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Financial System Report (March 2010)

-- Global Financial System Moving Towards Stabilization and Balance-Sheet Problem in the United States and Europe
-- Improvement in Financial Markets and Sluggish Demand for Funds
-- Kindling Credit Risk and Looming Interest Rate Risk
-- Towards the Stability of the Financial System

March 2010
Bank of Japan

The Current State of Japan's Financial System and Challenges: An Overview

Assessment of the current state of Japan's financial system

The global financial system has emerged from the critical situation that began in the autumn of 2008. It is now moving towards stabilization, with profits of major financial institutions in the United States and Europe recovering against the backdrop of improvement in their funding conditions in the financial markets. In this circumstance, Japan's financial system has remained stable as a whole. Increased credit costs and losses due to impairment in stockholdings reflecting the rapid drop in the level of economic activity and the decline in asset prices have been easing off. Recently, Japanese banks have taken measures that contribute to enhancing the stability of Japan's financial system, such as strengthening their capital bases through capital increase and reducing market risk associated with stockholdings.

However, the move towards stabilization of the global financial system has largely been underpinned by various policy measures. The balance-sheet adjustment notably in the household sector still continues in the United States and Europe. Bank lending has been declining. Concerns over sovereign risk have emerged in the international financial markets. Owing to these developments, attention is warranted because the global financial system remains weak.

As for Japan's financial system, while credit costs have been suppressed so far, the loan quality has been deteriorating. Market risk associated with stockholdings is still high at banks. Interest rate risk is looming as the result of increases in long-term investment. In this situation, Japan's financial institutions need to make continuous efforts to improve their risk management and strengthen their capital bases, while properly assessing their risk-return balance.

Financial intermediation function

Since the outbreak of the global financial crisis, growth in bank loans in the United States and Europe has been consistently declining. In contrast, bank loans in Japan significantly increased towards the beginning of 2009 against the backdrop of the decline in firms' sales and the shrinkage of CP and corporate bond markets. Since then, bank loans have started to decline because demand for funds for financing capital investment has decreased and the issuance of corporate bonds has increased. On the whole, the financial intermediation function of Japan's financial system has been maintained while bank lending, depending on the situation, has partly complemented the role played by the financial markets.

The improvement in firms' funding since the beginning of fiscal 2009 is not only due to an improvement in sales but mainly due to the firms' retrenchment. The capacity utilization rate, while it is rising, has not reached a level sufficiently above the break-even point. Although policy measures such as the government's emergency guarantee program have supported the funding of small and medium-sized firms, smaller firms still face severe financing conditions. Going forward, careful attention is warranted as to whether financial institutions can continue to appropriately perform their financial intermediation function.

Robustness of the financial system

Japanese banks' risks relative to Tier I capital have decreased somewhat as a whole since the beginning of fiscal 2009. Funding liquidity risk has been restrained in terms of not only yen currency but also foreign currencies against the backdrop of improving functioning in the global financial markets since the spring of 2009. As for the outlook, banks' capital bases are not likely to decline substantially as a whole, even if credit costs rise and stock prices stagnate under the severer macroeconomic conditions. Thus, the robustness of Japan's financial system has been maintained on the whole. Nevertheless, the capital adequacy ratios might stay at low levels at banks whose profitability and capital strength are relatively weak. Owing to such concerns, some degree of weakness still remains in Japan's financial system.

Looking at the prospect of the financial intermediation function as implied from the robustness analysis of the financial system, it should be noted that banks' cautious stance in their risk-taking could constrain real economic activity in a situation where their capital bases decline as a whole under the severer macroeconomic conditions.

Profitability of Japan's banking sector

Japanese banks face two challenges in terms of their profit structure: low profitability and large fluctuations in profits. Profitability of Japanese banks remains far below that of the U.S. and European banks, mainly due to low interest margins on loans. Large fluctuations in banks' profits are attributable to changes in credit costs and realized gains/losses on stocks. It should be noted that the profitability of Japanese firms is also far below that of their counterparts overseas. Banks' low profitability is thus paired with firms' low profitability.

Going forward, in the course of the Japanese economy's search for a new growth path, Japanese banks are expected to provide financial services depending on the characteristics of their client firms, by discerning the prospective development of each firm. In the long run, the provision of such financial services will promote an efficient allocation of economic resources and strengthen the profit bases on the part of firms as well as banks, thereby contributing to ensuring the stability of Japan's financial system.


This Report basically uses data available as of January 31, 2010.

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Financial System Research
Financial Systems and Bank Examination Department, Bank of Japan
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