Japanese banks in a higher-yield world

Recent changes in Japan’s fiscal and monetary policies have altered market dynamics. Whether Japanese banks will benefit from these developments or not remains to be seen.

For most of the past two decades, Japanese banks operated under a monetary regime that effectively limited interest rates from generating solid profits. During this time, the Bank of Japan (BOJ) maintained negative short-term rates while the lending rate stayed at 0.3 per cent and deposit rates were practically non-existent. Under such conditions, banks were constrained by extremely narrow interest margins.

The domestic environment has changed recently. Since 2024, Japan’s monetary and fiscal landscapes have shifted in ways that could reshape the outlook of the banking sector. Rising government bond yields and the gradual normalization of interest rates may allow banks to expand their margins. At the same time, higher yields could introduce new risks through greater market volatility and weaker credit demand.

The question is whether Japanese banks are entering a sustainable profitability upswing where interest rate and bond yields matter or they are merely experiencing a short-term adjustment to a higher-rate environment.

The return of rate spreads

Two notable shifts have shaped Japan’s financial markets after the pandemic.

The first is the BOJ’s departure from its historically ultra-low interest rate regime. In March 2024, the central bank began gradually raising the short-term loan rate, initially at 0.1 per cent. It has been raised three more times since to reach 0.75 per cent, as seen in Graph 1. These changes are aimed at ending deflationary pressures and achieving the 2 per cent inflation target.

The second shift comes from fiscal policy. New Prime Minister Sanae Takaichi introduced a more expansionary fiscal stance aimed at cushioning households from rising living costs. Financial markets have reacted by pushing Japanese government bond yields higher as investors reassess the future path of public debt.

While much of the discussion is focused on household finances and inflation, the implications for the banking sector are equally important. Rising yields and higher policy rates fundamentally alter the profit dynamics of Japanese banks, which have long operated under relatively narrow lending margins. In theory, higher interest rates should benefit banks: lending margins widen when loan rates rise faster than deposit rates. However, rapidly increasing yields also create financial stress by pushing bond prices lower and discouraging borrowing.

Japanese banks remain widely regarded as stable institutions with strong capital buffers and reliable funding bases. Even during periods of global financial stress, their balance sheets have remained comparatively resilient. Nevertheless, profitability has been constrained by Japan’s prolonged low-rate environment.

Despite the gradual increase in the key borrowing rate, interest rates on bank deposits have risen far more slowly and remain below 0.4 per cent. This has resulted in an average margin of about 0.5 percentage points since January 2025 as evidenced in Graph 1, allowing banks to benefit from the widening spread.

Another structural factor works in banks’ favour. Japanese depositors are savers by nature regardless of interest rate changes, meaning banks do not need to aggressively raise deposit rates to keep these funds. This funding stability allows banks to maintain wide spreads even when lending rates rise.

Holding on to bonds

Since 2022, Japanese long-term government bond yields have been on an increasing trend, even reverting to levels last seen in 2007-2008. The uptick accelerated following Takaichi’s expansionary fiscal agenda, which pushed yields above 2 per cent.

Logic suggests that when yields rise, the market value of previously owned long-term issued bonds declines. For Japanese banks that hold large shares of fixed income and other securities, such increase will affect their balance sheet valuations.

Graph 2 shows that securities accounted for over 30 per cent of all banks’ assets prior to 2012 but had declined beginning mid-2010s before stabilising starting 2022 at an 18 per cent share. This suggests that recent increases in yields have not affected the overall securities holdings of Japanese banks in a significant way.

Meanwhile, the structure of bank income has begun to change. Net interest income – the difference between interest income and interest expense – has been historically wide among Japanese banks. However, interest expense increased sharply post-pandemic, narrowing the net interest income, largely driven by increased interest expense by city banks. Much of the increase appears to have been driven by higher funding and hedging costs rather than a dramatic rise in deposit rates.

Over the longer term, net interest margins of Japanese banks have consistently declined, even among megabanks, reflecting years of ultra-loose monetary policy and compressed lending spreads. However, the BOJ’s about-face in the policy rate was envisioned to overturn this trend. If lending rates continue to rise faster than deposit rates, banks could benefit from widening spreads, allowing the sector to regain some profitability after decades of operating in an ultra-low-rate environment.

A turning point

For investors, the outlook for Japan’s banking industry now depends on how smoothly the transition towards higher interest rates unfolds.

If the BOJ continues tightening rates gradually while maintaining financial stability, banks could finally experience a sustained improvement in profitability. Wider lending spreads combined with stable deposit funding would mark a significant shift from the conditions that defined the past two decades.

However, if yields rise too quickly, bond market volatility and weaker credit demand could limit potential gains. Demographic trends also continue to weigh on domestic deposit and loan growth, particularly outside major metropolitan areas.

After decades of a near-zero interest rate era, Japanese lenders are once again exposed to shifts in the interest rate cycle. Whether this transition unlocks a long-awaited profitability renaissance or a new source of volatility will depend on how effectively banks can manage the opportunities and risks in a higher-yield world.