## 1. Consolidated Foreign Claims of Japanese Banks, end-September 2011

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### Abstract — overall findings
- Financial system spillovers from overseas exposures appear manageable for the present except in severe distress situations in the U.S. or the core European countries.
- Funding risks for Japanese institutions also seem limited, at present, except for some nonbank institutions that would need intensive monitoring.
- There is scope to deepen coordination with foreign supervisors and financial stability authorities to enable preemptive remedial actions before stress conditions set in.
- The note advances understanding of inward spillovers, provides deeper evaluation of cross-border exposures using stress tests and market surveillance, and combines quantitative analyses with qualitative assessments of on-shore and off-shore oversight frameworks.

### Overseas exposures — key statistics and observations
- Banks’ foreign assets are 37 percent of GDP; banks’ shareholders’ capital is 8 percent of GDP.
- Bank total assets: 180% GDP; shareholders’ capital: 8% GDP.
- Other financial sector total asset: 170% GDP.
- Net foreign asset: 11% GDP, 570 billon USD; alternative figure: Net foreign asset, 11% GDP, 560 billon USD; Net foreign asset, 27% GDP, 1.3 trillion USD; National net foreign assets 49% GDP, 2.5 trillion USD.
- Consolidated foreign claims of Japanese banks doubled from US$1.3 trillion at end-2004 to US$2.7 trillion as of September 2011 (BIS consolidated banking statistics, on ultimate risk basis).
- Asia accounts for 15 percent of total foreign claims; exposures to the United States still account for nearly half of overseas exposures.
- Foreign securities investments of insurance companies reached close to US$600 billion in 2010 (around 15 percent of total assets).
- Consolidated claims on nonbank corporate entities: nearly 60 percent of cross-border claims (US$1.5 trillion), mainly syndicated loans and project finance.
- Sovereign securities in banks’ overseas holdings: US$850 billion (about 30 percent of total cross-border claims); main sovereign holdings include U.S. Treasuries, German bunds and U.K. gilts.
- Remaining claims on foreign banks: about US$300 billion, or 13 percent of total cross-border claims.
- “Potential exposures” (derivatives contracts, guarantees extended and credit commitments): nearly US$400 billion.
- Insurance companies’ foreign security holdings: nearly 90 percent in bonds; over 70 percent in the U.S. or Europe.
- Exposure to peripheral European countries is negligible for both banks and insurance companies.

### Consolidated foreign claims by sector and country (Table 1 summary; in billions of USD)
- By sector (total = 2,715):
  - Banks: 336
  - Non-bank private sector: 1,528
  - Public sector: 851
  - Other potential exposures 1/: 374
- By country (selected entries):
  - US: 1,198 (other potential exposures: 177)
  - Cayman Islands: 216 (other potential exposures: 4)
  - United Kingdom: 177 (other potential exposures: 31)
  - Germany: 139 (other potential exposures: 16)
  - Australia: 110 (other potential exposures: 11)
  - France: 95 (other potential exposures: 23)
  - China: 55 (other potential exposures: 6)
  - Hong Kong SAR: 54 (other potential exposures: 14)
  - Canada: 53 (other potential exposures: 7)
  - Netherlands: 50 (other potential exposures: 6)
  - Rest of the world: 568 (other potential exposures: 78)
- 1/ Other potential exposures include derivatives contracts, guarantees extended and credit commitments.
- Source: BIS consolidated banking statistics (on ultimate risk basis), Table 9E.

### Channels of spillovers examined through the FSAP
- Categories examined: direct spillovers, funding market spillovers, and institutional spillovers.
- Direct spillovers: losses from overseas exposures (loans and securities) via top-down and bottom-up stress tests; counterparty risks via network analysis and EDF correlations.
- Funding market spillovers: yen money market surveillance; FX funding risks via liquidity stress tests and capital market surveillance.
- Institutional spillovers: regulatory framework for cross-border resolution and Financial Market Infrastructure (FMI) oversight assessments.

### Direct spillovers — stress test design and high-level findings
- Stress tests draw on parameters of the global double-dip scenario.
- Bottom-up stress tests stress loans, fixed income securities and equities, separated by region (United States, Asia, Europe, rest of world).
- Securities valuation losses are estimated for securities in all types of accounts, including held-to-maturity accounts.
- European sovereign losses estimated separately for GIIPS, France, Germany and United Kingdom in one scenario.
- Key stress-test findings:
  - Potential solvency impact from overseas channels is, at this moment, limited.
  - Contribution from overseas loans to credit costs is relatively small owing to small share and historically higher quality of these loans.
  - Valuation losses from foreign bonds and equities are limited, especially compared to those from Japanese government bonds (JGBs) and domestic equities.
  - Within foreign securities, major sources of losses in the global double-dip scenario are U.S. debt securities (mainly U.S. Treasuries), followed by debt securities of United Kingdom and Italy.
  - Losses from other European sovereigns, including Greece, Spain, Ireland, Portugal, France, and Germany, and foreign equity exposures are negligible.

### Insurance sector: exposures and solvency stress-test results
- Foreign securities account for around one-fifth and one-sixth of total assets in life and nonlife insurance companies, respectively.
- Bottom-up stress-test findings:
  - Under the severe double-dip scenario, solvency margins would be reduced by about 17 and 13 percent for life insurance and nonlife insurance companies, respectively, over two years.
  - Life insurance companies’ large holdings of JGBs and domestic equities notwithstanding, significant losses in that scenario are driven in part by losses on foreign securities.

### Counterparty and network risk measures
- Potential exposures via derivatives and contingent liabilities amount to nearly US$400 billion.
- Network analysis and EDF correlations identify the U.S. and core European banking systems as the key systemic risks for the Japanese banking system.
- Market distress correlation measures indicate moderate spillover risks between individual Japanese and United States./European G-SIFIs, except during crisis episodes.

### Simulation design and outcomes (three simulations)
- Simulation 1: interbank exposures only.
- Simulation 2: adds potential exposures at default (outstanding derivative contracts or contingent liabilities).
- Simulation 3: expands exposure-at-default to capture knock-on effects on related nonbank and sovereign sectors (assumes loss of 50 percent for nonbank exposures and 20 percent for public sector exposures).
- Key quantitative findings:
  - Japanese banks’ exposures to banks in the U.S., U.K., Germany, and France amount to US$184 billion (interbank exposures).
  - Including nonbank and sovereign exposures, the total rises to US$1609 billion.
  - US$1609 billion represents nearly 60 percent of Japanese banks’ total foreign claims.
  - Current Tier I capital ratio for internationally active Japanese banks is about 13 percent.
  - None of the countries other than the four systemically important ones (U.S., U.K., Germany, France) can generate impairment more than 25 percent of Tier I capital for Japan in the simulations.
  - Severe impairment occurs if:
    - (i) system-wide distress in the U.S. or U.K. banking systems; or
    - (ii) distress in German or French banking systems that spreads to their corporate/sovereign sectors; or
    - (iii) widespread strains in global funding markets that lead to more foreign bank failures.
- Selected simulation outcomes — Capital impairment of Japanese banks (in percent of pre-shock capital):
  - Australia: -6.1, -6.6, -12.4  / -6.4, -7.2, -13.7
  - China: -5.0, -5.9, -17.9  / -9.6, -12.0, -25.2
  - France: -4.7, -6.5, Fail  / -6.5, Fail, Fail
  - Germany: -6.8, -8.2, Fail  / -7.9, Fail, Fail
  - Hong Kong SAR: -1.7, -2.4, -6.7  / -5.0, -6.5, -16.0
  - Singapore: -2.5, -3.7, -11.2  / -5.9, -8.0, -16.0
  - United Kingdom: -9.7, -43.2, Fail  / -18.2, Fail, Fail
  - United States: -18.5, -73.8, Fail  / -30.1, Fail, Fail
- Note: A “Fail” indicates a 100 percent loss of capital under the specified simulation.

### EDF correlations and market-based interconnectedness
- EDFs used: one-year EDFs from Moody’s KMV for 29 G-SIFIs identified by FSB in November 2011, plus Nomura; sample period September 2008–December 2011.
- Crisis episodes examined: (i) Lehman shock (September–December 2008); (ii) Greece downgrade (April–June 2010); (iii) Eurozone turmoil (September–November 2011).
- Findings:
  - Average post-crisis EDF correlations indicate modest linkages between Japanese banks and other global G-SIFIs.
  - EDF correlations increase during crisis episodes; one large Japanese bank shows high EDF correlation with a U.K. bank.

### Yen money market and FX funding — behavior and stress-test results
- Yen funding conditions for Japanese financial institutions remained relatively stable upon the global financial crisis; increases in funding costs were much lower than those in U.S. dollar or euro funding markets.
- Repo markets in Japan largely used liquid JGBs as collateral; no major repo market turbulence.
- Banks received strong deposit inflows amid weak credit growth, reducing reliance on market funding.
- Post-2008: abundant yen liquidity and excess reserves at the BOJ rose to levels seen in past quantitative easing periods.
- FX funding risks:
  - International Japanese banks raise funding in overseas markets primarily through local deposits, interbank borrowing, repos and cross-currency funding using FX swaps.
  - Liquidity stress tests for three mega banks show they can sustain major disruptions to U.S. dollar funding sources for one week and one month using liquidity buffers (mainly excess reserve deposit at Federal Reserve System and borrowing through the system’s discount window).
  - Banks have been extending the maturity of swap contracts.
  - Securities firms may be more vulnerable because they do not have access to central bank standing liquidity facilities outside Japan.
- As of January 2012:
  - The U.S. dollar-yen CIP deviation has been closed, reducing U.S. dollar funding costs for Japanese financial institutions to U.S. dollar Libor levels.
  - U.S. dollar Libor itself is edging up and U.S. dollar Libor-OIS spread is rising.
  - European banks still face substantially higher U.S. dollar funding costs (and yen funding costs) than Japanese peers.
- Ongoing concern:
  - Continued rise in the cost of U.S. dollar funding could weigh on profitability even if access is maintained.

### Institutional spillovers — cross-border resolution and supervisory cooperation
- Cross-border resolution risks highlighted by Lehman Brothers’ failure; supervisory colleges are key to strengthen cross-border supervision.
- Assessment of Japanese authorities’ cross-border cooperation:
  - Strong cooperation and information sharing between Japanese authorities and foreign supervisors, including supervisory colleges for major banks, insurance, and securities companies.
- Recommendations to enhance home/host cooperation:
  - (i) More proactive engagement and coordinated, effective and timely sharing of relevant information with foreign bank supervisors.
  - (ii) Develop comprehensive plans to deal with insurance companies in a crisis situation and ensure plans are internationally coordinated by working with foreign supervisors (for example, through supervisory colleges).
  - (iii) Document a contingency plan to be followed in the event of a securities market intermediary’s failure.
- Specific sector-level recommendations:
  - Banking sector: FSA should continue enhancing home/host relationships and sign formal arrangements on information sharing for G-SIFIs.
  - Insurance sector: FSA should develop comprehensive plans for dealing with insurers in crisis; insurers should be required to prepare contingency plans.
  - Securities markets: Document contingency plans for intermediary failure and develop a resolution plan for large complex securities firms.

### Financial Market Infrastructures (FMI) interdependencies
- Overall: Spillover risk from FMI interdependencies is currently limited but rising and requires close monitoring.
- Main interdependencies:
  - Use of Continuous Linked Settlement (CLS) for yen FX transactions (CLS clears 68 percent of global currency trades daily in 17 major currencies).
  - Offshore clearing of yen-denominated OTC derivatives transactions.
  - Offshore settlement of JGBs in the two largest international central securities depositories (ICSDs).
- Specific statistics:
  - Net settlement of CLS in BOJ-NET FTS amounts to less than one percent of BOJ-NET FTS total settlement.
  - According to SwapClear website as of December 14, 2011, outstanding notional of yen denominated Interest Rate Swap (IRS) at the London-based CCP amounted to US$38.4 trillion.
  - SwapClear outstanding notionals: euro US$113.4 trillion; US$102.9 trillion; yen US$38.4 trillion.
- Observations and gaps:
  - Neither FSA nor BOJ currently gets sufficient information on offshore yen central clearing.
  - Authorities participate in OTC Derivatives Regulator Forum discussions to develop information sharing agreements on individual FMIs, including LCH Clearnet limited.
  - Recommendation: Continue and enhance monitoring of spillover risk from overseas FMIs, and be prepared for a default of one of the relevant overseas FMIs or foreign financial institutions if risk factors change.

### Conclusions and policy implications
- Overseas exposure risks are generally limited at present but can be significant under severe distress in the U.S. or core European banking systems.
- Cross-border exposures include hard-to-monitor instruments (off-balance sheet derivatives, credit lines, foreign currency capital and money market financing, transactions with hard-to-assess counterparties) and require strong collaboration with host-country authorities.
- Policy priorities:
  - Enhanced cross-border supervisory collaboration, especially with U.S., U.K., German and French supervisors.
  - Continued surveillance of overseas vulnerabilities, including in Asia, as Japanese banks expand in the region.
  - Improve data on cross-border exposures, including maturity and funding bases of foreign claims, and strengthen data collection and disclosure to aid macroprudential oversight.
  - Strengthen contingency planning and formalized information-sharing arrangements (bilateral or multilateral MOUs) and supervisory colleges for crisis management and resolution.

*Source: IMF Financial Sector Assessment Program material (consolidated chapter content).*

### 1. Consolidated Foreign Claims of Japanese Banks, end-September 2011 ...............................8

### 1. Consolidated Foreign Claims of Japanese Banks, end-September 2011

### Abstract — overall findings
- Financial system spillovers from overseas exposures appear manageable for the present except in severe distress situations in the U.S. or the core European countries.
- Funding risks for Japanese institutions also seem limited, at present, except for some nonbank institutions that would need intensive monitoring.
- There is scope to deepen coordination with foreign supervisors and financial stability authorities to enable preemptive remedial actions before stress conditions set in.
- The note advances understanding of inward spillovers, provides deeper evaluation of cross-border exposures using stress tests and market surveillance, and combines quantitative analyses with qualitative assessments of on-shore and off-shore oversight frameworks.

### Overseas exposures of the Japanese financial system — key statistics and observations
- Banks’ foreign assets are 37 percent of GDP; banks’ shareholders’ capital is 8 percent of GDP.
- Banks’ cross-border liabilities are primarily in the form of loans (wholesale funding); the share of currency and deposit is small.
- Insurance and pension funds hold substantial overseas portfolios with potentially large valuation exposure but are less likely to face liquidity risks because liabilities are longer term.
- Bank total assets: 180% GDP; shareholders’ capital: 8% GDP. (Figure annotations)
- Other financial sector total asset: 170% GDP. (Figure annotations)
- Net foreign asset: 11% GDP, 570 billon USD; another figure shown: Net foreign asset, 11% GDP, 560 billon USD; Net foreign asset, 27% GDP, 1.3 trillion USD; National net foreign assets 49% GDP, 2.5 trillion USD. (Figure annotations)
- Consolidated foreign claims of Japanese banks doubled from US$1.3 trillion at end-2004 to US$2.7 trillion as of September 2011 (BIS consolidated banking statistics, on ultimate risk basis).
- Overseas expansion funded mainly through excess domestic savings with currency swaps, local deposits, and overseas borrowing mainly in U.S. and U.K. markets.
- Geographical distribution shifted from Europe since mid-2008 to the Asian region (Asia accounts for 15 percent of total foreign claims); exposures to the United States still account for nearly half of overseas exposures.
- Foreign securities investments of insurance companies reached close to US$600 billion in 2010 (around 15 percent of total assets).
- Japanese banks’ consolidated claims on nonbank corporate entities: nearly 60 percent of cross-border claims (US$1.5 trillion), mainly syndicated loans and project finance.
- Sovereign securities in banks’ overseas holdings: US$850 billion (about 30 percent of total cross-border claims); main sovereign holdings include U.S. Treasuries, German bunds and U.K. gilts.
- Remaining claims on foreign banks: about US$300 billion, or 13 percent of total cross-border claims.
- “Potential exposures” (derivatives contracts, guarantees extended and credit commitments): nearly US$400 billion.
- Insurance companies’ foreign security holdings: nearly 90 percent in bonds (mostly sovereign bonds and investment grade corporate bonds); over 70 percent in the U.S. or Europe.
- Exposure to peripheral European countries is negligible for both banks and insurance companies.

### Consolidated foreign claims by sector and country (Table 1 summary; in billions of USD)
- By sector (total = 2,715):
  - Banks: 336
  - Non-bank private sector: 1,528
  - Public sector: 851
  - Other potential exposures 1/: 374
- By country (selected entries):
  - US: 1,198 (other potential exposures: 177)
  - Cayman Islands: 216 (other potential exposures: 4)
  - United Kingdom: 177 (other potential exposures: 31)
  - Germany: 139 (other potential exposures: 16)
  - Australia: 110 (other potential exposures: 11)
  - France: 95 (other potential exposures: 23)
  - China: 55 (other potential exposures: 6)
  - Hong Kong SAR: 54 (other potential exposures: 14)
  - Canada: 53 (other potential exposures: 7)
  - Netherlands: 50 (other potential exposures: 6)
  - Rest of the world: 568 (other potential exposures: 78)
- Source: BIS consolidated banking statistics (on ultimate risk basis), Table 9E.
- 1/ Other potential exposures include derivatives contracts, guarantees extended and credit commitments.

### Channels of spillovers examined through the FSAP
- Categories examined: direct spillovers, funding market spillovers, and institutional spillovers.
- Direct spillovers analysis:
  - Losses from overseas exposures (loans and securities): top-down and bottom-up stress tests (BOJ/FSA, banks, insurance companies, and IMF).
  - Counterparty risks: network analysis and EDF correlations (IMF).
- Funding market spillovers analysis:
  - Yen money market spillovers: capital market surveillance (IMF).
  - Foreign exchange (FX) funding risks: liquidity stress tests and capital market surveillance (BOJ/FSA, banks, IMF).
- Institutional spillovers analysis:
  - Regulatory framework for cross-border resolution: standard and codes assessments for the banking sector, insurance sector and securities markets (IMF Assessors).
  - Financial market infrastructures (FMIs): assessments of the oversight for FMIs (IMF Assessors).

### Direct spillovers — stress test design and findings
- Stress tests draw on parameters of the global double-dip scenario.
- Bottom-up stress tests for banks stress all types of overseas exposures: loans, fixed income securities and equities, separated by region (United States, Asia, Europe, and rest of the world).
- Securities valuation losses are estimated for securities in all types of accounts, including held-to-maturity accounts.
- In one scenario, losses from European sovereigns are estimated separately for GIIPs, France, Germany and United Kingdom.
- Key stress-test findings:
  - Potential solvency impact from overseas channels is, at this moment, limited.
  - Contribution from overseas loans to credit costs is relatively small owing to small share and historically higher quality of these loans.
  - Valuation losses from foreign bonds and equities are limited, especially compared to those from Japanese government bonds (JGBs) and domestic equities.
  - Within foreign securities, major sources of losses in the global double-dip scenario are U.S. debt securities (mainly U.S. Treasuries), followed by debt securities of United Kingdom and Italy.
  - Losses from other European sovereigns, including Greece, Spain, Ireland, Portugal, France, and Germany, and foreign equity exposures are negligible.

### Counterparty and network risk measures
- Counterparty risks assessed via network analysis and EDF correlations (IMF).
- Potential exposures via derivatives and contingent liabilities amount to nearly US$400 billion, representing a channel of indirect counterparty risk.

### Funding market and institutional spillovers — monitoring and policy implications
- Funding market spillovers monitored through yen money market surveillance and liquidity stress testing to assess FX funding risks.
- Institutional spillovers examined through cross-border resolution frameworks and FMI oversight assessments to identify gaps in legal authority, capacity to monitor emerging risks, and cross-border supervisory cooperation.
- Importance emphasized of legal authority and capacity to collaborate with other countries’ supervisory authorities and adherence to international practices while tailoring to local market realities.

_Italic: Source: IMF Financial Sector Assessment Program material (consolidated chapter content)._

### 12.      Regarding the insurance sector, potential losses from overseas exposures could

### _cr12263 - 12.      Regarding the insurance sector, potential losses from overseas exposures could

### Insurance sector: exposures and solvency stress-test results
- Foreign securities account for around one-fifth and one-sixth of total assets in life and nonlife insurance companies, respectively.
- Bottom-up stress-test findings:
  - Under the severe double-dip scenario, solvency margins would be reduced by about 17 and 13 percent for life insurance and nonlife insurance companies, respectively, over two years.
  - Life insurance companies’ large holdings of JGBs and domestic equities notwithstanding, significant losses in that scenario are driven in part by losses on foreign securities (Annex I).

### Counterparty risks and network analysis
- BIS data show large foreign claims of Japanese banks on U.S. and U.K. banks, implying that distress in large United States and United Kingdom counterparties may lead to distress for Japanese banks.
- Network analysis findings:
  - The U.S. and core European banking systems are the key systemic risks for the Japanese banking system.
  - Financial spillovers to Japan can be substantial if there is system-wide distress in the United States or United Kingdom banking systems, or a distress in German or French banking systems that spreads to their corporate/sovereign sectors.
  - Spillover risks from other banking systems, including Asian financial centers, are currently modest, even under severe assumptions including deleveraging effects; these risks may grow as Japanese banks expand into Asia.
  - Market distress correlation measures indicate moderate spillover risks between individual Japanese and United States./European G-SIFIs, except during crisis episodes (Annexes II and III).

### Funding market spillovers
- Yen money markets:
  - Yen funding conditions for Japanese financial institutions remained relatively stable upon the global financial crisis; increases in funding costs were much lower than those in U.S. dollar or euro funding markets.
  - No major turbulence in repo markets occurred due to almost all repos in Japan using liquid JGBs as collateral.
  - Funding strains were mainly experienced by foreign banks, whose balance sheets in Japan have contracted noticeably in recent years.
  - Going forward, there could be renewed surge in funding costs in the yen money market originating from overseas turbulences, especially risks with European banks with distressed sovereigns.
  - Risk-mitigating factors:
    - Japanese financial institutions have abundant yen liquidity with a large and expanding deposit base.
    - Japanese banks rely little on wholesale funding; bank liquidity stress tests show resilience against major closure of wholesale funding markets for three months.
    - Securities firms rely more on yen funding and need more prudent internal liquidity risk management; their funding is mainly for inventory financing and less for proprietary trading (Annex IV).
- FX funding risks:
  - Large international Japanese banks raise funding in overseas markets to match currency composition of overseas assets, primarily through local deposits (including CDs), interbank borrowing, repos and cross-currency funding using FX swaps.
  - Stress in overseas funding markets, including FX swap markets and the dollar funding market, could influence FX funding conditions for Japanese financial institutions.
  - Liquidity stress tests for three mega banks show they can sustain major disruptions to U.S. dollar funding sources, including difficulty rolling over FX swap contracts for one week and one month, using liquidity buffers (mainly excess reserve deposit at Federal Reserve System and borrowing through the system’s discount window).
  - Banks have been extending the maturity of swap contracts.
  - Securities firms may be more vulnerable because they do not have access to central bank standing liquidity facilities outside Japan.
  - U.S. dollar funding costs for Japanese financial institutions rose in the second half of 2011, including those using FX swaps, but access to funding (e.g., rollover of swaps) remained open.
  - Market surveillance indicates the rise in cross-currency dollar funding costs reflects generalized reduction in market liquidity rather than Japanese institutions’ funding distress (Annex V).

### Institutional spillovers and cross-border arrangements
- Cross-border resolution risks:
  - Failure of Lehman Brothers highlighted difficulties in resolving globally active firms under local-law-governed resolution frameworks.
  - Supervisory colleges are a key mechanism to strengthen cross-border supervision of globally active firms.
- Assessment of Japanese authorities’ cross-border cooperation:
  - Standard and codes assessments found strong cooperation and information sharing between Japanese authorities and foreign supervisors, including through supervisory colleges for major banks, insurance, and securities companies.
  - Recommendations for stronger home/host cooperation to anticipate and manage crises:
    - (i) More proactive engagement and coordinated, effective and timely sharing of relevant information with foreign bank supervisors.
    - (ii) Develop comprehensive plans to deal with insurance companies in a crisis situation and ensure plans are internationally coordinated by working with foreign supervisors (for example, through supervisory colleges).
    - (iii) Document a contingency plan to be followed in the event of a securities market intermediary’s failure (Annex VI).

### Financial Market Infrastructures (FMI) interdependencies
- Tighter FMI interdependencies have reduced settlement costs but increased potential for rapid, wide-spread disruptions.
- Current assessment:
  - Overall spillover risk from FMI interdependencies is currently limited, but interdependencies are rising and require close monitoring.
  - Main interdependencies for Japan include:
    - Use of Continuous Linked Settlement (CLS) for yen FX transactions (CLS clears 68 percent of global currency trades daily in 17 major currencies, including the yen).
    - Offshore clearing of yen-denominated OTC derivatives transactions.
    - Offshore settlement of JGBs in the two largest international central securities depositories (Annex VII).

### Conclusions
- Overseas exposure challenges and monitoring:
  - Risks from overseas exposures are usually not monitored as intensively as domestic exposures because overseas exposures still represent a small portion of Japanese financial sector balance sheets.
  - Cross-border exposures can involve difficult-to-monitor instruments (off-balance sheet derivatives, credit lines, foreign currency capital and money market financing, transactions with hard-to-assess counterparties).
  - Monitoring often requires strong collaboration with host-country authorities, which may be difficult to obtain.
  - Ensuring good collaboration frameworks with host-country authorities on cross-border crisis management and resolution is a key factor in limiting negative spillover effects during distress.

### Annex I — Losses from overseas exposures (summary)
- Solvency tests for banks:
  - Two approaches: top-down (TD) and bottom-up (BU).
  - TD tests overseas loans credit quality but not securities and does not differentiate by country/region.
  - BU stresses overseas loans and securities by major countries/regions, with differentiated assumptions for U.S., Europe, China, and rest of world; bonds receive additional country-level yield assumptions.
  - For all countries/regions outside Japan, macro assumptions calibrated using IMF’s GIMF model and expert judgment.
  - European sovereign bond yields for mild (severe) double-dip scenario simulated using the largest 10 (1) percentile of quarterly yield change between January 2009 and January 2012.
- Key quantitative findings:
  - Loans: Credit risk from overseas loan portfolio is much smaller than for domestic loans even in severe double-dip scenario.
  - Securities: Valuation losses from foreign securities are small; in the severe global double-dip scenario, losses from foreign fixed income assets reduce capital ratios by about 0.2 percentage points and are smaller than losses from domestic equities. Losses from foreign equities are negligible.
  - Within foreign fixed income losses, losses from United States debt securities are the largest due to much larger exposures to United States securities, especially U.S. Treasuries.
  - Within Europe, potential losses could stem from Italian and U.K. debt securities; losses from other distressed European countries, or Germany, are negligible despite substantial haircut assumptions.
- Insurance-sector specifics:
  - Foreign securities account for nearly 20 and 17 percent of total assets in life and nonlife insurance companies, respectively.
  - Severe double-dip scenario implied solvency margin reductions of 17 percent for life insurers and about 13 percent for nonlife insurers over two years.

### Annex II — Network analysis (summary)
- Methodology:
  - Based on Espinosa-Vega and Solé (2010), simulates failure of a country’s banking system and tracks spillover effects, including domino effects and asset/liability side impacts.
  - Two shocks considered:
    - (i) Credit shock: impact of a banking system defaulting on liabilities to foreign banks (assumes loss given default of 100 percent on interbank exposures).
    - (ii) Funding shock: impact of deleveraging by withdrawing funding from foreign banks (assumes withdrawal of 35 percent on interbank funding and 50 percent discount on forced asset sales).
  - Analysis uses bilateral exposures among 30 countries from BIS consolidated banking statistics as of end-September 2011 (except China, New Zealand, South Korea exposures inferred).
- Implication:
  - Wider spillovers indicate higher systemic importance of linked banking sectors; results point to U.S. and core European banking systems as primary systemic sources for spillovers to Japan.

*Source: _cr12263 - 12.      Regarding the insurance sector, potential losses from overseas exposures could*

### 31.      Three simulations are explored in the analysis. The first simulation focuses only

### _cr12263 - 31.      Three simulations are explored in the analysis. The first simulation focuses only

### Simulation design and channels
- Three simulations with increasing coverage/severity:
  - Simulation 1: focuses only on interbank exposures (direct cross-border interbank claims).
  - Simulation 2: adds potential exposures at default (outstanding derivative contracts or contingent liabilities such as guarantees, credit commitments). (Data source: Table 9C-E of BIS banking statistics.)
  - Simulation 3: further expands exposure-at-default to capture knock-on effects of banking-sector distress on related nonbank and sovereign sectors within the trigger country (assumes a loss of 50 percent for nonbank exposures and 20 percent for public sector exposures; sectoral exposures from Table 9C-E of BIS banking statistics).

### Key quantitative findings on spillovers to Japanese banks
- Aggregate exposure and impact:
  - Japanese banks’ exposures to banks in the U.S., U.K., Germany, and France amount to US$184 billion (interbank exposures).
  - Including nonbank and sovereign exposures, the total rises to US$1609 billion.
  - US$1609 billion represents nearly 60 percent of Japanese banks’ total foreign claims.
- Severity thresholds and capital context:
  - None of the countries other than the four systemically important ones (U.S., U.K., Germany, France) can generate impairment more than 25 percent of Tier I capital for Japan in the simulations.
  - Current Tier I capital ratio for internationally active Japanese banks is about 13 percent.
  - Losses from banking failures in the examined Asian countries (China, Australia, Singapore) would not put Japanese banks’ capital below the regulatory standard, given the 13 percent Tier I ratio.
- Conditions under which impairments become severe:
  - Severe impairment occurs if:
    - (i) system-wide distress in the U.S. or U.K. banking systems; or
    - (ii) distress in German or French banking systems that spreads to their corporate/sovereign sectors; or
    - (iii) widespread strains in global funding markets that lead to more foreign bank failures, producing larger credit losses for Japanese banks.
- Historical precedents:
  - Japanese banks were affected when U.S. and U.K. banking systems experienced distress in 2008, and to a lesser extent when French banks and sovereigns faced stress in 2011Q4.

### Simulation outcomes by trigger country (selected entries from Table 4)
- Capital impairment of Japanese banks (in percent of pre-shock capital) — Credit and Funding Shock / Credit Shock; Simulation 1 / Simulation 2 / Simulation 3:
  - Australia: -6.1, -6.6, -12.4  / -6.4, -7.2, -13.7
  - China: -5.0, -5.9, -17.9  / -9.6, -12.0, -25.2
  - France: -4.7, -6.5, Fail  / -6.5, Fail, Fail
  - Germany: -6.8, -8.2, Fail  / -7.9, Fail, Fail
  - Hong Kong SAR: -1.7, -2.4, -6.7  / -5.0, -6.5, -16.0
  - Singapore: -2.5, -3.7, -11.2  / -5.9, -8.0, -16.0
  - United Kingdom: -9.7, -43.2, Fail  / -18.2, Fail, Fail
  - United States: -18.5, -73.8, Fail  / -30.1, Fail, Fail
- Note: A “Fail” indicates a 100 percent loss of capital (banking sector failure) under the specified simulation.

### EDF correlations and market-based interconnectedness
- Data and coverage:
  - EDFs used: one-year EDFs from Moody’s KMV for 29 G-SIFIs identified by FSB in November 2011, plus Nomura; sample period September 2008–December 2011.
  - Crisis episodes examined: (i) Lehman shock (September–December 2008); (ii) Greece downgrade (April–June 2010); (iii) Eurozone turmoil (September–November 2011).
- Findings:
  - Average post-crisis EDF correlations (September 2008–December 2011) indicate modest linkages between Japanese banks and other global G-SIFIs.
  - One large Japanese bank shows high EDF correlation with a U.K. bank.
  - EDF correlations increase during crisis episodes, consistent with network-analysis results that severe distress in U.S. or Europe would more strongly affect Japanese banks.

### Yen money market and funding environment (summary)
- Crisis-era behavior:
  - Libor-OIS spreads for yen rose in late 2008 but remained much lower than U.S. dollar or euro funding stresses.
  - Domestic call markets exhibited spikes tied to lower market liquidity (larger bid-ask spreads), not generalized funding distress.
  - Yen funding conditions in Tokyo were more troublesome for foreign banks; funding cost increases for Japanese banks were fairly limited.
- Secured funding and JGB market infrastructure:
  - Japanese bond repos largely use liquid JGBs as collateral, which showed limited volatility during the crisis.
  - Rehypothecation practice was limited.
  - Banks received strong deposit inflows amid weak credit growth, reducing reliance on market funding.
  - JGB clearing and settlement systems remained well-functioning despite a short-lived surge in settlement “fails”; use of JGBCC (central counterparty) mitigated confusion.
- Post-2008 trends:
  - Abundant yen liquidity for Japanese institutions amid accommodative monetary policy; excess reserves at the BOJ rose to levels seen in past quantitative easing periods.
  - Call market volume declined; much of the reduction reflected large declines in foreign banks’ borrowings.
  - Foreign banks reduced call-market activity due to lower funding needs and higher counterparty risk; FX-swap market liquidity weakened as market-making declined, contributing to violations of covered interest parity and occasional negative cross-currency yen funding costs via USD/JPY swaps.
- Outlook risk:
  - Renewed surges in funding costs in the yen money market could arise from overseas turbulences, particularly if risks at foreign banks (notably European banks with distressed sovereigns) remain elevated and reduce market liquidity during generalized pressures.

### Policy implications and recommendations
- Cross-border supervisory collaboration:
  - Enhanced collaboration with U.S. and U.K. supervisors is important given large exposures and potential spillover risks, notably around off-balance-sheet derivatives contracts and credit lines.
  - Collaboration with German and French supervisors is also important, especially if banking problems spill over to sovereign sectors (or vice versa).
- Surveillance of overseas vulnerabilities:
  - Continued careful surveillance of potential vulnerabilities overseas, including in Asia, is required as Japanese banks expand in the region and trade linkages remain strong.
- Strengthening data availability:
  - Improve data on cross-border exposures, including maturity and funding bases of foreign claims, since BIS consolidated data lack these dimensions.
  - Strengthened data collection and disclosure (on nature and size of cross-border exposures) aids macroprudential oversight and helps contain speculation on potential impacts (example: disclosures regarding exposures to peripheral European countries).

*Source: IMF staff calculations and analysis, as presented in the supplied content.*

### 48.      Nonetheless, most of the Japanese financial institutions seem well prepared for

### _cr12263 - 48.      Nonetheless, most of the Japanese financial institutions seem well prepared for

### Yen liquidity preparedness and short-term market reliance
- Most Japanese financial institutions seem well prepared for potential volatilities in yen money markets.
- The banking sector:
  - Relies little on wholesale funding.
  - Banking sector liquidity stress tests indicate banks have enough liquidity buffer (mostly deposit at BOJ, cash and JGBs) to withstand freeze of wholesale markets for three months that stop the rollover of maturing market funding.
- Securities firms:
  - Rely more on market funding, including repos, requiring closer liquidity management than banks.
  - Their funding is mainly for inventory financing and little for proprietary trading.

- Chart axis values and labels included in source:
  - -1.0
  - -0.5
  - 0.0
  - 0.5
  - 1.0
  - 1.5
  - 2.0
  - 2.5
  - 3.0
  - euro FX swap
  - Uncollateralized call
  - Ye n  Li b o r
  - USD FX swap
  - Yen funding cost, 3 month 
  - (In percent)
  - Source: Bloomberg.

### Trends in U.S. dollar funding costs (findings)
- Internationally active Japanese institutions typically obtain FX (mostly USD) via local repos, interbank loans and CDs (including U.S. MMF deposits in branches and subsidiaries of Japanese banks), or cross-currency funding.
- Turbulences in global funding markets raise direct FX funding costs in local or offshore markets, and can limit access to FX funding. FX swaps market distress can add to cross-currency funding costs.
- As of January 2012, the stress in USD funding using yen has subsided:
  - The U.S. dollar-yen CIP deviation has been closed, reducing U.S. dollar funding costs for Japanese financial institutions to U.S. dollar Libor levels.
  - U.S. dollar Libor itself is edging up due to the counterparty risks in this market and U.S. dollar Libor-OIS spread is rising.
  - European banks still face substantially higher U.S. dollar funding costs (and yen funding costs) than Japanese peers.
- Possible market drivers:
  - Entry of new players picking up arbitrage gains.
  - A few market sources explicitly mentioned a sovereign asset holder as increasing yen bond holdings and raising the implied yield by swapping into dollars.
  - Other sovereign asset holders, particularly in Asia, may also be engaging in this trade, possibly explaining reported increase in foreign flows to JGBs and shorter-term financing bills.

### USD funding risks and resilience of Japanese banks
- Relative positioning:
  - The Japanese banking sector is relatively well positioned to secure FX funding compared to European peers.
  - Japanese banks typically have very conservative overseas securities investment (e.g., U.S. Treasury bonds), which has high liquidity in outright and repo markets.
  - European banks tend to have exposures in less liquid securities in the United States.
  - United States MMFs are also shifting their deposits to Japanese banks from European banks.
- Yen FX swaps versus euro FX swaps:
  - Yen FX swaps are much more stable than those using euros and banks are extending their swap maturities to prevent facing high rollover costs.
- Chart axis values and labels included in source:
  - 0
  - 0.5
  - 1
  - 1.5
  - 2
  - 2.5
  - 3
  - Euro FX swap  funding
  - LIBOR 3month
  - yen FX  swap  funding
  - BOJ FX funding facility 1/
  - USD funding  cost
  - (In percent)
  - Sources: Bloomberg
  - 1/ BOJ's USD lending facility charged OIS+ 100 bps up to mid December 2011 and then cut to + 50 bps. 3 month OIS is used for calculation

- FX liquidity stress test results for the three largest Japanese banks:
  - Show resilience to a shock to FX market funding.
  - A contraction of interbank funding, disruption in U.S. dollar-yen swap markets, deposit withdrawals, or realization of contingent liabilities could be met by:
    - Access to various FX credit lines.
    - Foreign asset sales.
  - Japanese banks’ excess reserve deposits at the U.S. Federal Reserve System could be mobilized to generate substantial FX liquidity.
  - Large amounts of collateral would allow borrowing in U.S. dollars through the Fed’s discount window.
- Factors supporting benign stress-test outcomes:
  - Accommodative U.S. monetary policy increasing excess reserve holdings.
  - Banks’ FX liquidity risk management: extending FX swap terms and issuing USD bonds, so only part of FX swap contracts are maturing in the stress-test horizons (one week and month).
  - Results could change if access to all funding markets remained closed to Japanese banks for over three months; such extent of distress did not happen even post-Lehman.

- Ongoing concern:
  - Continued rise in the cost of U.S. dollar funding could weigh on profitability of financial institutions even if access is maintained.

### Cross-border resolution risks — summary findings and recommendations
- Banking sector — BCP Assessment
  - Findings:
    - Some progress in cooperation and information sharing between the FSA and other home and host supervisors observed (Exchange of Letters, annual supervisory colleges).
    - Frequency of supervisory colleges and quality of information shared appear sufficient but room exists to enhance coordination for cross-border crisis and resolution.
    - Japan decided to sign institution specific formal arrangements on information sharing for the G-SIFIs by the end of 2012, following FSB discussion.
    - Since 2007, the FSA has undertaken a “Better Regulation” program, including strengthening cooperation with foreign supervisors.
  - Recommendations:
    - FSA should continue enhancing home/host relationships with foreign supervisors via more proactive ongoing information sharing (not only on a needs basis).
    - Share information that may have material effect on subsidiaries or branches in host countries and timely regular exchanges.
    - Continue efforts to sign more formalized arrangements including bilateral or multilateral MOUs with more foreign supervisors.

- Insurance sector — ICP Assessment
  - Findings:
    - FSA is a signatory to the IAIS Multilateral Memorandum of Understanding and has bilateral agreements where Japanese insurers have material operations.
    - FSA participates in colleges of supervisors for foreign insurers operating in Japan and is considering supervisory colleges for insurers with material foreign operations.
    - FSA has not yet developed comprehensive plans for dealing with Japanese insurers in crisis, though it has participated in developing such plans for some foreign insurers in Japan.
    - Insurers are encouraged—but not required—to prepare business continuity plans, which are reviewed by the FSA.
  - Recommendations:
    - FSA should develop comprehensive plans for dealing with insurers in crisis and ensure internationally coordinated plans via foreign supervisors (for example, supervisory colleges).
    - Insurers should be required to prepare contingency plans, including specific procedures for use in a gone-concern situation.

- Securities markets — IOSCO Assessment
  - Findings:
    - The Financial Instruments Exchange Act provides the FSA power to enter information arrangements with foreign authorities; FSA is a signatory to the IOSCO MMoU (signed in 2008).
    - FSA does not consider it necessary to enter specific bilateral MOU arrangements given MMoU signatory status, but has entered into exchanges of letters with a number of countries as evidence of cooperation.
    - A supervisory college and crisis management group were created in 2010 for a large complex firm; FSA and BOJ participate along with other jurisdictions’ regulators.
    - Colleges meet once a year with semiannual conference calls; regulators discuss possible crisis measures.
  - Recommendations:
    - Authorities should document a contingency plan for an intermediary’s failure, including regulatory actions to protect investors and manage situations.
    - Continue domestic discussions (FSA, BOJ) on cooperation in financial crisis management and elaborate contingency plans further.
    - Authorities are encouraged to develop a resolution plan for large complex securities firms.

### Spillover risks from FMI interdependencies
- Overall assessment:
  - Spillover risks from interdependencies with overseas FMIs have increased over the past decade but remain relatively limited in Japan.
  - Main interdependencies:
    - Use of CLS for yen FX transactions.
    - Offshore central clearing of yen denominated OTC derivatives transactions.
    - Participation of foreign financial institutions in Japanese FMIs.
    - Offshore settlement of JGBs in the two largest International Central Securities Depositories (ICSDs).
    - Use of SWIFT as a financial messages network provider.
  - Net settlement of CLS in BOJ-NET FTS amounts to less than one percent of the value of BOJ-NET FTS total settlement even though yen is the third largest currency settled in CLS, following the U.S. dollar and the euro.
- Specific statistics:
  - According to SwapClear website as of December 14, 2011, outstanding notional of yen denominated Interest Rate Swap (IRS) at the London-based CCP amounted to US$38.4 trillion.
  - Yen is the third currency cleared in SwapClear behind the euro (US$113.4 trillion) and US$102.9 trillion.
- Observations and gaps:
  - ICSDs participate in BOJ's JGB Book-Entry System as Foreign Indirect Participants; JGB settlement in the ICSDs seems limited.
  - None of the Japanese FMIs currently rely on the SWIFT network; in Japan SWIFT is used for bilateral transactions between financial institutions.
  - Neither FSA nor BOJ currently gets sufficient information on offshore yen central clearing.
  - Both authorities are participating in OTC Derivatives Regulator Forum discussions to develop information sharing agreements on individual FMIs, including London Clearing House (LCH) Clearnet limited.
  - Authorities monitor JGB offshore settlement and foreign FMI participants, but there is no concrete example of information exchanges under IOSCO MMoU to date.
- Recommendation:
  - Continue and enhance monitoring of spillover risk from overseas FMIs, and be prepared for a default of one of the relevant overseas FMIs or foreign financial institutions if risk factors change.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12263.pdf*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12263.pdf_