Rising interest rates will separate the strong from the weak.

We anticipate Japan's short-term policy interest rate will increase gradually in 2024. We expect it to rise about 0.1 of a percentage point this year and about another 0.25 of a percentage point in 2025 from -0.1% now. We do not expect an accompanying sharp deceleration in economic growth, which is affected by changes in monetary policy.

In S&P Global Ratings' base-case scenario, a gradual rise in yen interest rates will lift earnings in Japan's banking sector. However, the banking industry is likely to become more polarized when interest rates rise, reflecting disparity in the strength and weakness of each bank's core business. This report summarizes positive and negative effects of rising interest rates on bank management and explains how, as negative interest rate policy moves toward normalization, both positive and negative effects that emerge will amplify, reflecting unevenness in banks' strengths.

Base-Case Scenario: A Moderate Path For Japan

The rise in policy rates we expect for Japan will be moderate compared with rates as of the end of December 2023, and we do not expect such a change in policy rates to act as a sharp brake on economic growth. Our assumptions for key macroeconomic conditions for Japan are in the table below.

Table 1

Major Bank Creditworthiness Is Improving

We estimate higher yen interest rates will have a positive net effect equal to at least about 3% of the operating profits of the three major banking groups. This positive net effect breaks down as a 12% rise thanks to higher interest on loans and a 9% decline from costs arising from higher unrealized losses on bond holdings. (For details, please see our report "Japan Is Robust Enough For Rising Yen Rates," published Oct. 12, 2023).

For Japan's banking industry, which has been mired in a low interest rate environment for many years, even a slight increase in lending rates would significantly boost interest income from loans. Assuming short-term floating and long-term fixed loan rates rise 0.2% and 0.4%, respectively, from the end of March 2023, annual interest on loans for the three major banking groups would increase 35% from the end of March 2023. In our estimation, such an increase in interest on loans would be equal to 12% of operating profits.

On the other hand, rising yen interest rates will have several negative effects, in our view. First is higher unrealized losses on bond holdings. If we calculate the increase in unrealized losses on yen bond holdings based on a 0.4% rise in interest rates on long-term fixed-rate loans, we estimate the one-year, pro-rata effect of unrealized losses on bond holdings over the number of years held (assuming a duration of 1.5 years for yen bonds), which would put downward pressure on operating profits, would equal 9% of yearly operating profit.

Another indirect negative impact could be higher credit costs (in the event of a significant rise in interest rates) on outstanding loans. However, this would occur only when a borrower's creditworthiness is significantly impaired, such as when interest expenses increase beyond the ability of a borrower's normal annual income to cover it. In the range of interest rate hikes we currently assume, the three major banking groups will not experience significant deterioration in borrower creditworthiness (that is, an increase in credit costs from outstanding loans), mainly due to borrowers' increased interest expenses, in our view. Although we expect a slightly higher credit cost ratio (credit costs divided by amount of outstanding loans) for loans to small and midsize enterprises with inferior creditworthiness in 2024 as repayment of special policy measures with interest-free loans (so called zero-zero financing loans) begins in earnest, we believe the industrywide credit cost ratio in 2024 will remain about 0.2%, about the same level as in 2022 and 2023 (when special circumstances related to large client bankruptcies were present).

After weighing the positives and negatives, we assume a rise in yen-denominated interest rates would lift operating profit of the three major banks about at least 3%. However, our calculations do not incorporate the following three positive factors related to revenues, making our estimation conservative:

• We do not consider the effect of hedging positions in bond holdings,
• We do not account for increased bond interest income likely as existing bonds mature and are replaced with bonds with higher yields, and
• We do not factor in potential improvement in banks' bond portfolios through consideration of unrealized gains and losses, including on equity holdings. Currently, the major banks' entire portfolios of available-for-sale securities are in net profit positions thanks to appreciation of equity holdings.

Rising Interest Rates, Varying Impacts

We believe positive and negative factors for earnings that will emerge when interest rates rise will not manifest in the same way for each bank but rather will be amplified in a manner reflecting differences in each bank's strengths. Specifically, they will reflect differences in the realization of positive aspects of improvement in loan yields and bond yields, and differences in the negative aspects of increased unrealized losses on bonds and credit costs of loan exposures. In fact, looking at September 2023 interim results announced in November 2023 (excluding special factors related to MUFG's sale of MUFG Union Bank in fiscal 2022 and a change in the accounting period of Morgan Stanley under the equity method in fiscal 2023), net income for the three major banking groups increased about 20% year on year (excluding the special factors for MUFG above). On the other hand, results of the 69 regional banks listed on the Tokyo Stock Exchange were in stark contrast. Specifically, net income of TSE-listed regional banks fell about 4% year on year (excluding negative goodwill due to bank consolidations), and 60% of the 69 banks had lower net profits than the previous year or losses (see chart 1). Furthermore, the difference in half-year net profit compared with the level of the previous year became clearer depending on the size of unrealized gains or losses on available-for-sale securities (see chart 2).

Chart 1

Chart 2

Several factors underlie the disparity. First is a widening gap in positive earnings. When base interest rates rise, the degree of improvement in each bank's loan yield depends on its pricing power (that is, its loan pricing ability). This is a function of a bank's overall relationship with its customers. A bank unable to meet customers' various demands regarding financial products, and thus only providing follow-up offerings to those of the key banks has inferior bargaining power, and therefore pricing power, to main banks. Therefore, differences in ability to offer products are likely to result in differences in lending yields among banks.

Second, the yield on portfolios of bonds held will differ depending on whether it is possible to add new high-yield bonds to portfolios after interest rate hikes. Banks that have already written off unrealized losses on bond holdings and banks that maintain positive overall valuation differences on available-for-sale securities can actively purchase bonds when final yields (yields to maturity) on bonds are high (when the price of bonds are low). Those banks can then enjoy increasing interest incomes from bond holdings. On the other hand, banks with large unrealized losses from holding bonds will be unable to reconstruct their portfolios, resulting in little increase in interest income from holding bonds.

Third is a widening gap in negative earnings. The amount by which unrealized losses on bond holdings increase as interest rates rise depends on the interest rate risk (risk appetite) that each bank takes. In general, banks with weak profitability in conventional deposit-and-loan and fee-related businesses often take on substantial market risk to compensate for their low profitability. And since these banks generally do not have strong capital bases, they have been unable to cut losses on bond holdings (including by shortening durations or reducing balances) to improve their bond portfolios as interest rates have risen to date. In fact, our simulation of the impact of rising interest rates on unrealized losses on bond holdings by individual banks shows that banks with weaker financial strength tend to have larger unrealized losses. In fact, as seen in recent financial results for the fiscal 2023 first half (ended Sept. 30, 2023), the superiority or inferiority of unrealized gains on available-for-sale securities has had a differential impact on the earnings and financial strength of each bank (see charts 3 and 4).

Chart 3

Chart 4

Finally, differences arise in the way credit costs are recorded. When interest rates rise, borrower companies' interest payment burdens increase, in some cases lowering a borrower's debtor classification and increasing the bank's credit cost. In particular, the interest-paying ability of companies that have clung to survival, such as those using special policy measures featuring interest-free loans (so-called zero-zero financing loans) and those that avoided being classified in the category of restructured loans thanks to drastic business restructuring plans under the SME Financing Facilitation Act, will again be tested during a period of rising interest rates. Banks with strong financial standing are already taking a conservative approach in classifying and underwriting problem borrowers, and they are unlikely to incur large credit costs as interest rates rise. On the other hand, banks that are not well prepared for borrowers with low credit quality (with which banks with weak financial strength tend to transact) are likely to incur large credit costs in the future outweighing actual changes in the borrowers' business conditions.

In all, since gaps in financial strength also amount to gaps in preparedness for emergencies, we expect both positive and negative factors of interest rate rises to be amplified, reflecting gaps in bank strength, as the Bank of Japan's negative interest rate policy moves toward normalization.

Investment-Oriented Bank Risk Factors; Others

In the case of so-called normal commercial banks, where the amount of lending on the asset side greatly exceeds the amount of securities, the positive effect of increased net interest income from improved yields on lending and other activities exceeds the negative effect of increased unrealized losses on bond holdings. Therefore, in the case of the three financial institutions (Japan Post Bank Co. Ltd., Norinchukin Bank, and Shinkin Central Bank), which mainly invest in securities rather than lending, we expect a large negative effect of rising interest rates (increased unrealized losses) to become apparent first and an increase in interest on bonds replaced after maturity to occur later. Another risk factor for this group of banks, which invests heavily in U.S. Treasury bonds, is that still-high short-term U.S. interest rates (the funding rate) have pressured net interest income from U.S. bond investments. However, we have anticipated this and factor it into our ratings on each of the three banks by assigning to each a risk position assessment of moderate.

Divergence from our base-case scenario could also have severe consequences. If Japan's inflation rate were to deviate significantly from our macroeconomic assumptions, driven by increased production costs (cost-push inflation) rather than shortages of supply (demand-pull inflation), Japan's economic growth would be highly likely to slow significantly. Weakening consumer spending and deteriorating corporate performance would drive this slowdown. In this scenario, a downturn could hurt the corporate sector's ordinary profit and increase the banking sector's credit costs.

On the other hand, the percentage of weak banks in Japan's financial industry is limited and therefore we do not consider it significant enough to affect our BICRA for Japan. We also believe funding and liquidity of the three major banking groups and the Japanese banking system as a whole remains the key strength of the country's banking industry. Japanese banks benefit from a deep and stable deposit base.

This strength reflects Japanese individuals' strong savings orientation, in addition to firms' and households' positive net financial positions. In addition, high deposit insurance coverage (about 70% of outstanding deposits), little interest rate competition between bank's deposits and money market funds or money reserved funds, and the fact that settlement deposits are fully protected (regardless of the deposit insurance maximum amount) are also positive factors in maintaining customer confidence in bank deposits. These favorable funding conditions for Japanese banks differ from those in the U.S. and Europe, where funding and liquidity conditions have become more uncertain.

Lastly, nontraditional risks stemming from areas such as digitalization and cyber crime add to the conventional credit, market, and operating risks that banks face. Weaker banks, not only in Japan but in other countries, are more exposed to these nontraditional risks, in our view.

Related Research

• Japan Is Robust Enough For Rising Yen Rates, Oct. 12, 2023
• Banking Industry Country Risk Assessment: Japan, June 15, 2023
• Japan's Credit Risks Could Rise With Costlier Financing If Growth Falters, Feb. 23, 2023