One segment of Japan's banking sector is struggling to stay afloat — and the country's shrinking population and ultra-low interest rates seem likely to prolong those lenders' troubles.
Regional banks — those mid- and small-sized lenders that mostly serve the population outside major cities — have seen a decline in their profits from core lending and fees. In the financial year ended March 2017, more than half of those banks lost money on that business segment, Reuters reported.
More than 100 regional banks face dwindling prospects of growing their loan portfolios, due to the country's rapidly aging and shrinking population. Their margins are also squeezed by the Bank of Japan's long-running negative interest rate policy.
Regional lenders, which together account for around 40 percent of Japan's outstanding loans, have turned to other businesses such as securities trading to boost their bottom lines. That could expose Japan's financial sector to new risks, noted Harumi Taguchi, principal economist at IHS Markit.
"Banks could hold more equities and investment funds instead of holding government bonds," Taguchi told CNBC. She added that the lenders' asset quality would then be subject to movements in markets, which have been volatile since the start of the year.
The immediate threat to financial stability is limited for now, according to Taguchi. But the Bank of Japan, in its latest financial stability review in October, flagged the importance of banks strengthening their ability to handle risks that stem from rising securities investments.
"Making arrangements to meticulously conduct appropriate risk and profit management is essential for sustainable improvement in profitability through risk taking," the central bank said in its report.
Economy improves, but little good news for regional names
There have been signs of economic progress in Japan, which would typically mean better prospects for the banking sector.
But profitability at regional banks is likely to stay soft. Part of the problem is the BOJ maintaining its easy monetary policy , which erodes lending margins and yields from investments in government bonds.
In addition, populations are dwindling faster in the suburban and rural areas. That means regional banks — with operations concentrated in those places — would be more severely affected compared with their peers in the cities.
"As long as Japan's regional banks are geographically limited to the regions where their businesses are based, we believe they are unlikely to cope with effective solutions for their current problems," S&P Global Ratings said in a report.
Several regional banks have merged to better compete in an increasingly difficult environment. Daishi Bank and Hokuetsu Bank received the approval last December to merge in one of the latest — but certainly not the last — cases of regional bank consolidation.
The government can lend a hand in speeding up mergers between regional banks to help them survive, noted IHS Markit's Taguchi.
"Abe administration will urgently need to set a scheme to accelerate merger of regional banks with clearer oligopoly issues in order to increase Japan's financial stability," she said.
Trading Japan's banking sector
In spite of the troubles faced by regional banks, several analysts said now is a good time to pick up the country's banking stocks .
Nomura, for one, said Japan's three mega-banks — Mitsubishi UFJ Financial Group , Mizuho Financial Group and Sumitomo Mitsui Financial Group — are "highly undervalued."
"We are bullish on Japan's major banks," Nomura said in a report earlier this month. "Our top pick among Japanese banks is Mitsubishi UFJ Financial Group (MUFG), which is steadily enhancing its consolidated earnings power and is likely to continue to achieve profit growth."
Those three banks, like their regional peers, have struggled to expand their domestic lending. But they have survived the ordeal better by expanding overseas and using new technologies to be more efficient.
That has placed the large banks in a better position to benefit from both global and domestic economic recovery.
"This sector is hurt by continuing negative interest rates, but it appears that much of the potential damage is already in forecasts. A steepening U.S. yield curve would be positive for the megabanks," Jefferies analysts wrote in a report earlier this month.