Major Factors

Rationale

S&P Global Ratings classifies the banking sector of Japan (A+/Positive/A-1) in group '3' under its Banking Industry Country Risk Assessment (BICRA). Other main countries in group '3' are U.S., U.K., France, Australia, and Korea (see chart 1).

Our bank criteria use our BICRA economic risk and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating. The anchor for banks operating only in Japan is 'bbb+'.

Chart 1

We believe banks operating in Japan face low economic risks in global comparison. Japanese banks benefit from operating in a large and diversified economy with various competitive industries. These strengths offset certain structural weaknesses, such as Japan's aging society, low economic growth, and the government's limited fiscal flexibility to stimulate the economy because of its debt level, which is one of the highest among developed countries.

A slow and gradual economic recovery has likely helped Japan avoid credit-fueled asset bubbles. While an aging society poses challenges, economic growth has remained slow but steady since the first quarter of 2016. Real GDP grew in 13 quarters from the first quarter of 2016 on the brisk consumption and domestic investment. The economy contracted in the first and third quarters of 2018 because of the impact of extreme weather and natural disasters. Strong consumption and domestic investment, partly bolstered by the Bank of Japan's (BOJ) very accommodative monetary stance, have supported growth. At the same time, risks from economic imbalances remain low with credit expanding stably and a strong external position. Japan's private-sector debt (including loans provided by public financial institutions) was 138% of GDP in 2018 (households accounted for 55.2% of the total; corporate 82.9%). The financial positions of both the corporate and household sectors were sound. The gross nonperforming loans (NPLs) of all commercial banks remained low at 0.9% in 2018. The ratio may rise slightly due to increased uncertainty about business conditions amid U.S.-China trade friction. However, we expect the figure to remain low in 2019-2020, reflecting banks' cautious stance in underwriting loan assets and the sound financial positions of the household and corporate sectors. Despite this, an expansionary monetary policy raises the risk of imbalances in the fiscal sector.

Conversely, we view the industry risk faced by Japanese banks as relatively higher than that of their peers because of the fragmented market and its low profitability. S&P Global Ratings believes that the current situation, in which banks are enduring ongoing low profitability, poses a risk to the stability of Japan's banking system.

The negative interest rate policy seems to have bolstered the current domestic economic growth but failed to lift bank profitability because there is a surplus of funds in the private sector. Although the downward momentum in major banks' net interest margins (NIMs) seems to have eased, we do not see strong signs of recovery in the regional banking sector, which has a domestic market share of about 40%.

In considering a certain degree of overcapacity in competitive dynamics, as well as the negative interest rate environment and delayed restructuring by regional banks, we believe industrywide profitability will remain flat. However, considering profitability has been squeezed by large amounts of deposits at the BOJ--which yield extremely low returns among interest-earning assets but account for about 20% of total assets--return on risk weighted assets (RoRWA by S&P Global Ratings' definition), which indicates profitability against risks taken, does not seem to be significantly subordinated to that of European peers.

Systemwide funding remains a key strength of Japan's banking system. Banks typically benefit from a high and stable deposit base, reflecting Japanese individuals' strong preference for savings.

Economic and Industry Risk Trends

We maintain our view of the trend for Japan's economic risk as stable. In our opinion, the positive momentum and strength in Japan will continue, and economic recovery will therefore continue with steady growth. Consequently, we believe that economic resilience in the country, which impacts the banking sector, has improved (see table 1). Our outlook is stable because we expect the nominal economic growth rate over the next two years will be 0.7% in 2020 and 1.6% in 2021, even after the implementation a consumption tax rate hike of 2 percentage points in October 2019. Although Japan's inflation rate remains weak at below 1%, we see the economy as firmly on a stable trend given the last three years' almost uninterrupted real GDP growth.

We estimate Japan's per-capita GDP after 2018 will surpass the roughly US$41,000 mark and its weighted average per-capita income growth in fiscal 2013 (ended March 31, 2014) to fiscal 2022 will be about 1.2%. Nevertheless, we believe the BOJ's accommodative monetary policy, namely its negative interest rate policy, has bolstered economic growth. In our opinion, the sustainability of healthy growth hinges on the government's implementation of structural reforms, including deregulation of some industries and further relaxation of the labor market.

We see industry risk trend as stable. We believe that industry risks faced by Japanese banks would alleviate if the banks' operating performances and business sustainability stabilized. This could occur through an improvement in the interest rate environment, restructuring of expense structures, or industry consolidation. We see the possibility of this happening as slim.

Chart 2

Chart 3

Chart 4

Economic Risk  |  2

The key factors that support our economic risk score for Japan are: (1) a diversified and developed economy with a competitive export industry; and (2) moderate growth in private-sector debt and sound financial profiles among corporations.

Economic resilience: A high-income and well-diversified economy with severe fiscal challenges

Economic structure and stability.  Japan has the third-largest GDP in the world and a well-diversified economy. It remains a relatively high-income society despite years of low growth and deflation.

We estimate per-capita GDP will surpass the roughly US$41,000 mark after 2019, exceeding the average of the Organization for Economic Co-operation and Development (OECD) countries. We also estimate Japan's weighted average per-capita income growth at about 1.2% in fiscals 2013-2022. The government's economic reforms, dubbed "Abenomics," and the BOJ's negative interest rate policy since 2016 seem to have improved consumer sentiment and supported gradual growth in the economy. Economic growth has remained steady since the government embarked on its economic reform drive. Real GDP grew in 13 quarters since 1Q2016--all except for the first and third quarter of 2018, when extreme weather and natural disasters hurt the economy. Real GDP in the first quarter of 2019 grew 0.6% from the previous quarter (up 2.2% year on year) and nominal GDP grew 0.8% from the previous quarter (up 3.4% year on year). This offset the decline in the third quarter of 2018. In 2015, average per-capita income in Japan slipped to under US$36,000 from close to US$47,000 in the early 2010s. The higher figure in dollar terms in the early 2010s was mainly due to the yen's appreciation against the U.S. dollar at that time. However, nominal GDP growth on a yen basis was slow but steady for most of the last decade.

Despite the BOJ's aggressive monetary stance, inflation has not risen so much, as indicated by factors such as the consumer price index trending at less than 1%. In April 2018, the BOJ removed the timeframe for reaching its target of a healthy 2% inflation, but its monetary stimulus measures are likely to continue, in our view.

Chart 5

Macroeconomic policy flexibility.  In our opinion, Japan's deficit and high debt level have constrained its fiscal flexibility and, as a result, limited its ability to stimulate the economy.

Although tax revenues in Japan are growing, general government spending has also continued to increase, partly because of expanding social security spending associated with the nation's aging population. After two delays, the government is scheduled to hike consumption tax to 10% from 8% in October 2019. Over much of the next four fiscal years, we expect the general government balance to register deficits exceeding 3% of GDP annually. We estimate net general government indebtedness in Japan will be 130% of GDP at the end of fiscal 2019 and will exceed 130% of GDP by the end of fiscal year 2022.

The BOJ's sizable purchases of Japanese government debt have kept the government's borrowing costs low. Despite recent quarters of growth, the BOJ is expected to continue its stimulus measures, as the core inflation rate remains weak at below 1%. The central bank held 43% of Japanese government bonds (JGBs) outstanding (at the end of calendar 2018). An increase in real interest rates would severely strain the government's debt dynamics. Yields of JGBs with a maturity of 10 years or less are currently negative (below 0%).

Political risk.  We view political risk as low in Japan. Although political risk does not detract from our assessment of Japan's economic resilience, past political stalemates have occasionally posed risks to the timely and effective execution of fiscal and economic policies. Nonetheless, overall, Japan's homogeneous and cohesive society, generally effective checks and balances in the government, strong respect for the rule of law, and free flow of information facilitate policymaking. Yet we see slow decision-making among policy institutions somewhat impairing policy implementation.

Table 1

Economic imbalances: Risks from imbalances remain low with stable credit expansion and a strong external position, but an expansionary monetary policy raises the risk of fiscal imbalances

Private sector credit growth.   Credit expansion has been fairly stable over the past few years. Domestic private-sector credit was 138% of GDP in 2018, which is low compared with over 200% in the 1990s. Deleveraging in the corporate sector mainly caused the decline in domestic credit. However, demand for M&A funding and capital investment from the domestic corporate-sector has increased, and the ratio of annual growth of private credit to GDP in the past four years is moderately increasing at an annualized rate of about 1.3%. The ratio of domestic household-sector credit to GDP, on the other hand, has been stable, hovering at around 55%. We expect credit expansion to remain moderate, unless structural reforms gain good traction and trigger sharp increases.

Real estate prices.   The residential land price index (national average) has been rising for four consecutive years, and its upward momentum is accelerating. In 2019, the residential and commercial land price indexes increased by 0.6% and 2.8%, respectively (national average), from 2018. We believe this trend will continue in 2019 and 2020. In Japan, the rate of land price changes is diverging between metropolitan and regional areas. Land prices in metropolitan areas (Tokyo, Osaka, Nagoya) have been rising since 2012; land prices in regional areas only started rising in 2018. In addition, the increases are higher in metropolitan areas than in regional areas. In 2019, residential and commercial land price indexes for metropolitan areas increased 1.0% and 5.1% year on year, respectively. In contrast, the increases for residential and commercial land price indexes in regional areas were 0.2% and 1.0%, respectively, in 2019. More precise analysis of regional rates, however, shows different movements between two groups in the regions: the four core regional cities (Sapporo, Sendai, Hiroshima, Fukuoka) and the rest of the regions. Residential and commercial land price index at four core regional cities surged by 4.4% and 9.4% in 2019, respectively, outpacing metropolitan area increases. However, the rest of the regional areas were in the doldrums, with a decrease in the residential index of 0.2% and a negligible increase of 0.0% in the commercial index. The stats shows regional areas outside the four core regional cities has not completely bottomed out from the long-lasting stagnant period that began late 1990's. In select areas such as the metropolises, although the pace will slow somewhat in 2019, we expect residential and commercial land prices to continue rising. This reflects our view that the government's economic stimulus policy and capital inflows from overseas will continue. In rural areas, however, we believe population decline will constrain recoveries in transactions and prices.

Equity prices.   In our view, equity prices in Japan do not indicate a potential build-up of imbalances. The Nikkei Stock Index (Nikkei 225) fell 13% in 2018, on increasing uncertainty about international business conditions amid a sharp rise in trade tensions between the U.S. and China. Meanwhile, the index had by the end of June 2019 increased by 6% compared to 2018 year-end. We expect volatility in 2019, particularly given the BOJ's accommodative monetary policy and global political uncertainty surrounding trade. Meanwhile, equity prices appear to be recovering (for example, the Nikkei 225 index was 21,276 in June-end 2019) following decades-long stagnation, although its level still stands at about 55% of its 1989 all-time peak.

Current account and external debt position.  We associate Japan's current account balance and external debt position with limited vulnerability. Despite a slide in the household savings rate as the population ages, the current account remains in a constant surplus. This indicates that private-sector savings continue to exceed dissavings in the government sector. We expect Japan to post current account surpluses averaging about 2.5% of GDP in calendar years 2019-2022. We project that, with these surpluses, the external liquid assets of Japan's financial and public sectors will exceed total debt by 50%-90% of current account payments over the next few years. This metric does not includes external assets held by the nonfinancial sector, which are substantial. Taking all external assets and liabilities into account, we expect Japan's net international asset position to be close to 300% of its current account payments.

Table 2

Credit risk in the economy: Moderate growth in private-sector debt and sound financial profiles among corporations

Private-sector debt capacity and leverage.  Private-sector credit (households and corporates) was below 150%, which is one of the thresholds in assessing the credit risk score. Specifically, it was 138% of GDP in 2018.

The household debt level has been stable and the debt-to-GDP ratio has been around about 55% in recent years (55% in 2018). The ratio declined to about 55% from around 2012 from 63% in 2009. Most household debt is related to housing loans and Japan's residential property prices remain high by international comparison. Household debt is therefore generally sound, in our view.

On the other hand, corporate debt has increased slightly due to the domestic economic recovery. Demand for M&A funds among large corporations and for capital investment among medium-size corporations is increasing. In 2018, corporate debt as a percentage of GDP was 83% (derived from the BOJ's statistics for flow of funds, financial assets and liabilities, and private-sector credit, including that provided by non-banks and by corporate bonds issued by nonfinancial corporates). The figure is slightly higher than the past three years' average of 81%. However, given our expectation for moderate GDP growth, as well as the fact that leverage has hovered at around 80% for a long time, even if corporate debt as a percentage of GDP increases in next one to two years, we expect the increase in the ratio will be within 2-3 percentage points of the current level. For reference, private-sector credit (household and corporates) that excludes corporate bond issued by non-financial corporates as a percentage of GDP was 129% in 2018.

Commercial banks' gross nonperforming loans (NPLs) slightly increased, but the NPL ratio was at 0.9% in 2018, which is low compared with levels over the past 15 years. Although the tough operating environment--including a shrinking domestic market--and accelerating global competitiveness have put pressure on some parts of the corporate sector, particularly small and midsize enterprises (SMEs), we do not expect NPLs to surge. This is because the corporate and household sectors have sound financial capacity and banks are cautious about lending. However, as some regional banks have increased their risk appetite to compensate for declining profitability, we are closely monitoring industrywide trends in the NPL ratio.

Chart 6

Lending and underwriting standards.   We assess Japan's lending and underwriting standards as at least moderately conservative. Banks have tightened their underwriting policies and improved their risk management systems following banking crises in the early 2000s. For example, like their global peers, Japanese banks have set limits for concentration risk related to single borrowers or special sectors, such as real estate and construction, and they monitor such limits periodically. With some exceptions, most Japanese banks were largely unaffected by the global financial crisis due to their limited exposure to risky investments.

The average loan-to-value (LTV) ratio of residential mortgage loans is between 80%-90% but that of new loans has been increasing. This reflects borrowers' preferences to utilize fully their lending capacity amid very low interest rates. Although loan delinquencies are very low and stable, a higher LTV ratio could push up delinquencies if interest rates surge. Discounting unusual incidents such as a recent scandal surrounding a regional bank's inappropriate governance, Japanese banks extend most of their loans to homeowners and do not engage in risky loans such as subprime loans. It is also worth mentioning that almost all residential mortgage loans in Japan are on a resource basis with properties placed as collateral. The loss ratio of housing loans remains low and stable in the range of 0.01%-0.02% of total loans.

Payment culture and rule of law.  We view Japan's payment culture and rule of law as being at least moderately strong and consistent with our score of intermediate risk for credit risk in the economy. Japan's legal framework is effective and its payment culture is robust, which we can see in the overall solid performance of housing and corporate loans, efficient resolution of defaults, and stable recovery ratios. Lenders' loan monitoring systems are generally sophisticated, and consumer credit bureaus have fairly robust data. Improvements in foreclosure and auction processes following banking crises in the late 1990s and early 2000s resulted in more efficient and lender-friendly systems. These healthy systems have been maintained till now.

Table 3

Base-Case Credit Losses

We expect credit losses for Japanese banks over the next two to three years to remain stable. We think they should be able to absorb such losses with their earnings, supported by the current business environment and restrained risk appetite. However, currently squeezed NIMs will become a constraint if an economic slowdown pushes up credit costs and limits loss-absorbing capacity, in our opinion. We also hold the following views.

• Japan could record real GDP growth of 0.8% in 2019, 0.1% in 2020, and 1.2% in 2021 (see "Credit Conditions Asia-Pacific: Return Of Uncertainty," published June 27, 2019). Although real GDP growth in the January-March quarter of 2019 was strong at 2.2% (annualized), the scheduled consumption tax hike in October 2019 to 10% from the current 8% will suppress growth in rest of 2019 and 2020, in our view. In Japan, we saw consumption tax hikes temporarily suppress growth in 1997 and 2014.
• Inflation rose to 1.0% in 2018 due to increased prices of food items, fuel, and energy. We expect to see a slight uptrend in 2019 and 2020, influenced by the rise of commodity prices due to the consumption tax hike (forecast in 2020 is +2.1%). Unemployment will remain low at around 2.5%.
• Banks will continue to offset shrinking net interest income with low credit costs and business diversification.
• Real estate prices will remain on a mild upward trend, and there seems to be little concern over collateral values. The real estate investment trust (REIT) index has shown medium- to long-term growth as returns from good properties outpace other investments.
• It is possible the credit costs of financial institutions increase subject to the development of trade tensions between the U.S. and China, which may slow down global economy. However, financial institutions are less likely to incur massive losses from some big borrowers in sectors. This is due to banks' sufficient loan loss reserves against possible losses from ailing large corporates. On the other hand, we see some signs that small and medium-size regional banks are increasing lending to corporations with less creditworthiness than that of current existing borrowers. Therefore, we expect credit costs for the entire industry to slightly increase. However, as the exposure by those small institutions does not account for a large portion of industrywide exposure, the increase in credit costs will be limited.
• The household sector remains cautious in terms of borrowing and the debt-to-GDP ratio has not significantly increased.
• Underwriting standards have not significantly weakened.

Chart 7

Industry Risk  |  4

The key factors that support our industry risk score for Japan are a robust systemwide funding structure and prudent regulatory monitoring. On the other hand, we consider the risk of Japan's competitive dynamics to be high. We believe weakening profitability due to overcapacity, and weak earnings caused by lingering low interest rates, could further pose a risk to the stability of Japan's banking system. Despite their restrained risk appetite, the profitability of banks in Japan is lower than that of most of its peer countries in our BICRA group '3'.

Institutional framework: Enhanced regulatory framework in line with international standards

Banking regulation and supervision.  We view Japan as intermediate in terms of banking regulation and supervision. We consider the regulations in line with international standards.

Japan has been a member of the Basel Committee on Bank Supervision (BCBS) since the 1980s. Japanese banks with international operations started to comply with Basel III guidelines on capital requirements in March 2013. From March 2015, the minimum Common Equity Tier 1 (CET1) ratio for these banks was raised to 4.5%. The average CET1 ratio of Japan's four internationally active banking groups was 13.4% as of March 31, 2019. In addition, banks are required to set aside a capital conservation buffer of 2.5%. Along with this, a countercyclical capital buffer will be imposed, within a range of 0%-2.5%, subject to necessity as recognized by each respective country. In addition, the surcharge for global systemically important banks (G-SIBs) is scheduled to be increased by 1.0%-2.5%. The three largest banks in Japan (Mizuho Financial Group Inc. [Mizuho FG], Sumitomo Mitsui Financial Group Inc. [SMFG], and Mitsubishi UFJ Financial Group Inc. [MUFG]) are considered G-SIBs.

In addition to the conventional regulatory capital adequacy ratio, banks who comply with Basel III guidelines are required to clear a leverage ratio of 3% or more, a liquidity coverage ratio (LCR) of 100% or more, and a net stable funding ration (NSFR) of 100% or more (each required ratio is as of March 2019), by Japan's financial services agency (FSA).

In April 2018, FSA announced that Nomura Holdings is also required to fulfil total loss absorbing capacity (TLAC) requirements, in addition to the three G-SIBs mentioned above. The application of the regulation to Nomura will start from March 31, 2021, two years later than the start of full implementation period for the three G-SIBs (March 31, 2019).

Meanwhile, with regard to banks subject to domestic standards in calculating the regulatory capital ratio, a somewhat looser regulatory capital adequacy ratio that is slightly different from Basel III's standard has been applied. First, the major difference is the definition of regulatory capital under domestic standards. Regulatory capital under these standards only consists of the part called core capital (CET1 + preferred stock with mandatory conversion clause [or preferred capital issued by cooperative entity] + general loan loss reserves). And the minimum required capital ratio of domestic standard bank is 4%, which is lower than the Basel III standard that required to have 6% for the Tier 1 (= CET1 + additional Tier 1 [AT1]) ratio. The second major difference from the Basel III standard is the treatment of unrealized gains/losses on holding securities under the banking book. In calculating the capital adequacy ratio under domestic standards, no unrealized gains/losses on holding securities is taken into consideration as core capital.

In our bank analysis, we do not differentiate the applied method of capital calculation between banks under Basel III standards and those under domestic standards. We apply our own capital measurement, risk adjusted capital (RAC), to all our rated banks equally.

Regulatory track record.  In our view, Japan's regulator has learned lessons from a banking crisis in the early 2000s and has effectively prevented trouble in the industry for the past two decades or so. The FSA was established as an independent regulatory body in 1998 (formerly the Financial Supervisory Authority; now the Financial Services Agency) amid a financial crisis. The former regulator, the Ministry of Finance, was criticized for its forbearance and lack of expertise. The FSA is designed to have comprehensive authority over the regulation of financial markets and it covers all banks, brokerages, insurers, and finance companies. The FSA has improved disclosure requirements, clarified rules for write-downs and provisioning, and implemented an early warning system for capital and liquidity risks during the past two decades. In addition, in April 2019, the FSA announced a proposal for revision of an early warning system that requires regional banks with poor earnings to make improvements early.

The FSA, as well as the BOJ, monitors financial institutions very closely and frequently. For instance, all financial institutions including brokerages need to report to the BOJ their daily liquidity status and monthly solvency ratios. The BOJ and the FSA have previously taken timely actions when they found financial institutions in difficult conditions. Both institutions have strong capacity and the willingness to provide support to financial institutions in times of stress.

Other than the failure of the Incubator Bank of Japan Ltd. in 2010, we have not seen since 2003 failures of or government interventions in banks. However, Incubator Bank failed due to fraud and we view this case as an exception. Meanwhile, the government-run Deposit Insurance Corp. of Japan (DICJ) reduced insurance premiums from 2012 to reflect the low costs of financial assistance for troubled banks. Under the new scheme, which became effective in fiscal 2012, the premiums are retrospectively revised if no institutions become insolvent during the fiscal year and the balance amount is returned.

Governance and transparency.   We view governance and transparency in Japan as supportive of the banking sector. After the early 2000s banking crisis, banks have improved disclosure and transparency. For instance, they now disclose quarterly results and detailed information about their loan books, as well as apply stringent policies for loan categorization and reserves. Although Japanese corporations are able to apply International Financial Reporting Standards (IFRS), the majority of listed firms are reporting under the existing Japan Generally Accepted Accounting Principles.

After false accounting by Kanebo, a large textile and cosmetics company, led to the company being delisted in 2005 from the Tokyo Stock Exchange, the FSA has enhanced inspection of auditors and accounting firms. However, cases of accounting fraud such as Toshiba Corp.'s still occur occasionally. Therefore, we believe that the real challenges to governance and transparency are not in the institutional framework but in effective implementation of management measures among individual companies.

Most Japan-listed companies now engage the services of the four biggest auditing firms, which are affiliates of leading global accounting firms. We hold the view that the systems and the quality of the staff employed by large accounting firms are comparable to those in other developed markets.

The corporate governance system in Japan is different from that in the U.S. most Japanese corporations adopt an external auditor system instead of a committee system. After corporate laws were revised, the quality of corporate governance has improved. For instance, listed firms have to ensure that the majority of auditors are independent. However, the CEO gets to nominate the auditor, which constrains the effectiveness of this system. Generally, about 50% of board members of large banks are independent directors, although the ratio has been increasing.

Japan's three mega-banking groups--MUFG, Mizuho FG, and SMFG, which are classified as G-SIBs--have adopted a committee structure. The majority of their board members as well as their chairmen are independent directors.

The Companies Act was amended to adopt a corporate governance code requiring listed companies to appoint outside directors on a "comply or explain" basis. To further strengthen governance, the FSA also introduced a stewardship code to promote institutional investor activism.

Competitive dynamics: Steady risk appetite, but persistently low profitability indicates a less stable operating environment

Risk appetite.  We view Japan's banking industry as characterized by restrained risk appetite. In our view, commercial practices and the use of risky and complex products are not overly aggressive. We do not expect to see material changes to these practices in the coming years, although some banks are stepping up exposures in overseas markets, including emerging ones. Overseas income represented about 30%-35% of the consolidated operating profits of MUFG, Mizuho FG, and SMFG in fiscal 2018. We believe the present trend of overseas mergers and acquisitions could increase risks in their portfolios and erode capital. At the same time, they could weaken our assessments of major banks' risk positions and/or funding and liquidity. Similarly, regional banks are also increasing overseas exposures that might hurt their asset quality.

We view positively the major banks' focus on expanding noninterest income, which we think will limit the impact of constrained lending volumes and narrowing margins in a negative interest rate environment. The banking industry's average return on equity (ROE) in the past three years was 6.1%, in line with that in many developed countries in Europe but inferior to the one of U.S. and Australia. However, it is lower than the average (9.6%) of other sectors in the economy. Banks' ROE in fiscal 2018 dropped year on year by about 2 percentage points to 4.8%.

It was because that net income, which is the numerator in calculating ROE, decreased by about ¥0.8 trillion to ¥3.1 trillion. Many banks reported a decline in profits on the harsh business environment, but the main factor for a significant decline of ROE in 2018 was the plunge of Mizuho FG's net profit by ¥0.5 trillion from 2017. Mizuho's decline in profit was largely due to nonrecurring factors such as restructuring costs and losses on the sale of securities holdings. Accordingly, the ROE for the banking industry as a whole in fiscal 2019 is likely to recover to around 5.5%, unless major decline of profit occurs at major banks.

Generally, Japanese banks face moderate pressure from domestic shareholders. They are expected to provide stable funding to corporate and individual customers, and build solid franchises rather than focus on short-term earnings. Their restrained risk appetite also partly reflects the compensation schemes for Japan-based bankers--which are low compared to those in the U.S. and Europe--with a small portion directly linked to performance.

Industry stability.  We consider the industry to be unstable, reflecting persistent low interest rates as well as overcrowding. Both of these factors somewhat limit the ability of banks to take price leadership and charge appropriate risk premiums for loans to customers. Although major banks show some signs of recovery in profitability, the earnings prospects for regional banks remain bleak. Therefore, we believe the industry's overall profitability is likely to remain weak.

Chart 8

In terms of NIMs and ROE, the profitability of Japanese banks is much lower than that of their peers in the U.S., but generally on par or slightly lower than that of European peers. In our view, such low interest margins will be insufficient to cover credit costs under an adverse environment. We believe banks need to secure adequate premiums when making loans. Margins for housing loans and lending to blue-chip firms in Japan are wafer-thin, so developing new businesses while managing risks and significant retrenchment in cost are essential for improving profitability. We think persistent downward pressure on earnings indicates an unstable operating environment.

Chart 9

Meanwhile, one positive factor is Japanese banks' RoRWAs. If we compare the RoRWAs among G-SIBs (excluding U.S. and Chinese banks), Japanese banks stack up reasonably compared with those of their counterparts in the U.K. and Europe. The structure of Japanese banks' balance sheets is the main reason for the difference between their return on assets and their RoRWAs. Of their total assets, about 20% are deposits at the BOJ; about 10% are JGBs and municipal bonds. In other words, roughly 30% of their total assets are assets with limited credit risks with significantly low or no returns.

Table 4

The level of industry concentration is low. Japan's three biggest banks hold about 35% of total loans, while regional and cooperative banks have strong presences in local areas. We think the central bank's negative interest rate policy has since its introduction in 2016 dragged down market interest rates and further strained banks' interest margins. In fiscal 2018, domestic net interest income slipped 2% (weighted-average of 116 banks in Japan). This is much narrower than the percentage of change in the applied interest rate on existing loans (stock basis), which was 7% (applied interest rate dropped by 0.066 percentage points to 0.891%) year-on-year. The smaller decline is mainly due to an increase in outstanding loans and to banks shifting their outstanding holdings to higher-yielding securities to offset shrinking margins, in our view. We believe Japan's economy needs to maintain growth momentum and overcome deflation on a sustainable basis, before a move to positive interest rates is possible.

Although foreign banks have a considerable presence in value-added investment banking services, their presence in the commercial banking sector is limited. On the other hand, regional banks face stiff competition in urban areas--where they have ventured in pursuit of loan demand--from major banks and other financial institutions. At the same time, prospects in the regional banks home markets and local economies continue to diminish. We believe some of the weaker regional banks may fall into financial distress if they fail to improve the profitability of their core business within two to three years.

Market distortions.  Market distortion does not detract from our scoring in the competitive dynamics category.

The market share of government-owned and not-for-profit banks has been declining from 2000, but remains noteworthy at 12% as of 2018. This is lower than major Asian countries such as China, India, and Korea, and almost the same level as France. The nonbank sector accounted for only 2.2% of the total assets of all financial institutions in Japan in 2018.

There are no administrative controls over deposits and lending rates as they are fully liberalized. Government banks provide long-term loans at lower rates to cushion changes in the economic cycle.

Table 5

Systemwide funding: High share of deposit funding and remarkable depth in capital markets

Core customer deposits.   The systemwide funding structure is stable because core deposits are the main source of funding. Core deposits comprise 72% of total liabilities, and the ratio of core customer deposits to loans was 157% in 2018.

Individuals in Japan strongly prefer savings deposits; 53% of individual financial assets were savings deposits as of March 2018, surpassing 13% in the U.S. and 33% in the euro area (according to the BOJ's report on flow of funds, "Overview Of Japan, U.S., and the Euro area," published Aug. 14, 2018). This ratio has been quite stable for the past 15 years and we have not observed any substantial outflow of deposits under stress scenarios. However, we remain watchful of the steady rise in risky assets held by households.

External funding.  Japanese banks hold a net external creditor position thanks to strong support from core deposits. The ratio of the banking sector's net external debt to systemwide domestic loans is highly negative. Such borrowings are in dollars, euros, and other local currencies but they are mostly matched with assets, and banks take minimum foreign-currency risks. Systemwide liabilities in foreign currencies are close to 14% of total systemwide liabilities (in 2018).

Domestic debt-capital markets.   Japanese banks benefit from access to a domestic debt capital market that we consider moderately broad and deep. We consider the value of the market for private-sector commercial paper (CP) and bonds to be relatively small at 18 % of GDP (in 2018), compared to those in the U.S. and Europe. However, the market is developed and diversified. Major banks have relatively diversified funding tools including long-term bonds, CP, and securitizations with the aim of controlling interest rate risks.

Government role.   We view the government's role in systemwide funding as strong, given its provision of financial support and liquidity during the last banking crisis. The government has used a broad range of policy tools to support financial stability. The BOJ has a long record of providing substantial financing to the financial system (on a systemwide level and to specific institutions) during times of stress. Most commercial banks and brokerages have access to the central bank's lending facility and they are able to get funds from the BOJ if they provide eligible collateral such as government bonds, municipal bonds, and corporate bonds. In addition to this traditional approach, the BOJ is able to provide financial support in the form of special lending to maintain financial stability (Article 38 of the Bank of Japan Law).

Table 6

Peer BICRA Scores

The summary scores for some of Japan's peers (see table 7) show that Japan has performed better than peers with respect to its economic scores. Japan's economic risk score benefits from a strong external position and low credit risk. The score for economic resilience, however, is weaker than that for the U.S. and Australia due to Japan's limited fiscal flexibility. Japan's industry risk score is the same as that of Korea, but inferior to those of all other peer countries. Weakness in industry risk mainly reflects the competitive dynamics that arise from low interest rates and intense competition among banks, despite our strong assessment of systemwide funding in Japan relative to most of its peers. Japan's institutional framework is on par with its peers except for Australia. The higher assessment of Australia's institutional framework than its peers is based on the following observations: Australia's financial authorities are generally early adopters of regulatory best practices, and if necessary, they adopt more stringent standard than the Basel framework requires. For example, they apply stringent deductions when computing qualifying regulatory Tier 1 capital, higher loss-given-default floors on residential mortgages.

Table 7

Government Support

We classify Japan's government as highly supportive of the domestic banking system, in recognition of a long record of support and an enhanced safety net system.

The Japanese government has explicitly stated that it would support financial institutions to maintain the stability of the banking system. In practice, all depositors as well as debt holders, including subordinated debt holders, have been protected from bank failures since 1999, when the DIA was amended. The only exception was the payoff of Incubator Bank of Japan Ltd. in 2010. The FSA decided to let the bank fail because of its small size and limited connections within the banking system, which is evidenced by the fact that the bank was not involved in commercial banks' payment systems via their accounts at the BOJ.

During the banking crisis in the late 1990s, Article 102 of the DIA enhanced the government's ability to provide capital injections to prevent insolvency. We consider the country's institutional and administrative framework to be well developed, facilitating a timely and coordinated response to a potential systemic financial problem. In 2014, the government implemented the revised DIA to allow it to inject capital into a broader range of financial institutions if the failure of these institutions were to threaten the stability of the financial system. We think the revision reflects the government's strong commitment to support stability in the financial system.

The revision included the establishment of an orderly resolution framework for assets and liabilities of distressed financial institutions. Although the government technically established its scheme for the orderly resolution framework through the DIA amendment in 2014, we still believe the government maintains its highly supportive stance and it will provide support, including capital injections, to systematically important banking groups including holding companies if necessary. In fact, the FSA stated in the paper published April 2018 that preemptive capital-injection measures could be taken for major banks as well.

If the government determines that the country's financial system is facing a crisis--at the national or regional level--it can take preventive actions, including injecting capital into financial institutions, providing financial support for failed or insolvent banks, and putting failed institutions under public control through the acquisition of outstanding stock via DICJ.

In July 2003, the government took control of Resona Bank (a major national bank) and Ashikaga Bank (a regional bank). Neither institution had defaulted on its debt. Both institutions had also made all repayments, including those on subordinated instruments, in a timely manner. The government interventions were not subject to authorization by a supernational agency as Japan does not belong to any multinational unions.

On the other hand, the FSA also announced that it will adopt an ordinary resolution framework for four systemically important financial institutions groups in Japan (4 SIBs: three G-SIBs in Japan and Nomura Holdings). With regard to bail-in, Japan takes the contractual bail-in approach (which is implemented based on the contracts of hybrid instruments). As such, in a situation where a preemptive capital injection scheme and an ordinary resolution framework coexist, it is unclear in when and what kind of bank debt shall be bailed-in. In fact, "FSB 2018 Resolution Report: 'Keeping the pressure up'" issued in November 2018 showed the view that Japan's methodology of recapitalization via ordinary resolution framework is not clear. In the future, Japanese authorities will be required to elaborate more in the details of actual implementation plans of the resolution framework.

With regard to the financial resources to support Japan's financial system, we believe the government has sufficient resources. Although its debt level is high, the government is able to fund its debt at a low cost in the domestic market, supported by ample savings of households and corporations.

Table 8

Related Criteria

• Banking Industry Country Risk Assessment Methodology And Assumptions, Nov.9, 2011
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011
• Sovereign Rating Methodology, Dec. 18, 2017

Related Research

• Japan, April 30,2019
• Japan Banking Outlook 2019: The Three Main Risks, Dec. 19, 2019
• Why Japan's Regional Banks Aren't As Profitable As German And U.S. Peers, March 11, 2019
• The ¥16 Trillion Hurdle For Japanese Regional Banks, April 2, 2019
• Japan Post’s And JA’s Subsidy Model Flounders, June 5, 2019