Japan's banks are able to withstand recent market volatility.

The Nikkei average stock price dropped by more than 12% on Aug. 5 amid concern over the U.S. economy and monetary policy changes in Japan. Yen interest rates are changing after the Bank of Japan (BOJ) increased its policy rate for the first time in 17 years.

But the commercial banking groups rated by S&P Global Ratings are resilient to fluctuations in stock prices, interest rates, and exchange rates.

This report shows how market stress can affect the capital, profits, and unrealized losses on yen bonds at commercial banks.

The five major banking groups we rate include Japan's three megabank groups-- Mitsubishi UFJ Financial Group Inc. (MUFG),  Mizuho Financial Group Inc. (Mizuho FG), and  Sumitomo Mitsui Financial Group Inc. (SMFG)--as well as Sumitomo Mitsui Trust Holdings and Resona Holdings Inc. The seven rated regional banking groups are listed in table 1.

Huge unrealized gains protect against falling stock prices

The impact of stock market volatility on the risk-adjusted capital (RAC) ratios of rated commercial banks is muted, in our view. For every 10% decline in the Nikkei Stock Average, the RAC ratio would fall by about 10 basis points (bps) on average. Even under a strong stress scenario of a 50% drop in the index, the decline in the RAC ratios ranges from 30 bps to 170 bps, with averages of 50 bps for major banks and 80 bps for regional banks. This is based on RAC data as of Sept. 30, 2023, and assumes that the market value of each bank's equity portfolio declines at the same rate as the stock index (table 1).

The limited decline in RAC ratios relative to stock prices is due to large unrealized gains acting as a buffer. In calculating RAC ratios, unrealized gains on listed equities are built to reduce the risk-weighted assets (RWA) of listed equities to a minimum of zero. As of the end of September 2023, nearly half of the banks had zero RWA for equities after taking into account unrealized gains. This is against a backdrop of rising stock prices since 2023. Moreover, the index stood at ¥31,858 at the end of September 2023, while the closing price on Aug. 5, 2024, was about the same at ¥31,458. The buffer against a fall in stock prices from current levels would be even greater, given that the index has rebounded since Aug. 5.

Even if estimated RAC ratios fall below the threshold for our current assessments of capital and earnings, this would not necessarily lead to downgrades. For example, if the Nikkei average were to decline 30% from September 2023 to the ¥22,000 level, the RAC ratio would fall below the threshold for two of the 12 banks. However, our assessments take into account projections and unrealized profits that are not captured in the RAC framework, in addition to actual results.

Table 1

Ready for rising yen interest rates

The rated banking groups are preparing for higher yen interest rates, with each of the three megabanks' yen bonds having shortened durations of 0.3-2.1 years (after hedging) at the end of March 2024. In addition, with the BOJ holding more than 50% of Japanese government bonds (JGBs), private banks' holdings of yen bonds have declined over time.

S&P Global Ratings estimates that rising yen interest rates will raise the three megabanks' yen bond unrealized losses by about ¥350 billion at a 50 bp increase and ¥700 billion at a 100 bp increase (after hedging; table 2). This represents 7% to 14%, respectively, of their core net operating profit.

Since Resona Holdings and regional banks have longer durations for yen-denominated bonds than megabanks, we expect the increase in unrealized losses to be larger relative to their size.

It is important to note that, depending on the allocation of positions, there are limitations to duration-based estimates. For example, the duration of JGBs at Resona Holdings is relatively long at 9.2 years (after hedging). This leads to a large increase in valuation losses under this simulation, but as the basis point value (BPV) disclosed by the bank is ¥240 million on the same JGBs, the actual valuation loss would be considerably smaller than the amount estimated based on duration.

Table 2

Chart 1

Even after reflecting the valuation loss on yen bonds based on a scenario of rising interest rates, we estimate that the impact on the regulatory capital ratio will be negligible because of substantial, positive unrealized gains on securities, thanks to those on equities (chart 1). In Japan, the regulatory capital ratio for banks that adopt the domestic standard does not reflect unrealized gains/losses on securities, but here we define the regulatory capital ratio as reflecting unrealized gains/losses on yen bonds (including held-to-maturity), stocks, and foreign securities, and estimate the changes in the regulatory capital ratio.

On the other hand, we expect improvement in net interest income to be greater than the increase in unrealized losses on yen-denominated bonds if interest rate hikes are fully reflected. Even with an increase in interest rates to the extent realized so far (35 bps policy rate; 15 bps short-term prime rate)following the BOJ's policy change, the total net interest income of the three groups is expected to rise by about ¥470 billion on an annualized basis after interest rates are fully renewed (assuming a 40% tracking rate for deposit rates). The increase would be 8%-13% in each bank's core net operating profit for the year ended March 31, 2024.

Regional banks will benefit from higher interest rates later than major banks because the portion of their yen assets linked to market interest rates is smaller (chart 2). However, with net interest income accounting for about 80% of their total profits, regional banks' earnings are more likely to reflect the benefits of higher interest rates. In addition, the higher interest attached to BOJ current deposits will benefit all groups regardless of the competitive environment they face. We estimate that BOJ deposits account for about 40% of the yen assets of the three megabanks and 10%-30% of those of the rated regional banks.

Chart 2

Interest rate risk appears manageable even at the maximum stress values of the regulatory stress scenario analysis. The ratio of delta economic value of equity (EVE; see note 1) to Tier 1 capital (or total capital for domestic standard banks) in the maximum loss scenario varies, but for the majority it is in the single digits. Similarly, delta net interest income (NII; see note 2) in the maximum loss scenario is in the range of annual net core operating profit (chart 3).

The regulatory interest rate shock scenarios may not fit the current market environment in terms of assumptions, but they do provide a good indication of each bank's risk tolerance. We believe the base case is a gradual decline in policy rates in the U.S. and Europe, and a rise in Japan's policy rate to 0.5% by the end of 2025. In the regulatory scenario, interest rates for all currencies are assumed to shift in the same direction, although the range varies from currency to currency: for example, 100 bps for the yen rate, 200 bps for the U.S. dollar and euro, 300 bps for the Australian dollar.

Chart 3

Foreign exchange fluctuation of ¥10 per dollar would have little effect on earnings

We estimate the impact on core net operating profit or net operating profit of a ¥10 change in the dollar-yen exchange rate would be about 2%-4% for the five major groups, based on their explanations. Through overseas loans and investment in securities, a weaker yen will have a positive impact on earnings. The impact on capital adequacy ratios is limited due to the currency matching of assets and liabilities. Even when the impact is relatively large, we expect the effect on the common equity Tier 1 (CET1) ratio to be limited to about 10 bps per ¥10 change in the dollar-yen exchange rate. Regional banks and banks with mostly domestic operations are expected to see a smaller impact on their profits and capital.

A sharp reversal of the yen's depreciation trend would be a risk factor for the major banks in forecasting their earnings. S&P Global Ratings believes that if the yen rises beyond ¥130 to the dollar, the risk of a downward earnings revision will increase. Many of the five major groups have assumed an exchange rate of ¥140 to the dollar as the premise for their fiscal 2024 (ending March 2025) earnings forecast. The rate has been as low as ¥161 to the dollar, but the current level of around ¥145 is within each bank's expectations.

Chart 4

Notes

1. Delta EVE: the amount of decline in economic value of equity due to the interest rate variation based on regulatory stress scenarios.

2. Delta NII: decline in net interest income for 12 months due to the interest rate variation based on regulatory stress scenarios.

Related Criteria

• Risk-Adjusted Capital Framework Methodology, April 30, 2024
• Financial Institutions Rating Methodology, Dec. 9, 2021

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