The Bank of Japan’s dilemma: how to raise interest rates while shielding lenders

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Japan’s regulators are ramping up pressure on regional banks to pre-empt the kind of risks that took down Silicon Valley Bank as the country prepares for its first interest rate rise in more than a decade.

Even as Japan’s biggest banks churn out record profits and anticipate further gains from domestic rate increases, the country’s central bank warned in its recent Financial Stability Report that regional banks and shinkin financial co-operatives were exposed to interest rate risk after piling into long-term loans and securities.

Rising rates are normally welcomed by commercial banks, which can profit from a wider margin between what they charge for lending and what they pay to borrow. But dangers on the other side include so-called duration risk, which measures the exposure of long-term bonds to unexpected changes in interest rates. The risks can crystallise if banks are forced to sell long-term assets that are losing value as interest rates rise.

Regulators are growing concerned that stress on regional banks could deepen next year if the Bank of Japan finally ends its negative rate policy.

BoJ governor Kazuo Ueda told the Financial Times Global Boardroom conference this month that the country’s banking system was robust enough to withstand some increase in short-term interest rates if it were to begin policy normalisation. But he added: “It’s a matter of degree so . . . we’ll have to monitor the situation carefully.”

As of the end of September, Japan’s 97 regional banks reported unrealised losses on bonds and investment trusts totalling about ¥2.8tn ($19bn), up 70 per cent from the end of June, according to calculations by Nikkei. The amount jumped after 10-year Japanese government bond yields rose when the BoJ loosened its yield curve control policies in July.

“In the worst-case scenario, the banks can hold on to these unrealised losses,” said Toyoki Sameshima, analyst at SBI Securities. “But that means they won’t be able to make new investments to buy higher-yielding bonds when interest rates rise, so there is a risk of stagnation.”

Japan’s Financial Services Agency reacted to the failures of SVB and other US banks in March with scrutiny of smaller regional lenders, particularly those that could be exposed to similar risks. SVB was brought down by a huge portfolio of government bonds — which had no credit risk but massive, unhedged interest rate risk — and its base of uninsured depositors who swiftly ran for the exits.

Unlike Silicon Valley Bank, Japanese banks are home to small, sticky retail deposits, with most insured up to ¥10mn. However, while systemic risks of deposit flight seem low, analysts are on the hunt for outliers.

“One Japanese major bank was able to increase its deposits by over 40 per cent in around six months via a campaign that promised high interest rates,” said Nomura banking analyst Ken Takamiya.

“As this means there are depositors willing to shift their deposits to earn higher interest rates, the FSA is not ruling out the possibility of a flow in the opposite direction if concerns over credit spread,” he added.

While regulators scour the balance sheets of regional banks, shares in Mitsubishi UFJ Financial Group, Mizuho Financial Group and Sumitomo Mitsui Financial Group have risen about 40 per cent this year on the back of hopes for rate increases. The country’s three big banks are less exposed because they have a more diversified business model and have shifted to short-duration assets.

If the BoJ does end its negative interest rate policy by next spring, as is widely expected, it estimates that each percentage point increase in domestic interest rates will give an earnings boost of about ¥3tn to local lenders.

The central bank has come under increasing pressure to dial back its decade-old monetary easing measures in the face of rising inflation and a weakening yen. Its exit could have major ramifications for international bond markets, as Japanese financial institutions own trillions of dollars of overseas debt and are likely to invest more at home when interest rates start to rise.

In October, the BoJ decided to allow yields on the 10-year Japanese government bond to rise above 1 per cent, a step towards ending its seven-year policy of capping long-term interest rates.

The FSA remains sanguine about the overall risks in the Japanese banking system but is wary of the lack of experience bankers have in managing a tightening cycle.

There is also the new unknown of the growth of online banking, which has made it easier for depositors to transfer their money instantly as was the case in the US bank failures.

“It’s been a very long time since interest rates have risen in Japan,” said one FSA official. “Things are very different from last time when there was a rate hike since there wasn’t really online banking . . . we don’t know what will happen this time, and we are preparing ourselves for unexpected circumstances.”

Still, FSA officials have stressed that the risk of a deposit run at Japanese financial institutions remains low and analysts say the boost to net interest income from rate rises will outweigh the short-term paper losses suffered by banks.

Another risk to banks is that interest rate rises might spark more bankruptcies among small and medium-sized companies — particularly among so-called zombie companies that are more than 10 years old and have remained in business, aided by ultra-low rates, despite persistent losses. According to data provider Teikoku Databank, there were 188,000 such zombies as of March 2022.

Sameshima said banks were likely to take a cautious stance in cutting off lending following lessons drawn from the global financial crisis in 2008, when they allowed many small groups to go bankrupt too quickly and blew holes in their own balance sheets.

“The number of bankruptcies will rise, but the nature of the bankruptcies will be different from the ones we saw after the Lehman crisis,” Sameshima said. “The banks will try to think of a business strategy and firmly support the ones that look capable of surviving.”