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Asia-PacificMarch 23 2011

Mutual saving bank problems hit South Korea's finance sector

While South Korea's commercial banks have just enjoyed a record year for earnings, any joy within the country's banking sector has been quelled by problems within its debt-saddled mutual savings banks.
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Mutual saving bank problems hit South Korea's finance sectorWoori's privatisation by state-run deposit insurance agency Korea Deposit Insurance Corporation is expected to go ahead this year.

South Korean banks saw their year-on-year earnings surge 35.6% in 2010 thanks to increased interest income and profits from sales of stock holdings. Their combined net income in 2010 was won9400bn ($8.38bn), up 5.6% from won6900bn in 2009, itself an improvement on the crisis-hit figures of the previous two years.

However, with the good news came the bad. The non-performing loan (NPL) rate for domestic banks hit a six-year high in 2010, its worst since 2004 when the NPL rate was 1.9% in the wake of South Korea's 2003 credit card crisis. NPLs among the country's 18 local banks surged from won8400bn to won24400bn at the end of 2010, accounting for 1.86% of South Korea's total loans.

While the troubled real-estate, project finance, construction, shipbuilding and shipping industries all posed problems for the South Korean banking system, the issue of defaulted project finance loans is the country's most critical. The total sum of soured project finance loans surged to won6400bn in December 2010, with an NPL rate of 16.44%, up from won1200bn at the close of 2009, according to figures from the Financial Services Commission (FSC), South Korea's main financial regulator.  

Mutual pain

These defaults in the project finance loans arena have taken a particularly severe toll on South Korea's mutual savings banks, the country’s secondary lenders. However, since Kim Seok-dong took over as the FSC chairman in January, a series of restructuring measures has been taken to ease the beleaguered sector's suffering.

Eight mutual savings banks, including Busan Savings Bank, the biggest in the country by assets, have been placed in suspension due to their negative net assets or lack of liquidity to meet increasing requests for deposit withdrawals.

The watchdog is also inducing consolidation among savings banks, aimed at introducing bigger and more solid commercial banks, by putting the unviable ones up for sale. Woori Financial Group, South Korea's second largest financial group by assets, recently acquired the suspended Samhwa Mutual Savings Bank, while other banking groups are deciding whether to follow suit.

In the latest round of moves, the South Korean parliament passed a bill on March 12 proposed by the FSC to set up a “special restructuring account”, to which financial companies will contribute a total of won710bn annually from April 1, 2011 to the end of 2026 earmarked for restructuring the country's savings banks sector. The government will also inject an unspecified sum of tax-payer money into the fund.

The FSC has also pledged to start imposing stringent limits in the third-quarter of 2011 on risky investments made by savings banks, such as high-yield corporate bonds in property and shipping, while also curbing excessive lending activities and the issuance of subordinated bonds.

No threat

Analysts and South Korean regulators are largely in agreement that the problems with the country's savings banks will not result in a systemic threat to its major commercial banks. For one thing, the savings bank sector’s total assets of won86,500bn account for only 3.1% of the country’s total financial assets. Also, mutual savings banks, classified as non-banking financial institutions in the country, are subject to different regulations than commercial banks and cater to different clients, meaning they have a different risk profile.

South Korea's 105 regionally focused savings banks are funded through time deposits sourced at higher interest rates than those of the commercial banks and lend to lower-credit, second-tier property developers, or those who take riskier bridge loans for project financing, as well as the weaker small and medium-sized enterprises (SMEs) and households (ie, those that tend to fail in securing credits from commercial banks).

According to the FSC, 94 mutual savings banks are in full compliance with the 5% capital adequacy ratio requirement. Nevertheless, the sector's average default ratio on project finance loans escalated to 24.3% at the end of 2010, a sharp surge from 9.1% in 2005.

A good opportunity

However, potential buyers say the savings banks could be good purchases, despite their problems.

Euh Yoon-dae, chairman and CEO of KB Financial Group, South Korea's leading financial group by assets, says: “Though debt-saddled savings banks saw their asset soundness stay at critically weak levels, the situation for buyers is favourable as financial regulators have proposed a method called 'purchase and assumption'. Under the scheme, buyers are entitled to acquire only the viable assets, not all of them, on a selective basis.” 

Even this could pose risks, however. “Information transparency in most savings banks is lacking, since only 27 of them are listed on the local bourse," says Ernst Lee, a spokesperson at the FSC. "Also, project finance loans... is a troublesome area. It can deteriorate and proper pricing for assets and liabilities will therefore be difficult.” 

Big money

In contrast to the struggling savings banks are the large South Korean financial groups, which for the most part performed well in 2010 thanks to rebounding interest income and decreased loan-loss provisions. Woori Finance’s net earnings for 2010 reached won1200bn, growing 21.1% from won1030bn in 2009. Shinhan Financial, South Korea's third largest financial group, posted 82.6% year-on-year growth to won2380bn in earnings in the same period. Meanwhile, Hana Financial, the country's fourth largest lender by assets, achieved net earnings of won1.01bn last year, up a staggering 230% from a year earlier.

KB Financial, however, lagged behind its rivals due to low profitability and heavy exposure to a sluggish housing market and weak SMEs. In 2010, KB posted a profit of won88.3bn, far smaller than the won539.8bn profit for 2009. In the fourth quarter, KB posted a loss after its flagship unit, Kookmin Bank, spent nearly won652.5bn on a huge voluntary retirement programme in November, reducing its staff count by 3200, or 12.5%, in an effort to bolster efficiency and profitability. The group also spun-off its credit-card operations into a separate entity to cut exposures to bad loans.

M&A salvation?

With domestic competition intensifying, banks are looking at mergers and acquisitions (M&A) or organic growth, even overseas, to gain economies of scale.

What would have been the country’s biggest banking acquisition, Hana’s won4700bn purchase of a 51% stake in Korean Exchange Bank (KEB) from Lone Star, ground to halt following the FSC’s decision on March 16 to postpone approval of the deal. The FSC’s decision came after South Korea's supreme court ordered that Lone Star and its former local head be retried over allegations of stock manipulation of an affiliate of KEB in 2003. It means that the FSC could not make a decision on whether the US buy-out fund was eligible to control Korea Exchange Bank when it acquired the lender in 2003.

South Korea's banking sector is also bracing itself for a revival of the deferred Woori privatisation by the state-run deposit insurance agency Korea Deposit Insurance Corporation. The country's largest ever financial sector privatisation – a 57% stake valued at $6bn – was cancelled in December after two consortia, representing Woori employees and corporate clients, baulked at the hefty premium being sought by the government.

FSC spokesman Mr Lee reasserts the government’s commitment in pushing the privatisation through, targeting deployment of the viable privatisation routes, be they through block sales or tranche-by-tranche M&As, by June and completion by the end of the year. Pricing and market implications rather than premiums will be the government’s primary concerns, Mr Lee stresses.

Woori believes an expedited privatisation process will be a boon for the group. “Woori will have a better position in the market after the privatisation, which will allow the bank to form an optimal business portfolio, such as strengthening its non-banking subsidiaries,” says Seong Woo-seok, head of Woori’s investor relations. “Under the ownership of the government, we have restrictions on management of our organisation. We would feel more comfortable without the government's ownership since we already have the capabilities to compete in South Korea's financial market."

Looking overseas

KB, the country’s leader in retail banking, is also active in expanding overseas. Its 12 foreign networks span Japan, New Zealand, the US, the UK, China, Cambodia, Vietnam, Ukraine and Kazakhstan, offering corporate and retail banking for South Korean companies and expatriates. KB says it will continue to look for organic growth in fast-growing countries such as China, India and Indonesia, and will open branches in Ho Chi Minh City in Vietnam and Osaka in Japan, and a representative office in Mumbai in 2011. In 2010, the proportion of assets in overseas networks made up approximately 1.4% of  the group's overall total.

Despite South Korean banks’ aggressive overseas expansion and shared vision of breaking into the world's top 50 banks, they are generally beleaguered by dwindling profits and localised obstacles to their global ambitions. In 2010, the return on assets from Korean banks’ foreign operations was less than 1%.

“Ethnic banking focusing on Korean companies and residents abroad limits our growth and profits,” says KB's Mr Euh. “We aim to build and promote the strategies of inventing competitive financial products, penetrating niche markets and providing differentiated service to target local markets.”

Mr Lee says: “Korean banks tend to lack international finance experience and are rarely involved in large international deals... [They do not have staff] with crucial long exposures to international markets and language proficiency. Also, they lack strong networks with major international players that can enhance their opportunities of participating in major deals.”

Bolstering the home market

FSC chairman Mr Kim is expected to submit a revision bill to South Korea's Capital Market Consolidation Act in parliament in July or August, aimed at strengthening its domestic investment banking and capital markets beyond the traditional strength in retail banking. Its objectives will be to nurture home-grown megabanks and bolster the financial needs of South Korean companies abroad.

“We need to unbridle the regulatory strangleholds to prop up domestic project financing, corporate banking, corporate finance and even private equity and hedge fund industries to offer Korean companies diversified funding sources with lower costs for winning deals overseas,” says Mr Lee. 

Mr Euh adds: “There are some cases in large overseas projects [where the tender is based upon the] lender’s global ranking. To prepare for such cases, Korean lenders should increase their size by inorganic growth."

“Eventually, experience and ability to syndicate and arrange huge funds become critical, and so does the ability of pricing long-term lending by reflecting local circumstance and country risk. Precise valuation is possible when a lender has a professional understanding of the project. Korean lenders are inexperienced and lack funding when compared to global players."

More competition

Competition among South Korean banks is expected to heat up if the Woori privatisation and the Hana-KEB deal go ahead. Also, Shinhan will probably have a new chairman. Hang Dong-woo has been nominated for the role following a management feud that resulted in the departure of three of its top executives. Mr Han is expected to be officially appointed imminently.

South Korea's macroeconomic outlook is also positive, and both its government and international brokerages are expecting a 4% to 5% growth in gross domestic product in 2011. Bank of Korea, in line with other Asian governments’ efforts to contain inflation, cautiously raised the key interest rate by 25 basis points to 3% on March 10 this year.

The rate hike caused concerns that it would aggravate the country’s household debt burden, which neared won800,000bn as of the end of 2010, according to Bank of Korea statistics. In South Korea, the debt ratio against disposable income climbed to 143% in 2009 from 136% in 2007.

But even such seemingly bleak news can present an opportunity for the country's banks. “Bank margins could keep rising on rate hikes amid still-stagnant loan growth,” says Scott Lee, an analyst at UBS. “Also, we think Korean banks will meet our estimates for quarter-on-quarter net earnings, which we project to rise 144% in the first quarter of 2011. We expect this to be led by falling provisioning, down 16% quarter on quarter to 85 basis points,” he adds.

Heakyu Chang, a director at Fitch Ratings, says: “Household sector loans will continue to perform well, although delinquency rates will increase as and when interest rates increase.” Mr Chang adds that the average quarterly new NPL formation rate of the banking system is expected to drop in 2011, compared with 2010, given that South Korea's banks have gone through significant system-wide loan reviews in the past two years, resulting in sizable work-outs of corporate borrowers.

“That said, ailing property developers and SMEs which are fundamentally weak but which have survived so far, mainly due to the banks’ and authorities’ support measures, will continue to affect the banks’ loan quality as and when more of these measures are withdrawn,” he says.

Meanwhile, assuming no excessive inflation, commercial banks’ top-line profitability will improve, while their credit costs should fall due to the adoption of International Financial Reporting Standards, he adds.

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