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Financial System Report (April 2017)

April 19, 2017
Bank of Japan

Contents

Executive summary: comprehensive assessment of the financial system

Developments in financial markets

In global financial markets, rises in stock prices and interest rates became increasingly evident worldwide after the U.S. presidential election in November 2016. In Japan, a rise in stock prices and depreciation of the yen were observed, and highly accommodative financial conditions have been maintained under the Bank of Japan's "Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control." Meanwhile, with regard to the U.S. dollar funding environment among Japanese financial institutions, funding costs have remained high on the whole, although dollar funding premiums, particularly in short-term FX swap markets, have declined somewhat as dollar funding demand decreased due to a temporary restraint on foreign bond investment.

Examination of financial intermediation

Financial institutions' domestic loans outstanding have been increasing at a year-on-year growth rate of around 3 percent, amid accommodative lending stances among financial institutions and demand for funds from a wide range of industries. Overseas loans have maintained relatively high growth, even with dollar funding costs remaining at a high level. As for securities investment, financial institutions have maintained their stance of increasing their risk taking particularly by accumulating investment trusts further, although there have been some moves to temporarily hold back on foreign bond investment in response to the rise in U.S. interest rates since the fall of 2016. Institutional investors -- such as insurance companies and pension funds -- have continued to accumulate risky assets, particularly foreign bonds, in an environment characterized by prolonged low interest rates. Meanwhile, in financial markets, the issuance rates in the CP and corporate bond market have hovered at extremely low levels, and firms' debt financing has increased.

Signs of overheating in a large part of financial and economic activities have not been observed on the whole, although the funding environment for the non-financial private sector has been highly accommodative. Nevertheless, amid the continued low interest rate environment, banks have adopted the most accommodative lending stance since the bubble period. In addition, although the real estate market does not appear to show signs of overheating on the whole, acquisition of properties by J-REITs, etc. has spread from metropolitan areas to provincial areas and financial institutions have been increasing their real estate loans and investments in real estate funds. It is therefore necessary to carefully examine whether there will be an excessive decline in risk premiums or overly bullish expectations for rents.

Stability of the financial system

Japan's financial system has been maintaining stability. Indeed, financial institutions' capital adequacy ratios are sufficiently above regulatory requirements, and their capital levels are generally adequate relative to the amount of risk undertaken. The results of macro stress testing indicate that financial institutions as a whole are considered to have generally strong resilience against stresses. Developments in profits and capital after applying stresses, however, vary from one financial institution to another, suggesting heterogeneity with regard to their degree of resilience against stresses. Meanwhile, with regard to financial institutions' funding liquidity, while foreign currency-denominated lending and investment activity has continued to increase, they have a liquidity buffer that can cover funding shortages, even if market funding conditions for securing foreign currency become difficult for a certain period. Major banks in particular have made efforts to bolster their stable funding bases, mainly through increasing client-related deposits.

Potential vulnerabilities due to the decline in financial institutions' profitability

At present, financial institutions have sufficient capital bases, which will allow them to continue risk taking even if profitability remains subject to downward pressure for the time being. Going forward, if their portfolio rebalancing leads to an improvement in economic and price developments, this is in turn likely to bring about a recovery in profitability.

However, when focusing on the structural aspects of the financial system, financial intermediation services provided by Japanese financial institutions are relatively homogeneous and easily substituted by one another, and there are a large number of competing financial institutions. Competition among them is therefore considered prone to intensify, when demand for conventional financial intermediation services declines due to factors including population decrease. Excessive competition among financial institutions can reduce their profitability, thereby undermining their business stability. Put differently, there is a possibility that financial imbalances will build up and financial system stability will be impaired, if financial institutions shift toward excessive risk taking in order to maintain profitability as deposit and lending margins continue to decline as a trend. On the other hand, if the number of financial institutions whose loss-absorbing capacity declines due to a continued weakening of its profitability increases, the financial intermediation function of financial institutions as a whole could weaken, adversely affecting the real economy.

As such, regarding potential vulnerabilities due to the declining profitability of financial institutions, 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.

Challenges for financial institutions and actions by the Bank of Japan

Three challenges to be tackled by financial institutions, in order for Japan's financial system to ensure stability in the future, are outlined below. First, individual financial institutions need to work to improve their profitability by proceeding with efforts to develop and implement business strategies that utilize their core competence, for example, in the strengthening of their support for the regional economies and local firms, utilization of FinTech, and operational reforms for improving their management efficiency. Second, financial institutions need to strengthen their ability to respond to risks in areas where they are proactively stepping up their risk taking, such as overseas business and market investment. Third, large financial institutions need to be sufficiently aware of the increasing influence they may have on the financial system, and take further action including efforts to establish a solid financial base and strengthen business management frameworks to respond to the accumulation of risks, and make preparations to respond in an orderly manner in times of stress.

The Bank will continue to deal with these challenges on its part toward ensuring financial system stability, through its off-site monitoring and on-site examinations, among other efforts. In particular, as improving profitability is an issue of high importance and urgent priority, it will continue to strengthen its dialogue with relevant institutions, utilizing its off-site monitoring in tandem with its on-site examinations including new targeted on-site examinations focusing on profitability. With regard to the further advancement and utilization of stress testing, the Bank will also make progress in its dialogue with financial institutions and collaborative research.

Notice

This Report basically uses data available as at March 31, 2017.

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