Over the past ten years, Standard & Poor's Ratings Services' average rating on Japanese banks had fallen to the 'BBB' category from 'AA' in the early 1980s. During this period, the major overseas banks were able to maintain ratings in the 'A' category. In 2004, however, ratings on the operating banks in all seven major Japanese bank groups were raised and are now mostly in the 'A' category, narrowing the gap with their overseas peers.
The slump in ratings was the result of a substantial decrease in asset values in Japan, such as real estate, and a combination of falling economic growth followed by deflation since the late 1990s. These effects were exacerbated by thin spreads on bank lending, which hobbled the banks' capacity to write off surging nonperforming loans (NPLs). Banks' large holdings of shares in their corporate groups, which they were slow to unwind, further depressed the credit quality of Japanese banks, because of the major impact of plummeting stock prices.
However, with the economy in Japan finally entering a recovery, most of these concerns have begun to ease, and Standard & Poor's outlook for the overall Japanese banking industry is now positive. In December 2004 and January 2005, ratings on the Japanese major banks and regional banks were raised and outlooks revised upward. The upward revisions reflect diminished concerns over deterioration of the macroeconomic environment and asset erosion risk. Although the economy is now leveling off, Standard & Poor's considers that the operating environment for Japanese banks has begun to improve, evidenced by the progress in debt reduction by companies and the long-term slide in land prices coming to an end in some areas.
Nevertheless, Japanese banks still face many financial challenges. A recovery in the business environment does not directly lead to stabilization in credit costs. Concerns over profitability, particularly whether banks can generate sufficient profits to cover surges in credit costs, remain. While some major banks still have a substantial amount of public funds to repay, their capital quality is also still weaker than their international peers.
The first part of this report focuses on the standalone credit quality of the banks and the impact on their credit ratings from the Japanese government's support for the financial sector. In this section, three major factors that will exert strong influences on Japanese banks' credit quality are discussed: trends in interest rates; corporate performance and funding demand; and profit opportunities from fee businesses. The second part examines accounting policies and regulations on Japanese banking.
Standard & Poor's considers Japan's economic risk to be above average by international comparison. Japan is the second-largest economy in the world in terms of GDP, with diverse industries, high export competitiveness in automobiles and electronics, and a strong external liquidity position. Japan's export sector has been an anchor of stability for the economy over the past several years, with its current account balance showing continued surplus. In addition, large financial assets in the household sector standing at ¥1,424 trillion at December 2004, support liquidity at financial institutions.
Japan's GDP growth rate over the past five years struggled to a weak 1.1%, which compares unfavorably with countries with high economic risk scores. Since early 2003, however, Japan's economy has exhibited signs of recovery. Strong external demand, particularly from China, and investments in machinery and equipment—stemming from the positive effects of corporate sector restructuring and pent-up demand—resulted in real GDP growth of 2.7% in 2003, which was among the highest in developed economies. For 2004, real GDP growth is expected to have remained strong at about 2%. The recovery is likely to slow down in 2005, considering external factors such as unfavorable movements in foreign currency exchange rates or weaknesses in key export markets. However, the current slowdown is not expected to deteriorate into a full recession, largely because the corporate sector is in much better shape than several years ago, as Japanese companies have significantly pared down debt and reduced costs.
Despite these cyclical recoveries, structural weaknesses, such as an extremely high fiscal deficit and an aging population, compound Japan's economic risks. Japan's gross general government debt is high, estimated at 173% of GDP in 2003. In addition, Japan has been in primary deficit for the past several years and its debt-to-GDP ratio is still rising. Japan's rapidly aging population is posing another challenge. In only 24 years, the percentage of those aged 65 years or more doubled to 14% from 7%. Japan's total population might start to fall as early as 2007, according to the best-case scenario of official forecasts, which have been consistently more optimistic than historical data. Combined with its prohibitive immigration policy, basically unchanged for the past 60 years, Japan's demographics will pose significant challenges for fiscal consolidation, maintenance of the social security and health insurance systems, and sustainable economic growth. Solutions to these problems are crucial to achieve a sustainable economic recovery.
Deflationary pressure in Japan, measured by its CPI, has been easing, buoyed by higher global commodity prices, increased demand from abroad, particularly from fast growing China, and continuous monetary easing by the Bank of Japan (BOJ). However, significant depreciation of the U.S. dollar against the yen could offset some of these gains in Japan. At the same time, easing deflation will pose a significant challenge to BOJ. How and when it decides to change its monetary policy from the current stance of maintaining ultra low interest rates and creating excess liquidity in the market, to a more orthodox stance without jeopardizing macroeconomic growth while minimizing the increased interest burden for the country, particularly the heavily indebted central government, is a key issue.
The pace of recovery of the fundamental profitability of Japanese banks is slow, even though asset risks are decreasing steadily. The ratio of operating profit to regulatory capital before deducting credit costs (ROA) over the past five years is an average 0.75% for Japanese banks—still much lower than the 2.59% for most major banks in the U.S. At the same time, ROA volatility at Japanese banks is not significantly lower than that of the U.S. banks (see Chart 3).
The low profitability of Japanese banks is attributable to slim loan-to-deposit margins, the smaller contribution from fee income, and the large proportion of low-profit assets in their total assets. Nevertheless, profitability is likely to improve to some extent in the future.
Lending to SMEs
Fee income improving slowly
High proportion of low-profit assets
As of September 2004, major banks' consolidated total deposits, excluding CDs, far exceeded total lending by about ¥45 trillion. In addition, deposit concentration at major banks with relatively higher credit quality is likely to follow the removal of full government protection for bank savings deposits in April 2005.
The drop in the value of the major banks' bond holdings due to a rise in long-term interest rates is estimated at about 14%-20% of their Tier 1 capital (see Table 6).
Although these estimates do not incorporate the possible profit increase from a rise in short-term interest rates, it is possible that short-term interest rates could remain flat temporarily while long-term interest rates rise. As a result, Standard & Poor's considers that interest rate management will be a key determinant of the banks' future credit quality. In assessing the credit quality of Japanese banks, Standard & Poor's will intensify its focus on the banks' interest risk management, profitability, and risk hedging of bonds holdings.
The capital quality of Japan's major banks is improving, but remains low compared with that of the major overseas banks. This is mainly due to the higher proportion of weaker forms of capital, such as preferred stock, following public fund injections in the late 1990s, and the constraints on earnings from aggressive disposals of NPLs. However, capital quality is gradually improving, as the banks reduce the amount of deferred tax assets and losses carried forward. The capital quality of regional banks is better than that of the major banks, given the lower proportion of preferred stock and deferred tax assets in their Tier 1 capital.
The average Tier 1 capital ratio of the major Japanese banks is notably weaker than that of the major overseas banks (see Chart 7), although there is considerable disparity in adjusted core capital, which is a key indicator in Standard & Poor's credit analysis. The main factor behind low Tier 1 ratios is Japanese banks' high reliance on preferred stock in their capital.
Public funds that were injected as a part of the government's recapitalization measures are being repaid steadily. The total amount to service the fund injections, including repayment of subordinated debt by Mizuho Financial Group and Chuo Mitsui Trust & Banking during fiscal 2004, will have reached ¥3.2 trillion at the end of March 2005. Nevertheless, the public funds are mainly comprised of weak capital, such as subordinated debt and loans. As a result, when and how the public funds injected in the form of preferred stock will be repaid will be a key issue for the banks' capitalization. Although the impact of each repayment method will be different these include: repayment by buying back the stock; selling preferred stock to a third party; and selling the stock as common stock in the market. In general, the buyback method, which was executed by banks such as Mizuho Financial Group, results in a drop in its capital and therefore has a comparatively negative impact on its credit quality. The sale to a third party, executed by Bank of Tokyo-Mitsubishi and Sumitomo Trust & Banking Corp., has a neutral impact, given the level and structure of its capital account remains unchanged. The other method of selling preferred stock as common stock in the market, executed by Bank of Yokohama, has a positive impact on its credit quality, given the stock conversion will lead to an improvement in its capital quality, while the current level is maintained. Nevertheless, even if a bank adopts the first or second methods, the impact on Standard & Poor's ratings on the bank would be limited given this scenario has already been incorporated in the ratings analysis since the public funds were first injected. On the other hand, the ratings on the banks could be raised or outlooks revised to positive if the banks select the third method or convert preferred stock into common stock after selling to a third party.
The key challenge for Japanese banks in improving their credit qualities is their ability to successfully enhance profitability. Since the banks' nonperforming asset problems have bottomed-out, the next hurdle is to ensure continuing profitability to sufficiently cover their credit costs. The low quality of capital of banks remains a big problem, but profitability is the more crucial factor, since increased profits can improve capital quality through greater sums of retained earnings and the redemption of preferred stock.
Japanese banks and their credit qualities are very sensitive to changes in interest rates, corporate performance, and fee income. These factors and their likely credit impacts are described below.
Interest rate trends
Corporate performance and funding demand
Currently, Standard & Poor's rates 22 Japanese regional banks, including Tier I and Tier II regional banks. Some of these ratings have been assigned without an initial request from the bank.
The pace of NPL disposals at regional banks has been slower than that at the major banks. However, in general, the banks rated by Standard & Poor's have made some progress in improving their fundamental profitability, disposing of NPLs, and increasing capitalization. Based on this progress, Standard & Poor's upgraded 11 Japanese regional banks and revised upward the outlooks on its ratings on eight other regional banks in January 2005.
However, it is important to recognize that the trends in the credit quality of rated regional banks do not always match those of the entire regional bank industry since the rated banks are comparatively larger and generally have stronger credit quality than non-rated regional banks. An important factor affecting the banks' credit profiles is the condition of each regional economy. Although concerns over a relapse in the Japanese economy overall have receded, the health of regional economies varies widely. While some regions have experienced faster recovery of capital investment, driven mainly by the manufacturing sector, many regions still face the negative impact of reduced public projects and the long-term slide in land prices; although land prices in metropolitan areas have started to bottom out, the recovery in regional land prices is slow. Under these circumstances, Standard & Poor's expects improvements in credit quality will take longer for regional banks that have low profitability or that are located in regions experiencing slow economic recovery.
Standard & Poor's has assigned ratings to Norinchukin Bank and Shinkin Central Bank. Like regional banks, the operating performances of Japan's cooperative systems (JAs and shinrens) under Norinchukin, and credit cooperative banks (shinkin banks) under Shinkin Central Bank are vulnerable to the respective regional economies in which they operate. Accordingly, some of these entities have weak financial profiles. In addition, the operating performances of Norinchukin and Shinkin Central Bank are also vulnerable to interest rate fluctuations given their high securities-to-deposit ratios.
Standard & Poor's incorporates potential government support as well as assessments of financial profiles in determining its ratings on Japanese banks.
If the Japanese government determines that the country's financial system faces a crisis, it can take preventive action, including capital injections to financial institutions, financial support to failed or insolvent institutions in an amount exceeding the cost of payoff, and putting failed institutions under public control through acquisition of outstanding stock using Deposit Insurance Corp. Funds in the financial crisis account currently total ¥15 trillion.
In July 2003, the government injected ¥1.96 trillion into Resona Bank, whose capital was found to have slipped below 4% two months earlier. In November the same year, Ashikaga Bank was placed under regulatory control. Neither of the institutions had defaulted on debt, and all payments, including those on subordinated instruments, had been made in a timely manner.
The Law Concerning Special Measures for the Enhancement of the Functions of the Financial System was established in June 2004 to enable the government to inject capital into banks for which support would be difficult to provide under Article 102 of the Deposit Insurance Law. Expanding the scope for potential public support has had a positive effect on the credit quality of relatively small financial institutions and other financial institutions that are otherwise supposed to inject capital to these small financial institutions such as Shinkin Central Bank. However, as Kanto Tsukuba Bank Ltd. and Ibaraki Bank Ltd. are the only banks that have officially indicated they may apply for capital injections under this law, the system has yet to be widely utilized. Kiyo Bank and Wakayama Bank are reported to be considering joining the scheme, although no public announcements have been made.
Bank of Japan (BOJ) can provide financial support in the form of loans in order to maintain credit order (Article 38 of the Bank of Japan Law).
Methods of potential support from BOJ include:
However, BOJ support is not always utilized, since there are restrictions, such as the central bank's own financial health.
Risk factors regarding government support include the following:
The most recent default of a Japanese commercial bank based on Standard & Poor's criteria was Nippon Credit Bank in 1997 (see Table 8). However, the ability to provide capital injections to prevent insolvency has since been enhanced via Article 102 of the Deposit Insurance Law and the Law on Enhancement of the Functions of the Financial System, and such an insolvency case is unlikely to occur again in the near future. Furthermore, the Resona Bank capital injection and the special crisis management for Ashikaga Bank have also shown that these measures provide protection for all debt including subordinated debt.
However, as the government's position on providing support for banks may change over time, Standard & Poor's incorporates, albeit with less emphasis, individual default risks in its counterparty ratings on the banks. If the government safety net is strengthened further, and it is clear that any change in government policy will not reduce the effectiveness of the safety net, Standard & Poor's may raise its ratings on a bank even if its financial strength or profitability has not significantly improved.
Government initiatives, including the removal of the full deposit guarantee, tend to encourage bank reform efforts. As such, a key issue in improving bank ratings will be how the banks respond to the challenges in the operating environment to improve their financial profiles and profitability.
Two developments are leading to a gradual improvement in the transparency of financial reports by Japanese banks: the staged implementation of mark-to-market accounting, which was completed in fiscal 2001, and the introduction of quarterly financial disclosure in fiscal 2002.
Valuation of securities
Tax effect accounting
Loan loss provisions
Quarterly financial reports
Accounting for impairment of fixed assets.
Number of banks: As of May 1 2005, there were 2,165 financial institutions in Japan.
All of these financial institutions are insured by DIC, except for agricultural cooperatives. Agricultural cooperatives are insured by the separate, but very similar, Savings Insurance Corp.
System deposits: Total deposits of Japanese residents as of December 2004 stood at ¥967 trillion.