Unhedged investments threaten Japan banks' overseas profits

This is expanding into leveraged loans and collateralised loan obligations (CLOs).

Japanese banks are turning to overseas profits, but this does not come without cost, Oxford Economics said in a report.

Since the 2008 global financial crisis (GFC), institutions are increasingly relying on loans and higher returns in US fixed income to offset stagnation at home, but hedges are getting expensive and the yield curve is flattening. As a result, unhedged investment is rising and being expanded into leveraged loans and collateralised loan obligations (CLOs).

“CLOs have attracted attention for their similarity to collateralised debt obligations (CDOs), which were at the heart of the GFC. While there are some reasons to be more sanguine about the riskiness of CLOs relative to to CDOs, the former also have important vulnerabilities that could give rise to financial distress, so actual resilience during a crisis is uncertain,” the report explained.

Regulators need to be wary of build-up of associated fragilities, especially exchange rate risk, credit risk and liquidity risk as more institutions go for yields abroad.

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