Don’t be fooled by Japanese banks’ offshore growth: Fitch

Accumulated amount of all overseas investments by Japan's mega banking groups is about 2% of Tier 1 capital - but Fitch believes this growth is negligible in the near term.

In a release, Fitch Ratings says that active overseas expansion by Japanese mega banking groups has the potential to cover their weak domestic earnings and improve internal capital generation. However, absent any unexpected material developments such as major acquisitions, any immediate earnings growth outside of Japan is unlikely, and hence Fitch believes the impact of the banks' overseas growth alone on their ratings should be negligible, at least in near term.

Fitch estimates the accumulated amount of all overseas investments in financial institutions by Japan's three mega banking groups - Mizuho Financial Group, Inc., Sumitomo Mitsui Financial Group, Inc. and Mitsubishi UFJ Financial Group, Inc. - to be about 2% of Tier 1 capital for fiscal year ended March 2011 (FYE11) both at Mizuho (including a planned acquisition of Vietcombank) and SMFG. The figure is estimated to be at least 20% of Tier 1 capital at MUFG, reflecting investments in UnionBanCal Corporation ('A'/Stable) and Morgan Stanley ('A'/Rating Watch Negative), as well as the acquisition of a project finance asset portfolio from The Royal Bank of Scotland Group plc ('A'/Stable).

Earnings from overseas operations have been growing steadily as a result of both organic and non-organic growth, although they remain less than 20% of total gross profits (using sum of net interest revenue and fee income) at all three banks in FYE11 and have not been enough to drive earnings growth.

Stronger growth prospects in overseas markets, particularly in Asia, are the main reason for the mega banks' current interest in overseas expansion. Fitch notes that the attraction to overseas credit exposures also partly stems from their higher yields relative to domestic loans, while loan loss charges remain low, with NPL ratios in the major banks' overseas loan book at 0.9%, 1.5%, and 1.1% at Mizuho, SMFG, and MUFG, respectively in FYE11. Although competition for higher loan yields remains intense, especially across Asian markets, the mega banks may be able to offset this through growth in loan balances.

The agency also notes that returns on non-organic investments - as measured by percentage of annual profit contribution from investments - are also generally higher than yields earned from domestic assets including loan-deposit spreads in Japan and 10-year Japanese government bond yield (10-year JGB yield is around 1%), although the level of risks between the non-organic investments and domestic assets is not directly comparable.

Overseas organic growth without compromising risk management will take time and is unlikely to result in any immediate material increase in earnings given the Japanese banks' limited franchise in foreign markets, in Fitch's opinion. The agency therefore notes possibilities for them to continue making further incremental investments in overseas financial institutions to supplement organic growth.

However, Fitch does not expect future transactions to be materially larger than witnessed in recent years as the banks will face capital constraints under new regulatory Basel III rules. Given slow internal capital generation at the mega banks, Fitch believes it will take time for them to accumulate sufficient capital to make material overseas investments.

Until there is evidence that such overseas expansion can be executed successfully and prudently, the agency will continue to take a cautious view given the Japanese banks' lack of track record of success in making their overseas operations meaningful and sustainable profit contributors.