Sumitomo Mitsui Financial Stock: Block Trading Scandal

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A few risks cause a neutral outlook

The Sumitomo Mitsui Financial Group (NYSE: SMFG) (OTCPK: SMFNF) is the holding company of one of Japan’s three largest banks, along with Mitsubishi UFJ (MUFG) and Mizuho (MFG). Japanese banks are interesting companies to study for the possibility of obtaining stable foreign exposure, but they are limited due to low interest rates and GDP growth in the country. Of the three, SMFG certainly seems the strongest on paper, but some weaknesses are present which I will discuss. To sum up, I think the company offers little upside, even after a few months of weakness.

Market Manipulation Allegations = Costly and Endless Litigation

The main point of risk to consider is the result of issues stemming from nepotistic investment practices in their securities subsidiary, SMBC Nikko. The Financial Times recently published a report summarizing recent developments.

[For] SMBC Nikko, a century-old company whose owner Sumitomo Mitsui Financial Group is one of the biggest brands in the financial sector in Japan, [the allegations] proved spectacularly damaging.

After an 18-month regulatory investigation into alleged market manipulation in which a trader died after intense questioning, big clients fled the tarnished brokerage. Six senior bankers now face a criminal trial on charges that the group artificially inflated share prices before the blocks were sold.

SMBC Nikko’s business, morale and outlook are “apocalyptically poor”, according to a brokerage veteran.

Essentially, Japanese prosecutors claim that SMFG leveraged its extensive network of business connections to profit from block investments. While some say the government’s response is blunt, unsubstantiated and likely to lead to years of litigation, SMFG risks losing customers due to its poor reputation:

In their quest for scalps, the SESC and the Tokyo prosecutor’s office have guaranteed a lengthy trial that will revolve around a highly nuanced debate about the precise nature of the question of whether the act of buying shares in ultimately constitutes stock market manipulation within the meaning of its legal definition. of “price-fixing” and evidence of intent.

These two elements, according to legal experts who have been involved in other cases, would normally be enough to deter prosecutors.

Instead, they doubled down in a way that cast doubt on the future of one of Japan’s biggest financial brands.

As this is a relatively new development, I expect the issues to materially affect the business for a few quarters or more. In fact, a drop in performance is already visible on the SMBC Nikko segment. Since the last results, there has been a 22% reduction in the sector’s net income due to a slight decline in client assets and a sharp drop in commission income and product sales. This can be seen in the slide below. While some of this decline can be attributed to difficult comparables with the prior year, it is unclear what the full financial impact will be. This uncertainty will lead to underperformance as investors either sell or hesitate to buy.

Financial results of the subsidiary SMBC Nikko

SMFG

Russian exposure and lending risks higher than peers

SMFG has taken a price hit in recent months, even with the expectation of higher interest rates. This is partly due to the risk of loan losses resulting from the invasion of Ukraine. MUFG limits its exposure to Russia, but the bank remains exposed to the country to a higher degree than its peers, Mizuho and MUFG. SMFG claimed just 0.3% loan exposure to Russia in January 2022, compared to 0.2% for Mizuho and less than 1% for US banks.

Holding cash to combat the risk of customers not repaying their loans is known as a loan loss allowance, and higher values ​​may signal increased risk of the bank’s loans. Fortunately, Japanese banks appear to have reduced their exposure to risk, with loan loss provision amounts reduced from a year earlier. The exact amounts and management comments, as reported by S&P Global, are as follows:

MUFG, Japan’s largest bank, said it will set aside 300 billion yen in loan loss reserves for the current fiscal year, up from 331.4 billion yen the previous year. SMFG has set aside loan loss reserves of 210 billion yen for the current fiscal year, up from 274.4 billion yen a year earlier, while Mizuho will allocate 100 billion yen in loan loss reserves, compared to 235.1 billion yen for the fiscal year ending March 31…

…SMFG expects current-year net profit to rise 3.3% to 730 billion yen, while Mizuho expects net profit to rise 1.8% year-on-year to reach 540 billion yen.

“We will take a cautious stance” on global operations given high interest rates, Mizuho CEO Masahiro Kihara said in a separate May 13 earnings briefing.

SMFG appears to have performed adequate risk management prior to the invasion, particularly with respect to Russian exposure (no Ukrainian or Belarusian exposure prior to the invasion). However, due to the situation, management expects impacts to both NOI and net income, up to nearly $1 billion in losses. Interestingly, much of the impact is the result of SMFG’s large aircraft leasing segment, which is still heavily impacted by the pandemic, and might have had more of an impact had it not been for the pandemic. Fortunately, the rest of the company’s holdings appear to be doing well and growth is expected for the next full year.

Sumitomo Mitsui Financial Group - Financial impact of the invasion of Russia

SMFG

Financial update

Apart from these two points of risk, Sumitomo Mitsui Financial continues to hold its own as a low-risk financial investment. The company is carrying out a series of upgrades and diversification of its platform to improve its profitability and growth. It also follows strong performance in the payments and asset management segments as spending and investment normalize post-pandemic. Accordingly, I find that recession risks are not too much of a concern for current investors, and I will highlight a few other bullish points for those currently investing in SMFG.

Financial performance of Sumitomo Mitsui Financial Group

SMFG

Sumitomo Mitsui Financial Group - Long Term Financial Performance

SMFG

One of the main qualities of Japanese banks is their prudent financial policy. Due to slow growth over the years, this has led to relatively high dividends. Combined with SMFG buyouts and higher DPS, current investors are benefiting from positive shareholder practices. The current dividend yield hovers around 6% per share, so high-yield investors may find the holding attractive for their needs.

Sumitomo Mitsui Financial Shareholder Returns

SMFG

To further emphasize the continued security of investment, the management, including the current credit ratings of major banks, and SMFG as a holding company rank among the best banks in the world. Although ratings vary between all rating agencies, investors can be sure that SMFG consistently ranks near the top of the financial group. However, MUFG and Mizuho peers are also performing well and should be considered due to recent SMFG risks. It will be interesting to see if SMFG will be downgraded in the future following the Nikko incident, but no news has emerged as of yet. At this point, SMFG ranks quite low according to the BIS (see image below), and these rankings may be updated more recently.

Credit ratings of global bank holding companies.

SMFG

A ranking of banks by a variety of measures.  Highlights show Japanese majors.

Bank for International Settlements

Conclusion

While offering stable performance and a strong 6% dividend yield, the risks associated with trading potentially illegal securities may weigh on future share price performance. Financially, the segment offers only a small part of the overall benefits, but significant declines are already observed. People interested in investing should watch the performance and proceedings carefully, but I think most potential investors would be better off researching their peers, Mizuho or MUFG.

Thanks for reading. Feel free to share your thoughts on recent developments below.

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