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Bank of Japan : Financial System Report (Oct. 2013)

10/23/2013 | 04:02am US/Eastern

October 23, 2013
Bank of Japan

Comprehensive assessment of the financial system

Japan's financial system as a whole has been maintaining stability.

Judging from developments in financial markets and financial institutions' behavior, there is no indication warning of financial imbalances such as excessively bullish expectations. Volatility increased in each market after fiscal 2013 began, but the increase in volatility remains limited compared with that seen in previous stress periods.

Capital bases of financial institutions such as banks and shinkinbanks have on the whole been adequate in terms of capital adequacy ratios based on the regulatory requirements and capital relative to the amount of risk they bear. These institutions also have sufficient funding liquidity. Thus, with adequate capital bases and funding liquidity, they have generally strong resilience against various economic and financial shocks, including a significant economic downturn and a substantial rise in interest rates. Even if interest rates rose substantially without any improvement in economic activity, the stability of Japan's financial system would basically be maintained. However, attention should be paid to the possibility that the impacts of an interest rate rise will exceed those estimated under the assumptions, depending on the speed and extent of the rise in interest rates and the factors behind it. Some financial institutions have relatively weak capital bases, and are behind the curve in improving asset quality following the Lehman shock. Because their capital adequacy ratios may plunge in the wake of significant economic and financial shocks, they need to steadily strengthen their capital.

Financial intermediation has operated more smoothly than it did at the time of the previous Report. Specifically, financial conditions among firms and households have become more accommodative since the Bank's introduction of QQE. Financial institution lending has gradually grown, and financial intermediation through financial markets has been prevalent, as seen in the issuance of corporate bonds and equity financing.

In these circumstances, financial institutions' core profitability has remained on a downtrend, mainly due to the continued narrowing of interest rate spreads on loans. This does not immediately threaten the stability of the financial system and the functioning of financial intermediation, but the declining trend in core profitability is a challenge that should be resolved in the medium to long term.

Overview (summary of Chapters II to VI) Chapter II: Examination of the external environment

In the global financial markets and overseas economies, concerns over the European debt problem and over the effects of U.S. fiscal austerity that heightened in the first half of 2013 subsided somewhat compared with the situation at the time of the previous Report. On the other hand, expectations emerged of the U.S. Federal Reserve tapering asset purchases early and heightened subsequently. Due in part to the heightened expectations, concerns intensified over a possible rise in interest rates worldwide and over an outflow of funds from financial markets in emerging countries. Positive signs are now being seen in economic activity in Japan. Against this background, financial conditions among firms have generally improved, and the employment and income situation in the household sector has also shown some improvement. In these circumstances, households slightly raised their ratio of risky assets including investment trusts. Nonetheless, the financial strength of some small and medium-sized firms remains weak.

Chapter III: Examination of financial intermediation -- focusing on developments after introduction of quantitative and qualitative monetary easing

Financial conditions among firms and households have become more accommodative than they were at the time of the previous Report. Financial intermediation through financial markets -- such as corporate bond issuance and equity financing -- has become prevalent. The outstanding amount of Japanese government bond (JGB) holdings has decreased at financial institutions such as banks and shinkinbanks, as the Bank's JGB purchases under QQE expanded. On the other hand, there has been an overall expansion in the assets of financial institutions due to increases in the outstanding amount of current accounts held at the Bank, lending, and overseas assets. Lending increased, particularly to large firms, and that to small and medium-sized firms remained generally sluggish. However, some positive developments can be observed recently in lending to small and medium-sized firms. No major changes have been seen in investment of insurance companies.

Chapter IV: Risks observed in financial markets

In the Japanese government bond, stock, and foreign exchange markets, volatility temporarily increased after fiscal 2013 began. However, the increase in volatility remains limited compared with that observed in previous stress periods such as at the time of the Lehman shock. The rise in long-term interest rates in Japan since spring 2013 has been limited compared with that seen in the United States and Europe. Since June 2013 in particular, JGB yields have been notably stable while overseas yields have moved up on the whole. This has been partly due to the tightening of supply and demand conditions in the JGB market prompted by the Bank's large-scale JGB purchases as concerns over fiscal imbalances have not appeared to heighten. Stock prices have become stable, but are still subject to somewhat large fluctuations.

Chapter V: Risks borne by financial intermediaries

The capital bases of financial institutions such as banks and shinkinbanks have on the whole been adequate in terms of capital adequacy ratios based on the regulatory requirements and capital relative to the amount of risk they bear. Their capital has been enhanced, partly due to the accumulation of retained earnings. The amount of risk borne by financial institutions has been restrained because of reduced credit and interest rate risks. The amount of interest rate risk remained on a rising trend, but has started declining since the beginning of fiscal 2013. The decline in the amount of credit risk partly reflects continued improvement in the quality of financial institutions' assets. However, some financial institutions are behind the curve in improving their asset quality. It should be noted that some financial institutions have weak capital bases relative to the amount of risk they bear, including risks other than credit and interest rate risks. Financial institutions' core profitability has remained on a downtrend. Meanwhile, they have sufficient funding liquidity.

Chapter VI: Risk assessment of the financial system from a macroeconomic perspective

Most financial risk indicators do not show any signs of overheating that should be noted from a macroeconomic perspective. The results of macro stress testing indicate that financial institutions would be able to maintain a sufficient level of capital even if a significant economic downturn occurred or interest rates rose substantially without any improvement in economic activity. Nevertheless, a rise in interest rates may cause drastic changes in, for example, financial institutions' net interest income and investment behavior and the burden of debt repayments on firms and households, depending on the speed and extent of the rise in interest rates and the factors behind it. These changes may have greater impacts on financial institutions' profits and capital than those estimated under the macro stress testing assumptions. Furthermore, it should be noted that if significant economic and financial shocks occurred, capital adequacy ratios may plunge at financial institutions with weak capital bases relative to the amount of risk they bear. On the funding liquidity side, financial institutions have sufficient liquid assets to see themselves through stress events such as deposit outflows continuing for a certain period and a decline in the functioning of financial markets.

Notice

This Reportbasically uses data available as of September 30, 2013.

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 Reportfor commercial purposes.

Please credit the source when quoting, reproducing, or copying the contents of this Reportfor non-commercial purposes.

Inquiries

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

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