United States: Financial Sector Assessment Program-Financial System Stability Assessment

Abstract

The Japanese financial system has remained resilient through a series of shocks including the COVID-19 pandemic. Japan's large and globally well-integrated financial system withstood the pandemic, aided by strong capital and liquidity buffers, and extensive policy support. Credit provision to the private sector has remained robust, supporting a steady economic recovery. The financial system is at a critical juncture and confronts several challenges. After years of deflationary concerns and ultra-low interest rates, sustained inflationary pressures have emerged, leading the Bank of Japan (BOJ) to end its negative interest rate policy and yield curve control. In an evolving macroeconomic environment, key risks to macrofinancial stability stem from three main sources of vulnerability: the sizable domestic and foreign security holdings of financial institutions under mark-to-market accounting, notable foreign currency (FX) exposure of some banks, and signs of overheating in parts of the real estate markets. These risks could be accentuated by ongoing structural transformations from climate change, digitalization, and an aging population. The scenario-based risk analysis conducted by the FSAP suggests that the financial system remains broadly resilient to a range of adverse macrofinancial shocks, with some areas of susceptibility. • Banks are, in aggregate, well able to maintain their solvency position under a hypothetical adverse scenario comprising an increase in foreign and domestic interest rates and a decline in economic growth and asset prices, though some banks may be susceptible to the stress. Liquidity risks are found to be contained at the system level due to ample liquidity in Japanese Yen (JPY), but some banks appear susceptible due to notable liability-side FX exposures and undrawn FX commitments. • Insurers, especially life insurers, are sensitive to an increase in domestic and foreign interest rates though in aggregate, their capital remains well above the regulatory requirement. Insurers are not significantly exposed to liquidity risk, but some may face pressure under stress. • Investment funds appear generally well positioned to accommodate plausible-sized investor redemption shocks, though less-liquid funds could contribute to market volatility under more severe shocks. • In the nonfinancial private sector, smaller firms are particularly susceptible to an increase in default risk under the adverse scenario. Household defaults would rise from a very low level, but the impact could be lessened by the industry practice (5-year/125-percent rule) that could mitigate a sharp increase in mortgage payments. • Systemic contagion risks are limited by the strong capital positions of major financial institutions, but some institutions appear vulnerable to contagion risks. The climate risk analysis suggests that banks are generally resilient to a transition to net zero greenhouse gas (GHG) emissions by 2050. Banks' exposure to emission-intensive sectors