With the Bank of Japan’s ultra-easy monetary policy expected to stay for a while, the challenge for the country’s commercial banks is to come up with innovative ways to thrive in a low interest environment.

In late July, the BOJ tweaked its monetary policy framework to give itself more operative flexibility, and also let Japanese government bond (JGB) yields rise further than the bank had previously allowed under its ‘yield curve control’ policy. The changes were modest, with the BOJ now permitting the 10-year JGB yield to fluctuate around 20 basis points from its policy target of zero percent, up from 10 basis points previously. It also adopted forward guidance on policy, and pledged to maintain ‘extremely low levels’ of interest rates ‘for an extended period of time’. The mid-term consumer price index forecast is around 1 per cent, which will keep domestic rates very low, and the latest BOJ tweaks will not meaningfully change the investment flows into global bond markets from Japanese investors.

The relatively minor changes disappointed investors and institutions hoping that the BOJ would show signs of following the US Federal Reserve and the European Central Bank, both of which are moving toward policy normalisation.

On the plus side for Japan’s banks compared to their global peers, the country’s political climate is relatively stable: it isn’t facing any current unknowns similar to Brexit, and its banks also get solid regulatory support from Japan’s Financial Services Agency. But Japan’s entrenched easy monetary policy is the key difference that makes comparisons with counterparts in other developed countries moot.

Even as its counterparts take tightening steps, we see little chance that the BOJ will follow suit any time soon, as Japan’s inflation remains well short of the bank’s 2 per cent target. We expect to see this prolonged massive easing continue for the next two years, and probably beyond.

Many banks are profitable despite lower rates

With the inflation target beyond reach for now, another possible trigger that eventually could push the BOJ to take steps toward normalisation is the potential dysfunction of the financial sector. So far, however, institutions’ pain isn’t acute enough to nudge the central bank toward exiting its massive monetary easing.

Even with rates stuck at low levels, few banks are posting losses. Most of the regional banks are still profitable, thanks partly to portfolio gains on their securities, which means pressure on their capital is still limited. Japan’s banks are still able to stay above their Basel regulatory capital requirements, which gives them a buffer, but if their reserves were to come down, that would pressure their lending capability. Dwindling reserves could put the functionality of the financial system under pressure.

The smaller the banks are, the more their cost ratio rises. Banks’ core profit comes from their commercial banking business - interest on lending plus fee income, minus operating expenses. If their credit costs were to increase, or if they were to suffer more losses in their securities portfolios, many regional banks could easily start to book losses.

Japan’s major banks are holding up better than their smaller regional counterparts despite feeling the same domestic pressures, and have expanded their overseas business over the past five years. But this era of expanding overseas business is already over now that the Fed has begun hiking; overseas funding costs are rising, and global macro-economic conditions are becoming more challenging.

Japanese banks cannot simply hold their collective breath and wait for the eventual end of the BOJ’s easy policies, because an exit is not coming anytime soon. Overall, Japan’s banks need to turn the pain they are feeling from the BOJ’s easy policy into a catalyst to transform their businesses. In addition to cutting costs, here are other steps to take:

• They need to diversify away from traditional commercial banking models toward non-bank, or more comprehensive financial services.
• Adopting fintech solutions could help them expand fee income sources.
• Larger banks need to maintain their overseas presences not only in developed markets but in emerging ones as well, despite the higher risks in markets where they lack core funding bases of customer or retail deposits. As the low interest rate environment limits the potential of their domestic businesses, banks need to maintain whatever presence they have established in overseas markets to secure a source of future profits.
  Source: Thomson Reuters Eikon