Japan's regional banks are facing profitability pressure from low interest rates, weak loan demand and demographic changes. These challenges are likely to drive consolidation of the highly congested Japanese banking system over the next decade, as banks are forced to improve efficiency, says Fitch Ratings.

According to Fitch, Japan's ultra-low interest rates are having a more severe impact on the profits of regional banks than on the city banks, given that interest revenue on average accounts for 88 per cent of regional banks' total revenue, compared with 66% at city banks.

Regional banks are also dealing with weak loan demand and limited growth opportunities. Japan's largest cities, which are dominated by the city banks and some large regional banks, account for almost half of national economic activity and suffer less than other regions from structural challenges. In particular, populations are falling faster and ageing more quickly in the regions than in the cities, as young people are pulled to the cities by job opportunities. Demand for most banking services, especially lending, falls as a population ages.

According to Fitch, rising pressure on profits will strengthen the case for further consolidation among the 105 regional banks - which hold a loan market share of 44 per cent- over the next decade. Consolidation will face execution and, in some cases, anti-monopoly challenges, but should improve efficiency and support earnings over the longer term. In the short term, system integration may, however, require substantial financial investment. The pace of consolidation has already picked up since January 2016, with seven banks reorganising into four groups and 11 more planned by 2020.

Fitch undertook sensitivity analysis on the profit and capital for all 116 Japanese banks, and presents aggregated outcomes in our report released today. The analysis shows that regional banks are vulnerable to small rises in credit costs, as an additional 5bp increase would lead to 16 regional banks reporting losses without bond-trading gains. The weakest regional banks can sustain credit costs of about 2 per cent of loans before breaching regulatory minimum ratios, which Fitch views adequate in the current environment.