JAPAN’S financial regulator is running stress tests to see if too much cash in the system is stifling smaller banks’ ability to earn, unlike regulatory tests elsewhere that have been designed to see whether lenders had enough capital to cope with financial shocks.

    Two people with direct knowledge of the process said the Financial Services Agency (FSA) had initiated the tests on concerns that with 10-year Japanese government bond yields near a record low around 0.3 percent, regional lenders in particular could be at risk as the gap between what they pay for deposits and what they collect on loans and bond holdings shrinks.

    The FSA was not immediately available for comment.

    The action highlights one of the unintended risks of Prime Minister Shinzo Abe’s program to end decades of deflation with the support of the Bank of Japan (BOJ), which by injecting monetary stimulus into the economy is helping to keep interest rates at rock bottom.

    Critics say policymakers in Europe should be considering such risks, too.

    The European Central Bank completed a review of the resilience of eurozone banks in October and came under fire for not including a deflationary scenario in its stress test hypotheses, even though inflation and bond yields in much of the region are hovering barely above zero.

    ECB Vice President Vitor Constancio defended the omission by arguing that a “deflation (scenario) is not there because indeed we don’t consider that deflation is going to happen.”

    It was not immediately clear what scenario or assumptions the FSA was using in its assessment of the risk to regional and smaller banks, nor how the agency would follow up with lenders that appeared to be at particular risk from a period of persistently low, long-term interest rates.(SD-Agencies)