Financial System Report (October 2026)

In global and domestic financial markets, the expansion in global AI-related demand had the effect of improving market sentiment, although uncertainties remained high over the situation in the Middle East. Against this background, stock prices increased, and credit spreads on corporate bonds remained at low levels. However, uncertainties remain high over factors such as the future situation in the Middle East, the profitability and financing of AI-related investment, and developments in the foreign non-bank financial intermediary (NBFI) sector. ThisReportassesses the stability of the financial system under such an external environment. With regard to the foreign NBFI sector, private funds and other entities have been playing an increasingly prominent role as providers of financing amid the substantial increase in global AI-related investment. ThisReportexamines these recent developments and, in its macro stress testing, refines the specification of the impact of a decline in expectations regarding the profitability of AI-related investment and assumes the situation where shocks are amplified mainly by portfolio adjustments in the foreign NBFI sector, thereby assessing the adequacy of banks' capital. While no major financial imbalances have been seen in the domestic financial cycle, developments in asset prices, such as real estate prices and stock prices, continue to warrant careful attention and close monitoring. Furthermore, theReportexamines the effects of the rise in raw material and energy prices reflecting the situation in the Middle East on small and medium-sized enterprises (SMEs), as well as the effects of interest rate increases on the corporate and household sectors. In addition, it assesses banks' profits and loss-absorbing capacity during the phase of policy rate hikes and examines issues surrounding loan and deposit management. Moreover, given that advances in so-called "frontier AI" have further heightened cybersecurity threats, thisReportreviews the efforts undertaken by financial institutions, financial authorities, and other relevant entities. Japan's financial system has been maintaining stability on the whole. In the loan market, financial intermediation has continued to function smoothly as firms' demand for loans has continued to rise and banks' lending stance has remained active. Under these circumstances, no major financial imbalances have been seen in current financial activities. Japanese banks have sufficient capital bases and stable funding bases to withstand various stress situations, specifically including (1) stress equivalent to the global financial crisis that would cause major corrections in financial markets and the real economy at home and abroad; and (2) a compound stress of the materialization of geopolitical risks such as a rise in crude oil prices, together with a decline in expectations regarding AI, and a substantial rise in interest rates, all happening simultaneously. However, it is necessary to continue to carefully monitor the impact that factors such as the future situation in the Middle East, the profitability and financing of AI-related investment, and developments in the foreign non-bank financial intermediary (NBFI) sector have on the financial system through various channels. From a long-term perspective, if a structural decline in firms' loan demand, mainly reflecting the population decline, persists, banks' profitability and loss-absorbing capacity could decline, depending on the supply and demand balance in the loan market. This could lead to a contraction of financial intermediation activities or an overheating, such as an excessive search for yield. From the perspective of maintaining stability in Japan's financial system, close attention is warranted on future developments in the system, while examining both overheating and contraction risks (Chart I-1). The stock prices indicator has continued to deviate upward from its trend, as indicated by "red" in the heat map (Chart I-1). Nevertheless, in terms of stock valuations as of the end of September, price-earnings (P/E) ratios have remained broadly around their average levels since 2008, reflecting an increase in expected earnings per share (EPS), which is the denominator (left panel of Chart I-2). Risk premiums indicated by the equity yield spreads, i.e., the difference between expected equity yields and 10-year Japanese government bond (JGB) yields, have declined somewhat amid rising interest rates, but have remained at relatively high levels from a somewhat longer-term perspective (right panel of Chart I-2). Japanese stock prices have been rising, supported by expectations of profit improvements in sectors such as electric appliances, precision instruments, nonferrous metals, and machinery, which stand to benefit relatively more from the ongoing global expansion in AI-related demand. Thus, Japanese stocks could face adjustment pressure if profits do not expand in line with large-scale AI-related investments by hyperscalers and other firms across related industries. Given that Japanese banks have a certain amount of market risk associated with their stockholdings, close attention should continue to be paid to developments in risky asset prices, including stock prices. Overall, real estate prices have been rising, reflecting the economic recovery and price rises. Real estate prices to rents have largely remained in line with the trend (left panel of Chart I-3). That said, in the three major metropolitan areas, particularly in the Tokyo metropolitan area, the pace of price increase has been accelerating. A surge in construction costs and supply constraints due to labor shortages have likely contributed to the rise in real estate prices. In addition, robust property demand supported by a moderately recovering economy, coupled with demand for investments, including condominium transactions and commercial real estate purchases by foreign investors, has also likely contributed to this trend. The yield gap, which indicates real estate risk premiums, for commercial real estate in Tokyo has been declining due to the increases in property prices and interest rates. It remains necessary to closely monitor developments in the real estate market (right panel of Chart I-3). The presence of the foreign NBFI sector has expanded globally, raising concerns about risks such as the amplification of shocks in the event of stress. Although the share of financial assets held by the domestic NBFI sector in Japan is relatively low compared with other countries, there has been a steady increase in lending to and investment in the foreign NBFI sector by domestic banks, as well as in investments in Japanese stocks and bonds by the foreign NBFI sector, particularly those related to foreign funds (left panel of Chart I-4). Against this background, Japan's financial system may have become more susceptible to fluctuations in global financial markets and developments in foreign investment funds. Driven by strong expectations for growth in AI-related markets, hyperscalers, particularly in the United States, have significantly increased their business fixed investment recently. While hyperscalers have traditionally financed data center investment with their internal funds, they have recently increased external financing mainly through corporate bond issuance and have increasingly sought to secure rights to use third-party data centers via long-term lease commitments (middle and right panels of Chart I-4). Against this background, foreign NBFIs, including private funds, have been playing an increasingly prominent role as providers of financing for the part of such investment that hyperscalers cannot cover with their internal funds. In addition, the share of AI-related stocks in the portfolio of hedge funds conducting global equity investment has been increasing. If expectations regarding the profitability of AI-related investment were to decline, shocks could be amplified, mai