Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

Primary Credit Analyst: Ryoji Yoshizawa, Tokyo (81) 3-4550-8453; ryoji.yoshizawa@standardandpoors.com Secondary Contact: Kiyoko Ohora, Tokyo (81) 3-4550-8704; kiyoko.ohora@standardandpoors.com

Table Of Contents
Customers Are Blazing A Trail Overseas Overseas Expansion By Japanese Banks And Its Economic Rationality Japanese Banks Face Hurdles Expanding Overseas Notes Related Criteria And Research

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results
Efforts by Japanese banks to further expand their overseas business in recent years have achieved some success, but changes to their earnings structures pose risks, in Standard & Poor's Ratings Services' view. The promise of larger returns has attracted Japanese companies--the core customers of the banks--overseas as unfavorable demographic shifts and lackluster capital investment weigh on the domestic market. The ratio of ordinary profits generated by overseas subsidiaries of Japanese companies to those generated by domestic entities has risen to 45% from 8% in the past decade. To cope with these changes by customers, Japanese banks, especially major banks, are accelerating development of overseas business by expanding their own overseas offices and forming capital and business tie-ups with foreign financial institutions. Overview Japanese companies have expanded overseas significantly. Japanese banks have responded by expanding their networks and forming tie-ups with overseas banks. The banks have achieved a certain level of success and economic rationality, with overseas lending outperforming domestic lending. Potential risks include foreign currency funding, competition with major banks in local markets, and encountering differences in corporate culture in capital tie-ups and business development.

In response to changes in customers' needs, Japanese major banks (the three megabank groups) generated 18% of consolidated operating profit from their overseas-related businesses in fiscal 2012 (ended March 31, 2013). This ratio is up 5 percentage points from five years ago, and overseas-related business has performed favorably from a risk-return perspective. For example, overseas lending has performed better than domestic lending for the past five years, in terms of both spreads and the sum of three-month delinquencies and default rates. As such, major banks' overseas business development, which we consider a consistent reaction to their customers' needs, has so far achieved some positive results, in our view. Nevertheless, we see several risk factors when considering the banks' overall earnings structure and future business development. As core profits from the domestic customer segment have been falling--as much as 32% from five years ago--any deterioration in risk and return from overseas-related business would have a larger impact on banks' creditworthiness. Foreign currency funding, in particular, remains a key risk factor for banks expanding overseas. In addition, capital tie-ups between Japanese major banks and overseas banks, which have been increasing in recent years, are expected to bring significant returns. At the same time, however, external and internal hurdles remain, such as competition against major banks in local markets and differences in corporate culture. With regard to our assessment of Japanese regional banks, we have yet to incorporate any significant contribution from their overseas business as a positive factor because the segment's contribution to overall profit remains limited.

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

Customers Are Blazing A Trail Overseas

Unfavorable demographic shifts and lackluster capital investment at home have spurred Japanese companies to seek larger returns overseas. According to a Japanese government survey (see note 1), the number of Japanese companies conducting business overseas has grown in the past decade, regardless of the size of the company (see chart 1). In addition, although recurring profits generated at overseas subsidiaries dipped slightly in fiscal 2008 (ended March 31, 2009) from fiscal 2006, due partly to the global financial crisis, they almost doubled in fiscal 2011 compared with fiscal 2006 (see chart 2). Overseas business development by Japanese companies has progressed from simply building overseas strongpoints to a new phase of generating profits. At the same time, the survey reflects that overseas activity at small to midsize enterprises (SMEs) has contributed little to the profits of Japanese companies as a whole.
Chart 1

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

Chart 2

An increase in profit generation overseas has materially shifted the degree of profit contribution by overseas subsidiaries of Japanese industrial corporates in the last decade. The ratio of recurring profit generated by overseas subsidiaries to total recurring profit on the domestic front grew to 45% in fiscal 2011 from 8% in fiscal 2001 (see chart 3). As a result, overseas business now boasts a significant presence.

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

Chart 3

Structural changes at industrial corporates over the past decade also have implications for banks, in our view. If the yen were to fall further, profit increases that companies had expected would disappear to the extent that they had established themselves overseas. As such, banks would need to apply different sensitivities to currency fluctuations in estimating future profits of exporters and would not be able to expect a profit increase from the effects of a weaker yen, as they did in the past. This change may affect banks' view of the creditworthiness of companies. In addition, the overseas transfer of corporate production--a hollowing-out of domestic industries--may depress local economies that had benefited from hosting the factories of large corporations, and may ultimately worsen the already low profitability of regional banks.

Overseas Expansion By Japanese Banks And Its Economic Rationality

In response to corporate customers expanding overseas, Japanese banks, especially major banks, have been accelerating overseas expansion by bolstering their overseas office networks and forming tie-ups with foreign financial institutions. Standard & Poor's believes that this strategy by Japanese banks is consistent with their customers' needs and spontaneous for commercial banks. Table 1 summarizes Japanese banks' overseas ventures according to forms of tie-ups and areas of business. The table does not include business development through overseas branches and

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

subsidiaries because such forms of business development have always been common. Regional banks are not covered by this survey, because there are currently no cases of implementing a capital tie-up and of making a bank a consolidated subsidiary. The survey for the recent five years reveals that major banks increasingly entered into capital tie-ups with overseas institutions. The survey also shows that expansion is active in commercial banking in Asia, asset management, and acquisitions of aircraft finance and project finance.
Table 1

Notable Cases Of Overseas Business Development By Major Japanese Financial Institutions

Capital tie-up Business tie-up (Only tie-ups in Asia by banks regulated under international standards)

Consolidation (incl. equity method affiliates) Banks Investment banks Morgan Stanley--U.S. (MUFG/2008/22%/EM)

Unconcolidated (small investments)

Merrill Lynch--U.S. (MizuhoFG/2008/$1.2 billion in preferred stocks); Barclays--U.K. (SMFG/2008/1%) Bank of China (MUFG/2006/0.2%); Fubon Financial--Taiwan (MUFG/1991/0.1%); ICICI--India (MUFG/1984/0.001%); CIMB--Malaysia (MUFG/2006/5%); BNP--Indonesia (MUFG/2008/15%); Bank of East Asia--Hong Kong (SMFG/2012/9.5%); KB FG--Korea (SMFG/2008/under 2%); Shinhan FG--Korea (MizuhoFG/2006/1%); China CITIC Bank--China (MizuhoFG/2007/0.2%) State Bank of India (MUFG); Co-operative Bank--Myanmar (MUFG); Bangkok Bank--Thailand (MUFG); Canadia Bank--Cambodia (MUFG); Exim Bank of Korea (MUFG); Bank of China (SMFG); Industrial and Commercial Bank of China (SMFG); Agricultural Bank of China (SMFG); First Commercial Bank--Taiwan (SMFG); Metrobank--Phillipines (SMFG); RHB Bank--Malaysia (SMFG); Acleda Bank--Cambodia (SMFG); Korea Development Bank (MizuhoFG); State Bank of India (MizuhoFG); Maybank--Malaysia (MizuhoFG); BPI--Phillipines (MizuhoFG); BCEL--Laos (MizuhoFG); TDB--Mongol (MizuhoFG); BNI--Indonesia (MizuhoFG); DBS--Singapore (SMTHD); PT Bank DBS Indonesia (SMTHD); Reliance Group--India(SMTHD); Korea Exchange Bank (SMTHD)

Commercial banks

UnionBanCal Corp--U.S. (MUFG/1988/100%); Bank of Ayudhya--Thailand (MUFG/2013/TOB plan was announced in July 2013, aiming at acquiring over 50% of stock); Dah Sing Financial Group--Hong Kong (MUFG/2008/15% EM); VietinBank--Vietnam (MUFG/2012/20% EM); Bank Tabungan Pensiunan Nasional Tbk PT--Indonesia (SMFG/2013/from 24% to 40%); Vietnam Export Import Commercial Joint Stock Bank (SMFG/2008/15% EM); Vietcom Bank--Vietnam (MizuhoFG/2011/15% EM); Zijin Trust Co. Ltd.--China (trust company) (SMTHD/2010/20% EM); P.T. Bank Resona Perdania--Indonesia (Resona/1958/43%)

Others Asset management Aberdeen Asset Management PLC--U.K. (MUFG/2008/19% EM) AMP Capital Holdings Ltd--Australia (MUFG/2011/15% EM ) SWS MU Fund Management--China (MUFG/2011/33% EM); China Post & Capital Fund Management--China (SMFG/2012/24% EM); DBS Asset Management--Singapore (SMTHD/2011/Nikko Asset Management, a SMTHD group company, acquired 100%); Tyndall AM--Australia (SMTHD/2011/100%); New Smith Capital--U.K. (SMTHD/2011/40%EM) PF asset of Royal Bank of Scotland (MUFG/2010/business acquisition); Lease receivables of Royal Bank of Scotland (SMFG/2012/business acquisition) Mizuho Balimor Finance--Indonesia (MizuhoFG/2011/51%) Kotak Mahindra Bank--India (SMFG/2010/4.5%) BlackRock Inc--U.S. (MizuhoFG/2010/2%)

Project Finance (PF) etc.

Lease etc.

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

Table 1

Notable Cases Of Overseas Business Development By Major Japanese Financial Institutions (cont.)
Notes: Japanese major financial institutions include Mitsubishi UFJ Financial Group (MUFG), Sumitomo Mitsui Financial Group (SMFG), Mizuho Financial Group (Mizuho FG), Resona Holdings (Resona), and Sumitomo Mitsui Trust Holdings (SMTHD). Year in parenthesis is the year when agreement was entered into or acquisition was completed. EM--Equity Method. Source: Standard & Poor's based on financial statements, investor relations materials, and other public information released by the groups.

All three megabank groups saw an increase in net operating profit from overseas business, and contributions from overseas business to overall net operating profit rose to 20% in fiscal 2012 from 14% in fiscal 2007 (ended March 31, 2008) (see chart 4). Data for Japan's 64 regional banks is not available as not all of them disclose a breakdown of revenue from domestic and international business.
Chart 4

The simple average of the spreads on overseas lending by the three megabank groups is only two basis points (bps) above the spreads on their overall domestic lending, when it includes loans to retail borrowers (see chart 5). However, the comparison is more accurate when made against spreads on domestic lending to large corporations, because loans to large corporate borrowers in general account for most of Japanese banks' overseas lending (see note 2), and such lending usually carries thinner spreads than lending to retail borrowers such as SMEs and individuals. A comparison of spreads on overseas lending against spreads on lending to domestic large companies reveals that overseas lending is more profitable, with the spreads on overseas lending higher than those on domestic lending to large corporations by

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

69 bps. In addition, the risk volume of overseas lending is lower than that of domestic lending. Chart 6 shows the gap between these risk volumes, as represented by the ratios of the sum of three-month delinquencies and defaulted exposures divided by the credit risk exposures at the three megabank groups (see note 3). The average of the gap for the past five fiscal years, including the global financial crisis in fiscal 2008, stands at 85 bps, which evidences the lower risk volume of overseas lending. Accordingly, overseas lending is more advantageous to banks when considering risks and returns, which supports the economic rationality of the banks' move to accelerate overseas business.
Chart 5

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

Chart 6

Japanese Banks Face Hurdles Expanding Overseas

Despite a rational economic basis, the banks' expansion of overseas operations carries risk factors when considering banks' entire revenue structure and future development. While profits in the international business units of major banks are rising thanks to overseas expansion, banks' profit structures have been changing. Importantly, in our view, banks are expanding overseas in the midst of a material decrease in net operating profit on the domestic front. Although net operating profit of business units at the three megabank groups rose by 17% in fiscal 2012 from five years earlier (see chart 7), profits at domestic retail and corporate businesses, which had accounted for about 80% of overall profits, declined 32%, or to about 50% of total profits. The decrease in profits at domestic customers' business is largely countered by the material increase in profits from market-related business units, which rose 290% in terms of amount or to about 30% of total profits in five years. The remaining portion of the profit decrease was countered by an increase in profits in international business units, which rose by 62% or to about 20% of total profits in five years. If risk-returns at overseas business deteriorate, revenues from other businesses would only be able to absorb the decrease to a lesser extent than they did in the past. Accordingly, overseas factors may affect banks' creditworthiness to a larger extent, in our view. Foreign currency financing, in particular, could be a substantial risk factor. In general,

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Japanese Banks' Efforts To Boost Overseas Expansion Are Delivering Mixed Results

Japanese banks depend more on nondepository funding in foreign currencies, including interbank transactions, than funding in Japanese yen; leaving their creditworthiness and reputations vulnerable (see note 4). The loan-to-deposit ratios of overseas business units at banks exceed 120%, according to our estimate using data on deposits and loans disclosed by major banks.
Chart 7

Capital tie-ups are another potential challenge. Major banks have been pursuing such agreements in a growing market, mainly in Southeast Asia in the past five years (see table 1). In recent years, the tie-ups have been increasingly weighted toward consolidation, including equity method affiliates, rather than small investments. An example of a successful capital tie-up is the consolidation of U.S.-based UnionBanCal Corp. (UBC) by Mitsubishi UFJ Financial Group (MUFG) (MUFG's investment in the former entity of UBC dates back to 1988). However, as UBC is a regional bank based on the U.S. west coast, MUFG's investment in UBC is different from investing in nationwide banks, the form of investment that major banks have been promoting. Investment in nationwide banks is expected to produce material returns as it provides access to a wide, existing customer base. At the same time, however, such expansion carries a number of challenges for banks, including external barriers, such as a risk of unpredictable changes in the economy, politics, and regulatory environment of the host country or region and competition against major banks in local markets, as well as internal barriers, such as differences in corporate culture. As such, banks would need to

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overcome a number of challenges, including changes in corporate culture, in our view. Risk factors relating to overseas business are more uncertain than those relating to extensions of domestic business. To take this into account, we incorporate banks' overall financial strengths in our analysis of their creditworthiness. Regarding regional banks, we have yet to incorporate profit contributions from overseas business expansion in our analysis as a positive factor for their creditworthiness. Although SMEs--regional banks' main customers--have been developing business overseas, transaction volumes have been too small for regional banks to secure sufficient profit, and the banks often give up establishing their own offices overseas (see note 5). As a result, the number of operational tie-ups has been increasing among regional banks, instead of opening overseas offices or implementing capital tie-ups. Operating tie-ups have enabled regional banks to provide services in overseas markets such as by establishing Japan desks or using standby letters of credit. However, high lending rates in overseas markets often discourage customers to close transactions, and it is more common for customers to opt for financing in Japan in the form of loans extended by, for example, a parent company to its subsidiary. Furthermore, media commentators have noted that some companies have expertise and experience overseas superior to that of the regional banks themselves. Commercial banks are very likely to lose ground if they are unable to meet their customers' needs, in our view. The core operating profit of the 64 regional banks in fiscal 2012 fell by about 20% from five years earlier, while core operating profit of the three megabank groups increased 4% in the same period. In Standard & Poor's view, the regional banks are particularly challenged to meet the needs of customers with potential growth. In aiming to meet this challenge, the banks may pursue economies of scale through joint operations among their peers, in our view.

Notes
1. As defined in the Basic (Trend) Survey of Overseas Business Activities by the Ministry of Economy, Trade and Industry (METI). The survey covers Japanese companies that have overseas subsidiaries, excluding companies in finance, insurance, or real estate. "Overseas subsidiaries" refer to affiliates in which Japanese parent companies have ownership of 10% or more and a foreign affiliate in which the foreign subsidiary, which is funded more than 50% by a Japanese company, has ownership of more than 50%. 2. In general, approximately 50% of overseas lending by Japanese major banks is extended to Japanese large corporations. The remaining 50% is extended mostly to non-Japanese large corporations. 3. Each exposure was extracted from Basel-related disclosures. In this calculation, the numerator is the sum of three-month delinquencies and default exposure, which is different from actual credit costs. Accordingly, the ratio in this calculation is different from the actual credit loss ratio. 4. Japanese banks have far larger amounts of yen in deposits than in lending, due to a very solid deposit base in yen. In foreign currencies, banks often depend on funding from the interbank market, the direct financing market (negotiable certificates of deposit, commercial paper, and corporate bonds), and foreign currency deposits from corporate depositors that are less cohesive than those from individual depositors. Japanese banks experienced a so-called "Japan premium" in financing foreign currencies in late 1990s when concerns over the creditworthiness of Japanese banks grew in the market. Meanwhile, regulators have established measures to counter financial crises, such as allowing the

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Bank of Japan to supply foreign currency to Japanese banks. 5. Under the Banking Law and other related laws and regulations, banks that have overseas branches or overseas subsidiaries with voting rights of over 50% are required to meet Bank for International Settlements (BIS) capital ratio requirements. Meanwhile, banks that do not have overseas offices are required to meet domestic standards only. In general, BIS capital requirements are stricter than domestic standards, such as the treatment of valuation differences of securities. In addition, the administrative workload to calculate BIS capital ratios is large. As such, many regional banks opt to comply with domestic standards, or not to establish overseas offices, given the costs.

Related Criteria And Research

Higher Foreign Bond Issuance Could Provide Japanese Firms With Stable And Diversified Funding Sources, Oct. 11, 2013 Industry Report Card: Japan's Regional Banks Posted Steady Net Profits In FY2012 Amid Narrowing NIMs And Interest Rate Risk, July 18, 2013 Industry Report Card: Japan's Major Banks Post Strongest Results Since Fiscal 2006, Longer-Term Impact Of Abenomics Is Key For Their Future Performance, June 4, 2013 Industry Report Card: Increasing Global Monetary Easing Adds To The Risks Faced By Asia-Pacific's Top 40 Banks, May 28, 2013

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