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Financial System Report (September 2009)

September 2009
Bank of Japan

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The Current State of Japan's Financial System and Challenges: An Overview

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

1. Japan's financial system has generally been stable, although the effects from the global financial crisis that began in 2008 still remain. Financial conditions for firms' funding have continued to show signs of improvement after deteriorating from the end of 2008 to the beginning of 2009. The capital strength of financial institutions has not been impaired substantially. Risks inherent in Japan's financial institutions -- market risk associated with stockholdings and credit risk in particular -- have increased relative to their capital levels. Japan's financial institutions need to reinforce their capital strength and improve their risk management in order to perform their financial intermediation function properly.

Financial intermediation function

2. Funding conditions in financial markets, after deteriorating sharply from the autumn of 2008, have continued to show signs of improvement. That is in part due to the ample liquidity provision and special funds-supplying operations by the Bank of Japan. Bank loans to large firms -- those to manufacturing firms in particular -- have increased significantly. Bank loans to small firms, underpinned by government support, have declined, albeit at a slower pace than during past economic downturns. In terms of interest rates, an expansion in banks' interest rate margins on loans has been contained, despite the heightened credit risk among the firms reflecting the economic downturn. The financial intermediation function of Japan's financial system has generally been maintained to the extent that the adverse feedback loop between financial and economic activities has been contained.

3. In the corporate sector, the financial indicators representing repayment ability have worsened rapidly due to the plunge in sales. Economic conditions have recently stopped worsening and are projected to start recovering at a moderate pace from the second half of fiscal 2009. Firms have drawn up plans to improve their profits from the second half of fiscal 2009. The risk factors in the area of economic activity continue to be highly on the downside, and the severity in firms' business conditions may increase further. Careful attention is warranted as to whether financial institutions can properly perform their financial intermediation function by responding to the changes in firms' demand for funds.

Robustness of the financial system

4. In the situation where credit costs rise and stock prices stagnate, banks' capital bases are not likely to decline substantially. Accordingly, the robustness of Japan's financial system is not impaired as a whole. Nevertheless, banks' expected losses for the next several years could exceed their operating profits from core business, and the capital bases of banks whose capital strength is relatively weak might remain at low levels. Going forward, uncertainty appears to exist as to the sustainability of the robustness of the financial system.

5. The funding liquidity risk of Japan's financial institutions remains contained in terms of yen currency. In terms of foreign currency, while Japan's financial institutions do not have a large gap in the asset/liability structures, those institutions need to stay vigilant as to managing the funding liquidity risk properly, bearing in mind that the functioning of financial markets could worsen. As for interest rate risk, the difference in maturity of funding and investment has been on an increasing trend, in particular among the regional banks, as a result of increasing home mortgages on the asset side and ordinary deposits on the liability side. Banks need to manage interest rate risk properly, taking those points into consideration.

Challenges for the financial system

6. Japan's financial institutions need to understand the challenges that have accumulated over the years and take action to meet them.

First, Japan's financial institutions should secure stable profit bases and reinforce their businesses by managing credit risk and reflecting their credit risk assessment in pricing. They need to perform the financial intermediation function properly.

Second, Japan's financial institutions should cope with market risk associated with stockholdings. History suggests that stockholdings are unlikely to contribute to enhancing profit. In addition, banks' losses stemming from their stockholdings exceeded their operating profits from core business in the previous two years. Given the magnitude of the risk associated with stockholdings, those financial institutions need to step up their efforts to reduce that risk.

Third, Japan's financial institutions should strengthen their capital bases. They need to be able to cope with the risks that might materialize due to the changes in economic and financial circumstances. It is essential that they strengthen their capital bases through recapitalization as well as accumulation of the retained earnings.

Finally, Japan's financial institutions should prepare a solid foundation for the autonomous financial intermediation function, while the role of public support in alleviating the strains in firms' funding conditions is likely to be reviewed in the future. For Japan's economy to achieve sound development in the medium to long term, financial institutions are required to assess firms' growth potential and stability, and provide financial services accordingly. They are expected to contribute to furthering Japan's efficient resource allocation through the pricing mechanism.

Policy responses

7. In Japan, various policies have been implemented on the financial, monetary, and financial system fronts in order to cope with the global financial crisis.

With a view to supporting Japan's economy on the monetary policy side, the Bank of Japan, since last autumn, has carried out (a) reductions in the policy interest rate, (b) measures to secure financial market stability, and (c) special funds-supplying operations to facilitate corporate financing. On the financial system front, the Bank has conducted research and analysis of the financial system stability from a macro perspective by carrying out on-site examination and off-site monitoring in order to gauge each individual financial institution's business conditions and verify their risk management. Furthermore, the Bank uses information on financial market developments in its assessment of the financial system stability. Based on these analyses and assessments, the Bank has resumed its purchases of stocks held by banks and has provided subordinated loans to them in order to secure the stability of the financial system.

The Bank of Japan gives advice and guidance to individual financial institutions with respect to, for example, risk management. Furthermore, the Bank, from a macroprudential perspective, intends to properly assess the current state of the financial system and the challenges facing it. From the Bank's viewpoint, its assessment provides an insight into its policy making, thereby contributing to the stability of Japan's financial system.

Notice

Unless otherwise stated, this document uses data available as of August 31, 2009.

Please contact the Financial Systems and Bank Examination Department at the e-mail address below to request permission in advance when reproducing or copying the contents of this report for commercial purposes.

Please credit the source when quoting, reproducing, or copying the contents of this report for non-commercial purposes.

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