Companies in Japan's nonbank financial sector are ready for a rougher ride in 2024.

S&P Global Ratings forecasts the outlook for the credit quality of Japan-based nonbank financial institutions (NBFIs; referring to securities and leasing companies) will be stable this year.

Given increasing volatility of interest rates and an expected rise in domestic interest rates, the five major securities groups we rate--SMBC Nikko Securities Inc., Daiwa Securities Group Inc., Nomura Holdings Inc., Mizuho Securities Co. Ltd., and Mitsubishi UFJ Securities Holdings Co. Ltd.--are likely to enjoy increased earnings opportunities. However, sharp drops in revenues from losses on trading exposures due to higher-than-expected market volatility is a risk factor. In addition, a buildup in retail business revenue will not be enough to buffer fluctuations in wholesale business profits, in our view. We think a market downturn will likely test progress in increasing stable profits.

In our view, securities groups we rate are likely to maintain strong capitalization and control risk appetite within a manageable range in light of their current creditworthiness. This will be the case even when market volatility increases. We expect government measures encouraging a shift in individual financial assets from savings to investments will likely benefit the wider securities industry in the long run. Conversely, in the short-term such moves will likely produce only limited positive effects for large securities companies with face-to-face services because of further downward pressure on fee margins, including those of asset-based fees. Also, emergence of new customers and asset inflows thanks to the launch of the new Nippon individual savings account (NISA), a small investment tax exemption system, are likely to occur disproportionately at online brokerages. For online brokerages, which are seeing remarkable growth in account numbers, how to monetize incoming customer assets is important for their sustainable growth.

The four major Japan-based leasing companies we rate--Orix Corp., Mitsubishi HC Capital Inc., Sumitomo Mitsui Finance and Leasing Co. Ltd., and Tokyo Century Corp.--are likely to continue new investments in growth areas and areas of high profitability relative to risks, in our view. At the same time, we think they will ensure increased risks do not substantially exceed increased capital fueled by retained earnings. We expect leasing companies to achieve this by curbing investments in low-profitability areas and selling low-profitability assets.

In addition, when risks increase significantly, leasing companies are likely to ease pressure on capital through issuance of hybrid securities and other measures. On the other hand, we think leasing companies' creditworthiness may weaken if a delay in selling low-profitability assets and monetizing existing investments constantly increases downward pressure on capital. Furthermore, greater exposure to countries attracting higher economic risk than Japan is a risk factor that structurally reduces leasing companies' creditworthiness. We think such exposure will increase if the leasing companies strengthen overseas specialty financing business with higher profitability relative to risks and renewable energy business with high growth prospects.

We expect the four leasing companies to maintain adequate funding and liquidity. Persistently high foreign currency funding costs because of a sharp rise in policy interest rates in Europe and the U.S. are likely to have limited negative impact on leasing companies' incomes and expenditures, in our view. While rising domestic interest rates increase short- and long-term funding costs, their reflection in lease charges progresses gradually as contracts are renewed. Accordingly, we consider the positive impact on the companies' incomes and expenditures will be limited.

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Securities Industry

Rising Volatility, Interest Rates Spur Opportunity

We anticipate the major securities groups will find more revenue opportunities and increased customer flow in fixed income-related products. We hold this view because interest rates have become more volatile, reflecting rising expectations of monetary policy changes in Japan and the U.S., as well as a likelihood that domestic interest rates will rise.

The major securities groups' recent financial performance has tended to follow ebbs and flows in global markets business because of lower retail business revenue and highly volatile revenue in U.S. business, the primary generator of trading revenue. We expect this trend to continue in 2024. This is because efforts to prop up retail revenue are still underway and the outlook for the U.S. market is uncertain, although opportunities for trading revenue will likely increase in Japan.

We believe major securities groups are likely to keep risk volume manageable without taking excessive risks in light of current creditworthiness even as volatility rises and customer flows increase. In these situations, risk management of trading positions rises in importance. The groups aim to enhance their business base by allocating capital with an eye on profitability relative to risks, as well as by controlling risk volume with a reduced proportion of wholesale business risk assets to total risk assets. In addition, while taking high risks would reduce regulatory capital ratios, we have not seen a sharp drop in common equity tier 1 (CET1) capital ratios or an accelerated rise in value at risk (VaR) even during recent market fluctuations, excluding a one-off factor. Nevertheless, downward fluctuations in earnings may increase because of losses on trading positions due to higher-than-expected market volatility. We consider this a risk factor.

In their overseas businesses, the major securities groups will likely continue to allocate resources to the U.S. and seek revenue opportunities there in 2024, given the market's size and potential for growth. Therefore, decelerating growth and increased uncertainty in the U.S. economy would constrain earnings of their U.S. businesses, and we view this as a risk factor. Combined profit of U.S. business of major securities groups contributed 20% of total profits on a management accounting basis in the six months ended Sept. 30, 2023. We think Nomura urgently needs to secure revenue to cover rising costs due to inflation and investments for growth. Meanwhile, Mizuho's U.S. business accounts for most of its overall profits. Market conditions in the U.S. greatly affect not only the wholesale division's revenue but also customer flow in U.S. stocks and investment trusts of the retail division.

Market volatility supports fixed income trading

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Long Road To Cushioning Wholesale Revenue Volatility

Improved revenue in major securities groups' retail businesses will take time to buffer the earnings volatility of their wholesale businesses. Previously, lower revenue in retail business, which has relatively low earnings volatility, has hampered groups' efforts to improve their overall profits. Restructuring of retail business, which each group has undertaken, is entering a phase focused on increasing stable, asset-based revenue rather than reducing costs. Although improving cost coverage ratios is a positive factor for our assessments of their credit quality, we attribute the improvements partly to a tailwind from stock market conditions in 2023. We expect a market downturn to test how far the groups have come in bolstering the stability of their retail business profits. This is because even asset-based revenue fluctuates according to movements in the market value of customer assets.

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Cost reductions aside, building revenue is key to improving profitability

Profit and cost trend in retail business 

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Sound Capitalization Supports Ratings

Major securities groups' capital in terms of regulatory capital and risk adjusted capital (RAC) ratios are likely to remain sound, in our view. Despite market volatility likely remaining high in 2024, we expect strong capitalization as a buffer at each group even if their trading exposures increase. Nomura and Daiwa expect their CET1 ratios to decline when Basel III final rules are implemented on March 31, 2025, and they are well prepared for this, in our view.

Table 2

Sustainable Business Models Are Crucial

A shift in individual financial assets from savings to investments through government-promoted measures will likely benefit the securities industry across the board in the long run, in our view. It will likely enable securities companies to generate stable earnings from customer assets. It is also likely to create opportunities for the companies to offer customers more profitable products. In addition, it will likely spur activity in asset investment and management business even as competition intensifies.

We think large securities companies with face-to-face services are likely to reap limited benefits in business and earnings in the short term, because of further downward pressure on fee margins, including asset-based fees. We also think new customers and asset inflows thanks to the launch of the new NISA are likely to disproportionately benefit online securities companies. Major securities groups, which are focused on increasing customer asset balances under management, and online securities companies, which are accelerating the acquisition of mass customers, have different customer targets and strategies. In the long term, however, the two types of securities companies may compete for some customer segments because of the transfer of assets via inheritance and accumulation of customer assets at online securities companies.

For online securities companies, which are rapidly growing account numbers, we believe the key to growth will likely be how to monetize incoming customer assets. Comparing asset and revenue size per customer account in the first half of fiscal 2023 (ending March 31, 2024) of the retail division of Nomura Holdings, as a sample of a large face-to-face brokerage, and SBI Securities Co. Ltd., as a sample of an online securities company, shows a large difference. Nomura's customer asset balance was 10 times higher than that of SBI Securities, revenue was four times higher, and profits were nine times higher. Conversely, if we look at retail business profit margins, SBI Securities' were 1.5x higher than Nomura's, indicating high profit efficiency.

At online securities companies, polarization between companies that succeed or fail to expand customer bases will likely accelerate, leading to a shakeout and restructuring of the industry, in our view. Precipitating this will be the launch of the new NISA and SBI Securities' and Rakuten Securities' moves to cut commissions on domestic stock trading.

However, we believe online brokerages, which have an advantage in price competitiveness, are likely to face two hurdles to maintain their pace of profit growth. First, costs are likely to increase with business diversification and expansion. Second, transaction fees for investment products of new customers, who are beginning to build wealth, are zero or low commission. This is likely to make it difficult for online brokerages to benefit from the products in terms of flow-based revenue at a pace matching an increase in customer assets and a market turnaround. Consequently, we think success or failure in building a sustainable business model will likely be more important than expanding customer accounts. We predict online brokerages are likely to take different directions in strategy. Specifically, we expect varied strategies, such as business diversification, expanded customer services through alliances, and efforts to be the dominant online brokerage platform provider with low cost.

Leasing Industry

Capital And Risk Balance Remains; Capital Buffers Thin

We expect the four major Japan-based leasing companies we rate to maintain a balance between capital and risk relative to ratings in 2024. Still, we are paying attention to companies with thin capital buffers that continue to narrow. The balance sheet of the four companies as a whole has continued to expand in recent years. Driving this has been capital tie-ups, alliances, and mergers and acquisitions (M&A) in aircraft business, in addition to business expansion through organic growth in the real estate and renewable energy sectors.

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We believe the four major leasing companies are likely to control rising risk volumes to a certain extent so as not to substantially outpace increases in capital through retained earnings. The leasing companies are likely to continue to make new investments in areas that are highly profitable relative to risks. At the same time, we expect the companies to control capital allocation to business areas with low earnings, sell low-return assets, and exit existing investments. For example, in 2023 Mitsubishi HC Capital sold Diamond Asset Finance Co. Ltd., a subsidiary engaged in real estate-related business, and other subsidiaries DFL Lease Co. Ltd. and Shutoken Leasing Co. Ltd. In the same year, Tokyo Century transferred a portion of shares in leasing subsidiaries Orico Auto Leasing Co. Ltd. and Orico Business Leasing Co. Ltd. to Orient Corp.

If risk volumes increase significantly due to M&A and other factors, we expect the four companies to reduce capital burdens through capital increases and issuance of hybrid securities, as per past practice. In several cases companies conducting relatively large M&A transactions in recent years raised capital and issued hybrid securities to reduce downward pressure on creditworthiness. While the degree to which each company uses hybrid securities varies, we think the four companies still have sizeable room for additional use of hybrid securities.

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Majors Keep Improving Profitability Relative To Risks

The four major leasing companies are likely to continue to implement measures that improve profitability relative to risks, in our view. Under the constraint that the leasing companies need to retain certain financial soundness to continue external financing, the four companies should improve profitability to achieve an optimal balance between return on equity (ROE) and financial soundness. Three of the four companies, excluding Sumitomo Mitsui Finance and Leasing, are listed on the Tokyo Stock Exchange's top-tier prime market. Therefore, these three receive more pressure from shareholders to improve profitability than unlisted companies. As a result, they face more difficulty addressing the trade-off between financial soundness and profitability.

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To improve profitability, it is important to allocate resources to highly profitable businesses relative to risks, in our view. In particular, we believe whether leasing companies succeed in the following will be important to maintaining certain financial soundness and improving profitability (it will also eventually be a key consideration when we assess the stability of their creditworthiness):

• To expand low-risk commission business, such as asset management business, including real estate and aircraft;
• To further shorten the period to monetization and increase asset turnover (namely, to improve turnover from acquisition to sale of real estate properties, aircraft, and renewable energy facilities); and
• To rebalance their business portfolios through allocation of resources to high-profitability and high-growth businesses, enhancement of cost efficiency and productivity of low-profitability and low-growth businesses and added value of businesses in general, and divestiture.

ROE, a representative profitability indicator, can be broken down into two measures: Profitability relative to risks (pre-tax profits/risk-weighted assets (RWA)) and risk leverage (RWA/net assets). This makes it possible to distinguish to some extent whether the ROE of the leasing companies is attributable to the contribution of profitability relative to risks or to risk leverage. For instance, Orix's high profitability relative to risks supports its ROE. We attribute Orix's high profitability to earnings contributions partially from businesses other than financial services. Having said that, the company's investment assets include a considerable amount subject to capital deductions rather than RWA in the RAC calculation.

Meanwhile, Tokyo Century's profitability relative to risks is somewhat low, but high-risk leverage has raised its ROE. We view the company's risk leverage as high because it has made multiple investments based on its strategy to tie up with other companies. Furthermore, it has more equity-like assets relative to capital than the other three companies.

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We believe expansion of specialty business (aircraft, railcars, and ships) and renewable energy business (wholesale sales of electricity generated from solar, wind, and biomass) structurally raises the ratio of leasing companies' exposure to countries with higher economic and geopolitical risks than Japan. It also increases business concentration. Impairment losses on aircraft leasing resulting from the Russia-Ukraine conflict is an example of such risk, in our view. Expansion of both specialty and renewable energy businesses will also positively affect business diversification and improvement in profitability relative to risks.

However, a rise in ratios of overseas exposure could deteriorate leasing companies' creditworthiness. Consequently, we will closely monitor movements in such ratios, excluding noise factors such as exchange rate fluctuations. In addition, a rise in domestic interest rates to the degree assumed in our base-case scenario will likely have only limited impact on profitability of leasing companies' domestic businesses. Hence, it is unlikely to increase the leasing companies' domestic exposures, in our view.

Funding And Liquidity Adequate; Foreign Currency Funding Costs Manageable

We expect major leasing companies to maintain adequate funding and liquidity. The liquidity coverage measure and stable funding ratio, as we define them, of Orix, which conducts its business independent of any other group, remain high. Both measures of Mitsubishi HC Capital and Sumitomo Mitsui Finance and Leasing, which each have strong relationships with megabanks, fall below those of Orix. We think this is mainly because the two companies have kept liquidity on hand low in normal times from the standpoint of fund efficiency, knowing they are likely to receive liquidity from the megabanks in times of crisis. The combined long-term funding ratio of the four companies is likely to continue to rise moderately, in our view.

Persistently high foreign currency funding costs resulting from a sharp rise in policy interest rates in Europe and the U.S. in 2023 are likely to continue to exert limited negative impact on the leasing companies' incomes and expenditures, in our view. When policy rates of the U.S. and European countries start to fall, the companies' foreign currency funding costs will likely decline. Meanwhile, their lease charges are likely to increase, which may help improve their incomes and expenditures. This would occur because lease charges slightly lag funding costs as most lease charges are fixed during lease terms. Sensitivity of such factors would vary by company.

An increase in domestic interest rates, which would immediately reflect on domestic short-term funding costs, will increase new long-term funding costs. Conversely, it would reflect on lease charges gradually in line with renewal of contracts. Accordingly, we regard the short-term positive impact on leasing companies' incomes and expenditures to be limited.

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Related Research

• Global Credit Outlook 2024: New Risks, New Playbook, Dec. 4, 2023
• Banking Industry Country Risk Assessment: Japan, June 15, 2023
• Japan Brokerages' Resilience Hinges On Managing Market Changes, May 24, 2023