Japan’s Regional Banks Appear Oversold

Japan's banking stocks have been out of favor for a while. The sector's index is down 12% in the past 12 months versus a 1.2% drop for the TOPIX, and the average forward P/E of TSE 1st section banks is 9.9 compared with 16.80 for the TOPIX. The decline in bank equities in part reflects a general market downturn since August, which stems from the yen's rise against the dollar and fears that problems in the US subprime sector could cause a worldwide recession. The major banks' exposure to the subprime market and securitized assets makes them especially vulnerable to loan quality concerns.

Some of the investor distress is valid. In its September midyear release, for example, Mizuho Financial Group (MFG), one of the leading bank holding companies, announced a net loss of ¥27 billion, largely due to a ¥26 billion charge from subprime-related securitized assets. The loss was recorded despite an earlier report from Toyo Keizai in September that the bank's total exposure to securitized assets was only around ¥50 billion and that it was mostly AAA rated.

In mid-October, the head of the Japanese Bankers Association said that the total exposure to US subprime loan assets by Japanese banks was only around ¥1 trillion. He added that, given the size of the banks' total assets and profitability, even in a worst-case scenario this level of exposure could be absorbed without causing a serious liquidity problem for the banks.

Are profitability levels indeed adequate to sustain serious losses? S&P calculates that the domestic loan spread of major Japanease banks is 1.34%, 100 to 150 basis points below that of major US banks and not high enough to cover the credit reserve charges as well as operational costs. The loan spread is expected to improve gradually, however, as a 25-basis-point hike in the BOJ’s official discount rate [ODR] last year will have a positive impact on the banks' full fiscal year results. Mr. Fukui, head of the BOJ, continually mentions the need of another increase in the ODR to “normalize” Japan’s financial system, which has been under a zero-interest-rate regime for many years now. Another rate hike should create a positive environment for banks where they can more easily expand their loan spread.

Compared with major money center banking groups, most regional banks have no or very little exposure to U.S. subprime assets. Also, with the improvement of the economy and most of its loan problems behind it, credit reserve costs at major regional banks continue to decline. In May 2007, Moody’s lifted the average rating of Japan’s regional banks from A3 to A2. In particular, major regional banks based in areas around Tokyo like Chiba and Saitama, where the economy is doing well and property is recording real price increases, are expected to show both revenue and net profit growth in the medium term.

Chiba Bank (CHBAF.PK) is an example of a leading regional bank that is well positioned. It has 30%-plus market share of the loans in Chiba, an area where population and real estate prices are increasing because of the new Tsukuba Expresss railroad line and the expected addition of another express line to Narita Airport. It's selling at a reasonable 14.4 times forecast March 2008 earnings, below the average of other leading regional banks.

Another notable regional institution in the Tokyo area is Suruga Bank (SUGBY.PK), which is based in Shizuoka and Kanagawa. It is not among the largest banks but, compared with more traditional institutions, it has an innovative approach in developing retail products and exploiting the Internet. It was the first regional bank to open a so-called Internet branch at the start of net banking, and most recently it became the first bank to collaborate with Japan Post, the government-owned postal institution, following its privatization. In the first quarter of fiscal 2008 (ended June 2007), its ordinary income increased 25% year over year, led by the 3% increase in residential loans. In October, the bank revised its half-year ordinary profit estimate upward to ¥19.1 billion, a 22.7% improvement from the year before. Even though its 19.5 P/E is not the lowest in the sector, its growth potential and marketing flair make it worthy of consideration.

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Note: Bob Schneider co-wrote this article