South Korean Banks: Set to Surprise

The fundamental problem bedeviling the South Korean economy, and deterring investors from the country’s bank stocks, is the heavy indebtedness of households, now at 145 percent of gross domestic product (GDP). However, indebtedness is an inherent characteristic of the South Korean economy and no cause for undue alarm.

During the global economic travails of 2008, most observers expected a big blowout in credit card loans in South Korea—a dire forecast that never occurred. The delinquency ratio of credit card loans was much lower than expected, largely because of the country’s relatively stable employment conditions, even during the crisis. Monetary policy has remained loose and interest rates are 50 percent lower than their peak in 2008, making debt servicing much easier.

Only twice during the past two decades have individuals in South Korea earnestly embarked on deleveraging. The first time was during the Asian financial crisis in 1997; the second during the credit card crisis in 2002-2003.
Even the global financial meltdown of 2008 didn’t prompt South Koreans to significantly shed debt. To be sure, regulators have been trying to curtail retail loan growth, but strong consumption traits coupled with low borrowing costs have undermined those efforts.

Another impediment to a broad deleveraging has been an increase in the ranks of those age 35-54 years, considered the most active borrowing demographic. Consequently, a steady demand for mortgage loans should come as no surprise. Housing prices in areas outside Seoul and other big cities have been rising steadily since 2009, increasing the demand for loans and pushing national debt averages higher.

During the last three years, South Korean banks have been busy restructuring their balance sheets. At the same
time, asset quality has been improving as loans grew conservatively and at a slower pace, allowing for a more stringent evaluation of marginal borrowers. Banks also have steadily reduced their exposure to the higher-risk construction, shipping and shipbuilding sectors.

Until recently, many investors were reluctant to embrace this positive assessment and adopted a cautious, but not pessimistic, wait-and-see attitude. Therefore, even though bank stocks have risen this year, they still offer good value and are poised to surprise on the upside as soon as this year’s earnings reports start coming in.

When investing in South Korean banks, keep in mind that the property market traditionally has formed an important part of the credit cycle of the country’s banking sector. Home equity loans account for 67 percent of total retail loans and construction/real estate accounts for 37 percent of total corporate loans. About 50 percent of all loans are collateralized by real estate.

KB Financial (NYSE: KB) stands out as an investment in the South Korean banking sector. KB has been working hard to improve its operations on every level. The bank’s strategy has been to increase the fee-based income part of its business, a big positive for the bank because it doesn’t incur credit costs nor consume capital.

KB reported first-quarter 2012 earnings of USD533 million, in line with analysts’ expectations. Although KB’s corporate banking was solid, with robust loan growth of 2.2 percent quarter over quarter and falling loan loss provisioning, the retail segment was weaker than expected, leading to a 13 basis point contraction in net interest margin (NIM). South Korean banks generate about 80 percent of their operating earnings from interest income, so NIM fluctuations are closely followed.
KB’s shares trade at undemanding valuations of 0.65 times book value and six times earnings. During the lows of 2008, the stock traded at 0.44 times book value. The bank’s Tier 1 ratio stands at 11 percent, among the highest of its peer group.