Japan’s banks face fresh problem as pandemic casts pall
Japan’s banks have faced multiple crises over past decades, but the coronavirus pandemic has thrown out some fresh surprises — and could challenge their future growth, writes William Pesek.
Japanese officials don’t mouth the words ‘Lehman Brothers’ often, and certainly not casually. One reason: few are more sensitive to the risk of a banking system shock that shakes the entire economy.
Another: Tokyo takes great pride in having avoided the worst of Wall Street’s 2008 reckoning. Japanese bankers, having extricated themselves from a massive real estate-related bad loan crisis just a few years earlier, were loath to go all-in on subprime debt. Hence the relative calm in Japan as US and European banks quaked.
Japan may not be as lucky with Covid-19, as the fallout casts an inescapable pall over the economy. That has led Hitoshi Suzuki, a member of the policy board at the Bank of Japan, to use the L-word as he warned lenders might see credit costs surge to 2008 levels.
“If a second and third wave of infection hits Japan, financial institutions’ credit costs could balloon to levels near those hit after the collapse of Lehman Brothers,” Suzuki said in a speech on August 27. “With the economy having lost momentum to achieve our price target due to the pandemic, our monetary easing will last even longer.”
And, odds are, the BoJ will push even deeper into uncharted monetary territory as cratering global growth upends Japan’s year. Even more so than in 2008, Tokyo exudes calm-before-the-storm energy that’s unlikely to last.
So far, Japan’s largest financial institutions are generally on course to meet this fiscal year’s rather modest profit goals. Bad loan costs came in broadly near expectations in the April-June period. Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group and Mizuho Financial Group each saw quarterly profits slip amid moves to increase provisions for soured loans.
Collectively, the three institutions posted net income of about $3.7bn for April-June, equivalent to roughly 31% of their combined target for the full fiscal year. The bad news is that credit costs increased to about $2.8bn, or 27% of the banks’ full-year target.
Koichi Niwa, an analyst at Citi in Japan, is one of those who still see Japanese banks among the lucky ones as 2021 approaches. “Covid-19 is a very challenging situation but not so bad from the Japanese banks’ aspect,” says Niwa.
“Compared with the Lehman crisis, they can manage,” he says. “Because that was a bank crisis. This time, it’s not. In the 2008 Lehman crisis, banks had to survive — that was the mandate. This time, it’s how to support corporate clients — that is banks’ mandate. So that is under control.”
Yet keeping impairments in check amid the pandemic will challenge Japanese bankers as rarely before.
The national economy is under intense strain, contracting at a nearly 28% annualized rate between April and June. But when MUFG and others churn out profit forecasts these days, the underlying assumption is that the coronavirus will wane.
“Banks operating in Japan face low economic risks by global comparison,” says Ryoji Yoshizawa, a credit analyst at S&P Global Ratings. “We anticipate a recovery in 2021 supported by a rebound in global demand and government measures to boost fiscal stimulus and stabilise markets.”
The country’s conservatism that maddens some investors has its merits during a global reckoning.
“Japanese banks benefit from operating in a large and diversified economy with various competitive industries,” Yoshizawa says. “These strengths offset certain structural weaknesses, such as Japan’s ageing society, low economic growth, and limited fiscal flexibility to stimulate the economy because of the government’s debt level, which is one of the highest among developed countries.”
Those hopes could easily be dashed, exposing some significant cracks in the Japan-as-shelter-from-the-storm narrative.
Around the globe, banks are setting aside untold billions for likely tidal waves of companies and households unable to repay debt. This risk is bigger for Japan Inc, though. In recent years, Japan’s lenders counted on low ratios of potentially soured loans to support earnings.
Generally, Yoshizawa sees “downward pressure on Japan’s economic risk developing gradually”. That has Japan’s ratio of private-sector debt — corporations and households — to GDP rising only “temporarily” in 2020. Yet “should Covid-19’s adverse impact on the country’s economic growth be prolonged, or the speed of recovery slow substantially, our score for credit risk in the economy could come under pressure,” Yoshizawa says.
This dynamic owes much to the rock-bottom interest rate policies pursued by Suzuki and his BoJ colleagues. In a sense, banks became the collateral damage of BoJ governor Haruhiko Kuroda’s seven-plus-year effort to eradicate deflation once and for all.
Beginning in March 2013, the Kuroda-led BoJ began buying ¥80tr, or $753bn, of government debt annually. It expanded asset purchases to corporate bonds and a variety of asset-backed securities. Then the central bank pivoted to cornering the stock market via exchange-traded funds. It now owns at least $316bn of ETF holdings, more than 80% of Japan’s total market.
Though the BoJ’s largesse supported modest gross domestic product growth, it never got Japan close to the 2% inflation target.
In 2016, Kuroda’s team got truly radical with a negative interest rate plan. Japan’s banks have never quite been the same. As spreads effectively disappeared, industry insiders groused that Japan had invented a new model: ‘non-profit banking’.
Falling, or minuscule, net interest margins have become the norm at a time when growth is depressed and Japan’s fast-ageing population leaves fewer and fewer financing opportunities. Given Japanese banks’ relatively small dependence on fee businesses and trading income, rising credit costs hurt even more.
Shinichiro Nakamura, an analyst at Goldman Sachs in Japan, sees a “risk that high credit costs, mainly for SMEs and micro enterprises, could continue for longer than currently expected”. The extreme uncertainty at the moment, and limited visibility about what’s afoot for 2021, has banks shifting their profitability metrics.
“With many parts of the economy on hold or with substantial slowdown, the banks’ businesses have also seen a slowdown —and [they have] had to change the way to conduct business with clients, shifting to online from face-to-face,” says Kaori Nishizawa, a director at Fitch Ratings in Tokyo. “Core profits will come under some pressure, but more importantly, we would expect to see higher credit costs versus pre-Covid as various industries are facing difficulties.”
Michael Makdad, an analyst at Morningstar, notes that for big banks, return on equity “already dropped from around 6% to around 3% as credit costs have risen from 10bp of loans to around 30bp”. Yet, he adds, the conservatism with which banks operated before and after 2008 gives Japan an enviable cushion as global capital markets stumble.
Today’s return-on-equity trends, he says, are “better than during the Lehman shock because at that time the megabanks had more equity holdings and valuation losses and those had an even bigger impact than credit costs. Whereas now, equity holdings are somewhat smaller and anyway stocks aren’t down at the moment.”
Japan’s banks entered the Covid crisis with a reasonable number of shock absorbers. But reinforcing them remains a priority.
As Fitch’s Nishizawa puts it: “The major banks we rate have adequate capital buffers although we expect the pressure to be there with increases in risk weighted assets as the banks are providing loans to support corporates. We do not expect to see capital erosion from losses — like during the Lehman shock — but with lower profits, capital build-up will be slower.”
Offshore markets are a huge caveat, of course. Between 30% and 40% of mega banks’ loans are in overseas markets.
Nishizawa estimates that “overseas NPLs will rise slightly faster than domestic ones,” and will make up about 25% to 45% of mega banks’ total NPLs in the 2021 fiscal year. Fitch has lowered its operating environment scores for banking systems in a number of key markets where the Japanese banks expanded in recent years.
Here, Tokyo’s moves to ease loan repayment pressures, part of the government’s $2.2tr coronavirus rescue, created visibility troubles.
In May 2020, for example, bankruptcies in Japan fell to their lowest level since 2000, even as economic growth and employment prospects ground to a halt. Bank officials expect bankruptcies to spike as government relief programmes fade.
Makdad envisions an increase in evasive measures as external sectors turn against Japan Inc.
For the “internationally active” banks that are subject to Basel III, capital levels are slightly below the global systemically important banks’ average, particularly Mizuho, he says. “But it’s enough to maintain current dividends and I expect MUFG and SMFG will start hiking dividends again in a few years once the crisis is past,” Makdad says.
The handful of regional banks that have at least one overseas branch and are subject to international rules, he adds, are “amply capitalized.”
However, Makdad says the majority of regional banks and the major banks that aren’t particularly internationally active, such as Resona Bank, “have thinner capital bases than the global average”.
He adds: “If credit costs rise too much, it’s a problem for them. I don’t expect this for Resona, but some regional banks are likely going to need to raise additional capital if they can.”
Regional banks under fire
These regional bank challenges were central to the argument BoJ board member Suzuki made in his speech on August 27.
The when of his comments was pretty noteworthy, coming one day before prime minister Shinzo Abe’s surprise resignation announcement.
So was the where: in Hokkaido, Japan’s northernmost major island that’s home to some of the nation’s most prominent regional lenders.
They are also notorious. In November 1997, Hokkaido Takushoku Bank collapsed under the weight of bad loans in spectacular fashion at the height of the Asian financial crisis. At the time, it was Japan’s 10th largest bank. It fell just days before Yamaichi Securities, one of Japan’s top brokerages, crashed, too.
Papering over cracks
At the time, global markets feared Japan might join Thailand, Indonesia and South Korea on the brink of ruin. But Japan didn’t crash. It embarked on a decades-long journey of domestic bailouts, overlapping stimulus packages and a revolving door of governments papering over the cracks.
Two decades-plus later, in 2018, a problem at Suruga Bank, a regional institution headquartered in the Shizuoka prefecture, exposed the costs of complacency. In order to generate a profit, the bank’s management allegedly pressured lending officers to cut corners and engage in fraud in making housing loans.
It was not an isolated incident. But such practices exposed a bigger problem. Because Japan’s roughly 100 regional banks struggle to make money in a ultra-low interest rate environment, they have less incentive to lend. That deprives the BoJ of the multiplier effect that makes monetary policy so potent.
At the same time, the desire to support GDP locally can lead to the unproductive use of credit. Or, given Japan’s rapidly-ageing hinterlands, scant lending activity overall.
“Due to a combination of political pressure to keep lending to uncreditworthy customers and the BoJ’s ultra-low interest rates, the regional banks cannot make money on their core function: taking in deposits and making loans,” says Richard Katz, editor-in-chief of TheOriental Economist Report.
As of April-September 2019, well before the pandemic, regional banks in aggregate could no longer cover their operating expenses via income earned on loans minus interest paid on deposits, says Katz.
“Covid may make long-simmering problems come to the fore,” he warns.
Japan’s new prime minister Yoshihide Suga plans to tackle the problem right out of the gate. He says consolidating rural lenders is a top priority.
“Regional banks will need to push ahead with reforms on their own to strengthen their management bases and contribute to their own communities,” Suga said in early September when he made his bid to succeed Abe. “It will be up to each bank’s business judgment, but reorganisation could also be an option.”
Suga pointed to 2018 legislation that exempts merging regional banks from anti-trust statutes. “I want regional banks to make the best use of the special law to strengthen their management bases,” he says.
For now, though, Tokyo is still encouraging regional banks to shore up needy borrowers with fresh credit. What does this mean? Measures to mitigate a jump in bad loans are being moved to the backburner.
When Suga is asked about the crux of the problem in the Japanese capital, Katz says: “He denies that the source of the regional banks’ shaky finances was the BoJ’s near-zero interest rate policy. Rather, he insists it was just a problem of ‘too many banks’. This is a throwback of the old convoy system that presumed merging two sick banks would produce one healthy bank.”
No Lehman-like shock coming
These lenders are on the front lines of rural economies hollowed out by the depopulation trends of the last 20 years. Ever more workers and jobs migrated to Tokyo, Osaka and a handful of other metropolises. And the tourism flows that second and third-tier cities worked hard to attract disappeared amid Covid-19.
One of the biggest pandemic-related bankruptcies to date was Osaka-based hotelier White Bear Family with $262m of liabilities. That shackled Kansai Mirai Financial Group, a leading regional lender, with $7.5m of losses. In early August, it told Reuters it expects credit costs to almost triple this year to $118m.
Kansai Mirai, affiliated with nationwide lender Resona Group, is working to consolidate branches, cut costs and seek more advisory fee income, bank officials say.
But similar storylines are playing out in Japan’s heartland. Bank of Kyoto, for example, moved earlier this year to set aside $47m as a shock absorber against bad loans. That is roughly 10 times the provision in the previous five years.
“More than 70% of listed regional banks in the country reported year-on-year declines in net income or net losses for the year, due mainly to increases in credit costs and losses on securities investments,” says Tomoya Suzuki, assistant vice president and analyst in the financial institutions group at Moody’s Investors Service. “Further rises in credit costs will increase pressure on regional banks’ profitability as asset quality deteriorates.”