Bank of Japan: Financial System Report (April 2022)

April 21, 2022
Bank of Japan

  1. “Highlights” provides a brief summary of key analyzes in the April 2022 issue of Report.

Motivations behind the April 2022 issue of Report

April 2022 Report provides a detailed analysis of the risks currently facing Japanese financial institutions from the following three perspectives: (1) the impact of real-economy strains caused 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) the evolution of vulnerabilities that have been present since before the pandemic.

In the macro stress tests, the resilience of Japan’s financial institutions and financial system is examined under two downside scenarios that reflect the risks revealed by analysis of the real economy and financial markets.

Summary

Current assessment of the stability of the Japanese financial system

Japan’s financial system has maintained overall stability as COVID-19 continues to affect economic and financial activity at home and abroad.

The Japanese government and the Bank of Japan have implemented large-scale fiscal and monetary policy measures and taken flexible regulatory and supervisory measures, with the aim of supporting economic activity and keeping financial markets functioning. Earnings for companies that have been hit hard by the pandemic are weak. However, underpinned by the financial strength of financial institutions as a whole, policy responses have been effective and the financial intermediation function is being performed smoothly. Financial markets were 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

Based on macro stress test results, Japan’s financial system is expected to remain very robust even in the event of a resurgence of COVID-19 and a simultaneous rise in US long-term interest rates causing the economy to adjust. real and global financial markets. However, in the event of a substantial and rapid adjustment in global financial markets, a deterioration in the financial soundness of financial institutions and the consequent deterioration in the smooth functioning of financial intermediation could pose a risk of further downward pressure on real economy. In this regard, three risks deserve attention.

It should be noted that the impact of the situation in Ukraine on the Japanese financial system should be limited at this stage. However, future developments are highly uncertain and attention should be paid to the possibility that the impact on the financial system will amplify, possibly due to an adjustment in global financial markets such as those described below.

The first risk is the impact of the pandemic on the credit costs of domestic loans. Based on the results of a simulation of the financial conditions of enterprises and the cost of credit ratio of financial institutions, the deterioration of financial conditions of enterprises and the increase in credit costs of domestic loans should be contained in the assumption where the economy continues to follow a trend recovery, as businesses have generally maintained their financial strength since before the pandemic and various measures to support business financing have been very effective. However, as the impact of the pandemic varies across businesses and sectors, if there is a delay in the recovery, there is a risk of a negative impact, especially on corporate lending which has been heavily impacted. by the pandemic.

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

Although the credit risk of overseas lending as a whole has been contained, if global economic and financial conditions deteriorate, default rates could increase, particularly among low-rated borrowers. In addition, attention should be given to energy-related exposure, where the impact of global efforts to achieve a carbon-neutral economy could be strengthened, and to air transport-related exposure, where there is significant uncertainty about future industry demand.

With respect to securities investment, with the growing importance of non-bank financial intermediaries (NBFIs) such as investment funds in global financial intermediation business, there has been an increasing overlap in portfolios securities of Japanese financial institutions and investment funds, measured by the market value correlation of the portfolios. As a result, it seems increasingly possible that the market risk that Japanese financial institutions face in times of crisis will be amplified by the activities of NBFIs.

In terms of foreign exchange funding, in the event of a general deterioration in financial conditions, such as during the market turmoil in March 2020, Japanese banks could face significant stress, possibly accompanied by a widening of the spread between loans and deposits. With changing funding conditions, as evidenced by interest rate hikes in the US in particular, there is a need to continue to pay attention to funding management while strengthening the foreign currency funding base.

The third relates to risks associated with vulnerabilities that have been present since before the pandemic. In recent years, in an environment of low interest rates and structural factors putting downward pressure on profitability, Japanese financial institutions have been active in taking risks, mainly in high-impact loans. leverage, such as medium-risk domestic corporate loans, loans to the real estate sector, and loans related to large-scale M&A transactions. Such a picture is unchanged at present, while overall credit risk has remained low.

From a longer-term perspective, attention should be paid to the risk that the low interest rate environment and structural factors will continue to exert downward pressure on the earnings of financial institutions for an extended period, causing a gradual decline in financial intermediation, or on the contrary, to the possibility that the vulnerability of the financial system will increase, mainly due to the search for yield behavior of financial institutions.

Challenges for financial institutions

In a context of uncertainties about domestic and foreign economies such as the future evolution of 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 strength and their risk-taking. In this regard, (1) strengthened management of the three risks mentioned above, (2) support based on the sustainability of borrowers’ businesses and (3) good capital planning in conditions of considerable uncertainty are the keys. maintaining their financial strength.

In Japan, the environment surrounding its economy and society is undergoing major changes, for example, digital transformation and climate change, amid population decline and aging. In this context, financial institutions are expected to improve their services to achieve a sustainable society while maintaining soundness, with a view to contributing to increased productivity in Japan.

The Bank of Japan, in close cooperation with the Japanese government and foreign financial authorities, will endeavor to ensure the stability of the financial system and the smooth operation of financial intermediation. From a medium to long-term perspective, the Bank will actively support the initiatives of financial institutions by taking measures to address climate-related financial risks and by facilitating digital transformation.

Notice

This Report essentially uses data available at the end of March 2022.

Please contact the Department of Financial System and Banking Examinations at the email address below to request prior permission when reproducing or copying the contents of this Report for commercial purposes.

Please cite the source when quoting, reproducing or copying the contents of this Report for non-commercial purposes.

Regarding the economic and financial variables of each stress scenario in the macro stress testing, please see the scenario board [XLSX 26KB].

Requests

Financial System Research Division,
Financial System and Banking Examinations Department

Email: post.bsd1@boj.or.jp


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Don F. Davis