Before long the focus in Japan will shift from disaster response to recovery and rebuilding. Both the structure of the Japanese financial system and the experience of past natural disasters strongly suggest that Japan's banks will play a major role in the reconstruction effort. What remains to be soon, though, is whether Japanese banks can find a way to navigate the tricky demographics and economic situation of Japan and find a path to sustainable growth.

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Policy Concerns Move to the Back Burner
Before the Eastern Earthquake, investors were concerned about how Japan's large banks would navigate regulatory changes, particularly new rules about capital requirements. With the Bank of Japan ramming liquidity into the system and significant reconstruction needs, it is likely that Japanese bank officials are not going to regard Basel III standards as their top priority.

That is a particularly favorable development for Mizuho Financial (NYSE:MFG), as this bank had the most left to do in terms of getting its balance sheet in shape. By the same token, having stronger balance sheets going into this crisis should give Mitsubishi UFJ (NYSE:MTU) and Sumitomo Mitsui (Nasdaq:SMFG) more flexibility in expanding its loan book. (For more, see Banking: Introduction.)

Loan Demand Likely To Reverse Sharply
One of the major problems for the top three banks in Japan (Mitsubishi, Mizuho and Sumitomo) has been flagging loan demand. Smaller regional banks have seen some market share growth, due in part to the fact that banks like Shizuoka Bank, Suruga Bank, Bank of Kyoto and Bank of Yokohama have been keeping a lid on their fee increases relative to the larger banks. For the larger banks, though, it is has been more and more difficult to wring growth from core lending operations.

With widespread damage in the Tohoku region, though, that seems almost certain to change. If Japan follows its historical pattern, much of the aid to the victims of the quake and tsunami will consist of heavily subsidized (and/or government-guaranteed) rebuilding loans disbursed through the banking sector. And while the banks will have to be very careful not to be seen as exploiting the situation, they will nevertheless still be allowed to charge fees and make some profits from these loans.

It also is not just the citizens of Japan that will be looking for loans and rebuilding funds. Companies like Sony (NYSE:SNE), Panasonic (NYSE:PC), Hitachi (NYSE:HIT) and Toshiba have all seen damage to their facilities and may look to bank loans to fund the repairs.

While Japanese-based investment banks like Nomura (NYSE:NMR) may ultimately see corporate bond issues and equity raises to deal with this disaster, loans will likely be the short-term solution and major companies tend to deal with the major banks for those loans. Likewise, though companies like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) do have substantial operations in Japan, history suggests that the Japanese will retrench around their own home-grown lenders and financial services companies. (For more, see Opportunities Are Rising In Japan.)

Beware the Broken Window Effect
The lingering question for Japanese banks and investors in Japanese banks is what they can do to produce growth once the rebuilding operations have come to an end. Before this disaster Japanese banks were struggling with a slow-growth economy that simply did not need or want new loans to fund new businesses. In fact, the major Japanese banks were looking at long-term returns on equity in the mid to high single-digits - a level that just does not argue for investment.

With this disaster, though, it is clear that Japan's national debt is going stay high for a while longer and money that could have been used for productive purposes will instead go to reconstruction (the broken window effect). The question is whether it leads to any fundamental changes in how Japan operates. The last major disaster (the Hanshin earthquake in 1995) did not lead to any lasting change in Japan's economic or fiscal policy, but it seems fairly clear that change is needed.

The Bottom Line
If Japan can use this disaster as an opportunity to make a new start, Japanese banks could be more interesting than commonly thought. That said, investors should always be cautious of the "it's different this time" thesis and may instead want to stick to those areas of the Japanese economy that have been more competitive and dynamic in recent years. (For related reading, see The Japanese Earthquake's Effects On Insurers.)

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Tickers in this Article: MTU, MFG, SMFG, SNE, C, BAC, PC

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