Japanese banks' margins hit record low as negative rates, steep forex costs bite

Profits are under threat on several fronts.

Japan's largest banks will continue to grapple with shrinking net interest margins (NIM) on back of weak economic growth, the central bank's negative interest rate policy, and higher foreign-currency funding costs, according to a report by Fitch.

The report noted that NIMs at the three Japanese "mega banks" - MUFG, SMFG and Mizuho - have declined steadily since 2010, with the average NIM falling to a multi-year low below 0.7% in the fiscal year ending March 2016.

Fitch reckons that the pace of economic growth to remain at less than 1% through the medium term, and domestic loan demand will remain sluggish despite a slight uptick in investment activity.

Meanwhile, the Bank of Japan's negative interest-rate policy is also a net negative for the banking system, but the mega banks are likely to be less affected than regional banks.

Fitch estimates that this will add to pressure on domestic NIMs, and is likely to mean that banks will seek to maintain their overseas build-out, which could entail higher risk and add to their challenges in funding and capital management.

Foreign lending has been rising steadily over the past several years as banks have sought higher yields and diversification - primarily in the US and Asia. Rising overseas risk appetite could help bolster profitability, but Fitch believes that it will lead to a shift down the credit curve, and asset quality for foreign assets could face greater pressures.

Expansion abroad will also mean that the mega banks may need to strengthen foreign-currency funding. Foreign-currency deposits have already begun to rise significantly since 2011, bringing the overseas loans/deposits ratio steadily downward. Furthermore, foreign-currency funding costs have risen since the latter half of 2015, due partly to expectations of higher US rates.