Japanese banks past the worst but face headwinds

IFR Magazine, December 2009

Japan’s banks, like most in the world, will end 2009 in better shape than they entered it. But they do so with considerable headwinds to confront. On the positive side, the biggest banks escaped the financial crisis largely undamaged and in some cases internationally transformed; on the negative, they face a great challenge to flourish in a deflationary country, and must raise billions of dollars in capital to bolster themselves for the future.

The latest round of results do show some promising signs for Japanese banks – or at least an absence of bad news. “We are getting out of the nightmare,” says Hironari Nozaki, bank analyst at Citigroup Global Markets Japan. “Symbolic is the credit cost. Last year it was 80 to 90 basis points, depending on the bank; for the first half of this year, it is coming down to 40 or 50 basis points. It confirms that the worst is over.” And in Japan’s case, “the worst” refers to a double hit: not only the global financial crisis but prior impairments on real estate companies. The bigger players reported modest increase in first half profits, with declines in client-related business being offset by growth in trading revenue.

It’s also true that Japan doesn’t appear to face a wave of distressed debt of the scale that some might have expected. “The Japanese banks have actually got a lot better at managing their credit risk,” says Graeme Knowd, banking analyst at Morgan Stanley. “The average corporate has much less leverage than they had in the past.” Nana Otsuki, banking analyst at UBS notes that the government has been strongly committed to supporting the small to medium enterprise sector, so “it’s in reasonably good shape. Credit costs may creep up in this business environment but we don’t expect a large increase in losses in this area.” And in terms of personal lending, Nozaki at Citi says that while some individual customers are requesting changes in their mortgage arrangements, “so far the deterioration rate is quite low. Japanese mortgages are much healthier than US mortgages.”

But while all that suggests no crisis ahead, that’s a long way from saying that the future is bright. The immediate problem is the health of Japan itself. “Banks don’t grow unless the economy is recovering,” says Knowd. “The general rule is that you’ve got to get nominal GDP growth back in order to get real growth at the banks.” Although Japan’s economy is improving, with 4.8% annualized GDP growth in the third quarter compared to declines of over 10% in the fourth quarter of 2008 and first quarter of 2009, it is still in a period of deflation, and “even the best managed western bank would struggle to make money in a deflationary environment,” Knowd says. “Deflation doesn’t help banks.”

It particularly doesn’t help lending. “It is not easy for Japanese banks to expand their lending domestically in a deflationary environment,” says Otsuki. On first glance, Japanese lenders look to have been very active: hence the fact that the rankings for global loan arrangers in the first quarter of 2009 looked like a throwback to the 1980s, with three Japanese banks in the top five and Mizuho at the top. But in truth that reflected a paucity of lending from European and American names at that time, now largely returned to the fold.

There’s demographics working against them too. Yoshinobu Yamada, banking analyst at Deutsche Securities Inc in Tokyo, adds: “In the long term, if banks are sticking with domestic loans, the prospects are not great because we are expecting a decline in population starting five years from now.”

Consequently, Japanese banks have increasingly been looking overseas for lending growth. It’s hardly been a surge overseas – 99% of Mizuho’s loan proceeds in the second half of 2008 were domestic, and 93% of Sumitomo Mitsui’s – but Mitsubishi UFJ, with 24% of lending directed overseas, is perhaps illustrative of the future. “Japanese banks have to lend or invest overseas, at least to an extent,” says Otsuki. That said, increasing capital requirements may curtail this expansion. “Two years ago Japanese banks were in a great rush to expand their overseas lending,” says Nozaki. “But because of capital constraints they are getting a little bit nervous about expanding overseas businesses.”

In that environment it’s very hard to find an obvious area of growth. Fee-based income, such as sales of funds and other products to retail, have been woeful, but this may yet swing around to provide a driver. Nazaki notes an improvement in the sales of investment products to consumers. “I feel some recovery here,” he says. “The first half clearly showed a bottoming out in sales.” Yamada sees the same thing. “In the medium term, one to two years, the recovery of fee income should sustain some growth in Japanese banks.”Generally, though, he is wary about the fact that recent profit improvements in Japanese banks have been supported by trading; rather than rely on that, he’d like to see Japanese banks expand in retail, not just at home but internationally, where so far only Mitsubishi UFJ (with Union Bank of California) has dared to tread. “The wholesale market all depends on the market, the economy. Japanese banks need stable growth and that comes from the retail market.”

And so all roads seem to lead to international expansion as an engine for growth – and in this respect, Japanese banks’ responses to the financial crisis were fascinating. One can argue that Mitsubishi UFJ’s agreement to take a stake in Morgan Stanley was the turning point of the entire global financial crisis, and it certainly represented a rebalancing of power in global banking. Similarly, Nomura had said before the crisis really took hold that it had built a warchest for acquisition in order to expand in the Asian region; its acquisition of Lehman Brothers’ assets in Asia came swiftly afterwards.

The Mitsubishi UFJ/Morgan Stanley alliance is still taking shape: it was only on November 18 that the structure of the securities joint venture in Japan was announced. “It’s a little too early to say if it was successful or not,” says Otsuki. Clearly it has great potential, but the usual puzzles about cultural integration will have to be sold for it to be a triumph. In the meantime, some analysts are playing equally close attention to the relatively forgotten Union Bank of California acquisition, thinking it could be a springboard to bring in further retail assets in North America. “They may use it as a vehicle to acquire regional banks in the future,” suggests Nozaki.

Particularly outside Japan, there is widespread doubt that Nomura can make its Lehman venture work, but most feel it is too early to make a fair appraisal. “There is scepticism that the cultures can be melded, but a sense of excitement that if it worked it would be the first truly global Japanese financial institution,” says one analyst in Tokyo. “If Nomura can show it can be done, maybe it will make some of the more aggressive banks sit up, take notice, and think: maybe we can do it too.”

There is domestic activity too. The big event of the year was probably Citi’s sale of its Nikko Cordial business to Sumitomo Mitsui, but another transaction may yet prove more significant: the merger between Chuo Mitsui Trust and Sumitomo Trust, announced in November, although the holding company will not be set up until 2011 and the two banks will not come under its wing until the following year. Analysts have been positive about this deal. “Sumitomo Trust is the best managed bank in Japan,” says Knowd. “They see higher capital requirements coming and realise you have to make a return on it; the only micro way of doing that within the control of the bank’s management is a merger that gives you cost synergies.”

“Fundamentally this is a positive move, especially given that they will be able to reduce their costs,” adds Otsuki. “If you look at a past example of mergers between trust companies, Chuo and Mitsui, their cost bases reduced by about 30%.”

So what next? “For the mega-banks we are close to the end,” says Nozaki. “But there may be more opportunity for regional banks to get together. There are 64 large regional banks.” He does see some prospect of the country’s two remaining independent brokers, Nomura and Daiwa, being attractive to the megabanks, in order to help them get closer to vital deposit bases, but it’s a moot point whether that would appeal to the independents themselves.

Overhanging the whole sector is concern about global regulation, and the likelihood that Japanese banks will have to raise vast sums in order to improve their capital adequacy ratios. The capital raisings are already happening: on November 18 Mitsubishi UFJ announced plans to raise up to $11 billion of common stock to improve its capital base. Mizuho and Sumitomo Mitsui UFJ are widely expected to do the same.

In Japan as globally, analysts mainly feel that global regulation is going to impede bank profitability. “With higher capital requirements and more stringent regulation it’s not going to be easy for the banks to achieve the same level of return on equity,” says Otsuki.

But not everyone thinks the capital raisings will be as onerous as the market seems to believe. Knowd argues the earliest one could expect to see capital regulation introduced to Japan is March 2013, which broadly fits in with the Basel timeline (which would require implementation by December 2012). Additionally, capital adequacy can be addressed not just by raising more capital but by reducing assets.

“It’s not that they won’t issue capital, but there’s a difference between being desperate to issue capital and doing so because you want to,” Knowd says. “Doing it because you want to, with consideration given to shareholders, puts a different perspective on how and when you do a deal.”

Nozaki at Citi adds: “Banks have time to think about capital raising. The share prices are very weak right now so it is not the appropriate time for them to think about it.”

This brings us to the issue of cross-shareholdings, rife in Japanese banks and corporate life generally. Analysts don’t like these cross-shareholdings at the best of times, but Knowd argues that selling them in the next few years would be particularly sensible since, by reducing assets, it would also help improve capital adequacy ratios. By his calculations, both Sumitomo Mitsui Financial Group and Chuo Mitsui Trust (in its pre-merger form) could move their core tier one ratios over 7% purely by selling cross-shareholdings; indeed, only Mizuho would need to make substantial further reductions in assets beyond selling cross-shareholdings in order to hit the 7% mark.

It’s already beginning to happen: Mizuho started selling down shares in the first half. “If Japanese banks accelerate their cross-holding sales,” says Yamada, “it should be bad in the short term for the equity market but good in the long term for Japanese banks.”