By Leika Kihara
NAGOYA, Japan (Reuters) - Bank of Japan Governor Haruhiko Kuroda said on Monday the central bank was aware that prolonged ultra-loose monetary policy could squeeze financial institutions' margins and potentially destabilise the country's banking system.
Given subdued inflation and uncertainty surrounding overseas economies, however, he said the BOJ needed to maintain its massive stimulus programme while keeping a watchful eye on the merits and costs of its policy.
"The BOJ fully recognises that, by continuing monetary easing, financial institutions' strength will be cumulatively affected," Kuroda said in a speech to business leaders in Nagoya, central Japan.
Japan's banking system could destabilise in the event of a severe negative shock, if financial institutions more actively take on risk to make up for narrowing margins from years of low interest rates, he said.
"Although these risks are judged as not significant at this point ... the BOJ will scrutinise developments and encourage financial institutions to take action as necessary," he said.
Kuroda's remarks came after minutes released earlier on Monday showed the BOJ's nine-member board discussed the rising cost of prolonged easing at its rate review in September.
"One member said there was room to make the BOJ's policy framework more flexible in the future" if the economy continues to expand, the minutes showed.
Another member said the board should discuss how long the BOJ can maintain its stimulus programme, given perceived limits to its policy duration, the minutes showed.
While the BOJ will scrutinise financial risks from easing, it also needed to consider uncertainties surrounding Japan's economic outlook as Sino-U.S. trade frictions and rising protectionism could weigh on global demand, Kuroda said.
"The impact of such problems on Japan's economy is limited for now," Kuroda said. "But if the problems persist, the effect on Japan's economy could become bigger," he added.
"It's necessary to persistently continue with powerful monetary easing, while considering both the positive effects and side effects in a balanced manner," Kuroda said.
Subdued inflation has forced the BOJ to maintain its radical stimulus programme despite the rising demerits, such as the hit to financial institutions' profits from prolonged low rates.
The BOJ kept monetary policy steady last month and Kuroda ruled out a near-term interest rate hike amid risks from global trade disputes.
(Additional reporting by Stanley White in Tokyo; Editing by Chang-Ran Kim and Sam Holmes)