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Asia-PacificApril 22 2014

Japan's banks return to health, if not profitability

After years of rationalisation and restructuring following the Asian financial crisis in the 1990s, Japan's largest banks – Mitsubishi UFJ Financial Group, Mizuho and Sumitomo Mitsui Financial Group – are much healthier than their Western and Chinese counterparts, but they are still struggling to increase profitability.
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Japan's banks return to health, if not profitability

The collapse of the Japanese economy in the 1990s, and subsequent proliferation of non-performing loans (NPLs), forced the country's financial sector into a long, painful period of adjustment. This, according to Yoshinobu Yamada, senior analyst at Deutsche Securities, occurred largely after the Asian crisis, between 1997 and 2003.

“Banks shed 30% of their workforce and in the 2000s, after the public funds injection they received reduced their expenses considerably. In terms of restructuring, the three mega banks are now about 10 years ahead of their Western counterparts”, he says.

The power of three

These 'mega banks' – Mitsubishi UFJ Financial Group (MUFG), Mizuho and Sumitomo Mitsui Financial Group (SMFG) – are certainly well capitalised, with all three easily meeting the new Basel III common equity Tier 1 ratio final target. Mizuho Financial Group spokesperson Masako Shiono says: “Mizuho's ratio reached 8.16% by the end of March 2013.” Mr Yamada adds: “By the end of September 2013, at 11.6%, MUFG far exceeded the 2019 [common equity Tier 1 ratio] target of 8.5%, which includes the group of global systemically important banks surcharge. SMFG, at 9.9%, and Mizuho, at 8.78%, both cleared the final target of 8% that was set for them”.

The three banks are also profitable, having benefited from recent reversal gains in credit costs, given the very low NPL ratio, which currently stands at about 1.4%. Profits for all three banks for the fiscal year ending March 31, are likely to be the highest recorded since the fiscal year ending March 2006. 

For the first half of the fiscal year ending March 2014, MUFG’s net profit grew by 83% from a year earlier to Y530.2bn ($5.18bn), leading the bank to increase its target for the whole fiscal year by 20%, forecasting net income for the year of Y910bn. Mizuho's net income, for the first half of the fiscal year ending March 2014, grew 133% to Y429.8bn, also increasing its annual forecast by 20%, to Y600bn. SMFG, for its part, recorded an unprecedented Y505.7bn in first-half profit, raising its forecast for the year by 29% to Y750bn. 

One issue, however, that will challenge banks going forward will be capital management. Ken Takamiya, a Nomura bank analyst based in Tokyo, says: “Japanese banks need to explain clearly and consistently to shareholders how they plan to harness their solid balance sheets to strike the right balance between profit growth and shareholder returns.”

Change of tactics

Given the lack of alternative investment opportunities in the country's stagnant economy, banks saw their holdings of Japanese government bonds (JGBs) steadily rise. These went from accounting for 9% of total banking system assets in 2002 to 20% by 2012. Trading in JGBs, for a time, was good business for the banks. As yields steadily declined, they were able to sit back and enjoy the ride up on the value of their securities. 

The three mega banks earned Y660bn from JGB trading operations in the year to March 2013, more than seven times what they earned just five years earlier. However, recent volatility in the bond market has put a stop to this money-spinner. Graeme Knowd, associate managing director at Moody's, says: “Instead of taking on credit risk, banks had been taking on interest rate risks, but there is now more risk that these will increase rather than go down.”

According to the Bank of Japan, banks unloaded 20% of their Y108,000bn in JGB holdings between the end of May 2013 and the end of the following June. At the end of the fiscal year ending March 2013, SMFG's banking unit held Y20,700bn-worth of JGBs. By the end of December 2013, this had been reduced by more than half, down to Y9200bn. SMFG went from posting gains of Y113.8bn in the nine-month period ending December 2012 to Y9.7bn for the same period a year later. MUFG and Mizuho did likewise, cutting their holdings by between 30% and 40% within the same time period. 

Equity rally

In unloading their JGBs, banks repositioned themselves to benefit from the rallying equity markets, which began a bull run in late 2012. This allowed them to offset their diminishing returns on JGBs. Miki Murakami, director of financial institutions at Fitch Ratings, says: “For the full fiscal year ending March, bond gains are likely to have fallen substantially, due mainly to the banks' substantial reduction in JGBs. But the impact on earnings should be cushioned by higher equity gains up to the end of 2013, and marginal credit costs.”

The drivers of the rally have been the reflationary polices of Japanese prime minister Shinzo Abe, a weakening yen and increased optimism for the global economy. Tokyo's stock market index, Nikkei, rose by 57% in 2013, hitting a year high of 16,291 by the end of December, its highest level since mid-2007. The major banks profited handsomely. From a Y67.3bn loss a year earlier, SMFG netted profits of Y79.6bn from equity-related investments in the nine months ending December 2013. In addition, banks’ equity-related fees and commissions, such as those from investment trusts, accounting for between 5% and 10% of their non-interest income, also benefited from the rising stock market, with SMFG reporting a 7.6% rise to Y242bn in the final quarter of 2013. 

However, with the recent market concerns, Tokyo stocks, along with other world markets, have taken a nosedive, with the Nikkei stock average hitting a low of 14,008 on February 4, a line not seen crossed in almost four months, wiping 14% off the index since its December high. This looks likely to dent equity-related gains and fees and commissions generated from the sales of equity-related products.

Lending landscape

After Japan’s financial downturn in the 1990s, the total stock of loans fell by about one-third between 1996 and 2005. The country's mega banks derive about 30% to 40% of their gross profits from domestic lending, with the figure rising to between 50% and 70% for regional banks. So it is undoubtedly with a sigh of relief that since the end of 2012 domestic lending has started growing again, climbing for 13 consecutive months at major banks, with growth reaching 2.6% year on year in December 2013, the highest it has been since July 1992. 

However, a spokesperson at Japanese financial regulator, the Financial Services Agency, says: “While banks did increase lending by 3% from last year, compared to the expansion of the monetary base, this is not significant.”

Lacklustre demand for lending at home is compounded by the fact that companies are still only cautiously optimistic about the future, with many taking a wait-and-see attitude before increasing their capital spending. In addition, after years of painful deleveraging, companies are now very well capitalised, sitting on a pile of cash of about Y230,000bn, about the same size as the UK economy, with many companies’ capital structure being totally debt free. These healthy balance sheets are good for keeping credit costs low, but if and when they do start to spend again, they have ample liquidity on hand to fund such expenditures.

It must also be noted that revenues at Japanese banks are still among the lowest in the world. The loan-to-deposit ratio in the Japanese banking industry, a powerful determinant of their net interest margins (NIMs), has declined from 92% in 2000 to 68% in 2012. In addition, according to Naoko Nemoto of ratings agency Standard & Poor's (S&P): “If one were to measure Japan’s banks’ profitability on a net interest income by risk assets basis it becomes apparent just how low profitability is compared with their foreign peers. Japanese major banks achieved 1% versus 2.9% for the US, 1.7% for France and 3% for China, in 2012.”  

In S&P's view, a decrease in lending margins, which is a factor for low profitability, is likely to continue. Increasing the ratio will depend on how successful the government's Abenomics policies are in maintaining growth, defeating deflation and raising short-term interest rates. But, while lending is picking up, margins are still falling, meaning overall profitability from domestic lending remains shaky.

To highlight the point, SMFG reported that its domestic outstanding loan balance at its banking unit had increased by 4.3%, to Y48,500bn, at the end of December 2013 from Y46,500bn a year earlier, but that its lending profit in the fourth quarter of 2013 had fallen 3.2% year on year to Y344.6bn. 

Opportunities overseas

Another reason for the current profitability at the mega banks has been their increased willingness to explore opportunities overseas, given the lack of investment opportunities at home. Overseas lending at the three megabanks now accounts for 22.1% of total lending, up from 13% for the fiscal year ending March 31, 2007. Notable has been the increasing percentage of loans to Asia, which now represents almost one-third of all overseas lending.

MUFG has an emerging Asian loan book three times larger than JPMorgan's, two-thirds of it with non-Japanese borrowers, while Mizuho's Mr Shiono says: “Mizuho aims to be the top financial group in Asia.” 

With European banks retreating from Asia and Chinese banks grappling with mounting debt burdens at home, the field has been left wide open for Japanese banks. The opportunities are certainly attractive. Many Asian markets are underdeveloped with huge swathes of the population without bank accounts. In Indonesia, for example, where there are more than 200 million people, more than 70% of the population has no bank account. Demand for loans is also high, growing by 10% a year in Thailand and 20% in Indonesia. The spreads to be had on these are a lot higher than can be had in Japan. NIMs in Thailand are about 3%, while in Indonesia they range from 3% to 4%, certainly much more attractive when compared to the paltry 1% to 1.5% to be had in Japan.  

In December 2013, MUFG purchased a 72% stake in Thailand's fifth largest bank, Bank of Ayudhya Public. In May 2013, SMFG started the process that will ultimately see it owning a 40% stake in Indonesian mid-sized commercial bank Bank Tabungan Pensiunan Nasional, the maximum share allowed by foreign owners under Indonesian law.

Trouble ahead?

There are concerns about emerging markets, however. As investors adjust to a world of normalised monetary policies and higher rates amid US tapering, emerging economies are being put under increasing pressure. As outflows pick up, higher rates and weaker currencies will have investors increasingly asking how sustainable debts are, which will hurt the underlying economies, accelerating slowdowns in markets such as Thailand and Indonesia.

Moreover, the global economic recovery has been put in doubt with the recent emergence of weak economic data in the US and China. Manufacturing activity in the US, a measure of output, fell substantially in January. In addition, recent US employment figures have been disappointing. In China, persistent worries of a hard landing remain, where the official Purchasing Managers' Index data for January fell to a six-month low, underlying a weakening in both domestic and export orders.

These are not the only concerns for Japan's mega banks. Tighter regulation and tougher liquidity requirements for foreign-owned banks in both the US and Europe will curtail the international growth of these Japanese lenders. All three banks made substantial inroads into the US and European markets during the financial crisis, when they picked up cheap assets from their struggling Western counterparts. The new rules will be especially tough on MUFG, which set a target to become one of the 10 largest US banks by 2016, and, to this end, has made a series of acquisitions in the country. However, it is pressing ahead with this strategy, despite the new rules.

Indeed, across the board, Japan's mega banks remain defiant and unfazed by the challenges that face them. Takashi Morita, a spokesperson for SMFG, says: “We are committed for the long term, and although we may encounter temporary difficulties, we are determined to carry out our strategy no matter what.”

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