Japan’s banking sector has engineered an impressive turnaround, having managed through the asset quality problems it has suffered in recent years, according to a new report by Fitch Ratings.

Although two of Japan’s major banks reported net losses for the fiscal year ending March 2005, Fitch said it expects all seven of the major domestic banking groups to return to the black in the current year. The international ratings agency said it believes the major banks may report aggregate net profits of between ¥1.5 trillion to ¥2.0 trillion in fiscal 2006, “which would be their best performance since 1989, when their loan books were about 40% larger than they are now, domestic stock prices were three times higher, Japan’s real estate prices were booming and the bubble economy was in full swing.”

In the comment, Fitch noted the dramatic improvement in asset quality in the sector. The ratio of net non-performing loans to the banks’ aggregate equity was just 15% in fiscal 2005, down substantially from 95% in fiscal 2002. “This improvement in asset quality is the result of increasingly strict regulatory inspections, the banks’ own aggressive NPL disposals in recent years and substantially higher levels of loan-loss reserves,” it said, adding that it welcomes all of these developments.

The major challenge now facing the sector is how to raise earnings as loan books continue to shrink and margins remain thin, it added. Even if the sector reports the sort of record net profitability that Fitch anticipated in 2006, it would represent a return on total assets of about 0.3%-0.4%, which is only about one-third the level of comparable diversified major banking groups in other developed markets. “As a result, all of Japan’s major banks are adopting strategies to boost their retail operations, with particular focus on unsecured consumer and small-business lending, residential mortgages and fee and commission income,” it said.

The amount of public Tier 1 capital outstanding at the major banks is ¥5.3 trillion. Fitch expects most of the banks that have not already done so to repay the government within two to three years. “This will help to improve further the quality if not quantity of the sector’s regulatory capital,” it said. “With growing confidence, repaired balance sheets and no longer an obligation to repay the Japanese taxpayer, the major banks could start searching at home and overseas for bolt-on acquisitions as a relatively easy way to help solve the major question they all now face: how are they going to improve their earnings?”