How Japanese banks have coped

Since the late 1990s, Japanese banks have been operating in an ultra-low interest rate environment in which spreads between funding and lending rates have been compressed. As a result, banks’ net interest income has fallen over the past 15 years and banks have felt increasing pressure to reduce costs and find new sources of revenues other than domestic lending.

To make up for the contraction of their core business, banks expanded into Japanese government bonds (JGBs). The large-scale purchase of domestic government bonds allowed banks to continue de-risking, while keeping the size of the balance sheet constant or even expanding it. It has also helped banks to absorb the deposit inflow, while avoiding ventures into more risky assets.

Banks have adapted both the cost and income drivers of their business, as they were suffering from low interest margins and suppressed credit demand over a prolonged period of time. Profitability and efficiency gains have been limited though and masked by the efforts to digest bad loans since the bursting of the credit and asset price bubble in 1990.

— The larger city banks expanded overseas or into other business areas, such as trust business or securities services.

— Smaller and regional banks had far fewer options, expanding mainly into metropolitan areas, thereby increasing competitive pressures and squeezing margins even further.

— All banking groups have felt mounting pressure to absorb bad loans and increase efficiency. As a result, the Japanese banking sector has been going through an industry-wide phase of consolidation.

While Japanese banks have reduced their bad loan problem, they have also become increasingly exposed to their home sovereign — and the associated credit and interest rate risk. Risks from easy lending and a renewed credit and asset price boom are not yet acute, however. Moreover, Japanese banks’ equity holdings are likely to offset any negative impact monetary policy might have on their JGB exposure.

How much of the above statements would you agree with in the current environment? Would you be surprised to learn that this passage comes from a Deutsche Bank research report, authored by Christian Weistroffer, published on June 10, 2013? One might argue that the bad loan problem has been thoroughly worked through, but how many “zombie companies” are being kept alive by the zero interest rate policy?

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