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Financial System Report (March 2008)

March 2008
Bank of Japan

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

An assessment of the current state of Japan's financial system

1. Japan's financial system, on the whole, has remained stable despite global financial turmoil triggered by the U.S. subprime mortgage problem. The total risks borne by banks have largely been restrained, compared with their capital position. The robustness of the banking system against a stress scenario of interest rate risk and credit risk has remained relatively high.

2. In terms of profitability, both interest income and non-interest income of Japanese banks have become rather weak, and their core profitability has remained sluggish. Each bank's profitability and capital strength appear to be diverging among the regional banks. Japanese banks need to strengthen their profit base to ensure the sustained stability of the financial system.

3. Japanese banks have exposure to the U.S. subprime mortgage problem mainly in the form of investments in structured credit products, and they are less involved in the origination and distribution of such products compared with the U.S. and European financial institutions. Under such circumstances, Japanese financial institutions have contained losses stemming from the U.S. subprime mortgage problem within their current profit levels and capital strength, although such losses have increased as the problem has become serious. At present, the U.S. subprime mortgage problem is unlikely to jeopardize the stability of Japan's financial system.

Business conditions of Japanese banks

4. The profits of the major banks and the regional banks in the first half of fiscal 2007 declined from the previous year. While interest income bottomed out, non-interest income remained sluggish and both credit costs and general and administrative expenses increased; as a result, net income declined. In particular, credit costs, which had remained extremely low for several years, increased to a level consistent with the recent economic growth, since the reversals of allowances for loan losses ran their course. Losses also arose from loans and investments related to the U.S. subprime mortgage problem and nonbank finance companies, including consumer finance companies. The indicators of core profitability, which exclude the impact of volatile components such as credit costs, remained low, and improving the profitability of the banking sector continues to be an important business challenge.

5. In terms of soundness, the total risks borne by the major banks and the regional banks have largely been contained, compared with their capital positions. Credit risk of the major banks and the regional banks has marginally increased. Market risk associated with stockholdings remains the largest risk component at the major banks, and interest rate risk stays relatively high at the regional banks, compared with the major banks. In the meantime, the improvement in the capital positions at the major banks and the regional banks appears to have slowed.

6. Looking at alternative investments, which include the structured credit products related to the U.S. subprime mortgages, their outstanding amount and share in the total securities balance are on an increasing trend, while its increasing tempo is slow at the moment. Given the complex nature of risks inherent in such investments, as reconfirmed in the U.S. subprime mortgage problem, financial institutions need to properly gauge and manage the risk-return profiles of alternative investments as well as changes in such profiles.

Financial intermediation function and changes in its risks

7. In terms of risk assessment of the financial system from a macroprudential perspective, potential imbalances that might jeopardize the stability of the financial system, such as the expansion of credit aggregates and excessive risk-taking behavior, have been largely restrained. The expansion of credit aggregates has been kept relatively mild even under the prolonged accommodative monetary conditions. The private corporate sector remains in financial surplus, reflecting abundant cash flows at hand, and is still cautious in expanding debt-financing.

8. Looking next at the individual channels of financial intermediation, business conditions for real estate business financing have changed somewhat: the accelerated tempo of decline in J-REIT prices and the subdued tempo of increase in land prices in the metropolitan areas. Banks' lending attitude to real estate businesses seems to have turned slightly cautious. Considering the relatively high exposure of banks to real estate businesses, the risks related to real estate business financing need to be carefully monitored. In the mean time, new channels of financial intermediation, such as M&A financing, syndicated loans, and securitization markets, have been expanding. The risks associated with such new channels also need to be carefully monitored, in light of the recent downgrading of structured credit products due to domestic factors.

Robustness of the banking system

9. The robustness of the banking system against interest rate risk and credit risk, on the whole, has remained high. In terms of interest rate risk, increases in interest rates have an adverse impact on banks' profits in the short term through the decline in the market value of bond portfolios. In the medium term, however, 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 maturities of assets and liabilities. In fact, some regional banks with longer average maturity of loans lag behind other regional banks in recovery of interest income on loans. Such banks need to manage interest rate risk of the entire portfolio through, for example, hedging the risk by interest rate swap, off-balancing the loans, and accepting long-term liabilities such as time deposits, based on their own expectation for the future course of interest rates.

10. The robustness of the banking system against credit risk has also remained relatively high, based on the results of macro stress-testing that assumes a severe and prolonged economic downturn. Given an indication of deterioration of borrower classification, banks nevertheless need to watch changes in the risk-return balances of their loan portfolios, even though the quality of loan portfolios for the major banks and the regional banks has been largely kept high.

Lessons and challenges for the financial systems based on the U.S. subprime mortgage problem

11. While international financial markets have been in turmoil as the U.S. subprime mortgage problem has worsened and its assessment is thus bound to be tentative, the lessons and challenges for the financial systems so far can be summarized as follows. First, the multi-layered securitization intensified leveraging and undermined incentives for risk assessment. Indeed, financial institutions, in the course of originating and distributing structured credit products, failed to properly evaluate and manage the risks related to warehousing those products with little market liquidity and providing contingent liquidity support to investment vehicles. Second, a number of investors and financial institutions failed to evaluate the risks inherent in complex financial transactions. In that respect, financial institutions - intermediaries responsible for distributing risks - need to assess and manage risks properly. At the same time, market infrastructure needs to be further developed so as to enable a wide range of investors - agents assuming risks - to collect and evaluate information pertaining to risks, thereby promoting the effective functioning of market discipline.

12. From a macroprudential perspective, the potential imbalances jeopardizing the stability of the financial system had been growing under the stable macroeconomic environment and continued accommodative monetary conditions in the global economy. While it still remains a challenge to gauge and address those imbalances in a timely manner, it is important to assess the sustained stability of the financial system. The Bank of Japan, in light of the experience of the U.S. subprime mortgage problem, continues to present a comprehensive analysis and assessment of the stability of Japan's financial system and to enhance communication with market participants with the intention of contributing to the sustained stability of the system.

Notice

Unless otherwise stated, this document uses data available as of February 26, 2008.

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