The BOJ (Bank of Japan) has identified three main risks to the stability of the Japanese financial system – rising credit costs, investment losses and foreign currency funding risks.
According to the BOJ, if the current economic downturn is prolonged, an increasing number of companies – both at home and abroad – could face solvency issues and higher credit costs, leading to bad loans. In particular, the central bank has flagged risks associated with increased lending to middle-risk borrowers, real estate businesses, high-leverage projects such as M&A deals, and overseas energy companies hit by falling oil prices.
Additionally, banks could experience “deteriorating” losses on their securities investments due to “substantial adjustments” in financial markets. While investment losses to date have been largely offset by bond gains driven by interest rate cuts, there is now less room for further rate cuts in overseas markets, the BOJ says.
There are also risks that foreign currency funding could destabilise, though the BOJ says these risks have lessened due to swap lines provided by the US Federal Reserve.
The warnings in the BOJ’s latest Financial System Report, which also highlighted the resilience of the financial system to the economic slump, in terms of capital and liquidity, supported by “swift and powerful” policy measures from the government.
“Japan’s financial system is under strong stress but remains sound as a whole, with financial institutions providing necessary funds to support economic activity,” the report said. However, if the economy suffers a prolonged and deep slump, it could trigger a “negative feedback loop between the real economy and the financial sector”.
The BOJ says Japanese banks have already been taking an increasingly cautious approach to investing overseas, marking a shift from their earlier willingness to take on more risk in favour of better returns amid declining profitability in the low interest rate environment.
The overall credit quality of loan portfolios at Japanese banks remains high, and Japanese companies have maintained “robust financial bases” in retained earnings and cash, the BOJ said.