South Korea’s banks have managed to hold steady through Covid-19 and are now looking to the future of digital banking. Kimberley Long reports.
South Korea’s banks have come through the past two difficult years with relatively buoyant balance sheets and a positive outlook for the future. Thanks to a combination of solid groundwork in maintaining a strong banking system long before the pandemic struck and proactive responses from the regulators, the banking sector has remained robust.
Multiple measures were implemented by the Financial Service Commission to support banks through the turmoil of the pandemic. Steps included seeing the loan-to-deposit ratio (LDR) for commercial banks being eased from 100% to 105%, with the rate for savings banks and financial co-operatives raised by 10 percentage points. Liquidity coverage ratio (LCR) requirements in won have been lowered from 100% to 85%, and the foreign currency requirement was lowered from 80% to 70%. The measures are currently due to expire in March 2022; however, they have been extended multiple times since implementation in April 2020.
Matt Choi, director of financial institutions at Fitch Ratings, says: “In maintaining the capital buffer, banks were allowed to apply the final Basel III credit risk measurement as early as the second half of 2020. Banks saw their capital ratios boosted by two to three percentage points as a result. All the support measures together mean bank performance has sustained quite well. Fitch’s Viability Ratings (which measures the intrinsic creditworthiness of a bank) on South Korean banks have been on a positive trajectory overall, although there were some negative outlooks temporarily placed at the start of the pandemic.”
It is not common to see a digital bank reporting profits in the first few years of operation
The overall prudent banking climate helped South Korea’s banks to be well-prepared for the impact of the pandemic. Emily Yi, associate director at S&P Global Ratings, says: “The government injected capital to policy banks to support their execution of policy mandates amid the Covid-19 pandemic. The financial regulators also allowed an early adoption of the final Basel III credit risk framework from June 2020 for South Korean banks, leading to an increase in regulatory capital ratios.”
These additional measures brought some relief to the stresses of the pandemic. Arlene Sohn, analyst at Moody’s Investors Service, says: “Despite the easing, we had expected the banks to maintain these ratios close to the original requirements because the measures were temporary, and in fact, LDR remained largely stable at 97% as of September 30, 2021, while system average LCR and foreign currency LCR for the third-quarter of 2021 were 97% and 116%, respectively.”
Mr Choi says: “We expect more measures to wind down as the economy progresses, and we believe the banking sector can withstand the tightening of monetary policy due to the strong economy and sound underwriting standards overall.”
A real-world case study from Woori Bank demonstrates the impact of the pandemic. “Woori Bank’s credit cost remained low, declining further to six basis points for the first nine months of 2021, from 19 basis points in 2020 because the bank’s provisioning declined as disruptions caused by the pandemic gradually waned,” says a spokesperson from the digital group and strategic planning department at Woori Bank. “We do not expect the bank’s credit cost to increase meaningfully over the next 12 to 18 months, considering the bank’s conservative provisioning over 2020 to 2021, and our expectation of a gradual wind-down of the government’s fiscal and financial supports.”
High household debt
While overall the outlook for the banks is good, South Korea’s household debt levels are cause for concern. The Bank of Korea (BOK) reported household debt levels to nominal gross domestic product (GDP) was 106.5% in September 2021, or more than Won1.5tn ($1.25bn), up 5.8 percentage points from the previous year. This represents one of the highest household debt levels in the world, with average households in debt to 171.5% of their annual income. According to a study by the Bank for International Settlements of 43 countries at the end of 2020, the average household debt-to-GDP ratio is 62.1%.
This has not gone unnoticed, with the BOK issuing a warning in June 2021 on sell-offs and debt deleveraging. “Very high levels of household debt, combined with rising interest rates and the unwinding of the government’s support measures, could suggest higher asset quality pressure, primarily among marginal borrowers,” Ms Sohn explains.
Despite this, Ms Sohn is optimistic about the prospects and outlines several reasons why asset quality is not causing too great a cause for concern. She explains that the banks are subject to tightened underwriting policies from the regulator’s focus on decelerating household loan growth. A sizeable portion of the borrowers are considered prime borrowers, with figures from September 2021 showing 76% of household loan borrowers had a credit rating of between one and three out of 10, putting them into the prime borrowers category and the average loan-to-value for residential mortgages is between 40% and 45%, creating a collateral buffer. Further, households have strong balance sheets, with ratios of financial assets to financial liabilities of more than two to one over the past 12 months.
Mr Choi, however, takes a more cautious outlook. “Our overview of high and rising household debt is that it has increased the vulnerability of the banking sector towards severe economic shock. For now we do not expect the high household debt levels to impact the asset quality of the banks significantly in the near term,” he says. “Tighter prudential measures have been implemented by the authorities for the last few years and they’re getting tighter. With tightening monetary policy as well, it could increase the delinquency loan ratio in the next few years, but we believe it will be moderate due to the measures already in place.”
As a result of the above measures, Ms Yi says credit growth is expected to slow to around 5% annually over the next two years.
Strong neobanks
The rise in debt has in part come from the success of digital banks in South Korea, which have taken up a large slice of market share over a relatively short period, particularly in unsecured household loans.
Digital-only banks Kakao Bank, Toss Bank, and K Bank have built up sizeable user bases, with 16.5 million, eight million, and 6.1 million users respectively as of June 2021. Kakao Bank was established first, going live in July 2017. It grew out of the established KakaoTalk messaging app which dominates the South Korean market, with eMarketer research showing 97.5% of smartphone users have the app. Kakao Bank listed during August 2021, the first South Korean digital bank to do so, and surged 79% above initial public offering price to a market value of $29bn.
The success of these banks is above what has been seen elsewhere. Mr Choi says: “Both Kakao Bank and K Bank reported net profits in 2021. It is not common to see a digital bank reporting profits in the first few years of operation.”
The digital banks are taking up more market share, with the equity markets expecting growth to be significantly higher for Kakao Bank than for traditional banks. Ms Sohn explains that Kakao Bank is currently trading at 3.9 times the price to 2020 book value, while that of major financial groups in South Korea ranged from 0.4 to 0.5 times.
The incumbent banks are not complacent about the competition coming from the neobanks and have made strides forward in their own digital offerings. BOK statistics show that around 94% of all deposits and withdrawal transactions were contactless in the third quarter of 2021, and online banking accounted for around 72% of transactions. As of September 2021, virtual banks accounted for 3.5% of South Korea’s system household loans, or 1.5% of total system loans.
The growth of the digital banks has been curtailed by the regulator, with the Banking Act limiting the amount of business that virtual banks can conduct face-to-face, which makes it harder for them to extend home mortgages and corporate loans. However, regulatory changes due to come in during the first half of 2022 will provide a boost to the neobanks. An amendment to the Banking Act will allow virtual banks to conduct due diligence and sign joint contracts in person.
The neobanks are ready to capitalise on this. “Virtual banks plan to launch corporate loan products within the year,” Ms Sohn says. “How rapid virtual banks can grow their small and medium-sized enterprise lending business will depend on how fast they can develop underwriting models.”
The speed at which they can develop their underwriting is also noted by Ms Yi as a possible stumbling block to neobanks’ maintaining their rapid growth rate.
Mr Choi says: “The regulator is asking the digital lenders to increase the portion of loans to borrowers from the mid- and low-credit range to around 25% of total loans by the end of 2022. This segment has not yet grown due to the associated credit risk.”
The exploration into digital by the incumbent banks is not limited to mobile lending, as the Woori Bank spokesperson explains: “Woori Bank is exploring the effect cryptocurrency may have on the banking industry in light of central bank digital currency trends, technology validation and business model utilisation strategies. Although we are considering validating the new digital technology used by cryptocurrencies, the necessity of internalising such technology and its business potential, we believe that a regulatory framework that includes travel rules and business rights regulation must first be put in place before any substantive strategies can be formulated.”
Enter the metaverse
South Korea’s plans for digital expansion go far beyond simple banking services. Seoul has outlined plans to join the metaverse by 2023, with the aim to create a communication ecosystem for services covering tourism, education and civil services. The metaverse is a digital reality that uses aspects of social media, virtual reality and augmented reality to allow users to interact virtually in real time. Rather than simply observing content, users absorb themselves in the surroundings and conduct activities as they would in the physical world. The concept gained prominence in October 2021, when Facebook announced it was pivoting its business towards the metaverse.
The metaverse is perceived by some as the next big development in the digital world, and accordingly investment has begun. The Seoul metropolitan government has invested Won3.9bn on the project as part of its Seoul Vision 2030 plan to boost the city’s global competitiveness.
It is a trend on which South Korea’s banks have started to make moves. “As non-face-to-face channels have grown increasingly important following the pandemic, banks are planning to leverage the metaverse in their marketing strategies while already hosting conferences and meetings in virtual spaces,” Ms Yi says. “For example, one of the South Korean banks recently launched a virtual online game targeting younger customers where users can visit a virtual branch and experience banking services.”
“The metaverse is a hot topic in South Korea,” Mr Choi adds. “It will bring disruption in many industries, not only banking. South Korean banks are interested in the technology. Shinhan Bank announced it is to work with IT company KT Corp to develop digital capabilities. The market speculates that if KT Corp creates its own metaverse, then Shinhan Bank may open its branches there.”
It is a development that is on Woori Bank’s radar. The spokesperson for the bank says: “We expect that utilisation of the metaverse will serve as one possible strategy to offer enhanced financial services in business areas where it is difficult to deliver an optimal customer experience via mobile banking. The metaverse will also become more widely used as the number of customers who prefer banking via digital channels increases.”
How the technology can be used by bank customers and staff alike is part of the development process. “Woori Bank is currently looking into how to take advantage of the metaverse to recreate the physical branch banking experience for customers via a virtual contactless channel, as well as to offer a virtual space for employees to work-from-home and collaborate more extensively,” the spokesperson adds.
While these changes may have strong appeal to certain consumer demographics, there are still other parts of the population that need to be served in a more traditional fashion. Heakyu Chang, senior director of financial institutions at Fitch Ratings, believes there will be regulatory requirements to be met before a wholesale move is made into the digital-only offerings. “I suspect the changes will take a long time to implement due to the regulators. They want to know if elderly people and disabled people will still be able to access the banking services without difficulty.”
Mr Chang says the move to the metaverse is unlikely to be completed in the short term: “A lot of South Korean banks have said they would move into this space, but I suspect that would take them a long time. Eventually, operations would become virtual, with call centres and bank clerks engaging through the metaverse. This could bring about a lot of savings for banks. South Korea is very dense with bank branches and this incurs significant costs. Bank profitability has been low and this could help to reduce operational costs.”
The move into the metaverse is likely to be part of a broader trend between banks and technology companies, as they further explore the possibilities available to them. “Partnerships between banks and IT providers are becoming more prevalent,” Mr Choi says. “So, what does this mean for the banking sector? We think it could further accelerate the digital transformation of the banking sector. In the short term, it may involve additional costs in IT investment; but over the long-run we think it could bring enhanced operational efficiency for the whole banking sector.”
