MNI POLICY: BOJ Watching Real Estate, Bond Threat To Banks

Bank of Japan officials have grown more concerned that financial institutions will be hit harder by slower global growth and prolonged high U.S. interest rates, a shift in focus from worries about the pace of rate hikes highlighted in October’s Financial System Report, MNI understands.

The BOJ is concerned aggressive Federal Reserve rate hikes - and the prospect of the peak rate being maintained for a long time - will slow growth next year, possibly destabilising markets, crimping investor cash flows and sparking the need for asset sales. While Japan's Financial Services Agency oversees prudential regulation, the BOJ's role is to highlight economic and financial risks to institutions.

Real estate looms as a pressure point as U.S. funds are the biggest foreign investors. The weak yen and low interest rates have enticed foreign investors into Japan's real estate markets, with the pace of property transactions in the first half of 2022 exceeding 2007 levels, according to the BOJ. The Bank noted in October's Financial System Report that foreign investors have "continued to engage in trades at high prices."

The concern is if foreign investors either stop allocating capital, or worse, if they repatriate capital because of stresses in other parts of their portfolios, then Japanese real estate prices will fall and lead to losses at financial institutions. Japan's biggest banks have been the major source of lending to foreign investors buying real estate.

The BOJ is also closely watching Japanese regional financial institutions that have increased risk-taking on foreign currency interest rates by investing in or acquiring multi-asset and foreign bond investment trusts. The performance of U.S. bond investment trusts have deteriorated and will continued to be pressured should calls for further rates hikes by hawkish Fed members be delivered.

Not only have the valuation on these assets fallen due to rising interest rates, but their foreign currency hedging costs, which are ongoing funding costs, have increased. The deterioration in the performance of investment trusts could lead to dividend cuts and declines in net asset values.

The BOJ maintains its view that the stability of Japan’s financial system will not deteriorate immediately as institutions have sufficient capital, but they are wary some may face stress if assets prices were to fall sharply. (See MNI BRIEF: BOJ Warns Of Prolonged Stress Due To Rate Hikes)