Welcome to another issue of Net Interest, my newsletter on financial sector themes. This week, the subject is Norinchukin Bank. If you don’t know it, now’s the time to get up to speed. The bank commands nearly $500 billion of deposits which it deploys all over the world. Whatever market you’re looking at, chances are Norinchukin has driven through it. Paid subscribers also have access to notes on inflation accounting, US bank stress tests and a review of the GameStop saga.

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Farmers That Finance the World

Last time I was in Japan was the year before Covid. Together with my family, I travelled across the country by train, zig-zagging from Tokyo into the Kamikochi National Park (“the Japanese Alps”) before heading down to Kyoto and the south. I’d been to Tokyo several times before for business meetings, but this was the first time I’d ventured out into the country. 

As we rushed past fields and forests, my family marvelling at the speed of the trains and the tidiness of our bento-boxed lunches, I stared out the window, looking at something else. There’s no mention of it in the guide books, but the farms we passed play a central role in the global financial system. They are the source of a massive pool of savings that gets deployed right around the world. Japanese real estate, US subprime, private equity buyouts – all markets that have been financed from this pool. And sitting on top of it, commanding those flows, is a single financial institution: Norinchukin Bank. 

Japanese Raiffeisen

Like most modern economies, Japan has its roots in agriculture. In the late 19th century, agriculture, forestry and fishing accounted for over 75% of employment. The Meiji government of the time looked towards the West for ways to improve the productivity of their agricultural sector and took inspiration from the German cooperative movement.

We’ve discussed the cooperative movement here before, most recently in From Co-ops to DAOs back in January. Friedrich Wilhelm Raiffeisen, a mayor in Western Rhineland, established a credit cooperative for farmers in 1864. He had witnessed economic hardship in the agricultural community and came up with a scheme for members to pool savings in loan-fund associations, which they could draw on in the form of low-cost loans.

The Japanese took Raiffeisen’s idea and broadened it. Their farm village cooperatives pooled not only financing but also purchasing, selling and services, allowing farmers to share resources and extract the benefits of scale across multiple parts of their business. On the lending side, there weren’t initially enough savings in the system to fund the demand for loans, so the government filled the gap, funnelling funds to cooperatives via two special banks. 

Over time, the two special banks followed their best customers out of agriculture and into commerce as the economy shifted onto a more industrial footing. By 1920, less than 50% of the working population remained employed in agriculture. So the government set up a new bank to look after the sector: the Central Bank for Industrial Cooperatives. As well as channelling government funds to farming cooperatives, this bank managed flows between them, acting as a central bank for the sector. If one cooperative had surplus funds, the central bank would sweep them up and allocate them to others that were short. In 1943, the bank opened up to fisheries and forestry cooperatives as well, and changed its name to Norinchukin Bank: Nō - Rin - Chūō - Kinko (Agriculture - forestry - central - credit union).

After the Second World War, the agriculture sector continued to shrink. But farmers who stuck it out became more profitable, and their savings grew. Individual farmers parked excess funds with their local cooperatives, who passed them up to regional organisations (shinren). These regional organisations would lend out about half their money and pass the rest on to Norinchukin. By 1964, Norinchukin had gathered over 1 trillion yen of deposits; thirty years later, it had over 29 trillion yen. The only problem was that loan demand couldn’t keep up – in 1993, Norinchukin’s loan book was less than half the size of its deposits. It had to find something else to do with them. 

Having been a recipient of government funds in its early days, Norinchukin was now able to reciprocate. The bank used its excess deposits to buy government debt. Over the years, it became one of the largest buyers of Japanese national debt as well as a major provider of liquidity in the local interbank market. With prime rates as high as 9.5% during the 1980s, this was a profitable business. Indeed, farmers could earn more on their deposits than they could from farming. 

Soon, the bank supplemented its domestic investments with investments abroad. In 1979, it had started buying higher-yielding, low-risk foreign bonds including US treasuries. A change to the law in 1986 allowed it to offer the same services as other commercial banks, paving the way for it to establish an international securities subsidiary in London. And in 1989, it was given permission to make its first investment in equity markets abroad. 

By the end of 1989, Japanese banks were the largest in the world and Norinchukin itself was the eleventh largest with over $220 billion in assets, much of which were invested in securities markets. In a full page advert taken out in the Economist in 1991, Norinchukin described itself as “Japan’s top institutional investor”. The advert concluded: “Norinchukin Bank – continuing the search for better ways to respond to our clients’ international needs.” In truth, Japanese farming cooperatives didn’t have much need for an office on London’s Broadgate, but they did have a need for yield and that’s what Norinchukin provided. By offering additional interest on deposits – called incentive money, or shoreikin – Norinchukin promised a yield that required it to take a bit more risk.

Until the end of the 1980s, that wasn’t a problem. Depositors were happy and Norinchukin earned a healthy 21% return on its equity – the highest among Japanese banks – underpinned by a AAA credit rating. 

But then the market turned. Japanese banks tumbled from their perch as the largest in the world and Norinchukin wasn’t spared. 

The Jusen Problem

In the 1970s, housing loan corporations (jusen) emerged as major players on the Japanese real estate finance scene. They had originally been established to offer home mortgage loans but, driven by intense competition from banks during the 1980s, they shifted their focus to real estate developers. Up until 1990, the jusen companies had broad access to funding from a range of financial institutions but in April that year, the Ministry of Finance (MOF) introduced restrictions on lending to the real estate sector, shutting off several funding sources. One source that wasn’t shut off was agricultural cooperatives – the MOF made an exemption for them which they were only too happy to accommodate. With this new source of funds, jusens’ lending to the real estate sector grew sharply over 1990 and 1991. 

We know now of course that this coincided with the top in the Japanese real estate market. And it was quite the top! At the height of the market in 1991, all the land in Japan – a country the size of California – was worth about $18 trillion, or almost four times the value of all property in the United States at the time. 

When it collapsed, agricultural cooperatives were left holding the bag. On average, jusen companies borrowed 30% of their debts from sponsoring banks, another 30% from non-sponsoring banks, and the remaining 40% from agricultural cooperatives. Initially, there was an expectation that real estate values may recover, and a plan was pursued to restructure the debts. By 1994, it was apparent this was wishful thinking. A Ministry of Finance audit concluded that of a total 13 trillion yen of jusen assets, non-performing loans amounted to 9.6 trillion yen, of which 6.4 trillion yen was considered unrecoverable.

For the agricultural cooperatives, this was clearly very bad news. Many were threatened with bankruptcy, raising fears of a broad financial crisis with reverberations across the wider agriculture sector. To prevent that, authorities stepped in to apportion losses. After a fierce debate in the Diet, a package was approved allowing the use of taxpayers’ money. Parent banks wrote off all their equity stake and loans to these companies (worth 3.5 trillion yen), other creditor banks wrote off about 1.7 trillion yen of loans, and taxpayers took a hit of 680 billion yen – all of which left a burden on the agricultural cooperatives of just 530 billion yen. Their lobbying efforts paid off. 

Norinchukin itself posted a 54 billion yen loss in fiscal 1995, its first loss in the postwar period. Compared to many of the shinren in its orbit, it didn’t fare too badly. Over the following years, as crises flared up elsewhere in the Japanese financial system, Norinchukin kept its head down, focused on its core business. It retained its superior credit rating, allowing it to raise funds cheaply abroad and act as a commercial lender of last resort to banks at home. 

Seafood Stew

By the mid 2000s, Norinchukin had assets of 62 trillion yen ($525 billion). But it faced two challenges. First, the government had begun to reform the agriculture sector, requiring small-lot farmers – Norinchukin’s main customers – to consolidate in order to qualify for state subsidies. Other banks saw an opportunity to break into the agri-lending business and competition intensified. 

Second, low domestic interest rates squeezed the return Norinchukin could generate on deposits. It was more reliant than ever on securities markets to generate a return, with its loan/deposit ratio having fallen to below 30% by March 2006 from around 50% in the early 90s.

So it doubled down on its international exposure and invested in new-fangled higher yield securities from overseas – US mortgage-backed securities, CDOs and the like. 

If you don’t know what a CDO is, celebrity chef Anthony Bourdain gives a pretty good explanation in the movie, The Big Short:

Okay, I’m a chef on a Sunday afternoon setting the night’s menu at a big restaurant. I ordered my fish on Friday which is the mortgage bond that Michael Burry shorted. But some of the fresh fish doesn’t sell. I don’t know why, maybe it just came out halibut has the intelligence of a dolphin. So what am I going to do, throw all this unsold old fish, which is the BBB level of the bond, in the garbage and take the loss? 

No way. Being the crafty and morally onerous chef that I am, whatever crappy levels of the bond I don’t sell I throw into a “seafood stew.” See, it’s not old fish. It’s a whole new thing! And no one knows they’re eating three day old halibut. That is a CDO. 

By the end of 2005, Norinchukin had invested about 12 trillion yen in US asset-backed securities, double its investment in US treasuries. In 2007, even as cracks were appearing, it increased its exposure to 16 trillion yen, 37% of its total investment portfolio and committed to a target of 50%. “We have to buy so much that if we waited until the market recovered we would be too late,” a senior managing director at the bank told the Financial Times. “History always shows that as soon as the market touches bottom, it recovers at huge speed.”

As my friend James Aitken said at the time, “If Europe, in general, is the spittoon of structured products, then Norinchukin is the spittoon of structured credit.”

The market didn’t recover. By September 2008, unrealised losses on the bank’s balance sheet stood at 760 billion yen. A few months later, the company asked its members for a 1.9 trillion yen recapitalisation. 

The New New Thing

Its capital injection gave Norinchukin a lifeline and the bank pressed on, collecting deposits from farming cooperatives and investing them in assets with a more conservative risk profile. Profits never matched the levels the bank reached in its fiscal year ending March 2008. That year, with the benefit of a transient yield from its toxic securities portfolio, total income was 2.7 trillion yen. Income declined steadily in each of the subsequent five years, troughing at 953 billion yen in the year ended March 2012.

And then the team discovered CLOs.

Similar to the way CDOs invested in subprime mortgage-backed securities, CLOs invest in leveraged loans – bank loans to highly indebted firms, typically rated below investment grade. In  the years before the pandemic, the market for leveraged loans grew, accompanied by an increase in their securitisation into CLOs. As of June 2019, over half of outstanding leveraged loans had been securitised through CLOs.

Although the structure is similar, the product is not quite as toxic as CDOs. CLOs are less complex, they are little used as collateral in repo transactions and they are less commonly funded by short-term borrowing than was the case for CDOs. In addition, there is better information about the direct exposures of banks. 

But few investors jumped in as aggressively as Norinchukin. By September 2018, the bank had amassed a portfolio of $50 billion, equivalent to 85% of its tangible book value. In a sixth month period alone, it accounted for around a third of the increase in the size of the US CLO market and the bank ended up owning around 10% of the total market. 

As with its venture into CDOs, Norinchukin’s motivation was plain. It was paying 0.50% on deposits, but Japanese bonds were trading with negative yields – not a sustainable model. By contrast, AAA US CLO tranches offered a fully hedged return of over 0.80%. By focusing on the AAA segment, the bank hoped to minimise its risk exposure. “For a triple-A tranche, the Bank has never experienced a loss of principal both before and after the Global Financial Crisis of 2007-2008,” it told investors. 

Notwithstanding its protestations, policymakers became nervous, keen to avoid a rerun of crises past. Responding to their concerns, the bank put the brakes on its accumulation of CLOs at around $70 billion and has since pulled back. Fortunately for the market, that coincided with easing of rules in the US that allowed US banks back into the market to pick up the slack. 

Policymakers also put pressure on Norinchukin to refocus on lending to the agriculture sector.  The bank has dutifully grown its loan book from 12 trillion yen in 2018 to 23 trillion yen currently. Its medium term plan is to become a “leading bank that supports the agriculture, fishery and forestry industries, food production and consumption, and the daily lives of local communities”. Although it adds that “we strive to catch the winds of change and create new value”.

Rate Shock

It’s no wonder Norinchukin is trying to ramp up its loan book. Years of abnormally low interest rates have left its securities highly exposed to a rate shock. It’s a risk regulators are on to. In its latest financial system report (April 2022), the Bank of Japan notes that for the banking system overall, “The amount of interest rate risk associated with the yen-denominated bond investments of financial institutions has reached the highest level since records began in fiscal 2002.”

The Bank of Japan explained the increase in the amount of risk as being attributable to two factors. First, lengthening duration of bond portfolios that regional financial institutions in particular are undertaking for the purpose of compensating for the decline in profits from high-coupon bonds. Second, a rise in the outstanding amount of bond investments at all types of financial institutions since the start of the pandemic, partly due to the increase in the inflow of deposits.

Norinchukin has disclosed that a shock parallel upward move in rates would have the potential to wipe 2.58 trillion yen off the economic value of its equity, equivalent to 32% of common tier 1 capital (and 27% of overall tier 1 capital). Its portfolio has quite a long duration so that makes sense. Only 24% of the bank’s bond and credit portfolio resets within a year; 56% is fixed for at least five years. 

For now, Japanese rates look like they are being kept low, but only 23% of Norinchukin’s investment portfolio is yen-denominated. Its largest exposure is to the US Dollar, which accounts for 53% of its portfolio. And the rate move there has already begun, with a deleterious effect on Norinchukin’s balance sheet. In the calendar first quarter of the year, the bank’s capital base (common equity tier 1) fell 14% to 7 trillion yen after unrealised securities gains shrunk by almost half, from 1.7 trillion yen to 984 billion yen.

Increases in yields that have taken place since then will compound the drawdown in the calendar second quarter. And that’s before Japanese rates move higher – which, despite their best efforts, the central bank may not be able to prevent. 

Today, Norinchukin carries nearly $500 billion of deposits. For years it has struggled in an environment of low rates. Higher rates would advantage its model; the question is how well it manages the transition.