The return of J-banks

21 mars 2024

View of Shibuya Crossing in Tokyo, Japan, one of the busiest crosswalks in the world.

Japan’s banking sector has long been overlooked by investors. It’s considered either not essential to own or to be avoided due to the challenges posed by negative interest rates and deflation, which have consistently squeezed bank profitability. However, the recent rally in Japanese banking stocks since 2023 signals a potential return to normalcy. So, what exactly is happening within Japan’s banking sector, what factors are driving the rally and is it sustainable?

Looking back – Deflation and Japan’s ultra-loose monetary policy

Understanding the current situation entails looking back on Japan’s prolonged battle with deflation and the rationale behind introducing negative interest rates.

Japan has experienced deflation since the mid-1990s, following the collapse of its economic bubble in the early 1990s. Various economic factors, including a domestic consumption tax hike from 3% to 5% and the Asian currency crisis in 1997, put downward pressure on the Japanese economy. In response, the Bank of Japan (BOJ) gradually reduced its policy rate throughout the 1990s, eventually adopting a zero-interest rate policy in 1999. Despite briefly abandoning this policy in 2000, the BOJ introduced quantitative easing in 2001 after the bursting of the IT bubble in the US. Further challenges emerged with China’s entry into the World Trade Organization in 2001, putting deflationary pressure on Japan by supplying cheap labour. The Great Financial Crisis of 2008 intensified the issues. Exports were sluggish due to a strong yen against dollar (USD/JPY fell below the 76 level), and declining demand amid a global recession.

Change began to emerge in late 2012 with the introduction of Prime Minister Abe’s economic policies, known as Abenomics, which included quantitative and qualitative easing measures. This initially signalled a shift away from deflation. But the momentum stopped when the government hiked the consumption tax rate from 5% to 8% in April 2014. Then BOJ Governor Kuroda committed the BOJ to achieving 2% inflation, but the target was pushed further into the future.

Recognizing the need for intervention, the BOJ introduced negative interest rates in January 2016, surprising the market and causing significant disruptions. Subsequently, the BOJ introduced its yield curve control policy in September 2016, which had been in effect until it was terminated by the BOJ earlier this week.

Turning the tides by escaping deflation and normalizing interest rates

Fast forward to today, after decades of efforts to fight deflation, Japan is finally seeing signs of progress. Inflation has been consistently above the BOJ’s targets of 2% since May 2022, helped by price hikes and wage increases.

Historically, Japanese companies are reluctant to pass on higher costs to consumers or clients, fearing it may damage the relationship. Instead, they turn to cost-cutting measures internally. However, the unprecedented challenges during the pandemic forced many companies to negotiate higher prices with customers. To their surprise, most customers were cooperative and willing to accept the price increase, leading to improved margins across industries. The mindset of Japanese companies is also starting to change, where they are becoming more willing to pass on higher costs and reduce unprofitable businesses.

Additionally, Prime Minister Kishida’s government has been pushing corporates to increase wages, a key policy of its “new form of capitalism” campaign. Finally in April 2023, labour unions in Japan won the biggest pay increase in 30 years in their spring wage negotiations with management, achieving an average wage hike of 3.7%. In 2024, the union group announced an even higher raise of 5.28%. Although this largely applies to the biggest companies in Japan, smaller employers are likely to follow suit given the country’s tight labour market. With higher disposable income and improved consumer sentiment, the virtuous cycle should be able to support the sustainability of inflation. As a result, the BOJ decided to guide overnight lending rates to 0% to 0.1%, up from -0.1% to 0%, marking the first time the BOJ has raised its interest rates in 17 years.

Rallying behind banking: Equity markets and corporate governance reform

Equity markets are starting to view Japanese banking stocks as normal investment targets once again due to the end of deflation and interest rate normalization.

Another positive change is corporate governance reform. Although it has been several years since the Corporate Governance Code was established by the Tokyo Stock Exchange (TSE) in 2015, 2023 saw the most changes at Japanese publicly listed companies after the TSE called on companies’ management to be more mindful of the cost of capital and stock prices to enhance corporate value. This initiative particularly targets companies with price-to-book ratios below 1x. The vast majority of Japanese banks trade at a significant discount to their book value. Responding to this request, many banks laid out improvement plans aimed at enhancing Return on Risk-weighted Assets (RORA), Return on Equity (ROE) and shareholder returns.

Looking ahead, the prospects of Japanese banks appear promising, with sustainable inflation driven by economic growth and wage increases. In addition, the relocating of manufacturing facilities back to Japan amid the onshoring and reshoring trend, and increased loan demand, are also expected to benefit the sector. Japan is still in the very early phase of rate normalization, and Japanese banking stocks are still in the process of returning to normal compared with Japanese stocks in general. The improving financial metrics should also help J-banks to be more comparable to their global peers.

Spotlight on Concordia Financial Group

We initiated a position in Japanese regional bank Concordia Financial Group (7186 JP) in 2023. Concordia FG consists of three banks – the core is Bank of Yokohama, with over 100 years of history – and two other smaller banks, Higashi-Nippon Bank and Kanagawa Bank, which the group acquired in the past few years. As one of Japan’s largest regional banks, Concordia FG boasts efficient operations and strong loan growth, particularly in Tokyo and the Kanagawa Prefecture, which have seen the highest net migration from other areas and strong banking demand due to high concentration of corporates and SMEs.

Unlike some of the problematic regional banks in the US that rely on corporate deposits, Japanese banks have accumulated their deposits over time from loyal retail customers. In the case of Concordia FG, over 70% of deposits are from retail channels. Even after the bank run at Silicon Valley Bank (SVB) in March 2023, deposits at Concordia FG continued to grow steadily, with no obvious change in customers’ banking behaviour. The bank maintains a low securities-to-asset ratio of 12%. The same ratio was over 50% for SVB. The bank also has very tight risk controls in its lending practices, maintaining a conservative loan-to-asset ratio of 85%. The banks’ loan portfolio is well-diversified, with no exposure to the commercial real estate sector in the US.

Further prospects and technological advances

Despite Japan’s rising personnel costs, Japanese banks’ management teams remain committed to controlling costs. Recent years have seen continued downsizing efforts, including branch closures and reductions in the number of ATMs. Branch closures are not simply an effort to reduce network size, but part of a strategic shift to increase online banking usage and enhance convenience for consumers. Efforts include expanding the number of ATMs at convenience stores and providing non-branch ATMs in collaboration with other major banks.

Another Japan-based bank we invest in, Seven Bank (8410 JP), is expected to benefit from this trend. With banks seeking to streamline their ATM fleets, some have chosen to partner with Seven Bank, boasting the largest ATM network in Japan with over 27,000 ATMs. Its next-generation ATMs offer advanced features beyond simple deposits and withdrawals, including face recognition for identity verification, settlement with QR codes and the ability to open bank accounts. It also utilizes AI and IoT to predict cash demand more precisely and detect potential component failures, which helps to optimize ATM operations.

As Japan’s banking sector continues to adapt to evolving economic conditions, we remain optimistic about its long-term prospects.

Gestion d’actifs Global Alpha Ltée
mars 21st, 2024