November 29, 2017
Bank of Japan
New Frontier of Macroprudential Policy:
Addressing Financial Institutions' Low Profitability
and Intensified Competition
Speech at the Kin'yu Konwa Kai
(Financial Discussion Meeting) Hosted by the Jiji Press
Hiroshi Nakaso
Deputy Governor of the Bank of Japan
I. Introduction
Japan's financial crisis was reaching its climax 20 years ago in 1997. In November of that
year, four financial institutions, including a major one, failed in succession in a single
month, a period later referred to as Dark November.1 I clearly remember that this was when
Japan's financial system was on the verge of a meltdown. Since the comprehensive safety
net for financial system stability was underdeveloped at that time, which is not the case
today, the Bank of Japan bore the heavy load of taking measures to stabilize the financial
Tokuyu
system, including the so-called (special loans). While we barely managed to avert a
financial meltdown, the Bank suffered credit losses of about 200 billion yen from the
Tokuyu. Following this painful experience of the bursting of the bubble in the 1990s, Japan's
safety net has developed greatly, and it now protects financial system stability against
failures of not only deposit-taking financial institutions but also securities companies,
insurance companies, and financial holding companies.
Thus, in Japan, crisis management tools have been expanded based on the lessons learned
during the financial crisis. At the same time, the importance of having a policy to prevent a
financial crisis from materializing by detecting the accumulation of financial imbalances
became recognized. In order to maintain the stability of the financial system, it is not
necessarily sufficient to adopt measures based on the microprudential perspective of
identifying risks borne by individual financial institutions and encouraging improvement in
their business activities. It is also important to take measures based on the macroprudential
perspective of assessing risks of the whole financial system with due consideration to the
interconnectedness of the real economy, financial markets, and behavior of financial
institutions. Such importance of macroprudential policy became widely recognized around
the globe when the global financial crisis jolted the world economy 10 years after Japan's
financial crisis. Today, I will talk about macroprudential policy and its challenges while
touching on the Bank's experiences thus far and the recent situation of Japanese financial
institutions.
Financial crises do not always emerge in the same form. Thus, we should bear in mind that
conditions of the time. It is important to accurately assess such potential vulnerabilities of
the financial system from a macroprudential perspective and take appropriate policy
measures. Even if these measures are extraordinary or unconventional based on historical
standards, the Bank should take these measures when necessary to ensure financial system
stability.
At present, Japan's financial system is maintaining stability, but I think that attention should
be paid to the potential vulnerabilities. That is what I will talk about today; more
specifically, the problem of financial institutions' low profitability and intensified
competition, with a main focus on regional financial institutions. This problem is closely
related to Japan's structural problems, such as a decline in population and the number of
firms, and it is a phenomenon that advanced economies have never experienced before
(Chart 1). In this sense, the impact of financial institutions' low profitability and intensified
competition arising from the decline in population and the number of firms is a financial
vulnerability that takes a totally different form from the past. Regional financial institutions
need to appropriately address this issue in order to continue to play an important role in
supporting the regional economy. The Bank also has to explore a new frontier of prudential
policy by itself.
II. Assessment of Systemic Risk
Before going into a detailed explanation about the potential vulnerabilities of Japan's
financial system, let me first talk about macroprudential policy.
If the financial cycle becomes large in magnitude or many financial institutions become
more interconnected by increasing common exposure or forming mutual asset-liability
arrangements, systemic risk will emerge and spread within the financial system. The
objective of macroprudential policy is to strengthen the resilience of the financial system
and contain systemic risk.
In order to implement macroprudential policy, we first need to assess systemic risk.
Specifically, the assessment is composed of two main parts. The first is to assess the
financial cycle. We examine whether the current conditions are in an expansion phase or a
contraction phase of the cycle, considering the outlook. The second is to identify sources of
systemic risk, or potential financial vulnerabilities, and to diagnose the financial system's
resilience to the stress. For example, we conduct stress testing to assess whether financial
institutions have sufficient capital and liquidity under stress events.
Assessment of Financial Cycle and Results of Stress Testing
Financial System Report
The Bank publishes the (FSR) semiannually, with the objective of
assessing systemic risk. Regarding the financial cycle that is the first part of the assessment,
on the whole no imbalances in financial and economic activities can be observed while the
funding conditions for firms and households have been highly accommodative. With banks'
very active lending stances, the real estate market seems overheated in some areas; however,
our aggregate financial cycle indicator estimated from major financial activity indexes has
shown no significant imbalances recently (Chart 2).2
Moreover, with regard to the resilience of the financial system against the stress that
concerns the second part of the assessment, the results of stress testing indicate that capital
adequacy ratios at financial institutions remain above the regulatory requirements on the
whole even when a tail event comparable to the Lehman shock occurs. While regional
financial institutions have actively stepped up their risk taking in recent years by increasing
their real estate loans and investments, the adverse shocks in the real estate markets seem to
exert only a limited impact on the financial system from a macroprudential perspective,
partly because real estate-related markets have not boomed as much as they did during the
real estate boom from 2006 through 2007.3
In other words, as the peak of the current financial cycle is not high, even if the cycle starts
to contract, the trough is unlikely to be deep. Also, even when the trough is as deep as the
level observed during the Lehman shock, financial institutions maintain sufficient capital to
2
Looking at Chart 2 in detail, during the bubble period in the late 1980s, the financial expansion
had led to the economic expansion. In the early 1990s after the burst of the bubble, the financial
contraction had caused the economic downturn. Afterward, the real economy went through several
business cycles with short-lived recovery phases, as the balance sheet adjustment at firms and
financial institutions continued; in other words, the financial cycle remained in a stagnation phase.
Since the beginning of the 2000s, the adjustment of excess debt by firms and the disposal of
nonperforming loans by banks have run their course and the financial cycle has entered into a
recovery phase, and thus the economic recovery has lasted a long time. Later, the real economy
deteriorated significantly due to the Lehman shock but recovered relatively quickly as no significant
financial imbalances were accumulated.
3
For details, see Chapter V in the April 2017 issue of the FSR.
withstand that stress. Thus, there is no concern about large-scale systemic risk at present,
and it can be judged that Japan's financial system has been maintaining stability.
Warning from the Stock Market
Nonetheless, there is no guarantee that the financial system can continue to maintain
stability in the future. The stock market seems to send us a critical signal on this point. The
expected default frequency (EDF) for financial institutions extracted from stock price
movements has been rising recently, mainly for regional banks (Chart 3).4 The short-term
EDF has been more or less unchanged, albeit with some fluctuations such as a temporary
rise following the Bank's introduction of the negative interest rate policy in early 2016.
Meanwhile, the medium- to long-term EDF has been following a moderate upward trend
since even before the introduction of Quantitative and Qualitative Monetary Easing (QQE)
in 2013 and the negative interest rate policy.
So, will regional financial institutions give rise to systemic risk that poses threats to the
stability of the financial system? In Japan, no regional financial institutions are designated
as either Global Systemically Important Banks (G-SIBs) or Domestic Systemically
Important Banks (D-SIBs). Although regional financial institutions are not individually
systemic institutions, they can be "systemic as a herd" if many of them hold common
exposure and show similar behavior. From a macroprudential perspective, it is important to
look at regional financial institutions as a whole and pay attention to whether the similarity
of individual financial institutions' behavior will lead to the emergence of systemic risk.
Due to Japan's financial crisis in the 1990s, almost 180 small and medium-sized financial
institutions including shinkin banks and credit cooperatives failed. Such financial
institutions were not individually systemic institutions, but they held common risk exposure
through the extension of real estate loans. Thus, as a failure of one bank reminded the
people of a default risk of another bank, a systemic risk associated with a chain of bank runs
was recognized. To avoid the materialization of such risk, the government set forth blanket
guarantees for all forms of bank liabilities including deposits. Based on this, the Bank
provided individual financial institutions that were on brink of bankruptcy with loans to
maintain the stability of the financial system (the so-called Tokuyu).5
A key issue that these experiences raised about prudential policy is whether a future stress
event will result in business instability of only the specific financial institution or in
simultaneous (or a chain of) business instability of many financial institutions that hold
common exposure. In the former case, a financial institution with business instability can be
barred from the financial system. In the latter case, however, there is a concern that the
impact will spread across the entire financial system and develop into systemic risk. The
stock market sends us a critical signal on this point as well. The CoVaR, which is a widely
used systemic risk indicator measured based on developments in the stock market
capitalization of regional banks, has shown an upward trend recently against the
background of the heightened comovement between the stresses faced by individual banks
(Chart 4).6 Thus, the indicator extracted from the stock market implies the possibility that
business conditions will become unstable simultaneously at many regional financial
institutions that have common exposure.
While the EDF and the systemic risk indicators have been rising, regional financial
institutions have sufficient capital and liquidity at present. Thus, there are no immediate
threats to the stability of the financial system. As I mentioned earlier, our stress testing also
confirms this point. Then, how should we interpret the difference between the results of
stress testing and market signals? The results of stress testing show that Japan's financial
system has resilience to "acute" stresses comparable to the Lehman shock. However, even
though financial institutions have sufficient capital at present, the stability of the financial
system will not be guaranteed in the future if "chronic" stresses weigh persistently on many
financial institutions' profits. If they fail to secure returns that meet their cost of capital for a
5
More specifically, the Bank provided troubled financial institutions with funds needed to repay
deposits through the Tokuyu. After these financial institutions failed, the Bank received full
repayment of the Tokuyu from funds provided by the Deposit Insurance Corporation (DIC) to these
institutions in accordance with the Deposit Insurance Act amended in 1996. In principle, the Tokuyu
is an uncollateralized loan, but under such scheme, the Bank was not exposed to credit risk in
extending the Tokuyu to deposit-taking financial institutions. (Meanwhile, the Bank bore credit costs
in providing the Tokuyu and capital to securities companies.)
6
Using stock market data, the CoVaR measures the size of stress in the financial system, which
comprises the following two factors: the stress faced by individual banks and the comovement
between the stresses faced by individual banks.
prolonged period due to common and chronic stresses, we cannot exclude a possibility of
simultaneous (or a chain of) impairment of capital held by many of the financial institutions
that hold common exposure. With a price-to-book (P/B) ratio of less than one, the stock
market seems to be sending us a warning about the impact of "chronic and common"
stresses (Chart 3).7
III. Background of Regional Financial Institutions' Low Profitability
Now, let me touch on the characteristics of the structure of financial institutions' profits
before identifying "chronic and common" stresses that exert downward pressure on regional
financial institutions' profits.
International Comparison of Financial Institutions' Profitability
The recent decline in financial institutions' profits is a phenomenon that can be observed not
only in Japan but commonly in advanced economies, where the low interest rate
environment has prevailed. However, even in this situation, the low profitability of Japanese
financial institutions is striking from an international perspective (Chart 5). Regional
financial institutions in particular have lower gross operating profits per employee than U.S.
and European financial institutions of a similar size. Such low profitability is due not only
to Japanese financial institutions' low net interest income that is susceptible to interest rate
developments but also to low net non-interest income that is not susceptible to these
developments.8
Since the 2000s, Japanese financial institutions have been making efforts to expand their fee
and commission-based business with the aim of diversifying their profit sources, but the
share of net non-interest income in gross operating profits (the net non-interest income
ratio) nevertheless is generally small from an international perspective (Chart 6). By size,
whereas the net non-interest income ratio of major financial groups is on par with that of
their U.S. counterparts, regional financial institutions' net non-interest income ratio is only
around 10 percent, which is much lower than that of U.S. and European financial
institutions of the similar size.
For U.S. and European financial institutions, net non-interest income represents an
important profit source as they increase opportunities to obtain various fees and
commissions by meticulously setting the content of services based on characteristics and
preferences of their clients. For example, in Europe, financial institutions secure a profit
source by charging a reasonable fee for the issuance and use of debit and credit cards and
providing bespoke solutions for high net worth individuals. Moreover, due to the spread of
Internet banking, they also have started to impose fees for services such as paper-based
balance statements. In the United States, fund management services that meet firms'
outsourcing needs have been established as paid-for services. On the other hand, in Japan,
there are more than a few examples where financial institutions do not impose any fees on
financial services that incur a reasonable amount of costs, such as services related to
account maintenance and management.
These differences in the stance regarding the setting of fees and commissions for financial
services in Japan and abroad also show up clearly in the composition of household
consumption expenditure. The item composition of the consumer price index (CPI) in
various countries shows that the weight of financial services in Japan is much lower than in
the United States and Europe (Chart 7). Furthermore, in contrast to the United States and
Europe, where the prices of financial services have been rising at an annual rate of about 2
percent, in Japan, the prices of financial services have for a long time essentially remained
unchanged. These facts mean that whereas for financial institutions in the United States and
Europe, fee and commission income from households forms a stable source of profits,
Japanese financial institutions lack such profit source.
Intensified Competition among Banks
I have pointed out that financial institutions in Japan have lower gross operating profits per
employee than their U.S. and European peers, and the breakdown showed that not only their
net interest income but also their net non-interest income, which is not susceptible to
interest rate developments, is low (Chart 5). These observations suggest that Japanese
financial institutions' low profitability is due not only to persistent low interest rates but also
to other structural factors. Specifically, one likely factor is that competition among financial
institutions has continued to intensify for a long time. Looking at an international
comparison of the number of financial institutions' branches that actually provide financial
services, the number of financial institutions' branches per capita in Japan appears relatively
low; however, if the number of post office branches, which provide bank agency services, is
included, the figure is about the same as that in some European countries, which are
regarded as being overbanked (Chart 8).9 Additionally, the number of financial institutions'
branches per habitable land area is conspicuously large in Japan. Of course, this is also due
to the high population density of Japan. But if financial institutions' branches are densely
crowded in a small area, depositors and firms will have a number of branches to choose
from. Thus, the state of competition among them will intensify.10
In particular, in terms of attracting deposits, financial institutions in Japan were competing
intensely with each other, as well as with the postal savings system, from before World War
II until recent years. Because deposit and lending margins were sufficiently large when
interest rates were regulated, opening branches and collecting as much deposits as possible
was rational behavior which would directly lead to profit growth for private financial
institutions. For this reason, and partly due to competition from the postal savings system, it
was difficult for private financial institutions to adopt a strategy of charging deposit-related
fees. Even after deposit and lending margins narrowed against the backdrop of interest rate
liberalization and the low interest rate environment, the fierce competition among financial
institutions continued. Banks were fully aware that if only they started charging fees, it was
highly likely that deposits would flow out to other banks or the post office. Under these
circumstances, a business model premised on not charging deposit-related fees seems to
become entrenched at financial institutions. Thus, as financial institutions have little net
non-interest income and greatly depend on net interest income for profits, a decline in
population and the number of firms spurs lending competition among financial institutions,
pushing down net interest income in a structural manner.
To sum up, the true identity of "chronic and common" stress that exerts downward pressure
on regional financial institutions' profits is a persistent decline in population and the number
of firms observed in almost all regions of Japan under the fierce competition among
financial institutions (Chart 1). Our estimation results show that structural factors such as
population decline, in addition to a decline in market interest rates due to monetary easing,
have largely contributed to the shrinkage of deposit and lending margins of regional
financial institutions over the past decade (Chart 9).11 While the forecast over the next 10
years will change depending on the future path of market rates, chronic stresses such as
population decline are expected to continue to exert downward pressure on deposit and
lending margins. That is, even if market rates rise and funding costs increase, loan interest
rates will not be raised sufficiently due to intensified competition caused by chronic stresses.
Thus, there is a possibility that deposit and lending margins will not improve very much.
IV. Competition among Banks and Macroprudential Policy
Going forward, the problem of financial institutions' low profitability is expected to be
exacerbated, given the structural changes to the business environment, such as the shrinking
regional population and business base. Next, I will go over how this will affect the financial
system.
Impact on Financial System Stability
The decline in population and the number of firms, which is a structural factor underlying
the intensified competition among financial institutions, is not an idiosyncratic shock
occurring in certain areas, but a common shock occurring across Japan (Chart 1). Moreover,
this common shock is not a temporary one but is expected to remain in the future. If such
chronic stresses continue to exert downward pressure on regional institutions' profits, it
becomes highly likely that financial institutions will engage in excessive risk taking. For
example, they may take on market risk associated with securities investment without proper
risk management, or they may take on excessive credit risks in lending -- that is, extend
loans at an interest rate that is not high enough to cover credit costs.
At present, regional financial institutions do not take on excessive market and credit risks
relative to their capital.12 However, the point is on how chronic stresses will have an effect
in the future, and a warning from the stock market seems to address this point. In particular,
because Japanese regional financial institutions' provision of non-interest services
accompanying lending transactions is limited compared to their U.S. and European
counterparts and Japanese major banks, the degree of differentiation in lending transactions
is low, and they tend to engage in interest rate competition (Chart 6). In fact, financial
institutions' lending stances have been as active recently as during the bubble period, while
their lending margins tend to be narrower than planned under intensified competition among
financial institutions (Chart 10). In other words, as demand for loans has been sluggish
under the chronic stress of a decline in population and the number of firms, financial
institutions have increased common exposure; namely, a decline in net interest income
resulting from lending competition among financial institutions.
I mentioned earlier that the CoVaR, a systemic risk indicator of regional banks, has been
rising recently due to an increase in the comovement between the stresses (Chart 4). This
seems to reflect the effects of an increase in common exposure caused by intensified
13
competition. Many regional financial institutions are not necessarily individually
shinkin
systemic institutions. Nonetheless, there are more than 500 regional banks, banks,
and credit cooperatives in total, and these institutions face the chronic and common shock
of a decline in population and the number of firms, and they hold common exposure of a
decline in net interest income resulting from intensified competition. Therefore, regional
financial institutions taken as a whole are systemic as a herd, and chronic stresses that they
share in common could greatly affect the stability of the financial system through
intensification of competition.
Impact on Financial System Efficiency
Chronic stresses may affect not only the stability but also the efficiency of the financial
system. The intensified competition among financial institutions amid the decrease in the
number of firms has started to have an effect on the business relationships between financial
institutions and firms. The average number of financial institutions that each firm transacts
with across branches has been on an uptrend (Chart 11). As the number of firms within
business areas is decreasing, financial institutions' efforts to look for new transaction
opportunities and boost their corporate business seem to have led to an increase in the
number of financial institutions that each firm transacts with.
For firms, this means that they have been able to obtain more favorable loan conditions by
increasing the number of financial institutions that each of them transacts with. However, if
it becomes common for firms to choose the financial institution offering the lowest loan
interest rate among a number of financial institutions when taking out a loan, regardless of
whether the financial institutions have any transaction history or capacity to support
businesses, business relationships between firms and their main bank will weaken. This
may lower the efficiency of financial intermediation.
Under relationship banking, financial institutions accumulate soft information that is
difficult to quantify, such as a manager's talent and a project's future business value, by
monitoring client firms through long-term business relationship. Based on this soft
information, they can provide financial services including lending business. The following
two advantages have been pointed out with regard to such relationship banking. First, by
accurately assessing the future value of firms, financial institutions can encourage firms to
engage in profitable investment projects while keeping firms away from inefficient ones.
Second, if firms face funding difficulties due to external shocks, financial institutions that
are well aware of the firms' future value can provide liquidity assistance. That is, for firms,
they purchase liquidity insurance by paying a reasonable amount of loan interest rates.
These two advantages contribute to the efficient allocation of funds across the entire
economy. However, as lending margins narrow significantly due to intensified competition
among financial institutions, they eventually will lose their incentives to engage in
information production activities that are costly, such as the assessment of a manager's
talent and a project's future business value. If financial institutions do not have sufficient
information about their client firms, extended funds may be used for inefficient investment
activities. Financial institutions may also become cautious about extending loans at their
own risk to firms that face stresses. If financial institutions lose their information production
capacity, they may try to obtain guarantee by credit guarantee corporations to loans to small
and medium-sized firms, and may increase their incentive to shift their credit risks to the
public sector.14
On the other hand, firms may prefer to transact with financial institutions that offer lower
loan interest rates in normal times while they may depend more on emergency measures by
the government or public finance in times of stress. This would generate a moral hazard. In
the end, in the case of public finance with solid support, excessive lending competition
among banks could undermine firms' incentives to raise their productivity. This could result
in inefficient resource allocation across the entire economy, or hamper the economic natural
selection mechanism.
At present, firm-bank relationships have not weakened to this extent. However, if the
competition among banks continues to intensify due to chronic stresses, how this will affect
the efficiency of the financial system going forward warrants attention.
V. Macroprudential Approach to Chronic Stresses
I have explained that the chronic and common stress of a decline in population and the
number of firms has exerted downward pressure on financial institutions' profits, adversely
affecting both the stability and efficiency of the financial system by creating a highly
competitive environment. This is a serious problem from a macroprudential perspective.
How should we tackle this problem?
14
This problem can be understood in the context of "market failure." Asymmetric information
between a firm as a borrower and a bank as a lender can be resolved by long-term relationship and
banks' information production capacity. However, if banks' loan interest rates decline to a level that
cannot compensate for their information production costs, firm-bank relationships will weaken. In
other words, the poor functioning of the loan market will leave the market failure arising from
asymmetric information unresolved. On the other hand, if a bank ultimately can transfer a firm's
credit risk to the public sector, the bank may be able to continue extending loans. In this case,
however, taxpayer money will be used to bear the firm's credit cost in the end. Therefore, lending by
banks that do not engage in information production activities entails negative externalities. This
situation also causes a market failure.
Unfortunately, it is difficult to solve this problem by utilizing the traditional
macroprudential policy tools. If further bullish expectations of firms and households and
banks' risk-taking operated in tandem and a higher degree of overheating was observed in
the financial cycle, capital regulation such as the countercyclical capital buffer (CCyB) and
credit regulation such as the loan to value (LTV) limit would be effective.15 However, as I
have already mentioned, we do not face such a situation at this moment (Chart 2). In
addition, in the case where financial institutions' low profitability is caused by chronic and
common stresses, capital regulation that requires banks to accumulate capital is not an
appropriate prescription. As accumulation of capital under such measures is expected to
further reduce the profitability (ROE), it seems difficult for financial institutions with low
profitability to increase their capital in the financial market.16
Microprudential Approach that Incorporates a Macroprudential Perspective
In order to contain systemic risk among regional financial institutions, enhancing off-site
monitoring and on-site examinations is the first important step. Off-site monitoring and
on-site examinations are primarily regarded as a microprudential measure. By carrying
them out from a macroprudential perspective in an industry-wide and collective manner,
however, they are capable of producing effects as a form of macroprudential policy.17
15
The CCyB indicates a variable capital surcharge, one of the Basel III capital adequacy
requirements. Capital reserves are required for materialization of potential losses in the banking
sector, when risks in the financial system are expected to increase due to excessive credit extension.
On the other hand, the restriction on the LTV ratio is concerned with the ratio of loans to the
collateral market value in extending real estate loans. When risks in the real estate industry are
expected to increase, lowering the LTV ratio would contain further credit expansion.
16
When the tighter capital adequacy ratio is applied, banks have the following two options: (1)
increasing their capital (an action affecting the numerator) and/or (2) reducing their risky assets (an
action affecting the denominator). If it is difficult to increase their capital, financial institutions will
refrain from extending loans. Thus, there is a possibility that competition among them will become
less intense. Depending on how much the capital adequacy ratio will be added, however, this
measure can be a "powerful drug" that forces financial institutions with relatively weak capital bases
to leave, and this does not seems a realistic option -- at least, this is not suitable for the first line of
defense.
17
In this regard, the Federal Reserve seems to have a similar awareness of the issues. Members of
the Financial Stability Subcommittee of the Conference of Presidents (COP) of the Federal Reserve
Banks conducted a