The era of ultra-low interest rates in Japan is now over. Interest rates have been rising gradually over the past few years. This shift has improved banks’ net interest income, allowing profitability to surge after years of stagnation under the prolonged low-rate environment.
At the same time, higher interest rates can also pose risks for the banking sector. Rising rates reduces the value of interest rate-sensitive assets such as bond and loans. Understanding the risks behind banks’ strong performance is therefore important to ensure that the banking sector can continue supporting sustainable growth in the Japanese economy.
In particular, recent pressures on the yield curve highlight the need to assess banks’ resilience to interest rate shocks.
Rise of the yen yield curve
Since early 2025, the yen yield curve has experienced a widening gap between short-term and long-term rates, with long-term rates rising faster than short term rates—a phenomenon known as bear-steepening.
This reflects not only the gradual rise in short-term policy rates, but also several other factors, including evolving inflation expectations, fiscal developments, and supply-demand dynamics in longer-tenor bonds.
The yen yield curve has also been affected by spillovers from bond markets in advanced economies, where fiscal developments and inflation concerns initially drove higher yields.
More recently, geopolitical developments in the Middle East since February 2026, together with rising energy-related commodity prices, have fueled inflation concerns and added further bear-steepening pressures on the yield curve.
Interest rate risk management by major banks
Although longer-term interest rates have risen more sharply over the past few years, the increase was largely well telegraphed. This gave banks time to prepare for the Bank of Japan’s rate hikes.
Japanese banks have adopted several strategies to mitigate the impact of rising interest rates on their securities portfolios, including:
- reducing holdings of debt securities,
- moving debt securities from available-for-sale to held-to-maturity portfolios,
- shortening the duration of debt security holdings, and
- using swaps and structured products to hedge against losses from rising interest rates.
A closer look at the balance sheets of major banking groups shows that overall debt security holdings have not declined materially. However, there has been a clear shift in the maturity profile and accounting treatment of these holdings.
Major banks have reduced holdings of bonds with residual maturities between one and five years, while increasing holdings of debt securities with maturities of less than one year. This has effectively shortened the average maturity of debt holdings and reduced overall duration exposure.
Shorter duration strengthens banks’ resilience against valuation losses arising from higher interest rates. In addition, banks have expedited the transfer of securities from available-for-sale to held-to-maturity portfolios, suggesting they adjusted positions early to minimize mark-to-market losses from rising rates.
Estimated interest rate risks
Given these risk management strategies, we assessed the resilience of Japanese banks to interest rate shocks using the international framework for interest rate risk in the banking book (IRRBB).
One key measure under the framework is the Economic Value of Equity (EVE), which captures the net present value of cash flows from a bank’s assets and liabilities. EVE can be used to estimate how changes in interest rates affect the economic value of banks’ balance sheets.
The results suggest that Japanese banks have improved their resilience to rising interest rates over the past few years.
In general, rising interest rates tend to reduce banks’ EVE. However, Japanese banks appear to have strengthened their balance sheets through proactive asset-liability management and improved risk mitigation practices. These measures have reduced the sensitivity of EVE to changes in key interest rates.
More importantly, stress test results suggest banks have also become more resilient to bear-steepening.
Under a scenario involving a 100-basis-point increase in short-term rates and a more severe 300-basis-point-increase at the ultra-long end of the yield curve, resilience improved due to both lower interest rate sensitivity and stronger capital accumulation.
Policy implications
Our analysis underscores the importance of banks remaining vigilant against interest rate risks.
Banks need to continue strengthening asset and liability management practices as they adapt to the possibility of further rate increases and a structurally higher interest rate environment. Maintaining capital levels that are commensurate with risk profiles will also remain important for preserving banking sector soundness.
Banks should also continue using interest rate derivatives effectively to mitigate potential losses from a higher and steeper yield curve.
At the same time, banks and authorities should maintain close dialogue on interest rate risks amid heightened uncertainty over the interest rate outlook.
Tensions in the Middle East have increased risks to both growth outlook and inflation expectations. Together with spillovers from global financial markets, these developments could further affect yields and increase volatility in the mark-to-market value of yen-denominated assets and liabilities.
Recent developments therefore serve as another reminder of the importance of sound interest rate risk management as Japanese banks navigate this new era of higher interest rates.