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Financial System Report (October 2021)

October 21, 2021
Bank of Japan

  1. "Highlights" provides a brief summary of key analyses in the October 2021 issue of the Report.

Motivations behind the October 2021 issue of the Report

The October 2021 Report provides a detailed analysis of the following major risks: domestic credit risk as well as risks associated with securities investment and foreign currency funding, 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 financial soundness of small and medium-sized enterprises (SMEs) while taking details of the degree of heterogeneity in corporate profits across firms into account, and considering that the challenges facing firms are gradually shifting from a financing issue to a solvency issue. On the risks associated with securities investment and foreign currency funding, this Report examines the transmission effects of an adjustment in global financial markets on securities investment and funding conditions faced by Japanese financial institutions, while taking into account implications brought to light by the degree of overlap between securities portfolios of individual financial institutions and those of non-bank financial intermediaries (NBFIs), and by differences in funding profiles across financial institutions.

In the macro stress testing, the resilience of Japan's financial institutions and the financial system is examined under three 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 pandemic 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, with risk sentiment remaining favorable on the whole, there have been continuing inflows of funds to the stock market and emerging market economies.

Future risks and caveats

According to the results of the macro stress testing, Japan's financial system is likely to remain highly robust even in the case of future resurgence of COVID-19 or adjustment in global financial markets and emerging economies due to a rise in U.S. long-term interest rates. 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. A simulation of the impact of the pandemic on corporate financing and firms' debt repayment capacity suggests that 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 the pandemic 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 the pandemic and of loans' embedded vulnerabilities since before the outbreak. In this regard, attention should also be paid to the developments in the real estate industry, which had increased its lending since before the pandemic, and in the profits of borrowers with a large amount of borrowings that significantly increased their leverage.

Credit risk of overseas loans is generally contained as overseas economies recover on the whole. Nevertheless, there are signs of deterioration in some portfolios that seem to be severely affected by the pandemic. Moreover, attention needs to be paid to energy-related exposure where the impact of global efforts toward achieving a low-carbon economy could strengthen, and to exposure related to air transportation where 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. In recent years, there has been a growing overlap in the securities portfolios of Japan's financial institutions and investment funds, measured by the correlation of market values of the portfolios, and there seems to be a growing possibility that the market risk that Japanese financial institutions face at times of stress is amplified by not only their investment behavior but also the activities of NBFIs. The analysis in this Report shows that financial institutions with a higher degree of overlap with investment funds tend to be affected much more by shocks in global financial markets.

The third risk is a destabilization of foreign currency funding due to the tightening of foreign currency funding markets. With Japan's financial institutions having expanded their foreign currency assets, there were stress events such as the market turmoil in March 2020, where financial institutions were forced to change their funding instruments significantly. According to an analysis of the determinants of foreign currency funding instruments and their funding rates, funding conditions are not only affected significantly by changes in global market conditions such as in interest rates and redemption rates of investment funds but also depend on financial institutions' funding profiles, including the degree to which funding counterparties are diversified. With the future risk of an adjustment in global financial markets in mind, attention should continue to be paid to the foreign currency funding basis and financing management.

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

Future developments in the spread of COVID-19 and their impact on the domestic and overseas economies remain 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 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 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. 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-September 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.

With regard to economic and financial variables of each stress scenario in the macro stress testing, please see the scenario table [XLSX 28KB].

Inquiries

Financial System Research Division,
Financial System and Bank Examination Department

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