Japan's banking system relatively stable, says Moody's

It warns of rising number of higher risk assets though.

Moody's Japan K.K. says that the outlook for Japan's banking system over the next 12-18 months is stable.

The outlook reflects Moody's expectation that the banks' operating environment, asset risk and liquidity will remain stable, outweighing pressure on domestic profitability from the Bank of Japan's negative interest rate policy (NIRP).

But, Moody's notes that the NIRP has pushed yields on most low risk assets — including Japanese government bonds of most tenors — to near-zero or negative. This situation will encourage the banks to realize capital gains on bond holdings, and invest in higher risk domestic and — particularly for the three megabanks — overseas loan assets.

Moody's also says that the banks will see higher risk-weighted asset (RWA) growth becoming a key source of capital consumption in the coming years, although most banks can offset this pressure by selling equity holdings, which would lower RWA and reduce capital volatility.

The stable outlook is based on Moody's assessment of five drivers: Operating Environment (stable); Asset Risk and Capital (stable); Profitability and Efficiency (deteriorating); Funding and Liquidity (stable); and Government Support (stable).

On the operating environment, Moody's baseline scenario assumes that Japan's real GDP growth will quicken to 0.7% and 0.9% in 2016 and 2017, up from 0.5% in 2015, driven by fiscal stimulus and expectations of continued loose monetary policy.

Moody's says domestic loan growth should register around 3% on an annualized basis in the coming 12-18 months compared with 2%-3% since 2013, reflecting a stronger economic outlook, as well as the impact from the NIRP in lowering borrowing costs and in adding to the banks' incentives to grow their loan books.

With asset risk and capital, Moody's says that asset performance will be strong, supported by low borrowing costs and a generally strong corporate sector balance sheets. A notable exception would be the megabanks' exposures to the troubled oil & gas sector. Nonetheless, any loss will be limited by their focus on investment-grade borrowers.

As for profitability, Moody's report explains that the banks' profitability will deteriorate over the next 12-18 months, because the NIRP will pressure the banks' domestic loan profitability, owing to its impact in lowering net interest income.

Nevertheless, the final impact on the system's overall profitability under the current policy setting is limited, because: (1) margin declines are not uniform across all domestic loans; and (2) the largest banks show relatively low dependence on domestic lending for revenues.

On funding and liquidity, Moody's says the banks' domestic liquidity remains strong, a result of their stable customer deposit base, and very low dependence on confidence-sensitive market funding. While the megabanks have become more constrained in their ability to fund their overseas loans with stable, low-cost funding instruments, this pressure will remain manageable.

Moody's expects that the three megabanks will gear down their overseas loan growth over the next 12-18 months, as they take into account the generally subdued outlook in their key lending segments, and a potential rise in US interest rates. Moody's also expects that the three banks will see little impact from the imminent US money market reforms, because they
have curtailed their CD/CP issuance and focused on increasing their foreign currency deposits.

The level of government support for the banks remains unchanged. The Japanese authorities have clearly signaled that they will avoid using bail-in or other resolution schemes that impose losses on deposit and debt creditors on a going-concern basis.

Moody's rates 32 banks in Japan. These banks cover approximately 80% of total system assets. The three megabank groups — Mitsubishi UFJ Financial Group, Inc. (MUFG, A1 stable), Mizuho Financial Group, Inc. (Mizuho, A1 stable), and Sumitomo Mitsui Financial Group, Inc. (SMFG, A1 stable) — controlled about half of total system assets at end-March 2016.

Moody's has maintained a stable outlook on the Japanese banking system since November 2012.