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Japan’s rebuilding effort following last week’s earthquake is estimated to be significant, as high as Yen 10,000 billion (US$120 billion). Increased demand for the currency has translated into a surging yen, even prompting a coordinated intervention of central banks selling the currency. Pictures reveal the task at hand in public infrastructure, housing and commercial buildings. Government funding will be core to this effort and funds will need to be raised, adding to already high government debt. With many Japanese corporates self-indemnifying for earthquake risk, Japan’s remaining three mega-banks, Sumitomo Mitsui Financial Group (OTC:SMFJY), Mitsubishi UFJ Group (NYSE:MTU) and Mizuho Financial (NYSE:MFG) can play a role in corporate funding. Over this past week, the three Japanese mega-banks have declined approximately 15%, slightly more than the overall market index (NKY).

The banks’ recent disadvantage now is a source of strength. Stagnant growth and deflation in Japan for more than a decade has meant weak lending growth, but strong deposit growth. Excess deposits to fund lending of this magnitude are already on bank balance sheets. As of Dec 2010, each mega-bank held at least Yen 13,000 billion in surplus deposits, all three cumulatively holding Yen 70,000 billion (US$875 billion).

Whether the banks undertake profitable lending is key. The magnitude of poor corporate credit underwriting was revealed following the 1989 Japanese market and real estate crash, when the sector cumulatively wrote off an astonishing 30% of the loan book. Since then, credit risk processes have improved and regulatory oversight of the banks strengthened. Since then, continued sluggish loan growth and low interest rates have compressed loan-deposit spreads (currently at 150 basis points), with profitability, efficiency and core Tier 1 ratios weak.

This leaves the banks with less flexibility to chase growth at the expense of unprofitable margins. In the post-war rebuild, Japanese banks played an important role in allocating credit that sparked the miracle that became the Japanese economy. Last week’s earthquake presents a similar opportunity. An increase in lending volumes would allay margin compression, which is currently being driven by already near-zero deposit rates.

All three banks are trading below 70% of book value given the weak domestic outlook and bank performance. An opportunity to mobilize deposits through profitable lending using the same cost base would change their outlook and earnings favorably, a strong basis for stock price appreciation.

Source: Japanese Banks Can Play Major Rebuilding Role