Japan bank recovery in peril as quake to prolong ultra-low rates

The massive earthquake that struck Japan could make its banks hostage to another vicious cycle of low interest rates, hitting profit margins and derailing the sector's recovery from the global financial crisis.

One immediate threat to bank earnings after the disaster comes from the plunge in stock markets. But longer term, the bigger risk is weakness in core domestic lending, as the Bank of Japan maintains its ultra-easy monetary policy for months and possibly years to come.

While the actions of the BOJ, which has lined up hundreds of billions of dollars in funds to stabilise the banking system, will help lenders get access to cheap money near term, it will dent any long-term hope they had of a pick-up in loan margins.

"Japanese banks have been waiting 20 years for interest rates to normalize to higher levels so that they can earn decent lending spreads. This earthquake may postpone any hopes of a recovery of their profits," said Kristine Li, Asia-Pacific financials credit analyst at RBS in Singapore.

Reacting to the disaster, Japan's three megabanks -- Mitsubishi UFJ Financial Group, Mizuho Financial Group and Sumitomo Mitsui Financial Group -- fell more than 10% on the stock market last week, with Mizuho, which suffered a failure of computer systems, down 14.2%, the most.

Years of economic stagnation have left Japan's interest rates near zero, keeping bank spreads low and hurting their margins. Low prevailing rates mean banks have little room for further cuts to entice new customers.

The return to profit by the big banks following the financial crisis was driven mainly by gains in their trading books as financial markets recovered.

Hopes of sustaining the pick-up in returns hinged on seeing a rise in profitability from domestic lending or else heading overseas for expansion.

And at the start of the year there were slivers of optimism that Japan's economy was starting to turn the corner, boosting expectations that lending growth might turn positive.

Now, while domestic lending may rise as companies rush for loans to finance the rebuilding effort, loose monetary policy combined with banks' sense of social obligation means it's unlikely to prove profitable for them.

"Even if demand for bank lending increases now, we think it would be difficult, and indeed undesirable, to raise loan rates and be seen to be preying on the weak," wrote JP Morgan bank analysts Katsuhito Sasajima and Akito Kono in a research note.

The moves to expand overseas may also take a backseat.

"Banks will likely prioritize domestic rehabilitation over overseas expansion, so we may see a halt or some delays to their overseas expansions," said Keita Kubota, assistant investment manager at Aberdeen Asset, which owns regional Japanese banks.

If stocks continue to drop, then financial companies will start to see their capital bases dented.

"As time goes by, downward pressure on banks' asset quality is likely to increase. The biggest threat (to banks) at this moment is a fall in stock prices," said Tetsuya Yamamoto, senior analyst at Moody's in Tokyo.

Unlike Western lenders, Japanese banks take stakes in their corporate clients to seal business ties, making banks sensitive to swings in equity prices.

Japan's banks owned a total 21.09 trillion yen (USD 261.6 billion) of shares as of end-March 2010, data from the Japanese Bankers Association shows.

The biggest by assets, Mitsubishi UFJ, owned 3.7 trillion yen worth of shares as of end-December, while No. 2 Mizuho and No. 3 Sumitomo Mitsui held 2.5 trillion worth as of end-September and 1.9 trillion as of end-March 2010, respectively.

Most analysts, however, are agreed that the Nikkei will need to fall well below the 9,000 mark -- it is currently at 9,206.75 -- for them to breach their break-even level.

"Sizeable equity losses seem unlikely," said Ismael Pili, head of Asian financials research at Macquarie Bank in Hong Kong, who says that the near-term falls in bank share prices could present a buying opportunity, favouring Mizuho.

Other analysts warn that even if the risk of capital losses from equity markets is averted, Japan's major lenders still face a tougher slog trying to boost profitability.

That could be made harder if the earthquake sends some of their major international investors running away for good, spooked by the threat of further natural disasters.

"This disaster highlights one of the risks of investing in Japan - it is an earthquake country. We had the Kobe earthquake just 16 years ago," said Li at RBS.

This then may ultimately mean that the years spent failing to grow their core domestic businesses are far from over.

"From a valuation point, Japanese banks were priced for no growth and no recovery anyway, that's even more so now," said Michael Kerley, the London based director of Pan Asian Equities as Henderson Global Investors.

(USD 1 = 80.610 Japanese Yen)