The general consensus is that since the crisis of the late 1990s, Japan’s banking industry has done a commendable job in strengthening its collective balance sheet, improving asset quality, cutting costs and bolstering capital.
Now all the industry needs to do is to find ways of addressing its weak profitability, described by the IMF as “chronically low”. Ryoji Yoshizawa, a senior director within financial services and international public finance ratings at Standard & Poor’s in Tokyo, says that this low profitability is the by-product of years of highly conservative rebuilding since the crisis. “Capitalisation levels have recovered, but it has taken a very long time,” he says. “One of the reasons Japanese banks have been able to achieve capitalisation levels that are on a par with US and European banks is that over the past 20 years they have taken very little risk.”
This is reflected in the structure of the banks’ balance sheets today. About 20% of their assets are in deposits at the Bank of Japan, with another 10% invested in JGBs and municipal bonds, says Yoshizawa. In other words, roughly 30% of their total assets are in assets with no credit risk but virtually no return.
The result, says Yoshizawa, is that, contrary to popular belief, Japanese banks’ return on risk-weighted assets (RWAs) stacks up reasonably compared with those of their counterparts in Europe and the US. It is their return on total assets of about 0.3% and their return on equity of below 7% that is so unflattering by global standards.
Against the backdrop of negative interest rates and vanishingly thin lending margins, improving those ratios will be quite a challenge. As the IMF notes in its most recent analysis of the Japanese financial system, published in July, “profitability of banks is persistently low and net interest margins are on a downward path. Very low interest rates — combined with a de facto zero lower bound on deposit rates and a flattening of the yield curve — and low credit demand have been pressuring on bank profitability and on net interest margins.”
‘Strongly undervalued’
Little wonder, then, that equity investors have not been rushing to overweight the Japanese banking sector. Nomura pointed out in early August that Japan’s three megabanks have been trading at discounts to book value of about 40%, on which basis it sees them as “strongly undervalued”.
Analysts say that with more than 30% of their shares held by overseas shareholders, addressing the issue of relatively weak profitability has become an increasingly important priority for the megabanks. “Since the introduction of the Japanese corporate governance code in 2015, the large Japanese banks have all introduced return on equity (ROE) targets,” says Graeme Knowd, managing director at Moody’s in Tokyo. “They all believe that they can generate ROEs of 5% or 6% quite comfortably, which is in line with their views on cost of capital in Japan, but with overseas investors looking for higher returns, they have set higher targets than this.”
In its latest investor presentation, for example, Mitsubishi UFJ Financial Group (MUFG) is explicit about its ROE target of between 8.5% and 9% in FY2017, up from 7.25% in FY2016.
The snag, for Japanese banks, is that pressures on profitability will be further aggravated by the BoJ’s negative interest rate policy (NIRP), which means that the banks are unable to draw much benefit from the strength in the economy or the rise in corporate earnings. According to research published by Mizuho Research Institute (MHRI), net profits in the corporate sector are now returning to levels substantially above those at the end of the bubble period around 1990. “The interest paid by companies to financial institutions was close to ¥40tr ($364bn) at the beginning of the 1990s,” says MHRI. “By contrast, interest payments are currently at levels of about ¥7tr.”
In other words, adds MHRI, “despite the unprecedented high profits of companies, [these] profits are being returned to shareholders as dividends whereas the same level of returns are not being paid to financial institutions.”
With no sign of an imminent normalisation of monetary policy in Japan, pressures on interest income are likely to intensify over the foreseeable future. Fitch, for example, sees the banks’ lending-related revenues falling by up to ¥100bn under the NIRP. To offset declining net interest income, says Fitch, domestic loans will need to grow at an annual rate of 5%-6%, or almost double the past three fiscal years’ average growth rate.
Continued pressure on margins in the domestic market inevitably means that in pursuit of earnings Japanese banks will have little option but to explore riskier sources of profits, such as international lending. S&P’s Yoshizawa says that the largest banks have already had some success in bolstering earnings through increasing overseas lending and stepping up efforts to generate fee income in areas such as sales of investment trusts to yield-starved depositors.
But this, says Yoshizawa, is hardly a realistic option for regional banks with no overseas footprint and little know-how in development and distribution of fee or commission generating products. The challenge is aggravated by diminishing loan books. “Profitability pressures are even more intense for smaller institutions outside urban regions, due to declining populations,” warns the IMF.
The search for enhanced capital efficiency
For the larger banks, meanwhile, Knowd at Moody’s says that rating agencies would rather see the conundrum of weak profitability addressed through a range of capital-strengthening measures than by the pursuit of higher margins overseas. Cost-cutting is one option, although as Knowd points out, Japanese banks already have reasonably manageable costs. According to an international comparison of banks’ costs in 2015, published last year by S&P, at 62.45% the average cost to income ratio (CIR) among Japanese banks is on the high side in an Asian context, but is only slightly higher than in the US and stacks up well in comparison with Europe.
Enhanced capital efficiency is at the top of the big Japanese banks’ to-do lists. One of MUFG’s stated objectives for 2017 is to “repurchase and cancel [its] own shares in order to enhance shareholder returns, improve capital efficiency and conduct capital management flexibly”. MUFG is also committed to a further reduction of its equity holdings, which have already been pared from more than 50% of its tier one capital in March 2008 to 16.6% at the end of March 2017.
Sumitomo Mitsui Financial Group (SMFG), meanwhile, has already reduced its strategic listed holdings from about ¥6tr (book value) in 2001 to well below ¥2tr in late 2016.
Mizuho has also made encouraging progress on reducing cross-holdings. It says its book value reduction plan for FY2015-FY2016 aimed at reductions of ¥250bn, but delivered ¥275bn, and plans a total of ¥550bn by FY2019.
Japan’s megabanks are the only global systemically important banks (G-SIBs) in Asia Pacific to which the Financial Stability Board’s (FSB) TLAC requirements will start to apply from 2019. Under these requirements, the large Japanese banks need minimum external TLAC of 16% by March 2019, rising to 18% in March 2022. Adding a 2.5% capital conservation buffer and GSIB capital buffers of 1% for Mizuho and SMFG and 1.5% for MUFG brings the banks’ TLAC requirements up to between 21.5% and 22% by 2022.
SMFG has been at the forefront this year of using the euro market as a means of strengthening its TLAC. Having issued €500m of senior unsecured notes in January, it returned to the euro market in early June with a two-tranche transaction raising €750m in a five year floating rate note and €500m in a 10 year fixed rate tranche. Total demand for the issue reached almost €3bn.
A notable feature of MUFG’s capital strategy this year, meanwhile, has been its use of the MTN market as a complement to dollar benchmark issuance as a source of TLAC debt. In January, it printed its first euro denominated holdco bond from its MTN programme, issuing a $200m transaction sold to a single investor.
Moody’s believes there is abundant potential for more TLAC-eligible debt supply from Japan’s megabanks, estimating in a recent report that issuance could exceed $80bn over the next three years, bringing their total outstanding TLAC bonds to ¥11.2tr ($97.5bn) by March 2022.
Fitch, meanwhile, says the megabanks could raise as much as $50bn in TLAC by 2019 alone. “This issuance will address the current $4bn shortfall from the 2019 requirements, build a safety margin and refinance a portion of the $18bn in legacy instruments that will come due over the next few years,” Fitch observes.
International investors will be called upon to absorb much of this supply. “While Japanese banks’ capital positions are relatively strong, they will clearly need to raise more TLAC-eligible debt,” says Knowd as Moody’s. “We would expect the megabanks to run with the minimum amount of AT1 and tier two and the maximum of senior. While the AT1 and tier two are likely to be issued in yen, we would expect all the senior to be raised in dollars. Unless they can raise it in yen and swap into dollars, it makes no sense for the Japanese banks to raise senior TLAC-eligible debt in yen when they have deposits coming out of their ears which they’re unable to deploy.”
The numbers speak for themselves: as of March, bank deposits in Japan amounted to just over ¥1,000tr, with loan-to-deposit ratios at about 70% — half what they were in the late 1980s.
While the international component of Japanese banks’ TLAC debt requirement looks hefty, ratings agencies say they have no misgivings about the banks’ capacity to raise the necessary senior debt. “We see the banking sector as solid and bail-in risk is low, so we’re not concerned that the banks won’t be able to raise the funding they need,” says Knowd.