Here's why most Japanese banks could tolerate a 3 percentage-point rise in interest rates

They can still meet required capital levels.

Most Japanese financial institutions could meet required capital levels even if interest rates rise 3 percentage points from 2012 levels, Standard & Poor's Ratings Services said.

Here's more from S&P:

The bank of Japan (BOJ) aims to defeat deflation within the next two years or so. If realizing this target becomes highly likely, Standard & Poor's expects long-term interest rates in Japan to rise.

On the other hand, the volatility risk of bond prices has been growing in tandem with an increase in the outstanding balance of bonds held by Japanese financial institutions. The interest rates of 10-year Japanese government bonds (JGBs) were around 0.6% before the announcement of the BOJ's monetary easing policy.

Since the announcement, however, they have risen to the 0.9% - 1.0% range and are more volatile. Amid signs that interest rates are already rising, Standard & Poor's analyzed how much the rise in rates could strain Japanese banks and destabilize the financial sector, based on our estimated figures for individual banks.

As a result, even if interest rates rise 3 percentage points from 2012 levels, and if we take Japanese banks' unrealized gains on equity holdings into account, we see most of the banks able to meet the required capital levels by a wide margin. The 10-year JGB rate was about 1.0% as of March 2012. However, there are some banks that are unlikely to reach their required capital levels.

In addition, as the market usually incorporates expectations at an early stage, even an interest rate rise of only 2 percentage points may impact the banking system.

We see a major gap in the banks' tolerance for an interest rate rise by their amount of bond holdings and capital ratios. If interest rates rise 2 percentage points and if we do not take the banks' unrealized gains on equity holdings into account, about 40% of a total 112 city and regional banks (as of March 31, 2012) would fail to meet a 5.5% required capital adequacy ratio for city and regional banks.

Under a 2 percentage point rise in interest rates and a 5.5% required capital adequacy ratio, and we take unrealized gains on equity holdings into account, those banks as a whole would need to reduce their risk assets by about \18 trillion.

The impact of an interest rate increase differs according to the economic circumstances. If the strategy to revive Japan's economy that Prime Minister Shinzo Abe's administration has spelled out--dubbed "Abenomics"-- and the monetary easing measures that the BOJ has implemented gain traction and accelerate growth, they would bring about advantages for the banks such as loan growth and a decrease in credit costs.

This may mitigate the negative impact of a rise in interest rates. On the other hand, if an economic recovery ends up short-lived and undermines confidence in financial discipline, it may trigger a rise in rates.

In this case, we believe the impact of the interest rate rise on financial institutions would be more serious. In our view, financial institutions would be better positioned to withstand interest rate risk if they enhance their risk management and improve their capital, profitability, and soundness of assets, by developing various risk scenarios, including a rise in interest rates.