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Japanese Regional Banks Pass Stress Tests. What Now?

2022-03-15T13:55:31+08:00March 15, 2022|Blog|

Japanese Regional Banks Pass Stress Tests. What Now?

Author: Dr. Trung Thanh Vu, Associate Economist

Regional banks in Japan were struggling with structural challenges even before the start of the COVID-19 pandemic. A shrinking pool of borrowers in an aging population, severe competition among banks, and a low interest rate environment held back the regional banks’ efforts to diversify their income sources and strengthen their financial performance. The pandemic only compounds their challenges.

Because of social distancing measures and business disruptions, borrowers, including business owners and households, face a decline in their incomes and are at risk of loan defaults. As a result, regional banks are likely to see lower profitability and higher credit costs, further weakening their financial soundness. Will regional banks remain resilient in the post-pandemic world? What are the policies that can support them to strengthen their profitability and overall soundness?

Regional banks remain broadly resilient

Stress test results revealed in AMRO’s 2021 Annual Consultation Report on Japan assume an adverse yet plausible scenario in which there is a drastic increase in the nonperforming loans (NPLs) of regional banks over the next two years. Under the adverse scenario, all regional banks can sustain their capital buffers above the minimum requirement, although small and medium regional banks will be more affected than their top-tier counterparts. In addition, while credit losses will likely rise moderately over the next two years, regional banks can cover those losses.

A few reasons explain the resilience of Japanese regional banks.

First, the government guarantees most of the new loans from regional banks to private companies. As a result, banks are immune from most of the credit losses in the short term. In fact, regional banks were able to maintain stable capital buffers amid the pandemic. The average capital adequacy ratio of regional banks slightly increased in FY2020-2021, partly because many new loans were guaranteed, with zero or low-risk weight in the banks’ total assets.

Second, the moderate rises in expected credit losses are consistent with the fact that Japanese firms have been receiving large precautionary loans on the back of the government’s support measures. If firms continue to hold sufficient cash reserves to cover their obligations, it will likely prevent an increase in the firms’ probability of default and prevent a sharp rise in potential credit losses for the banks.

Third, regional banks have proactively increased their loan-loss provisions as a precautionary measure against rising credit losses in the future. Furthermore, they are making progress in upgrading their business foundation and have achieved some cost reductions.

Lastly, after going through the experience of high NPLs in the 1990s, Japanese banks have significantly enhanced their credit risk management, which should help them better control NPL risk post-pandemic.

However, structural challenges may loom large

Challenges such as sluggish credit demand in an aging population, especially in small cities and rural areas where regional banks are located, require long-term solutions. Even if the authorities and regional banks initiate reforms now, those challenges cannot be addressed completely in the medium term.

Furthermore, the extent of any permanent scarring from the pandemic on the Japanese economy – and its impact on credit risks – is still unknown. If the pandemic persists or worsens, the probability of default by Japanese companies may rise, especially among those that were already weak before the pandemic or those that suffered a substantial decline in operating cash flows during the pandemic. If these firms eventually default and the government’s support measures are withdrawn, regional banks will face a further deterioration in their asset quality.

More government support is needed

Financial regulators have been assessing the resilience of regional banks by conducting stress tests bi-annually. However, more stringent assumptions could be added to the stress tests. For example, a stress test that assumes the government’s support measures would be withdrawn at some point would help identify weaker banks and provide some indications of the timeline for unwinding the government’s special lending programs to avoid a cliff effect.

Second, as some regional banks have expanded their business models to include trading and real estate companies, they could end up holding riskier assets. While financial regulators continue to conduct oversight of high-risk investments by regional banks via on-site examination and off-site monitoring, either weekly or daily dialogue with vulnerable banks or major regional banks would be useful.

Third, the government’s support to facilitate the consolidation of regional banks, such as the subsidy program to cover merger costs, can be further expanded. Additionally, the Bank of Japan’s Special Deposit Facility can offer a higher interest rate on deposits to encourage regional banks to strengthen their core business foundations.

Fourth, the use of digital technology could help banks improve their management. The authorities could continue to support the regional banks’ business diversification strategy, customized to an aging society, while promoting digital transformation such as software investment, IT training support, and cybersecurity management.

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AMRO Blog is a forum for the views of AMRO staff and officials on pressing economic and policy issues. The views expressed are those of the author(s) and do not necessarily represent the views of AMRO and its Executive Committee. You are welcome to republish AMRO Blog post but please attribute the piece to the author(s), and note that it was first published as AMRO Blog, with a link to our blog.

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