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By Bloomberg

Plunging interest rates are helping reduce Japanese banks’ bad debt to record-low levels almost a fifth of their highs 13 years ago.

The drop in borrowing costs that narrowed Japanese net interest margins to the slimmest in Asia also was a factor in driving bad loans below 10 trillion yen ($80 billion) for the first time, Financial Services Agency data showed last week. That’s helped to prop up earnings for banks that clawed back reserves set aside for soured loans that didn’t materialize.

The biggest banks such as Mitsubishi UFJ Financial Group Inc. have been forced to look overseas for profits as Bank of Japan easing slashed interest margins at home, while regional lenders have been hurt by stagnant rural economies. The FSA data showed an upside, with bad debt dropping to 9.14 trillion yen at the end of March, 1.6 percent of all credit, from 43 trillion yen in 2002 in the wake of Japan’s banking crisis.

“It’s a very benign credit environment, and has been for a long time,” said David Threadgold, a Tokyo-based analyst at Keefe, Bruyette & Woods, a boutique investment bank. “Banks are lending at extremely low interest rates to what they perceive to be high-quality borrowers, and the decline in credit costs has offset the decline in spread.”

Some 59 of Japan’s 84 publicly traded regional banks booked funds previously set aside for bad loans as profit last fiscal year, adding a combined 57.8 billion yen to income, Nomura Holdings Inc. analysts Ken Takamiya and Tatsuki Hoshiko wrote in May.

Not Forever

The respite may be short-lived. Japan’s three largest banks -- Mitsubishi UFJ, Sumitomo Mitsui Financial Group Inc. and Mizuho Financial Group Inc. -- are forecasting credit costs will rise about 78 percent to 310 billion yen in the 12 months ending March from a combined 174 billion yen last fiscal year.

“These good times are not going to last forever,” said Takashi Miura, an analyst at Credit Suisse Group AG in Tokyo, citing the potential for non-performing loans to rise over the next five years. “While this may not be such a problem for the megabanks, rising credit costs will squeeze regional banks’ profit and may even set off reorganization in the sector.”

The drop in bad loans represents a turnaround from the near-collapse of Japan’s banking system after an asset price bubble burst in the early 1990s. The government spent about 12 trillion yen bailing out 54 financial institutions including Resona Holdings Inc., which repaid the last of its public funds this year. Others were forced to merge, creating the megabanks.

Less Risky

Default risk at the three lenders has declined since the global financial crisis. Credit-default swaps insuring bonds issued by Mitsubishi UFJ’s main lending unit have fallen to 54 basis points from as high as 209 points in 2011, following the nation’s record earthquake and tsunami.

Mitsubishi UFJ’s share price has climbed 30 percent this year, exceeding the 19 percent advance in Japan’s Topix stock index. Sumitomo Mitsui and Mizuho have also outperformed the equity gauge so far in 2015.

Rising values of collateral such as real estate on the back of efforts to stimulate the world’s third-largest economy have contributed to the drop in bad-loan costs, Miura said.

Another factor is a now-expired debt moratorium law that reduced bankruptcies, he said. Miura estimates as much as 1 percent of total loans, or 5 trillion yen, may not have been booked as non-performing due to the provisions enacted in 2009 to support small companies amid the global financial crisis.

Bankruptcies among Japanese companies fell below 10,000 for the first time in 24 years in the 12 months ended March, according to Tokyo Shoko Research Ltd.

“Corporate balance sheets are extremely strong,” Threadgold at Keefe, Bruyette & Woods said.