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April 17, 2019
Bank of Japan
This April 2019 issue of the Report provides analyses with a particular focus on the following four areas.
First, this issue provides an analysis and assessment of financial stability risks related to the real estate market from a wide range of perspectives, with the bubble period in mind as a base of comparison. The motivation is that the real estate loans to GDP ratio in the heat map has turned "red," which means a large deviation from the trend in the direction of overheating.
Second, to understand the reasons behind the decline in profitability of Japan's regional financial institutions, this issue provides a comparative analysis of the profit structures of Japan's and European financial institutions, both of which are experiencing a low-interest rate environment. Moreover, the potential vulnerabilities of Japan's financial institutions are quantitatively assessed by using stock market information, which reflects the collective view of market participants on these institutions' future profitability.
Third, in addition to regular stress testing that assumes immediate realization of a risk, this issue includes stress testing that extends the simulation period and assumes that a stress event occurs in 5 years' time. The aim of this scenario is to quantitatively examine what would happen to financial stability if the already prolonged declines in regional financial institutions' profitability and capital adequacy ratios were to continue at the same pace into the future.
And fourth, the boxes of this issue provide analyses of the systemic importance and digitalization of major financial institutions, which could have significant impacts on financial stability. The former analysis takes up the issue of global financial connectedness and resonance, which is a reflection of financial institutions' systemic importance. The latter analysis outlines the current status of financial institutions' digitalization efforts and the recent rapid progress of a wide range of cashless payment initiatives.
Financial intermediation, particularly bank lending, has continued to be active on the back of monetary easing by the Bank of Japan. In the domestic loan market, loan interest rates have been hovering near historically low levels and loans outstanding have continued to grow at a year-on-year rate of around 2.5 percent. Lending to large firms related to merger and acquisition (M&A) deals has increased, and business fixed investment-related lending to small firms has also increased across a wide range of industries. In the CP and corporate bond market, fund-raising by large firms has been increasing on the whole as issuance rates have hovered at extremely low levels. In global financial markets, stock prices and credit market spreads had previously shown temporary instability reflecting heightened uncertainty over the global economy, but they have recently started to calm. Against this background, Japanese financial institutions have maintained upward momentum in their overseas exposure, particularly through lending and investment in overseas credit products such as highly rated collateralized loan obligations (CLOs) and investment-grade corporate bonds.
Under these financial intermediation activities, the funding conditions for firms and households have been highly accommodative. Against this background, the expansion in the financial cycle has continued as the total credit to GDP ratio has deviated upward from its trend. However, financial and economic activities as a whole have shown no signs of overheating as observed during the bubble period in the late 1980s. That said, rapid growth of the outstanding amount of real estate loans has continued and a deviation of the real estate loans to GDP ratio from its trend has marked a record high for the post-bubble period. Based on information from a wide range of sources, including information about changes in land prices, Japan's real estate market cannot be judged as experiencing overheating. However, the following possible vulnerabilities of the real estate market warrant close attention: (1) the increase in loans has been mainly driven by those to small firms and rental housing businesses run by individuals; (2) the financial institutions that have been active in extending such loans tend to have relatively low capital adequacy ratios; and (3) in addition to lending, financial institutions have increased equity-type investment in real estate investment trusts (REITs) and real estate investment funds. Moreover, regional financial institutions, which are important for their support of firms and the general economy in their region, have been actively extending loans to middle-risk firms with relatively low creditworthiness. For such loans, however, regional financial institutions have continued to face difficulty in securing profit margins commensurate with the risks involved. It is thus necessary to pay attention to the vulnerability of financial institutions to a future rise in credit costs. The expansion in the financial cycle has supported the current overall economic expansion. 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.
With respect to international finance, Japanese financial institutions have generally maintained a high quality of overseas loans' portfolios, but have shown some increase in lending to relatively high-risk firms amid the intensified competition with overseas financial institutions and higher foreign currency funding costs. Moreover, Japanese financial institutions have become more active in risk taking in securities investment by increasing their holdings of overseas credit products and investment trusts. Consequently, they have become exposed to more diverse and complex market risks. Therefore, it should be noted that these financial institutions have become more susceptible to the impact of a widespread repricing of risky assets stemming from a possible downturn in the global economy.
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 during tail events like the failure of Lehman Brothers (the Lehman shock).
However, the profitability of domestic deposit-taking and lending activities, which are the core financial intermediation functions, has continued to decline. This seems to be mostly caused by structural factors such as the decrease in growth expectations and the secular decline in loan demand associated with the shrinking population, as well as the prolonged low interest rate environment. In response to the decline in domestic business profitability, major financial institutions have aggressively expanded their global activities and pursued group-wide strategies to provide comprehensive financial services, resulting in an increase in their systemic importance and global financial connectedness. Regional financial institutions have become more active in domestic lending to middle-risk firms and the real estate industry, as well as in securities investment. However, as they have generally not been able to secure profits commensurate with the increase in risk-weighted assets, their capital adequacy ratios and stress resilience have declined moderately. Should this situation persist, downward pressure on the real economy from the financial system could intensify in the event of stress, as the capital of financial institutions would decrease substantially due to increased credit costs and securities-related losses.
In order for the financial system to maintain stability into the future, financial institutions need to address the following four business challenges. First, financial institutions should strengthen efforts to raise their profitability. Specifically, they need to (1) set their loan interest rates commensurate with the risks involved, (2) increase profits derived from fees and commissions by providing consulting and advisory services to firms and services supporting households' wealth management, and (3) drastically increase their business efficiency. 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 increased their risk taking. Regional financial institutions need to strengthen their risk management in response to the increases in their lending to middle-risk firms and the real estate industry and in their investment through the purchases of investment trust products. Major financial institutions need to ensure a solid financial base in accordance with their systemic importance and conduct business management on a global and group-wide basis. Third, financial institutions should adapt to digitalization. In Japan, a wide range of cashless payment initiatives have been making progress and an increasing number of financial institutions have been making use of open application programming interfaces (APIs), artificial intelligence (AI), and cloud computing. Financial institutions need to make clear policies regarding the use of digital technology and establish frameworks for cyber security and data protection accordingly. Finally, financial institutions should implement appropriate capital policies, including those pertaining to sufficient capital levels, dividend payout plans, and the effective use of unrealized gains on securities. The Bank of Japan will support financial institutions' efforts 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.
This Report basically uses data available as at end-March 2019.
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For details of the stress scenario in the macro stress testing, please see the scenario table [XLSX 18KB].
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