Why the success of Abenomics is crucial for Japan's three mega-banks

Will lending growth be sustained?

In a report, Fitch Ratings says growing optimism over Japan's macroeconomic prospects does not automatically result in an immediate improvement in the performance or risk profiles of Japan's three mega banks - Mitsubishi UFJ, Sumitomo Mitsui and Mizuho.

The economy is showing early signs of a turnaround. However, a sustained pick-up in domestic lending activity is still some way off, in light of Japan's unfolding structural economic reforms.

One reason to expect subdued loan demand for the foreseeable future is the excess liquidity at Japanese corporations. This is reflected in the net cash position of the corporate sector, which was at a five-year high at JPY62tn (or 13% of GDP) at end-June. Nearly one-half of this was funded by internal capital generation.

Another reason for our current scepticism is that we do not expect much of an increase in household lending.

This is because it is difficult to foresee a strong or sustained rebound in household loan demand until Japan's structural reforms successfully increase inflation expectations, along with commensurate or larger increases in labour income.

Meanwhile, low onshore interest rates are likely to persist. This, alongside a sluggish pace of loan growth, will limit much improvement in the margins of the mega banks' core domestic operations.

The mega-banks have reduced their investments in Japanese Government Bonds (JGBs) to about 3x of their Tier 1 capital at end-June from 4x at end-March. This resulted from JGB buybacks by the Bank of Japan (BOJ) as part of its continuing efforts to double the monetary base by 2014.

The banks' excess cash, from the proceeds of JGB sales, has been re-parked at the BOJ's current account - whose balance has risen sharply to JPY35tn or 7.3% of GDP at end-June, up from 2.5% a year ago.

It remains to be seen if these excess funds will eventually be lent onshore, or be used for funding greater cross-border activity.

The mega-banks' JGB investments remain substantial despite the recent reduction. These are unlikely to fall much further amid the absence of stronger near-term onshore loan demand. But risks arising from large JGB holdings should remain contained by the banks' tight duration management, matched with ongoing improvement in capital buffers.

Favourable stock market conditions, reflecting investors' expectations for future economic recovery, could indeed boost the mega-banks' mark-to-market gains. But this is unlikely to speed up further reduction in their stock investments and ease related market risk.

The mega banks have already lowered their equity exposure to around 25%-30% of Tier 1 capital, from over 100% a few years ago. The remaining exposure is important for maintaining business relations with issuers, and will prove difficult to sell down.