Japanese Regional Banks On Course To Zero by Shannon McConaghy – Horseman Capital Management
The Bank of Japan (BOJ) “comprehensive assessment” and move to “yield curve control” has further fixed the Japanese regional banks on a course to zero; with the BOJ explicitly committing, over the “long-run”, to negative interest rates in the maturities most crucial for bank survival. Around 87% of regional bank assets have maturities between the overnight “short-term policy rate” and 10 year “target long term rate”. Over coming quarters more and more regional bank loans and J GB holdings will re-set onto interest rates that fail to cover the cost of bank operations. I feel there is a dramatic underappreciation of the sustained dive coming for regional bank earnings as yields remain around current levels.
This note looks at the ways in which the new BOJ policy could drive regional bank earnings negative. As such, the base-case assumption throughout is that the BOJ maintains current targeted interest rates. In reality, it is probable that at some stage the BOJ will push rates further negative. BOJ Governor Kuroda recently stated that the BOJ will “respond to developments in economic activity and prices as well as financial conditions” and “with regard to possible options for additional easing, the main policy tool will be fixrther cuts in the negative short-term policy interest rate and lowering the target level of the long-term interest rate”. Kuroda’s reaction function for further negative rates appears to be declining inflation numbers and implicitly Yen strength, which leads to falling inflation. In my opinion we can expect 1) Declining inflation; as point-of-sales price data, which provides a reliable leading indicator, shows “The falling trend in price is extending to more categories of products, and the negative growth is looming into view” (N owCast), and 2) Yen strength; the Yen still has 14% to strengthen to its long term real effective exchange rate, Japan’s current account surplus remains near record levels and one of J apan’s largest trading partners, China, remains on a devaluation path.
In visualising the scale of the effects to come from existing policy on regional banks I felt the following graph was most helpful. In addition to assuming that yields remain fixed for the foreseeable future the following simple assumptions are made and discussed over the following pages;
- Loan Portfolio Income: a 22bp decline in average outstanding loan rates as old loans continue to roll off onto the current new loan rate.
- Interest & Dividends on Securities: “gains from cancellation of investment trusts” are depleted and J GB holdings roll onto negative rates.
- Ordinag Expenses: Rise as provision rates rise to levels seen in other major developed economies and credit costs return to 4obp.
I believe these are all rather generous assumptions and indeed I expect the situation will likely be worse than these forecasts next year on all counts. Furthermore, these negative earnings impacts are not “one-off ‘ but will rather continue to deteriorate beyond next year. It is also important to remember this is aggregated data and some bank earnings will experience a more rapid decline than the aggregate.
Japanese Regional Banks
Assumption 1: Loan Portfolio Income: a 22bp decline in average loan rates as old loans continue to roll off onto the current new loan rate.
In the chart below, the golden line reflects the average rate that Japanese regional banks secured for new loans in that monthl. The new loan rate has most closely tracked the decline in 3 year J GB yields (brown line). Which is not surprising given regional bank loans have a median of ~3 years to maturity. This year, as Negative Interest Rate Policy (N IRP) removed the zero bound on J GBs, the new loan rate fell by 22bp. The new loan rate remains 1.23% above the 3 year J GB yield, which also happens to be the average spread since 2010. What is highly unfortunate for the banks is that their own borrowing costs have in large not fallen below the zero bound, with ~90% of their funding coming via deposits (green line). That ~85% of regional bank loans have a maturity of less than 10 years, where the BOJ has now pegged the corresponding J GB rates below deposit rates, is a clear reason why the new policy is not favourable for banks. As long as short dated J GBs and the new loan rate remain where they are, the average loan rate for the banks outstanding loan portfolios (black line) will fall to meet the new loan rate. This usually takes around two years. The implied 22bp decline in the average loan rate, with flat deposit rates, would see a ~30% fall in ordinary profit next financial year March 2018.
Loan income is also likely to continue to deteriorate beyond next year. The Japanese Financial Services Authority (J FSA) forecasts 60% of regional bank loan books will be loss making by 20252. Importantly the JFSA’s forecasts are based on shrinking loan books due to demographics, effects that are in addition to the roll-down effects from N IRP I have demonstrated above. I have previously written on J apan’s Wage markets, but do not factor these into my base case for next year as these effects are difficult to exactly quantify over the short-term.
Whilst on the subject of mortgages, I feel there has been unwarranted excitement in bank stocks around the steepening of super-long end rates. Firstly, I believe the BOJ is unlikely to allow super-long rates to rise much further for fear of insurance companies repatriating overseas assets and rapidly strengthening the Yen. Secondly, I believe the BOJ’s concerns around the impact of near zero 30 and 40 year rates on the life insurance industry have abated, with Dai-Ichi Life disclosing a return to above 100% economic solvency ratio. It seems the J GB market agrees, super-long yields have fallen over the last week. Thirdly, it is also important to note that the super-long rate segment for banks is dominated by the Japan Housing Finance Agency’s (J HFA) “Flat 35 S”. This is in effect a government mechanism for targeting long dated mortgage rates, the Abe Cabinet has even previously included a reduced rate (via an increased discount factor) as a government growth policy. The J HFA’s KIKO 113 priced on 16th Sept at a record low weighted average coupon of 0.7% for an average maturity of 30.5 years. That is a 32bps fall from the KIKO 105 issued at the start of the year in other words, the decline in long date mortgage rates continues to exceed the 22bps decline in average new loan rates.
Assumption 2: Interest 8: Dividends on Securities: “gains from cancellation of investment trusts” depleted and J GB holdings roll to negative
As previously written, some Japanese banks have been overstating core recurring earnings, by reflecting one-off equity gains on investment trust holdings within Interest and Dividends on Securities. The B_OJ acknowledges “a large amount of profits from investment trusts due to cancellations (realization of unrealized gains) recorded as an increase in net interest income at some banks”. I believe investment trust