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Korean banks have been shifting away from mortgages with bullet payments and floating rates toward amortizing and fixed-rate mortgages. Standard and poor's sees these efforts as positive for the stability of Korea's banking system but at the expense of the system's profitability. Banks with the greatest exposure to mortgage loans--namely, standard Chartered bank Korea, Kookmin bank, Citibank Korea, woori bank, and Shinhan Bank--will benefit most from the shift.
Korean banks have been shifting away from mortgages with bullet payments and floating rates toward amortizing and fixed-rate mortgages. Standard and poor's sees these efforts as positive for the stability of Korea's banking system but at the expense of the system's profitability. Banks with the greatest exposure to mortgage loans--namely, standard Chartered bank Korea, Kookmin bank, Citibank Korea, woori bank, and Shinhan Bank--will benefit most from the shift.
Korean banks have been shifting away from mortgages with bullet payments and floating rates toward amortizing and fixed-rate mortgages. Standard and poor's sees these efforts as positive for the stability of Korea's banking system but at the expense of the system's profitability. Banks with the greatest exposure to mortgage loans--namely, standard Chartered bank Korea, Kookmin bank, Citibank Korea, woori bank, and Shinhan Bank--will benefit most from the shift.
System At The Cost Of Profitability Primary Credit Analyst: Cheul Soo Cho, CFA, Hong Kong (852) 2533 3559; cheulsoo.cho@standardandpoors.com Secondary Contacts: HongTaik Chung, CFA, Hong Kong 85-2-2533-3597; hongtaik.chung@standardandpoors.com Geeta Chugh, Mumbai (91) 22-3342-1910; geeta.chugh@standardandpoors.com Table Of Contents The Resilience Of Korean Banks' Mortgage Loans To Credit Risk Will Continue To Improve The Shift Will Strengthen The Stability Of Korea's Banking System The Shift Will, However, Constrain Banks' Profitability And Test Their Ability To Manage Interest Rate Risk The Ratings Impact Is Likely To Be Limited, Although Mortgage Banks Will Benefit The Most Appendix Related Criteria And Research FINANCIAL INSTITUTIONS RESEARCH WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JUNE 8, 2014 1 1330446 | 301447691 Safer Mortgage Loans Will Strengthen The Stability Of Korea's Banking System At The Cost Of Profitability While households in other advanced economies focused on deleveraging following the financial crisis in 2008, households in Korea kept gradually accumulating debt. The largest proportion of household debt comes from mortgage loans, and Korean regulators are taking notice. They are advocating the increased use of amortizing mortgage loans and fixed-rate mortgage loans in a banking system that until now has extended a disproportionate amount of bullet and floating-rate mortgage loans, which generally entail more credit risk. Standard & Poor's Ratings Services sees these efforts as positive for the stability of Korea's banking system but at the expense of the system's profitability. Nonetheless, we don't expect these changes to trigger any immediate changes to our ratings on Korean banks. Overview Korean banks have been shifting away from mortgages with bullet payments and floating rates toward amortizing and fixed-rate mortgages. This shift will strengthen the stability of the banking system amid relatively high household debt in Korea but will also constrain net interest margins somewhat. Banks with the greatest exposure to mortgage loans--namely, Standard Chartered Bank Korea, Kookmin Bank, Citibank Korea, Woori Bank, and Shinhan Bank--will benefit the most from the shift. The Resilience Of Korean Banks' Mortgage Loans To Credit Risk Will Continue To Improve The characteristics of the mortgage loans that Korean banks extend have been improving from a credit risk perspective. To strengthen the stability of the country's banking system and to address concerns over rising household debt, the Financial Supervisory Service (FSS) has urged banks to shift away from mortgage loans with bullet payments--whereby the entire principal is repaid at maturity--toward amortizing mortgages--in which principal is repaid gradually over the life of the mortgage. The FSS has also issued guidance urging banks to extend a greater amount of fixed-rate mortgage loans and a smaller amount of mortgages bearing floating rates. As a result, the shares of both amortizing mortgages and fixed-rate mortgages in the entire banking system's mortgage book have been increasing. The composition of Korean banks' mortgage loan books will further improve as the banks work to comply with the guidance to increase amortizing mortgage loans to 40% of their mortgage books by the end of calendar 2017, compared with an average of 19% as of the end of 2013 (see chart 1). Given that amortizing loans are generally long term and bullet loans have short maturities, we believe Korean banks' ability to issue covered bonds with long WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JUNE 8, 2014 2 1330446 | 301447691 maturities is likely to support the expansion of amortizing loans. The banks will be looking to match their long-term amortizing loan assets with debt financing of similar maturity. We believe it should be a reasonably undemanding task for banks to further increase amortizing loans to meet the regulatory guidance, given that the shift toward amortizing loans from bullet loans should not add any significant risks for the banks. Chart 1 To comply with the guidance, banks will also need to boost the amount of fixed-rate mortgage loans they extend to 40% of their mortgage books, compared with an average of 16% as of the end of 2013 (see chart 2). In our view, the FSS included this provision because it sought to lower the interest rate risk that household borrowers bear ahead of the Bank of Korea's much-anticipated hike in the policy rate, which will likely result in a surge in floating rates on various loan products. We believe the banks will face some challenges to further increase fixed-rate loans to meet the regulatory guidance (for further detail see the section, The Shift Will, However, Constrain Banks' Profitability And Test Their Ability To Manage Interest Rate Risk). As fixed-rate mortgage loans become more prevalent in the system, institutional investors will eventually take on more interest rate risk that was previously borne by mortgage borrowers. This is because the FSS includes fixed-rate mortgage loans sold to the government-related entity (GRE) Korea Housing Finance Corp. (KHFC) when calculating the share of fixed-rate loans in a bank's mortgage book. KHFC securitizes the loans and sells them predominantly to WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JUNE 8, 2014 3 1330446 | 301447691 Safer Mortgage Loans Will Strengthen The Stability Of Korea's Banking System At The Cost Of Profitability institutional investors, who bear the interest rate risk. We estimate that banks sell about 80% of the fixed-rate mortgage loans that they originate to KHFC, which purchases the fixed-rate loans in line with its policy role of improving the stability of housing finance in the country. Chart 2 The Shift Will Strengthen The Stability Of Korea's Banking System Korean banks face moderate risks from relatively high household debt in the country, in our opinion. Domestic household debt-to-GDP is high relative to levels across the region. In addition, compared with regional peers, Korean banks have a sizable amount of bullet loans, which accounted for about 30% of their mortgage loan books as of the end of 2013. Stringent loan-to-value (LTV) and debt-to-income (DTI) requirements and affordable housing prices relative to income levels in Korea mitigate the credit risk stemming from the elevated household debt, in our view. Housing prices in Korea are roughly five times average annual household income, indicating a level of affordability that is better than that of many regional peers (see chart 3). WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JUNE 8, 2014 4 1330446 | 301447691 Safer Mortgage Loans Will Strengthen The Stability Of Korea's Banking System At The Cost Of Profitability Chart 3 We believe the ongoing shift to amortizing mortgage loans and fixed-rate mortgage loans will mitigate rising household credit risks. In our view, amortizing loans have much less credit risk than loans with bullet payments at maturity. Principal on amortizing loans, which generally have long maturities in Korea, is repaid over time as a component of a borrower's periodic payment obligations. On the other hand, principal on bullet loans, which typically have short maturities, remains constant until maturity. Borrowers of bullet loans are thus exposed to the risk that they will not be able to refinance the loan should the need arise. Moreover, unfavorable economic conditions at maturity could amplify this risk because banks would likely be less willing to lend under the stressed conditions. We also see fixed-rate loans as less risky than floating-rate loans. Borrowers of floating-rate loans are exposed to interest rate risk, which is likely heightened during periods of rising interest rates. (We forecast the Bank of Korea to start raising rates from 2016.) On the other hand, interest rates of fixed-rate loans are constant, shielding borrowers from any fluctuations in rates and improving their ability to budget their debt obligations in the long term. The Shift Will, However, Constrain Banks' Profitability And Test Their Ability To Manage Interest Rate Risk We expect a limited negative impact on the banks' profitability from the shift toward amortizing mortgage loans from bullet loans. Loan yields may fall marginally as we see banks offering slightly lower rates on amortizing loans compared with bullet loans to attract new borrowers to amortizing loans. Lower credit costs should offset lower yields WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JUNE 8, 2014 5 1330446 | 301447691 Safer Mortgage Loans Will Strengthen The Stability Of Korea's Banking System At The Cost Of Profitability because amortizing loans have less risk compared to bullet loans from a bank credit risk perspective. In contrast, we see the negative impact from the shift toward fixed-rate loans from floating-rate loans as a potential threat to profitability. Specifically, we expect lower yields on fixed-rate mortgage loans, higher funding costs for banks, and heightened prepayment risk to constrain the banks' net interest margins (NIMs). This could further depress Korean banks' profitability, which is currently among the lowest in the region. Banks' loan yields may fall. To attract borrowers to fixed-rate mortgage loans, banks have been offering lower interest rates on fixed-rate loans, at least initially, compared with floating-rate loans. Banks' funding costs may rise. To match their increasing share of fixed-rate mortgage loan assets, which are generally long-term, banks need to increase their proportion of fixed-rate, long-term debt financing. Long-term funding is generally more expensive than short-term funding. Prepayment risks may constrain profitability. During periods of falling interest rates, borrowers with fixed-rate mortgage loans are likely to refinance at lower rates to prepay their existing mortgage loans, if prepayment penalties are smaller than interest rate benefits. This will hurt the NIMs of banks, especially those that had fully matched their fixed-rate mortgage loan assets with fixed-rate liabilities. To hedge prepayment risks, banks can embed call options in fixed-rate debt financing, allowing them to repurchase the debt at convenient times but also increasing the cost of their overall debt funding. Nevertheless, we expect the constraints on profitability from the shift toward fixed-rate loans from floating-rate loans to be modest. The amount of fixed-rate mortgage loans that banks hold on their balance sheets will remain small, because banks are likely to continue to sell a large share of such loans to KHFC. Moreover, we believe demand for the resulting securitizations that KHFC sells will remain robust, particularly from Korean life insurers, which need to match the duration of their long-term liabilities with high-grade, long-term assets that provide steady cash flows. That said, if banks are unable to off-load fixed-rate mortgage loans from their balance sheets, banks will take sizable interest rate risks. In addition, most of the fixed-rate loans that banks carry on their balance sheets are hybrid loans (fixed-rate for the first several years and floating-rate thereafter), which constrain banks' profitability much less than pure long-term, fixed-rate loans. Hybrid loans are also classified (partially) as fixed-rate loans under the FSS's methodology and will thus partly contribute to meeting the regulatory guidelines. The Ratings Impact Is Likely To Be Limited, Although Mortgage Banks Will Benefit The Most We see the impact from the shift in mortgage loan types as moderate and unlikely to trigger changes to our ratings on the Korean banks that we rate in the short term. In the long run, the shift--particularly that toward amortizing loans from bullet loans--could improve the asset quality of banks, in our view. We believe those banks with the highest exposure to mortgage loans will benefit the most: namely, Standard Chartered Bank Korea Ltd., Kookmin Bank, Citibank Korea Inc., Woori Bank, and Shinhan Bank. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JUNE 8, 2014 6 1330446 | 301447691 Safer Mortgage Loans Will Strengthen The Stability Of Korea's Banking System At The Cost Of Profitability Appendix Table 1 Shift In Attributes Of Korean Bank Mortgage Loan Assets To From Regulatory guidance Amortizing Bullet Amortizing loans to account for 40% of each bank's mortgage book by 2017 end, versus 19% as of 2013 end Fixed Floating Fixed-rate loans to account for 40% of each bank's mortgage book by 2017 end, versus 16% as of 2013 end Note: Maturities of bullet mortgage loans are generally short, ranging from one to five years. Home-equity loans, through which the borrower collateralizes his or her home to finance large expenditures, account for a large share of all bullet mortgages. Meanwhile, maturities of amortizing mortgage loans are generally long, ranging from 10 to 30 years. Table 2 Effect Of Shift On Credit Risk Of Korean Banks' Mortgage Loan Assets To From Effect on credit risk of mortgage assets Amortizing Bullet Asset quality should improve because principal decreases over time and borrowers bear no refinancing risk at maturity. Fixed Floating Asset quality should improve because borrowers bear no interest rate risk. Table 3 Effect Of Shift On Korean Banks' Profitability To From Effect on banks' profitability Amortizing Bullet Marginally negative to NIM, reflecting slightly lower rates offered for amortizing loans (versus bullet) to attract new borrowers Fixed Floating Potential threat to NIM because (1) banks will offer lower rates on fixed-rate loans (versus floating); (2) funding costs will rise, as banks increase their proportion of long-term, fixed-rate funding; and (3) borrowers tend to prepay their mortgages when interest rates are falling. However, the ability to sell fixed-rate mortgage loans to KHFC limits the risk NIM--Net interest margin. Related Criteria And Research Related Criteria Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 Related Research Credit FAQ: Why Standard & Poor's Sees Relatively High Risks At Nonbank Deposit-Taking Institutions In Korea, April 6, 2014 Korea's Major Commercial Banks Face Hurdles In Lifting Profitability In 2014, Feb. 13, 2014 Korea Banking Outlook 2014: Asset Quality And Profitability Likely To Remain Subdued, Feb. 11, 2014 Court Receivership Of Korea's Tongyang Group Could Adversely Impact High-Yield Notes And Korean Financial System, Oct. 17, 2013 Banking Industry Country Risk Assessment: Korea, Sept. 9, 2013 Market Conditions To Test Korean Banks Foreign-Currency Funding, Liquidity; But Banks Better Positioned To Manage Risk, June 26, 2013 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JUNE 8, 2014 7 1330446 | 301447691 Safer Mortgage Loans Will Strengthen The Stability Of Korea's Banking System At The Cost Of Profitability Structural Challenges Could Hamper Korean Banks' Creditworthiness In The Medium To Long Term, June 9, 2013 Korean Government Fund For Indebted Households Could Raise Moral Hazard And Strain Financial Institutions' Asset Quality, April 4, 2013 Default By Yongsan Project Finance Vehicle Could Pressure Asset Quality And Earnings Of Korean Banks And Insurers, March 14, 2013 Weakened Profitability Of Korea's Major Commercial Banks Likely To Persist In 2013, Feb. 8, 2013 Continued Pressure On Korea's Mutual Savings Banks Could Marginalize The Sector Over Time, Oct. 25, 2012 Credit FAQ: What's Behind Our Rating Actions On Korean GRE-Banks After The Sovereign Upgrade, Oct. 11, 2012 Effectiveness of Koreas New Regulations To Crimp High Household Indebtedness Remains To Be Seen, Feb. 29, 2012 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). 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