Japanese Banks: High Inherent Risk from Bond Market Volatility

As US and European banking majors were sinking under the weight of on and off-balance sheet toxic assets from the US sub-prime debacle, Japan's megabanks found themselves in the glow of unaccustomed financial health. Ostensibly, Japan's major banks survived the crisis and are generally believed to have restructured their businesses. Yet the stock prices of Japan's big three megabanks continue to tank, in an ongoing bear market that has continued since Japan's excess credit bubble burst in 1990, and aggregate market cap of the big three megabanks is even lower than it was 13 years ago at the depth of the crisis.

Simply put, Japan's banking sector has destroyed trillions of yen of shareholder capital. In November 2007, the combined market cap of the big three was about JPY22 trillion, compared to the combined market value of nine predecessor banks of the three financial groups that totaled JPY27 trillion at the end of December 1997. Further, the recent market capitalization of the three megabanks is JPY11.2 trillion, which represents a total JPY16 trillion or so of destroyed shareholder value since December 1997.

Granted, stock prices of the big three have not gone straight down. As NPLs bottomed and the government stepped in to nationalize Resona Holdings in 2003, the big three megabanks staged a powerful rally. From a combined market capitalization of JPY4.7 trillion in April 2003 to a JPY39.7 trillion high in March 2006, the market capitalization of the big three surged 8.4-fold as Japan's economy staged a recovery and interest rates began to normalize. However, it has been downhill since, with total market capitalization shrinking back to JPY10.3 trillion and stock prices peaking well before the stock market as a whole peaked in mid-2007.

In addition to a shrinking profit base, megabank stock prices have been heavily weighed down by cross-holding unwinding as banks reduce their stock holdings and corporates reciprocate, and repeated "beggar-thy-neighbor" capital calls of between JPY500 and JPY800 to bring regulatory capital up to the levels required by the new Basel Accord. Until a recovery along the lines of that seen in 2004~2006 is apparent, we see minimal upside potential in the major bank stocks.

In their October global financial stability report, the IMF noted significant inherent risks to Japanese banks from a "shock" to the Japanese government bond (JGB) market that causes a spike in JGB yields. Japanese banks remain undercapitalized compared to their global competitors as equity investments are still 75% of tangible common equity for the money center banks, profitability is weak because of the BOJ's QE and net interest margins on loans are at ultralow levels.

Such a spike actually happened in June 2003, when a sharp rise in bond market volatility sparked by investor realization that Japan's banking crisis was under control and the economy was recovering caused banks to re-adjust their assumed risk in their Value at Risk (VaR) models that led them to temporarily dump JGBs, causing JGB yields to surge from an historical low 0.45% to 1.6% in just three months. The bank regulators have been running internal risk scenarios for the regional banks suggesting that such a move would cause bond losses in the trillions of yen for the banks.