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April 22, 2016
Bank of Japan
Japan's financial system has been maintaining stability. Financial intermediation has continued to operate smoothly. While the heightened volatility particularly in global financial markets since the summer of 2015 has had a considerable impact on Japan, the effects on the stability and functioning of the financial system have been limited due in part to the Bank of Japan's quantitative and qualitative monetary easing (QQE) with a negative interest rate.
Looking at developments in global financial conditions, since the summer of 2015, investors' risk aversion has increased, mainly against the background of the decline in commodity prices, the slowdown in emerging and commodity-exporting economies, and market speculation concerning differences in the trajectory of monetary policies among advanced economies. Consequently, there was a significant heightening of financial market volatility through the first quarter of 2016, while in some regions, including Europe, concern about the financial conditions and the quality of assets of financial institutions increased. These impulses have been transmitted to Japan mainly in the form of a substantial decline in stock prices, continued yen appreciation, and a rise in foreign currency funding costs. Nevertheless, interest rates declined further owing to the effects of QQE with a negative interest rate, and the credit market has been stable relative to that of overseas markets. Meanwhile, Japan's economy has continued its moderate recovery trend, with strong fundamentals as seen from, for example, the narrowing trend in the primary fiscal balance.
Financial institutions' domestic loans have continued to grow at a 2.0-2.5 percent year-on-year rate, reflecting demand for funds in a wide range of industries, such as from large firms, to support their merger and acquisition activities, as well as from the real estate sector. Financial institutions have continued to adopt a positive stance toward undertaking more risk in their business operations, and have been active in lending to firms -- particularly small- and medium-sized firms -- including borrowers with lower credit ratings, while continuing to support, for example, start-up firms, business revitalization, and firms' business matching. Overseas loans have been growing at a year-on-year rate of around 10 percent, as banks have also been active in overseas lending, with a view toward supporting the global expansion of Japanese firms and capturing overseas financial needs, while taking into account their ability to raise foreign currency funding. As for securities investment, financial institutions have been investing further in assets such as foreign bonds and investment trusts, while their outstanding holdings of yen-denominated bonds remain at a high level. Recently, however, some financial institutions have become more cautious regarding the extension of overseas credit, especially to emerging economies, and investment in assets such as stock investment trusts, due in large part to unsettled global financial conditions.
Institutional investors -- such as insurance companies and pension funds -- and depository institutions with a focus on market investment -- such as Japan Post Bank and the central organizations of financial cooperatives, have continued to reallocate their investments away from domestic bonds toward risky assets, such as foreign bonds, in response to a further decline in domestic interest rates. In terms of households' investment activities, basically there appears to be a continued tendency to increase investments in investment trusts and other risky assets, suggested by the widening use of Nippon Individual Savings Account (NISA) and wrap accounts. Recently, however, the trend among households to hold more risky assets has weakened, primarily reflecting unsettled global financial conditions. Meanwhile, with regard to financial intermediation through financial markets, equity financing has decreased recently in response to the decline in stock prices, although firms' proactive financing stance seems to have remained largely unchanged. Issuing conditions for CP and corporate bonds have remained favorable alongside developments such as a further decline in interest rates. Financial conditions among firms and households have become more accommodative.
Regarding developments in financial intermediation mentioned above, signs of financial imbalances such as excessive risk taking and credit growth, and overheating in financial activity have not been observed.
The financial bases of financial institutions have been adequate on the whole. Their capital adequacy ratios are sufficiently above regulatory requirements. Although the amount of risk borne by financial institutions has increased mainly due to the heightened volatility in global financial markets, aggregate risks that financial institutions are undertaking still remain contained relative to their capital bases. Examination through stress testing also indicates that the financial system is considered to have generally strong resilience against stresses. Moreover, financial institutions have sufficient yen funding liquidity. As for foreign currency funding, financial institutions have liquidity buffers that can cover possible outflows even if funding conditions become difficult for a certain period, and have made steady progress in efforts to bolster stable funding sources. Nevertheless, foreign currency funding costs are on a rising trend, in a situation where market funding continues to account for a large share of foreign currency funding. A broad range of domestic entities will likely continue working toward increasing their demand for foreign currencies. Therefore, careful attention should be paid to the liquidity situation in the foreign currency funding market, including the effects of international financial regulations.
The total credit-to-GDP ratio has remained unchanged. With regard to a wide range of financial activity indicators, including the total credit-to-GDP ratio, no large deviations from their trends have been observed. In the real estate market, transaction activity has been buoyant, albeit with regional differences, and the growth rate of financial institutions' real estate-related loans has been rising. However, developments in nationwide land prices and on other fronts suggest that the real estate market does not appear to be in a state of overheating on the whole.
Meanwhile, financial institutions' profits have been on a growing trend, and are exerting positive effects, particularly on the financial bases of financial institutions. The trend of growing profits has been maintained mainly due to the decrease in credit costs and gains from securities investments. However, spreads, as well as profits from domestic deposit-taking and lending activities, which form the core of financial institutions' profitability, have remained on a declining trend, given the continued decline in interest rates. Developments in core profitability warrant careful attention, as financial institutions' ability to absorb losses and take risks could be restrained if this trend persists.
To summarize the above assessments from the viewpoint of the effects of QQE with a negative interest rate, it can be observed that market interest rates have declined further -- with even long-term interest rates entering negative territory, and a wide range of interest rates on deposits and loans have been declining. Under these circumstances, financial institutions and other entities have been prompted to take portfolio rebalancing a step further, including by taking an increasingly active stance toward lending. These changes contribute to smoother functioning of the financial system.
Nevertheless, the transmission of the above effects is constrained by several factors. For example, a broad range of entities in financial markets have postponed their transactions as they have been in the midst of reviewing their investment strategies and operational arrangements, including their IT systems. Investors and firms have avoided transactions with a negative interest rate. As a result, signs of a holdup in the flow of funds have been observed, for example, a large sum of funds have remained within trust banks and major banks. Meanwhile, the heightened volatility in global financial markets after the beginning of 2016 has led to a decline in stock prices, yen appreciation, and an increase in foreign currency funding costs. It has also worked to restrain risk taking among financial institutions and other entities to some extent. The policy effects are expected to propagate further as these issues are resolved.
With regard to financial institutions' profits, although further downward pressure is likely to be experienced for the time being, financial institutions are likely to continue with proactive credit intermediation, as they have generally secured sufficient capital bases. If financial institutions' portfolio rebalancing activities lead to an improvement in economic and price developments, this is in turn likely to bring about a recovery in core profitability. However, if the recent trend of declining profits persisted, it could eventually lead to a weakening in their credit intermediation function. It is necessary to examine both the risk of overheating -- excessive accumulation of macro risks and exuberant asset prices -- and the risk of a gradual pullback in financial intermediation due to a persistent decline in profits, with regard to the impact of QQE with a negative interest rate on financial stability.
In order to contribute to economic growth through the smooth operation of financial intermediation while ensuring future financial system stability, efforts are necessary for financial institutions to steadily respond to the accumulation of macro risks and structural changes in the financial system that could become a source of potential fragility.
From the viewpoint of the accumulation of macro risks, (1) Japan's financial system is increasingly exposed to developments in overseas economies, as well as the vagaries of financial markets at home and abroad. Increasing the financial system's robustness to the propagation of risks stemming from overseas as well as financial markets, and securing and enhancing a stable foreign currency funding base continue to be important tasks, taking into account the growing trend in financial institutions' overseas loans and foreign securities investment, including those by institutional investors. Moreover, (2) the increasing systemic importance of large financial institutions and (3) the decline in profitability associated with domestic deposit-taking and lending operations can be considered structural changes in the financial system. The shrinking population and customer base -- in addition to the low interest rate environment -- is exacerbating the problem of low profitability of regional banking especially. QQE with a negative interest rate can be considered to exert significant effects on all three of the above-mentioned risks, as its effects propagate.
As for additional factors that may affect financial stability in the longer term, the following points can be brought up: (4) the sustainability of the shift "from saving to investment" in the household sector; (5) the proliferation of IT utilization in the finance field, including FinTech, as well as the increasing importance of cyber security protection.
The Bank will make the following efforts toward ensuring financial stability, while providing support to financial institutions and other entities in adapting to the new environment of negative interest rates.
Through its off-site monitoring and on-site examinations, the Bank will encourage individual financial institutions to deal with the above-mentioned macro issues by ensuring their soundness. In doing so, the Bank will essentially focus on encouraging institutions to refine management practices that facilitate the adoption of a positive approach toward risk taking and global business expansion, taking into account that financial institutions' capital bases have remained adequate. With regard to large financial institutions, while keeping in mind their systemic importance, the Bank will encourage them to bolster their financial bases and improve their business management practices to guard against the manifestation of risks, and to make the necessary preparations to respond in an orderly manner in times of stress. With regard to regional financial institutions, in view of the importance of ensuring the stability and improvement of their profitability, the Bank will focus on assessments of their medium- to long-term profitability and discussions on future business plans based on these assessments. At the same time, the Bank will reinforce the efforts of regional financial institutions to further support regions and firms, as well as to improve their financial tools and risk management practices. At seminars and other events, the Bank will also engage in themes that will contribute to the strengthening of financial intermediation functioning and business management practices. As part of its effort to respond to financial globalization, the Bank will increase its coordination with overseas central banks and other organizations, while deepening its understanding of developments in the overseas financial system and financial markets. With regard to international financial regulations, the Bank will contribute to efforts to establish standards and implement them, keeping in mind the need to strike a fine balance between the financial system's robustness and its smooth functioning. As for measures related to transaction activities, the Bank will act to ensure financial stability, including by demonstrating its lender-of-last-resort function when appropriate. In the context of the above measures, the Bank will continue with appropriate efforts to engage in coordination with related authorities, particularly the Financial Services Agency.
This Report basically uses data available as of March 31, 2016.
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