Japan’s notoriously profit-starved banks face an embarrassment of riches as Covid-19 slams the economy: a record $3tr of excess cash.
For two decades now, Japanese banks wrestled with cash hoards and the side effects of ultra-low interest rates. They’re not alone in the pandemic era, of course. With households around the globe spending less and paying down debt and governments handing out cash, banks everywhere are unusually flush.
Yet the equivalent of 60% of gross domestic product worth of excess cash is off the charts even for Japan — and it speaks to why the economy is walking in place as the US, Europe and China pivot toward steady growth.
In July, Japan’s bank lending came in at the slowest pace in nearly nine years, growing just 1% year-on-year. The slowdown underscores the fragile nature of Japan’s revival from the pandemic. It also gets at why the most aggressive monetary easing experiment ever known in history is failing.
Banks hoarding the combined GDP of Australia and Brazil is costing Bank of Japan the multiplier effect that makes monetary policy so potent. Since March 2013, BOJ governor Haruhiko Kuroda pumped trillions of dollars into the financial system. And yet, inflation never got more than halfway to Tokyo’s 2% target. Today, the worry again is prices falling negative.
“Ideally, banks should get rid of deposits that are greatly in excess of the amount of loans and securities they are able to prudently buy, so there would be no need to hold trillions of dollars’ worth of cash as a kind of plug,” says Michael Makdad, a senior equity analyst at Morningstar. “It would be great, too, for banks if this could be accomplished by individuals moving their savings out of bank deposits into risk assets like stocks and mutual funds, which would give banks a revenue opportunity to sell.”
Japan, though, has a collective confidence problem. Despite promises by the government to increase competitiveness, there’s little demand for credit or courage by bankers to extend it.
The answer, analysts say, is for banks to deploy large chunks of this cash pile. In the year ending in March, deposits at Japan’s top three banks alone jumped $375bn, with Mitsubishi UFJ Financial Group accounting for more than half.
Deployment options include the gamut of higher-yielding foreign debt: US Treasury securities; corporate bonds; real estate and other assets. MUFG, for example, is eyeing real estate trusts and private equity along with other alternative assets.
As MUFG chief executive Hironori Kamezawa said in May: “A growth in our deposits is proof of customers’ trust in us. But to be honest, it’s a tough challenge how to manage it.”
Japan’s biggest regional banking groups, including Concordia Financial Group, are pivoting to US Treasuries and mortgage bonds to pump up returns. Nana Otsuki, chief analyst at Monex — which operates retail online brokerages in Japan — says there’s growing interest in non-traditional areas and illiquid assets that enliven returns.
To make the switch is easier said than done, of course. The news cycles of the last two years have been dominated by banks that took big swings — only to miss when things went awry.
The good, the bad and the ugly
In 2019, Mizuho Financial Group took a $6bn charge while writing down losses of overseas bonds as US yields spiked. In 2020, Japan Post Bank experienced stressful moments as bets on collateralized loan obligations went sideways.
In April, Nomura Holdings admitted it sustained a $2.9bn hit amid the collapse of Archegos Capital Management. The US-based hedge fund missed some highly leveraged margin calls, resulting in Nomura’s worst quarterly loss since the 2008-2009 global financial crisis.
The good news: Nomura may already be getting its stride back, says Shunsaku Sato, a credit analyst in the financial institutions group at Moody’s Japan. Though Moody’s has a negative outlook on Nomura, Sato says things “could return to stable if the large loss in its US subsidiary is an isolated incident and the company returns on track, while improving controls to limit tail risk and large losses”.
Mike Kanetsugu, chairman of the Japanese Bankers Association and chairman of MUFG, warned in a press conference in April: “We need to pay close attention to whether a second or third Archegos might emerge.”
The bad news: the lesson many CEOs may have learned is that it’s safer to continue ploughing money into Japanese government bonds.
The key, says Kiuchi Takahide, a former BOJ official who is now an executive economist at the Nomura Research Institute, is finding a happy medium between higher risk and one’s true tolerance. That way, banks can do their best to avoid nasty surprises. “Where there’s mispricing,” Takahide says, “financial chaos tends to follow.”
Timidity seemed a virtue in the months and years after the Lehman Brothers shock 13 years ago. At the time, Japanese banks revelled in their lack of exposure to subprime debt — the toxic assets that were felling banking systems around the globe. Government officials touted Japan’s insularity as a strength.
In 2013, finance minister Taro Aso said during a seminar, with full sincerity, that poor foreign language skills saved the day.
“Many people fell prey to the dubious products, or so-called subprime loans,” Aso said. “Japanese banks were not so much attracted to these products, compared with European banks. Managers of Japanese banks hardly understood English, that’s why they didn’t buy.”
Yet in the 12 to 13 years since the subprime crisis, Japan’s interest rate environment has become even less conducive to healthy bank profits. In January 2016, the BOJ began an experiment with a negative interest rate policy (NIRP), part of its shock and awe effort to end deflation once and for all.
NIRP, in essence, aimed to level borrowing costs across the yield curve and incentivise banks to extend credit to companies. That, in turn, might empower chieftains to increase investments. In practice, though, the policy ended up being a threat to Japan’s banks and corporates to mobilise their cash reserves in case they become eroded.
It backfired, too, because by wiping out spreads between short, medium-term, and longer-term JGBs, banks can’t harness one part of the yield to profit by lending based on another. It means that the BOJ is still penalising banks without generating the expected revival of demand.
Along with the BOJ’s large JGB purchases, NIRP helped deaden secondary trading activity. Within six months of negative rates, MUFG began threatening to scrap its domestic bond trading business.
In the years since, it hasn’t been surprising to see peers refuse to go down the NIRP rabbit hole. Former Bank of England governor Mark Carney, for example, has said he’s “not a fan” of NIRP. He worries the strategy punishes savers and make it hard for banks to make a profit.
Economist Daniel Gros, a fellow at the Centre for European Policy Studies, notes that the complexity of NIRP might reduce its effectiveness. This includes having to manage a “two-tier system”, whereby excess bank reserves are exempted from the negative deposit rate.
“In Japan, the negative rate is still only negative 0.1%, a negligible magnitude, but even still, a large part of reserves is exempted,” Gros says. “This shows that central banks in general have been concerned about limiting the impact of negative rates on bank profits.”
Just not enough, as Japan’s struggles show. Even so, the BOJ has stubbornly stuck to its guns. It is getting further away from generating 2% inflation. And structural headwinds will still be bearing down on the industry even if Tokyo ramps up vaccinations fast enough to generate steady economic growth.
Covid pressure
For most analysts, it’s hard to be optimistic.
“There is a good chance that loan interest rates — which have been falling since 2008 — are finally starting to bottom out and stop falling further,” Makdad says. “But I don’t see a reason to expect interest rates to actually start rising unless inflation appears in Japan. For banks, the risk is that credit costs start to rise before loan interest rates do.”
Kaori Nishizawa, a director at Fitch Ratings, expects profitability to “remain weak in the short term”. Generally, she expects “lower trading revenue and somewhat elevated credit costs will constrain profitability while the banks continue to address structural challenges”.
As of reporting up to June, the “deterioration in non-performing loan ratios was contained, despite increases in NPLs and special-mention loans in the financial year ended March 2021,” Nishizawa says. Fitch, she adds, expects NPL ratios at Japan’s banks to remain below 2% “although the ratios could rise further when temporary government relief measures expire” or when some special-mention loans “transition into NPLs”.
It remains an open question whether the incoming government might be forced to increase Covid relief measures. Japan was set for a leadership change as GlobalCapital went to press, after prime minister Yoshihide Suga said in early September that he would not run for another term as leader of the ruling Liberal Democratic Party, throwing open the race to find Japan’s next prime minister.
Among Suga’s possible successors are former foreign ministers Taro Kono and Fumio Kishida, as well as former defence minister Shigeru Ishiba. Of them, Kishida has called for a new stimulus package worth several tens of trillions of yen as soon as possible.
Japan is seeing record Covid-19 infection rates — and broadening local government state-of-emergency decrees. Some of the government’s Covid mitigation efforts have irked the financial industry. Case in point: lawmakers asking financial institutions to lean on clients in the hospitality industry. The idea, detailed in July, was for financiers to help cajole bar and restaurant owners to comply with restrictions on serving alcohol at night.
Unsurprisingly, banks pushed back, arguing it’s not their job to enforce compliance with government safety measures. Soon enough, some members of the cabinet were issuing apologies. Lower house parliament member Masanobu Ogura spoke for many when he said: “This tops the list of bad moves that you must not do.”
Along with Covid, Makdad adds, the “biggest problem for Japanese banks for the past decade has been super-low and falling lending rates in part reflecting the presence of too many banks in the banking system. It’s possible that Covid will result in fewer regional banks a decade from now. But there are also too many cooperatives and other” vested interests around the nation, particularly the politically powerful agricultural industry.
This so-called Norinchukin Bank system is a microcosm of how rural Japan can often seem like the tail wagging the proverbial dog. It’s a financial institution created by laws dating back to 1923, grouping together the Japan Agricultural Cooperatives, Japan Fishery Cooperatives, Japan Forest Owners’ Cooperatives, and other rural members.
Using deposits from its various individual members and customers, this umbrella bank lends funds to members and related industries. Along with funding businesses, this includes housing loans, auto loans and education loans. Any industry consolidation would imperil local financing and political dynamics.
Such arrangements, and the way they’re seen to be part of rural tradition and culture, demonstrate why change can be so difficult in Japan.
At the same time, Makdad says, “if credit costs were to rise from their very low levels, there is room for profitability to decline further or even for the sector to become loss-making. In short, the environment is such that Japanese banks are not even close to enjoying economic moats.”
Soon after taking office in September 2020, Suga had said there are “too many regional banks” and pledged to revitalise rural economies facing shrinking populations. In November, his team telegraphed subsidies to encourage Japan’s 100-plus regional institutions to merge, increase productivity and raise their technological games. Since then, the reforms fell by the wayside.
Ikuko Fueda-Samikawa, principal economist at the Japan Center for Economic Research, wrote in a note this year that a “multifaceted examination of the degree of financial excess” reveals regional differences in the degree of overbanking. “If current trends continue, the financial excess will increase nationwide in 10 years, except in the major metropolitan areas,” she adds.
A workable solution, she stresses, requires the public and private sectors to cooperate to raise the industry’s competitive game.
“Based on past cases,” Fueda-Samikawa says, “the realignment can be expected to have a cost-cutting effect, but it is unlikely to be a fundamental solution for improving profitability. [The need for] collaboration with different industries is gathering momentum, with initiatives going beyond just realignment to improve profitability and diversify profit sources.”
Loosening control
Technology remains a chronic problem for the largest of Japanese institutions.
On August 20, Mizuho suffered its fifth digital glitch in six months, disrupting over-the-counter services at 460 branches nationwide. The outages, which the bank blamed on backup hardware failing, came just as regulators were finishing on-site inspections related to a system snafu earlier in the year. Mizuho’s ATMs were swallowing thousands of cash cards.
The Tokyo Stock Exchange has also had its run of tech stumbles. Exhibit A is an October 1, 2020, hardware failure that brought all trading to a halt.
The TSE’s first full-day suspension of dealing since 1999 was a blackeye for the government’s pledge to prioritise digitalisation and increase Tokyo’s role as a global financial centre. It was a setback, too, for Tokyo’s hopes of wooing investment banks and fund managers from Hong Kong as China ended the city’s autonomy from the mainland.
Yet one reason financial change in Japan is so hard is that the banking system has, for decades, often acted more like a safety net than a vibrant for-profit industry. Rarely has that been truer than over the last 20 months of pandemic-related disruption.
Sean Campbell, an economist and head of policy research at the Financial Services Forum, can’t help but marvel at how Japanese “large banks acted as the fastest-growing supplier of credit to the real economy from the start of the Covid-19 pandemic.” The first nine months of 2020 saw an annualised 7% surge in loan growth, which he notes is three times the average annual rate of increase over the previous five-year period.
A report published jointly in May by the FSS, the Institute of International Finance and the International Swaps and Derivatives Association, said the large increase in bank deposits during the pandemic shows the strength of large banks, as they entered the health crisis with high levels of capital and liquidity, underscoring their safety and soundness.
“Banks in other jurisdictions saw similar rates of increase in deposits,” adds the report. “In Japan, while deposits exhibited a steadily rising trend in the period leading up to early 2020, the initial months of the pandemic saw a dramatic spike in bank deposits.”
Yet Japan’s aptitude for navigating crisis is of little use to sort out its $3 trillion dilemma.
In reality, says Jesper Koll, a long-time observer of Japanese markets, Japanese companies are more globally exposed than many realise. He notes that roughly 64% of profits of companies listed on Japanese stock markets come from global sales and operations. So, from a top-down macro perspective, global events matter more than local zigs and zags.
A decade ago, Koll says, about 50% of Japan Inc’s profits came from the external sector. It is now 60% thanks to Japanese banks and financial firms going global.
“It’s a little-known fact that Japanese banks have been the largest provider of credit in non-China Asia for three years running,” Koll says. At home, though, banks’ profit margins are being squeezed by the BOJ.
“If interest rates are not allowed to rise, banks can’t grow their profit margins,” Koll says. “To get bullish on Japanese financials in general, and banks in particular, we need to see an end to the Bank of Japan’s current policy of yield-curve control.”
In particular, he says, the BOJ must let 10-year yields rise. The spectre of greater profits, Koll notes, would give bankers more confidence to take risks — and deploy their cash hoards. s
