The Bank of Japan’s October 2026 Financial System Report assesses Japan’s financial system as stable, with no major imbalances in financial activity and sufficient capital and funding to withstand severe shocks. Expanded stress tests incorporate weaker expectations for artificial intelligence (AI) investment returns and shocks amplified by nonbank portfolio adjustments. The assessment nevertheless highlights vulnerabilities from overseas financial exposures, rising interest rates and asset prices, alongside growing cyber threats. The revised compound stress scenario combines higher oil prices and interest rates with falling AI investment expectations, sharper economic weakness in Asia and market disruption amplified by nonbanks. Average capital ratios remain above regulatory requirements across institution categories, although the Common Equity Tier 1 ratio for banks subject to international standards falls to 8.9% at the end of fiscal 2028, compared with 12.8% in the baseline. Growing links with overseas funds could transmit shocks through both lending exposures and Japanese securities markets. Overseas funds and data centers account for 9% and 3%, respectively, of the three megabanks’ overseas lending. These exposures warrant attention to underlying asset values, borrower concentration and potentially rapid drawdowns of committed credit lines during stress. Domestically, higher interest rates are improving core operating profits but increasing unrealized losses on yen bonds, particularly at regional financial institutions. Deposits attracted by higher rates may also be less stable, requiring careful management of funding and interest rate risk. Stock prices remain above trend, although forward earnings multiples are broadly around their average since 2008, while rising property prices and interest rates are compressing commercial property yield spreads. Borrower vulnerabilities are concentrated among smaller firms exposed to energy costs and households taking increasingly long mortgages. Institutions are expected to explain risks and strengthen portfolio management for mortgages exceeding 35 years. The report also reviews responses to frontier AI cyber threats, which could accelerate attacks and shorten the time available to patch vulnerabilities. This follows the May 2026 joint request by the Financial Services Agency and the Bank of Japan for institutions to strengthen controls under management oversight.
Bank of Japan finds financial system stable under expanded stress tests, flags risks from AI investment and overseas nonbanks
The Bank of Japan’s October 2026 Financial System Report concludes that the system remains stable, with average capital ratios above regulatory requirements even under expanded tests combining weaker AI investment expectations, higher oil prices and interest rates, and shocks amplified by nonbanks. Growing overseas fund exposures could transmit market stress to Japan, while rising rates are improving bank earnings but increasing bond valuation losses and funding risks. The report also highlights risks associated with mortgages exceeding 35 years and faster cyberattacks enabled by frontier AI.