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Risk exchange

7 November 2014 By Andy Mukherjee

Japan’s banks may end up swapping their old nemesis with a new enemy.

The central bank’s bulked-up bond-buying plan will relieve lenders of the burden of financing Japan’s overextended government. Shrinking their portfolio of Japanese government bonds (JGBs) helps to reduce the risk that even small increases in interest rates will leave banks with big losses. But if Japanese companies remain reluctant to invest, the lenders’ spare cash may stoke bubbles in stocks and property. In that case, banks could arguably end up living more dangerously than before.

The banking system’s holdings of JGBs have shrunk by 9 percent since the Bank of Japan launched its bold programme of quantitative easing in April 2013. If the monetary authority’s recently expanded money-printing plan continues through 2016, the BOJ could end up absorbing about 58 percent of the 286 trillion yen ($2.5 trillion) of JGBs currently sitting on banks’ balance sheets.

For Japanese banks, a leaner government bond portfolio won’t by itself be a bad thing. In 2012, the International Monetary Fund warned that a 1 percent jump in interest rates in 2017 would cause mark-to-market losses large enough to wipe out 26 percent of the Tier 1 capital of the country’s smaller regional lenders.

That threat is now replaced by another risk, as banks come under pressure to find new uses for their cash. Overseas credit demand won’t hold up in a slowing global economy, and a weak yen could spoil Japanese companies’ appetite for foreign assets. That makes banks more likely to chase returns at home. Unless Japanese manufacturers start borrowing aggressively to finance new investment, banks are more likely to boost lending against stocks and property.

In 2012, Japan faced the risk of a European-style “doom loop” of mutual dependence between lenders and their sovereign. The next risk could be lending supported by soaring asset prices rather than rising real incomes. Forcing banks to take more risk is part of the Bank of Japan’s plan to stimulate the economy and end deflation. Investors in Japanese banks will eventually need to think about whether the new enemy is more or less dangerous than the old foe.

 

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