The Bank of Japan (BoJ) released its October 2026 Financial System Report, concluding that the nation's financial system has maintained overall stability. In the loan market, financial intermediation continues to function smoothly, supported by rising firm demand and an active lending stance from banks. Despite this, the BoJ highlighted several areas requiring close monitoring, specifically the sustainability of global AI-related demand and the potential for shocks to be amplified by the foreign non-bank financial intermediary (NBFI) sector.
In its macro stress testing, the BoJ refined its assessment to include a scenario where a decline in expectations regarding the profitability of AI-related investments triggers significant portfolio adjustments within the foreign NBFI sector. While the results indicate that the stability of Japan's financial system is maintained under these conditions, the central bank noted that the increasing role of private funds in financing hyperscaler investments has made the system more susceptible to global market fluctuations. Major Japanese banks have increasingly focused on overseas lending to foreign funds and data centers to capture high interest rate spreads.
Regarding asset prices, Japanese stock prices have risen, driven by expectations of profit improvements in sectors like electric appliances, precision instruments, nonferrous metals, and machinery. However, the BoJ warned that stocks could face adjustment pressure if profits fail to align with large-scale AI investments. In the real estate sector, prices are rising due to economic recovery and supply constraints, with accelerating price increases noted in the Tokyo metropolitan area. The yield gap for commercial real estate in Tokyo has been declining due to the simultaneous rise in property prices and interest rates.
On the credit side, the BoJ observed that while corporate bankruptcies and default rates remain largely unchanged from pre-pandemic levels, there is significant disparity among small and medium-sized enterprises (SMEs). While the operating profit-to-sales ratio has improved for high-performing SMEs, it remains negative for those in the lower distribution range. The report also examined a hypothetical 100 percent rise in crude oil prices, finding that while the overall increase in default probabilities for SMEs is limited, certain firms with susceptible cost structures could see significant increases in default risk.
Finally, the report addressed the impact of rising interest rates. In the corporate sector, the share of de facto debt-free firms is trending upward, and for firms with borrowings exceeding cash holdings, interest coverage ratios (ICRs) and debt ratios have shown moderate improvement. From a long-term perspective, the BoJ cautioned that a structural decline in loan demand, potentially driven by Japan's population decline, could eventually impact banks' profitability and loss-absorbing capacity.