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October 22, 2020
Bank of Japan
Japan's financial system has been maintaining stability on the whole, while COVID-19 continues to have a significant impact on economic and financial activity at home and abroad.
The Japanese government and the Bank of Japan, in close cooperation with overseas authorities, have swiftly implemented large-scale fiscal and monetary policy measures to support economic activity and maintain the functioning of financial markets. With regard to regulation and supervision, flexible actions have been taken to encourage financial institutions to smoothly provide funds necessary to support economic activity. Although corporate and household financing is under considerable stress due to the severe downward pressure on the real economy, the smooth functioning of financial intermediation has been maintained due to financial institutions' robust financial bases both in terms of capital and liquidity as well as such policy and supervisory measures. Financial markets have generally started to regain stability after they were significantly destabilized in March 2020, although they have remained sensitive to uncertainty.
Looking ahead, even in the case where the economic recovery remains very moderate, Japan's financial system is likely to remain highly robust. However, developments in the spread of COVID-19 and their impact on the domestic and overseas economies are subject to considerable uncertainty. Under the severe stress event of the persistently stagnated pace of economic recovery and significant adjustments in financial markets, a deterioration in financial institutions' financial soundness and the resultant impairment of the smooth functioning of financial intermediation could pose a risk of further downward pressure on the real economy. In this regard, the following three risks warrant particular attention. From a macroprudential perspective, it is important to prepare for these risks and do the utmost to ensure the stability of the financial system and the smooth functioning of financial intermediation.
The first risk is an increase in credit costs due to the potentially prolonged economic downturn at home and abroad. In Japan, a rise in defaults will likely be restrained for some time even though substantial declines in corporate sales and profits and an increase in corporate debt have continued. This is because firms have strengthened their financial bases both in terms of capital and cash reserves in recent years and because various measures to support corporate financing have been highly effective. However, if the economic downturn was prolonged, firms could continue to see a decline in their debt servicing capacity. In particular, close attention should be paid to the impact on lending to areas where vulnerabilities accumulated before the COVID-19 outbreak; namely, (1) lending to middle-risk firms with lower returns, (2) lending to the real estate industry, and (3) lending to high-leverage projects related to large-scale merger and acquisition (M&A) deals.
The overall credit quality of the overseas loan portfolios of Japanese banks has remained high. On a more granular level, however, Japanese banks have sizeable exposure to energy-related project finance loans, which are susceptible to a decline in crude oil prices, and to object finance loans for the acquisition of aircraft, which face a decline in global demand. In addition, large exposure to firms with lower profitability has been on an uptrend as Japanese banks have been actively increasing overseas loans. Careful risk management is essential given that the current downturn in overseas economies is more severe than that during the global financial crisis (GFC).
The second risk is a deterioration in gains/losses on securities investment due to substantial adjustments in financial markets. Under the prolonged low interest rate environment in Japan, Japanese financial institutions have been actively taking on market risk, particularly for domestic and overseas credit products and investment funds, to search for yield. As financial markets have started to regain stability, the losses on financial institutions' securities investments have been limited so far. However, there are some cases where unrealized losses on particular products have increased. As uncertainty regarding financial markets remains high, it is necessary to review whether the existing risk management frameworks functioned well under the market adjustments in March 2020 and to push ahead with efforts to enhance the effectiveness of the frameworks.
The third risk is destabilization of foreign currency funding due to the tightening of foreign currency funding markets mainly for the U.S. dollar. Japanese banks have worked to ensure their funding stability by, for example, extending the term of market funding and enhancing corporate client-related deposits as they have expanded overseas loans in recent years. Their efforts as well as the enhancement of the U.S. dollar liquidity swap line arrangements by six central banks helped to prevent major disruptions to foreign currency funding in March even when their foreign currency-denominated loans increased sharply due to the withdrawal of funds from committed lines. As foreign currency funding markets are still vulnerable to shocks, Japanese banks need to make continuous efforts to strengthen their foreign currency funding bases and liquidity management.
Future developments in the spread of COVID-19 and their impact on the domestic and overseas economies remain highly uncertain. Against this backdrop, the major challenge for financial institutions is to smoothly fulfill their financial intermediation function by balancing their financial soundness and risk taking. Careful assessment of the sustainability of the borrowers' businesses, in addition to the provision of swift liquidity support, will become increasingly important. In this respect, providing effective support tailored to the needs of borrowers by assisting with their core business and financing as well as facilitating their business succession, transfer, and restructuring will become more essential. These initiatives will promote more efficient allocation of resources, thereby contributing to an improvement in the productivity and vitality of the national and local economies. Financial soundness is one of the primary foundations for financial institutions to play these roles. (1) Strengthened management of the three risks mentioned above, (2) adequate loan-loss provisioning based on the sustainability of borrowers' businesses, and (3) sound capital planning under considerable uncertainty are the keys to maintaining their financial soundness.
The environment surrounding Japanese society is undergoing major changes, including population declines and aging, digital transformation and working-style reforms, as well as heightened interest in climate change. In the medium to long run, financial institutions are expected to contribute to achieving a sustainable society in the post-COVID-19 era by offering higher value-added financial services. To face the challenges, they need to step up their efforts to enhance operating efficiency and business bases.
The Bank of Japan, in close cooperation with the Japanese government and overseas financial authorities, will make efforts to ensure the stability of the financial system and the smooth functioning of financial intermediation. From a medium- to long-term perspective, the Bank will actively support financial institutions' initiatives by preparing institutional frameworks for the financial system and taking measures to facilitate digital transformation.
This Report basically uses data available as at end-September 2020.
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For details of the stress scenario in the macro stress testing, please see the scenario table [XLSX 17KB].
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