Regional banks in Japan, which primarily serve individuals and small businesses within their regions, have been struggling with low profitability, driven by prolonged low interest rates, aging and shrinking population, and their intrinsic ties to the subdued economic vitality of their region, i.e., their municipalities or prefectures. Today, Japan stands at the threshold of a new economic era. Favorable economic forces undergirded by robust wage growth, accommodative financial conditions, and ongoing fiscal support, have sparked renewed optimism on the country’s goal of shifting a deflationary low growth economy toward one with higher inflation and economic growth. However, inimical forces of demographic headwinds remain a significant structural challenge, threatening long-term sustainability.

What do these forces mean for Japan’s regional banks? How can regional revitalization initiatives and government policies serve as counterweights to these structural pressures?

Medium-term tailwinds vs. long-term headwinds affecting regional banks

After eight years of implementation, the Bank of Japan terminated the yield curve control framework and the negative interest rate policy in March 2024 and renormalized its monetary policy framework using the short-term interest rate as its main policy instrument. The short-term policy rate was gradually raised to around 0.5 percent. In the medium term, regional banks are poised to benefit from the current interest rate upcycle as monetary policy normalizes in response to an upward shift in wage-inflation cycle. As of September 2024, net interest income of regional banks increased by 9.0 percent year-on-year, as interest rates rose.

While net interest income also depends on factors such as asset portfolios and different mix of loan interest rates, the transmission of policy rate hikes to loan rates generally boosts banks’ net interest income. However, regional banks tend to pass on rising market rates to borrowers less aggressively than city banks (those typically headquartered in major Japanese cities and operate nationwide), which may limit potential gains.

In the long term, regional banks will continue to face structural challenges amid demographic shifts. Japan became a super-aged society in 2007, and its population started shrinking in 2011. These demographic trends are expected to exert persistent downward pressure on regional banks’ profitability via two channels:

    1. Public pension and private savings: An aging population could put pressure on public pension systems and accelerate the drawdown of private savings, according to an IMF working paper.
    2. Shrinking balance sheets: Amid aging and shrinking population, loans per capita would be more affected than deposits per capita, leading to smaller balance sheets and reduced loan-to-deposit ratios as shown in an IMF analysis on Japan’s financial sector.

In short, while economic tailwinds may provide medium-term support, demographic headwinds could erode long-term profitability for regional banks.

Will the uplift in profits driven by the higher interest rate under the new monetary policy framework to guide the short-term interest rate be enough to offset the structural challenges posed by demographic shifts? Most likely, no. Despite recent improvements for regional banks as a whole, profitability has become more uneven across regional banks compared to a decade ago. Without proactive strategies to address demographic challenges, less profitable regional banks may fail to fully benefit from the interest rate upcycle. This could force them to scale back lending or take on excessive risks, potentially undermining financial intermediation in the long term.

Regional revitalization as a strategy

Regional revitalization strategies provide a key countervailing force against demographic shifts. Japan has pursued regional revitalization (“chiho sosei”) strategies since 2014. According to Hijino, these include national policies aimed at attracting and retaining residents through support and cash incentives for relocation and housing, child-rearing and healthcare, employment and entrepreneurship. Other initiatives include leveraging the National Special Strategic Zones to catalyze private sector investment and utilizing big data analysis via the regional economy and society analyzing system (RESAS) to guide local decision-making.

While these ongoing regional revitalization policies are positive steps, now is an opportune moment to take stock of past initiatives and apply lessons learnt, as Japan prepares to launch its next decade of regional revitalization strategies by mid-2025.

Virtuous cycle of regional banks and regional revitalization partnership

A collaborative approach, where regional banks and financial authorities continue to work hand-in-hand, will be vital to foster financial intermediation and financial stability.

Regional banks, as key financial service providers deeply rooted in local communities, must continue enhancing profitability and service quality. This includes embracing digital transformation, forming strategic business alliances, improving operational efficiency, while maintaining prudent risk management.

At the same time, financial authorities have also played a role in supporting regional banks and encouraging them to sustain effective financial intermediation over the long term. For example, the Financial Services Agency has promoted business integration and restructuring among regional banks, often through mergers and acquisitions, based on the new anti-monopoly act.

Regional banks and regional revitalization are truly joined at the hip. Strengthening one inherently supports the other. Sustaining profitability enables regional banks to better serve their regional economies, while healthy local economies reinforce bank performance.

To effectively address Japan’s demographic challenges and secure sustainable, inclusive growth, stronger collaboration among regional banks, financial authorities, and government-led regional revitalization initiatives is essential. A more holistic approach should be adopted—one that leverages the RESAS information system, strengthens coordination across government agencies, promotes regional tourism, and allocates targeted fiscal incentives to the prefectures most impacted by demographic shifts.

With synergistic efforts across stakeholders, Japan can lay the groundwork for resilient regional economies that thrive well into the future and pose valuable lessons for other countries coping with aging societies.