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(Adds quotes from former officials, context)
By Sumio Ito and Leika Kihara
TOKYO, Aug 8 (Reuters) - Japanese financial authorities are joining forces to scrutinise for the first time banks' exposure to a potential spike in interest rates, with a focus on the risks to regional lenders when the central bank eventually ends its massive easing.
Japan's 105 regional lenders hold 40.8 trillion yen ($400 billion) of Japanese government bonds as investment, equal to about 8 percent of gross domestic product. Policymakers worry that if economic growth picks up or investors think the central bank is leaning towards tapering its JGB purchases, yields could surge and the value of the JGBs held by the banks would fall.
Regional banks have been in a bind. With local economies depopulating in this fast-ageing society, loan demand tepid, and scant resources to seek profits overseas, they have little alternative for their huge deposits - about half of the country's - but to hold JGBs.
While the risks look small now with Japan's economy recovering and interest rates extremely low, the country's financial authorities are not letting down their guard. The health of regional banks is key to the stability of the financial system and the livelihoods of millions of people.
The Financial Services Agency and the Bank of Japan are scrutinising the smaller lenders' interest-rate risk as they jointly step up their "macroprudential" oversight - looking to identify and minimise risks to the financial system amid broad shifts in the economy, people involved in the process say.
"At present, interest rates are very low and stable, but we don't know when or how the financial environment will change," the FSA's new commissioner, Kiyoshi Hosomizo, told regional bank heads in a private meeting last month, according to a person who attended the meeting.
Regional banks, which sit below the five major banks in Japan's financial pyramid, have total deposits and loans roughly equal to the biggest lenders but are largely tied to shrinking local economies outside the vibrant big cities. They vary greatly, with the market value of the listed banks ranging from over $7 billion for the Bank of Yokohama Ltd just outside Tokyo, to barely $50 million for Howa Bank Ltd in the western city of Oita.
The FSA, the financial industry regulator, has been prodding regional lenders to consider mergers and acquisitions for greater efficiency to cope with the bleak economic outlook. So far, the local bank chiefs have shown no willingness to give up their local fiefdoms and consolidate.
"Regional banks just can't find any profitable bank loans in their regions because regional economies are decaying with the demography," said Takashi Kozu, former head of the BOJ's Bank Examination Division and co-chair of a Basel Committee working group on macroprudential supervision.
While stronger institutions could handle higher rates, "those banks with thin capital buffers will suffer seriously," said Kozu, chief research fellow at the Ricoh Institute of Sustainability and Business. "Therefore the FSA and BOJ are trying to be vigilant" on rate risks.
The plan by Japan's public pension fund, the world's biggest at around $1.24 trillion, to tweak its portfolio weightings and invest in higher-yielding assets is also fuelling talk of a rise in JGB yields. The fund will likely cut its weighting for JGBs to around 40 percent from a current 60 percent target, two people with knowledge of the allocation review told Reuters on Thursday.
The FSA and BOJ set up a joint task force in June to share information on the nation's financial institutions, with a new focus on systemic risks. The rate risk for regional banks was highlighted in a July report by the bank regulator.
The FSA's future stress tests will include simulations of higher rates on banks and the broader financial system, one source said. Spokesmen for the FSA and BOJ declined to comment.
The FSA is expected to put more focus on macroprudential oversight when it compiles its annual bank-inspection guidelines in the next month or so, people familiar with the inspection process say. It is unclear if the authorities will take new regulatory action.
The FSA, whose inspections have focused on the health of individual banks, is tapping the BOJ's expertise on financial-system stability to ensure a smooth transition out of nearly two decades of deflation, the sources say.
While BOJ Governor Haruhiko Kuroda says it is too early to discuss winding down the central bank's 16-month-old "quantitative and qualitative easing", the recent attention on interest-rate risk shows that in practical terms Japan's financial authorities have begun eyeing the exit.
Kuroda's central bank has crushed Japan's market interest rates - the 10-year JGB yields barely 0.5 percent - by purchasing 70 percent of the government's debt issuance in an unprecedented monetary easing.
The BOJ estimates that most banks have capital buffers to withstand a 2 percentage-point rise in long-term rates. But a 1-point rise would hit regional banks with 3 trillion yen ($29 billion) in valuation losses on their JGB holdings, more than the 2.6 trillion yen estimate for the more profitable major banks.
Regional banks hold less in JGBs than the major banks relative to deposits or assets. But policymakers privately worry that the smaller lenders have made little progress in trimming their bond holdings while remaining reliant on longer-term debt and lacking other outlets for their cash.
Since the global financial crisis, Japan's major banks have greatly reduced their interest-rate risk by shortening the duration of the debt they hold - making them less vulnerable to rising long-term yields - and selling down their government bond holdings, the FSA said last month in its Financial Monitoring Report. Regional banks, by contrast, have offset their JGB decreases by purchasing corporate debt, the report says.
Major banks slashed debt with more than five years to maturity to 13 percent of their holdings by March 2013 from 23 percent in 2008, while regional banks held flat at about 50 percent in longer-term debt, according to data compiled by Japan Macro Advisors.
The BOJ and FSA believe Japan's banking system remains sound with no immediate signs of financial imbalances.
"The authorities are always monitoring and they can take precautionary steps like using administrative guidance behind the scenes to get a weaker second-tier regional bank or savings and loans to increase its capital," said former FSA commissioner Hirofumi Gomi, an adviser to the law firm Nishimura & Asahi.
Still, the BOJ is becoming more mindful of the potential drawbacks of its easing and the market volatility it may cause when it starts to wind down the stimulus.
"In general, it's true that prolonged monetary loosening could lead to future financial imbalances as markets engage in excessive risk-taking," Deputy Governor Hiroshi Nakaso told a news conference last month.
"There are various debates on what roles macroprudential policies and monetary policy should play in addressing financial imbalances," said Nakaso, who has played a key role in enhancing macroprudential policies and is spearheading recent coordination with the FSA. "Still, I think there's a certain role monetary policy can play." ($1 = 102.1500 Japanese Yen) (Additional reporting by Takahiko Wada, Ritsuko Ando and Taiga Uranaka; Editing by William Mallard and Ryan Woo)