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Financial System Report (October 2019)

October 24, 2019
Bank of Japan

Features of and motivations behind the October 2019 issue of the Report

This October 2019 issue of the Report provides analyses with a particular focus on the following three areas.

First, this issue provides an analysis and assessment of potential risks and vulnerabilities associated with the overseas exposure of Japanese banks. The motivation is that financial institutions, particularly major banks, have increased overseas lending and overseas credit investment such as leveraged loans and collateralized loan obligations (CLOs) since the global financial crisis, and accordingly have increased connectedness with overseas.

Second, this issue provides an analysis of developments in operating efficiency of regional financial institutions, its difference among institutions by type of banks, and their factors. The analysis takes into account regional financial institutions' efforts to improve operating efficiency under the continued decline in profitability in recent years, such as overhead cost savings and increases in net non-interest income. Based on the results of this analysis, the section for stress testing in this issue conducts medium- to long-term simulation and stress testing that assumes the realization of the tail event in the medium term, taking into account the effects of further improvement in operating efficiency on profitability going forward.

Third, this issue outlines the background behind the rise in credit costs and the related outlook, given that financial institutions' credit cost ratios have recently started to rise, particularly for regional financial institutions, although levels have remained low.

In terms of the structure of the Report, this issue newly includes a chapter that comprehensively examines domestic and overseas financial vulnerabilities (Chapter IV). Also, in the assessment of various risks, this issue includes a new section regarding the risks that have become increasingly important in recent years, such as those associated with cybersecurity, anti-money laundering, and digitalization (Section F of Chapter V), in addition to the regular assessment of credit risk, market risk, and liquidity risk.

Executive summary

Developments in financial intermediation

Financial intermediation has been active in both the loan and securities markets on the back of monetary easing by the Bank of Japan. Domestic loans outstanding have been growing at around 2 percent annually, exceeding the economic growth rate, as loan interest rates have been hovering near historically low levels. In the CP and corporate bond market, fund-raising by large firms has been increasing as issuance rates have hovered at extremely low levels. In global financial markets, stock prices have shown some instability reflecting concerns about a global economic slowdown and geopolitical uncertainties. Meanwhile, long-term interest rates have declined significantly, mainly driven by heightened expectations for monetary easing in the United States and Europe, and credit spreads have remained tight, reflecting investors' search for yield. Against this background, Japanese financial institutions have maintained a moderate uptrend in their overseas exposure.

Examination of financial cycle and financial vulnerabilities

Under these financial intermediation activities, the expansion in the financial cycle has continued; however, financial and economic activities as a whole have shown no signs of overheating observed during the bubble period in the late 1980s.

That said, attention should continue to be paid to the accumulation of vulnerabilities under the continued expansion in the financial cycle. On the domestic front, the total credit to GDP ratio has continued to rise. Although the ratio remains lower than in the bubble period, the upward deviation from its trend is getting close to the scale in that period. Meanwhile, loans to low-return borrowers with narrow profit margins have been increasing. Credit costs remain low but have recently started to rise, particularly for regional financial institutions. As the background behind the increase in credit costs, recent evidence suggests (1) a delay in business restructuring of low-performing firms that have received protracted support from financial institutions and (2) some slackening of loan screening and credit risk management by financial institutions in the process of increasing their lending in recent years. The outstanding amount of real estate loans has been increasing and has surpassed the level seen during the bubble period; moreover, the deviation of the real estate loans to GDP ratio from its trend has marked a record high for the post-bubble period. So far, Japan's real estate market as a whole cannot be judged as experiencing overheating; however, there is the possibility of a build-up of risks that are different from those observed during the bubble period, such as the increase in long-term lending to rental properties amid the declines in population and number of firms. On the one hand, the increase in domestic credit has supported a trend of economic expansion. On the other hand, the above vulnerabilities could build up pressure on balance sheet adjustments and thereby amplify downward pressure on the economy in the event of a future negative shock, should the higher economic growth remain unrealized in a longer-term.

With respect to international finance, as the overseas exposures of Japanese banks increase, Japan's financial system, including banks' foreign currency funding condition, is becoming more susceptible to the effects of overseas financial cycles. Notably, in recent years, Japanese banks, particularly major banks, have increased their investment in leveraged loans to borrowers who have low creditworthiness, as well as in CLOs backed by these loans. The overall credit quality of the overseas loan portfolio has remained high, and most of the CLOs that the banks hold are AAA-rated tranches. However, attention should be paid to a risk of a decline in ratings and market prices of CLOs in the case of a sudden change in economic and market conditions, since borrowers of leveraged loans are vulnerable to deterioration in business conditions and an easing in lending standards for these loans has continued in recent years.

Stability of the financial system

Japan's financial system has been maintaining stability on the whole. Financial institutions, despite the above-mentioned vulnerabilities, generally have strong resilience in terms of both capital and liquidity with respect to tail events like the onset of the global financial crisis.

However, financial institutions' profitability, particularly that of domestic deposit-taking and lending activities, has continued to decline. This seems to be not only due to the prolonged low interest rate environment but also, from a longer-term perspective, due to structural factors such as the secular decline in loan demand associated with the shrinking population and the decline in the potential growth rate. Against this backdrop, major financial institutions have expanded their global activities and pursued group-wide strategies to provide comprehensive financial services, resulting in an increase in their systemic importance. Regional financial institutions have been actively taking risks in domestic lending and securities investment. However, as they have not been able to secure adequate returns relative to the risks involved, their capital adequacy ratios have continued to decline moderately. Should this situation persist, loss-absorbing capacity in the event of stress would decrease, and downward pressure on the real economy through a weakening of the financial intermediation function could intensify.

Challenges for financial institutions

The analyses highlight the following four business challenges that financial institutions need to address. First, financial institutions should strengthen efforts to raise their profitability. Specifically, they need to (1) enhance their capacity to provide more attractive financial services such as solution-related services for firms and services supporting households' wealth accumulation, (2) keep their loan interest rates commensurate with the risks involved and increase their non-interest income, and (3) review their expense structure. In order to maintain sufficient stress resilience into the future through an improvement in core profitability, financial institutions, while making necessary investment for strategic purposes, need to further promote measures to improve operating efficiency, which they have already been working on in recent years. To strongly promote these efforts, mergers and alliances can be effective options. Second, financial institutions should enhance their risk management in areas where they have actively increased their risk taking. Regional financial institutions need to strengthen their risk management for lending to middle-risk firms and the real estate industry and also for investment in securities such as investment trust products. Major financial institutions need to address risks associated with overseas investment and lending, as well as the resultant increase in foreign currency funding. Major financial institutions also need to improve their business management on a global and group-wide basis. Third, financial institutions should adapt to digitalization. Financial institutions need to develop strategies to exploit the potential gains offered by digital technology and establish frameworks for cybersecurity management and anti-money laundering controls while taking strategic risk into account. Finally, financial institutions should implement appropriate capital policies. They need to clarify capital policies, including those pertaining to sufficient capital levels, dividend payout plans, and the effective use of unrealized gains on securities, and they also need to improve communication with shareholders and a wide range of other stakeholders. The Bank of Japan will support the aforementioned efforts by financial institutions through on-site examinations and off-site monitoring, and will also closely monitor the impact on the financial system of financial institutions' various forms of risk taking from a macroprudential perspective. The Bank will also hold discussions with the relevant parties in order to prepare an institutional framework for the financial system that will serve as an important element for financial institutions in meeting their structural challenges.

Notice

This Report basically uses data available as at end-September 2019.

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 17KB].

Inquiries

Financial System Research Division, Financial System and Bank Examination Department

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