Japanese mega-banks still lead in liquidity

But they're vulnerable to interest-rate risk.

Moody's Japan K.K. said that Japan's three mega-banking groups continue to demonstrate strong liquidity positions when compared to their global peers, while their substantial equity issuance after the 2008 global financial crisis has helped them address previous relative weaknesses in their core capital positions.

The three banking groups are Mitsubishi UFJ Financial Group, Inc. (MUFG), Sumitomo Mitsui Financial Group, Inc. (SMFG), and Mizuho Financial Group, Inc. and their subsidiaries.

At the same time, the banks' huge holdings of Japanese government bonds (JGB) -- while acting as a key source of their liquidity -- also expose them to considerable interest-rate risk from potential volatility in the JGB market. And when compared to their ample levels of domestic liquidity, the mega-banks' foreign-currency liquidity profiles are modest and constrained by their approach to funding their overseas businesses.

Moody's views were contained in a just-released report, titled: "MUFG, SMFG, Mizuho: Japanese Mega-Banks Continue to Derive Strength from Robust Liquidity Profiles and Improved Capital Positions."

As the report notes, the mega-banks' liquidity and capital buffers have improved their ability to withstand periods of market dislocation and are two major factors supporting their current ratings.

At end-2012, the mega-banks' JGB holdings totaled some JPY102 trillion or near 20% of their total assets. Although the presence of government bonds on their balance sheets exposes them -- as indicated -- to fluctuations in market valuations, they can deploy their JGB holdings as collateral for funding in both JPY and foreign currencies in times of stress.

However, as the report notes, Prime Minister Shinzo Abe's new administration and the coming change in the leadership of the Bank of Japan (BOJ) have raised expectations of greater efforts to end deflation, possibly leading to increased volatility in the JGB market in 2013.

If yields were to rise in response to growing optimism about Japan's economic prospects and increased inflationary expectations, there could be positive offsetting factors, such as a rise in net interest margins and opportunities for growth. On the other hand, a rise in yields caused by concerns about Japan's fiscal position would be clearly negative for the mega-banks.

In this context, the report says that if higher inflationary expectations, due to the change in government and BOJ policy, lead to a steepening in the JGB yield curve, then the mega-banks could -- given the short duration of their bond holdings -- use it as an opportunity to reinvest their maturing JGB into instruments with higher returns.

A far worse, but highly unlikely, scenario is that the threat of runaway inflation leads to a collapse of confidence in the JGB market or even JPY-denominated assets. Only in this situation would Moody's expect the asset quality and liquidity positions of the mega-banks to come under pressure.