The recent debt workout scheme of Taeyoung Engineering & Construction Co. underscores rising credit risks for real estate project financing in Korea. We believe more construction companies and related projects will encounter financial strain given Korea's subdued property market and elevated domestic interest rates.

S&P Global Ratings believes the credit risk is more acute for nonbanks, such as mutual savings banks, finance companies (especially for installment finance or leasing companies), or securities firms. The risk stems from their large exposure relative to their assets, and the weak quality of commercial projects.

However, the potential for systemic risk is low. Banks and insurers, which control about 65%-70% of the equity/assets in Korea's financial system, have relatively modest exposure to real estate projects. They generally also have adequate loss-absorbing capacity. Financial system exposure to real estate projects is about Korean won (KRW) 172 trillion (about US$128 billion), or about 2.5% of total assets or 25% of equity, as of end-September 2023.

We believe the government will provide extra support, if needed, to prevent a hard landing in the property market. This is on top of KRW85 trillion of measures that have been introduced to stabilize financial and real estate markets in recent years (see table 1).

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Taeyoung E&C Debt Workout Warrants Caution

Most financial institutions should be able to manage the impact of Taeyoung E&C's debt workout scheme. While it varies by lender, the exposure relative to the size of institution is moderate, based on our estimates. As for banks, the main creditors to the company, their exposure is 0.1%-0.2% of the total assets or 1%-2% of the shareholders' equity. Furthermore, guarantees from the government agency Korea Housing & Urban Guarantee Corp. cover a sizable part of the real estate project exposure. Financial institutions, however, could face a greater burden stemming from difficulties at construction companies and related real estate projects should the current property market weakness continue.

What's happened?

On Jan. 12, 2024, creditors led by Korea Development Bank approved a debt workout scheme for Taeyoung E&C, the sixteenth largest construction company in Korea in terms of construction capacity. Creditors will conduct due diligence on the company for the next three months and devise final workout plans.

The company's financial profile was particularly vulnerable to the prevailing property market weakness, in our view. Taeyoung E&C has significant guarantees to real estate project financing and its debt-to-equity ratio was much higher than domestic peers' at about 258% on a separate financial statement basis as of end-September 2023.

Property Market To Remain Sluggish

Korea's property market is unlikely to meaningfully recover over the next one to two years. We expect the central bank will start to lower the policy rate gradually from 2024, but the rate should remain high relative to the low of 0.5% set during the COVID-19 pandemic.

The policy rate will likely fall to 2.5% by end-2025, by our estimates, compared with the current 3.5%. Housing prices showed signs of bottoming out during the second and third quarters of 2023, but slipped again toward the year-end. We partly attribute this to the financial regulator's tightening measures, such as the introduction of stress debt servicing-to-income ratio requirements and closer monitoring of the banks' growth against a pick-up in household loans. Housing prices in Korea (nationwide average) declined by about 10% in real terms in 2023.

In our view, the government will not likely seek to boost the property market at this stage because housing prices are high after a rapid rise in the past few years. High household leverage suggests the government will remain keen to manage the pace of household debt growth to gradually lower the ratio of household debt-to-GDP. We estimate Korea's household debt-to-GDP ratio at about 105% at end-2023--one of the highest levels globally.

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If housing prices unexpectedly plunge, we believe the government will likely step in to prevent a hard landing. Our assumption centers on the government's record of managing overall property price volatility. The government relaxed loan-to-value ratio requirements in Seoul and other major cities to counter a rapidly cooling property market in recent years.

The government also launched a one-year "special bogeumjari" loan program (effective from Jan. 30 2023) worth about KRW39.6 trillion. The program provides mortgage loans at a more accessible fixed-rate to a wider range of households by easing existing eligibility criteria, such as borrowers' income level. The government has announced a special housing loan program worth about KRW26.6 trillion to support families with newborns. The program starts at the end of this month, and is available for couples with a combined annual income of below KRW130 million. These measures are part of government efforts to support affordable housing, in our view, and are not meant to boost housing prices.

Mutual Savings Banks And Finance Companies Are More Vulnerable

Mutual savings banks and finance companies (such as installment finance or leasing companies) are more vulnerable to weakness in real estate project financing. This stems from their large exposure relative to assets, and the weak quality of projects. The rapid growth in their exposure over the past several years indicates these institutions have a higher appetite for growth and risk, versus banks.

The biggest risk flows from their high exposure to commercial real estate projects that are at an early stage of development. Here we refer to bridge loans which account for 30%-50% of the project financing loans of these institutions, by our estimate. The bridge loans typically are of a relatively high interest rate.

Loans to real estate projects accounted for about 7% of the total assets or 65% of the shareholders' equity of mutual savings banks, as of end-September 2023. For finance companies, the figures were about 6% and 35%, respectively. The delinquency ratios for real estate project financing loans had more than doubled from a year ago to about 5.6% for the mutual savings banks, and 4.4% for finance companies, as of end-September 2023.

Mutual savings banks already face considerable strain because of the rise in credit losses and higher funding costs, which have eroded net interest margins. About half of the 79 mutual savings banks recognized net losses during January-September 2023. The annualized return on average assets (ROAA) for the mutual savings banks was about -0.1%, compared with 1.2% for full-year 2022. The financial performance of finance companies has held up relatively well so far. Their annualized ROAA declined modestly to about 1.5% during January-September 2023.

We may see some negative credit events, especially among the small players in these segments, but we do not believe these present material risks to the financial system. Lending by mutual savings banks accounts for only about 3% of total gross loans among deposit-taking institutions in Korea.

Although there are many finance companies, and the volume of aggregate assets is sizable--at about 10% of the total assets of banks--the sector comprises largely affiliates of major banking groups or large corporate conglomerates. Such institutions could tap into the financial resources of the parent, if needed. Entities under major banking groups generate synergies from cross-selling and customer referrals. In addition, credit card companies, which have only small exposures to real estate project financing, account for about 45% of the total assets of finance companies.

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Major Securities Firms Can Take The Strain

We believe large established securities firms can withstand the difficulties associated with their sizable exposure to real estate project financing. These firms generally have a larger liquidity buffer, diverse funding sources, and adequate risk management compared with small and midsize players. Major securities firms under the banking groups should also benefit from timely and sufficient group support, if needed, in our view. These top 10 securities firms accounted for about three-quarters of the total shareholders' equity of the brokerage sector, as of September 2023.

Their sizable exposure to real estate project financing mainly takes the form of guarantees on short-term asset-backed commercial paper. The uncertain viability of real estate projects means securities firms could assume underlying credit risks if these instruments are not rolled over. This would hinder the regulatory leverage ratios of securities firms. The firms may also set aside additional provisioning, depending on the quality of the project. We estimate their exposure to real estate project financing (guarantees and loans) totaled about KRW28 trillion as of end-September 2023, or about 33% of their shareholder equity.

Small stand-alone securities firms could face significant pressure for short-term refinancing if property risk escalates. These firms have a weaker business presence and a less-diversified business structure than their large and established peers, exposing them to greater volatility in revenue. Some firms have aggressively expanded their business over the past several years by offering real estate project financing guarantees.

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Asset Quality Strain To Persist For MG Community Credit Cooperatives

Concerns about asset quality at MG Community Credit Cooperatives (MGCCC) will likely persist, considering their sizable loan exposure to the construction and real estate sectors, including project financing. MGCCC comprises 1,293 credit cooperatives as of end-June 2023. The institution was created to improve members' lives and contribute to the development of local communities. On an aggregate basis, the cooperatives accounted for about 6% of total gross loans and 7% of deposits among the deposit-taking institutions as of end-September 2023.

The loan balance of MGCCC has grown at an average of about 14% a year during 2018-2022, compared with the growth of banks at about 7.5%. Their delinquency ratio jumped to 5.4% as of end-June 2023, compared with 3.6% at end-2022. This is much higher than the banks' delinquency ratio of about 0.35% at end-June 2023, and for that of other credit cooperatives or credit unions, at about 2.8%.

In our view, the financial resources available at Korean Federation of Community Credit Cooperatives (KFCCC) mitigate the risk of contagion emanating from MGCCC. The body is a de facto central bank for community credit cooperatives, and can draw on government support if necessary. The federation is consolidating financially weak credit cooperatives with healthier ones.

The government has responded swiftly to the deposit outflows from certain weak MGCCC in July 2023. The government reiterated its willingness to offer support, alleviating depositor concerns and averting the risk of contagion. Under the Community Credit Cooperatives Act, depositors are protected for up to KRW50 million by the depositor protection reserves under KFCCC. The federation could receive support from the government through borrowings when needed in accordance with the act.

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Banks And Insurers Can Contain Risks Related To Real Estate Project Financing

The adequate risk management and underwriting of Korean banks will likely help them manage the risks from real estate project financing. In our view, the banks learned a lesson from the previous asset quality stress of construction and real estate project financing following the global financial crisis. We estimate banks' exposure to construction companies and financing for real estate projects at about 1.5% of total loans, respectively, at end-2023. This represents a decrease from about 5% each during the peak in 2008.

The banks mainly focus on residential projects in major cities with guarantees from government agencies. We view commercial real estate projects as riskier because they are more sensitive to economic conditions, especially during a property market downturn. The banks' delinquency ratio for construction industry is fairly low at about 0.5% as of end-September 2023 despite a modest rise in recent years, while there were no delinquent loans for real estate project financing.

We also believe insurers' risk appetite is generally not high given their focus on asset and liability management. Their exposure to real estate projects is manageable, at about 4% of the total assets. Like banks, they also focus more on residential projects. The delinquency ratio for their loans to real estate projects remained low at about 1.1% as of September 2023.

Korean banks and insurers have adequate loss-absorbing capacity, in our view. They manage the regulatory capital ratios well above the minimum requirements. Korean banks' average Basel III common equity Tier 1; Tier 1; and BIS capital ratios were about 13.0%; 14.3%; and 15.6% as of end-September 2023. The insurers' average capital adequacy ratio under Korean-Insurance Capital Standard was about 224% as of end-September 2023, compared with the minimum regulatory requirement of 100%.

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Real Estate Project Financing Unlikely To Become A Systemic Risk

Operating conditions are tough, but the issues in real estate project financing will not evolve into a material risk to the financial system, in our view. Still, overall exposures are manageable in the financial system at about KRW172 trillion, or about 2.5% of total assets or 25% of equity, as of September 2023.

We anticipate the government will also provide more support measures, if needed. Support measure of up to KRW85 trillion are in place (see table 1). These include:

• A bond market stabilization fund;
• Corporate bond and commercial paper purchase program by policy financial institutions;
• Guarantees provided to real estate project financing by government agencies; and
• Loans and guarantees to construction companies.

If the situation worsens, it could have negative secondary order impact to broader economy. Stress on construction companies and the related real estate projects would hurt consumer sentiment and consumption. Moreover, those small and midsize subcontractors and suppliers to construction projects may also face financial difficulties, adding asset quality burden to financial institutions.

Table 1

Related Research

• Banking Industry Country Risk Assessment: Korea, Nov. 30, 2023
• Global Banks Outlook 2024: Forewarned Is Forearmed, Nov. 16, 2023
• Korea (the Republic of), Oct. 30, 2023
• No Material Disruption For Korean Banks From MG Community Credit Cooperatives Stress, July 17, 2023
• Wider Opening In Korea Banking Is Not An Immediate Threat To Incumbents, July 10, 2023
• Korea's Large Securities Firms Are Better Equipped To Handle Liquidity Stress, Nov. 3, 2022