Japan's five major banking groups could be in for a long wait before a doubling of credit costs in the past year recedes to pre-pandemic levels.

S&P Global Ratings forecasts that the groups' aggregate credit costs will decrease to about ¥650 billion in fiscal 2022 (ending March 31, 2023), based on its macroeconomic scenario. Each group's earnings will grow 5%-10% annually under our base-case scenario, with asset quality and capital levels remaining stable.

Two risk factors might stymie a recovery. First, credit costs could be higher than our expected scenario if household and corporate borrowers riding a wave of support from the government's pandemic-related economic stimulus do not recover their ability to repay debt. Second, the groups face downside risks from irregular conditions in global capital markets. These may lead to higher foreign currency funding costs and lower earnings in capital markets divisions.

Efforts to reduce strategic shareholdings will help stabilize capital ratios, in our view. Each of the five banking groups has progressed plans to slash strategic shareholdings. We think reduced stockholdings will help stabilize the groups' capital ratios. At the same time, each needs to enhance its earnings capacity, in our view.

Japan's five major banking groups are Mitsubishi UFJ Financial Group Inc. (MUFG), Mizuho Financial Group Inc. (Mizuho group), Sumitomo Mitsui Financial Group Inc. (SMFG), Resona Holdings Inc., and Sumitomo Mitsui Trust Holdings Inc. (SMTH). We rate Resona Bank Ltd. and Sumitomo Mitsui Trust Bank Ltd.

Table 1

A Scenario For Recovery

The five groups' heightened credit costs are likely to abate in fiscal 2022, in our base-case scenario. We expect their aggregate credit costs to decline to about ¥650 billion in fiscal 2022 from over ¥1.1 trillion in fiscal 2020. Our expectation of their credit costs for fiscal 2022 would be on par with the ¥632 billion result in fiscal 2019, which included forward-looking loan loss provisions. Our macroeconomic scenario is for a quicker recovery from the current pandemic than from the global financial crisis of 2008-2009. Thus, we expect accumulated credit costs for the three years from the start of the pandemic to be about 60% of the total for the three years from the start of the financial crisis. We forecast Japan's real GDP growth will be 2.7% in 2021 and 2.0% in 2022, respectively (on a calendar year basis; forecasts of GDP growth in chart 1 are on a fiscal year annualized basis).

Chart 1

The five major banking groups will grow their profits 5%-10% annually in the next two years, under our base-case scenario. This will be thanks mainly to a rebound in economic activity and lower credit costs. Fiscal 2020 profits were almost in line with those of the previous fiscal year despite higher credit costs. Major factors behind solid performance include growing demand for lending from corporations moving to secure liquidity and increased fee income amid buoyant activities in capital markets. We expect earnings momentum to continue in fiscal 2021.

Table 2

We expect each group to manage asset quality and maintain an appropriate level of regulatory capital. Asset quality of the five banking groups deteriorated slightly in fiscal 2020, as measured by their combined gross nonperforming loan (NPL) ratio, amid the COVID-19 pandemic (see chart 2). However, pandemic-related government financial assistance for corporations and relief payments to individuals limited the slide. We expect downward pressure on asset quality to remain, particularly for assets in industries that the pandemic has severely affected. However, potential harm to profits from future erosion of asset quality is likely to remain manageable. This is because the five major banking groups have made forward-looking loan loss provisions to cope with the COVID-19 pandemic.

Common equity tier 1 (CET1) ratios for the five groups as of the end of fiscal 2020 were almost in line with, or moderately improved from, the previous year. Rises in unrealized gains on stockholdings thanks to higher domestic stock prices and accumulation of profits have boosted each group's regulatory capital. Increased regulatory capital wiped out the impact of higher regulatory risk-weighted assets (RWA) stemming from declines in asset quality and growth in lending. In addition, each group has allocated much of the rise in its deposit balance to investments in Japanese government bonds (JGBs) and deposits at the Bank of Japan. This also has moderated the increase in regulatory RWA of each group, in our view.

Chart 2

Table 3

Main Risk Factors On The Path To Economic Recovery

The first risk factor is potentially weaker creditworthiness of corporate and individual borrowers currently buoyed by the Japanese government's economic stimulus package. Most financial support in response to the COVID-19 shock is temporary. Accordingly, the groups' credit costs could increase if borrowers' capacity to repay debt does not recover by the time such measures end or subsidies on interest diminish three years after implementation of loans advanced under the stimulus package (see "Japan Banking Outlook 2021: Expect Rising Credit Risks," published Jan. 14, 2021). Meanwhile, the banking groups shifted in the second half of fiscal 2020 from supporting corporate customers' financial needs in the early stage of the COVID-19 crisis to addressing longer-term capital needs. We think capital financing amid accelerated secular shifts to do with energy transition and digitalization will require each banking group to demonstrate stronger abilities to assess targeted businesses and industries.

The second risk factor is irregular conditions in global capital markets in the recovery from the pandemic. Rising volatility or repricing in markets could potentially hurt the five groups' foreign currency funding environment or securities portfolios. We assess the groups as having high stability in funding and liquidity compared with international peers. Therefore, any deterioration in the foreign currency funding environment during the recovery process could pressure creditworthiness. In fiscal 2020, when the pandemic started spreading globally, foreign currency funding conditions remained stable as major central banks collaborated globally to provide dollar funding. Foreign currency lending of the four groups apart from Resona Holdings declined about 9% from the previous year (see chart 3). This was mainly because corporate borrowers' needs for dollar funding were mostly satisfied and their funding activities had shifted to capital markets amid favorable conditions.

The groups' securities subsidiaries produced largely strong financial results in fiscal 2020 (see "Japan Brokerages Enjoyed Tailwinds, Now Structural Reform Is Key," published May 27, 2021). However, the subsidiaries' revenues and profits in overseas businesses are highly volatile, and they could risk making substantial trading losses relative to business scale in the event of market dislocations.

Chart 3

Cutting Strategic Shareholdings; Stabilizing Capital Ratios

We think the five groups' efforts to reduce strategic shareholdings will likely help improve their capital ratios and make them more predictable. Each group has pushed ahead with plans to slash strategic shareholdings. Among others, SMTH recently announced its intention to cut its cross-shareholdings to zero with an acceleration of such efforts. We apply very high risk-weights to equity investments under our risk-adjusted capital (RAC) framework. This is one reason Japan's major banking groups have lower RAC ratios than major non-Japanese global systemically important banks (G-SIBs; see note 1) (see chart 4). Strategic shareholdings also can erode stability of each group's capitalization because movements in stock prices have the potential to alter capital ratios.

Chart 4

A key challenge we see for the five groups is to develop stable revenue bases without relying on stockholdings. Major U.S. banking groups lost profitability temporarily in fiscal 2019, due mainly to the COVID-19 pandemic and in part to changes in provisioning standards. However, U.S. peers still remain far more profitable than Japan's major banking groups (see chart 5). In addition, dividends and capital gains on sales of strategic shareholdings have supported net profit at Japan's major banking groups (see chart 6). Prior to the COVID-19 pandemic, each group had expanded overseas operations, which are more profitable than domestic operations. However, a persistent low interest rate environment globally would push down profitability at overseas businesses. We will monitor any developments in business sectors or regions that each group targets for earnings opportunities. This is because the direction each group takes for future growth could affect its creditworthiness, in our opinion.

Chart 5

Chart 6

Major banks view ongoing efforts to reduce greenhouse gas emissions as a business opportunity. Japan's government aims to achieve carbon neutrality by 2050, and each of the five groups is accelerating efforts to reduce such emissions. Many financial institutions and investors are likely to support companies working to reduce emissions, mainly in carbon-intensive industries. Through engagement with corporate customers, major banking groups set target financing amounts to reduce carbon emissions. The groups are also moving to raise those target amounts.

Table 4

Note

1. This report uses data on Citigroup, Bank of America, JPMorgan Chase, Barclays, HSBC, BNP Paribas, and Deutsche Bank, which we refer to collectively as the major foreign G-SIBs.

G-SIBs (global systematically important banks) refer to banks designated by the Financial Stability Board and include Japan's three megabank groups.

Issuer Review

Table 5

Related Research

• Japan Brokerages Enjoyed Tailwinds, Now Structural Reform Is Key, May 27, 2021
• Japan Banking Outlook 2021: Expect Rising Credit Risks, Jan. 14, 2021
• Banking Industry Country Risk Assessment: Japan, Aug. 6, 2020