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Financial System Report (October 2012)

October 19, 2012
Bank of Japan

Overview

The external environment surrounding Japan's financial system

Regarding the external environment surrounding Japan's financial system, uncertainty about the future has been high.

In global financial markets, some nervousness continues to be seen, although investors' risk aversion mainly due to the European debt problem has recently been subsiding moderately. In European countries facing serious fiscal situations, an adverse feedback loop among fiscal conditions, the financial system, and the real economy has materialized. In many emerging economies including China, economic growth has been slowing. In the United States, although the burden on repayments on households has started to ease, it has continued to weigh on the economy.

Japan's economic activity is leveling off more or less. In this situation, firms have been taking a cautious stance in financing, and firms' financial conditions have generally improved. However, some small and medium-sized firms have continued to face severe financial conditions, and principal and interest repayments relative to income for households with housing loans remain generally large. In the public sector, government debt has accumulated, with a continuing fiscal deficit.

Financial institutions' performance of financial intermediation

Financial conditions of firms and households in Japan are accommodative. Issuing conditions for CP and corporate bonds have remained favorable on the whole, and firms continue to see banks' lending attitudes as being on an improving trend. In these circumstances, banks' domestic loans outstanding have increased, particularly for reconstruction-related working capital and funds related to mergers and acquisitions, although loans for business fixed investment are lackluster. Major banks have increased overseas loans, and the share of their loans in the global loan market has grown. Meanwhile, although the regional financial institutions' outstanding amount of loans has increased as a whole, growth in loans to local firms in nonmetropolitan areas has been slow. In this situation, financial institutions have gradually proceeded with efforts to support local firms' exploration of new markets and business succession by utilizing their own customer networks to improve the firms' business conditions.

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. Due attention should be paid, however, to a further increase in the amount outstanding of Japanese government bonds (JGBs) held by financial institutions. Moreover, although the amount of risks banks and shinkin banks bear as a whole has been decreasing relative to capital, their core profitability has declined. Attention should be paid to the possibility that, if the growth rate of Japan's economy continues to decline in the medium to long term due to the decreasing population and the aging of society, financial institutions' profitability will continue to decrease.

Resilience of the financial system

The macro stress testing shows that the resilience of Japan's financial system is generally strong as a whole. Banks' capital bases as a whole would be able to avoid significant impairment, even if a significant economic downturn similar to that observed after the Lehman shock or an upward shift of domestic interest rates for all maturities by 1 percentage point occurs. Moreover, even if banks become unable to raise funds from some markets, they would generally hold a sufficient amount of funding liquidity both in the domestic and foreign currencies.

Nevertheless, close attention should be paid to the possibility that, if a large economic downturn occurs, capital adequacy ratios will plunge for banks whose quality of loans is relatively low. Furthermore, if domestic interest rates rise significantly by exceeding the aforementioned assumption, due attention needs to be paid to the possibility that banks' capital will decline to a noticeable extent and such effects will be amplified through an adverse feedback loop between the financial system and the real economy. Banks could require additional funding sources under a particularly severe situation in which 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. However, in order for financial institutions to maintain smooth financial intermediation while ensuring their capability to respond to stresses on the economy and financial markets, they need to address the three major challenges discussed below.

First, financial institutions need to enhance the effectiveness of risk management. As for credit risk, it is important for financial institutions to strengthen measures to help ailing borrowing firms improve their business conditions, and at the same time appropriately manage credit risk based on the borrowers' capacity for self-reconstruction. Financial institutions need to examine market risk from multidimensional perspectives with the use of stress testing and other methods, in order to achieve balanced investment portfolios and manage risk in accordance with financial institutions' capital. Japan's financial institutions are required to continue to conduct strict risk management for funding liquidity both in domestic and foreign currencies.

Second, financial institutions need to further strengthen their capital bases. It is indispensable for them to enhance their capital not only to be prepared for various stresses but also to continue financial intermediation in areas with high risk and return through investments and loans to growing business areas at home and abroad. In addition, the new requirements for capital adequacy ratios 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 need to construct stable profit bases. Financial institutions' customer networks are large compared with other industries, and there is room for the institutions to more effectively support local firms' exploration of new markets and business succession by utilizing their own customer networks. They could strengthen their own profitability by increasing business opportunities and receiving adequate commissions through such valuable information services. In supporting firms with growth potential such as start-ups, financial institutions are expected to tap potential demand by increasing the usage of financial instruments such as asset-based lending (ABL) and utilizing the functioning of funds. Moreover, strategic business partnerships and integration among financial institutions could not only improve business efficiency but also expand their customer networks and in turn strengthen their profit bases.

Notice

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

Please credit the source when quoting, reproducing, or copying the contents of this Report for non-commercial purposes.

Inquiries

Financial System Research Division, Financial System and Bank Examination Department

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

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