Are Japanese banks' earnings really bouncing back?

Is Japanese major banks' sharp recovery real?

   Earnings are recovering rapidly at Japan's major banks. But it is probably too early to say that their bottom lines are in the pink again and about resume a growth track.

   For three subsidiary banks under the Mizuho Financial Group, combined net income in the first quarter (April-June) of the year ending March 31, 2006 rose 83% year on year to 287.9 billion yen (non-consolidated). Bank of Tokyo-Mitsubishi posted an increase of 49.2% to 67.9 billion yen, and for Sumitomo Mitsui Banking Corporation (SMBC) the rise was 13.6% to 169.7 billion yen. At UFJ Holdings, which booked a 95.1 billion yen loss last year, two subsidiaries posted a combined net income of 161.9 billion yen.

Reduction in nonperforming loans is driving the recovery

   The main reason for the banks' revival is smaller losses on disposal of nonperforming loans. Mizuho booked 119.4 billion yen in the preceding year in such losses, but this term the total has shrunk to 5.8 billion yen. UFJ too has seen a dramatic improvement, from 740.0 billion yen to 10.7 billion yen. At the same time, due to improved balance sheets at borrowers amid an upturn in corporate profitability, banks are seeing gains from reversal of loan loss reserves built up over the years. At the Mizuho, Bank of Tokyo-Mitsubishi, and UFJ groups, nonperforming loan settlement accounts have actually turned positive due to these reversals, pushing up earnings substantially.
   But Japan's banks are not out of the woods yet. Interest income-income generated by the interest margin (spread of interest paid on deposits compared with interest received on loans)-is the backbone of banking revenue, accounting for some sixth-tenths of major banks' gross business profit. Only Mizuho posted a year-on-year increase in interest income. Of the other groups, UFJ saw interest income decline 13.9%; for SMBC the slide was 13.6%, and at Bank of Tokyo-Mitsubishi it was flat. With corporate borrowing demand failing to grow strongly and yields on loans continuing to dwindle gradually amid intensified competition, the difficult operating conditions faced by banks in Japan have hardly improved at all.

Nonperforming loans could surge again

   We should not be complacent about the sharp fall in losses on disposal of nonperforming loans. Currently the Financial Services Agency, Japan's main supervisory authority for the banking sector, conducts regular annual inspections into Japan's major banks, and passing these financial checkups has become a kind of guarantee of banks' soundness. If the Agency's inspectors find that a bank has understated borrowers' credit risk, the bank in question is forced to build up its loan loss reserve again and take other measures to deal with bad debt.

   However, Agency inspections grew more rigorous from September 2005 in line with this tougher approach and its possible results, banks could suffer a new surge in losses from disposal of nonperforming loans in the period to March 2006. A case in point: SMBC was expecting nonperforming loan losses to total 450.0 billion yen for the term ended March 31, 2005, but Agency inspectors doubled that figure. As a result, the bank could suffer a net loss.
   Even at top European and US banks with deep experience of bad debt management, credit costs from "frozen" and nonperforming loans can account for 0.1-0.2% of their loan balance. In this light, we may wonder at the minute total (5.8 billion yen) of losses on disposal of nonperforming loans posted by Mizuho between April and June on its \60 trillion-worth of loan assets.