Japanese Regional Banks Non Performing Loan Time Bomb – Horseman Capital

Whilst I have recently highlighted many serious issues at Japanese regional banks. It is the vast amount of hidden non-performing loans (NPLs) that worry me most. The ignition point for this time bomb will likely come with the mass retirement of bankrupt “baby boomer” Small to Medium size Enterprise (SMB) owners that have just started turning 70.

Japan’s long history of underreporting NPLs reached a new level in 2009, when the then Financial Services Minister stated:

“We’re going to get financial institutions to provide firms with more loans”. “Banks won’t have to treat debt on which they provide a moratorium as bad… I ’m not going to leave small companies in the lurch unable to get loans. If a bank takes that approach, I’ll hit them with a business improvement order. ”

Soon after, the Small to Medium Size Enterprise Financing Facilitation Act (SMBFFA) was passed. Which KPMG suggests “provided many borrowers (including SMEs with financial difficulties) with almost automatic extensions or loan rescheduling opportunities”. At the same time the Japanese Financial Services Authority (J FSA) changed its financial supervision measures, to ensure that banks when dealing with SME requests to modify loan conditions: “contribute to reducing the burden relating to its repayment of debt” (i.e. reduce the SME’s monthly payments) and “grant credit appropriately to SME managers who have had changes” (i.e. give more money to SMB’s that can’t meet their monthly payments). As long as it can be “expected that an SME will formulate a business improvement plan” the loan “would not fall under the category of a restructured loans”. (i.e. if the SME says it will come up with a business plan the bank should not record the loan as non-performing).

The following National Institute for Research Advancement (N IRA) article provides a more readable outline of the policy from page 3. The author of the NIRA report felt “it is probably safe to assume that almost all of the loans for which terms have been changed would have been classified as non-performing under the previously enforced standards”. The NIRA note refers to J FSA data which at the time, October 2011, showed that loans modified under the SMEFFA amounted to ¥38.9bn, of which ¥25.3bn was loans from Japanese regional banks. This J FSA data was sporadically updated until March 2014, at which time loan modification approvals under SMEFFA had risen to ¥142.8tn, of which Japanese regional banks accounted for ¥67.3tn.

Japanese Regional Banks

It is important to clarify that this data does not reflect the outstanding loan amounts, as the data double counts loans when additional modifications are made and/ or when loans with modifications in place are rolled-over. We can however get a rough idea of the outstanding loan amount, by estimating the amount of completely new approvals given in each year and adding those amounts up. The Research Institute of Economy, Trade 8: Industry completed a survey in October 2014 of SMEs that had “modified loan conditions” under the SMBPPA. One of the survey questions asked in which year the SME received its first loan modification under the SMEFFA. As we can see below just under half (48.4%) of these SMEs received their first loan modification in 2009-2010, soon after the policies began. More companies applied for their first loan modification in 2011, 2012, 2013 and 2014.

Japanese Regional Banks

By using the data in Chart 2 and the data in Chart 1, we can estimate that in October 2014 the total of loans outstanding with modified conditions under the SMEFFA amounted to ¥93.9tn, of which ¥50.3 was provided by Japanese regional banks. This is 2.73x the total net assets at Japanese regional banks (¥ 18.4tn) on their combined balance sheets in that year (Source: Japan Bankers Association). And is 8.5x larger than the non-performing loans officially stated by Japanese regional banks in that year (¥5.9tn) (Source: J FSA).

“Although the SME Financing SmoothingAct expired at the end of March 2013, the JFSA has not reversed the rule that allows banks to classify the restructured loans to SMEs as normal”. “Even after the expiration of the Act on Temporary Measures to Facilitate Financing for Small and Medium-Sized Enterprises, more than 90% of applications for changes in loan terms are accepted by financial institutions”. Whilst the J FSA seems to have stopped reporting the total value of loans modified it does still report the number of loans modified. The number of loans has continued to grow, again this includes further modifications and roll overs of previously modified loans. It is also important to note that applicants can and do apply for modifications to loans at multiple banks.

Japanese Regional Banks

The previously mentioned RIBTI survey makes for interesting reading. Of those SMEs that received modified loan conditions:

*52.8% said they would have gone out of business without the loan modifications.
*54.7% had their monthly repayments deferred and 37.9% received grace on principal repayments.
*Only 43% said that the business plan they submitted provided a clear image of the future for their company.
*And 24.4% did not even bother to submit the required business plan.
*23.6% say their business conditions haven’t changed since then, whilst 17.3% say their conditions have deteriorated further.
*Of those that modified conditions more than once 58.3% always expected to change repayment terms again from the beginning.

The outlook remains poor for SMEs in Japan with the Teikoku Credit Databank Survey in June 2015 suggesting “47.5% of companies anticipate their “core business” market to shrink in the future, while 19. 7% expected an expansion “. Whilst a weaker Yen has lifted larger corporate export earnings, it has hurt SMEs who largely import for domestic demand “46.2% firms in Japan stated that the yen’s depreciation had done more harm rather than good to them, while only 8.2% considered the yen’s depreciation an advantage”.

Banks meanwhile have been forced to continue to lend to troubled SMEs: “If we only keep looking for healthy companies for lending money, there won’t be much left for us,” (Hideki Yoshida, a chief loan officer at Hachijuni Bank). “We won ‘t flatly say no just because a company has a poor credit rating or bad earning figures” (Shigeharu Sanada of Bank of Tokyo Mitsubishi UFJ)

It is relatively easy to identify the industries where SMEs are in deep trouble. The following data comes from the March 2014 aggregated SME results database. Japan’s real GDP and its SME business confidence have both declined since then (Source: Ministry of Finance and Shoko Chukin). I have filtered the data down to the smallest SMEs, those with less than 5 employees, for industries I feel face the most oversupply versus dwindling demand. In my travels around regional Japan I saw many restaurants, service providers and retail stores operating with a few staff and no customers.

Japanese Regional Banks

The key question from a market timing perspective is how long can SMEs go on making losses with negative equity. It seems that demographics will soon bring this to

1, 2  - View Full Page