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November 27, 2018

IMF published its staff report and selected issues report under the 2018 Article IV Consultation with Japan. Directors recognized the challenges facing the financial sector, especially from demographic pressures and low interest rates. They welcomed the progress made in implementing the 2017 FSAP recommendations, particularly the new more forward-looking supervisory framework. Directors highlighted the importance of enhancing risk management, financial oversight, and the macro-prudential framework.

The staff report highlights that the Japanese Financial Services Agency (JFSA) is moving toward a new forward-looking and dynamic supervisory framework. Implementation of certain FSAP recommendations—particularly on macro-prudential policies and crisis management and resolution—is incomplete. The overall banking sector remains well-capitalized and liquid. Nonetheless, the amount of risks taken by some financial institutions have exceeded their capital levels. Market risks from a large decline in equity prices or a sharp rise in Japanese Government Bond (JGB) yields could lead to substantial losses for major banks and life insurers, while solvency concerns and higher risk taking due to demographic challenges and low interest rates are more severe for regional banks. The riskiness of credit allocation has increased significantly in recent years on the back of strong growth in lending to small enterprises and has exceeded the levels seen during the global financial crisis. Moreover, banks have increased substantially their holdings of investment trusts while long-term investors have stepped up their risk taking in foreign securities. Risks associated with these activities should be carefully monitored and assessed against financial institutions’ risk management capacity.

The assessment suggests that the financial sector policies should be enhanced to contain the build-up of systemic risks in line with the 2017 FSAP recommendations. Capital requirements should be better tailored to an individual bank’s risk profiles, corporate governance could be further strengthened across the banking and insurance sectors, and an economic-value-based solvency regulation for the insurance sector should be introduced. The recent move of JFSA to include four more banks in its stress testing framework is welcome, while the macro-prudential framework should be further strengthened in line with FSAP recommendations.

Additionally, the recent stress testing conducted by the Bank of Japan highlighted authorities’ concerns over the impact of low profitability on capital levels and increased lending to financially vulnerable firms. It is recommended that strengthening the crisis management and resolution framework would help reduce expectations of public support and facilitate the smooth exit of unviable financial entities. Also, JFSA recently expanded the total loss-absorbing capacity (TLAC) requirement to one domestic systemically-important bank; it could further facilitate financial institutions’ efforts to leverage fintech and should continue to strengthen crypto-asset oversight.

 

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Keywords: Asia Pacific, Japan, Banking, Insurance, Article IV, FSAP, Stress Testing, Macro-prudential Framework, JFSA, IMF

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