The 48 percent drop in the Nikkei 225 Stock Average since the beginning of 2008 decimated the value of equities held by banks, making it harder for them to maintain capital ratios and limiting their ability to lend. Earlier efforts to buoy bank balance sheets have so far failed to arrest Japan’s descent into what may be the worst recession since World War II.

“Authorities are showing that they will not let a vicious spiral take hold between the financial system and the economy,” said Toru Kitani, who manages the equivalent of $2.9 billion at Sompo Japan Asset Management Co. in Tokyo.

Holders of subordinated bonds get paid after investors in senior debt in the event of a bankruptcy, so the BOJ’s action means the institutional investors will still have an incentive to subscribe to bonds sold by the banks.

The Bank of Japan may today announce an increase in the amount of government bonds it buys from lenders as Prime Minister Taro Aso prepares a third stimulus package to ease the nation’s recession, according to economists.

The Bank of England last week started buying UK government bonds to expand reserves in the financial system and the US Federal Reserve may unveil a similar program this week.

Government bond purchases

More purchases of Japanese government bonds would help avert a jump in bond yields, which have risen on concern that the government will have to sell more debt to pay for the stimulus. The yield on the benchmark 10-year bond rose to 1.295 percent at Tuesday’s close from 1.165 percent.

In the past two days, bank stocks surged on speculation the central bank was considering the subordinated debt purchases.

Mitsubishi UFJ Financial Group Inc., Japan’s largest bank by market value, rose 13.8 percent in the past two days. Mizuho Financial Group Inc. climbed 12 percent and Sumitomo Mitsui Financial Group Inc. added 14 percent.

The government started its attempts to shore up bank capital in December last year by offering to buy as much as ¥12 trillion of preferred shares.

Lenders have been reluctant to participate in that program because of concern a government-sponsored injection of funds could damage their reputations. The preferred shares may also convert into common stock if the lenders fail to pay dividends or if they are unable to repay the funds by a set date. Only three regional banks applied for the funds.

A separate proposal last month by the Bank of Japan to buy stock held by the banks was met by reluctance because the lenders did not want to sell their holdings, after which they would be obliged to book further losses.

Source: Bloomberg