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Financial System Report (April 2012)

April 19, 2012
Bank of Japan

Overview

The environment surrounding Japan's financial system

Regarding the environment surrounding Japan's financial system, uncertainty about the future has been high, while global financial markets have regained stability to some extent. In Europe, concern over the debt problem has adversely affected banks' funding conditions. In response to deterioration in funding conditions, banks' lending attitudes have grown cautious and reinforced economic stagnation in European countries. In the United States, balance-sheet adjustments by households have continued to weigh on the real economy. In emerging economies as a whole, a slowdown in economic growth and a decline in inflationary pressure have been progressing moderately, but some of the economies face uncertainty as to whether they can achieve price stability and economic growth simultaneously.

In Japan, firms' financial conditions have generally improved, as seen in their high level of interest payment capacity. However, small and medium-sized firms and households with housing loans have continued to face severe financial conditions.

Financial institutions' performance of financial intermediation

Financial conditions of firms and households in Japan have continued to ease amid the low interest rate environment. Issuing conditions for CP and corporate bonds have remained favorable, and banks' lending attitudes have been positive. Banks' loans outstanding turned to an increase, reflecting demand for working capital and funds related to mergers and acquisitions. Nevertheless, borrowing demand for business fixed investment remains sluggish.

In these circumstances, banks' loan interest rates have been declining. This is because banks' funding costs decrease and issuing conditions for CP and corporate bonds remain favorable amid monetary easing. Moreover, banks' loan interest rates have declined, partly because various types of financial institutions have increasingly competed on lending. Due to declining profits on domestic loans, Japan's banks, particularly the major banks, have increased overseas loans, and the share of their loans in the global loan market has started to increase moderately.

Risks in the financial system

In the examination of the financial system to ascertain financial imbalances, there is no indicator that warns of financial imbalances stemming from bullish expectations. The amount of risks financial institutions bear as a whole has been decreasing relative to capital. Due attention should be paid, however, to a large amount of JGBs held by financial institutions, while Japan's government debts have accumulated considerably.

The outlook for global financial markets has been highly uncertain. In these circumstances, Japan's banks and life insurance companies have increased investment in domestic and foreign securities. In addition, the share of banks' overseas loans in overall loans has been increasing gradually. Therefore, attention should be paid to the fact that business conditions of financial institutions have become susceptible both directly and indirectly to developments not only in Japan's economy and financial markets but also in overseas economies and financial markets. Despite the recent decrease in banks' credit costs arising from domestic loans, the quality of bank loans has not improved considerably. Although banks' capital adequacy ratios have risen reflecting the accumulation of retained earnings, their profitability has declined.

Resilience of the financial system

The macro stress testing shows that the resilience of Japan's financial system has generally strengthened. Banks' capital bases as a whole would be able to avoid significant impairment, even if some degree of stress arises, such as a temporary economic downturn with a plunge in stock prices, or an upward shift of domestic interest rates for all maturities by 1 percentage point. Nevertheless, attention must be paid to the possibility that capital adequacy ratios will remain low for banks with relatively low profitability and weak capital bases.

Based on the results of stress testing under more severe assumptions, the following points warrant vigilance in order to ensure long-lasting stability of the financial system. First, if the economy becomes stagnant for a protracted period, banks' credit costs could continue to exceed their profits. Second, severe shocks in domestic and overseas financial markets, such as a downward shock to stock prices and an upward shock to bond yields occurring simultaneously, would immediately cause deterioration in banks' realized gains/losses on securities holdings. Meanwhile, the deterioration would be amplified through a feedback loop between the financial system and the real economy. Attention should be paid to the possibility of sporadic surges in market interest rates triggered by decreased confidence in fiscal sustainability, as was observed recently in Europe. Third, although banks have generally secured a sufficient amount of foreign currency liquidity, they would need additional funding sources under a situation where a number of measures for foreign currency funding become inoperative simultaneously.

Challenges to ensure stability of the financial system

Japan's financial system as a whole has been maintaining stability. In order to ensure the long-lasting stability of Japan's financial system and to maintain smooth financial intermediation, financial institutions need to address the following three major challenges.

First, financial institutions should enhance the effectiveness of risk management. In order to contain credit risk with respect to domestic lending business, financial institutions should strengthen measures to help ailing borrowing firms improve their business conditions and to appropriately implement credit risk management based on the assessment of borrowers' capacity for self-reconstruction. As for overseas lending business, they need to improve their screening procedures and follow-up monitoring, including those at their overseas entities. To contain market risk, financial institutions should examine the risk from multidimensional perspectives by, for example, taking into account correlations between domestic and overseas financial markets, and then achieve balanced investment portfolios and manage risk in accordance with financial institutions' capital. Furthermore, Japan's banks are required to conduct strict risk management for funding liquidity, including that for foreign currency liquidity.

Second, financial institutions should further strengthen their capital bases. Stable capital bases are indispensable for them to maintain smooth financial intermediation in highly profitable areas, such as overseas lending as well as investment and lending to growing business areas. The new Basel requirements will be applied in an orderly manner to internationally active banks from 2013. Financial institutions will be required to strengthen their capital bases steadily.

Third, financial institutions should construct profit bases suited to changes in the social structure. The profitability of Japan's banks has been declining, and banks in local areas in particular face severe business conditions amid the decreasing population. In order to raise the profitability of credit extension as core business, financial institutions need to prompt firms' restructuring by identifying and supporting firms and business areas with high growth potential. In other types of business, they are expected to create new financial services suited to developments in the social structure, such as the decreasing population and the aging of society. Another possible option to strengthen profit bases is to work on strategic business partnerships and integration, thereby improving business efficiency and expanding their customer network.

Notice

This Report basically uses data available as of March 31, 2012.

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