Banks:Initiation,Evolution of Regional Banks,Quest for Regional Competence

Reiterating our Attractive industry view for Japanese banks. Why is this a goodentry point? 1) Geopolitical risk has receded (Exhibit 1); 2) our Japan reflationbasket (MSJNREFL Index, bank weight 26%) has rebounded from a Sep 11 bottom(Exhibit 2), and we expect investors to explore the biggest opportunities for aJapan reflation trade (our strategy team is overweight the IT, financial and realestate sectors in Japan); 3) the breakeven inflation rate (a leading indicator forJapan’s bank stocks) is near its summer 2016 level, offering risk-reward appeal(Exhibit 3); and 4) with valuation for banks (forward P/B) settling at the levelimmediately prior to the Nov 2016 US presidential election, investor positioningin banks is probably now light (Exhibit 4).

    Adding the regional banks subindustry to our coverage: Our subindustrypreference within banks remains the major banks, centering on megabanks. Thisreflects 1) global easing of financial regulations, 2) real structural reforms byJapanese banks, and 3) changes in BoJ monetary policy, which leave significantupside from current share price levels. Meanwhile, analysis of past share pricesand valuations suggests that subsector rotation within the banking industry canbe effective: namely, major banks are likely to be the first to outperform inresponse to macro events, but once their multiples have expanded, we wouldexpect outperformance by the regional banks to follow (Exhibit 7). Within theindustry, we prefer major banks (top pick: SMFG) to regional banks (top pick:Fukuoka FG).

    Stock market interest in regional banks is low given structural factors, but riskfrom lack of exposure to this space is emerging: Based on the rate of decline inthe working-age population (which correlates closely with loan growth), weestimate that the lending balance in regional areas will shrink by 10-20%between 2015 and 2025 (Exhibit 51), with regional economies facing inevitablecontraction and loan yields in decline. Accordingly, we think the predominantview in the stock market is that regional banks are not investable for structuralreasons. Yet the 5 banks that we are adding to coverage have distinctive businessmodels, and a presence that cannot be ignored over the longer term. For the 3banks that we rate OW in particular (Fukuoka FG, Chiba Bank, Shizuoka Bank),we believe there is risk from being on the sidelines. Our preference is 1) FukuokaFG, 2) Chiba Bank, 3) Shizuoka Bank, 4) Suruga Bank, and 5) Concordia FG.