Japan's three megabanks are battening down the hatches after a bumper year.

Fiscal 2022 (ended March 31, 2023) results for the groups again demonstrated their earnings capacity following a strong fiscal 2021. Their favorable results have enabled them to take adequate measures to prepare for slowdowns in the U.S. and domestic economies, in our view. Strong performance has enabled them to take preventive measures against future costs, such as improving valuation gains and losses of their securities portfolio through restructuring, increasing allowances for loan losses, and writing down impairment of fixed assets. The three groups are aiming for higher growth in net income in fiscal 2023, having started the year with a degree of resilience. The three groups forecast 10% growth in aggregate net profit to ¥2.73 trillion in fiscal 2023. This growth is likely to mitigate the impact of downside risk, if it occurs, in our view.

Japan's three megabank groups are Mitsubishi UFJ Financial Group Inc. (MUFG), Mizuho Financial Group Inc. (Mizuho FG), and Sumitomo Mitsui Financial Group Inc. (SMFG).

The solid returns of the three megabank groups reflect the diversity of their business bases and their efforts to improve profitability in recent years. The three groups made a ¥2.48 trillion aggregate net profit in fiscal 2022, exceeding their ¥2.31 trillion forecast. It was their highest combined net profit in nine years and on par with a record high ¥2.51 trillion in fiscal 2013. Despite weak performance in both market operations and fee income from retail sales of financial products due to market turbulence, groupwide profits got a lift from increased net interest income and fees related to loans and increased earnings from commissions on foreign exchange and derivative sales. On the stock side, the three groups made a record-high ¥1.2 trillion in total realized losses related to bonds in fiscal 2022. However, the groups recorded gains from sales of stocks, supported by strong stock prices, and termination of investment trusts, which mostly offset the impact of the losses. The groups' net unrealized gains (pretax, including held-to-maturity debt) were ¥3.9 trillion as of March 31, 2023, down from ¥5.6 trillion a year earlier. However, this improved by about ¥2 trillion from ¥1.8 trillion at the end of September 2022. Accordingly, all three groups made net valuation profits.

Having met their capital adequacy targets, the three groups are likely to start deploying capital. In March 2023, the Tokyo Stock Exchange (TSE) requested listed companies take capital costs and stock prices into consideration in management as the groups' focus was shifting to improvement in return on equity (ROE). In response to the request, the groups now aim for a 1.0x price-to-book (P/B) ratio, which will also accelerate improvement in profitability. Their asset size will inevitably grow as deposits continue to rise. With the domestic business environment set to remain competitive even if interest rates rise, groups are likely to make growth investments mainly in overseas markets. Given uncertainties in the global economy, mainly in the U.S., we believe risk management that captures changing market conditions, including foreign currency funding, is going to be more important.

Table 1

Two Major Risk Factors Loom Over Asset Quality: Deteriorating Creditworthiness Of Large-Lot Borrowers, And Changes In The U.S. Economy

The three megabank groups will maintain asset quality mostly at current levels under our base-case scenario. The groups' aggregate credit costs to average balance of aggregate loans is likely to be about 20 basis points (bps) in fiscal 2023 (ending March 31, 2024), almost unchanged from fiscal 2021, given our Japanese macroeconomic forecast (real GDP growth of 1.0% in 2023 and 1.1% in 2024). The groups have lower net nonperforming loan (NPL) ratios than before the pandemic, partly because of forward-looking provisioning against bad loans (see chart 2). We anticipate the three groups will curb both deterioration in asset quality and a rise in credit costs of their overall loan portfolios. At the same time, however, we incorporate into credit costs the impact of growing loans in their consumer finance businesses as well as in their Asian subsidiaries, which have higher provisioning rates even during ordinary business conditions. We also incorporate the impact of deterioration in the creditworthiness of large-lot borrowers.

In fiscal 2022, the megabank groups' aggregate credit costs totaled ¥580.4 billion, slightly lower than the ¥610 billion they had anticipated. These figures exclude the impact of MUFG's sale of U.S.-based MUFG Union Bank N.A. (MUB). Credit costs were about 20bps, improved from 30bps the previous fiscal year and close to the level we had assumed (see chart 1). In fiscal 2022, the groups did not experience major bankruptcies among large-lot borrowers such as the fiscal 2021 failure of Marelli Holdings Co. Ltd., a major auto parts supplier in Japan. Nevertheless, we saw several bankruptcies of smaller companies that had increased their use of debt through leveraged buyouts and mergers and acquisitions in fiscal 2022.

We believe Japan's economy will continue to recover moderately, which will underpin the three groups' earnings capacity and contain credit risk. Gradual easing of COVID-19 pandemic-related restrictions since the middle of 2022 has rapidly normalized economic activity in Japan. Given the recovery in human mobility, credit risk arising from the pandemic has been receding as we can see signs of recovery in business performance of companies that increased debt during the pandemic, such as those in the transportation industry. Meanwhile, higher costs and higher interest rates are replacing the pandemic as factors contributing to increased credit costs, in our view. Given that the three groups implemented conservative provisioning in the fiscal 2022 fourth quarter (January to March 2023) to prepare for downside risk, we believe material growth in credit costs will be contained even if the credit risk environment deteriorates.

Chart 1

Chart 2

Since the COVID-19 pandemic, credit costs of the three megabank's entire portfolios have been stable, except for those related to individual factors such as large-lot borrowers. We think the risk factor that could potentially trigger an increase in credit costs across the entire Japanese banking industry is the process of beginning repayments of so-called zero-zero loans that the government provided mainly to small and midsize enterprises severely hit by the pandemic (see "Japan Banking Outlook 2023: The Impact Of Raising Interest Rates," published Jan. 17, 2023). However, we believe deterioration in the finances of borrowers of zero-zero loans will have only limited direct impact on the three groups' loan portfolios. This is because loans guaranteed by state-run credit guarantee corporations, including zero-zero loans, account for less than 1% of total loans at the three groups on an unconsolidated basis of their main operating banks.

Securities Holdings Focus Shifts From Foreign To Domestic Bonds; Stock Prices Are Key

We believe unrealized losses on foreign bonds, which have surged since fiscal 2021, remain manageable. The three groups have been reducing risk through hedging, realizing losses, and shortening durations. At the same time, the outlook for U.S. interest rates has improved slightly. Accordingly, the groups' unrealized losses from foreign bonds were smaller as of March 31, 2023, compared with a year earlier (see chart 3). On the other hand, unrealized gains and losses from domestic bonds are more volatile and susceptible to fluctuations in yen interest rates. This is because the three groups have a larger outstanding balance of domestic bonds, mainly Japanese government bonds (JGBs), than foreign bonds. The three groups have been adjusting positions in their securities portfolios to shorten durations of yen-denominated bonds. Consequently, we believe the groups have contained risk relating to a rise in yen interest rates.

Chart 3a

Chart 3b

Chart 3c

Chart 4

In fiscal 2022, the groups maintained net unrealized gains on securities despite large valuation losses on foreign bonds. This was largely attributable to unrealized gains on stocks. In terms of profits and losses, gains from stock sales and the unwinding of investment trusts effectively offset about ¥1.2 trillion in realized losses related to bonds (see chart 4). We closely monitor stock price movements in reviewing the three groups' securities portfolios.

The three megabank groups have been reducing their strategic shareholdings as a part of their management goals. We believe such efforts could help them address rises in unrealized losses from securities stemming from any rise in yen interest rate (see chart 5). The three groups sold about ¥280 billion of strategic shareholdings in aggregate on a book value basis in fiscal 2022. Partly thanks to the low book value and solid stock prices, MUFG and SMFG posted about ¥400 billion in gains from sales of strategic shareholdings. We estimate that the three groups aim to sell over ¥300 billion more of their strategic shareholdings on a book value basis in fiscal 2023 and expect them to use the sale proceeds to increase the soundness of their securities portfolios.

Chart 5

Groups Begin Utilizing Capital After Hitting Soundness Targets

The three megabank groups will likely expand growth investments and assets to improve profitability after having met capital ratio targets in their management plans. The groups' regulatory capital ratios declined materially in fiscal 2022, due to increased unrealized losses from securities, mainly foreign bonds. However, adjusted common equity tier 1 (CET1) ratios, which exclude appraisal differences and serve as targets in their management strategies, continued to improve and reached their medium-term targets. Consequently, the groups are prepared to a certain degree for uncertainties in their business environment, such as financial instability that may arise in the U.S., and have a buffer for growth investments.

The three groups are likely to seek better profitability, such as ROE, while maintaining sound capital ratios. Improving profitability has become more important since the TSE asked listed companies to draft plans to achieve 1.0x P/B ratios and disclose their progress, despite an absence of deadlines or penalties. To improve profitability, the groups will have to use their capital to increase risk assets and enhance shareholder returns in addition to existing efforts in this regard. Both increased risk assets and enhanced shareholder returns are likely to lower each group's risk adjusted capital (RAC) ratio, an indicator we use to measure loss absorbing capability, as well as to lower each group's regulatory capital ratio. Excluding the impact of the sale of MUB, the three groups' total deposits have continued to grow, up 6% as of March 31, 2023, from a year earlier. Accordingly, increasing investment assets will be a priority for the groups to improve their profitability.

The three groups will likely find growth opportunities in commercial banking business in Asia as well as investment banking and transactions with large corporates in the U.S. MUFG had been ahead of the other two groups in these areas. However, SMFG has accelerated capital injections in overseas markets, such as investments in local banks and nonbanks in Vietnam, the Philippines, and India since 2021, and its April 2023 announcement of an increase in its stake in U.S. investment bank Jefferies Financial Group Inc. Meanwhile, Mizuho FG in May 2023 announced its acquisition of U.S. M&A advisory company Greenhill & Co. Inc. Accordingly, we expect the groups to achieve geographical diversification and expansion of business scope.

Table 2

Foreign Currency Asset And Liability Management And Funding Costs Are The Focus Until Prospects For U.S. Dollar Interest Rates Become Clearer

We believe the three megabank groups will maintain stable foreign currency funding structures. Meanwhile, controlling funding costs will grow in importance. Rising U.S. interest rates since 2022 have improved interest income from foreign currency lending and have also increased costs for deposits and medium- to long-term funding. The groups' foreign currency deposit bases are weaker than their yen deposit bases in stability, sensitivity to interest rates, and diversification. As the U.S. interest rate yield curve continues to be distorted, we focus on whether the groups are able to conduct appropriate asset and liability management and manage their funding costs in the event of a sudden change in funding environment.

The three megabank groups' total medium- and long-term foreign currency funding and customer deposits continued to exceed the sum of their foreign currency loans as of March 31, 2023. Medium- to long-term funding does not require short-term refinancing, and customer deposits are generally highly stable. Accordingly, these are resilient to deterioration in the funding environment. In 2022, the depressed bond market helped drive a large increase in bank loans. But through March 2023, the loan balance at banks declined in line with a recovery of the bond market. Still, given that the groups' foreign currency loan balance is likely to keep increasing, a persistent rise in foreign currency funding costs could weaken profitability of their foreign currency-denominated assets.

Chart 6

Risks From U.S. And Europe Have Not Spread To Japan, And Issuance Of AT1 Bonds Has Resumed

Financial instability stemming from U.S. regional banks and Credit Suisse have heightened rapidly since March 2023. We do not foresee contagion spilling into the Asia-Pacific region, including Japan (see "Credit Conditions Asia-Pacific Q2 2023: Still Steady, Banking Turmoil Risk Is Moderate Here," published March 28, 2023). Asia-Pacific's credit risk environment has been stable, supported by growth of regional economies in line with a recovery of the Chinese economy. On the other hand, in the U.S., persistently high policy interest rates due to a lagging decline in the inflation rate and lingering financial instability heightens uncertainties over the prospect of a soft landing of the U.S. economy (see "Economic Outlook U.S. Q2 2023: Still Resilient, Downside Risks Rise," published March 27, 2023). We believe the three megabank groups' earnings and asset quality will be susceptible to trends in the U.S. economy, which accounts for about 30% of their overseas lending and about 10% of their total lending.

Under these circumstances, SMFG raised ¥140 billion with issuance of AT1 bonds in mid-April in Japan. This indicates stability of the primary market in Japan and investors' strong confidence in Japanese megabank groups. AT1 bond issuance was suspended globally when AT1 bonds lost value after Credit Suisse's AT1 bonds were written off through a government-facilitated takeover by UBS Group AG. In May, MUFG followed SMFG and issued ¥330 billion in AT1 bonds, proving the restored stability of the Japanese bond market.

On the other hand, financial instability in the U.S. has not yet subsided. The three groups face limited direct impact from U.S. regional bank failures. Meanwhile, their exposure to U.S. commercial real estate, currently of concern to the market as a potential secondary impact, is also not significant and is likely to be manageable based on their disclosures. Attention should be paid to how any turmoil would spread in terms of scale and routes, as well as to increased costs at each group if the turmoil leads to tighter regulations.

Related Research

• Global Credit Conditions Q2 2023: Balancing Resilience And Turbulence, March 30, 2023
• Global Economic Outlook Q2 2023: Real Resilience Meets Financial Fragility, March 29, 2023
• Credit Conditions Asia-Pacific Q2 2023: Still Steady, Banking Turmoil Risk Is Moderate Here, March 28, 2023
• Japan Banking Outlook 2023: The Impact Of Raising Interest Rates, Jan. 17, 2023