Thwarted at every turn
20 March 2018
It is not difficult to see why the Japanese banking sector remains skeptical about the merits of Abenomics. Net income has fallen consistently since peaking in FY2013, while return on equity has dropped by a quarter (see Chart 8). The weak environment can be attributed to 1) negative side-effects from the Bank of Japan’s unconventional policy programme 2) insufficient non-interest based income 3) lackluster overseas earnings. We see few signs that any of these issues are likely to be addressed in the near term, meaning Japan’s banks are likely to continue to struggle versus their international peers.
To be clear, unconventional monetary policy is not unequivocally negative for the banking sector. Indeed, by lowering real yields the policy should create new opportunities for banks by stimulating loan demand. There are indeed signs that loan growth is picking up. Domestic loan growth has been running in excess of 2% year-on-year of late and has exceeded the previous year’s level for more than six years. The bigger problem though has been the incessant spread compression as average interest rates on loans have fallen steadily, while deposit rates are stuck at close to zero, preventing banks from re-pricing liability margins lower. We see few signs that banks are regaining pricing power yet. Loan-to-deposit ratios continue to fall due to excess system deposits, while chronic overbanking means loan terms are ferociously competitive. This leaves a more aggressive pick-up in the credit cycle as the best hope for an improvement in banks’ loan portfolios. While we have seen a sustained improvement in new loans to the non-manufacturing sector, there has been a softening of late. By contrast, the manufacturing sector continues to ignore bank finance as a primary means of financing fixed investment plans (see Chart 9).
Given the persistent weakness in banks’ loan books, Japan’s lenders have been focused on improving the sources of non-interest income such as banking product fees and asset management. Unfortunately, they have been slow to diversify away from traditional banking services, with the ratio of fee-based income low by international standards. Interestingly, one of the biggest contributors to fee-based business for the mega banks comes from investment banking. This reflects a contrarian reaction to the financial crisis, with large banks seeking to increase exposure to securities brokerages rather than reduce it. Mizuho recently appointed its brokerage chief as group CEO, while Mitsubishi UFJ has tied up with Morgan Stanley and SMFG has acquired Nikko Securities. Unfortunately, this strategy has yet to yield a meaningful contribution to earnings, given less profitable trading operations and higher regulatory scrutiny. Other sources of non-interest income such as investment trusts have been helped by the launch of tax-free investment schemes, but retail customers remain risk adverse. An expansion of overseas banking operations has also failed to redeem performance. Despite expanding aggressively into new geographies, profitability has been hit by the rising cost of non-yen funding, especially in US dollars. With dollar liquidity issues related to regulatory practices in the US, we think this situation will continue despite the prospects for domestic relief. With banking sector revenues likely to remain hamstrung, the focus will fall on banks’ ability to control costs and tackle their inflated workforce. Progress is likely to be slow.