(Bloomberg) -- Japan’s financial regulator is examining how vulnerable lenders would be to a sudden slump in government bonds should the nation’s central bank pivot away from its ultra-loose monetary policy in future. 

At stake is around $1.1 trillion in debt held by megabanks and regional lenders, potentially sparking a wave of markdowns if the central bank loosens its grip on 10-year JGB yields. As of March, just under two-thirds of that amount was held in government bonds, and the remainder in municipal and corporate bonds, according to data from the Japanese Bankers Association.

“Large unrealized losses could happen,” said Toshinori Yashiki, deputy director-general at the nation’s Financial Services Agency, in an interview. “If banks, including regional lenders, are forced to book large losses on securities, even temporarily, it could hurt trust in them,” he said.

Banks in the world’s third-biggest economy are already grappling with widening markdowns on their foreign bond holdings after they were caught off-guard by rapid rate hikes at the Federal Reserve and an ensuing jump in Treasury yields. 

The regulator’s scrutiny now highlights the growing risk of a monetary policy pivot at home after years of yield hunting by Japanese lenders. Nearly a decade of massive monetary stimulus by Bank of Japan Governor Haruhiko Kuroda has driven down returns on loans, bonds and other assets, and markets are weighing the likelihood of policy changes when Kuroda steps down in April next year.

Yashiki stressed the agency is looking at domestic bond portfolios as part of a broader market risk review this year and it has not been prompted by the assumption of any imminent monetary policy change in Japan.

The veteran regulator said the agency increased the number of teams dedicated to checking market risk at lenders to three from two this summer to be able to examine more regional banks.

“There are those whose securities risks have grown significantly,” he said. While it is too early to make any broad conclusion, risk management can be improved at some regional lenders, he said.

Some of these institutions have been buying longer-tenor JGBs in a search for yield, but such securities experience bigger price changes, he said. “So if yields rise, the hits will be bigger. We need to pay close attention,” he said.

At least some traders are betting the central bank will have to tweak its policy of capping 10-year yields as inflation pushes higher. Ten-year Japanese swap rates — which are popular with international funds — were trading around 0.60% Tuesday, well beyond the BOJ’s 0.25% ceiling for the benchmark bond.

To be sure, yen rate hikes also benefit Japanese banks by boosting their lending income. But over time, paper losses can still hurt the health of a lender’s investment portfolio, Yashiki said. 

“By holding bonds with unrealized losses, banks cannot make new investments in higher yielding assets,” he said.

--With assistance from Cormac Mullen.

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