Fitch has issued a special report assessing the impact of falling stock markets on Japan's major banks and concluded that the indirect impact via their stock holdings is now close to the point where their capital ratios may come under pressure.

"Although Japanese banks have escaped the massive write-downs in their investments and hence the erosion in capital faced by their counterparts in the US and Europe, they are being directly affected by a reduction in unrealised gains in their equity investments," says David Marshall, Managing Director of Fitch's Asia-Pacific financial institutions team. His comments come in the midst of the recent volatility in stock prices, which reflects bearish sentiment in the market attributable primarily to financial instability in the US and Europe.

Fitch notes that falling stock markets presented a problem for the Japanese banks during their long crisis but was alleviated by the rise in the Tokyo stock market from 2003. Now that stocks are falling back to 2003 levels, losses on stock investments are once again posing risks to banks' capital. However, on the positive side banks have significantly reduced their exposure to the stock market in line with stricter regulatory guidelines imposed after the last crisis. The agency estimates that in aggregate the banks' unrealised profits on stocks start to disappear when the TOPIX Index (a representative stock index calculated by the Tokyo Stock Exchange) is around 900. Up to this point, the decline in the market affects only Tier 2 capital as unrealised profits shrink. But when the TOPIX falls below 900, these turn into unrealised losses and start to directly impact Tier 1 capital.

In addition, it is becoming apparent that Japan will experience economic stagnation. "Having experienced a favourable credit environment for several years, when risks were primarily related to yen interest rate movements, Japanese banks now face challenges in the form of credit risks as well as market risks - a new but also an old issue," commented Mr. Marshall. Last week's failure of a JREIT and a medium sized life insurance company will also cast shadows over the credit market, he added.

In its scenario analysis, Fitch combines losses on stock investments with unrealised losses on "other" securities (in practice mainly structured investments) and concludes that the major Japanese banks in aggregate should still be able to report a Tier 1 ratio above the regulatory minimum of 4pct even if the TOPIX falls to 600. Such a drop would be unprecedented as the low point reached in 2003 was 770. Nevertheless, even though they escaped the worst of the subprime crisis, the indirect impact via their stock holdings is now close to the point where their capital ratios may come under pressure.

The TOPIX ended at 1,087 on 30th September 2008, when Japanese banks closed their book for their interim period. The level was 10% below the index for end-March 2008. Stock prices further dropped in October; to the 800s level on the 10th.