MNI POLICY: BOJ Alert As Rising Yields Pressure Fragile Banks

Bank of Japan officials are alert to the risk that further changes to its yield curve control policy could encourage market participants to target regional financial institutions that lack adequate capital to dispose of unrealised losses on yen-denominated bond holdings, MNI understands.

Unrealised bond losses among regional lenders are assessed to have not increased sharply after the BOJ’s decision in December to widen its band around the 10-year yield curve target to 50bp from 25bp, but further changes to the policy under a new governor could increase vulnerabilities among some institutions and restrain their intermediation role in the financial system. This could prompt investors and traders to take positions that profit from a decline in the value of their stocks or bond issues. (See MNI POLICY: New BOJ Gov Must Keep Rates Low, Ensure Recovery)

The BOJ's cautious approach to modifying YCC would consider any additional valuation hit to existing unrealised losses as its policies had induced lenders to buy longer-end yen bonds and foreign bonds. While unrealised losses don’t affect capital adequacy ratios until those positions are sold, losses on yen bonds are expected to have risen from October 2022 when the BOJ estimated unrealised losses had increased for all types of financial institutions. (See MNI POLICY: BOJ Wary As 10-Year Yield Rise Hits Some Banks)

There is a risk that should the BOJ move towards allowing long-term interest rates to be determined by the markets, traders and investors could accelerate bond selling and increase the pressure on the BOJ to commit to large scale scale purchases of Japanese government bonds (JGBs). The BOJ bought a record JPY23.7 trillion of government bonds in January to defend its yield curve cap from attack by market participants betting on a near-term interest rate hike.

LONG DURATION

Regional institutions have increased the duration of their bond portfolios through investments in foreign bonds, foreign bond investment trusts and super long-term JGBs, exposing them to increased losses as interest rates rise.

The amount of interest rate risk associated with financial institutions’ investment in yen bonds, in terms of 100 basis point value, was assessed as close to the highest level since records began in fiscal 2002, the BOJ said in its October Financial System Report.

The ratio of the amount of risk to the amount of capital had risen to around 10% for major banks, around 20% for regional banks and around 30% for shinkin - credit association - banks, the BOJ said. The noted that ratio was dispersed widely among regional banks and shinkin banks.

Major banks that had increased investment in foreign bonds have incurred unrealized losses in the wake of the rate hikes by the Federal Reserve, but the scale of unrealised losses have declined due to drop in U.S. bond yields, the BOJ said.