Japan Banks Cheap, But Not Cheap Enough

Japan's top three banks have had 10 percent wiped off from their market cap since the March 11 earthquake and tsunami.

Women walk past the logo of Japan's second-largest bank Mizuho Financial Group in Tokyo.
Toru Yamanaka | AFP | Getty Images
Women walk past the logo of Japan's second-largest bank Mizuho Financial Group in Tokyo.

Sumitomo Mitsui Financial Group (SMFG), Mizuho Financial Group and Mitsubishi UFJ Financial Group (MUFG) have been further knocked below liquidation value, making them very cheap to buy. But analysts say: not cheap enough.

"There's no good reason to buy Japan financials," says Brian Waterhouse, Senior Analyst for Japan Banks at CLSA. "Investing in banking stocks is not the way to play on reemerging Japan."

Kenneth Herceg, Director of Japanese Equity Sales Trading from Citi is not bullish on Japan banks either. He does not think they are a buy even at these low valuations. "Japan banks always look cheap," he says.

MUFG's price to book now stands at 0.6 times, while SMFG and Mizuho are at 0.7 and 0.8 times, respectively.

"I don't think there is much downside for bank shares right now. But on a one to two year view, these are not the stocks to buy," adds Waterhouse, who has been analyzing this sector for 34 years.

Why? The immediate reason is that the big lenders are not going to benefit from the post-quake rebuilding efforts. Says Waterhouse, "Yes, rebuilding efforts will cost hundreds of billions, but that will be the responsibility of the government. We don't think the banks will be major participants."

Lending Will Continue to Decline

In recent years, Japan Inc. has also shown a preference to tap the market directly for fresh funds, instead of going to local lenders.

Japanese firms issued bonds worth 10 trillion yen last year, and are expected to raise a similar amount this year. That is 20 trillion yen in corporate bonds over a two-year period, an unprecedented figure, according to Waterhouse.

Overall lending remained negative for the 15th straight month in February. And Waterhouse expects it to continue shrinking.

Because of slow lending, loans account for only around 40 percent of the three top banks' total assets in Japan. That's low compared with between 50 and 60 percent for European banks and 70 percent for Australian banks, according to David Marshall, Senior Analyst for Asia-Pacific Financials at CreditSights.

Net interest margin is also low - typically around one percent for Japanese banks versus above two percent for many international lenders Like HSBC.

Fee incomes will likely remain sluggish as lenders have relatively unsophisticated product offerings, says Marshall.

"On one hand, it's good that Japanese banks are taking less risks. But on the other, they are not able to charge a higher fee."

Large JGB Holdings: High Hidden Risks

Another reason to worry is their large holdings of Japanese government bonds or JGBs. The concern is that the reconstruction effort will make JGBs less valuable in the long-term, as Tokyo adds on to its already high debt burden.

Japan banks hold 40 percent of total outstanding JGBs compared with one to three percent held by Japanese households.

JGBs make up around 20 percent of total assets of the three big Japanese banks accounting for about 100 trillion yen.

With such an oversized bond portfolio, Japan banks are more vulnerable to interest rate volatility. The saving grace is that Japanese banks have limited their interest rate risk by keeping maturities relatively short, says Marshall. The longest average duration of their JGB portfolios is MUFG's 3.2 years.

But Marshall warns, "The health of these lenders essentially depends on the Japanese government's fiscal status. The current debt to GDP ratio [of over 200 percent] is worrisome."

Equity Holdings: Smaller But Significant

The other big drawback comes from these lenders' equity holdings. The three mega banks, Mizuho, SMFG and MUFG held a combined 8.42 trillion yen worth of equities as of March 10, the day before the earthquake, according to CreditSights.

The large Japanese banks have been selling down their equity portfolios after the financial crisis, but at present, equities still account for around two percent of total assets. Inevitably, banks will be hurt if there is a dramatic drop in the Japanese share market.

The Nikkei 225 fell about 20 percent in the first two sessions immediately after the quake. The index has recovered since and is now down about 5 percent.

Both Mizuho and SMFG are large shareholders of Tokyo Power Electric or Tepco, the operator of the Fukushima Daiichi nuclear power plant.

SMFG holds 2.2 percent in Tepco, while Mizuho holds 1.5 percent .Tepco has plunged nearly 80 percent since March 11, and uncertainty about the future of the nuclear power plant operator has put pressures on the banks' share prices.

But Herceg sees some positive for the banks, however slim. He believes the current environment could offer some room for banks to expand lending and margins. "Japan banks could see an up tick in lending in the next 3-6 months, because of Japan's rebuilding efforts."

Also Japan banks pay reasonable dividends. "But no one is buying Japanese banks for their dividends," says Herceg.

The outlook then for Japanese banks is far from bullish. Says Kristine Li, Senior Director of Credit Strategy, Asia Pacific from RBS, "We are bearish on Japan banks in the long term. We will see increasing non-performing loans and write-downs. And their long exposure to Tepco also poses risks. It all adds up."