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Industry Report Card: Japan Regional Banks Face Drawn-Out Profit Recovery


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Industry Report Card: Japan Regional Banks Face Drawn-Out Profit Recovery

Japan's regional banks got a temporary lift this past year, but it doesn't change their longer-term trajectory.

Financial results of 11 Japanese regional banks we rate were better than we expected in fiscal 2020 (ended March 31, 2021), benefitting from a large economic package the central government funneled to the private sector amid the coronavirus pandemic.

Regional banks' (see note 1) combined core net operating profit rose 6.7% year on year and pretax net profit fell only 4.2%. Net interest income, which accounted for about 77% of their combined gross profit, rose 2.1% thanks to active use of loans with government guarantees. Regional banks' credit costs to outstanding loan balance saw a limited rise to 19 bps.

However, we expect regional banks' credit quality to come under pressure because the fundamental problem of their continually declining profitability remains unresolved amid a low earnings environment. Also, we see continuing risk of materialization of losses from borrowers. In addition to scales of economies and demographics in home markets, progress in revenue diversification is a key factor that we see widening gaps in revenues bases.

Japan's economy will recover at a moderate pace, in our view. As government support gradually diminishes, focus areas for credit risk will shift from borrowers' liquidity to debt repayment. During this process, we expect credit costs to remain higher than their pre-pandemic levels.

In 2020, we identified five rated regional banks as facing credit pressure because their businesses were likely to become less stable. We took rating actions on two of them in June 2021 (see "Japan-Based Hokkoku Bank Downgraded To 'BBB+' On Tough Business Conditions; Outlook Stable," published June 23, 2021, and "Japan-Based Keiyo Bank 'A-/A-2' Ratings Affirmed On Lower Profitability; Outlook Remains Stable," published June 23, 2021). We will consider downgrading the other three if they fail to improve their revenue and cost structures even as the pandemic subsides and if we determine they have weaker business bases relative to the average of Japan's banking sector.

Profitability: Revenue diversification is key as benefits from government support fade

In fiscal 2020, regional banks saw a 6.7% year-on-year increase in core net operating profit (aggregate of the 11 regional banks unless otherwise stated), excluding gains or losses on bonds and on cancellation of investment trusts. Net interest income, which comprised about 77% of gross profit, increased 2.1% year on year. This was due to an increase in loans outstanding because of a sudden rise in borrowers' liquidity needs amid COVID-19 and a decline in foreign currency funding costs, even though yields on loans and investment securities continued to decline. Pretax net profit declined only 4.2% because a considerable increase in gains on sales of stocks partially offset higher credit costs.

Regional banks' net interest margins will continue narrowing, in our opinion. We base this view on intensified competition in their home markets and metropolitan areas they have entered, causing yields on newly extended loans, mainly on housing loans, to fall below those on existing loans. In fiscal 2020, regional banks had an average net interest margin before credit costs and operating expenses of 0.90%, down 4 bps year on year. This is despite more loans guaranteed by credit guarantee corporations (CGCs), which generate higher yields than general loans, because of the government's economic stimulus measures. The decline continued at the same pace as in fiscal 2019 (see chart 1).

Chart 1


We see the rapid increase in lending for liquidity needs amid COVID-19 subsiding and new loans growing rather moderately in fiscal 2021. A substantial increase in demand from small and midsize enterprises (SMEs) for loans related to capital expenditure is unlikely, in our view, considering continued surplus funds in the corporate sector from prior to the pandemic, as well as a delay in economic recovery, mainly in domestic demand. Research from the Shoko Chukin Bank shows SMEs' budgeted capital expenditures for fiscal 2021 are lower than the previous fiscal year.

Progress in regional banks' revenue diversification, in addition to scales of economies and demographics in home markets, is leading to expanding gaps in revenue bases of regional banks we assess. Even though rated regional banks' business bases are relatively strong for the overall regional banking sector, gaps are appearing in revenue size, revenue source, and revenue and cost structure (see chart 2). We also see their business environment and management strategies reflected in their risk-return profiles (see chart 3).

Chart 2


Chart 3


S&P Global Ratings believes institutional support from the Bank of Japan (BOJ) and the government, such as a subsidy scheme and a review of regulations on banks' business scope, may incentivize regional banks to restructure their businesses and diversify revenue sources. However, the positive impact of such support on earnings is likely limited, given a continued decline in fundamental earnings capacity (see "Fintech Can Revive Japan’s Regional Banks," published Jan. 14, 2021 and "Bank Of Japan Incentive Of Limited Help To Regional Banks," published Nov. 11, 2020). Regional banks' efforts to reduce costs are slowing as investments for information technology (IT) related to digitalization rise. Therefore, we view further rationalization as essential. Combined total operating costs of rated regional banks rose 1.4% year on year in fiscal 2020 due to factors including increased IT-related costs. This more than offset the effects of restricted sales activities during the pandemic.

This June, we downgraded ratings on one and lowered our stand-alone credit profile (SACP) on another of the five rated regional banks we assessed as facing credit pressure since last year, arising from our forecast of lower business stability. We maintain negative outlooks on our long-term issuer credit ratings on the remaining three regional banks, given their groupwide revenue bases, including economic conditions in home regions; their return on S&P Global Ratings risk-weighted assets; and historical records and prospects for improvement of their medium- to long-term revenue and cost structures. Meanwhile, we will consider downgrading them if their revenue and expense structures do not improve even as the pandemic eases, leading us to view their business bases as less stable relative to the average of Japan's banking industry.

Asset Quality: Likely Longer Timeline For Materialization Of Borrowers' Credit Risk

S&P Global Ratings expects Japanese banks' credit costs to stay higher than before the pandemic as government support for the private sector (households and corporates) diminishes moderately (see chart 4). As a result of the government's large economic stimulus package, the ratio of regional banks' credit costs to average outstanding loan balance was 19 bps in fiscal 2020, a limited increase from 12 bps in fiscal 2019. About 50% of growth in outstanding loans was for loans that are effectively interest-free and unsecured loans that the government guarantees (see chart 5).

Chart 4


Chart 5


Regional banks, including those we rate, recorded some loan loss provisions in a preventive manner in fiscal 2020, but only a small number took a forward-looking approach, in our opinion. Therefore, rises in their combined credit cost and nonperforming loan ratios were limited. The average credit cost ratio of the 62 regional banks in Japan for which we have data also rose only slightly to 15 bps in fiscal 2020. In contrast, the ratio was 33 bps for major Japanese banking groups (see note 2), which did take a forward-looking approach in posting loss provisions, centered on their overseas credit exposure.

Our forecast combined credit cost ratio for the 11 regional banks for fiscal 2021 incorporates the likelihood of a downward revision of the banks' classifications, or even defaults, of some borrowers in sectors severely affected by the pandemic (see chart 6) and some large borrowers in their home regions. Our forecast also incorporates credit cost assumptions for Japan's overall banking industry. We estimate Japan's GDP will grow more slowly than those of other major advanced economies at 2.5% in 2021 and 2.1% in 2022. In addition, some government support is winding down. For example, new applications for effectively interest-free and unsecured loans from private-sector banks closed on March 31, 2021.

Chart 6


We view regional banks as likely to continue grappling with elevated credit costs, with borrowers' capacity to repay debt under pressure amid the prolonged pandemic. Credit risk will shift from borrowers' liquidity to debt repayment, which is complicated by regional banks' important role in supporting regional economies. Interest subsidies on effectively interest-free loans run for three years. This will likely help borrowers' interest payments in the short run. However, scheduled amortization for some loans executed a year ago will kick in this summer. With banks' liquidity support for borrowers subsiding, we consider it important that regional banks remain selective in providing additional loans and equity-like financing in the future amid changes in social systems and industry structures.

Keeping risk-taking within loss-absorbing capability and maintaining appropriate asset and liability management has become more important, in our view. The challenge for fund management is that customers' deposits to regional banks have exceeded corporate funding needs, owing to, for example, government subsidies to customers (some borrowers likely deposited proceeds of loans for liquidity support into banks; therefore, overall corporate deposits may decline somewhat as the pandemic subsides). In addition, regional banks' borrowing increased through the BOJ's special funds-supplying operations in response to COVID-19. Rated regional banks' security holdings as of March 31, 2021, grew about 15% from a year earlier. Their deposits on the asset side, which mostly consist of placements to current accounts held at the BOJ, increased about 87% (see chart 7) to represent roughly 20% of total assets.

Chart 7


Low reinvestment yields on Japanese government bonds lead us to expect regional banks will continue investing in securities and financial instruments with higher risk-return profiles, such as foreign bonds and investment trusts, depending on market conditions. Realized gains on sales of stocks increased substantially in fiscal 2020 (see chart 8), together with higher unrealized gains on listed stocks thanks to a rise in share prices, while losses on sales of bonds increased. Income from securities investments is more volatile than that from lending business, in our view. Volatility risk in income may materialize in the future, particularly when overseas interest rates rise or stock markets enter a correction.

Chart 8


Capitalization: Remains favorable; fund management and stock market trends need monitoring

Rated regional banks' capitalization will likely continue to underpin their credit profiles, providing them with firm loss-absorbing buffers, in our view. Capitalization of rated regional banks is more favorable than for major Japanese banks and is comparable with non-Japanese banks. Their combined risk-adjusted capital (RAC) ratio was 9.7% on a weighted-average basis as of Sept. 30, 2020 (see chart 9), almost flat from 9.8% as of Sept. 30, 2019 (we calculate the RAC ratio as of March 31, 2021, after obtaining required details).

Chart 9


We attribute a well-controlled rise in regional banks' risk-weighted assets despite the pandemic to CGCs-guaranteed loans, which account for a large part of their new lending, as well as to expanded unrealized gains on stockholdings because of higher stock prices. Increased capital through steady accumulation of profit despite continued stable shareholder returns also lifted the capital ratios.

How RAC ratios of rated regional banks perform in the future will depend, in our view, on the risk they take in fund management given substantially higher surplus funds. The ratios also depend on stock market movements, with unrealized gains on stockholdings influencing the ratios considerably. Therefore, a huge drop in stock prices may cause the ratios to decline through a rise in risk-weighted assets. Meanwhile, a sizable increase in lending is unlikely to lead to a fall in the ratios, considering a sudden increase in borrowers' funding needs in fiscal 2020. It is also unlikely rated regional banks will make substantial equity investments to support customers' business restructuring. We consider the risk of such investments as high.

Table 1

Key Financial Indicators In Fiscal 2020
% Gross nonperforming loan (NPL) ratio Loan loss reserves/NPLs Net NPL ratio Credit costs/outstanding loan balance
Rated regional banks§ 1.6 44.4 0.9 0.19
Major banking groups (consolidated basis)† 1.1 70.5 0.3 0.33
Return on assets (ROA) (pretax profit) ROA (core net operating profit) Overall interest rate spread including general and administrative expenses‡ Common equity Tier 1 capital ratio of the banks subject to international capital standards** Core capital/risk assets ratio of the banks subject to domestic capital standards
Rated regional banks§ 0.29 0.33 0.21 14.5 11.0
Major banking groups (consolidated basis)† 0.30 0.36 0.05 13.1 N.A.
Growth rate of outstanding balance of deposits Growth rate of outstanding balance of securities Growth rate of outstanding balance of loans Net interest margin decline rate (percentage point)§§
Rated regional banks§ 10.5 14.6 4.3 0.04
Major banking groups (consolidated basis)† 9.4 22.9 1.2 0.05
All figures are on a consolidated basis. Fiscal year ended March 31, 2021. §11 Japanese regional banks rated by S&P Global Ratings. †Japan's five major banking groups. ‡Calculated by deducting funding costs from yields on interest-earned assets, based on figures from domestic businesses. **Excludes figures for Resona Holdings. §§Calculated by deducting yields on deposits from yields on loans, based on figures from the domestic businesses. N/A--Not applicable.

Table 2

Japanese Rated Regional Banks' ICRs, SACPs, And Subscores
Issuer credit rating Outlook Stand-alone credit profile (SACP) Anchor SACP subscore
Business position Capital and earnings Risk position Funding & Liquidity
Funding Liquidity

Chiba Bank Ltd.

A- Stable a- bbb+ Adequate Adequate Strong (+1) Average Strong

Shizuoka Bank Ltd.

A- Stable a- bbb+ Adequate Strong (+1) Adequate Average Strong

Hachijuni Bank Ltd.

A- Stable a- bbb+ Adequate Strong (+1) Adequate Average Strong

Bank of Kyoto Ltd.

A- Stable a- bbb+ Adequate Strong (+1) Adequate Average Strong

Iyo Bank Ltd.

A- Stable a- bbb+ Adequate Strong (+1) Adequate Average Strong

Gunma Bank Ltd.

A- Stable bbb+ bbb+ Adequate Adequate Adequate Average Strong

Keiyo Bank Ltd.

A- Stable bbb+ bbb+ Moderate (-1) Strong (+1) Adequate Average Strong
Higo Bank Ltd. And Kagoshima Bank Ltd.* A- Negative bbb+ bbb+ Adequate Adequate Adequate Average Strong

Hokuriku Bank Ltd.§

A- Negative bbb+ bbb+ Adequate Adequate Adequate Average Strong

Hokkoku Bank Ltd.

BBB+ Stable bbb bbb+ Moderate (-1) Adequate Adequate Average Strong
*SACP and subscores for Kyushu Financial Group. §SACP and subscores for Hokuhoku Financial Group.


1. The 11 Japanese regional banks that S&P Global Ratings rates are Bank of Kyoto Ltd., Chiba Bank Ltd., Gunma Bank Ltd., Hachijuni Bank Ltd., Higo Bank Ltd., Hokkoku Bank Ltd., Hokuriku Bank Ltd., Iyo Bank Ltd., Kagoshima Bank Ltd., Keiyo Bank Ltd., and Shizuoka Bank Ltd. We used the group figures of Hokuhoku Financial Group Inc. for Hokuriku Bank Ltd.

2. The holding companies of Japan's five major banking groups are Mitsubishi UFJ Financial Group Inc., Mizuho Financial Group Inc., Sumitomo Mitsui Financial Group Inc., Resona Holdings Inc., and Sumitomo Mitsui Trust Holdings Inc.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Satoru Matsumoto, Tokyo + 81 3 4550 8673;
Secondary Contact:Chizuru Tateno, Tokyo + 81 3 4550 8578;

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