Tailwinds in Japan's banking industry will likely strengthen in 2025, moderately bolstering banks' business bases, in our view.  Stable growth in the Japanese economy could provide a buffer against negative impacts. And it may need to, as strong headwinds may arise due to uncertainty in the global economy, and increased volatility due to market and geopolitical risks brought about by the change of U.S. government. Market conditions such as foreign exchange rates and stock prices will support the performance of major banks, in our view. (See "Global Credit Outlook 2025: Promise and Peril," Dec. 4, 2024.)

Interest rates, while no longer negative, are rising more slowly in Japan than they did overseas.   We believe this reduces the likelihood of the adverse effects of rate hikes seen overseas. S&P Global Ratings expects the policy rate in Japan would be raised to 0.75% by the end of 2025, and the economy to remain generally stable (see Table 1). The sound macroeconomic environment, a prerequisite for the Bank of Japan (BOJ) to raise the policy rate, will also strengthen banks' creditworthiness.

Strong corporate borrowing demand will likely ease competition in lending rates and prevent deterioration in the quality of bank loans, we believe.   As the recovery in consumption has been sustained rather than being transient, cost increases due to inflation and rising labor expenditures continue to be passed on to final prices.

We estimate banks' outstanding loans will increase at an annual rate of about 3% in 2025, driven by capital investment following the economic recovery. This also includes forward-looking demand for investment in response to changes in the economic environment, such as labor-saving and digitalization, and transition finance. As strong borrowing demand will ease competition in lending rates, we expect major banks and regional banks in urban areas to lead the improvement in credit spreads.

Table 1

Key Credit Drivers

Higher interest rates more positive than negative

Rates will continue to boost banks' performance in 2025, in our view.   According to the Japan Bankers Association, the gross interest income of 110 non-consolidated banks improved as of mid-fiscal 2024 (ends March 31, 2025) due to strong growth on loans and deposits (see chart 1). We estimate that about 60% of the increase in gross interest income is due to the rise in lending rates (also including improvement in lending spreads), while the increase on deposits is mostly due to higher interest rates. The increase in funding costs has been limited, and centers on interest on deposits received.

We expect improved net interest income to be further accelerated at major banks.   The bigger banks have a high proportion of market-linked base interest rates in their lending assets, and strong demand for funds from customers. Looking at the BOJ's average contracted lending rates (on a stock basis), the effects of the interest rate hikes in March and July appear early at major banks (see chart 2).

At regional banks, which have a higher proportion of fixed-rate loans and floating-rate loans linked to the short-term prime rate, we expect the main effects of the hike in the short-term prime rate to carry over into 2025. A similar effect will also arise upon additional interest rate hikes, in our view.

Chart 1

Chart 2

We believe deposits in Japan will become a stable source of profit.   This is because interest rates will be set appropriately against further hikes and changes in the yield curve. For interest rates on deposits, Japanese banks offer tracking rates at about 40% of the yield curve, with the major banks leading the pricing (see chart 3). These rates enable securing a margin of about 60% by investing into safe assets.

To capture future asset management opportunities, some banks strategically use deposit rates, such as by offering higher interest on saving deposits to younger depositors, or those who meet certain conditions such as the balance of assets under management. However, since the balance of deposits at most banks still greatly exceeds the balance of loans, it is unlikely that interest rate competition on deposits will spread throughout the financial system.

The balance of deposits will likely remain firm, and contribute to an increase in profits by containing funding costs.   A rise in corporate loan demand, expansion in household consumption, and shift from deposits to investments will cause a decrease in the balance of deposits. But strong corporate performance and increasing disposable income through wage rises will contribute to growth in deposits. As such, the balance of deposits entering a declining trend seems less likely at this point.

Although there has been a notable increase in purchases of investment assets compared with the previous system under the new Nippon individual savings account (NISA), a small investment tax exemption system for individuals launched in January 2024, this is not yet strong enough to threaten the balance of deposits. It is also unlikely for the cost of deposits to increase due to a strong shift from ordinary deposits to term deposits. Even during the last period of rising interest rates from 2006 to 2008, the growth of term deposits was sluggish despite the rise in deposit rates.

Chart 3

Chart 4

The slow rise in Japan's short-term interest rate will alleviate risks from higher interest rates, we believe.   The gradual increase limits the likelihood of structural negative net interest margins, and growing bond valuation losses due to higher interest rates. At the current pace of policy rate hikes, it is unlikely the Japanese yen yield curve will be inverted. Even if a temporary distortion occurs, the difference in interest rates will be small.

As medium- to long-term interest rates have risen since 2022, ahead of the policy rate, banks have constrained bond-holdings. Therefore, there is little room for a sharp rise in valuation losses. Given the high proportion of bank's highly sticky core deposits, concerns about liquidity, such as through deposit outflows, will also be constrained.

The negative impact of a rise in interest rates will vary depending on the composition of assets and liabilities, and the amount of securities held, but we expect the net benefits from higher rates to be stronger in 2025.

Chart 5

Credit costs: economic environment constrains deterioration of asset quality

We expect strong economic growth to restrain credit costs in 2025.   Credit costs should be around 20 basis points (bps) of outstanding loans in 2025, broken down into halves of ordinary credit costs and costs on the assumption that a sudden deterioration in the creditworthiness of companies could occur.

The recent increase in bankruptcies and defaults in Japan is mainly from small businesses that typically do not qualify for bank credit. The subrogation rate of loans guaranteed by credit guarantee corporations, including interest-free loans (so-called zero-zero financing loans), whose borrowers are small and viewed to have relatively low creditworthiness within the banks' lending portfolio, has recently increased but remains at the pre-COVID level (see chart 6).

We expect the deterioration in creditworthiness of individual companies to be the main driver of credit costs.   The specific allowance for loan losses has been on a slight upward trend in the first half of fiscal 2024, while many banks have reversed the general allowance for loan losses that had been booked under the pandemic. We expect this trend to continue, reflecting the improvement in the economy.

Chart 6

Key Risk Factors

Uncertainty resulting from the new U.S. administration will test Japanese banks

Economic slowdown is the biggest negative factor for Japanese banks, in our view.   Expectations for stability in the domestic economy and prices will support further rate hikes and sustain banking industry tailwinds. The policy rate previously began to rise in July 2006. But the onset of the global financial crisis and accompanying economic downturn saw the rate fall from 0.5% to 0.1% from October to December 2008. Deterioration in the global economy counteracts tailwinds, and becomes a strong headwind for banks' creditworthiness.

Japanese banks have a certain degree of resilience to sudden changes in market conditions, we believe   (see "Japan Banks Primed For Market Turbulence" Aug. 19, 2024). We view greater risks in the funding environment of foreign currencies, which are weaker compared with domestic funding for Japanese banks. Appreciation of the yen will have a negative financial impact on the major banks, which have benefited from the currency's depreciation since fiscal 2022 (ended March 2023). However, since the major banks have been improving the profitability of overseas credit during the same period, we view it unlikely that it will deteriorate their business bases. A decline in the performance of export-oriented companies due to the stronger yen, or a slowdown in overseas economies, will likely be negative factors that would impact the business environment of Japanese banks.

Gains on the sale of strategic investment stocks will continue to provide a buffer in 2025 to absorb costs, in our view.   Since 2023, non-life insurance companies have accelerated the reduction of strategic investment stocks, and firms are gaining momentum to eliminate cross-shareholdings. We expect reduction of strategic investment stocks in the banking industry to proceed significantly in and after 2025. Gains on the sale of such stocks will also promote the realization of unrealized losses on bonds and other securities, and help soak up the increase in credit costs. The book value of strategic investment stocks held by banks is generally low, and therefore we expect substantial gains could result upon sale, even when the stock price becomes lower.

Efforts to improve shareholder value a potentially strong headwind

Such efforts will increasingly be viewed as a negative factor in evaluating banks' creditworthiness.   For actions taken by banks, a decline in capitalization is a negative factor as it is a reduction of loss-absorbing capacity. While capitalization requirement provides a bulwark against excessive capital policies, it also lures banks to pursue profitability.

One aspect of this is the banking industry's growing risk appetite for alternative investments, including private credit and private equity. Even within the ordinary lending business, an increase in transition financing is leading to an increase in the number of opportunities for project financing, which is more complex than general lending, and in mezzanine loans and equity investments, which are riskier. This raises the possibility of transformation in banks' credit portfolios.

Similar efforts taken by corporate entities also have many negative aspects in evaluating banks' creditworthiness.   There has been an increase in cases where corporate entities' financial conditions have deteriorated, such as through mergers and acquisitions, delisting, dividend increases, and share buybacks (Refer to " Japanese Companies Hear Shareholders: Reverberations For Ratings" Aug. 12, 2024). The size of buyouts (MBOs and LBOs) funded by bank borrowings is also increasing, expanding the scope for participation by banks other than the major banks. With an expected increase in debt servicing amid higher interest rates, as well as ongoing structural changes in the economy, banks are required to enhance their credit management to prevent sudden increases in credit-related costs due to unexpected large-scale defaults.

Weakening tailwinds remind banks of headwinds

The normalization of the business environment through higher interest rates and economic growth clarifies banks' strengths and weaknesses.   The size and method of benefits provided by higher interest rates and economic growth are not uniform for all banks. Major banks and those located in metropolitan areas enjoy increased demand for loans, a stable deposit base, and have the capacity to compete in terms of lending and deposit rates. Banks that do not have a competitive business base, or that face an exodus of residents and economic activity from their main areas to other prefectures, are vulnerable against interest rate competition.

This gap will widen further as stronger banks accelerate investment for the future, in our view.   As major banks and Internet-only banks expand their services, geographic barriers will be lowered, and traditional physical advantages in deposit and loan operations will be eroded. Economies of scale are needed to deal with increasingly sophisticated risks, such as increasing cyber risks and money laundering. In recent years, numerous financial institutions have closed or reduced their foreign exchange operations, citing lack of cost-effectiveness in dealing with money laundering. These decisions also accelerate the decline in competitiveness of weaker banks.

Related Research

• Global Credit Outlook 2025: Promise and Peril, Dec. 4, 2024
• Economic Outlook Asia-Pacific Q1 2025: U.S. Trade Shift Blurs The Horizon, Nov. 24, 2024
• Global Banks Outlook 2025: Cautiously Confident, Nov. 13, 2024
• Japan Banks Primed For Market Turbulence, Aug. 19, 2024
• Banking Industry Country Risk Assessment: Japan, July 31, 2024
• Japanese Companies Hear Shareholders: Reverberations For Ratings, Aug. 12, 2024
• Japan Megabanks Set For Growth, June 16, 2024
• Japan Regional Banks' Breezy Performance To Hit Capital Headwind, June 10, 2024
• Japan's Bumper M&A Risky For Banks, April 22, 2024