The pandemic is dividing the strong from the weak.

COVID-19 and emergency responses to it have unleashed powerful forces. Surging global demand, extraordinarily benign financing conditions, strained supply chains, and soaring energy prices are just some. These and other influences of the pandemic and its aftershocks rocking corporations and economies will remain of central importance to creditworthiness across the globe this year.

In our view, global credit momentum will remain positive in 2022, with supportive fiscal and monetary policy still heavily underwriting financing conditions and economic growth easing to a more sustainable pace. Nevertheless, the recovery's foundations are relatively fragile and vulnerable to setbacks. The pandemic remains very active, with the omicron variant posing a new threat and vaccination rates worryingly low in many parts of the world. Our base case is for continuing low default rates and improving credit prospects in Japan and globally; but uncertainties abound and risk premiums are uncomfortably low.

The Japanese economy is susceptible to global economic trends. Japanese bank earnings, in turn, are highly linked to domestic macroeconomic trends. We forecast these earnings will remain greatly affected by the pandemic and its aftermath in 2022. In particular, Japan's regional banking industry shows no sign of improvement in underlying profitability. It faces greater challenges than the major banks, in our view. Furthermore, we think excessive debt, which has risen around the world as a side effect of measures to ease long-term monetary policy, will become a major risk factor for Japanese banks, as it has for banks in other countries, depending on future developments concerning inflation and interest rates.

Government Support Skews Established Trends

Japan's economy, like those of other developed countries, was severely affected by the pandemic in 2020 and 2021 (table 1). However, swift and massive government support for the private sector (the general corporate sector, excluding finance and insurance companies, and the household sector) dramatically changed the correlation between the credit cost ratio (credit costs divided by outstanding loans) of Japan's private banks and economic growth. As a result, private banks' credit cost ratios remained low at an average of about 0.2% (in fiscal 2020, ended March 31, 2021) even as economic growth stalled, deviating significantly from past trends (chart 1).

The financial condition of the domestic corporate sector has a major effect on the quality of Japanese bank assets. However, the net debt ratio (debt minus cash and deposits, divided by total assets) of Japanese companies has barely risen (bar graph in chart 2) in recent times. This is because although they have taken advantage of various financial support measures to increase their liabilities, at the same time they have boosted their cash and deposits. Doing so increased liquidity on hand and helped the companies prepare for emergencies. On the other hand, there has been a rise in the gross debt ratio of companies before deductions of cash and cash equivalents. In the first half of fiscal 2021 (April-September 2021), Japanese banks' end-balance of overall lending increased about 5% (domestic business sector: +7%; international business sector: -2%) compared with the first half of fiscal 2019, before the pandemic.

Chart 1

Chart 2

Major Banking Groups Are Recovering And Bolstering Defenses

Despite the macroeconomic stress that COVID-19 has wrought, we see improvement in the fundamental profitability of Japan's three largest banking groups (Mitsubishi UFJ Financial Group Inc., Mizuho Financial Group Inc., and Sumitomo Mitsui Financial Group Inc.). This trend differs significantly from that of banks with strengths in regional areas, such as Resona Holdings Inc. and regional banks, which have yet to halt their decline in fundamental profitability.

On the surface, financial results for the first half of fiscal 2021 ended September 2021 indicate all three major banking groups and regional banks had solid financial performances, with substantially higher fundamental core operating profits and net income. However, a closer look reveals increased core operating profits were mainly due to more net interest income from higher loan balances, as the corporate sector boosted borrowings to cope with COVID-19-related emergencies. More net income was mainly a result of significantly restrained credit costs amid large government support for the corporate sector and not due to any improvement in banks' fundamental risk-return profitability.

Nevertheless, a close examination of the three major banking groups to the exclusion of other banks finds them preparing for future uncertainties. Evidence for this includes:

• Improving net interest margins on loans to domestic corporations;
• Reasonably high actual or forecast credit costs, in line with declining profitability of lending clients (their actual posted credit cost ratio for fiscal 2020 was 0.39% and their announced forecast for fiscal 2021 is 0.17%); and
• Already reduced loan exposures because customers with relatively strong financial conditions compared with those of regional banks have started to repay excess borrowings (the balance of loans at the end of September 2021 was -2% of the balance at the end of March 2021).

In addition, an increase in fee income is also a positive factor for creditworthiness. This is in stark contrast to the situation of regional financial institutions. At these banks, loan margins continue to decline, credit-related expenses remain insufficient for the conditions of financially pressured small and midsize enterprises (SMEs), and loan balances as of September 2021 show continued increases from the same time the previous fiscal year.

Regional Banks Look Unprepared To Respond To Underlying Stresses

Thanks to massive government support for the private sector, corporate bankruptcies in Japan have remained lower than they were before the pandemic, such as in 2019 (chart 3). In addition, banks' credit costs have not increased significantly, as mentioned above. From a macro perspective, the pandemic has not led to a significant increase in the corporate sector's net debt ratio. However, this economic calm is all thanks to government support. In reality, the eruption of the coronavirus has slowed Japan's economic growth rate and Japanese companies' earnings have generally declined despite some differences among individual entities.

According to a Ministry of Finance survey published Oct. 27, 2021, 59% of companies said business performance had decreased compared with normal conditions (14% said business performance increased; 27% reported no particular impact). Deterioration in business performance was particularly pronounced in the department store, transportation, and accommodation and restaurant industries. And while 80% of companies had no plan to raise additional funds, due to sufficient cash reserves secured via government funding support, companies in these three industries formed a relatively large percentage (about 50%) of those that needed additional funds.

A large difference could be seen by size of company, with 12% of large companies responding that they needed additional funds, compared with 31% of SMEs. Furthermore, in the three major metropolitan areas of Tokyo, Nagoya, and Osaka--mother markets of the three major banking groups--the percentage of companies that said they needed additional funds was below the national average of 20%, while in many regional areas the percentage was over 30%.

In other words, while an overall macro view of companies offers no clear picture, because distress in each industry and region is diluted, a closer look by size and region shows distress deepening among SMEs and regional companies, the main customers of regional banks. Meanwhile, regional banks have set aside an insufficiently low level of loan loss reserves (declared credit costs) to reflect declining profitability of borrowers compared with major banks (chart 4). In addition, the government's emergency support is temporary. Therefore, regional banks will be tested on their ability to withstand deteriorating asset quality in 2022 and beyond.

Chart 3

Chart 4

The Specter Of Inflation And Other Risk Factors

Generally, when inflation rises, market interest rates also rise, often positively affecting banks' mid- to long-term earnings. However, the recent rise in the private sector (corporate and household) debt ratio because of stress from the pandemic produces risks that negative effects of cost-push inflation (including greater interest cost of debt) will outweigh positive effects of increasing earnings in the private sector and that debt repayment capacity of borrowers will decline. In other words, in a phase of declining capital to total asset ratios, loss-absorbing capacity is reduced and declining income of individual economic entities could become a major risk factor for the global and Japanese macroeconomies. Therefore, we are closely monitoring how the rise in global inflation affects the creditworthiness of bank loans.

In addition, Japanese banks have rather high ratios of bond holdings to total assets compared with global peers. This increases the risk that higher interest rates will lead to higher unrealized losses on securities holdings. At the same time, looking at recent developments in stock markets, we cannot ignore the risk that rising interest rates may hurt stock prices. We calculate holdings of bonds (government, municipal, and corporate) and stocks (excluding stocks incorporated into investment trust funds) accounted for about 10% and 2%, respectively, of Japanese banks' total assets as of the end of March 2021.

Furthermore, a study of the relationship between the inflation rate and domestic bank lending rates over the past 15 years shows bank lending rates have actually declined even when inflation has been positive in recent years. Specifically, while there have been three recent periods of positive inflation in Japan--2006 to 2008, 2013 to 2015, and 2017 to 2019--only in 2006-2008 did the short-term prime rate and other bank lending rates in the final month of the inflationary period exceed those in the month before inflation took hold. Bank lending rates declined 0.1 percentage point at the end of the second period and remained unchanged at the end of the third.

Despite periods of inflation in recent years, two main factors have restrained rises in the interest rates banks charge for domestic lending. First, the private sector (corporate and household) has had an overall surplus of funds and low demand for loans. Second, the competitive environment among banks has worsened because of an expansion of low-interest loans (housing loans and loans to SMEs) from regional banks in metropolitan areas. Therefore, in Japan, unlike in other countries, higher inflation and a resulting rise in market interest rates may not improve banks' net interest margins on loans.

Also, during past rises in U.S. interest rates, depending on the pace of transition, withdrawal of investment funds has temporarily disrupted economies of emerging countries. Therefore, we need to pay attention to the impact changes in U.S. interest rates might have on international financial markets and in particular this year on Japanese major banks' overseas lending.

Developments in China's economy, which has shown signs of a slowdown, especially in the real estate sector, could also be a risk factor for Japan's major banks. This is because China, the world's second-largest economy, accounts for about 17% of global GDP and has large direct and indirect impacts on international financial markets.

We also believe developments in overseas credit are a risk factor for regional banks. This is because their search for yield in the face of declining interest margins and other profit opportunities may lead them to increase exposure to areas in which they do not have strong positions, such as overseas investments and domestic equities. In addition, we believe any upheaval in the regional bank industry could become a risk factor for Japanese banking as a whole. This is because turmoil among regional banks, which account for 36% of Japanese banks' total assets (according to data from the Japanese Bankers Association), could develop into a systemic risk for the entire industry.

Notwithstanding the above, it remains the case that banks cannot escape the influence on their creditworthiness of macroeconomic conditions in each of the regions in which they operate. Therefore, as with banks in other countries, Japanese banks' creditworthiness in 2022 will depend on the economic landscape, where uncertainties are increasing as the omicron variant spreads, posing a renewed threat from the pandemic.

Related Research

• Japan Megabanks’ Earnings Capacity To Improve, Dec. 13, 2021
• Japanese Regional Banks: The Pandemic Bonanza Is A Blip, Sept. 26, 2021
• Banking Industry Country Risk Assessment: Japan, Aug. 5, 2021