Japan's mega-banks – Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group and Mizuho Financial Group – have faced a number of challenges over the past few years, from the country's low-interest-rate environment to its ageing population. However, by diversifying their revenue sources and geographical portfolios, these lenders are managing to defy stagnant domestic conditions.

The Japanese banking sector has not had an easy ride. It has faced a low-interest-rate environment for decades due to the Bank of Japan's loose monetary policy to tackle almost 20 years’ worth of deflation. Demographically, Japan has an ageing population, low fertility rates and a shrinking work force. A general lack of innovation has seen its corporate sector stagnate, while its small and medium-sized enterprises (SMEs) have struggled to flourish. Until recently, private consumption had remained low for years, while the country's gross domestic product growth shrunk by 0.1% percentage points in 2014. 

This tough environment has affected the performance of Japan's banks. Though well capitalised by global standards, Tier 1 capital for Japan’s mega-banks – Mitsubishi UFJ Financial Group (MUFG), Sumitomo Mitsui Financial Group (SMFG) and Mizuho Financial Group – has slightly deteriorated year on year in 2015, according to The Banker Database. Their pre-tax profits have also declined in the same time period. 

However, starved of interest income, these mega-banks have successfully ventured into new businesses and geographies to diversify revenue sources. Their expansion abroad, the growth of fee-based business and the reorganisation of their entire financial groups have been impressive.

To continue growing, however, analysts say that Japanese banks will need to prepare for the inevitable rise of interest rates at home and will need to focus more on SMEs and the real economy.

Japan M&A

Beating low rates 

Japan’s economy has been experiencing deflation for almost two decades, ever since it raised its consumption tax rate in 1997. The country's core inflation rate reached a record low of -2.4% in 2009. In July 2015, it stood at 0.1%, but the central bank’s inflation target for fiscal year 2016 is 2%, after having failed to hit this level in 2015. To beat deflation, the Bank of Japan has been lowering interest rates since 2001, effectively coining the modern-day term 'quantitative easing'. Japan’s interest rates have remained unchanged at 0.1% since late 2008. In 2014, real interest rates plummeted to -0.4%. (See The Banker's interview with Haruhiko Kuroda.

Despite these low interest rates, lending demand in the country has remained limited. Market participants attribute this to Japan’s failure to implement the structural reforms needed to revitalise the country's economy, its business sector and its labour market; monetary easing alone cannot solve Japan’s macroeconomic woes, they say.

“Under this deflationary and low-interest-rate environment we have had difficulties in increasing our balance of loans. The profit from loans has been declining,” says Koichi Miyata, president and CEO of SMFG.

“There is too much liquidity and a large lending supply, while demand for loans is quite low among consumers and corporates due to a sluggish economic environment. If you look at the money flow in Japan, savings of consumers and corporates are very large while the public sector is the largest borrower,” adds Nobuyuki Hirano, president of MUFG.

Lending demand

But local market participants argue that corporates have recently started increasing their capital expenditure again, meaning lending demand is also on the rise. “Over approximately the past four years, Japanese banks’ outstanding domestic lending balance has consistently increased by 2.5% to 2.6% year on year as we and other banks deploy savings into Japan's industry,” says Mr Hirano. In 2014, SMFG’s issuance of domestic corporate loans increased by 4% (the equivalent of Y1500bn, or $12bn) year on year.

However, this alone is not sufficient to make lending profitable again. “The problem domestically is that even if lending strengthens, the margin of the lending business continues to shrink. And this trend will continue for the next two years,” says Yasuhiro Sato, president and group CEO of Mizuho Financial Group.

Mr Sato does not blame this situation on low rates alone. He believes that Japan has too many banks, especially regional and smaller firms, and that fierce competition is dragging lending rates down further. Consolidating is one of the solutions, he says, and some regional bank mergers have already occurred. But considering how politically charged bank consolidation can be, market participants feel mergers might not materialise swiftly. “It is not easy, but some mergers have already been completed. If we have more severe circumstances in the future, consolidation will quicken,” says Mr Sato.

Japan top banks

Diversifying revenue sources

With limited opportunities for interest income, Japan’s mega-banks are increasingly collaborating with firms in their own financial groups, including securities or trust banks, to offer additional services other than lending and to diversify revenue sources. SMFG, for instance, has acquired securities firm SMBC Nikko Securities and credit card company Cedyna to broaden the group’s business portfolio.

Increasing fee-based income has also been a priority in diversifying revenue sources. This includes offering investment products to yield-hungry Japanese investors who have become less risk averse to diversifying their holdings.

“Japanese households have Y1,700,000bn [$13,670bn] in financial assets, 52% of which are in bank deposits with near 0% interest rates. We provide them with investment instruments such as mutual funds, annuity insurance, equity and wrap accounts for them to diversify their portfolios in terms of products and currencies – US dollar, euro or even emerging markets currencies,” says MUFG’s Mr Hirano.

Mizuho’s Mr Sato believes Japanese individuals are increasingly interested in “products with Asian flavour. To cater to this demand we need some acquisition within Asia".

This new investor trend does not stop at retail buyers. Japanese institutional investors, including Japan Post Bank and the mega-banks themselves, have started diversifying their portfolios away from low-yielding Japan government bonds (JGBs). Indeed, the Bank of Japan has become the largest JGB investor worldwide, with holdings worth $1960bn as of July 31, 2015.

To capture this trend, mega-banks are focusing more upon asset management. Mizuho is looking to set up an asset management company, according to Mr Sato. MUFG is also interested in this business line. “We are trying to increase assets under management, which give us a more solid fee income,” says Mr Hirano. 

SMFG recently acquired Citibank of Japan’s retail banking business, which targets high-net-worth individuals, to help increase its assets under management. “[Citi’s business] has a deposit balance of Y2400bn and has 32 branches only in the metropolitan areas,” says Mr Miyata.

Ageing population

Mega-banks are also finding opportunities for fee-based businesses among Japan’s ageing population. The World Bank estimates that 26.59% of Japan’s population is 65 years old or above, and that population size is slightly shrinking.

While this represents what many would recognise as a fiscal time bomb – as Japan will need to support care, welfare and pension systems to cater for this elderly population – mega-banks have found ways to service older clients. 

“This may be a negative factor, but it is becoming a potential growth opportunity for our fee-based business," says Mr Miyata. "For example, we can help the elderly population preserve inheritance assets,” says Mr Miyata at SMFG. “An ageing population could be a growth opportunity also for our corporate clients in ways such as supporting advanced medical care or nursing.”

Investment banking push

Japan's mega-banks have also been working on growing their lenders' fee-based businesses as a way to strengthen and internationalise their investment banking franchises. MUFG acquired 22% in Morgan Stanley in 2008 and created a joint-venture company  with the US lender in Tokyo that gives MUFG clients access to global capital markets. Since 2008, MUFG has completed seven acquisitions in the US, some through collaborating with the Federal Deposit Insurance Corporation, the independent US government agency designed to maintain stability in the country's banking system.

Meanwhile, Mizuho acquired Royal Bank of Scotland’s North America loan assets for $3bn in March 2014, and hired more than 100 people from RBS’s US debt capital markets (DCM) operations. “[In the US we lend] through Mizuho’s balance sheet and take care of DCM using RBS. If we look at this year’s first quarter, business volume and revenue have almost doubled compared with 2014,” says Mr Sato.

This investment banking expansion is already bearing fruit. As of August 3, Japanese outbound merger and acquisition (M&A) activity reached its highest year-to-date volume on record at $60.23bn, according to Dealogic. This is already about 12% higher than the annual volume for 2014 ($53.4bn). Japan also outpaced China as the most active cross-border acquiror in Asia-Pacific this year.

For the year to date, Mizuho tops the league table for Japanese outbound M&A, accounting for 38.69% of overall deals, according to Dealogic.

“We start the relationship by using our balance sheet [lending], then we add non-interest services such as DCM or equity capital markets or overseas M&A to enjoy the high return on risk-weighted assets [RWAs]. To reach higher capital and return-on-equity ratios, we need high returns on RWAs, and therefore we need to increase non-interest income. We can’t over-focus on lending,” says Mr Sato.

Global race

In addition to building international investment banking franchises, Japanese banks have expanded across the world to put excess cash to work and to diversify revenue sources. Low lending volumes and strong deposit bases mean Japanese banks have extremely high loan-to-deposit ratios. Between 2007 and 2015, the loan-to-deposit ratios of Japan's mega-banks ranged from 65.36% (for MUFG) to 91.37% (for Mizuho Financial Group), according to The Banker Database. 

SMFG aims to generate 15% of its overall revenues abroad for fiscal years 2014-16. Its overseas profit ratio grew from 20% in 2010 to 33% in 2014. MUFG’s proportion of net operating profits generated abroad grew from 15% in fiscal year 2011 to 27% in fiscal year 2014, and is estimated to reach 33% by 2017. For Mizuho, the volume of lending and profits generated outside Japan has been increasing by 20% to 30% year on year.

Indeed, Japan's mega-banks have an even stronger competitive advantage in Asia now that many European peers have retreated to their domestic markets, argues Mr Sato. “French, German and UK banks have not been expanding their business in Asia as much as they used to. They have to shrink their balance sheets due to uncertainty in European economies,” he says.

This advantage could continue as stricter regulation – through leverage ratios, total loss-absorbing capacity, the internal ratings-based approach and Basel III – will have a greater impact upon European institutions than it will well-capitalised Japanese banks, according to many working within the industry.

In addition, thanks to their strong balance sheets and expertise, Japan's mega-banks have been dominating global project finance league tables. “We have been number one in the global project finance league table for the past three years,” says MUFG’s Mr Hirano.

Japanese mega-banks also benefit from a significant hedge on foreign currency loans in the form of huge domestic deposit bases. “As the regulations on capital and liquidity tighten, we have to have a stable, solid funding source. That is exactly what Japan’s domestic deposit base acts as – it is very sticky. We use it to hedge foreign currency loans, in particular of long-term nature such as project finance,” says Mr Hirano.

Asia takeover 

Due to its geographical proximity, strong demographics, highly unbanked populations and enormous infrastructure spending needs, Asia remains a key market for Japanese banks looking to expand. 

Mizuho has more than 40 offices in Asia. However, the situation in China, where the bank has 18 offices, is causing concern for Mr Sato. “Because of the current economic environment I have some uncertainty on whether we should expand further or not,” he says. “Even our Japanese clients are starting to realise that a ‘China plus 1’ strategy is necessary. In addition to their China operations, they need to have operations elsewhere in Asia. That is why Mizuho would like to focus on India, Indonesia and the Philippines.” 

In India, Mizuho has banking branches in Mumbai, New Delhi, Bangalore and Chennai and a securities branch in Mumbai. It will be opening a banking branch in Ahmedabad this fiscal year.

SMFG’s Mr Miyata is also keen on the Indian market, especially now that it has a pro-business prime minister in Narendra Modi. “I am sure that there will be major-scale infrastructure projects to be done in India. We are very strong in project finance, so there are a lot of opportunities for us,” he says.

But it is Indonesia that SMFG appears to find the most exciting out of all the Asian behemoths. “The situation is totally the reverse of what we see in Japan. The population is young and growing. We are going to make a very long-term commitment in Indonesia,” says Mr Miyata.

SMFG has increased its stake in Indonesian lender Bank Tabungan Pensiunan Nasional (BTPN) to 40% – a figure imposed by the Indonesian government to limit foreign ownership in its banks. Still, this is a considerable achievement, since Indonesia is often seen as one of the more protectionist banking sectors in the region. Working closely with the Indonesian regulators and having local advisors, including a former minister, was the key to securing this level of investment in BTPN, says Mr Miyata. As BTPN focuses on serving Indonesian SMEs, this investment should help SMFG tap into second-tier corporate customers in the country.  

MUFG's Asean focus

Despite having a presence in almost 50 countries worldwide, the Association of South-east Asian Nations (Asean) represents a key region for MUFG. Growth in this area is spearheaded by Thailand, where MUFG acquired 72% of Bank of Ayudhya in 2013. It then integrated its Bangkok branch to form the fifth largest bank in the country.  

Away from the Asean region, MUFG carried out a similar-style acquisition in California, where it integrated its business on the west coast of the US with Union Bank to become the 13th largest US bank by deposit balance. This integration model is one that Mr Hirano is keen to use more frequently, particularly in Asean countries such as Indonesia and the Philippines. 

In Indonesia, MUFG already has a significant presence and a 12% foreign currency lending market share. “That’s extremely high. To give you an idea, our market share of [foreign currency] lending in Japan is also 12%,” says Mr Hirano. 

However, notwithstanding the mega-banks’ successful ventures abroad, Japan’s lenders largely remain wary of over-expanding internationally. “What we observed during the Lehman crisis was that those global banks that had expanded too much in foreign markets faced challenges, as foreign businesses are more volatile, and the support from their own home countries was limited. We strongly believe that the home market business is our core and we need to continue to expand,” says Mr Hirano.

Real economy contributions

When it comes to domestic expansion in Japan, local banks are optimistic as they already see the economy improving. SMFG’s Mr Miyata believes there are signs that deflation is reversing. Asset prices (real estate and stock prices) and private consumption are rising – a trend that will only strengthen as tourism in Japan continues to grow – partly on the back of a weaker yen, but also because Tokyo will be hosting the 2020 summer Olympic Games. 

“Wage levels are now increasing. The margin of the wage hike is more than enough to compensate for the temporary negative impact following the 3% increase in consumption tax,” says Mr Miyata.

The strong depreciation of the yen has also benefited local corporates, especially those involved in exports, such as automotive firms. But to strengthen Japan’s industry further, its mega-banks – which have historically focused on servicing top-tier firms at home and abroad – accept that they need to focus more on local SMEs.

“I have to admit that mega-banks in Japan have historically not supported SMEs enough. That has resulted in Japanese society having a limited number of entrepreneurs. At this juncture we have to support SMEs more,” says Mr Miyata.

SMFG is already taking action. SMEs account for half of the lender's 4% increase in issued loans in 2014. In its recent internal reorganisation, SMFG moved to better support its SME customers. “[We now] have a one-stop service for business owners that have retail and SME needs,” says Mr Miyata.

Managing risks

To continue growing and to sustain Japan’s economic recovery in the coming years, the country's mega-banks have one eye on the Bank of Japan’s interest rate increases, a knock-on effect of the US Federal Reserve's tapering programme.

A sharp increase in interest rates could be harmful as it would potentially squeeze the value of JGBs. Though it has been reduced, mega-banks still have JGB exposure. However, if the increase is about 25 basis points per quarter, it will widen the spread between deposits and loans, which is good for the lending business, according to Mr Sato.

More broadly, Mr Sato is worried about the excess liquidity that monetary easing has generated worldwide. “This is one of the seeds of [a potential] crisis,” he says. “Capitalism may have a cyclical trend, so we have to be careful in identifying the weakest link that will spur the next market turmoil. It could be Europe or China,” he says.

Japan’s mega-banks have worked to strengthen their capital bases and diversify revenue sources to withstand the country’s economic stagnation and sustain future shocks. To contribute to Japan’s recovery further, however, there is a widespread acknowledgement that they should better support SMEs. 

And despite some doubts over Japan’s recovery, the presidents of its mega-banks are optimistic about their country’s comeback. To the sceptics, Mr Hirano says: “Japan is addressing its structural issues. Change may not be as quick as expected or as it should be, but it is still happening.”

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