Safer Mortgage Loans Will Strengthen

The Stability Of Korea's Banking

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
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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
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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
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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).
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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
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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.
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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
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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
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