Japan’s banks, like most in the world, will end 2009 in better shape than they entered it. But they do so with considerable headwinds to confront. On the positive side, the biggest banks escaped the financial crisis largely undamaged and in some cases internationally transformed; on the negative, they face a great challenge to flourish in a deflationary country, and must raise billions of dollars in capital to bolster themselves for the future.

The latest round of results do show some promising signs for Japanese banks – or at least an absence of bad news. “We are getting out of the nightmare,” says Hironari Nozaki, bank analyst at Citigroup Global Markets Japan. “Symbolic is the credit cost. Last year it was 80 to 90 basis points, depending on the bank; for the first half of this year, it is coming down to 40 or 50 basis points. It confirms that the worst is over.” And in Japan’s case, “the worst” refers to a double hit: not only the global financial crisis but prior impairments on real estate companies. The bigger players reported modest increase in first half profits, with declines in client-related business being offset by growth in trading revenue.

It’s also true that Japan doesn’t appear to face a wave of distressed debt of the scale that some might have expected. “The Japanese banks have actually got a lot better at managing their credit risk,” says Graeme Knowd, banking analyst at Morgan Stanley. “The average corporate has much less leverage than they had in the past.” Nana Otsuki, banking analyst at UBS notes that the government has been strongly committed to supporting the small to medium enterprise sector, so “it’s in reasonably good shape. Credit costs may creep up in this business environment but we don’t expect a large increase in losses in this area.” And in terms of personal lending, Nozaki at Citi says that while some individual customers are requesting changes in their mortgage arrangements, “so far the deterioration rate is quite low. Japanese mortgages are much healthier than US mortgages.”

But while all that suggests no crisis ahead, that’s a long way from saying that the future is bright. The immediate problem is the health of Japan itself. “Banks don’t grow unless the economy is recovering,” says Knowd. “The general rule is that you’ve got to get nominal GDP growth back in order to get real growth at the banks.” Although Japan’s economy is improving, with 4.8% annualized GDP growth in the third quarter compared to declines of over 10% in the fourth quarter of 2008 and first quarter of 2009, it is still in a period of deflation, and “even the best managed western bank would struggle to make money in a deflationary environment,” Knowd says. “Deflation doesn’t help banks.”

It particularly doesn’t help lending. “It is not easy for Japanese banks to expand their lending domestically in a deflationary environment,” says Otsuki. On first glance, Japanese lenders look to have been very active: hence the fact that the rankings for global loan arrangers in the first quarter of 2009 looked like a throwback to the 1980s, with three Japanese banks in the top five and Mizuho at the top. But in truth that reflected a paucity of lending from European and American names at that time, now largely returned to the fold.

There’s demographics working against them too. Yoshinobu Yamada, banking analyst at Deutsche Securities Inc in Tokyo, adds: “In the long term, if banks are sticking with domestic loans, the prospects are not great because we are expecting a decline in population starting five years from now.”

Consequently, Japanese banks have increasingly been looking overseas for lending growth. It’s hardly been a surge overseas – 99% of Mizuho’s loan proceeds in the second half of 2008 were domestic, and 93% of Sumitomo Mitsui’s – but Mitsubishi UFJ, with 24% of lending directed overseas, is perhaps illustrative of the future. “Japanese banks have to lend or invest overseas, at least to an extent,” says Otsuki. That said, increasing capital requirements may curtail this expansion. “Two years ago Japanese banks were in a great rush to expand their overseas lending,” says Nozaki. “But because of capital constraints they are getting a little bit nervous about expanding overseas businesses.”

In that environment it’s very hard to find an obvious area of growth. Fee-based income, such as sales of funds and other products to retail, have been woeful, but this may yet swing around to provide a driver. Nazaki notes an improvement in the sales of investment products to consumers. “I feel some recovery here,” he says. “The first half clearly showed a bottoming out in sales.” Yamada sees the same thing. “In the medium term, one to two years, the recovery of fee income should sustain some growth in Japanese banks.”Generally, though, he is wary about the fact that recent profit improvements in Japanese banks have been supported by trading; rather than rely on that, he’d like to see Japanese banks expand in retail, not just at home but internationally, where so far only Mitsubishi UFJ (with Union Bank of California) has dared to tread. “The wholesale market all depends on the market, the economy. Japanese banks need stable growth and that comes from the retail market.”

And so all roads seem to lead to international expansion as an engine for growth – and in this respect, Japanese banks’ responses to the financial crisis were fascinating. One can argue that Mitsubishi UFJ’s agreement to take a stake in Morgan Stanley was the turning point of the entire global financial crisis, and it certainly represented a rebalancing of power in global banking. Similarly, Nomura had said before the crisis really took hold that it had built a warchest for acquisition in order to expand in the Asian region; its acquisition of Lehman Brothers’ assets in Asia came swiftly afterwards.

The Mitsubishi UFJ/Morgan Stanley alliance is still taking shape: it was only on November 18 that the structure of the securities joint venture in Japan was announced. “It’s a little too early to say if it was successful or not,” says Otsuki. Clearly it has great potential, but the usual puzzles about cultural integration will have to be sold for it to be a triumph. In the meantime, some analysts are playing equally close attention to the relatively forgotten Union Bank of California acquisition, thinking it could be a springboard to bring in further retail assets in North America. “They may use it as a vehicle to acquire regional banks in the future,” suggests Nozaki.

Particularly outside Japan, there is widespread doubt that Nomura can make its Lehman venture work, but most feel it is too early to make a fair appraisal. “There is scepticism that the cultures can be melded, but a sense of excitement that if it worked it would be the first truly global Japanese financial institution,” says one analyst in Tokyo. “If Nomura can show it can be done, maybe it will make some of the more aggressive banks sit up, take notice, and think: maybe we can do it too.”

There is domestic activity too. The big event of the year was probably Citi’s sale of its Nikko Cordial business to Sumitomo Mitsui, but another transaction may yet prove more significant: the merger between Chuo Mitsui Trust and Sumitomo Trust, announced in November, although the holding company will not be set up until 2011 and the two banks will not come under its wing until the following year. Analysts have been positive about this deal. “Sumitomo Trust is the best managed bank in Japan,” says Knowd. “They see higher capital requirements coming and realise you have to make a return on it; the only micro way of doing that within the control of the bank’s management is a merger that gives you cost synergies.”

“Fundamentally this is a positive move, especially given that they will be able to reduce their costs,” adds Otsuki. “If you look at a past example of mergers between trust companies, Chuo and Mitsui, their cost bases reduced by about 30%.”

So what next? “For the mega-banks we are close to the end,” says Nozaki. “But there may be more opportunity for regional banks to get together. There are 64 large regional banks.” He does see some prospect of the country’s two remaining independent brokers, Nomura and Daiwa, being attractive to the megabanks, in order to help them get closer to vital deposit bases, but it’s a moot point whether that would appeal to the independents themselves.

Overhanging the whole sector is concern about global regulation, and the likelihood that Japanese banks will have to raise vast sums in order to improve their capital adequacy ratios. The capital raisings are already happening: on November 18 Mitsubishi UFJ announced plans to raise up to $11 billion of common stock to improve its capital base. Mizuho and Sumitomo Mitsui UFJ are widely expected to do the same.

In Japan as globally, analysts mainly feel that global regulation is going to impede bank profitability. “With higher capital requirements and more stringent regulation it’s not going to be easy for the banks to achieve the same level of return on equity,” says Otsuki.

But not everyone thinks the capital raisings will be as onerous as the market seems to believe. Knowd argues the earliest one could expect to see capital regulation introduced to Japan is March 2013, which broadly fits in with the Basel timeline (which would require implementation by December 2012). Additionally, capital adequacy can be addressed not just by raising more capital but by reducing assets.

“It’s not that they won’t issue capital, but there’s a difference between being desperate to issue capital and doing so because you want to,” Knowd says. “Doing it because you want to, with consideration given to shareholders, puts a different perspective on how and when you do a deal.”

Nozaki at Citi adds: “Banks have time to think about capital raising. The share prices are very weak right now so it is not the appropriate time for them to think about it.”

This brings us to the issue of cross-shareholdings, rife in Japanese banks and corporate life generally. Analysts don’t like these cross-shareholdings at the best of times, but Knowd argues that selling them in the next few years would be particularly sensible since, by reducing assets, it would also help improve capital adequacy ratios. By his calculations, both Sumitomo Mitsui Financial Group and Chuo Mitsui Trust (in its pre-merger form) could move their core tier one ratios over 7% purely by selling cross-shareholdings; indeed, only Mizuho would need to make substantial further reductions in assets beyond selling cross-shareholdings in order to hit the 7% mark.

It’s already beginning to happen: Mizuho started selling down shares in the first half. “If Japanese banks accelerate their cross-holding sales,” says Yamada, “it should be bad in the short term for the equity market but good in the long term for Japanese banks.”

China report: Banking sector

Take a look at China’s banking sector and you could be forgiven for thinking the global financial crisis never happened.

In 2008, as US and European banks floundered in the worst financial turmoil since the Great Depression, Industrial and Commercial Bank of China – now the largest bank by market capitalization in the world – logged a 35.2% increase in net profit to RMB111.2 billion. China Construction Bank, the second biggest, climbed 33.99% to RMB92.64 billion, and Bank of China 14.42% to RMB64.36 billion.

No other bank results around the world look remotely like these. And, far from just consolidating, in 2009’s uncertain environment these banks have continued to grow at an extraordinary pace, particularly in terms of lending. Loans in the first half of 2009, at RMB7.4 trillion, have already surpassed annual new loans in any previous year, according to Bank of America Merrill Lynch. This is already way ahead of a targeted Y5 trillion for 2009 suggested by China’s leaders at the start of the year.

But is this all a bust waiting to happen? In the last financial meltdown, the Asian financial crisis of 1997-98, China’s big four state-owned banks each ended up with billions of renminbi of bad debts [non-performing loans, or NPLs] which eventually had to be taken off them and disposed of by custom-made asset management companies. In effect, they were bailed out by the state. It is widely assumed that risk management practices have improved dramatically since then and that the quality of loan books has improved with them. But if that’s wrong – and possibly even if it’s right – then this vast extension of credit could lead to considerable problems for the banks a year or two down the line.

The positive view is that a rising tide lifts all boats and that there’s therefore nothing to worry about in an economy that looks on track to post 8% GDP growth this year. “We are positive on the Chinese banking sector, as our view of banking is very much related to China’s macro position,” says Ning Ma, equities analyst at Goldman Sachs Asia. “We see strong growth for China’s GDP in the next two years, and perhaps five years down the road.” The question is whether China can successfully accelerate GDP growth without making the system overheat. “So far we haven’t seen indications of overheating,” Ma says. “We hope loan growth will slow down gradually to a more sustainable level – that will be quite positive for China’s economic growth sustainability and for the banking sector. But the PBOC [People’s Bank of China] and CBRC [China Banking Regulatory Commission] are very vigilant on the macro overheating risks.”

Most analysts believe it is a question of when, rather than if, China starts reining policy in to cool things down. Dong Tao, research analyst at Credit Suisse, feels it’s already happening to an extent, with the PBOC issuing punitive notes to some aggressive smaller banks, but feels it will be a while before tightening starts in earnest. “The recovery of the Chinese economy is highly uneven, with the export sector still struggling and the job market deteriorating,” he says. “Until exports show a clear sign of recovery and the unemployment rate stabilizes, we do not think Beijing will tighten aggressively and think it would avoid high profile measures such as interest rate hikes due to concern over shocking public confidence.” Tao expects what he calls “a soft lid” on overall lending in the second half of the year, with “a more assertive PBOC” emerging at the end of this year or early next – a consensus view among China economists.

The timing of this assertion has a big impact on the knock-on effects for the banks. “Until recently there were no signs of a credit bubble which would normally imply an increase in NPLs,” says Paul Cavey at Macquarie Bank. But “the system today is that loan growth is at 30% while economic growth is more like 6%. That makes it more likely there will be a credit bubble in future.” To Cavey, it’s all a question of timing. “If it only goes on for one year it’s not so bad. If it’s two or three years, there’s no reason we wouldn’t see the rise in NPLs every economy sees after a credit splurge.”

That said, it’s important to take a close look at where the lending is going. While 30% growth in loans is alarming, it is partly explained by the RMB4 trillion stimulus package announced by the central government late last year, much of which has gone into infrastructure development, which is correspondingly where a lot of bank finance is ending up.

“The banking sector is playing a big role in terms of financing state infrastructure investments,” says Frank Gong, chief China economist at JP Morgan (and promoted to Vice Chairman of China Investment Banking since the interview). “It’s good credit lending because infrastructure borrowings for these projects are guaranteed by the State. It’s more exposure to sovereign risk than company risk.” Additionally, China tends to privatize its infrastructure quite quickly through local or Hong Kong listings, which creates a quick source of capital to repay creditors.

That said, not everything is going to infrastructure: Ma at Goldman estimates around 30% of new loans, with around 6% to real estate developers, about the same to mortgage consumer lending, and the bulk instead to corporate and agricultural lending. “Pretty much everyone is receiving lending,” he says. Tao at Credit Suisse argues that the bulk of new lending is being channeled towards real estate, with June data showing a 61% increase in household loans compared to May, to RMB303.6 billion in June alone. “Lending to public infrastructure projects should have moderated, as most of them received funding early,” he says.

Nevertheless, mortgage lending is historically quite safe in China, says Yifan Hu, chief economist at Citic Securities. “It’s a very safe asset in China,” she says. “People save more [than elsewhere in the world] and normally put 30 to 40% as a down payment, so generally they are high quality loans. I don’t have too much worry about these.” Instead, she thinks local government infrastructure borrowing may be the bigger potential problem for the future, although she believes the sector should be able to handle any increase in NPLs.

Either way, there’s no problem so far – the latest data from the CBRC shows that non-performing loans in China dropped in the first half of 2009, both in terms of volume (RMB518.1 billion at the end of the second quarter, down from RMB 549.5 billion three months earlier) and ratio (1.77%, down from 2.04%). Coverage, too, has improved, from 123.9% to 134.3%.

China’s regulators, however, are preparing for more difficult conditions. In July, Liu Mingkang, the CBRC chairman, warned in July about rising loan risks and urged banks to strengthen their risk controls. The CBRC has asked banks to lift their provision coverage ratio over 150% in 2009, and has sent out circulars requiring that borrowers clearly state the purpose of their loan applications, in order to ensure that the money is ending up in fixed asset investment rather than the stock markets.

Naturally, the future of Chinese banks is not just about lending. All the major banks have sought to develop strength in wealth management, leveraging off the increasing wealth of Chinese consumers and the limited channels for them to invest and diversify their assets. “There is very strong fee income in this area,” says Ma. “But fee income is still a low base: it’s less than 15% of revenues for most Chinese banks. The near term earnings drivers are actually the net interest margin, balance sheet growth and asset quality.” The first of those, the net interest margin, is widely felt to have bottomed in the first or second quarter of this year, which is one reason many analysts are now seeing upside to Chinese bank share prices.

There is so much working in favor of Chinese banks – economic growth, state stimulus, a vast and largely untapped population, growth wealth and sophistication – that the only thing investors are really likely to worry about is whether risk management standards have improved sufficiently to fend off the dangers of over-extended credit. “I think they have,” says Samantha Ho, investment director at Invesco with responsibility for several Greater China portfolios. “Of course the concerns are understandable when there is such loan growth, about what happens if there is a slowdown. But I don’t think it would be too serious. We are watching closely.”

BOX: BROKERS

In China, securities houses are separated from banks and insurers by law. For the most part, brokerage and investment banking has been left to local houses like CICC, Citic Securities, Guotai Jenan Securities and Galaxy Securities, although a handful of international names have been able to get a foothold.

The growth of this industry reflects the sophistication of China’s markets and the institutions that invest in them. “Overall, the quality of research on A-share companies has increased expontentially over the last few years,” says Chris Keogh, senior advisor to the chairman at Gao Hua Securities in Beijing, a group that is partnered with Goldman Sachs. “There is much more rigorous and sophisticated modeling.” He has also seen a move by local brokers to build out coverage of mid cap and small cap companies. “As domestic mutual funds become more sophisticated in their investment strategies, there’s going to be larger and larger demand for high quality research in the mid to small cap space.”

Alongside this, the institutional marketplace itself is growing in sophistication too: institutions are receiving higher quality research and sales, getting greater corporate access, and listed companies themselves have improved their disclosure of information to the marketplace. “With the markets becoming more sophisticated, institutional clients definitely show increased demand,” says Yifan Hu, chief economist at Citic Securities. Citic’s brokerage not only covers almost 400 A-shares, it also has a global economic research team, partly because Chinese clients increasingly want an understanding of global influences on the domestic market. “They [domestic clients] have a much higher demand for macro research than overseas clients in my experience,” she says. “I used to work for Merrill Lynch, and there when we talked about China macro economy we might see the client twice a year. In China they’re very curious and I will see them four times a year.”

Where next? “Where I think the market has to evolve to – and I see our biggest institutional clients looking for help here – is in further development around execution services,” says Keogh. For example, it is difficult for institutions to complete large block orders. Keogh thinks the market is reading for algorithmic and program trading, systems that exists in bigger western markets to facilitate larger and more complex orders. This which would also help fund managers execute passive strategies and would help to address the long-standing overhang of state-owned shares that have become tradable during a program of share reform over the last four years, but have yet to reach the market.

For securities houses, the bulk of the institutional equities customer base is made up of domestic mutual funds, local corporate clients, international QFII [Qualified Foreign Institutional Investor – international groups given a quota to invest in China’s restricted A-share markets] clients and increasingly pension funds. On the debt side, it’s commercial banks, credit unions and funds. Securities houses are also trying to launch private wealth management businesses, as are the mainstream banks. “The holy grail for domestic brokers is understanding how to help out with the excess renminbi liquidity that now exists in mainland China,” says Keogh. Goldman/Gao Hua is trying to address that with private wealth management and asset management businesses.

The access of foreigners to the market has been gradual. The brokerage CLSA has had a longstanding joint venture in China, called China Euro Securities, but the two most closely watched have been those involving Goldman Sachs and UBS. The Goldman Sachs structure includes two ventures: one, Goldman Sachs Gao Hua, in which the US house owns a 33% stake, contains investment banking businesses such as underwriting and advisory; another, Gao Hua Securities, holds the research and brokerage side of the business. UBS took over a securities company created from a struggling local brokerage, Beijing Securities, in 2006; it holds a 20% stake in the business but effectively controls its management.

These businesses stand out because in addition to underwriting, they have been permitted to get into research, trading and private wealth management. They were seen very much as test cases, and have recently been followed by two new ventures, involving Credit Suisse and Deutsche Bank. These, however, are so far more limited, and for the moment are only permitted to handle M&A advisory and underwriting of debt and equity issues in the domestic market – not secondary market trading or research.

League tables haven’t looked like this since the 1980s. Rankings for global loan arrangers in the first quarter of 2009, compiled by Dealogic, show three Japanese banks in the top five worldwide – with Mizuho at the top. The trinity of Mizuho, Sumitomo Mitsui Banking Corp and Mitsubishi UFJ Financial Group between them led almost exactly half of the 1,453 loans Dealogic tracked worldwide in that three-month period.

This is partly because of an absence of activity at American and European banks rather than an increase at the Japanese. But it’s still very notable that volumes for the Japanese banks have held up so well. In fact, in some cases they’ve done better than hold up: during the October to December quarter, in arguably the worst climate for global finance in history, Japanese deal volumes went up more than 50% compared to the same quarter in 2007. In the first quarter of 2009, they were down year-on-year for the industry as a whole, but at two of the three megabanks – which account for 90% of the market in Japan – their volumes actually went up.

It’s tempting to think that this shows Japanese banks stepping into the void internationally left by western lenders, but the truth is this is predominantly a story about Japanese borrowing. According to data from ThomsonReuters, 93% of Sumitomo Mitsui Financial Group’s loan proceeds in the second half of the 2008 financial year were in Japan, and 99% of Mizuho’s.

Partly, the strength of domestic activity is a consequence of the closing of Japan’s bond markets to lower rated credits. “Single A companies have seen their bond issuance reduced,” says Mayuko Suzuki in the syndication department of Sumitomo Mitsui. “Therefore they want to arrange more syndicated loans.”
At the same time, the domestic Japanese institutions who typically participate in syndicated loans were not badly hit by sub-prime and their lending appetite did not drop anything like as drastically as elsewhere. “Japanese regional banks, who are the main buyers for the loans, were not significantly damaged and are relatively strong in their capacity to lend,” explains Sadahiro Sato, general manager of the syndicated finance division at Bank of Tokyo-Mitsubishi UFJ, part of Mitsubishi UFJ Financial Group. “Also, Japanese individuals have shifted from investment trusts and stocks to deposits. That means regional banks’ total deposits have increased and they have been looking for a way to invest that.”

They’re still happy enough to take part in lower rated credits. “Of course there are many terms and conditions,” says Takashi Tadokoro, senior vice president in Sumitomo Mitsui’s syndication department. “But we do not have any difficulty in placing or selling loans to investors.”