Major Factors

Rationale

S&P Global Ratings classifies the banking sector of Korea (AA/Stable/A-1+) in group '3' under its Banking Industry Country Risk Assessment (BICRA). Other countries in group '3' include Australia, Japan, France, Czech Republic, U.K., U.S., and Chile.

Chart 1

BICRA Overview

We expect Korea's economy to stay relatively resilient in the global context, despite our view that GDP will shrink in 2020, based on our estimates, due to the COVID-19 pandemic. We anticipate a recovery next year supported by a rebound of global demand and the government's fiscal stimulus and market-stabilization measures. The country has a solid fiscal and external position. In our view, the risk of a sharp correction in property prices is low, considering prudent regulatory measures taken to manage broadly stable credit growth and real-estate prices in Korea over the past decade. That said, Korea's high private-sector leverage could result in high credit costs if unfavorable economic conditions--such as a prolonged impact of COVID-19 and intensifying trade tensions between the U.S. and China--materialize.

A stable and significant proportion of banks' system-wide funding is derived from customer deposits. System stability benefits from steady regulatory actions to reduce the banks' dependence on short-term foreign-currency funding, strengthen underwriting standards for household lending, and improve mortgage loan structures in favor of fixed-rate and amortizing installment-type mortgages.

We anticipate a sizable increase in credit costs stemming from weakening asset quality for export-focused sectors such as shipbuilding, auto, refining, and steel amid tepid global demand. Small and midsize enterprises (SMEs) in the export value chain will also suffer. On the domestic front, COVID-19 will exert headwinds on the Korea's wholesale, retail, accommodation, and food service industries. That said, the banks' strengthened risk management, as indicated by steady improvements in the nonperforming loans (NPL) ratio and credit costs, will likely prevent significant asset quality deterioration, in our view.

Overall, we expect Korean banks' moderate asset growth to support their current capitalization despite a weakening of profitability in 2020. Household loan growth will likely continue to slow down. Corporate loan growth will increase this year due to funding and liquidity support for the businesses affected by the COVID-19 led by policy banks as well as guarantees provided by the government agencies. That said, we expect the corporate loan growth to become moderate in the coming few years as the banks shift their focus on risk management as the outbreak recedes. In our view, policy banks are exposed to higher volatility in financial performance compared with commercial banks. This is due to their high exposure to weak corporate segments such as shipbuilding and shipping, though some recovery in these sectors has reduced the credit costs in the past few years.

We use BICRA economic risk and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating. The anchor for banks operating only in Korea is 'bbb+'.

Economic And Industry Risk Trends

We view Korea's economic risk as stable. We anticipate a solid rebound will follow this year's economic contraction. The recovery will be supported by the pent-up consumption built during the pandemic and regained momentum in exports, as well as the government's comprehensive fiscal stimulus and financial market stabilization measures. We expect Korean banks to manage their credit risks backed by their prudent underwriting standards. Property prices could face modest downward pressure in real terms amid sluggish housing demand, following the Korean government's various measures to manage household credit growth and property prices as well as economic damage wrought by the pandemic. Strengthened mortgage lending restriction in Seoul and major satellite cities such as prohibitions of new mortgage loans for buyers of high-price homes or multiple homeowners as well as higher comprehensive withholding taxes on properties could restrain speculative housing demand, in our view. Banks' underwriting standards have strengthened with the enforcement of debt-service ratio (DSR) for household lending, along with more stringent debt-to-income (DTI) and loan-to-value (LTV) requirements for new residential mortgage loans in the designated areas over the past few years.

We view industry risk as stable. Korean banks will likely maintain the current capitalization, backed by their moderate asset growth. This is despite a weakening of profitability, which we attribute to a sizable increase in credit costs due to COVID-19 and a contraction of net interest margin (NIM) under persistent low interest rates. We anticipate a gradual recovery in profitability with reduction in credit costs as the economy rebounds in 2021 onwards. We believe that the banks' stable and sizable share of customer deposits supports system-wide funding. These banks will likely manage foreign currency funding and liquidity risks despite a potential increase in market volatility on the back of their improved risk management track record amid tightened regulatory oversight. We also expect the financial regulator to effectively manage issues that could be caused by high household debt, including risk emanating from residential mortgages.

Economic Risk  |  3

The key factors that support our assessment of economic risk in Korea are the country's well-diversified economy and the government's sound fiscal position and robust net external creditor position that underpins economic resilience despite a COVID-19 induced recession. We anticipate a recovery in the economy in 2021 supported by a rebound of global demand, fiscal stimulus, targeted funds to stabilize financial markets, as well as monetary easing. We also see a low risk of a sharp correction in property prices. That said, high private-sector leverage in the economy dilutes these positives.

Economic resilience: Negative impact of COVID-19 on the economy cushioned by comprehensive government response

Economic structure and stability.  

Korea has created a well-diversified and prosperous economy. We believe the country's long-term growth prospects remain solid but the disruption to economic activity brought about by the COVID-19 pandemic will lead to a downturn this year. We project Korea's GDP will shrink by 1.5% in 2020, its first annual economic contraction in more than 20 years. Growth will rebound strongly to 5% in 2021, supported by the release of pent-up consumption built up during the pandemic and recovery of global trade conditions. The government's stimulus measures to boost consumption, employment, and provide funding and liquidity for affected business and households also underpin the growth. We project Korea's average GDP per capita will rise to just above US$35,000 in 2022, from approximately US$30,000 in 2020. We estimate the trend rate of real per capita GDP growth to be 2.3%, higher than that of most of Korea's high-income peers.

The Korean economy is not dependent on a particular industry or export market. The export-oriented manufacturing sector, weighing in at a little more than a quarter of annual GDP, includes Korea's highly competitive electronics, automobile, communications equipment, chemical products, and shipbuilding industries. Export growth was lackluster in 2019, owing to weaker global trade conditions and the Korea-Japan trade spat. That said, Korean exports remain very competitive and the country's tradable sector has steadily advanced up the value-chain in the last decade. Over the long term, Korea's ability to sustain external competitiveness and healthy GDP growth will depend on boosting productivity as the country's population ages. Korea's economic growth was resilient during the global financial crisis in 2008, backed by the good performance of these globally competitive exporters--which also partly supported the performance of SMEs in the value chain.

Macroeconomic policy flexibility.  

Korea has shown a consistently good fiscal performance and relatively low net indebtedness. Years of accumulated surpluses has afforded the government the flexibility to pass ample stimulus measures without endangering its fiscal health. Korea's net general government debt, calculated using our estimates of liquid assets held by the pension funds and government deposits, is a modest 5.3% of GDP in 2019. We expect it to increase to about 8% of GDP in 2020 owing to COVID-19 events.

We also believe the Korean won's status as a floating and actively traded currency supports the flexibility of Korea's macroeconomic policy. The sharp depreciation of the Korean won helped to cushion the impact of a contraction in external demand in 2008-2009. In our view, Korea's monetary policy supports sustainable economic growth through effective transfer of changes in the policy rate via a well-developed financial system. Policy rate cut and the resulting reduction in financing costs helped to soften the fall in domestic demand in the uncertain economic environment. The Bank of Korea's inflation-targeting regime--which has been in place since the Asian financial crisis about two decades ago--has been largely successful in maintaining a stable economy while managing market expectations about inflation. This has supported the credibility of the central bank's monetary policy independence. Market interest rates have typically moved in line with policy rate adjustments. Nevertheless, Korea's high household debt could constrain monetary flexibility, in our view.

Political risk.  

The Korean economy is exposed to security risks associated with North Korea. Although inter-Korean conflicts have at times escalated, South Korea's established institutional framework helped it to manage potential geopolitical risks. The current administration of President Moon Jae-in has pursued a more conciliatory policy toward North Korea than the preceding government. Nevertheless geopolitical risks from North Korea persist with the stalling of denuclearization talks. While a historic meeting among leaders of North Korea, the U.S., and South Korea took place at the truce village of Panmunjom on June 30, 2019, no material political developments have followed.

Korea has a strong record of implementing policies for sustainable public finances and balanced economic growth in the past decade. Major policy changes are generally announced in advance and implemented following consultation and debate.

Table 1

Economic imbalances: Low risk of a sharp property price correction

Economic pressure stemming from the COVID-19 would be temporary, and the economic activities will likely rebound. We expect private-sector credits to continue to grow albeit at a slower pace. We view Korea's economy continues to be in an expansionary phase. We also believe a sharp drop in property prices is unlikely over the next two years, considering prudent regulatory measures taken to manage broadly stable credit growth and real-estate prices in Korea over the past decade.

Private-sector credit growth. 

We anticipate private-sector credit growth--measured against GDP--to gradually stabilize toward 2022, after the ratio picked up in 2020 due to contraction in GDP. Overall private-sector credit will likely grow moderately over the next few years owing to financial institutions' focus on risk management and reduced bond issuances in debt capital markets amid heightened financial market volatility. We believe corporate loan growth will likely slow down after some pick up in 2020 due to funding and liquidity support for the businesses affected by the COVID-19 led by policy banks and guarantees provided by the government agencies. Korea's private-sector credit growth has been largely stable at about 5% annually over the past decade.

We believe the authorities will continue to be active in managing the pace of household credit growth and potential volatility in property prices. In our view, a series of regulatory measures announced in recent years have been effective, stabilizing the property market. The latest such comprehensive measures were announced in December 2019, with more restrictive residential mortgage lending regulations, especially in Seoul and major satellites cities. These included applying different levels of maximum loan-to-value (LTV) ratios depending on the house price. Banks must adhere to a maximum LTV ratio of 40% for mortgages of houses valued below Korean won (KRW) 900 million, and 20% for mortgages of values between KRW900 million and KRW 1.5 billion. Banks are prohibited from originating new mortgage loans for houses valued above KRW1.5 billion. The authorities also designated more areas subject to a cap on presale price of new private apartments especially in Seoul and major satellite cities and proposed additional hikes in overall property withholding taxes. These tightened regulations follow various measures that were implemented since 2018, including restriction of new mortgage loans for multiple homeowners in the designated areas, higher overall property withholding taxes, and implementation of a cap on presale prices of new private apartments in certain districts to control overall property prices and relieve burden for new homebuyers.

Korean banks' underwriting standards have also strengthened in recent years with increasing oversight on borrowers' capacity for repayment along with tightened regulatory requirements. Debt-service ratio (DSR) guidelines have been enforced on banks' household lending from end-October 2018 onwards. Nationwide commercial banks, for example, are required to maintain risky loans (DSR over 70%) below 15% and highly risky loans (DSR over 90%) below 10% out of total loans; and the average DSR must be below 40% by 2021. This is in addition to the strengthened DTI guidelines to include borrowers' principal repayments on all existing mortgage loans from January 2018. Stricter requirements for LTV and DTI had been enforced since 2017, capping both ratios at 40% at origination for mortgages, from 70% and 60%, respectively, for Seoul and major satellite cities.

We also believe that higher risk weights on household loans in calculating banks' loan-to-deposit (LDR) ratios started from January 2020 will prompt banks to curb down household loan growth. The risk weights of household loans have increased by 15 percentage points while the risk weights of corporate loans (excluding loans to individual business owners) have reduced by the same amount. We acknowledge that there is a temporary relaxation of LDR requirement by 5% point until June 2021 as part of support measures under COVID-19. Nevertheless, the banks' overall tightened lending attitude toward household loans will likely continue, in our view.

At the same time, the regulator has continuously enforced rules to make structural improvements in mortgage loans, which led to a steadily higher proportion of amortizing and fixed-rate mortgage loans. As of end-2019, about half of banks' mortgage loans were amortizing and fixed-rate, which have steadily increased from about 15% for each at the end of 2012.

Real estate prices. 

We expect a modest decline in real estate prices in Korea (nationwide average) in real terms following the tightened residential mortgage underwriting standards along with regulatory property measures enforced in recent years. We also anticipate housing demands to be sluggish due to the economic blow from COVID-19. Nevertheless, we view a sudden drop in housing prices as unlikely--considering the government's track record of managing overall property price volatility in the past. As the pandemic recedes, the rebound in economic activities will likely support household income levels and therefore housing demand. Nationwide average housing prices have increased only modestly in real terms over the past decade, and they are relatively low and stable compared with other Asia-Pacific countries such as Hong Kong, Australia, and Singapore.

Divergence in property prices across the region--especially in Seoul--could increase imbalances in the economy. The average housing prices in Seoul increased about 3.5% per annum in real terms in the past five years, while prices in other regional provinces declined by about 1.0% per annum during the period. Regulatory measures in recent years have focused more on containing housing prices in Seoul and major satellite cities.

Housing demand in Korea has gained momentum since the government introduced deregulation measures in the property market in the second half of 2014. However, subsequent measures since 2016 to tighten household lending standards confirms our view that such deregulation was to improve overall housing market conditions rather than boost real estate prices and, in turn, household wealth.

We believe the commercial real estate market will not add pressure to Korea's economic imbalances. Commercial real estate prices, vacancy rates, and rental rates have been largely stable in the past couple of years. Despite no strict LTV regulatory guidelines for commercial real estate loans unlike residential mortgage loans, Korean banks generally adopt prudent underwriting practices and conservative assumptions when calculating the value of collateral.

Equity prices.  

The trend in equity prices does not indicate any significant additional build-up of economic imbalances, in our opinion. The banking sector's direct exposure to equity markets is also very low. Inflation-adjusted equity prices have decreased by 5.7% in the past two years. In 2019, equity prices fluctuated due to intensified trade tensions between the U.S. and China as well as between Korea and Japan but ended 7.7% higher than that end-2018 on a nominal basis.

Current account and external debt position.  

Korea's consistent current account surplus helped by exports and net creditor position support its net external strength. The domestic banking sector became a net external creditor in 2014, from having net external debt of 25% of current account receipts (CAR) in 2009. The average maturity of the banking sector's gross external debt has also lengthened, and the share of Korea's total short-term external debt in CAR has decreased. While Korea runs consistent and wide current account surpluses, we project its current account surplus will average about 3.8% of GDP over the next three years in the face of weaker macroeconomic conditions, down from an average of 5.3% over the last five years. The Bank of Korea's foreign exchange reserves stood at about US$404 billion as of April 2020, compared with about US$364 billion by the end of 2014.

Table 2

Chart 2

Credit risk in the economy: High private-sector leverage could result in high credit losses

Private-sector debt capacity and leverage.  

Korea's private-sector leverage is high, at about 190% of GDP by the end of 2019--both in absolute terms compared with other countries' as well as in the context of per capita GDP of US$31,762. Both household and corporate sector debt are high. We expect the private-sector leverage to edge higher in 2020 given our expectations of economic contraction, and then stabilize gradually along with economic rebound and moderate private-sector credit growth in the coming few years.

We believe heavy household indebtedness could result in high credit losses, particularly if a prolonged impact of COVID-19 and intensifying trade tensions between the U.S. and China materialize. The ratio of household debt to disposable income (excluding individual business owners) continued to rise to about 160% at the end of 2019, from about 120% at the end of 2008. That said, household loan growth continued to slow down to about 5% on a year-on-year basis in 2019, steadily lowering from about 10% year-on-year in 2016--owing to the banks' tightened underwriting standards alongside regulatory measures on property market. The banks' household loan quality has remained fairly stable over the past several years with a delinquency ratio at around 0.3%.

In our view, potential risks stemming from high household indebtedness would be tempered by: (1) low LTV ratios, which we estimate at 50%-55% by end-2019; (2) the increasing use of fixed-rate and amortizing loans, which has increased to about half of the mortgage loans as of end-2019--compared with about 15% for both at the end of 2012; and (3) high household financial assets, which are on average about twice the household debt. About 45% of household financial assets consists of cash and deposits.

We see relatively high risks at nonbank deposit-taking institutions, which account for about 20% of the banking system's total loans and 30% of total deposits by the end of December 2019. We view these institutions' underwriting standards as slightly weaker than that of banks. Loans from these institutions had grown relatively fast compared to banks but the growth rapidly slowed down since 2018 after the implementation of more stringent underwriting standards guided by the regulator. These include tightened oversight on borrowers' repayment capability with stricter income proof and requirement of principal-amortizing for new mortgage lending. DSR guidelines were also enforced from June 2019, following the banks.

Corporate-sector debt is also high, and we attribute this partly to a relatively heavy concentration in capital-extensive manufacturing and their SMEs in the value chains. While we expect the banks' corporate loan growth to increase moderately this year, especially led by policy banks, to provide support for SMEs including individual business owners suffering from COVID-19; meanwhile, corporate bond issuances will be sluggish due to deterioration in business conditions and heightened financial market volatility. We expect the banks to turn more cautious about corporate loan growth in 2021, focusing on risk management. We note that there was some deleveraging in 2015-2017, along with the restructuring of some large corporates in weak sectors, the government's initiatives to deleverage quasi-government institutions, and private enterprise's risk management.

The performance of manufacturing exporters such as shipbuilding, steel, and auto will remain volatile amid globally weakened demand as well as some supply disruptions caused by COVID-19. We expect major policy banks to face higher volatility in financial performances due to their large exposure to shipbuilding and shipping while commercial banks have steadily reduced their exposures over the past several years. This setback comes after operating conditions in the shipbuilding and shipping sectors improved in the past few years, with new ship orders and better cost alignment. Korean banks' exposures to the troubled wholesale, retail, accommodation and food services industries are collectively about 10% of total loans as of end 2019.

While we expect economic recession induced by the COVID-19 to be short-lived under our base-case scenario, partly backed by Korea's ability to stem the spread, a prolonged global pandemic as well as an intensifying trade conflicts between the U.S. and China could significantly deteriorate global demand. This, in turn, would pressurize corporates' financial conditions, in our view.

Lending and underwriting standards.  

Strengthened regulatory guidance and oversight of the credit quality of both corporates and households in the past several years will prompt banks to tighten their lending standards. We believe LTV ratios will likely remain fairly low, especially considering the banks' focus on managing risk and the government's tighter stance on household loan growth and property market regulation. We expect the average LTV ratio of Korean banks to remain largely stable in the 50%-55% range in the coming few years for residential mortgages, which form approximately 30% of total loans in the banking system. In late 2015, regulatory authorities conducted additional credit risk evaluations of large corporate sectors and they guided banks to put aside additional provisioning and tighten loan classifications. In 2016, the authorities cooperated with bank creditors to restructure large corporates in the shipbuilding and shipping industries to increase efficiency of these corporates. They also flagged the more problematic SMEs during their regular credit evaluation and asked banks to follow suit. As a result, banks' asset quality and credit costs have steadily improved and reached an historic low level in recent years. We also believe there is no significant concentration in corporate lending by sector, single name, or foreign currency. The use of securitization and derivatives to shift risks off companies' balance sheets is also limited in our view.

Payment culture and rule of law.  

We consider the legal framework in Korea to be predictable and supportive of creditor rights. Creditors generally are able to recover collateral without inordinate delays in the event of foreclosures. Korea scores reasonably well on the World Bank's rule of law and control of corruption indicators, at +1.24 and +0.60, respectively.

Table 3

Base-Case Credit Losses

Korean banks' asset quality and credit costs will suffer in 2020. Nevertheless, we expect the impact to be manageable considering the banks' strengthened risk management and reduction in risky corporate exposures. The government's capacity to foster recovery is also crucial to our view. The government announced fiscal stimulus and financial market stabilization measures worth about KRW 250 trillion (about 13% of nominal GDP in 2020) to boost domestic consumption and employment, and supply funding and liquidity to the affected business and households. In addition to loans and guarantees led by the policy banks and the government agencies, the government has established funds for the stabilization of key industries (i.e., airline and shipping) and financial markets. The measures also include wage subsidies for the affected businesses, unemployment benefits, and emergency relief payments for general households. In addition, the central bank is easing monetary policy to support the economy.

We expect to see some challenges on the exporters such as shipbuilding, auto, refining and steel due to weakening global demands and some supply disruptions. We also anticipate modest pressure from the construction and real estate sectors amid sluggish domestic housing demands. Wholesale, retail, accommodation, and food service industries faced headwinds from depressed private consumption amid the pandemic.

NPLs for household segment will also rise but stay relatively low level compared with corporate loans. We do not anticipate a sharp drop in property prices. The banks' LTV ratio for mortgage loans are relatively low. The banks' strengthened underwriting standards such as enforcement of DSR guideline to ensure borrowers' capacity for repayment will also prevent significant asset quality deterioration, in our view. The NPL ratio of household loans has remained fairly stable at around 0.2%-0.3% over the past many years.

Korean banks have over the past several years tightened underwriting standards, written off bad loans, and built in additional provisioning under regulatory guidance for relatively weak corporate sectors such as construction, shipping, and shipbuilding. The industrywide NPL ratio was about 1.0% as of end-December 2019, a historic low. The credit cost as % of gross loans also steadily improved to the historic low of about 0.2% in 2019. That said, some major policy banks remain highly exposed to these corporate sectors and will likely see volatility in credit losses. We expect a gap in asset quality to remain between commercial banks and policy banks.

Our base-case credit loss estimates take into account:

• Korea's GDP contraction of 1.5% in 2020 (2019: 2.0% growth) followed by a recovery of 5.0% in 2021 and 3.9% in 2022.
• Unemployment rate to increase to about 5.2% in 2020 and then gradually stabilize to 4.7% in 2021 and 4.3% in 2022. This is compared to 3.8% in 2019.
• Continued focus of banks on managing risks with tightened underwriting standards. We believe the COVID-19 outbreak will result in a manageable rise in credit costs for Korean banks, amid some asset quality pressures to certain sectors.
• Modest softening in real estate prices in real terms in the coming year. We believe the government will stay responsive on the property market with regulatory measures, when needed, against potential volatility in price movements like in the past.

The key downside risk to our base-case credit loss estimates is a prolonged outbreak of COVID-19 and intensifying trade tension between the U.S. and China. This would reduce Korea's exports, and weaken domestic demand, and lead to smaller gains in income for households that are already highly leveraged. A weakened labor market and a slump in the overall economy could also trigger a fall in real estate prices. Credit losses could also rise beyond our base-case forecasts due to significant single-name concentrations at major policy banks and riskier lending by the nonbank deposit-taking sector.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID‐19 have pushed the global economy into recession. As the situation evolves, we will update our assumptions and estimates accordingly.

Table 4

Chart 3

Industry Risk  |  4

The key factors that support our assessment of industry risk in Korea are the stable and sizable share of customer deposits--which support system-wide funding--and improving regulatory supervision, scope, and coverage despite a mixed regulatory record. There will be some pressure on the banks' profitability on account of COVID 19-induced economic downturn in 2020, however, we expect it to gradually improve in 2021 onwards. Korean banks' profitability is relatively low on an international comparison, albeit on an improving trend in recent years led by reduction in credit costs.

Institutional framework: Mixed record but improving regulatory supervision

Banking regulation and supervision.  

In our view, banking regulation and supervision in Korea are generally in line with international standards. We believe the regulator is committed to closing the gaps in a few areas between Korean and international regulations. For instance, it is trying to improve banks' corporate governance and internal controls as well as tighten the classification of problem loans during the restructuring of large corporates. The Financial Supervisory Service (FSS) is Korea's central regulator. It was established in 1999 by combining four supervisory bodies. The regulator monitors financial institutions frequently and closely with detailed disclosure.

Regulations include prescribed ratios for LTV and DTI in designated areas such as Seoul and major satellite cities as well as implementation of DSR and foreign-currency liquidity requirements. Korean banks adopted Basel III standards in December 2013 and their average Tier 1 capital ratio increased to 12.3% based on Basel III compared with 11.1% based on Basel II. This is partly due to the regulator's conservative guidance based on Basel II standards for classifying Korean banks' regulatory capital. The regulators closely monitor the banks and bank holding companies' Basel III capital ratios with the requirement of a capital conservation buffer of 2.5% and an additional capital buffer of 1% for the domestic systemically important banks (D-SIBs) from 2019 onwards. Five major bank holding companies--Shinhan Financial Group Co. Ltd., KB Financial Group Inc., Hana Financial Group Inc., NongHyup Financial Group Inc., and Woori Financial Group Inc.-- as well as their bank subsidiaries are designated as D-SIBs for 2020.

The financial regulator consistently monitors foreign-currency funding and the liquidity condition of banks through regular stress tests. It has also imposed the Basel III foreign-currency liquidity coverage ratio (LCR) requirement of 80% in addition to the overall LCR requirement of 100%. We note that the lowered liquidity requirements announced in April 2020 are temporary; the foreign currency LCR was reduced to 70% from 80% and the overall LCR to 85% from 100%, until the end of September 2020. This is to encourage banks to provide funding and liquidity support for the business affected by COVID-19.

The regulator also introduced additional measures on capital adequacy, funding, and asset quality requirements amid the COVID-19. These include the early adoption of the revised Basel III credit risk framework for banks from the second quarter of 2020 (other revision such as Basel III operational risk from 2023) which will likely increase the banks' average BIS ratio by 0.8 percentage point. This is partly due to lower credit risk weights for SME loans in calculating regulatory capital ratios. Moreover, risk weights were lowered for the banks' contribution to the stock market stabilization fund (total KRW10.7 trillion). In addition to the eased LCR requirement, there is a temporary relaxation of the loan-to-deposit ratio by 5 percentage points until June 2021.

The regulator will also allow financial institutions to maintain current asset quality classifications and to extend maturities for SME loans (including loans to individual business owners) and unsecured household loans, in cases where borrowers have been impacted by COVID-19. The maturity extension of principal repayment does not add burden on credit costs at this stage. However, the asset quality of those loans could deteriorate rapidly if the negative economic impact of the pandemic prolongs, and push up credit costs.

DSR guidelines have been enforced on household lending for banks from end-October 2018 onwards, which will ensure that they manage the average DSR at 40% for commercial banks and 80% for regional as well as policy banks by 2021. The regulator has also tightened both the LTV and DTI ratio requirements for Seoul and key satellite cities in recent few years. Strengthened DTI guidelines were implemented to include borrowers' principal repayments on all existing mortgage loans from January 2018.

We believe the LTV ratio requirements for Korean banks are largely in line with the standards of international peers. The DTI regulation--which has not been implemented in many other economies--will also likely remain an effective measure to control any significant increase in household debt. Korea's regulator has also tightened loan classification and provisioning requirements for nonbank deposit-taking institutions, including credit card companies.

Regulatory track record.  

In our view, Korea's regulator has a mixed record of preventing potential problems in the banking sector--although financial system supervision has improved after two major crises, the Asian financial crisis in 1997-1998 and the domestic credit card bubble in 2003-2004. However, issues surrounding response timeliness remain--with regard to the regulator's handling of real-estate project finance loans in 2010 and problems faced by mutual savings banks in 2010-2012. Some of these banks suspended operations due to capital shortages and their limited ability to restructure. However, such events did not evolve into systemic risks.

The regulator has introduced measures to reduce the banking system's reliance on short-term foreign-currency funding. This reliance had left Korean banks in a liquidity crunch during the global financial crisis. The regulator has also introduced measures to ease the growth of household indebtedness and manage property prices. We believe the regulator will continue to focus on managing the pace of household credit growth and maintaining property prices at reasonable levels.

Furthermore, the regulator has imposed rules to make structural improvements to mortgage loans--which has led to higher proportion of amortizing and fixed-rate mortgage loans. We believe this will help banks manage systemic risks related to sharp increases in interest rates although this is unlikely in the coming one to two years. DSR guidelines were enforced on household lending for both banks and other institutions such as credit cooperatives, mutual savings banks, insurers, and finance companies to ensure borrowers' capacity for repayment.

We expect the regulators to strengthen their monitoring of the banks' governance and internal controls related to product design and sales processes for customer protection. In March 2020, the Financial Services Commission (FSC) imposed fines on two major commercial banks for mis-selling practices and loosening internal controls related to the high-risk derivative-linked funds (DLFs) sold in 2019, which resulted in significant losses for some customers. These banks have also been suspended from selling private equity fund products for six months. In April 2020, FSS also announced plans to tighten regulation on private equity funds to protect investors, by strengthening external audit, reporting and disclosure requirements of the funds and raising the monitoring responsibility of banks and brokers which sell such funds to retail investors. This follows an incident where Lime Asset Management halted redemption of some funds it managed, worth about KRW1.7 trillion, in October 2019. FSS is looking into whether the banks or brokers which sold Lime's troubled funds are responsible for the mis-selling of the funds. The regulator plans to establish a bad bank which will take over troubled funds at Lime and liquidate its assets to minimize losses for investors.

Governance and transparency.  

Governance and transparency in the Korean banking industry remain adequate. Banks in Korea publicly disclose detailed information on their financial performance and loan books on a quarterly basis. The majority of Korean companies have adopted International Financial Reporting Standards (IFRS) for accounting from 2011 and material accounting restatements are unusual. We believe corporate governance standards have improved amid tighter monitoring by the regulator.

Chart 4

Competitive dynamics: Banks' profitability will be pressurized by the COVID-19

Risk appetite.  

In our view, banks in Korea show a moderate risk appetite. In the past, profitability in Korea's banking sector was slightly more volatile than in other sectors of the economy. This was partly due to exposures to the construction and real estate industries. Korean banks increased their exposure to construction and real estate rapidly--including real estate project financing--when the property market was booming. This resulted in relatively high profitability during 2005-2007. However, the banks incurred large credit losses especially from real estate project financing loans after the global financial crisis, when the property market cooled. The banks' exposure to real-estate project financing loans have steadily reduced and accounted for about 1% of total loans by end-2019 from about 4% at end-2008. We also note that the banks' loan exposures to overall real estate and leasing industries are highly collateralized.

We expect Korean banks' profitability to be weighed down by the economic contraction in 2020. This follows a stable profitability in recent years especially with a turnaround at policy banks since 2017. Banks' credit costs have improved to a historic low in 2019, backed by steady improvements in asset quality and some gains from the recovery of written-off assets. However, we estimate a large, though manageable increase in credit costs this year. The global economic downturn will hurt Korea's export-oriented firms and the SMEs that populate the supply chain. Headwinds are also expected on the wholesale, retail, accommodation, and food service industries. The banks' NIM will also face downward pressure amid the persistent low interest rates, following the central bank's policy rate cut to 0.5% from 1.25% at end-2019 (25bp cut in May and 50bp cut in March 2020). Nevertheless, Korean banks' moderate growth appetite with a continuing focus on risk management will likely underpin their current capitalization in the coming years. We do not expect banks to undertake more significant risks. Korean banks' average return on assets stayed at about 0.5% in recent years after having turned around from about 0.1%-0.2% in 2015-2016.

Industry stability. 

We believe that Korean banks' profitability remains relatively low compared with global peers such as Australia, the U.S., Hong Kong, and Singapore. This is partly due to a competitive domestic banking scene and a reliance on net interest income amid persistently low interest rates. The relatively low profitability suggests that Korean banks would struggle to generate risk-adjusted returns on core banking products to meet their cost of capital, which could cause potential instability in the system.

The market share of almost all banks in Korea has been stable for the past decade despite some mergers and acquisitions. Although some foreign banks moved into the nationwide commercial banking sector via acquisitions in the 2000s, they have had difficulty expanding their presence, partly due to competition. There are six nationwide commercial banks, six regional banks, five policy banks, and, since 2017, two internet-only banks in Korea. These 19 banks account for roughly 70% of total deposits in the banking system as of December 2019. A third internet-only bank will likely enter the market in mid-2021 after receiving a preliminary approval in December 2019.

In our view, digital banks will not likely cause any material change in the competitive landscape in the coming few years. The two internet-only banks collectively comprise only about 0.5% of the loans and deposits in the banking system as of December 2019. We expect the incumbent banks to continue to dominate the banking scene, even as the market opens wider to digital competition. Incumbents have already established a range of digital and mobile banking services, taking advantage of the country's high internet and smartphone penetration. Korean banks are pro-innovation and quick to adopt new technology. For example, in response to similar offerings by internet-only banks, major banks have also introduced several retail-loan products that customers can access through their mobile phones with quicker approval process. We also expect fintech companies have low potential to disrupt the payment system, given Korea's high credit card and internet and mobile banking penetration. Fintech companies mainly focus on simple transactions such as money transfers, account inquiry services, and settlement services, which has not been a major revenue source for banks.

Market distortions.  

In our view, market distortions are limited in the Korean banking sector. There is no significant presence of government-owned and not-for-profit banks. Government-owned and not-for-profit banks account for about 16% of total deposits as of December 2019, with NongHyup Bank (A+/Stable/A-1) having the largest market share at about 9%, followed by the Industrial Bank of Korea (IBK; AA-/Stable/A-1+) at about 4.5%, and Korea Development Bank (KDB; AA/Stable/A-1+) at about 1.5%. We believe NongHyup Bank does not materially distort competitive dynamics because it continues to operate along commercial lines in addition to its policy banking role for the agricultural industry. IBK is the largest SME lender that provides the majority of new lending to SMEs even under stressed economic conditions while KDB provides long-term facility loans on the back of its development financing role with a specialty in corporate financing.

We also do not see significant market distortion from nonbank deposit-taking institutions because the major borrowers from these institutions are mostly households that have lower access to mainstream commercial bank lending because of their relatively weaker personal credit standing or ability to provide sufficient collateral to satisfy commercial banks' lending requirements. These institutions fund their lending businesses mostly with retail customer deposits and their reliance on wholesale funding is limited. The financial regulator has been focusing on improving the underwriting standards of these institutions to manage overall asset quality in the banking system.

We view competition from other nonbank financial companies as limited, given banks' dominance in terms of size. In addition, some significant nonbank financial companies are owned by major bank holding companies, which have made efforts to generate synergy from cross-selling products and by sharing customer accounts.

We have not seen frequent administrative controls or material directed lending by the government in the Korean banking system. However, market distortions could become significant if the government implements borrower-friendly initiatives to lower banks' lending rates for SMEs and households on a continual basis, resulting in prolonged deterioration in Korean banks' profitability.

Table 5

Systemwide funding: Sizable and stable customer deposits a key support

Core customer deposits. 

The system-wide funding structure of the Korean banking system is stable because core customer deposits are the main source of funding. We estimate the ratio of system-wide domestic core customer deposits to system-wide domestic loans to be about 75% by the end of 2022. We also estimate that over 80% of total core deposits are from households. This ratio has been fairly stable for the last decade and we have not observed any substantial outflow of deposits under stressed situations. Koreans have quite a strong preference for deposits and roughly 45% of financial assets owned by individuals are deposits as of December 2019.

External funding. 

Korean banks have maintained their net small creditor position since 2014. In 2008-2009, Korean banks experienced a foreign-currency liquidity crunch amid the global financial turmoil. Although some reliance on short-term foreign-currency funding remains a risk in our view, we believe that the banks will likely manage the risk despite potential increase in market volatility on the back of their risk management track record amid tightened regulatory oversight. Banks have lengthened the average tenor of their foreign-currency debt and secured more liquid foreign-currency assets, compared with during the global financial crisis. For example, Korean banks' share of short-term external debt versus their total external debt was about 50% at the end of December 2019 from about 73% at the end of the third quarter of 2008.

Chart 5

Domestic debt capital markets. 

We consider that funding sourced from domestic debt capital markets is more stable than externally sourced funding, although it is less stable than core customer deposits. In our view, the outstanding debt issued by Korea's private sector within the domestic capital markets is sizable, accounting for about 77% of GDP at the end of 2019. There is also an active domestic capital market for issues by investment-grade and some non-investment-grade companies, including issues with medium-term maturities.

Government role.  

Based on the past track records, we believe the Korean government will provide support to Korean banks in a preemptive manner and at an early stage if they were to come under financial stress. For example, the government provided guarantees for foreign-currency debenture issues and established a recapitalization fund to strengthen the capitalization of banks during the global financial crisis in 2008-2009. We also believe the Bank of Korea has built up sizable foreign-currency reserves (worth US$404 billion as of April 2020), which could support funding and liquidity needs under stressed scenarios. Against the tightened market liquidity amid the COVID-19 pandemic, the BOK established a bilateral currency swap with the U.S. worth about US$60 billion in March 2020 for six month period.

Table 6

Peer BICRA Scores

Economic risks that banks operating in Korea face are broadly in line with those in most of the peer countries (see table 7). We continue to assess economic imbalances in Korea as very low, similar to that of Japan. In our opinion, Australian banks are exposed to imbalances emanating from high house prices and household debt, subdued consumer and business sentiment, and the country's external weakness. High private-sector debt remains a weakness in Korea. Japan and Taiwan's household debts are lower than Korea's and these two countries have stronger household financial net assets. Japan's higher GDP per capita also supports the private sector's debt-bearing capacity.

We view Korea's banking industry as less fragmented than that of Taiwan. There is a lower proportion of state ownership in Korea of both loans and deposits compared with some of its peers. That said, we believe Korean banks' relatively low profitability on international comparison could undermine their competitive dynamics albeit on an improving trend in recent years. Although we consider the Korean banking system's partial reliance on external funding as a potential risk, we view the dependence to be much lower than in Australia, which relies more on net external borrowings and receives less funding support from domestic deposits.

Table 7

Government Support

We classify the Korean government as highly supportive toward domestic banking, suggesting that the government is highly likely to intervene directly and rescue failing banks. The government has a track record of introducing various regulatory measures and providing support to the banking system in times of distress. For example, it provided guarantees to foreign-currency debenture issuances and established a recapitalization fund to strengthen the capitalization of banks in 2008-2009. This is because Korean banks play a key role in providing funding to priority sectors of the economy.

Under current regulations, Korean regulators could put insolvent banks through a resolution process. However, the bail-in of senior creditors is not an option. The Financial Stability Board has suggested that Korean authorities should ensure that there are sufficient resources that can be bailed in, particularly in systemic banks. We believe Korean authorities are closely monitoring bail-in developments in many other Asian countries that have had a strong tendency for bailout, and are likely to come up with more details in the coming few years. We believe the new frameworks could reduce moral hazard. However, a resolution regime that includes bail-in of senior creditors could prompt us to review the Korean government's willingness to support the banking sector--leading to negative rating actions on systemically important banks.

Table 8

Related Criteria And Research

Related Criteria

• Banking Industry Country Risk Assessment Methodology, Nov. 9, 2011

Related Research

• Banking Industry Country Risk Assessment Update: May 2020, May 27, 2020
• Asia-Pacific Financial Institutions Monitor 2Q2020: COVID-19 Crisis Could Add US$440 Billion To Credit Costs, May 14, 2020
• How COVID-19 Is Affecting Bank Ratings, April 22, 2020
• Asia-Pacific Credit Conditions Stay Tight As Pandemic Hits Western Economies, April 22, 2020
• Global Credit Conditions: Rising Credit Pressures Amid Deeper Recession, Uncertain Recovery Path; April 22, 2020
• Republic of Korea 'AA/A-1+' Ratings Affirmed; Outlook Stable, April 21, 2020
• Economic Research: Jobs And The Climb Back From COVID-19, April 20, 2020
• Asia-Pacific Recession Guaranteed, March 17, 2020
• Korea's Major Banks Can Sustain Capitalization Despite Tougher Conditions, Feb. 13, 2020
• Korean Banks Will Likely Weather Headwinds Arising From Coronavirus, Feb. 5, 2020
• The Future Of Banking: Korean Banks Surf The Wave Of Tech Disruption, Dec. 10, 2019
• No Winners In Korea-Japan Trade Spat But Korea Has More To Lose, Sept. 18, 2019