OREANDA-NEWS. Fitch Ratings has affirmed the Long-Term Issuer Default Ratings (IDRs) on two Japan-based regional banks - Shizuoka Bank, Ltd. (The)'s (Shizuoka) at 'A' with a Negative Outlook and Suruga Bank Ltd.'s (Suruga) at 'A-' with a Stable Outlook.

A full list of rating actions is provided at the end of this rating action commentary.

KEY RATING DRIVERS

VIABILITY RATING (VR) AND IDRs

The IDRs of Shizuoka and Suruga are driven by their VRs. Like other banks in Japan, most regional banks continue to face a challenging operating environment. This includes rising uncertainty over the sustainability of government initiatives to stimulate economic growth and competitive pressures in a very low, if not negative, interest-rate environment. Strong funding and liquidity, sustained by a firm deposit base, are key strengths for the Japanese banking system and for both banks' ratings.

The Negative Outlook for Shizuoka reflects the constraint of its VR being rated equal to that of Japan's sovereign rating (A/Negative). It would be difficult for the bank to avoid failure in the event of a sovereign default, even though its intrinsic profile is otherwise stable, due to Shizuoka's high exposure to Japanese government bonds (JGBs) relative to its capital. The bank's JGB holdings were 68% of Fitch Core Capital (FCC) at end-March 2016, despite decreases in the previous few years.

The Stable Outlook for Suruga's IDRs reflects Fitch's view that harsh credit cost rises will not crystalise and the bank's credit profile will be underpinned by adequate risk controls and buffers, particularly in terms of earnings capacity.

Shizuoka's VR of 'a' reflects its sustained strong capitalisation, with an FCC ratio of 16.3% at end-March 2016, leading franchise in Shizuoka Prefecture and potential buffers against credit-risk through high guarantee/collateral coverage, including public guarantees. Constraining factors for Shizuoka's VR include limited options to diversify its revenue base and the negative interest rate policy squeezing its profitability due to the bank's reliance on lending.

Suruga's VR of 'a-' factors in its above-domestic peer profitability, with a return on assets of 0.9% for the year ending March 2016, compared with mega banks' average of 0.4%. Suruga has also improved its net interest margin, with increased balance in higher-yield non-housing loans, whereas the net interest margins of domestic peers contracted. The bank's relatively high profitability is backed by its unique business model, which differentiates itself from typical Japanese commercial banks by focusing on the retail business; providing a wide range of retail clients with multi-purpose loans. Profitability is also supported by Suruga's proactive risk control, although to some degree it may reflect the bank's higher risk appetite. Suruga's VR is constrained by a lack of diversification due to the bank's concentration on retail lending and its small asset size, with consolidated total assets of JPY4trn, compared with Shizuoka's JPY11trn, at end-March 2016.

SUPPORT RATING (SR) AND SUPPORT RATING FLOOR (SRF)

Shizuoka's SR of '2' and SRF of 'BBB-' reflect Fitch's belief that the sovereign has a strong propensity to support the bank, if necessary, due to Shizuoka's size relative to other banks in its prefecture and nationally.

Fitch believes the sovereign's propensity to support Suruga, which has an SR of '4' and an SRF of 'B', may be more limited due to the bank's marginal systemic importance within Japan's financial system and small operational size.

RATING SENSITIVITIES

VIABILITY RATING (VR) AND ISSUER DEFAULT RATINGs (IDR)

The VR for Shizuoka could be downgraded if the sovereign's rating is downgraded, in light of the bank's rating's proximity to the Japanese sovereign's IDRs. The bank's VR is unlikely to be rated above the sovereign's rating due to Shizuoka's significant sovereign exposure and high dependence on the domestic economy for its business operation and revenue generation.

Positive rating action for Suruga is likely to stem from further structural improvement in the domestic operating environment, leading to sustainable loan expansion and faster internal capital generation without a large increase in risk appetite. However, Suruga's IDRs and Outlook are constrained by the Japanese sovereign's IDRs, even if its VR was upgraded to 'a'. Fitch believes structural improvement is remote and will take some time.

Both banks' VRs and IDRs could be downgraded if substantial deterioration in the operating environment increases performance volatility, resulting in the banks taking more risk to offset the negative environment's effects without a corresponding increase in loss-absorption buffers. This includes increased exposure to market risk, although Fitch expects it to be small, or involvement in industry consolidation, leading to potentially higher earnings or capital volatility.

SUPPORT RATING (SR) AND SUPPORT RATING FLOOR (SRF)

Shizuoka's SR and SRF are based on Fitch's assessment of the sovereign's ability and willingness to support the bank, and are therefore sensitive to changes in the sovereign's rating. A downgrade in the sovereign's ratings to 'A-' or below would be likely to lead to a downgrade in Shizuoka's SR and SRF.

Suruga's SR and SRF are not immediately sensitive to the sovereign rating, as Fitch already factors in a limited probability of support. Fitch may change its perception about the sovereign's willingness to support Suruga subject to the evolution of the bank's regulatory framework.

The rating actions are as follows:

Shizuoka:

- Long-Term Foreign - and Local-Currency IDRs affirmed at 'A'; Outlook Negative

- Short-Term Foreign - and Local-Currency IDRs affirmed at 'F1'

- Viability Rating affirmed at 'a'

- Support Rating affirmed at '2'

- Support Rating Floor affirmed at 'BBB-'

Suruga:

- Long-Term Foreign - and Local-Currency IDRs affirmed at 'A-'; Outlook Stable

- Short-Term Foreign - and Local-Currency IDRs affirmed at 'F1'

- Viability Rating affirmed at 'a-'

- Support Rating affirmed at '4'

- Support Rating Floor affirmed at 'B'