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FSRystem
inancial
eport
Summary
October 2019Bank of Japan
2
I. Executive summary
II. Risks observed in financial markets
A. Global financial markets
B. Japanese financial markets
III. Examination of financial intermediation
A. Financial intermediation by financial institutions
B. Financial intermediation by institutional investors
C. Investment in financial assets and funding activities by the private non-financial sector
IV. Examination of financial vulnerabilities
A. Summary
B. Vulnerabilities in domestic financial activities
C. Vulnerabilities in international financial activities
V. Financial institutions' financial bases and risk profiles
A. Financial institutions' profitability
B. Credit risk
C. Market risk
D. Foreign currency funding liquidity risk
E. Financial institutions' capital adequacy
F. Risks associated with digitalization
VI. Macro stress testing
A. Regular macro stress testing
B. Medium- to long-term simulation and stress testing incorporating improvements in operating efficiency
VII. Toward ensuring financial stability in the future
An analysis of potential risks and vulnerabilities associated with the overseas exposure of Japanese banks
Background behind the recent rise in credit costs
Medium- to long-term simulation and stress testing taking into account improvement in operating efficiency
Features and motivations
Contents
This issue newly adds a chapter that comprehensively examines domestic and overseas financial vulnerabilities (Chapter IV) and a section regarding the risks associated with digitalization, which have been becoming increasingly important in recent years (Section F of Chapter V).
New section
New chapter
3
Examination of financial cycle and financial vulnerabilities
The expansion in the financial cycle has continued; however, financial and economicactivities as a whole have shown no signs of overheating observed during the bubbleperiod in the late 1980s.
That said, attention should continue to be paid to the accumulation of vulnerabilities underthe continued expansion in the financial cycle. On the domestic front, the total credit toGDP ratio has continued to rise. Although the ratio remains lower than in the bubble period,the upward deviation from its trend is getting close to the scale in that period. Meanwhile,loans to low-return borrowers with narrow profit margins have been increasing. Credit costsremain low but have recently started to rise, particularly for regional financial institutions(FIs). The outstanding amount of real estate loans has been increasing and has surpassedthe level seen during the bubble period; moreover, the deviation of the real estate loans toGDP ratio from its trend has marked a record high for the post-bubble period. With respectto international finance, as the overseas exposures of Japanese banks increase, Japan'sfinancial system, including banks' foreign currency funding condition, is becoming moresusceptible to the effects of overseas financial cycles.
Executive summary
4
Stability of the financial system
Japan's financial system has been maintaining stability on the whole. FIs generally havestrong resilience in terms of both capital and liquidity with respect to tail events like theonset of the global financial crisis.
However, FIs' profitability, particularly that of domestic deposit-taking and lending activities,has continued to decline. This seems to be not only due to the prolonged low interest rateenvironment but also, from a longer-term perspective, due to structural factors such as thesecular decline in loan demand associated with the shrinking population and the decline inthe potential growth rate. Against this backdrop, major FIs have expanded their globalactivities and pursued group-wide strategies to provide comprehensive financial services,resulting in an increase in their systemic importance. Regional FIs have been activelytaking risks in domestic lending and securities investment. However, as they have not beenable to secure adequate returns relative to the risks involved, their capital adequacy ratioshave continued to decline moderately. Should this situation persist, loss-absorbing capacityin the event of stress would decrease, and downward pressure on the real economythrough a weakening of the financial intermediation function could intensify.
Executive summary (cont'd)
5
Part I. Examination of financial vulnerabilities
Summary
Vulnerabilities on the domestic front
Heat map of Financial Activity Indexes
Financial gap and risks to economic growth (GaR)
Vulnerabilities on the international front
Regional financial institutions
Cre
dit
risk Loans to middle-risk firms
and the real estate industry
Mar
ket
risk
Cre
dit
risk Overseas
lending
Mar
ket
risk
Decline in profitability of domestic deposit-taking and lending activities
Active risk taking to secure profits
Major banks
Potential impact offuture domestic
economic downturnor strengthening ofstructural factors
Risks associated with digitalization:cyber risk, anti-money laundering measures, strategic risk*
*Strategic risk includes climate-related risk in a broad sense.
Potential impact ofoverseas financial
cycles
Securities investment that entailsrisks associated with overseas
interest rates, stock prices,exchange rates, credit, etc.
Overseascredit
investment
Inte
rnat
iona
lbu
sine
ss
Foreign currency liquidity
Dom
estic
busi
ness
Examination of financial vulnerabilities: summary
Profitability of FIs' domestic deposit-taking and lending activities has continued to decline.Against this backdrop, FIs have become more active in risk taking to secure profits.
The major vulnerabilities of Japan's financial system:
(International) expansion of overseas exposures and securities investment that entailsoverseas risks;
(Domestic) loans to middle-risk firms and the real estate industry.
6
Decline in profitability of domestic deposit-taking and lending activities
The decline in profitability of FIs' domestic deposit-taking and lending activities is not onlydue to the prolonged low interest rate but also, from a longer perspective, due to somestructural factors such as the secular decline in loan demand associated with the declinein the potential growth rate reflecting the shrinking population.
The narrowing of FIs' deposit-lending margins started at the end of the 1990s, when thechronic excess savings in the corporate sector began. This structural change has led to arise in the share of debt-free firms and therefore a continued slackening of loan demand.
Against this backdrop, loans to "low-return borrowers," for which through-the-cycleprofitability is difficult to guarantee, have been on an increasing trend.
7
-50
0
50
100
150
200
-1
0
1
2
3
4
80 85 90 95 00 05 10 15
Savings-investment balance bycorporations (rhs)Domestic deposit-lending margins (lhs)
%
FY
Excess savings
Excess investment
tril. yen
Chart IV-1-1: Deposit-lending margins among domestically licensed banks and excess savings by corporations
Chart IV-1-2: Share of debt-free firms
0
10
20
30
40
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
10th-90th percentile rangeMedian
%
FY
Chart IV-2-9: Loan share of low-return borrowers among financial institutions
Source: Teikoku Databank. Source: Teikoku Databank.
25
30
35
40
45
7
8
9
10
11
12
13
14
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Debt-free firms (lhs) debt-free firms (rhs)
%
FY
%
De facto
Vulnerabilities on the domestic front: heat map of Financial Activity Indexes (FAIXs)
The heat map helps detect signs of overheating or contraction over the financial cycle byshowing the degree of the deviation of FAIXs from their trends by different colors.
13 out of the 14 FAIXs appear as "green," which signals neither an overheating nor acontraction, implying that financial and economic activities as a whole have not shownexcessive movements similar to those seen during the bubble period.
The real estate loans to GDP ratio, which turned "red" in the previous issue, has remained"red."
8
CY
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19DI of lending attitudes of financial institutions
Growth rate of M2
Equity weighting in institutional investors' portfolios
Stock purchases on margin to sales on margin ratio
Private investment to GDP ratio
Total credit to GDP ratio
Household investment to disposable income ratio
Household loans to GDP ratio
Business fixed investment to GDP ratio
Corporate credit to GDP ratio
Real estate firms' investment to GDP ratio
Real estate loans to GDP ratio
Stock prices
Land prices to GDP ratio
Real estate
Asset prices
Financialinstitutions
Financialmarkets
Privatesector
Household
Corporate
Chart IV-2-1: Heat map
Source: Bloomberg; Cabinet Office, "National accounts"; Japan Real Estate Institute, "Urban land price index"; Ministry of Finance, "Financial statements statistics of corporations by industry"; Tokyo Stock Exchange, "Outstanding margin trading, etc."; BOJ, "Flow of funds accounts," "Loans and bills discounted by sector," "Money stock," "Tankan."
Vulnerabilities on the domestic front: real estate market
The upward deviation of the real estate loans to GDP ratio from its trend has marked arecord high for the post-bubble period, although regional FIs in particular have becomecautious about extending new loans to the real estate industry.
Based on a wide range of relevant information, including information on land prices,Japan's real estate market cannot, as a whole, be judged as experiencing overheatingdriven by overly optimistic growth expectations as in the bubble period.
However, there is the possibility of a build-up of risks that are different from thoseobserved during the bubble period, such as the increase in long-term lending to rentalproperties amid the declines in population and number of firms.
9
Chart IV-2-2: Real estate loans to GDP ratio
2
4
6
8
10
12
14
16
18
80 83 86 89 92 95 98 01 04 07 10 13 16 19
Original seriesTrend
%
CY
Chart IV-2-5: Land prices to GDP ratio
0
50
100
150
200
250
300
350
80 83 86 89 92 95 98 01 04 07 10 13 16 19
Original seriesTrend
Jan.-Mar. 2000=100
CY
Chart III-1-12: Real estate loans among financial institutions
Source: Cabinet Office, "National accounts"; BOJ, "Loans and bills discounted by sector." Source: Cabinet Office, "National accounts"; Japan Real
Estate Institute, "Urban land price index."
-40
-20
0
20
40
60
-10
-5
0
5
10
15
07 08 09 10 11 12 13 14 15 16 17 18 19
Outstanding amount (lhs)Newly extended loans (rhs)
y/y % chg. y/y % chg.
CY
Vulnerabilities on the domestic front: some FAIXs close to "red"
The total credit to GDP ratio has deviated upward from its trend and is getting close to itsupper threshold because the outstanding amounts of not only bank loans but alsocorporate bonds and CP issued have increased against the background of highlyaccommodative funding conditions.
Among the other FAIXs that are currently "green," some of them are getting closer to "red"(the DI of lending attitudes of financial institutions and the corporate credit to GDP ratio).
It is necessary to carefully examine whether: (1) some shift of FAIXs in the direction ofoverheating occurs; (2) the total number of FAIXs signaling overheating increases.
10
Chart IV-2-6: Total credit to GDP ratio
100
120
140
160
180
200
80 83 86 89 92 95 98 01 04 07 10 13 16 19
Original seriesTrend
%
CY
Chart III-3-1: Outstanding amount of firms' funding
-4
-3
-2
-1
0
1
2
3
4
06 07 08 09 10 11 12 13 14 15 16 17 18 19Equity financeBorrowing from financial institutionsCorporate bondsCPTotal
y/y % chg.
CY
Chart IV-2-8: DI of lending attitudes of financial institutions
-30
-20
-10
0
10
20
30
40
50
80 83 86 89 92 95 98 01 04 07 10 13 16 19
Original seriesTrend
% pts
CY
Accommodative
Severe
Source: Cabinet Office, "National accounts"; BOJ, "Flow of funds accounts."
Source: I-N Information Systems; JASDEC; BOJ.
Vulnerabilities on the domestic front: the financial gap
The "financial gap," the weighted average of the deviation rates of FAIXs from their trends,has fallen somewhat. The fall is mainly attributable to temporary factors such as the stockprice decline from the end of 2018 to early 2019.
The core features of the recent developments have remained unchanged from theprevious issue: (1) its level remains near the highest in the post-bubble period; (2) thecurrent phase has marked the longest period of a positive financial gap since the burst ofthe bubble economy; and (3) a wide range of FAIXs are in positive territory.
11
Chart IV-2-10: Financial gap and output gap
-8
-6
-4
-2
0
2
4
6
8
-2.5-2.0-1.5-1.0-0.50.00.51.01.52.02.5
83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19
Financial gap (lhs)Output gap (rhs)
CY
%Decomposition of financial gap
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
10 11 12 13 14 15 16 17 18 19
Stock-related componentBusiness fixed investment-related component, etc.Real estate-related componentCredit-related component, etc.Financial gap
CY
Note: Financial Activity Indexes included in each component are as follows:Stock-related component: stock prices, equity weighting in
institutional investors' portfolios, stock purchases on margin to sales on margin ratio.
Business fixed investment-related component, etc.: private investment to GDP ratio, business fixed investment to GDP ratio, household investment to disposable income ratio.
Real estate-related component: real estate loans to GDP ratio, real estate firms' investment to GDP ratio, land prices to GDP ratio.
Credit-related component, etc.: total credit to GDP ratio, corporate credit to GDP ratio, household loans to GDP ratio, DI of lending attitudes of financial institutions, growth rate of M2.
Vulnerabilities on the domestic front: GDP-at-risk (GaR)
The extent to which developments in the financial gap may pose a risk to the realeconomy from a longer-term perspective is examined, using the "GDP-at-risk" approach.
The estimated probability distribution of GDP growth over the next 3 years has exhibited afatter tail on the downside in recent years, although this tail is not as fat as during thebubble period.
The recent expansion in the financial cycle has led to an increase in the downside tail riskto economic growth from a somewhat longer-term perspective by building up pressure onbalance sheet adjustments on the back of the cumulative effect of low interest rates.
12
Chart IV-2-12: Financial vulnerabilities and risks to economic growth over the next 3 years (GaR)
Note: The chart presents the time series of probability distributions of annualized changes in output gap over the next 3 years at each point in time.
Chart IV-2-13: Comparison of risks to economic growth by period
0.0
0.1
0.2
0.3
0.4
0.5
0.6
-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6
Latest (April-June quarter of 2019)October-December quarter of 2012January-March quarter of 1990
probability density
changes in output gap over the next 3 years, ann., % pts
CY
probabilitydensity
Vulnerabilities on the international front: increase in major banks' overseas lending
Overseas lending by major banks has been increasing since the global financial crisis.The share of overseas lending in their total lending has reached a historic high.
The increase in the foreign claims is likely attributable to the fact that, compared to U.S.and European FIs, their risk-taking capacity was not significantly impaired by the globalfinancial crisis.
The pace of increase has slowed as international competitive pressure has resumed,reflecting the recovery of financial soundness of overseas FIs, particularly the U.S. banks.
The credit quality of the overall overseas loan portfolio has remained high. Recently,however, some FIs have increased their lending to firms with relatively higher risk.
13
Chart IV-3-4: Overseas loans outstanding of major banks
0
10
20
30
40
0
20
40
60
80
100
120
85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17
Overseas loans outstanding (lhs)Share of overseas loans in total loans (rhs)
tril. yen %
FY
Chart IV-3-5: Composition of major banks' overseas loans by credit rating
0102030405060708090
100
15 16 17 18"Need attention" and below B BB BBB and above
%
FY
050
100150200250300350400450500
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
CY2009=100Japanese financial institutionsU.S. financial institutionsEuropean financial institutionsOther financial institutions
CY
Vulnerabilities on the international front: large increase in leveraged loans
Syndicated loans constitute a major form of lending from Japanese banks to non-Japanese firms in the United States, while the share of such loans in the overall overseascredit portfolios of Japanese banks is presumably not high yet.
Loans to investment-grade firms make up the largest share in the syndicated loansunderwritten by Japanese banks.
In recent years, however, the rate of increase in underwriting of loans to lower-rated andnon-investment-grade firms (i.e., leveraged loans) by Japanese banks has been substantiallyhigher than that by U.S. and European FIs.
14
Chart B1-2: Developments in syndicated loans underwritten by Japanese banks
Note: "Leveraged" and "IG" indicate syndicated loans rated BB or below and rated above BB, respectively.Source: Dealogic.
Syndicated loans underwritten Developments in leveraged loansby Japanese banks by rating
0
10
20
30
40
50
60
70
80
0
50
100
150
200
250
300
00010203040506070809101112131415161718
bil. U.S. dollarsLeveraged (lhs)IG (lhs)Ratio for Japan (rhs)Ratio for U.S. and Europe (rhs)
CY
leveraged loans ratio, %
Vulnerabilities on the international front: global connectedness via overseas lending
An analysis using granular data indicates an increase in the common exposure, i.e., thedegree of overlap in borrower categories, between Japanese major banks and overseasFIs in the underwriting market of syndicated loans, particularly for leveraged loans. Suchloans entail a higher credit risk and raise concerns about vulnerabilities in a recession.
Attention needs to be paid to the fact that, as a result of the tighter connectedness withoverseas FIs, Japan's major banks and financial system are becoming more susceptibleto the effects of overseas financial cycles.
15
Note: 1. "Leveraged" and "IG" indicate syndicated loans rated BB or below and rated above BB, respectively.
2. The figures in the chart are simple averages of Japanese G-SIBs' Interconnectedness Indexes calculated with respect to other G-SIBs.
Source: Dealogic.
Chart B1-4: Japanese G-SIBs' Interconnectedness Index
Calculation methodology for the Interconnectedness Index
Step 1. The distance between banks and is defined as follows:
Step 2. The Interconnectedness Index for bank is calculatedbased on this distance:
Interconnectedness of bank 1 100
* Weights are calculated from the number of common transactions.
The distance between banks and (between 0 and 1) =
′
* Categories are classified by country and industry.
70
75
80
85
90
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18CY
Leveraged
IG
Vulnerabilities on the international front: overseas credit investment by major banks
Investment in overseas credit products by Japan's FIs has mainly focused on investment-grade corporate bonds, but growth in investments in, for example, collateralized loanobligations (CLOs) has been increasing. There are substantial differences acrossindividual FIs in their investment stance regarding these products and the size andcomposition of their exposure.
The amount of CLOs arranged in 2018 reached a new record, reflecting the increase ininvestor demand when market participants were concerned about U.S. policy rate hikes.
The CLO investment of Japanese banks currently accounts for about 20 percent of theirinvestment in overseas credit products overall. Their share of the total outstanding amountin the global CLO market is also considerable, accounting for approximately 15 percent.Most of this investment is in tranches with the highest AAA credit rating.
16
Chart III-1-25: Outstanding amount of overseas credit product investment among major banks and other financial institutions
0
20
40
60
80
15 16 17 18
Other overseas credit productsCLOsHigh-yield bondsInvestment-grade corporate bonds
FY
tril. yen
Note: Covers major banks, Japan Post Bank, and a central organization of financial cooperatives.
Chart IV-3-7: Issuance of CLOs
Source: Bloomberg; Creditflux, "CLO-i."
0
20
40
60
80
100
0
50
100
150
200
250
300
350
400
00010203040506070809101112131415161718
Equities, etc. (lhs)Non-IG (lhs)IG except AAA (lhs)AAA (lhs)Refinancing ratio (rhs)
%
CY
bil. U.S. dollars
Interest paymentDividend payout
AAA-rated tranche
Other notes
Interest payment
Bond holders
Balance sheet of a CLO
Investors
Underlying asset 1(Leveraged loan)
・・・
Underlying asset 2(Leveraged loan)
Underlying asset 3(Leveraged loan)
(B)
(A)
(a)
(b)
(i)(ii)
(iii)
Interest income
Interest payment capacity (Interest income (A) / Interest payment (a) )Collateral adequacy (Collateral value of underlying assets (B) / Outstandingamount of AAA-rated tranche (b) )Quality of underlying assets (ratings)
Vulnerabilities on the international front: structure of a CLO
A CLO is a securitized product with a structure that distributes interest income from theunderlying leveraged loans to investors who own AAA-rated tranches and other notes.Repayment of principals and interest payments to the AAA-rated tranches take priorityover payments to other notes.
The soundness of an AAA-rated tranche is monitored by indicators such as (i) interestpayment capacity (A>a in the chart), (ii) collateral adequacy (B>b), and (iii) quality ofunderlying assets (i.e., ratings).
17
Structure and soundness indicators of a CLO
Vulnerabilities on the international front: soundness of AAA-rated tranches of CLOs
Various indicators for the soundness of AAA-rated CLO tranches show that (i) the incomefrom the underlying assets is currently sufficient and substantially exceeds the amount ofinterest payments to AAA-rated tranches.
(ii) The collateral adequacy ratios, i.e., the collateral value of the underlying asset amountoutstanding divided by the AAA-rated tranche amount outstanding, are higher than thosebefore the global financial crisis, implying that the robustness of AAA-rated tranches hasrisen.
On the other hand, (iii) the quality of the underlying leveraged loans (i.e., average ratings)has been deteriorating particularly since the beginning of 2015.
18
Chart IV-3-9: Soundness indicators of AAA-rated tranches of CLOs(i) Interest payment capacity (ii) Collateral adequacy (iii) Weighted average rating score
of underlying assets
0100200300400500600700800900
1,000
05 07 09 11 13 15 17
%
CY1,800
2,000
2,200
2,400
2,600
2,800
3,000
3,200
05 07 09 11 13 15 17CY90
100
110
120
130
140
05 07 09 11 13 15 17
%
CY
Note: 1. "Interest payment capacity" (median) indicates interest income from underlying loans divided by interest payment to AAA-rated tranches.2. "Collateral adequacy" (median) indicates the ratios of the outstanding of underlying assets to that of AAA-rated tranches.3. An increase in "weighted average rating score of underlying assets" (median) indicates a downgrading of underlying assets.
Source: Creditflux, "CLO-i."
Vulnerabilities on the international front: credit risk of AAA-rated tranches
Using granular data, the credit stress simulations examine changes in the robustness ofAAA-rated tranches based on changes in the ratings of underlying assets during theglobal financial crisis.
Scenario 1 assumes a downgrading by only half as much as during that period; Scenario2 assumes a downgrading of the same extent as during that period; Scenario 3 imposesan additional severe assumption that the recovery rate of defaulted underlying assets isonly half that observed during the global financial crisis.
In all scenarios, the income from the underlying assets continues to exceed the amount ofinterest payments, and the collateral value of the underlying assets remains higher thanthe outstanding amount of AAA-rated tranches.
19
Chart B2-1: Changes in the composition of the rating of underlying assets by scenario
Source: Creditflux, "CLO-i."
0102030405060708090
100
Data as atend of 2018
Scenario 1 Scenario 2 Scenario 3
DefaultedCCC and belowBBBIG
%
Chart B2-2: Stress simulation of credit risk for AAA-rated tranches of CLOs
Note: 1. In the left-hand chart, interest income from loans with a rating of CC or below is assumed to be zero.The value for "Data as at 2018" is the median.
2. In the right-hand chart, the value of loans with a rating of B or above is calculated by book value, while the value of loans with a rating below B is calculated by market value. The market value used here is estimated using the median of transaction prices for each rating in 2009. In Scenario 3, the value of loans with a rating of below B is calculated at half the price of the market value. The value for "Data as at 2018" is the median.
Source: Creditflux, "CLO-i. "
Interest payment capacity Collateral adequacy
80
90
100
110
120
130
140
Data as at2018
Scenario 1 Scenario 2 Scenario 3
%
0
50
100
150
200
250
Data as at2018
Scenario 1 Scenario 2 Scenario 3
%
Vulnerabilities on the international front: market risk of AAA-rated tranches
The market stress simulations examine the impact on the price of CLOs by assuming thatthe market spread for the tranches of each rating increases to the maximum levelobserved during the global financial crisis, based on the fact that: (1) a substantial numberof AAA-rated tranches were downgraded to AA or below; (2) the spreads of tranches ratedAA or below, in particular, increased substantially.
The results indicate that even AAA-rated tranches would experience a price drop of about10 percent due to the increase in spreads. If AAA-rated tranches were downgraded to AAor A, their prices would drop by 20 to 30 percent. In addition, there exists the possibilitythat, in the event of market stress, an amplification of price drops due to an increase indurations could be observed.
20
Chart B2-3: Stress simulation of market risk for AAA-rated tranches of CLOsChanges in the rating of CLO tranches Market value of CLO tranches in the event of stress
(case of 2-year duration)
Note: In the right-hand chart, changes in the market values are calculated based on the maximum increase in spreads for each rating during the global financial crisis. The price changes are simulated as changes in the present values caused by the increase in discount rates, which are assumed to increase by the same amounts as the spreads. The market values shown here are scaled by AAA-rated tranches before stress, which are normalized to 1.
Source: Bloomberg; Creditflux, "CLO-i."
0
20
40
60
80
100
Data as atend of 2018
Scenario 1 Scenario 2
Non-IG BBB AAA AAA
%
0.0
0.1
0.2
0.30.4
0.5
0.6
0.70.8
0.9
1.0
AAA AA A BBB BB
value of AAA-rated tranches before stress = 1
Ratings in the event of stress
Vulnerabilities on the international front: market risk of AAA-rated tranches (cont'd)
These simulation results suggest that AAA-rated tranches of CLOs are reasonably robustin terms of credit risk, i.e., protected against a loss of principal or a suspension of interestpayments in the event of stress. However, attention should be paid to, among other things,the risk of a decline in market prices, due to a downgrading of ratings in the event of asudden change in economic and market conditions.
21
22
Part II. FIs' financial bases and risk profiles
FIs' profitability
Background behind the rise in credit costs
FIs' capital adequacy
0.0
0.5
1.0
1.5
2.0
2.5
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
06 07 08 09 10 11 12 13 14 15 16 17 18
Other (lhs) Tax-related expenses (lhs)
Realized gains/losses on stockholdings (lhs) Realized gains/losses on bondholdings (lhs)
Credit costs (lhs) Pre-provision net revenue (excluding trading income, lhs)
Net income (lhs) Net interest income (rhs)
tril. yen tril. yen
FY0
2
4
6
8
-6
-4
-2
0
2
4
6
06 07 08 09 10 11 12 13 14 15 16 17 18FY
tril. yen tril. yen
0
1
2
3
4
5
6
-3
-2
-1
0
1
2
3
06 07 08 09 10 11 12 13 14 15 16 17 18
tril. yen tril. yen
FY
FIs' profitability
FIs' net income in fiscal 2018 remained high from a historical perspective. However, itshowed a somewhat large decline.
Pre-provision net revenue (PPNR) excluding trading income continued to follow adecreasing trend, reflecting the persistent downward trend in domestic net interest income.
Gains from securities trading were sluggish due in part to market developments such asthe rise in U.S. interest rates and the decline in stock prices. Credit costs remained lowbut showed some increase. Financial results for fiscal 2018 highlight that the offsettingeffects that have supported the FIs' declining core profitability have become less powerful.
23
Chart V-1-1: Developments in and decomposition of net income
Source: Published accounts of each bank; BOJ.
Major financial groups Regional banks Shinkin banks
Background behind the rise in credit costs
Credit cost ratios (i.e., credit costs divided by total loans outstanding) have remained lowbut started to rise, particularly for regional FIs. Firms' default rate has risen slightly.
Two major points behind the recent rise in credit costs: first, some low-performing firmswith a long-standing business relationship with their FIs have been facing a delay inbusiness restructuring; and second, there is some slackening of loan screening and creditrisk management amid FIs' efforts to increase lending.
Against this backdrop, an increasing number of FIs have raised loan-loss provisions. FIsneed to become even more aware of the possible effects on credit costs associated withthe materialization of downside risks to the economy.
24
Chart V-1-3: Credit cost ratios by type of bank
-0.2
0.0
0.2
0.4
0.6
0.8
06 08 10 12 14 16 18
Major banksRegional banks banks
%
FY
Shinkin
Chart V-1-6: Firms' default rate
Source: The Risk Data Bank of Japan.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19
%
CY
Chart V-1-5: Financial institutions' view on developments in credit costs
Note: View on future credit costs.
0
10
20
30
40
50
60
Willincrease
Willsomewhatincrease
Will bemore orless flat
Willsomewhatdecrease
Willdecrease
Regional banks banks
ratio, %
Shinkin
-1.2
-0.8
-0.4
0.0
0.4
0.8
14 15 16 17 18Risk-weighted assets Hybrid debt capital instrumentsRetained earnings Other factorsChanges in capital adequacy ratios
FY
change from previous period, % pts
FIs' capital adequacy
Capital adequacy ratios have been sufficiently above the regulatory levels for all types.
However, those of domestic banks have continued to gradually decline in recent years.This decline mainly reflects the fact that retained earnings are growing at a slower pacethan risk-weighted assets, partly due to the increase in loans to low-return borrowers.
25
Chart V-5-1: Financial institutions' capital adequacy ratiosInternationally active banks Domestic regional banks Domestic shinkin banks
Chart V-5-2: Factors of changes in capital adequacy ratiosDomestic regional banks Domestic shinkin banks
4
6
8
10
12
14
16
18
02 04 06 08 10 12 14 16 18
%
FY0
2
4
6
8
10
12
14
16
18
12 14 16 18 20
%
FY
CARTier 1 capital ratioCET1 capital ratio
Regulatory levels(including capital conservation buffer)
CET1Tier 1CAR
4
6
8
10
12
14
16
18
02 04 06 08 10 12 14 16 18
%
FY
Capitaladequacy ratioTier 1 capitalratioCore capitalratio
-1.2
-0.8
-0.4
0.0
0.4
0.8
14 15 16 17 18
change from previous period, % pts
FY
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
11 12 13 14 15 16 17 18
Unrealized gains/losses on securities
Amount of risk
Core ROA
∆Net non-interest income
∆Adjusted overhead ratio
Population (year-on-year change)
∆Unemployment rate
Target ratio
FY
cumulative changes from FY2010, % pts
Estimation of capital adequacy ratios that FIs use as a yardstick
Changes in FIs' capital adequacy ratios could affect their risk-taking behavior such aslending.
The estimation results for the capital adequacy ratio that domestic banks use as ayardstick of their business stability (the "target ratio") show that average actual capitaladequacy ratios are recently falling below the target ratio. Regional banks may besomewhat raising their target ratios partly due to declines in unrealized gains that theyhave used as a de facto buffer.
Attention needs to be paid to the possibility that FIs' lending attitudes might become morecautious given that the capital adequacy ratio at regional FIs started to decrease.
26
Chart V-5-5: Target and actual capital adequacy ratios
Chart B3-2: Decomposition of target ratio
4
6
8
10
12
14
05 07 09 11 13 15 17
Target ratioActual capital adequacy ratio
%
FY
Results of the survey on shareholder governance
A recent survey of regional banks shows that among around 60 regional banks that usedor referred to the cost of equity, nearly 80 percent indicated that their own sustainableearnings "underperform" (or "underperform strongly") their cost of equity.
Many respondents cited "increase in non-interest income" and "cost reduction" as theircounter-measures to meet shareholder requests.
Regional banks are aware that their profitability falls below the level requested byshareholders and try to ensure various income sources and improve operating efficiency.
27
Chart V-5-10: Comparison between earnings and the cost of equity
Survey question: "How are your bank's sustainable earnings compared to the cost of equity?"
0
10
20
30
40
50
60
70
80
90
100
Outperform strongly
Outperform
Are almost balanced
Underperform
Underperformstrongly
%
Chart V-5-11: Counter-measures to meet shareholder requests
Note: Results of the survey on business management and shareholder governance conducted in fiscal 2019. The survey covers listed regional banks (for those affiliated with financial holding companies, only banks with the largest total assets are covered).
Survey question: "What counter-measures has your bank taken to achieve the business target thatyour shareholders focus on?" (up to five options could be selected)
0102030405060708090
100
Incr
ease
in n
on-in
tere
st in
com
e
Cos
t red
uctio
n
Mor
e ac
tive
lend
ing
in th
epr
efec
ture
whe
re th
e he
ad o
ffice
is lo
cate
d
Shar
e bu
ybac
ks
Sale
s of
stra
tegi
c st
ockh
oldi
ngs
Mor
e ac
tive
lend
ing
in th
ene
ighb
orin
g pr
efec
ture
s or
urb
anar
eas
Incr
ease
in d
ivid
end
payo
uts
Incr
ease
in s
ecur
ities
inve
stm
ent
Rea
lizat
ion
of g
ains
on
secu
ritie
sfo
r div
iden
d pa
yout
s
Mer
gers
and
allia
nces
Res
train
t in
lend
ing
or s
ecur
ities
inve
stm
ent w
ith h
igh
risks O
ther
%
28
Part III. FIs' resilience to tail risk
Regular macro stress testing
Medium- to long-term simulation and stress testing incorporating improvements in operating efficiency
6
7
8
9
10
11
12
13
13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29FY
Improvementsin operating efficiency
capital adequacy ratio, %Simulation Period
ImmediateStress Event Future
Stress Event
Extended Baseline
Stress resilienceat the present moment
Stress resilience in the future
Overview of the macro stress testing (MST)
(1) A regular MST that assumes the immediate realization of risk; and (2) a medium- tolong-term MST that assumes that a stress event occurs in 5 years' time are presented.
The second MST was conducted in the previous issue to examine the implication of apossible prolonged decline in Japan's FIs' profitability for the future financial stability.
This issue also estimates how regional FIs' efforts to improve operating efficiency, such asoverhead cost savings and increases in net non-interest income, will affect the futureprofits and financial soundness of regional FIs, and incorporates those effects into themedium- to long-term baseline scenario.
The aim of the second MST is to show, with a certain degree of practicality, the possibilitythat changes in FIs' activities improve their profitability and stress resilience.
29
Macro stress testing in this issue of the Report
Results of the regular MST
The results of the regular MST assuming a realization of an immediate tail eventcomparable to the global financial crisis indicate that net income substantially declinesdue to an increase in credit costs and securities-related realized losses, as well as adecline in PPNR excluding trading income.
Capital adequacy ratios decrease correspondingly but exceed regulatory requirements onaverage for all types of banks.
30
Note: "Other factors" includes taxes, dividends, and CET1 regulatory adjustments.
12.9
8.3
456789
101112131415
Base
line
Incr
ease
in u
nrea
lized
loss
es o
n se
curit
ies
hold
ings
Incr
ease
in c
redi
t cos
ts
Dec
reas
e in
PPN
R (e
xcl.
tradi
ng in
com
e)
Det
erio
ratio
n in
real
ized
gai
ns/lo
sses
on
secu
ritie
s ho
ldin
gs
Dec
reas
e in
risk
-wei
ghte
d as
sets
Oth
er fa
ctor
s
Tail
even
t
%CET1 capital ratioIncreasing factorDecreasing factor 12.0
11.3
456789
101112131415
Base
line
Incr
ease
in c
redi
t cos
ts
Dec
reas
e in
PP
NR
(exc
l. tra
ding
inco
me)
Det
erio
ratio
n in
real
ized
gai
ns/lo
sses
on
secu
ritie
s ho
ldin
gs
Dec
reas
e in
risk
-wei
ghte
d as
sets
Oth
er fa
ctor
s
Tail
even
t
%Core capital ratioIncreasing factorDecreasing factor
9.6
7.3
456789
101112131415
Base
line
Incr
ease
in c
redi
t cos
ts
Dec
reas
e in
PPN
R (e
xcl.
tradi
ng in
com
e)
Det
erio
ratio
n in
real
ized
gai
ns/lo
sses
on
secu
ritie
s ho
ldin
gs
Incr
ease
in ri
sk-w
eigh
ted
asse
ts
Oth
er fa
ctor
s
Tail
even
t
%Core capital ratioIncreasing factorDecreasing factor
Chart VI-1-7: Decomposition of the CET1 capital ratio and the core capital ratio (fiscal 2022)Internationally active banks Domestic regional banks Domestic shinkin banks
Regional FIs' operating efficiency (adjusted overhead ratios)
The medium- to long-term simulation uses the adjusted overhead ratio (OHR), the ratio ofoverhead costs to core gross operating profits, as an indicator for measuring operatingefficiency. A lower value of the adjusted OHR means that an FI's operating efficiency ishigher.
The adjusted OHRs of regional FIs have been on an upward trend since the mid-2000s(i.e., operating efficiency has been on a downward trend) as the decline in core grossoperating profits has outpaced the decline in overhead costs.
Currently, the average adjusted OHR for regional banks is around 70 percent, while thatfor shinkin banks is around 80 percent.
31
Chart VI-2-1: Adjusted OHR of regional financial institutions
Regional banks Shinkin banks
40
50
60
70
80
90
75
100
125
150
175
200
225
250
82 86 90 94 98 02 06 10 14 18
Adjusted OHR (rhs)Overhead costs (lhs)Core gross operating
FY1982=100
FY
%
profits (lhs)
40
50
60
70
80
90
75
100
125
150
175
200
225
250
82 86 90 94 98 02 06 10 14 18
Adjusted OHR (rhs)Overhead costs (lhs)Core gross operating profits (lhs)
FY1982=100
FY
%
Regional FIs' overhead cost savings
About 80 percent of regional FIs have reduced their overhead costs over the last 5 years,with about half of them saving on overhead costs at an average annual rate of greaterthan 1 percent.
Regional FIs in recent years have been accelerating their efforts to streamline operationswhile paying attention to making IT investments and securing the human resourcesnecessary for strategic business evolution.
32
Chart VI-2-4: Overhead costs of regional financial institutions
Regional banks Shinkin banks
-30
-20
-10
0
10
20
30
40
50
90 94 98 02 06 10 14 18
10th-90th percentile range25th-75th percentile rangeMedian
5-year % chg.
FY-30
-20
-10
0
10
20
30
40
50
90 94 98 02 06 10 14 18
10th-90th percentile range25th-75th percentile rangeMedian
5-year % chg.
FY
Regional FIs' net non-interest income ratio
Net non-interest income ratios for regional banks and shinkin banks have remainedlargely unchanged in recent years, and their levels have been below those of major banksin Japan and their regional FI peers abroad.
33
Chart VI-2-5: Developments in net non-interest income ratio
Note: Net non-interest income ratio = net non-interest income / core gross operating profits
0
5
10
15
20
25
30
35
40
45
05 06 07 08 09 10 11 12 13 14 15 16 17 18
Major banksRegional banks banks
%
FY
Shinkin
Chart VI-2-6: Comparison of net non-interest income ratio by type of bank and by region
By type of bank By region
Note: 1. In the left-hand chart, net non-interest income ratio is defined in the same way as in Chart VI-2-5. Data as at fiscal 2018.
2. In the right-hand chart, net non-interest income ratio is calculated as (gross operating profits - net interest income) / gross operating profits. Gross operating profits here include realized gains/losses on securities holdings. For Japan, data cover regional financial institutions. For the United States and Europe, financial institutions whose gross operating profits are larger than the maximum of Japan's regional financial institutions are excluded. Data are averages over fiscal 2015-2017.
Source: OECD; S&P Global Market Intelligence; BOJ.
0
10
20
30
40
50
60
banks Regional banks Major banks
25th-75th percentile rangeMedian
%
3.1%
10.5%
33.7%
Shinkin0
10
20
30
40
50
60
Japan United States Europe
25th-75th percentile rangeMedian
%
17.6%
10.9%
37.3％
Top value: bil. yen; middle and bottom values: %
-5% -10% -15%
+151.8 +45.5 +7.0
<15.4> <13.3> <12.5>
+89.7 +34.2 +10.2
<8.7> <5.6> <4.2>
[+1.4]<12.3>
Actual values of FY2018Top value: assumed amount of increase in net non-interest incomeMiddle value: assumed rate of increase in net non-interest income
Bottom value: assumed net non-interest income ratio
Core grossoperating profits
Net non-interestincome
Three cases of overhead cost savings over the next 10 years
Regional banks 4,141.0 510.3 [+29.7] [+8.9]
Shinkin banks 1,594.7 57.2 [+156.7] [+59.7] [+17.8]<3.6>
Simulation assumption (1): assumed improvements in operating efficiency
The medium- to long-term simulation incorporates improvements in operating efficiency,such as (1) overhead cost savings, and (2) increases in net non-interest income such asfees and commissions, both of which are the focus of regional FIs in recent years, into thebaseline scenario.
Hereafter, this case is referred to as the "increasing efficiency case" and compared to the"constant efficiency case," which assumes no such improvements in operating efficiency.
The "increasing efficiency case" assumes that the adjusted OHR improves by around 5percentage points. This size of improvement is calculated assuming net interest incomefixed at the current level. If this improvement were achieved immediately, the adjustedOHR would be around 65 percent and 75 percent for regional banks and shinkin banks.
For regional banks, this improvement can be achieved by increasing their net non-interestincome by about 10 percent over the next 10 years and saving by about 1 percent peryear on their overhead costs, which is the observed average pace in recent years (Seethe table below).
34
Chart VI-2-9: Combination of overhead cost savings and increases in net non-interest income
0
5
10
15
20
25
-60 60-70 70-80 80-90 90-
10th-90th percentile rangeMedian
size of improvement, % pts
adjusted OHR, %
Simulation assumption (1): assumed improvements in operating efficiency (cont'd)
From individual FIs' perspective, the above assumption is consistent with assuming animprovement in operating efficiency to the level achieved by the top 10 percent of FIshaving similar characteristics such as size and belonging to the same bank type.
The size of improvements in operating efficiency for each FI is estimated by a quantitativemethod called "stochastic frontier analysis."
Since there is a considerable dispersion of adjusted OHRs among individual FIs, thedifficulty of achieving the assumed level is not the same across these institutions.
The aim of assuming improvement in operating efficiency in the medium- to long-termsimulation is not to uniquely present the scenario most likely to be realized or the level ofoperating efficiency that FIs should aim for, but to understand the severity of FIs' futureprofit environment and the importance of various efforts to respond to it by showingseveral hypothetical scenarios and the simulation results under those scenarios.
35
Chart VI-2-10: Assumed improvement in operating efficiency
Regional banks Shinkin banks
Note: Figures in the chart indicate the assumed size of reductions in adjusted OHR in the increasing efficiency case.
0
5
10
15
20
25
-60 60-70 70-80 80-90 90-
10th-90th percentile rangeMedian
size of improvement, % pts
adjusted OHR, %
Simulation assumption (2): supply-demand balance in the loan market
36
A mechanism in which the secular decline in loan demand leads to a fall in lendingmargins through a loosening of the supply-demand balance in the loan market is the sameas the one assumed in the previous issue. The "loan demand index," calculated as thenumber of borrowing firms per bank branch, was used as a proxy variable.
As in the previous issue, it is assumed that, in tandem with the continued decline in theloan demand index, the share of loans to low-return borrowers continues to rise.
Chart VI-2-12: Loan demand index (medium- to long-term baseline scenario)
Chart VI-2-11: Share of "branch-in-branch" among all branches
0
1
2
3
4
5
6
0
2
4
6
8
10
12
14
06 07 08 09 10 11 12 13 14 15 16 17 18
Overall (rhs)Major banks (lhs)Regional financial institutions (rhs)
%
CY
%
Source: The Japan Financial News Co., Ltd.
10
15
20
25
30
35
40
45
50
06 08 10 12 14 16 18 20 22 24 26 28
Major banksRegional banks banks
%
Simulation
FY
Shinkin
Source: Teikoku Databank.
2.0
2.5
3.0
3.5
4.0
4.5
60
70
80
90
100
110
120
06 08 10 12 14 16 18 20 22 24 26 28Loan demand index (previous version)Loan demand index in the constant efficiency caseLoan demand index in the increasing efficiency caseNumber of firms with a positive amount of borrowings (rhs)
FY2006=100 mil. firms
FY
Simulation
Decrease in loan demand
Chart VI-2-13: Share of loans to low-return borrowers (medium-to long-term baseline scenario)
Note: "Loan demand index in the constant efficiency case" takes into consideration the effect of the de facto decreases in the number of branches by using "branch-in-branch" consolidation. "Loan demand index in the increasing efficiency case" additionally supposes that overhead cost saving efforts induce streamlining of branches, etc.
Source: Ministry of Internal Affairs and Communications; Teikoku Databank; The Japan Financial News Co., Ltd.
Simulation assumption (2): supply-demand balance in the loan market (cont'd)
37
FIs have recently been introducing so-called "branch-in-branch" consolidation and jointbranches, as well as "lightweight" branches. The simulation attempts to refine the loandemand index, taking into account the effects of changes in the branch operations on thesupply-demand conditions in the loan market.
Namely, (1) the de facto decline in the number of branches due to the increased use of"branch-in-branch" consolidation, and (2) streamlining of branch operations as part ofoverhead cost savings assumed in the "increasing efficiency case," both of which willmoderate the downward trend in the loan demand index somewhat going forward.
Chart VI-2-12: Loan demand index (medium- to long-term baseline scenario)
Chart VI-2-11: Share of "branch-in-branch" among all branches
0
1
2
3
4
5
6
0
2
4
6
8
10
12
14
06 07 08 09 10 11 12 13 14 15 16 17 18
Overall (rhs)Major banks (lhs)Regional financial institutions (rhs)
%
CY
%
Source: The Japan Financial News Co., Ltd.
10
15
20
25
30
35
40
45
50
06 08 10 12 14 16 18 20 22 24 26 28
Major banksRegional banks banks
%
Simulation
FY
Shinkin
Source: Teikoku Databank.
2.0
2.5
3.0
3.5
4.0
4.5
60
70
80
90
100
110
120
06 08 10 12 14 16 18 20 22 24 26 28Loan demand index (previous version)Loan demand index in the constant efficiency caseLoan demand index in the increasing efficiency caseNumber of firms with a positive amount of borrowings (rhs)
FY2006=100 mil. firms
FY
Simulation
Decrease in loan demand
Chart VI-2-13: Share of loans to low-return borrowers (medium-to long-term baseline scenario)
Note: "Loan demand index in the constant efficiency case" takes into consideration the effect of the de facto decreases in the number of branches by using "branch-in-branch" consolidation. "Loan demand index in the increasing efficiency case" additionally supposes that overhead cost saving efforts induce streamlining of branches, etc.
Source: Ministry of Internal Affairs and Communications; Teikoku Databank; The Japan Financial News Co., Ltd.
Simulation assumption (3): macroeconomic variables
The way to set paths for the macroeconomic variables is identical to the previous issue.
Regarding the output gap, the first 3 years of the scenario are identical to the baselinescenario in the regular macro stress testing. For the subsequent 7 years, the scenario isbased on the assumption that the output gap gradually converges to zero, i.e., its long-runequilibrium level. Population continues to decline moderately in line with the medium-fertility and medium-mortality case. The potential growth rate evolves in the range of 0.5-1.0 percent, which is close to the current level.
Government bond yields evolve in line with the forward rates implied by the yield curve.Stock prices and foreign exchange rates are assumed to be constant over the simulationperiod.
38
Chart VI-2-8: Nominal interest rates (medium-to long-term baseline scenario)
Source: Bloomberg; Ministry of Finance.
Chart VI-2-7: Output gap (medium- to long-term baseline scenario)
-5
-4
-3
-2
-1
0
1
2
3
06 08 10 12 14 16 18 20 22 24 26 28
%
Simulation
FY-0.4
0.0
0.4
0.8
1.2
1.6
2.0
06 08 10 12 14 16 18 20 22 24 26 28
Long-term interest rates (10-year JGBs)Short-term interest rates (3-month T-Bills)
%
Simulation
FY
Simulation result (1): loans outstanding
In the baseline scenario, growth in loans outstanding of domestic banks gradually slows,reflecting the decline in Japan's population and the shrinking of the positive output gap.Loans outstanding of internationally active banks maintain a largely constant growth rate,with the decline in domestic lending -- as observed in domestic banks -- being offset bythe growth in overseas lending.
39
Chart VI-2-14: Loans outstanding in the increasing efficiency case(medium- to long-term baseline scenario)
-6
-4
-2
0
2
4
6
8
06 09 12 15 18 21 24 27
OverseasDomesticLoans outstanding
y/y % chg.
Simulation
-6
-4
-2
0
2
4
6
8
06 09 12 15 18 21 24 27
OverseasDomesticLoans outstanding
y/y % chg.
Simulation
-6
-4
-2
0
2
4
6
8
06 09 12 15 18 21 24 27
OverseasDomesticLoans outstanding
y/y % chg.
Simulation
FY
Internationally active banks Domestic regional banks Domestic shinkin banks
Simulation result (2): interest rates on securities and lending rates
Even with market interest rates turning upward, lending rates remain more or lessunchanged except for at the very end of the simulation period, due to the continuingstructural downward pressure reflecting the decline in loan demand. Yields on securitieswill decline even from a somewhat longer-term perspective, reflecting the fact that yieldcurves both at home and abroad are currently flattening.
As the "increasing efficiency case" incorporates the effects which somewhat moderate thedownward trend in loan demand, downward pressure on lending margins is alleviatedcompared to the "constant efficiency case."
40
Chart VI-2-15: Interest rates on securities and lending rates in the increasing efficiency case(medium- to long-term baseline scenario)
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
09 11 13 15 17 19 21 23 25 27 29Other factors Interest ratesLoan demand Lending margins
FY
change from FY2009, % pts
Simulation0.0
0.5
1.0
1.5
2.0
2.5
06 08 10 12 14 16 18 20 22 24 26 28
Lending ratesInterest rates on securities
%
Simulation
FY
Interest rates on securities and lending rates Decomposition of lending margins(domestic banks) (domestic business sector)
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
06 09 12 15 18 21 24 27
Increasing efficiency case Constant efficiency case
Simulation
%
FY-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
06 09 12 15 18 21 24 27
Simulation
%
Simulation result (3): net income
As a result, net income of domestic banks follows a downward trend throughout thesimulation period. However, average net income ROA of domestic banks in the"increasing efficiency case" significantly shifts upward compared to the "constantefficiency case," which does not assume any improvements in operating efficiency, asdoes the entire cross-sectional distribution of net income ROA.
While the improvement in operating efficiency in the "increasing efficiency case" cannotfully compensate for the downward pressure on profits in domestic deposit-taking andlending activities and in securities investment and the upward pressure on credit costs, itdoes make a substantial positive contribution to profits.
41
Domestic regional banks Domestic shinkin banks
Chart VI-2-16: Net income ROA (medium- to long-term baseline scenario)
Note: The shaded areas indicate the 10th-90th percentile range in the increasing efficiency case, and the thin dotted lines indicate the 10th-90th percentile range in the constant efficiency case.
Chart VI-2-17: Decomposition of net income ROA in the increasing efficiency case(medium- to long-term baseline scenario)
Domestic banks
-0.2
-0.1
0.0
0.1
0.2
18 19 20 21 22 23 24 25 26 27 28 29
Profits from the increase in efficiency
Profits from domestic lending
Profits from overseas lending andinterest and dividends from securitiesCredit costs
Realized gains/losses on securities holdings
Net income ROA (before taxes)
Simulation
change from FY2018, % pts
FY
6.26.6
0
4
8
12
16
20
24
23 24 25 26 2710th-90th percentile range Tail event in the constant efficiency caseTail event in the increasing efficiency case Baseline in the increasing efficiency case
%
Tail event scenario in 5 years' time
FY
10.411.0
0
4
8
12
16
20
24
23 24 25 26 27
%
Tail event scenario in 5 years' time
Results of stress testing: an immediate tail event and a tail event in 5 years' time
Comparing the immediate tail event and that in 5 years' time for domestic banks, theresults of the latter are more severe because, over the next 5 years, (1) the share of loansto low-return borrowers is assumed to increase, leading to more credit costs in the eventof stress; and (2) locking in gains on securities and the decline in unrealized gains areassumed to continue, leading to larger impairment losses.
The capital adequacy ratios are higher in the "increasing efficiency case" than those in the"constant efficiency case" by around 0.5 percentage points. Although these results aresubject to a large margin of error, they suggest that wide-ranging efforts by FIs to improveoperating efficiency will significantly enhance their future financial soundness and stressresilience.
42
Chart VI-1-6: CET1 capital ratios and core capital ratios (immediate tail event scenario)
Chart VI-2-20: CET1 capital ratios and core capital ratios (tail event scenario in 5 years' time)
Domestic regional banks Domestic shinkin banks
Note: "10th-90th percentile range" is for the tail event in the increasing efficiency case.Note: "10th-90th percentile range" is for the tail event.
Domestic regional banks Domestic shinkin banks
7.3
0
4
8
12
16
20
24
18 19 20 21 2210th-90th percentile range Baseline Tail event
Simulation
%
FY
11.3
0
4
8
12
16
20
24
18 19 20 21 22
Simulation%
43
Japan's financial system has been maintaining stability on the whole. However, FIs' profitability,particularly that of domestic deposit-taking and lending activities, has continued to decline.
A recovery in the profitability of FIs is important for ensuring stability of the financial system into thefuture. To achieve this, it is essential to raise the potential growth rate of Japan's economy andrevitalize regional economies. For this to be achieved, various entities need to make their efforts:firms to increase their productivity; and the government to reform regulations and institutions, andstimulate innovation. FIs can also play an important role by providing solution-related services forfirms regarding business succession and restructuring, as well as financial services supportingwealth accumulation by households in response to the rise in longevity. FIs have already beenintensifying such efforts, but they need to further accelerate efforts to improve operating efficiency,including those indicated in this Report.
Against this backdrop, in order for the financial system to maintain stability into the future and carryout its financial intermediation functions effectively even in the event of stress, FIs need to addressthe following four business challenges.
First, FIs should strengthen efforts to raise their core profitability. Specifically, they need toaccelerate efforts to (1) enhance their capacity to provide more attractive financial services suchas solution-related services for firms and services supporting households' wealth accumulation,(2) keep their loan interest rates commensurate with the risks involved and increase their non-interest income based on the provision of enhanced services, and (3) review business processesand expense structures. To strongly promote the improvement in operating efficiency, effectiveoptions include mergers or collaboration with other FIs, as well as alliances with firms in otherbusiness areas.
Toward ensuring financial stability in the future
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Second, FIs should enhance their risk management in areas where they have actively increasedtheir risk taking. In terms of credit risk, FIs need to strengthen their risk management for lendingto middle-risk firms and the real estate industry and for overseas lending. It is also important forFIs to take into account characteristics of their loan portfolios and future prospects whenmanaging loans and setting loan-loss provisions. In terms of market risk, FIs need to improvetheir risk management in response to the wide-ranging and complex risks associated with creditinvestment and investment trusts. In terms of liquidity risk, FIs need to secure stable foreigncurrency funding bases. Moreover, major FIs with systemic importance need to ensure a solidfinancial base, strengthen their governance on a global and group-wide basis, and prepare todeal with a stress event in an orderly manner.
Third, FIs should adapt to digitalization. While advances in digitalization can possibly erode theprofit opportunities of existing FIs, they can also provide FIs with tools for expanding the frontiersof services that FIs can provide and fundamentally increasing their operating efficiency. In termsof strategic risk as to whether FIs are able to develop appropriate business strategies in responseto changes in the business environment, adaptation to digitalization is one of the most importanttopics recently. Therefore, FIs need to develop strategies to exploit the potential gains offered bydigital technology and establish frameworks for cybersecurity management and anti-moneylaundering controls.
Toward ensuring financial stability in the future (cont'd)
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Finally, FIs should implement appropriate capital policies. Given that both investors and firmshave been more closely scrutinizing capital efficiency and payouts to shareholders in recentyears, striking the right balance between appropriate payouts and enhancement of capital isparticularly important for regional banks whose profitability has continued to decline. FIs need todevelop business plans that appropriately take capital costs into account according to theirgovernance structure, which differs between corporations and cooperative institutions. At thesame time, they need to clarify capital policies, including those pertaining to sufficient capitallevels, dividend payout plans, and the effective use of unrealized gains on securities, and theyalso need to improve communication with shareholders and a wide range of other stakeholders.
In order to ensure the stability of the financial system, the Bank of Japan, through on-siteexaminations, off-site monitoring, and other activities such as holding seminars, will continue toprovide support to FIs in their efforts to address the challenges listed above.
In conducting on-site examinations and off-site monitoring, the Bank will continue to focus ongrasping FIs' future profitability and financial soundness and sharing its views with these institutions.In doing so, the Bank will concentrate on examining FIs' resilience to downside risks and activelyengage in dialogue with FIs about which the Bank has concerns regarding their future profitabilityand financial soundness. Such dialogue will cover the capital levels necessary for these institutionsto perform their financial intermediation functions in a stable manner into the future as well asmanagement policies that can secure such capital levels.
As FIs grapple with structural problems, it is important to develop an institutional framework for thefinancial system that adapts to structural changes such as digital technology innovations and toconsider how government FIs should function. The Bank of Japan will hold discussions with theparties concerned, taking these issues into account.
Toward ensuring financial stability in the future (cont'd)
