A decade on from the first quakes of the global financial crisis, Japan occupies little space in summaries of the crash. In one of the most lauded recent tomes, Adam Tooze’s Crashed, the index entry for the third largest economy in the world refers to just three pages.
But if its banking sector came out relatively unscathed then, it has developed its own vulnerabilities since. In particular, Japanese banks have ramped up their holdings of foreign assets, and in this respect there are even parallels with European banks before the crisis (see chart).
Between 2007 and 2017, global dollar assets on the books of Japanese banks rose by 88%, according to the Bank for International Settlements. In contrast, for European banks they fell by 44%.
“Japanese banks certainly seem to have stepped into the gap left by European banks that have been trying to step away from some of these types of activities,” says Freya Beamish, chief Asia economist at Pantheon Macroeconomics in Newcastle.
This trend is common to the three megabanks — Mitsubishi UFJ FG, Sumitomo Mitsui FG and Mizuho FG — as well as their smaller competitors. It raises questions about how safe these overseas exposures are, and how reliable banks’ overseas funding is.
But understanding why this situation has come about requires starting with the state of affairs in Japan.
Where’s the profit?
The Bank of Japan’s loose monetary policy makes profits hard to come by for the banks. While deposit rates have been at rock bottom for some time, lending rates have declined more slowly, as bonds mature and are replaced with ones offering thinner returns, and lending rates gradually fall. This has meant that banks’ net interest margins have been whittled down.
“Every year for the last several years their overall asset yields including their loan yields have come down,” says David Marshall, co-head, Asian bank research at CreditSights in Singapore. “But the funding costs can’t come down because they’ve been at zero for years.”
The BoJ did tweak its policy in July to allow greater movement in the 10 year government bond yield, which hovers at around zero.
Beamish sees this as the latest sign of the BoJ worrying that its price stability aim of 2% inflation is interfering with its aim to have financial stability: loose monetary policy to stimulate inflation is damaging banks’ profits and forcing them to engage in risky overseas business.
But without much greater tightening the BoJ is unlikely to help the banks very much, particularly if the Federal Reserve carries on hiking, making dollar assets even more attractive.
Larger movements in bond yields may give banks trading opportunities, but not material ones.
“If you look at the actual income that’s derived from trading, it’s very low,” says Marcel Thieliant, senior Japan economist at Capital Economics in Singapore.
And even raising interest rates is not guaranteed to help the banks straight away either.
Big firms choose between issuing bonds or borrowing from the banks. As bond yields rise, therefore, banks may be able to tempt them back into the fold.
But other borrowers, whether smaller companies or households, never had the luxury of issuing bonds in the first place. So when it comes to the lending rates, bond yields are less significant than banks’ pricing power.
The number of financial institution branches per capita in Japan (including post office branches, which offer bank agency services) is higher than in the US and the UK but lower than in France, Italy and Germany, according to the BoJ.
But the saturation of the sector becomes apparent when looking at the spatial density of branches. Japan’s population is packed closely together, and bank branches are also concentrated in a relatively small area, meaning customers have lots of choice.
The number of branches per kilometre in Japan is more than double what it is in all the aforementioned countries.
The BoJ says firms are transacting with more and more banks. This competition drives down margins.
Demographic changes mean that competitive pressures will only get worse, all other things being equal.
Japan’s population is both ageing and shrinking quickly: deaths have exceeded births in every year since 2007, according to government data, and last year’s gap was the biggest yet.
As their owners retire, many SMEs could close if they cannot find successors, and this could pose a threat to regional banks, warns Harumi Taguchi, principal economist for Japan and the Pacific Islands at IHS Markit in Tokyo.
Given these challenges for the lenders, the BoJ may decide it is not worth changing monetary policy drastically in any case.
“Whether high interest rates would help on the financial stability front isn’t entirely clear,” says Thieliant. “I think even the Bank of Japan is not entirely clear. But high interest rates would definitely make it less likely that the bank will ever achieve its price stability target, so I think the trade-off will basically remain the same.”
Banks have looked to adapt. They have tried to focus more on income from fees, although the BoJ says the regional banks still take a lower share of revenue from this than banks in other countries.
SMFG and MUFG have also boosted profits through consumer lending arms. “That’s really quite high margin by Japanese standards,” says Marshall.
Yet these solutions are not adequate. The banks still need to go abroad for profit.
Overseas balance sheet
So what risk are the banks taking?
Default rates for foreign loans are lower than even for the safe domestic loans. But low profit margins mean that the regional banks would be exposed to any shocks.
“A lot of them have very little capacity to deal with any kind of risks simply because their profits are extremely slim, or they record losses,” says Thieliant. “Their capital ratios have fallen.”
But for the megabanks, Marshall thinks credit risk fears could be “a bit overblown”.
“They are generally not trying to pursue the highest margins that they can find. They are willing to accept relatively modest returns and of course taking on what they think is relatively modest to low risk,” he says.
But there is circumstantial evidence of Japanese banks’ exposure to China, according to Beamish. If tightening by the Federal Reserve squeezes liquidity in emerging markets, this could blow back, she says.
Perhaps more worrying is the fragility in the overseas funding programmes banks use to match these foreign assets.
US money market funds have stopped buying as much of their debt, after reform in 2016 caused many to shy away from banks’ commercial paper, certificates of deposit and asset-backed commercial paper. Japanese banks saw an increase in funding costs for these types of debt, according to the BIS.
They also pay a premium over banks from other countries for repo funding with the money market funds, according to the BIS, because the Japanese banks concentrate on the same limited pool of lenders.
The banks also swap surplus Japanese deposits into other currencies, but it is feared this could be unsustainable in the event of the swaps markets freezing up.
Net cross-currency derivatives exceed 30% of Japanese banks’ dollar assets, compared with 10% for non-US banks in total, according to International Monetary Fund statistics reported by Pantheon. And the swaps providers have become flightier since the crisis.
US banks are less likely to offer this service. Instead, Japanese financial institutions get 70% of their foreign currency derivatives from hedge funds and sovereign wealth funds, according to Pantheon. These are probably fair-weather suppliers, exacerbating any sudden shortage of liquidity.
Japanese lenders have tried to attract corporate deposit holders. But even this source of funding is not as stable as it looks.
“The US banks have been busy making efforts to keep the stickier retail and corporate deposits,” says Marshall. “Whereas I think the Japanese have been taking on the ones that are probably more susceptible to moving, depending on what rates are on offer, so although they have increased their overseas deposits I’m not sure it’s in the form of very stable deposits.”
The upshot of all this is that Japanese banks are vulnerable on either side of the balance sheet. If banks cannot access short-term overseas funding, they may be forced into selling their foreign assets rapidly, thus driving down the price of the remaining stock.
“It’s a maturity mismatch story that could unravel from either end,” says Beamish.
Shades of Europe
Are Japanese banks really heading towards a crunch point?
“It’s hard to really see a trigger but one can say there are weaknesses in their overseas funding that would become problematic if there was a loss of confidence in those banks,” says Marshall, speaking of the megabanks. “But it’s hard to see why that would happen.”
The comparison with European banks in the pre-crisis era is alluring, but requires caveats. Liquidity coverage ratios of the foreign balance sheets of the banks are better than the figures for German and French ones even now, according to Beamish.
And the assets European banks invested in were a different kettle of fish to the Japanese banks’ exposures: sub-prime mortgages are not the same as sovereign debt. Meanwhile, the BoJ should be able to access dollars from the US Federal Reserve through a swap line.
Japanese banks will hope that, in the event of another global financial crisis, they will again play a very low-key role. But nevertheless a few warning lights are flashing.