| WAKKANAI, Japan
WAKKANAI, Japan First the commercial fisheries began shutting down in this hardscrabble corner of Japan's northern coast. Then tourism fizzled.
Now, the small-town bank that serves Wakkanai, at the tip of Hokkaido, is grappling with a problem common throughout Japan's financial system: to survive years of deflation it has had to stray far from its core mission of making loans, and the easy investment income it has come to rely on is looking shaky.
"There's no demand for productive loans," says Masatoshi Masuda, president of the town's Wakkanai Shinkin bank.
Japan's big banks are starting to feel some benefit from "Abenomics" - the radical policy mix of massive monetary easing, fiscal stimulus and growth-orientated reforms pursued by Prime Minister Shinzo Abe since his return to power last year.
But economic revival feels a long way off in places like Wakkanai, and the country's smaller lenders, unable to make loans to multinational companies or overseas, risk being left behind to face either consolidation or closure.
"We don't feel any impact of Abenomics here," said Katsumi Ogawa, an official at the Wakkanai Chamber of Commerce.
LOTS OF CASH, NO TAKERS
Just like Tokyo's megabanks, Wakkanai Shinkin has plenty of cash. But very few in this port city of 38,000 want to borrow. Wakkanai Shinkin loans out only one-fifth of the $3.86 billion it holds in deposits.
Most of the rest has been ploughed into domestic bonds, a portfolio that makes its balance sheet look more like that of an investment club than a traditional lender.
It's an extreme case that illustrates just how badly warped Japan's banking system has become after a decade and a half of deflation. Facing weak demand for loans, banks have come to rely heavily on investment in bonds, including debt issued by the government - one of the few reliable borrowers.
As a result, hundreds of billions of dollars in savings from Japan's boom years have been cut off from potential investment by companies and entrepreneurs.
Lending at major banks has bounced back this year after more than three years of steady decline, but much of the demand is coming from housing and real-estate investment and to fund acquisitions overseas.
In remote, often depressed areas like northern Hokkaido, prospects for building a loan book can be particularly sparse.
The situation is especially severe for community-focused "shinkin" lenders, which resemble U.S. credit unions and are restricted by regulation to make loans only to local small businesses and individuals.
"The prospects are grim for shinkin banks to reduce securities investment. There are limits to loan demand growth," said Nobutomo Watanabe, researcher at Norinchukin Research Institute, a Tokyo-based think tank.
FEWER FISH, FEWER VISITORS
The fisheries off Wakkanai, Japan's northernmost city that faces the Russian island of Sakhalin across the Soya Strait, once processed huge catches of Alaskan pollock, a staple of fish fillet sandwiches. But volume is one-seventh of what it was 40 years ago. The industry was hit hard by the Soviet Union's assertion of a 200 nautical-mile fishing zone in 1977.
The town also features twice-daily direct flights from Tokyo, but tourist numbers have dropped by nearly half over the past decade as visitors opted for other Hokkaido locations with easier access and better facilities.
"There is no business here," said Satsu Sato, 77, who runs a bar in Wakkanai that features cheap drinks and free karaoke. "We have to depend on fish and tourists but we're not getting as many tourists as we used to."
With few promising local borrowers, Wakkanai Shinkin was early among Japanese financial institutions to shift its money to Japanese government bonds (JGBs), as well as corporate bonds and other securities, where it could earn more reliable returns.
Over the past decade, shinkin lenders' total JGB holdings have risen nearly two-thirds to 10.6 trillion yen ($106.69 billion), while their corporate bond holdings also rose 50 percent to 16 trillion yen.
Shinkin lenders' average loan-to-deposit ratio is less than 50 percent, compared with more than 60 percent in 2002, according to Shinkin Central Bank Research Institute.
The bigger banks waded deeply into the bond market in 2008 as the financial crisis set in, riding a prolonged rise in JGB prices fuelled by easy monetary policies.
Japan's three megabanks - Mitsubishi UFJ Financial Group (8306.T), Mizuho Financial Group (8411.T) and Sumitomo Mitsui Financial Group (8316.T) - earned 660 billion yen from JGB trading operations in the year to March 2013, more than seven times what they earned just five years earlier.
"It has been hard to make ends meet with banking profits alone," said Tetsu Komori, president of Sawara Shinkin bank in Chiba prefecture, northeast of Tokyo. He credits profits from securities investments with helping his bank clean up a soured loan portfolio after Japan's asset price bubble burst 20 years ago and helping it to weather the subsequent economic downturn.
THAT SHINKIN FEELING
Japan's dramatic monetary easing, including a bond-buying program unleashed in April that puts the equivalent of 70 percent of all new JGB issuance with the central bank, has brought volatility to a market that had seemed a one-way bet.
The yield on the benchmark 10-year JGB fell to a record low 0.315 percent on April 5, the day after the Bank of Japan unveiled its radical plan to double the monetary base over two years in pursuit of a 2 percent inflation target.
But yields rebounded sharply in following weeks, making JGB investment suddenly appear far riskier to investors uncertain about how the central bank's surprise move will affect the market over the longer term.
"At the beginning of this financial year (in April), we bought only half the amount of JGBs we had planned," said a senior official at a shinkin lender near Tokyo.
"(Before) the JGB yields were stable, we did not have to do much. But now we are busy, looking for other investments," said the official, who spoke on condition his bank was not named because of the sensitivity of the matter.
Banks unloaded 20 percent of their 108 trillion yen in JGB holdings between end-May and end-June, Bank of Japan data shows.
That has made larger institutions more willing to lend. But it has not made companies more willing to borrow. Japanese corporations, excluding the financial sector, had a massive $2.3 trillion in cash on their books at the end of March.
The stakes are large. Japan's banks and shinkin lenders hold a combined 756.2 trillion yen ($7.71 trillion) in deposits, industry data shows, so a return to the lending ratios of more than a decade ago could make an extra three-quarters of a trillion dollars or more available for investment.
With prospects for new lending limited and the bond market gravy train under threat, the banks face pressure to consolidate.
Japan's big banks, plagued by a mammoth overhang of bad loans in the aftermath of the late-1980s asset price bubble, have already reorganized from 20 so-called city banks into just three megabanks.
Now, under Abenomics, consolidation is picking up among regional banks, which face problems similar to shinkin lenders in economically struggling regions.
Yachiyo Bank 8409.T and Tokyo Tomin Bank 8339.T, two small Tokyo-based banks, have begun talks on a merger next year, sources familiar with the matter have told Reuters.
The ranks of shinkin banks have thinned over the past decade and a half to 270 from 400, largely through mergers of institutions in heavily populated areas. But in Wakkanai, bank president Masuda sees no obvious merger partner.
Masuda says Wakkanai's portfolio reflects Japan's economic reality: the national and local governments need more money than private sector borrowers. "We are already have 50 percent of the local loan market," he said. "Simply, it's too high a share."
($1 = 98.1150 Japanese yen)
(Additional reporting by Guo Cheng; Editing by Edmund Klamann and Alex Richardson)