Rising Interest Rates Loom for Japanese Banks

As rates start creeping up, banks should monitor risks and review their balance of assets and debts

From Standard & Poor's RatingsDirect

Spurred by the continuing recovery in the Japanese economy, the Bank of Japan (BOJ) has officially ended its quantitative easing policy. Although it may take some time before the BOJ implements an actual rate hike, the policy shift heralds a period where market interest rates will start creeping up.

Higher short-term interest rates generally improve bank spreads on deposits and lending, benefiting their profitability over the short term, and the recent boost in domestic bank share prices reflects these expectations. However, bank earnings also depend on the competitive environment and depositor demands. Taking these factors into consideration, the net effect of rising interest rates can play out in a number of different ways. Standard & Poor's has constructed several scenarios for how a rise in money market rates could affect bank earnings, and in particular, how lending profits could be wiped away by competitive factors and losses on bonds.

Higher Short-Term Interest Rates Widen Lending Margins

Higher short-term interest rates basically improve bank spreads on deposits and lending, increasing gross profit. Most domestic bank loans carry floating rates that change in line with money market interest rates. Among the major banks, floating rates are applied to 80% of their total lending balance. About 50%-60% of floating-rate lending is determined based on the TIBOR (Tokyo Inter-bank Offered Rate) or other money market rates, plus a set spread. Interest rates on other types of lending are determined based on short-term prime rates. These are applied to loans with one-year or shorter maturity and are extended to corporations with high credit quality. However, loan rates are not completely linked to money market rates, since banks may modify their lending terms according to various business strategies.

On the other hand, demand deposits are not very sensitive to changes in market interest rates. Demand deposits account for more than half of banks' total deposit balance: 67% at major banks and 50% at regional banks. The outstanding balance of demand deposits surpasses that of floating lending in banks' current balance sheets, so higher money market rates are expected to lead to an improvement in spreads on deposits and lending. If medium- and long-term interest rates also rise, banks' losses on Japanese government bond (JGB) holdings will likely grow. Gains or losses on JGB holdings are already rather marginal. Therefore, the effect of wider spreads would likely overwhelm losses on JGBs, leading to a net gain in profits.

Some banks have already announced earnings projections that incorporate the impact of higher interest rates. For example, a management plan announced by Mitsubishi UFJ Financial Group Inc. (MUFG) in February 2006 is premised on a 36-basis point (bp) increase in short-term interest rates (three month TIBOR) from fiscal 2005 through fiscal 2008. MUFG estimates its combined earnings from retail and corporate segments will increase by approximately ¥170 billion compared to earnings in fiscal 2005. The increase is equivalent to 12% of net interest income in fiscal 2005.

Lending Margins Respond to Market Rates

The most recent rising phase for interest rates was a 20 bp hike in the uncollateralized call rate after the BOJ lifted its zero interest rate policy in August 2000. However, interest rates began to drop shortly after the central bank implemented its quantitative easing policy in March 2001.

Interest rates rose consistently from 1988 through 1990. Short-term money market rates had bottomed out in 1988 and then followed a hike in overseas interest rates. The official discount rate of 2.05% in May 1989 was raised by the BOJ four times, finally hitting 3.25% in August 1990. The short-term prime rate also rose to 8.25% in December 1990 from 4.25% in 1989. Deposit rates did not climb nearly so much over the period, so the average spread at major banks and regional banks improved gradually over the period, reaching 2.33% in fiscal 1991 compared to 0.76% in fiscal 1988.

The financial environment was very different at the tail end of the bubble economy. Land prices were peaking in 1991, and private borrowing demand was strong. Nationwide bank lending grew 13% from 1988 to 1989, and banks could easily pad their loan portfolios with high margin real-estate loans. Furthermore, deregulation of deposit interest rates was limited to selected account types, such as large-sum time deposits, accounting for only 41% of total deposit balances in 1989, so banks did not compete heavily on deposit interest rates.

Factors Affecting Earnings Increases

To what degree higher interest rates will contribute to earnings heavily depends on a bank's asset and debt structure. Also important is the degree of linkage between lending and deposit interest rates to money market rates.

While most corporate lending rates are linked to money market rates, interest on loans extended to small and midsize enterprises (SMEs) is usually based on short-term prime rates and is not automatically changed in time with money market rates. So if a bank offers low lending rates to SMEs, competitive pressures will drive other banks to follow suit. In setting rates on corporate lending, banks must also keep an eye on competition from other financing methods, such as bond issuance and securitization.

A record percentage of assets are now invested in demand deposits, attributable to the fact that there is no substantive difference in interest rates between demand deposits and time deposits. As interest rates start to rise, however, demand depositors are expected to shift their funds to alternative financial products offering higher terms, such as term deposits or money management funds, so banks' fund procurement costs may increase.

Depositors' complaints over the lack of interest on their savings are pressuring banks to raise rates, particularly now that earnings are recovering. Deregulation has changed the competitive dynamics of the market, and depositors may increasingly demand higher interest from banks as market rates rise.

Interest rates on individual deposits used to be uniformly set by regulators among all banks, essentially eliminating competition based on deposit terms. However, depositors appear to be waking up to rate differences, as shown by the success of Internet-based banks, which have collected more than ¥100 billion in deposits by offering higher interest rates. A widening gap between the interest rates offered by various banks is likely to stimulate depositors to switch to different institutions.

Another uncertainty is the imminent privatization of Postal Savings. Interest rates on Postal Savings are set slightly lower than commercial bank deposits as a counterbalance to the Post Office's advantages as a government entity. However, Postal Savings may be compelled to take a more aggressive stance after its privatization in 2007, driving competition in the deposit market even higher.

Expected Increase Of Revaluation Losses From Bond Holdings

Should medium- and long-term interest rates rise in line with a short-term interest rate hike, it would devalue the bond holdings of banks. Revaluation losses of securities holdings would not have a direct impact on earnings, but it would weaken banks' capital positions.

Should medium- and long-term interest rates rise in line with a short-term interest rate hike, it would devalue the bond holdings of banks. Revaluation losses of securities holdings would not have a direct impact on earnings, but it would weaken banks' capital positions.

The average duration of regional banks' bond portfolios is about 3.5 years (according to investor relations information), longer than the 2.5% average among major banks. Assuming that the average duration of regional banks' bond portfolios is three years, the decrease in interest income widens to 3.8% from 0.2%. Depending on the yield curve, the rate of net income decrease could accelerate if medium-to-long term interest rates rise more substantially than short-term interest rates.

The above simulations tell us that the negative impact of higher interest rates on banks' bond holdings is not negligible relative to the positive impact on lending operations. The bond effect is particularly significant depending on the maturities of a bank's bond portfolio and its yield curve.

Domestic banks carry higher interest risk than their overseas peers. This is mainly because Japanese banks tend to invest much of their surplus funds in JGBs. U.S. banks usually carry a lower percentage of bond holdings in their asset portfolio and mitigate interest rate risk through hedging and securitization. A common standard for risk control among U.S. banks is to keep interest income changes within 5% against a 1% change in interest rates.

Revaluation losses on bond holdings could be regarded as insignificant if bonds are held until maturity or if the bank holds sufficient capital. However, when interest rates rise considerably and are expected to continue to do so, financial institutions are pressed to determine whether they should continue to hold their bonds or liquidate them at a loss. Mizuho Financial Group Inc., for example, reviewed its bond portfolio and booked an ¥80 billion loss on the sale of bonds in the first half of fiscal 2005, in preparation for higher interest rates.

Bond losses could also be offset by latent profits on stockholdings, as corporate profits tend to rise in tandem with interest rates. However, the correlation between interest rates and stock prices is not stable, so banks should be wary of a divergence between interest rates and share prices.

The JGB market is heavily supported by purchases from the Japanese mega banks. Should the mega banks change their investment policies and stop buying JGBs, it could cause bond prices to slide. Borrowing demand has been sluggish, compelling banks to park their cash in JGBs, but now demand for loans is showing signs of picking up.

Confronted with a likely rise in interest rates, banks should monitor risks and review their balance of assets and debts. In addition, they may also need to shore up their earnings by focusing more on value-added services, reforming their cost structures, and boosting capitalization as a buffer against adverse changes in interest rates.

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