A better future ahead for Korean banks

Our view on Korean commercial banks has brightened after our recent visits. Although there are some weaknesses, the banks’ fundamentals have improved.

The three main concerns regarding Korean banks are (1) funding vulnerability, (2) the high level of consumer leverage, and (3) exposure to real-estate project finance and construction, in our opinion.

We recommend policy banks over commercial banks at current levels.

External funding. Although from a funding perspective Korean banks are vulnerable to an external shock, they are less reliant on short-term external debt and wholesale funding. Short-term external debt as a percentage of total external debt declined to 59% at end-March 2011, the lowest level in a decade, from around 72% in Q3-2008. Also, the KRW loan-to-deposit ratio of the commercial banks is below 100%, down from a peak of 129% at end-November 2007.

Household leverage. High household leverage is a source of concern, but barring a sudden interest-rate shock, it is more of a long-term risk. Consumer loans represent c.50% of banks’ loan portfolios, and 60% of household debt is in the form of residential mortgages where the average loan-to-value ratio is below 50%. Although 90% of mortgages are floating-rate, which exposes consumers to payment shock if interest rates rise quickly, we do not expect further interest-rate rises in 2011, and expect 75bps of increases in 2012.

The government has proposed a package of measures aimed at reducing the risks posed by household debt, including increasing the percentage of fixed-rate mortgages to around 30% by 2016 from 5% currently. At this stage, it is unclear which measures will actually be implemented.

Real-estate project finance exposure. While the REPF sector has experienced stress, the amount of exposure has been declining and now represents less than 3% of total loans, down from 4.5% in 2009. From a macro point of view, we are encouraged by the steady decline in unsold homes and the relative stability of house prices.

Other trends. NPL formation over the next few quarters should remain at roughly the same levels as in Q2-2011. Regulatory guidance is that banks should have an NPL ratio of around 1.5% by end-2011. In terms of earnings, over the next few quarters, the banks will likely report a slight improvement in profitability, underpinned by lower loan-loss provisions and stable net interest income.

Finally, from a capital adequacy perspective, the Tier 1 capital ratio for domestic Korean banks continues to improve, increasing to 11.6% at end-June 2011. While Korean banks are still not as well capitalised as their Singaporean or Hong Kong counterparts, their capital adequacy has improved overall, putting them almost on par with Malaysian or Thai banks.

Fair value. In the current market, the fair-value differential between policy banks and commercial banks is 50bps, in our view. At current levels we would rather own the policy banks rather than the commercial banks.