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Banking on recovery

14 Nov 2003

Stock market investors who bought into the bank sector earlier this year did so in expectation of a modest recovery in prices. Instead, prices have rocketed and the investors have been handed a windfall.

Japanese bank stocks have staged an impressive rally during the last six months, moving to the forefront of a stock market rally after leading an earlier retreat to 20 year lows. The banks account for 8.2% of Topix and have risen a thumping 62% since the March 11 low for the index.

Shares in Mizuho, Japan's largest bank calculated by assets, and Sumitomo Mitsui Financial Group, the second largest, more than doubled during this rally. UFJ, the fourth largest bank, had by late September surged almost 300%.

But much of this is catching up for the devastating erosion of shareholder value in recent years. The bank sector had by March this year plunged a sickening 91% (to an all-time low) from its 1989 peak, making it the worst performer of the 33 industry groups that make up Topix.

And on the basis of evidence in the past 14 years, this might all mean absolutely nothing. The Topix banks' index has rallied at least 40% on three other occasions since Japan's stock indices peaked in December 1989, only to then plummet back to ever worse lows.

Not cross with holdings
In a rare virtuous circle, the rally has boosted the value of the banks' equity investments, generally known as cross-shareholdings. Japan's seven biggest banks had unrealised gains of ¥2.6tr ($23bn) on their ¥16tr of shares as of August 30, according to Daiwa Institute of Research. At the end of the last fiscal year on March 31, that figure was unrealised losses of ¥1.2tr.

But many hope that the stock market rally will not lead the banks to slow or even curtail the sale of their cross-holdings. The banks have been set a deadline by the regulators to lower the value of their cross-shareholdings to below their tier one capital levels by March 2004.

But rising prices rather than increased disposals might help the banks meet that deadline, thereby slowing the jettison efforts.

The current Koizumi administration certainly appears intent on keeping up the pressure on the banks. In a move that is in the short term beneficial to the bank system and the stock market, Japan's central bank recently said it would extend stock purchases from lenders by one year to September 2004 in an effort to help them bolster balance sheets.

Although this does in the medium to long term create another cross-holding problem, this time the holdings will in part switch into state hands.

The Bank of Japan started buying shares directly from lenders in November last year to help them cut losses and had purchased ¥1.78tr in stocks from banks as of September 12.

Analyst upgrades
A Goldman Sachs report in early September identified a warming of investor sentiment toward Japanese banks that has accompanied the economic upturn. The firm added Sumitomo Mitsui Financial Group and UFJ to its list of recommended stocks.

The basis for Goldman analyst David Atkinson's opinions was the acceleration in the disposal of non-performing loans at both Japanese institutions, which have been considered laggards in the reform stakes.

Atkinson noted that the amount of NPLs held by SMFG and UFJ, as defined by him, had decreased by 45%, an improvement that was well ahead of his expectations.

There is still more to do. According to the Financial Services Agency, the seven biggest lenders had ¥20.7tr ($181.5bn) of bad debt at the end of March, 10% more than the amount the banks themselves calculated.

Hearteningly, the gap between major banks and the Financial Services Agency in their estimates of the banks' risky and bad loans has narrowed, as indicated by recent FSA data. The FSA's inspections of 12 major banks between November 2001 and May this year showed their bad loans and loans requiring surveillance stood at ¥43.73tr, only 10.1% higher than the banks' self-assessed amount of ¥39.72tr. That difference has in the past been far more marked.

Safe assets only
While the NPL crisis gradually abates, lending by Japanese banks has slid about ¥130tr ($1.16tr) since September 1996 as the economy has slipped into recession twice, according to BoJ data.

In that same period, banks' holdings of JGBs more than tripled to ¥91tr ($812bn).

"JGBs remain the default asset of choice for financial institutions," explains Cameron Umetsu, senior economist at Nomura International. "Core lending by the banks has been contracting due to a general lack of credit demand, leading the banks to take JGBs as surrogate loans.

"They at least give a positive carry, are liquid and there are also few dangers at the short end of the curve."

Aside from real economy asset declines, it is also a concern that many of the banks are taking stock positions in companies in return for a haircut on problem loans. This ultimately means that Japan might have another cross-shareholding problem later, albeit a lesser one than that which has plagued the banks for the past decade while the market indices have slumped.

In general, many take the view that Japan's big banks are, albeit slowly, becoming less recalcitrant. The historic aversion of the banks to change is gradually eroding by force of the government's efforts and the collective will of the institutional investment community.

14 Nov 2003