Industry Report Card:

Japan's Major Banks' Preparedness For Downturn OfCredit Cycle Is A Key FocusJune 20, 2019

Industry Ratings Outlook

Ongoing difficult business conditions, as expected, were a drag on the operating performance ofJapan's five major banking groups in fiscal 2018 (ended March 31, 2019).

Their ability to generate earnings, their foreign currency-denominated funding, and theirresilience to credit-related costs remain key factors following the release of their fiscal 2018results, in S&P Global Ratings' view.

Japan's five major banking groups are Mitsubishi UFJ Financial Group Inc., Mizuho FinancialGroup Inc., Sumitomo Mitsui Financial Group Inc., Resona Holdings Inc., and Sumitomo MitsuiTrust Holdings Inc. We rate Resona Bank Ltd. and Sumitomo Mitsui Trust Bank Ltd.

In terms of earnings capability, we are watching for progress in restructuring domestic operations,for which business conditions continue to worsen. Given this, efforts to expand overseas have ledus to pay more attention to foreign currency-denominated funding and liquidity. We are alsofocused on their capitalization, which indicates the degree of resilience each group would have toincreased credit costs and impairment losses in a credit cycle downturn.

In fiscal 2018, the five banking groups' consolidated net operating profit before loan lossprovisions on an aggregate basis slipped 5% year on year to ¥3.0 trillion. We attribute this to twofactors. First, net interest margins, especially from small and midsize enterprises in Japan,continue to shrink. Second, revenue is weak in the groups' market divisions. Consolidated pretaxnet profit fell 24% to ¥2.9 trillion. This was a consequence of a reversal of credit costs on anaggregate basis the previous fiscal year. Impairment losses on fixed assets, including losses oninformation technology (IT) systems and branch networks during restructuring, added to thedecline in pretax net profit. Net profit after taxes dropped 24% to ¥2.0 trillion.

A Profitability Gap With Overseas Peers

Profitability continued to decline in fiscal 2018 for the five groups. This suggests theirloss-absorbing capacity that covers credit costs continues weakening. Interest income on anaggregate basis dropped 1% year on year. The decline was smaller decrease than in fiscal 2017,but shrinking loan spreads to small and midsize enterprises in Japan pushed down interest

Industry Report Card:

Japan's Major Banks' Preparedness For Downturn OfCredit Cycle Is A Key FocusJune 20, 2019

PRIMARY CREDIT ANALYST

Toshihiro Matsuo

Tokyo

(81) 3-4550-8225

toshihiro.matsuo@spglobal.com

SECONDARY CONTACTS

Chizuru Tateno

Tokyo

(81) 3-4550-8578

chizuru.tateno@spglobal.com

Kensuke Sugihara

Tokyo

(81) 3-4550-8475

kensuke.sugihara@spglobal.com

Ryoji Yoshizawa

Tokyo

(81) 3-4550-8453

ryoji.yoshizawa@spglobal.com

www.spglobal.com/ratingsdirect June 20, 2019 1

income (see chart 1). In addition, trading revenue and other net operating profits, includingbond-related revenues, on an aggregated basis dropped more than 10% year on year. This wasdue to the adverse effect of equity and bond market turbulence in the fourth quarter of 2018 andlosses from sales of foreign bonds such as U.S. treasuries. The average return on assets (ROA) forthe five groups on a pretax net profit basis stood at 0.34%, down 0.1 percentage point from theprevious fiscal year. This was partly because an unfavorable performance for the assetmanagement business led to a decrease in fee income (see chart 2). The average ROA of selectedmajor non-Japanese global systemically important banks (major foreign G-SIBs; see note 1)continued to rise and was up about 0.9% in fiscal 2018 (ended Dec. 31, 2018). This shows that theprofitability gap between them and Japan's five major banking groups is widening in terms ofoutstanding assets.

Chart 1

Chart 2

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

Together with profitability, capital is one of the pillars of loss absorbing capacity for the five majorbanking groups. It remains weaker than that of the foreign major G-SIBs. The simple average ofthe risk-adjusted capital (RAC) ratios of the five Japanese groups was 7.4% as of Sept. 30, 2018.This remains weaker than the about 9.2% estimated simple average of the foreign major G-SIBsas of Dec. 31, 2018 (chart 3). This gap is mainly because of the large equity portfolios of Japan'sfive groups. They have been reducing their strategically-held equity portfolios, but some groupshave also increased their exposures to indirect holdings of equities, including exchange tradedfunds (ETF). Therefore, risk-weighted assets of the five groups' equity holdings in aggregateaccounts for about 12% of total under our RAC framework as of Sept. 30, 2018, which is high.Furthermore, the five groups are dependent on proceeds from equity sales for revenue (see chart4).

Chart 3

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

Chart 4

Credit Costs Remain Low

We do not believe risk associated with credit costs is large enough to sway our assessment of themajor banks' credit quality at this point. Meanwhile, we focus on each group's resilience toincreased credit costs and impairment losses in a possible downturn in the credit cycle. We do soby looking at each banks' level of profitability and capital against risk. The five groups booked¥139.9 billion in credit costs on an aggregate basis. This was lower than the ¥378.5 billion thebanks projected at the beginning of the fiscal year. The groups expect credit costs to increase infiscal 2019, to a total of ¥532.5 billion.

Normalized loss rates for each group under our RAC framework range between 0.16% and 0.25%.We expect the ratio of credit costs to outstanding loans to remain below the normalized loss rate,unless the global economy enters a downturn. Meanwhile, all five groups maintained grossnonperforming loan (NPL) and net NPL ratios at 0.84% and 0.33% on average, respectively. Thisindicates favorable asset quality (see chart 5). However, credit costs may increase in theiroverseas assets. The groups have expanded overseas to improve profitability, including intoemerging markets in anticipation of economic growth.

Focus On Structural Reform Progress And Foreign Currency Financing

The business environment for Japanese banks has been deteriorating. This is most noticeable inthe weakening profitability of regional banks. The five majors have also seen profitability in theirdomestic banking businesses weaken. Under these circumstances, we are looking at the progressamong the five groups toward improved profitability through structural reform initiatives. The fivegroups have been working to improve profitability by reviewing the components of theirrevenue/cost through structural reform and by reinforcing their overseas operations. The groupshave streamlined their operations by:

- Revising domestic IT systems,

- Reshuffling branch networks; and

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

- Reorganizing group companies, including banking subsidiaries.

Regarding personnel expenses, the groups do not have short-term plans to reduce them but pushthem down gradually over the next five years or so. On the other hand, the groups need to invest inforward-looking projects, such as those in fintech. They also need to spend more on maintainingand expanding overseas businesses. The overhead ratio (OHR) of the five groups was below 60%until fiscal 2014. It has gradually risen since then and reached 69% in fiscal 2018, but this was inpart due to a decrease in gross operating revenue.

Japanese banks' ability to maintain stable funding in foreign currencies at low costs has becomekey to their creditworthiness. This is because Japanese banks will inevitably expand theiroverseas businesses to sustain their profitability. The groups' loan-to-deposit ratios on anaggregate basis, including loans and deposits in foreign currencies, was about 63% in fiscal 2018.Deposits therefore far exceed loans. Meanwhile, the loan-to-deposit ratio in foreign currencieswas 139%, excluding Resona Holdings, which engages predominantly in domestic business. Thissuggests that their funding and investing structures in foreign currencies diverge widely fromthose in the domestic currency (see chart 6). The four groups have maintained the same foreigncurrency funding structures for the past three years. Under these structures, they rely onshort-term markets for about 30% of funding, through instruments such as commercial paper andrepurchase agreements. Medium- to long-term funding accounts for about a quarter of the total,and mainly consists of foreign bonds, such as foreign currency-denominated TLAC bonds issuedby bank holding companies. However, this mid- to long-term funding also includes a reasonablylarge amount of currency swaps.

Chart 5

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

Chart 6

Macroeconomic Factors May Affect Ratings In The Future

As well as changes in the creditworthiness of each group, we believe a change in our sovereignrating on Japan or in our Banking Industry Country Risk Assessment (BICRA) for Japanese banksare the key factors that could affect our ratings on the five groups.

If we raise our sovereign rating on Japan, we may also raise our ratings on the groups. We considerthe Japanese government to be highly supportive of domestic financial institutions. However, wewould also factor in our stand-alone credit profiles on each group in our assessments. The outlookon the long-term sovereign credit rating on Japan is positive.

On the other hand, a decline in the profitability of Japanese banks, amid persistent low interestrates and intense competition, may damage the stability of Japan's banking system. There is amore than one-in-three chance that we will lower our industry risk score for Japan in the BICRA.Our 'a-' anchor for domestic banks, the starting point in our credit analysis for banks operating inJapan, is therefore under downward pressure. However, lowering Japan's industry risk score byone notch would not pull down the anchors of Mitsubishi UFJ Financial Group, Mizuho FinancialGroup, and Sumitomo Mitsui Financial Group. The anchors for three groups are 'bbb+', given theirlarge proportion of overseas businesses.

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

Note

1. This report uses data on Citigroup, Bank of America, JPMorgan Chase, Barclays, HSBC, BNPParibas and Deutsche Bank, which we refer to collectively as the major foreign G-SIBs.

G-SIBs (global systematically important banks) refers to the 30 banks designated by the FinancialStability Board and comprises Japan's three megabank groups, nine banks based in the Americas,14 British and European banks, and four Chinese banks.

Table 1

Regulatory Capital Ratios And Leverage Ratios For Japan's Five Major BankingGroups

Mitsubishi UFJFinancial Group

Inc.

MizuhoFinancial Group

Inc.

Sumitomo MitsuiFinancial Group

Inc.Resona

Holdings Inc.

Sumitomo MitsuiTrust Holdings

Inc.

%March

2018March

2019March

2018March

2019March

2018March

2019March

2018March

2019March

2018March

2019

CET1 ratio 12.58 12.23 12.49 12.76 14.50 16.37 12.58 11.47 11.33 12.18

CET1 ratio excludingunrealized securitiesgains after fullimplimentation of BaselIII

10.10 10.00 10.15 10.71 11.80 13.50 9.50 9.30 N/A N/A

Leverage ratio 5.01 4.94 4.28 4.42 5.01 4.88 N/A N/A 3.98 4.67

Note: Ratios for March 2019 include preliminary figures. Ratios for Resona Holdings Inc. are reference data disclosed by the company.CET1--Common equity tier 1. N/A--Not applicable. Source: S&P Global Ratings, based on company disclosures.

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

Table 2

Issuer Review

CompanyIssuer creditrating

Seniorunsecureddebt rating Comments Analyst

MitsubishiUFJFinancialGroup Inc.

A-/Positive/-- A- MUFG's consolidated net operating profit declined 13% year onyear; net profit slumped 12% to ¥872.6 billion. These declines areprimarily attributable to a decrease in income from marketsbusinesses and an increase in overseas expenses. The decrease innet profit is also in part attributable to Mitsubishi UFJ Nicos Co.Ltd. recording a temporary decline of about ¥162 billion, includingthrough an impairment loss from revisions to an IT systemintegration plan. MUFG's net NPL ratio remained low, slipping to0.2%. A decline in housing loan volume slightly pushed downoutstanding lending. Foreign outstanding lending was flat, afterexcluding the impact of foreign exchange movements. Overseasbusiness and business with domestic large companies performedsteadily. Meanwhile, net operating profit from the retail andcommercial banking business group declined 16% because of weaksales of investment products and a continued reduction in spreads.MUFG is replacing assets with low profitability in its overseasportfolio. We believe this will improve its controls on funding,foreign currency investments and profitability. However, we arewatching closely for whether risk increases after the assetreplacement. MUFG's CET1 and leverage ratios are adequate, inour opinion. It expects to earn ¥900 billion in net profit in fiscal2019 on the following assumptions: the domestic loan and depositbusiness remains difficult, Bank Danamon Indonesia Tbk.contributes to earnings, and overseas expenses increase.

ChizuruTateno

MUFG BankLtd.

A/Positive/A-1 A See comments above. ChizuruTateno

MitsubishiUFJ TrustandBankingCorp.

A/Positive/A-1 A See comments above. ChizuruTateno

MizuhoFinancialGroup Inc.

A-/Positive/-- A- Mizuho FG's consolidated net operating profit dropped 14% year onyear to ¥393.3 billion. The performance of its businesses withoverseas and large Japanese companies was favorable. However,the company had posted losses of ¥194.7 billion due its investmentportfolio restructuring, including realizing losses on foreign bonds.Net profit declined a substantial 83% year on year to ¥96.5 billion.This was primarily due to impairment losses from fixed assets,including software and branches. Credit costs increased materiallyand depressed earnings, because the effect of a net reversal ofcredit costs worth ¥156.3 billion recorded in the preceding fiscalyear ended. However, credit costs for outstanding loans was at alow 0.02%. Its gross NPL and net NPL ratios (based on ourstandards) levelled off, at 0.8% and 0.4% respectively. Theimpairment loss had only a limited impact on its regulatory capital.Its CET1 ratio rose year on year to 12.76% and the leverage ratio isat an adequate level in light of regulations. Mizuho FG announced afive-year management plan starting in fiscal 2019. The groupexpects to post ¥470 billion of net profit in fiscal 2019, about ¥100billion less than targeted in the past two fiscal years. The groupbases its expectation of lower profits on assumptions that creditcosts will increase and sales proceeds from strategically-heldstocks will decrease.

KensukeSugihara

MizuhoBank Ltd.

A/Positive/A-1 A See comments above. KensukeSugihara

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

Table 2

Issuer Review (cont.)

CompanyIssuer creditrating

Seniorunsecureddebt rating Comments Analyst

MizuhoTrust &Banking Co.Ltd.

A/Positive/A-1 -- See comments above. KensukeSugihara

SumitomoMitsuiFinancialGroup Inc.

A-/Positive/-- A- SMFG's net operating profit fell marginally, by 1% to ¥1,192.3billion; net profit declined 1% to ¥726.7 billion. Both were at almostthe same level as the previous fiscal year after factoring out theeffects of the group's reorganization. Expenses decreased 0.6%,which suggests the group controls the expenses adequately. Creditcosts increased 15% to ¥110.3 billion. For a second year in a row,SMFG set aside about ¥47 billion in provisions for refunds ofovercharged interest at its consumer financing subsidiaries.Meanwhile, the group recorded ¥89 billion in capital gains from areduction in strategically held shareholdings and ¥116.3 billion ofprofit from stocks it sold as part of the group's reorganization.SMFG manages its asset quality properly, maintaining its NPL ratioat a low level of 0.3%. Both the CET1 ratio and the leverage ratiohave hovered at adequate levels. For fiscal 2019, SMFG forecasts anet operating profit of ¥1,180 billion, almost flat year on year, and anet profit decline to ¥700 billion, given an increase in credit costs.

ToshihiroMatsuo

SumitomoMitsuiBankingCorp.

A/Positive/A-1 A See comments above. ToshihiroMatsuo

ResonaHoldingsInc.

Not rated Resona Holdings consolidated two regional banks, resulting in amaterial increase in income year on year. However, based onfigures calculated by the group on a five-bank basis (those underthe Resona umbrella) showed net operating profit before loan lossprovisions decreased 6% to ¥225.6 billion and net profit down 28%to ¥175.1 billion. The effect of temporary factors relating toconsolidation of subsidiaries and reorganization has beeneliminated; ¥22.7 billion was posted for disposal of losses from itssecurities portfolio, including futures. Aggregated outstandingaverage lending in the banking book inched up 2.6%, but netinterest income slumped ¥18.3 billion. The decline in net interestincome followed a fall in lending rates. Fee income, which ResonaHoldings aims to enhance, increased ¥6 billion and provided somerelief. Credit costs were low, and the gross and net NPL ratios, bothon an aggregate basis of Resona group banks, improved to 1.2%and 0.9% respectively. The launch of Kansai Mirai Financial GroupInc. led to an increase in risk assets, lowering its capital ratio(according to domestic standards) to 10.10% from 10.65% a yearago. However, its CET 1 ratio is at a favorable 11.47%, according tocompany estimates. Resona Holdings pushed down its target forearnings from market business for fiscal 2019, as well as its netprofit target to ¥160 billion, down by ¥10 billion from the bank'sforecast in its medium-term management plan. The earnings andnet profit targets are both attributable to shareholders of theparent.

KensukeSugihara

ResonaBank Ltd.

A/Stable/A-1 -- See comments above. KensukeSugihara

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

Table 2

Issuer Review (cont.)

CompanyIssuer creditrating

Seniorunsecureddebt rating Comments Analyst

SumitomoMitsui TrustHoldingsInc.

Not rated Sumitomo Mitsui Trust Holdings' (SMTH) net operating profitbefore loan loss provisions increased ¥11.6 billion from theprevious year to ¥282.2 billion, and net profit jumped ¥19.9 billion.Net interest income increased ¥19.3 billion on SMTH's adjustedbasis, which includes losses and gains from the investment ofsurplus funds. This was in part due to improvements of margins inthe overseas segment. Fee income increased 2% year on year, asfees in total have offset the decrease in commission for sales ofinvestment trusts. As such, fee income still constituted a largeportion of its gross operating revenue at 57%, providing stability toSMTH's earnings. SMTH posted an increase in the bottom-lineprofit, partly because of the tax effects of worth ¥15 billion,following the introduction of consolidated taxation, even though itdisposed of evaluation losses of ¥12 billion and impairment lossesof ¥19 billion for IT systems and goodwill of subsidiaries. The grossand net NPL ratios were low, standing at 0.3% and -0.1%,respectively. SMTH maintained adequate CET1, leverage, andliquidity coverage ratios based on regulatory standards. SMTHaims at earning ¥180 billion of net profit in fiscal 2019. Although itscapital build is likely to be constrained by an increase in dividends,share buybacks, and redemption of eligible legacy Tier 1 bonds,SMTH will moderate the growth of risk assets under its control.Accordingly, we do not expect its capital ratio to deterioratematerially.

KensukeSugihara

SumitomoMitsui TrustBank Ltd.

A/Positive/A-1 A See comments above. KensukeSugihara

Related Research

- Japan Banking Outlook 2019: The Three Main Risks, Dec. 19, 2018

- Banking Industry Country Risk Assessment: Japan, Oct. 3, 2018

This report does not constitute a rating action.

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

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Industry Report Card: Japan's Major Banks' Preparedness For Downturn Of Credit Cycle Is A Key Focus

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