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Morningstar | In Tough Japanese Banking Market, SMFG Looks Like the Best Bet for Future Returns

We are transferring coverage of Japan's six largest banking groups, all of which we rate as having no moat and a stable moat trend. This includes the three so-called "megabanks" that together account for 25% of banking-system loans and 29% of deposits: Mitsubishi UFJ Financial Group, or MUFG (8306 JP), Sumitomo Mitsui Financial Group, or SMFG (8316 JP), and Mizuho Financial Group (8411 JP). It also includes three second-tier banks: Sumitomo Mitsui Trust (8309 JP), Resona (8308 JP), and Japan Post Bank (7182 JP). Our top pick is SMFG, with 33% upside from the current share price to our fair value estimate of JPY 5,960, based on our expectations for solid returns from its consumer finance and credit card businesses. Japan Post Bank has the most downside, with our fair value estimate of JPY 952 being 29% below the current share price.

The environment for banks has been tough for years in Japan, and we expect it to remain so. Long-running deflation, which started in earnest in the late 1990s and has yet to end conclusively, has led to persistently low demand for credit. The loan/deposit ratio is only around 55% at present, down from 74% in 2000. Japanese corporates, which in aggregate had a liabilities/net assets ratio of 4 times in the mid-1990s, have reduced this to a healthy 129% as of June, but companies continue to prioritize using cash flow to pay down debt rather than aggressively making new investments. Individuals similarly are generally loath to borrow, given stagnant nominal incomes. With low demand for credit and a surfeit of liquid deposits, competition among banks has pushed the average interest rate on new bank loans down by 100 basis points over the past decade to below 0.7% at present. While there are reasons to hope this has started to bottom out, a catalyst for a material rise in lending rates is not apparent, especially with the Bank of Japan committed to keeping policy rates extremely low "for an extended period."

Facing such bleak prospects in their home market and with their previously low capital levels replenished, MUFG, SMFG, and Mizuho all expanded their overseas business after the global financial crisis as the retreat of European and other banks from Asia created an opening for them. The three Japanese megabanks’ proportion of loans outside of Japan more than doubled from 16% in March 2010 to 33% by March 2015, a ratio that has since been stable and was most recently 34%. However, Japanese banks do not have any inherent advantage in multinational banking or local banking overseas, and we view only certain areas, such as the large aircraft-leasing business that SMFG bought from RBS in 2012, as likely to deliver sustainable returns over a full credit cycle in excess of those available in Japan. Hence, the key to the three megabanks' share prices lies in their domestic businesses, in our view. From this perspective, SMFG looks better placed than MUFG and especially Mizuho because of its large consumer finance and credit card businesses in Japan that are quite profitable, facing less interest-rate competition than corporate lending. Mizuho faces the direst situation among the three because it almost entirely lacks a profitable retail business, but we view the group as having the potential for long-term upside if it can cut costs dramatically and leverage structural changes related to financial technology, or fintech, rather than being disrupted by them. Our fair value estimates for SMFG, MUFG, and Mizuho are JPY 5,960, JPY 797, and JPY 202.4, respectively, 33% above the current price for SMFG, 15% for MUFG, and 5% for Mizuho.

For the second tier of banks, the stories are more differentiated according to the specific businesses of each. We view Sumitomo Mitsui Trust’s fiduciary services businesses, where it is the market leader in managing corporate and government pensions and trails only Nomura (8604 JP) in managing investment trusts, as somewhat moaty and likely to generate respectable returns over the medium and long term, but its commercial banking business is undifferentiated and subscale. Our fair value estimate is JPY 4,844, 4% above the current share price. Resona enjoys significant market shares in the regions where it operates, reaching 40% in Saitama north of Tokyo and more than 20% in the Kansai area including Osaka, but this has mostly led to a slight cost advantage rather than any visible pricing power, in our view. Resona could see further efficiency improvements as it integrates three smaller banks in Kansai and moves them to its IT systems. Our fair value estimate is JPY 625, 2% above the current share price. Lastly, Japan Post Bank has more customer deposits than any other financial institution in Japan (15% of systemwide deposits) but has the fatal flaw of lacking a lending business (its market share of loans is only 1%). The Japanese government has financial and political incentives to ensure that the environment supporting Japan Post Bank remains benign, but we think it will be difficult for the bank to achieve returns on equity of even 4% in the next four years (its highest annual ROE ever, since converting from a government entity, was 3.8% in fiscal 2007). Our fair value estimate for Japan Post Bank is JPY 952, 29% below the current share price.