Regional banks in Japan have become increasingly vulnerable to market factors in recent years as a result of a growing dependence on securities income, and 2017 is likely to bring more of the same.

Thinning domestic margins have been a headache for all Japanese lenders for decades, compounded by the central bank's introduction of negative rates in early 2016. Yet unlike the megabanks, which have looked to tap their sizable overseas operations to make up for low domestic margins, the smaller, mostly Japan-focused regional banks have had to boost investments in stocks and bonds.

In the fiscal first half ended Sept. 30, the combined net profit of Japan's 64 first-tier regional banks fell 13.8% year over year to ¥469.3 billion, according to data from the Regional Banks Association of Japan. The average margin for these banks was 0.23% for the six-month period, down from 0.25% in fiscal 2015.

And with the Bank of Japan unlikely to end its negative interest rate policy any time soon, 2017 will likely be as tough a year for regional banks as 2016 has been. Their operating environment could worsen even further, should bond and stock markets go sour.

"The regional banks sustain themselves with income from bonds and stocks, as well as returns from reserves for nonperforming loans. This business model is vulnerable to big changes in the markets," Shinya Furue, an analyst at Norinchukin Research Institute, told S&P Global Market Intelligence.

While the megabanks have been able to geographically diversify away from Japan, it has been more difficult for smaller lenders to do so. As a result, their business portfolio is less diversified and more risky, Furue added.

Income generated from bonds and stocks at regional banks accounted for 25.06% of their operating income in the first half, compared with 21.96% in the prior fiscal year, according to S&P Global Market Intelligence data.

This is also significantly higher than 19.42% in fiscal 2013, the year Haruhiko Kuroda took office as governor of the central bank and launched his program of super-loose monetary policy.

At some regional banks, securities income is almost at par with interest income. At 77 Bank Ltd., securities income made up 42% of operating income in the first half, while interest income took up 53%. Similarly, at Chugoku Bank Ltd., securities income made up 35% of operating income, not that far behind interest income at 45%.

This growing dependence on bonds and stocks makes lenders more vulnerable to market factors, a risk not gone unnoticed by Japanese regulators. In an October report, the BOJ warned: "Regional banks have become more active in investing in risky assets such as mutual funds and foreign bonds amid a trend of falling interest margins."

"Most regional banks have sufficiently high levels of capitals to withstand [such risks], therefore they are likely to maintain this active position for the time being. In the meantime, if the fall in core operating income continues and leads to a dent in regional banks' strength in operations, they could reach a point where they are unable to increase further investment in risky assets."

In response, Japan's Financial Services Agency has been examining banks with the aim of containing any systemic risks, an FSA official told S&P Global Market Intelligence.

One potential area of market vulnerability for Japan's regional banks in 2017 is the U.S. markets, as the majority of Japanese lenders' foreign assets are denominated in U.S. dollars. Rising U.S. interest rates have reduced dollar-denominated bond prices since Donald Trump won the U.S. presidential elections in November, creating unrealized losses for holders of dollar-denominated bonds. This, however, has been offset by higher stock prices, which work in regional banks' favor.

"The current strong dollar and high U.S. stock prices seem to have gone a little too far. There will be a swing back next year, probably by March, as it becomes clear what Trump would do as president," said Tsuyoshi Ueno, senior economist of NLI Research Institute. Ueno thinks the downside may be limited, however, as U.S. economic fundamentals have been strong in recent months.

"This, however, does not mean the regional banks can rest relaxed. If markets perceive Trump's policies negatively, we might see a weak dollar, falling share prices and low interest rates in the U.S., which would cripple developed countries' markets," Ueno said.

As of Dec. 29, US$1 was equivalent to ¥116.45.

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