Moody's: Japan banking system stable, but pressure on domestic profitability

Moody's Japan K.K. says that the outlook for Japan's banking system over the next 12-18 months is stable, reflecting Moody's expectation that the banks' operating environment, asset risk and liquidity will remain stable, outweighing pressure on domestic profitability.

Moody's notes that overseas credit risk is rising for the three mega-bank groups, while offshore risk is low for most other banks.

Regulatory pressure on the banks to accelerate sales of long-held equity holdings will reduce volatility in capital ratios and help unlock unrealized gains, at a time when pressure to improve returns on equity is also increasing.

Moody's conclusions were contained in its just-released report on Japanese banks, entitled, "Strong Liquidity, Low Domestic Asset Risk Drive Stable System Outlook".

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).

Operating Environment: Moody's expects Japan's real GDP to rise by around 0.5% in 2015 and 1.0% in 2016, even after accounting for potential slower growth in China. The Bank of Japan's (BOJ) quantitative and qualitative monetary easing since April 2013 has helped reduce the banks' large holdings of Japanese government bonds (JGBs), in turn lowering their interest-rate risk.

Asset Risk and Capital: The mega-banks' expansion outside of Japan will increase their credit costs overseas to levels more in line with local averages. Domestically, Japanese banks' problem loan levels are low and will remain largely unchanged over the outlook horizon. Moody's expects capital ratios to remain roughly stable in 2015-16, with modestly positive loan growth meaning that more risk assets are replacing JGBs that have zero risk weights.

Profitability: Over the next 12-18 months, Japanese banks' profitability will decline because lower net interest income will offset incremental increases in fee income, while there is little room to cut costs further. Net interest income will drop, even as loan growth rises to around 2%-3% (compared with shrinking loan balances as recently as 2011), because market interest rates have compressed across the yen yield curve.

Funding and Liquidity: Japanese banks have one of the lowest ratios of market funding globally, with very little reliance on confidence-sensitive sources of funding. Yen liquidity will remain a credit strength over the outlook horizon for Japanese banks. The mega-banks, however, rely on large corporate deposits to fund overseas loans and will face new challenges in foreign-currency liquidity if non-yen loan growth starts to outpace deposits.

Government Support: Moody's does not anticipate material changes to its support assumptions for the Japanese banking system over the coming 12-18 months and expects the authorities to continue to demonstrate a strong willingness and sufficient ability to provide support to any troubled bank. However, Moody's also notes that regulations are changing, especially for global systemically important banks (G-SIBs), a category that includes the three mega-banks. G-SIBs will be required to hold substantial loss-absorbing capital, including bail-in debt.

Moody's rates 33 banks in Japan -- 31 commercial banks and two government-related banks -- with our rated universe covering approximately 80% of total system assets. The three mega-bank groups controlled about half of total system assets at end-March 2015. Weighted by assets, the banks' average baseline credit assessment (BCA) is baa1, and their average deposit rating is A1.