IMF Still Cautious on Japan's Financial Stability
According to a September 5, 2003 IMF report (Japan: Financial System Stability Assessment and Supplementary Information), Japan's banking system is still exposed to significant credit and market risks. The fragility of the banking system stems from; a) stock problems, and b) flow problems. The stock problems include continuing asset quality problems, including large NPLs, a weak
capital base and exposure to the stock market. The flow problems include a lack of underlying profitability that has inhibited the banks from dealing with asset quality issues in a timely manner. The average Moody's financial strength ratings for the Japanese major banks is between D- and E+, compared to other G-7 banking
systems where average ratings trend in the A- to C+ range. Profitability and return on equity for Japanese banks are but a fraction of other G-7 countries.
In their description of the impact of low nominal interest rates on the banking system and financial markets, the IMF outlines the negatives of the BOJ's ZIRP (zero interest rates) policy as outlined below. It almost sounds as if the IMF were suggesting the possible positives of the current back-up in interest rates.
1) low nominal rates have undermined the usefulness of the term "non-performing loan" in detecting financial distress, by easing the financing constraints on borrowers. With nominal interest rates so low, many companies with minimal cash flow can still service their debt despite being close to insolvency. Official NPL numbers do not cover these so-called "impaired" loans.
2) While low nominal rates have allowed viable companies to restructure their balance sheets at lower cost, these low rates have also delayed the exit of nonviable firms.
3) The flattening of the yield curve has made it more difficult for banks and insurers to raise core profitability.
4) Low interest rates have dampened activity in the call money market. Banks have largely bypassed the call money market and instead have placed excess reserves at the BOJ or resorted to bilateral dealings. Thus the BOJ has emerged as the main supplier of liquidity.
5) Low nominal rates have lowered the franchise value of retail banking and has slowed the process of consolidation.
Most interesting however were the stress test results.
The IMF's stress test sample includes 7 city banks, 21 regionals 2 central banks of the credit cooperatives, and the life insurers. In terms of equity market-linked stress, a 20% decline in stock prices would cause losses to the City Banks worth 37% of their shareholder equity, but net of the deferred tax assets (DTAs) included in Tier 1 capital, would represent 102%of "real" shareholder equity. This gives a clear indication of just how serious falling stock prices impact on the value of bank
capital. As the Topix is up 26% for the fiscal year to date, the real shareholder equity of the major banks has improved by over 102% since the end of March, 2003.
Conversely, a 100bps rise in bond yields would cause losses worth 17% of the City Banks' shareholder equity, or 43% of capital net of DTAs. As JGB yields have backed up from under 0.50% to 1.6%, 43% capital net of DTAs has lost in the bond market sell-off.
Consequently, the net impact of the recovery in stock prices and the bond market sell-off has been to produced net gains worth some 59% of bank capital net of DTAs, allowing them to pull back from the brink of de facto net negative equity.
But the IMF warns that while a systemic financial sector crisis seems unlikely in the short term, expeditious and forceful action is required to avoid further deterioration, and government intervention will be required to reduce the risks. In other words, if "old guard" politicians and the banks themselves continue to impede FSA efforts to implement the Financial Revitalization Program, Japan will
face yet another "March" crisis down the road.
The IMF review is available at:
IMF Japan Review
