Moody's: Japanese regional banks facing pressure to take more risks to maintain asset yields

Moody's Japan K.K. says that continued negative pressure on asset yields -- as a result of the Bank of Japan's extremely accommodative monetary policy -- may encourage greater risk taking by Japan's regional banks.

Regional bank shareholders and management have long accepted low returns on equity in favor of operational and financial stability. And even though profitability has been weak, regional banks' credit profiles have generally improved on the back of strong capitalization and liquidity metrics amid very weak loan demand.

However, with continued negative pressure on asset yields, the sector may be reaching the end of a cycle.

"Japanese regional banks that wish to prevent further declines in shareholder returns under the current interest rate environment will need to accept greater risks, which could weaken their asset risk and capital profiles," says Shunsaku Sato, a Moody's Vice President and Senior Credit Officer.

"This pressure towards increased risk taking could exert downward pressure on the regional banks' ratings, though this is likely to be a long-term process," adds Sato.

Sato was speaking on Moody's just released sector-in-depth titled, "Low Returns Accepted by Shareholders Support Regional Bank Ratings."

Moody's says downward pressure on investment yields will intensify, as higher coupon Japanese government bonds (JGBs) banks purchased years ago -- when the prevailing rates were much higher -- mature and are reinvested at current low yields.

At end-March 2015, yields on five and 10-year JGBs were just 13 basis points bps) and 40 bps, respectively.

In Moody's view, banks operating in markets with relatively weak local loan demand are more vulnerable to earnings compression because they face greater challenges in growing their loan portfolios and hold a larger proportion of their earning assets in investment securities with falling average returns.

In an effort to grow loan books, regional banks have been expanding organically into adjacent markets, and into Tokyo and other large metropolitan markets, but they face stiff competition from the incumbents.

Alternatively, banks may choose to broaden their borrower base within the markets they already serve and where they face less competition, but that will increase underwriting and risk control challenges.

Conversely, top-tier regional banks that operate in relatively vibrant markets may see further positive pressure on their credit profiles if they can accumulate capital without materially increasing their risk profile.

These banks have access to more lending opportunities locally; a situation that lowers the incentive to take on more investment risk.