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Financial System Report (September 2010)

-- Growing future uncertainty about the global financial system
-- Changes in the role of banks in credit markets
-- Strengthening the capital base and accumulating risks
-- Challenges for Japan's financial institutions and the Bank of Japan's approach

September 2010
Bank of Japan

The current state of Japan's financial system and challenges: An overview

Assessment of the current state of Japan's financial system

Japan's financial system has maintained its stability as a whole. In terms of financial intermediation, banks have continued to hold an expanded share in the overall credit markets through lending and investment in bonds. Bank loan rates have been declining markedly. Provision of credit to firms and other entities has been carried out smoothly on the whole. Japan's financial system has also enhanced its robustness. Banks have sought to strengthen their capital bases mainly by successively issuing common shares. As a result, the amount of risks held by Japan's banks relative to their capital has decreased.

Nevertheless, due attention should be continuously paid to the spillover risk to Japan of a shock originating in the global financial system amid heightened future uncertainties induced by such incidents as the surfacing of the European sovereign debt problems and growing concerns over the slowdown of the U.S. economy. On the domestic front, banks' core profitability has fallen further due to a narrowing of loan spreads against a backdrop of firms' sluggish demand for funds. In addition, the overall quality of bank loans has continued to decline, particularly for small and medium-sized firms whose recovery in financial standing has been delayed compared with large firms. This also warrants vigilance.

Bearing in mind both the domestic and global financial and economic environments, Japan's financial institutions need to tackle the following challenges. The first challenge is to secure sufficient capital that can cover the losses in case stress impacts the financial system in the future, given the declining quality of bank loans. Banks should strengthen their capital bases, taking account of international moves toward implementing the new capital requirements. The second challenge is to continue a scheduled reduction of market risk associated with stockholdings, bearing risk characteristics in mind. The risk remains that a plunge in stock prices could reduce capital. The third challenge is to secure stable profits. Improvement in core profitability enables Japan's financial institutions not only to accelerate the pace of retained earnings accumulation but also to increase the chances of further capital increases. They are expected to secure profit opportunities by seeking out firms and business areas with high growth potential. This also contributes to the smooth functioning of financial intermediation in future years. At the same time, they need to strengthen profitability on a risk-adjusted basis by enhancing the effectiveness of risk management, particularly for credit and market risks.

Financial intermediation function

Japanese financial institutions' amount of credit to domestic firms has decreased since fiscal 2009. On the corporate finance front, firms' demand for funds has declined as funding conditions of firms, mainly large firms, have stabilized. Funding conditions of small and medium-sized firms have also continued to improve, evidenced by lower dependence on public guarantee, albeit gradually. Nevertheless, not a few such firms still find themselves in a tight funding condition.

In Japan, financial institutions' amount of credit appears to be approximately balanced with economic activity in light of the long-term trend. By type of intermediary, banks have continued to complement part of the credit provision previously made by other financial institutions, including institutional investors. In the meantime, bank loan rates and issuing rates on corporate bonds, including long-term credits and credits to firms with relatively low credit ratings, have been declining extensively, and the accommodative funding environments has been maintained. As a collective, these factors indicate that Japan's financial system has continued to smoothly carry out the financial intermediation function as a whole.

However, the following points warrant attention from the viewpoint of ensuring an ongoing smooth financial intermediation function. First, room for a further decline in loan rates has seemed to gradually become limited. Second, given the larger share of banks in the credit markets, if a new shock were to hit the banking sector, its effects would likely spread to the overall credit markets somewhat more directly.

Robustness of the financial system

In fiscal 2009, Japanese banks' amount of various risks relative to their capital decreased against a backdrop of banks' efforts to strengthen their capital bases, among other measures. Banks' funding liquidity risk has also been restrained both in yen currency and foreign currency despite growing strains in the global financial markets with the surfacing of the European sovereign debt problems in 2010.

However, a continuous lowering of banks' loan quality and a decline in loan rates have been taking place simultaneously, while banks' core profitability has remained unimproved. Not a few non-manufacturing firms and small and medium-sized firms have suffered a delay in the recovery of their financial standing, while business performance has improved as a whole. Consequently, large credit costs compared with profits could develop, which may reduce banks' profits in future years. In addition, interest rate risk has accumulated further particularly at the regional banks amid an increased preference for investment in government bonds. Market risk associated with stockholdings remains a significant risk factor, particularly at the major banks, despite their efforts toward progressive reduction.

As for the outlook, banks' capital bases as a whole would avoid being significantly impaired, owing to recent capital increases and the improvement in the financial standing of large manufacturers in particular, even if a slowdown in economic activity and a plunge in stock prices simultaneously take place under a stress scenario. This simulation result shows that Japan's financial system has enhanced its robustness.

Nevertheless, the capital ratios of banks with relatively weak profitability and a relatively weak capital base could remain at a low level into the future. This suggests that certain factors inherent in Japan's financial system still warrant vigilance. It should also be noted that banks could perform the financial intermediation function to a lesser degree by reducing lending that would constrain real economic activity in the recovery process, in which banks would restore their capital ratios impaired under the stress scenario.

Notice

This Report basically uses data available as of August 31, 2010.

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