Credit Suisse Asia Equity Focus Near-term rally expected for Japanese megabanks

Watered-down Basel 3 capital requirements alleviate funding risks for Japanese banks

The new Basel 3 capital requirements are, in our view, likely to spark a relief rally in the share prices of Japanese megabanks. The main reason for this assumption is that some of the key criteria have been watered down and the implementation horizon is more generous than expected. We note one particular positive for Japanese banks, which should lower the pressure to shore up core Tier 1 capital. The restriction pertaining to deferred tax assets (DTA) has been eased. Initially, the Basel Committee had planned to restrict accounting DTA as common equity Tier 1 capital, but now DTA may account for up to 10% of banks' common equity component. Megabanks are likely to have had DTA in excess of the stipulated 10%, but nevertheless we see the changed terms as supportive of megabanks' share prices. In our view, investors' sentiment toward Mizuho Financial Group (8411 JP, BUY) is likely to receive a large boost, as it has the lowest core Tier 1 ratio among the three megabanks. Our TOP PICK within the group is Mitsubishi UFJ Financial Group (8306 JP, BUY); with 6.9% (after adding back DTA), it comes the closest to meeting Basel 3 standards, and if it can generate sufficient retained earnings, it could be capable of achieving 8% without a public offering.

The following aspect shapes the earnings outlook for megabanks. Bank lending has been on a downtrend, which is partly due to the excess cash held by corporates and the conservative lending policies pursued by megabanks, limiting access to the credit markets of riskier borrowers. Instead, banks have been large buyers of Japanese government bonds (JGB), which sent the JGB yield to the current lows. We therefore have low expectations regarding growth in lending income and expect net interest margins to remain tight due to banks' focus on high-quality borrowers.

That said, we expect megabanks to post relatively robust Q1 results due to the buoyancy of the bond market. This phenomenon is unlikely to be repeated in Q2, however. Hence, the key driver of the earnings recovery at megabanks in FY 2010 is the decline in credit costs. Japan's economy has accelerated and with our GDP forecasts for 2010 and 2011 of 3.3% and 1.8% respectively, growth ranges above the Bank of Japan estimated potential GDP growth rate of 1%–1.5%. As corporate profits are also expected to see a brisk recovery in FY 2010, this will likely favor a decline in non-performing loans and boost banks' net income.

In our view, the watered-down Basel 3 capital requirements and positive Q1 earnings surprises are likely to spark a near-term rally in megabanks. Sumitomo Mitsui Financial Group (8316 JP, BUY) has already set the tone, reporting stellar Q1 net income of JPY 211.8 bn, up 200% YoY. Recurring profits of JPY 273.2 bn compare to JPY 665 bn FY 2010 consensus estimate. And exact in line with expectations, trading profits and lower provisions were the drivers.