MBFJF - Sumitomo Mitsui Financial Group: Block Trading Scandal And Updated Performance

• While continuing their measured performance, a few risks have arisen as of late.
• The most critical is allegations of illegal block trade practices, such as informing clients before trades occurred.
• I will remain neutral and recommend that potential investors consider other banks in the meantime.

A Few Risk Cause Neutral Outlook

The Sumitomo Mitsui Financial Group ( SMFG ) (SMFNF) is the holding company for one of the top three largest banks in Japan, along with Mitsubishi UFJ ( MUFG ) and Mizuho ( MFG ). Japanese banks are interesting companies to study for the opportunity to gain stable foreign exposure, but 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 that I will discuss. To summarize, I believe the company offers little upside, even after a few months of weakness.

Market Manipulation Allegations = Costly and Endless Litigation

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

[For] SMBC Nikko, a century-old business whose owner Sumitomo Mitsui Financial Group is one of Japan’s biggest financial industry brands, [the allegations] have proved spectacularly damaging.

After an 18-month regulatory probe into alleged market manipulation during which one trader died after intense questioning, large clients have fled the tarnished brokerage. Six senior bankers now face criminal trial over accusations the group artificially boosted share prices before the sale of the blocks.

Business, morale and prospects at SMBC Nikko are “ apocalyptically bad ”, according to one veteran of the brokerage.

Essentially, Japanese prosecutors claim SMFG has leveraged their large network of business relationships to gain benefit through block investments. While some say the response by the government is heavy-handed, unsubstantiated, and likely to lead to years of litigation, SMFG is likely to lose clients as a result of the bad reputation:

In their pursuit of scalps, both the SESC and Tokyo Prosecutors’ Office have guaranteed a long trial that will hinge on highly nuanced debate over the precise nature of whether the act of buying shares at the end of the day constitutes stock manipulation under its legal definition of “price fixing”, and the provability of intent.

Both of these, say legal experts who have been involved in other cases, would normally be enough to deter prosecutors.

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

As this is a relatively new development, I expect issues to materially affect the company for a few quarters, or more. In fact, a decline in performance can already be seen in the SMBC Nikko segment. As of the last earnings, there has been a 22% reduction in segment net income because of a slight decline in client assets and a sharp decline in both commission revenues and product sales. This can be seen in the slide below. While some of this decline can be attributed to tough comparables to the prior year, it is unknown what the full financial impact will be. This uncertainty will lead to underperformance as investors either sell or are hesitant to buy.

Russian Exposure and Higher Loan Risks Than Peers

SMFG has taken a hit in price over the past few months, even with the expectation of rising interest rates. Part of this is due to the risk of loan losses as a result of the Invasion of Ukraine. MUFG is limiting their exposure to Russia, but the bank remains exposed to the country to a higher degree than peers, Mizuho and MUFG. SMFG claimed only 0.3% loan exposure to Russia as of January 2022, compared to 0.2% for Mizuho and less than 1% for US banks .

Holding cash to combat the risk of clients failing to pay back loans is known as loan loss provision, and higher values may signal increased risk of the bank's loans. Thankfully, it seems that Japanese banks have reduced their risk exposure as loan loss provision amounts are reduced when compared the prior year. The exact amounts and executive commentary, as reported by S&P Global , are as follows:

MUFG, Japan's biggest bank, said it will set aside ¥300 billion in loan-loss reserves for the current fiscal year, down from ¥331.4 billion in the prior year. SMFG set aside loan-loss reserves of ¥210 billion for the current fiscal year, down from ¥274.4 billion in the previous year, while Mizuho will allocate ¥100 billion in loan-loss reserves, compared to ¥235.1 billion in the fiscal year that ended March 31...

...SMFG expects net profit in the current fiscal year to rise 3.3% to ¥730 billion, while Mizuho expects its net profit to increase 1.8% year over year to ¥540 billion.

"We'll take a conservative stance" on global operations given the high interest rates, Mizuho CEO Masahiro Kihara said at a separate earnings briefing on May 13.

SMFG seems to have performed adequate risk management prior to the invasion, particularly in regards to Russian exposure (no Ukrainian or Belarus exposure prior to invasion). However, as a result of the situation, management expects impacts to both net operating profit and bottom-line profit as a result, up to almost $1 billion in losses. Interestingly enough, much of the impact is the result of SMFG's large aircraft leasing segment, which is still heavily impacted by the pandemic, and perhaps would have been more impactful if not for the pandemic. Thankfully, the rest of the company holdings seem to be performing well and growth is expected for the next full year.

Financial Update

Outside of these two risk points, Sumitomo Mitsui Financial continues to hold their place as a low-risk financial investment. The company is performing a range of upgrades and diversification to their platform to drive improved profitability and growth. This also follows solid performance in the payments and asset management segments as spending and investing normalizes after the pandemic. As a result, I find that recessionary risks are not too much of a worry point for current investors, and I will point out some other bullish points for those currently invested in SMFG.

One key quality of Japanese banks is conservative financial policy. As a result of slow growth over the years, this has led to relatively high dividends. When combined with SMFG's buybacks and rising DPS, current investors have the benefit of positive shareholder practices. The current dividend yield is hovering around 6% per share, so high yield investors may find the holding to be interesting for their needs.

To further highlight the continued safety of the investment, management, including current major bank credit ratings, and SMFG as a holding company ranks among the top banks in the world. While the ratings vary between all the ratings agencies, investors can feel confident that SMFG constantly ranks near the top of the financial group. However, peers MUFG and Mizuho also perform similarly well and should be considered due to SMFG's recent risks. It will be interesting to see if SMFG will get downgraded in the future as a result of the Nikko incident, but no news has emerged to date. To that point, SMFG ranks quite low according to BIS (see image below), and those rankings may be more recently updated.

Conclusion

While offering steady performance and a solid 6% dividend yield, the risks associated with potentially illegal securities trading may weight on the future share price performance. Financially, the segment offers only a small portion of overall profits, but meaningful declines are already being seen. Those interested in investing should monitor the performance and proceedings carefully, but I believe most potential investors may be better off researching the peers, Mizuho or MUFG.

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

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