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The new Financial Services Agency policy on supervision of the banking industry urges regional banks to shift the emphasis of their lending decisions from the creditworthiness of their corporate borrowers to the firms’ business potential. This marks a major turnaround by the FSA, which since the creation of its predecessor in 1998 amid the financial sector crisis has focused on banks’ financial health by getting them to shed nonperforming loans.

The new policy can potentially benefit both the regional banks — whose future profitability is increasingly in doubt with the nation’s aging and shrinking population — and promising small and medium-size companies having trouble getting bank loans to expand their operations due to a lack of collateral or other guarantees. The FSA, however, should be careful so that its new policy won’t constitute excessive intervention by the industry watchdog on the banks’ business. It needs to be mindful of the risk of effectively prodding banks to lend more in its position of power as supervisor.

An FSA survey of the regional banks’ management and their client companies found that they essentially restrict their lending to major companies and local government organizations with low risk of the loans becoming irrecoverable, practically excluding smaller firms that do not have collateral that they can secure against loans. Many blame this risk-averse stance to years of FSA supervision of the banking industry that prioritized cleaning up their bad loans and rigorous assessment of their borrowers’ financial conditions.

The FSA says such a lending policy is hurting the banks’ own prospects. The banks compete with each other to offer low-interest loans to a limited range of big firms, and the borrowers’ appetite for loans remains weak even though interest rates are at historic lows under the Bank of Japan’s massive monetary stimulus operations. According to an FSA forecast released in September, more than 60 percent of the roughly 100 regional banks in Japan stand to suffer losses in their mainstay lending operations and sale of financial products in their 2024 business year — compared with the roughly 40 percent that sustained such losses in 2014.

The regional banks’ business environment is increasingly severe, with many of the nation’s regional economies reeling from the aging of the population and exodus of younger workers to major metropolitan centers, which erodes demand for funding by local banks. The BOJ’s protracted monetary easing has also hurt their earnings. The negative interest rate policy introduced by the central bank in February further cut their profit margins on lending, with 69 of the 83 regional banks listed on stock exchanges expecting to suffer lower net profits in the year to March 2017. The FSA says the banks, for their own survival, need to switch to a new business model by seeking out new borrowers.

The FSA seeks to change the banks’ lending practices by introducing a new set of indexes that gauge each of the bank’s contribution to the regional economy they serve — in a turnaround from its supervision policy that focused on the banks’ disposal of nonperforming loans and stringent assessment of risky assets. This way, the FSA hopes the banks will lend more to small and medium-size local businesses that may be short on creditworthiness but have promising potential. Such firms expanding their operations with greater support from local financial institutions and contributing to revitalizing the region’s economy should indeed be a win-win for both the banks and the loan recepients.

The banks still need to be aware that the turnaround in the FSA’s policy will be no guarantee against the risks involved in lending to less creditworthy borrowers. The business climate remains tough in regions that face an exodus of young workers and a slump in consumer spending due to the aging of the local population, and loans to businesses in such an environment will carry the risk of turning sour. The FSA will need to be fully aware of such risk as it pushes regional banks to alter their lending practices.

The FSA reportedly plans to assess the banks’ contribution to the regional economies by looking at the number of local businesses whose performance has improved with support from the banks, non-collateralized loans extended by the banks and cases in which the banks facilitated the launch of business startups with their funding. It will also try to prod them to change their lending practices through hearings of both the banks and their clients.

Since its tough inspection policy has no doubt played a key role in the banks’ caution against risky lending today, the FSA’s new policy should have a certain impact on the mindset of the banks. But it is the job of banks in the first place to explore and support promising business projects of their clients by weighing their potential against the risks — without being prodded by industry regulators. The watchdog should exercise caution in implementing its new policy so that it doesn’t go so far as to dictate the banks’ actions.

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