Industry Rakes in Over 1 Trillion Yen Amid Government and Bank of Japan Turmoil

In Effect, ‘Burden on the Public’!?

The Bank of Japan’s interest rate hike at the end of July triggered a global stock market decline. Although emergency meetings between the government and the Bank of Japan were held, and numerous “damage control comments” from the Bank’s vice governor were issued, market turmoil persists. Amidst this chaotic drama, there is an industry reaping significant benefits: the banking sector.

The interest rate applied to excess reserves in current accounts has been raised from 0.1% to 0.25%, with the entire industry expected to see “over 1 trillion yen in revenue.” Moreover, this increase in revenue is said to lead to a “real burden on the public.” Experts provide an explanation.

With money deposited by individuals and businesses, the Bank of Japan’s current accounts earn interest.

The impact of the turmoil in the financial markets was likely too significant to ignore. There remains an important aspect of the Bank of Japan’s monetary policy changes made at the end of July that hasn’t been thoroughly discussed. This pertains to the statement: “The applicable interest rate for the complementary current account system will be set at 0.25%.” Below is a somewhat technical explanation, but it is very important, so please bear with me.

Private banks consistently deposit money into the Bank of Japan’s current accounts. Due to the rules of the reserve requirement system, banks are obligated to deposit a certain percentage of the money entrusted to them by individuals and businesses into the Bank of Japan’s current accounts. The minimum amount that must be deposited with the Bank of Japan is called the “required reserve amount,” while the portion exceeding this minimum is referred to as “excess reserves.”

The complementary current account system provides interest on these excess reserves. The Bank of Japan pays interest on the money held in the current accounts, though there is no interest on the current accounts of private banks.

 

1.3 trillion yen in effective “taxes” distributed to banks!?

What’s the problem with this? The amount of excess reserves is enormous. The average balance for July (from July 16 to August 15) was 519 trillion yen. With an interest rate of 0.25%, this amounts to about 1.3 trillion yen annually. This will be distributed directly to the banking industry.

Now, here’s the key point: when this significant amount of money flows from the Bank of Japan to the banks annually, the national treasury payments that the Bank of Japan makes to the government decrease. For the government, this means a reduction in revenue. In other words, the interest that the Bank of Japan pays to banks can be viewed as an effective burden on the public. To avoid misunderstanding, it’s almost like distributing tax-like money to banks.

 

But the story doesn’t end here. As will be discussed later, if there are no adjustments to the Bank of Japan’s monetary policy in the future, the interest on excess reserves will increase every time the policy interest rate is raised. If the increase is from 0.25% to 0.5%, and if excess reserves amount to 500 trillion yen, the interest could reach 2.5 trillion yen annually.

The Bank of Japan’s cash flow turns to deficit, and its balance sheet deteriorates.

As interest rate hikes continue, another issue arises: the deterioration of the Bank of Japan’s balance sheet. Looking at the Bank’s financial statements, as of March 2024, the balance of government bonds held is 590 trillion yen, with an average yield of 0.289%.

If the Bank pays 0.5% interest on 500 trillion yen in excess reserves, the interest expense on these excess reserves would exceed the income generated from government bonds, resulting in a “negative spread.” If this negative spread persists, the Bank’s cash flow could fall into deficit.

Additionally, the government bonds held already have over 9 trillion yen in unrealized losses. Is there any rationale for incurring such risks to pay substantial interest on excess reserves?

 

 

The Federal Reserve faces negative equity and the payment of interest on reserve deposits is not unique to the Bank of Japan.

Now, I would like to shift to explaining from the Bank of Japan’s perspective. First, the policy of paying interest on reserve deposits can be considered an irregular monetary policy for central banks. However, in recent years, central banks in Europe and the United States have pursued monetary tightening, during which the Federal Reserve (FRB) and the European Central Bank (ECB) have also been paying interest on reserve deposits. This is not a unique policy to the Bank of Japan.

As a result, the balance sheets of central banks in Europe and the U.S. have significantly deteriorated. For example, the FRB, which implemented substantial interest rate hikes, experienced a negative spread in 2022. The situation has not improved, and by the first half of 2023, it fell into negative equity, with liabilities exceeding assets. The FRB’s financial results for 2023 show a staggering deficit of $114.3 billion (about 16 trillion yen), the largest in its history.

The Bank of Japan takes the stance that there is “no problem”. Is the deterioration of central bank balance sheets “temporary”?

Regarding the deterioration of the FRB’s balance sheet, opinions within the United States are divided. The prevailing view seems to be that “since the U.S. can issue the dollar as a reserve currency, it will be fine in the long run.” However, since 2023, payments of profits to the U.S. government have stopped, leading to growing concerns as time passes (it’s somewhat abrupt, but I suspect this situation is related to the surge in gold prices).

Naturally, the Bank of Japan also maintains that there is “no problem.” In a research paper published in December 2023 titled “Central Bank Finances and the Operation of Monetary Policy,” it states that “in a scenario where monetary policy shifts toward tightening and the balance sheet contracts, there may temporarily be a deficit; however, in such cases, it is generally expected that profits will eventually recover.”

The purpose of providing interest on reserve deposits is to ensure the penetration of tightening effects.

As mentioned earlier, regular bank current accounts do not earn any interest. So why does the central bank provide interest on banks’ reserve deposits?

Before entering a phase of monetary tightening, central banks in Japan, the U.S., and Europe implemented quantitative easing policies that flooded the financial markets with funds. This led to a sharp increase in reserve deposit balances. If the central bank attempts to tighten monetary policy without offering interest on reserve deposits, what happens? Let’s explain using the Bank of Japan as an example.

Currently, the Bank of Japan’s policy interest rate, the uncollateralized overnight call rate, has a target of 0.25%. If no interest is paid on current accounts, banks will find it pointless to keep funds there and will seek to invest them in short-term financial markets to earn any interest. This would lead to a large influx of funds into the uncollateralized call market, exerting downward pressure on the overnight rate.

As a result, many transactions are likely to occur at rates lower than 0.25%. The daily financial adjustments by the Bank of Japan (BOJ operations) would not be able to prevent this situation, leading to a failure to achieve the desired tightening effect—this is a significant problem.

Therefore, by offering a policy rate equivalent to the interest on reserve deposits, banks can avoid having to engage in short-term financial market transactions. When banks do operate in the uncollateralized call market, they will aim for transactions at rates higher than 0.25%. Consequently, this makes it easier for the Bank of Japan to maintain its target. This understanding is shared among central banks.

 

Does the concept not apply to Japan, which is on the mend from deflation?

However, in Japan’s case, there is considerable room for debate on whether the aforementioned methods are appropriate. In simple terms, if the target is set at 0.25% and the actual short-term interest rates fall below this, one might ask, “Is there any problem with that?”

In cases like the U.S., where the economy overheats and faces severe inflation, rapid and significant interest rate hikes make sense. This is because there is a risk that the effects of monetary tightening could diminish, leading to a delayed response in curbing inflation.

On the other hand, for Japan’s economy, which has endured “lost 30 years” due to serious deflation, there seems to be no urgency to transition to a “world with interest rates.” The “supply-demand gap,” which indicates the divergence between total demand and potential supply capacity, remains negative, and it cannot be said that we are in a phase of economic expansion. Price pressures are weak, and even the Bank of Japan admits that achieving its inflation target of +2% year-on-year is uncertain.

In Japan’s case, rather than worrying about the diminishing effects of monetary tightening, it would be prudent to be more concerned about over-tightening. The fact that the uncollateralized overnight call rate has fallen below the target does not suggest an imminent cause for concern.

Rather, the downsides are becoming more apparent. Banks can earn interest spreads without risk by leaving funds in Bank of Japan current accounts. While reserve deposits are supposed to be merely a means of settlement, they have turned into a market for investment. Given that corporate demand for funds is not robust, substantial excess reserves are likely to persist.

During the era of “negative interest rate policy,” the interest on excess reserves was the policy interest rate.

Personally, I believe that when the Bank of Japan raised rates at the end of July, it would have been sufficient to keep the interest on excess reserves at 0.1%. I anticipate the following counterarguments:

• If the interest on excess reserves is set lower than the policy interest rate, which is the uncollateralized overnight call rate, then the effective policy interest rate will become the interest on excess reserves.

→ This is true, but it is not particularly problematic. During the period of “negative interest rate policy” (up to March 2024), the policy interest rate was effectively the interest on excess reserves. It would be acceptable to either revert the interest on excess reserves back to the policy interest rate or not.

• If the Bank of Japan cannot guide the uncollateralized overnight call rate to its target of 0.25%, it will raise questions about the effectiveness of its monetary policy and undermine its credibility.

→ This too can be understood when considering the enormous excess reserves. Before the introduction of the negative interest rate policy, when the interest on excess reserves was 0.1%, the uncollateralized overnight call rate frequently fell below 0.1%, but this did not become a problem. If we are discussing the credibility of the Bank of Japan, the deterioration of its balance sheet would be a far more serious issue.

 

The question arises whether “subsidies funded by the public burden” are permissible even for the most profitable mega banks.

Some argue that this could be a way to restore the balance sheets of banks damaged by the negative interest rate policy. Perhaps this is the real reason.

However, if we look at the U.S. situation, where the policy interest rate has been raised multiple times in a short period and an “inverted yield” has persisted—where long-term rates are lower than short-term rates—then it makes sense. This scenario has significantly impacted banks, leading to the collapse of several regional banks in the U.S.

In contrast, domestic banks show a completely different picture. While second-tier regional banks are struggling, the earnings of first-tier regional banks have improved considerably in recent years. The mega banks have reported record profits for the fiscal year 2023, with Mitsubishi UFJ Financial Group (FG) and Sumitomo Mitsui FG achieving record highs, and Mizuho FG nearly reaching its highest profit. The combined net profit of these three banks exceeds 3 trillion yen!

Looking at the breakdown of excess reserves, urban banks account for an overwhelming share, surpassing 200 trillion yen. This means that the interest income from excess reserves for the five banks, including the mega banks and Resona Bank, amounts to 500 billion yen (with most coming from the three mega banks). This is where profits that come with a public burden could be provided.

Moving forward, will the Bank of Japan continue to grant interest on excess reserves equivalent to the policy interest rate target, like other central banks abroad? Or will there be a correction at some point? The next monetary policy meeting of the Bank of Japan is scheduled for September 19 and 20. I sincerely hope questions will be raised to the Bank of Japan’s governor during the press conference.