South Korea's Balancing Act

October 10, 2014

At the moment, policies meant to deal with South Korea’s slowing economy and high level of household debt are putting pressure on its already-weakened banking sector. Banks operating in Korea have struggled with profitability, causing many to restructure and downsize. For instance, foreign banks such as Standard Chartered, HSBC and Citibank have trimmed headcount, sold business operations or closed retail units. 

The slow economy and weak business sentiment have resulted in slower loan growth, and have also prompted the Bank of Korea (BOK) to respond with monetary easing, which naturally squeezes bank margins. There have already been several rate cuts in the last couple of years, but in August the BOK cut the policy rate again in order to restore confidence and boost the economy. As a result of falling net interest spreads and bank lending rates, bank returns on assets and equity have suffered, and margins will continue to be pressed until the central bank raises rates.

President Park Geun-hye’s plans to tackle high household debt are also pressuring banks. Park’s efforts to relieve heavily indebted households have resulted in the implementation of a debt write-off program called the personal debt rehabilitation scheme (PDRS, aka the Happiness Fund). Because banks must sell their loans at a loss to the state fund when borrowers apply successfully for the scheme, this has resulted in a rise in loan impairments and a general deterioration of asset quality.

The majority of household debt is made up of mortgages, so prudential regulators are also trying to strengthen the resilience of mortgage loans to credit risk. While this should stabilize the banking system, it will also further hamper bank profits. Specifically, regulators are encouraging a shift from floating rates and bullet payments toward fixed rates and amortizing mortgages. As a result, bank-funding costs have risen and net-interest margins have been constrained, as banks have sought to attract borrowers by offering lower rates on fixed-rate loans. Banks must also match the increasing amount of fixed-rate loan assets with similarly long-term debt financing, which tends to be more expensive than short-term funding. Prepayment risk, or the risk of borrowers refinancing at lower rates, may also bite into profits.

These issues are often cyclical, but they are also indicative of a broader struggle in South Korea’s financial services sector. The government is stringent in regulating the safety of the financial sector, but at the same time domestic banks find it difficult to compete internationally and foreign banks struggle to make a profit in Korea due to the culture of intervention and protectionism.

View interactive chart.