By Makiko Yamazaki

TOKYO Japan's financial regulator will closely monitor how central bank policy impacts regional banks, as the world's third-largest economy approaches the normalisation of its monetary settings after years of massive easing.

The Financial Services Agency (FSA) "will monitor how potential changes in the financial markets and client situations will affect regional banks' profits and health," the regulator said in its annual policy outlook released on Tuesday.

The Bank of Japan last month modified its yield curve control (YCC) scheme and allowed interest rates to rise more flexibly, a measure officially targeted to sustain easing but seen by markets as a prelude to dismantling decades of stimulus.

Higher interest rates could increase unrealised losses on domestic bonds held by Japanese banks, although such losses could be offset by stronger net interest margins from their lending business.

Large banks have shortened the duration of their bond portfolios in anticipation of higher yields, but analysts say some smaller, regional banks do not have such flexibility.

The FSA said in the policy outlook that it would "encourage regional banks to take necessary steps ahead of time" to address potential changes in the financial and economic situations.

The policy outlook, set yearly, lays out guidelines for the FSA's supervision and direction of banks and other financial firms. It also summarises upcoming legislative amendments.

(Reporting by Makiko Yamazaki. Editing by Sam Holmes)