BOJ Report Assesses Stability of Financial System in Japan

The report highlights that the financial system of Japan has been stable. Looking ahead, even in the case where the economic recovery remains moderate, the financial system is likely to remain highly robust. However, developments in the spread of COVID-19 and their impact on the domestic and overseas economies are subject to considerable uncertainty. Under the severe stress event of the persistently stagnated pace of economic recovery and significant adjustments in financial markets, a deterioration in financial institutions' financial soundness and the resultant impairment of the smooth functioning of financial intermediation could pose a risk of further downward pressure on the real economy. In this regard, the following three risks warrant particular attention.

• The first risk is an increase in credit costs due to the potentially prolonged economic downturn at home and abroad. In Japan, close attention should be paid to the impact on lending to areas where vulnerabilities accumulated before the COVID-19 outbreak. The overall credit quality of the overseas loan portfolios of Japanese banks has remained high. Careful risk management is essential given that the current downturn in overseas economies is more severe than that during the global financial crisis.
• The second risk is a deterioration in gains or losses on securities investments due to substantial adjustments in financial markets. Under the prolonged low interest rate environment in Japan, Japanese financial institutions have been actively taking on market risk, particularly for domestic and overseas credit products and investment funds, to search for yield.
• The third risk is destabilization of foreign currency funding due to the tightening of foreign currency funding markets mainly for the U.S. dollar. As foreign currency funding markets are still vulnerable to shocks, Japanese banks need to make continuous efforts to strengthen their foreign currency funding bases and liquidity management.

Future developments in the spread of COVID-19 and their impact on the domestic and overseas economies remain highly uncertain. Against this backdrop, the major challenge for financial institutions is to smoothly fulfill their financial intermediation function by balancing their financial soundness and risk taking. Careful assessment of the sustainability of the borrowers' businesses, in addition to the provision of swift liquidity support, will become increasingly important. In this respect, providing effective support tailored to the needs of borrowers by assisting with their core business and financing as well as facilitating their business succession, transfer, and restructuring will become more essential. From a medium to long-term perspective, BOJ will actively support initiatives of financial institutions by preparing institutional frameworks for the financial system and by taking measures to facilitate digital transformation.

Keywords: Asia Pacific, Japan, Banking, Securities, Stress Testing, COVID-19, Credit Risk, Financial Stability, BOJ