(Bloomberg) — Japan’s financial regulator plans a sweeping crackdown on $67 billion of high-yield loans backed by government bonds and other assets that have gained popularity among regional banks even after officials warned about their risks.
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The Financial Services Agency will scrutinize banks that have increased purchases of Japanese government bonds that are repackaged into loans over the past year, said Toshinori Yashiki, director-general of the agency’s strategy development and management bureau. Brokerages that are actively pitching these products to lenders will also be in the regulator’s crosshairs, he said in an interview on Thursday.
The FSA is stepping up enforcement after it noticed some regional banks are buying more of these products despite the regulator’s warning in January 2024. Officials are also concerned that some lenders lack proper risk management for the opaque products and could suffer mounting losses if market rates move against them.
The regulator has a strong sense “that there are banks that have started or greatly increased repackaged loans since our alert last year,” Yashiki said, without identifying any banks or brokerages.
The amount of regional banks’ repackaged loans, including those backed by assets other than JGBs, was nearly ¥10 trillion ($67 billion) as of September, an increase of about 20% to 30% from a year earlier, according to Yashiki. He declined to say how much of the total was backed by JGBs specifically, only that it was in the billions of dollars.
“Given the growth of these assets, it is understandable that regulators, to mitigate systemic risks, would crack down on the improper use of such loans,” said Michael Makdad, a senior analyst at Morningstar Inc.
The Topix Banks Index of shares fell 1.8% on Friday afternoon in Tokyo, in line with the benchmark Topix’s 2.2% decline.
While Yashiki said it’s the prerogative of bank management to decide what assets to invest in, a closer scrutiny by the regulator is likely to dissuade the lenders from buying the loan products.
These products typically bundle Japanese government bonds or other assets with derivatives contracts to enhance returns. Banks lend money to special purpose companies or other vehicles that use the money to buy government bonds. The banks then receive income from the bonds and the derivatives.
The products are gaining traction because the buyers don’t have to mark them to market, thus avoiding the possibility of booking paper losses. By contrast, when banks hold JGBs directly, they have to account for the declining value of the bonds if interest rates rise.
The FSA is concerned that, depending on how the products are structured, the holders could suffer so-called negative spread. That occurs when the returns become less than what the banks pay out for deposits.
While terms of these loans vary, Yashiki said that the risk of losses depends on how the contracts are structured and the difficulty of unwinding them in a timely manner under adverse market conditions.
“Repackaged JGB loans lack economic rationality, at least in terms of costs and risk returns,” Yashiki said. “It’s difficult to get their fair value.”
There’s no rule requiring banks to disclose these loans, which are also attractive for banks because they count them as lending, adding to their mainstay businesses.
“They are effectively a bond investment. But if banks are buying such loans to avert mark-to-market or to make their loan balances grow, it runs counter to the purpose of disclosure,” Yashiki said. “I doubt such loans will contribute to communities they serve.”
The products hold allure for regional lenders, many of which lack expertise and scale to pursue more diversified investment portfolios like those of the nation’s largest banks. Their revenue sources are relatively limited, as few operate overseas or do investment banking business.
“This may send the buy-side a strong message — particularly to small and medium-sized financial institutions — they they must strengthen their risk management and literacy,” said Hideyasu Ban, a senior analyst at Bloomberg Intelligence.
Securities firms and trust banks that sell these loans will be also put under scrutiny. Yashiki said the agency will examine whether aggressive marketing by some brokerages is one of the factors driving demand.
The FSA will discuss with the banking industry ways to disclose repackaged loans to enhance transparency, he said.
“If this form of product is inappropriate,” said BI’s Ban, “the sell-side will just need to continue efforts to come up with something different for customers who need to solve problems concerning their investment portfolio management.”
