Regulatory Risks Abound In The Search For New Growth Sources

BMI View: We believe that Japanese banks will face growing regulatory risks and costs in their diversification efforts to grow revenues unrelated to traditional streams from their domestic market, which will weigh further on the sector's outlook. Externally, they face greater regulatory uncertainty as authorities in various countries are likely to in various banking system. Domestically, banks are likely to face higher costs due to growing public expectations for financial institutions to ensure that both their related entities and clients fully comply with all regulation.

We believe that even as Japanese banks seek to diversify away from traditional revenue streams in their domestic market, they will encounter greater risks as the changing sector landscape is likely to result in tighter regulatory conditions both domestically and globally. We expect these risks to make it more difficult for Japanese banks to grow these new businesses quickly and profitably, constituting another reason supporting our downbeat outlook of the sector, on top of the severe downside risks for banks that stem from high levels of government debt.

Greater Regulation Amid Financial Stability Concerns

Obstacles Cap Revenue Growth Beyond Japan
Japan - Non-Domestic Revenues For Top Four Banks, %

Regulatory Risks Abound In The Search For New Growth Sources

BMI View: We believe that Japanese banks will face growing regulatory risks and costs in their diversification efforts to grow revenues unrelated to traditional streams from their domestic market, which will weigh further on the sector's outlook. Externally, they face greater regulatory uncertainty as authorities in various countries are likely to in various banking system. Domestically, banks are likely to face higher costs due to growing public expectations for financial institutions to ensure that both their related entities and clients fully comply with all regulation.

We believe that even as Japanese banks seek to diversify away from traditional revenue streams in their domestic market, they will encounter greater risks as the changing sector landscape is likely to result in tighter regulatory conditions both domestically and globally. We expect these risks to make it more difficult for Japanese banks to grow these new businesses quickly and profitably, constituting another reason supporting our downbeat outlook of the sector, on top of the severe downside risks for banks that stem from high levels of government debt.

Obstacles Cap Revenue Growth Beyond Japan
Japan - Non-Domestic Revenues For Top Four Banks, %

Greater Regulation Amid Financial Stability Concerns

On the external front, we expect heightened concerns over financial systems in other countries to make the regulatory environment more uncertain for Japanese banks and may be left with greater costs and/or potential losses. Indeed, an example of these changes in the external regulatory environment is the efforts of US regulators to implement the Volcker rule in a bid to reduce moral hazard and excessive risk-taking by institutions in the US banking system. The rule, in its original form, would also prohibit non-US financial institutions with a banking presence in the US from proprietary trading and investing in private funds. This would have locked out Japanese banks from certain segments of the private equity space, and/or prevent private equity funds from raising funds from both US and non-US entities. If the rule was applied in its original form, non-US banks could have been forced to sell existing stakes in these funds, which could have resulted in losses, and/or missed growth opportunities - something which Japanese banks desperately need. Although the Volcker rule was eventually revised in favour of non-US banks (which include Japanese banks) in December 2013 and again recently in February, now allowing them to sidestep the rule through the use of different fund structures, we highlight that more changes in regulation relating to financial stability could materialise. Indeed, given that the reminders of the importance of banking stability remain in the foreground, as China faces its own "shadow banking" problems, we believe that further regulatory changes cannot be discounted.

Heightened Public Expectations To Increase Compliance Costs

Moreover, we believe that Japanese banks will face growing regulatory risks and their associated costs on the domestic front as well, as both regulators and the public appear to have raised expectation of the degree to which financial institutions should ensure that their affiliates and customers are in compliance with the law (and other regulations). Indeed, we believe Mizuho Financial Group Inc's recent troubles have been instructive in this respect, highlighting the higher standards that banks are held against, and the reputational risks that accompany should banks miss the mark. Earlier in December, Mizuho's chairman, Takashi Tsukamoto, stepped down to take responsibility over the loans that an affiliate, Orient Corporation, made to organized crime gangs in Japan (yakuza). The company has been rebuked twice by the banking regulator, Japan's Financial Services Authority (FSA), and was ordered to present business-improvement plans twice within the span of two months because of this issue. More recently, in March, the firm came under more pressure as there was news that it could be named a defendant in a lawsuit that filed by investors on the back of losses due to the collapse of the Japanese Bitcoin exchange, Mt. Gox. The class action complaint filed in the Chicago federal court accuses Mizuho of being complicit in the fraud at Mt. Gox alleged by the plaintiffs, and specifically highlighting the bank's continual provision of banking services despite knowledge that the exchange had failed to segregating funds that belonged to its customers from its own.

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