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Financial System Report (September 2008)

September 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 continued turmoil of global financial system stemming from the U.S. subprime mortgage problem. However, improvement in banks' core profitability has stalled, and the gaps in their profitability and capital strength have widened.

The total risk borne by banks has been largely restrained, relative to their capital positions. However, credit risk has started to increase amid the sluggish economic growth, and future developments require vigilance. In addition, market risk associated with stockholdings has further increased its weight in the risk component at the major banks, and interest rate risk has been at a higher level at the regional banks than at the major banks. Meanwhile, both for the major banks and the regional banks, improvements in their capital adequacy ratios witnessed in recent years have slowed due to a decrease (an increase) in unrealized gains (losses) on securities.

2. While Japanese banks' losses stemming from the U.S. subprime mortgage problem increased as the problem became more serious, such losses seem to have been contained within their current profit levels and capital strength, since Japanese banks' related exposures were mainly in the form of investments in structured credit products. Therefore, at present the U.S. subprime mortgage problem is not likely to jeopardize the stability of Japan's financial system. However, negative interaction between the weakened function of financial intermediation and downward pressure on economic activity has become a concern in the United States. Thus, its effects on the global economy and further effects on Japan's economy warrants caution.

3. In terms of profits, Japanese banks' financial statements clearly showed that their core profitability became sluggish as credit costs returned to past average levels. After recording an all-time high in fiscal 2005, net income of the major banks and the regional banks declined for two consecutive years. In particular, net income of the major banks declined by half compared with that in fiscal 2005. For the regional banks, the number of banks that registered net losses increased despite the limited effects of the U.S. subprime mortgage problem. Banks' high profits in recent years were largely attributable to the fact that credit costs decreased substantially and temporarily as a result of the reversals in loan-loss allowances accumulated in the past. Both the major banks and the regional banks need to establish business models taking into account each bank's comparative advantage such as managerial resources and business bases, thereby enhancing core profitability.

Risks for the financial system

4. Credit costs have started to increase amid the sluggish economic growth, which demands meticulous credit risk management by financial institutions, including interest rate setting commensurate with risk. Nevertheless, interest margins on loans remain narrow relative to credit risks, and an increase in those margins factoring in a rise in credit risks is yet to be seen. For the financial institutions to carry out their financial intermediation function in a smooth and sustainable manner, from the perspective of credit management they need to make adjustments as necessary reflecting changes in credit risks. How such behavior of financial institutions influences their profits and firms' funding situations needs to be carefully examined. In addition, amid a certain degree of stagnation in the flow of funds in real estate finance, financial institutions' lending stance has become cautious against the backdrop of the diminishing tempo of increases in land prices in the metropolitan areas, worsened supply and demand balance for condominiums, and rise in office buildings' vacancy rates. The financial environment surrounding the real estate sector has become increasingly severe.

5. Financial conditions have been accommodative, with interest rates being maintained at low levels relative to economic activity. Nevertheless, potential imbalances that might jeopardize the stability of the financial system, such as the rapid expansion of credit aggregates and excessive risk-taking behavior, have been largely restrained. The private corporate sector remains in financial surplus, reflecting abundant cash flows, and the expansion of credit aggregates through the financial sector has been kept relatively mild. However, profitability of housing loans, which are the key product of bank loans to individuals, has been worsening substantially reflecting prevalence of preferred interest rates, thus resulting in increases in interest rate risk.

Robustness of the financial system

6. Based on the results of macro stress-testing that assume substantial fluctuations in interest rates and economic activity, the robustness of the banking system against interest rate risk, credit risk, and market risk associated with stockholdings has remained high on the whole. Nevertheless, in assessing the overall stability of the financial system, it should be noted that the gap in resilience against stresses between individual institutions has widened. It should also be noted that the number of financial institutions incurring unrealized losses on securities has been increasing due to fall in stock prices, and their capital position has become susceptible to further changes in stock prices.

7. Triggered by the U.S. subprime mortgage problem, a mechanism has come to the fore in which financial institutions' behavior is influenced by economic fluctuations and in turn amplifies the fluctuations, the so-called procyclicality of the financial system. That mechanism needs to be considered in three stages: (1) changes in banks' capital adequacy ratios; (2) changes in banks' credit exposures; and (3) changes in the magnitude of economic fluctuations. In Japan, during the period when banks' capital was considerably eroded due to the nonperforming loan problem, it might have been the case that insufficient capital became a bottleneck constraining their lending behavior, thereby producing downward pressures on economic activity. Whether changes in banks' capital adequacy ratios affect their lending behavior and result in greater fluctuations in economic activity will depend on banks' management of their capital buffers and the prevailing financial and economic conditions.

Management challenges for Japanese banks

8. Improvement in the banking sector's profitability has been pointed out repeatedly as an important management challenge for Japanese banks. However, looking at Japan's financial system, many financial institutions have been competing with each other to provide relatively homogeneous services at low prices. Against such a backdrop, it is a difficult task to map out specific prescriptions to improve profitability. Nevertheless, as previous issues of the Financial System Report have emphasized, the roadmap for Japanese banks continues to be to properly assess the risk-return balances and to provide diversified and differentiated financial services by responding to customers' needs. Both the major banks and the regional banks are expected to establish their business models taking into account their comparative advantages such as individual conditions of managerial resources and the business bases.

9. The major banks appear to raise profits from the retail and wholesale banking businesses in a relatively balanced manner, and rely less on the asset management business, compared with the U.S. and European financial institutions. As for geographical operations, their reliance on domestic business is high but profitability is relatively low, while international business is relatively profitable but its contribution to overall profit is limited. In addition to providing high-value-added financial services to raise the profitability of domestic business, banks need to promote concentration in core competence with a comparative advantage from the viewpoint of enhancing efficient use of capital. For international business, banks need to take strategic approaches to establish a profit base from a long-term perspective.

10. For the regional financial institutions, the gaps between institutions with respect to profitability and capital strength have become increasingly obvious. The regional  financial institutions need to strengthen their business bases in order to carry out the financial intermediation function in a stable manner to facilitate the development of regional economies. In this regard, small financial institutions have much room to enjoy economies of scale. By eyeing mergers and management integration, which require a high degree of management decision, as one option, regional financial institutions are expected to pursue economies of scale to enhance cost and profit efficiency, thereby raising core profitability and stabilizing their business base.

Notice

Unless otherwise stated, this document uses data available as of September 16, 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