The asset quality of Japanese megabanks is expected worsen after their bad loans rose to the highest levels in at least six years.

Mitsubishi UFJ Financial Group Inc., Sumitomo Mitsui Financial Group Inc. and Mizuho Financial Group Inc. said at their respective earnings press conferences that they are prepared to increase buffers against loan losses in the current fiscal year ending March 31, 2023, amid uncertain prospects of the economy. The banking groups are targeting a combined ¥610 billion in total credit costs for the current fiscal year, less than their total credit costs of ¥840.9 billion in the fiscal year ended March 31.

"There are no elements that would make them optimistic [about their businesses]," said Toyoki Sameshima, a senior analyst at SBI Securities Co. Ltd.

The megabanks' earnings are closely linked to the assessment of their borrowers’ ability to repay. While asset quality remained largely resilient throughout the pandemic, importers in Japan are facing new challenges posed by rising oil and energy prices, the weakening yen and supply-chain disruptions following global sanctions against Russia after its invasion of Ukraine.

The megabanks' nonperforming loan, or NPL, ratios could rise further, with industries such as restaurants, transportation and other services likely hit hard, said Takahide Kiuchi, executive economist at Nomura Research Institute.

"The effects from higher import prices, combined with the aftermath of the pandemic and higher interest rates, will emerge more clearly later," Kiuchi said.

Growing inflationary pressure and higher interest rates are among some elements causing downside risks to the creditworthiness of borrowers, said Chizuru Tateno, a credit analyst at S&P Global Ratings Japan. Tateno expects NPL ratios at the megabanks to stay in a controllable range.

Worsening asset quality

In the fiscal fourth quarter ended March 31, the Japanese megabanks' combined loan loss provisions totaled ¥508.08 billion, the largest amount in at least five quarters, including ¥304.14 billion for Mitsubishi UFJ Financial, ¥116.67 billion for Sumitomo Mitsui Financial and ¥87.27 billion for Mizuho Financial, according to S&P Global Market Intelligence data.

The banking groups also reported year-over-year increases in their NPL ratios for the fiscal year ended March 31. Mitsubishi UFJ Financial's NPL ratio for the period climbed to 1.33% from 1.27%, while Sumitomo Mitsui Financial's rose to 1.27% from 1.44%, and Mizuho Financial's increased to 1.33% from 1.01%.

Behind the growing NPL ratios at the banking groups are increasing bad loans. Mitsubishi UFJ Financial's NPLs for the fiscal year ended March 31 came to ¥1.472 trillion, the highest level since fiscal year ended March 31, 2017, more than half of which was bound for domestic customers. Sumitomo Mitsui Financial's NPLs grew to ¥1.15 trillion, the highest level since fiscal year ended March 31, 2015. Mizuho Financial's NPLs grew to ¥1.12 trillion, also the highest level since fiscal year ended March 31, 2015.

This came amid Japan's economy shrinking 0.2% in the first quarter on accelerating inflation and a surge in cases of the omicron variant of COVID-19, according to the country's Cabinet Office. The world's third-largest economy contracted in three of the last five quarters and has yet to return to its pre-pandemic output level. This compares to the U.S. economy, which shrank 0.4% on a quarter-over-quarter basis in the first quarter, while the EU saw GDP growth of 0.44% and China’s GDP contracted 1.3%.

"We have to be careful about domestic businesses because the inflation could hurt their credit," Masahiro Kihara, CEO of Mizuho Financial, said during a separate earnings press conference on May 13.

Exposure to Russia

A partial contribution to rising NPLs at the Japanese megabanks is their exposure to Russia. Sumitomo Mitsui Financial’s outstanding loans to Russia stood at $2.92 billion as of March 31, about half of which was extended to local companies, while the exposure of Mitsubishi UFJ Financial and Mizuho Financial to Russia for the period came to ¥310 billion and $2.92 billion, respectively.

"We cut our [Russian] deals drastically but we can't be optimistic [about our Russian operations] because they remain fluid," Jun Ohta, Sumitomo Mitsui CEO, said during an earning press conference on May 13.

The banks also said at their respective earnings conferences they would not rule out setting aside more reserves against their exposures to Russia, after they set aside a combined ¥331.1 billion for their Russia operations in the fiscal year ended March 31, nearly 40% of their total loan loss provisions for the period.

As of May 30, US$1 was equivalent to ¥127.48.