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Financial System Report (September 2007)

September 2007
Bank of Japan

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An Assessment of the Current State of Japan's Financial System and Its Challenges: An Overview

1. Japan's financial system, on the whole, has remained stable. The functioning of the system in financial intermediation has improved and its robustness against various types of shocks has strengthened. Nevertheless, banks' long-term profitability remains rather weak when taking into account the need for sufficient capital bases to ensure the sustained stability of the financial system. Banks need to review their business lines, based on a proper grasp and assessment of risk-return balances, and to develop and deliver higher-value-added financial services by responding to diversified customer needs, in order to strengthen their profit base.

2. In terms of soundness, Japanese banks' capital positions have improved both in quality and quantity. Compared to the early 2000s, total risks borne by banks have largely been restrained, and, at the same time, market risk associated with stockholdings has become the largest component of risks borne by the banking sector overall. Regarding profitability, Japanese banks' profits have remained close to all-time-high levels, partly supported by significant declines in credit costs in the past few years. In fact, assuming that the real GDP growth rate will remain at levels slightly higher than the potential growth rate, the credit cost ratio is estimated to be in the range of approximately 0.2-0.4 percent. Indicators of core profitability, which exclude the impact of volatile components such as credit costs, have remained low. Improving profitability thus remains an important business challenge for banks (Chapter I).

3. Some Japanese financial institutions have invested in U.S. subprime mortgage-related products as alternative investments. However, the share of investments in such products in financial institutions' total assets outstanding is small and, at the moment, the subprime mortgage problem in the United States is unlikely to significantly affect the stability of Japan's financial system. Nevertheless, financial institutions need to properly grasp and manage risk-return profiles of alternative investments as well as changes in such profiles, with due consideration of the complex nature of risks inherent in such investments (Chapter I).

4. The functioning of Japanese banks in financial intermediation has continued to improve in tandem with the easing of banks' capital constraints, which has led to an expansion of their risk-taking capacity. Bank loans have been increasing moderately and progress has been made in the diversification of borrowers and loan types. In the meantime, new channels of financial intermediation relating to the M&A and real estate business have been expanding, reflecting increased inflows of funds through various investment funds. Against this background, Japanese banks have become more deeply involved in such new channels through the extension of loans for M&A-related transactions and non-recourse loans to real estate funds. Although loan conditions in Japan, such as covenants and collateral valuations, have yet to ease significantly, interest rates on non-recourse loans have been declining. Risks related to real estate financing, including future developments in risk-return balances of non-recourse loans, thus warrant careful monitoring (Chapter II).

5. Japan's financial system has become more robust against changes in interest rate and credit risks. Although in the short term, increases in interest rates produce an adverse impact on banks' profits through the decline in the market value of bond portfolios, in the medium term they improve profits through higher net interest income. Such an improvement in banks' profits is more evident in the case of the major banks than the regional banks, reflecting the different maturity structures of assets and liabilities. Meanwhile, credit risk has declined significantly even under a stress scenario assuming a severe and prolonged economic downturn, reflecting the improved quality of banks' loan portfolios. Nevertheless, close attention has to be paid to the possibility of deterioration not only in credit risk but also in market risk associated with stockholdings in the case of an economic downturn (Chapter III).

6. Looking at the profitability of Japan's banking sector from a long-term perspective, interest margins have been too narrow to sufficiently cover average credit costs, while general and administrative expense ratios have been restrained. Profitability has remained rather weak from the viewpoint of ensuring necessary capital positions to maintain the sustained stability of the financial system (Chapter IV).

7. Japan's banking sector needs to map out strategies as to how to enhance its profitability from a long-term perspective. To this end, each bank needs to seek its own way to expand interest margins. In this context, each bank needs to differentiate its financial services and diversify the price-quality mix of its services in response to customer needs. In this process, banks are expected to shift their management resources to higher-value-added financial services, such as investment banking and global payment operations. To enable the development of such business, banks need to properly assess risk-return balances and thereby explore new avenues to make use of their capital through the reorganization of existing business lines (Chapter IV).

8. The report highlights three directions in which, based on a proper assessment, risk-return balances can be improved. First, the profitability of the traditional banking business with large firms based on long-term stockholdings needs to be improved, since such business does not produce sufficient returns to cover costs once the market risk associated with such stockholdings is included. Second, credit portfolio management (CPM) is expected to contribute to improving the allocation of banks' loan portfolios in terms of their distribution by firm size, industry, and region through a proper assessment of risk-return balances. Third, small and medium-sized enterprise (SME) financing needs to incorporate proper assessment of risks associated with loans to SMEs by making use of credit scoring methods, while establishing the necessary infrastructure, including mechanisms enabling banks to make use of credit bureaus (Chapter IV).

Notice

Unless otherwise stated, this document uses data available as of August 24, 2007.

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Financial Analysis and Research
Financial Systems and Bank Examination Department, Bank of Japan
E-mail: post.bsd1@boj.or.jp