Before a financial institution enters into an OTC derivative with a new client, it completes verification of the client, a review of its creditworthiness, and decisions on collateral and a credit limit. The roles at this stage are divided among the units that drive sales, the credit review department, and the officers who oversee legal compliance.

What each is for

KYC and credit review serve different purposes. KYC keeps financial institutions from being used to move funds obtained through crime or to finance terrorism. The Act on Prevention of Transfer of Criminal Proceeds requires banks, financial instruments business operators, and others to verify clients' identifying information and other matters, keep records of transactions, and report suspicious transactions1. In the Act's terms, the part of KYC that it sets out is "verification at the time of transaction."

Credit review prepares the institution for the loss it would suffer if a client failed. Consider a hypothetical example in which Company G, a corporate client, enters into an FX forward with a financial institution to cover an import payment. The forward is to "buy USD 1 million one year from now at 150 yen per dollar." If the exchange rate falls to 140 yen per dollar partway through, the forward becomes a promise under which the institution sells dollars worth 140 yen each for 150 yen. Its value to the institution is a gain of about 10 million yen2. If Company G fails at that point, the institution could lose that gain. This risk of loss is called counterparty credit risk, and the amount that could be lost at the moment the counterparty fails is called exposure3. Because a financial institution can take on exposure in this way, it examines the client's creditworthiness before it starts trading and considers ways to limit the loss, such as collateral4.

If the exchange rate instead rises to 160 yen per dollar, the forward is worth about 10 million yen to Company G, and the institution's exposure is zero. From Company G's side, the forward on its own loses 10 million yen at 140 yen and gains 10 million yen at 160 yen. Either way, Company G buys the USD 1 million at 150 yen, so the yen cost of its import payment is fixed at 150 million yen.

The steps before execution

The overall flow of client business is covered in The Client Business Flow. Four steps are completed before a trade is proposed or executed. Each step rests on a different source, noted at the end of the step.

Banks organize this work in line with the Financial Services Agency's "Comprehensive Guidelines for Supervision of Major Banks, etc." The Basel Committee on Banking Supervision published the final version of its "Guidelines for counterparty credit risk management" in December 2024. They cover the credit risk of counterparties in derivatives and similar trades. The Basel guidelines are aimed mainly at banks and set out practices for effective management5.

  1. Verification at the time of transaction. The institution confirms the client's name, address, purpose of the transaction, and other matters from documents and the client's own statements, and keeps a record (Act on Prevention of Transfer of Criminal Proceeds).
  2. Checking that the client is not an anti-social force. The institution screens the client in advance using information on anti-social forces (the FSA's supervisory guidelines for major banks).
  3. Credit review. A credit review department kept separate from the units that drive sales assesses creditworthiness from the client's financial condition and other information (the FSA's supervisory guidelines for major banks, the Basel guidelines).
  4. Deciding on collateral and the credit limit. Based on the review, the institution decides whether to require collateral and sets a cap on its exposure to each client (the Basel guidelines).
Company GInstitutionASF unitCredit reviewAsks about anFX forward,submits docsVerifiesclient,keeps recordScreens foranti-socialforces infoAssessescredit fromfinancialsDecidescollateraland limitMoves on toproposal andexecution
Figure 1Workflow for KYC and credit review (in the order of the numbered steps above; the division of departments is one example)
Figure description

The figure lays out steps 1 to 4 above by department, using the Company G FX forward as the example (the "Institution" lane is the financial institution itself, and "ASF unit" is the department in charge of overall responses to anti-social forces). It starts with Company G's inquiry and submission of documents, and the four steps are completed before the move to proposal and execution. The figure shows the case in which the steps simply proceed. Department names and divisions of work differ from one institution to another.

Who carries out the steps, in what order, and which positions approve them is decided by each institution in its own rules. Institutions must make efforts to set internal rules for verification at the time of transaction and related measures, and banks set a credit policy that includes decision-making authority6.

What verification at the time of transaction covers

The transactions that require verification (specified transactions) are listed in a Cabinet Order. Besides contracts to open a deposit account and contracts to lend money, they include contracts for OTC derivatives transactions under the Financial Instruments and Exchange Act7. When the client is a corporation, the institution confirms the following four items8.

Item to confirm Example for Company G How it is confirmed
Identifying information (name and head office address) Company G's trade name and head office address The client presents a certificate of registered matters or a similar document, or the institution receives the registration information through the registration information service
Purpose of the transaction Hedging the currency risk of import payments Company G states it
Nature of the business Importing and selling parts Checked against the articles of incorporation, the certificate of registered matters, or similar documents
Identifying information of the beneficial owner Name, address, and date of birth of the individual who holds more than one-quarter of Company G's voting rights The person acting for Company G (such as its head of finance) states it

The methods in the table are some of those set out in the Ordinance for Enforcement of the Act9. A beneficial owner is an individual who can effectively control a corporation's business. For a stock company, this is an individual who holds, directly or indirectly, more than one-quarter of the total voting rights. If there is no such individual, it is an individual who has a dominant influence on the business through investment, financing, trading, or other means; if there is none of those either, it is the individual who represents the corporation and executes its business10.

When an individual actually carries out the procedure on Company G's behalf, such as its head of finance (a representative), the institution also confirms that individual's name, address, and date of birth11. The results go into a verification record, which is kept for seven years from the day the transaction contract ends or a similar date12. For later transactions with a client whose verification record the institution keeps, transactions specified by Cabinet Order do not need to be verified again13. At the same time, the institution takes measures to keep the information it confirmed up to date14.

If a client does not cooperate with verification, the institution may refuse to perform its obligations under the transaction until the client does15. And if the institution judges that property it received may be criminal proceeds, it reports this to the competent authority (a suspicious transaction report)16.

Checking that the client is not an anti-social force

Anti-social forces are groups or individuals that pursue economic gain through violence, intimidation, or fraud. They are identified by both their attributes, such as organized crime groups, companies associated with them, and corporate racketeers, and their conduct, such as violent demands or unjustified demands that go beyond legal liability18. A financial institution confirms before trading that the client is not an anti-social force, and keeps out of any relationship with anti-social forces, including transactions. This approach goes back to the "Guidelines for How Companies Prevent Damage from Anti-Social Forces" (our translation), adopted in 2007 by the executive meeting of the Japanese government's Ministerial Meeting Concerning Measures Against Crime. Banks set up arrangements to cut off such relationships in line with the FSA's supervisory guidelines for major banks, which reflect the purpose of those 2007 guidelines19.

The core of the check is screening before trading. A department in charge of overall responses to anti-social forces keeps a database of information on anti-social forces under central control and uses it to screen counterparties. The institution also includes organized crime exclusion clauses in its contracts and terms of business to keep anti-social forces from becoming counterparties20. Securities firms and other financial instruments business operators carry out the same advance screening and use the same exclusion clauses, in line with the "Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc."21

Advance screening cannot catch everything. There are cases in which anti-social forces use companies they are involved with to build trading relationships that look like ordinary business, and trouble arises later19. Banks therefore also review existing contracts after the fact. If a counterparty turns out to be an anti-social force after trading, the bank reports this to senior management and ends the relationship as quickly as possible22.

What credit review looks at

In credit review, the credit review department assesses creditworthiness by combining the client's financial condition with non-financial information. In line with the FSA's supervisory guidelines for major banks, a bank separates the units that drive sales from the unit that reviews credit. The review unit gets a clear picture of the borrower's financial condition, the use of funds, the source of repayment, and similar matters, and uses it to check that the credit rating (the grade an institution assigns internally to a client's creditworthiness, also called an internal rating) is correct23.

Financial analysis uses indicators calculated from the figures in the financial statements. A document from the Bank of Japan's Center for Advanced Financial Technology that explains how to build internal ratings gives the following examples of financial indicators24.

Aspect Example indicators
Size Equity capital, net assets
Safety Equity ratio, current ratio
Profitability Ordinary profit to total capital, operating profit to sales
Growth Revenue growth, profit growth

Examples of non-financial information to add to the assessment include industry characteristics (growth, volatility of market conditions, barriers to entry) and company characteristics (customer base, technical capability, cash flow management, parent company support)25. For Company G, the review would look at financial safety through ratios such as the equity ratio, then add the volatility of the market for the parts it handles and whether it has a parent company's support.

For reviewing derivatives counterparties, the Basel guidelines say that a bank also checks non-financial information such as reputation, strategy, and how risk is actually managed, and uses the information obtained through KYC to assess creditworthiness4. For a counterparty that does not provide enough information, the guidelines say the bank sets internal ratings, credit limits, and collateral terms conservatively (more strictly)26. They also say the review continues after trading starts, and that if the counterparty's situation changes, the bank revisits the internal rating, the products it may trade, the terms of the contracts, and the credit limit4.

Behind the Basel guidelines are cases such as Archegos in 2021, which exposed weaknesses in reviewing counterparties, in risk measurement and management, and in governance27.

How collateral and credit limits are set

Based on the result of the credit review, the institution decides whether to require collateral and how large the credit limit should be. For the collateral framework, the Basel guidelines say that a bank sets collateral terms to match the size of the exposure from the trades, the quality (eligibility) of the collateral it receives, and the counterparty's credit risk, and changes the amount of collateral it receives as the exposure moves28. The terms for exchanging collateral on derivatives are set in the credit support annex (CSA), the collateral agreement attached to the ISDA (International Swaps and Derivatives Association) Master Agreement29.

In the Company G example, if the institution has received 10 million yen of collateral from Company G to match the forward's positive value, the 10 million yen of exposure is covered by the collateral even if Company G fails at that point.

A credit limit is a cap on exposure set for each counterparty. The Basel guidelines say that when a bank starts trading with a new counterparty, it estimates the expected trades and the amount of risk4. They also say the size of the limit is kept within the range of risk the bank is willing to take (its risk appetite), and is changed if the counterparty's creditworthiness or the exposure changes30. Setting trading policy and limits is among the example uses of internal ratings31. For Company G, the institution would estimate the amounts and maturities of the FX forwards it expects to enter into and set the limit based on those estimates and the review result.

Once a limit is set, how usage is checked against it before execution and how usage is measured are covered in Credit Limit Management.

Departments and roles

The roles divide as follows. Department names and the division of work differ from one institution to another.

Role What it does Basis
Front office (sales and trading) Makes proposals to clients; kept separate from the unit that reviews credit The FSA's supervisory guidelines for major banks23
Credit review department Credit review, checking credit ratings The FSA's supervisory guidelines for major banks23
Department in charge of overall responses to anti-social forces Central control of information on anti-social forces, screening of counterparties The FSA's supervisory guidelines for major banks20
Supervising manager Oversees verification at the time of transaction and related measures, approves high-risk transactions Act on Prevention of Transfer of Criminal Proceeds, the FSA's supervisory guidelines for major banks17

Notes

  1. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 1 (purpose) and Article 2, paragraph 2, item 1 (banks) and item 21 (financial instruments business operators). ↩

  2. An approximation that values the forward as the difference between the current exchange rate and the forward rate times USD 1 million: (150 yen − 140 yen) × USD 1 million = 10 million yen. It ignores the interest rate difference up to maturity and discounting. ↩

  3. Counterparty credit risk: Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 6 (in Japanese). Exposure: Bank of Japan Financial System and Bank Examination Department, Center for Advanced Financial Technology, "信用リスク管理態勢の整備" (Developing a credit risk management framework) (August 2019), page 6 (in Japanese). ↩

  4. Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 9, "Onboarding（取引開始時）" (Onboarding) and "Ongoing credit assessment（継続モニタリング）" (Ongoing credit assessment) (in Japanese). ↩ ↩2 ↩3 ↩4

  5. Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 4, "背景・経緯" (Background), and page 7, "適用範囲、比例適用、リスクベースの対応" (Scope, proportionality and risk-based approach) (in Japanese). ↩

  6. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 11, item 2. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-2-3-2-1-2(1) (page 108) (in Japanese). ↩

  7. "犯罪による収益の移転防止に関する法律施行令" (Order for Enforcement of the Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 7, paragraph 1, item 1(a) (contracts to accept deposits), item 1(n) (contracts to lend money), and item 1(i) (contracts to carry out acts such as those in Article 2, paragraph 8, items 1 to 6 of the "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation); OTC derivatives transactions are item 4 of that paragraph). The transactions excluded from item 1(i) are in Article 4 of the "犯罪による収益の移転防止に関する法律施行規則" (Ordinance for Enforcement of the Act on Prevention of Transfer of Criminal Proceeds, in Japanese). ↩

  8. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 4, paragraph 1, items 1 to 4. ↩

  9. "犯罪による収益の移転防止に関する法律施行規則" (Ordinance for Enforcement of the Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 6, paragraph 1, item 3(a) and (b), and Article 7, item 2 (identifying information); Article 9 (purpose of the transaction); Article 10, item 2 (nature of the business); and Article 11, paragraph 1 (beneficial owner). ↩

  10. "犯罪による収益の移転防止に関する法律施行規則" (Ordinance for Enforcement of the Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 11, paragraph 2. An individual who holds voting rights is excluded if it is clear that the individual has no intention or ability to effectively control the business, or if another individual holds more than half of the voting rights. ↩

  11. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 4, paragraph 4 and paragraph 1, item 1. ↩

  12. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 6. ↩

  13. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 4, paragraph 3. ↩

  14. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 11, opening sentence. ↩

  15. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 5. ↩

  16. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 8, paragraph 1. ↩

  17. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-1-3-1-2(1)① and ②(c), and (2) (pages 152–154) (in Japanese). The appointment of the supervising manager is in Article 11, item 3 of the "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese). ↩ ↩2

  18. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), the reference note to III-3-1-4-1, "反社会的勢力のとらえ方" (How anti-social forces are identified) (page 159) (in Japanese). ↩

  19. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-1-4-1, "意義" (Purpose) (page 158) (in Japanese). ↩ ↩2

  20. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-1-4-2(2)① and (3) (page 160) (in Japanese). ↩ ↩2

  21. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.) (October 2026), III-2-11, "③ 適切な事前審査の実施" (3. Appropriate advance screening) (page 93) (in Japanese). ↩

  22. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-1-4-2, the introduction to "主な着眼点" (Main points of focus), (4), and (5)① (pages 159–161) (in Japanese). ↩

  23. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-2-3-2-1-2(2) and (5) (pages 108–109) (in Japanese). ↩ ↩2 ↩3

  24. Bank of Japan Financial System and Bank Examination Department, Center for Advanced Financial Technology, "信用リスク管理態勢の整備" (Developing a credit risk management framework) (August 2019), page 14, "④財務指標の選択" (4. Choosing financial indicators) (in Japanese). ↩

  25. Bank of Japan Financial System and Bank Examination Department, Center for Advanced Financial Technology, "信用リスク管理態勢の整備" (Developing a credit risk management framework) (August 2019), page 18, "⑥定性情報の反映" (6. Reflecting qualitative information) (in Japanese). ↩

  26. Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 8, "Information Disclosure（情報開示）" (Information disclosure) (in Japanese). ↩

  27. Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 6, "Introduction / はじめに" (Introduction) (in Japanese). ↩

  28. Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 10, "Margining（証拠金・担保）" (Margining) (in Japanese). ↩

  29. Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 3, "Glossary," entry for CSA (in Japanese). ↩

  30. Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's Guidelines for counterparty credit risk management) (April 2025), page 15, "Limits（信用枠・リミット）" (Limits) (in Japanese). ↩

  31. Bank of Japan Financial System and Bank Examination Department, Center for Advanced Financial Technology, "信用リスク管理態勢の整備" (Developing a credit risk management framework) (August 2019), page 9, "①目的の明確化" (1. Clarifying the purpose) (in Japanese). ↩