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Financial System Report (October 2011)

October 18, 2011
Bank of Japan

Overview

Increasing future uncertainty over the external environment

Regarding the environment surrounding Japan's financial system, future uncertainty is increasing. In Europe, a series of sovereign debt problems have surfaced across peripheral countries since the end of 2009 and have led to a deterioration in banks' funding conditions. In the United States, amid the ongoing balance-sheet adjustments by households, the ratio of nonperforming housing loans remains at a high level. On the other hand, in emerging economies, the economic growth rate has recently slowed somewhat, although strong signs of overheating are still observed in the real estate market amid accommodative financial conditions. Under these circumstances, global financial markets remain nervous.

Meanwhile, in Japan, firms' funding conditions generally remain on an improving trend even after the Great East Japan Earthquake. However, some small and medium-sized firms and households have continued to face severe financial conditions.

Ongoing easiness in financial conditions

Financial conditions of firms and households in Japan have generally continued to ease amid the low interest rate environment. Even since the disaster, issuing conditions for CP and corporate bonds have generally been favorable, and banks' lending attitudes have been positive. Banks as a whole have expanded housing loans outstanding and have been extending loans in growing business areas. In the disaster areas, financial institutions have been providing funds to meet borrowing demand under public guarantee associated with the disaster.

Behind banks' positive lending attitudes lie sluggish borrowing demand of firms and households as well as steady inflows of deposits. In seeking a new source of profits, the major banks are actively undertaking overseas lending and the regional banks are increasing loans outside their home prefectures. Banks' lending competition has intensified particularly in metropolitan areas, thereby reducing bank loan rates.

Restrained risks at financial institutions

In Japan, macro risk indicators have not confirmed an accumulation of financial imbalances, as the ratio of total credit to GDP continues to hover around the long-term trend. Risks borne by banks and other financial institutions have generally been restrained relative to capital. The credit cost ratio and the nonperforming-loan (NPL) ratio of Japan's financial institutions have remained lower than those of their U.S. and European counterparts, and their funding liquidity risk for the yen and foreign currencies has been restrained.

However, as correlations between domestic and overseas financial markets have been high, domestic financial markets remain slightly nervous. Japan's banks and life insurance companies continue to hold a high level of market risk associated with their stockholdings and have gradually increased market exposure through investment in Japanese government bonds (JGBs) and foreign bonds. Attention should therefore be paid to the fact that business conditions of financial institutions have become susceptible to developments in overseas financial markets both directly and indirectly. Moreover, despite the recent decrease in banks' credit costs, the quality of bank loans has not improved. The NPL ratio of consumer finance companies has also been on an increasing trend, and thus developments in credit costs also warrant due attention.

Sustained robustness of the financial system

Japan's financial system has maintained its robustness. Banks' capital bases as a whole would be able to avoid significant impairment, according to the macro stress testing conducted with a severe scenario of a considerable downturn in the economy and a plunge in stock prices taking place simultaneously or of domestic interest rates rising significantly. Nevertheless, for banks with relatively low profitability and weak capital bases, the possibility that their capital adequacy ratios will remain low requires attention.

Based on the results of macro stress testing, the following points warrant vigilance in order to ensure long-lasting stability in the financial system. First, if the economy becomes stagnant for a protracted period, banks' credit costs could increase and exceed their profits for some years. Second, given high correlations between domestic and overseas financial markets, changes in overseas government bond markets or stock markets could spread instantaneously to domestic markets and cause banks' realized gains/losses on domestic securities holdings to deteriorate significantly. Against this background, it has become more important for banks to reinforce their capital bases.

Challenges to ensure stability in the financial system

Japan's financial system as a whole has been maintaining stability since the disaster. In order to ensure long-lasting stability in the financial system and maintain smooth financial intermediation, the following three major challenges need to be addressed.

First, financial institutions should enhance the effectiveness of risk management. They are required to strengthen measures to help ailing borrowing firms improve their business conditions in order to raise the quality of their bank loans and eventually to contain credit risk. To contain market risk, they should take into account correlations between domestic and overseas financial markets to gauge risks associated with securities investment from multiple perspectives and then formulate balanced investment portfolios and manage market risk in an amount sufficiently covered by their capital. Furthermore, funding liquidity risk, particularly in foreign currencies, requires strict risk management.

Second, financial institutions should further strengthen their capital bases. Stable capital bases are indispensable for them to continue conducting smooth financial intermediation, including their responses to the demand for funds for rebuilding after the disaster as well as development and support of growing business areas. New Basel requirements will be applied in an orderly manner to internationally active banks from 2013. Financial institutions therefore face the need to strengthen their capital bases steadily.

Third, financial institutions should construct stable profit bases. They are required to secure stable profits to accumulate retained earnings or to smoothly increase capital in order to strengthen their capital bases. Financial institutions should continue to expand their profit bases by developing and supporting firms and business areas with high growth potential and make efforts to contain fluctuations in profits by setting prices to make new services profitable.

Notice

This Report basically uses data available as of September 30, 2011.

Please contact the Financial System 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.

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Inquiries

Financial System Research Division, Financial System and Bank Examination Department

E-mail : post.bsd1@boj.or.jp