The failure of the Silicon Valley Bank (SVB) has rattled markets in the U.S. and raised fears that other banks could follow suit. While the effects in Asia have so far been minimal, the high-profile collapse nonetheless raises questions about the health of South Korea’s own banking system.

SVB was a medium-sized bank by U.S. standards, and its collapse had a limited direct impact on South Korean investors. SVB collapsed due to distinctive investment strategies and rising interest rates. 

But other banks, including those in South Korea, may also be vulnerable given persistent inflation and potential further interest rate increases.

A Korea Pro Analysis indicates:

• Most large South Korean banks are well-capitalized by world standards, but many have booked substantial capital losses in the last year due to rising interest rates.
• An SVB-style bank run and failure seems unlikely, but more vulnerable financial institutions have already seen significant write-downs on their assets’ value.
• The government seems to be concerned primarily with the profits the banks are making rather than their unrealized losses on assets they hold.
• Meanwhile, some influential investors are concerned that the banks hold large amounts of cash on their balance sheets rather than paying out dividends to shareholders.
• Regulatory uncertainty, low dividends and poor long-term prospects hold the industry back, which means that the banks are liable to remain in their low-valuation (Korea discount) trap.

BANK HEALTH

Banking is a risky business. It involves taking people’s cash (bank deposits) for interest (a cost for the bank) and lending them out to other people for interest (income for the bank). Banks also invest people’s savings in stocks, bonds and other assets to generate a return. The spread between the rate banks pay savers and the rates of return it generates on assets, including loans to other people, is how a bank makes profits. 

The biggest issue here is what is called the maturity mismatch. Depositors can withdraw their cash at any time, but a bank often cannot demand full repayment of a loan or sell the securities (shares, bonds and other financial instruments) on demand at cost. This mismatch can lead to bank failures if enough depositors demand their money back at once.

To prevent bank failure, banks are required to hold a certain amount of capital in reserve. The key measure here is tier-1 capital, which refers to the portion of the bank’s equity considered riskless or at least near riskless. This includes cash and common stock.

Since the Asian financial crisis of the late 1990s — South Korean banks have sought to maintain large and growing capital buffers against potential losses. The large banks are especially well-capitalized, with ratios similar to or higher than major U.S. banks, though below the European average. 

However, like banks elsewhere (in the U.S. and the E.U.), Korean banks have taken substantial losses on the value of their assets due to rising interest rates, which have pushed down the value of many financial assets. These are book losses — the assets remain on the books and have not been sold for a loss. 

The size of the losses is not that large. Further, these losses have resulted from violent swings in interest rates and stock market declines, swings that appear unlikely to be repeated going forward. But crises are not just a product of the fundamentals; speculative manias and panics often drive markets up and down. 

Moreover, there are clear signs of vulnerability in the Korean financial system. Like the U.S., with its increasingly fragile-looking regional banks, some of Korea’s savings banks have less healthy capital buffers and more worrisome loan books. 

The most obvious way a crisis might emerge is through the housing market. The banks have lent a great deal to households to finance purchases, though most of this lending has gone to households with good credit ratings. 

Project financing (PF) for construction is the more immediate source of vulnerability. As the Bank of Korea’s (BOK) most recent Monetary Credit Policy Report made clear, non-banking financial institutions, like insurers, savings banks, securities firms and credit card companies, have been heavily involved in such lending. 

PF is riskier than mortgage lending because, in case of a real estate market downturn, the owners of the new property being financed may have to sell it at a discount or even be unable to sell it. When the housing market goes bad, more PF tends to go bad more quickly than mortgage lending, or at least, that is the assumption undergirding the higher interest rates PF borrowers pay. 

A crisis with PF could hurt the financial system generally, with banks and other financial institutions needing cash injections or being forced to cut back on lending. Currently, overall delinquency rates across the financial industry are low, but there are risks that will worry the central bank and financial regulators going forward.

U.S. one-hundred-dollar bills, Jan. 24, 2014 | Image: Pexels

MONEY PLEASE

Like the Federal Reserve (Fed) has discovered in the U.S. with the SVB crisis, the BOK is in a bind. With inflation still elevated and the Korean won depressed against the dollar, the BOK has good reason to keep raising rates. But with the real estate market in trouble — a market for the most significant asset held by households and the country’s financial institutions — excessive rate raising could put financial stability and the livelihoods of many households at risk.

The banking regulators have begun a crackdown on what South Korean President Yoon Suk-yeol has called a “money party.” He has decried their excessive reliance on income from high interest rates and the growing spread between loan and savings interest rates discussed above. This spread is not historically high but rising, and President Yoon’s call for greater competition in a highly concentrated market appears reasonable.

Banks have pricing power; the market is concentrated. And when the prices rise — in this case, the price of money (interest rates) — firms with pricing power may take advantage by raising prices even more quickly. This seems to be part of what is happening with the banks. 

Regulators have proposed making it easier to create specialized banks that lend to particular groups or allowing non-banking financial institutions, such as securities, to offer more banking services. The problem is that the risks in the system make size more important: Bigger capital buffers make big banks safer in times of stress. 

The government is also pushing the banks to expand overseas in search of alternatives to the domestic market. The latter is growing more slowly and faces structural decline due to the aging population and a lack of credible future growth engines. Banking is risky by definition and potentially far more so when expanding into new, unfamiliar markets. But diversification into new markets can also, paradoxically, lower risk and improve profitability. 

As a long-term ambition, Korean banks becoming more involved in other parts of Asia with greater growth prospects appears sensible. But the timing might not be right in times of considerable volatility and downside risk — with recessions potentially on the horizon. 

Meanwhile, investors are interested in immediate returns. Korean banking stocks already trade at a significant discount compared to non-financial Korean firms and especially to banking stocks in other countries. One of the reasons offered for this is the low dividends the banks have paid their shareholders. In other words, buying and holding bank stocks is not worth it because one gets so poorly rewarded. 

Activist investors are calling for the banks to raise their dividend payouts. Banks are not forced to hold their dividend rates artificially low by law. But shadow regulation (otherwise known as window guidance) has allegedly ensured that banks feel obliged to retain more capital than they otherwise would. 

The South Korean government has also previously indicated a desire to end administrative guidance of the banking sector. But given the current desire to control interest rate spreads, bank profitability may suffer, making it less likely dividends will rise much.

Edited by John Lee