The Risky Bets Putting Japan’s Local Banks on Dangerous Path

(Bloomberg) -- Japan’s regional banks, desperate to shore up waning earnings, are making risky bets that could blow up in the next economic downturn.

In search of returns squeezed by negative interest rates, local lenders have been boosting real-estate and small-business loans that led bad-debt costs to triple last fiscal year. And with their holdings of Japanese government bonds falling to about half the levels of five years ago, they are increasing exposure to foreign assets.

In a sign the risks are building, Moody’s Investors Service recently said it may downgrade a dozen regional banks on concern that they can’t maintain profits without lending to weaker borrowers and investing in more volatile assets. Days later, the 104 year-old Shimane Bank Ltd. raised emergency capital to clean up its investment portfolio and expand lending to riskier local firms.

Japan’s rural banks “can make profits only under the most benign conditions for credit quality, and these will not continue indefinitely,” said David Marshall, an analyst at CreditSights Inc. They’re ill-prepared for any crisis because “they are not pricing appropriately for risk.”

Lenders are being blighted by years of depopulation and urbanization that’s leading to the demise of rural communities. The nation’s financial regulator is pressing them to overhaul their business models and speed up consolidation.

Below is a series of charts that illustrate the predicament of the nation’s regional banks.

Net income at the nation’s more than 100 local lenders fell to a seven-year low in the year ended March, according to the Financial Services Agency. About one in four of them have reported losses in their core lending and fee businesses for at least five years running, the most recent FSA figures show. To make up for that weakness, banks have been relying on gains from sales of their equity and bond holdings, leaving them at the mercy of swings in financial markets.

Over the past few years, banks enjoyed moderate bad-loan costs as low interest rates and a steady economic recovery curtailed defaults. That helped lenders claw back excess loan-loss provisions and book the cash as profit.

More recently, however, credit costs have surged as banks increased loans to riskier borrowers. According to CreditSights, regional banks’ provisions still only amount to 0.13% of loans, below a normal level of around 0.25%, but if they rise to 0.5% -- a possible scenario in a serious downturn -- that would push them into losses.

Regional banks have been increasing domestic loans at a much faster pace than their larger peers in Tokyo, creating a 205.6 trillion yen ($1.9 trillion) pile on which they may have to take the higher provisions. Yet they have very little to show for it, thanks to the drop in interest rates. Their combined net interest income reached the lowest in more than a decade last fiscal year, FSA figures show.

Japanese banks have a lower average net interest margin than their European peers, even though both markets are contending with negative rates. And there’s a risk that rates may fall even further below zero, with Bank of Japan Governor Haruhiko Kuroda saying in September that he had become more inclined to add stimulus.

“With a recovery in net interest income not in sight and credit costs on the rise, regional banks are in a tough earnings environment,” said Toyoki Sameshima, an analyst at SBI Securities Co.

Japan’s Topix Banks Index of shares has slid 3.9% this year, compared with a 5% gain in the benchmark Topix.

Dangers are mounting abroad, too. Japanese banks traditionally parked their excess deposits in the nation’s bonds to collect a modest fixed income. That all changed in 2013, when the Bank of Japan escalated its campaign of buying bonds to revive the economy.

Read how Japan’s small banks are loading up on risk

As domestic yields tumbled, lenders reduced their holdings and stepped up purchases of assets such as foreign bonds, leaving them exposed to risks ranging from currency fluctuations to changes in interest rates.

What’s more, many assets accumulated most recently are reported as “other” securities, adding a layer of opacity to the banks’ risk-taking. CreditSights says this item includes structured products and investment trusts, which consist of anything from corporate bonds to overseas stocks.

To contact the reporters on this story: Taiga Uranaka in Tokyo at turanaka@bloomberg.net;Yuki Hagiwara in Tokyo at yhagiwara1@bloomberg.net

To contact the editors responsible for this story: Marcus Wright at mwright115@bloomberg.net, Russell Ward

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