Over the last couple of years the Japanese banking sector has hauled itself back from the brink of bankruptcy to show good signs of recovery. Robert McKillop examines the recent turnaround
Over the course of the last couple of years, the Japanese banking sector has exhibited a remarkable turnaround in fortunes. When the Nikkei 225 Index tested the 7,600 level at the end of April 2003, the Japanese financial system was under intense pressure and the main banks were priced at levels that suggested something close to impending bankruptcy.
However, the government underlined their commitment to supporting the banking sector via the massive bailout of Resona, Japan's fifth largest bank. This show of government support combined with structural changes and FSA pressure to reduce non-performing loans has enabled the beleaguered banking sector to recover. Consequently, Japanese banking stocks are approaching what many investment managers see as fair value. However in our view current pricing does not reflect the attractive prospects for the sector in general.
In particular, one of the key drivers for the sector is an upturn in M&A activity. While this kind of change is always likely to be viewed as positive in a sector burdened by old-school thinking and traditional alliances, it is the nature of this M&A activity that suggests a transformation of the sector is occurring for the better.
With the fallout from the non-performing loans situation effectively now in the past, the merger between MTFG and UFJ marks what we see as the first 'merger for growth' rather than 'merger for survival' in the sector. This move has come about largely due to the disintermediation of corporate financing - corporates moving from indirect financing to direct financing to capital markets - which is an ongoing theme in Japan. While the overall demand for capital is low with companies generating record levels of cashflow, large corporates are turning more and more to the cheaper capital markets and away from their over-dependence on conventional means of bank financing. This phenomenon is eroding the traditional customer base of Japan's major banks and has forced them to look across different areas of the lending market as they battle to gain position and market share ahead of the possible end of deflationary pressures which have plagued Japan for years.
all Change please
In response to the trend of disintermediation, Japanese banks have moved to diversify their product offerings, shifting their focus towards small and mid-sized (SME) corporate lending. SME lending is also the target of Japan's many regional banks so competition is likely to be intense in this area, although the rewards are considerable. This move follows a successful foray into the mortgage arena, which was prompted by the government's downsizing of the Housing Loan Corporation, although this area too is now highly competitive. Additionally, the banks plan to target consumer loans, credit cards and other high margin fee businesses. So while overall loan growth may not show appreciable signs of a pick up, the shift in product mix to higher margin offerings is likely to provide a boost to the bottom line. We believe the market has failed to fully price in the benefits of the improvement in the product mix from the large city banks.
It is not only the banks themselves that are proactively recognising the need for change. The FSA's Financial Reform Program is likely to encourage the creation of financial conglomerates with the mega-banks at the centre. These conglomerates would encompass the full spectrum of all of the sub-sectors of the traditionally compartmentalised financial system in Japan, including banks, insurance, brokerage and consumer finance operations. The FSA also plans to come up with new legislation for supervising these new financial conglomerates. The active promotion of mega-banks into financial conglomerates by the FSA and changes to the commercial code are likely to drive M&A activity further. One such change comes in the form of the introduction of Western-style purchase method merger accounting and its treatment of goodwill in April 2006. Within the banking sector, we believe this may act as a driver for further realignment in the trust bank sector between remaining independent companies such as Sumitomo Trust and Banking.
Bailing out the banks
Also fuelling the drive towards the creation of financial conglomerates is the government's deregulation programme. We believe this will be another key driver for the sector and will help to encourage M&A activity and consolidation across various segments of the financial landscape. The FSA have realised that bailing out the banking system is an expensive business. In an effort to improve the profitability and durability of the banking industry, the FSA has actively promoted methods to enable banks to enter new business lines to help restore their profitability levels in the face of the threat of disintermediation.
For example, from December 2004 banks were able to act as intermediaries in equity investment and related areas. This represents a market with massive potential, given the high number of large domestic deposit holders. If banks are able to turn some of these low interest earning cash piles into higher margin equity investments, then the implications could be potentially very significant for profitability, especially if retail demand for equities were to take off as it did in the US and UK in the late 1990s. However, it must be remembered that the cautious nature of the typical domestic Japanese investor may mean this theme takes sometime to develop.
As a result of these deregulation efforts, banks and brokers are forming much closer links than had been previously necessary in an effort to boost their fee income. Banks are now able to sell investment trusts and have been allowed partial access to selling selected insurance products. This has proved to be very successful, particularly in the annuities field where sales recently have been growing at over 40% despite relatively high commission fees. We expect to see further deregulation of the types of insurance products banks can sell in the near future. Banks are also trying to turn the trend of disintermediation to their advantage by developing investment banking operations that can handle the capital market business of their traditional clients. We have seen evidence of this occurring already with Mitsubishi Tokyo Financial Group (MTFG) transferring their investment banking division to Mitsubishi Securities and also through the wholesale brokerage joint venture between Smitomo Mitsui Financial Group (SMFG) and Daiwa Securities. This latter operation has given rise to speculation of a potential full-scale merger between Daiwa Securities and SMFG.
We believe the long-term investment argument for the Japanese financial sector is compelling, built on the desire of the FSA to create a strong banking sector. However, we also believe that in the short to medium term there remains significant upside to current consensus profit expectations. In their traditional lending business, the market still believes that the main banks are reliant on loan volume growth and remain sceptical on their ability to raise loan margins. However, we think that market share gains and product mix shifts will support volumes and pricing respectively. Consequently net interest income will be higher than the market expects. Further upside to profit expectations could come from an acceleration of growth in fee income as annuity and investment trust sales continue to grow. We continue to retain a heavy position within the finance sector as we expect equity prices will need to adjust upward to reflect both the higher level of profit growth and the fresh opportunities that will arise from deregulation and consolidation.
There is substantial equity upside potential in Japanese banking both in the short and long term.
Banks have found new revenue streams thanks to the de-regulation of the sector.
Consolidation in the industry will prove a powerful driver for stock performance.
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