Bank Risk Taking and Financial Stability: Evidence from Japan's Loan Market

We examine banks' risk taking in lending to small and medium-sized enterprises under the prolonged low interest rate environment in Japan. Specifically, we identify "low-return borrowers," whose borrowing interest rates are low relative to their financial soundness. Using bank-firm level data for millions of Japanese small and medium-sized enterprises, we find that bank loans to low-return borrowers have increased more than those to other normal firms in recent years and such risk taking by banks has been driven by the low interest rate environment as well as the increase in competition among banks. In addition, we show that highly capitalized banks with low profitability increased loans to such vulnerable borrowers more than lowly capitalized banks. These results suggest riskiness of credit allocation has increased in Japan's loan market, but it does not seem to pose an immediate threat to financial stability.