With the collapse of Silicon Valley Bank (SVB) and Signature Bank, the risks of a tightening Fed cycle are on the minds of investors around the world. Few countries are potentially as exposed as Japan, which has exported large amounts of savings into fixed income instruments in the US.

The episode appears to have left a deep impression on Japan’s monetary policy thinking. Nomura Research Institute economist and former Bank of Japan board member Takahide Kiuchi commented to CNBC in March that normalization of Japan’s negative interest rate now may not occur until the second half of next year.

To put that caution into perspective, however, Japan’s inflation has broken 4%, making this Japan’s most significant bout of inflation in decades. Moreover, energy prices, the most important driver thereof, show no sign of falling. Following the above remarks, in early April, Saudi Arabia and other OPEC+ countries announced surprise production cuts. The government was also forced to ask households and companies to save energy over the winter, but gasoline and heating oil subsidies are currently slated to end in May. Japan’s energy sufficiency ratio of 12% ranked 35th out of the 36 OECD countries in 2019; it was forced to reactivate several nuclear power plants to make up for the import shortfall.

Given this external dependence, whatever considerations are causing Japan to risk further weakness in the yen must be more important than its terms of trade on energy. Japan’s 100-odd regional banks, which account for about half of Japanese bank lending, appear to be a major culprit. Having been long singled out for their stagnation but protected by low borrowing costs, the end of the road may finally be approaching for some.

Innovation amidst aging

This corner of Japan’s financial system illustrates the effects of weak demographics over the long term. The rural regions in which many such banks are located have long been beset by demographic aging and depopulation. In 2022, the government designated over half of municipalities as wholly or partially underpopulated.

The financial weakness of regional banks started to be discussed more openly following the 2016 imposition of yield curve controls, which kept 10-year government bond rates around zero. In 2017, Japan’s Financial Services Agency (FSA) reportedly warned about their long-term core profitability, particularly in the case of rate increases. One problem it singled out at the time was an over-dependence on collateral in lending, which favors existing ventures over innovative start-ups.

Since that time, the government has become increasingly assertive about the need for either innovation or consolidation. The topic was a signature issue for Yoshida Suga, who was Prime Minister from 2020-2021.

In 2020, in the wake of COVID, the government started offering financial incentives of up to 3 billion yen for consolidation. It also eliminated some anti-competition rules for mergers between banks in the same prefecture. The central bank also offered higher rates on reserves for regional banks which either improve their profitability or decide to consolidate.

Merging can be an expensive proposition, exacerbated by outdated IT systems. Thus, the government’s plans align with the larger objective of digital transformation, which has often lagged due to aging clienteles.

The government further relaxed certain restrictions on business scope, allowing banks to play a more active role in rural revitalization. It allowed banks to take full ownership of unlisted local companies in areas with few alternative investors, up from 50%. It also encouraged banks to broaden their service offerings into consulting. FSA Commissioner Endo Toshihide admonished, “instead of sitting and waiting for companies to ask for money, why not go to companies yourself offering advice and consultancy on how to find customers and grow your business? If you look at the reality of regional economies, the local businesses themselves are stumped over how to expand. They need support.”

Fitch Ratings noted in 2021 that “diversification into these consulting-type services is a rare form of fee income diversification among developed-market banks.”

Impact limited to stock price

Despite this green shoot, however, the overall financial situation has been difficult. As domestic opportunities gradually dried up over years of low-rate policy, regional banks started accumulating assets overseas. Between 2012 and 2022, the foreign portion of their asset portfolios grew from 10% to 30%. Being the world’s third largest economy, such a large position in Japan is bound to affect US markets. By 2020, Japan accounted for 15% of the entire global market of collateralized loan obligations (CLOs), which provides an important channel for US interest rate policy, as well as exchange rate fluctuations, to affect Japan. Japan is also the largest foreign owner of US treasuries.

The banks now carry some 4 trillion yen of unrealized losses on overseas assets, although they also have strong capital buffers. Government guarantees on the interest for 23 trillion yen in COVID-related loans to SMEs will also come to an end soon, creating a perfect storm. Following the SVB collapse, the Tokyo Stock Exchange banks index fell 16% in three days.

Toshinori Yashiki, deputy director-general of the FSA, characterized worries about regional banks as external in nature. “Overseas media seem to be focusing on Japanese regional banks in association with the SVB collapse, but I'd like to emphasize that they are completely different,” he told Reuters, while also acknowledging that an increase in interest rates would constitute a significant risk.

The central bank largely agreed in a March briefing, while releasing an annual report pointing to certain deficiencies in risk management in regional financial institutions.

Several unique factors contributed to the run at SVB, none of which apply to Japan’s banking sector. SVB’s depositor base was unusually concentrated, which contributed to both the speed of the run and the portion of deposits which exceeded the US $250,000 deposit insurance limit. Furthermore, due to both inadequate risk management and regulatory oversight, SVB’s large holdings of US bonds were unhedged, while most Japanese banks have hedged the currency risks on their overseas bond holdings.

Thus, the main question for Japan is what happens as its bond holdings, and associated hedge contracts, expire. Currency hedging costs rose sharply in 2022, driven by higher short-term borrowing USD costs, according to analysis by Brad Setser and Alex Etra at the Council on Foreign Relations. Thus, Japan has pulled back on its foreign positions on a large scale, even in relation to the US market. Commercial banks reduced their position in foreign bonds from US $850 billion to under US $600 billion over the course of 2022. Japan’s overall net international investment position (NIIP) decreased somewhat more, from US $3.57 trillion in December 2021 to US $3.18 trillion.

Aging population, new energy infrastructure

Implicitly, Japan is paying for gas by drawing down its forex savings. Japan’s trade deficit reached a record of $155.27 billion in 2022, second only to 1979 (a year which also featured an energy crisis), and similar in magnitude to its change in investment position last year. Both the investment and trade trends appear likely to persist through 2023, creating a difficult balancing act for the central bank. It must mop up the excess liquidity that has now returned home due to this technical reason, or else risk further devaluation of the yen as that money once again finds overseas investment targets.

Incoming Governor Kazuo Ueda is however still not convinced that the longer-term trend is inflationary. In his inaugural news conference, he also made note of bank stability concerns following decades of zero rates as one reason for caution when normalizing monetary policy.

The fate of the regional banks is a microcosm of concerns about macroeconomics, demographics, and internal transformation by mature banks. The most important longer-term lesson for other countries with aging populations, including Taiwan, Korea, and even China, is that energy independence is essential for an aging economy. Higher prices hurt retirees in any economy, but local production helps ensure that global energy markets do not impact overall currency valuation. Moreover, super-aged economies might have less ability to respond with agility to external shocks.

Renewable energy infrastructure will often be located outside of major cities, and will be operated remotely. Thus, green financing will allow regional banks to play a role in Japan’s energy transition, rural revitalization, and digital transformation at the same time. First, however, these banks will likely need to survive an industry shake-up.