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Financial System Report (October 2014)

October 17, 2014
Bank of Japan

Comprehensive assessment of the financial system

Japan's financial system has been maintaining stability. Financial intermediation has operated more smoothly than before.

Functioning of the financial system

Financial institutions have continued to adopt more proactive lending attitudes both at home and abroad. In Japan, they are now geared toward taking more risks in their business operations by, for example, extending loans to firms with relatively low credit ratings. They are also steadily engaging in the fostering of growing businesses and the revitalization of firms. Financial institutions' domestic loans have grown at a somewhat faster pace, and they have gradually extended loans to a wider range of regions and industries. Meanwhile, the narrowing of interest rate spreads on loans has continued reflecting the fact that the pace of increase in demand for funds remains moderate. The rate of increase in overseas loans has remained high, as financial institutions are actively supporting Japanese firms' international operations. As for securities investment, financial institutions have increasingly taken on risks, albeit to a small extent, particularly by increasing their holdings of investment trusts while maintaining their outstanding amount of yen-denominated bonds at a high level. Regarding financial intermediation through financial markets, favorable issuing conditions have been maintained, as evidenced by sustained high levels of equity financing. Under these circumstances, financial conditions among firms and households have become more accommodative.

Stability of the financial system

Regarding developments in the above-mentioned financial intermediation, no indication of overheating has been observed, including a significant divergence in the amount of credit from its trend. In global financial markets, while volatility has remained at a low level, "search for yields" by investors has been increasingly notable, accompanied by capital inflows into risky assets and a narrowing of risk premiums. As for Japanese markets, long-term interest rates have remained at low levels as a generally low-volatility environment has continued, and stock and credit markets have remained firm. However, there is no indication of excessively bullish expectations.

Capital bases of financial institutions have been adequate on the whole. Their capital adequacy ratios are sufficiently above regulatory levels. Although market risk associated with stockholdings and interest rate risk borne by financial institutions have increased somewhat since the time of the previous Report, financial institutions have achieved higher levels of capital mainly due to their accumulation of profits. Significant developments in the accumulation of risks relative to capital have not been observed. Under these circumstances, financial institutions generally have strong resilience against stresses arising from shocks including a significant economic downturn or a substantial rise in interest rates. However, attention should be paid to the possibility that an economic or financial shock will have an impact on the stability of the financial system, depending on its speed and extent, as well as the factors behind it. With respect to funding liquidity, financial institutions have sufficient funding liquidity in yen funds. The funding structure for foreign currencies is characterized by a high share of market funding, but thanks to efforts by financial institutions to lengthen the maturities of foreign-currency funding instruments, financial institutions have secured a sufficient amount of liquidity to cover fund shortages even if they face difficulties in funding for a certain period of time.

Toward ensuring financial stability in the future

Looking into the future, as the on-going globalization of the economy and the transformation of industrial structures -- at both the national and regional levels -- progress further, the financial intermediation function of and risks borne by the financial system will change both in terms of quality and quantity. Japan's growth potential and the future course of its economic and price developments will affect financial institutions' stance and performance in securities investment through interest rates and stock prices. In addition, intensification of search for yields by investors in global financial markets could affect Japanese markets, depending on future developments. As such, the financial and economic environment will continue to change constantly both at home and abroad, transforming the financial system's risk profile.

At the same time, if the narrowing trend in financial institutions' interest rate spreads on domestic loans and the declining trend in their profitability are prolonged, financial institutions' capacity to take risks and absorb losses could be constrained. Moreover, progress is being made with fundamental international financial regulatory reforms as well as in structural changes to the global financial system, as Japan's financial system has been strengthening its overseas connections due to the globalization of the economy. These factors could affect the stability and functioning of Japan's financial system in the medium term.

Based on the above considerations and from the viewpoint of ensuring financial stability in the future, the following three points can be raised as key management challenges for financial institutions. How they tackle these challenges will serve as a key factor for determining financial institutions' future soundness and profitability.

First, financial institutions are expected to respond appropriately to demand for funds associated with economic recovery as well as to contribute to enhancing the vitality of national and regional industries. They need to enhance their financial intermediation function -- as demonstrated by engagement in active efforts such as investments and loans in growing businesses, revitalization of firms, and the spurring of industrial restructuring -- and strengthen financial tools as well as risk management to make this possible.

Second, financial institutions are expected to continue expanding their overseas operations with progress in the globalization of Japan's economy. Given the high share of market funding for foreign-currency funds, they need to secure a stable funding base and strengthen credit management and other functions in step with expanding operations. At the same time, large financial institutions that conduct business operations globally need to attain higher levels of soundness and business management, including appropriate responses to international regulatory reforms, given that they have a significant impact on the stability and functioning of the financial system as a whole.

Third, securities investment in asset-liability management (ALM) continues to hold great significance under the continued "deposit surplus" situation. Since 2013, financial institutions have been reviewing their risk balance by, for example, increasing investment in investment trusts and foreign securities. Nevertheless, yen-denominated bonds continue to hold the central position in financial institutions' securities investment, and the risk associated with yen interest rates is still at a relatively high level compared with past ones. Financial institutions need to establish clear guidelines for the ALM and appropriately execute risk taking as well as management.

The Bank will deepen dialogue with financial institutions through daily off-site monitoring and on-site examinations, particularly on their actions to deal with the challenges described above as well as their profitability, while encouraging them to improve their business and risk management. It will also exchange views with financial institutions on the actual situation surrounding national and regional industries as well as firms, challenges toward enhancing their vitality, and on possible actions from the financial side. Furthermore, it will promote the sharing of awareness of issues and knowhow by holding seminars on themes that would contribute to enhancing the functioning of financial intermediation and risk management.

In order to ensure the stability of the financial system as a whole, the Bank will continue to examine the stability and functioning of the system from a macroprudential perspective. Based on the examination, as necessary, it will work to share a common understanding and to hold discussions with a wide range of participants in the financial system on matters including where risks lie, what issues to tackle, and how to respond appropriately to given circumstances.

Notice

This Report basically uses data available as of September 30, 2014.

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Inquiries

Financial System Research Division, Financial System and Bank Examination Department

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