A surge in large M&A in Japan is piling up credit risk at the country's banks.

Conditions in Japan's banking system increase risk concentrations at lenders as takeover activity rises, in S&P Global Ratings' view. M&A activity in Japan has bucked global trends, surging to ¥18.1 trillion in 2023. This was 53% higher than the value of M&A concluded in 2022 (chart 1). M&A will likely remain active, reflecting structural change, chiefly because of government pressure to lift corporate performance. Such deals in recent years have grown in both size and the amount of debt funding involved.

However, Japanese banks' appetite to issue and hold loans endures, reflecting traditional customer relationships and a low loan-to-deposit rate. At the same time, the country's secondary market for loans and its speculative corporate bond market are limited. This exacerbates the difficulty banks face in balancing credit concentration and rising needs for large M&A.

Chart 1

More M&A drives up credit concentration risk

Financing deals has driven down creditworthiness and raised risk related to borrower concentration.   With the increasing scale of M&A, many recent transactions have pushed up debt at the companies involved. This higher debt results from large cross-border transactions in which share exchanges are not practical or from cases involving financial sponsors such as private equity companies. Such highly leveraged borrowers, including banks' existing clients, are vulnerable to deterioration in their operating environment. Single borrower concentration at large Japanese banks has long been higher than at global systemically important banks overseas, according to how we measure concentration risk under our risk-adjusted capital model. This is the flip side of Japanese banks' close relationships with their clients, in our view (chart 2).

Chart 2

Financial institutions also risk incurring simultaneous losses on large syndicated loans.   In 2022, for example, major Japanese banks forgave a total ¥450 billion (about US$3 billion) extended to Marelli Holdings as a syndicated loan for a single leveraged buyout (LBO). Although LBO loans account for only about 2% of Japan's three megabanks' total loan portfolios, the outstanding amount of LBO loans increased 26% in the nine months to December 2023, according to S&P Global Ratings' research.

Difficulty reducing exposure increases risk of credit concentration. Concentration risk is unlikely to materialize so long as borrowers have sound creditworthiness.   Yet, in the yen market it is difficult for banks to reduce exposure to lending. This is because the secondary loan market is limited for particular reasons. For example, banks and customers often resist transferring loans, because of value placed on customer relationships in Japan's main bank system. Banks also like to hold a share of customers' outstanding borrowings. Of about ¥500 trillion in loans outstanding in Japan's entire banking system, only about ¥4 trillion are transferred per year. Also, while acquisitions involving LBO target companies or financial sponsors are highly leveraged, the domestic market for speculative grade corporate bonds is small. This makes it difficult for banks to shift risk to the corporate bond market. Furthermore, credit default swaps are not traded actively enough to be effective risk hedging instruments.

Table 1

Table 2

Structural changes fuel ongoing M&A

Demand for M&A will continue, fueled by corporate need for growth investments and restructuring.   Shareholders and government are increasingly pushing listed Japanese companies to improve their capital efficiency. Under mounting pressure, some companies have gone private through management buyouts. Other drivers of M&A include energy transition needs and climate-related targets, efforts to secure supply chains, and business succession because of aging management. According to our estimates, if listed Japanese companies with a price-to-book ratio of less than 1x devote just 1% of their assets to M&A, the amount would reach ¥34 trillion.

Japan's Corporate Governance Code (CGC) is driving changes in corporate behavior.   The Financial Services Agency (FSA) and Tokyo Stock Exchange (TSE) introduced the code in 2015, a year after the FSA rolled out its Stewardship Code, as part of the government's "Japan Revitalization Strategy." The FSA and TSE have revised and strengthened the codes twice. An important objective of the CGC is to encourage management to exercise sound entrepreneurship using appropriate discipline. Both codes encourage companies and shareholders to act autonomously to increase corporate value and attain sustainable growth.

At the same time, stricter TSE rules directly pressure listed companies.   TSE listing rules require companies to explain failure to comply with the CGC. Also in March 2023, the TSE called on companies to shift mindset to achieve sustainable returns over and above capital costs, pointing out that about half of listed companies in the TSE's prime market division and about 60% of listed companies in its standard market division have ROE of less than 8% and a price-to-book ratio of 1x. The TSE also requires that listed companies make relevant disclosures on their approaches to analyzing and improving corporate value.

An accommodative environment supports financing.   With megabanks' loan-to-deposit ratios slumping below 60%, M&A financing is a lucrative opportunity. Highly leveraged loans such as those for corporate buyouts in particular can generate higher margins than ordinary loans. Other incentives inducing banks to offer M&A financing are support of client needs and fee income. Private equity funds have also become entrenched in Japan. Another characteristic of the country is that public-private funds have become involved in large corporate restructuring for policy purposes.

Balancing functioning financial markets and promoting corporate value

Government and regulators pay close attention to risks but also to nurturing conditions for corporate restructuring.   The FSA, the Bank of Japan, private equity funds, and financial institutions jointly released a report (published by the Japanese Bankers Association on March 25, 2024, as secretariat for this working group) on issues for sustainable growth of Japan's LBO market. The report discussed use of private debt funds and the secondary loan market to expand the LBO market's investor base. It also said practical aspects of promoting the LBO market will be examined and put in place. Also, in 2023 the Ministry of Economy, Trade and Industry strengthened the description of acquisition without consent contained in its "Action Guidelines for Business Acquisitions." This may increase cases of nonconsented acquisitions.

Banks must control credit concentration to avoid excessive risk.  As M&A become larger and more highly leveraged, it is unlikely that Japan will develop an active market for the transfer of risk among its diverse credit market participants, at least in the next few years. Limited need on the part of banks to transfer loans, due to business practices and perceptions of risk to individual borrowers, may also hinder development of the secondary market. This imbalance poses two risks. One is Japanese banks become exposed to potential credit concentration. The other is lack of progress in reorganization of Japanese companies to improve their value due to capacity constraints of banks. Therefore, Japanese banks need to control concentration of credit related to M&A while keeping their eye on risk and return.