Why Japanese banks' core profitability lacks strength

Core lending has yet to benefit from Abenomics.

Better-than-expected results for the Japanese mega banks as well as the regional banks in the first-half of the financial year (H1FYE14) was driven by favourable market conditions and a less onerous operating environment, says Fitch Ratings. 

Fitch, however, notes that the key uncertainty for the banks is that their core profitability lacks strength. .

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However, core lending has yet to benefit from any Abenomics-induced strengthening of Japan's economy. This is because the recent upturn has yet to result in a significant pick-up in loan demand or wider interest margins.

Easier financial market conditions alongside tight operating and credit cost controls have already boosted the risk-absorption capabilities of the mega banks. This resulted in our upgrades of their Viability Ratings in March.

Supportive financial conditions have continued to prop up a market-driven pick-up in earnings. This was clearly evident as the three mega bank groups saw their aggregate pre-tax profit jump by over 70% versus H1FYE13, with the main drivers being gains from equity investments and a reversal of loss-provisions.

The strength of the earnings momentum has resulted in all the mega banking groups and most of the large regional banks revising up their full-year earnings projection. However, the projections also suggest weakening confidence about the earnings momentum being sustained through the remainder of the financial year.

Loan performance has also continued to improve. The mega banks' gross NPL ratio (on a risk-monitored loan basis) declined to 1.9% at end-September from 2.2% at end-March. Moreover, interest-rate risk is also being mitigated by the significant sales of Japanese government bonds (mostly to the central bank) - with the three mega banks lowering their aggregate holdings by over 20%.

We expect credit profiles to remain steady in the next few quarters as a supportive policy stance should persist. This is notwithstanding the emergence of internal risks such as a possible slowdown in private demand in response to the forthcoming consumption tax hike, or of external threats such as a renewed slump in the world economy.

The key uncertainty for the banks, however, is that their core profitability lacks strength. Mega banks' loan/deposit yields inched lower to 1.2% in H1FYE14, from 1.3% in FYE13.

Moreover, there has been no discernible pick-up in domestic loan demand despite the recent increases in private capital expenditure. This highlights the highly liquid nature of Japan's corporate sector, and which is limiting the necessity of recourse to bank borrowing.

All of this means that the banks continue to rely on non-core earnings such as market-related gains. The 60% increase in the TOPIX between September 2013 and September 2012 certainly helped, as did a containment of bond yields by the BOJ's purchases of government securities.

However, there are lingering doubts over the durability and breadth of Japan's growth recovery. The July-September annualised GDP growth of 1.9% was marginally higher than market expectations. But much of it was due to public spending, with no notable pick-up in private activity.