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Financial System Report (October 2018)

October 22, 2018
Bank of Japan

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

It has become increasingly important to accurately assess financial vulnerabilities amid the prolonged low interest rate environment. Active financial intermediation -- particularly bank lending -- has contributed to an improvement in the real economy. However, if excessive risk taking spreads across financial intermediation activities, the real economy could undergo significant adjustment pressure in the future. Furthermore, when the real economy deteriorates considerably -- in other words, when a tail risk materializes -- unless financial institutions have sufficient stress resilience, they could face difficulty in maintaining their financial intermediation function, which could in turn exacerbate the real economy through a negative feedback loop.

Motivated by the above considerations, this October 2018 issue of the Report is concerned most with the following three areas of analysis. First, we quantitatively assess the tail risk in terms of deterioration in the real economy from a macroprudential perspective. Specifically, we use a new analytical approach called "GDP-at-risk" (GaR) to visualize the downward risks to the economy caused by financial vulnerabilities. Second, we refine the measurement of financial institutions' risk profiles, such as the amount of risk and the heterogeneity among these institutions, to take into account the recent behavior of financial institutions' risk taking and risk management. In particular, this issue of the Report focuses on two aspects: (1) in terms of credit risk, the actual conditions of lending to middle-risk firms and overseas lending, the two types of lending in which financial institutions have increased their risk taking in recent years; and (2) in terms of market risk, the effects of an increasing realization of gains from the sale of securities, as well as the effects of a growing exposure to stock investment trusts. Third, we conduct a more detailed analysis of financial institutions' stress resilience to tail risks, by incorporating the effects of financial institutions' recent risk taking into the Financial Macro-econometric Model (FMM). The FMM measures credit costs by taking into account the tendency that, when the real economy deteriorates, default rates of middle-risk firms increase in a nonlinear manner to a greater degree than those of financially sound firms.

Executive summary

Developments in financial intermediation

Domestic financial intermediation -- particularly bank lending -- has continued to be active and supported a moderate expansion of Japan's economy on the back of monetary easing by the Bank of Japan. In the domestic loan market, the interest rates for 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. Business fixed investment-related lending to small firms in particular has increased across a wide range of industries as lending competition has intensified among regional financial institutions. In the CP and corporate bond market, an increasing trend in large firms' fund-raising for working capital, refinancing, and M&A deals has continued as issuance rates have hovered at extremely low levels.

Financial institutions have maintained the upward momentum of their overseas investment and lending activities, reflecting the continued steady growth of the global economy. Institutional investors such as life insurance companies have also increased their overseas exposure.

Financial cycle and potential vulnerabilities

The funding conditions for firms and households have been highly accommodative, but the financial cycle has shown no signs of overheating as observed during the bubble period in the late 1980s. Financial institutions have maintained their active lending attitudes amid the prolonged favorable macroeconomic environment backed by economic expansion and low interest rates. The expansionary phase of the financial cycle has continued as the total credit to GDP ratio has increased with a relatively large deviation from the long-term trend, reflecting an increase in lending to middle-risk firms and the real estate sector. These financial developments have supported the economic expansion to date and also suppressed downside risk to the real economy in the near future. However, from a somewhat longer-term perspective, if the growth potential of Japan's economy does not increase, then the recent financial developments could build up pressure on balance sheet adjustments and thereby amplify downward pressure on the economy in the event of a future negative shock. This is because, if financial institutions and borrowers were to base their behaviors on overly optimistic projections, then they could suffer unexpected losses in the event of a deterioration of the macroeconomic environment.

International financial conditions have featured a prolonged period of increasing global debt outstanding and investors' search for yield. The portfolio quality of Japanese financial institutions' overseas loans has remained high on the whole, but some financial institutions have increased lending to relatively high-risk firms, driven by intensified competition with overseas financial institutions and higher foreign currency funding costs. With regard to securities investment, Japanese financial institutions have maintained a relatively high level of overseas exposure from a somewhat longer-term perspective. Therefore, continued attention should be paid to whether policy rate hikes in the United States, international trade tensions, and a rise in geopolitical uncertainties particularly over emerging market economies could affect Japan's financial markets and financial institutions through capital outflows from emerging markets and a widespread repricing of risky assets.

Stability of the financial system

Financial institutions generally have strong resilience in terms of both capital and liquidity during 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, financial institutions' core profitability has continued to decrease amid the persistent decline in the population and the number of firms as well as the prolonged low interest rate environment. Under these circumstances, regional financial institutions' capital adequacy ratios have gradually decreased because the pace of increase in financial institutions' capital has not necessarily kept up with the pace of increase in the amount of risk assets. Stress testing results in this Report indicate that financial institutions are able to maintain their capital above regulatory requirement levels even under a stress situation, as was the case for the tests conducted in previous issues of the Report. However, financial institutions tend to become more cautious in their risk taking if their capital adequacy ratios fall substantially or they continue to register net losses. Therefore, it should be noted that in the event of stress, downward pressure on the real economy from the financial system would be more likely to intensify than in the past. Financial institutions have significant heterogeneity in their loss-absorbing capacity, and those that have actively engaged in risk taking relative to their loss-absorbing capacity, in areas such as lending to middle-risk firms and the real estate sector, as well as securities investment, could experience larger declines in their capital because of credit costs and losses on securities.

Challenges from a macroprudential perspective

In order for the financial system to maintain stability into the future, financial institutions need to raise their core profitability. At the same time, the corporate sector needs to increase medium- to long-term growth expectations, which is the other side of the same coin. To this end, financial institutions' consulting and advisory services for firms are important, in addition to firms' own efforts to improve productivity and the government's initiatives to increase the economy's growth potential. Financial institutions have already been making such efforts, but it will likely take more time until they bear fruit in the form of an increase in financial institutions' profitability. It is therefore necessary for financial institutions to increase their non-interest income such as fees and commissions and drastically raise their business efficiency, as well as to improve the profitability of their loans.

Financial institutions also need to enhance their risk management in areas where they have increased their risk taking, such as lending to middle-risk firms, real estate lending, overseas lending, and securities investment. In particular, financial institutions have been increasing the amount of loans to low-return borrowers whose borrowing interest rates are low relative to their credit risk through the business cycle. It is thus increasingly important for financial institutions to examine whether their loan-loss provisions are appropriate and set their loan interest rates commensurate with the risks involved while taking into account possible future developments in the macroeconomic environment. In addition, in order to ensure sufficient loss-absorbing capacity, financial institutions need to examine whether their policies on capital and profit distribution including dividends, and their strategies for utilizing unrealized gains on securities are appropriate in terms of their stress resilience. The Bank of Japan will support such efforts by financial institutions through on-site examinations and off-site monitoring, and will also continue to closely monitor the impact on the financial system of financial institutions' various forms of risk taking from a macroprudential perspective. Based on the results of the macro stress testing for individual financial institutions outlined in this Report, among other information, the Bank intends to increase its dialogue with financial institutions in order to promote a deeper common understanding with regard to resilience to stress.

Notice

This Report basically uses data available as at end-September 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 23KB].

Inquiries

Financial System Research Division, Financial System and Bank Examination Department

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