For more than a hundred years, the Shimane Bank has been the economic heart of its remote Japanese prefecture, financing local companies through the vicissitudes of war, earthquake and rapid economic growth. 

But last Friday, it all fell apart, highlighting an often-forgotten financial stability risk that could affect not just Japan but the entire global economy. After years of ultra-low interest rates had slashed its loan income, Shimane Bank announced a sudden blow-up in the securities portfolio it had turned to instead, and an emergency capital raise of ¥2.5bn ($23m) from SBI Holdings.

In order to return to profit, Shimane Bank plans to ramp up higher-margin lending to “medium risk” companies, which did not meet its financial standards in the past. But in a prefecture where the population is already 25 per cent below its peak, and projected to fall another 15 per cent by 2045, good credit risks are hard to come by. 

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The plight of this local stalwart is mirrored across Japan’s vast regional banking system, which accounts for half of the country’s banking assets. In provincial towns across the country, bankers are looking at relentless declines in their income, leaving dozens of teetering institutions with an incentive to gamble on risky property loans or exotic investments overseas. 

Holding more than $3tn in assets, Japan’s regional lenders are bigger than the Italian banking system, and their excess deposits make them a crucial buyer of everything from collateralised loan obligations in the US to covered mortgage bonds in Denmark. 

“Japan has built up the world’s largest net foreign lending position. Japanese financial institutions pump this capital out to the rest of the world: they are the beating heart of international capital flows,” said Shannon McConaghy, an asset manager at Horseman Capital in London, who follows the regional banks. 

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“The reduction in their return, due to negative rates, has forced the heart to take on more and more risk to keep on beating. The problem arises when this risk stresses the heart so much that capital stops beating out.” 

The basic business model for Japan’s regional banks is straight out of It’s a Wonderful Life: take deposits from local people, lend them out to local businesses, and earn a small margin. As Japan’s regions aged and declined, however, they ended up with more deposits from elderly savers than loans to growing borrowers. 

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For a long time, the answer was to buy Japanese government bonds, which yielded more than 1 per cent — but that changed when the Bank of Japan began its massive purchase programme in 2013, adding negative interest rates in 2016. The yield on 10-year JGBs is now -0.25 per cent. As existing JGBs mature, the regional banks cannot replace them. 

They have responded in two ways: by reversing existing loan-loss provisions, to reflect the stronger economy, and selling assets from their securities portfolio to realise capital gains. The trouble is, neither can go on forever. “In 2013, 7 per cent of ordinary profits came from equity gains. By 2018, that was 23 per cent,” said Kaori Nishizawa, who covers banks at Fitch Ratings in Tokyo. “Some banks are going to run out of that resource soon.”

In an attempt to boost their loan income, the regional banks have been fuelling a boom in apartment construction across Japan, sometimes moving out of their local area to tap demand in the big cities. 

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Brian Waterhouse of Windamee Research said: “Lending to real estate has been the key drift. There are now more real estate loans outstanding than there were back in December 1989 at the height of all the craziness that was the so-called ‘Bubble Economy’. Regional banks are really leading that charge.”

“As long as you have net inflows and rising prices, it works, but if you have a drop off in people buying then a collapse in property prices gives you a serious problem for the regionals,” he added.

The other option for regional banks is to look abroad. They have been buyers of US debt packaged into structured products such as collateralised loan obligations, or CLOs.

Ken Takamiya, banks analyst at Nomura, said the regional banks were hedging their currency risk and sticking to the top-rated triple A tranche of CLOs, but the products are still a long way from their core competence. 

“The big question, especially at smaller regional banks, is whether they are really aware of where the risk is for these investments,” he said.

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Mr McConaghy argues that the problem is more severe than just a declining net interest margin in their home market. He believes past forbearance has left the regional banks stuck with many loans to small companies where the owner is about to retire or the collateral has dubious value. 

“The worst part of the situation is the zombie loans. Japanese banks have under-reported credit costs for years, but these are rising from the dead,” he said. “The hidden non-performing loans at some banks will be big enough to prevent a white knight coming in and make capital raising difficult.” 

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The parlous state of the regional banks is not news to regulators who are keeping a close watch on Japan’s provincial towns. The Financial Services Agency has pushed the competition regulators for an exemption to normal antitrust rules, in the hope that a wave of mergers will allow the regional banks to cut costs and sustain their profitability. 

In a closely-watched test case, Fukuoka Financial Group and Eighteenth Bank — the two dominant players in Nagasaki prefecture — were allowed to merge. But many analysts question how much good it does to bring weak banks together. 

“My thesis is that mergers are not necessarily an effective solution,” said Mr Takamiya, arguing it can take seven to 10 years to fully combine systems and branch networks. “The trouble with mergers is that it takes such a long time to have an effect.”

He said the banks need to act quickly, while they still are still profitable enough to invest, in order to control costs and develop fee-based businesses for their corporate customers. 

The question is how much time they have left. Reserves for loan losses are minimal and the system’s capital ratios are already falling. In a deep downturn, no amount of local affection will be enough to bail out the regional banks — and the consequences could be worldwide.

Via Financial Times