But so far there has been no risk to financial stability because cheap loans and government grants have sustained vulnerable companies, the BoJ said, preventing any rise in corporate defaults. The report illustrates the world's success in stopping a financial crisis linked to Covid-19 but exposes the risks if there is a weak recovery in 2021 and 2022.

In a scenario where a tepid recovery leads to a high level of corporate defaults, the deteriorating health of banks and resulting limits on their ability to lend "could pose a risk of further downward pressure on the real economy", said the BoJ.

The central bank was watching out for rising credit costs from corporate defaults, losses on the large security portfolios held by banks and trouble in the dollar funding markets lenders use to finance their foreign assets.

There has been little rise in Japanese defaults. That is partly because Japanese companies have stronger balance sheets than foreign counterparts, said the BoJ, and partly because government support has tided over vulnerable businesses such as hotels and restaurants. But it said debt-servicing capacity could weaken, especially in areas where banks took risks before Covid-19 in pursuit of higher yields, such as loans to midsize firms, real estate and financing for merger and acquisition deals.

The BoJ said that international lending by Japan's megabanks was mainly to companies less exposed to Covid-19, such as manufacturers. But it highlighted their involvement in project finance deals, which are suffering from the low oil price, and loans backed by loans to finance aircraft that have been hit by the fall in international travel.

In a severe downside scenario, the BoJ forecast that bank capital ratios could drop to levels that would constrain their ability to lend. Curbs on credit could further harm the recovery, it added.

The central bank said it was watching out for rising credit costs from corporate defaults

• Bank of Japan