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Bank of Japan wakes up to the downside of monetary easing

Expressions of concern over weak lenders reflect shift in priorities for central bank

Bank of Japan Gov. Haruhiko Kuroda must balance the need to push prices higher against the threat to lenders' financial health from ultralow interest rates.

TOKYO -- When the Bank of Japan began its program of monetary easing -- printing money to buy bonds -- almost two decades ago, the idea was to snap the country out of its long deflationary funk. Now the bank is waking up to the side effects: banks that are barely profitable and reluctant to lend.

Ultralow interest rates hurt banks' earnings by shrinking their interest margins. That is, the difference between how much they can charge borrowers and how much they must pay depositors. Those margins are razor thin and 70% of Japan's small regional banks posted net losses or profit declines in the April to September period this year.

For the first time, the central bank warned of threats to banks' balance sheets from prolonged low interest rates in its financial system report published on Oct. 22. Examples from the U.S. Federal Reserve and the European Central Bank show that the low interest rates of the past few years have increased the risk of economic fluctuations, the report said.

The report was compiled by bank's financial system and bank examination department, which handles bank audits. It drew objections from the monetary affairs department, which decides financial policy. One BOJ board member also complained that the report only stresses the negative aspects of low interest rates.

Officials from the monetary affairs department felt they were being blamed for BOJ's decision to keep short-term interest rates at -0.1% and long-term interest rates near zero. But an official in the financial system department said it was merely expressing concern that, during the next recession, the real economy could suffer because of greater financial instability.

Reflecting these worries, the bank added the phrase, "It is necessary to pay close attention to future developments," in its "Outlook for Economic Activity and Prices" report published Oct. 31. Because that report provides the monetary affairs people criteria for determining monetary policy, BOJ Gov. Haruhiko Kuroda and other members of the policy board began talking about the drag on bank earnings from monetary easing.

Kuroda expressed concern over the side effects in a speech on Nov. 5, saying, "The Bank fully recognizes that by continuing such monetary easing, financial institutions' strength as a whole will be affected by low profitability, mainly through a decline in their lending margins, and that this could have an impact on the stability of the financial system, as well as the functioning of financial intermediation."

That echoed comments from Yukitoshi Funo, a member of the BOJ's policy board, who used nearly identical language in a speech on Nov. 7.

On July 31, when the BOJ widened the range of its long-term interest rate target, Kuroda told reporters that the bank's policy would not be influenced by worries about bank earnings. But its position changed drastically over the next three months or so.

The BOJ shifted its emphasis because it had become apparent that monetary easing will run longer than originally planned. The bank has admitted that it will not be able to reach its 2% inflation target before fiscal 2020 at the earliest.

The financial system and monetary affairs departments have feuded before, locking horns in February 2016, when the BOJ introduced a negative interest rate policy.

Back then, the monetary affairs department took the initiative, pushing short-term interest rates below zero and surprising financial markets. That provoked a strong reaction from banks. The BOJ's negative interest-rate policy "will increase anxiety among households and companies," said Nobuyuki Hirano, president and group CEO of Mitsubishi UFJ Financial Group. Officials from the financial system and bank examination department brought BOJ board members and bank executives together to calm the situation.

But the BOJ could not ignore the lenders' complaints. In its September 2016 statement, when it began adjusting long- and short-term interest rates, it included "financial conditions" in its criteria for action.

"The Bank will make policy adjustments as appropriate, taking account of developments in economic activity and prices, as well as financial conditions, with a view to maintaining the momentum toward achieving the price-stability target of 2%," the statement said.

"The prolonged low interest rates are an indirect cause of the Suruga Bank scandal," said a BOJ official. The bank's sloppy standards for housing loans were unacceptable and resulted in a six-month business suspension order. But the worsening investment environment caused by ultralow interest rates may have encouraged it to take excessive risks.

Falling revenues will eventually hurt banks' ability to channel funds to business just as the U.S.-China trade war threatens to trigger the next economic downturn.

"There is no need to exit easy policy and it's too early to debate a strategy now," Kuroda said after the BOJ maintained its easing measures on Dec. 20. The risk-bearing experiment is set to continue.

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