With strengthened resilience, Japan's megabanks are ready to grow.

S&P Global Ratings predicts the country's three megabank groups will accelerate expansion of their business bases and implementation of measures to enhance profitability. The groups showed their ability to generate stable profits in fiscal 2023 (ended March 31, 2024). They have prepared for growth with steps to address interest rate risks and with investments in overseas growth areas. In addition, rising domestic rates will improve the business environment.

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).

We expect the three groups' profits to remain high in fiscal 2024. Progress in replacing assets to improve profitability is evidenced in positive results for fiscal 2023. Also reflected are increased profit opportunities through corporate activities. This will likely continue contributing to earnings in fiscal 2024. In fiscal 2023, the three groups' aggregate net profit increased 26% to a record high of ¥3.1 trillion. In addition, external factors have helped increase net profit, such as high stock prices, the weak yen, and robust economic conditions in the U.S.

In our view, the groups are preparing for investment opportunities by addressing risks such as persistently high U.S. interest rates and rising domestic interest rates. They shortened the duration of Japanese government bonds and controlled their securities portfolios in fiscal 2023. The groups had already realized unrealized losses on foreign bonds by selling them in previous years. We assume they will continue to invest in foreign bonds cautiously because the timing and speed of the decline in U.S. interest rates remain uncertain. We consider the quality of assets related to the groups' overseas commercial real estate (CRE) to be manageable. This is because the proportion of overseas real estate nonrecourse loans is small and exposure to offices in the U.S. or real estate in China is extremely limited.

We expect the three megabank groups to continue to focus on regions with growth prospects, namely Asia and the U.S. We believe that achieving the groups' main goal of improving profitability may hinge on their ability to grow previous investments into stable revenue drivers.

We see the following risk factors for the megabank groups:

• Reduced profit opportunities and increased credit costs due to lower domestic consumption and slower economic growth;
• Decreased earnings and losses caused by sudden changes in market conditions such as stock prices and interest rates; and,
• Negative impact of emerging geopolitical risks on the global economy, particularly in the U.S. and Asia, and deterioration in the foreign currency funding environment.

Table 1

High Earnings To Continue

We predict the three megabank groups will likely continue to generate high profits in fiscal 2024 even without the market conditions they enjoyed in fiscal 2023. We take this view because they are starting to see the effects of efforts to improve profitability, such as replacing assets in loan portfolios, as well as measures to expand their business base. Furthermore, we anticipate financing needs and profit opportunities for their investment banking businesses will likely increase. Large domestic companies have accelerated their efforts to enhance corporate value, and this is likely to continue in fiscal 2024. In addition, the lifting of negative interest rates in March 2024 will contribute to the megabank groups' interest income in fiscal 2024. Also, a potential further hike in domestic interest rates could have a positive impact, such as an additional increase in interest income and more securities investment options through domestic bonds.

In fiscal 2023, the three groups' aggregate net operating profits increased 21% and net profit totaled ¥3.1 trillion. This is a significant increase over the previous record high of ¥2.5 trillion in fiscal 2013, before the introduction of negative interest rates. Increased interest income resulting from corporate financing needs and improved interest margins drove the increase in net income, as did increased fee revenue reflecting corporate activities and favorable market conditions. Rising stock prices pushed up gains on sales of securities, which also contributed to the growth in profits. Several external factors, such as high stock prices, depreciation of the yen, continued high interest rates in the U.S., provided a boost to megabanks (see chart 1). All three groups have announced further profit growth forecasts for fiscal 2024. Their forecasted net profit totals ¥3.3 trillion in aggregate.

The weak yen has boosted the financial performance of the megabank groups. Many large companies that are customers of the megabanks have benefited from the depreciating currency. This has resulted in an increase in the megabank groups' fee revenue. We consider the weak yen's impact on the groups' regulatory capital ratios to be neutral. This is because risk-weighted assets have increased, which negatively affects the ratio because the denominator increases. Meanwhile, yen-denominated profits and foreign currency translation adjustments have increased, which positively affects the ratio because the numerator increases.

We think risk factors for the megabank groups include reduced profit opportunities and higher credit costs due to lower domestic consumption and slower economic growth. A decrease in earnings precipitated by sudden changes in market conditions and losses related to loan and securities portfolios are also risks. Faltering economic growth in Asia and the U.S., focus areas from which they seek to capture more earnings, and emerging global geopolitical risks could also loom over earnings, in our view.

As part of their efforts to improve profitability, the three groups control expenses while making growth investments. We believe this is key to improving capital efficiency, given the increasing costs of strategic investment and digitalization, as well as factors that may raise costs, such as inflation and response to regulations.

Chart 1

Asset Quality Remains Sound; Credit Costs May Fluctuate

We expect the three megabank groups to maintain sound asset quality (see chart 3). In our base-case scenario of low but stable domestic economic growth (real GDP growth of 0.8% in 2024 and 1.1% in 2025) and moderate interest rate increases (policy interest rate of 0.25% in 2024 and 0.5% in 2025), credit costs are unlikely to rise considerably in the next one to two years. We project the groups' aggregate credit cost ratio will likely be 20-30 basis points (see chart 2). Our assumption incorporates growth in lending to small and midsize enterprises and retail in emerging Asian countries with higher economic risk, and credit costs arising from domestic consumer finance business. Moreover, considering that credit costs related to large borrowers accrued in fiscal 2023, we think the financial conditions of large domestic and overseas borrowers could increase fluctuations in credit costs. Therefore, we predict credit costs will likely remain higher than pre-pandemic levels, although they are kept low. The three groups' aggregate credit costs totaled ¥878.3 billion and the credit cost ratio was 29 basis points in fiscal 2023.

Chart 2

Chart 3

We regard the quality of assets related to the groups' overseas CRE to be manageable. We take this view because we estimate, according to disclosures, overseas real estate-related exposure accounts for less than 5% of total exposure and the proportion of nonrecourse loans is small in terms of overseas real estate-related exposure. In addition, exposure to offices in the U.S. or real estate in China is extremely limited.

Capturing U.S. And Asia Market Growth Will Raise Profitability

We expect the three megabank groups to continue to focus on Asia and the U.S.--regions with growth prospects. We believe that achieving the groups' main goal of improving profitability may depend on their ability to grow previous investments into stable revenue drivers. The groups have largely completed laying the foundations of their businesses in these regions. Also, they have been expanding businesses to capitalize on market growth by investing in peripheral businesses. In fiscal 2023, the groups announced a number of investments and plans. These include MUFG's PT Mandala Multifinance Tbk and DMI Finance Private Ltd.; SMFG's Vietnam Prosperity Joint Stock Commercial Bank and SMFG India Credit Company; and Mizuho FG's Greenhill & Co. Inc. and Kisetsu Saison Finance (India) Pvt. Ltd.

Conditions vary across emerging economies in Asia. In 2023, we revised upward our Banking Industry Country Risk Assessment (BICRA) for India. This was based on our view that an improved operating environment and good economic prospects will lead to better asset quality and strengthened resilience of the financial sector. On the other hand, our BICRA for Vietnam is low, reflecting high economic and credit risks. This is based on our expectation that credit costs and nonperforming loans will likely remain high. In fiscal 2023, SMFG recorded impairment losses of VPBank SMBC Finance Co. Ltd. (FE Creidt) , a Vietnamese nonbank financial company in which it has invested.

In the domestic retail business, the megabanks have invested in recent years mainly in the digital domain. The aim of this is to expand customer bases to include younger demographic groups and create financial ecosystems. We monitor whether the groups will continue to reduce costs. Also, we are paying attention to the investments and measures banks have taken to expand customer bases of their retail businesses and to raise earnings in an efficient manner.

Megabanks Primed To Withstand Interest Rate Changes And Capture Profit Opportunities

In our view, the three megabank groups have been preparing to capitalize on profit opportunities. They have dealt with interest rate risks, such as persistently high U.S. interest rates and rising rates at home (see chart 4a). They have done this using strong core earnings as well as gains on the sale of cross-shareholdings amid a robust stock market. In fiscal 2023, there was a movement by the groups to shorten the duration of Japanese government bonds. As for foreign bonds, the groups have reduced risk volume in past years. We think they have managed risk prudently with regard to foreign bonds because the timing and speed of the decline in U.S. interest rates remain uncertain. On the balance sheets of the three groups, securities comprise about half of their loans and about 60% of their deposits at the Bank of Japan. Accordingly, we believe risk in the groups' securities portfolios remains manageable.

Both unrealized gains and gains on sales of securities significantly increased in fiscal 2023 (see chart 4b). We believe the reasons for this are that a sharp rise in stock prices boosted gains on reduction of strategically held stocks and the groups improved their bond portfolios (see chart 4c). In fiscal 2024 and onward, gains on the sale of securities may not be as high as in the previous year, depending on stock prices and the pace at which the groups reduce stock holdings. Nevertheless, a large amount of realized or unrealized losses will unlikely accrue within overall securities portfolios, in our view, given the condition of each group's bond portfolio and continued reductions in strategically held stocks.

Chart 4a

Chart 4b

Chart 4c

Megabanks Maintain Sound Financial Health And Have Addressed New Regulations

We predict the three groups are unlikely to significantly improve their capital measured by their regulatory capital ratios, which are currently at sound levels, and risk-adjusted capital (RAC) ratios as we define them. We base this on the following:

• The groups will accumulate and replace assets to build highly profitable portfolios as part of their efforts to improve profitability;
• They have already reached their target capital ratios based on full implementation of Basel III in five years; and
• The groups will likely provide shareholder returns aggressively as part of capital allocation.

The three groups issued Additional Tier 1 (AT1) bonds in fiscal 2023 (see chart 5). They did this as part of capital policies to build an optimal capital structure mix. Also, the groups are preparing for potential changes in market conditions and proactively issued AT1 bonds while the environment was favorable. The stable issuance of AT1 bonds underpins our RAC ratios. In fiscal 2023, MUFG and SMFG issued AT1 bonds in overseas markets for the first time. Issuing bonds abroad can count toward a record of accessing broad and multilayered markets, leading to diversification of funding markets. At the same time, it will likely contribute as a source of long-term foreign currency financing to meet lending demand, in our view.

Chart 5

We expect the megabank groups' foreign currency funding to remain stable, supported by customer deposits and medium- to long-term market financing (see chart 6). At the end of March 2024, the total balance of foreign currency loans, excluding foreign exchange impact, decreased, partly as a result of the groups' efforts to improve the profitability of overseas lending. Nevertheless, foreign currency loans will likely grow in the next one to two years, reflecting robust needs for foreign currency lending, in our view. Consequently, we believe that management of foreign currency funding, including costs, remains important for the three groups.

Chart 6

Table 2

Related Research

• Global Economic Update: Policy And Exchange Rate Forecasts Revised On New Fed Funds Rate Expectations, May 2, 2024
• Japan's Bumper M&A Risky For Banks, April 22, 2024
• Global Credit Conditions Q2 2024: Between Economic Resilience And Market Exuberance, April 2, 2024
• Global Economic Outlook Q2 2024: Still Resilient, With Gradual Rate Cuts Ahead, March 28, 2024
• Japan Banking Outlook 2024: BOJ Hikes Will Widen Disparities, Jan. 23, 2024