Horseman Capital: Japanese Regional Banks Overstating Core Recurring EarningsVW Staff
Horseman Global: Japanese Regional Banks Overstating Core Recurring Earnings
There is something funny going on with Japanese regional banks, somehow they have reported an increase in “Interest and Dividends on Securities” over the last four years whilst interest rates have collapsed. The ¥818bn in “Interest and Dividends on Securities” in the last fiscal year March 2015 is a material amount, it equates to almost all of their ¥821bn total Net Profits. This increase in “Interest and Dividends on Securities” is surprising because 75% of regional bank security holdings are fixed income (government bonds 53% and corporate bonds 22%), with an average maturity of 4 years according to the Bank of Japan. Japanese Government Bond (J GB) yields have fallen to essentially zero out to an 8 year maturity and Japan’s corporate bond yields have compressed in lock step.
One-off valuation gains on bonds and other securities are typically not included within “Interest and Dividends on Securities” as this line is supposed to only reflect core recurring earnings (i.e interest and dividends) and sits within “Net Interest Income”. The March 2014 Bank of Japan (BOJ) annual review of “Financial Results of J apan Bank’s” indicates banks have however been including “large amounts” of one-off valuation gains:
“Operating profits from core business expanded at both major banks and regional banks, with a large amount of profits from investment trusts due to cancellations (realization of unrealized gains) recorded as an increase in net interest income at some banks” and within the footnotes “Similar to interest and dividends mainly from bonds and stocks, profits from investment trusts due to cancellation are counted as “interest and dividends on securities, ” a component of net interest income, not as gains/losses on sales of securities.” (BOJ, October 2014). Note the BOJ has not realeased a review for March 2015, see below.
My conversations with banks indicate that the investment trusts refered to by the BOJ above are largely investments in Japanese equity indicies (Topix and Nikkei). The loop-hole which allows the special treatment of capital gains is that they are a private arrangement against another counterparty and are not publicly offered. This essentially adds counterparty and liquidity risk without removing any of the underlying market risk.
We can see from aggregated regional bank balance sheet data that the category of “Other Securities”, where these private investment trusts sit, have more than doubled from 2012. The ¥16.5tn now outstanding almost equates to the entire ¥17tn of Net Assets (Shareholders Equity) at regional banks. This is surprising given all the positive noise made about Japanese banks selling down their equity holdings. For regional banks to generate capital gains on their private investment trust holdings they must have been buying them, then selling, then buying more again. It looks like they bought a whole lot of equities for March 2015.
Some Japanese regional banks are more exposed than others, Shizuoka Bank’s “Other Securities” in March 2015 equated to 115% of Net Assets and 134% of Tier 1 capital, more than its J GB holdings. Shizuoka Bank’s Financial Year March 2015 Annual Report states that “If the prices of equity securities and other securities held decline, impairment losses or valuation losses could adversely affect the operating results and financial standing of the Group”. I personally can see a scenario of the Topix Index falling 40-60% due to currency and macroeconomic factors (Link: Yen and Yuan Likely To Move Another 25%), the impact on net assets and core tier 1 capital would be devistating.
Even if equities do return to March 2015 levels by fiscal year end March 2016, the “Net Interest Income” and “Net income” of regional banks will likely decline substantially year-on-year without the capital gains on private investment trusts experienced in previous years (gains require an up year in equities). Future earnings may also underwhelm analyst forecasts unless equity markets continue to rise year after year at a similar rate seen in Japan since 2012. This is why one-off capital gains are not generally seen as core recurring earnings.
It certainly seems that analysts are factoring in a continuation of one-off equity returns in their earning forecasts. The 7 sell-side analyst forecasts that I have access to for Shizuoka Bank estimate on average that “Net Interest Income” will rise 4.5% this year and rise further out to 2018 (they don’t break down “Interest and Dividends on Securities”). It is well known that analysts forecasts have a high tendency to extrapolate past trends. Shizuoka Bank trades on a 14.6x P/E for its Fiscal Year March 2015 earnings which includes gains on investment trust sales. This is a significant premium to the MSCI World Bank Index at 10.25x P/E. We don’t know what the Shizuoka Bank and other regional bank earnings would be without their investment trust gains.
The real underlying question here from a macro perspective is why did Japanese regional banks go to this extent to optically boost core recurring earnings in the short term whislt greatly increasing risk? It certainly seems that their earnings would have been very poor without one-off equity gains due to the compression of interest rates. Media reports indicate that the Japanese F SA is highly concerned about regional bank core recurring earnings and is conducting a number of reviews (links Regional Banks Face Stress Test For Ultra-low Rates and Japan FSA investigating region bank property lending). The FSA’s Financial Monitoring Report suggests the situation is set to get worse and worse.
“Due to low yield from loans, Japanese regional banks profitability of lending is declining overall. As the interest rate is lowered, loans with relatively high yields tend to be repaid one after another to be replaced with new loans with lower interest rates. Assuming that this trend continues, the ordinary profits of about 20 percent of all the regional banks in the future (fiscal year ending March 2018) are calculated to be less than or half of what they are now (fiscal year ending March 2014)” F SA 2015 Financial Monitoring Report
The Regional Bank Association is also expressing concern “In the low interest rate environment, there are only about 20 banks [out of 64 in the first tier} that can cover their operating costs fiom lending income”(Kazuyoshi Terakado, Head of The Regional Bank Association).
The primary cause of these profitability problems for the regional banks is of course the crushing of interest rates under the BOJ’s Quantitaive Easing (QB) program. Some within the BOJ are fully aware of this, during the October 2014 “Halloweeen surprise” meeting, some BOJ board members “expressed concern with regard to the effects a further decline in interest rates would have on financial institutions’ profits and their intermediation function” (BOJ minutes). Interest rates have declined substantially since that meeting but the one-off equity gains reported under recurring core profits temporaily disguised this. I am not sure how they will continue to disguise this now that equity markets have fallen. It is interesting that in this environment the BOJ has not released an annual review of “Financial Results of Japan Bank’s” for Fiscal Year March 2015, I wonder what it would say if they did?
If the BOJ does increase its rate of QE, which I think it will struggle to do given the lack of J GB liquidity (Link: Japanese QQE Costs and Side Effects), then interest rates are likely to decline further and bank core retained earnings deteriorate. It is not certain that an equity market rally will occur to help the banks disguise this impact via investment trust gains. If the BOJ do not increase QE but remain at the current J GB purchase rates then yields will still decline (as liquidity continues to dry up), bank’s earnings will still fall and they could be at risk of substantial equity losses as the market is underwhelmed. If the BOJ is forced to taper QE, which they eventually will be, the equity losses could be catastrophic in the short term even if core profit was to recover over the longer term. Japanese regional banks are an appealing short either way.