Japan will step up surveillance of banks' risk control as interest rises abroad create latent losses in their foreign bond holdings, reflecting concerns about the impact of U.S. monetary tightening on the country's financial system.

The Financial Services Agency "will hold dialogues with the banks about control of market risk" because global interest rate rises had caused unrealised losses on their holdings of foreign bonds, the regulator said in annual policy guidelines released on Wednesday.

Looking for higher returns than have been available locally, major Japanese banks have invested heavily in foreign bonds, mainly U.S. Treasuries. But when yields rise, as they have in response to monetary tightening by the U.S. Federal Reserve and other central banks, the value of bonds falls.

The current round of aggressive foreign interest rate rises has caught major Japanese banks off guard.

Combined valuation losses on overseas bond holdings at Mitsubishi UFJ Financial Group and two other top banking groups stood at 2.656 trillion yen ($19.12 billion) at the end of June, an increase of more than 50% from the end of March.

The Bank of Japan has not joined the global cycle of interest rate rises, because Japan's inflation is still moderate and its economy fragile.

The financial regulator also said it would encourage major lenders to beef up management of risk relating to foreign-currency liquidity, particularly because Japanese banks' market-based currency procurement was vulnerable to sudden market fluctuations.

The regulator added that it and the central bank would conduct stress tests on banks' risk exposures.

This year's policy guidelines mentioned a need to address potential issues related to leveraged buyout financing. Prolonged ultra-low interest rates at home are pushing major banks to look beyond traditional lending in search of yields.

Japan's Marelli Holdings Co, an auto parts supplier that KKR & Co bought with high leverage, entered a court-led restructuring process in June with more than 1 trillion yen of debt. That has caused massive losses at roughly two dozen creditors, including Mizuho Financial Group.

($1 = 138.91 yen)