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Financial System Report (April 2014)

April 23, 2014
Bank of Japan

Comprehensive assessment of the financial system

Japan's financial system as a whole has been maintaining stability.

Judging from developments in financial markets and financial institutions' behavior, there is no indication warning of financial imbalances such as excessively bullish expectations. The volatility of stock prices temporarily increased from the beginning of 2014, but volatility has generally been low in the Japanese government bond (JGB) and foreign exchange markets.

Capital bases of financial institutions such as banks and shinkin banks have been adequate on the whole, and these institutions have sufficient funding liquidity. Thus, they generally have strong resilience against various economic and financial shocks, as they would maintain their capital adequacy ratios above regulatory levels even under stresses arising in scenarios involving a significant economic downturn and a substantial rise in interest rates. However, attention should be paid to the possibility that the impacts of an economic downturn and an interest rate rise spread to the financial system, depending on the speed and extent of the economic downturn and the rise in interest rates, as well as the factors behind them. Some financial institutions have relatively weak capital bases, and are behind the curve in improving asset quality following the Lehman shock. These institutions need to steadily strengthen their capital.

Financial intermediation has operated more smoothly than it did at the time of the previous Report.

Financial institutions have adopted more proactive lending attitudes at home and abroad, and some of them have increasingly taken on risks associated with securities investment, albeit to a small extent. Financial intermediation through financial markets has become prevalent. In these circumstances, financial conditions among firms and households have become more accommodative. Financial institutions' loans have grown at a faster pace, particularly those to small and medium-sized firms, and these institutions have extended loans to a wider range of industries and regions.

The recent economic recovery has had positive effects on the profits of financial institutions. The positive effects include an increase in profits related to stock investment, an increase in sales of stock investment trusts, and a decrease in credit costs. However, the core profitability of domestic business operations relating to deposits and loans has remained on a downtrend, mainly due to the continued narrowing of interest rate spreads on loans. Business conditions among regional financial institutions are particularly severe. The decline in core profitability does not immediately affect the stability or functioning of the overall financial system. Nonetheless, the declining trend in core profitability is a challenge that should be resolved because it may constrain financial institutions' ability to absorb losses and take on risks in the medium to long term.

Overview (summary of Chapters II to VI)

Chapter II: Examination of the external environment

Overseas economies -- mainly advanced economies -- are starting to recover, although a lackluster performance is still seen in part. In this situation, while concerns over the European debt problem have abated further, global financial markets have remained susceptible to developments in U.S. monetary policy and emerging economies. After the turn of the year, some developments indicating nervousness were temporarily observed in global financial markets as concerns mounted over prospects in some emerging countries with structural problems, such as current account deficits, and risk-taking by investors was reduced.

Japan's economy has continued to recover moderately as a trend, albeit with some fluctuations due to the consumption tax hike, and financial conditions among firms and the employment and income situation in the household sector have generally improved. The ratio of risky assets including investment trusts has risen among households. As for the fiscal balance, fiscal deficits have persisted, but the national and local governments' primary deficit to GDP ratio is expected to improve, partly due to the consumption tax hikes.

Chapter III: Examination of financial intermediation

Financial conditions among firms and households have become more accommodative under quantitative and qualitative monetary easing (QQE) compared with those at the time of the previous Report. Funding conditions have improved not only for large and medium-sized firms, but also for small firms, and interest rates on housing loans have declined.

Financial intermediation through financial markets has become prevalent, particularly in equity financing. As the Bank of Japan's JGB purchases under QQE have expanded, financial institutions such as banks and shinkin banks have increased their holdings of risky assets, including loans. Financial institutions' domestic loans have grown at a faster pace, particularly those to small and medium-sized firms, and these institutions have extended loans to a wider range of industries and regions. Overseas loans have continued to show relatively high growth. Regarding securities investment, investment in instruments such as foreign securities and stock investment trusts has increased, albeit slightly. Meanwhile, no major changes have been seen in investment by investors other than financial institutions, such as insurance companies.

Chapter IV: Risks observed in financial markets

In Japan's financial markets, the volatility of stock prices temporarily increased from the beginning of 2014. This is because investors became increasingly risk averse given nervousness in some emerging markets and a decline in stock prices globally. JGB yields have been stable due to factors such as the continued tightening of supply and demand conditions in the JGB market prompted by the Bank's large-scale JGB purchases. The volatility of foreign exchange rates has shown a decreasing trend.

Chapter V: Risks borne by financial intermediaries

At financial institutions such as banks and shinkin banks, capital adequacy ratios as a whole have been rising recently, and these institutions have ratios well above regulatory levels. Interest rate risk and credit risk declined, while market risk associated with stockholdings increased, reflecting a rise in the market value of stocks held. As a result, the amount of risk borne by financial institutions has increased on the whole, but its pace of increase has been almost consistent with the rate of capital growth, and financial institutions' capital bases have generally been adequate. Financial institutions have also secured sufficient funding liquidity. Nevertheless, there are still some financial institutions with low levels of bank capital adequacy relative to the amount of risk they bear, and these institutions need to steadily strengthen their capital.

The recent economic recovery has had positive effects on the profits of financial institutions. The positive effects include an increase in profits related to stock investment, an increase in sales of stock investment trusts, and a decrease in credit costs. However, the core profitability of domestic business operations relating to deposits and loans has remained on a downtrend, mainly due to the continued narrowing of interest rate spreads on loans. Business conditions among regional financial institutions are particularly severe. The decline in core profitability does not immediately affect the stability or functioning of the overall financial system. Nonetheless, the declining trend in core profitability is a challenge that should be resolved, because it may constrain financial institutions' ability to absorb losses and take on risks in the medium to long term.

Chapter VI: Risk assessment of the financial system from a macroeconomic perspective

Judging from developments in financial markets and financial institutions' behavior, the financial risk indicators show no warning of financial imbalances such as excessively bullish expectations at present. The results of macro stress testing indicate that financial institutions on the whole would be able to maintain the levels of capital adequacy ratios above regulatory levels even if a significant economic downturn similar to the Lehman shock occurred or long-term interest rates rose by about 2 percentage points with an economic downturn. Nevertheless, an economic downturn and a rise in interest rates may cause a stronger adverse feedback loop between the real economy and financial activity via an increase in the burden of firms' interest payments, depending on the speed and extent of the economic downturn and the rise in interest rates, as well as the factors behind them. This may have impacts on financial institutions' profits and capital, and ultimately on the financial system. Furthermore, it should be noted that if significant economic and financial shocks occurred, capital adequacy ratios may plunge at financial institutions with weak capital bases relative to the amount of risk they bear. On the funding liquidity side, financial institutions have sufficient liquid assets to see themselves through stress events such as deposit outflows continuing for a certain period and a decline in the functioning of financial markets.

Notice

This Report basically uses data available as of March 31, 2014.

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Inquiries

Financial System Research Division, Financial System and Bank Examination Department

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