Exploratory Scenario Analysis Considering the Growing Presence of Domestic and Foreign Investment Funds

Central banks around the globe have increasingly incorporated the NBFI (Non-Bank Financial Intermediary) sector into their stress testing exercises, including exploratory scenario analyses, reflecting its growing importance in recent years. This paper outlines the methodology used to develop the scenario for the exploratory analysis presented in the Financial System Report (April 2025) issued from the Bank of Japan, which explicitly examines the impact of stress amplified by investment funds on Japanese financial institutions. The scenario considers a case in which investment funds, predominantly open-end funds, liquidate their securities holdings in response to a negative shock in the global financial market and the real economy, similar to what happened during the Global Financial Crisis. The negative shock is amplified through three primary channels: (i) a further decline in asset prices, (ii) a deeper slowdown in the real economy triggered by the asset price decline, and (iii) impairments of investments and loans to overseas funds. The resulting amplifying impact on the capital adequacy ratio by the end of the simulation period (end of FY 2027) is approximately a 1 percentage point reduction for IABs (internationally active banks). The increase in credit costs, stemming from the deterioration of the real economy, broadly reduces the ratio across all banks, while the declines in asset prices and impairments of investments and loans also contribute to the decrease for IABs. Immediately following the onset of stress, the sharp decline in asset prices exacerbates the valuation gains and losses of securities. It is notable, however, given limited data and research available on the NBFI sector, including open-end funds and hedge funds and their potential ripple effects on the broader financial system, our findings should be considered exploratory. They are based on a certain set of assumptions and therefore warrant careful interpretation.