Japanese Banks' High-Risk Painkiller

Using derivatives to hedge against money-losing lending could put a dent in profitability.

Derivatives have never been so attractive to Japanese banks. From protecting their floating-rate loans against losses to helping them lend abroad, the same kind of funky financial engineering that took the rap for the credit crisis is able to solve so many problems faced by the likes of Mitsubishi UFJ and Mizuho.

Engineers Engaged

The amount of Mitsubishi UFJ's derivatives that count as hedges spiked in 2015

Source: Company filings

* Years refer to fiscal periods ending March 31.

As the Tokyo interbank offered rate threatens to dip below zero, several Japanese banks are resorting to using derivatives to hedge against money-losing lending, Bloomberg News reported Tuesday. At the same time, they're increasing overseas loans because in a world of negative interest rates, that's where they can get better returns, even if the risks are higher.

Greener Pastures

Mizuho has increased foreign loans by about 43 percent since September 2012

Source: Company filings

Take Mizuho, the nation's second-biggest bank by assets. Domestic loans grew by 100 billion yen ($915 million) in the period from Sept. 30 to March 31, versus $16 billion for foreign advances. At Mitsubishi UFJ, the biggest, offshore loans increased by $25.6 billion.

Foreign Allure

The difference between what Mizuho makes on loans abroad versus what it gets for lending at home is narrowing, but remains pretty wide

Source: Company filings

Considering Japanese banks make more money on overseas loans, that doesn't sound too problematic. But the issue is they still have a lot more deposits at home than they do abroard, which means that some of their international advances will have to be financed with yen collected domestically.

Geographic Mismatch

At Mitsubishi UFJ, deposits at home still far outweigh those abroad

Source: Company filings

To offset the risk of currency fluctuations, banks need to hedge, and to do that, they need to buy derivatives, which aren't cheap.

Even taking into account that additional cost burden, it may still work out from a financial standpoint. From a capital-cost perspective, however, all this engineering can take its toll.

According to the latest rules being discussed by the Basel Committee on Banking Supervision, over-the-counter derivatives, such as the ones banks need to hedge cash flows from foreign loans or floating-rate facilities, would only be exempt from counting as a capital cost if a lender posts cash as collateral for the instrument. In other words, money a bank could otherwise have lent would now have to be parked somewhere to back up a swap. The alternative is to set aside 20 cents of capital for every dollar lent, but every dollar of capital committed to an asset reduces the ability of a bank to lend, and can put a dent in profitability.

That puts lenders in a tight spot. The best way to increase gains in a negative-rate environment is to resort to derivatives, but those same instruments ultimately impact upon earnings or require the banks to issue more equity. Banks are likely to do the math and choose the path of higher returns. New banking rules or no, expect derivatives to become Japanese banks' next big trend.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at clangner@bloomberg.net

    To contact the editor responsible for this story:
    Katrina Nicholas at knicholas2@bloomberg.net

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