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Financial System Report (April 2022)

April 21, 2022
Bank of Japan

  1. "Highlights" provides a brief summary of key analyses in the April 2022 issue of the Report.

Motivations behind the April 2022 issue of the Report

The April 2022 Report provides a detailed analysis of the risks currently faced by Japanese financial institutions from the following three perspectives: (1) the impact of stress in the real economy brought about by the spread of COVID-19 on credit risk; (2) the risk of global economic and financial shocks, such as an adjustment in global financial markets, affecting financial institutions' overseas lending, securities investment, and foreign currency funding; and (3) developments in vulnerabilities that have been present since before the pandemic.

In the macro stress testing, the resilience of Japan's financial institutions and financial system is 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 affect economic and financial activity at home and abroad.

The Japanese government and the Bank of Japan have been implementing large-scale fiscal and monetary policy measures and taking flexible regulatory and supervisory actions, with the aim to support economic activity and maintain the functioning of financial markets. Profits of firms that have been significantly affected by the pandemic are weak. 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. Financial markets have been nervous, reflecting concerns about a reduction in the degree of monetary easing in the United States and Europe as well as the situation in Ukraine.

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 a resurgence of COVID-19 and a simultaneous rise in U.S. long-term interest rates leading to an adjustment in the real economy and global financial markets. 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, there are three risks that warrant attention.

It is notable that the impact of the situation in Ukraine on Japan's financial system is likely to be limited at this point. However, there is high uncertainty over future developments, and attention should be paid to the possibility that the impact on the financial system will become larger, possibly through an adjustment in global financial markets such as the ones described below.

The first risk is the impact of the pandemic on credit costs of domestic loans. Based on the results of a simulation of firms' financial conditions and financial institutions' credit cost ratio, deterioration in firms' financial conditions and rises in credit costs of domestic loans are likely to be contained on the premise that the economy continues to follow a recovery trend, as firms on the whole have maintained their financial soundness since before the pandemic and various measures to support corporate financing have been highly effective. However, as the impact of the pandemic varies across firms and industries, if there is a delay in the recovery, there is a risk of an adverse impact, particularly on loans to firms that have been significantly affected by the pandemic.

The second is the risk that future global economic and financial shocks, such as an adjustment in global financial markets, will have an adverse impact on Japanese financial institutions' overseas lending, securities investment, and foreign currency funding.

Although credit risk of overseas loans as a whole has been contained, if global economic and financial conditions deteriorate, default rates may rise, particularly among borrowers with low ratings. Moreover, attention needs to be paid to energy-related exposure where the impact of global efforts toward achieving a carbon-neutral economy could strengthen, and to exposure related to air transportation where there is significant uncertainty over the industry's future demand.

Regarding securities investment, with the increasing importance of non-bank financial intermediaries (NBFIs) such as investment funds in global financial intermediation activities, there has been a growing overlap in the securities portfolios of Japanese financial institutions and investment funds, measured by the correlation of market values of the portfolios. As a result, there seems to be a growing possibility that the market risk that Japanese financial institutions face at times of stress is amplified by the activities of NBFIs.

In terms of foreign currency funding, if there is widespread deterioration in financial conditions such as at the time of the market turmoil in March 2020, Japanese banks may face significant stress, possibly accompanied by the widening loan-to-deposit gap. With funding conditions changing, as seen in U.S. interest rate increases in particular, it is necessary to continue to pay attention to financing management while strengthening the foreign currency funding basis.

The third is risks associated with vulnerabilities that have been present since before the pandemic. In recent years, amid the low interest rate environment and structural factors putting downward pressure on profitability, Japanese financial institutions have been active in risk-taking mainly with regard to lending with high leverage, such as lending to domestic middle-risk firms, lending to the real estate industry, and lending related to large-scale M&A deals. Such a picture is unchanged at present, while the overall credit risk has been low.

From a longer-term perspective, attention should be paid to the risk that the low interest rate environment and structural factors continue to exert downward pressure on financial institutions' profits for a prolonged period, leading to 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

Amid uncertainties over domestic and overseas economies such as future developments in the spread of COVID-19 and geopolitical risks, 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 improve their services to achieve a sustainable society while maintaining their soundness, from the perspective of contributing to increasing productivity in Japan.

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 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 2022.

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 26KB].

Inquiries

Financial System Research Division,
Financial System and Bank Examination Department

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