Rated regional banks' positive performance continues, with the most well capitalized under growing pressure to deliver higher returns.

Core business profits of the eight Japanese regional banks we rate were flat in fiscal 2023 (ended March 31, 2024) year on year despite higher operating expenses.

The rated regional banks, which have relatively strong business and financial bases compared with other regional banks in Japan, are preparing for higher domestic interest rates. This includes selling bonds with unrealized losses and replacing low-yielding assets. In S&P Global Ratings' view, regional banks' net interest income, representing most of their revenue, will increase gradually, at a more moderate pace than that of major Japanese banks.

On the downside, our credit assessment finds that the capital ratios of rated regional banks with higher capital buffers are more likely to come under pressure. This is mainly due to the banks' efforts to improve capital efficiency in response to corporate governance reform measures in Japan. Structural issues across the regional bank sector, such as weak demand for lending and worsening demographics in regional markets, will continue over the medium to long term.

The eight rated regional banks' combined core net operating profit (excluding gains and losses on cancellation of investment trusts) declined only 1.3% in fiscal 2023 (see table 1). This was mainly due to higher loan interest income and higher fee income related to corporate customers and assets under management, which offset higher operating expenses, including Hachijuni Bank's merger of Nagano Bank Ltd. in June 2023. Pretax profit grew 15.2% (or 10.6% excluding the impact of negative goodwill from the merger), reflecting an about 30% decline in losses on bond sales and an about 60% increase in gains on the sale of stocks. Credit costs increased moderately but remained low at 3 basis points (bps) of the outstanding balance of loans.

The eight Japanese regional banks that S&P Global Ratings rates are Bank of Kyoto Ltd., Chiba Bank Ltd., Gunma Bank Ltd., Hachijuni Bank Ltd., Hokuriku Bank Ltd., Iyo Bank Ltd., Kagoshima Bank Ltd., and Shizuoka Bank Ltd.

Table 1

Net Interest Income Will Gradually Increase With Higher Policy Rates

We expect profitability of rated regional banks will improve over the next one to two years.   New loan margins, which had already risen in anticipation of the Bank of Japan's (BOJ) normalization of interest rates, have been rising further (see chart 1) in response to the central bank's move to raise its policy rate to 0.0%-0.1% in March 2024. We forecast Japan's policy rate will be 0.25% by the end of 2024 and 0.5% in 2025. In addition, rated regional banks are likely to benefit from rising interest rates because of their earnings structure, whereby net interest income accounts for about 80% of total revenues (see chart 2). We also believe regional banks are unlikely to pass much of a rise in policy rates to customers in deposit rates. This is because their deposit bases consist primarily of retail customers in their home markets.

Chart 1

Chart 2

We expect improvement in profitability of regional banks to be mild relative to that for major Japanese banks.   This is because most regional bank lending is linked to fixed rates or short-term prime rates (including housing loans), rather than to market rates (see chart 3). Short-term prime rates that most Japanese banks adopt have remained unchanged since January 2009. Also, lending yields have declined in recent years with increased competition, and banks have not raised lending rates for a long time. We believe banks will face difficulty raising lending rates particularly in regional markets. We also base our expectation of slow improvement in the profitability of regional banks on the relatively long durations of their bond holdings.

Chart 3

Central bank measures are also likely support each regional bank's earnings institutionally.   The BOJ applies positive interest rates to financial institutions' current account balances at the central bank. Amid the COVID-19 crisis, the BOJ introduced a special deposit facility program to support regional financial institutions paying a 0.1% interest rate on excess reserve balances in their current accounts. For many regional banks, this is set to expire in September 2024. However, as part of its revised monetary policy framework, the BOJ in March 2024 decided to apply 0.1% to the entire excess balance on the current account, instead of the basic balance. As a result, we estimate rated regional banks with large current account balances will continue to earn billions of yen in net interest income.

We believe rated regional banks will step up efforts to improve their return on risk-weighted assets (RORA).  Loan needs remain limited in regional markets, with some exceptions for pockets of strong economic activity. The rated regional banks increasingly seek to expand business in the Tokyo metropolitan area and to position market-based lending, including structured finance, as a focus area. These regional banks, which have been working to improve cost efficiency, face pressure of rising operating expenses, including for personnel plus branch stores and IT systems. Collaboration announced in March 2024 between the Tsubasa Alliance led by Chiba Bank and the Judankai group led by Hachijuni Bank in noncompetitive fields such as systems-related, efficiency improvement, and cyber security is an important initiative to maintain and improve profitability, in our view.

Chart 4a

Chart 4b

Cost-Push Inflation May Increase Credit Costs, But Interest Rate Risk Will Remain Manageable

Rated regional banks' credit costs may trend higher over the next year or two.  This is because bankruptcies of small and midsize enterprises (SMEs) across Japan have risen to pre-COVID-19 levels due to labor shortages and inflation. Also, Japanese corporations' interest payment burdens have begun to rise. We do not expect credit costs to increase sharply for all rated regional banks, as we believe the Japanese economy will grow moderately (0.8% real GDP growth in 2024 and 1.1% in 2025). However, we see an increase in cost base and the end of COVID-19-related support measures by the government affecting corporates' financial conditions unevenly, particularly SMEs. In addition, unlike major Japanese banks, regional banks often allocate inadequate loan loss provisions for future needs, plus we tend to see a lag in recognition of credit costs.

Chart 5

Rated regional banks will manage interest rate risk, in our view.   We base this view on our expectation of a moderately paced rise in domestic interest rates. Looking at the aggregate securities investment portfolio of the eight regional banks, we see a recovery underway in their foreign bond balance, which declined due to higher overseas interest rates. In addition, they are replacing low-yielding Japanese yen bonds (see chart 6). Unrealized losses on bonds (including those categorized as "other," such as foreign bonds) remain about 5% of net assets. Rated regional banks have taken steps to mitigate interest rate risk, such as interest rate swaps. Unrealized gains on equity holdings would offer some cushion in the event of losses on bond sales (see charts 7 and 8).

Chart 6

Chart 7

Chart 8

We think rated regional banks also continue a restrained approach in their asset and liability management.   For interest rate risk in the banking book (IRRBB), the eight regional banks' simple average delta economic value of equity (EVE) in the scenario of an upward parallel shift in interest rates (100 bps for the Japanese yen and 200 bps for the U.S. dollar and euro) remained limited at 3.9% of Tier 1 capital or core capital (as of the end of September 2023). Japanese yen bond holdings require lower funding costs than foreign bond holdings. Thus, we forecast that net interest income from Japanese yen bonds is less likely to turn negative even if domestic interest rates rise a certain degree.

Capital Ratios Are Under Pressure As Profitability Improves And Shareholder Returns Strengthen

Rated regional banks' capitalization remains more favorable than that of major Japanese banks.   This is likely to continue to underpin their credit quality as a loss-absorbing buffer. We consider their capital ratios comparable with those of overseas banks. At the end of September 2023, the eight banks' weighted-average risk-adjusted capital (RAC) ratio was 9.5%, unchanged from a year earlier. We attribute this to a reduction in risk-weighted assets in their equity holdings, resulting from factors such as disposal of strategically held shares and inflated unrealized gains on listed stocks through favorable market conditions, despite increased corporate exposure. In addition, as part of its capital policy and funding diversification, Gunma Bank issued Additional Tier 1 (AT1) bonds--the first among Japanese regional banks--in January 2024.

Rated regional banks' capital ratios will likely come under pressure as corporate governance reform progresses further.  The Tokyo Stock Exchange is urging listed companies to promote management placing greater focus on stock prices and capital efficiency. In response, rated regional banks are working to strengthen earnings capacity relative to risk and shareholder returns (see chart 9) to improve profitability such as return on equity (ROE). As a result, risk-weighted assets may increase or capital accumulation may slow over the next year or two. Although partly a temporary effect until full implementation of final Basel III standards, regional banks with high capital adequacy ratios and significant unrealized gains on equity holdings are particularly likely to face pressure on returns from shareholders, likely causing their RAC ratios to decline (see chart 10).

Chart 9

Chart 10

Capitalization looks untroubled even if elevated share prices were to correct.   We do not expect such a move would materially impact our assessment of regional banks' capitalization. We estimate a 50% drop in market value of equity holdings from current levels would only cause each banks' RAC ratio to fall 0.0-1.2 percentage points, depending on unrealized gains on these holdings. This is because there has been a significant increase in unrealized gains on listed equity holdings as a result of a stock market rally to date. However, if two or more factors mentioned above occur simultaneously, it would negatively affect banks' credit quality through a drop in capital ratios.

Table 2

Table 3

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