Taking Stock of Japanese Megabanks’ Credit Profiles in Volatile Markets

Recent market turmoil, triggered by the Bank of Japan’s interest rate hike and disappointing US jobs data, has resulted in a sell-off in Japanese megabanks’ stocks. Cash and short-duration bond investors may be wondering if they should worry about these banks’ credit profiles. Here is a balanced analysis to help them make an informed decision.

Japanese Megabank Stocks Saw Heavy Losses

On July 31, 2024, The Bank of Japan hiked its key interest rate to 0.25% from 0.10% to curb the yen’s slide against the U.S. dollar. Three days later, on August 5, concerns about more aggressive interest rate cuts in the U.S., following a weaker than expected labor report, triggered a sell-off in major Japanese stock indices. The Nikkei 225 index plunged 12.4% on that day, marking its largest single-day drop since the 1987 Black Monday crash. The three Japanese megabanks, Mitsubishi UFJ (-29%), Sumitomo Mitsui (-25%), and Mizuho (-29%), took even larger losses in the three-day period before recovering 17%, 16% and 18% , respectively, through August 21. The selloff was sharply accelerated by traders unwinding the so-called yen carry trade, which drove up the price of the yen relative to the dollar, and forced traders to sell positions in risk assets.

Investors are rightfully concerned about the credit profiles of the Japanese megabanks in a rising interest rate environment when the Federal Reserve and other major central banks are cutting rates. The question is, should these concerns be grave enough to pull back from investing in the banks’ commercial paper and other short-term credit instruments?

Reasons to Remain Constructive

We believe the following factors argue for continued support for Japanese megabanks:

• Diversified Business Models: Japanese megabanks have diversified business models, including a mix of domestic and international operations, which can help mitigate the impact of economic downturns.
• Historical Stability: Japanese megabanks have demonstrated resilience through various economic cycles and market events.
• Credit Quality: Japanese banks have a reputation for maintaining high credit quality, with a strong focus on risk management and conservative lending practices.
• Strong Capital Buffers: Japanese megabanks have built substantial capital buffers over the years, all posting Common Equity Tier 1 (CET1) ratios above 10%. These reserves provide a safety net against potential economic downturns and credit losses, mitigating credit risk.
• Regulatory Oversight: Japanese banks are subject to strict regulatory supervision, which helps ensure their stability and resilience.
• Implicit Government Support: Given their systemic importance to the Japanese economy, the megabanks are likely to receive support from the Bank of Japan and the Japanese government in times of severe stress. This could include liquidity injections, capital injections, or other forms of assistance.
• Short-Duration Focus: Short-duration bond investors have limited exposure to long-term interest rate risks, which may provide some insulation from the immediate impacts of market volatility. Over time, the banks’ profitability and asset quality may be more significantly influenced by changes in long-term interest rates.

Reasons to be Cautious

Being constructive on the megabanks’ credit outlook in the face of market volatility does not mean ignoring the challenges they face. Here are a few to consider:

• More Unwinding on the Way: The sudden shift in interest rate projections in Japan and the US led investors to unwind yen carry trades. Investors should expect the volatility to continue, which may affect the banks’ trading portfolios and potentially impact their liquidity positions and funding costs.
• Interest Rate Risk: Japanese banks continue to have significant exposure to interest rate risk via holdings in long-term bonds with low yields. A rapid increase in interest rates could lead to marked-to-market losses in these banks’ security portfolios, reducing their capital buffers.
• Economic Slowdown: Despite recent progress, the Japanese economy’s reliance on exports means that a global economic slowdown could negatively impact banks’ asset quality and profitability.

Recommended Actions

Due to the recent volatility, we advise short-duration bond investors eyeing Japanese megabanks to consider the following measures:

• Monitor Credit Metrics: Keep a close eye on the banks’ credit metrics, such as their CET1 ratios, net interest margins, and asset quality.
• Gauge Market Sentiment: Extreme market volatility can create funding and liquidity challenges for banks. Stay vigilant by following sentiment-based indicators such as credit default swap (CDS) spreads.
• Diversify Portfolio Holdings: Allocate investments across different asset classes, sectors, and geographies to minimize exposure to a particular market sector.
• Maintain a Short-Duration Focus: Stick to short-duration high-quality bonds which are less sensitive to interest rate changes and can provide a stable source of returns.

By taking a balanced and informed approach, institutional cash investors can navigate the current market turmoil and make informed decisions about their investments in Japanese megabanks.

Conclusion

While the recent market turmoil has raised concerns about the credit profiles of Japanese megabanks, their strong capital buffers, diversified business models, and regulatory support should reassure short-duration bond investors. However, it is essential to continue monitoring the banks’ credit metrics, such as their CET1 ratios, net interest margins, asset quality, signs of broader economic challenges, regulatory changes, and overall market conditions to ensure that their credit profiles remain stable.