial institution underinspection, but that these developments have not been reflected on the current accounting period, they shall seek an opinion from theinstitution’s external auditors.

4. Self-assessment accuracy standards

Should the results of verifications of the accuracy of self-assessments indicate that any of the following apply to the self-assessment results of thefinancial institution under inspection, inspectors shall judge the self-assessments as inaccurate.”

Note that judgements of the accuracy of self-assessments must be based on borrower conditions (financial position etc.) on the provisional basedate or base date, not on the inspection date.

(1) There are problems with the appropriateness of the self-assessment standards and because of this there are misjudgements in the borrowerclassifications, credit categories, or classified amounts on the provisional base date or base date.

(2) Assets sampled and assessed by the financial institution under inspection according to its own self-assessment sampling standards:

1) Were assessed as of the base date, but the borrower classifications, credit categories, or classified amounts as of the base date were wrong.

2) Employed assessment as of the provisional base date in lieu of assessment as of the base date, but the borrower classifications, creditcategories, or classified amounts as of the provisional base date were wrong.

3) Were accurately assessed as of the provisional base date, but important subsequent changes in borrower conditions, loan repayment status,appraised collateral value, amount of credit or other matters required, according to the institution’s self-assessment standards, a review onthe base date, which was not done, so that the borrower classifications, credit categories, or classified amounts as of the base date werewrong.

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(3) Other assets that the chief inspector specifically designates for sampling:

Are designated as “classified assets.”

However, when the financial institution under inspection has established a sampling exclusion threshold below which credits are notsampled, these credits shall be excluded if the threshold is deemed rational in light of a general evaluation of the institution’s asset size andnature, and the influence on write-offs and reserves etc.

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AttachmentAttachmentAttachmentAttachment

ItemItemItemItem Verification of the appropriateness of self-Verification of the appropriateness of self-Verification of the appropriateness of self-Verification of the appropriateness of self-assessment standardsassessment standardsassessment standardsassessment standards

Verification of the appropriateness of self-assessmentVerification of the appropriateness of self-assessmentVerification of the appropriateness of self-assessmentVerification of the appropriateness of self-assessmentresultsresultsresultsresults

RemarksRemarksRemarksRemarks

1.1.1.1. Credit classification methodCredit classification methodCredit classification methodCredit classification method “Credit” refers to loans and creditssimilar to loans (loan securities, foreignexchange, interest receivable, accountsreceivable, suspense payments similar toloans, and per contras for acceptances andguarantees). Credits are classifiedaccording to the following method.

In managing credit risk, institutionsare also expected in principle to performself-assessments for assets other than thoselisted above when there are credit risksassociated therewith, and also for off-balance sheet assets. In these cases, theinstitution must clearly articulate the scopeof assets etc. subject to self-assessments.

Institutions calculating their capitaladequacy ratios according to internationalstandards shall perform self-assessmentsfor off-balance-sheet assets. Institutionscalculating their capital adequacy ratiosaccording to domestic standards are notrequired to perform self-assessments for off-balance-sheet assets, but it is desirable thatthey do so.

Note: “Institutions calculating theircapital adequacy ratios according tointernational standards” refers tofinancial institutions calculatingtheir capital adequacy ratiosaccording to the Basle standards;“institutions calculating theircapital adequacy ratios according todomestic standards” refers tofinancial institutions calculatingtheir capital adequacy ratiosaccording to domestic standards,and so throughout.

(1)(1)(1)(1) Basic conceptsBasic conceptsBasic conceptsBasic concepts In assessing assets, institutions shallin principle perform credit ratings andclassify borrowers according to these creditratings. Having done this, they shallconsider individually the uses to which thefunds for the credit are employed and thestatus of the credit’s collateral, guaranteesor other security provisions. This shall formthe basis for categorizing credits accordingto their repayment risk and loss of valuerisk.

Note that institutions calculating theircapital adequacy ratios according tointernational standards are required to

In verifying credit classification methods, check thatcredit ratings are rational and consistent with borrowerclassifications (when credit ratings are employed), thatborrower classifications are accurate, that the use offunds etc. is considered individually, and that accurateadjustments are made for collateral, guarantees, andother security provisions. Verify also that classificationsare accurate in light of self-assessment results.

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perform credit ratings. Institutionscalculating their capital adequacy ratiosaccording to domestic standards mayclassify borrowers without performingcredit ratings but it is desirable that creditratings be introduced into their systems.

(2)(2)(2)(2) Credit ratingsCredit ratingsCredit ratingsCredit ratings Credit ratings are a measure of thedegree of credit risk associated with theborrower and shall be performed based onthe financial position of the borrower,ratings issued by ratings agencies,information from credit research bureaus,and other relevant data. Credit ratingsmust be consistent with the borrowerclassifications described below.

For institutions performing credit ratings, verifythat the credit rating is rational in light of theborrower’s financial position, the ratings issued byratings agencies, information from credit researchbureaus, and other relevant data, and that theinstitution maintains consistency between the conceptsunderlying its credit ratings and borrowerclassifications.

When credit ratings are performed based oninternal data in the possession of the financialinstitution under inspection, verify the reliability of thedata and the sufficiency of the sample. Verify that theinstitution supplements this data with data fromoutside credit research bureaus and the like in the eventthat internal data is inadequate.

Verify that the institution reviews the credit ratingregularly and whenever there is need as indicated bybusiness conditions and forecasts relating to theborrower, reviews of the ratings issued by ratingsagencies, and the evaluation given the borrower by themarkets etc. Verify also that the auditing divisionchecks the accuracy of the credit rating.

Note: “Ratings agency” refers to aninstitution performing ratings inaccordance with the “designation ofratings agencies and ratingspursuant to the provisions ofArticle 9-3:4:e of the Ministry ofFinance Ordinance on Disclosure ofCorporate Information.”

(3)(3)(3)(3) Borrower classificationsBorrower classificationsBorrower classificationsBorrower classifications Borrowers are to be classified as followsin light of conditions etc. at the borrower asevidenced in principle by credit ratings.(Project finance credits do not need to followthese classifications.)

In verifying borrower classifications, check thatclassifications are accurate in light of conditions etc. atthe borrower as evidenced in principle by credit ratings.Note that project finance credits may be classifiedaccording to the degree of repayment risk.

Borrower classifications would requirecomprehensive judgement. Begin by consideringrepayment ability as evidenced by the borrower’sfinancial position, cash flow, and profitability etc., factorin the nature of the industry etc. and the forecast forbusiness continuity and profitability, and then evaluatethe borrower’s ability to pay the debt at maturity fromcash flow, the appropriateness of its businessimprovement plans etc., and the support provided byfinancial institutions etc.

Note: “Project finance” refers, forexample, to a non-recourse loanthat is used to finance a specificproject (business), with the fundingfor payments of interest andprincipal on the loan limited to thecash flow (profits) generated by theproject. In this type of financing,the loan is secured only by theassets of the project. This definitionapplies throughout this document.

Note: “Cash flow” refers to currentprofits adjusted for depreciationcharges and other non-asset items,and so throughout.

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Particularly for medium, small, and microcompanies, consider the company’s technology skills,sales capacity and growth potential, remuneration torepresentative director and directors, income and assetsof directors etc., guarantee status, and guarantee abilityetc. to arrive at a comprehensive judgment of thecompany’s business status.

When factoring in the existence of a parentcompany for the borrower, it is not sufficient todetermine the borrower classification merely on thebasis of the parent company having a strong financialposition. When factoring in support from the parentcompany, inspectors must fully check the parentcompany’s track record in supporting subsidiaries andthe potential for support in the future.

If the borrower is using official financing(“government funding” hereinafter), for example, centralor local government subsidies for the interest paymentson loans from private financial institutions, consider theborrower classification in terms of the nature of thegovernment funding utilized in addition to the financialposition of the borrower itself.

1)1)1)1) ““““NormalNormalNormalNormal”””” A “normal” borrower has strong resultsand no particular problems with itsfinancial position.

Verify if these borrowers are actually “normal”borrowers.

2)2)2)2) ““““Needs attentionNeeds attentionNeeds attentionNeeds attention”””” A “needs attention” borrower hasproblems with lending conditions (i.e.,waivers, reductions, or deferrals ofinterest), has problems with fulfillment(i.e., de facto arrears on principal orinterest payments), has poor results or isunstable, has problems with its financialposition, or otherwise requires specialattention and management.

It is desirable that “needs attention”borrowers be divided into “specialattention” borrowers and other borrowers.

Verify if these borrowers are actually “needsattention” borrowers.

If the institution divides “needs attention”borrowers into “special attention” borrowers and othersborrowers, verify that the classifications areappropriate. Check that “needs attention” borrowers donot include borrowers that would ordinarily be classifiedas “in danger of bankruptcy” in light of their financialposition etc., but have been classified as “needsattention” borrowers merely because their parentcompany etc. has a strong financial position.

If borrowers meet criteria A-C below, check whetherthey are “needs attention” in light of the considerationsto the left. Do not immediately classify them as “needsattention”.

Note: “Borrowers needing specialattention” are “needs attention”borrowers for which all or part ofthe credits require specialattention, and so throughout.

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A. Borrowers that are in the red because of start-upcosts but have not departed much from their initialbusiness plans may be considered “normal”.

“Borrowers that are in the red because ofstart-up costs but have not departed much fromtheir initial business plans” refers to borrowerswith rational initial business plans that areproceeding roughly according to plan when resultsand plans are compared, and that evince a highpotential to achieve their plans.

Specifically, these borrowers will inprinciple target profitability within about fiveyears and will have at least 70% of the sales andprofits targeted in their initial business plans.

These standards are merely yardsticks fordetermining the rationality and achievability ofbusiness plans. They should not be appliedmechanically or uniformly when reviewing theborrower classification of companies that are in thered because of start-up costs.

Reviews of borrower classification entail acomprehensive judgement that takes into accountthe nature of the industry, the nature of thebusiness, the size of the business, the ability torepay the loan in full from cash flow, theborrower’s technology skills, sales capacity, andgrowth potential, and other relevant factors.Inspectors should not immediately classify aborrower as “needs attention” merely because itdoes not formally meet these standards.

B. The following kinds of borrowers may be classifiedas “normal” even if they are in the red.

These standards are merely yardsticks fordetermining the rationality and achievability ofbusiness plans. They should not be appliedmechanically or uniformly when reviewing theborrower classification of companies that are in thered because of start-up costs.

Reviews of borrower classification entail acomprehensive judgement that takes into accountthe nature of the industry, the reasons for thelosses, the internal reserves of the company, andthe forecast for the future. Inspectors should notimmediately classify a borrower as “needs

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attention” merely because it does not formally meetthese standards.

a) Losses are caused by transient factorssuch as losses on the sale of fixed asset,and the borrower is certain to return toprofitability in a short period of time.

b) Medium, small, and micro companies thatare in the red, but there are deemed to beno particular problems with therecoverability of the credit.

C. A borrower that has dishonored bills,accommodation bills, or has discount bills forwhich there are doubts regarding payment atmaturity may be classified as “normal” if a generalevaluation of the borrower’s profits and financialposition indicates that it has the ability to bear thecost of the dishonored bill etc.

3)3)3)3) ““““In danger of bankruptcyIn danger of bankruptcyIn danger of bankruptcyIn danger of bankruptcy”””” An “in danger of bankruptcy” borroweris not bankrupt now but is facing businessdifficulties and has failed to make adequateprogress on its business improvement planetc. so that there is a large possibility of itfalling into bankruptcy in the future (thisincludes borrowers that are receivingsupport from financial institutions etc.).

Specifically, an “in danger ofbankruptcy” borrower is continuing inbusiness now but is already in de factoinsolvency, with its business resultsmarkedly depressed and its debt service inarrears so that there are serious concernsabout final repayment of principal andinterest. In other words, these areborrowers with a high likelihood ofgenerating losses for the institution and alarge potential to go bankrupt in the future.

Verify that these borrowers are actually “in dangerof bankruptcy” borrowers.

However, when a borrower has formulated abusiness improvement plan etc. predicated on supportfrom financial institutions etc. and all of the conditionsbelow are met, the business improvement plan may bedeemed rational and possessed of a high potential forachievement, and therefore the borrower may beclassified as a “need attention borrower.”

These standards are merely yardsticks fordetermining the rationality and achievability ofbusiness plans. They should not be applied mechanicallyor uniformly when reviewing the borrower classificationof companies that have formulated businessimprovement plan etc.

Reviews of borrower classification entail acomprehensive judgement that takes into account thenature of the industry, the forecast for businesscontinuity and profitability, the ability to repay the loanin full from cash flow, the appropriateness of thebusiness improvement plan etc., and the availability ofsupport from financial institutions etc. Inspectorsshould not immediately classify a borrower as “in dangerof bankruptcy” merely because it does not formally meetthese standards.

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In particular, medium, small, and micro companiesmay not always formulate business improvement plansetc., and in these cases, inspectors should consider thecompany’s technology skills, sales capacity and growthpotential, remuneration to representative director anddirectors, income and assets of directors etc., guaranteestatus, and guarantee ability etc. to arrive at acomprehensive judgment of the company’s businessstatus. Do not immediately classify a borrower as “indanger of bankruptcy” merely because it has notformulated a business improvement plan etc.

Additionally, when a borrower is using governmentfunding to formulate a business improvement plan etc.and the business improvement plan etc. has beenreviewed by the central or prefectural government,inspectors should take account of the involvement of thecentral or prefectural government and itsappropriateness in light of conditions at the borrower.

A. The period for the business improvement plan etc.should in principle be no more than about fiveyears and the plan should have a high potential forachievement.

However, this may include businessimprovement plans etc. with periods of betweenfive and ten years if, after the plan is formulated,progress in its achievement has been generallyaccording to plan (at least 80% of the sales andcurrent profit targets), and the borrower is deemedlikely to continue to achieve the plan in the future.

B. The plan will in principle enable the borrower to beclassified as “normal” when it is completed.However, it is acceptable for the borrower to beclassified as “needs attention” after the completionof the plan, provided that after completion of theplan it will not require rebuilding support fromfinancial institutions and will be able to continuein business on its own.

C. There are documents or other confirmationsattesting that all financial institutions etc. withwhich the borrower does business (including thefinancial institution under inspection) havecompleted formal internal procedures for providingsupport as called for in the business improvementplan etc. and that an agreement on support hasbeen reached.

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However, in cases in which it is possible torebuild the company with support only from thefinancial institution under inspection, or in casesin which it is possible to rebuild the company withsupport from only some of the financial institutionsetc. with which the borrower does business(including the financial institution underinspection), it is sufficient for there to bedocumentary or other confirmations that thefinancial institutions etc. involved have completedformal internal procedures and reached anagreement on support as called for in the businessimprovement plan etc.

D. Support from financial institutions etc. must belimited to waivers and reductions of interest,maintenance of lending balances and the like andmay not include the relinquishment of credits, cashgifts, or other provisions of funds to the borrower.

However, this shall include cases in whichthe institution has already provided funds to theborrower (relinquishment of credits, cash gifts) butis not expected to do so after the initiation of thebusiness improvement plan etc., and cases inwhich plans require the provision of cash to theborrower (relinquishment of credits, cash gifts) butfull reserves have already been allocated for thelosses forecast from this support and there are noforecasts for further losses in the future.

Note that when the borrower is making useof government funding, interest subsidies and thelike made by prefectural governments withsubsidies from the central government as providedfor in government funding programs are notincluded in relinquishment of credits etc.

4)4)4)4) ““““Effectively bankruptEffectively bankruptEffectively bankruptEffectively bankrupt”””” An “effectively bankrupt” borrower isnot yet legally and formally bankrupt, butis in serious business difficulties fromwhich it is considered impossible to rebuild.In other words, the borrower is for allpurposes bankrupt.

Specifically, this refers to borrowerswho are still formally in business but whosefinancial position includes large amounts ofnon-performing assets or excessive

Verify that these borrowers are actual “effectivelybankrupt” borrowers.

If the borrower is not legally or formally bankruptbut has voluntarily gone out of business or otherwiseeffectively ceased operations, verify that it has beenclassified as “effectively bankrupt”.

A. Among “borrowers who have formulated a businessimprovement plans etc. predicated on support fromfinancial institutions etc.,” those who are farbehind in the achievement of their business

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borrowings compared to the borrower’sability to repay. The borrower haseffectively been in serious insolvency for aconsiderable period of time and has no hopeof business improving; or, the borrower hastaken large losses from natural disasters,accidents, rapid changes in businessconditions and the like, has no hope ofrebuilding, and has in effect been in arrearsfor a prolonged period of time in itspayments of principal and interest.

improvement plans etc. and have no hope of arapid recovery in their results in the future and noforecast for the completion of their businessimprovement plan etc., or those for which somecorrespondent financial institutions have notagreed to provide support based on the businessimprovement plan etc. should, if there is a certainlikelihood of bankruptcy in the future, be deemed“in serious business difficulties with no hopes ofrebuilding,” and therefore may be classified as“effectively bankrupt”.

B. “In effect been in arrears for a prolonged period oftime” shall be interpreted in principle as effectivearrears of six months or longer that are notdeemed transient arrears.

5)5)5)5) ““““BankruptBankruptBankruptBankrupt”””” A “bankrupt” borrower is legally andformally bankrupt. This would includebankruptcy, liquidation, reorganization,rehabilitation, composition, and suspensionof dealings on the bill exchange.

Verify that these borrowers have been classified as“bankrupt”.

(4)(4)(4)(4) Adjustment for collateralAdjustment for collateralAdjustment for collateralAdjustment for collateral Categorize assets secured withcollateral as follows. If the asset is securedwith superior collateral, the estimateddisposal value of which covers the value ofthe asset, it is “non-classified;” if it issecured with ordinary collateral, theestimated disposal value of which coversthe value of the asset, it is in Category II.

Use the following to calculateappraised collateral value and estimateddisposal value.

Verify that assets secured with collateral have beencategorized, and that the appraised value and estimateddisposal value are rational, as described left.

1)1)1)1) Superior collateralSuperior collateralSuperior collateralSuperior collateral Deposits etc. (deposits, savings,premiums, money trusts with guaranteedprincipal, insurance and mutual-aidpolicies with returns at maturity, and sothroughout), government bonds and othersecurities of high creditworthiness,commercial bills of certain settlement, andsimilar instruments.

Verify that the instruments listed left arecategorized as “superior collateral.”

A. Note that for “insurance and mutual-aid policieswith returns at maturity,” the estimated disposalvalue is the amount received were the policycancelled on the base date.

B. “Government bonds and other securities of highcreditworthiness” refers to the securities listed in2.(2)1), the equities not subject to classification aslisted in 2.(3)1), and the foreign securities notsubject to classification as listed in 2.(4)1) when

Note: “Commercial bills of certainsettlement” includes cases in whichseparate deposits are retained forprovisional payments against bills.

Note: “Deposits etc.,” “governmentbonds and other securities of highcreditworthiness,” and “commercialbills of certain settlement” shall notbe deemed superior collateral if

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these instruments are deemed to be safe and haveno particular problems.

If an asset is secured with securities otherthan “government bonds and other securities ofhigh creditworthiness,” these securities mustsatisfy the requirements of liquidity—they must beeasily disposable.

C. “Commercial bills of certain settlement” refers tobills from issues with no problems in theirfinancial position or cash flow, when those bills arecertain to be settled on the date of maturation.However, accommodation bills issued to providefinancial support (i.e., cash flow etc.) with no basisin actual commercial transactions are excluded.

there are any impediments tocollection by disposal of collateral.

2)2)2)2) Ordinary collateralOrdinary collateralOrdinary collateralOrdinary collateral Collateral other than “superiorcollateral” that is disposable from anobjective perspective.

For example, real estate collateral,industrial factory foundation collateral etc.

Verify if the instruments listed to the left arecategorized as “ordinary collateral.”

Real estate collateral etc. shall in principle not behandled as ordinary collateral if mortgage rightregistration has been reserved. However, it may behandled as ordinary collateral if there are rationalreasons for reserving registration, if all of the requireddocuments for registration have been collected, and ifimmediate registration is possible.

Even in these cases it is appropriate to registerwithout fail in order to counter the claims of thirdparties, and it is necessary that the setting of mortgagerights for the real estate collateral is appropriatelymanaged.

3)3)3)3) Appraised collateral valueAppraised collateral valueAppraised collateral valueAppraised collateral value An appraised value (market value)calculated objectively and rationally.

Verify that appraised collateral values arecalculated objectively and rationally.

A. For borrowers categorized as “in danger ofbankruptcy”, “effectively bankrupt”, and“bankrupt”, reviews of the appraised value of realestate securing assets (re-appraisal, oradjustments to market, and so throughout) mustbe made at least once per year and it would bedesirable that they be made once per half-year,because the allocation to individual reserves mustbe calculated each accounting term. Reviews ofappraised values should be based on the mostrecent official land prices, standard land prices,inheritance tax appraisal values, or the likeavailable on the base date or provisional base date.

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For borrowers categorized as “needsattention”, it would also be desirable that theappraised value of real estate securing assets bereviewed once per year.

It is desirable that appraisals of real estatevalue be performed by qualified real estateappraisers for properties above a certain thresholdvalue.

It is desirable that appraisals of rental officebuildings and the like utilize the “returns method”in addition to “recent sales” and “official landprices” and the like.

B. If there are changes in the method by whichcollateral is appraised (for example, a change inthe standard from official land prices toinheritance tax appraisal values), verify that thereare rational reasons for the change.

4)4)4)4) Estimated disposal valueEstimated disposal valueEstimated disposal valueEstimated disposal value A value based on the appraised valuein 3) above considered certain to berecovered were the collateral disposed of.This must take full account of the nature ofthe property as a credit security. If theappraised value is of sufficiently highprecision, the appraised value andestimated disposal value may be equal.

Verify that the estimated disposal value iscalculated in an objective and rational manner based onthe appraised value of the collateral.

A. Verify that the multipliers used to calculate theestimated disposal value are rational.

Estimated disposal values may be deemedappropriate if they are below the values arrived atwhen the appraised value is multiplied by themultipliers shown below.

Real estate collateral

Land: 70% of appraised value

Building: 70% of appraised value

Securities collateral

Government bonds: 95% of appraised value

Government-guaranteed bonds: 90% ofappraised value

Listed equities: 70% of appraised value

Other securities 85% of appraised value

B. If the appraised value is used as the estimateddisposal value, verify that there is rationaljustification for considering the appraised value tobe of high precision. For example, if a considerablenumber of collateral have been actually been

Note: “Other securities” refers tomunicipal bonds (both publicly andprivately placed), public corporationbonds without governmentguarantees, bank debentures,exchange-listed industrial bonds

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disposed, and comparisons of disposal prices andestimated disposal value document that disposalprices are higher than estimated disposal value,and this assertion can be confirmed, it may bedeemed “rational justification.”

C. If there is a recent appraised value from a realestate appraiser or if there is a minimum sale priceset by a court, the appraised value may be deemedto be of sufficient precision that this price is usedas the estimated disposal value.

Note that for prices other than appraisedvalues from real estate appraisers and minimumsale prices set by courts, the appraised value maybe used as the estimated disposal value as long asthere is rational justification for considering theappraised value to be of high precision.

from corporate issuers, andsecurities investment trustbeneficiary certificates.

(5)(5)(5)(5) Adjustment for guarantees etc.Adjustment for guarantees etc.Adjustment for guarantees etc.Adjustment for guarantees etc. Categorize assets secured withguarantees etc. as follows. Asset securedwith “superior guarantees” shall be deemed“non-classified.” Asset secured withordinary guarantees etc. shall be deemedCategory II.

Guarantees from non-financial institutions shall notbe deemed guarantees if there are proceduralinadequacies, for example, if the board of directors of thecompany has not completed approval procedures for theguarantee.

Guarantees etc. made with the intention of reducingrisk assets for capital adequacy ratio purposes,guarantees etc. made with the intention of reducing non-performing assets on the final settlement date, and thelike shall not be deemed to secure the asset unless theterm of the guarantee etc. exceeds the period from thebase date to the final settlement date of the nextaccounting term.

1)1)1)1) Superior guarantees etc.Superior guarantees etc.Superior guarantees etc.Superior guarantees etc.

A. Guarantees of extremely highcertainty of fulfillment, for example,guarantees from public creditguarantee institutions, guaranteesfrom financial institutions, guaranteesfrom guarantee institutionsestablished jointly by a number offinancial institutions, guarantees fromguarantee institutions establishedjointly by a number of localgovernments and financialinstitutions, loss reimbursement

Verify that the guarantees described left have beencategorized as superior guarantees.

A. “Public credit guarantee institutions” refers toinstitutions that are established by law andallowed to provide guarantee services. Examplesinclude the Credit Guarantee Association, theAgriculture, Forestry and Fishing GuaranteeFund, and the Agriculture, Forestry and FishingGuarantee Association.

Note that there are some types ofguarantees from public credit guaranteeinstitutions that do not guarantee the full value ofthe asset.

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guarantees from local governments.However, even these guarantees shallnot be deemed “superior guarantees” ifconditions at the guaranteeinstitutions etc., proceduralinadequacies, and similar factors raisedoubts about subrogated repayment,or if the bank (cooperative, union) doesnot intend to seek fulfillment of theguarantee.

B. Guarantees from non-financialinstitutions will be deemed superiorguarantees if the guarantor is adividend-paying exchange-listed orover-the-counter-traded company, hassufficient resources to provideguarantees, and has signed a formalguarantee contract.

C. “Home loan guarantee insurance” andthe like from the Housing LoanCorporation and other publicinsurance companies, and “home loanguarantee insurance” and similar

If any of the following apply, a guarantee isto be deemed to satisfy the “conditions at theguarantee institutions etc., proceduralinadequacies, and similar factors raise doubtsabout subrogated repayment, or if the bank(cooperative, union) does not intend to seekfulfillment of the guarantee” clause and thereforethe guarantee is not to be deemed a “superiorguarantee.”

a) The bank has not claimed subrogatedrepayment from the guaranteeinstitutions etc. because of poor businessconditions etc. at the guaranteeinstitution, or the bank has claimedsubrogated repayment but has notreceived it for these reasons. (Thisexcludes the public credit guaranteeinstitutions in A above.)

b) The financial institution receiving theguarantee has refused to acceptsubrogated repayment from the guaranteeinstitutions etc. because it has forgotten ordelayed subrogated repayment proceduresor had other inadequacies in guaranteefulfillment procedures.

c) The financial institution receiving theguarantee has no intention of seekingfulfillment of the guarantee for otherreasons.

B. Guarantees from non-financial institutions thatare non-dividend-paying exchange-listed or over-the-counter-traded companies may be deemedsuperior guarantees if the lack of dividendpayment is for transient reasons and the businessconditions and financial position etc. of thecompany indicate that it is certain to restoredividends the next accounting period, and thecompany has sufficient resources to provideguarantees and has signed a formal guaranteecontract.

C. Examples of public insurance other than that fromthe Housing Loan Corporation would include“export bill insurance” and “overseas investmentinsurance” provided under the trade insurancesystem.

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policies from private insurancecompanies.

2)2)2)2) Ordinary guaranteesOrdinary guaranteesOrdinary guaranteesOrdinary guarantees Guarantees other than superiorguarantees.

For example, guarantees from non-financial institutions (other than those in 1)B. above) and individuals that havesufficient guarantee resources.

Verify that the guarantees described left arecategorized as ordinary guarantees.

3)3)3)3) Guarantee reservation andGuarantee reservation andGuarantee reservation andGuarantee reservation andmanagement supervisionmanagement supervisionmanagement supervisionmanagement supervisionpledgespledgespledgespledges

When a non-financial institution in a guaranteereservation and/or management supervision pledgenotes guarantee reserves etc. for the borrower in thefinancial statements of the guaranteeing company as adebt guarantee or a guarantee-like action, or when it isclear that the nature of the action would legally bedeemed of equivalent effect to a guarantee, it may betreated as a formal guarantee provided that documentsand other materials attest that formal internalprocedures have been followed at the company inquestion and that the company in question has sufficientresources to provide guarantees.

(6)(6)(6)(6) Credits not subject toCredits not subject toCredits not subject toCredits not subject toclassificationclassificationclassificationclassification

The following credits are not subject toclassification.

1) Discount bills of certain settlement,credits that are deemed certain ofcollection within a short period of timefrom specific repayment sources, andcredits deemed to be normal operatingcapital.

2) Credits secured with deposits etc. orwith “government bonds and othersecurities of high creditworthiness” orwith other superior collateral, orcredits for which emergency bindingmeasures have been taken for depositsetc., up to the amount of the estimateddisposal value.

Verify that the credits described to the left havebeen treated as “credits not subject to classification.”

1) Bills issued by borrowers the credits of which havebeen categorized as “in danger of bankruptcy”,“effectively bankrupt”, or “bankrupt”, shall not betreated as discount bills of certain settlement forself-assessment purposes.

“Credits that are deemed certain ofcollection within a short period of time fromspecific repayment sources” refers to cases in whichit is verifiable from relevant documents that loanedfunds will be collected within about one month.

2) Operating capital for borrower classifications “indanger of bankruptcy, ” “effectively bankrupt, ” and“bankrupt” shall not be treated as normaloperating capital for self-assessment purposes.Note that operating capital for “needs attention”borrowers may not be treated as normal operatingcapital for all “needs attention” borrowers in self-assessments. Treatment will depend on individualjudgements of conditions at the borrower.

Note: “Specific repayment sources”refers to the monies from capitalincreases, bond issues, sale of realestate, agency commissioncontracts and the like when depositis certain within a short period oftime, or to borrowings etc. fromother financial institutions that iscertain to be allocated torepayment, provided that thecertainty of deposit can be verifiedfrom the capital increase or bondissue prospectus, the sales contract,the agency commission, fundtransfer requests, or other

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3) Credits with superior guarantees andinsurance and mutual-aid credits ofcertain payment.

4) Credits held against companies inwhich the government is ashareholder or against localgovernments.

Operating capital for “in danger ofbankruptcy” borrowers shall be treated accordingto the degree of collection risk when repaymentfunds from specific repayment sources aredeposited to deposit accounts with the bank(cooperative, union) and collection is consideredpossible.

Generally, the following formula should beused for calculating normal operating capital forcompanies in wholesaling, retailing, andmanufacturing, but calculations do not recognizethe uncollectable amount of accounts receivableand/or bills receivable or loans against non-performing inventories as normal operatingcapital, so an amount equivalent to this will needto be deducted prior to calculation.

Normal operating capital = Sales credits[accounts receivable + bills receivable(excluding discount bills)] + Inventory assets(ordinary inventory goods excluding non-performing inventories) - Purchasing liabilities[accounts payable + bills payable (excludingbills payable for facilities)]

If more than one financial institution islending operating capital, multiply by the lendingshare of the financial institution under inspection.

3) 3. When the use of funds from credits with superiorguarantees is designated as “operating capital,”and the total of this operating capital and otheroperating capital exceeds the normal operatingcapital, the amount of the credit not subject tocategorization shall not exceed the amount of thenormal operating capital.

4) Do not treat credits against borrowers to which acompany with government investment hasprovided investments or loans or against borrowersin which a local government has providedinvestments or loans as “not subject toclassification.” Verify that they have in principlebeen categorized in the same manner as creditsagainst ordinary industrial companies.

Specifically, when there is rationaljustification that support from the government-invested company or support from the local

documents.

Note: “Normal operating capital”refers to operating capital deemedto be perennially necessary in orderto conduct normal business.

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5) For cooperative financial institutionsexpecting to recover credits from thereturn of investments because of thewithdrawal or expulsion of aninvestor, credits equivalent to theamount of the investment.

government is certain, study the borrower categorywith reference to the nature of support. Verify thatthe institution does not merely deem a credit “notclassified” because a government-invested companyor local government is providing investment orloans.

(7)(7)(7)(7) Credit categorization standardsCredit categorization standardsCredit categorization standardsCredit categorization standards Categorize credits according to theborrower classification. It is acceptable,however, to categorize project financecredits according to the degree of risk ofcollection without regard to borrowerclassification.

It is also acceptable to categorize homeloans and other standardized loans toindividuals according to simplified criteria,for example, arrears status.

Verify that credits are categorized accuratelyaccording to borrower classification as adjusted forcollateral and guarantees, and whether there are anynon-classified credits. For project finance credits thatare not categorized according to borrower classification,verify that categorization has been done according to thedegree of risk of collection.

When categorization is according to simplifiedstandards, verify the rationality of the standards andthe application of the standards.

1)1)1)1) ““““NormalNormalNormalNormal”””” credits credits credits credits Credits to normal borrowers are non-classified.

Verify that credits to normal borrowers are non-classified.

2)2)2)2) ““““Need attentionNeed attentionNeed attentionNeed attention”””” credits credits credits credits Credits to “needs attention” borrowersare in principle assigned to Category IIwhen they meet the requirements listed inA through E below for the portion in excessof the estimated disposal value for superiorcollateral or in excess of the guarantee forsuperior guarantees etc.

A. Dishonored bills, accommodation bills,and discount bills doubtful to besettled at maturity.

B. Funds to compensate for losses ordefaulted credits, funds to support orundertake the obligations of poorly-performing affiliates etc.

Note: Credits to borrowers withlosses carried over and non-performing asset etc. shall in principle

Verify that the credits described left have beencategorized as “need attention” credits.

Below are the interpretations to be used for thecategorized credits left.

B. Calculate the bank’s (cooperative’s, association’s)lending commensurate to carried over losses etc.and the bank’s (cooperative’s, association’s) shareof lending as follows:

Bank’s (cooperative’s, association’s) lendingcommensurate to carried over losses etc. = Amountof carried over losses etc. x bank’s (cooperative’s,

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be categorized in this category whenthey are deemed to have been used tocover losses carried over etc.regardless of the name under whichthey were loaned. In calculating thecategorized amount, if it is unclearwhich credits will be used to coverlosses carried over etc., it ispermissible, as exceptional treatment,to calculate a credit amountcommensurate with the coverage ofcloses carried over etc. taking accountof the amount of the borrower’s lossescarried over and non-performingassets etc. and the bank’s(cooperative’s, association’s) share oflending to the borrower.

C. Credits for which there have beensubstantial mitigations of lendingterms (reductions, waivers or deferralsof interest, grace periods onrepayment of principal etc.), creditswith extremely long repaymentcontracts, or credits with otherlending condition problems.

association’s) share of lending

Bank’s (cooperative’s, association’s) share oflending = Bank’s (cooperative’s, association’s) totallending (excluding discount bills) / Totalborrowings of the borrower (excluding discountbills)

C. “Credits for which there have been substantialmitigations of lending terms” refers to credits forwhich the borrower’s business conditions etc. havedeteriorated to the point that it is difficult to makerepayment according to contract and theinstitutions has provided reductions, waivers ordeferrals of interest or grace periods for principalrepayment as a support measure for the borrower,or credits for equipment funds that should berepaid from revenues but are allowed repayment infull on the date of maturity without a rationalreason therefore.

“Credits with extremely long repaymentcontracts” refer to loans of equipment funds thathave repayment periods longer than the useful lifeof the equipment in question, or to loans that,judging from the use to which funds are put etc.should be repaid within a certain period but have arepayment period in excess of the normalrepayment period because of problems with theborrower’s earnings ability, financial position orthe like.

Additionally, when a borrower is usinggovernment funding, inspectors should make acomprehensive judgement taking account of thenature of the government funding and the factorsleading to the loan of government funding todetermine whether there has been a substantialmitigation of lending conditions or whether there isan extremely long repayment contract. They

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D. Credits with problems in fulfillment(principal repayment or interestpayment effectively in arrears) orcredits deemed to have a highpotential for repay problems in thefuture.

E. Credits for which the financialposition etc. of the borrower indicatesa greater than normal collection risk.

should not immediately judge government fundingto be credits for which there have been substantialmitigations of lending terms or credits withextremely long repayment contracts.

3)3)3)3) ““““In danger of bankruptcyIn danger of bankruptcyIn danger of bankruptcyIn danger of bankruptcy””””creditscreditscreditscredits

All credits to “in danger of bankruptcy”borrowers in excess of the estimateddisposal value of superior collateral and theamount protected with superior guaranteesetc. shall be categorized. The estimateddisposal value from ordinary collateral, theamount deemed collectable from ordinaryguarantees, and the amount deemedcollectable from liquidation dividends in theevent of bankruptcy shall be assigned toCategory II. The remainder shall beassigned to Category III.

If the appraised value of ordinarycollateral is of sufficiently high precision,an amount equivalent to the appraisedvalue of the collateral may be assigned toCategory II.

Verify that credits to “in danger of bankruptcy”borrowers have been categorized as described left.

Refer to the following for interpretations of“collectable amounts.”

A. “Amount deemed collectable from guarantees”refers to an amount deemed to be certain ofcollection in light of the assets and guaranteeresources of the guarantor. If the assets andguarantee resources of the guarantor have notbeen confirmed or if collection under the guaranteeis uncertain, the credit shall be considered not tobe protected by the guarantee and this portionshall be assigned to Category III. Verify that thishas been done.

B. “Amount deemed collectable from liquidationdividends” refers to an amount deemed to becertain of collection when it is possible toaccurately measure the assets of the borrower (forexample, the financial institution under inspectionhas a clear grasp of the collateral provided by theborrower to other lenders) and create a liquidationbalance sheet for the borrower, assuming theestimated liquidation dividend etc. is rational.

If an “amount deemed collectable fromliquidation dividends” is categorized as CategoryII, verify that the estimated liquidation dividendetc. is rational.

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4)4)4)4) ““““Effectively bankruptEffectively bankruptEffectively bankruptEffectively bankrupt”””” and and and and““““bankruptbankruptbankruptbankrupt”””” credits credits credits credits

All credits to “effectively bankrupt” and“bankrupt” borrowers in excess of theestimated disposal value of superiorcollateral and the amount protected withsuperior guarantees etc. shall becategorized. The estimated disposal valuefrom ordinary collateral, the amountdeemed collectable from ordinaryguarantees, and the amount deemedcollectable from liquidation dividends in theevent of bankruptcy shall be assigned toCategory II. The difference between theappraised values and estimated disposalvalues of superior collateral and ordinarycollateral shall be assigned to Category III.The remainder shall be assigned toCategory IV, no hope of collection.

If the appraised value of ordinarycollateral is of sufficiently high precision,an amount equivalent to the appraisedvalue of the collateral may be assigned toCategory II. The amount of any uncertaintyof collection from guarantees shall beassigned to Category IV, though it may bereassigned to Category II at the point atwhich collection under the guarantee isdeemed possible.

Verify that credits to “effectively bankrupt” and“bankrupt” borrowers have been categorized asdescribed left.

Credits to “effectively bankrupt” and “bankrupt”borrowers should, to the extent possible, be categorizedas Category II for the portion deemed collectable fromcollateral etc., with the amount deemed uncollectableassigned to Category IV. Note that nothing should beassigned to Category III except “the difference betweenthe appraised values and estimated disposal values ofsuperior collateral and ordinary collateral.”

Refer to the following for interpretations of“collectable amounts.”

A. “Amount deemed collectable from guarantees”refers to an amount deemed to be certain ofcollection in light of the assets and guaranteeresources of the guarantor. If the assets andguarantee resources of the guarantor have notbeen confirmed or if collection under the guaranteeis uncertain, the credit shall be considered not tobe protected by the guarantee and this portionshall be assigned to Category IV. Verify that thishas been done.

B. For “effectively bankrupt” credits, the amountdeemed collectable from liquidation dividends”refers to an amount deemed to be certain ofcollection when it is possible to accurately measurethe assets of the borrower (for example, thefinancial institution under inspection has a cleargrasp of the collateral provided by the borrower toother lenders) and create a liquidation balancesheet for the borrower, assuming the estimatedliquidation dividend etc. is rational.

For “bankrupt” credits, the “amount deemedcollectable from liquidation dividends” refers to 1)the expected amount of repayment within fiveyears from the date a notification of liquidationdividend etc. is received from a liquidator etc.should such notice be received; 2) an amountdeemed to be certain of collection when it ispossible to accurately measure the assets of theborrower (for example, the financial institutionunder inspection has a clear grasp of the collateralprovided by the borrower to other lenders) andcreate a liquidation balance sheet for the borrower,

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assuming the estimated liquidation dividend etc. isrational.

If the amount deemed collectable fromliquidation dividends etc. is assigned to CategoryII, verify that the estimate of the liquidationdividend etc. is rational.

C. Verify that categorization has in principle beenmade as follows for borrowers that have been thesubject of a filing for rehabilitation under theCorporate Reorganization and Rehabilitation Lawetc., a filing for composition under the CompositionLaw etc., a filing for bankruptcy under theBankruptcy Law, a filing for initiation ofliquidation or initiation of special liquidation underthe Commercial Code, or other similar action.

a) Are rehabilitation collateral rights inprinciple assigned to Category II?

b) Among ordinary rehabilitation credits, isthe amount deemed collectable within fiveyears of the approval of the rehabilitationplan assigned to Category II and anyamount deemed to require in excess of fiveyears assigned to Category IV?

c) Are relinquished credits assigned toCategory IV?

If progress is generally according to plan(for example, the borrower has achieved ingenerally 80% of the sales etc. and current profitstargeted in the rehabilitation plan etc.) after acertain period of time has elapsed from theformulation of the rehabilitation plan etc. and theborrower classification and category are reviewed,verify that categorization and classification areaccording to the degree of collection risk.

(8)(8)(8)(8) Credits to foreign Credits to foreign Credits to foreign Credits to foreign governmentsgovernmentsgovernmentsgovernmentsetc.etc.etc.etc.

In light of the special nature of creditsto foreign governments, central banks,government-affiliated institutions and stateenterprises, these credits are to becategorized according to objective facts andnot according to the criteria in (7) above.For example, in cases like the following,consideration should be given tocategorizing credits according to the degreeof collection risk in light of political or

Inspectors should verify that credits to foreigngovernments etc. are categorized according to collectionrisk as indicated by the country’s financial conditions,economic conditions, and foreign exchange balances. Atthe very least, they should verify that the creditsdescribed left have been categorized.

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economic conditions in the country inquestion.

1) Payment of principal and interest isone month or more in arrears.

2) Contracts have been signed withinfive years of the scheduled maturity todefer loan repayments, provide flat-rate relending from major creditorbanks, or take other similar measures(“deferral of debt repayment etc.”hereinafter).

3) A request has been received fordeferral of debt repayment etc. and amonth or more has elapsed without acontract being signed.

4) The facts described in 1)-3) above areconsider likely to occur in the nearfuture.

(9)(9)(9)(9) Credits to foreign privateCredits to foreign privateCredits to foreign privateCredits to foreign privatecompanies and to Japanesecompanies and to Japanesecompanies and to Japanesecompanies and to Japanesecompanies abroadcompanies abroadcompanies abroadcompanies abroad

Categorize credits to foreign privatecompanies and Japanese companies abroadaccording to the criteria found in (7) above.

However, when arrears etc. are clearlythe result of the country’s foreign exchangebalance, categorize according to the criteriain (8) above.

Note that self-assessments should takeaccount of the nature of business dealingsin the country, its markets, and the statusof collateral.

Verify that credits to private companies andJapanese companies in countries the government ofwhich has been categorized according to (8) above arecategorized according to (7) above, and categorizationaccording to (8) above has been considered.

Verify that the institution understands the natureof business dealings in the country, its markets, and thestatus of collateral.

(10)(10)(10)(10) Interest Interest Interest Interest receivablereceivablereceivablereceivable similar to similar to similar to similar toloansloansloansloans

For interest receivable that is similar to loans,verify that the institution is in principle not postingthose for “in danger of bankruptcy, ” “effectivelybankrupt, ” and “bankrupt” borrowers as assets. Verifyin particular that it is not posting uncollected interestfrom “effectively bankrupt” and “bankrupt” as assets.

However, when the institution posts uncollectedinterest as assets in light of the potential to collect thisinterest because of protection measures etc., verify thatthis uncollected interest is categorized according to thedegree of collection risk.

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When uncollected interest from “in danger ofbankruptcy” borrowers is posted as assets, verify thatthe credit to the borrower is subject to reporting andpublication as described in (11) below. Check that theinstitution is not posting uncollected interest as assetswhen it should not be in order to exclude the loan forwhich there is uncollected interest from disclosure as amanaged credit.

(11)(11)(11)(11) Relationship with creditRelationship with creditRelationship with creditRelationship with creditcategories under the Lawcategories under the Lawcategories under the Lawcategories under the LawRegarding EmergencyRegarding EmergencyRegarding EmergencyRegarding EmergencyMeasures to RevitalizeMeasures to RevitalizeMeasures to RevitalizeMeasures to RevitalizeFinancial FunctionsFinancial FunctionsFinancial FunctionsFinancial Functions

Below is the relationship between thecredit categories set forth in Article 4 of theLaw Regarding Emergency Measures toRevitalize Financial Functions and theborrower classifications etc. in thisinspection manual.

Note that under the provisions ofArticle 3:2:1 of the Law RegardingEmergency Measures to Restore theSoundness of Financial Functions (Law No.143 of 1998), the institutions required toassess assets according to the criteriadescribed in Article 6:2 of the LawRegarding Emergency Measures toRevitalize Financial Function are: banks,trust banks, long-term credit banks,shinkin banks, credit cooperatives, laborcredit associations, National Association ofShinkin Banks, National Central Society ofCredit Cooperatives, National Federation ofLabor Credit Associations, CentralCooperative Bank for Agriculture andForestry, Credit Federation of AgriculturalCooperatives, Credit Federation of FisheryCooperatives, and bank holding companiesetc.

Verify that classification is made according to theborrower classification etc. as determined based on thefinancial position and business performance etc. of theborrower pursuant to the criteria set forth in Article 4 ofthe Concomitant Orders to the Law RegardingEmergency Measures to Revitalize Financial Functions.

Article 6 of the Law Regarding EmergencyMeasures to Revitalize Financial Functions requiresthat the results of asset assessments be reported to theFinancial Reconstruction Commission. Article 7 requiresthat they be published. Article 78 and Article 86 of thelaw provide for penal measures should the reports to theFinancial Reconstruction Commission be falsified.Therefore, if the results of self-assessments underArticle 6 of the law are found to be inaccurate, endeavorto fully and accurately determine the cause (caused bythe appropriateness of self-assessment standards or bythe way in which self-assessments are conducted, or byother factors) and the future improvements to be madeby the financial institution under inspection.

1)1)1)1) ““““NoNoNoNon-classifiedn-classifiedn-classifiedn-classified”””” credits credits credits credits “Non-classified” credits are “creditswith no problems in terms of the financialposition or business performance of theborrower; all credits not classified as“special attention”, “risk”, “unrecoverable orvalueless credits. “Non-classified” creditsare credits to “normal” borrowers andcredits to “needs attention” borrowers thatdo not fall into the category “specialattention”.

Verify that the credits described left have beencategorized as “normal” credits.

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2)2)2)2) ““““Special attentionSpecial attentionSpecial attentionSpecial attention”””” credits credits credits credits “Special attention” credits are creditsto “needs attention” borrowers that are“three months or more in arrears(payments of principal or interest are threemonths or more in arrears from the dayafter the contracted payment date) or havebeen given relaxed lending conditions(credits for which there have beenmodifications to contractual conditions inorder to give advantageous concessions toborrowers that have fallen on economicdifficulties for the purpose of aiding theirrebuilding and support and therebypromoting collection of the credit). (Article 4of the Concomitant Orders to the LawRegarding Emergency Measures toRevitalize Financial Functions).

Manage “special attention” creditsseparately from other “needs attention”credits.

Verify that the credits described left have beencategorized as “special attention” credits. In doing this,refer to the definition of “credits with relaxed lendingconditions” for risk-managed credits as set forth inArticle 19-2:1:5:c(4) of the Concomitant Orders to theBanking Law and the comments on credits with relaxedlending conditions in Article 1-10-3-2-3 of the officialBusiness Processing Guidelines (deposit-taking financialinstitutions).

Verify that the institution categories credits thatare not formally in arrears but are in fact three or moremonths behind as “special attention” credits.

Note: To verify whether credits are not actually inarrears, check internal sign-off documents and tracefunds provided to the borrower, looking for loansdisbursed near the repayment date used as funds torepay principal and interest.

3)3)3)3) ““““RiskRiskRiskRisk”””” credits credits credits credits “Risk” credits are credits with a highlikelihood that the principal will not becollected and interest not receivedaccording to the contract because thefinancial position and business performanceof the borrower have worsened, althoughthe borrower is not yet bankrupt.” In otherwords, these are credits to “in danger ofbankruptcy” borrowers.

Verify that the credits described left have beencategorized as “risk” credits.

4)4)4)4) ““““Unrecoverable or valuelessUnrecoverable or valuelessUnrecoverable or valuelessUnrecoverable or valueless””””creditscreditscreditscredits

“Unrecoverable or valueless” creditsare “credits to borrowers that have falleninto bankruptcy, corporate rehabilitation,composition or the like, or similar credits.”These are credits to “effectively bankrupt”borrowers and “bankrupt” borrowers.

Verify that the credits described left have beencategorized as “unrecoverable or valueless”.

(12)(12)(12)(12) Credits to consolidatedCredits to consolidatedCredits to consolidatedCredits to consolidatedsubsidiariessubsidiariessubsidiariessubsidiaries

Verify that credits to consolidated subsidiaries(including affiliated “non-banks”) have been categorizedas follows.

1) Credits to consolidated subsidiaries of the financialinstitution under inspection

Credits to consolidated subsidiaries shouldin principle be assessed according to the self-

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assessment methods of the financial institutionunder inspection and assigned a borrowerclassification according to an accuratemeasurement of the financial position etc. of theconsolidated subsidiary.

However, in cases in which it is difficult toassess the consolidated subsidiaries according tothe self-assessment methods of the financialinstitution under inspection because of theindustry of the subsidiary or the laws of thecountry in which it is located, borrowerclassification shall be made according to assetassessment results made with methods similar tothe self-assessment methods of the financialinstitution under inspection.

2) Credits to consolidated subsidiaries of otherfinancial institutions

Categorize according to the same methodsas credits for non-financial institutions.

2.2.2.2. Securities categorization methodSecurities categorization methodSecurities categorization methodSecurities categorization method

(1)(1)(1)(1) Basic conceptsBasic conceptsBasic conceptsBasic concepts When assessing securities, categorizethem in terms of their marketability andsafety.

Judgements of safety are in principlemade with the same concepts as used forcredits and will depend on the financialposition etc. of the issuer of the security.However, it is acceptable to use simplifiedcriteria for the issuer’s financial positionetc. when classifying securities.

Verify that securities are categorized accurately interms of marketability and safety.

(2)(2)(2)(2) BondsBondsBondsBonds Verify that bonds are classified as described left.

For judgements of safety in particular, verify thatcategorizations are made with the same concepts asused for credits based on the financial position etc. of theissuer.

1)1)1)1) Bonds not subject toBonds not subject toBonds not subject toBonds not subject toclassificationclassificationclassificationclassification

The following bonds are not subject toclassification.

A. Government bonds, local governmentbonds

B. Government-guaranteed bonds (public

Verify that no bonds from issuers with any otherthan a “normal” borrower classification are treated asnon-categorized.

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corporations etc.)

C. Special bonds (issued by publiccorporations or companies in whichthe government has invested but notgovernment-guaranteed).

D. Bank debentures

E. All bonds from issuing companies thathave been rated BBB (triple B) orbetter in their most recent rating by aratings agency.

F. All industrial bonds issued bycompanies issuing exchange-listedindustrial bonds; all bonds selected forover-the-counter price quotations.

However, the bonds described in E andF shall be classified if a study of thefinancial position of the issuer or the natureof the industrial bond based on the sameconcepts as for credits indicates problemswith safety.

2)2)2)2) Bond classification methodBond classification methodBond classification methodBond classification method A. Study the financial position of theissuers of all bonds except those listedin A-F in 1) above using the sameconcepts as for credits. If the studyreveals no particular problems withsafety, or if there is a superiorguarantee from a financial institutionetc., treat the bond as non-classified.

B. The book value of bonds described inthe proviso to 1) above and bondsother than as described in A above isassigned to Category II; the estimatedloss for bonds likely to generate lossesis assigned to Category IV.

Note that privately-placedbonds are categorized according to thedegree of risk of loss of value using thesame method as for credits.

If the institution does not havecredits against the issuer of the bond,it may categorize the bond accordingto simplified criteria.

Verify that the estimated loss has been assigned toCategory IV for bonds issued by parties with borrowerclassifications of “effectively bankrupt” or “bankrupt”.

Verify that privately-placed bonds are categorizedusing the same methods as credits.

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(3)(3)(3)(3) EquitiesEquitiesEquitiesEquities The following equities are not subjectto classification.

Verify that equities are categorized as describedleft.

For the safety standard in particular, verify that theinstitution has studied the financial position of theissuer of the equity using in principle the same conceptsas for credits.

1)1)1)1) Equities not subject toEquities not subject toEquities not subject toEquities not subject toclassificationclassificationclassificationclassification

A. Exchange-listed equities, over-the-counter-registered equities, andunlisted equities issued by exchange-listed companies.

B. Equities issued by companies in whichthe government has invested(excluding liquidation companies).

C. Equities from issuing companies thebonds of which have been rated BBB(triple B) or better in their most recentrating by a ratings agency.

However, the equities described aboveshall be classified if a study of the financialposition of the issuer based on the sameconcepts as for credits indicates problemswith safety.

Verify that no equities from issuers with any otherthan a “normal” borrower classification are treated asnon-classified.

2)2)2)2) Equity categorization methodEquity categorization methodEquity categorization methodEquity categorization method A. Study the financial position of theissuers of all equities except thoselisted in A-C in 1) above using thesame concepts as for credits. If thestudy reveals no particular problemswith safety, treat the equity as non-classified.

B. Categorize the equities described inthe proviso to 1) above and equitiesother than as described in A aboveaccording to the degree of risk of lossof value using in principle the sameconcepts as for credits. However, thebook value of categorized exchange-listed equities and over-the-counter-registered equities that arecategorized should be assigned toCategory II. In cases in which theasset position of the issuer hassignificantly worsened, assign to

A. Verify that equities issued by parities withborrower classifications of “in danger ofbankruptcy” (excluding exchange-listed equitiesand over-the-counter-registered equities) are inprinciple assigned to Category III.

B. Verify that equities issued by parties withborrower classifications of “effectively bankrupt” or“bankrupt” are in principle assigned to CategoryIV.

C. If the institution holds equities subject toclassification as part of a securities investmenttrust or designated money in trust account etc. inorder to avoid classification, verify that the equityis categorized according to the degree of risk of lossof value.

D. If the institution uses the cost method to appraiseexchange-listed equities, verify that its standardsfor mandatory appraisal reductions under theCommercial Code are rational. Specifically, verify

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Category IV an amount equivalent tothe reduction in book value whendecreases in the net assets of theissuer mandate reductions in the bookvalue of the equity, except when theasset position is deemed likely torecover in a reasonable period of time.

If the institution does not havecredits against the issuer of theequity, it may categorize the equityaccording to simplified criteria.

that at the very least, the institution assigns anamount equivalent to the difference between themarket value and the book value of the equity toCategory IV when the market value of a listedequity has lost 50% or more against the book value.However, it shall be acceptable to deem an equityas having no possibility of price recovery if its pricehas not been above 50% of book value at least oncein the past year.

Verify that the same method is used tocategorize over-the-counter-registered equitieswhen the cost method is used for appraisalpurposes.

(4) Foreign securities Verify that foreign securities are categorized asdescribed left.

1) Foreign securities not subjectto classification

The following foreign securities are notclassified.

A. All equities issued by companies listedon foreign or domestic exchanges andall bonds issued by companies issuinglisted bonds.

B. Bonds selected for over-the-counterprice quotations on either foreign ordomestic markets.

C. Bonds issued by internationalinstitutions established under treatiesto which Japan is a signatory, bondsissued by governments or similarinstitutions (state governments etc.)or municipalities of countries withwhich Japan has relations.

D. Equities and bonds issued by financialinstitutions licensed etc. bygovernments of countries with whichJapan has relations.

E. All bonds from issuing companies thathave been rated BBB (triple B) orbetter in their most recent rating by aratings agency, and all equities issuedby companies issuing said bonds.

However, the foreign securitiesdescribed above shall be categorized if a

Verify that no foreign securities from issuers withany other than a “normal” borrower classification aretreated as non-classified.

Note: “International institutionsestablished under treaties to whichJapan is a signatory” refers to theInternational Bank forReconstruction and Development(IBRD), the International FinanceCorporation (IFC), theInteramerican Development Bank(IDB), the European Bank forReconstruction and Development(EBRD), the African DevelopmentBank (AfDB), and the AsianDevelopment Bank (ADB).

36

Item Verification of the appropriateness of self-assessment standards

Verification of the appropriateness of self-assessmentresults

Remarks

study of the asset and/or financial positionof the issuer based on the same concepts asfor credits indicates problems with safety.

2) Foreign security classificationmethod

A. Study the asset and financial positionof the issuers of all foreign securitiesexcept those listed in A-F in 1) aboveusing the same concepts as for credits.If the study reveals no particularproblems with safety, or if there is asuperior guarantee from a financialinstitution etc. (including a financialinstitution licensed by the governmentof a country with which Japan hasrelations), treat the foreign securitiesas non-categorized.

B. The book value of foreign securitiesdescribed in the proviso to 1) aboveand bonds other than as described inA above is in principle assigned toCategory II; the estimated loss forforeign securities likely to generatelosses is assigned to Category IV.

Note that foreign equities andprivately-placed bonds are categorizedaccording to the degree of risk of lossof value using the same method as forcredits when deemed appropriate to doso.

If the institution does not havecredits against the issuer of theforeign security, it may categorize theforeign security according to simplifiedcriteria.

Verify that those foreign securities for which it isdeemed appropriate to categorize using the samemethods as for bonds and equities are categorizedaccording to these methods.

(5) Other securities Categorize other securities in a mannersimilar to 1) to 4) above. Beneficiarycertificates for loan trusts are non-classified.

Categorize beneficiary certificates forsecurities investment trusts according tothe degree of risk of loss of value.

Verify that investment trust beneficiary certificatesfor which there are quoted base prices or the like arecategorized according to the degree of risk of loss ofvalue.

37



Remarks

3. Method of categorization for otherassets (i.e., assets other thancredits and securities)

Categorize assets other than creditsand securities as follows.

Use the same methods as for creditswhen performing categorization for self-assessments of assets and off-balance-sheetinstruments with credit risks other thancredits and securities.

Pay particular attention to liquidationtechniques that move credits off the balancesheet but do not fully transfer credit risksto third parties so that the financialinstitution under inspection still holds allor a part of the credit risk. Categorize theseassets with the same methods as used forthe underlying assets in the creditsecuritization instrument and categorizeaccording to the degree of risk of loss ofvalue for the credit risk portion held by thefinancial institution under inspection.

Verify that assets other than credits and securitiesare categorized as described left.

Verify that asset and off-balance-sheet instrumentswith credit risks other than credits and securities arecategorized using the same methods as credits.

In particular, when the financial institution underinspection holds all or a part of the credit risks for creditliquidation instruments that take credits off the balancesheet, verify that the risk portion held by the institutionhas been categorized according to the degree of risk ofloss of value.

(1) Suspense payments Categorize all suspense payments otherthan those that are similar to loans(suspense payments related to claims orloans resulting from subrogated repaymentbased on guarantees) according to thecollection risk and the degree of risk of lossof value.

Verify that all suspense payments other than thosethat are similar to loans are categorized according tocollection risk and degree of risk of loss of value.

(2) Chattels and real estate Categorize the book value of ownedchattels and real estate not used forbusiness purposes (offices, branch officesetc.) as Category II.

However, in cases in which theestimated disposal value of the ownedchattel or real estate is significantly belowthe book value and there is little likelihoodof it recovering in a reasonable period oftime, and when there is deemed to be aneed to reduce the book value to correspondwith the decrease in estimated disposalvalue, assign the estimated disposal valueto Category II and the difference betweenthe estimated disposal value and the bookvalue to Category IV.

Verify that chattels and real estate have beencategorized as described left.

Verify that real estate listed on the books as“business real estate” is categorized as owned chattelsand real estate if 1) it is for the purpose of employeewelfare but seldom used, or 2) it is not in actuality usedfor business purposes and it is not certain that it will beused for business purposes in the future.

At the very least, when the estimated disposalvalue of owned chattels and real estate issubstantially below the book value (as a rule ofthumb, the estimated disposal value is at least 50%below the book value) and when there is deemed to belittle likelihood of the estimated disposal valuerecovering, verify that the difference between the bookvalue and the estimated disposal value is assigned toCategory IV.

38



Remarks

(3) Golf club memberships Assign to Category II except for thoseheld for welfare purposes.

However, when there are deemed to beproblems in the financial position of theissuer of the membership, assign aborrower classification using the sameconcepts as for credits regardless of thepurpose for which the membership is held.Assign those classified as “needs attention”or “in danger of bankruptcy” to Category II;those classified as “effectively bankrupt” or“bankrupt” for which the facilities can stillbe used as Category II; and those for whichthe facilities cannot be used as Category IV.

When golf club memberships are heldnot as “other assets” but on securitiesaccounts, use appropriate securitiesmethods for their categorization.

If the institution does not have creditsagainst the issuer of the membership, itmay use simplified criteria incategorization.

Verify that golf club memberships are categorizedas described left.

When memberships are held on securities accounts,verify that they are categorized as described left.

(4) Miscellaneous assets Categorize assets other than thoseabove according to their collection risk anddegree of risk of loss of value in light of thenature of the asset.

Verify that miscellaneous assets are categorized asdescribed left.

A. For purchasing credits issued by non-financialinstitution that are deemed to be long-term creditsbecause of continuing purchases at set amounts,verify that the purchasing credit is categorizedusing the same methods as for credits.

Note that banks that have establishedspecial transaction accounts and use thoseaccounts to purchase on a continual basispurchasing credits issued by non-financialinstitution so as to be deemed to be providing long-term credits, have inaccurately categorized thecredit and also inaccurately calculated their capitaladequacy ratio, and are furthermore in violation ofArticle 17-10 (ban on inter-account transfers) of theConcomitant Orders to the Banking Law (Law No.10 of 1982). Verify that this has not taken place.

B. When the financial institution under inspectionuses trust schemes to liquidate credits, and thefinancial institution under inspection holds

39



Remarks

beneficiary certificates in the loan credit trustscheme, verify that these loan credit trustbeneficiary certificates are categorized using thesame methods as credits.

40

Inspections of Write-offs and Reserves

I. Purpose of inspectors of write-offs and reserves

Write-offs and reserves are a means of estimating in an timely and appropriate manner the losses etc. on credits etc. expected to be incurred by thefinancial institution in the future based on self-assessment. There is a strong need for financial institutions to maintain the soundness of their assets inorder to fulfill their public and social responsibilities, and provisions of write-offs and reserves according to the degree of credit risk are vital inaccomplishing this. It is therefore necessary to for financial institutions to provide appropriate levels of write-offs and reserves for the credit risks theyhold.

Article 3:2:2 of the Law Regarding Emergency Measures to Revitalize Financial Functions requires financial institutions to provide appropriatereserves as set forth by the Financial Revitalization Commission in light of their self-assessment results.

In addition to these laws etc., financial institutions are also required to provide for write-offs and reserves under the Commercial Code and thecorporate accounting principles, and external auditors are required to appraise the effectiveness of internal controls on write-offs and reserves when theyaudit financial statements.

Therefore, when inspecting write-offs and reserves, inspectors should assume that financial statements have been audited by external auditors andverify the status of systems and processes for write-offs and reserves, the appropriateness of write-offs and reserves levels and rationality of write-offsand reserves calculations, and whether the total value of write-offs and reserves is commensurate to the degree of credit risk to which the financialinstitution under inspection is exposed.

Notes:

1. Default reserve criteria shall be revised as required by any future modifications to write-off and reserve provisions by the Financial RevitalizationCommission.

2. Appraisals of credits using the discount present value method may be introduced taking into account deliberations in the Corporate AccountingCommission etc. and the status of utilization at financial institutions.

II. Method of inspecting write-offs and reserves

Inspectors shall begin by performing “process examination.” That is, they will first verify the status of the systems that the institution has put inplace for write-offs and reserves and the appropriateness of the institution’s write-off and reserve levels. Having done this, they will then verify whetherwrite-offs and reserves have been provided for in an appropriate manner.

Should there be problems identified during inspections, the inspectors shall endeavor to exchange opinions with the financial institution. Forexample, inspectors shall provide the financial institution under inspection with the viewpoints of the authorities, shall fully recognize the thinking ofthe financial institution in this regard, and shall directly confirm the viewpoint of the accounting auditors in the presence of the financial institution.

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III. Verification of the institutions’ write-off and reserve systems

Inspectors shall verify the status of the systems that the institution has put in place for write-offs and reserves by checking the items listed below.

1. Formulation of write-off and reserve standards

Do write-off and reserve standards conform to all applicable laws and ordinances, to corporate accounting principles, and to the framework setforth in the inspection manual?

Have formal bank procedures been followed by the board of directors in determining and codifying write-off and reserve standards?

Do write-off and reserve standards specify the scope of assets subject to write-offs and reserves, the divisions responsible for performing andauditing write-offs and reserves, and the lines of responsibility for write-off and reserve standards and their application?

Are the opinions of the auditing divisions (credit auditing office, inspections division etc.) and compliance management divisions sought in theformulation and revision of write-off and reserve standards, not just the opinions of divisions performing self-assessments (sales-related divisions andassets assessment divisions)?

Have write-off and reserve manuals been formulated and codified for use in appropriate provisions of write-offs and reserves?

From the perspective of assuring the reliability of financial institution soundness, it is desirable that the specific content of write-offs and reservesbe actively disclosed along with the disclosure of self-assessment results under the provisions of Article 7 of the Law Regarding Emergency Measuresto Revitalize Financial Functions.

2. Status of write-off and reserve systems

Are there sufficient checks on divisions performing self-assessments and divisions performing settlement so that write-off and reserve values arecalculated appropriately? For example, 1) a system in which divisions performing self-assessments calculate individual default reserve amounts andthe auditing division audits this amount and calculates general default reserve amounts, or 2) a system in which individual default reserve amountsare calculated with the cooperation of the sales-related divisions by an asset assessment division that is independent of the sales related divisions,and the asset assessment division calculates general default reserve amounts, or 3) a system in which divisions performing self-assessments calculateindividual default reserve amounts, settlement-related divisions calculate general default reserve amounts, and auditing divisions audit the results ofthese calculations.

Are personnel versed in write-offs and reserves assigned to the divisions performing self-assessments and the auditing divisions?

Do the auditing divisions etc. provide requisite education and training for divisions performing self-assessments etc?

Is the auditing division independent of the divisions performing self-assessments and divisions performing settlement (the Head BookkeepingOffice etc.)? Do directors in charge of divisions performing self-assessments and divisions performing settlement have concurrent responsibilities forauditing divisions? If directors in charge of auditing divisions are also in charge of divisions performing self-assessments and divisions performingsettlement, are there sufficient checks in place to ensure that audits are appropriate and not subject to the influence of the financial institution’sresults etc?

42

Does the auditing division verify that write-offs and reserves are performed appropriately and in accordance the write-off and reserve standardsand write-off and reserve manual?

It is desirable that the auditing division does not just verify the accuracy of write-off and reserve results but also verifies the appropriateness ofreserve rates, the appropriateness of the total reserve amount etc, and the appropriateness etc. of the reserve amount etc. in the previous term.

Does the financial institution keep sufficient records and documents in its divisions that government inspectors, auditors and others are able toverify the performance of write-offs and reserves after-the-fact?

3. Reporting of write-off and reserve results to the board of directors

Are write-off and reserve results reported regularly and appropriately to the board of directors?

Does the board of directors receive timely reports on the status of write-off and reserve systems (changes in divisions performing or auditing write-offs and reserves etc.)?

4. Auditing by auditors and external auditors of write-off and reserve systems

Do auditors and external auditors who are not subject to the influence of the directors appropriately audit the status of write-off and reservesystems as described in 1-3 above?

IV. Verification of the appropriateness of write-off and reserve standards

Inspectors shall check whether the write-off and reserve standards formulated by the financial institution are clear and appropriate, whether theirframework is in line with the standards set forth by the Financial Revitalization Commission pursuant to Article 3:2:2 of the Law Regarding EmergencyMeasures to Revitalize Financial Functions and with the framework described in the Attachment, whether they are justified by the Commercial Codeand corporate accounting principles etc., and whether they are based on self-assessment results. If the financial institution uses an original frameworkfor its write-off and reserve standards, inspectors shall verify the relationship between the institution’s framework and the model framework in theAttachment, and shall determine whether individual rules within the institution’s write-off and reserve standards are rational (for example, rules forcalculating reserve rates based on credit ratings, rules for calculating reserve rates based on industry or location etc.), and shall verify that specific costsand losses that are highly probable to be incurred in the future are estimated rationally.

Inspectors shall also verify that the basic concepts employed in write-off and reserve standards are consistent and continuous, and that there is arational reason for any changes in the basic concepts used in write-off and reserve standards.

V. Verification of the appropriateness of write-off and reserve results

Inspectors shall use the methods described in the Attachment to verify that write-offs and reserves are being calculated appropriately and inaccordance with the write-off and reserve standards. This verification process should endeavor to form an accurate picture of the institution’s systems forwrite-offs and reserves, reporting of write-off and reserve results to the board of directors, and internal and external auditing of write-off and reservesystems.

43

Note that write-off and reserve results will effect an institution’s capital adequacy ratio and therefore when the results of write-off and reservecalculations are deemed to be inappropriate, inspectors must fully endeavor to confirm and accurately identify the causes for the inaccuracy (because ofwrite-off and reserve standards or because of the way in which write-offs and reserves are performed, or because of poor business results) andimprovements to be made by the financial institution under inspection in the future.

1. Base date

The base date shall be handled as per V:1 of the self-assessment manual.

2. Specific inspection methods etc.

(1) Scope of verification

The scope of appropriateness verifications shall be write-off and reserve results for all assets on the base date. Priority attention shall begiven to verification of the accuracy of write-offs and reserves for credits to borrowers classified as “in danger of bankruptcy”, “effectivelybankrupt”, or “bankrupt”. Should borrowers that should have been classified as “in danger of bankruptcy”, “effectively bankrupt”, or “bankrupt”be found to be classified as “normal” or “needs attention” in self-assessments, verification shall place priority on determining whether the neededwrite-off and reserve amounts have been calculated for these credits.

(2) Specific verification methods

Inspectors shall, in accordance with the borrower classifications from self-assessments, use the materials employed by the financialinstitution under inspection in its write-off and reserve calculations to verify the accuracy of write-offs and reserves according to the write-offand reserve standards of the financial institution under inspection.

Should borrower classifications be changed in inspections, inspectors shall accurately measure the additional write-off and reserve amountrequired assuming that write-offs and reserves are calculated according to the write-off and reserve standards of the financial institution underinspection using the new borrower classifications. Note that inspectors will also need to verify that the write-off and reserve standards of thefinancial institution under inspection are rational in these cases.

3. Standards for judging the appropriateness of write-offs and reserves

Should the results of verifications of the appropriateness of write-offs and reserves indicate that any of the following apply to the write-off andreserve results of the financial institution under inspection, inspectors shall judge it inappropriate.

(1) There are problems with the appropriateness of write-off and reserve levels because inappropriate write-off and reserve amounts were calculatedon the base date.

(2) The institution failed to apply appropriate write-off and reserve levels for borrower classifications and credit categories in light of self-assessment results.

(3) Appropriate write-offs and reserves were not made because of mistakes in self-assessment results.

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Attachment

Item Verification of the appropriateness of write-off and reserve standards

Verification of the appropriateness of write-off andreserve results

Remarks

1. Default reserves Default reserves shall be made at leastfor credits (loans and credits similar toloans) using rational estimates of losseshighly likely to be incurred in the future.

In the calculation of default reservesthere should be a consistent linkage betweenthe results of self-assessments based oncredit ratings and write-offs and reserves. Inother words, perform self-assessments basedon credit ratings that take account ofborrower credit risks, and calculate write-offs and reserves based on the results ofthese self-assessments.

Note that for institutions utilizingrational and appropriate internal models toquantify credit risks, the total defaultreserves must fully meet the expecteddefault loss value for the portfolio as a wholeas deduced from the quantification of creditrisks.

Verify calculations of default reserves in principleby verifying that there is a consistent linkage betweenself-assessments and write-offs and reserves that takesaccount of credit ratings and that write-offs andreserves are in line with write-off and reservestandards.

Next, verify that the total write-offs and reserves ofthe financial institution under inspection are atsufficient levels for the credit risks to which theinstitution is exposed. If the institution employs arational and appropriate internal model to quantifycredit risks, verify that the total default reserves are atlevels above the expected default losses deduced fromthe quantification of credit risks.

(1) General default reserves In calculating, ordinary default reserves,for credits against “normal” borrowers andcredits against “needs attention” borrowers,calculate past default rates and bankruptcyprobabilities in principle for each creditrating or at least for each borrowerclassification using the methods shownbelow. Find the loss rate expected to beincurred in the future (the expected lossrate), and calculate an expected loss amountby multiplying the credit value in principlefor each credit rating and at least for eachborrower classification by the expected lossrate. Post default reserves at valuescommensurate to the expected loss amount.

The basic principle for calculatinggeneral default reserves is to calculateexpected loss amounts using a migrationanalysis of individual credit ratings and/orborrower classifications.

In addition, it is desirable that generaldefault reserves be calculated in light of the

Verify that calculations of general default reservesfor “normal” borrowers and “needs attention” borrowersrationally estimate expected loss amounts based onwrite-off and reserve standards for each credit ratingand/or borrower classification.

Specifically verify the following items.

1) Verification of average time to maturity

If the institution calculates expected lossamounts over a set period in the future by averagetime to maturity, verify that the average time tomaturity is rational.

Specifically, verify how the institutionreflects average time to maturity in creditsassociated with current account overdrafts, how itreflects average time to maturity for credits thathave in fact become long-term, fixed credits eventhough contractual periods are short-term, andother issues that would impinge upon therationality of average time to maturity.

45



Remarks

nature of the credit risks associated with thecredits held by the financial institutionunder inspection. For example, a methodcould be used in which expected lossamounts are calculated by specific groups aswarranted by the nature of the institution’sportfolio (borrower industry, borrowerlocation, credit amount, size of borrower,individual/company etc.).

The expected loss rate is determinedafter making needed adjustments forchanges in economic conditions, changes incredit policies, changes in portfolio make-up(credit ratings, borrower industry, borrowerlocation, credit amount, size of borrower,individual/company, credit security etc.), andcorrecting this for past default rates and/orbankruptcy probability forecasts.

Should there be a rapid worsening ofeconomic conditions in particular, the weightof more recent calculation periods should beincreased in the determination of pastdefault rates and bankruptcy probabilities orthe expected loss rate should be adjusted toreflect recent increases in default rates andbankruptcy probabilities, or some othersimilar method should be employed.

General default reserve calculationmethod

Expected loss amount calculationmethod

Expected loss amount = Credit amount xExpected loss rate

Examples of specific methods forcalculating expected loss rate

1) Using Default rates

Default write-off loss amount /Credit amount

2) Using bankruptcy probability

Bankruptcy probability x (1 -forecast collection rate)

(Note: There is also a method thatsubstitutes unsecured percentage or

If the institution categorizes credits to“needs attention” borrowers by degree of credit riskto calculate expected loss amounts for specificcategories over a set period in the future, verifythat the future periods used for individual creditrisk categories are rational.

2) Verification of default rates and bankruptcyprobabilities

If the institution employs a method basedon default rates, verify that the expected lossamount reflects the amount of all losses, includingdirect write-offs, indirect write-offs, relinquishedcredits, and losses on credits sold. If the institutionemploys a method based on bankruptcyprobabilities, verify that the number ofbankruptcies at the very least reflects all loans to“effectively bankrupt” and “bankrupt” borrowers.

It is appropriate that the number ofbankruptcies reflects the number of loans to “indanger of bankruptcy” borrowers in some form.Verify that the method for doing so is rational, forexample, adding to the number of bankruptcies anumber found by multiplying the number of “indanger of bankruptcy” loans by the bankruptcyprobability. If the institution does not reflect thenumber of “in danger of bankruptcy” loans in thenumber of bankruptcies, fully verify that the totalamount of general default reserves are at levelscommensurate to the credit risk exposure of thefinancial institution under inspection, thatcalculations of expected loss amounts in earlierperiods were at sufficient levels, and that theinstitution compares expected loss amounts basedon default rates.

If the institution employs migrationanalysis by credit rating or borrower classificationfor the calculation of default rates, verify thatthere is rational justification for this analysis.

If the institution employs a method thatuses bankruptcy probabilities and there is alikelihood that large losses will be incurred so thatthe expected loss amount as calculated fromdefault rates is higher than the expected lossamount as calculated from bankruptcyprobabilities, it is desirable that the institution

46



Remarks

average loss percentage for “1 -forecast collection rate.”

post as default reserves the expected loss amountcalculated using the default rate-based method.

3) Verification of exclusion of abnormal values

If the institution excludes losses orbankruptcies associated with specific borrowersfrom its default rates and/or bankruptcyprobabilities because these values are “abnormal,”verify that there is rational justification for theexclusion.

Specifically, if the institution excludeslosses and bankruptcies associated with specificborrowers from calculations of default rates and/orbankruptcy probabilities as “abnormal” values byclaiming that the borrower should have beenclassified as “in danger of bankruptcy” but wasinstead classified as “normal” or “needs attention,”verify that the losses and bankruptcies arereflected in calculations of default reserves in someform, for example, by including them incalculations of expected loss amount for credits to“in danger of bankruptcy” borrowers.

Verify whether the institution excludes as“abnormal” values losses and/or bankruptciesassociated with specific industries and/or locationsby claiming that there are sharp differencesbetween losses and bankruptcies in theseindustries and/or locations and losses and/orbankruptcies in other industries and/or locations.In these cases it is not appropriate to excludelosses and/or bankruptcies to specific industriesand/or locations as “abnormal.” Rather, it isdesirable that the institution group credits byindustry and/or location, calculate default ratesand/or bankruptcy probabilities for each group,find expected loss rates for each, and calculateexpected loss amounts as the credits to each groupmultiplied by the expected loss rate for the group.

4) Verification of calculation period for default ratesand bankruptcy probabilities

Verify that calculations of expected lossamounts are based at the very least on defaultrates and bankruptcy probabilities for thepreceding three calculation periods.

If the calculation period is not three past

47

ItemItemItemItem Verification of the appropriateness of write-Verification of the appropriateness of write-Verification of the appropriateness of write-Verification of the appropriateness of write-off and reserve standardsoff and reserve standardsoff and reserve standardsoff and reserve standards

Verification of the appropriateness of write-off andVerification of the appropriateness of write-off andVerification of the appropriateness of write-off andVerification of the appropriateness of write-off andreserve resultsreserve resultsreserve resultsreserve results


periods, verify that there is a rational reason why,for example, data has not been accumulated. Insuch cases, identify the time at which sufficientdata will have been accumulated to enable the useof default rates and bankruptcy probabilities forthree calculation periods and verify that themethods used to calculate expected loss amountsduring the interim are rational.

5) Verification of expected loss rates

Verify that the financial institution underinspection captures changes in economic conditionsthat would effect the borrower’s business, changesin credit policies, changes in portfolio make-up,and other relevant information in thedetermination of expected loss rates. If theinstitution corrects rates for changes in economicconditions etc., verify that there is rationaljustification for the corrections in light of the wayin which the institution captures changes ineconomic conditions etc.

If the financial institution under inspectionhas identified large changes in economic conditionsetc., but has not made necessary corrections, verifythat there is rational justification for not makingcorrections.

6) Verification of expected loss amounts fromprevious periods

Compare expected loss amounts and actualdefaults and/or bankruptcies from previous periodsto verify that levels were adequate. If thisverification indicates that expected loss levels wereinadequate, verify the reasons why (for example,did past calculations of expected loss amountscorrect for forecasts at the time of calculation?),and verify that expected loss rates are corrected atthe base date.

1)1)1)1) Default reserves for credits toDefault reserves for credits toDefault reserves for credits toDefault reserves for credits to““““normalnormalnormalnormal”””” borrowers borrowers borrowers borrowers

Default reserves for credits to “normal”borrowers should estimate an expected lossamount for a set period in the future thatcorresponds to the average time to maturityof the credits. It is acceptable for expectedloss amounts to be estimated for the next oneyear in the future.

Verify that default reserves for credits to “normal”borrowers are rationally estimated based on write-offand reserve standards and utilizing an expected lossamount for a set period in the future or for the next oneyear that corresponds to the average time to maturity ofcredits to “normal” borrowers.

When the institution estimates the expected lossamount for the next one year, verification of the

48




In calculating expected loss amounts,use average default rates and/or bankruptcyprobabilities for at least the last threecalculation periods (three year average ofcumulative default rates and/or bankruptcyprobabilities for a set period in the pastcorresponding to a set period in the future)to calculate past default rates, correct forexpected future losses to find an expectedloss rate, and multiply the amount of creditsto “normal” borrowers by the expected lossrate (if calculating the expected loss amountfor the next one year, calculate the averageone-year default rate and/or bankruptcyprobability for the past three calculationperiods).

rationality of the “set period in the future” vis a vis theaverage time to maturity may be omitted.

2)2)2)2) Default reserves for credits toDefault reserves for credits toDefault reserves for credits toDefault reserves for credits to““““needs attentionneeds attentionneeds attentionneeds attention”””” borrowers borrowers borrowers borrowers

Default reserves for credits to “needsattention” borrowers should estimate anexpected loss amount for a set period in thefuture that corresponds to the average timeto maturity of the credits. It is acceptable toclassify “needs attention” borrowersaccording to their degree of credit risk and toestimate expected loss amounts for setperiods in the future deemed rational foreach classification.

For example, it would be acceptable toestimate expected loss amounts for theaverage time to maturity or the next threeyears for credits to “special attention”borrowers and estimate expected lossamounts for the average time to maturity orthe next one year for other “need attention”borrowers.

In calculating expected loss amounts,use average default rates and/or bankruptcyprobabilities for at least the last threecalculation periods (three year average ofcumulative default rates and/or bankruptcyprobabilities for a set period in the pastcorresponding to a set period in the future)to calculate past default rates, correct forexpected future losses to find an expectedloss rate, and multiply the amount of creditsto “needs attention” borrowers by the

Verify that default reserves for credits to “needsattention” borrowers are rationally estimated based onwrite-off and reserve standards and utilizing anexpected loss amount for a set period in the future thatcorresponds to the average time to maturity of credits to“needs attention” borrowers, or for a set period in thefuture deemed rational for each category when “needsattention” borrowers are categorized by degree of creditrisk.

If the institution calculates an expected loss amountfor a set period in the future based on credit riskcategories, verify that the calculation of the expectedloss amount is rational.

If the institution calculates a three-year expectedloss amount for “special attention” borrowers and a one-year expected loss amount for other borrowers,verification of the rationality of the “set period in thefuture” vis a vis the average time to maturity may beomitted.

Note: To be reviewed in the event ofa change in the standardspromulgated by the FinancialRevitalization Commission for“special attention” borrowers.

Note: “Credits to ‘special attention’borrowers” refers to credits to“needs attention” borrowers whenall or part of the credits to theborrower have been classified asrequiring special attention, and sothroughout.

49




expected loss rate (if calculating the expectedloss amount for the next one year, calculatethe average one-year default rate and/orbankruptcy probability for the past threecalculation periods).

(2)(2)(2)(2) Specific default reservesSpecific default reservesSpecific default reservesSpecific default reserves and and and anddirect write-offsdirect write-offsdirect write-offsdirect write-offs

For specific default reserves and directwrite-offs, calculate in principle an expectedloss amount for each individual “in danger ofbankruptcy”, “effectively bankrupt”, and“bankrupt” borrower, and either post asdefault reserves or directly write off anamount equivalent to the expected lossamount.

Calculate required amounts forindividual default reserves each period.

Verify that individual write-off amounts and directwrite-offs are calculated in principle by estimating anexpected loss amount for each individual “in danger ofbankruptcy”, “effectively bankrupt”, and “bankrupt”borrower, and that an amount equivalent to theexpected loss amount is either posted as defaultreserves or directly written off.

1)1)1)1) Specific dSpecific dSpecific dSpecific default reserves forefault reserves forefault reserves forefault reserves forcredits to credits to credits to credits to ““““in danger ofin danger ofin danger ofin danger ofbankruptcybankruptcybankruptcybankruptcy”””” borrowers borrowers borrowers borrowers

For reserves against credits to “indanger of bankruptcy” borrowers, estimatein principle an expected loss amount for a setperiod in the future deemed rational forcredits to each individual “in danger ofbankruptcy” borrower and post an amountequivalent thereto as default reserves. It isacceptable to estimate an expected lossamount for the next three years.

Sample calculations of expected lossamount for credits to “in danger ofbankruptcy” borrowers

A. Using Category III credit amountsmultiplied by expected loss rate as theexpected loss amount (including the useof a remainder after the amountcollectible from rationally estimatedcash flow is deducted)

When using Method A above, inprinciple calculate a past default rate and/orbankruptcy probability for each credit ratingor at least for each borrower classification of“in danger of bankruptcy” borrowers, find aloss rate expected for the future (expectedloss rate), and in principle multiply theamount of Category III credits to theindividual borrower by the expected loss rateto calculate an expected loss amount. Post an

For individual write-offs and reserves againstcredits to “in danger of bankruptcy” borrowers, verifythat the estimated loss value has been rationallyestimated for a set period in the future.

Specifically, verify the items below and verify thatestimates cover the full value of Category III loans,including the difference between the appraised valueand estimated disposal value of general collateral.

A. Using Category III credit amounts multiplied byexpected loss rate as the expected loss amount

a) Verification of the “set period in thefuture”

Verify that the “set period in thefuture” used to estimate expected lossamounts is rational. However, thisverification may be omitted if theinstitution estimates expected lossamounts for a three-year period.

b) Verification of default rates andbankruptcy probabilities

If the institution employs a methodbased on default rates, verify that theexpected loss amount reflects the amount

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amount equivalent to the expected lossamount to default reserves.

The expected loss rate should inprinciple be determined for each individualborrower based on past default rates and/orbankruptcy probabilities corrected for futureforecasts in light of changes in economicconditions, forecasts for business conditionsin the industry etc. of the borrower, forecastsfor local economic conditions in the businessterritory of the borrower, and other relevantinformation.

In calculating expected loss amounts,use average default rates and/or bankruptcyprobabilities for at least the last threecalculation periods (three year average ofcumulative default rates and/or bankruptcyprobabilities for a set period in the pastcorresponding to a set period in the future)to calculate past default rates, correct forexpected future losses to find an expectedloss rate, and multiply the amount ofCategory III credits by the expected loss rate(if calculating the expected loss amount forthe next one year, calculate the average one-year default rate and/or bankruptcyprobability for the past three calculationperiods).

If the financial institution has aconsiderable number of borrowers classifiedas “in danger of bankruptcy” borrowers andit is difficult to calculate write-off andreserve amounts in light of the collateral andother security status for individualborrowers, it is acceptable to use a singleexpected loss rate for each group of credits to“in danger of bankruptcy” borrowers below aset threshold level, and to post an amountequivalent to the expected loss amount asdefault reserves. In such cases, the scope ofcredits to “in danger of bankruptcy”borrowers below a set threshold value forwhich group expected loss rates are appliedshall be within a range deemed rational inlight of the size and nature of the assets ofthe financial institution under inspection,and calculations of expected loss rates must

of all losses, including direct write-offs,indirect write-offs, relinquished credits,and losses on credits sold.

If the institution employs a methodbased on bankruptcy probabilities, verifythat the number of bankruptcies at thevery least reflects all loans to “effectivelybankrupt” and “bankrupt” borrowers.

c) Verification of exclusion of abnormalvalues

If the institution excludes losses orbankruptcies associated with specificborrowers from its default rates and/orbankruptcy probabilities because thesevalues are “abnormal,” verify that there isrational justification for the exclusion.

d) Verification of calculation period fordefault rates and bankruptcy probabilities

Verify that calculations of expectedloss amounts are based at the very leaston default rates and bankruptcyprobabilities for the preceding threecalculation periods.

If the calculation period is not threepast periods, verify that there is a rationalreason why, for example, data has notbeen accumulated. In such cases, identifythe time at which sufficient data will havebeen accumulated to enable the use ofdefault rates and bankruptcy probabilitiesfor three calculation periods and verifythat the methods used to calculateexpected loss amounts during the interimare rational.

e) Verification of expected loss rates

Verify that the financial institutionunder inspection captures changes ineconomic conditions forecasts for theindustry etc. of the borrower, and localeconomic conditions for the businessterritory of the borrower. If the financialinstitution under inspection has identifiedlarge changes in economic conditions etc.,but has not made necessary corrections

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be rigorous and clear. for individual borrowers, verify that thereis rational justification for not makingcorrections.

f) Verification of expected loss amounts fromprevious periods

Compare expected loss amounts forindividual borrowers and actual defaultsand/or bankruptcies for individualborrowers from previous periods to verifythat levels were adequate. If thisverification indicates that expected losslevels were inadequate, verify the reasonswhy (for example, did past calculations ofexpected loss amounts correct for forecastsat the time of calculation?), and verifythat expected loss rates are corrected atthe base date.

g) Verification of amount collectible fromcash flow etc.

If the institution excludes an amountcollectible from cash flow from theCategory III amount for individualborrowers, verify that the cash flowestimate is rational and that theremainder when the collectible amount isdeducted from the Category III amount istreated as the expected loss amount.

If the financial institution has aconsiderable number of borrowersclassified as “in danger of bankruptcy”borrowers and omits considerations ofcredit security in favor of expected lossamounts based on group expected lossrates for borrowers below a set thresholdvalue, verify that the calculation of groupexpected loss rates is rational. In thesecases, it is acceptable to calculateexpected loss rates for “in danger ofbankruptcy” borrowers below a setthreshold value as a single group. Verifythat the scope of credits for “in danger ofbankruptcy” borrowers below a setthreshold value is rational.

Note: “Collectible amount from cashflow” refers to the portion that isdeemed certain of collection fromthe amount of current profits forthe individual borrower adjustedfor depreciation charges and othernon-financial items in principleover a period of three years or overa period of five years if theborrower has formulated a businessimprovement plan etc.

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B. Using a remainder found bysubtracting a collectible amount fromthe credit amount as the expected lossamount for credits that have a saleablemarket (deeming a rationallycalculated saleable value as thecollectible amount)

B. Posting as default reserves an expected lossamount found as the remainder when a saleableamount is deducted from the Category III amount

If credits have a market on which they canbe sold and the institution uses the amount atwhich the credit can be sold as the collectibleamount, and the institution deducts this collectibleamount from the credit amount to arrive at aremainder that is used as the expected lossamount, verify that the calculation of the saleableamount for the credit is rational, and verify thatthe remainder when the collectible amount isdeducted from the Category III is used as theexpected loss amount.

2)2)2)2) Specific Specific Specific Specific default reserves anddefault reserves anddefault reserves anddefault reserves anddirect write-offs for direct write-offs for direct write-offs for direct write-offs for ““““effectivelyeffectivelyeffectivelyeffectivelybankruptbankruptbankruptbankrupt”””” and and and and ““““bankruptbankruptbankruptbankrupt””””borrowersborrowersborrowersborrowers

For credits to “effectively bankrupt” and“bankrupt” borrowers, use the amount ofcredits for each individual borrowerclassified as Category III or Category IV asthe expected loss amount and ether postdefault reserves or make direct write-offs ofan amount equivalent to the expected lossamount.

Verify that for credits to “effectively bankrupt” and“bankrupt” borrowers, the institution uses the amountof credits for each individual borrower classified asCategory III or Category IV as the expected loss amountand either posts default reserves or makes direct write-offs of an amount equivalent to the expected lossamount.

Verify that the institution uses the total amount ofcredits classified as Category III or Category IV as theexpected loss amount, and that it does not deem theportion certain of collection as Category II and deductthe collectible amount from the Category III amount.

3)3)3)3) Reserves against specificReserves against specificReserves against specificReserves against specificforeign creditsforeign creditsforeign creditsforeign credits

For reserves against specific foreigncredits, determine the countries to becovered based on their financial conditions,economic conditions, foreign exchangereserves and other factors, and clarify whichcredits to the governments of thesecountries, private companies in thesecountries, and Japanese companies in thesecountries are subject to reserves againstspecific foreign credits.

Multiply the relevant credits by anexpected loss rate estimated from thefinancial conditions, economic conditions,foreign exchange reserves and other factorsin specific countries to find an expected lossamount. Post an amount equivalent to thisexpected loss amount to the reserves against

Verify that the scope of countries and scope ofcredits subject to reserves against specific foreigncredits, and the methods of calculating expected lossrates and expected loss amounts are rational. Inparticular, verify that calculations of expected loss ratesare rational in light of the saleable value for creditsfrom specific countries on saleable markets, and thecredit rating given to specific countries by ratingsagencies.

Verify that reserves against specific foreign creditsinclude expected loss amounts as found by multiplyingall credits from relevant countries by an expected lossrate estimated from the financial conditions, economicconditions, foreign exchange reserves and other factorsin the country. However, credits deemed collectiblebecause they are secured with deposits, or because theyare secured with guarantees or insurance from parties

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specific foreign credits. domiciled outside of the country in question, creditsdenominated in the local currency of the country inquestion, and credits employing structures that avoidtransfer risks may be excluded.

Specifically, verify that for those credits to “normal”and “needs attention” borrowers that are subject toreserves against specific foreign credits, the institutionposts ordinary default reserves and also reservesagainst an expected loss amount found by multiplyingthe amount of the credit by an expected loss rate thatestimates financial conditions etc. in the country inquestion.

For credits to “in danger of bankruptcy”, “effectivelybankrupt”, and “bankrupt” borrowers that are subject toreserves against specific foreign credits, verify that theinstitution posts expected loss amounts based on thefinancial position etc. of the individual borrower, andthat it also posts as reserves against specific foreigncredits or individual default reserves an expected lossamount found by multiplying the remainder when theinitial expected loss amount is subtracted from theoriginal credit to the borrower by an expected loss rateestimated from financial conditions etc. in the countryin question.

4)4)4)4) Verification of theVerification of theVerification of theVerification of theappropriateness of the totalappropriateness of the totalappropriateness of the totalappropriateness of the totalvalue of default reservesvalue of default reservesvalue of default reservesvalue of default reserves

Verify that the total value of credits is at a levelsufficient for the degree of credit risk to which thefinancial institution under inspection is exposed.

Note: Standards for the totalamount of default reserves will bereviewed in the event of a change inthe write-off and reserve standardspromulgated by the FinancialRevitalization Commission

2.2.2.2. Reserves other than defaultReserves other than defaultReserves other than defaultReserves other than defaultreservesreservesreservesreserves

For reserves other than default reserves,rationally estimate and post highly probablecontingency amounts. Note that the namesof reserves used below are only examplesand do not preclude the use of other names.

Verify that the institution rationally estimates andposts reserves for highly probably contingency losses inaddition to default reserves.

If the institution does not post reserves other thandefault reserves even though it is exposed to thepotential for highly probably contingency losses, verifythat there is rational justification for not posting thesereserves.

.

(1)(1)(1)(1) Reserves against losses fromReserves against losses fromReserves against losses fromReserves against losses fromthe sale of creditsthe sale of creditsthe sale of creditsthe sale of credits

If the price of collateral real estatesecuring credits sold to a joint creditpurchasing agency has fallen or in othersimilar conditions, calculate an expected loss

Verify that calculation of the market price of realestate collateralizing sold credits is rational, thatreserve standards are rational, and that thesestandards are at least at the levels described left.

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amount deemed like to be incurred as aresult of the fall in the price of the soldcredit, and post an amount equivalent to theexpected loss amount as reserves againstlosses from the sale of credits.

At the very least, when the market priceof sold credits is more than 50% below theinitial selling price, that portion of thedifference between the initial selling priceand the market price of the sold credit to beborne by the selling financial institutionshall be posted as reserves. Likewise, if thecredit is deemed certain of sale by the end ofthe next settlement period, that portion ofthe difference between the initial sellingprice and the estimated selling price of thecollateral real estate to be borne by theselling financial institution shall be postedas reserves.

Note: The expected loss amount from afall in the price of collateral real estate is notan expected loss amount from a default ofthe credit to the joint credit purchasingagency, and it is therefore not appropriate toclassify the borrower as “in danger ofbankruptcy”, “effectively bankrupt”, or“bankrupt” for the joint credit purchasingagency or to post individual default reserves.However, credits to the joint creditpurchasing agency are subject to ordinarydefault reserves (except for credits for whichthere is a rational justification for exclusionfrom ordinary default reserves).

(2)(2)(2)(2) Reserves against support forReserves against support forReserves against support forReserves against support forspecific borrowersspecific borrowersspecific borrowersspecific borrowers

If the institution is engaged in therebuilding and support of borrowers thathave fallen into difficult economic straits byrelinquishing credits or providing cashgrants, they shall in principle calculate anexpected loss amount for the support andpost an amount equivalent to the expectedloss amount as reserves against support forspecific borrowers.

Specifically, in calculating the reservesfor support to consolidated subsidiaries ofthe financial institution under inspection(including affiliated “non-banks”), the

Verify that all borrowers expected to be givensupport by relinquishment of credits or other cashgrants etc. are covered, and that the calculation ofexpected loss amount from support to specific borrowersis rational.

If the institution provides support by relinquishingcredits and the expected loss amount from this supportsposted as individual default reserves, verify that thereis rational justification for posting it as individualdefault reserves and that calculation of the expected lossamount is rational.

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institution shall calculate an amount for theremaining Category III and Category IVvalues after deducting (allocating toCategory IV credits first) a collectibleamount for the subsidiary (total amountposted to capital plus collectible amountfrom cash flow during the period of thebusiness improvement plan) from thecategorized amount for the subsidiary inlight of the asset assessment results for thesubsidiary, and shall use the same methodsas for write-offs and reserves to calculate awrite-off and reserve amount for thesubsidiary which shall be posted to reservesagainst support for specific borrowers as theexpected loss amount from support to thesubsidiary. In this case, the entire amountclassified as Category IV and an amountfrom that is classified as Category IIIcalculated using the same methods as theinstitution’s write-off and reserve standardsrequire for credits to “in danger ofbankruptcy” borrowers shall be posted toreserves against support for specificborrowers as the expected loss amount fromsupport to the subsidiary.

The expected loss amount from supportrendered to specific borrowers throughrelinquishment of credits and cash grantsetc. should basically be posted to thereserves against support for specificborrowers, but when support is rendered byrelinquishing credits and the expected lossamount from support to specific borrowerswith borrower classifications of “in danger ofbankruptcy” is within the scope of thiscredit, and when the amount of the expectedloss amount is negligible so that there islittle need to set reserves against support forspecific borrowers, or when there is otherrational justification, the amount may beposted as individual default reserves.

(3)(3)(3)(3) Other reserves againstOther reserves againstOther reserves againstOther reserves againstcontingency lossescontingency lossescontingency lossescontingency losses

If the institution is exposed to thepotential for highly probable contingencylosses other than (1) and (2) above, post arationally estimated amount likely to be

Verify that future losses are rationally estimatedand posted to other reserves against contingency losses.

In particular, when credit liquidation schemes areused to take credits off balance sheet, verify that an

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borne to other reserves against contingencylosses as the expected loss amount.

In particular, if the financial institutionunder inspection engages in creditliquidation schemes that take credits offbalance sheet but do not fully transfer creditrisks to third parties so that the institutionretains all or a part of the credit risk, post anamount equivalent to the expected lossamount from the Category III portion andthe full amount of the Category IV portion toother reserves against contingency losses asthe expected loss amount.

expected loss amount is posted to other reserves againstcontingency losses as described left.

3.3.3.3. Securities appraisalSecurities appraisalSecurities appraisalSecurities appraisal In appraising securities, post an amountequivalent to the expected loss amount fromthe Category III portion to reserves againstinvestment losses, and directly write off theentire Category IV portion.

Verify that in the appraisal of securities theinstitution has posted an expected loss amount to thereserves against investment losses or has directlywritten off an expected loss amount as described left.

(1)(1)(1)(1) Bond appraisalBond appraisalBond appraisalBond appraisal For privately-placed bonds issued by “indanger of bankruptcy”, “effectivelybankrupt”, or “bankrupt” borrowers,calculate expected loss amounts using thesame methods as for default reserves. Postan amount equivalent to expected lossamount from the Category III portion toreserves against investment losses, anddirectly write off the entire Category IVportion.

Verify that bond appraisal methods are rational,and that the institution posts the expected loss amountto reserves against investment losses or directly writesit off.

If the institution classifies privately-placed bondsusing the same method as it does for credits, verify thatexpected loss amounts are calculated using the samemethods as default reserves.

If the institution uses the same classificationmethods as for credits but has not posted expected lossamount to reserves against investment losses or directlywritten them off, or of it needs to make classificationsbut has not and therefore has not posted reserves ormade write-offs, verify that there is rational justificationfor not doing so.

(2)(2)(2)(2) Equity appraisalEquity appraisalEquity appraisalEquity appraisal For equities issued by “in danger ofbankruptcy”, “effectively bankrupt”, or“bankrupt” borrowers (excluding exchange-listed equities and over-the-counter-registered equities), calculate expected lossamounts using the same methods as fordefault reserves. Post an amount equivalentto expected loss amount from the CategoryIII portion to reserves against investmentlosses, and directly write off the entire

Verify that equity appraisal methods are rational,and that the institution posts the expected loss amountto reserves against investment losses or directly writesit off as described left. If the original cost method isused, and there are clear standards for mandatorywrite-downs of value pursuant to the provisions of theCommercial Code, verify that these standards arerational.

If the institution classifies equities using the samemethod as it does for credits, verify that expected loss

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Category IV portion.

If there is a recognized need to reducebook values, directly write off the CategoryIV portion as an expected loss amount.

amounts are calculated using the same methods asdefault reserves.


(3)(3)(3)(3) Foreign security appraisalForeign security appraisalForeign security appraisalForeign security appraisal For foreign securities classified with thesame methods as used for credits and issuedby “in danger of bankruptcy”, “effectivelybankrupt”, or “bankrupt” borrowers,calculate expected loss amounts using thesame methods as for default reserves. Postan amount equivalent to expected lossamount from the Category III portion toreserves against investment losses, anddirectly write off the entire Category IVportion.

Verify that foreign security appraisal methods arerational, and that the institution posts the expected lossamount to reserves against investment losses or directlywrites it off as described left.

If the institution classifies foreign securities usingthe same method as it does for credits, verify thatexpected loss amounts are calculated using the samemethods as default reserves.


(4)(4)(4)(4) Securities investment trustSecurities investment trustSecurities investment trustSecurities investment trustbeneficiary certificate appraisalbeneficiary certificate appraisalbeneficiary certificate appraisalbeneficiary certificate appraisal

The Category IV portion for securitiesinvestment trust beneficiary certificates isdirectly written off as the expected lossamount.

Verify that expected loss amounts are written off forsecurities investment trust beneficiary certificates asdescribed left.

4.4.4.4. Appraisal of other assetsAppraisal of other assetsAppraisal of other assetsAppraisal of other assets In the appraisal of other assets, verify that expectedloss amounts are posted as reserves or directly writtenoff as described left.

(1)(1)(1)(1) Suspense payment appraisalSuspense payment appraisalSuspense payment appraisalSuspense payment appraisal For suspense payments other than thosesimilar to loans, post as reserves or directlywrite off the Category IV portion as theexpected loss amount.

(2)(2)(2)(2) Chattel and real estateChattel and real estateChattel and real estateChattel and real estateappraisalappraisalappraisalappraisal

For chattels and real estate, post asreserves or directly write off the Category IVportion as the expected loss amount.

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(3)(3)(3)(3) Golf club membership appraisalGolf club membership appraisalGolf club membership appraisalGolf club membership appraisal For golf club memberships, post asreserves or directly write off the Category IVportion as the expected loss amount.

(4)(4)(4)(4) Miscellaneous assets appraisalMiscellaneous assets appraisalMiscellaneous assets appraisalMiscellaneous assets appraisal A. For purchasing credits classified withthe same methods as used for creditsand issued by “in danger ofbankruptcy,” “effectively bankrupt”, or“bankrupt” borrowers, calculateexpected loss amounts using the samemethods as for default reserves. Post anamount equivalent to expected lossamount from the Category III portion toreserves against investment losses or todefault reserves. For Category IVpurchasing credits, post an amountequivalent to expected loss amountfrom the Category IV portion toreserves against investment losses or todefault reserves, or directly write offthis amount.

B. For loan credit investment trustbeneficiary certificates classified withthe same methods as used for creditsand used to liquidated credits from “indanger of bankruptcy,” “effectivelybankrupt,” or “bankrupt” borrowers,calculate expected loss amounts usingthe same methods as for defaultreserves. Post an amount equivalent toexpected loss amount from theCategory III portion to reserves againstinvestment losses or to defaultreserves. For Category IV purchasingcredits, post an amount equivalent toexpected loss amount from theCategory IV portion to reserves againstinvestment losses or to defaultreserves, or directly write off thisamount.

If the institution classifies purchasing credits orloan credit investment trust beneficiary certificatesusing the same method as it does for credits, verify thatexpected loss amounts are calculated using the samemethods as default reserves.


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Inspections of capital adequacy ratiosInspections of capital adequacy ratiosInspections of capital adequacy ratiosInspections of capital adequacy ratios

I.I.I.I. Inspections of the accuracy of capital adequacy ratiosInspections of the accuracy of capital adequacy ratiosInspections of the accuracy of capital adequacy ratiosInspections of the accuracy of capital adequacy ratios

When inspecting the capital adequacy ratio of the financial institution under inspection, verify that calculations of the portions relevant to credit riskare accurate and in conformance with “Standards for Capital Adequacy Ratios Pursuant to Article 14-2 of the Banking Law (Ministry of Finance NoticeNo. 55).

Place priority in inspections on whether capital adequacy ratios are calculated appropriately in light of the “Supervisory Guidelines (issued by theFSA)”, paying particular attention to the following.

1. Verify that the tax effect equivalent (amount commensurate to deferred tax assets) used in the capital account is calculated appropriately. If thetax effect equivalent posted is higher than estimated income tax for the next five years (before adjustments for future increases or decreases intemporary term-end differences) multiplied by an effective tax rate, verify that there are rational reasons for this.

2. If the institution has borrowed subordinated loans or issued subordinated bonds, verify that the subordinated borrowings are eligible for inclusionas owned capital in the capital adequacy regulations.

3. If the institution has utilized debt-based methods to raise capital that include special clauses to add on “step up interest rates” or the like, verifythat the step up interest rates etc. are not excessive.

4. If the institution issues preferred investment certificates in foreign special purpose companies, verify that these preferred investment certificatesfully conform to the intentions of the Basle Agreement.

5. If the institution has issued bank guarantees etc. (including credit liabilities that have an effect equivalent to a guarantee) for assets held andthese guarantees etc. extend across settlement terms or are issued on the last day of the settlement term, verify that it has not reduced its risk assetseven if the time to maturity for the guarantee is less than one year.

However, this excludes cases in which there is a justifiable reason for the guarantee etc. and continuing reductions of credit risks can be expected.

6. If the institution transfers credits with repurchase agreements that extend across settlement terms, verify that the contracts do not giveincentives to exercise repurchase rights and repurchase credits within one year from the settlement term.

7. Verify that there are no other reductions etc. of risk assets contrary to the intentions of the capital adequacy regulations.

II.II.II.II. Verification Verification Verification Verification of the effect of write-off and reserve inspection results on capital adequacy ratiosof the effect of write-off and reserve inspection results on capital adequacy ratiosof the effect of write-off and reserve inspection results on capital adequacy ratiosof the effect of write-off and reserve inspection results on capital adequacy ratios

If the results of inspections of write-offs and reserves indicate insufficient write-off and reserve levels, endeavor to calculate additional required write-off and reserve values and the degree of impact this will have on the capital adequacy ratio. In other words, verify the degree to which the capitaladequacy ratio will be reduced if additional required write-offs and reserves are made.

Specifically, handle these situations as described below, taking care to form a consensus among the chief inspector, the financial institution underinspection, and the external auditors.

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1.1.1.1. Study write-off and reserve levelsStudy write-off and reserve levelsStudy write-off and reserve levelsStudy write-off and reserve levels

Write-off and reserve levels shall be deemed inadequate in the following cases.

(1) Verifications of self-assessment standards and/or self-assessment results indicate inappropriate self-assessment standards or inaccurate self-assessment results, so that changes in borrower classifications etc. result in an increase in classified amounts (assigned to Category II, Category III, orCategory IV), and therefore predict an increase in write-off and reserve values.

(2) Verifications of write-off and reserve standards and/or write-off and reserve results indicate inappropriate write-off and reserve standards and/orinappropriate calculations of write-off and reserve values so that an increase in the write-off and reserve values is forecast.

2.2.2.2. Calculation of additional required write-off and reserve valuesCalculation of additional required write-off and reserve valuesCalculation of additional required write-off and reserve valuesCalculation of additional required write-off and reserve values

Pay close attention to the following in calculating additional required write-off and reserve values, and endeavor to fully exchange opinions with thefinancial institution under inspection and external auditors.

(1) For the case in 1(1)

If the write-off and reserve standards of the financial institution under inspection are deemed appropriate, calculate additional required write-off andreserve values based on the write-off and reserve standards.

If the write-off and reserve standards of the financial institution under inspection are deemed inappropriate, calculate additional required write-offand reserve values based on write-off and reserve standards found as described in (2)1 below.

(2) For the case in 1(2)

1) If the write-off and reserve standards of the financial institution under inspection are deemed inappropriate, fully exchange opinions withthe financial institution under inspection and external auditors regarding the parts deemed inappropriate, determine how to improve write-off andreserve standards, and calculate additional required write-off and reserve values based on the corrected write-off and reserve standards.

2) If the write-off and reserve results of the financial institution under inspection are deemed inappropriate, calculate the write-off and reservevalues had appropriate write-offs and reserves been provided based on the write-off and reserve standards of the financial institution underinspection, and calculate the additional write-off and reserve required.

III.III.III.III. Monitoring of the financial institutiMonitoring of the financial institutiMonitoring of the financial institutiMonitoring of the financial institutionononon’’’’s response to declines in the capital adequacy ratios response to declines in the capital adequacy ratios response to declines in the capital adequacy ratios response to declines in the capital adequacy ratio

To monitor the financial institution’s response to declines in the capital adequacy ratio, calculate the capital adequacy ratio assuming that additionalrequired write-offs and reserves had been provided for during the settlement term, provide the results of these calculations to the financial institutionunder inspection, and confirm them with the institution.

Inspectors should accurately monitor the responses being considered by the financial institution under inspection in providing for additional requiredwrite-offs and reserves in the future. Specifically, inspectors should accurately monitor the response of the financial institution under inspectionregarding write-off resources (profit forecasts, asset sales etc.), capital increase plans, and risk asset measures.

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Study the appropriateness of this response, verify what the capital adequacy ratio will be in the next settlement term as a result of provisions ofadditional required write-offs and reserves as called for in appropriate response plans, and endeavor to form a consensus among the chief inspector, thefinancial institution under inspection and the external auditors.

In addition, verify whether the capital adequacy ratio this settlement term and next settlement term could be at levels that would invoke PromptCorrective Actions as set forth in Article 21-2 etc. of the Concomitant Orders to the Banking Law (1982 Ministry of Finance Ordinance).

In doing this, verify whether the institution falls under the provisions of Article 21-3:2 or 3 of the Concomitant Orders.

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