inancial ystem eport
Bank of Japan March 2008
This report mainly covers 12 major banks and 109 regional banks. The 12 major banks comprise Mizuho Bank, The Bank of Tokyo-Mitsubishi UFJ, Sumitomo Mitsui Banking Corporation, Resona Bank, Mizuho Corporate Bank, Saitama Resona Bank, Mitsubishi UFJ Trust and Banking Corporation, Mizuho Trust and Banking Company, The Chuo Mitsui Trust and Banking Company, The Sumitomo Trust and Banking Company, Shinsei Bank, and Aozora Bank. The 109 regional banks comprise the 64 member banks of the Regional Banks Association of Japan and the 45 member banks of the Second Association of Regional Banks, as of September 30, 2007.
In the charts, "I" and "II" represent the first half and second half of the relevant year, respectively.
Unless otherwise stated, this document uses data available as of February 26, 2008.
Please contact the Financial Systems and Bank Examination Department at the e-mail address below to request permission in advance when reproducing or copying the contents of this report for commercial purposes.
Please credit the source when quoting, reproducing, or copying the contents of this report for non-commercial purposes.
Financial Analysis and Research Financial Systems and Bank Examination Department, Bank of Japan [email protected]
Financial System Report Bank of Japan March 2008
Contents
1 Preface 41 Chapter II Financial Intermediation Function and Changes in 2 An Assessment of the Current State of Its Risks Japan's Financial System: An Overview A. Recent Economic and Financial Developments
Box 1 The U.S. Subprime Mortgage Problem B. Risks Associated with Banks' Financial Intermediation Function from a Macro Perspective 12 Chapter I Business Conditions of Japanese Banks C. Individual Risk Factors Associated with Financial Intermediation A. Developments in Banks' Profits Box 8 Originate-and-Distribute Model: Flow of B. Developments in the Components of Profits Funds Perspectives Box 9 Quantitative Risk Valuation of Real C. Risks Estate-Related Exposure
D. Banks' Capital 60 Chapter III E. Financial Market's Assessment of Japan's Financial System Robustness of the Banking System
Box 2 Subprime Mortgage-Related Loans and A. Simulation Analysis of Interest Rate Risk Investments of the Japanese Major Banks B. Macro Stress-Testing of Credit Risk and Risk Box 3 Valuation and Accounting Treatment of Associated with Stockholdings Structured Credit Products Box 4 Business Conditions of Nonbank Finance Box 10 Macro Stress-Testing of Risk Associated Companies with Stockholdings Box 5 Privatization of Postal Services and Establishment of Japan Post Bank Box 6 Profit Differentials in the Regional Banking Sector Box 7 Funding Liquidity Risk in Money Market
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2 Preface
The Bank of Japan publishes the Financial System Report The Bank continues to contribute to ensuring the stability of biannually with two objectives. The first objective is to Japan's financial system and enhancing its functioning. To present a comprehensive analysis and assessment of the that end, the Bank continues to analyze Japan's financial stability of Japan's financial system. The second objective is system, publish its research results, and take policy to facilitate communication with the concerned parties in measures as needed to support the sustained stability of the order to contribute to the sustained stability of the financial financial system. system.
In advancing the Bank's macroprudential research, the stability of the financial system is analyzed in two aspects: the functioning of the system and its robustness. The functioning of the system needs to be assessed whether it promotes an efficient allocation of economic resources, thereby contributing to the sound development of the economy. The robustness needs to be assessed whether any potential imbalances that might jeopardize the stability of the financial system are largely contained and whether the financial system is robust against such imbalances. Macroprudential research also provides a valuable insight into the assessment of monetary policy's transmission channels.
The March 2008 issue explores the impact of the U.S. subprime mortgage problem on Japan's financial system in addition to assessing the functioning and the robustness of the financial system. It also analyzes the risks inherent in the banking sector, by focusing on each individual bank's profitability and capital strength that appear to be diverging. Moreover, the report examines the risks in the financial system – both the banking sector and the non-banking sector – as a whole from macro and micro perspectives.
1
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1. Japan's financial system, on the whole, has remained 4. The profits of the major banks and the regional banks in stable despite global financial turmoil triggered by the the first half of fiscal 2007 declined from the previous U.S. subprime mortgage problem. The total risks borne year. While interest income bottomed out, non-interest by banks have largely been restrained, compared with income remained sluggish and both credit costs and their capital position. The robustness of the banking general and administrative expenses increased; as a result, system against a stress scenario of interest rate risk and net income declined. In particular, credit costs, which had credit risk has remained relatively high. remained extremely low for several years, increased to a level consistent with the recent economic growth, since 2. In terms of profitability, both interest income and the reversals of allowances for loan losses ran their non-interest income of Japanese banks have become course. Losses also arose from loans and investments rather weak, and their core profitability has remained related to the U.S. subprime mortgage problem and sluggish. Each bank's profitability and capital strength nonbank finance companies, including consumer finance appear to be diverging among the regional banks. companies. The indicators of core profitability, which Japanese banks need to strengthen their profit base to exclude the impact of volatile components such as credit ensure the sustained stability of the financial system. costs, remained low, and improving the profitability of the banking sector continues to be an important business 3. Japanese banks have exposure to the U.S. subprime challenge. mortgage problem mainly in the form of investments in structured credit products, and they are less involved in 5. In terms of soundness, the total risks borne by the major the origination and distribution of such products banks and the regional banks have largely been contained, compared with the U.S. and European financial compared with their capital positions. Credit risk of the institutions (see Box 1 for the summary of the problem). major banks and the regional banks has marginally Under such circumstances, Japanese financial institutions increased. Market risk associated with stockholdings have contained losses stemming from the U.S. subprime remains the largest risk component at the major banks, mortgage problem within their current profit levels and and interest rate risk stays relatively high at the regional capital strength, although such losses have increased as banks, compared with the major banks. In the meantime, the problem has become serious. At present, the U.S. the improvement in the capital positions at the major subprime mortgage problem is unlikely to jeopardize the banks and the regional banks appears to have slowed. stability of Japan's financial system.
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6. Looking at alternative investments, which include the M&A financing, syndicated loans, and securitization structured credit products related to the U.S. subprime markets, have been expanding. The risks associated with mortgages, their outstanding amount and share in the such new channels also need to be carefully monitored, total securities balance are on an increasing trend, while in light of the recent downgrading of structured credit its increasing tempo is slow at the moment. Given the products due to domestic factors.
complex nature of risks inherent in such investments, as (Robustness of the banking system) reconfirmed in the U.S. subprime mortgage problem, financial institutions need to properly gauge and manage 9. The robustness of the banking system against interest the risk-return profiles of alternative investments as well rate risk and credit risk, on the whole, has remained high. as changes in such profiles. In terms of interest rate risk, increases in interest rates have an adverse impact on banks' profits in the short term (Financial intermediation function and changes in through the decline in the market value of bond its risks) portfolios. In the medium term, however, they improve
7. In terms of risk assessment of the financial system from a profits through higher net interest income. Such an macroprudential perspective, potential imbalances that improvement in banks' profits is more evident in the case might jeopardize the stability of the financial system, of the major banks than the regional banks, reflecting the such as the expansion of credit aggregates and excessive different maturities of assets and liabilities. In fact, some risk-taking behavior, have been largely restrained. The regional banks with longer average maturity of loans lag expansion of credit aggregates has been kept relatively behind other regional banks in recovery of interest mild even under the prolonged accommodative monetary income on loans. Such banks need to manage interest conditions. The private corporate sector remains in rate risk of the entire portfolio through, for example, financial surplus, reflecting abundant cash flows at hand, hedging the risk by interest rate swap, off-balancing the and is still cautious in expanding debt-financing. loans, and accepting long-term liabilities such as time deposits, based on their own expectation for the future 8. Looking next at the individual channels of financial course of interest rates. intermediation, business conditions for real estate business financing have changed somewhat: the 10. The robustness of the banking system against credit risk accelerated tempo of decline in J-REIT prices and the has also remained relatively high, based on the results of subdued tempo of increase in land prices in the macro stress-testing that assumes a severe and prolonged metropolitan areas. Banks' lending attitude to real estate economic downturn. Given an indication of deterioration businesses seems to have turned slightly cautious. of borrower classification, banks nevertheless need to Considering the relatively high exposure of banks to real watch changes in the risk-return balances of their loan estate businesses, the risks related to real estate business portfolios, even though the quality of loan portfolios for financing need to be carefully monitored. In the mean the major banks and the regional banks has been largely time, new channels of financial intermediation, such as kept high.
3
(Lessons and challenges for the financial systems stability of Japan's financial system and to enhance based on the U.S. subprime mortgage problem) communication with market participants with the 11. While international financial markets have been in intention of contributing to the sustained stability of the turmoil as the U.S. subprime mortgage problem has system. worsened and its assessment is thus bound to be tentative, the lessons and challenges for the financial systems so far can be summarized as follows. First, the multi-layered securitization intensified leveraging and undermined incentives for risk assessment. Indeed, financial institutions, in the course of originating and distributing structured credit products, failed to properly evaluate and manage the risks related to warehousing those products with little market liquidity and providing contingent liquidity support to investment vehicles. Second, a number of investors and financial institutions failed to evaluate the risks inherent in complex financial transactions. In that respect, financial institutions – intermediaries responsible for distributing risks – need to assess and manage risks properly. At the same time, market infrastructure needs to be further developed so as to enable a wide range of investors – agents assuming risks – to collect and evaluate information pertaining to risks, thereby promoting the effective functioning of market discipline.
12. From a macroprudential perspective, the potential imbalances jeopardizing the stability of the financial system had been growing under the stable macroeconomic environment and continued accommodative monetary conditions in the global economy. While it still remains a challenge to gauge and address those imbalances in a timely manner, it is important to assess the sustained stability of the financial system. The Bank of Japan, in light of the experience of the U.S. subprime mortgage problem, continues to present a comprehensive analysis and assessment of the
42
Box 1: The U.S. Subprime Mortgage Problem
Since the summer of 2007, international financial markets have been in turmoil as the U.S. subprime mortgage problem has worsened. Securitization markets in the United States and European countries have lost their normal functioning, and stock markets have remained volatile. In addition, increasing downside risks to the U.S. economy have fueled uncertainty about the global economic outlook (for the effects of the U.S. subprime mortgage problem on financial markets, see also "Financial Markets Report – Developments during the Second Half of 2007," Financial Markets Department, Bank of Japan, January 31, 2008 [Currently only available in Japanese. Forthcoming in English]).
Japan's financial institutions have some exposure to the U.S. subprime mortgage-related products as investors, but they have been less involved in the origination and distribution of structured credit products, compared with the U.S. and European counterparts. Japan's financial institutions seemed to have contained losses stemming from the U.S. subprime mortgage problem within their current profit levels and capital strength, although such losses have increased as the problem has become more serious. At present, the U.S. subprime mortgage problem is unlikely to jeopardize the stability of Japan's financial system (see Chapter I B, C and Box 2 for the effects of the U.S. subprime mortgage problem on Japan's financial institutions).
Box 1 summarizes the background and the current state of the U.S. subprime mortgage problem, as a premise for analyzing and assessing the stability of Japan's financial system (see Chart B1-1 for the overview of securitization markets related to the U.S. subprime mortgages).
Chart B1-1: Securitization Market Related to the U.S. Subprime Mortgages
Origination Distribution Investment Monolines
Prime Guarantee Banks mortgages Insurers Tranching ABS Pension Mortgage Commercial 7.0 tril. U.S. dollars CDOs funds banks banks Securitization …… Sales Senior …… Alt-A Commercial Investment Resecuritization mortgages banks banks Mezzanine 1.2 tril. U.S. dollars Hedge funds Equity MMFs Subprime Liquidity / credit …… mortgages U.S. mortgage markets enhancement Funding 9.7 tril. U.S. dollars 1.5 tril. U.S. dollars SIVs Funding mismatch (as of end-2006) Conduits ABCP ABCPs
(Subprime mortgages)
Subprime mortgages are referred to the loans extended to households with relatively lower creditworthiness, and provided mainly by mortgage banks that focus exclusively on mortgages. Those mortgages start with small amounts of repayment for initial two to three years with adjustable interest rates to higher ones afterward, on the
5 assumption of the appreciation in housing prices. Therefore, when housing prices peaked out, refinancing of those loans became difficult and resulted in a rapid rise in delinquency rates, thereby aggravating the vulnerability of the financial system.
The current problem is characterized by the fact that the financial market turmoil stemming from the subprime mortgages, whose market size was not large in the entire U.S. economy, spilled over very quickly into the rest of the world through securitization markets. The market size of subprime mortgages hovered around 15 percent of the entire U.S. mortgage market, and less than 30 percent even if Alt-A mortgages, which have somewhat better credit score borrowers than the subprime mortgages, were added. However, since securitization markets for mortgages were well-developed and the risk-return profiles and the holding structure of the structured credit products were quite complex, the effects of the subprime mortgage problem became wide-spread in a short period of time.
The origination and distribution of structured credit products related to mortgages have been regarded as a typical example of the "originate-and-distribute business model." Financial institutions converted mortgages into structured credit products, thereby removing credit risks and liquidity risks associated with mortgages from their balance sheets, and transferring them to various financial institutions and investors. In such a process, financial institutions repackaged mortgages several times and split them into tranches such as senior, mezzanine, and
equity to generate complex structured Chart B1-2: Home Price Indices in the United States1
credit products. At the same time, they y/y % chg. 25 made wide use of an investment strategy 20 to create a funding mismatch and raise 15 leverage through off-balance sheet 10 5 investment vehicles, such as conduits and 0 HPI published by OFHEO structured investment vehicles (SIVs). -5 S&P/Case-Shiller Home Price Indices -10 (Developments in the U.S. subprime CY2000 01 02 03 04 05 06 07
mortgage problem) Note: 1. Both the HPI published by OFHEO and S&P Case-Shiller Home Price Indices are indices of the prices for single-family home re-sales. The HPI measures average price changes in repeat sales or refinancings by The developments in the U.S. subprime GSEs (Fannie Mae or Freddie Mac) on the same properties. At the same time, S&P Case-Shiller Indices measures not only GSEs' re-sales or mortgage problem can be summarized in refinancing, but high price residentials and subprime mortgage residentials. the four stages below. Sources: OFHEO; Standard and Poor's. Chart B1-3: ARM Delinquencies in the United States The first stage was up to the spring of % 2007. During this period, the delinquency 35 30 rates of subprime mortgages spiked 25 2002 20 rapidly as a rise in housing price 2004 15 2005 decelerated and interest rates increased 10 2006 (Chart B1-2, B1-3). In particular, the 5 2007 0 age in delinquency rates on 2006-07 vintage of 1 5 9 1317212529333741454953576165 months adjustable-rate mortgages (ARM), even Sources: JPMorgan; Intex.
6 before the timing of the substantial reset to higher mortgage repayment, increased more quickly than those on the prior vintages. As a result, there was a growing concern that the asset values of financial products backed by subprime mortgages were eroded.
The second stage was from June to July 2007, when Chart B1-4: Spreads of the U.S. Subprime Mortgage-Related the spreads of subprime mortgage-related Structured Credit Products (ABX-HE2006-1)1 structured credit products, once widened in the bps bps 10,000 1,200 early spring of 2007 and subdued for a while, BBB (left scale) 8,000 1,000 AA (right scale) further widened (Chart B1-4). In the meantime, 800 6,000 AAA (right scale) there was a growing concern that hedge funds with 600 4,000 the investment position on those structured credit 400 2,000 200 products might incur losses, and that the business 0 0 conditions of financial institutions holding such Jan. Jul. Jan. Jul. Jan. 2006 07 08 hedge funds might be jeopardized. In addition, Note: 1. ABX-HE 2006-1 is a credit default swap index linked to rating agencies downgraded a wide range of subprime residential mortgage-backed securities (RMBS). Its reference pool is 20 subprime RMBS issued within the structured credit products, making investors period between July and December 2005. cautious to invest in structured credit products on Sources: JPMorgan Chase; Markit. the whole.
In the third stage, after the summer of 2007, adjustments in securitization markets spilled over into a wide range of financial markets. Even highly liquid stock markets became substantially volatile, and other financial markets, including leveraged buy-out markets, were also affected.
In addition, as the rollover of asset-backed commercial papers (ABCPs) issued by investment vehicles holding the U.S. subprime mortgage-backed assets Chart B1-5: Amount Outstanding of ABCPs1 became difficult (Chart B1-5), financial tril. U.S. dollars institutions provided funding support to those 1.3 1.2 investment vehicles, thereby suddenly 1.1 increasing funding pressure in the U.S. dollar. 1.0 0.9 Consequently, in the money markets of the U.S. 0.8 dollar, the U.K. sterling, and the euro, term 0.7 0.6 premiums rose. Despite central banks' massive 0.5 liquidity provisions, the spreads between CY2001 02 03 04 05 06 07 08 overnight and term interest rates widened (Chart Note: 1. Seasonally adjusted. Source: FRB. B1-6, see Chapter I C for funding liquidity risk of Japanese banks).
7 Chart B1-6: Interbank Rates in the United States and Europe1
United States United Kingdom Euro Area % % % 6.5 LIBOR (3-month) 7.5 5.5 6.0 Overnight 7.0 5.0 5.5 5.0 6.5 4.5 4.5 6.0 4.0 4.0 5.5 3.5 3.5 3.0 3.0 5.0 2.5 4.5 2.5 Jan. Jul. Jan. Jan. Jul. Jan. Jan. Jul. Jan. 2007 08 2007 08 2007 08
Note: 1. Overnight interest rates are the effective federal funds rate in the United States, the GBP overnight deposit rate in the United Kingdom, and the euro overnight index average (EONIA) rate in the Euro Area. Source: Bloomberg. Since August 2007, in order to deal with destabilized money markets, central banks in the United States and European countries made massive and long-term liquidity provisions beyond their conventional policy frameworks as well as reduced their policy rates. In December 2007, after having entered the fourth stage explained below, five central banks (the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of England, and the Swiss National Bank) took coordinated measures to deal with tight money market conditions toward the turn of the year. The Bank of Japan, along with Sveriges Riksbank, made an announcement to welcome such action. Thanks to the liquidity provisions by those central banks, after the turn of the year, the turmoil in the money markets was mitigated, and the spreads between overnight and term interest rates narrowed.
In the fourth stage, since October 2007, major U.S. and European financial institutions increased losses in their financial statements due mainly to markdowns of the U.S. subprime mortgage-related products as time passed. Sponsor banks were forced to bring back risky assets held by investment vehicles onto their balance sheets in response to the significant deterioration of such assets. While, in the course of the process, a plan to establish a new vehicle jointly by several banks to preserve the troubled investment vehicles was explored, market pressures finally urged sponsor banks to directly shoulder their risks. Recently, the risks of falling housing prices leading to additional losses in the areas other than subprime mortgages, such as the rising delinquency rates of consumer loans and commercial mortgages, have transpired.
Against such a backdrop, in order to avoid a decline in the capital adequacy ratios, stemming from increases in risky assets as well as realized and unrealized losses of structured credit products, major U.S. and European financial institutions took measures to enhance their capital base one after another by, for example, raising capital from sovereign wealth funds. However, the substantial tightening of banks' lending standard has provoked concern over the possibility that the banks' reduced risk-taking capability might lead to a credit crunch, thereby affecting economic activity (Chart B1-7). After the turn of the year, the downgrading of monolines – financial insurers to structured credit products – has become another concern in securitization markets.
8 Chart B1-7: United States Senior Loan Officer Opinion Survey on Bank Lending Practices [1] Net Percentage of Domestic Respondents [2] Net Percentage of Domestic Respondents Increasing Spreads Tightening Standards for C&I Loans of Loan Rates over Banks' Cost of Funds
% % 70 80 60 Large and medium-sized firms 60 Large and medium-sized firms 50 Small firms Small firms 40 40 30 20 20 0 10 -20 0 -40 -10 -20 -60 -30 -80 CY 2000 01 02 03 04 05 06 07 08 CY 2000 01 02 03 04 05 06 07 08 Source: FRB.
(The backgrounds of the U.S. subprime mortgage problem)
There seems to be several factors behind the fact that the subprime mortgage problem became serious and affected a wide range of financial markets – from the deterioration of subprime mortgages and structured credit products backed by the subprime mortgages, to the impaired functioning of money markets especially in the United States and European countries.
First, at the time of originating subprime mortgages, mortgage banks might have loosened lending standards amid prolonged accommodative monetary conditions and rising housing prices. As the mortgage scheme of small initial repayment with adjustable interest rates to higher ones in two to three years proliferated, mortgages became available to the households with low creditworthiness who were otherwise unable to pass the mortgage screening.
Second, in the process of transferring risks from financial institutions to investors, a mechanism of amplifying risks, i.e., raising leverage, had been embedded. Some investment vehicles intentionally generated a maturity mismatch between their assets and liabilities by investing in structured credit products with longer maturities against short-term funding in ABCPs. That behavior suggests that investors and banks behind such investment vehicles were taking highly leveraged positions as well as credit, liquidity and interest rate risks, thereby pursuing higher returns.
Third, the banking system, on the whole, seemed to take excessive risk. In retrospect, risk was amplified by higher leverage and continued to remain within the system, while such risk was initially considered to be separable from the system. Financial institutions involved in securitization business suffered serious losses from the revaluation of their inventory assets, such as underlying assets and structured credit products, in the process of securitization business. That was because market liquidity of such inventory assets was generally low, and financial institutions were unable to reduce such inventories quickly when investors became increasingly risk-averse. As the rollover of ABCPs issued by investment vehicles became difficult, sponsor banks were urged to provide a large amount of liquidity to ABCP conduits through contingent liquidity lines, and SIVs through implicit commitments.
9 Fourth, investors might have purchased structured credit products, even though they were unable to assess the complicated risks. Some investors, including small to medium-sized financial institutions, relied on the ratings and valuation models provided by external experts. Indeed, a spate of downgradings for a wide range of structured credit products resulted in undermining investors' basis for risk-return assessment.
(Lessons and challenges for the financial systems)
While international financial markets have been in turmoil as the U.S. subprime mortgage problem has worsened and its assessment is thus bound to be tentative, the lessons and challenges for the financial systems so far can be summarized as follows. First, the multi-layered securitization intensified leveraging and undermined incentives for risk assessment. Once the financial environment deteriorated, it accelerated the re-evaluation of risks and aggravated deleveraging, amplifying the scale and depth of adjustments in the financial markets. In other words, large and complex financial institutions in the United States and European countries, which progressively moved toward the originate-and-distribute business model, appeared to fail to properly evaluate and manage the risks inherent in diversified and complicated financial transactions. Moreover, it reaffirmed that the risks were likely to manifest themselves in an abrupt and wide-ranging manner in light of the progress in the financial and economic globalization and information and communications technology.
Second, the financial system relying heavily on the originate-and-distribute model excels in distributing risks not only among banks but among different types of investors. The model thus enables the distribution of funds and risks in a more efficient way by making use of financial markets. To make the system function in an efficient and a stable manner, it is important to develop market infrastructure and thereby promote the effective functioning of market discipline. In that respect, two points are particularly noteworthy: first, financial institutions – intermediaries responsible for distributing risks in securitization – need to assess and manage risks; and second, a wide range of investors – agents assuming risks – need to collect information about risks and evaluate them accordingly.
In terms of risk assessment and management at financial institutions, they may well underestimate the risks related to warehousing structured credit products with little market liquidity and the risks related to providing contingent liquidity support to investment vehicles. Indeed, massive holdings of structured credit products were intended to help banks engage in the originate-and-distribute business proactively, and investment vehicles played an important role in doing such businesses. In short, proper risk assessment and management would play a crucial role in the course of expanding the originate-and-distribute business in the financial system.
In terms of collecting information and evaluating risks at investors, the originate-and-distribute business calls for further disclosure of information in order to ensure the effective functioning of market discipline, as seen in the conventional capital markets. It is also vital to establish more solid market infrastructure, including improvement in credit rating agencies. Recent experience based on the U.S. subprime mortgage problem leaves a number of items to be reflected such as whether or not investors understood well the meaning of credit ratings and the risks in the complex credit products. The framework of financial regulation and supervision needs to take account of incentive compatibility so as to let market discipline work and promote initiatives of financial institutions. In that
10 regard, financial supervisory authorities and central banks of countries continue to make efforts toward the stability of international financial systems. In fact, the Financial Stability Forum published an interim report to G7 Finance Ministers and Central Bank Governors in February 2008, proposing policy directions for strengthening the resilience in such areas as the underpinnings of the originate-and-distribute business model, the uses and role of credit ratings, and the market transparency (e.g., the disclosure requirement under Pillar 3 of Basel II).
Finally, from a macroprudential perspective, it is important to assess potential imbalances jeopardizing the stability of the financial system on a real-time basis. With hindsight, such imbalances were growing in the stable macroeconomic environment and continued accommodative monetary conditions in the global economy. While it still remains a challenge to gauge and address those imbalances in a timely manner, the stability of the financial system needs to be constantly assessed in terms of its sustainability.
11 I. Business Conditions of Japanese Banks
A. Developments in Banks' Profits
1. Net income
Chart 1-1: Net Income/Loss Net income in the first half of fiscal 2007 declined Major banks from the first half of the previous year for both the tril. yen 4 major banks and the regional banks (Chart 1-1). The
2 net income for the major banks declined by half, a sharp contrast, compared with the first half of the 0 previous year when they recorded an all-time high on a -2 Second half biannual basis for two consecutive years. The regional First half -4 banks declined, albeit slightly, for two consecutive Fiscal year -6 years since the first half of fiscal 2005 when they FY 1985 87 89 91 93 95 97 99 2001 03 05 07 recorded an all-time high on a biannual basis. Regional banks Looking at the factors for fluctuations in net income, tril. yen 1.5 although net interest income for both the major banks 1.0 and the regional banks increased marginally, the
0.5 increase in credit costs and general and administrative 0.0 expenses pushed down net income (Chart 1-2).
-0.5 Especially for the major banks, credit costs that -1.0 marked below zero in the first half of fiscal 2006 rebounded and increased, pushing down net income. -1.5 FY 1985 87 89 91 93 95 97 99 2001 03 05 07 The negative credit costs in the first half of fiscal 2006
were due to reversals in loan-loss allowances which Chart 1-2: Contributions to Changes in Net Income/Loss Major banks Regional banks exceeded the sum of provisions and write-offs. difference from the previous year, tril. yen difference from the previous year, tril. yen 6 3 1.5 0.6 The financial statements for the first half of fiscal 2007
4 2 1.0 0.4 are marked by the two types of losses in loans and
2 1 investments. First is the losses incurred by the 0.5 0.2 0 0 structured credit products related with the U.S. 0.0 0.0 subprime mortgage problem. While the losses -2 -1 including unrealized losses were still limited in the first -4 -2 -0.5 -0.2 FY 2002 04 06 06/I 07/I FY 2002 03 04 05 06 06/I 07/I 1 half of fiscal 2007, they increased as the U.S. subprime Net interest income Non-interest income General and 2 administrative expenses mortgage problem became serious. Consequently, Credit costs Others Net income/loss Notes: 1. Non-interest income = net fees and commissions + trading those losses are likely to further push down net income profits + other operating profits - net realized bond-related gains/losses. in the entire fiscal 2007 for the major banks, although 2. Credit costs = loan-loss allowances + write offs - recoveries of written-off claims. the losses are projected to be limited to a size that
12 1,2 could be absorbed by the major banks' current profit Chart 1-3: Credit Cost Ratios and Core ROE of Banks Major banks levels and capital strength (see Box 2 for the major ROE, % Actual result 16 FY 2005 Trade-off line of FY 2003 banks' loans and investments related with the U.S. 14 12 Trade-off line of FY 2005 subprime mortgage, and see Box 3 for the valuation of 10 Trade-off line of FY 2007/I 8 structured credit products). Second is the losses in 6 FY 2007/I loans and investments (credit costs and losses on 4 2 write-down of stocks) towards consumer finance 0 -2 FY 2003 companies, consumer credit companies, and credit card -30 0 30 60 90 120 150 credit cost ratio, basis points (bps) companies that incurred following the second half of Regional banks ROE, % fiscal 2006 (see Box 4 for business conditions of 16 nonbank finance companies). 14 12 10 8 FY 2005 6 2. Core return on equity 4 FY 2007/I 2 0 The degree of improvement in banks' profitability can -2 FY 2003 be seen in the core return on equity (core ROE), which -30 0 30 60 90 120 150 credit cost ratio, basis points (bps) is calculated by excluding the impact of volatile Fluctuation of Core ROE (Illustration) ROE, % A: Changes in ROE due to the change in profit components such as credit costs, gains/losses on 14 ） current period generating capacity (shift of the line 12 B: Change in ROE due to the change in credit securities, and corporate income tax from net income 10 cost ratio (movement on the line） 8 A (see Chart 1-3). The core ROE moved to the upper left break-even 6 credit cost ratio of the chart from fiscal 2003 to fiscal 2005, reflecting a 4 B 2 previous period decline in credit cost ratios, but due to its rise, the core 0 -2 ROE moved to the lower right of the chart in fiscal -20 0 20 40 60 80 100 credit cost ratio, bps 2006 and in the first half of fiscal 2007. In other words, Notes: 1. ROE of the first half of fiscal 2007 is annualized. while the downward-sloping relationship between the 2. See Hattori, Masazumi, Joji Ide, and Yasuo Miyake, "Bank Profits in Japan from the Perspective of ROE Analysis," Bank of core ROE and credit cost ratios remained almost Japan Review 2007-E-3, 2007, for details. unchanged, the core ROE moved up and down in Chart 1-4: Banks' Core ROEs1,2,3,4 response to changes in credit cost ratios. That indicates ROE in FY 2007/I, % 30 Improved (22 banks) that the fluctuations in the banks' profits for the past 20 several years mainly reflected the fluctuations in the 10 credit cost ratios and that improvement in core Deteriorated (93 banks) profitability remained stagnant. 0
Moreover, the core ROE for each bank is calculated by -10 -10 0 10 20 30 fixing credit cost ratios at 30 basis points, which ROE in FY 2003, % corresponds approximately to the expected average Notes: 1. Credit cost ratio is assumed to be 30 basis points. 2. The regional banks which experienced mergers since fiscal 2003 credit cost ratio under economic growth of around 2 fall outside this chart. 3. The bank that has liabilities exceeding its assets falls outside this percent (Chart 1-4, see the September 2007 issue of the chart. 4. When credit cost ratio is assumed to be 40 basis points, the distribution of core ROEs is similar to the above.
13 Financial System Report). The result shows that the
level of the core ROE for the first half of fiscal 2007
varied considerably from bank to bank, and many banks did not improve their core ROEs, compared with
the level in fiscal 2003.
The above analysis suggests that the improvement in
core profitability remained sluggish both for the major banks and the regional banks. Although the declining net interest income bottomed out, non-interest income
increased slowly, and general and administrative
expenses took an upturn. For Japanese banks, improving the core profitability has remained an
important challenge (see Box 5 for the overview of
Japan Post Bank established through privatization and split-up of Japan Post in October 2007. In this Report, Japan Post Bank is neither included in the major banks
nor in the regional banks. Also see Box 6 for profit
differentials in the regional banking sector).
B. Developments in the Components of Profits Chart 1-5: Net Interest Income1 Major banks Regional banks Next, the developments in the components of profits tril. yen tril. yen tril. yen tril. yen 3.0 3.0 6 6 will be examined more closely. 5 2.5 5 2.5
4 2.0 4 2.0 The net interest income of the major banks and the
3 1.5 3 1.5 regional banks had in recent years been showing a 2 1.0 2 1.0 declining trend due to a decrease in net interest income 1 0.5 1 0.5 on loans (Chart 1-5). For the first half of fiscal 2007, 0 0.0 0 0.0 FY 200203040506 06/I 07/I FY 2002 03 04 05 06 06/I 07/I however, both the major banks and the regional banks Net interest on loans and bills discounted Net interest and dividends on securities Others showed a slight increase. The increase in net interest
income on loans was attributable to the expansion of Note: 1. The composition of interest expenses is calculated assuming that the ratio of each component to total expenses is the same as the total interest margins on loans (i.e., the interest rate on ratio of interest on loans and bills discounted, interest and dividends on securities, and other interest income to total interest lending minus the interest rate on interest-bearing income. liabilities) for the major banks and an increase in loans
outstanding for the regional banks. Net interest income
and dividends on securities had been gradually increasing.
14 Below, to analyze net interest income on loans – the largest component in net income – in more detail, it is divided into two components: interest margins and the Chart 1-6: Total Interest Margin on Domestic Loans Major banks Regional banks volume of loans. Then the overall gains and losses on % % securities, non-interest income, and general and 2.5 2.5 2.0 2.0 administrative expenses are analyzed in sequence. 1.5 1.5 1.0 1.0 0.5 0.5 1. Interest margins on loans 0.0 0.0
-0.5 -0.5 First, interest margins on loans (Chart 1-6), which had FY 2002/I 03/I 04/I 05/I 06/I 07/I FY 2002/I 03/I 04/I 05/I 06/I 07/I Interest rate on lending been on a diminishing trend in the past few years, Interest rate on interest-bearing liabilities Interest margin on loans turned upward in the second half of fiscal 2006 for the Chart 1-7: Decomposition of Changes in Interest Margins on major banks, and continued to narrow, albeit by a Domestic Loans1,2,3 small amount, for the regional banks. The interest rate Major banks Regional banks changes in interest rate on lending, bps changes in interest rate on lending, bps on interest-bearing liabilities turned upward in the first 20 20 Average of Average of major banks half of fiscal 2006 for both the major banks and the 15 15 regional banks regional banks. The interest rate on lending turned 10 10 5 5 upward in the first half of fiscal 2006 for the major 0 0 banks. For the regional banks, it turned upward in the -5 -5 second half of fiscal 2006, a half year behind the major -5 0 5 10 15 20 -5 0 5 10 15 20 changes in interest rate on changes in interest rate on banks. interest-bearing liabilities, bps interest-bearing liabilities, bps Notes: 1. Changes are between the first half of fiscal 2007 and the second Next, for each bank, the changes in interest margins on half of fiscal 2006. 2. Observations above the 45-degree line indicate that the interest loans are divided into changes in interest rates on margin on loans improved in the first half of fiscal 2007 when compared with the second half of fiscal 2006. lending and changes in interest rates on 3. The observation for one of the banks falls outside this chart (i.e., below -5 basis points of changes in interest rate on lending). interest-bearing liabilities (Chart 1-7). While changes in interest rates on interest-bearing liabilities Chart 1-8: Interest Rate Spreads on Deposits1,2 concentrated around 10 basis points for both the major % 0.8 banks and the regional banks, changes in interest rates 0.7 FY 2007/I FY 2006/II on loans varied considerably. That contrast shows that 0.6 0.5 changes in interest rates on loans strongly affect the 0.4 degree of improvement in interest margins on loans. 0.3 0.2 Notably, many of the major banks showed an 0.1 0.0 improvement in interest margins on loans (those above Ordinary 1M 3M 6M 1Y 2Y 3Y 5Y deposits the 45 degrees line) whereas the regional banks lagged Notes: 1. Interest rate spread on deposits = market interest rate - deposit in raising interest rates on loans. rate. 2. LIBOR data are used for market interest rate for 1-month to 1-year maturity, and the swap rate data for 2-year maturity or Meanwhile, interest rate spreads on deposits (i.e., more. The overnight call rate is used for market interest rate for market interest rates minus interest rates on deposits) ordinary deposits. Sources: Bloomberg; Bank of Japan, "Average Interest Rates on Time Deposits by Term (New Receipts)."
15
had continued to widen since March 2007 (Chart 1-8).
That reflects the fact that the rise in market interest
rates is larger than that in interest rates on deposits, as
seen during the periods of rising interest rates in the
past. Looking more closely, however, the interest rate
spreads on 3-month time deposits remained relatively
small as a result of offering preferential interest rates,
while those on 1-year or longer time deposits were
large. Chart 1-9: Year-on-Year Change of Loans in Domestic and International Sectors Major banks Regional banks y/y % chg. y/y % chg. 6 4 2. Bank loans International sector 4 Domestic sector 3 Outstanding bank loans (Chart 1-9) continued to 2 Total 2 0 increase both for the major banks and the regional -2 1 banks, although the pace of increase slowed. For the -4 0 major banks, the decrease in bank loans to the -6 -1 -8 domestic sector was particularly prominent, which was -10 -2 offset by the increase in bank loans to the international FY2001/I 02/I 03/I 04/I 05/I 06/I 07/I FY2001/I 02/I 03/I 04/I 05/I 06/I 07/I sector. Chart 1-10: Bank Loans Outstanding by Type of Borrower y/y % chg. Next, looking at the contribution of various types of 4 loans to the domestic sector (Chart 1-10), the rate of 2 0 changes in loans to small firms turned positive in the -2 second half of fiscal 2005, while that of changes in -4 loans to individuals remained positive. In the first half Large firms -6 Medium-sized firms of fiscal 2007, loans to small firms turned negative, Small firms -8 Individuals Total loans while loans to large firms increased at a higher rate -10 FY 2001/I 02/I 03/I 04/I 05/I 06/I 07/I than the previous periods. Against that background, the
Source: Bank of Japan, "Loans and Discounts Outstanding by Sector." rate of increase in outstanding bank loans fell slightly
Chart 1-11: Housing Loans Outstanding in the first half of fiscal 2007. tril. yen Domestic banks Japan Housing Finance Agency 200 Other deposit taking institutions Others In the last few years, the pace of increase in housing loans, the driving force behind the increase in loans to 150 individuals, had been slowing (Chart 1-11). Bank loans 100 to individuals had experienced strong growth due to the replacement of loans from the Japan Housing 50 Finance Agency (formerly the Government Housing 0 Loan Corporation of Japan), but such replacement FY 1995 96 97 98 99 2000 01 02 03 04 05 06 appeared to be coming to a halt. Source: Japan Housing Finance Agency.
16 Chart 1-12: Ratio of Loans Outstanding in the Three Major With respect to the regional allocation of loans, the Metropolitan Areas (Tokyo, Osaka, and Aichi) to Overall Loans Outstanding1 ratio of loans in the three major metropolitan areas to % % 84 24 overall loans was more or less unchanged at the major Major banks（left scale） banks, following the decline from 2003 to 2005, and Regional banks（right scale） 82 22 the ratio was rising at the regional banks reflecting involvement in the syndicated loan market (Chart 80 20 1-12).
78 18 CY1999 2000 01 02 03 04 05 06 07 3. Overall gains and losses on securities Note: 1. Figures are based on the Bank of Japan's "Table of Deposits, Vault Cash, and Loans and Discounts Outstanding of In the first half of fiscal 2007, both the major banks Domestically Licensed Banks by Prefecture." and the regional banks recorded overall losses on Chart 1-13: Overall Gains/Losses on Securities1 securities holdings (Chart 1-13). The fall in the stock Major banks Regional banks tril. yen tril. yen prices during the first half of fiscal 2007 pushed down 6 3 unrealized gains on stocks, while overall gains/losses 4 2 on bonds remained almost unchanged. 2 1
Looking at the unrealized gains/losses on securities at 0 0 the end of the first half of fiscal 2007, unrealized gains -2 -1 for domestic stocks (excluding those for affiliate -4 -2 companies), which account for a large share of FY 2001020304050607/I FY 2001 02 03 04 05 06 07/I unrealized gains, declined substantially for both the Overall gains/losses on bonds Overall gains/losses on stocks Overall gains/losses on securities major banks and the regional banks (Chart 1-14). For Note: 1. The overall gains/losses on securities are changes in the sum of the major banks, unrealized gains on securities of net realized securities gains/losses and changes in net unrealized securities gains/losses when compared with previous half-year. affiliated companies, which account for the second Chart 1-14: Unrealized Gains/Losses on Securities largest share after domestic stocks, decreased due to a Major banks Regional banks fall in the stock prices of consumer finance companies, tril. yen tril. yen 12 6 consumer credit companies, and credit card companies 10 5 within the same financial group. 8 4 6 3 4 2 Meanwhile, unrealized gains/losses on foreign 2 1 securities and others remained marginal on the whole, 0 0 and therefore, the influence of unrealized losses on -2 -1 -4 -2 structured credit products included in the above items FY 2001 02 03 04 05 06 07/I FY 2001 02 03 04 05 06 07/I Others appeared to be limited. Risks of alternative investments Securities issued by affiliates Foreign securities including structured credit products are analyzed Domestic stocks Government bonds and municipal bonds thoroughly in the next section. Total
17 Chart 1-15: Composition of Non-Interest Income 4. Non-interest income Major banks Regional banks
tril. yen tril. yen tril. yen tril. yen Non-interest income had increased since 2000, but had 3.0 1.5 0.8 0.4 been sluggish in the past several years (Chart 1-15). 0.6 0.3 2.0 1.0 For the major banks, overall non-interest income 0.4 0.2 declined for two consecutive years, reflecting a slight 1.0 0.5 0.2 0.1 decrease in net income from fees and commissions and
0.0 0.0 0.0 0.0 a fall in profits on foreign exchange and derivative FY 2002 03 04 05 06 06/I 07/I FY 2002 03 04 05 06 06/I 07/I Others Gains related to foreign exchange and derivative transactions 1 transactions. The regional banks maintained an Net income from fees and commissions Note: 1. Figures are profits from selected items in trading profits and increase as a whole, but its growth rate slowed down. other operating profits. Chart 1-16: Ratios of Non-Interest Income to Gross Profits1 As a result, the non-interest income ratio for the major % 45 banks fell and the one for the regional banks remained 40 35 almost flat, while net interest income increased for 30 both the major banks and the regional banks (Chart 25 Major banks 20 Regional banks 1-16). 15 10 Looking into the banks' income from fees and 5 0 commissions – the largest component in non-interest FY 2000 01 02 03 04 05 06 07/I income (Chart 1-17) –, for the major banks, the fees Note: 1. Ratio of non-interest income to gross profits = non-interest income / (net interest income + non-interest income). related to investment banking such as arrangement of Chart 1-17: Composition of Income from Fees and syndicated loans and M&A decreased, and the income Commissions1 Major banks Regional banks from the sales of investment trusts and private pension
tril. yen tril. yen tril. yen tril. yen 2.4 1.2 1.0 0.5 policies showed somewhat a sluggish movement. For
1.0 2.0 0.8 0.4 the regional banks, the increase in the income from the 1.6 0.8 0.6 0.3 sales of investment trusts and pension policies 1.2 0.6 0.4 0.2 0.8 0.4 underpinned the rise in their income from fees and 0.4 0.2 0.2 0.1 commissions. 0.0 0.0 0.0 0.0 FY 2003 04 05 06 06/I 07/I FY 2003 04 05 06 06/I 07/I Others Funds transfer services Sales of investment trusts and private pension policies 5. General and administrative expenses Investment banking Note: 1. Figures are gross income from fees and commissions of domestic operations. Finally, general and administrative expenses for both Chart 1-18: Year-on-Year Change of General and Administrative the major banks and the regional banks had Expenses Major banks Regional banks increasingly shown an upward trend because personnel y/y % chg. y/y % chg. 8 3 Personnel expenses expenses began to increase in addition to other 6 2 Other expenses 4 1 expenses (Chart 1-18). Such an increase in the general 0 2 -1 and administrative expenses seems to reflect financial 0 -2 -2 -3 institutions' step toward forward-looking resource Total -4 -4 allocation such as an introduction of a new data -6 -5 -8 -6 processing system, recruitment of new employees, FY 2000 01 02 03 04 05 06 07/I FY 2000 01 02 03 04 05 06 07/I
18 active investments in the new business sector, and reconstruction of the overseas sector. Looking ahead, it is important that such forward-looking resource allocation leads steadily to strengthening banks' profitability.
Chart 1-19: NPL Ratios and the Amount of NPLs1,2 Major banks
C. Risks 30 tril. yen % 10 Ratio of NPLs to total credit exposure 25 1. Credit risk (right scale) 8 20 Banks' nonperforming loans (NPLs) were steadily 6 15 decreasing with the continued expansion of Japan's 4 10 economy. The ratio of NPLs to total credit exposure at 5 2 the major banks declined to 1.5 percent at the end of 0 0 the first half of fiscal 2007, down from a peak of 8.7 FY 2000 01 02 03 04 05 06 07/I percent at the end of fiscal 2001. The ratio at the Loans requiring "special attention" (left scale) Doubtful loans (left scale) regional banks also declined to 4.0 percent at the end Unrecoverable or valueless loans (left scale) of the first half of fiscal 2007, compared with 8.1 Regional banks percent at the end of fiscal 2001 (Chart 1-19). tril. yen % 30 Ratio of NPLs to total credit exposure 10 (right scale) The NPL ratio at the regional banks stopped declining 25 8 at a higher level than the one at the major banks. 20 6 Among the regional banks, the NPL ratios still 15 4 remained high at some banks (Chart 1-20). 10
5 2 The business environment including the customer base 0 0 and the business relationship differs between the major FY 2000 01 02 03 04 05 06 07/I banks and the regional banks. Therefore, a simple Notes: 1. NPLs disclosed under the Financial Reconstruction Law. 2. Figures include NPLs which are transferred to subsidiary comparison cannot be made as to the level of NPL companies for corporate revitalization. ratios and the pace of NPL disposals. Nevertheless, the Chart 1-20: NPL Ratios at the Regional Banks1 number of banks ratio of unrecoverable or valueless loans and doubtful 40 loans to total NPLs was still at a relatively high level at 30 the regional banks, and the pace of the removal of NPLs from banks' balance sheet at the regional banks 20 was slower than at the major banks. In order to 10 improve the profitability of loans, the banks need to 0 adequately evaluate the risk-return balances of loans, 0-3-4-5-6-7-8-9-10Over% 10 and through reallocating the loan portfolios, they need Note: 1. As of the end of the first half of fiscal 2007. to step up their efforts to dispose of NPLs.
19 1,2,3 Chart 1-21: Credit Costs and Credit Cost Ratios Next, the credit cost ratio at the major banks rose from Major banks tril. yen % fiscal 2006, while it remained nearly unchanged for the 10 Credit costs (second half, left scale) 3.0 Credit costs (first half, left scale) regional banks (Chart 1-21, the major banks' credit cost 8 Credit cost ratio (whole year, right scale) 2.4 ratio [annualized basis] rose from 0.06 percent in fiscal 6 1.8 2006 to 0.29 percent in the first half of fiscal 2007, and 4 1.2 the regional banks' credit cost ratio declined from 0.38 2 0.6 percent to 0.37 percent during the same period). In the 0 0.0 September 2007 issue of the Financial System Report, -2 -0.6 the forecast for the credit cost ratio was approximately FY 2000 01 02 03 04 05 06 07/I 0.2 percent to 0.4 percent at the major banks with GDP Regional banks tril. yen % growth rate of around 2 percent. The level of the credit 3.0 1.5 cost ratio in the first half of fiscal 2007 was at large 2.5 within that forecast range. 2.0 1.0
1.5 The credit cost ratio at the major banks rose sharply
1.0 0.5 from the first half of the previous year partly because the reversals of provisions for loan losses in the first 0.5 half of fiscal 2006 (the credit cost ratio was minus 0.22 0.0 0.0 FY 2000 01 02 03 04 05 06 07/I percent) diminished. The rise in the credit cost ratio
Notes: 1. Credit cost ratio = credit costs/total loans outstanding. 2. From fiscal 2000 to 2005, figures include credit costs of was also attributable to the provisions for loan losses to subsidiary companies for corporate revitalization. 3. Figures for credit cost ratios in the first half of fiscal 2007 are consumer finance companies, consumer credit annualized. companies, and credit card companies. From the
Chart 1-22: Banks' Stockholdings1,2 second half of fiscal 2006, the credit cost ratio turned tril. yen 30 positive at the major banks, and for fiscal 2006 as a Major banks whole, it became positive (0.06 percent). 25 Regional banks 20
15 2. Market risk associated with stockholdings 10
5 Banks' stockholdings based on acquisition prices 0 remained almost unchanged (Chart 1-22). Market risk FY 2001020304050607/I associated with stockholdings declined slightly during Notes: 1. Figures are based on acquisition prices. 2. On a consolidated basis. the first half of fiscal 2007, reflecting declines in
banks' stockholdings based on market prices. As a result, the ratio of market risk associated with stockholdings to banks' core capital (Tier I) continued to hover around 40 percent for the major banks and little less than 30 percent for the regional banks (Chart 1-23).
20 Chart 1-23: Ratios of Market Risk Associated with Banks' As seen in the previous section, however, unrealized Stockholdings to Tier I Capital1 % Unrealized gains/losses on stocks gains on stockholdings declined due to a fall in stock 100 at major banks Unrealized gains/losses on stocks prices. For the major banks and the regional banks, the 80 at regional banks Risks at major banks decline in unrealized gains exceeded the decline in 60 Risks at regional banks market risk associated with stockholdings. 40
20 As pointed out in the September 2007 issue of the 0 Financial System Report, it is important to properly -20 analyze and evaluate risk-return balances of banks' FY 200001020304050607/I stockholdings. Note: 1. Bank of Japan estimation. As measured by 1-year, 99 percent VaR (using TOPIX as a risk factor).
3. Funding liquidity risk Chart 1-24: Three-Month Spreads between LIBOR and OIS bps The emergence of "funding liquidity risk" – the risk 120 that banks face difficulties in meeting their liquidity 100 JPY needs in the money market – on a global basis is one of GBP 80 USD the characteristics of the global financial market 60 EUR turmoil stemming from the U.S. subprime mortgage 40 problem (see Box 1 on how such risks manifested 20 themselves). The spread between interbank interest 0 rates on term instruments and the overnight index swap Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. Feb. 2007 08 (hereafter LIBOR-OIS spread) – one of the indicators Sources: Bloomberg; Meitan Tradition. of liquidity premiums for financial institutions – widened sharply for major currencies from August 2007 (Chart 1-24, see Box 7 for details). By contrast, the LIBOR-OIS spread of the Japanese yen remained relatively stable.
While the situation deteriorated, a bank run on Northern Rock in the United Kingdom was an example of the serious funding liquidity problem. The Northern Rock's balance sheet was structured in a way that the bulk of the long-term assets such as housing loans was funded with the short-term instruments in the financial market. As the short-term money market became unstable, it became increasingly evident that Northern Rock was vulnerable to funding liquidity risk.
In Japan, by contrast, the liabilities of Japanese banks were structured in a way that deposits account for most
21 1 Chart 1-25: Domestic Interest-Bearing Assets and Liabilities of the liabilities and the share of short-term funding tril. yen 400 Others from the market is small (Chart 1-25). 300 Loans and bills 200 discounted In that context, how banks' funding needs are met by Bonds 100 the central bank's collateralized loans and surplus 0 Stocks funds under a stress scenario, where banks cannot raise -100 Deposits -200 funds from the market at all in a short period, is Long-term -300 wholesale funding2 estimated (Chart 1-26). The result shows that the -400 Short-term 3 Japanese banks as a whole had ample funding capacity Major banks Regional banks wholesale funding
Notes: 1. As of the end of the first half of fiscal 2007. enough to substitute for all the money market 2. Long-term wholesale funding = bonds and notes + borrowed money (excluding borrowed money from the Bank of Japan). financing. In addition, the Bank of Japan daily checks 3. Short-term wholesale funding = CDs + call money + payables under repurchase agreements + payables under securities lending the funding liquidity risk of the Japanese banks transactions + short-term corporate bonds + borrowed money from the Bank of Japan. through monitoring.
Chart 1-26: Ratios of Banks' Funding Capacity to Their Market Borrowing1,2,3,4 In sum, the funding liquidity risk of the Japanese banks % 1,000 as a whole was limited even in the midst of Interquartile range deterioration in the overseas money markets as the 800 Median Minimum U.S. subprime mortgage problem worsened. 600
400 4. Interest rate risk 200 Next, interest rate risk in the banking books of the 0 FY 2003/I 03/II 04/I 04/II 05/I 05/II 06/I 06/II 07/I major banks and the regional banks is examined.
Notes: 1. Ratios of banks' funding capacity to their market borrowing = (Market lending up to three months + reserve deposits + First, the average length of time for the renewal of the government bond holding)/market borrowing up to three months 2. Ratios of banks' funding capacity to their market borrowing are interest rates (hereafter, average maturity) of major sorted out in ascending order. The minimum, 25th, and 50th percentiles (median) are shown. items in the banking books is examined (Chart 1-27). 3. Government bond holding is adjusted according to the ratio of the collateral value to the face value of the government bonds On the one hand, the average maturity of bonds was accepted by the Bank of Japan at the end of September 2007. 4. Banks consolidated by another bank or one holding company are shortening for the regional banks, and the average summed up to one banking group. Data exclude banks with no market borrowing. maturity of bonds of the major banks was even shorter
Chart 1-27: Average Maturities of Banks' Assets and Liabilities1 than that of the regional banks. On the other hand, the Major banks Regional banks average maturity of loans was lengthening especially years years years years 2.0 3.5 2.0 3.5 for the regional banks. Against such a background, the
1.5 3.0 1.5 3.0 maturity gap between assets and liabilities remained almost unchanged for both the major banks and the 1.0 2.5 1.0 2.5 regional banks. For the regional banks it was 1.21 0.5 2.0 0.5 2.0 years, double that of the major banks (0.64 years).
0.0 1.5 0.0 1.5 FY 2002 03 04 05 06 07/I FY 2002 03 04 05 06 07/I The ratio of interest rate risk relative to banks' Tier I Maturity gaps between Loans (left scale) assets and liabilities (left scale) capital (Chart 1-28 [1]) was at a restrained level of 10 Time deposits (left scale) Bonds (right scale) Note: 1. Bank of Japan estimation.
22 Chart 1-28: Interest Rate Risks in the Banking Books percent for the major banks, while it was at a relatively (100bpv)1,2 high level of 24 percent for the regional banks, [1] Ratios of the Interest Rate Risks to Banks' Tier I Capital Major banks Regional banks % reflecting the aforementioned difference in the 40 40 % maturity gap between assets and liabilities. 30 30 20 20 10 10 Decomposing changes in the ratio of interest rate risk 0 0 relative to banks' Tier I capital from the previous -10 -10 -20 -20 period (Chart 1-28 [2]), the increase in Tier I capital FY 2002 03 04 05 06 07/I FY 2002 03 04 05 06 07/I Time deposits Bonds Loans and the decrease in interest rate risk of bonds were Interest rate risks in the banking books [2] Contributions to Changes in the Ratios of the Interest Rate both pushing down the overall ratio, whereas by Risks to Banks' Tier I Capital contrast, the increase in interest rate risk of loans was Major banks Regional banks difference from the previous year, % points chg. difference from the previous year, % points chg. 4 4 pushing up the overall ratio. The contribution of 2 2 interest rate risk of loans to increase in the overall 0 0 interest rate risk was particularly large for the regional -2 -2 banks. -4 -4
-6 -6 Looking at each regional bank's loan portfolio, the FY 2003 04 05 06 07/I FY 2003 04 05 06 07/I Tier I Bonds Time deposits Loans distribution of its average maturity showed a tendency Interest rate risks in the banking books Notes: 1. The risks are estimated based on the assumption that market for longer maturity (Chart 1-29). That was partly due interest rates rise by 100 basis points at all maturities. 2. Bank of Japan estimation. to an increase in housing loans with medium- and Chart 1-29: Regional Banks' Average Maturity of Loans1,2,3 years 10th-90th percentile range long-term fixed interest rates in recent years. In that 2.0 Median light, some banks shifted to variable-rate housing loans 1.5 in order to restrain the rise in its average maturity. As such, the impact of a rise in market interest rates on 1.0 banks' net interest income is likely to vary further from 0.5 FY2000 01 02 03 04 05 06 07/I bank to bank. Notes: 1. Bank of Japan estimation. 2. Average maturity of loans for the regional banks is sorted out in ascending order and 10th percentile, 50th percentile (median), In that context, the average maturity of loans and the and 90th percentile are shown. change in interest rates on loans during the first half of 3. Dashed lines indicate the range between the 10th percentile and the 90th percentile around the 50th percentile (median) in fiscal fiscal 2007 were negatively correlated (Chart 1-30). In 2000. Chart 1-30: Regional Banks' Average Maturity of Loans and the 1,2,3 other words, during the period of market rate rises, Changes in Interest Rate on Lending changes in interest rate on lending, bps banks with longer average maturity of loan portfolios 20 15 had more difficulty reflecting market rate rises on their 10 loans; their profits were thus more likely to be 5 squeezed. That is examined thoroughly in Chapter III 0 where the results of interest rate risk simulations are -5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 shown. average maturity of loans, years Notes: 1. Bank of Japan estimation. 2. As of the end of the first half of fiscal 2007. The changes in interest rate are between the first half of fiscal 2007 and the second half of fiscal 2006. 3. The observation for one of the banks falls outside the chart (i.e., below -5 basis points of changes in interest rates on lending).
23 Chart 1-31: Alternative Investments 5. Risk in alternative investments [1] "Other Securities1","Monetary Claims Bought2" and Ratios to Total Securities3 Major banks Regional banks Finally, "alternative investments" such as investments
tril. yen % tril. yen % in structured products, credit products, and hedge 15 10 6 10 Amount outstanding (left scale) 8 8 funds – the financial products that have risk-return Ratio (right scale) 10 4 6 6 profiles different from the traditional assets – are
4 4 5 2 considered. When the sum of "other securities" and 2 2 "monetary claims bought" in banks' balance sheet is 0 0 0 0 used to estimate the size of alternative investments, its FY 2001 02 03 04 05 06 07/I FY 2001020304050607/I [2] Ratios to Total Securities outstanding amount and share in the total securities and number of banks 60 monetary claims bought showed an increasing trend, 50 40 though its growing pace was recently slowing (Chart 30 1-31 [1]). Such alternative investments accounted for 20 10 9.6 percent of the total balance of securities and 0 monetary claims bought at the major banks and 7.0 0-5 -10 -15 -20 over 20 % percent at the regional banks. It should be noted that Notes: 1. "Other securities" refer to banks' holdings of securities other than government bonds, corporate bonds, and stocks. there were some banks that had higher shares of 2. "Monetary claims bought" include beneficial interests in trust. 3. Total securities include monetary claims bought. alternative investments (Chart 1-31 [2]).
1,2 Chart 1-32: Banks' Alternative Investments Looking at the composition of alternative investments, [1] Portfolios Major banks Regional banks residential mortgage-backed securities (RMBS), which tril. yen tril. yen Investment trusts 20 10 included those originated in Japan, had the largest Hedge funds 8 15 share both for the major banks and the regional banks Multi-layered structured 6 credit products and others at the end of the first half of fiscal 2007. Other than 10 ABS collateralized by 4 corporate claims 3 ABS collateralized by retail RMBS, investment in hedge funds was relatively large 5 4 2 claims CMBS 5 for the major banks and that in investment trusts was 0 0 RMBS sizable for the regional banks (Chart 1-32 [1]). [2] Ratios of Risks to Tier I Capital6 Major banks Regional banks Computing the ratio of risks in alternative investment % % Investment trusts 8 8 Hedge funds portfolios to Tier I capital, it was 7.5 percent for the 6 6 ABS collateralized by major banks and 6.5 percent for the regional banks in corporate claims 3 4 4 ABS collateralized by the first half of fiscal 2007 (Chart 1-32 [2]). That retail claims 4 CMBS 5 2 2 suggests that risks from alternative investment remain RMBS 0 0 within manageable levels. Notes: 1. As of the end of the first half of fiscal 2007. 2. The definition of alternative investments here is different from that of Chart 1-31. For example, some RMBS are not included in It should be noted that there are several caveats in Chart 1-31. 3. Lease claims for example. interpreting the estimate. The estimate is as of the end 4. Credit card claims for example. 5. Commercial mortgage-backed securities. of the first half of fiscal 2007 and any further 6. Bank of Japan estimation. As measured by 1-year, 99 percent VaR (using Lehman indices, Dow Jones hedge fund indices and development in market prices and volatility in TOPIX as risk factors). The composition of multi-layered alternative investment portfolios is not reflected in the structured credit products and others is assumed to be the same as that of the other part of securitization portfolio.
24 estimate. Furthermore, the coverage and availability of market data may not be sufficient, and there may be a risk not fully incorporated in the data.
As the U.S. subprime mortgage problem has made it clear that many types of alternative investments have a complex nature, it is important to evaluate and manage their risk-return profiles.
D. Banks' Capital
1 1. Banks' capital adequacy ratios and risk Chart 1-33: Capital Adequacy Ratios and Tier I Capital Ratios Major banks Regional banks balance % % 14 14 Banks' capital adequacy ratios that continued to Capital adequacy ratio 12 12 Tier I capital ratio improve in recent years appeared to moderate at the 10 10 end of the first half of fiscal 2007 for both the major banks and the regional banks (Chart 1-33). The core 8 8 capital adequacy ratios (Tier I ratios) showed only a 6 6 slight rise from the end of fiscal 2006 due to a decrease 4 4 in the net income, marking 7.7 percent for the major FY 200001 02 03 04 05 06 07/I FY 200001 02 03 04 05 06 07/I banks and 8.5 percent for the regional banks. The Note: 1. On a consolidated basis. capital adequacy ratios, whose numerator includes Tier Chart 1-34: Overall Amount of Risk and Tier I Capital1 Major banks Regional banks II, Tier III, and deductions as well, decreased to 12.4 tril. yen tril. yen percent for the major banks. That reflects a fall in 30 15 Tier I capital unrealized gains on stocks, since many of the major Tier I capital 10 banks are subject to the international standards that 20 allow unrealized gains of the securities to be included 10 5 in Tier II capital. The regional banks remained almost unchanged at 10.7 percent. 0 0 FY 2002 03 04 05 06 07/I FY 2002 03 04 05 06 07/I 3 When evaluating the amount of risks examined in the Credit risk 2 Market risk associated with stockholdings Interest rate risk 45Operational risk previous section relative to the level of banks' capital, the total risks borne by banks were restrained on the Notes: 1. Bank of Japan estimation. 2. Credit risk is calculated by subtracting the expected loss (EL) whole (Chart 1-34). For the major banks, market risk from the maximum loss (EL + UL) based on the Basel II risk weight formulas with a confidence level of 99 percent. In the associated with stockholdings continued to be the estimation, borrowers classified as requiring "special attention" or below (in terms of credit quality) are considered to be in a largest share in the overall amount of risks while the state of default. 3. Market risk associated with stockholdings is calculated by the amount of credit risk became smaller. same method as in Chart 1-23. 4. Interest rate risk is limited to yen-denominated bond portfolios and calculated by the same method as in Chart 1-28. It remains an important challenge for banks to evaluate 5. Operational risk is defined to be 15 percent of gross profits based on the Basel II basic indicator approach.
25 1 Chart 1-35: Banks' Risk-Weighted Assets the balance between the amount of total risks and their [1] Total Risk-Weighted Assets Major banks Regional banks capital, thereby improving the efficiency of capital
tril. yen tril. yen 320 160 allocation. 300 150 280 140 260 130 240 120 220 110 2. Banks' risk-weighted assets and capital 200 100 FY 2004 05 06 07/I FY 2004 05 06 07/I Market risk equivalent assets and others Operational risk equivalent assets Banks' risk-weighted assets and capital that constitute Credit risk-weighted assets (off-balance-sheet items) Credit risk-weighted assets (on-balance-sheet assets) the capital adequacy ratio are decomposed. First, [2] On-Balance-Sheet Assets Major banks Regional banks risk-weighted assets decreased at the end of fiscal 2006 tril. yen tril. yen 250 150 due partly to the transition to Basel II, but increased at
130 200 the end of the first half of fiscal 2007, mainly 110 150 reflecting a rise in credit risk-weighted assets (Chart 90
100 700 1-35 [1]). FY 2006 07/I FY 2006 07/I Corporate exposures Retail exposures Equity exposures Securitization exposures Others Looking at the items of on-balance-sheet assets (Chart [3] Off-Balance-Sheet Items 1-35 [2], most of the increases were attributable to the Major banks Regional banks tril. yen tril. yen 50 5 loans to the corporate sector and individuals for both 40 4 the major banks and the regional banks. With respect 30 3 20 2 to securitization exposures, their share in the total 1 10 assets was low and their amount of the increase 0 0 FY 2006 07/I FY 2006 07/I remained marginal. Commitments Guarantees Derivative exposures Others Note: 1. On a consolidated basis. Chart 1-36: Composition of Capital1 Off-balance-sheet items were, in general, on an Major banks increasing trend for the major banks as seen in % 14 12 10 commitment contract-related items (Chart 1-35 [3]). 8 6 4 The share of off-balance-sheet items in the 2 0 -2 risk-weighted assets of the regional banks remained FY 2002 03 04 05 06 07/I Regional banks small and no significant changes were seen. % 14 12 10 Second, looking at the capital adequacy ratio from the 8 6 composition of capital (Chart 1-36), both at the major 4 2 0 banks and the regional banks, ordinary stocks and -2 FY 2002 03 04 05 06 07/I retained earnings were on an increasing trend, which Tier III and deductions Others included in Tier II capital 2 Tier II capital Unrealized gains on securities holdings decelerated somewhat in the first half of fiscal 2007. Subordinated debts Preferred securities 3 Tier I capital Preferred stocks Others included in Tier I capital Unrealized gains on securities were diminishing. The Tier I ratio Net deferred tax assets Capital adequacy ratio ratio of deferred tax assets to banks' capital was kept at Notes: 1. Only the banks subject to international standards are allowed to include unrealized gains into Tier II. The proportion of an extremely low level. unrealized gains is smaller at regional banks than at major banks, many of which are subject to international standards. 2. Issued by offshore operating companies and included in minority At the major banks, the shares of preferred stocks, interests. 3. Issued by consolidated offshore special purpose companies.
26 preferred securities (included in Tier I capital), and Chart 1-37: Repayment of Public Funds tril. yen subordinated debts (included in Tier II capital), 14 Amount injected 1 12 remained at high levels. In that respect, increasing Tier Amount repaid 2 I capital and enhancing the quality of assets remain an 10 8 important challenge for the major banks. 6 4 Meanwhile, banks continued to repay public funds. As 2 a result, nearly 8.9 trillion yen – about 75 percent of 0 the total public funds injected since 1998 CY2000 01 02 03 04 05 06 07 08
Notes: 1. The sum of public funds injected pursuant to the Early (approximately 12.4 trillion yen) – had been repaid by Strengthening Law, the Financial Function Stabilization Law, the Deposit Insurance Law, the Financial Reorganization the end of December 2007 (Chart 1-37). Nevertheless, Promotion Law, and the Financial Functions Strengthening Law. 2. At face value. the pace of repayment slowed after the three mega Source: Deposit Insurance Corporation of Japan. financial groups fully repaid public funds in fiscal Chart 1-38: Credit Rating and Prices of Bank Stocks1 2006. number of changes in ratings Jan. 5, 1996 = 100 400 120
E. Financial Market's Assessment of Japan's 200 80 Financial System 0 40 With regard to the financial market's assessment of
Japan's financial system, while considerable variation -200 0 CY 1996 97 98 99 2000 01 02 03 04 05 06 07 08 among indicators remained, more indicators on the Upgrades (left scale) Downgrades (left scale) whole showed signs of deterioration, as the U.S. TOPIX subindex for banks (right scale) TOPIX (right scale) subprime mortgage problem worsened (Charts 1-38 Note: 1. The number of upgrades and downgrades is the sum of the number of changes in ratings made by the following credit rating and 1-39). On the one hand, the credit ratings of agencies: Moody's Investors Service, Standard and Poor's, Fitch Ratings, Rating and Investment Information, and Japan Credit Japanese banks continued to be revised upward. On the Rating Agency. Sources: Tokyo Stock Exchange; Bloomberg. other hand, banks' stock prices declined substantially, Chart 1-39: CDS Premiums of Major Banks1 underperforming the overall stock prices. Credit bps default swap (CDS) premiums for three major 120 100 U.S. and European banks Japanese banks also rose but not as sharply as the U.S. Japanese banks and European banks. 80 60
Looking at the movements of those indicators in more 40 detail, first, the credit ratings of Japanese banks, 20 especially large regional banks, were revised upward, 0 Jan. Apr. Jul. Oct. Jan. due to the improvement in the qualities of their assets 2007 08 and capital base (Chart 1-38). Second, the stock prices Note: 1. The values for Japanese banks are calculated as the simple average of the CDS premiums of Mizuho Corporate Bank, The of Japanese banks declined from the summer of 2007 Bank of Tokyo-Mitsubishi UFJ, and Sumitomo Mitsui Banking Corporation. The values of U.S. and European banks are the at a faster pace than those of the U.S. and European simple average of those of Citigroup, Bank of America, JPMorgan Chase, Wells Fargo, Goldman Sachs, HSBC, and banks directly affected by the U.S. subprime mortgage UBS. Sources: Tokyo Financial Exchange; Bloomberg.
27 Chart 1-40: Prices of Bank Stocks problem (Chart 1-40). Such a plunge in banks' stock Jan. 1, 2007＝100 120 prices appears to reflect the lowered expectation of an 110 upturn in banks' business, attributable more to the 100 problems specific to Japan than to the effect stemming 90 from the U.S. subprime mortgage problem. 80 TOPIX 70 S&P 500 Third, the CDS premiums for three major Japanese 60 DJ Euro STOXX banks rose with some fluctuation from late July in 50 Jan. Apr. Jul. Oct. Jan. 2007, in part reflecting heightened concern over the 2007 08 U.S. subprime mortgage problem (Chart 1-39). Source: Bloomberg. However, the increases in the CDS premiums for those Japanese banks were smaller than those for the major banks registered in the United States and Europe.
Those indicators of the market's assessment of Japan's financial system show that the conclusions vary considerably depending on the perspective, i.e., whether one places greater weight on the stability or the profitability of the financial system, as pointed in the previous Financial System Reports.
While Japan's financial system has largely overcome the NPL problem after the bursting of the asset price bubble and it has become increasingly stable over the years, improvement in the profitability of banks' core business remains a major challenge from a long-term perspective. As a result, higher credit ratings reflected the increasing stability of the financial system, while the weak performance of banks' stock prices reflected market concern over the long-term profitability of banks' core business.
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Box 2: Subprime Mortgage-Related Loans and Investments of the Japanese Major Banks
The Japanese major banks reported 600 billion yen Chart B2-1: Major Banks' Losses in the Subprime 1 in net loss related to the subprime mortgage-related Mortgage-Related Loans and Investments tril. yen loans and investments by the fourth quarter 2.5 Fourth quarter of 2007 (October to December) of 2007 (Chart B2-1). The 2.0 (Oct.-Dec.) losses increased by 460 billion yen in three months 1.5 First half of fiscal 2007 (Apr.-Sep.) following the first half of fiscal 2007, when they 1.0 reported 140 billion yen in net loss. 0.5
0.0 The losses comprised realized losses (including Losses in the subprime Estimated net income mortgage-related loans and of fiscal 20072 write-down) of structured credit products, provisions investments for loan losses on LBO projects and losses related to Notes: 1. Figures of financial groups. The reported coverage differs liquidity support facilities, as well as from bank to bank. 2. The estimated net income of fiscal 2007 is as of the monoline-related losses. announcements of the financial statements of the quarter ending in December 2007. Source: Published accounts. The losses associated with the U.S. subprime mortgage problem have proliferated in terms of size and range as the problem has been aggravated. Nevertheless, the losses for fiscal 2007 are projected to be limited to an amount absorbable by major banks' annual net income.
Looking at the major banks' exposure at the end of September 2007, used for calculating the capital adequacy ratio, to the structured credit products, the total amount including exposure to those other than the subprime mortgage-related products increased, compared with the end of March 2007, while the risk assets remained almost unchanged. As a result, the average risk weight declined (Chart B2-2). In terms of the risk weight distribution of the exposure, the risk weight equal to or lower than 20 percent was predominantly large, reaching at about 80 percent of the total. By contrast, the exposure to low-rated products (i.e., equal to or below BB- for banks adopting internal ratings-based approach) and non-rated products – the most disadvantageous items in the calculation of the capital adequacy ratio, classified as deduction items – were only about 3 percent of the total (Chart B2-3). Nevertheless, attention should be paid to risk management as even the credit ratings of high-rated products have been revised downward recently. Chart B2-2: Securitization Exposures of the Major Chart B2-3: Securitization Risk Weights of the Major Banks1 Banks1
FY tril. yen % 20 50 2006 15 45 07/I 10 40
5 35 0 20406080100% 22 0 30 0-20% -100% Over 100% Deduction from capital FY 2006 07/I Exposures (left scale) Notes: 1. Financial groups' consolidated exposures as investors. Risk-weighted assets (left scale) 2. "-20 (100) percent" indicates "below 20 (100) percent" or Average of risk weights (right scale) "20 (100) percent and below." Source: Published accounts. Note: 1. On a consolidated basis.
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Box 3: Valuation and Accounting Treatment of Structured Credit Products
In the wake of the U.S. subprime mortgage problem, the spreads for structured credit products such as HEL ABS and ABS CDO widened considerably (see Box 1 for the summary of the problem). Several factors behind the observed widening of spreads have been pointed out, such as investors' demand for larger premiums due to insufficient disclosure and fire-sales to unwind the leveraged positions. This box attempts to shed light on the observation that the spreads of lower tranches of structured credit products widened considerably as the underlying pooled assets deteriorated, and, in particular, such tendency has been more evident for multi-layered structured credit products. In addition, the box summarizes the accounting treatments of structured credit products.
To begin with, the basic framework of structured credit Chart B3-1: Framework of Structured Credit Products
products is briefly reviewed Structured credit products Multi-layered structured credit products (Chart B3-1). Structured credit Underlying pooled products are generally split into tranches Underlying Senior Senior * tranches by the level of seniority pooled assets Mainly senior tranches of structured and subordination in the payment Mezzanine credit products Mezzanine Equity Equity from underlying pooled assets. e.g., High-grade CDO squared. Broadly speaking, the tranche Underlying pooled with the first seniority is called Underlying Senior tranches Senior "senior," while the one with the pooled assets* Mainly mezzanine most subordinated is called Mezzanine tranches of structured Equity credit products Mezzanine "equity." A tranche between * Underlying pooled assets of structured credit products Equity include home mortgages, nonrecourse loans, credit card e.g., Mezzanine CDO squared. senior and equity is called loans, and receivables. "mezzanine." The level of subordination for each tranche is generally determined depending on the risk attributes of underlying pooled assets and the tranche's target level of ratings. In many cases, the senior tranche accounts for the majority of the deal, while the equity and the mezzanine share a small amount of the remaining. Structured credit products are often pooled and compounded further into another type of structured credit products by re-creating the seniority and subordination structure. In this process, even the pool of mezzanine tranches can be transformed into not only equity and mezzanine tranches but also senior tranche. As examined below, however, even if the risk attributes of underlying pooled assets are the same, the risk attributes of multi-layered structured credit products may vary, depending on whether the underlying tranches is closer to senior or equity.
Next, the effects of changes in the default rate and default correlation of underlying assets on the loss distribution and the spreads of tranches are examined. First, the rise in the default rate widens the spreads of all the tranches because it increases the overall losses to investors. Second, the changes in default correlation, while keeping the default rate unchanged, influence the loss distribution among the tranches, thereby changing the relative size of spreads across the tranches.
The effect of changes in default correlation is further explained below (Chart B3-2). In the first case of low default correlation with high diversification effects in the pooled underlying assets, losses are likely to be realized in a dispersed manner. In the second case of high default correlation with low diversification effects, by
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contrast, losses are likely to be Chart B3-2: Default Correlation and Spread of Tranches realized in a concentrated manner. In that case, the senior （Underlying pooled assets） （Realized losses） （Spread of tranches） losses tranche is more likely to suffer Low default＝ correlation Senior Equity losses because the losses once High diversification effects realized tend to become large enough to exhaust the buffer in time While keeping default rate While keeping total amount the equity tranche. At the same Default rate unchanged, change in of losses unchanged, change default correlation leads to in loss distribution between time, the equity tranche is more Default correlation change in frequency and tranches leads to change in likely to avoid losses, because concentration of defaults. relative size of spreads. losses High default＝ correlation of higher probability of zero Senior Equity Low diversification effects default events. Consequently, when default correlation rises, the spread decreases in the time equity tranche, while it increases in the senior tranche. Since the mezzanine tranche stays between the two, the way its spread changes becomes more similar to that of equity, as its relative position comes closer to equity.
A numerical exercise using a simplified version of a plain CDO is carried out to examine the effects of changes in the default rate (λ) and default correlation (ρ) on the sensitivity of the break-even spread (i.e., the spread making the value of default payments equal to the value of premium receipts). Chart B3-3 shows that the rise in the default rate causes an upward shift in the relationship between spread and default correlation for all the tranches. As for the effects of the rise in default correlation, the equity tranche shows an upward-sloping curve, while the senior tranche shows a downward-sloping curve when keeping the default rate constant. That reflects the shift in the loss distribution toward the upper tranches when default correlation rises. Mezzanine spreads initially show an upward-sloping curve at low default rate, but turn into a downward-sloping curve as the default rate increases. That is because the rise in the default rate induces the mezzanine tranche to be located in a more subordinated position, thus making the mezzanine tranche closer to the equity tranche.
Chart B3-3: Break-Even Spreads of CDOs1,2,3
bps Equity (0-3%) bps Mezzanine (3-7%) bps Senior (7-100%) 8,000 1,500 100 λ = 0.02 6,000 80 λ = 0.01 1,000 60 4,000 λ = 0.005 40 500 2,000 20
0 0 0 0.1 0.3 0.5 0.7 ρ 0.1 0.3 0.5 0.7 ρ 0.1 0.3 0.5 0.7 ρ Notes: 1. Bank of Japan estimation. 2. The normal one-factor copula model is adopted in the numerical study above. The number of obligors in the underlying pooled assets and notional amount of each obligor are assumed to be 500 and 1 respectively. Maturity of the underlying tranches, recovery ratio, and risk free rate are assumed to be 5 years, 40 percent, and 5 percent respectively. 3. Figures in parentheses are attachment (lower limit of tranches) and detachment (upper limit of tranches) of each tranche.
The next numerical exercise examines the behavior of break-even spreads of multi-layered structured credit products, using a simplified version of a CDO squared. Chart B3-4 shows a case of the CDO squared with the senior underlying tranches of 10 percent attachment and 14 percent detachment (e.g., high-grade CDO squared). The chart shows that all the tranches of the CDO squared exhibit an upward-sloping curve, similar to a plain
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CDOs' senior tranches, with respect to the rise in default correlation, in the case of a low default rate (λ＝0.005). The chart also shows that, as the default rate increases, such an upward-sloping curve turns toward a downward-sloping, similar to a plain CDOs' equity tranche, from the lower tranche. By contrast, Chart B3-5 shows a case of the CDO squared with the mezzanine underlying tranches of 3 percent attachment and 7 percent detachment (e.g., mezzanine CDO squared). The chart shows that all the tranches of the CDO squared exhibit a downward sloping curve at a high default rate (λ＝0.02), since the underlying tranches consist of portions close to equity. To sum up, the multi-layered structured credit products such as CDO squared, whether they are senior or not, can possess risk attributes similar to equity, as the underlying tranches become subordinated.
Chart B3-4: Break-Even Spreads of the CDO squared with the Senior Underlying Tranches1,2
bps Equity (0-3%) bps Mezzanine (3-7%) bps 600 600 400 Senior (7-100%) 500 500 λ = 0.02 300 400 λ = 0.01 400 300 λ = 0.005 300 200 200 200 100 100 100 0 0 0 0.10.30.50.7ρ 0.10.30.50.7ρ 0.1 0.3 0.5 0.7 ρ
Notes: 1. Bank of Japan estimation. 2. It is assumed that each underlying tranche of CDO squared above consists of 100 obligors. Attachment and detachment of each underlying tranche are assumed to be 10 percent and 14 percent respectively. Assumptions of parameters for underlying pooled assets are the same as Chart B3-3.
Chart B3-5: Break-Even Spreads of the CDO squared with the Mezzanine Underlying Tranches1,2 bps Equity (0-3%) bps Mezzanine (3-7%) bps Senior (7-100%) 5,000 λ = 0.02 4,000 1,500 4,000 λ = 0.01 3,000 1,200 3,000 λ = 0.005 900 2,000 2,000 600 1,000 1,000 300 0 0 0 0.10.30.50.7ρ 0.10.30.50.7ρ 0.1 0.3 0.5 0.7 ρ
Notes: 1. Bank of Japan estimation. 2. All the assumptions are the same as Chart B3-4 except that attachment and detachment of each underlying tranche are assumed to be 3 percent and 7 percent respectively.
To compare the three numerical exercises above, 1,2 Chart B3-6 plots the spread sensitivity of the Chart B3-6: Spreads of Senior Tranches bps senior tranches, showing that the descending order 2,000 CDO squared with the mezzanine underlying tranches of impacts on spreads is the CDO squared with the CDO squared with the senior underlying 1,500 tranches mezzanine underlying tranches, the CDO squared CDO
with the senior underlying tranches, and the CDO. 1,000 In other words, the senior spread in the multi-layered structured credit products has a 500
tendency to intensify its sensitivity to increase in 0 the default rate of the pooled underlying assets, as 0.005 0.01 0.02 0.03 λ the relative position of the underlying tranches Notes: 1. Bank of Japan estimation. 2. The result above is the case of ρ = 0.2 in the previous charts. becomes subordinated.
In purchasing and managing credit structured products, it is important to examine the difference in risk attributes by products and tranches as well as the structure of those products. Such structures include: credit enhancement for upper tranches such as an over-collateralization test (i.e., the paydown of the senior occurs when an excess
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portion of underlying pooled assets fall below a certain level), and assessment on managers of managed-type products whose underlying assets can be flexibly rebalanced.
Next, the accounting treatment of the valuation of structured credit products is reviewed. First, in the United States, the Financial Accounting Standards Board (FASB) published the Statement of Financial Accounting Standards No.157 (FAS 157) entitled "Fair Value Measurements" with effect from November 2007. In the statement, fair value was classified in the descending order of pricing observability in the market from level 1 to 3, and stipulated valuation methods according to each category. In addition, with respect to the interpretation of FAS 157, a business group of accounting offices, the Center for Audit Quality (CAQ) published a guideline focusing on market liquidity, "Measurement of Fair Value in Illiquid (or Less Liquid) Markets," in October 2007. The guideline articulated that, market prices are considered to be fair value even when the prices declined due to the supply-demand imbalance in the market, and not to use less objective "level 3" information as much as possible. Nevertheless, even though such guidelines were published, fair value measurements of structured credit products related to the U.S. subprime mortgage seem to remain difficult, because their market prices are not easily observed.
1 Second, in Japan, valuation methods of securities are Chart B3-7: Valuation of Securities in Japan 1. Trading market stipulated in "Accounting Standards for Financial Instruments" (Accounting Standards Board of Japan) Exist Not exist and "Practical Guidelines Concerning Accounting for 2. Actual transactions Financial Instruments" (The Japanese Institute of Certified Public Accountants) (Chart B3-7). According Exist Extremely little to those standards and guidelines, following factors are 3. Rational valuation considered to be crucial in the valuation of securities in Japan: (1) whether trading market exists, (2) whether Possible Impossible actual transactions exist, and (3) whether the valuation Market price Rational value Acquition value of securities can be estimated in a rational manner. Note: 1. The classification above is a sketch of accounting Applying those standards and guidelines in practice, standards pertaining to reasonable market values. however, remains difficult in Japan as in the United States. Here, the rational valuation is based on the reasonable estimates by management and also is derived by using discounted cash flow analysis or prevailing pricing models.
As such, accounting judgment about the valuation of structured credit products related to the U.S. subprime mortgage problem and other structured credit products would not be easy. Nevertheless, it would be crucial for financial institutions to strive to stave off market concern stemming from the aggravation of the U.S. subprime mortgage problem by properly applying the existing accounting standards, disclosing their related losses, and also setting provisions and/or writing off those losses.
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Box 4: Business Conditions of Nonbank Finance Companies
The five largest consumer finance companies (CFCs: Acom, Aiful, Promise, Sanyo Shinpan Finance, and Takefuji) recorded net losses in fiscal 2006 due to a jump in provisions for refunding excess interest repayments and a rise in loan-loss provisions (Chart B4-1). Subsequently, while some companies ran deficits because of additional provisions, many reported profits in the first half of fiscal 2007, and the profits of the CFCs as a whole are likely to turn positive, albeit small, for the entire fiscal 2007. In the meantime, the actual reimbursements so far were within their expectations, while yet to show a clear sign of peaking out (Chart B4-2).
Chart B4-1: Net Income of Five Large CFCs1 Chart B4-2: Reimbursement1,2 tril. yen bil. yen 2 90
1 60
0 30 Net operating income -1 Net income 0 -2 CY 2006/2Q 3Q 4Q 07/1Q 2Q 3Q 4Q FY 2003 04 05 06 07 (Forecast) Notes: 1. Based on values for Acom, Aiful, Promise, and Takefuji. Note: 1. Based on values for Acom, Aiful, Promise, Sanyo Shinpan 2. Excludes the portion of interest repayments Finance, and Takefuji. applicable to the loan principal. Source: Published accounts. Source: Published accounts.
Outstanding loans of the CFCs were declining at a Chart B4-3: Outstanding Loans and Loan Rates1
year-on-year rate of about 10 percent, since the CFCs tril. yen Outstanding loans (left scale) % 8 24 tightened their lending standards in response to the Loan rates (right scale) 6 23 enactment of the Amendment to the Money-Lending Business Law in December 2006 (Chart B4-3). Loan 4 22
rates were also declining as the CFCs refrained from 2 21
lending at grey-zone interest rates, and write-off rates 0 20 FY 2003 04 05 06 07 were recently increasing. (Forecast) Note: 1. Based on values for Acom, Aiful, Promise, Sanyo The CFCs' capital adequacy ratios (net assets/gross Shinpan Finance, and Takefuji. assets) declined in fiscal 2006 due to large net income Source: Published accounts. losses; nevertheless, they remained relatively high and Chart B4-4: Net Income of Nine Large Credit Card marked 25 percent on average at the end of the first half and Consumer Credit Companies1 tril. yen of fiscal 2007. 2.0 Net operating income Net income Credit card and consumer credit companies, which earn 1.5 1.0 almost half of their net operating income from cashing 0.5 and card-loan businesses, are in severe business 0.0 condition. They are also facing the challenges of the -0.5 increase in refunding excess interest repayments, the FY 2003 04 05 06 07 (Forecast) decline in outstanding loans, and the decline in loan Note: 1. Based on values for Mitsubishi UFJ NICOS, Orient rates. The major credit card and consumer credit Corporation, Central Finance, APLUS, JACCS, Credit Saison, UC Card, OMC Card, and AEON companies as a whole reported net losses in fiscal 2006 CREDIT SERVICE. Source: Published accounts. due partly to a large loss reported by some companies.
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They are expected to report losses, though by a small Chart B4-5: Net Income of Six Large Business Finance 1 amount, again in fiscal 2007 amid increasing Companies bil. yen provisions for refunding excess interest repayments 200 Net operating income Net income (Chart B4-4). Against such a backdrop, major credit 150 card and consumer credit companies attempt to map 100 out business strategies, for example, by focusing on 50 the card business. They also explore the reorganization 0 and consolidation of their industry for the purpose of -50 FY 2003 04 05 06 07 cost reduction. (Forecast) Note: 1. Based on values for SFCG, LOPRO, NIS Group, Many business finance companies, which depend INTER, Ikko, and APREK. Source: Published accounts. heavily on unsecured loans and mainly lend at grey-zone interest rates, were also facing declining profits due to the decline in loan rates and the rise in nonperforming loans (Chart B4-5). Some companies, taking into account the balance between the reduction of loan rates and the risk of loan-losses, were trying to secure profits by shifting their loans from unsecured loans to loans with mortgage collateral.
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Box 5: Privatization of Postal Services and Establishment of Japan Post Bank
On October 1, 2007, Japan Post Bank, Japan Post Insurance, Japan Post Service, and Japan Post Network were established as subsidiaries of Japan Post Holdings and the privatization process of the postal services began. On the same day, the Bank of Japan began providing current account services to Japan Post Bank.
Japan Post Bank is a commercial bank which conducts businesses based on the Banking Law, but during the transition phase towards its final privatization deadline, it is temporarily constrained in its business scope. The scope for operation at the start of privatization was limited to those originally conducted by Japan Post and any new operation is subject to the approvals by the Prime Minister and the Minister for Internal Affairs and Communications upon hearing opinions from the Postal Services Privatization Committee. After the start of the privatization process, Japan Post Bank was granted mainly the following operations in December 2007: (a) participating in syndicated loans and lending to special purpose companies (SPCs), (b) trading of public bonds, (c) trading of trust beneficiary interests and stocks, (d) acquisition or transfer of loans, (e) interest rate swap and interest rate futures transactions, and (f) reverse repo transactions.
Within the time frame of the end of September 2017 as the final deadline for complete privatization, Japan Post Bank will aim to be listed on the stock market. Japan Post Bank will be fully privatized when either of the following takes place: (a) when Japan Post Holdings disposes of all Japan Post Bank's stocks it holds, and (b) when the Prime Minister and the Minister for Internal Affairs and Communications decide, upon taking Japan Post Bank's business condition into consideration, that fair competition with other financial institutions will be secured and that Japan Post Bank can provide adequate services.
Chart B5-1: Balance Sheet of Japan Post Bank at the Outset of Privatization Process tril. yen Cash and deposits 5.8 Savings 188.9 Securities 170.8 Special savings 131.7 Japanese government bonds 155.5 Ordinary savings 47.7 Local government bonds 8.0 Borrowed money 24.8 Loans 3.9 Total liabilities 215.8 Deposits to fiscal loan fund 38.8 Total net assets 7.7 Total assets 223.6 Total liabilities and net assets 223.6
Capital adequacy ratio (international standards) 54.0% Source: Japan Post Holdings.
The size of Japan Post Bank at the outset of the Chart B5-2: Balance of Postal Savings tril. yen % 210 Privatization -4.5 privatization process was slightly less than 80 percent Outstanding deposits (left scale) process began y/y % chg. (right scale) of the overall size of the regional banks, with total 200 -5.0 assets of 223 trillion yen and a savings balance of 188 190 -5.5 trillion yen (Charts B5-1 and B5-2). Capital was 7.7 180 -6.0 trillion yen. At the planning phase, the capital adequacy ratio calculated according to the 170 -6.5 Apr. Oct. Apr. Oct. international capital adequacy framework was 54.0 2006 06 07 07 percent. Source: Japan Post Bank.
36
Chart B5-3: Japan Post Bank's Profits Projections 100 mil. yen FY 2007 (half year) FY 2008 FY 2009 FY 2010 FY 2011 Operating income 12,920 24,480 23,520 23,010 22,090 Interest income 12,100 22,720 21,610 20,930 19,840 Operating expenses 10,750 19,130 17,510 16,930 17,020 Interest expenses 3,300 5,230 3,650 2,950 2,850 General and administrative expenses 7,100 13,190 13,150 13,270 13,460 Personnel expenses 510 1,000 980 970 970 Other expenses 4,770 8,830 9,110 9,310 9,530 Commission expenses paid to 3,140 6,270 6,290 6,210 6,060 Japan Post Network Net operating income 2,170 5,350 6,010 6,080 5,070 Pre-tax income 2,170 5,350 6,010 6,080 5,070 Net income 1,300 3,210 3,610 3,650 3,040 Deposits (in tril. yen)1 187.3 185.4 183.8 172.2 164.2 Note: 1. At the end of fiscal year. Source: Japan Post Holdings.
In terms of profit outlook, interest income mainly Chart B5-4: Net Asset Value of Investment Trust Sold from securities accounts for more than 90 percent of Privatization the net operating income (Chart B5-3). And, Japan tril. yen 1.2 process began Post Bank has a network of 234 direct branches. 1.0 Moreover, it entrusts teller operations to 24 thousand 0.8 0.6 post offices and small post offices as the bank's agents. 0.4 Because of that, nearly 50 percent of the general and 0.2 0.0 administrative expenses are expected to be Apr. Oct. Apr. Oct. commission expenses paid to Japan Post Network. 2006 06 07 07 Sources: Japan Post Bank; Japan Post Holdings. In the meantime, looking at the sales of investment trusts, which comprise a major part of income from fees and commissions, net asset value of investment trusts sold has remained almost unchanged since the start of the privatization of process of the postal services (Chart B5-4).
37
Box 6: Profit Differentials in the Regional Banking Sector
The regional banks' profits for the first half of fiscal 2007, compared with the profits in fiscal 2001 – the most recent cyclical trough –, improved on the whole as the adverse impact of credit costs diminished (Chart B6-1). However, some banks lagged behind in improving their profits. This Box analyzes the regional banks' profitability by classifying 109 regional banks according to (a) economic size of the region (gross prefectural product [GPP] in fiscal 2004) the bank is based on (hereafter, business base) and (b) bank's total fund volume as of the first half of fiscal 2007 (Chart B6-2). In principle, the average figures are used for analysis for the period from fiscal 2004, when credit costs more or less settled at the current level, to the first half of fiscal 2007.
Chart B6-1: Fund Volume and ROA of the Regional Banks Chart B6-2: Classifying 109 Regional Banks
ROA, % 3 3 ROA, % fund FY 2001 volume [GPP small, fund volume large] [GPP large, fund volume large] FY 2007/I
0 0 2.8 tril. yen 4.0 tril. yen -1 -1 1.9 tril. yen [GPP small, fund volume small] [GPP large, fund volume small] -2 -2
GPP small 5.9 tril. yen GPP large <24 prefectures> <23 prefectures>
Looking at ROA (net income before taxes/total assets) Chart B6-3: ROA by Groups % by group, the highest is the group of large GPP and a 2 large fund volume, followed by the group of large GPP 1 and a small fund volume, the group of small GPP and 0 a large fund volume, and the group of small GPP and a -1 -2 small fund volume (Chart B6-3). Regardless of the size GPP large, GPP large, GPP small, GPP small, of GPP, both the ratios of interest income to total fund volume large fund volume small fund volume large fund volume small Interest income Non-interest income General and administrative expenses Credit costs assets (hereafter, interest income ratio) and general and ROA administrative expenses to total assets (hereafter, expense ratio) are higher for the groups of the smaller fund volume. In particular, the expense ratio differs significantly between fund volume groups. The ratio of credit costs to total assets (hereafter, credit cost ratio) is relatively higher for the groups of the smaller fund volume and GPP. In the meantime, the ratio of non-interest income to total assets (hereafter, non-interest income ratio) is more or less the same among the groups.
The above results imply that the expense ratio is Chart B6-4: Credit Cost Ratios and NPL Ratios largely influenced not by the business base, but by the % % 4 12 GPP large fund volume, while, in terms of credit cost, the quality GPP small 10 3 of a loan portfolio is influenced by both the fund NPL ratio 8 (right scale) volume and the business base. 2 6 Credit cost ratio 4 Looking at the time-series developments in the credit 1 (left scale) 2 cost ratio according to the size of GPP (Chart B6-4), it 0 0 had been lower for the regions with small GPP than FY 1998 99 2000 01 02 03 04 05 06 07/I regions with large GPP until fiscal 2003, contrary to
38
the current situation. Subsequently, the credit cost ratio for regions with small GPP became higher than that for regions with large GPP in fiscal 2004 and the difference somewhat widened thereafter. Also, in terms of nonperforming loan (NPL) ratio, it was lower for the regions with small GPP than the regions with large GPP until fiscal 2002, but became higher in fiscal 2003. In the group of small GPP, both the current credit cost ratio and the NPL ratio were somewhat high since the region's economic recovery was relatively moderate, and the removal of the NPLs from their balance sheet was delayed after provisioned.
Next, within the two groups – the group of small GPP Chart B6-5: ROA within the Two Groups and a small fund volume and the group of large GPP and GPP small, fund volume small average, % a large fund volume –, the banks are further classified 3 2 into those with higher-than-average ROAs and those 1 with lower-than-average ROAs to analyze the changes in 0 profit structure (Chart B6-5). With respect to the sample -1 -2 period, the average ROA from fiscal 2004 to the first half -3 Higher ROA Lower ROA of fiscal 2007 is compared with that from fiscal 2000 to -4 2003, when credit costs as a whole had remained high. FY 2000-03 FY 04-07/I FY 2000-03 FY 04-07/I
GPP large, fund volume large Within the group of small GPP and a small fund volume, average, % 3 the banks with higher-than-average ROAs improved their 2 ROAs between the above two periods, while the banks 1 0 with lower-than-average ROAs rather worsened their -1 ROAs, remaining below zero percent. That is because the -2 -3 credit cost ratio substantially declined in the case of the -4 Higher ROA Lower ROA banks with higher ROAs, while it increased in the case of FY 2000-03 FY 04-07/I FY 2000-03 FY 04-07/I Credit costs the banks with lower ROAs. In terms of the interest General and administrative expenses Non-interest income Interest income income ratio and the expense ratio, the difference ROA between the two groups of banks was not as large as in the case of the credit cost ratio. That suggests that, within the group of small GPP and a small fund volume, the banks with relatively high ROAs increased their profits by containing credit costs.
Making the same comparison for the group of large GPP and a large fund volume, both the banks with higher-than-average ROAs and lower-than-average ROAs improved their ROAs between the two periods, while the extent of improvement was more obvious for the first one. That is because the credit cost ratio and the expense ratio declined more markedly in the case of banks with higher-than-average ROAs. Those banks seem to have substantially contained their credit costs and general and administrative expenses through the drastic disposal of NPLs and rationalization efforts. In addition, the increase in the non-interest income ratio contributed, albeit marginally, to increasing profits.
In sum, for the regional banks, while there were differences according to the business base and fund volume, how credit costs and general and administrative expenses were contained seems to have been critical for enhancing bank profitability. For the regional banks to further enhance profitability in the future, they need to improve the interest income ratio and the non-interest income ratio in addition to properly controling credit costs and general and administrative expenses. In order to do so, each regional bank needs to pursue forward-looking allocation of managerial resources in business areas with its competitive edge, upon accurately gauging the region's economic condition in which the bank is based on.
39
Box 7: Funding Liquidity Risk in Money Market
As an indicator for funding liquidity risk in the money market, the spread between interest rates on term instruments (LIBOR) and overnight index swap (OIS), hereafter the LIBOR-OIS spread, has been receiving a lot of attention (Chart 1-24).
The OIS transaction is an interest rate swap that exchanges the uncollateralized overnight interest rate of a certain period for the fixed interest rate. For example, a bank that raises funds for three months by rolling over overnight transactions, can hedge the volatility risk of overnight interest rates by conducting the OIS transaction of "receive overnight interest rate and pay 3-month fixed interest rate."
In a case in which banks are able to raise funds without difficulty in the interbank market on a daily basis, the OIS rate and the interbank interest rate on term instruments are almost identical and the LIBOR-OIS spread tends to be extremely small. However, when Chart B7-1： Three-Month LIBOR-OIS Spread (Illustration) banks face funding liquidity risk and the fragility Interest rate of fund raising in the interbank market becomes Period that a bank Daily expected funding rate borrows from a (thick line) acute, banks' expected fund-raising interest rate central bank at a high rate Expected funding rate for three months (LIBOR) tends to exceed the OIS for three months Three-month average of Premium paid rate (Chart B7-1). As such, the LIBOR-OIS overnight interbank rate for central (OIS rate) spread is considered to reflect the degree of bank credit LIBOR-OIS funding liquidity risk banks are facing. spread
The LIBOR-OIS spread for all major currencies rapidly widened after August 2007 when the short Daily overnight interest rate (thin line) term money market experienced a crunch in Now Three months later funding liquidity (Chart 1-24). Although the spread temporarily narrowed, it widened again towards the year-end. That developed into an unprecedented case in which five central banks cooperated in providing ample supplies of liquidity to the market on December 12, when uncertainty over funding liquidity reached its peak (see Box 1). In the meanwhile, the LIBOR-OIS spread for the yen widened as in the case with other major currencies, but the widening was relatively moderate.
Meanwhile, the LIBOR-OIS spread for the U.S. dollar continued to substantially exceed 50 basis points even after August 17, 2007, when the Federal Reserve Bank of New York narrowed the premium margin of discount interest rates to 50 basis points from 100 basis points. That suggests the seriousness of a liquidity shortage particularly in the U.S. dollar funds among major currencies. Behind the problem, it is pointed out that some banks were unable to use the discount window due to collateral constraints, or they avoided using it for fear of hurting their reputation. One should be aware of the trade-off below: a narrower premium margin is likely to mitigate the funding liquidity risk more effectively in vulnerable market conditions, while a narrower premium margin reduces the incentive for banks to properly manage their liquidity risk in normal market conditions. Reference: Ooka, Eiko, Teppei Nagano, and Naohiko Baba, "Recent Development of the OIS (Overnight Index Swap) Market in Japan," Bank of Japan Review 2006-E-4, 2006.
40 II. Financial Intermediation Chart 2-1: Economic Growth and Prices in Japan [1] Real GDP Growth Rate Function and Changes in Its y/y % chg. 6 Risks 4 This chapter starts with a summary of recent 2 macroeconomic and financial conditions in Japan. It 0 then examines the risk factors behind the financial
-2 system both from macro and micro perspectives. -4 CY 2001 02 03 04 05 06 07
[2] CPI (Excluding Fresh Food) A. Recent Economic and Financial y/y % chg. Developments 1.0
2000-base CPI Since the publication of the September 2007 issue of 0.5 2005-base CPI the Financial System Report, Japan's economy has 0.0 been expanding moderately as a trend, although the pace of growth seems to be slowing mainly due to the -0.5 drop in housing investment (Chart 2-1 [1]). Japan's -1.0 economy is expected to continue expanding CY 2001 02 03 04 05 06 07 moderately, although the pace of growth is likely to Sources: Cabinet Office, "National Accounts"; Ministry of Internal Affairs and Communications, "Consumer Price Index." slow for the time being. Chart 2-2: Market Interest Rates As explained in Box 1, however, amid the aggravating [1] Short-Term Interest Rates % effect of the U.S. subprime mortgage problem, due 0.8 Uncollateralized call rate (overnight) attention should be paid to such factors including FB (3-month) 0.6 uncertainties about overseas economies and global TB (6-month) financial markets as well as the effects of high energy 0.4 and materials prices. 0.2
On the price front, the year-on-year rate of change in 0.0 consumer prices (excluding fresh food) has been rising CY2004 05 06 07 08 due to the increase in the prices of petroleum products [2] Medium- and Long-Term Interest Rates (JGBs) and food products (Chart 2-1 [2]). The year-on-year 2.5 % 2-year rate of change in consumer prices is projected to 5-year 2.0 10-year follow a positive trend due to the rise in the prices of petroleum products and food products in the short run 1.5 and the positive output gap in the longer run. 1.0
0.5 Against such a background, the overnight call rate – the operating target of the Bank of Japan – has 0.0 CY2004 05 06 07 08 remained at its target level of around 0.5 percent in the Sources: Bloomberg; Japan Bond Trading Co., Ltd.; Bank of Japan.
41 short-term money market (Chart 2-2 [1]). As for
interest rates on term instruments, upward pressure
increased mainly for over the year-end rates; otherwise, they remained relatively stable compared to
those in the United States and Europe. Such Chart 2-3: Stock Prices Jan. 4, 1968=100 Jan. 6, 1992=1000 developments in Japan's short-term money market 2,000 600 TOPIX (left scale) suggest that the effect of turmoil in the U.S. and
1,500 TOPIX subindex for banks European markets continues to be restrained in Japan (right scale) 400 (see Chapter I C and Box 7 for funding liquidity risk). 1,000
200 With regard to the government bond market, long-term 500 interest rates (newly issued 10-year bonds) declined in
0 0 line with those in the United States and Europe. They CY 2000 01 02 03 04 05 06 07 08 have recently stayed at around 1.4 percent (Chart 2-2 Source: Tokyo Stock Exchange. [2]). In the stock market, reflecting concern over the 1,2 Chart 2-4: Credit Spreads on Bonds U.S. economy's possible recession and a decline in % points 1.4 stock prices worldwide, investors appear to have AA A BBB 1.2 become more risk averse. Moreover the outlook for 1.0 Japanese firms' business performance has become 0.8 rather more pessimistic against a background of the 0.6 stronger yen. All those developments have led to the 0.4 0.2 continued weakness in the stock market (Chart 2-3). 0.0 CY 200404 05 06 07 08 Looking at the credit market, credit spreads seem to
Notes: 1. The ratings indicated above are those by Japan Rating & have widened in the United States and Europe in the Investment Information. 2. Spreads on bonds with 4 to 6-year maturities against 5-year wake of the U.S. subprime mortgage problem. The Japanese government bonds. Sources: Japan Securities Dealers Association; Bloomberg. spreads in Japan have also widened, albeit marginally
Chart 2-5: Corporate Bankruptcies1 (Chart 2-4). number of cases tril. yen 6,000 6 Meanwhile, the number of corporate bankruptcies is 5,000 5 somewhat on the rise. Sector-wise, the construction 4,000 4 industry has contributed to the rise in bankruptcy. 3,000 3 Area-wise, bankruptcies have risen in the metropolitan 2,000 2 areas (Chart 2-5). The amount of debts involved in the 1,000 1 bankruptcies for 2007 exceeded the previous year for 0 0 the first time in seven years in part due to a large CY 2001 02 03 04 05 06 07 failure in the real estate businesses. Number of cases (left scale) Amount of debt involved in the bankruptcies (right scale) Note: 1. The data are quarterly. Land prices in the metropolitan areas continued to rise Source: Tokyo Shoko Research, "Tosan Geppo (Monthly Review of Corporate Bankruptcies)." until recently. Their rate of increase appears to have
42 1,2 peaked out. In the regional areas, land prices have kept Chart 2-6: Land Prices [1] All City Areas in Japan [2] Six Major City Areas declining, albeit at a decelerating pace (Chart 2-6). difference from the previous half-year, % chg. difference from the previous half-year, % chg. 0 12 Residential land Commercial land 8 -2 B. Risks Associated with Banks' Financial 4 Intermediation Function from a Macro 0 -4 Perspective -4
Next the risks associated with financial intermediation -6 -8 CY 2000 01 02 03 04 05 06 07 2000 01 02 03 04 05 06 07 CY are examined based on financial and economic data. Notes: 1. The Urban Land Price Index is based on surveys conducted at the end of March and September each year. 2. The six major city areas are the 23 wards of Tokyo, Yokohama, Nagoya, Kyoto, Osaka, and Kobe. Source: Japan Real Estate Institute, ''Urban Land Price Index.'' 1. Flow of funds
The "Flow of Funds Accounts" shows that the overall picture of the funds surplus/deficit structure by sector Chart 2-7: Financial Surplus/Deficit1 ratio to nominal GDP, % Private non-financial firms remained unchanged from the late 1990s: households 15 General government surplus Households and private non-financial firms continued to register a 10 Overseas surplus, while general government continued to 5 register a deficit (Chart 2-7). From fiscal 2005, the 0 surplus of households grew, reflecting an increase in -5 income. By contrast, due to increased demand for -10 deficit business fixed investment, the surplus of private -15 FY 1994 96 98 2000 02 04 06 07/I non-financial firms gradually decreased after peaking Note: 1. In order to remove effects of seasonality, the figures for the first in fiscal 2003 despite their effort to cut down on half of fiscal 2007 are calculated using data from the second half of fiscal 2006 to the first half of fiscal 2007. interest-bearing liabilities. As a result, households Source: Bank of Japan, "Flow of Funds Accounts." continued to register the largest surplus from fiscal
2006.
Chart 2-8: DI for Demand for Loans: Classified by Borrower The fact that private non-financial firms still ran a Type1
DI, % points surplus, albeit at a decreasing level, indicates that those 30 firms' appetite for external funds remained benign 15 against a background of ample cash flows in the accommodative financial environment. 0
From the banks' perspective on the firms' demand for -15 Firms bank loans, the number of respondents selecting Households -30 stronger demand continued to exceed the number of CY2001 02 03 04 05 06 07 respondents selecting weaker demand from 2005 Note: 1. DI for demand for loans = (percentage of respondents selecting "substantially stronger" + percentage of those selecting (Chart 2-8). Recently, however, the demand lost "moderately stronger" × 0.5) - (percentage of those selecting "substantially weaker" + percentage of those selecting momentum somewhat. The volume of total financial "moderately weaker" × 0.5) . Source: Bank of Japan, "Senior Loan Officer Opinion Survey on Bank Lending Practices at Large Japanese Banks."
43 Chart 2-9: Financial Liabilities of Private Non-Financial Firms1 liabilities of private non-financial firms remained Ratio of total financial liabilities of private non-financial firms to nominal tril. yen GDP (right scale) % 1,400 250 almost flat even in the middle of the moderate 1,200 200 1,000 expansion of Japan's economy (Chart 2-9). 800 150 600 100 The volume of financial assets held by households 400 50 200 continued to follow a moderate uptrend, reaching 0 0 FY 1980 85 90 95 2000 05 07/I 1,536 trillion yen at the end of September 2007 (Chart Loans Securities other than shares Shares and other equities Deposits 2-10). Above all, the share of holdings of currency and Trade credits and foreign trade credits Others Note: 1. Loans, shares and other equities, and securities other than shares deposits was nearly stable, while the share of holdings are evaluated at face or book values. Source: Bank of Japan, "Flow of Funds Accounts." of investment trusts increased. That suggests that a 1 Chart 2-10: Financial Assets Held by Households gradual shift "from savings to investment" remained on tril. yen Ratio of total assets held by households to nominal % 2,000 GDP (right scale) 350 track, though currency and deposits still accounted for 300 1,500 250 the largest share of the overall financial assets and the 200 1,000 shift from safe to risky assets remained limited. 150 500 100 50 With regard to the financial sector channeling funds 0 0 between the fund-investing sector and the fund-raising FY 1980 85 90 95 2000 05 07/I Currency and deposits Insurance and pension reserves sector, there was no significant change in the Shares and other equities Investment trusts 2 Bonds Others intermediation structure, where depository institutions Notes: 1. Shares and other equities, investment trusts, bonds, and some financial products which are included in others are evaluated at still play a leading role (Chart 2-11). The financial market prices. 2. Bonds = securities other than shares - (trust beneficiary rights + assets in the insurance and pension funds as well as mortgage securities). Source: Bank of Japan, "Flow of Funds Accounts." other financial intermediaries were expanding Chart 2-11: Financial Assets of Financial Sector gradually, but their size in the overall financial sector ratio to nominal GDP, % 600 Other financial intermediaries 1 remained small. Among "other financial Insurance and pension funds 500 Depository corporations intermediaries," financial dealers and brokers, 400 investment trusts and special purpose companies were 300
200 gaining shares (Chart 2-12). While the shares of "other
100 financial intermediaries" were still limited, evidence 0 suggests that the intermediation via those institutions, FY 1985 88 91 94 97 2000 03 06 Note: 1. Other financial intermediaries include securities investment trusts, including securitization in the credit market, was nonbanks, financial dealers and brokers, and financial auxiliaries. Source: Bank of Japan, "Flow of Funds Accounts." gradually gaining ground in Japan's financial system. Chart 2-12: Financial Assets of Other Financial Intermediaries
80 ratio to nominal GDP, % Looking at the financial sector in the United States,
60 "other financial intermediaries" were the driving force
40 behind the expansion of the overall financial sector 20 from the second half of the 1990s (Chart 2-13). It 0 appears that the originate-and-distribute business FY1985 88 91 94 97 2000 03 06 Structured-financing special purpose companies and trusts model prevailed through those intermediaries (see Box Financial auxiliaries Financial dealers and brokers Securities investment trusts 8 for the originate-and-distribute model from the flow Finance companies Source: Bank of Japan, "Flow of Funds Accounts."
44 Chart 2-13: Financial Assets of Financial Sector in the United of funds perspectives). States ratio to nominal GDP, % 500 Other financial intermediaries 1 Insurance and pension funds 400 Depository corporations
2. Credit creation from a macro perspective 300
This section examines the credit performance in the 200 100 current financial environment. 0 CY 1985 88 91 94 97 2000 03 06 First, regarding the level of short-term interest rates Note: 1. Other financial intermediaries are the sum of investment trusts, relative to the real economy, the real interest rate gap financial dealers and brokers, nonbanks, and funding companies. Source: FRB, "Flow of Funds Accounts of the United States." (i.e., the real interest rate minus the trend growth rate) Chart 2-14: Short-Term Real Interest Rate and Real GDP Growth Rate % Short-term real interest rate 1 stayed negative from around 2003 (Chart 2-14). 10 Real GDP growth rate (y/y % chg.) 2 Despite the narrowed gap somewhat reflecting the 8 Growth rate of real GDP trend (y/y % chg.) 6 adjustments in policy interest rates, it has been more 4 2 significantly negative than the past. As a result, the 0 -2 level of real interest rates, adjusted for inflation, -4 Real interest rate gap relative to the level of the real economic activity has -6 CY 1985 88 91 94 97 2000 03 06 remained low, and the accommodative financial Notes: 1. Short-term real interest rate = call rate (overnight, uncollateralized) - y/y % chg. in CPI (excluding fresh food). environment has been kept intact. 2. Real GDP trend is calculated by applying the HP filter. Sources: Cabinet Office, "National Accounts"; Ministry of Internal Affairs and Communications, "Consumer Price Index"; Bank of Second, regarding the level of credit aggregates Japan. Chart 2-15: Financial Liabilities in the Private Non-Financial relative to the level of the real economic activity, both Sector and Loans Outstanding by the Banks ratio to nominal GDP, % ratio to nominal GDP, % the ratio of financial liabilities of the private 300 200 non-financial sector and the ratio of bank loans 280 180 outstanding to nominal GDP remained almost 260 160 240 140 unchanged at levels close to those in the mid-1980s 220 Liabilities of non-financial sector (left scale)1,2 120 3 (Chart 2-15). That suggests that the expansion of credit Loans outstanding by banks (right scale) 200 100 aggregates seems benign relative to the tempo of the FY 1985 87 89 91 93 95 97 99 2001 03 05 07/I Notes: 1. The figures for the non-financial sector are the sum of private expansion in economic activity. non-financial corporations, households, and private non-profit institutions serving households. 2. Shares and other equities, and securities other than shares are Banks' lending attitude continued to be accommodative evaluated at face or book values. 3. Banks are comprised of the domestically licensed banks and against a background of their improved risk-taking foreign-owned banks in Japan. Source: Bank of Japan, "Flow of Funds Accounts." capacity due to easing capital constraints of banks and Chart 2-16: Lending Attitude of Financial Institutions as 1 improved creditworthiness of borrowers. Recently, Perceived by Firms DI, % points 40 however, their lending attitude toward small firms 30 became somewhat less accommodative (Chart 2-16). 20 10 0 In sum, potential imbalances stemming from excessive -10 Large firms expansion in credit aggregates and banks' excessive -20 Small firms -30 risk-taking behavior, which might jeopardize the CY1996 97 98 99 2000 01 02 03 04 05 06 07 Note: 1. DI = "accommodative" - "severe." stability of the financial system, are deemed to be Source: Bank of Japan, "Tankan (Short-Term Economic Survey of restrained. Enterprises in Japan)."
45 3. Credit risk and interest rate spread on loans
Turning to the relationship between credit risk and
interest rate spread on loans, the second one has
remained extremely low, and that raises the possibility that the spread is unable to cover the credit cost (see
discussion over Japanese banks' interest income ratios Chart 2-17: DI for Spread of Loan Rates1 in Chapter IV of the September 2007 issue of the DI, % points High credit rating 80 Medium credit rating Financial System Report). 60 Low credit rating Forecast
40 According to a survey regarding banks' stance on
20 setting interest margins, the number of banks
0 responding to narrower spreads has been on a down
-20 trend. The number of banks planning to raise interest
-40 margins has been increasing (Chart 2-17). CY 2000 01 02 03 04 05 06 07 08
Note: 1. DI for spread of loan rates = percentage of respondents selecting Given the aforementioned developments, a "widened" - percentage of respondents selecting "narrowed." All responses were given, taking account of lending margins over the multivariate time-series model is applied to decompose past three months. Source: Bank of Japan, "Senior Loan Officer Opinion Survey on Bank the change in interest rate spreads on loans into three Lending Practices at Large Japanese Banks." factors: (1) long-term changes in the lending market Chart 2-18: Decomposition of Changes in Interest Rate Spreads on Loans1,2,3,4 environment; (2) cyclical changes induced by the bps Long-term changes (left scale) % business cycle; and (3) short-term changes due to the 40 Cyclical changes (left scale) 2 Short-term changes (left scale) 20 Interest rate spreads on loans (left scale) 1 stickiness of loan interest rates (Chart 2-18). The
0 0 figures representing changes in spreads and their
-20 -1 components are computed as the deviation from those
-40 -2 in the first quarter of 2000 (i.e., 167 basis points). The
-60 -3 analysis suggests that both the short-term changes and Output gap (right scale) -80 -4 cyclical changes contributed to narrowing spreads until CY2000 01 02 03 04 05 06 07 the mid-2006. Recently, however, the contribution Notes: 1. Bank of Japan estimation. 2. Interest rate spread on loans = average contracted interest rate on from those factors remained nearly flat. new loans and discounts (short-term) - CD interest rate (3-month). 3. Figures are the deviation from those in the first quarter of 2000 In general, the rise in lending rates lags behind changes except for output gap. 4. For details, see Box 1 of the March 2007 issue of the Financial in the market interest rates; thus, reducing the interest System Report. margin in the short term as the market interest rates
rise. Moreover, economic expansion contributes to narrowing spreads due to the improvement in
borrowers' creditworthiness and the accommodative
lending attitude on the part of lenders.
The aforementioned results suggest two things. First, the narrowing pressure on spreads attributable to
46 short-term changes has subsided against a background of gradual adjustments in market interest rates. Second, as the momentum of economic expansion has decreased, the narrowing pressure on spreads attributable to cyclical changes has weakened somewhat.
The performance of banks' credit portfolios as a whole has been kept high. Looking ahead, further improvement in its performance is unlikely to take place. More concretely, the probability of changes in transition matrices from "normal" borrowers or borrowers that "need attention" to borrowers requiring
"special attention" or below within a year is computed Chart 2-19: Changes in Probability of Downgrade to NPLs1,2,3,4 to draw distributions of the annual change in the % points 3 deterioration of creditworthiness probability (Chart 2-19).
That chart shows that, first, medians remained at 0 around zero after fiscal 2005, indicating that the number of banks whose probability of change in -3 Interquartile range 10th-90th percentile range transition matrices improved and the number of banks Median improvement of creditworthiness whose probability of change worsened were balanced. -6 FY 2002 03 04 05 06 Second, the number of banks facing worsening credit Notes: 1. Bank of Japan estimation. risk increased somewhat from fiscal 2004, as the 75th 2. Changes in probability of downgrade to NPLs for the major banks and the regional banks are sorted out in ascending order. and 90th percentiles of the distribution were on a 10th, 25th, 50th, 75th, and 90th percentiles are shown. 3. Probability of downgrade to NPLs = Loans outstanding that are gradual uptrend. Due attention should be paid to classified in "Normal" and "Need attention" less "Loans requiring special attention" at the beginning of the period and whether such marginal changes in the quality of credit downgraded to "Loans requiring special attention" and lower classifications at the end of the period/Loans outstanding that are portfolios may proliferate. classified in "Normal" and "Need attention" less "Loans requiring special attention" at the beginning of the period.
4. Exclude banks which experienced mergers in past periods.
4. Off-balance-sheet transactions and overseas capital flows
Turning to the developments in the off-balance-sheet items, the use of derivative transactions and commitment lines increased.
In particular, the outstanding amount of credit default swap (CDS) transactions increased rapidly in recent years, reaching 145.7 billion dollars in the first half of
47 Chart 2-20: CDS Amounts Outstanding1 bil. U.S. dollars fiscal 2007 (Chart 2-20). The demand for such 160 transactions was on an increasing trend as financial 140 institutions made wider use of CDS to hedge credit risk 120 as part of credit portfolio management (CPM). 100 80 Furthermore, not only the amount outstanding of 60 commitment lines increased but the amount 40 outstanding of commitment lines drawn down 20 0 increased steadily (Chart 2-21). CY 1999/I 2000/I 01/I 02/I 03/I 04/I 05/I 06/I 07/I
Note: 1. Figures are based on the notional amounts outstanding bought of In sum, the expansion of off-balance-sheet transactions credit default swaps. Source: Bank of Japan, "Results of the Regular Derivatives Market was solid, and further developments need to be Statistics in Japan." carefully monitored with a view to capturing the
Chart 2-21: Amount of Commitment Lines overall credit risk exposure of financial institutions. tril. yen 35 Amount outstanding of commitment Finally, with regard to the developments in 30 lines extended Amount outstanding of commitment international capital flows, Japanese banks' 25 lines drawn down cross-border claims in all currencies and local claims 20 15 in non-local currencies, based on the BIS consolidated 10 international banking statistics, steadily increased from 5 around 2002 in response to strong global demand for
0 CY2001 02 03 04 05 06 07 funds. They reached 1.8 trillion dollars in September
Source: Bank of Japan, "Commitment Lines Extended by Japanese 2007 (Chart 2-22). While the lending attitudes of the Banks." U.S. and European financial institutions have become
Chart 2-22: Consolidated Cross-Border Claims of Japanese Banks1 tighter after the U.S. subprime mortgage problem, tril. U.S. dollars Japanese banks' international claims are expected to 2.0 Others Offshore continue expanding. Among the regions, Japanese 2 1.6 Asia and the Pacific region Europe banks' exposure was mainly concentrated in the United United States 1.2 States and Europe, and Asia and the Pacific region 0.8 accounted for relatively a small share.
0.4
0.0 CY 2000 01 02 03 04 05 06 07 C. Individual Risk Factors Associated with
Notes: 1. Consolidated cross-border claims in all currencies and local Financial Intermediation claims in non-local currencies of Japanese banks to each country and region. Finally, individual risk factors for the functioning of 2. Asia and the Pacific region is comprised of Australia, New Zealand, Hong Kong, Singapore and 25 countries defined as financial intermediation are examined from a micro "Asia/Pacific" in the Statistics. Source: Bank of Japan, "Consolidated International Banking Statistics in perspective. Japan."
48 Chart 2-23: Loans to Real Estate Industry1 1. Banks' real estate-related exposure Major banks Regional banks tril. yen tril. yen In recent years, the amount of loans to the real estate 35 35 30 30 industry remained almost unchanged for the major 25 25 banks while it was on an increasing trend for the 20 20 15 15 regional banks (Chart 2-23). Real estate-related 10 10 exposure – including loans, equity participation and 5 5 bond investment – of the major banks and the regional 0 0 FY200102 03 04 05 06 07/I FY200102 03 04 05 06 07/I banks was about 32 trillion yen and 21 trillion yen Note: 1. Figures include nonrecourse loans. Source: Bank of Japan, "Loans and Discounts Outstanding by Sector." respectively, as of the end of September 2007 (Chart 1 2-24). The share of that exposure to overall credit Chart 2-24: Exposures to Real Estate Sector Major banks Regional banks outstanding was about 11 percent for both the major tril. yen tril. yen 35 35 banks and the regional banks (see Box 9 for the quantitative risk valuation of real estate-related 30 30 exposure). 25 25
Creditworthiness of real estate businesses is influenced 20 20 by the change in the rates of investment return for real 15 15 estate. Examining the relationships between the default 100 10 0 rates of real estate businesses and the rates of changes J-REIT bonds and investment on real estate funds including J-REITs in real estate prices, the former was influenced by large 2 Unused commitment lines swings in real estate prices (Chart 2-25). CMBS Privately-placed bonds on real estate businesses and banks' stockholdings in real estate businesses Given the above observation, the robustness of real Nonrecourse loans estate businesses' balance sheets is examined against Loans to real estate businesses Notes: 1. Bank of Japan estimation. an unexpected fall in real estate prices. First, the loan 2. Figures for unused commitment lines are as of the end of March 2007. Figures for the other exposures are as of the end of to value (LTV) of real estate businesses as a whole September 2007. Sources: Toyo Keizai Inc., "The Kaisha Shikiho (the Japan Company (Chart 2-26 [1]) declined gradually from fiscal 2002 to Handbook)"; Japan Securities Dealers Association, "Trading Volume of CP, Private Placement Corporate Bonds, etc."; fiscal 2005. It leveled off thereafter. Second, the real Published accounts; Bank of Japan, "Loans and Discounts Outstanding by Sector." estate businesses are divided into two: "income Chart 2-25: Default Rate of Real Estate Firms and the Rate of gain-oriented real estate businesses," earning profits Change in Asset Price on Real Estate Investment1,2 mainly from income gains such as lease and 1.5 %%Default rate (left scale) 50 The rate of change in asset price (right scale) management of real estate properties, and "capital 1.0 25 gain-oriented real estate businesses," earning profits mainly from capital gains such as sales of developed 0.5 0 real estate properties and dealings in properties. The
LTV of the first type was on a declining trend while 0.0 -25
CY 198588 91 94 97200003 06 that of the second type was rising. That suggests the Notes: 1. Bank of Japan estimation. possibility that the capital gain-oriented real estate 2. Rate of change in asset price = (asset price at the end of period - asset price at the beginning of period)/(asset price at the businesses became somewhat active in external beginning of period). Sources: Teikoku Databank; MTB-IKOMA.
49 1,2 Chart 2-26: LTV Ratios of Real Estate Businesses financing. [1] LTV Based on On-balance- [2] LTV Based on Total Liabilities 3 % sheet Liabilities Only % including Off-balance-sheet 100 100 4 Liabilities In addition, many capital gain-oriented real estate 90 90 businesses possessed real estate-related contingent 80 80 70 70 liabilities off balance sheets, such as a commitment for 60 60 the purchase of real estate properties under 50 50 development. Taking such contingent liabilities into 40 40 account in calculating the LTV as a stress scenario, the 30 30 FY 2002 03 04 05 06 FY 2002 03 04 05 06 LTV of the capital gain-oriented real estate businesses Average of real estate businesses shifted upward, while that of the income gain-oriented Capital gain-oriented type 5 6 Income gain-oriented type real estate businesses showed little change (Chart 2-26 Notes: 1. Bank of Japan estimation. 2. Figures are based on 68 consolidated companies listed from [2]). Those results suggest that close attention needs to fiscal 2002 to 2006. 3. (Interest bearing liabilities - cash and deposit)/(inventory assets + be paid to off-balance-sheet liabilities in addition to income properties). 4. (Interest bearing liabilities + contingent liabilities - cash and on-balance-sheet liabilities. deposit)/(inventory assets + income properties). 5. "Capital gain-oriented type" businesses mainly earn profit from capital gain, for example, by selling real estates. Looking next at the inventory turnover period, the 6. "Income gain-oriented type" businesses mainly earn profit from income gain, for example, by leasing real estate properties or average period was longer in the capital gain-oriented property administrations. real estate businesses, with sales properties as Chart 2-27: Inventory Turnover Period of Real Estate inventory, than the income gain-oriented real estate Businesses1,2,3 years businesses (Chart 2-27). As for the recent trends, the 1.0 Average of real estate businesses inventory turnover period of the capital gain-oriented Capital gain-oriented type 0.8 Income gain-oriented type real estate businesses gradually became longer from 0.6 fiscal 2005, while that of the income gain-oriented real 0.4 estate businesses remained unchanged. Such an
0.2 increase in the average inventory turnover period itself
0.0 does not necessarily indicate an increase in risk of the FY 2003 04 05 06 real estate businesses. Nevertheless, there seems to be Notes: 1. Bank of Japan estimation. 2. Figures are based on 68 consolidated companies listed from a slowdown in sales of condominiums and the fiscal 2002 to 2006. 3. Inventory turnover period = inventory assets/sales. adjustment in their prices very lately. Future
developments in the average inventory turnover period Chart 2-28: Lending Attitude of Financial Institutions1 DI, % points need to be monitored carefully in order to check the 80 60 robustness of the business against a rapid fall in real 40 All industries 20 estate prices. 0 -20 The diffusion index of financial institutions' lending -40 attitude (Chart 2-28) shows that the lending attitude -60 Real estate industry -80 against the real estate industry was "accommodative" CY198083868992959820010407 Note: 1. DI = "accommodative" - "severe." from 2005, and the difference in the diffusion index Source: Bank of Japan, "Tankan (Short-Term Economic Survey of Enterprises in Japan)." between that industry and all industries was shrinking.
50 Chart 2-29: Price Index of J-REITs1 Recently, however, the index for the real estate Mar. 31, 2003=100 300 Tokyo Stock Exchange REIT Inde1x industry declined and its difference with all industries 250 TOPIX widened. That suggests that financial institutions' 200 lending attitude viewed from the real estate industry 150 became somewhat cautious. 100
50 CY 2004 04 05 06 07 08
2. Real estate funds Note: 1. The Tokyo Stock Exchange REIT Index is a capitalization-weighted index based on all REITs listed on the Tokyo Stock Exchange. With respect to real estate funds, the price index of Source: Tokyo Stock Exchange. 1 J-REITs, which rose in the second half of 2006, Chart 2-30: Trading Volume of Foreigners (J-REIT) bil. yen % plunged partly because overseas investors turned to net 450 Purchases (left scale) 70 Sales (left scale) 300 60 sellers as the U.S. subprime mortgage problem Balance (left scale) Composition ratio (right scale) 150 50 worsened (Charts 2-29 and 2-30). As for the inflow of 0 40 funds to the real estate market via real estate funds, the -150 30 expansion of J-REIT investment assets slowed -300 20 somewhat, while private real estate funds increased -450 10 CY 2004 05 06 07 08 substantially (Chart 2-31). Indeed, the growing pace of Note: 1. Composition ratio is the ratio of volume of foreigners' sales and purchases to total trading volume of market participants whose the private real estate funds accelerated even after capitals are above 3 billion yen. adjusting for an increase in the number of respondents Source: Tokyo Stock Exchange. Chart 2-31: Size of the J-REIT and the Private Real Estate Fund in the survey. That indicates the possibility of Market1 tril. yen accumulation of properties within private real estate 12 10 funds. J-REITs Private real estate funds 8
6 Cap rates of office type properties in Tokyo – the 4 benchmark in the real estate property in Japan – were 2 declining in recent years with the expectations for rent 0 Mar. Dec. Mar. Dec. Jun. Dec. Jun. Dec. Jun. Dec. rises, though the pace of decline was gradually slowing 2003 04 05 06 07 Note: 1. Figures for private real estate funds do not include foreign funds (Chart 2-32). Net operating income (NOI) of individual doing business in Japan. According to the STB Research Institute, if foreign funds were included, the figure for December office type properties owned by J-REITs, which 2007 would reach 13.0 trillion yen. Source: STB Research Institute. hovered around 1 percent until recently, rose to 2 Chart 2-32: Cap Rate of Typical Class A Office Building in 1 percent in 2007 (Chart 2-33). Most notably, the Tokyo % NOI-weighted median exceeded the unweighted 5.5 median, suggesting that NOIs were on an uptrend with 5.0 large-scale office type properties being a driving force. 4.5 There is wariness, however, in the future profitability 4.0 of some residential and commercial properties at the Apr. Oct. Apr. Oct. Apr. Oct. 2005 06 07 moment. In addition, there seems to be a decline in Note: 1. The average of cap rates of average-sized class A office building in Tokyo business area. fund inflows to private real estate funds in some Source: Japan Real Estate Institute, "Japanese Real Estate Investor Survey."
51 Chart 2-33: The Rate of Change in Net Operating Incomes (NOIs) of Office Type Properties Owned by channels. To properly gauge the risks for nonrecourse J-REITs in Tokyo1,2,3,4 loans and equity participation to real estate funds, it is y/y % chg. 3 Unweighted median necessary to examine the effects of such changes in the NOI-weighted median business environment on the projection of rents and the 2 feasibility of exit plans.
1
3. M&A financing 0 FY 2005/I 05/II 06/I 06/II 07/I Notes: 1. Bank of Japan estimation. Global M&A activity marked a new record high in 2. NOIs are adjusted by dividing NOIs per one square meter by the 2007 following 2006, partly reflecting the increase in number of business days in a half-year period. 3. Excludes the office type properties that do not disclose their the inflow of funds through private equity funds (Chart floor space or those whose operating period is short. 4. NOI-weighted median is derived by weighting the rate of change 2-34). However, a closer look at the developments in in NOIs by the level of each NOI. Source: The Association for Real Estate Securitization. 2007 indicates that the activity in the second half of 2007 (July–December 2007) slowed substantially, compared with the first half of 2007, as evident in the
United States, against a backdrop of the worsening U.S. subprime mortgage problem.
Chart 2-34: Size of M&A Market Worldwide M&A activity in Japan showed steady growth in line tril. U.S. dollars ten thousands 6 United States Europe Other areas 5 with the global trend since 2002. Although the pace of Number of M&As (right scale) 5 Value (left scale) 4 growth slowed somewhat in the past few years (Chart 4 3 2-35), domestic M&A activity in the second half of 3 2 2 2007 was relatively stable, in contrast with global
1 1 M&A activity. The size of domestic M&A market was 0 0 slightly larger than 10 trillion yen, accounting for only CY 1996 98 2000 02 04 06 07/I II 2 to 3 percent of the global market. Source: Thomson Financial.
Chart 2-35: Size of M&A Market in Japan To analyze the risks associated with M&A financing in tril. yen thousand 25 4 Japan, the leverage ratio (debt/earnings before interest, Value (left scale) 20 Number of M&As (right scale) 3 taxes, depreciation, and amortization [EBITDA]) of 15 acquired firms is compared between Japan, the United 2 10 States and Europe (Chart 2-36). The median of three 1 5 countries/regions stayed at an almost identical level of 0 0 CY1996 98 2000 02 04 06 07/I II around 5 multiples on average. Looking at the 90th
Source: RECOF. percentile of the sample distribution, however, the leverage ratio of acquired firms in the United States was considerably high at around 60 multiples whereas
those in Japan and Europe remained at a relatively low level of around 20 multiples.
52 1 Chart 2-36: Leverage Ratio of M&A Targets The leverage ratio of Japanese firms on the whole, multiple 90th percentile 80 calculated based on the "Financial Statements Statistics 60 of Corporations by Industry, Annually," continued to 40 decline from their peak in fiscal 2001, and it marked 9 20 0 multiples in fiscal 2007 (Chart 2-37). The median of CY 2000 01 02 03 04 05 06 07 the leverage ratio for acquired firms in Japan stayed Japan United States Europe around 5 multiples, which was below the overall level. 10 multiple 50th percentile (median) 8
Those observations show that firms to be acquired in 6 4 domestic M&A were those with relatively low 2 leverage and high recovery rate. Given the increasing 0 CY 2000 01 02 03 04 05 06 07 trend of M&A transactions in Japan, however, risks Note: 1. Leverage ratio = debt/ EBITDA. associated with M&A financing warrant careful Source: Thomson Financial. Chart 2-37: Leverage Ratio of Macro Average and M&A Targets attention. in Japan1,2 multiple 30 Financial Statements Statistics of Corporations by For example, it appears loans for leveraged buy-outs Industry, Annually (on a fiscal year basis) 3 (LBOs) – one form of M&A financing – are 90th percentile of M&A targets 20 increasingly replaced at relatively low interest rates by conventional corporate loans shortly after the buyout. 10 Median of M&A targets3 Except for the case of a significant reduction of the firm's leverage ratio after an initial buyout, the 0 CY 2000 01 02 03 04 05 06 07 screening process during the course of refinancing Notes: 1. Leverage ratio of Financial Statements Statistics of Corporations needs to be carried out cautiously, for example, by = total debt/(earning before taxes + interest rate + depreciation). 2. Figure of Financial Statements Statistics of Corporations in applying the same screening standard as that for the fiscal 2007 is estimated using data from the first quarter to third quarter of 2007. initial buyout. 3. 90th percentile and median in Japan are the same as those of Chart 2-36. Sources: Thomson Financial; Ministry of Finance, "Financial Statements Statistics of Corporations by Industry, Quarterly," "Financial Statements Statistics of Corporations by Industry, Annually." 4. Syndicated loans Chart 2-38: Syndicated Loans Arranged in Japan1,2 tril. yen number of syndicated loans Although the volume of syndicated loans in Japan 30 3,500 3,000 25 showed an increasing trend in the past few years, it 2,500 20 marked a year-on-year decrease in 2007 (Chart 2-38, 2,000 15 see also Box 6 in the September 2007 issue of the 1,500 10 1,000 Financial System Report for the outline of syndicated 5 500 loan market in Japan). Telecommunications and 0 0 manufacturing sectors experienced a significant CY 2001 02 03 04 05 06 07 Total amount of syndicated loans (left scale) Number of syndicated loans (right scale) increase from 2005 to 2006, although demand for Notes: 1. Figures from fiscal 2001 to 2003 are from Thomson Financial, syndicated loans in those sectors came to a halt in and those for other years are from the Bank of Japan. 2. Figures cover syndicated loans arranged by the major banks and 2007, reflecting a decrease in the number of large-scale the regional banks in any currencies.
M&A deals. Consequently, that led to a decrease in the Sources: Thomson Financial; Bank of Japan, "Loans Syndicated and Loans Transferred."
53
volume of syndicated loans in 2007. Chart 2-39: Size of Syndicated Loans1
bil. yen Interquartile range 50 In addition, deals in the syndicated loan market were 10th-90th percentile range downsizing (Chart 2-39). The downsizing of a deal 40 Median was characterized by the decline in the number of 30 large-size deals and the concentration into small-size 20 deals.
10 In light of increasing M&A deals and further 0 implementation of credit portfolio management in CY2001 02 03 04 05 06 07
Note: 1. Figures for syndicated loans arranged in Japan. Japan, the syndicated loan market is likely to be a more Source: Thomson Financial. important market in meeting various needs in financing
activity. Thus, ongoing efforts by market participants
to enhance market infrastructure are all the more
important in the development of the market.
5. Domestic structured credit market Chart 2-40: The Outstanding Issue of Structured Credit Products by Type of Underlying Assets The amount of issues in the domestic structured credit tril. yen 12 market continued to increase in recent years; however, Others 10 CDO it decreased significantly in 2007 compared with the Real estate 8 Residential mortgage previous year (Chart 2-40). Behind that was a Consumer 6 Lease substantial decline in the issuance of residential 4 mortgage-backed securities (RMBS), as a result of 2 weaker demand for domestic residential mortgages.
0 The downgrading of domestic structured credit CY 2000 01 02 03 04 05 06 07
Source: Deutsche Securities Inc. products in 2007 was concentrated on consumer loan
asset-backed securities (ABS) and small and
Chart 2-41: Number of Downgrades of Structured Credit Products by Type of Underlying Assets during medium-sized enterprise collateralized debt obligation 1,2 2007 (CDO) (Chart 2-41). That suggests that domestic
20 factors were the driving force behind the downgrading. Number in deals The effect of the U.S. subprime mortgage problem on 15 Number in tranches the market was thus considered limited at this point.
10 As for consumer finance companies, triggered by the
5 medium-sized consumer finance company's filing for
civil rehabilitation proceedings in September 2007, the 0 CMBS RMBS ABSs CDOs Others market view of consumer finance business has
Notes: 1. ABSs are all backed by consumer finances. deteriorated. The market implied default probabilities, 2. Figures include multiple downgrades in one tranche or one deal. Source: Credit Suisse.
54 computed from CDS premiums of major consumer Chart 2-42: Market Implied Default Probabilities of Major Consumer Finance Companies1,2,3 finance companies, surged significantly from the % 5 second half of 2007 (Chart 2-42), although caution is in order in interpreting the level of the market implied 4 default probabilities because it might be influenced by 3 the presence of market liquidity premiums. 2
Lastly, the current condition of Japanese ABCP market 1 is reviewed. In the wake of the U.S. subprime 0 mortgage problem, liquidity risk manifested itself in Feb. Aug. Feb. Aug. Feb. Aug. Feb. 2005 06 07 08 the U.S. ABCP market. In Japan, the underlying assets Notes: 1. Bank of Japan estimation. 2. Figures are the average of market implied default probabilities of of the ABCPs, mainly sponsored by banks, were five consumer finance companies (Acom, Aiful, Promise, Sanyo Shinpan Finance, and Takefuji) estimated using the premium of mostly composed of trade receivables (Chart 2-43). By three- and five-year credit default swap. The bold line indicates the estimated probability based on the assumption of 45 percent contrast, the underlying assets of the ABCPs in the recovery rate. The shadow bound is the area between the estimated probabilities based on the assumption of 30 percent United States comprised a great variety (Chart 2-44). recovery rate and 60 percent recovery rate. 3. The dashed line located between 1.5 and 2.0 percent represents Among them, residential mortgages and CDOs the historical default rate of companies rated below BB by occupied large shares. In other words, the structure of Rating and Investment Information in July 2007.
Japanese ABCP programs was mainly Chart 2-43: The Outstanding Issue of ABCPs Sponsored by Japanese Banks by the Type of Underlying Assets1 funding-oriented, responding to firms' demand for working capital. Thus, the maturity gap between assets Trade receivables and liabilities in Japanese ABCP programs was Trade receivables and considered limited. leases End-Sep. 2007 Leases 4.4 trillion yen Corporate loans
Others
Note: 1. Bank of Japan estimation. Sources: Japan Securities Depository Center Inc.; Japan Securities Dealers Association; Published accounts of credit rating agencies.
Chart 2-44: The Outstanding Issue of ABCPs in the United States by the Type of Underlying Assets1,2
Mortgage CDO Auto Credit cards End-Mar. 2007 Commercial 983 billion U.S. Trade receivables dollars Student loans Equipment Consumer Others
Notes: 1. Dollar-based ABCPs rated or surveyed by Standard and Poor's. 2. Covers 90 percent of ABCPs surveyed by the FRB. Source: Standard and Poor's.
55
Box 8: Originate-and-Distribute Model: Flow of Funds Perspectives
In Japan's financial system, the "originate-and-distribute model," in which various financial intermediaries including banks transfer and re-allocate funds and risks through credit markets, has prevailed in addition to the "originate-and-hold model," in which banks assume the whole intermediary services between the fund-investing sector and the fund-raising sector. Chart B8-1: Financial Intermediation Fund-investing sector In the originate-and-distribute model, investors purchase (e.g., households) indirect securities issued by financial intermediaries, and Financial intermediary investors' funds will be channeled through credit markets in (e.g., mutual funds) Or i
Financial g
order to invest in structured credit products that have been ina intermediary Credit markets t (e.g., commercial e- and- originated by other financial intermediaries. The funds are banks) distr
ultimately transferred to the fund-raising sector (the right-hand nd-hold model a Financial intermediary i - bute model (e.g., SPCs)
side of Chart B8-1). Compared with the originate-and-hold inate g
model (the left-hand side of Chart B8-1), which has prevailed Ori Fund-raising sector over the years, the originate-and-distribute model has the (e.g., firms) following characteristics: (i) credit markets are used in the process of financial intermediation; (ii) different types of financial intermediaries are involved that are intended to channel funds between the fund-investing sector and the fund-raising sector; and (iii) risks will be shared among a wide range of investors and intermediaries.
(Financial intermediation through the originate-and-distribute model: Japan-U.S. comparison)
This section compares the originate-and-distribute models in Japan and the United States based on the flow of funds statistics. First, in terms of the channel between the fund-investing sector and the financial intermediary, the outstanding balance of mutual funds reached 22.8 percent of nominal GDP (117.6 trillion yen) at the end of September 2007 in Japan (Chart B8-2). That was mainly due to an increase in households' investment in mutual funds. During the same period in the United States, the outstanding balance of mutual funds marked 76.5 percent of nominal GDP (10.7 trillion dollars), a size far exceeding that of Japan. That also reflected households' increasing appetite for mutual funds.
Chart B8-2: Mutual Funds Investment by Sectors1,2 Japan United States ratio to nominal GDP, % ratio to nominal GDP, % 25 90 Others Others Private non-financial corporations Non-financial business 20 Financial institutions Financial institutions Households Households 60 15
10 30 5
0 0 FY 1995 96 97 98 99 2000 01 02 03 04 05 06 07 CY 1995 96 97 98 99 2000 01 02 03 04 05 06 07 Notes: 1. Charts in 2007 are as of the end of September 2007. That applies to all the Charts in this box. 2. The U.S. mutual funds are the sum of money market mutual fund shares and mutual fund shares. Households include private nonprofit institutions serving households in Japan and nonprofit organizations in the United States respectively. Sources: Bank of Japan, "Flow of Funds Accounts"; FRB, "Flow of Funds Accounts of the United States."
56 Second, in terms of the channel between the financial intermediaries, the assets held by mutual funds in Japan reached 22.5 percent of nominal GDP (115.7 trillion yen) at the end of September 2007. That was mainly due to a rapid increase in outward securities after fiscal 2002. In the United States, while outward securities investment is not available, the mutual funds mainly invested in corporate equities (Chart B8-3).
Chart B8-3: Assets Held by Mutual Funds1 Japan United States
ratio to nominal GDP, % ratio to nominal GDP, % 25 90 Currency and deposits Currency and deposits Credit market instruments Securities other than shares 20 Corporate equities Other assets Shares and other equities Outward investment in securities 60 15 Other assets 10 30 5
0 0 FY 1995 96 97 98 99 2000 01 02 03 04 05 06 07 CY 199596979899200001020304050607 Note: 1. The U.S. mutual funds are the sum of money market mutual fund shares, mutual fund shares, and closed-end and exchange-traded funds. Sources: Bank of Japan, "Flow of Funds Accounts"; FRB, "Flow of Funds Accounts of the United States."
Finally, in terms of the channel between the financial intermediary and the fund-raising sector, the asset composition of the special purpose companies (SPCs) is markedly different between Japan and the United States (Chart B8-4). The SPCs in Japan mainly hold loans to companies as underlying assets, and the total assets outstanding stood at 8.1 percent of nominal GDP (41.8 trillion yen) at the end of September 2007. By contrast, the major part of underlying assets of the SPCs in the United States is residential mortgages, and the total assets outstanding registered 30.6 percent of nominal GDP (4.3 trillion dollars). That suggests that the securitization of mortgage-type assets had been more active in the United States.
Chart B8-4: Assets Held by Special Purpose Companies1 Japan United States
ratio to nominal GDP, % 10 ratio to nominal GDP, % Others 35 Trade credits and foreign trade credits Others 8 30 Agency- and GSE-backed securities Loans to companies and governments Trade receivables Consumer credit 25 Commercial mortgages 6 Housing loans Consumer credit 20 Residential mortgages 4 15 10 2 5 0 0 FY 1995 96 97 98 99 2000 01 02 03 04 05 06 07 CY 1995 96 97 98 99 2000 01 02 03 04 05 06 07
Note: 1. The special purpose companies in the United States are the issuers of asset-backed securities. Residential mortgages in the United States comprise home mortgages and multifamily residential mortgages. Sources: Bank of Japan, "Flow of Funds Accounts"; FRB, "Flow of Funds Accounts of the United States."
Globalization and progress in information and communications technology will drive Japan's financial sector to incorporate the originate-and-distribute model in its current business model based on long-term customer relationships. Based on the experience and lessons learned from the recent U.S. subprime mortgage problem, it remains a challenge to enhance its intermediary function by building resilient market infrastructure that helps market discipline function more effectively.
57
Box 9: Quantitative Risk Valuation of Real Estate-Related Exposure
Banks have various kinds of exposure related to real estate such as loans to real estate businesses, real estate nonrecourse loans, and CMBS. That calls for assessing the risks related to real estate businesses in a comprehensive manner. This Box considers a framework to assess the default rate of real estate-related exposure quantitatively by using the variation in real estate prices as a common risk factor. As an example, the box uses loans to real estate businesses and real estate nonrecourse loans which account for a substantial portion of banks’ total real estate-related exposure.
First, the case of loans to real estate businesses is considered. There is a negative correlation between the default rate of the real estate industry and the single-year capital return on real estate investment (see Chart 2-25). That suggests that its default rate can be modeled as a function of the variation in real estate prices. The following incorporates the rate of change in real estate prices as an explanatory variable into the framework of the firm value model (so-called, conditionally independent credit risk model). According to that model, default occurs when the firm value, which is a random variable, falls below a certain level (threshold). In applying the model in business practice, it is often assumed, for simplicity, that the firm value is a latent variable following normal distribution. Applying McNeil and Wendin (2007), however, it is assumed here that the firm value of the real estate industry is composed of the rate of change in real estate prices and a latent variable following normal distribution. By doing so, the variation in real estate prices can be explicitly incorporated into the default risk of real estate businesses. Serial correlation is incorporated into the latent variable in order to take account of inertia in the default rate.
The following numerical study uses default data of real estate business from Teikoku Databank and the rate of change in real estate prices provided by MTB-IKOMA. The observation period is 22 years from 1985 to 2006. The Markov Chain Monte Carlo method is used in estimating parameters.
The posterior distribution of the estimated parameters shows that the posterior probability of the coefficient regarding the rate of change in real estate prices being less than zero is below 5 percent, which suggests that the coefficient is significant.
Based on the estimation results above, the Chart B9-1: Distribution of One-Year-Ahead Conditional Default Rate of the Real Estate Industry1 posterior distribution of the conditional default Relative Frequency rate of one year ahead is calculated at the end Actual default rate of the real of 2002 and 2006 respectively, in order to CY 2006 estate industry in 1992 check the effects of changes in real estate prices CY 2002 on the default rate of the real estate industry (Chart B9-1). The conditional default rate at 99th percentile is derived in order to examine the behavior in the right tail area. At the end of 2006, the default rate at 99th percentile was 0.1 0.4 0.7 1.0 1.3 1.6 %
Note: 1. Bank of Japan estimation. 0.66 percent, reflecting favorable conditions such as the rise in real estate prices observed in 2006. However, at the end of 2002, when the rise in real estate prices had not started yet, the default rate at 99th percentile was 1.15 percent, a level close to the actual default rate of the real estate industry at the time of the collapse of the bubble economy.
58
Next, the default rate of real estate nonrecourse loans is examined. Since there are few default cases of real estate nonrecourse loans due to their short history in Japan, it is difficult to directly calculate the default rate of those loans. However, treating nonrecourse loans as "put option whose underlying asset is real estate," the default risk of those loans against the drop in real estate prices can be evaluated. Consider a simple case of a lender's payoff at the time of maturity for a real estate nonrecourse loan (zero-coupon loan for simplicity) without amortization. If the real estate price at maturity PT exceeds the principal D (PT>D), the principal will be repaid to the lender, while if the price is below the principal (PT Based on that concept, the default rate of one year Chart B9-3: Default Rate by LTV at the Time of 1,2,3 ahead is calculated for various levels of LTV. The Lending default rate, % result shows that the default rate becomes higher as 1.5 the LTV at the time of lending becomes high, due to the increase in the probability that the real estate 1.0 prices drop below the principal at the time of 0.5 maturity (Chart B9-3). In practice, however, the recovery of the principal will depend on various 0.0 structures to protect preferential debts (e.g., 50 55 60 65 70 75 % LTV financial covenants based on LTV or DSCR [debt Notes: 1. Bank of Japan estimation. service coverage ratio] that can trigger a change in 2. Geometric Brownian motion is adopted as underlying stochastic process of real estate prices. the priority of the payment). The effects of those 3. Parameters of the process are estimated using the data "single-year capital appreciation return" of conditions should be taken into account in MTB-IKOMA. evaluating the amount of risk. In sum, the risk related to real estate-related exposure can be captured by using the rate of change in real estate prices as a common risk factor. It is necessary to further sophisticate and improve not only risk assessment and management of individual projects but portfolio management of real estate-related exposure as a whole. Reference: McNeil, Alexander J., and Wendin, Jonathan P., "Bayesian Inference for Generalized Linear Mixed Models of Portfolio Credit Risk," Journal of Empirical Finance, vol.14, no.2, 2007, pp.131-149. 59 Chart 3-1: Basic Structure of Banks' Income Simulation Model III. Robustness of the Banking Estimation of the amount outstanding System of assets and liabilities of banks This chapter examines the robustness of Japan's Funds from every product maturing at each point in time are reinvested in the same banking sector against changes in interest rate risk and product with the same maturity, so that the amount outstanding is assumed to be constant. credit risk associated with economic fluctuations. ＋ A. Simulation Analysis of Interest Rate Risk Future scenarios of Forecasts for banks' interest rates deposit and lending rates In the same way as the previous Financial System 1. Baseline The paths in each Reports, the interest rate risk of the banks is analyzed 2. Parallel shift scenario are estimated 3. Steepening based on banks' past by using a simulation model that incorporates the price-setting behavior. 4. Flattening actual balance-sheet structure of the major banks and the regional banks at the end of first half of fiscal 2007 as well as their interest-rate-setting behavior in the past Capital gains/losses Net interest income from bond holdings (see Chart 3-1 for the outline). First, assets and liabilities according to products and Chart 3-2: Spot Rate Curves1 [1] Baseline Scenario maturities at the end of September 2007 are estimated % End of FY 2007/I 4 End of FY 2008/I for both the major banks and the regional banks. In 3 End of FY 2009/I End of FY 2010/I addition, it is assumed that every product is rolled over 2 upon maturity and thus the composition of assets and 1 0 liabilities will remain unchanged. 012345678910 years to maturity [2] Parallel Shift Scenario Second, with respect to the future path of market % 4 interest rates, four scenarios are considered (Chart 3 3-2): [1] a baseline scenario (future short-term interest 2 1 rates follow the path implied by the forward rate curve 0 at the end of September 2007), [2] a parallel shift 012345678910 years to maturity scenario (interest rates at all maturities shift upward [3] Steepening Scenario % compared with the baseline scenario by 1 percentage 4 3 point over one year), [3] a steepening scenario (the 2 10-year spot rate shifts upward compared with the 1 0 baseline scenario by 1 percentage point, and upward 012345678910 years to maturity shift becomes smaller as time-to-maturity shortens, and [4] Flattening Scenario [4] a flattening scenario (the overnight rate shifts % 4 3 upward compared with the baseline scenario by 1 2 percentage point, upward shift becomes smaller as 1 time-to-maturity lengthens, and flattens at the level of 0 012345678910 the long-term forward rate). It should be noted that the years to maturity Note: 1. Bank of Japan estimation. 60 interest rate scenarios here are set to crystallize the risks of the banking sector and do not necessarily mean that they are likely to manifest themselves. Chart 3-3: Impact of Rises in Market Interest Rates on Banks' Profit1,2 Third, banks' interest-rate-setting behavior for various [1] Baseline Scenario Major banks Regional banks products is estimated, using the past values of tril. yen tril. yen 0.8 deposit/lending rates and market rates. In the 0.8 0.4 0.4 estimation, it is assumed that (i) the spread between 0.0 0.0 time deposit/lending rates and the corresponding Net interest income -0.4 -0.4 market rate with a similar maturity converges on its Capital gains/losses on -0.8 bond holdings -0.8 Total historical average in the long term, and (ii) based on -1.2 -1.2 FY 2007/I 08/I 09/I 10/I FY 2007/I 08/I 09/I 10/I the past performance, the ratio of the ordinary deposit rate to the 1-month LIBOR is about 25 percent. [2] Parallel Shift Scenario Major banks Regional banks tril. yen tril. yen Finally, using the scenarios of future interest rates and 0.8 0.8 the estimation results mentioned above, out-of-sample 0.4 0.4 forecasts for banks' deposit/lending rates are obtained 0.0 0.0 and the future paths of net interest income as well as -0.4 -0.4 the capital gains/losses from bond holdings are -0.8 -0.8 -1.2 -1.2 calculated. From this Report, the treatment of the FY 2007/I 08/I 09/I 10/I FY 2007/I 08/I 09/I 10/I capital gains/losses from bond holdings in the baseline [3] Steepening Scenario scenario is altered due to the fact that the changes in Major banks Regional banks the present value of bond holdings are associated with tril. yen tril. yen 0.8 0.8 the expected yield curve shifts at the end of September 0.4 0.4 2007. By contrast, in three scenarios of upward shifts 0.0 0.0 in yield curves, unexpected yield curve shifts lead to -0.4 -0.4 the unexpected changes in the present value of bond -0.8 -0.8 -1.2 -1.2 holdings, which are treated as capital gains/losses from FY 2007/I 08/I 09/I 10/I FY 2007/I 08/I 09/I 10/I bond holdings as before. [4] Flattening Scenario Major banks Regional banks The overall picture of the impact of a rise in market tril. yen tril. yen interest rates on banks' net profits can be summarized 0.8 0.8 0.4 0.4 as follows (Chart 3-3). First, looking at net interest 0.0 0.0 income, the increase in interest payments on short-term -0.4 -0.4 debts such as deposits and market-based financing -0.8 -0.8 tends to exceed the increase in interest income from -1.2 -1.2 FY 2007/I 08/I 09/I 10/I FY 2007/I 08/I 09/I 10/I lending and bond holdings in the short term. Therefore, Notes: 1. Bank of Japan estimation. Figures for net interest income are in all the scenarios, net interest income for both the changes from actual results in the first half of fiscal 2007. 2. Net interest income from domestic operations in the first half of major banks and the regional banks slightly declines fiscal 2007 was 1.9 trillion yen for the major banks and 2.1 trillion yen for the regional banks. 61 from the initial level of the first half of fiscal 2007, bond holdings both for the major banks and the where net interest income from domestic operations regional banks are the largest in the short term among was 1.9 trillion yen for the major banks and 2.1 trillion the three scenarios of upward shifts in yield curves. yen for the regional banks. In the medium term, net Those losses are, nevertheless, less than the amount of interest income for the major banks exceeds the initial net interest income recorded in the first half of fiscal level at a relatively early stage, while for the regional 2007. In addition, net interest income declines in the banks it does not reach the initial level for a while. short term both for the major banks and the regional That is because the maturity of both lending and bonds banks. That is due to the increase in interest payments is longer for the regional banks than for the major on short-term debts, since the rise in short-term interest banks, and the negative impact of the regional banks' rates is larger than that in the steepening scenario past lending and bond investment with low interest described later. In the medium term, however, the rates on their future interest income remains longer amount of increase in interest income from lending (Chart 1-27). exceeds that in interest payments on deposits. Second, looking at the capital gains/losses from bond In the steepening scenario, capital losses from bond holdings in three scenarios of upward shifts in yield holdings occur in the short term both for the major curves, the capital losses occur in the short term, while banks and the regional banks. In the medium term, the they diminish in the medium term. The magnitude of increase in interest income from lending gradually the losses and their diminishing pace depend on the exceeds that in interest payments on deposits, as is the changes in the shape of the yield curve. case in the parallel shift scenario. The results of each scenario can be summarized as Finally, in the flattening scenario, significant capital follows. In the baseline scenario for the major banks losses from bond holdings occur in the short term both and the regional banks, the increase in interest for the major banks and the regional banks. In the payments on short-term debts exceeds that in interest medium term, net interest income for the major banks income from lending and bond holdings in the short increases, as in the other scenarios, while that for the term as the yield curve rises gradually, and thus net regional banks recovers at the slowest tempo among interest income for the major banks and the regional the four scenarios due to the large gap between the banks both decreases slightly. One year later, however, maturity of their assets and liabilities. for the major banks, net interest income restores the In sum, when the yield curve shifts upward gradually, initial level of the first half of fiscal 2007. As for the as implied in the baseline scenario, the changes in net regional banks, since the pace of recovery in interest interest income and net capital gains from bond income from lending and bond holdings remains slow, holdings have only a marginal impact on profits for it takes two years for its net interest income to regain both the major banks and the regional banks. In the the initial level. In both scenarios, the impact is other three scenarios of upward shifts in yield curves, marginal relative to the size of net interest income capital losses from bond holdings arise in the short during the first half of fiscal 2007. term, while the amount of capital losses remains below In the parallel shift scenario, the capital losses from half-year net interest income. In the medium term, net 62 interest income for the major banks recovers in all of the three scenarios of upward shifts in yield curves. Recovery of net interest income for the regional banks, however, remains small and gradual due to the long maturity of their assets. The negative impact on net interest income in the simulation period (over three years) becomes particularly large in the flattening scenario. To quantitatively analyze the effects of the prolonged Chart 3-4: Interest Income on Loans1 average maturity of loans on the recovery of interest [1] Baseline Scenario [2] Parallel Shift Scenario 2007/I = 100 2007/I = 100 income on loans, loan portfolios of banks above the 200 200 90th percentile of the average maturity of loans among 180 180 the regional banks are aggregated. Then, the pace of 160 160 the recovery for the aggregated portfolio is compared 140 140 under the four scenarios with the major banks and the regional banks (Chart 3-4). 120 120 100 100 The analysis shows that, in all the scenarios, the FY 2007/I 08/I 09/I 10/I FY 2007/I 08/I 09/I 10/I recovery pace of interest income on loans for banks [3] Steepening Scenario [4] Flattening Scenario with long average maturity of loans is at about 70 2007/I = 100 2007/I = 100 200 200 percent of that of the regional banks as a whole. As pointed out in Chapter I, amid lengthening the average 180 180 maturity of loans, the differences among banks tended 160 160 to widen in recent several years (Charts 1-27 and 140 140 1-29). Lengthening the average maturity of loans and 120 120 widening the differences among banks are likely to be 100 100 one of the key factors in explaining why there is a FY 2007/I 08/I 09/I 10/I FY 2007/I 08/I 09/I 10/I Major banks difference in the pace of loan interest margins' Regional banks Banks above the 90th percentile of the average maturity of loans improvement (Chart 1-30). For banks whose average maturity of loans were lengthening, proper Note: 1. Bank of Japan estimation. management of interest risk of the entire portfolio is needed through, for example, interest rate swap, off-balancing the loans, and utilizing long-term liabilities such as time deposits, based on their own expectation for the future course of interest rates. 63 B. Macro Stress-Testing of Credit Risk and Risk Associated with Stockholdings This section assesses the robustness of Japan's financial system against a severe and prolonged economic downturn from the viewpoints of credit risk and risk associated with stockholdings. 1. Macro stress-testing of credit risk Chart 3-5: Steps of Macro Stress-Testing As was done in the September 2007 issue of the [Step 1] Financial System Report, the robustness against credit Transition matrices compiled Credit score data provided by the Bank of Japan + by Teikoku Databank risk is assessed by using a framework incorporating a (for 4 years) (for 21 years) mechanism in which an economic downturn increases Estimation of transition matrices (for 21 years) credit risk by downgrading firms' creditworthiness (see Chart 3-5 and Box 8 of the September 2007 issue of [Step 2] the Financial System Report). Extraction of changes in transition matrices. Analysis of the relationship between changes in transition matrices and macroeconomic variables. It should be noted, however, that in the macro [Step 3] stress-testing of this Report, the way to assess credit Setup of stress scenario based on VAR model risk is altered. The ratio of a maximum loss to Tier I [Step 4] capital is calculated for both stress and baseline Estimation of the ratio of credit risk to Tier I capital scenarios, and the difference between the two ratios is Assessment of robustness used to assess credit risk (in the following, this indicator is referred to as "excess credit risk," Chart 3-6). Chart 3-6: Effects of Stress on Credit Risk Maximum loss under the stress scenario (99th percentile) The September 2007 issue of the Report used data on ity s n Maximum loss under the baseline scenario (99th percentile) e loan portfolios at two different points of time, and d Loss distribution under lity i focused on the maximum loss in the stress scenario to b the stress scenario a b Effects of o r assess the robustness against stress. However, it is P the stress on credit r＝isk difficult for this approach to gauge the impact of credit Excess credit risk risk on banks' capital under stress. Loss distribution under the baseline scenario The maximum loss in the baseline scenario is likely to Loss be covered, with an expected loss (EL) portion by provisions and an unexpected loss (UL) portion by allocated risk capital. Therefore, the difference of the maximum loss to Tier I ratio between the baseline scenario and the stress scenario can be interpreted as 64 the indicator of an increase in credit risk which imposes an additional burden on Tier I capital. In the following, the indicator is used to assess the robustness. As for the path of the real GDP growth rate, in line with the September 2007 issue of the Financial System Report, a vector autoregression (VAR) model is constructed using five variables – real GDP, the CPI (excluding fresh food), the amount outstanding of bank lending, the nominal effective exchange rate, and the overnight call rate. The baseline scenario assumes no external shock after the fourth quarter of 2007 to compute a path of real GDP growth rate. The stress scenario assumes an adverse shock to GDP in the fourth quarter of 2007 of a size that is likely to occur with a probability of 1 percent in an annualized base, Chart 3-7: GDP Growth Rate under Stress Scenario: and the shock will subside by half in three quarters. Deviation from Baseline Scenario1,2 The real GDP growth rate in the stress scenario is % points 1 lower than that in the baseline scenario by about 4 0 percent points in fiscal 2008, and subsequently -1 recovers to the baseline in about two to three years -2 (Chart 3-7). However, it should be noted that the stress -3 scenario is set to crystallize the risks in Japan's banking -4 sector, and does not necessarily mean that they are -5 FY 2006 07 08 09 10 11 likely to manifest themselves. Notes: 1. Stress scenario is the real GDP growth rate under the assumption of an adverse shock to GDP in the third quarter of fiscal 2007. Chart 3-8 shows the amount of excess credit risk for 2. Bank of Japan estimation. the major banks and the regional banks in the stress Chart 3-8: Excess Credit Risk1 scenario using data on loan portfolios at the end of ratio to Tier I, % September 2007. According to the estimate, the 60 Major banks 50 increase in the amount of excess credit risk induced by Regional banks 40 the decline in real GDP growth rate peaks out in fiscal 30 2008, subsequently subsides as GDP growth rate 20 recovers, and approaches the baseline level. 10 In the meantime, the maximum excess credit risk to 0 FY 2007 08 09 10 11 Tier I capital is estimated at about 50 percent. Credit Note: 1. Bank of Japan estimation. risk in the major banks and the regional banks to Tier I 65 capital is currently contained at the level of 25 to 35 percent as a whole, as pointed out in Chapter I. Excess credit risk under the stress scenario is estimated to put the additional impact on banks' capital larger than the current level of UL for credit risk. Judging from the current profit levels and the capital positions including Tier II capital in the banking sector, it appears that the level of excess credit risk remains under control. Since the purpose of macro stress-testing is to crystallize the risk inherent in the banking sector, it continues to be important for banks to keep an eye on changes in the risk-return balances of their loan portfolios. While the quality of banks' loan portfolios seems to have remained sound as a whole, the transition in borrower classifications indicates some signs of deterioration, albeit limited, as pointed out in Chapter II. In order to examine the above point in depth, those regional banks are picked, whose probability of Chart 3-9: Excess Credit Risk for Banks Whose Probability of 1 Downgrade to NPLs Increased downgrade to NPLs increased 2 percent points or more ratio to Tier I, % 80 Banks whose probability of in fiscal 2006. Then macro stress-testing for those downgrade to NPLs increased banks is conducted (Chart 3-9). The results show that, from FY 2005 to 2006 2 60 Regional banks for the banks whose probability of downgrade to NPLs 40 increased, the increase in excess credit risk is larger and the declining pace of excess credit risk is slower 20 than the regional banks as a whole when the shock subsides. That result implies that the pace of increase 0 FY 2007 08 09 10 11 in excess credit risk is faster than that for the regional Note: 1. Bank of Japan estimation. banks on the whole. In addition, when the shock 2. Probability of downgrade to NPLs is calculated by the same method as in Chart 2-19. subsides, the pace of decrease in excess credit risk is slower as well. Such an asymmetric property between an economic downturn and an economic recovery is likely to be more significant for those regional banks whose probability of downgrade to NPLs increased than the regional banks as a whole. In general, the lower the borrower classification in the 66 transition matrix is, the stronger the borrower's specific factor influences, and the weaker the economic fluctuation factor influences. In an economic downturn, the probability of downgrading from upper to lower classification goes up. In a recovery, by contrast, the probability of upgrading from lower to upper classification does not change as much. Thus, once the borrower's classification is being downgraded in a severe economic downturn, the borrower tends to remain in lower classification and the borrower's classification improves only gradually in an economic recovery. 2. Macro stress-testing of risk associated with stockholdings Next, macro stress-testing for risk associated with stockholdings is introduced in this Report. The previous Financial System Reports pointed out that, when the stress of a severe and prolonged economic downturn was imposed on the financial system, not only credit risk would increase by way of firms' defaults and deterioration in borrowers' classification but also risk associated with stockholdings would manifest itself through the plunge in stock prices. In addition, as pointed out in Chapter I, market risk associated with stockholdings, along with credit risk, accounted for a substantial portion of the overall amount of risks held by the banking sector. It is therefore deemed important to assess the banking sector's robustness against risk associated with stockholdings during an economic downturn. This Report analyzes risk associated with stockholdings under stress by assuming the two mechanisms below (see Box 10 for the outline of the analysis). First, a severe shock to the economy is likely to worsen the prospects of corporate profits and 67 increase default probability, thereby lower corporate ratings as well as stock prices. Second, a sever shock to the economy is also likely to increase the uncertainty of the stock market and its volatility. The same stress scenario is used for macro stress-testing of credit risk to estimate the future path of stock prices (TOPIX) and their volatility. Given the estimated paths of the level and the volatility of stock prices, the ratios of unrealized gains/losses and market risk to Tier I capital are estimated as deviations from those in the baseline scenario. Then, the additional impact of stress is assessed by deducting unrealized gains/losses from market risk, since the risk associated with stockholdings is likely to manifest itself in these two forms under stress. Chart 3-10: Risk Associated with Stockholdings under Stress The results show that unrealized gains of stock Scenario1,2 Major banks holdings substantially decline, compared with those in deviation from baseline, ratio to Tier I, % points the baseline scenario due to a plunge in stock prices 50 Unrealized loss (Chart 3-10). By contrast, changes in market risk are 40 Market risk 30 limited since the decline in outstanding balance of Risks associated with stockholdings because of the plunge in stock prices 20 stockholdings 10 offsets the rise in volatility. 0 Based on those results, due attention needs to be paid -10 FY 2006 07 08 09 10 11 to the possibility that, in the stress scenario of a severe and prolonged economic downturn, risk associated Regional banks with stockholdings manifests itself in the form of a deviation from baseline, ratio to Tier I, % points 50 decline in unrealized gains of stockholdings stemming 40 from the substantial fall in stock prices, in addition to 30 the increase in credit risk. As shown in Chart 1-34, 20 market risk associated with stockholdings had a high 10 0 proportion in the overall risk both for the major banks -10 and the regional banks, and thus it is critical to assess FY 2006 07 08 09 10 11 and manage risk-return balances of stockholdings. Notes: 1. Bank of Japan estimation. 2. Risk associated with stockholdings is the sum of market risk and unrealized gains/losses. 68 Box 10: Macro Stress-Testing of Risk Associated with Stockholdings The previous Financial System Reports assessed the robustness of the financial system by macro stress-testing that deals solely with credit risk. However, as the Reports repeatedly pointed out, when the stress of an economic downturn is imposed on the economy, not only credit risk increases by way of firms defaults and deterioration of borrower classification, but also risk associated with stockholdings is also likely to manifest itself due to a fall in stock prices. As pointed out in Chapter I, market risk associated with stockholdings, along with credit risk, accounted for a substantial portion of the overall amount of risk held by banks. Therefore, macro stress-testing against risk associated with stockholdings is conducted to assess the robustness of the financial system. First, the relationship between stock prices and the business cycle is summarized. During an economic downturn, there is a tendency that stock prices fall and volatility rises (Chart B10-1). That relationship reflects a mechanism in which the shock of an economic downturn, through a decline in prospects for corporate profits and an increase in probability of default, lowers stock prices and increases stock market uncertainty, leading to a rise in volatility. That implies that it is important to analyze credit risk and risk associated with stockholdings together in assessing the stress of an economic downturn on the financial system. Chart B10-1: Business Cycle and Stock Price Stock Price1 Volatility1,2 TOPIX, Jan. 4, 1968 = 100 % 3,000 2.0 Average during recession periods 2,500 1.5 2,000 1,500 1.0 1,000 0.5 Average during non recession periods 500 0 0.0 CY 199193959799200103050708 CY 1991 93 95 97 99 2001 03 05 07 08 Notes: 1. Shaded areas indicate recession periods. 2. Historical volatility is computed using daily returns during one year. Source: Tokyo Stock Exchange. Second, the robustness of the financial system against risk associated with stockholdings during an economic downturn needs to be assessed from two viewpoints; unrealized gains/losses and market risk measured by value-at-risk (VaR) associated with stockholdings. A fall in stock prices will reduce the unrealized gains. However, the direction of change in market risk is unable to be determined a priori, since market risk is likely to increase with a rise in volatility due to a fall in stock prices, while it is also likely to decrease with a decline in the market value of banks' stockholdings. Given the relationship between business cycle, stock prices, and volatility, the simulation of unrealized gains/losses and market risk is carried out as follows (see Chart B10-2 for the overview of the entire process). First, the portfolio of stockholdings is assumed to be constant at the level of the latest period throughout the forecast period. Second, the future path of stock prices is estimated by common factor components in transition 69 matrices for borrower classification, which is also used in the macro stress-testing of credit risk (Chart B10-3). The transition of borrower classification captures changes in firms' creditworthiness, and stock prices are also considered to change, reflecting the prospects of corporate profits and default probability. Therefore, the transitions of borrower classification and stock prices have a strong positive correlation. Finally, the future path of stock price volatility is estimated. By using the past relationship between stock price changes and volatility, the level of volatility is computed from stock price changes estimated by common factor components in transition matrices (Chart B10-4). The stock price changes and the volatility are used to compute the future paths of unrealized gains/losses and market risk. The robustness is assessed, based on the results of the predictions of unrealized gains/losses and market risk. Chart B10-2: Basic Structure of Macro Stress-Testing of Risk Associated with Stockholdings Negative macroeconomic shock Macro stress-testing Deterioration in borrowers' of credit risk creditworthiness Rise in volatility Fall in stock prices Risk Risk Change in market risk Decrease in unrealized gains Risk ? Change in risk associated with stockholdings Increase in credit risk Chart B10-3: Stock Price and Common Factor Chart B10-4: Stock Price Change and Volatility1,2 Components1 historical volatility, % 2.0 Jan. 4, 1968 = 100 3,000 0.6 1.5 TOPIX (left scale) 2,500 0.4 Common factor 1.0 2,000 component (right scale) 0.2 1,500 0.5 0.0 1,000 0.0 -0.2 500 -40 -20 0 20 40 60 80 100 year-on-year change of stock price, % 0 -0.4 Notes: 1. Year-on-year change of stock price is computed using FY 1985 87 89 91 93 95 97 99 2001 03 05 average of daily price level data during last one year for each period. Note: 1. Common factor component is estimated by the Bank of 2. Historical volatilities are computed using daily returns Japan. during one year. Source: Tokyo Stock Exchange. Source: Tokyo Stock Exchange. 70