Moody's Japan K.K. says that the ability of Japanese regional banks to absorb potential credit and/or investment losses through recurring earnings has been shrinking. Net interest spreads continue to decline, due to persistently low interest rates and intense competition.



"Cost-cutting efforts have only offset around one-quarter of the decline in the banks' net interest income, and around one-third of the slowdown in net fees," says Shunsaku Sato, a Moody's Vice President and Senior Credit Officer.



Sato explains that while the flow-based loss-absorption capacity of Japanese regional banks continues to shrink, their willingness to accumulate earnings to at least match the growth of earning assets -- rather than distributing such earnings to their shareholders -- is becoming increasingly important in sustaining their loss-absorption capacity.



"As for credit costs, we expect such costs to rise from the current unsustainable low levels," adds Sato.



Moody's analysis is contained in its just-released report titled "Banking - Japanese Regional Banks: Ability to Absorb Losses Through Earnings Continues to Shrink," and is authored by Sato.



Moody's report points out that the banks' recurring profitability has been declining. Pre-provision income (PPI) -- excluding capital gains -- for the 64-member banks of the Regional Banks Association of Japan declined by almost 7% over the past five years, while earning assets grew by 17%.



The PPI ratio -- calculated using PPI as a percentage of earning assets -- declined to 43 basis points (bps) from 54 bps over the same five-year period.

On credit costs, Moody's says such costs will rise, given that during the fiscal year ended 31 March 2015, aggregate net credit costs for the regional banks amounted to just one basis point of loan balances.



Moody's report notes that even a small uptick in credit and investment losses to 20 bps or a level equivalent to the 10-year average net credit cost for the regional banks, would severely damage the profitability of the average Japanese regional bank. As for credit and investment losses of 40 bps -- a level which has previously been reached -- such a loss would wipe out most of the banks' earnings.



Moody's further notes that the banks have been building their capital base to sustain their risk absorption capacity. As a group, the regional banks retained approximately 60% of their earnings over the past five years; resulting in an annual internal capital generation ratio of 4%, or roughly in line with the growth in earning assets.



As a result, the banks' ratio of common equity to earning assets has remained stable at just below 5%



