Japan has some of the world’s biggest banks. They are notable for their immense size. They are just as well known for their low profitability and the limited scope to improve profits in their home market.
The Bank of Japan, the central bank, lamented the strikingly low profitability of Japanese lenders as recently as October in a report on the health of the financial system.
It should know. Its decision to push ahead with negative interest rates in January 2016 – an attempt to resuscitate a flat-lining domestic economy – further limited the banks’ ability to make a profit.
When David Marshall, an analyst at CreditSights, surveyed Japan’s banking sector at the end of 2016, he painted a grim picture and described the sector as “non-profit banking”.
He pointed to falling net interest margins, weak loan growth and the demographic cliff that has haunted Japanese policymakers for years: 27% of Japan’s population is aged 65 or over, compared with an average of 17% for OECD countries.
Is Marshall’s a fair description? By the end of the first half of Japan’s financial year on September 30, 2017, two of the three megabanks – Mitsubishi UFJ Financial Group (MUFG) and Sumitomo Mitsui Financial Group (SMFG) – managed to book double-digit increases in net income, with only Mizuho seeing its profitability fall.
But a closer look at the numbers is more revealing.
Mizuho and SMFG both shrank their loans to domestic clients between March and September 2017, while MUFG managed only to keep its own domestic loan portfolio flat.
More alarmingly, the three banks are being forced to stomach net interest margins of between 0.4% and 0.7%, according to CreditSights, which is considerably lower than the roughly 3.15% that US banks can earn, according to data from the St Louis Fed.
Faced by this rather depressing picture, MUFG, Mizuho and SMFG have taken two tacks. One is a series of cost-cutting measures that sound ambitious but that, according to some Tokyo-based bankers, may not amount to much in the near term.
Mizuho has said it will cut 19,000 jobs, albeit over the rather lengthy horizon of the next 10 years. MUFG wants to automate thousands of jobs, but this does not necessarily mean eliminating headcount, according to one person who was briefed on the plan. SMFG has a similar plan to reduce staff by 4,000 in what it described as non-focus areas, possibly by just transferring them elsewhere.
Japanese banks need to get access to cheap dollar funding, and they can best do that by acquiring consumer deposits in the US- Jonathan Kindred, Morgan Stanley
The other strategy the three banks have all embraced to some degree is diversifying away from their domestic market.
“Regardless of the policies of the Bank of Japan, the aging population means we know this market is going to get smaller,” says a senior banker at one of the megabanks. “We have no choice but to look outside Japan for growth.”
MUFG, the largest of the three by assets, has been the most aggressive in its overseas acquisitions, taking stakes in Morgan Stanley, Vietinbank and Security Bank of the Philippines, and taking control of Union Bank of California and Thailand’s Bank of Ayudhya.
Mizuho and SMFG have been less acquisitive offshore, but neither has sat on its hands. Mizuho bought the North American assets of the Royal Bank of Scotland in 2015. SMFG nabbed General Electric’s European private equity financing business in the same year and acquired a US railcar leasing business in June 2017.
In Tokyo, the experts Asiamoney spoke with all agreed that this overseas push was only just beginning. The disagreement came when we asked how exactly the three banks should pull off that expansion and where they should go.
Japanese banks face a very big hurdle when attempting to find overseas markets in which to expand: their sheer size.
MUFG had total assets of ¥303.3 trillion ($2.7 trillion) at the end of March 2017. That makes it bigger than any European or US bank, according to a report that S&P Global Market Intelligence put out in May. The only other banks with a bigger pool of assets are China’s big four state-owned banks: Agricultural Bank of China, Bank of China, China Construction Bank and Industrial & Commercial Bank of China.
Where can such an enormous bank turn to if it is to increase its profits in a meaningful way? Where should SMFG and Mizuho, which face the same hurdles and can boast assets of around $1.75 trillion each, turn for their own offshore expansions?
These questions came up repeatedly on Asiamoney’s recent trip to Tokyo. The suggestions offered to us, by a mix of megabank employees and foreign rivals, broadly fell into two camps: the US consumer market or pan-Asian investment banking.
The fact that these different geographies also call for different market approaches should come as little surprise.
The growth of Asia promises an ever-expanding pool of investment banking fees, much of which will come from Japanese firms moving overseas. But the region’s deposit base is too small for Japanese banks, even in the unlikely event that they could become big deposit-takers in any particular southeast Asian country.
The US is the opposite.
According to figures released by the Federal Reserve in December, the country’s commercial banks hold deposits of $11.9 trillion. Breaking into that market is a tantalizing proposition for Japan’s megabanks, but muscling in on the country’s hyper-competitive investment banking landscape looks altogether more difficult.
“Can they compete with Goldman Sachs and Morgan Stanley in investment banking? No,” says a Japanese banker at a foreign firm. “Can they compete with Citi, JPMorgan or Bank of America in corporate banking? No. They need to focus on buying regional banks [in the US], but that requires really knowing the local economies well.”
Most rivals agree that the most sensible acquisition for a Japanese bank in the US would be a regional player. But the focus on smaller banks – at least small by US standards – throws up a number of obstacles. The first is finding the right target.
“If a decent target were to come up which wasn’t hugely overbid and over-priced, they would all be interested,” says Orlando Faulks, head of corporate finance, Japan, at Deutsche Bank. “The difficulty is getting the right target. It has to be big enough to be interesting and not full of bad loans. Then you have to ask: why are they selling?”
The last important US regional bank acquisition by a Japanese lender was finalized in 2008, when MUFG bought the 35% or so in Union Bank of California it did not already own.
The deal was suggested to Asiamoney several times as a good example for others to follow, but it is clear that while there were bargains on offer in 2008, prices have gone up since then. This is another problem facing Japanese banks.
US regional banks were trading at an average price-to-earnings ratio of 18.7 on December 11, 2017, according to data from Morningstar. That is not an absurd valuation in US terms given that the average for the S&P500 was 22.7, but since Japan’s megabanks all trade at stock prices of less than 10 times earnings, they may be reluctant to pay up to break into the US, bankers say.
The megabanks would be more tempted if they regarded US bank acquisitions as a way of getting access to cheap dollar funding, rather than simply considering the market in isolation.
Japanese banks can use their dollar funding base to lend to clients across the world, including funding overseas acquisitions from their domestic clients, so increasing their US presence could help in that regard.
|Jonathan Kindred, president and chief executive of Morgan Stanley Japan|
“The US is obviously the richest market in terms of opportunity,” says Jonathan Kindred, president and chief executive of Morgan Stanley Japan. “It also happens to be rich in price right now, but the banks need to get access to cheap dollar funding, and they can best do that by acquiring consumer deposits in the US. This should be an important initiative of theirs.”
The other issue is finding reliable local management. Several rivals say this hurdle is particularly worrisome because Japanese banks may be wary of falling too closely under the watch of US banking regulators, a scary proposition given the willingness the Federal Reserve has shown in imposing heavy fines on banks that fall short of its standards.
“The Japanese banks have not bought anything since Union Bank of California; the reason is that I think they rightly felt you can’t run a US bank,” says Tetsuya Kodama, chair of Barclays in Japan.
Referring to Nobuyuki Hirano, the well-respected chief executive of MUFG, Kodama wonders: “Do we have the Hiranos that can run a bank like that? People are a bit scared.”
None of these obstacles is insurmountable, but the lack of activity since MUFG’s acquisition of Union Bank of California shows they are certainly slowing things down. What about the other idea: making an overseas investment banking push?
This approach has been given more focus by the megabanks, but when you discuss it with Japanese bankers and their foreign rivals, one name comes up again and again: Nomura.
Nine years ago, Nomura was the poster-child for Japanese banks with global investment banking ambitions. Now, it is used as a case study to show just how easily things can go wrong.
Nomura case study
Nomura’s recent performance shows the difficulty of making overseas operations work consistently. The bank’s farthest-flung overseas divisions – Europe, the Middle East and Africa (EMEA) and the US – both fell back into losses in the second quarter of the 2017 financial year.
The big problem was tumbling fixed income revenues in both regions, says Marshall at CreditSights.
The losses in EMEA and the US did not spell doom for Nomura, since its profits in Asia ex-Japan make up the shortfall. But the net balance means a “near total reliance on Japan” for earnings in the second quarter, according to Marshall. As Moody’s put it at the end of October, Nomura’s operating performance meant that “the viability of the overseas operations [are] again in question”.
The bank bought the European and Asian operations of Lehman Brothers in 2008, helping draw a line under a crisis that threatened to engulf the entire US banking system.
A problem was that Nomura was unable – or perhaps unwilling – to keep its top-paid stars.
Some now question quite what Lehman has added to Nomura’s business. The firm has made impressive strides in bulking up its fixed income offering, but the progress does not appear linked to the Lehman acquisition. As for equities, Nomura cut the European equities business in April 2016.
Nomura’s travails with Lehman offer a warning to other Japanese banks looking to make meaty investment banking acquisitions overseas. But why did Nomura struggle to make the most of the acquisition?
The common answer is that the Japanese bank failed to merge its own culture with Lehman’s own swashbuckling, risk-taking approach to the world. This is a simplistic answer but one that comes up again and again when the acquisition is discussed.
It is tough enough to marry cultures – recall the scepticism about merging Bank of America and Merrill Lynch, for instance – but these problems increase many times when it is a Japanese bank swallowing a US investment bank.
“The foreign bankers bring their own people in, the culture doesn’t fit, and generally it becomes a race against the clock for when the banks will pull the plug on them,” says a senior foreign banker in Tokyo.
This is a conundrum facing Japan’s megabanks as they explore their overseas investment banking ambitions. But they do not need to take an all-or-nothing approach. Those with long experience of Japanese banks suggest they take baby steps instead.
For example, Mizuho hired more than 100 investment bankers from Royal Bank of Scotland in 2015, shortly after agreeing to buy RBS’s North American loan portfolio. This was “clearly a big positive” for the Japanese bank’s attempt to win offshore debt capital markets business, according to the head of capital markets at a rival firm.
“Thinking about Japanese culture, this smaller way of expanding makes more sense,” he says. “Buying a whole bank is going to cause big cultural difficulties.”
There is also one obvious move that Japanese banks should do to expand their offshore business while at the same time avoiding too many cultural problems, in part because it would require less hiring. They can follow their own domestic clients, many of whom are turning overseas for growth.
Comfort for corporations
Japan’s corporations should feel much more comfortable than the country’s megabanks at the moment. Corporate profits are on a tear, easily on track for their best-ever year, according to Nicholas Smith, Japan strategist at CLSA.
A strong global economy has ensured buoyant demand for Japanese exports, helped by the weakness of the yen. But, perhaps certain the boom time cannot last, Japanese companies are making efforts to move overseas.
SoftBank, the ultra-acquisitive technology company run by Masayoshi Son, has hogged the headlines with a seemingly endless series of deals that includes the $31.8 billion purchase of UK chip designer ARM Holdings.
Asahi struck two deals for the European assets of Anheuser-Busch InBev last year, paying a combined $10.6 billion; Takeda Pharmaceuticals paid around $5.5 billion for Ariad in the US; and NTT Data Corp bought Dell’s IT services business for just over $3 billion.
“Outbound M&A is on a structural rising trend, and that looks very much set to continue,” says Deutsche’s Faulks. “It used to be the preserve of the mega-cap company, but you’ll start to see smaller companies going offshore for M&A now. They will have gained confidence seeing the big companies make a success of it.”
This is not, however, the great news it might at first seem for Japan’s megabanks. Although Japanese companies moving into other markets certainly give the megabanks a chance to expand their overseas lending or transaction banking businesses, they are generally not enjoying a boon in fees from these M&A deals. Instead, Japanese companies are relying on foreign banks more often than not.
“They have potential to provide bridge loans and perhaps refinance some of the debt that arises,” a banker at a foreign rival says. “But when it comes to winning advisory slots, Japanese companies are going to expect you to understand the target well.”
The exception is Mizuho. The bulk of the M&A advisory work the bank has done has been on reasonably small deals, such as the $781 million acquisition of certain US assets of Air Liquide by Mitsubishi Chemical Holdings or Tokyo Century Group’s $595 million purchase of an aircraft leasing company in the US. But by getting close to SoftBank, Mizuho has managed to get a foothold on two multi-billion dollar deals: the $3.28 billion takeover of Fortress Investment Group and the mega-takeover of ARM.
In DCM, the megabanks have had much more success taking advantage of the offshore push by Japanese corporations. Japanese issuance of dollar and euro bonds had hit $132 billion by December 12, 2017, according to Dealogic data. That is already an increase of more than 28% from 2016, which was itself a record year for offshore issuance from Japan.
Japanese banks have made the most of this rise in issuance. Mizuho was the fifth-choice bookrunner for Japanese firms going to the dollar or euro markets in 2017, closing $41.4 billion of transactions. SMFG made eighth place with $25.2 billion of deals. MUFG, which split its league table credit with Morgan Stanley because of the joint venture between the two banks, still clinched eleventh place with $17.6 billion of deals. (When combined with Morgan Stanley, its $47.8 billion dollar and euro deals for Japanese issuers would push it past Mizuho.)
This is good news. The problem is that it means Japanese banks will rely on the same list of clients that are struggling to make money from onshore, rather than building new ones. To truly expand their investment banking franchise without tussling too frequently with the biggest and best US and European banks, their rivals suggest Japanese banks look to Asia.
Southeast Asia problem
Although MUFG sold its stake in Malaysia’s CIMB in September, the Japanese bank has been the clearest in adopting a strategy of spreading across Asia.
MUFG’s stakes in Vietinbank, Security Bank of the Philippines and Bank of Ayudhya have given it access to three fast-growing countries in southeast Asia.
Reports that it was looking to take a 40% stake in Indonesia’s Bank Danamon would mean it also had access to the biggest economy in that region. (MUFG sent a carefully worded rebuttal to questions from Asiamoney on this acquisition, saying the reports were “not based on any announcement made by us”.)
Southeast Asia is the obvious place for Japanese banks to expand, rivals and megabank employees say. China appears off-limits for any big push for political and regulatory reasons. South Korea and Taiwan offer little in the way of growth , whereas southeast Asia, which the Asian Development Bank thinks will grow 5% this year, appears a much more sensible bet. As long as Japanese banks are willing to wait.
The problem with southeast Asia as an alternative to the US consumer market is the small size of economies in the region and, even worse, the small size of the region’s banking systems.
To take an extreme example, MUFG could buy every single bank and non-bank financial institution in the Philippines and barely add 10% to its asset base. This despite the fact that bank loans tend to dominate financing options in the country, leaving little room for the bond market to play a role.
Clearly, a push into southeast Asia investment banking is not going to have an immediate impact on Japanese banks.
But many of those interviewed by Asiamoney still think southeast Asia is the best place for Japanese banks to expand. The presence of Japanese companies across the region can ensure consistent revenue streams over the next decade; the heady growth prospects of the region can then take centre stage when the time is right.
“Asia may be small, but it is growing,” says the head of investment banking at a Japanese firm. “Asia as a whole could be bigger than the US consumer market in 10 years. It makes sense for them to focus on investment banking there.”
This is not, of course, an either/or distinction. Morgan Stanley’s Kindred, while pointing out that a push into US banking should be a priority for Japanese banks, sees no reason for that to get in the way of a steady build-out closer to home.
“In the long term, they should be planting seeds in Asia and creating the right footprint there,” he says.
In any case, all agreed that the urgency for Japanese banks to move overseas was only getting stronger.
In this context, the reasonably slow pace of deals, especially from SMFG and Mizuho, may come as a surprise. There are no easy answers for firms that still depend on their domestic markets for much of their revenues, but which can no longer rely on domestic sources to drive their profit growth.
“It’s really difficult for the Japanese bank CEOs right now,” says one sympathetic foreign rival. “As a Japanese person, I want the megabanks to be successful overseas, but it is so tough.”