By Sumio Ito
TOKYO (Reuters) - Japan's financial regulator has told the country's smaller banks they must find new ways to make profits if they are to survive, warning many face risks when interest rates eventually rise and that some are already in a precarious state.
Some lenders are only managing to stay in the black through bond-trading gains, Financial Services Agency Commissioner Nobuchika Mori told regional bank leaders in closed-door meetings last week, according to two participants.
The unusually blunt language for a Japanese bureaucrat indicated "a real sense of crisis," said one of the participants, who declined to be identified as the discussions were private.
Japan's more than 100 regional banks are struggling as lending opportunities wane with the shrinking of their local populations - pain that has been exacerbated by a squeeze on lending margins from the Bank of Japan's negative interest-rate policy.
The FSA has been nudging them for several years to shore up their finances, but Mori's comments mark an escalation of concern that regional banks are failing to reform while they have the cover of essentially free money from the central bank.
The central bank's massive buying of Japanese government bonds, part of its radical policies to stoke inflation, offer lenders almost guaranteed profits. But if market interest rates should rise and bond prices fall, regional banks would be left with huge losses on their books.
"If institutions simply undertake securities investments to improve today's earnings figures with no thought for tomorrow, or waste precious time getting immediate returns without thinking about customers, they will really run out of options and reach a dead end," Mori was quoted as saying by the participants.
He told the bankers they must find sustainable business models while they still have time - remarks that one participant said he took as pressure on the banks to merge or take other drastic action.
The FSA declined to comment on the remarks by Mori, who was reappointed this month to a rare third term as FSA chief.
Regional lenders, which hold about half the country's $4 trillion in outstanding bank loans, are grappling with stagnating local economies as the country's overall population rapidly ages and as young people move to major cities.
But they have seen little in the way of consolidation in contrast to their bigger rivals, which shrank in number from more than 20 to just 3 "megabanks" in the years after a 1990s domestic banking crisis.
The 95 regional banks judged by domestic standards had overall capital equal to 9.86 percent of risk-weighted assets at the end of June, down from 10.2 percent a year earlier, FSA data show. By comparison, Japan's megabanks saw their international capital-adequacy ratios improve to 16.29 percent from 16.17 percent over the same period.
A few regional banks have begun to merge, but some of them are finding their plans stymied by Japan's antitrust regulator.
The FSA late last year began investigating banks' ability to manage interest-rate risk and last month decided on a rule for regional banks to guard against potential bond losses in the event of sharp interest-rate swings.
(Reporting by Sumio Ito; Additional reporting by Takahiko Wada; Writing by Thomas Wilson; Editing by William Mallard and Edwina Gibbs)