Japan's SMFG to issue preference shares

The latest capital raising exercise by Sumitomo Mitsui Financial Group (SMFG) shows that Japanese banks are weak, although for different reasons than their Western counterparts who have been hurt by their exposure to the subprime crisis. Japanese banks are suffering from a slowing economy, narrow interest margins and excessive exposure to the stockmarket. So, like Western banks, they are busy raising capital.

The ¥538.2 billion ($5.84 billion) worth of perpetual preference shares SMFG plans to issue through a private placement on December 18 should take some of the pressure off the company’s capital adequacy ratios, which have become increasingly thin. An unconfirmed rumour that SMFG, the smallest of Japan's mega-banks by assets, could add an extra ¥260 billion to the sum already announced gave the market further reason to cheer, and helped push SMFG’s share price 9.6% higher to ¥342,000 in Thursday's trading. (The counter reached a high of ¥1.36 million in 2006.)

According to Reuters, the preference shares will be taken up by a collection of around 20 Japanese institutional investors, including real estate and insurance companies.

SMFG’s announcement on Thursday follows a decision made public on November 19 to set up a wholly owned overseas special purpose subsidiary in the Cayman Islands to issue perpetual preference shares. The proceeds will partly be used to redeem an existing series of bonds maturing on January 26, 2009, which amounts to ¥283 billion. The remaining ¥255 billion will be added to the existing tier-1 capital of ¥4.5 trillion, an increase of under 6%. That means the extra capital raising – if it materialises – will be welcome, since it could roughly double the percentage increase.

The structure for issuing the non-cumulative preference shares is complex but has advantages. Under the terms of the deal, the offshore group vehicle will issue the shares, and then make what is essentially an intra-company loan with the proceeds. This combines tax benefits with a boost to the tier-1 capital cushion, points out Peter Kilner, managing partner at Clifford Chance in Tokyo.

“One of the reasons for the structure is that interest paid on the loan should be deductible by Sumitomo Mitsuin Banking Corporation (SMBC) for tax purposes, which would not be the case if SMBC were to pay dividends on the preference shares direct,” he explains.

SMBC is the actual bank and the main asset within the SMFG group.

The preference shares will be issued in four tranches of ¥113 billion, ¥140 billion, ¥140 billion, ¥145.2 billion, with coupons of 4.57%, 5.07%, 4.87% and 4.76% respectively. The tranches all come with fixed rates until various dates, including 2014, 2016 or 2019, before switching to a floating rate. One of the tranches comes with a step-up clause.

Even prior to the announcement earlier this month that Japan has entered a recession, SMFG was being hit by the steeply declining stockmarket. The TOPIX index has dropped by almost one-third since March this year. Reductions in unrealised stock gains initially hurt tier-2 capital, but once the gains turn to losses, essential tier-1 capital also begins to get eaten away. The decline in Japan’s stockmarket over the past months has been so fast that it has raised the alarm about Japanese banks.

Observers say the fact that Japanese banks as a group own some 15% of the listed Japanese market cap is a sign that the banking sector is not yet ‘normalised’. The ownership is down substantially from its peak, but still leaves the banks vulnerable to swings in the equity market. The shareholdings are part of the elaborate cross-shareholding arrangement that originally arose to protect Japanese companies from hostile – often defined as ‘foreign’ – takeovers.

Fitch Ratings writes in a recent report that SMFG’s unrealised gains on stocks had fallen from ¥936 billion in March to ¥786 billion in September, while losses on bonds amounted to ¥60 billion. The cost of these figures to tier-1 capital amounted to almost half of tier-1 equity. Fitch adds that the unrealised gains of the eight major banks disappear completely when the TOPIX index hits 900 points. At this point, tier-1 capital starts to crumble. As of Thursday, the simple moving average of the TOPIX over the past 50 days was 878 points, and 1,052 points over the past 100 days.

Fitch estimates that the major banks’ tier-1 capital would be dragged down to the minimum permissible 4% if the TOPIX slid to 600 points. SMFG’s capital raising therefore makes good sense, as does that of its peers. In fact, a total of $30 billion in capital raisings have been announced this year by the Japanese banking sector.

According to the Fitch report, SMFG had a tier-1 capital ratio of 7.08% in September, compared to 7.36% for Mitsubishi UFJ Financial Group and 7.36% for Mizuho. SMFG was the only bank that saw its tier-1 capital adequacy ratio improve somewhat between March and September. SMFG had a total (including tier-2) capital ratio of 10.25% in September, down from 10.56% in March. This is not high by international standards, says Fitch.

The ratings agency welcomes additional capital, whatever the form, but notes that the quality of the mega banks’ capital will not be improved by such moves. Indeed, core capital is related to shareholder equity, and is supposed to reflect the concentrated value of the company based on the original shareholders’ equity and retained earnings. Using hybrid capital to complement the former shows that net earnings may not be growing at a healthy pace. SMFG's net income of ¥83 billion in the six months to September 2008 was down over 50% on the ¥171 billion it earned in the same period last year.

SMFG and the other banks are not just facing market risk via their dangerous shareholdings, they are also facing credit risk as the Japanese economy slides into recession. Credit costs for the first half of the 2009 financial year (ending March 2009) doubled for the eight major banks. SMFG has the highest net non-performing loans to tier-1 capital ratio among the major banks, at 11.5%. Problem loans appear to have risen as a result of the weakening of the real estate sector, defaults among small businesses, and losses on the exposure to Lehman Brothers, which Fitch computes at about ¥150 billion for the major banks.

SMFG is no doubt regretting the $1 billion it spent on its passive (voting rights are 2%) stake in Barclays PLC in June, whose share price has fallen precipitously in the interim. Its only comfort is that its rival MUFG’s $9 billion investment in Morgan Stanley hasn't performed well either.