Annual Report on

The Japanese Economy and Public Finance


- Japanese Economy Heading for New Growth Era

with Conditions for Growth Restored -

Cabinet Office

Government of Japan

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Section 4 Present Conditions and Problems at Japanese Banks

    Japanese banks' non-performing loan problem, which had once grown serious on a burst of the economic bubble and a financial crisis, has at last been resolved thanks to their tough efforts to reduce such loans. While banks' business capacity has recovered, their profitability has still remained lower than the global average. As companies' fund-raising activities have changed through structural reforms as reviewed earlier, banks are now required to develop new business approaches meeting the new fund supply/demand environment. In this respect, retail banking services for consumers have attracted attention as a new profit-making opportunity. But there are many relevant problems to solve. As far as banks' traditional funding services for companies are concerned, regional banks have begun efforts to expand loans to small regional companies.

1. Present Conditions of Japanese Banks

(Banks reduce non-performing loan ratios and recover business capacity)
    The ratio of non-performing loans to total outstanding loans at major Japanese banks(51) in March 2006 came to 1.8% on a preliminary basis, indicating a sharp decline from a peak of 8.4% in March 2002 (Figure 2-4-1). These banks have recovered their business capacity on profit growth and aggressive fund-raising operations (capital at major banks(52) totaled 30.6 trillion yen with their capital adequacy ratio at 12.1% at the end of FY2005). The non-performing loan problem at the major banks has almost been resolved. Regional banks' non-performing loan ratio has also declined, though more slowly than the major banks' ratio. (The regional banks' non-performing loan ratio fell from 8.3% in September 2002 to 4.5% in March 2006.) At the end of March 2006, banks' stock prices had risen back to the December 1999 level (of the TSE banking stock index at 484.12). Banks' financial intermediation has been improving as their capital adequacy ratios have been recovering with their risk tolerance increasing. Private sector banks' outstanding loans in February 2006 scored the first year-to-year rise in eight years and two months. While disposal of non-performing loans has achieved steady progress under banking system reforms, financial institutions have stepped up investment and alliances across their business boundaries to develop new financial services and new businesses.
Figure 2-4-1 Improving Situation of Banks' Non-performing Loans
    In order to prevent the banking system from being shaken by non-performing loans again, banks must improve their business capacity and tolerance. In this respect, they are required to (1) expand their capital bases, (2) set interest rates at appropriate levels and enhance controls on credit risks, and (3) stabilize their financial profiles through improvement of profitability. We here would like to review the present conditions and problems, mainly at Japanese financial institutions (primarily banks) at a time when Japan's financial system has reached a turning point.

(Japanese banks inferior to foreign financial institutions in safety, profitability and business models)
    As Japanese banks' financial intermediation has been being normalized on further progress in disposal of non-performing loans, they have improved and enhanced (1) their safety (capital base), (2) their profitability and (3) their financial functions (business models). But they are still inferior to large foreign banks.
(1) Safety (capital base)
    Capital adequacy ratios at the major Japanese banks maintain over 12% level and are improving further. In capital levels and quality, however, they are still weaker than foreign banks. Tier 1 capital's share of the total capital base at the major Japanese banks is around 55%, lower than levels above 70% for US banks. Capital base should be enhanced in accordance with the risks due to loans and securities holdings. The lending concentration risk, or the ratio of loans to the 20 largest borrowers to capital, is reportedly higher at Japanese banks than at foreign banks(53) (Appended Figure 2-6).
    The total capital base includes not only profit that banks have earned on their own and funds that they have raised from the capital market, but also deferred tax assets. While US banks have booked little deferred tax assets, such assets account for more than 10% of Tier 1 capital at Japanese banks. The percentage had been even higher in the past (Figure 2-4-2). Japanese banks should reduce credit concentration risks, public funds and deferred tax assets, and utilize their own profit to maintain and enhance their capital base.
Figure 2-4-2 Changes in Capital Base Breakdown at Major Japanese and US Banks
(2) Profitability
    An important challenge for Japanese banks is how to increase their profit ratios, which are relatively lower than those for European and US banks. Japanese banks have been characterized by their low profit margins on loans. Unless profit margins are large enough to cover credit costs, banks' financial profiles may deteriorate on massive loan losses. Japanese banks' loan-loss rate (credit cost ratio) stands at around 1%, close to the US level. However, their loan profit margin (profitability) is not large enough to cover credit costs. Japanese banks must enhance their profitability (Figure 2-4-3).
Figure 2-4-3 Changes in Loan Profit Margins for Japanese and US Banks
(3) Business models (financial functions)
    Banks' business models are closely linked to their profitability. Japanese banks' mainstay service is lending to companies. As loans to large companies have failed to increase, however, banks have invested about 30% of deposits in government bonds and other low-return financial instruments. Recently, banks have shortened terms to maturity for their government bond holdings to curb interest rate hike risks, leading to even lower yields on securities holdings. While loans have failed to increase with interest rates remaining at extremely low levels, the challenge for Japanese banks has been to expand non-interest revenues. At present, fee revenues from sales of investment trusts and other financial products for individuals and corporate services (such as syndicated loan arrangements) are contributing to their earnings. But non-interest revenues' share of total revenues at Japanese banks is still relatively lower than at large European and US banks (Appended Figure 2-6).

(Possibility of lower profitability resulting from overbanking)
    Banks' profitability can be affected by the revenue mix and national market competition conditions, as well as by the macroeconomic environment. In respect to competition in Japan's domestic lending market, Japanese banks' low profitability is frequently attributed to overbanking(54).
    Overbanking is defined variously, related to the number of financial institutions, banking branches or their employees in one country, a (indirect) lending scale as compared with a national economic size, or a decline in the loan-deposit ratio (loans < deposits). In addition, the presence of public sector financial institutions should be taken into account.
    International comparison of overbanking indicators must be carefully interpreted since such indicators differ depending on such factors as territorial size, population density, regulations and financial practices. As far as the number of banks or their branches is concerned, the United States is dominant. However, this fact may not be simply interpreted as indicating overbanking in the United States. Many overbanking indicators imply likely overbanking in Japan.
    The ratio of outstanding loans to nominal GDP is 126% in Japan, against 40% in the United States where direct financing is prevailing. The ratio stands at 123% in Germany and at 107% in Britain, exceeding 100% like in Japan (Figure 2-4-4). In Britain, large banks account for more than 80% of the lending market. In Japan, however, major banks' share of the lending market is limited to a level just above 40%. Among bank categories, major banks have the greatest share. But non-major banks' share of the market exceeds 50%.
Figure 2-4-4 Comparison of Banks in 5 Major Countries (Japan, US, U.K., Germany and France)
    In the United States and Europe since the 1990s, bank bankruptcies attributed to non-performing loan problems, deregulation of interstate banking and the EU establishment have worked to reduce the number of banks on consolidations or mergers between banks. In Japan, major banks have been reorganized into three major groups after the 1990s. At present, however, Japan's financial system, which is centered on indirect financing, has relatively clearly differentiated markets according to the categories of lenders (Figure 2-4-5 (1)). Strong regional banks exist at a local level. Nationwide price leaders with powerful business resources, such as large British banks, do not exist in Japan.
Figure 2-4-5 Japan's Lending Market
    The loan-deposit ratio has remarkably declined in rural regions (Figure 2-4-5 (2)). A nationwide fall in the loan-deposit ratio indicates slack demand for loans including those to companies. In rural regions, aging population, falling land prices and industrial structure problems indicate that banks may have difficulties in utilizing deposits for lending services in the future. Loan-deposit ratios slip below 80% at major Japanese banks. At European and US banks, however, such ratios exceed 100% due to robust loans and difficult collection of deposits, which indicate their market situation is different from that of Japanese banks (Appended Figure 2-6).
    Japanese banks' loans to highly profitable manufacturing companies have been falling since the mid-1980s. Instead, their loans to real estate and services companies with lower profitability increased in the first half of the 1990s (Figure 2-4-5 (3)). As noted in Chapter 1, incentives are expected to grow for large Japanese companies, including manufacturers, to increase direct financing. In this way, opportunities may decline for banks' lending to companies with highly profitable business operations. If banks fail to set appropriate interest rates on loans to less profitable companies with greater credit risks or dispose loans to financially plagued borrowers amid an intensifying competition to expand loans to highly profitable borrowers, their profitability may decline.

2. Future Problems Facing Banks

(1) Emphasizing Retail Banking in Pursuit of Greater Profitability

(Shift to financial conglomerates and retail banking)
    In Japan, banks and securities companies have gradually become financial conglomerates by participating in each other's business turfs since the 1990s. Since the early 2000s, major banks merged into megabank groups. A financial conglomerate generally means a business group that provides wide-ranging financial services covering at least two of banking, securities and insurance services(55).
    The first advantage for financial conglomerates is a wide dispersion of risks through a wide range of financial services. Loan losses have correlations with economic conditions and corporate bankruptcies while non-interest revenues from insurance services have no link to such external variables. This is a reason for which Japanese banks have recently been trying to enhance non-interest revenues including fees on sales of investment trusts, pension schemes and insurance products.
    The second advantage is the maintenance and expansion of the customer base. By providing customers with various financial services, a financial conglomerate may be able to hold customers and prevent relevant revenues from going out of its group. This is convenient for customers, allowing them to conduct one-stop shopping of financial products including deposits, securities and insurance policies.
    The third advantage is the cost-saving synergy effect. Banking, insurance and securities firms within a conglomerate can share business resources, including branches, employees, systems and brands, to save fixed costs. Another advantage may be the development and provision of innovative financial products that a bank, an insurer or a securities firm alone cannot provide.
    Disadvantages of a financial conglomerate include difficulties in management of risks involving a wide range of operations. While one-stop shopping is convenient for customers, they could suffer losses on combined sales of financial products under a financial conglomerate. A shift to financial conglomerates may thus bring about both advantages and disadvantages.

(Emphasis shifting to retail banking at foreign banks)
    In foreign countries, large banks have activated integrations and mergers of different financial services and shifted the emphasis to retail banking since the 1990s. They have combined banking, securities and insurance services to increase their customers, assets, branches and market shares.
    Japan has also seen a beginning shift to the retail banking business model as well as to financial conglomerates. At many of the European and US banks ranked as global leaders in terms of assets, more than 50% of revenues come from retail banking. At Japanese banks, however, retail banking accounts for only 10% of revenues. As reviewed earlier, lending to companies has been sluggish with the loan-deposit ratio declining, making the business environment tougher for banks. This has led banks to secure revenues by selling various financial products, including investment trusts, pension insurances, housing loans and credit card services, to individuals. The growing emphasis on retail banking is seen at regional banks as well as major banks in Japan. We here would like to review retail banking services for individuals in Japan.

(Banks' robust sales of investment trust and pension insurance products)
    Investment trusts have become Japanese banks' core products for retail banking since they were allowed to sell these trusts in December 1998. As of April 2006, investment trusts sold at banks accounted for 29.0 trillion yen or 39.0% of total outstanding net assets of publicly traded investment trusts (Figure 2-4-6). Bank-sold investment trusts exceeded 50% of total outstanding net assets of stock investment trusts in August 2005 for the first time ever. This meant that banks outperformed securities companies in stock investment trust sales. The eight major banks have accounted for some 48% of total outstanding net assets of bank-sold investment trusts. Regional banks' share has also increased to about 36%(56). In October 2002, banks were allowed to sell pension insurances over the counter. Such sales have expanded smoothly. At the end of March 2006, accumulated pension insurance sales at banks totaled some 10.6 trillion yen(57). Banks' over-the-counter sales of investment trusts and pension insurances are expected to exert influences on households' asset selection. As banks that are the most familiar financial institutions for consumers sell investment trusts and pension insurances, Japan's financial system may see a shift from savings to investment. At a time when banks are required to expand non-interest revenues, fee revenues from sales of investment trusts and pension insurances have grown more important. At the major banks, fee revenues from investment trust and pension insurance sales account for 10% to 20% of total fee revenues. The share for fee revenues from these sales has been rising, supporting banks' overall operating revenues. At US banks featuring higher shares for non-interest revenues, shares for fee revenues from mutual fund and insurance sales are not so high. Their fee revenues center on fees on cash, deposit and credit card services. Stock investment trusts, which are selling well over the counter at banks, are vulnerable to market fluctuation risks. While banks give priority to a short-term revenue expansion, they may fail to secure stable revenue sources over a medium to long term, unless customers' financial assets at banks are increased through provision of services meeting customer needs.
Figure 2-4-6 Breakdown of Outstanding Net Investment Trust Assets by Seller

(Intensifying competition for housing loans for individuals)
    Behind banks' recent expansion of housing loans, the housing loan market has shifted to commercial banks on the Government Housing Loan Corporation's decision to terminate its direct housing loans. Banks for their part expanded housing loans in view of higher profit margins for these loans (see Chapter 1 Section 3-4 titled, "An upturn in bank loans"). Housing loans' share of total outstanding bank loans soared to 24% at the end of December 2005. Extremely low interest rates and firm housing starts have also contributed to the expansion of banks' housing loans.
   Banks are trying to attract customers with preferential (lower) lending rates, well-devised schemes and other incentives, while nonbank lenders are providing super-long-term housing loans carrying lower fixed interest rates than offered by banks. Commercial banks' housing loans cover 100% of housing prices, compared with 80% for loans provided by the government corporation. This means that borrowers' default could force banks to recover less than the government corporation by selling collateral assets. Competition has also intensified over loans provided through housing suppliers. If the suppliers come to choose banks that are more advantageous for their sales, such as conducting less stringent screening, there is a risk for practical easing of the loan criteria.
    As noted earlier, some 50% of commercial banks' housing loans limit selectable time periods for fixed interest rates to less than 10 years. Since proportion of fixed interest rates on 10-year or longer loans are lower in Japan, borrowing individuals are forced to bear the risk of interest rate hikes coming after fixed-rate periods. Even if interest costs are low during fixed-rate periods, such costs after these periods may rise sharply depending on interest rate hikes after these periods. According to an estimated burden of interest rate hikes on housing loan borrowers as cited earlier (Appended Note 1-4), for example, a person with annual income of 6.14 million yen borrowing a 23.63 million yen housing loan with a five-year fixed-rate period may see the ratio of annual loan repayments to annual income rising by 5.4 percentage points to 22.7%, or annual loan repayment increasing by 330,000 yen, after the fixed-rate period, if interest rates increase by 2.5 percentage points during the five-year period. As the ratio of loan repayments to annual income increases, a borrower may grow more likely to default on repayments. In Japan, interest rates have never risen since variable-rate loans and selectable fixed-rate periods were introduced. In the future, however, banks may have to be alert to default risks.

(Banks required to identify consumer needs regarding consumer finance)
    Banks are positioning unsecured loans and credit card services for consumers as key retail banking services coming after housing loans and investment trust sales, for which competition has been growing fiercer. Behind their willingness to undertake such consumer finance services is these services' high profitability. Interest income on credit card loans and cash advance services, though depending on customers' creditworthiness, exceeds 10%(58). In the past, banks had not been positive about unsecured loans to consumers. Major banks are trying to take advantage of their customer base for expanding consumer loans by utilizing borrower examination and loan collection know-how learned from consumer finance companies under their capital and business alliances. The so-called "gray zone interest rates" have allowed both banks and consumer loan companies to coexist for consumer finance services. In this respect, attention may have to be paid to arguments about an interest rate regulation reform involving the gray zone.
    Some banks' joint ventures with other banks or credit card companies have been undertaking credit card services (revolving credit and cash advance services). Credit card services not only bring about high interest revenues for banks but also allow them to analyze customers' consumption patterns and lifestyle data and offer financial products meeting customer needs. The services are thus expected to have synergistic effects on banks.
    Credit card debt in Japan stood at 26.6 trillion yen (in FY2003) (Figure 2-4-7), amounting to 9.6% of the nation's final household consumption expenditure (276.5 trillion yen in FY2003). The percentage is still lower than the 25% in the United States. The US system, where financial markets allow households to boost their propensity to consume by providing various borrowing means, may not necessarily be viewed as a global standard. If credit cards are used for purchases more and more in Japan, the nation's credit card market may be expected to expand further. In this sense, we may have to take note of the fact that revolving credit and cash advance services through credits cards, rather than unsecured loans, are dominant in the US consumer finance market and have become a major retail banking revenue source for large US banks. In Japan, consumers dominantly favor lump-sum payments rather than installment payments on credit card debt. If lump-sum payments remain dominant, Japanese banks cannot be expected to earn as much as US banks from credit card services. Unlike US consumers, Japanese avoid having deposits and loans simultaneously. Although young people with less savings easily rely on immediate, convenient consumer loans, growth of Japan's credit card services may depend on whether Japanese consumers would expand borrowings.
Figure 2-4-7 Banks' Consumer Finance Services

(Emphasis on customers and profitability required for expanding retail banking market)
    As reviewed above, Japanese banks are shifting to financial conglomerates and emphasizing retail banking services in a bid to enhance their profitability. Customers may expect banks to provide fine-tuned services and advice. Specifically, banks are expected to inform customers of mechanisms, advantages and risks of specific financial products, offer the most suitable products selected from various choices from a neutral viewpoint, and regularly follow up on products sold to customers. If banks provide financial services under their own logic without grasping customer needs, they may lose customers' confidence and fail to expand their market.
    When considering how to provide financial services across business boundaries, banks may consider the advantages and disadvantages of financial conglomerates and choose some other methods. In fact, some foreign banks that had taken the initiative to develop into financial conglomerates have chosen to identify their strengths, focus on core services, withdraw from unprofitable operations and offer a variety of products through alliances with other firms.
    In April this year, Japan created a new bank agent system, allowing nonbank firms to serve as agents of banks. This enables consumers to secure or improve their access to financial services and gives banks opportunities to make efficient use of various sales channels. For example, banks may take advantage of the capabilities and know-how of companies with wide customer networks for selling investment trusts and pension plans. Banks may also be able to replace branch management costs to commissions paid to agents. They now have a wider range of alternative management measures. Depending on the utilization of bank agents as sales fronts, banks may be able to not only expand sales channels for financial products but also create new business models.

(2) Regional Financial Institutions Expected to Finance Local Companies

(Regional financial institutions' financial profiles sensitive to local economic conditions)
    In anticipating the future course of regional financial institutions, we should pay attention to business conditions that affect their profitability. Economic gaps between companies and between regions have grown more remarkable. For example, small non-manufacturing companies' diffusion index for business conditions, though improving, still remains negative. As reviewed in Chapter 1, some rural cities still see double-digit annual declines in land prices.
    We conducted a principal component analysis, a kind of multivariable analysis, to look into relations between the business performances of regional banks (64 ordinary and 48 second-tier regional banks) and business conditions (Figure 2-4-8). The principal component analysis is a statistical technique for simplifying a dataset by reducing multidimensional datasets to datasets with lower dimensions called principal components. We here extracted representative attributes from multiple financial indicators of safety, profitability and efficiency at regional banks. We then measured the strength of the extracted representative attributes by the rate of contributions to business performances. The first principal component, which features the highest contribution rate, indicates how great a regional bank's economic performances are. The second principal component, which has the second highest contribution rate, includes a negative factor for the capital adequacy ratio and a positive factor for the non-performing loan ratio, indicating a bank under reconstruction. We here calculated regional banks' scores for the first principal component, indicating degrees of business performances, and looked into relations between high-score (or low-score) banks and their business environments.
Figure 2-4-8 Business Environments Affecting Profitability of Regional Banks
    High-score banks are usually based in the Tokyo metropolitan region or any of the government-designated cities for local services. In order to identify relations between banks' principal component score (business performance) gaps and their business environments, we regressed each bank's principal component score as an explained variable to gross domestic product and a lending market share in the prefecture where the bank is based. A finding was that there are significantly positive relations. Another estimation using prefectural rates of commercial district land price changes in place of prefectural GDP also indicated significantly positive relations. Business performances are better for banks that are based in regions with larger economic and population sizes and more commercial functions (as well as rising or recovering commercial district land prices) and have higher market shares. But the above analysis cannot explain some part of the business performance gaps by regional economic sizes and market shares. This part may represent value-added gaps attributable to differences between banks' business skills.
    Regional financial institutions' business performances are thus closely linked to regional economic structure. Sizes, customers and roles of banks based in the Tokyo metropolitan regions may be different from those of banks in other regions. Regional banks may have less economy-of-scale advantages than the major banks for retail banking services. Regional banks with no business advantages are growingly required to improve their business performances while securing regional economic development.

(Potentials of regional banks as financers of regional companies)
    As regional small companies still depend on borrowings from banks for raising funds, regional banks have potentials to secure profitability by meeting such fund demand. Risk management regarding loans to small companies has been conceived of as difficult because such loans are frequently unsecured. However, some regional banks have reaffirmed their regional business characteristics and have been trying to develop new business models.
    The government's New Action Program concerning enhancement of Relationship Banking Functions (FY2005-2006), as released in March 2005, called for enhancing relationship banking to facilitate business turnaround and small company finance, citing such specific measures as 1) strengthening functions to support the creation and opening of new businesses, 2) strengthening functions of management consultations and support for client companies, 3) aggressive efforts for prompt business revitalization, and 4) strengthening measures for new Small-and Medium-sized Enterprises (SMEs) financing. This means that regional banks should take advantage of financial and other quantitative information about small companies and their business management data gained through long-term trading relations to qualitatively improve relations with customers and demonstrate their originality to develop services with higher value added.
    The qualitative improvement of relations with customers includes enhancement of the transparency of customers' financial profiles, which is consistent with regional banks' desirable debt governance at small companies in relationship banking. Regional banks should earn income from their efforts to enhance the transparency of corporate information and solve customer companies' problems.
    Regarding 4), promotion of loans that do not depend heavily on collateral or guarantee, banks have expanded loans utilizing credit scores to quantitatively and automatically analyze credit risks without depending on collateral or guarantee. Regional banks may effectively utilize such transaction banking approach to develop business models based on relationship banking. Regional banks may also choose to merge with each other in pursuit of economy of scale or develop new products and management know-how through positive alliances with major banks in order to reduce costs and improve credit risk management.

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