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Financial System Report (April 2021)

April 20, 2021
Bank of Japan

Motivations behind the April 2021 issue of the Report

The April 2021 Report provides a detailed analysis of two major risks: domestic credit risk and securities investment risk, and then uses a stress testing framework to examine the robustness of Japan's financial system. On the domestic credit risk stemming from the spread of COVID-19, this Report presents a simulation of SMEs' financial soundness that incorporates the following features, which are currently observed in Japan's economy: (1) the challenges facing firms are gradually shifting from a short-term liquidity issue to a medium- to long-term solvency issue, and (2) the impact of the pandemic significantly varies not only across firm sizes and industries but also among firms in the same industry. On the securities investment risk, this Report examines how the growing presence of non-bank financial intermediaries (NBFIs), e.g., investment funds, in the global financial system changes the risk profiles of Japan's financial institutions, in light of the experience in March 2020, when the global financial market suddenly became volatile. Then, in the macro stress testing, the resilience of Japan's financial institutions and the financial system are examined under two downside scenarios that reflect risks revealed from the analysis on the real economy and on the financial markets.

Executive summary

Current assessment of the stability of Japan's financial system

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, swiftly implemented large-scale fiscal and monetary policy measures and took flexible regulatory and supervisory actions to support economic activity and maintain the functioning of financial markets. Firms that are significantly affected by the spread of COVID-19 experience funding difficulties. However, underpinned by the financial soundness of financial institutions on the whole, the policy responses have been effective and the financial intermediation function is being fulfilled smoothly. In financial markets, investors' risk sentiment has improved and inflows of funds to the stock market and emerging market economies have been increasing rapidly.

Future risks and caveats

According to the results of the macro stress testing, even in the case of future resurgence of COVID-19, Japan's financial system is likely to remain highly robust as financial institutions have improved their financial soundness after the global financial crisis (GFC). However, in the event of a substantial and rapid adjustment in global 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. The first risk is an increase in credit costs due to a delay in economic recovery at home and abroad. According to a simulation that takes into account that firms' challenge is gradually shifting from securing funds to repaying debts, credit risk of domestic loans will be contained when the economy follows a recovery trend. Underpinned by the fact that firms on the whole have maintained their financial soundness, various measures to support corporate financing seem to be highly effective in restraining that risk. However, as the impact of COVID-19 significantly varies across firms and industries, if there is a delay in the recovery, there is a risk of an adverse impact on the creditworthiness of loans to firms that are significantly affected by COVID-19 and of loans embedded vulnerabilities since before the outbreak. Regarding the vulnerabilities, attention should be paid to the developments in the changing conditions in the real estate market, which is closely related to financial institutions' businesses, and in the profits of borrowers with a large amount of borrowings that significantly increased their leverage in relation to merger and acquisition (M&A) deals.

Credit risk of overseas loans is generally contained, as the amount of Japanese banks' overseas loans to industries that are severely affected by COVID-19 are not so large. Nevertheless, attention regarding energy-related exposure needs to be paid to the possibility of a significant decline in crude oil demand in the long run, as the impact of global efforts toward achieving a low carbon economy is likely to strengthen. Exposure related to air transportation also deserves attention as there is significant uncertainty over the industry's future demand.

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 investing, particularly in domestic and overseas credit products and investment trusts, to search for yield. Meanwhile, the importance of non-bank financial intermediaries (NBFIs) such as investment funds in financial intermediation activities has been growing in the global financial system. An analysis on structural changes in the cross-border network mediated through securities investment shows that the impact of foreign investment funds' transactions on the prices of Japanese financial institutions' securities portfolios has been increasing. This suggests that, due to a growing interlinkage between the Japanese and overseas financial systems, the market risk that Japanese financial institutions face at times of stress is amplified by the activities of overseas NBFIs.

The third risk is a destabilization of foreign currency funding due to the tightening of foreign currency funding markets, mainly for the U.S. dollar. During the March 2020 market turmoil, foreign currency-denominated loans of Japanese banks increased sharply due to the withdrawal of funds from their committed lines. At the same time, some difficulties were observed temporarily in their market funding of foreign currency. Japanese banks' recent efforts to stabilize their funding, as well as the effect of an enhancement of the U.S. dollar liquidity swap line arrangements by six central banks, helped to prevent major disruptions in their foreign currency funding. Based on the lessons learned from the experience of the March 2020 market turmoil, the shift in their focus of attention from securing the stability of their foreign currency funding to cost reductions requires continued vigilance, as the improvement in the profitability of overseas operations is becoming an increasingly important management challenge for Japanese banks.

Even after the pandemic subsides, it is likely that the low interest rate environment and structural factors will continue to exert downward pressure on financial institutions' profits. Against this backdrop, attention should be paid to the risk of a gradual pullback in financial intermediation, or on the contrary, to the possibility that the vulnerability of the financial system increases, mainly as a result of financial institutions' search for yield behavior.

Challenges for financial institutions and actions by the Bank of Japan

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. In this regard, (1) strengthened management of the three risks mentioned above, (2) offering support and 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.

In Japan, the environment surrounding its economy and society is undergoing major changes, e.g., digital transformation and climate change, amid the decline in and aging of the population. Against this background, financial institutions are expected to contribute to achieving a sustainable society in the post-COVID-19 era by improving their services while maintaining their soundness.

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. As part of such efforts, the Bank will facilitate the strengthening of business foundations of regional financial institutions through the Special Deposit Facility to Enhance the Resilience of the Regional Financial System. From a medium- to long-term perspective, the Bank will actively support financial institutions' initiatives by preparing institutional frameworks for the financial system, by taking measures to respond to climate-related financial risks, and by facilitating digital transformation.

Notice

This Report basically uses data available as at end-March 2021.

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] .

Inquiries

Financial System Research Division,
Financial System and Bank Examination Department

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