With the Japanese economy continuing to recover, asset quality for the four leading Japanese banks has continued to improve, according to a new report from Dominion Bond Rating Service.

However, the rising tide is not lifting all boats equally. DBRS says that the degree of asset quality recovery has become exceedingly differentiated among these four banks. Mitsubishi Tokyo Financial Group, Inc. has achieved good success in reducing its problem loans to below 3%, while Sumitomo Mitsui Financial Group, Inc. and Mizuho Financial Group, Inc. have made reasonable progress. UFJ Holdings, Inc. continues to struggle with a high level of problem loans still to be cleaned up, as two major banks attempt to acquire it.

The key upside to the asset quality recovery is that an increased portion of operating profits will now flow to the bottom line, such that greater retained earnings should bolster the capital position of the banks.

However, with the worst of the asset quality problems now behind them, the banks’ management faces a more difficult challenge, DBRS suggests. “Management must devise innovative and differentiating strategies that will position their banks to boost profitability to the level of major international banks, as the economy recovers from a prolonged economic downturn,” it says. “The strategies of the Japanese banks are similar as they pursue the same customer groups, with the result being intense price competition and erosion of profit margins.”

While conditions have stabilized, the outlook for future performance is still sluggish, influenced by the following: rising interest rates, net interest income continues to be pressured by declining loan balances and weaker net interest spreads, and capital ratios remain weak and capital quality is poor.

On a positive note, the banks continue to make progress in the following areas: reducing operating costs and improving efficiencies; adding new fee-based products to increase fee and commission income; and, meaningfully shifting the attitude in Japanese banking to profitability over growth among the rated companies. However, interestingly, the battle for UFJ arose out of fear of a fall in the size rankings, not due to ambitions of profitability improvement.

On that topic, DBRS expects MTFG will succeed in winning the battle for UFJ, which may be negative for UFJ shareholder value, but is clearly positive for UFJ bondholders. The key uncertainties at this point are SMFG’s next steps, and whether UFJ’s problem asset cleanup is a success. Timing is also as issue, as it is not good if the takeover uncertainty is prolonged.