Japanese Banks, Tier 1 capital and financial system stability.

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The Japanese government and the BoJ are having serious trouble coordinating the communication of their intent to the markets vis-a-vis the level and direction of interest rate moves, as we have already pointed out here: https://nipponmarketblog.wordpress.com/2013/05/19/too-much-of-a-good-thing/

As the FT also reports:

“After Haruhiko Kuroda’s first meeting as BoJ governor on April 4, the bank said it would lower interest rates across the yield curve, thus pushing investors into riskier assets such as loans and stocks. At the same time, it said it aimed to achieve a 2 per cent rate of inflation at the earliest possible opportunity – implying upward pressure on rates. Since then, prices of bonds have slumped amid record levels of volatility, as traders have struggled to adjust portfolios in light of what some called the ‘Kuroda shock’.  Kazuhiko Sano, chief strategist at Tokai Tokyo Financial Holdings, said investors are ‘very confused’, adding that ‘many are reluctant to buy bonds right now'”

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More than anything, it is probably the increase in volatility in the JGB market that is putting investors off. The majority of institutional investors, not least the Japanese banks, most likely employ some form of VaR (Value-at-Risk) analysis of their holdings, and one would assume that because of the increased JGB market volatility of late, investors’ JGB holdings are adding a lot more risk to portfolios than investors typically expect.The following chart shows the 60-day standard deviation on JGB yields:

Var Shock 1

This type of environment will naturally tend to suppress investor enthusiasm for buying additional JGBs and most likely even lead to a reduction in those holdings. The IMF sums it up nicely:

“JGB market exposures represent one of the central macrofinancial risk factors. This risk reflects the possible impact on public debt sustainability of changes in yields and related effects on investor confidence; the increased role of the private financial sector in covering government borrowing needs; the prospect that ongoing demographic shifts will reduce private saving; and growing household interest in investing abroad.”

As we have alluded to in the past, the JGB market is now akin to a giant game of musical chairs, and increasingly it appears that investors (foreign as well as domestic institutions) are beginning to nervously eye a chair to sit on should the music suddenly stop. The risk is that JGB holders start to reduce their holdings significantly in anticipation of a fall in the market, which of course then becomes a self-reinforcing effect. The BoJ is apparently meeting institutional investors tomorrow, no doubt in an attempt to try to persuade them to sit tight and maintain their JGB holdings “for the good of the country”, or something similar.

NipponMarketBlog very much doubts whether this ‘talking to’ would be enough to dissuade holders of JGBs from selling if they genuinely think the JGB market is facing a collapse (or even a mild slump).

However, there is one other important facet to this issue. Precisely because JGB’s have historically been seen as essentially risk free (because of the assumption that the Japanese government would never default on its debt), JGBs are to a large extent used by both major banks and regional banks in Tier 1 capital.They also represent very large proportions (around 70%) of life insurers’ securities holdings and 90% of insurance cooperatives’ securities holdings.

Within the context of the above, instead of yields on JGBs being viewed as the “risk free rate of return”, it might be more fitting to see them as “return free risk”.

At any rate, if JGBs do fall then the banks (and other institutions) face a ‘marked-to-market’ valuation loss on their JGB holdings and then their Tier 1 capital takes a hit. According to the BoJ itself, if the entire yield curve is pushed up by 100 basis points, the associated fall in JGBs would wipe out 20% of Japanese regional banks’ Tier 1 capital, and at least 10% of Major banks’ Tier 1 capital.

So in effect, the more effective Abenomics becomes (in terms of creating cost-push inflation and thus forcing interest rates higher), the weaker the financial system becomes. Not exactly a path any government or central bank would like to find itself on.

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Consider also that both the increased volatility and the prospective marked-to-market losses on JGB holdings among the banks, will increase the likelihood of banks having their credit rating cut (as happened last year when credit rating agency Fitch cut its rating of the sector from ‘A’ to ‘A-‘), which in turn will make it more expensive for them to operate.

At the extreme, one should theoretically be able to assess actual market nervousness about this issue by observing the correlation of bank shares with the equity market as a whole. In a normal market (especially in what on the face of it appears to be a bull market), one would expect bank stocks to be highly positively correlated with the broader market, f.ex. the Nikkei 225.

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However, if the rise in the equity market is of a ‘less healthy’ kind and simply caused by an exodus from a JGB market now perceived to be much more risky than in the past, then this would entail a worsening of bank balance sheets and hence a fall in bank shares, ultimately even to the point where bank stocks become negatively correlated with the broader market. This would signal the emergence of a truly dysfunctional market, and it would bode very ill for the overall stability of the financial system.

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