Twenty Years Later – The Japanese banks

December 7, 2010.

The Japanese banks are finally emerging from a two decade long restructuring.
This at a time when most global banks are flat on their backs.
One would think this is a huge business opportunity.
Are the Japanese banks about to dominate global finance again?

In the late 1980’s, 5 out of the top 10 largest banks in the world were Japanese.
They were benefitting from a strong economy, cheap cost of capital and capital ratios inflated by overvalued stock portfolios.
Being Japanese, these banks became global behemoths by dramatically undercutting profit margins.

It all came to an abrupt end.
The Japanese asset bubble burst.
Bankers, at first, ignored the problem.
They believed the economy would bounce back.
With the bounce, nonperforming loans were expected to quickly become performing again.
That did not work out.

The government finally urged the banking sector to get its act together.
With the help of consolidation, banks started to write off bad loans in the late 1990’s.
This being Japan, the process was gradual and slow.
It took another decade or so.

Today, we may have reached the end of this process.
NPLs are down to sustainable levels, balance sheets are stronger, profits are rebounding.
Consolidation has led to a smaller number of too-big-to-fail banks.
All of those now even bigger and less likely to be let go.
Furthermore, all banks have been shedding their cross shareholdings.
The number of corporations with cross-held shares with banks is down to 43% from 88% in 1995.

With profits up more than 150% year-over-year, investors are paying attention.
However there is a problem.
Japanese banks’ role in the economy has shifted dramatically.
Their main purpose is now the financing of the huge public debt.
They are now essentially a branch of the Treasury.

A quick look at the largest among them illustrates this new emphasis.
Mitsubishi UFJ’s governement debt portfolio is growing by leaps and bounds.
It is now bigger than its corporate loan portfolio, which, in turn, is shrinking.
Indeed, a new twist on the crowding out effect.

Interest rates are not – at least not yet – pushed higher by the never ending supply of JGBs.
Instead, rates are kept low by the banks’ redirection of funds from the private sector to the public sector.
But, if the laws of gravity apply to Japan, the unlimited supply of public debt will eventually have an effect on rates.
Foreign demand for JGBs is nonexistant.
Savings have nosedived to a paltry 2%.
One wonders just how long the banks will be able to fill in the gap.

Here is the predicament.
Japanese banks’ spread is razor thin, somewhere around 1.3%.
With deposit rates at 0.02%, not much can be done on the cost side.
So, for these spreads to increase to more sustainable levels, lending rates have to go up.
Higher interest rates, however, will destroy the value of the banks ballooning portfolios of JGBs.
This in turn will destroy capital ratios so painstakingly rebuilt over two decades.

In some parts of the world, sovereign debt is already a dirty word.
Just ask the German and French banks.
But the posterchild for fiscal madness is not Greece.
It is Japan.
Value investors should not be lured by the low price to book levels at which Japanese banks are trading.
Value destruction has become bankers’ specialty all over the world.

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