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Financial System Report (April 2018)

April 19, 2018
Bank of Japan

Features of and motivations behind the April 2018 issue of the Report

This April 2018 issue of the Report analyzes bank loan markets, which have been increasingly active in recent years, with particular focus on the relationship between interest rates and credit risk. Under the prolonged low interest rate environment worldwide, credit spreads on corporate bonds and other credit products have narrowed to historically low levels in many advanced economies, and concern over complacency in investors' risk perception and possible risk repricing has been pointed out. The motivation behind this issue of the Report is to examine whether similar developments and issues have been observed in bank loan markets.

Reflecting the prolonged economic expansion and the subsequent decline in firms' default rates, financial institutions' credit costs have been at historically low levels. However, when credit costs are calculated based on the past default rates, there is a possibility that the amount of credit risk potentially held by financial institutions could be underestimated, reflecting the persistently low economic volatility. In order to check whether financial institutions are sufficiently resilient against risks, it is important to examine how firms' financial condition will change in response to a possible deterioration of the macroeconomic environment and how it will subsequently affect financial institutions' loss-absorbing capacity. Credit risk varies significantly among individual firms, reflecting differences in their financial condition. Thus, financial institutions need to set loan interest rates at levels that match each firm's credit risk. This has become more important given the recent increase in the number of financial institutions that have boosted lending to middle-risk firms. This issue of the Report examines the financial condition and behavior of individual firms, particularly middle-risk firms, and provides in-depth analysis of financial institutions' lending stance toward these firms (including interest rate setting behavior) and their resilience to risks. Further, the potential vulnerabilities of the financial system are assessed, and tasks and challenges for financial institutions regarding credit risk management are outlined.

Executive summary

Assessment of financial intermediation and financial cycle

Financial intermediation has remained well-functioned on the back of the Bank of Japan's monetary easing, supporting the moderate expansion of Japan's economy. In the domestic loan market, the interest rates of both short-term and long-term loans have been hovering around historically low levels and loans outstanding have continued to grow at a year-on-year rate of around 2 percent. In particular, business fixed investment-related lending to small firms has been increasing in a wide range of industries as lending competition has been intensifying among regional financial institutions. In the CP and corporate bond market, large firms' funding has been growing at a faster pace as issuance rates have hovered at extremely low levels. Meanwhile, global financial markets have been stable on the whole, although stock prices in advanced economies dropped substantially in response to the rise in U.S. long-term interest rates, which reflected increased inflation expectations. With continued growth in overseas economies, overseas investment and lending activities by Japanese financial institutions have maintained upward momentum.

The funding conditions for the non-bank private sector have been highly accommodative, but no particular signs of overheating are observed in the current phase of the financial cycle. Stock prices, which increased somewhat sharply until early 2018, have been more or less in line with the expected improvement in corporate profits. Although financial institutions and firms have been expanding the size of their balance sheets, such size has not become excessive relative to GDP. While the outstanding amount of loans to the real estate industry has registered relatively higher growth, a growing number of financial institutions have turned cautious over the risks associated with adjustments in the real estate market and credit concentration in the real estate industry, thus making their stance on real estate-related lending more restrictive. Domestic investors have also become cautious in property acquisitions due to concern over the risk of entrenched real estate valuations. Due attention should be paid to the possibility that the vulnerabilities of the financial system could potentially increase if financial institutions do not receive an appropriate level of return relative to risk from their lending and securities investment, despite not excessively expanding the size of their balance sheets.

Stability of the financial system

Financial institutions have generally strong resilience in terms of both capital and liquidity in times of tail events such as the failure of Lehman Brothers (the Lehman shock). Thus, it can be judged that Japan's financial system has been maintaining stability on the whole. However, there is some heterogeneity in financial institutions' resilience against stress. Furthermore, the current sufficiency of their level of capital does not necessarily guarantee the future stability of the financial system, because financial institutions face chronic stress, such as the persistent decline in the population and the number of firms, which determine the secular demand for financial transactions. In other words, even if financial institutions currently have the capacity to absorb losses from acute stress such as the Lehman shock, their future capital may eventually be adversely affected if their core profitability continues to fall due to chronic stress. A significant number of regional financial institutions have realized gains on sales of securities in order to maintain net income levels and a higher dividend payout ratio despite a decline in their pre-provision net revenue (excluding trading income). Continuing to unreasonably realize gains on sales of securities will reduce interest and dividend income on securities holdings in the future. Furthermore, unrealized gains on securities do actually function as a capital buffer on an economic value basis. Therefore, it is important for financial institutions to consider desirable profit distribution, including how much to return to shareholders.

Vulnerabilities due to financial institutions' credit risk taking

Financial institutions have actively extended loans at low interest rates, particularly to so-called "middle-risk firms," against the backdrop of the effects of intensified lending competition under chronic stress and monetary easing. This reflects the fact that the potential loan demand by middle-risk firms will easily materialize in response to lower loan interest rates offered by financial institutions, as these firms hold a smaller amount of internal funds and are more sensitive to loan interest rates compared to financially sound firms. The increase in loans to middle-risk firms is generally observed in financial institutions with a higher capital adequacy ratio and higher risk-taking capacity. At the same time, such an increase tends to occur in financial institutions with lower core profitability and stronger risk-taking incentives. In fact, financial institutions tend to be complacent in their perception of credit risk amid the prolonged benign macroeconomic conditions, such as economic expansion and low interest rates. If financial institutions and firms act on the premise that such a favorable macroeconomic environment will continue in the future, their balance sheets could be impaired by unexpected losses in the event of a reversal in the macroeconomic environment. The ratio of financial institutions' loan-loss provisions for overall normal loans has remained at a historically low level that is below even that before the Lehman shock. However, in the event of negative shocks, such as an economic downturn or a rise in interest rates, firms -- especially middle-risk firms with low profitability and ability to repay their debt -- could be downgraded and credit costs could rise sharply.

Challenges from a macroprudential perspective

There is a possibility that financial imbalances could build up if financial institutions shift toward excessive risk taking in order to maintain profitability. There is also a possibility that the financial intermediation function could weaken if financial institutions lose their loss-absorbing capacity due to the continued decline in their core profitability. Thus, there exist both overheating and contraction risks. In order for the financial system to maintain its stability into the future, financial institutions should accelerate their efforts to ensure sustainable profitability and strengthen their capacity to address risks in the areas where they actively continue to take risks, such as domestic and overseas lending as well as investment in stocks and foreign bonds. In this regard, bearing in mind any future changes in the macroeconomic environment, financial institutions that have actively extended loans to middle-risk firms need to set appropriate interest rates reflecting the risks involved, and improve the effectiveness of credit risk management, including examining whether their loan-loss provisions are appropriate. In particular, when making loan-loss provisions, financial institutions need to appropriately smooth out cyclical fluctuations from a medium- to long-term perspective so that loan-loss provisions are not excessively affected by the current favorable macroeconomic environment. At the same time, they should deepen relationships with client firms and thereby actively support these firms' efforts to raise productivity. The Bank of Japan will support such efforts of financial institutions through, for example, its on-site examinations and off-site monitoring and will continue to closely monitor, from a macroprudential perspective, the impact on the financial system of financial institutions' various risk taking.

Notice

This Report basically uses data available as at end-March 2018.

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.

For details of the stress scenario in the macro stress testing, please see the scenario table [XLSX 27KB].

Inquiries

Financial System Research Division, Financial System and Bank Examination Department

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