Japan’s financial regulator is set to implement stricter measures on the $67 billion market for high-yield loans backed by government bonds. These loans have become increasingly popular with regional banks, despite ongoing warnings about their potential risks.
Financial Services Agency’s Crackdown
The Financial Services Agency (FSA) plans to closely monitor banks that have increased their purchases of Japanese government bonds (JGBs) repackaged into loans over the past year. According to Toshinori Yashiki, director-general of the FSA’s strategy development and management bureau, the regulator will also target brokerages that are actively marketing these products to lenders.
The crackdown comes after the FSA noted that some regional banks have continued to buy these products, despite a warning issued by the regulator in January 2024. Officials are concerned that some banks lack proper risk management and could face significant losses if market rates move unfavorably.
Yashiki emphasized that while bank management has the discretion to choose investments, the FSA’s increased scrutiny is likely to discourage lenders from pursuing these loan products.
The Appeal of Repackaged Loans
Repackaged loans typically bundle Japanese government bonds with derivatives to boost returns. Banks lend money to special purpose companies or other entities, which then use the funds to purchase government bonds. The banks earn income from both the bonds and the derivatives attached to the loans.
One reason for the growing appeal of these loans is that buyers do not need to mark them to market. This avoids the potential for paper losses that would occur if the bonds’ value declines as interest rates rise.
However, the FSA has raised concerns about the risks associated with these products. In some cases, banks could experience negative spread, where the returns on the loans fall below the costs of the deposits they’ve taken on.
The structure of these loans can vary, and the difficulty of unwinding them in adverse market conditions poses a significant risk, Yashiki explained. He also stated that repackaged JGB loans are economically irrational when considering the associated costs and risks.
Rising Popularity of Repackaged Loans
As of September, regional banks held nearly ¥10 trillion ($67 billion) in repackaged loans, including those backed by assets other than JGBs. This marked an increase of 20% to 30% from the previous year. While the exact amount backed by JGBs is not disclosed, it is believed to be in the billions of dollars.
Currently, there is no requirement for banks to disclose the presence of these loans. For banks, they are an attractive option because they can be counted as lending, boosting their overall lending portfolios.
Yashiki expressed concerns about the transparency of these loans. “They are effectively a bond investment, but if banks are buying such loans to avoid mark-to-market accounting or to grow their loan balances, it undermines the purpose of disclosure,” he said. “I doubt these loans will benefit the communities they serve.”
Risk of Mismanagement and Transparency Issues
The allure of these products for regional lenders lies in the fact that many do not have the resources or expertise to manage more diversified investment portfolios like those of Japan’s larger banks. Many of these regional banks have limited revenue sources, as few are involved in international business or investment banking.
Securities firms and trust banks that sell these loans are also under the FSA’s microscope. The regulator plans to examine whether aggressive marketing by brokerages has fueled demand for these high-risk products.
Looking ahead, the FSA intends to work with the banking industry to discuss ways to improve the disclosure of repackaged loans, ultimately enhancing transparency in the market.
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