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Asia-PacificOctober 1 2015

Japan’s smaller banks: a different kind of reinvention

Narrower scopes, smaller balance sheets and limited global footprints are not stopping smaller Japanese banks from reinventing themselves at a time when diversifying revenue sources is key. Stefania Palma assesses their progress.
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Japan’s banking sector is not an easy place to navigate. The country's demographic challenges – an ageing population and shrinking workforce – and macroeconomic issues such as deflation, low interest rates, corporate stagnation and low consumption demand are not making for a smooth ride.

One of the biggest impacts on Japanese banks is diminishing interest income. The country's two-decade-long deflation period saw the Bank of Japan set low rates from as early as the early 2000s. Deflation squeezed local corporates’ capital expenditure demand and low rates squeezed banks’ interest income. This means lenders are having to diversify revenue sources and reinvent themselves.

Without the chunky balance sheets of Japan's mega-banks, diversifying is tougher for smaller banks. But Tokyo-based commercial bank Aozora Bank, and regional banks Tokyo TY Financial Group and Bank of Yokohama, show that smaller banks are developing new fee-based products, expanding their business even through mergers and acquisitions (M&A), and growing international operations.

Solving Japan

Japan’s ageing population and stagnation in the corporate sector are hitting smaller banks as they often focus on small and medium-sized enterprises (SMEs) and local retail customers. And the average age in Japan's regions is higher than anywhere else in the country, leaving many family-run SMEs without succession plans. “We help companies to find a solution through M&A,” says Tatsumaro Terazawa, president of Bank of Yokohama – a regional bank with the largest branch network in the Kanagawa prefecture and south-west Tokyo. SMEs account for 60% of the bank’s loans.

An ageing population also means a shrinking workforce, which is particularly harmful for local economies. “The problem now is that labour demand is stronger than labour supply. There is nearly full employment with an unemployment rate of 3.3% as of July 2015. The solution is to get women or older people to work,” says Mr Terazawa.

In the corporate sector, Japan has lost both competitiveness and dynamism. Long-term deflation and strong depreciation of the yen have encouraged companies to leave Japan and develop factories elsewhere in the Asia-Pacific region. Convincing them to come back is crucial, says Akihiro Kakizaki, president of Tokyo TY Financial Group, a Tokyo-based entity formed by the October 2014 integration of Tokyo Tomin Bank with Yachiyo Bank.

“[Japanese companies] built new world supply chains that do not go through Tokyo at all, taking away business. The major manufacturers are moving to other countries and SMEs are following them. [This has contributed to] financial demand shrinking,” says Mr Kakizaki.

Deflation and low interest rates have also broken banks’ conventional risk assessment mechanisms. Typically, banks differentiate clients’ risk via interest rates on loans – the higher the risk, the higher the loan rate. “But this scheme does not work anymore, especially for low-risk clients. The interest rates we’d set are so low that the spread becomes way too low,” says Mr Kakizaki.

Diversification key

With risk assessment mechanisms failing and interest income dropping, banks are having to diversify revenue sources away from pure lending. In retail, Tokyo-based Aozora Bank is taking advantage of Japan’s ageing population and finding its niche in wealthy older customers. “Most of our customers are 50 years old or above, and the average individual deposit is of Y5m [$42,000] or above, which is about 10 times the average individual deposit in Japan,” says Shinsuke Baba, president and chief executive of Aozora Bank.

Aozora Bank is even growing its interest income, despite low interest rates, by lending abroad, where capital expenditure demand is stronger than in Japan. At the end of March 2015, Aozora Bank’s ratio of foreign to total lending was 27%. “Our interest income in fiscal year 2014 increased [by Y6.3bn year on year to Y50bn] as a result,” says Mr Baba.

Outside of Japan, the lender targets local corporates rather than Japanese firms because otherwise it would just be like lending domestically – there is extreme competition resulting in tighter margins, says Mr Baba.

Some 75% of Aozora Bank’s overseas lending targets North America, followed by the rest of Asia and then other regions, including Europe. “In the US, the lending market is large, liquidity is deep and there is transparency in clients’ financials. For a foreign bank like us, it is more comfortable and convenient than other sectors,” says Mr Baba.

But things were not always this rosy for Aozora Bank. Formerly Nippon Fudosan Bank, the lender collapsed in 1998 on an accumulation of bad debt following the 1990s Japanese asset price bubble. In 2000, it started receiving public funds to aid its survival and it was renamed Aozora Bank in 2001. But as a Lehman Brothers unsecured creditor, Aozora was hit hard also during the financial crisis of 2008.  

“The bank went through massive restructuring efforts [thereafter], which were a key turning point for us. Our current business approach comes from these tough times,” says Mr Baba.

But things are turning around. The bank repaid its remaining Y143.3bn in public funds early, in June 2015. Despite the repayment, the bank’s Tier 1 capital adequacy ratio stands at 10.5% – a strong figure by international standards. The ratio could grow by a further 0.5% in the next three years. In addition, between financial years 2010 and 2014, Aozora Bank’s net revenue increased from Y77.9bn to Y92.8bn and net income grew from Y32.8bn to Y43.7bn.

New services

As with Aozora Bank, Bank of Yokohama is also pushing international lending. A surge in loans to Asia has propped up its credit balance to overseas entities by 58.4% to reach Y138.5bn in 2015.

Increasing fee income through new services is another way to diversify revenue sources. Bank of Yokohama has created investment products to protect its customers’ financial assets and purchasing power, as low interest rates deteriorate returns on retail customers’ deposits.

“It is important for [customers] to build investment portfolios rather than just keeping money in deposits. We created a new investment product called the inflation-adjusted Japanese government bonds fund for retail clients,” says Mr Terazawa. The lender also collaborated with Sumitomo Mitsui Trust Bank in launching investment products to maintain and increase clients’ capital and profits, says Mr Terazawa.

Elsewhere, Aozora Bank is focusing on selling financial products such as syndicated loans, investment trusts and derivatives-embedded products to yield-hungry regional financial institutions, whose investment portfolios have been historically dominated by Japanese government bonds. These are now generating low yields due to the Bank of Japan’s quantitative easing. “Their difficulty is an opportunity for us,” says Mr Baba.

Aozora Bank is also focusing on fee-based specialty financing, including real estate non-recourse loans, leveraged buyout domestic loans, recovery financing and buying, and extinguishing distressed assets such as non-performing loans from other banks. “This is our differentiating factor versus other banks. As a result, we even receive fee payments,” says Mr Baba.

Tokyo TY Financial Group is also diversifying revenue sources with services such as Club TY and salary payment service Mae-kyu. Open to all its clients, Club TY offers fee-based financial services including debt restructuring, M&As, entrepreneur support and business matching. Mae-kyu helps Tokyo TY’s corporate clients pay part-time staff, who typically are not paid on set monthly dates. This means corporates need cash for salary payments throughout the month.

“Companies may need the cash before [the usual] pay-day. We give them the cash to sustain these types of salary payments. McDonald’s is one of our clients because it has a lot of part-time staff,” says Mr Kakizaki. As of March 2014, 500 companies and 550,000 people had signed up to the Mae-kyu service.

Beating competition

The reinvention of Japan's smaller banks is made trickier as they often come up against mega-banks, such as Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group and Mizuho Financial Group.

For Tokyo TY Financial Group, whose target area is Tokyo, competition is fierce. “Tokyo has many business opportunities but it is a very competitive market with mega-banks, other regional banks and shinkin banks present in the territory. We need sizeable volume and strong market relations to become the number one bank for SME financing,” says Mr Kakizaki.

The Tokyo Tomin Bank and Yachiyo Bank merger was key in deepening Tokyo TY’s market relations. Tokyo Tomin focused on corporate customers with sales revenues of up to Y1bn, while Yachiyo’s clients had sales revenues between Y1bn and Y10bn. The integration also added Yachiyo’s 30 Kanagawa branches to Tokyo Tomin’s 72-branch network in Tokyo and Yachiyo’s 50 Tokyo branches.

And Tokyo TY’s expansion is not over. It has signed a letter of intent for a merger with ShinGinko Tokyo – a bank set up by the government to support SMEs in Tokyo – and the deal could be finalised in April 2016. Mr Kakizaki says: “This [deal] will allow us to build relationships with the local government and take advantage of its ties to the academic sector and local industries. This can help us service new parts of the city.”

Despite fierce competition, Tokyo remains attractive in Mr Kakizaki’s eyes as it accounts for 10% of Japan’s gross domestic product. And given its role as host, Tokyo will be even more attractive leading up to the 2020 summer Olympics Games. “The construction and tourism industries will be favoured. I am looking at these industries for business opportunities,” says Mr Kakizaki.

Bank of Yokohama also feels its area is overcrowded, but smaller banks might still have an edge over mega-banks, according to Mr Terazawa. “In Kanagawa, there are mega-banks and regional banks, so it is very competitive. [But] generally mega-banks’ customer base is different from regional banks’ as they do not really focus on SMEs, which are regional banks’ main customers,” he says.

Building overseas

Expanding international operations is another way for Japanese banks to diversify revenue sources. While mega-banks have the balance sheet to do this, growing internationally is not an obvious or easy option for smaller banks. “Regional banks like us often do not have sufficient capacity to expand significantly overseas,” says Mr Terazawa.

But it is important for regional banks to operate abroad because when SMEs expand internationally, mega-banks do not support them, says Mr Kakizaki. Due to limited capacity, smaller Japanese lenders tend to establish alliances with local banks first rather than setting up expensive operations immediately.

Bank of Yokohama has signed business agreements with Metropolitan Bank and Trust Company and State Bank of India to support its customers in the Philippines and India, respectively. It also has a branch in Shanghai, and representative offices in Hong Kong and Bangkok. “In the past six years, the number of our customers with operations in Asia has doubled. Apart from meeting their funding needs, we provide legal, tax and labour issues and consulting services,” says Mr Terazawa.

China is the largest foreign market for Bank of Yokohama, followed by Thailand. In terms of growth potential, Vietnam and Indonesia are the strongest, adds Mr Terazawa.

In Tokyo TY’s case, the group supports its customers in China through consultancy Tomin Business Consulting Shanghai. “We have 10,000 corporate clients and 1000 of them have offices or operations in China,” says Mr Kakizaki. Tokyo TY also has business alliances with five regional banks in China and local banks in Thailand, Indonesia, India, Vietnam and the Philippines.

Aozora Bank also prefers collaborating with local banks when investing in Asia, as the region, with its very diverse markets, remains challenging. The lender has links with Singapore’s OCBC, Indonesia’s Bank Central Asia, Thailand’s Kasikornbank and Taiwan’s CTBC.

As for mainland China, Aozora Bank has a Shanghai representative office, but does not plan to grow operations as of now. “But it does not mean we are not interested. Mainland China is a huge market – we cannot ignore it,” says Mr Baba. “We are exchanging views with OCBC and CTBC regarding business in China.”

Not all bad

Although Japan is not an easy market at present, local bankers stress that Japanese lenders are not in crisis. Decreasing interest income, for instance, does not mean banks’ performance is poor overall, says Mr Terazawa. “[Diminishing interest rates also mean] credit costs are declining sharply. [And] with the decline of interest [rates], the value of the bonds is increasing, which is good for bond holders such as Japanese banks,” he adds. Indeed, last year, Bank of Yokohama’s net income (Y67.5bn) was the highest ever recorded.

“Japanese banks’ performance is relatively good. We have fewer credit-related problems now,” adds Mr Kakizaki.

In addition, Japanese banks of all sizes tend to be well capitalised thanks to the strict risk management regimes they implemented following the Asian financial crisis of 1997. The Tier 1 capital adequacy ratio for Aozora Bank stands at 10.5%, for Bank of Yokohama it totals 12.56% and for Tokyo TY it stands at 9.26%. Community-focused local lenders such as Bank of Yokohama, which has a chunky loan-to-deposit ratio of 80%, also tend to have very large deposit bases to fall back on.

Even at a macroeconomic level, Japan’s revival might come sooner than expected, argues Mr Terazawa. “Companies’ profits are rising, the employment situation is improving, and the gap between aggregate supply and aggregate demand is getting smaller. So next year the expectation of inflation will be maintained and I think [Bank of Japan’s] 2% consumer price index target will be reached,” he says.

Dealing with the country’s demographic and macroeconomic difficulties for smaller lenders is even less straightforward than for mega-banks, due to limited resources, smaller balance sheets and a smaller global footprint. But the strategies and performances of Japan’s small banks demonstrate reinvention is occurring across the country's banking sector.

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