The forecast is for fog, everywhere. Japan's banking sector, however, looks relatively well equipped to navigate this.

Accumulated capital, low nonperforming loan (NPL) ratios, and our base-case growth forecast for the Japanese economy mean 2023 is likely to be a stable year for banks here. However, our global economic base case may not hold. Plenty, such as the inflation trend, is tinged with uncertainty.

Interest rates are a major focus for us this year. A rise in interest rates would be basically positive for Japanese banks, in S&P Global Ratings' view. This is because we think any possible rise in interest rates, which would reflect inflation in Japan, would likely remain relatively mild. However, bank interest income from loans is unlikely to improve much unless short-term interest rates rise. In addition, some banks could be hurt by increasing unrealized losses on available-for-sale (AFS) bonds if interest rates rise.

Then there are credit costs. We expect these to hover around the same level as last year. Negative factors, however, could come to outweigh the positives and push up such costs. For instance, credit costs could rise if higher interest rates hamper borrowers' ability to pay off debt. In addition, earnings of small- and midsize enterprises (SMEs) have had the support of temporary government measures amid the COVID-19 pandemic. These earnings could deteriorate as the government winds down its support measures. This could become another factor that impacts bank credit costs.

Japan's Economic Growth Should Exceed Other Major Developed Countries'

Japan's real GDP will grow 1.2% in 2023, in our view. Even in our downside scenario (see "Global Credit Conditions Downside Scenario: Inflation, Geopolitics Are Twin Threats To Our Base Case," published Dec. 8, 2022), we forecast 0.9% growth for Japan in 2023.

Therefore, we expect Japan to have one of the highest growth rates among major developed economies in 2023 (See table 1). We base this projection on our views that:

• Japan's inflation is relatively low among major countries,
• Bank of Japan (BOJ) monetary tightening is mild (short-term interest rates remain accommodative), and
• The degree of slowdown in economic activity is moderate.

However, Japan's fairly stable macroeconomic prospects do not mean we consider the outlook for Japan's banking industry to be rosier than those of other major countries. While pressure from economic risks should be somewhat smaller than that on peer countries, industry risks are as high. This is because of factors such as vulnerable competitive dynamics (see "Banking Industry Country Risk Assessment: Japan," published June 15, 2022). In addition, some Japanese private corporate sectors cannot pass rising raw material prices on to consumers or are overleveraged by debt or bank borrowing. For this reason, there is a risk that banks' credit costs will increase to a greater degree than we expect when interest rates rise.

On top of this, we see a reasonably high risk that our global economic base case does not hold, given uncertainties such as the inflation trend.

Table 1

Impact Of Higher Rates: Positive For Loan Interest Income, Negative For Unrealized Profit/Losses On Bonds

Banks will not improve interest income from loans unless short-term interest rates rise. In December 2022, the BOJ shocked markets with a tweak to its yield curve control policy, allowing long-term interest rates to rise more. Accordingly, yields for 10-year Japanese government bonds (JGBs) almost doubled to about 0.5%, the new upper limit (up from 0.25%) under the yield curve control policy. On short-term rates, however, the BOJ remains very accommodative. In fact, short-term interest rates used by markets, such as Tokyo interbank offered rate (TIBOR), which significantly impact bank lending rates, have barely risen (see chart 1).

Meanwhile, the negative impact from declining prices of holding AFS bonds outweigh the benefits of increasing interest income for loans, in our view. Unrealized losses on AFS bonds on banks' books had been rising even before the BOJ's shock move in December. Tables 2 and 3 show our estimates of the impact of higher interest rates on net interest income of loans and unrealized losses on AFS bonds.

Case 1 assumes:

• Long- and short-term yen interest rates rise +0.25 percentage points; and
• Major overseas interest rates, including those denominated in U.S. dollars, are up +2.0 percentage points.

In this scenario, we estimate net interest income would increase 6% in the first year and the proportion of unrealized losses on bonds would increase to 15% of Tier 1 capital. In currencies other than yen, we assume net interest margins will not increase much. This is because on the liability side, interest rates for funding have also risen significantly. In fact, financial results at major Japanese banks in the first half of fiscal 2022, through Sept. 30, 2022, (full year ends March 31, 2023) largely followed this trend.

Meanwhile, as of Jan. 6, 2023, short-term interest rates such as three-month TIBOR had only increased 1 basis point (0.01%) after the BOJ's December monetary policy change. These short-term rates have a significant impact on major banks' overall lending rates. Therefore, with respect to net interest income on loans, we conducted the scenario analysis seen in case 2, based on the current situation. In this case, we assume yen interest rates rise +0.05 percentage point for short-term loans and +0.1 percentage point for long-term loans. Our assumptions for currencies other than the yen were as in case 1. Our analysis under case 2 showed that net interest income on loans rose +2% in the first year.

In terms of net loan income, it would be somewhat optimistic for us to forecast a large improvement based on BOJ policy changes on long-term interest rates. Stock-based loan yields across Japanese banks in November 2022, based on the BOJ's latest data from December 2022, are still down 0.1 basis point (0.001%) from the previous month. This is mainly due to lower yields at regional banks; those at major banks have shown improving trends. In addition, demand for loans in regional areas remains limited. Regional banks also continue to offer lower interest rates in urban areas to try to win new loan business from the majors. These developments lead us to believe rates when applying for loans are unlikely to increase much in Japan for now.

For banks' net interest margin on loans to improve, short-term interest rates would need to rise more. Take Germany's situation. Interest rates on corporate loans rose between 0.8 percentage point to 1.9 percentage points in 2022, depending on time to maturity, according to the Bundesbank's "Financial Stability Review 2022," published Nov. 24, 2022. The European Central Bank lifted its negative policy rate; short-term interest rates also rose. The German banking industry, which has suffered similar low interest margins on loans to Japan's, is now heading on a diverging path.

A comparison of disclosure data that the Basel Committee requires, changes in banks' net interest income over the previous year (deltaNII), and changes in banks' economic value (deltaEVE) to Tier 1 capital ratios between 22 rated Japanese banks and 67 rated European banks at the end of each fiscal year 2021 shows not much difference. We consider the figures between Japanese and European banks to be generally comparable (see "When Rates Rise: Among Japanese Banks, Beware Of Bondholdings," published Aug. 22, 2022). However, in the case of Japan, interest rate sensitivity of financial institutions that focus on securities investment rather than lending (Norinchukin Bank, Japan Post Bank Co. Ltd., and Shinkin Central Bank) is extremely high. While the risk of high interest rate sensitivity has already been factored into our current rating assessments of these financial institutions, we are closely watching to see if this will have a significant impact on their creditworthiness in the future, as bond prices fluctuate more widely and change more rapidly.

Chart 1

Table 2

Table 3

Impact Of Weaker Yen: Almost Neutral On Creditworthiness

Investors often ask about the impact of the dollar-yen exchange rate on banks' financial standing. We believe the impact, while somewhat negative, is basically manageable for major banks. This is because positive factors from a flagging currency offset negatives, in our view. The Japanese currency traded at ¥150 against the U.S. dollar in October 2022. It has since rebounded to about ¥130. This is about ¥9 yen (or about 7%) weaker than at the end of fiscal 2021 for Japanese banks (March 31, 2022).

First, the positives. A weak yen increases interest income from foreign currency-denominated assets. Also, for the wider Japanese economy, the weaker yen has positively affected corporate profits, so it has had a somewhat positive effect on the overall asset quality of banks.

On the other hand, the weaker yen has somewhat negatively affected Japanese banks' conventional regulatory capital adequacy ratios. Risk-weighted assets (RWA), the denominator in calculating the ratio, increase as the value of assets denominated in foreign currencies converted into yen increases. On the other hand, the weaker yen is positive for banks' capital, the numerator of the ratio. This is due to the accumulation of retained earnings resulting from increases in net interest income denominated in foreign currencies and rises resulting from foreign currency translation adjustments for investments in overseas subsidiaries. All told, we consider the combined effects on the numerator and denominator of the capital adequacy ratio to mean the slightly negative impact of a weaker yen is manageable for banks.

At the end of the first half of fiscal 2022 (Sept. 30, 2022), the yen was 19% weaker than six months earlier. Common Equity Tier 1 capital ratios (CET1 ratios) at the three major Japanese banking groups had declined approximately 1 percentage point compared with the March 2022 level. The weighted-average CET1 ratio at the end of September was 11.3%. However, this decline included negative impact due to an increase in unrealized losses on AFS bonds. Excluding the impact of these bonds, we estimate that a pure effect of depreciation of the yen was largely neutral, with the numerator factor (increase in foreign currency translation adjustment accounts) and the denominator (increase in RWA) almost canceling out each other.

Credit Costs: Corporate Leverage Is A Risk

We forecast the ratio of credit costs (credit costs divided by outstanding loans) will be 0.2% in 2023. This is around the same level as in 2022. We expect positives and negatives to balance out over the course of this year, leaving the ratio stable. On one side, a diminished ability to repay debt among corporations because of higher interest rates will pressure the ratio. On the other, decreasing credit costs thanks to expected positive GDP growth will help.

We believe government measures helped Japan avoid severe economic crisis at the height of the pandemic. Japan's economy, like those of other developed countries, was severely affected by the pandemic from 2020 to 2021. However, due to the government's swift and large support measures for the private sector--households plus corporations excluding financial and insurance companies--the ratio of banks' credit costs remained low at about 0.2% of loans outstanding from 2020 to 2021. This sharply deviates from past trends in relation to economic growth rates (see chart 2). Through regression analysis, we can see credit cost ratios in 2020 and 2021 would have been about 0.6% and 0.4%, respectively (see the dotted lines in chart 2). This is 0.4 percentage point and 0.2 percentage point higher than they were with government support.

The credit cost ratio in 2022, meanwhile, is likely to be unchanged at about 0.2% from 2021, in our estimate. Statistics for full calendar 2022 are not yet available. In 2022, the benefits of economic recovery from the worst of the pandemic seem partly offset by weaker creditworthiness at some large borrowers.

We expect the ratio of credit costs to remain about 0.2% in 2023 and for economic growth to be almost in line with that of 2022. Still, the ratio is higher than the level regression analysis indicates. This is because many small- and midsize enterprises (SMEs) in 2023 will have to start repaying so-called zero-zero loans provided by the government. These loans were offered under a scheme the government launched in March 2020 to support mainly SMEs hit by the pandemic. The loans have a moratorium on principal repayments (zero principal repayments) for a maximum of five years. In addition, borrowers do not bear the burden of interest payments as each prefecture subsidizes that for the initial three years of the loans (zero interest payment). Further, the loans will be taken over by Credit Guarantee Corp., a public institution, in the event of future default. However, banks in most cases had existing exposure to standard loans taken out by the same borrowers in addition to those under this program. Therefore, zero-zero loan defaults would imply a likelihood of banks incurring additional credit costs.

Credit costs, in our view, are likely to be higher than those calculated through our economic growth forecasts. In 2023, SMEs, the main customers of regional banks, and some other corporations are likely to give up rebuilding pandemic-ravaged businesses. Recent higher material prices and other challenges add additional heavy burdens on these companies. In fact, corporate bankruptcies, kept low by various types of government measurements, began rising on a year-on-year basis from April 2022. This trend continued through November 2022, the most recent month for disclosure of bankruptcies. Distortions related to past credit costs will gradually emerge in 2023.

Large corporations are not immune. Credit costs should increase for some of the bigger players in 2023 too. Companies such as those that struggle to pass on rising raw material prices to consumers through price hikes, require large capital expenditures, or do heavy investment activity on financial products look shaky. This is because they face significant pressure on their debt-serving abilities due to rising interest rates, slimmer sales margins, or increasing volatility of invested financial products. In general, the leverage ratio of companies in developed countries, including Japan, has increased relative to pre-pandemic levels. This is due to preparedness for emergencies such as pandemics and the Russia-Ukraine conflict. For this reason, we are closely watching how rising inflation affects companies' abilities to repay debt. We are closely monitoring the credit portfolios of individual banks and will reconsider their creditworthiness if necessary.

Chart 2

Other Issues On Our Radar: NBFI Sector, Nontraditional Risks (Digital, ESG, Cyber)

We see a reasonable possibility that our global economic base case will need to be adjusted. This is because the macroeconomic situation is fraught with uncertainty. And banks' creditworthiness cannot escape the effects of the macroeconomic conditions of the regions in which they operate. Therefore, if issues such as inflation lead us to make downward adjustments to our base case, this could have implications for the banks we rate.

Nonbank financial institutions (NBFIs) could face more acute and rapidly emerging issues than banks, in our view. We noted this in "Global Bank Country-By-Country Outlook 2023: Greater Divergence Ahead," published Nov. 16, 2022. NBFIs typically have less-diversified business profiles than banks. They also tend to be more reliant on market funding. In addition, looking at the financial industry as a whole, we are closely monitoring how NBFIs' share of the overall industry has surged over the past 10 years. The global development of NBFIs is having a significant impact on the banking industries of every country.

Nontraditional risks stemming from areas such as digitalization and cyber crime, as well as problems related to environmental, social, and governance factors, add to the conventional credit, market, and operations risks banks face. Weaker banks, in our view, are more exposed to these nontraditional risks.

Related Research

• Global Credit Conditions Downside Scenario: Inflation, Geopolitics Are Twin Threats To Our Base Case, Dec. 8, 2022
• Global Bank Country-By-Country Outlook 2023: Greater Divergence Ahead, Nov. 16, 2022
• When Rates Rise: Among Japanese Banks, Beware Of Bondholdings, Aug. 22, 2022
• Banking Industry Country Risk Assessment: Japan, June 15, 2022