Mounting fears of rising bad debt at Japan's banks

AGGRESSIVE attempts by the Bank of Japan to force-feed local business with new bank loans in order to get the nation's economy moving again have been gaining traction lately. But some are beginning to worry that an unintended consequence could be a mounting level of bad debt in the system.

The good news is that, according to published data by the BoJ, Japan's "recent economic recovery has had positive effect on the profits of financial institutions through gains from investment in stocks, sales of investment trusts and decrease in credit costs".

The bad news is that "core profitability (of banks) relating to deposits and loans has remained on downward trend, mainly due to the continued narrowing of interest rate spreads on loans" while "business conditions among regional financial institutions are particularly severe".

This "does not immediately affect the stability or functions of the overall financial system", the BoJ said, but the decline in core profitability "is a challenge that should be resolved because it may constrain financial institutions' ability to absorb losses and take on risks".

BoJ officials declined to comment on the record about these trends but there are expressions of concern among some of them in private. Japan pulled through a massive banking crisis in the 1990s after the collapse of its bubble economy and it has had a long fight back to good health.

While the Japanese banking system did recover quite robustly, bank lending stagnated in line with the stagnant economy as neither business nor consumers were anxious to take on new credit while they continued paying down old debts.

All this changed when Prime Minister Shinzo Abe's Liberal Democratic Party swept to political power in Japan at the end of 2012 and Mr Abe installed a new governor at the BoJ, Haruhiko Kuroda, to spearhead an aggressive monetary drive aimed at ending deflation and reviving the economy.

A key part of this drive was for the BoJ to make huge purchases of government bonds and other financial assets from banks so that they in turn could turn on the credit taps for Japanese business and consumers. The central bank pumped out term loans at guaranteed low interest rates to push banks into lending.

But analysts say Japanese firms are not responding to "Abenomics" in the hoped-for way by investing in new plant and equipment and borrowing money to finance such investment. Also, loans for housing and durables are liable to be hit by the recent sales tax hike in Japan.

The upshot of all this is that Japanese banks - a plethora of smaller regional banks in particular - are now competing aggressively for what lending business is available, driving down spreads in the process and risking an erosion in credit quality.

At the same time, banks located in those still many regions of Japan that have yet to feel the full benefit of Abenomics are invading the turf of bigger banks in cities and urban areas, again driving down profitability and risking a potential rise in non-performing loans.

Another factor involved is that huge swathes of Japanese manufacturing business have moved abroad in recent years, so much so that a good deal of financing for new investment is also done offshore. This also means that Japan's exports are not responding as hoped to the weaker yen.

Finance officials will not say so openly but what they appear to fear is that the financial system continues to be pumped full of new liquidity which could contribute to an asset bubble and a rise in non-performing loans rather than fuelling new domestic investment and consumption.

The BoJ warned in its latest Financial System Report published this month that "attention should be paid to the possibility that the impact of an economic downturn and a rise in interest rates (might) spread to the financial system depending on the speed and extent of (such) a downturn".

Some financial institutions, the BoJ added rather ominously, "have relatively weak capital bases and are behind the curve in improving asset quality following the Lehman shock (in 2008). These institutions need to steadily strengthen their capital".