Financial System Report (April 2020)
April 21, 2020
Bank of Japan
Motivations behind the April 2020 issue of the Report
Since late February 2020, the global outbreak of the coronavirus disease 2019 (COVID-19) has been influencing global financial markets and the real economy significantly. Against this backdrop, this April 2020 issue of the Report discusses current developments and issues that warrant close vigilance going forward regarding the effects and risks of the outbreak for Japan's financial stability, bearing in mind the financial vulnerabilities that had accumulated before the outbreak.
Assessment of the stability of Japan's financial system and discussion of future challenges
The global outbreak of the coronavirus disease 2019 (COVID-19) has been exerting very substantial downward pressure on the global economy and has been destabilizing global financial markets. There have been a large decline in stock prices across countries, adjustments in U.S. and European credit markets that had been expanding, a tightening of the key-currency U.S. dollar funding markets, fund outflows from emerging market economies, and a plummet in the crude oil prices. Facing a sudden erosion in sales and profits, firms around the world have increased demand for funds, while financial institutions' credit costs are likely to increase due to an economic downturn. As a result, financial institutions' capital and liquidity have come under intense pressure.
To address this situation, governments and central banks, working in close coordination, have implemented powerful fiscal and monetary policy measures to support economic activity and corporate financing and to maintain the functioning of financial markets. In terms of regulation and supervision, flexible actions have been taken such as the deferral of full implementation of the finalized Basel III standards by one year and the encouragement of banks to use their capital and liquidity buffers. Owing to these actions, a large-scale credit contraction in the global financial system has been avoided so far.
Despite undergoing great stress, Japan's financial system has been maintaining stability on the whole and continues to provide the funds essential for economic activities. This owes to the fact that (1) financial institutions have considerable resilience in terms of both capital and liquidity, as examined in the analyses including macro stress testing in previous issues of the Report, (2) the Japanese government and the Bank of Japan have implemented swift and powerful policy measures, and (3) Japanese firms on the whole have maintained robust financial bases both in terms of retained earnings and cash availability.
Future risks and caveats
Nevertheless, significant uncertainty remains about future developments regarding the global spread of COVID-19 and the resulting magnitude and duration of downward pressure on the real economy.
The currently observed stress on the financial system originates from the shock to the real economy caused by the wide range of constraints on people's physical activities due to the disease outbreak. Thus, the nature of the current stress significantly differs from stresses in the past caused by the bursting of bubbles triggered by and resulting in the adjustment of financial imbalances. It should be noted, however, that domestic and overseas financial systems had accumulated various vulnerabilities due to the search for yield under the prolonged low interest rate environment, even before the outbreak of COVID-19. Should the substantial deterioration in the real economy be prolonged, full-fledged financial adjustments through such vulnerabilities could give rise to a negative feedback loop between the real economy and the financial sector. Based on these observations, the following three risks to Japan's financial stability warrant close attention.
The first risk is that credit costs could increase due to an economic downturn at home and abroad. Should the impact on the real economy be protracted, problems stemming from tightened liquidity conditions could turn into solvency problems for an increasing number of firms at home and abroad. Under the prolonged low interest rate environment, Japanese financial institutions have increased domestic loans to middle-risk firms, loans to rental real estate businesses, and loans related to high-leverage projects such as large-scale merger and acquisition (M&A) deals. In term of overseas loans, Japanese financial institutions have increased loans to firms with relatively low creditworthiness including in energy-related sectors. These loans seem generally vulnerable to an economic downturn. The second risk is that gains/losses on securities investment could deteriorate due to substantial adjustments in financial markets. In recent years, large financial institutions have been increasing their overseas credit investment while regional financial institutions have been increasing their holdings of investment trusts, which are subject to various risks. The third risk is that foreign currency funding might be destabilized due to the tightening of foreign currency funding markets mainly for the U.S. dollar. Financial institutions in recent years have expanded stable funding sources such as client-related deposits to fund increased overseas lending and securities investment. However, they still depend on market funding to a non-negligible extent. Should their foreign currency funding become unstable, this could lead to a deterioration in their gains/losses on overseas business through, for example, the unwinding of overseas positions. The second and third risks mean that risks can propagate more easily between overseas and Japan's financial systems.
Japanese financial institutions have remained highly resilient even under the current stress. In addition, the powerful policy actions by the Japanese government, the Bank of Japan, and overseas authorities should provide economic and financial support to protect against the materialization of these risks. Thus, Japan's financial system remains and will remain stable, although close vigilance is required regarding future developments.
Challenges for financial institutions and actions by the Bank of Japan
For the time being, with the COVID-19 outbreak exerting considerable stress on the financial sector and economic activity both at home and abroad, financial institutions face a challenge in supporting economic activity by smoothly fulfilling their financial intermediation function while maintaining their own financial soundness. Once the disease subsides, financial institutions have an important role to play in providing support to firms to help them improve their business conditions and aid the economic recovery in general.
From a longer-term perspective, financial institutions also face challenges with regard to structural issues such as the prolonged low interest rate environment, the population decline, and excess savings in the corporate sector, the nature of which might be affected by changes in economic activity and corporate behavior due to the COVID-19 outbreak. With the persisting downward pressure on profits in domestic deposit-taking and lending activities, (1) large financial institutions need to improve their governance in response to their systemic importance, which has been increasing through the expansion of their global operations. (2) It is increasingly important for regional financial institutions to establish business models that enable them to secure profits by contributing to the revitalization of regional economies. (3) A shared challenge for major banks and regional financial institutions is the need to strengthen their capabilities of risk management in areas where they actively take risks by learning from the lessons of the ongoing stress. Furthermore, (4) financial institutions need to make steady efforts to address risks and opportunities that arise from medium- to long-term changes in the business environment springing from digitalization and climate change.
The Bank of Japan, in close coordination with the Japanese government and overseas financial authorities, will do its utmost amid the spread of COVID-19 to ensure financial stability and provide full support for the smooth functioning of financial intermediation by financial institutions. From a medium- to long-term perspective, the Bank will actively encourage financial institutions' efforts to address the above four challenges.
This Report basically uses data available as at end-March 2020.
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 16KB] .
Financial System Research Division,
Financial System and Bank Examination Department
E-mail : email@example.com