Japan's regional banks got a temporary boost, but how they adapt to a changing environment could further widen differences in their profitability.

Financial results of 11 Japanese regional banks we rate improved in fiscal 2021 (ended March 31, 2022). Combined core net operating profit increased year on year, but much of this was down to temporary support measures from the central government and the Bank of Japan (BOJ). We also note deterioration in unrealized positions on available-for-sale securities due to higher overseas interest rates. With this in mind, we believe sustaining improved profitability remains challenging.

Among Japanese regional banks we rate (see note 1), differences in earnings capacity are widening based on revenue and cost structure profiles, progress in revenue diversification, in addition to the demographics and economic size of respective home markets. Therefore, we may consider downgrading banks that fail to promptly adapt to changes in business environment, leading us to view their revenue bases as weaker than the average of Japan's banking industry.

Rated regional banks' combined core net operating profit rose 17.3% and pretax net profit increased 20.2% year on year in fiscal 2021, thanks to institutional support from the Japanese government and the BOJ and increased interests and dividends from investment securities (see table 1). Operating expenses dropped 2.5% year on year, partially backed by the BOJ's special deposit facility program. Credit costs decreased 36.2% year on year, reflecting ample liquidity support provided to corporations amid the COVID-19 pandemic. The credit costs to outstanding loan balance improved to 12 basis points (bps) from 19 bps.

Table 1

Profitability: Divergences Amid Low Earnings Environment

We expect interest income on loans for regional banks we rate (aggregate of the 11 regional banks unless otherwise stated) to continue declining. Their average net interest margin before credit costs and operating expenses was 0.88% in fiscal 2021, a decrease of 2 bps year on year. Combined interest income on lending was lower than in fiscal 2020, due to lower yields on newly extended loans, mainly mortgages (see chart 1). This more than offset higher loan yields and loan balance resulting from a surge in loans guaranteed by credit guarantee corporations (CGCs) triggered by the pandemic.

We believe their gross operating revenue will likely remain under pressure; it is mainly interest income on loans, which comprises more than 70% of net interest income (see chart 2). This is because the government's support program, which allowed private financial institutions to provide unsecured and effectively interest-free loans, ceased to be available at the end of March 2021, and we expect borrowers to repay these pandemic-relief loans gradually.

Chart 1

Chart 2

We believe the core, underlying problem facing Japanese regional banks--weakening fundamental earnings capacity--will become clearer as the impact of institutional support measures on net interest income diminishes. The BOJ's provision of special funds in response to COVID-19 will come to end on Sept. 30, 2022. Its special deposit facility program is also set to expire at the end of fiscal 2022, following the revision of its maximum limit in 2021. We estimate these institutional support programs have contributed billions of yen annually to net interest income for many rated regional banks.

The profitability of regional banks we rate will increasingly diverge between those adapting to changes in the business environment and those failing to do so, in our view. Many have high market shares in their respective areas of operation. However, gaps in profitability have widened based not only on the demographics and economic size of their home markets, but also on their revenues and cost structures and progress in revenue diversification (see charts 3 and 4). In recent years, an increasing number of regional banks, including Hokkoku Bank Ltd., Shizuoka Bank Ltd., and Iyo Bank Ltd., have changed or plan to change to a holding company structure through a sole share transfer. Lowering the proportion of their lending businesses, which have limited prospects for growth, and establishing new revenue streams in areas where they have a competitive advantage will grow in importance for the regional banks in our view, given the prolonged low interest rates.

Chart 3

Chart 4

Furthermore, we think the future competitiveness and profitability of Japanese regional banks hinge on information technology (IT) and cyber risk management strategies. For example, digital transformation (DX) could offer new revenue opportunities and lower the barrier to entry for competitors by removing geographic constraints. In addition, regional banks have recently sought to develop further decentralized networks in their operations. We believe expertise in the way this has been managed directly affects their exposure to cybersecurity risk. However, they will need to reduce costs sufficiently to promote IT and DX investments, in our view.

We also focus on cases where changing customer needs, for example to address environmental challenges, have led to organizational changes at regional banks. This occurred when the shift to vehicle electrification in the automobile industry indirectly prompted collaborations between regional banks facing common issues--Shizuoka Bank Ltd. and Bank of Nagoya Ltd. formed a business alliance, as did Gunma Bank Ltd. and Ashikaga Bank Ltd. Regional banks play an important role in supporting local economies. We believe providing appropriately timed transition financing for decarbonization through such alliances will help prevent nonperforming loans from arising in the future and create new revenue opportunities.

Asset Quality: Long-Term Credit Risk In Lending And Interest Rate Risk In Investment

We believe Japanese rated regional banks will continue to suffer sporadic credit costs on large borrowers and sectors struggling to recover from the COVID-19 pandemic. This is because the Japanese economy is recovering only moderately, fueling uncertainty. We forecast real GDP growth rates of 2.3% in 2022 and 1.9% in 2023, due to a weak rebound of the domestic economy. In fiscal 2021, regional banks we rate had a ratio of credit costs to average outstanding loan balance of 12 bps, down from 19 bps in fiscal 2020. However, we view their credit costs as somewhat higher than pre-pandemic levels, given a surge in COVID-19 relief loans (see chart 5).

Issues such as cost-push inflation, depreciation of the yen, and extensive borrowing due to COVID-19 may hinder recovery in the operating performance of small and midsize enterprises (SMEs) or further worsen their ability to pay debt. The manufacturing industry is on track for recovery. In contrast, while operating performance in the nonmanufacturing sector may improve temporarily thanks to pent-up demand, debt repayment capacity, in terms of net debt-to-EBITDA ratio, has been deteriorating moderately for SMEs in the real estate and transportation sectors since the beginning of the pandemic (see chart 6). Regional banks' CGC-guaranteed lending soared through the pandemic. However, the banks are still exposed to credit risk arising from proper loans (bank loans without guarantees). We believe credit risk of such exposure may be higher than it was before the pandemic, as proper loans incurring interest will more likely remain within the borrowings of corporate customers with weak repayment capacity.

Chart 5

Chart 6

It remains important for regional banks to keep their risk-taking within their loss-absorbing capacity, in our view. The environment for securities investment will remain unstable. The total outstanding balance of securities held by the 11 banks at the end of fiscal 2021 was nearly flat from a year earlier. However, some banks realized losses on foreign bonds or posted gains on sales of stocks (see chart 7). Additionally, unrealized gains on foreign bonds and fixed income-related investment trusts deteriorated substantially and turned to unrealized losses in the fourth quarter of fiscal 2021 due to higher overseas interest rates (see chart 8).

We think interest rate risk management has become more important for regional banks. In recent years, a growing number of regional banks have sought longer durations on bonds or have tried to expand exposure to multi-asset investment trusts that take interest rate risk on foreign bonds. Rated regional banks' available-for-sale securities have net unrealized gains if we take into account unrealized gains on stocks. However, income from securities investments is more volatile than that from the lending business, in our view. Thus, we consider securities investment as a risk factor that heightens revenue volatility.

Chart 7

Chart 8

We believe rated regional banks will need to invest surplus funds strategically, given limited demand for loans in home markets and low yields on yen-denominated bonds and deposits at the BOJ. Their investments in Japanese government bonds and municipal bonds increased in fiscal 2021. In fiscal 2022, these banks may also raise exposure to yen-denominated bonds reflecting slight improvement in domestic interest rates, as we expect them to retain a conservative stance toward investing in foreign bonds, due to rising overseas interest rates. Furthermore, their deposits on the asset side, mostly held in current accounts at the BOJ, increased 25.9% year on year at the end of fiscal 2021 (see chart 9) to represent 23.5% of total assets, backed by the BOJ's institutional support measures.

Chart 9

Capitalization Remains Favorable; Risk Factors Like Stock Market Volatility To Remain Manageable

Rated regional banks' capitalization will likely continue to underpin their credit profiles, providing them with loss-absorbing buffers. We consider their capitalization to be more favorable than that of major Japanese banks (see note 2) and comparable with overseas peers. Their combined risk-adjusted capital (RAC) ratio was 9.6% on a weighted-average basis as of Sept. 30, 2021, changing little from 9.7% a year earlier (see chart 10. we calculate the RAC ratio as of March 31, 2022, after obtaining required details). We note additional guaranteed loans helped regional banks contain growth in risk-weighted assets while profits accumulated into capital amid the pandemic.

Chart 10

Volatility in the RAC ratios of rated regional banks, arising from factors such as equity market movements, will likely remain in ranges tolerated by our current credit assessment levels. A large drop in stock prices may cause their RAC ratios to decline, as unrealized gains on stockholdings influence the ratios. However, we estimate that a 30% drop in the market value of rated regional banks' stockholdings from that of Sept. 30, 2021 (when the Nikkei Stock Average was ¥29,453), keeping other conditions unchanged, would only cause their respective RAC ratios to fall within 0.0-1.0 percentage points, depending on the amount of unrealized gains on stocks.

In our view, accumulation of capital by regional banks may decelerate, as many started to pursue aggressive shareholder return policies, raising dividend payout ratios and buying back their shares. Additionally, RAC ratios may come under pressure if rated regional banks materially increase equity investments to corporate customers, for example, to support their restructuring efforts. We consider the risk of such investments as high.

Table 2

Table 3

Notes

1. The 11 Japanese regional banks that S&P Global Ratings rates are Bank of Kyoto Ltd., Chiba Bank Ltd., Gunma Bank Ltd., Hachijuni Bank Ltd., Higo Bank Ltd., Hokkoku Bank Ltd., Hokuriku Bank Ltd., Iyo Bank Ltd., Kagoshima Bank Ltd., Keiyo Bank Ltd., and Shizuoka Bank Ltd. We used the group figures of Hokuhoku Financial Group Inc. for Hokuriku Bank Ltd.

2. The holding companies of Japan's five major banking groups are Mitsubishi UFJ Financial Group Inc., Mizuho Financial Group Inc., Sumitomo Mitsui Financial Group Inc., Resona Holdings Inc., and Sumitomo Mitsui Trust Holdings Inc.

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