In a somewhat shocking break from the age-old tradition of lying and obfuscation, Bank of Japan policy board member Takehiro Sato raised significant concerns about global financial stability in a speech last week. In addition to raising concerns about Japanese economic fragility, Sato warned that due to the impact of negative interest rates, he "detected a vulnerability similar to that seen before the so-called VaR (Value at Risk) shock in 2003."
Financial institutions are facing the risk of a negative spread for marginal assets due to the extreme flattening of the yield curve and the drop in the yield on government bonds in short- to long-term zones into negative territory. When there is a negative spread, shrinking the balance sheet, rather than expanding it, would be a reasonable business decision. In the future, this may prompt an increasing number of financial institutions to take such actions as restraining loans to borrowers with potentially high credit costs and raising interest rates on loans to firms with poor access to finance.
...a weakening of the financial intermediary functioning could affect the financial system's resilience against shocks in times of stress. In addition, an excessive drop in bond yields in the super-long-term zone could also make the financial system vulnerable by increasing the risk of a buildup of financial imbalances in the system.
There is also the risk that financial institutions that have problems in terms of profitability or fiscal soundness will make loans and investment without adequate risk valuation. From financial institutions' recent move to purchase super-long-term bonds in pursuit of tiny positive yield, I detect a vulnerability similar to that seen before the so-called VaR (Value at Risk) shock in 2003.
Simply put, as Bloomberg notes, Sato is concerned the government bond market is heading for an historic collapse after 10-year yields plunged below zero, forcing banks to pile into super-long-term bonds in pursuit of tiny positive yields. This is creating huge concentrated positions with increasing duration risk (as we detailed previously), causing a vulnerability “similar to that seen before the so-called VaR (Value at Risk) shock in 2003,” when an initial jump in yields triggered a spectacular sell-off by breaching banks’ models for estimating potential losses.
The ripples from such a move - as we saw in Germany last year - would be unstoppable given the size, concentration, and leverage of the JGB market.