That said, the banking sector has underperformed the Korea Composite Stock Price Index (KOSPI), as investors remain skeptical in the face of lingering high levels of household debt as well as the recent spike in delinquency ratios of retail loans.

These underlying business conditions for banks are not new, explaining why South Korean financials have consistently underperformed Seoul’s benchmark KOSPI:

Source: Bloomberg

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.

Historically, the fundamental issue bedeviling the South Korean economy has been the heavy indebtedness of households, now at 145 percent of GDP. Although this problem can’t be completely disregarded, indebtedness is an inherent characteristic of the South Korean economy and no cause for undue alarm.

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.

The bottom in South Korea’s housing market occurred in the middle of 2010. Since then, the so-called secondary markets have recovered the strongest. On the other hand, big cities that represent about 70 percent of real estate market capitalization have moved sideways. Real estate prices in South Korea’s major metropolitan areas, especially in housing, are now at least 20 percent lower than their peak in 2007.

The fact is, high leverage will remain a long-term characteristic of the South Korean economy. Since 2005, South Korean banks have encountered difficulties in attracting deposits and funding their activities. The reason: non-bank institutions offering investment and trust products expanded at a rapid clip and were able to offer better returns. Between 2005 and 2008, bank deposits grew by USD85 billion while mutual funds (including equity, hybrid and bond funds) grew by USD110.6 billion.

As the 2008 global financial crisis eased, this fund flow trend reversed. An increase in market volatility, combined with a restructuring of non-bank financial institutions, enticed investors back to more stable bank deposits. During the past four years, banks have again started to see deposits growing smartly while mutual funds and other related vehicles have been shrinking. Banks are now the vehicles of choice for deposits and many other financial services.

With the trauma of the 2008 meltdown still fresh in their minds, South Korean bank managers have been in no hurry to resume their excessive loan growth practices. For now, getting rid of risky assets is a priority. Regulators also are making sure that lending strategies employed by South Korean banks are cautious. 

As the chart below shows, non-performing loans (NPLs) have been coming down while NPL coverage ratios have been rising. The latter is 70 percent for some banks, helping ease their costs associated with NPL sales and write-offs.

Regulators and banks in South Korea are trying to curb excessive loan growth, rather than force deleveraging. This strategy is born of the 2002-03 credit card crisis, when policy makers tried to force a fast deleveraging among credit card holders that didn’t work.

Source: Bloomberg

An upside for the South Korean banking sector is the unlikelihood of any major macro shock to the underlying economy, which is on track for a growth rate this year of about 3 percent. Worrisome developments related to credit quality would include a surge in the unemployment rate or a big drop in disposable income, two improbable scenarios.

Unemployment remains at around 3 percent, with no indication that a rapid deterioration is in the cards. Wages are the key source of debt servicing, which means stable employment conditions won’t translate into serious deleveraging efforts.

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. Currently, monetary policy has remained loose and interest rates are 50 percent lower than their peak in 2008, making debt servicing much easier.

Also keep in mind that South Korea is marked by a tradition of “public service” whereby the government and large corporations find concerted ways to support the job market during difficult economic times.

South Korea’s leaders run the country with the foresight, discipline and efficiency of world-class corporate managers. For big private sector corporations, that means holding back layoffs, while for the government it means increasing public sector employment. For example, in 2010 the government spent around USD3.5 billion creating 580,000 new jobs in the public sector, a big number for a country of South Korea’s size.

The upshot is that the South Korean economy will benefit from a generally positive global economy this year, which is why it makes sense to add South Korean bank stocks to your portfolio. A quick glance at the GIS model portfolio shows that the KB Financial Group (NYSE: KB) is the best South Korean financial to own.