A bleak forecast by the Bank of Japan that nearly 60 percent of the nation’s regional banks will suffer net losses 10 years from now serves to remind us of the tough prospects facing these financial institutions. They will have to overcome a dwindling client base brought on by the accelerating population decline in many regions across Japan and the tightening profitability of their lending business.

The worsening performance of regional banks bodes ill for the companies and other borrowers that sustain regional economies. The BOJ’s report cites mergers between struggling banks as an option for their survival, but that alone won’t resolve the problems biting into their profitability. Leaders at these banks need to redouble their efforts to explore a new, sustainable model so they can stay open for business.

The financial system report released last month by the central bank warned that growth in the regional banks’ outstanding loans will slow down if the business demand for lending continues to fall at the current pace, while the cost of setting aside loan loss reserves in case their lending turns sour will increase. While currently only about 1 percent of all regional banks post net losses, the ratio will increase to 58 percent 10 years from now, the BOJ said. If a financial crisis like the one that followed the 2008 Lehman Brothers collapse were to happen five years from now, the regional banks would sustain greater damage than if such a crisis took place today, because profitability and capital adequacy are expected to decline in coming years, the central bank said.

Management problems at regional banks would threaten the appropriate supply of financial services to the clients in the regions they serve, thus harming the local economies. The central bank report cautions that a decline in the regional banks’ financial health could force them to cut back on their lending, thereby adding downward pressure on the economic activities in the regions they cover.

The business environment in which regional banks have been operating has indeed been growing increasingly severe as the ultra-low interest rates under the BOJ’s extended policy of monetary easing eat into the profit margins on their lending. In the April-December period of 2018, more than 80 percent of the 79 regional banks listed on the Tokyo Stock Exchange and other markets posted either reduced profits or losses. Warnings about reduced profitability in regional banks’ lending operations are nothing new.

In its report, the BOJ urged the banks to set interest rates that match the risk associated with the loans, make efforts to increase the profitability of their commission business, and review the process of their operation and expense structures in order to improve their financial health. But that’s all easier said than done.

In recent years, many regional banks have increased lending to the real estate sector — where a relatively high degree of interest rate revenue was expected — and a separate BOJ report last month warned that real estate-related lending is overheating for the first time since 1990, the peak of the asset-inflated bubble boom, particularly among regional lenders. However, the regional banks’ lending to the real estate sector is reportedly slowing down after the revelation of improper screening of housing loans by Suruga Bank, based in Numazu, Shizuoka Prefecture, which had once been hailed for its strong profits even as other regional banks were mired in lower profitability.

Meanwhile, some of the regional banks, in their competition with each other to attract the dwindling pool of clients, are said to be increasing loans with interest rates that don’t match the risk of the borrowers going bankrupt — a risk that could result in greater losses in case the economy takes a turn for the worse.

Some regional banks have pursued mergers and management integration for survival. The BOJ report says that mergers and tieups among the regional banks, as well as collaboration with firms in other sectors, are among the effective options to beef up their business foundation. So far, mergers that would result in the integrated institution dominating an overwhelming share of the local market have been subjected to strict screening in view of antimonopoly concerns. This was seen in the case of Fukuoka Financial Group and Eighteenth Bank, whose integration was put on hold for more than two years until the Fair Trade Commission approved it last year on condition that they would transfer some of their loans to clients in Nagasaki Prefecture to other banks to reduce the market share of the new bank to be created through the merger.

The government is now reportedly exploring exceptions to the Antimonopoly Law to facilitate such mergers if the banks’ financial health is deemed a risk to their local economy. Mergers may indeed save struggling regional banks, but that alone won’t solve all of their management problems. It will remain a major challenge for many of the regional banks to establish sustainable business models that meet their evolving business environment.