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Fitch: Gradual Interest Rate Hike in Japan Positive for Banks

Fitch Ratings argued that the tightening of Japan’s monetary policy, including increases in policy interest rates, would help lift Japanese banks’ domestic net interest margins (NIM).

Fitch’s assessment stated:

“The decision of the Bank of Japan to raise its benchmark unsecured overnight call rate target by around 10bp to the range of 0%-0.1% follows the central bank’s adjustment of its Yield Curve Control policy in 2023. Fitch expects further gradual tightening of the policy over the next two years, but we only anticipate the policy rate to rise to 0.25% by the end of 2025.

Profitability is the weakest aspect of the independent credit profiles of the banks we rate, but higher domestic loan NIMs will support overall profitability, even considering banks’ plans to increase deposit rates. Higher reinvestment yields on securities such as Japanese government bonds (JGBs) will also enhance profitability if policy rates are held at the higher levels we expect over the medium term.

However, we believe that interest rates will need to rise significantly above our projected levels for 2024-2025 to affect the profitability factor in our assessments of banks’ credit profiles, particularly considering the possibility of factors that would partly offset the increase in NIMs, thereby exerting pressure on profitability. These factors include short-term realized valuation losses on existing Japanese securities portfolios, potential adverse foreign exchange effects on profits earned outside Japan if the yen strengthens further with higher rates, and higher funding costs. If Japan experiences structurally higher inflation and wage growth, this could also make it more difficult for banks to contain their costs.

We expect profitability for regional banks to provide less uplift compared to mega banks. NIM increases will be weaker for them due to the potential difficulty in raising lending rates and their higher exposure to market risk. Regional banks tend to have longer duration JGB holdings compared to mega banks, exposing them to larger valuation losses as yields rise but also offering higher returns on reinvestment.

Capitalization could improve over time if banks prefer to retain some of the earnings growth. Our outlook for banks’ capital factor scores is currently negative, reflecting our view that they will remain under pressure due to the increase in risk-weighted assets resulting from the implementation of final Basel III rules, as well as vulnerabilities to global market valuations and volatility.

Additional effects on banks’ credit profiles could arise through the impact of currency liquidity and general market risk, as well as potential changes in banks’ strategies and risk appetites (though the latter is not our base case). We expect mega banks to continue expanding overseas, particularly in the US and APAC, but higher domestic NIMs may lead them to focus more on the domestic market.

If we consider the higher likelihood of Japan experiencing stable inflation accompanied by moderate wage increases supporting consumption and sustainable economic growth, this improved macroeconomic outlook, along with the potential upward effect of higher interest rates, could support a revision of the banks’ Operating Environment (OE) factor score from ‘a-‘ to ‘a’. However, it may take time for the net effect of wage and price dynamics on medium-term economic growth expectations to become clear.

An upgrade of the OE score to ‘a’ would not create upward pressure on the independent Viability Ratings (VRs) of Japanese banks, while a downgrade from ‘a-‘ to ‘bbb+’ could lead to some banks having their VRs lowered. Under an ‘a-‘ or ‘a’ OE score, upgrades to mega banks’ ratings would require sustainable improvement in profitability, supported by successful implementation of management strategy and a continuously maintained activity profit/risk-weighted asset ratio above 1.4%—the latter being reflected by maintaining ordinary Tier 1 equity at above 15%.”

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Yemliha Toker

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