Japanese mega banks' operating environment remain sluggish

New growth opportunities are scarce.

The uncertainties around the future success of Japan's economic reforms will put a damper on the operating environment for the country's major banks, whose earnings had been buoyed in the fiscal year ending March 2014 (FYE14) and 1HFYE15 due to optimism around "Abenomics."

According to a release from Fitch Ratings, Japan's sovereign ratings were placed on Rating Watch Negative on 9 December 2014, due to high and rising government debt, and increased uncertainty about the authorities' commitment to the objective of fiscal consolidation.

Domestic operations still dominate the Japanese mega banks' revenues and assets, but the operating environment remains sluggish and new growth opportunities appear scarce in the near term.

As such, core domestic earnings prospects remain flat, and so Fitch anticipates the banks pushing ahead with offshore expansion - organic and inorganic - to boost profitability.

However, such expansion is likely to entail additional risk, as the banks expand their interests primarily in emerging markets.

Fitch believes that execution of offshore expansion strategies will be one of the larger influences on the mega banks' Viability Ratings (VRs) over the next 18 months, as will the sovereign rating.

The fervour created by the Japanese government's plans for economic reforms stimulated local markets over the past 18 months by increasing business volumes and fee generating prospects, and propelling stock indices.

As such, the banks' still-high equity holdings boosted overall profitability and capitalisation. But Fitch views such gains as unsustainable and thus having no impact (by themselves) on the banks' VRs.

Here's more from Fitch Ratings:

That said, the mega banks have lowered their equity holdings to around 25% of their Fitch core capital (FCC). Their exposures to Japanese government bonds have also been cut substantially, though they still equate to around 2.6x aggregate FCC.

This has given the banks ammunition to build their offshore exposure, which they hope will make a larger contribution, from the current 30% (in terms of gross operating profit).

Low funding costs and higher yields from offshore loans appeal to the banks from a net interest margin (NIM) perspective, but Fitch expects growing competition in Asia to suppress overseas NIM and make meeting growth targets increasingly challenging.

As such, any substantial improvement in NIM would likely derive from a material increase in risk appetite. If that is the case, Fitch expects the banks to appropriately mitigate such risk through the building of additional capital buffers.

However, substantial improvement in capitalisation is unlikely into FYE16 as a weaker yen could further increase risk weighted assets at a time when the banks are under pressure to raise their dividend payout.

Given potential calls for legacy Tier 1 capital, the banks may issue additional Tier 1 securities in the coming few years, but such instruments themselves would not count towards their FCC, Fitch's primary measure for capitalisation.

Meanwhile, the fluid situation around total loss-absorbing capacity (TLAC) requirements makes it difficult to assess how much (or which instruments) Japan's mega banks - designated as global systemically important banks - will need to raise in qualifying TLAC over the coming years.

Nevertheless, Fitch believes that the mega banks will be able to largely satisfy the requirement through refinancing of subsidiary banks' senior debt at the parent level.