Financial System Report: October 2026

In domestic and overseas markets, uncertainty surrounding developments in the Middle East remained high, while expanding global demand related to AI helped improve market sentiment; stock prices rose and corporate bond spreads remained low. In light of these conditions, the Bank of Japan reviewed the stability of Japan’s financial system. The analysis is based, in principle, on information available through the end of September 2026.

In the lending market, corporate funding demand increased, and financial intermediation proceeded smoothly amid financial institutions’ proactive lending stance, with no major imbalances evident in current financial activity. Financial institutions were assessed as having capital and stable funding bases capable of withstanding stresses combining a Lehman-style shock, geopolitical risks, a decline in expectations for AI, and a sharp rise in interest rates.

If the structural decline in corporate borrowing demand, driven in part by population decline, continues, financial institutions’ earnings and loss-absorbing capacity may weaken depending on supply and demand in the lending market, potentially leading to stagnant financial intermediation or excessive pursuit of yield. To ensure future stability, it is necessary to monitor risks in both directions, of stagnation and overheating, and keep track of developments.

Cyber incidents pose risks to individual financial institutions and users, and are also considered important from a macroprudential perspective because their effects can spread to other financial institutions. Resilience must be strengthened at both individual institutions and across the financial system as a whole.

Stock prices are above trend, while as of the end of September, the PER was broadly in line with its average since 2008 amid rising expected EPS. The spread between the expected earnings yield on equities and the 10-year government bond yield narrowed somewhat as interest rates rose, but remained relatively high over a somewhat longer horizon. The possibility of a stock price correction if earnings growth commensurate with AI investment does not materialize is a concern, and developments warrant close monitoring in light of financial institutions’ equity risk exposures.

Real estate prices rose amid economic recovery and higher prices, while the ratio to rents remained broadly in line with trend. The pace of increase accelerated in the three major metropolitan areas, particularly the Tokyo metropolitan area. Supply constraints, firm property demand, and transactions in investment condominiums and commercial real estate by overseas investors may have contributed. Tokyo’s commercial real estate yield gap declined as prices and interest rates rose, warranting close monitoring.

The share of financial assets held by domestic nonbanks is lower than in other countries, but domestic financial institutions’ investments and loans to overseas nonbanks, as well as overseas nonbanks’ investments in Japanese equities and bonds, have increased, mainly in connection with overseas funds. Capital investment by hyperscalers, particularly in the United States, has grown, with external financing such as corporate bonds and long-term leases becoming more prominent. Private funds and others have gained prominence as funding providers for the portion that cannot be covered with internal funds, and hedge funds’ holdings of AI-related stocks have also increased. If expectations decline, portfolio adjustments could amplify shocks and transmit them to Japan.

The macro stress test refined the scenario of declining future expectations for the profitability of AI-related investment and also assumed amplification through portfolio adjustments by overseas nonbanks. The results indicated that the financial system could remain stable, but the sustainability of global AI demand and its effects need to continue to be assessed carefully.

Corporate bankruptcies and default rates are above pre-pandemic levels but remain broadly flat. Among small and medium-sized enterprises, earnings vary widely, and those in the lower tier remained in the red with little change. Higher raw material and energy prices associated with developments in the Middle East are considered to be weighing particularly on SME earnings. Under an assumption of a 100% rise in crude oil prices, the share of SMEs whose default probability increases is generally limited, although a meaningful rise is seen in some groups of firms with cost structures that make them more vulnerable.

Among businesses, the number of firms with effectively no debt has been rising over time, while ICRs and debt ratios at firms with net borrowing have improved gradually, increasing overall resilience to interest rates. However, the effects vary with dispersion in financial indicators and the type of lending rate. For households, while rates on floating-rate mortgages have risen, improvements in employment and income conditions, including wage increases, are expected to ease repayment burdens. Mortgages have grown in size mainly because property prices have risen, and use of ultra-long-term loans of over 35 years has increased to keep monthly repayments within a certain range. Financial institutions are expected to provide borrowers with adequate explanations and carefully manage risks.

Economic recovery and rising interest rates have contributed to continued improvement in core business net income as credit costs remain subdued, while unrealized losses have expanded, particularly at regional financial institutions with high holdings of yen-denominated bonds. Many financial institutions have reduced their yen bond balances or shortened duration, and the resulting reduction in interest rate risk has helped contain unrealized losses. Regional financial institutions with high loan-to-deposit ratios tend to set higher rates on time deposits; deposits attracted this way may be more sensitive to interest rate and economic developments and less sticky. Financial institutions are therefore expected to manage their positions with market fluctuations and balance sheet changes in mind.

Through on-site examinations and monitoring, the Bank of Japan encourages financial institutions to address potential vulnerabilities. From a macroprudential perspective, it will also continue to monitor the effects of financial institutions’ diverse risk-taking on the financial system.