Chapter 8. The Opportunities and Risks of Abenomics in the Financial Sector

Dennis Botman, Stephan Danninger, and Jerald Schiff
Published Date:
March 2015
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Serkan Arslanalp, Raphael Lam and Malhar Nabar 

Crucial to the success of the Abenomics program to shift the Japanese economy to permanently higher growth and inflation is the role of the financial sector. This chapter examines the risks and opportunities for the sector and highlights financial sector policies that could enhance the effectiveness of the policy framework.

The new policy framework could have a fundamental impact on the financial sector. The Bank of Japan (BoJ) expects its monetary easing program to affect the financial system and the economy through three channels (BoJ 2013). First, large-scale purchases of Japanese government bonds (JGBs) are expected to suppress long-term interest rates across the yield curve (the interest rate channel). Second, a clear commitment to achieve the new inflation target is expected to raise inflation expectations and boost private demand through a decline in real interest rates (the expectations channel). Third, investors and financial institutions investing in JGBs are expected to shift from these instruments to risk assets such as stocks and foreign-denominated bonds or to increase lending within their portfolios (the portfolio rebalancing channel).

In this chapter we explore how the domestic and cross-border balance sheets of Japanese institutions may change under the government’s new policies. A key finding is that the impact is likely to depend on whether all three arrows of Abenomics are implemented together, as recommended in Chapter 3.

In this chapter, we first take stock of portfolio allocations and discuss the performance of the financial sector during the past decade. We next look at some of the opportunities that could arise from the implementation of a complete package of policies under Abenomics for the domestic and cross-border activities of Japanese financial institutions. We then examine new risks that may emerge, in particular from an incomplete package of policies under the program. We conclude with some policy options to help manage these risks, maintain financial stability, and support growth.

Portfolio Allocations Toward Risk Capital

The success of Abenomics depends in part on whether Japanese financial portfolios rebalance away from large holdings of currency and government securities toward higher-yielding, riskier assets. Portfolio rebalancing is important for all three arrows: enhancing the transmission of monetary easing by lowering borrowing costs, providing an impetus for eventual fiscal consolidation by exerting market discipline on the government, and supporting the growth strategy by intermediating risk capital.

Over time, investment strategies across most major investor groups appear to have broadly adjusted to an environment with mild deflation and low nominal interest rates, in which safe and liquid assets have delivered steady, albeit low, real returns. Portfolio allocations across households, banks, pension funds, and insurance companies remain heavily weighted toward “safe assets,” consisting of currency, deposits, and government securities.

While some rebalancing away from this mix of safe assets appears to be under way, the process has so far not advanced that rapidly. In most cases, the allocations to safe assets continue to be well above portfolio shares prior to the global financial crisis (Figure 8.1). Specifically, the portfolio share allocated to currency, deposits, and government securities declined during Abenomics’ first year for households, public pensions, and other financial intermediaries, such as securities investment trust companies. Banks, insurance companies, and corporate pension funds, however, have maintained their overall allocation to risk-free assets. Although banks’ holdings of JGBs have fallen since the launch of the quantitative and qualitative monetary easing (QQE) framework, the increase in their excess reserve holdings at the BoJ has offset this to maintain a broadly unchanged share of low-yield assets in bank portfolios.

Figure 8.1Allocation to “Safe Assets” by Investor Type

(Percent of total assets)
(Percent of total assets)

Sources: Bank of Japan, Flow of Funds; Haver Analytics; and IMF staff estimates.

Note: The bars in each panel represent the share of currency, deposits, and government securities, in percent (left-hand side). The line represents the share of Japanese government bonds, in percent (right-hand side).

1 Starting in 2007:Q4, assets of postal savings are included under banks.

In a bank-dominated financial system such as Japan’s, the potential of the financial sector to provide risk capital is linked closely to the health of bank balance sheets. After a period of balance sheet repair and consolidation during the 1990s and early 2000s (necessitated by the collapse of the 1980s real estate bubble and the 1997–98 Asian financial crisis), the Japanese financial system fared well during the global financial crisis. Bank buffers and asset quality appear stronger now than during the last decade. Capital ratios have increased in aggregate across all categories of banks (city, regional, shinkin) (Figure 8.2) and loan-loss reserves are below levels seen during the last decade (Figure 8.3). The evidently healthy state of bank balance sheets suggests that there is room for banks to increase exposure to riskier projects either by funding new ventures directly or by investing in risk assets in capital markets. With lower funding costs under the QQE, supply constraints on risk capital allocation are arguably even lower now than was the case previously.

Figure 8.2Regulatory Capital to Risk-Weighted Assets


Source: Financial Services Agency.

Note: As of the end of the fiscal year (that is, end-March of the second of the two years) except in the case of FY2013/14, which refers to the half-year ending in September 2013.

Figure 8.3Banks’ Loan-Loss Reserves

(Percent of total loans, three-month moving average)

Sources: CEIC; and IMF staff estimates.

Portfolio rebalancing toward riskier assets, however, requires more than willingness and capacity on the supply side to shift exposures in that direction. Other actors in the economy have a role to play in this as well—intermediaries that help share risks by securitizing small business loans; institutional investors that take direct exposures in new ventures; and, ultimately, end-users.

Even prior to the global financial crisis, securitization activity in Japan was relatively low (less than 2 percent of GDP at its peak). Within this small envelope, securities were backed mostly by mortgages (Figure 8.4). Small business loans constituted a negligible underlying asset class used in securitization. Banks have typically originated small business loans and maintained them on their books to maturity, rather than selling them off to institutional investors for securitization. This business model has led to a concentration of small-business-related credit risk on bank balance sheets, compared to a model in which a larger fraction of small business loans is originated for subsequent distribution, leading to a diffusion of credit risk across multiple intermediaries.

Figure 8.4Securitization Product Issuance by Underlying Assets

(Percent of GDP)

Sources: CEIC; Japan Securities Dealers Association; and IMF staff estimates.

Note: CDO = collateralized debt obligation, CMBS = commercial mortgage-backed security, RMBS = residential mortgage-backed security.

Other investors in small businesses such as venture capital firms have typically been less prominent in Japan than in other Organisation for Economic Cooperation and Development countries (Nabar and Syed 2011, Lam and Shin 2012). Linked to the low level of venture capital activity, initial public offerings—often used as exit routes for early investors to cash out their seed capital—are also relatively low in Japan. In 2013, when the stock market rose some 60 percent in local currency terms, capital raised through initial public offerings in Tokyo was closer to the levels seen in emerging markets and smaller advanced economies than to the amounts raised in New York or London (Figure 8.5).

Figure 8.5Global IPOs: Top Ten Exchanges by Capital Raised, 2013

(Percent of total)

Sources: Ernst & Young, Global IPO Trends; and IMF staff estimates.

Note: ASX = Australian Securities Exchange, BM&FBOVESPA = Bolsa de Valores, Mercadorias & Futuros de São Paulo, BMV = Bolsa Mexicana de Valores, HKEx = Hong Kong Exchanges and Clearing Ltd., IPO = initial public offering, LSE = London Stock Exchange, NYSE = New York Stock Exchange, SET = Stock Exchange of Thailand, SGX = Singapore Exchange, TSE = Tokyo Stock Exchange.

Looking beyond intermediation infrastructure, increasing risk capital allocation ultimately depends on the demand for loanable funds. Loan officer surveys have typically pointed to tepid demand as the reason for slow credit growth. To the extent this reflects firms’ perceptions of poor growth prospects and lack of new investment opportunities, efforts to boost risk capital allocation will need to focus more on take-up. There is some evidence from private nonresidential investment trends that firms have so far not been persuaded about a step shift in domestic growth prospects (Figure 8.6). In contrast, firms have continued to expand overseas, as seen in the pickup in outward foreign direct investment, even as domestic private capital expenditure softened in 2013.

Figure 8.6Private Nonresidential Fixed Investment and Outward FDI

(Percent of GDP)

Source: IMF staff estimates.

Note: FDI = foreign direct investment.

Previous studies (Lam and Shin 2012, Caballero, Hoshi, and Kashyap 2008) have pointed to several underlying reasons for low demand, in many cases related to factors in the broader economy beyond the financial system. In the first instance, there is limited restructuring or exit of nonviable small and medium-sized enterprises (SMEs) because refinancing tends to be easily available and this has curtailed incentives for troubled borrowers to voluntarily enter into mergers and workouts (exit rates are about a third of those in other advanced economies, see Lam and Shin 2012). Furthermore, multiple creditors and wide use of personal guarantees create further barriers to workouts and business transfers.

The persistence of nonviable SMEs combined with regulatory barriers in several sectors deters entry (Lam and Shin 2012 also note that entry rates are roughly a third of those in other advanced economies). As Caballero, Hoshi, and Kashyap (2008) argue, the persistence of “zombie” borrowers has affected existing healthy firms and potential entrants in multiple ways. It has tended to reduce profits for healthy firms by driving down market prices while keeping wages higher than they otherwise would have been, slowed investment and employment growth among healthy firms, worsened collateral value and prevented solvent banks from lending to them, and deterred entry. The overall effect has been to block the needed structural transformation of the economy.

Over and above this, as Lam and Shin (2012) point out, public guarantees have further compounded the problem by facilitating rollovers and delaying repayments. These public guarantees have come in different forms: standard and special/emergency credit guarantees; safety-net lending by government-affiliated financial institutions; temporary SME financing facilitation; and relaxed Financial Services Agency’s guidelines to classify restructured loans under the normal category, which means smaller loan-loss provisioning by banks.

In sum, amid weak growth prospects and a deflationary mindset, gaps in intermediation capacity (securitization, venture capital) and factors that impede demand for risk capital (insufficient SME restructuring, entry, and exit) appear to have contributed to skewing portfolio allocations toward safe and low-yielding assets. While potentially holding back the emergence of new growth areas, these distortions have also had serious implications for the financial sector. The banking system, in particular, continues to face challenges, such as the steady decline in the profitability of lending operations and large JGB holdings, which are a source of interest rate risk (discussed in more detail in the following section).

Japanese Banking Sector: Interest Rate Risk

Large JGB holdings of Japanese banks imply that even a modest rise in interest rates can have important implications for financial stability (IMF 2012). The large issuance of JGBs over the past two decades has been financed mostly through the domestic financial sector, with banks’ JGB holdings currently just over 15 percent of total assets, representing an important source of exposure to interest rate risk. If interest rates were to rise sharply, losses from such exposures could reduce capital ratios across a range of financial institutions. For instance, a 100 basis point parallel rise in domestic bond yields could lead to mark-to-market losses of 13 percent of Tier 1 capital for major banks and 21 percent for regional banks based on latest available data (BoJ 2013).

This section explores how the new policies under Abenomics could affect the interest rate risk of Japanese banks. In particular, it illustrates that their exposures could decline substantially during 2014–15 as the BoJ becomes a large buyer of JGBs. But this may rise again to current levels if structural and fiscal reforms disappoint over the medium term.

Throughout the exercise, we use three hypothetical scenarios based on IMF (2013): (1) a baseline pre-Abenomics scenario; (2) a complete Abenomics package under which the QQE, fiscal consolidation, and ambitious structural reforms lead to lower government funding needs and higher growth; and (3) an incomplete Abenomics package under which inflation expectations adjust in a sluggish manner, possibly because of the lack of a structural reform program, requiring further fiscal stimulus to close the output gap and boost inflation in the near term (Table 8.1).

Table 8.1Alternative Scenarios
BaselineThe pre-Abenomics baseline is taken as the December 2012 forecasts in the IMF’s World Economic Outlook.
Complete Policy PackageAmbitious structural reforms are taken to raise the trend long-term growth to 2 percent (IMF 2013).

Inflation expectations are aligned to the inflation target quickly within the timeframe forecast by the Bank of Japan.

Medium-term fiscal adjustments are undertaken to put debt on a downward trajectory.
Incomplete Policy PackageLong-term growth remains stagnant without structural reforms.

Inflation expectations adjust in a sluggish manner and align only gradually with the target.

Further fiscal stimulus is taken to stimulate near-term growth and inflation, but the lack of medium-term fiscal adjustment leads to a rising risk premium.
Source: IMF (2013).
Source: IMF (2013).

Japanese banks have played a key role in the JGB market, essentially serving as the marginal buyers of JGBs given their role as primary dealers and market makers. Accordingly, Japanese banks’ purchases of JGBs have been determined to a large extent by the following factors: (1) net issuance of JGBs, (2) social security fund net purchases of JGBs, (3) BoJ’s net purchases of JGBs, and (4) foreigners’ net purchases of JGBs. More specifically, the following stylized equation can explain most of the variation in Japanese banks’ holdings of JGBs since 2000 (top and bottom charts of Figure 8.7).

where Bt represent Japanese banks’ JGB holdings at time t;D0,t represents the cumulative net issuance of JGBs between 2000 and t; SSF0,t, CB0,t, and FOR0,t represent the cumulative net purchase of JGBs by social security funds, the BoJ, and foreigners, respectively; and alpha represents a time trend that captures the secular purchase by other investors, in particular insurance and pension funds (that is, alpha is equal to ¥9 trillion).

Figure 8.7Demand and Supply Balance in the JGB Market

Sources: Bank of Japan, Flow of Funds statistics; Japan Post Bank; and IMF staff estimates.

Note: JGB = Japanese government bonds.

1 Depository corporations include the Japan Post Bank, with the figures after 2007 estimated from company reports. Insurance funds include Japan Post Insurance. Social security funds include the Government Pension Investment Fund. Other domestic includes households and corporations. Domestically licensed banks include major and regional banks.

2 Predicted purchases of JGBs by depository corporations are based on total net issuance, social security fund purchases, Bank of Japan purchases, and foreign purchases.

It seems unusual at first glance that JGB yields or other macro variables do not enter into the equation, but the equation captures the dynamics because (1) it simply relies on the supply and demand balance in the JGBs market; (2) Japanese insurance and pension funds have had a historically stable demand for JGBs due to their asset liability matching policies, and (3) other domestic nonbanks, including mutual funds, are negligible buyers of JGBs (top chart of Figure 8.7).

Based on these historical relationships and hypothetical scenarios discussed earlier, Japanese banks’ JGB holdings are projected for 2014–17 as follows (as explained further in Arslanalp and Lam 2013) and as summarized in Table 8.2.

Table 8.2Projected Net Purchases of Japanese Government Bonds, 2013–17(Annual average; trillions of yen)
Pre-AbenomicsAbenomics: complete packageAbenomics: incomplete package
Net JGB Issuance25.925.328.7
Bank of Japan14.720.020.0
Depository Corporations5.0−5.56.9
Insurance and Pension Funds9.09.09.0
Social Security Funds−4.0−4.0−4.0
Other Domestic0.00.00.0
Source: IMF staff projections.Note: The Bank of Japan net purchases of Japanese government bonds (JGBs) are 50 trillion yen both in 2013 and 2014. Net purchases by insurance and pension funds are based on historical trends. Net purchases by social security funds are based on trends in the last four years.
Source: IMF staff projections.Note: The Bank of Japan net purchases of Japanese government bonds (JGBs) are 50 trillion yen both in 2013 and 2014. Net purchases by insurance and pension funds are based on historical trends. Net purchases by social security funds are based on trends in the last four years.
  • Net JGB issuance. Cumulative net issuance of JGBs over the medium term is based on IMF general government gross debt projections under the three scenarios provided in IMF (2013). In all these scenarios, general government debt is assumed to be issued as follows: 75 percent in JGBs, 20 percent in Treasury bills, and 5 percent in local government bonds, in line with the broad pattern of debt issuance in recent years.

  • Central bank purchases. The BoJ’s net JGB purchases over 2013–14 are projected based on the April 2013 policy announcement (¥50 trillion each in 2013 and 2014), and its holdings are assumed to be constant thereafter (that is, we assume the BoJ will roll over any JGBs maturing in its portfolio over the following three years). Under the pre-Abenomics scenario, the BoJ’s JGB purchases are projected based on the Open-Ended Asset Purchasing Method introduced in January 2013.

  • Social Security Fund purchases. Social security funds are assumed to remain net sellers of JGBs under current demographic trends by ¥4 trillion per year.

  • Insurance and pension fund purchases. Insurance and pension funds are expected to broadly maintain their liability-driven investment strategy, and to continue buying about ¥9 trillion of JGBs per year on a net basis.

  • Foreign purchases. The foreign share of JGBs is projected to increase from 4½ percent at the end of 2012 to 7 percent by the end of 2017 under complete policies, but fall to 2 percent under incomplete policies, as the rise in the risk premium does not assuage foreign investors’ concerns about fiscal sustainability. The figures of 7 percent and 2 percent represent the highest and lowest foreign share registered in the JGB market since 2000.

A final simplifying assumption is that net purchases of JGBs and other domestic bonds by major and regional banks take place proportional to their current holdings. That essentially means that, under the scenarios, major and regional banks maintain their relative shares in the JGB, local government, and corporate bond markets (some cases in which this may not hold will be discussed below).

Based on these assumptions, Japanese banks’ interest rate risk is calculated as mark-to-market losses to Tier 1 capital from a hypothetical 100-basis-point parallel rise in the domestic yield curve, in line with the methodology of the BoJ in the Financial System Report and as shown in the equation.

For the duration of banks’ JGB holdings, we assume a gradual reduction given that the BoJ is expected to expand the duration of its JGB holdings under the QQE.1 For Tier 1 capital, we assume that bank capital grows in line with nominal GDP (that is, mainly through retained earnings and not through capital raising, in line with the current market guidelines of large financial institutions).2

Based on this framework, the scenarios highlight that the interest rate risk exposures of Japanese banks could decline substantially over the next two years as the BoJ becomes a large buyer of JGBs (Figure 8.8). In particular in the near term, both complete and incomplete Abenomics scenarios show a substantial decline in the interest rate risk exposures of major and regional banks on account of large BoJ purchases, as well as fiscal consolidation, higher profitability, and Tier 1 capital growth due to structural reforms under the complete scenario. In contrast, under the pre-Abenomics baseline, the interest rate risk exposures of major and regional banks would have risen steadily over the medium term, highlighting growing financial stability risks. As such, financial sector stability would benefit greatly from successful Abenomics, with risks expected to shift from interest to market risk as portfolio rebalancing commences.

Figure 8.8Banks’ Sensitivity to a 100-Basis-Point Interest Rate Shock

(Percent of Tier 1 capital)

Sources: Bank of Japan; and IMF staff estimates and projections.

Note: Solid lines (—) represent the pre-Abenomics scenario; dashed lines (- -) the Abenomics: complete package scenario; and dotted lines (…) the Abenomics: incomplete package scenario.

At the same time, the scenarios suggest that interest rate risk may rise again if structural and fiscal reforms disappoint over the medium term. Under such an incomplete policy package, banks’ JGB holdings and interest rate risk exposure may rise quickly again, as banks may, once again, have to absorb large government financing needs and their profitability and Tier 1 capital growth may decline because of lower growth. Consistent with the analysis in Chapter 3, where we showed that a complete policy package was critical to overcome the structural headwinds from population aging and to achieve the two-percent inflation target in a stable manner, these results indicate that a complete policy package is also vital for reducing interest rate risk in the banking sector and, ultimately, reducing tail risks from the fiscal–financial nexus.

Japanese Financial Institutions Expanding Abroad

An important component of portfolio rebalancing is greater cross-border lending activity. Cross-border activities of Japanese financial institutions have risen over the past few years, particularly to Asia. As a result, major Japanese banks have attained an important global and regional footprint, with their cross-border consolidated claims abroad increasing since 2005, reaching nearly $3 trillion (about 15 percent of total banking and trust assets) as of March 2013, according to data from the Bank for International Settlements. Claims on Asia have more than doubled since the global financial crisis, and now account for about 10 percent of total foreign consolidated claims. The expansion abroad has made Japanese banks key players in regional and global syndicated loans and project finance. Overseas gross profits now account for about 30 percent of total gross profits (about half of which arise from net interest income, with higher net interest margins on foreign loans than domestically). At the same time, major brokerage firms and life insurers have sought acquisitions or strategic partnerships overseas.

The current trend is often compared to previous episodes of overseas expansion by Japanese financial institutions. Those can be broadly classified into three waves: (1) the rapid expansion in the 1980s until the bursting of the asset-price bubble in 1990; (2) the expansion during the mid-1990s; and (3) the expansion abroad beginning from 2006, which temporarily slowed during the global financial crisis (Figure 8.9). A question to explore would be how the current trend of overseas expansion compared to these earlier episodes and whether the growing cross-border activity will continue under Abenomics.

Figure 8.9Japanese Financial Institutions: Global Ranking and Expansion Overseas

Several domestic and regional factors contribute to the increasing trend of overseas activity among Japanese financial institutions.

  • Limited domestic opportunities have generated a need for major Japanese banks to expand abroad. As noted, domestic credit demand was sluggish in the past few years because of stagnant growth, though it has picked up recently. Large corporations have limited funding needs as they accumulated sizable surpluses (rising to about 6 percent of GDP). Structural factors—such as high leverage among SMEs, population aging, and sluggish growth in Japan’s regions—have limited domestic opportunities. At the same time, lingering deflation has limited the decline of the real interest rate to sufficiently stimulate credit demand. The shrinking net interest margin on loans (about 0.6–1.2 percent now relative to about 1.2–2.1 percent in the early 2000s) tends to limit banks’ core profitability as interest income accounts for more than two-thirds of their total income.

  • Major banks weathered the global financial crisis well and have capacity to take on more foreign exposures. They have abundant yen liquidity supported by a stable deposit base, and, as noted, further strengthened their capital adequacy after the global financial crisis, in part to meet the Basel III requirements. The resilience of Japanese banks’ balance sheets has placed them in a good position to further expand overseas, despite lingering global and regional uncertainty.

  • Regional and global factors, such as large financing needs in emerging Asia, have offered new business opportunities for Japanese banks. Major banks have benefited from the increasing outward foreign direct investment and trade linkages of Japanese firms. Financing needs for infrastructure in emerging Asia are large (about $8 trillion), according to data from the Asian Development Bank. These generate demand for cross-border financial activity between Japan and various foreign direct investment destinations.

  • Deleveraging of European banks since 2010 has accelerated the pace of overseas expansion. Japanese banks, among other local Asian banks, have stepped up financing to gain market share against the scale-back of European banks in the region.

To analyze the role of these factors more formally for their contribution to the rise in cross-border bank lending, Lam (2013) conducted an empirical analysis to assess the determinants of banks’ overseas expansion. The analysis also assesses whether and how the current expansion is different from previous episodes. Several other studies also looked into the factors contributing to cross-border banking through factor analyses and institutional features (Shirota 2013, Focarelli and Pozzolo 2005).

The empirical results suggest that global and regional factors explain a large part of the rise of foreign claims. Regarding domestic factors, the resilience of the major Japanese banks, particularly the strengthening of capital adequacy and low nonperforming loans, even during the global financial crisis, was found to contribute around one-third of foreign claims growth. As such, cross-border expansion is likely to continue under Abenomics. The empirical estimates suggest that the substitution effect between domestic and overseas lending contributed about 5 percent to the growth of foreign claims in Japan, indicating that recovering domestic opportunities may moderately slow, rather than reverse, overseas expansion.

Although Japanese financial institutions and the economy as a whole would benefit from a more diversified income base through banks’ expanding abroad, a gradual and cautious approach in overseas strategies is warranted. Expanding overseas will nevertheless help financial institutions improve their profitability by better allocating their liquidity and developing local markets in Asia. But banks may also favor a gradual expansion to maintain their balance sheets under the global regulatory reform agenda (for example, Basel III requirements). A rapid expansion could lead to buying foreign assets at high prices or entering unfamiliar local markets that could eventually result in heavy losses, as happened in the late 1980s and 1990s.

Potential Risks

Although the analysis in this chapter suggests that, if successful, Abenomics has the potential to reduce banks’ interest rate risk exposures, weaken bank–sovereign linkages, and encourage more cross-border activities, new risks to the financial system may emerge. In particular:

  • Foreign exchange funding risks. Quantitative and qualitative monetary easing could lead Japanese financial institutions (major banks and insurance companies) to go overseas more aggressively as they reallocate their portfolios. Higher overseas exposures may add to funding risks as securing stable and long-term dollar funding has remained a challenge for Japanese financial institutions. Supervisors should encourage banks to further improve their resilience against shocks by strengthening their funding sources and risk management, such as by closely monitoring the overseas maturity mismatch and foreign currency- denominated loan-to-deposit ratios. Cross-border collateral arrangements—in place with Singapore and Thailand and agreed to be established with Indonesia—could also help reduce local currency funding risks in overseas markets.3 Cross-border risk monitoring arrangements with foreign supervisory authorities can also help monitor risks from these activities, including foreign exchange funding risks. In that regard, the supervisory agencies in Japan have signed the Financial Stability Board’s Multilateral Framework for sharing the information of global, systemically important banks through the data gap initiatives in early 2013 based on discussions at the board.

  • Japanese regional banks. A key risk factor for regional banks is low profitability stemming from weak loan demand in their core business areas. As a result, an important source of income for these banks is interest generated from long-term domestic bonds. In that context, if credit demand in regional economies is slow to pick up, and given limited opportunities for cross-border expansion, regional banks may decide to maintain their JGB holdings or even extend their maturity further, making them more susceptible to interest rate risk. This could happen especially if structural reforms disappoint, yielding an incomplete policy package. Though regional banks individually are small, as a group they are systemically important (with about 40 percent of banking system assets excluding the Japan Post Bank and agricultural cooperatives).

  • Rising risk premium. A lack of medium-term fiscal adjustment may lead to a rising risk premium in JGB yields, as discussed in Arslanalp and Lam (2013). This could lead to substantial losses in the financial system, despite the current decline in JGB holdings, and undermine financial stability.

Policy Options

The authorities have taken a number of steps to strengthen the financial sector’s ability to provide risk capital to the economy and facilitate more portfolio rebalancing abroad. In January 2014, the Japan Exchange Group, the Tokyo Stock Exchange, and Nikkei launched a new index, JPX Nikkei 400, a return-on-equity-focused index to encourage companies and investors to pay more attention to corporate governance and profitability. In early 2014, the Government Pension Investment Fund decided to shift part of its domestic equity allocation from the Tokyo Stock Price Index (TOPIX) to the new index, which could prompt other institutions to follow. In January 2014, the government launched tax-free investment accounts designed to encourage Japanese households—with more than $16 trillion in financial assets—to put more of their saving into stocks, bonds, and investment trusts instead of parking them in bank accounts. In February 2014, the BoJ decided to extend its facilities to stimulate bank lending and support economic growth by one year, while doubling their size and extending their repayment period to four years.

While BoJ asset purchases could take up a significant amount of interest rate risk from Japanese banks in the next two years, their JGB holdings and related interest rate risk exposures could rise again in the absence of accompanying fiscal and structural reforms. Strengthening capital requirements for domestically active banks and private sector-led consolidation in the regional banking sector could help mitigate downside risks of incomplete policies on the more vulnerable parts of the banking sector. By strengthening their capital base, such policies could also allow these banks to take better advantage of the potential reduction in their interest rate risk exposure and increase lending to SMEs and other corporations. And that could, in turn, support the authorities’ growth objectives by enhancing the provision of risk capital.

But further provision of risk capital will require actions that go beyond banks. Specifically:

  • Securitization. There is room for boosting securitization activity backed by small business loans, possibly by encouraging more information sharing across multiple credit registries on the repayment and default history of individual firms. There may also be scope for greater coordination between the Ministry of Finance and the BoJ to facilitate greater use of the central bank’s existing growth-supporting facilities for asset-backed lending (by further easing terms on BoJ facilities, including by lowering funding costs and extending the maturity of the loans). Risks and abuses associated with the originate-to-distribute framework underlying securitization could be contained by requiring originators to hold an equity position/loss absorption buffer on the underlying loans.

  • Venture capital. The Government Pension Investment Fund reforms first proposed in November 2013 and adopted in October 2014, along with the shift in the portfolio targets, are an encouraging development in this regard. A further shift in targets toward riskier assets such as venture capital could spur faster growth in funding for new businesses. As was seen in the United States, the 1979 reform of the Employment Retirement Income Security Act allowed pension funds to invest in high-risk assets leading to an increase in venture capital funding, a rising share of corporate research and development financed by venture capital firms, and better quality patenting (measured by citation accounts) associated with this.

  • Restructuring and exit of nonviable SMEs. As noted, the persistence of nonviable firms, kept afloat in part by restructured loans and progressively easier terms of financing, impedes credit intermediation and risk taking in several ways, such as by deterring the entry of new firms and the expansion of healthy firms, and by eroding the risk assessment capabilities at banks. Achieving turnover rates that reflect underlying fundamentals will involve phasing out credit guarantees, overhauling bankruptcy procedures, and, where needed, consolidating regional banks whose capital buffers are weakened by calling in nonperforming loans. At the same time, small business entry could be facilitated by reducing the time and cost of starting businesses, including through streamlining business registration procedures and upgrading credit registries and personal credit information.


In this chapter we explored how the domestic and cross-border balance sheets of Japanese institutions may change under the government’s new policies. Indeed, portfolio rebalancing is a key element of the transmission of the BoJ’s monetary easing program. It would also facilitate higher economic growth through greater provision of risk capital and weaken bank–sovereign linkages. On the latter, a key vulnerability of Japan’s financial system is its high exposure to interest rate risk as a result of large JGB holdings, and the results presented in this chapter suggest that this risk will persistently decline if Abenomics is successful. In contrast, incomplete Abenomics that fails to raise potential growth and restore fiscal sustainability implies that interest rate risk exposure could quickly rise again. This is because banks may once again have to absorb large government financing needs and their profitability, and Tier 1 capital growth could decline in the absence of sufficiently ambitious structural reforms.

The present analysis finds that Japanese banks are well positioned to scale up foreign exposures, thanks to their relatively resilient balance sheets and continued growth in Asia. Stronger domestic growth in Japan under successful Abenomics could mitigate the pace, but is unlikely to reverse the expansion as global and regional pull-factors play a more prominent role in the growth of cross-border claims. At the same time, increasing cross-border activity could pose funding risks and supervisory challenges, and require continued close monitoring.

We discussed a number of policy options to expand the provision of risk capital. The analysis presented in this chapter suggests that additional policy efforts should focus on intermediation (securitization and venture capital) and on take up on the demand side (exit and entry of firms, corporate restructuring).


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In particular, we assume the average remaining maturity of domestic bond holdings will decline from 2.5 to 2 years for major banks and from 4 to 3.5 years for regional banks over 2013–14.

Alternatively, we can assume that Tier 1 capital will grow at a constant rate of 4.2 percent. This would take into account the average return on equity of Japanese banks (about 6 percent) and the average dividend payout ratio of Tokyo Stock Exchange listed companies (about 30 percent). The results are broadly the same.

Under these arrangements, Japanese banks can draw funding from the host overseas central bank by posting JGBs as collateral with the BoJ. Haircuts are determined by the host central bank and the BoJ acts as custodian.

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