Despite better recent performance, Japan's securities groups still have a lot of work to do.

They remain vulnerable to changes in external environment due to geopolitical risks and uncertainty about the direction of central banks' monetary policies in fiscal 2024 (ending March 31, 2025), in S&P Global Ratings' view. Key credit factors for major securities groups we rate include strengthening asset-based revenues in retail business and implementing measures to stabilize revenue generation in wholesale business, such as by achieving higher profitability relative to risks. We also think enhancing and maintaining risk management capabilities will be key to adequately handling sudden increases in market volatility.

The five major securities groups we rate are SMBC Nikko Securities Inc., Daiwa Securities Group Inc., Nomura Holdings Inc., Mizuho Securities Co. Ltd., and Mitsubishi UFJ Securities Holdings Co. Ltd. They performed well in fiscal 2023. Their combined net revenue (revenue net of financial expenses) and net income increased 20.6% and 133.7%, respectively. We attribute the strong performance to the following. First, stock markets remained on a run. Second, the major securities groups successfully monetized volatility in market variables, such as interest rates, in Japan and elsewhere. And third, investment banking businesses, including underwriting and mergers and acquisitions (M&A), grew amid booming stock markets and low domestic interest rates.

Strong Stock Markets Boost Operating Performance

The five major securities groups' aggregate net revenue and net income grew 20.6% and 133.7% in fiscal 2023. We attribute this to the following factors. First, stock trading and sales of financial products increased due to robust domestic stock market conditions throughout the year. This significantly improved retail revenue, including fee income related to stock trading and investment trusts. Second, major securities groups were able to take advantage of volatility in interest rates and foreign exchange rates globally as earnings opportunities. And third, demand for investment banking, including underwriting and M&A, also remained strong thanks to robust stock market conditions and low domestic interest rates (see table 1 and chart 1).

Chart 1a

Chart 1b

Retail Business: Transforming Earnings Structure Only Half Done

We anticipate the five major securities groups will continue measures to stabilize their retail business earnings in fiscal 2024. Their retail earnings structures, including volatile flow-based revenue, remain highly sensitive to market conditions. Therefore, to stabilize their earnings bases, they are working to increase asset-based revenue under a policy focused on assets under management that generate recurring revenue. Specifically, they are redesigning their compensation and organizational systems and are allocating more internal resources to more profitable customer categories, such as the face-to-face sales channel for affluent customers.

To increase asset-based revenue from these clients, major securities groups need to develop strong wealth management and financial planning capabilities backed by solid investment and taxation expertise meriting the fees they charge. They also need to differentiate services by offering a wide range of products. However, they will likely take time to stabilize overall retail earnings. This is because asset-based revenue fluctuates with changes in stock prices of outstanding client assets (see chart 2). Also, while it varies for each securities group, asset-based revenue generally does not represent a significant proportion of total retail revenue.

Chart 2

Meanwhile, ordinary customers have fewer assets and are less profitable than affluent clients. Thus, we believe the major securities groups seek to retain a certain number of such customers through low-cost, non-face-to-face approaches, including online consultation and mobile phone applications. Major securities groups are under pressure to lower brokerage fees for domestic stock trading as online securities companies waive certain fees. In addition, investment trusts using passive investing strategies are under heavy structural pressure to reduce fees. To accelerate the shift from savings to investment, the Japanese government introduced an updated version of the Nippon Individual Savings Account (new NISA), a tax-exempt program for small investments, in January 2024. Public interest in investment has been increasing, partly due to a favorable market environment. However, given continued pressure on fees, we will be watching each securities group's positioning of its general customers according to its strategy to increase client assets.

Wholesale Business: Management And Monetization Of Market Volatility Is Key

In wholesale business, we believe trading skills and risk management capabilities in markets business will continue to be key for the five major securities groups in fiscal 2024. In investment banking, it is important that the groups monetize opportunities, including Japanese corporations' restructuring needs to achieve higher capital efficiency and a 1x price-to-book value ratio (PBR). While geopolitical risks remain high and inflation rates are difficult to predict, uncertainty about the direction of monetary policies of major central banks in Japan, Europe, and the U.S. is heightening volatility in market variables. A certain level of sustained volatility is a positive factor because it increases customer flow and earnings opportunities in markets business. On the other hand, higher-than-expected volatility can expose major securities groups to an environment that makes it difficult to manage their trading positions. This can put their trading skills and risk management capabilities to the test. Some securities firms have articulated their intention to reduce capital allocation to markets businesses with low profitability relative to risks. The major securities groups would need to optimize their capital allocation in a dynamic manner, balancing opportunity losses and improvement in profitability relative to risks.

Furthermore, major securities groups' wholesale revenue depends on their U.S. business performances. U.S. government and mortgage agency bonds are an important source of income in their fixed income, currencies, and commodities (FICC) businesses in North America, given the relatively large market size and revenue of their bond businesses. However, wholesale business is a high-cost business, with high labor costs relative to its contribution to earnings. It also faces increasing cost pressure due to higher wages because of inflation in recent years and continued depreciation of the yen. To stabilize profitability of wholesale business, we believe it is important to continue to control and reduce fixed costs, establish and maintain business bases and franchises that generate profits commensurate with costs, and narrow down priority areas.

Chart 3a

Chart 3b

Chart 3c

Chart 3d

Chart 3e

We see certain business opportunities in M&A and advisory in Japan (chart 4). This is because of Japanese companies' restructuring needs, including corporate divestitures and sales of subsidiaries, to improve capital efficiency and achieve PBRs of 1x will likely remain high. Capturing and monetizing such business opportunities will remain an important source of revenue, in our view. Also, Japanese companies have a strong need to enter overseas markets, not only for growth but also because of concern about erosion of domestic markets due to market maturity, an aging population, and declining birthrates. However, we think it is difficult for Japanese firms to conduct outbound cross-border M&A deals. This is because overseas companies have relatively high values due to high overseas stock prices and a weaker yen. It would also be important to strengthen franchises and expertise to win transactions and generate revenue in the U.S. and Europe. In underwriting business, the environment for issuing bonds in offshore markets such as the U.S. is likely to remain challenging. This is partly due to growing market expectations that the European Central Bank and particularly the U.S. Federal Reserve (FRB) will be much slower to cut interest rates. In Japan, meanwhile, some market participants believe the Bank of Japan will raise interest rates more quickly than initially expected, out of concern about a weaker yen and rising import prices. However, conditions for bond issuance in the domestic market are likely to remain more favorable than in overseas markets, with demand for refinancing strong. The outlook for equity underwriting remains uncertain because stock market conditions have a strong influence.

Chart 4

Chart 5

Nomura and Daiwa To Maintain Discipline

We expect Nomura Holdings and Daiwa Securities Group to retain favorable regulatory capital ratios and capital ratios under our risk-adjusted capital framework (see chart 6). The two major securities groups continue to take a disciplined approach to shareholder returns, aiming to achieve a target return on equity (ROE) of about 10% despite continued pressure in this area. Efforts to reduce volatility, for example by controlling some market risk exposure to reduce their cost of capital, contribute to improved financial health, in our view.

We expect both groups to comply with finalized Basel III rules from the end of fiscal 2024. Applying the finalized rules will result in significantly higher risk weights for both listed and nonlisted stocks, despite a reduction in certain credit risk weights. In addition, the revised internal method approach (IMA) under the finalized framework will determine market risk using an expected shortfall measure with a 97.5% confidence level instead of value at risk (VaR) with a 99% confidence level and stressed VaR. Also, regulatory capital ratios will likely become more sensitive to changes in market conditions.

Nomura and Daiwa are likely to manage their finances conservatively considering the possibility of their regulatory capital ratios falling or becoming more volatile due to the application of finalized Basel III standards. The two major securities groups estimate their regulatory capital ratios and common equity tier 1 (CET1) ratios will fall two to four percentage points. However, after applying finalized Basel III rules, the two groups are likely to use excess capital, if any, to improve capital efficiency, such as for growth investments and shareholder returns.

Chart 6

Table 1

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• Japan Nonbank Sector Eyes Greater Resilience, Profitability, Feb. 1, 2024