Japan
Financial Sector Stability Assessment Update

The macroeconomic environment of Japan has constantly been under pressure owing to rising public debt and fiscal deficits. Credit demand has been limited and has shown weak profitability. Growing risks have heightened concerns about a possible feedback to financial stability. This report summarizes the findings of the financial sector stability assessment of Japan. The Executive Board recommends a broad-based financial reform plan that could contribute to private sector growth. Suggested measures included allocating market-based credit to SMEs, improving the framework for capital markets, and consolidating and streamlining of regional banks.

Abstract

The macroeconomic environment of Japan has constantly been under pressure owing to rising public debt and fiscal deficits. Credit demand has been limited and has shown weak profitability. Growing risks have heightened concerns about a possible feedback to financial stability. This report summarizes the findings of the financial sector stability assessment of Japan. The Executive Board recommends a broad-based financial reform plan that could contribute to private sector growth. Suggested measures included allocating market-based credit to SMEs, improving the framework for capital markets, and consolidating and streamlining of regional banks.

Table 1.

Japan FSAP—High Priority Recommendations1/

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High Priority items need immediate attention and implementation within three years. These should be read along with Table 2 that lists other Medium Priority recommendations where implementation is recommended over a three to five year horizon.

I. Background

5. Japan confronts a challenging macrofinancial operating environment (Table 4, Figure 1). On the macroeconomic front, deflationary pressures remain, growth is sluggish, public debt and deficits are large, and the external environment is highly uncertain. The financial system (Figure 2, Annex IV) faces limited credit demand, a flat yield-curve, and weak profitability. At the same time, some policies and market practices in the financial system may have limited risk-taking and posed bottlenecks on credit intermediation, in turn contributing to low growth and structural challenges.

Table 2.

Japan FSAP—Medium Priority Recommendations

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Notes: These are Medium Priority recommendations to be implemented before the next FSAP update. This should be read along with Table 1 on the High Priority recommendations.
Table 3.

Japan FSAP—Risk Assessment Matrix

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Table 4.

Japan FSAP—Selected Economic Indicators, 2007–2013

Nominal GDP: US$5,867 billion (2011)

Population: 127.8 million (2011)

GDP per capita: US$45,900 (2011)

Quota: SDR 15,628.5 million

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Sources: Global Insight, Nomura database; IMF, Competitiveness Indicators System; and Fund staff estimates and projections, as of February 21, 2012.

Annual growth rates and contributions are calculated from seasonally adjusted data.

Contribution to GDP growth.

Based on normalized unit labor costs; 2000=100.

Figure 1.
Figure 1.

Japan FSAP—Macroeconomic Developments

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Figure 2.
Figure 2.
Figure 2.

Japan FSAP—Japanese Financial System Structure

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

A01ufig01

Banks Claims on the Public Sector

(In Percent of GDP)

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Sources: Central banks across countries and Haver Analytics

6. Growing risks to fiscal sustainability have heightened concerns about possible feedback to financial stability. Gross public debt has grown sharply over the past decade, reaching 220 percent of GDP at end-FY2011, the highest ratio globally. An increasing share of the financial system’s balance sheet is invested in JGBs. Fiscal-financial sector linkages have also increased due to crisis-related financial support to the economy through credit guarantees and safety-net lending. However, household and corporate balance sheets appear sound, and continued demand for bank deposits has provided indirect support for government debt markets. BOJ purchases of JGB—through its step-up of existing bond purchases and recent asset purchase program—have also provided support and liquidity for the financial system.

7. The financial system has remained stable during the global financial crisis and the recent devastating earthquake (Tables 56). Temporary liquidity squeezes in the interbank and corporate debt markets at the peak of post Lehman crisis raised some funding costs, but financing conditions gradually returned to normal, including as a result of action by the authorities to support credit and liquidity. Banks were insulated from the subprime crisis partly due to their limited exposures to complex asset classes and derivative markets. Overall, the payment systems remained well-functioning, despite some short-lived surges in settlement fails. Only some regional banks had concentrated exposures to earthquake-hit areas, and nonlife insurers absorbed losses from the catastrophe by drawing down on their reserves. Specific steps were taken to ease funding conditions and avoid a tightening of financing conditions for SMEs, including U.S. dollar funds-supplying operations and special government credit guarantees.

Table 5.

Japan FSAP—Key Policy Measures by the FSA During the Global Financial Crisis and After the Great East Japan Earthquake

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Sources: FSA, OECD (2009).
Table 6.

Japan FSAP—Key Policy Measures by the Bank of Japan During the Global Financial Crisis and After the Great East Japan Earthquake

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Source: BOJ.1/ Additional measures involves the relaxation of collateral requirements to include asset-backed CPs, coverage of corporate debts, debt issued by real estate investment corporations, government guaranteed CP, loans on deeds to the public sector, selected foreign government bonds, and standards of corporate debt in disaster areas such as eligible collaterals.

II. Current State of Financial Stability

A. Financial System—Performance and Soundness

8. The Japanese banking sector has become much better capitalized over the last decade (Tables 78, Figures 34). Since the last FSAP, Japanese banks’ capital adequacy ratio (CAR) and Tier 1 capital ratios have improved steadily, including as city banks issued equity in 2009–10. Their liquidity position also remains comfortable, as they hold large amounts of liquid assets as a share of both short-term liabilities (around 50 percent) and total assets (about 20 percent).

Table 7.

Japan FSAP—Banking Sector Soundness: All Banks, 2001–2011

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Sources: Japanese authorities and IMF staff calculations.1/ Including city banks, regional banks and shinkin banks (consolidated basis for banking groups).

Aggregated with the unconsolidated basis data.

Include the figures of Credit cooperatives and National Federation.

Capital defined as net asset on the balance sheet.

Table 8.

Japan FSAP—Soundness of Banking Sector and Selected Balance Sheet Components, 2001–2011

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Sources: Japanese authorities, Japanese Bankers Association, CEIC, IMF staff calculations.

Aggregated with the unconsolidated basis data. City + regional bank columns include trust bank data

Capital defined as net asset on the balance sheet.

Figure 3.
Figure 3.

Japan FSAP—Soundness of Banking Sector

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Source: FSA.
Figure 4.
Figure 4.

Japan FSAP—Comparative Soundness of the Banking System

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Sources: FSAand IMF FSl website.Note: All figures are in percent as of end-2010. excepl for Italy (2010Q2) and Japan (2011Q1).ROA figures are averaged over 2008-10. Figures for Japan include all city and regional banks.
A01ufig02

Distribution of total capital ratio: All banks 1/

Total captial ratio in percent

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Source: Japanese Bankers’ Association.1/ Including city, tier 1 and 2 regional, trust and (former) long-term credit banks. if capital ratio is below 0, it is set at 0.
A01ufig03

Distribution of return on equity (ROE): All banks 1/

ROE in percent

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Source: Japanese Bankers’ Association.1/ Including city, tier 1 and 2 regional, trust and (former) long-term credit banks. if ROE is below 0, it is set at 0.

9. Internationally active banks are preparing for Basel III implementation. The Basel III capital framework will be put in place for internationally active banks from 2013 on, following the medium-term schedule set by the FSA.2 The FSAP team estimates that applying immediately and in full the Basel III capital definition for the major banks, while keeping the Basel II definition of risk weighted assets (RWA), would reduce their core Tier 1 and Tier 1 capital ratios by about 2 percentage points and total capital adequacy ratios (CARs) by 6 percentage points. In addition, the three mega financial groups estimate that more prudent risk weights (in line with Basel III phase-in as of September 2011) would reduce Tier 1 capital ratios by about an additional 1 percentage point. However, as noted, these financial groups have recently been issuing equity capital, reducing dividend payments, and accumulating retained earnings. Therefore, as of September 2011, they benefit from a solid capital basis of about 14¾ percent CAR, 11⅓ Tier 1 ratio, and 9⅓ core Tier 1 ratio (on a Basel III basis).

10. At the same time, Japanese banks face growing challenges (Tables 78, Figures 34). Japanese banks’ profitability has improved since the 2003 FSAP, but remains consistently below international norms. Net interest margins (NIM) have been exceptionally weak given the low interest rate domestic environment. This is encouraging banks to increasingly diversify or take on greater risk exposures, including overseas or, for regional banks, through increased JGB portfolio durations. While bank asset quality improved substantially during the past decade, it has recently shown signs of deterioration, and nonperforming loan (NPL) levels may be underestimated due to measures to support SMEs.

11. Insurance companies meet their solvency requirements, but these do not reflect a full economic valuation of their assets and liabilities (Figure 5). Both life and nonlife insurers showed strong regulatory solvency margins under the requirements prior to FY2011. The new solvency requirements that took effect in FY2011 (e.g., as a result of additional risk recognition and new risk calibration) are estimated to have reduced solvency margins by about 20–30 percent, although keeping them still well above the regulatory minimum. Importantly, however, the new requirements still do not incorporate full economic valuation. The profitability of the insurance sector has risen only marginally in recent years, but is expected to improve gradually.

Figure 5.
Figure 5.

Japan FSAP—Financial Soundness of the Insurance Sector

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

12. Although substantial reforms were made to Japan’s public pensions in 2004, significant challenges to the viability of the system remain. Key elements of the 2004 reforms, such as macroeconomic indexation of benefits, have yet to be implemented. Also, although some additional changes with regard to indexation are currently under consideration, they do not include what are perhaps the most significant items—raising the retirement age beyond age 65, and harmonizing the system across sectors. The private pension system in Japan has also been evolving and growing, but it still remains small compared to the public pension system.

13. Major Japanese securities firms appear adequately capitalized and have strong liquidity buffers compared to their foreign peers. The largest securities companies have Tier 1 capital ratios of 16–24 percent. The sector has been hit hard by global market turbulence since 2007 and core profitability has contracted sharply, reducing equity and raising leverage above comparators. Declining turnovers in equity and bond markets have cut commission income, and net losses were recorded in 2008, 2009, and 2011. Continued pressures on profitability could further push some smaller firms to exit, though the traditional nature of Japanese security firms’ business limits the risks of disorderly exits.

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Sources: Bankscope, company reports and IMF staff calculation.

Over non-interest operating income

A01ufig04

Securities Firms in Japan

(in percent, unit, in fiscal years (2011 data is for March 2011))

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Sources: Japan Securities Dealers Association.
A01ufig05

Credit Default Swap Spreads for Selected Broker/Dealers and Banks

(In basis points)

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Source: Bloomberg L.P.1/ Including Nomura holdings and Daiwa securities.2/ Including Goldman Sachs and Morgan Stanley.

B. Key Risk Factors

14. JGB market exposures represent one of the central macrofinancial risk factors (Figure 6). This risk reflects the possible impact on public debt sustainability of changes in yields and related effects on investor confidence; the increased role of the private financial sector in covering government borrowing needs; the prospect that ongoing demographic shifts will reduce private saving; and growing household interest in investing abroad.3 Interest rate risk sensitivity is especially prevalent in regional banks and insurance companies (JGBs representing about 70 percent of life insurers’ securities holdings and 90 percent of insurance cooperatives’ securities holdings). 4 In addition, the main public pension scheme, as well as Japan Post and Norinchukin bank, also have large JGB exposures (Box 1).

Figure 6.
Figure 6.

Japan FSAP—Market Risk Exposures in the Financial System

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Note: The figures on shareholdings are collected from securities reports based on disclosure of top 10 shareholders.1/ Modified duration indicates the impact of interest rate changes on bond prices and is proportional to the average maturity. The figure is from the September 2010 FSR.

15. There are multiple sources of credit risk in the banking system (Table 8). Historically, domestic corporate loans have been the largest source of credit costs, a risk exacerbated by large and concentrated exposures to a few companies or industries for major banks, or to local industries for regional banks. In addition, SME-related credit costs could rise further if growth slows down or if SMEs that benefited from relaxed regulatory requirements for restructured loans fail to recover once these support measures are removed. Other credit risk exposures, such as those reflecting an acceleration of overseas expansion that may strain underwriting and risk management standards, or mortgage-related exposures (Figure 7), appear modest but require close monitoring.

Figure 7.
Figure 7.

Japan FSAP—Real Estate Market and Mortgage-Related Exposures

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Source: OECD.

16. Equity market risk exposures have declined but remain important (Figure 6, Table 8). City banks’ equity holdings still represent around half their capital, but Basel III implementation should incentivize them to further reduce such exposures. Regional banks’ equity holdings are smaller but still around 30 percent of capital. Nonlife insurers’ equity holdings have decreased to about 20 percent of assets at present, but are twice the level observed in other advanced countries. In the life sector, equity holdings represent only 5½ percent of total assets.

17. Japanese financial institutions are presently well positioned to deal with potential foreign exchange (FX) market volatility. The U.S. dollar is the most important currency for yen FX transactions (¾ of total). The net FX positions of Japanese banks are small, limiting potential valuation losses. In addition, Japanese financial institutions actively manage FX liquidity risks by using local repos, interbank loans and certificates of deposit, or cross-currency funding using FX swaps to obtain foreign exchange (mostly U.S. dollar). The cost of some of these funding sources (especially swaps) has been unstable in recent months, and in response, banks have lengthened the term of FX swaps and issued U.S. dollar bonds. Securities firms will also need to manage carefully their day-to-day liquidity due to their reliance on market funding, in particular in FX swaps markets.

A01ufig06

USD Funding Cost

(In percent)

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Source: Bloomberg.1/ BOJ’s USD lending facility charged OIS + 100 bps up to mid December 2011 and then cut to + 50 bps.

C. Resilience—Stress Tests

18. The FSAP stress tests were conducted in close collaboration with the BOJ and FSA, building on their existing practices (Tables 911). The top-down bank stress tests were based on the framework used by the BOJ in its Financial System Report (FSR), and bottom-up tests with common assumptions were conducted for major banks and insurers.5 All calculations were performed by the BOJ (top-down for the banking sector), or by participating banks and insurance companies (bottom-up), based on assumptions and parameters agreed with the FSAP team. The baseline scenario reflects World Economic Outlook projection as of September 2011.6 Three adverse scenarios capturing the key macrofinancial risks were applied to both the banking and insurance sectors:

  • A global double-dip including a significant slowdown in China (mild, with a one standard deviation shock to real GDP growth; and severe, with a two standard deviations shock);

  • A protracted growth slowdown over the medium-to-long-term with further deflationary pressures; and

  • A global double-dip mild scenario combined with a 100 bps parallel shift of the yield curve (representing a moderate market yield shock in line with Japan’s experience in the past 15 years).

Table 9.

Japan FSAP—Stress Test Matrix (STeM) for the Banking Sector: Solvency Risk

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The narrow banking system includes city, trust, regional (tier 1 and 2), foreign, bridge and internet banks, Shinkin bank and credit cooperatives. The broader system additionally includes J-Post and Norinchukin bank.

The relative size of the bottom-up sample are measured by the size of their banking entities in each financial group (overlapping with top-down sample). However, the actual assets covered by bottom-up exercises are larger as financial group consolidation includes exposures held by nonbank entities in a group (including securities firms and consumer finance companies). Assets (RWA) of three mega banks covered in top-down amount to 88 (96) percent of the bottom-up data for the three mega financial groups.

Table 10.

Japan FSAP-Stress Test Matrix (STeM) for the Banking Sector: Liquidity Risk

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The narrow banking system includes as city, trust, regional (tier 1 and 2), foreign, bridge and internet banks, Shinkin bank and credit cooperatives. The broader system additionally includes J-Post bank and Norinchukin bank.

Table 11.

Japan FSAP—Stress Test Matrix (STeM) for the Insurance Sector

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Sources: IMF and FSA.
Figure 8.
Figure 8.

Japan FSAP—Key Macroeconomic Assumptions for Stress Tests

Citation: IMF Staff Country Reports 2012, 210; 10.5089/9781475506358.002.A001

Sources: Bloomberg, FSA, BOJ, and staff estimates.

Separately, sensitivity analyses for a larger market yield (single-factor) shock were conducted as part of the top-down tests for banks.7 Insurance stress tests also examined the impact of some insurance-specific shocks.

Banking sector

19. The banking sector appears broadly resilient to all of the above scenarios, although some regional banks are vulnerable (Figures 913). Aggregate capital ratios for the whole sector remain well above Basel III requirements. In addition, internationally active banks are also likely to meet Basel III capital requirements on an individual basis, reflecting their high initial capital buffers, and the gradual phase in of Basel III rules that provides time to build capital through retained earnings.8 However, regional banks, in particular Tier 2 regional banks, are at greater risk. This sub-group, which represents 7 percent of the system’s total assets, starts with lower CARs given their less stringent regulatory requirements (4 percent, Basel II-based total CAR), and experiences sharper drops in capital than other groups under the protracted growth and double-dip mild with market yield shock scenarios, due to relatively large credit and JGB-related risk exposures.

Figure 9.