Japanese banks are currently trading around their lowest valuations in more than a decade, encouraging value investors back into the sector. 
For value investors, the investment thesis seems clear. Given the current low valuations, any improvement in Japan’s interest rate environment could be exponentially reflected in the share prices of banking stocks. While this argument has merit, improving rates alone are not enough to overcome the long-term challenges that remain within the sector, including oversaturation and unfavourable demographics.
While Japanese banking stocks have looked cheap for many years, we believe there are many good reasons for this.
Weak earnings and profitability
The Bank of Japan’s (BoJ) ultra-loose monetary policy has created a very difficult environment for banks to make a profit. A combination of quantitative easing (QE) and negative interest rates have effectively scythed through Japanese bank earnings. Since 2013, the BoJ’s QE programme has suppressed long-term bond yields, resulting in a steady decline in bank earnings from lending. As bonds have matured, they have been replaced with those offering progressively lower yields, meaning the interest banks can charge on customer loans has also steadily fallen.
At the same time, weaker demand for new loans from cash-rich corporates and an aging population have compounded the negative impact on earnings. Banks were dealt another blow in January 2016, with the BoJ’s introduction of a negative interest rate policy. Designed to encourage greater spending and boost inflation, the policy has eroded bank earnings further as returns on cash reserves have all but evaporated. Given this backdrop, the earnings outlook for the sector appears weak and it is hard to see this changing soon.
A competitive environment
Japan has one of the most crowded banking industries in the world. The number of bank branches per 100,000 people, including post office branches also offer banking services, is 34 – compared with a global average figure of about 12. In highly-populated areas, the density of banking options is especially apparent, providing customers with ample choice. Given this competitive landscape, profit margins are continually squeezed.
Even if we do see an improvement in interest rates, the positive flow through to bank bottom lines is diluted, as much of this will ultimately be competed away. The saturation of bank branches is a structural problem that will continue to drag on earnings and profits until we see some meaningful sector consolidation.
Shifting population trends
The outlook for Japan’s many small and mid-sized regional banks looks particularly challenging. With a core business of domestic lending, the negative interest rate environment has been damaging. Regional banks have seen a steady decline in earnings over recent years, with many posting losses or seeing margins squeezed toward zero. In addition, populations in rural and suburban areas of Japan are declining, as well as getting older. Regional banks are acutely exposed to these structural trends and face declining prospects for growing loan portfolios.
This pressure has already prompted some regional banks to merge in order to better compete in an increasingly difficult environment. While positive, we need to see a lot more consolidation before any meaningful impact is felt. Meanwhile, other regional banks struggling to grow loan books are turning to riskier assets – as well as other businesses, like securities trading or M&A – to boost bottom lines. Given the potential lack of expertise in these areas, this opens Japan’s financials sector up to a range of possible new risks.
Opaque cross shareholdings
Japan’s history of corporate cross-shareholding is also relevant. Certainly, improved governance standards over the past decade have seen an undeniable reduction in the practice of cross-company ownership. The slow unwinding of these complex arrangements has played a part in encouraging foreign investment and helped to drive Japanese equities higher over recent years. Nevertheless, the culture of interrelated companies owning large stakes in each other’s businesses remains a feature of the market.
Nowhere is this more evident than in the banking sector, with companies relying on lenders as friendly shareholders to ensure financing, fend off takeover threats and provide united support against more demanding investors. While cross-ownership is particularly evident among Japan’s major banks, many mid-size and smaller banks also maintain similar corporate relationships. These often-opaque alliances are the antithesis of progressive governance, encouraging management complacency and diluting accountability to minority shareholders.
In short, Japan’s domestic banking environment remains challenging. Loose monetary policy, negative interest rates, fierce competition and structurally weak loan growth are all negative influences on earnings. In order to boost earnings, some banks are also diversifying into new businesses and regions, and these moves imply increased credit risk.
Archie Ciganer is portfolio manager of the T. Rowe Price Japanese Equity fund. The views expressed above are his own and should not be taken as investment advice.