"Corporate Soundness Indicators Underestimate Risk... Significant Loss Potential for Banks"

Bank of Korea Releases Financial Stability Report
Bank Default Rates Rise if Corporate Latent Risks Materialize
Significant Credit Losses Expected in Banks if Economic Slowdown Coincides

The Bank of Korea explained that potential risks still remain inherent in the corporate credit sector of our country, and if these risks materialize along with a global economic slowdown, it is estimated that significant credit losses will occur in the corporate loan sector of domestic banks.

It also pointed out that considering the banks' potential credit losses, the current corporate loan soundness indicators may be underestimating credit risk.

Currently Favorable Delinquency Rates... Thanks to Government Support

In the Financial Stability Report released on the 21st, the Bank of Korea stated that "uncertainty about the global economy is increasing, and as a result, the operating environment for domestic companies is deteriorating, leading to an increase in credit risk in corporate loans."

According to the Bank of Korea, as of the end of the first quarter of this year, the delinquency rate on corporate loans at domestic banks was 0.34%, and the non-performing loan ratio was 0.51%, both at favorable levels. However, this is interpreted as a result reflecting the low interest rate environment during the COVID-19 period, government financial support, and the lenient lending attitude of financial institutions.

The Bank of Korea explained that if interest rates rise, COVID-19 financial support measures end, and macroeconomic conditions change rapidly, latent credit risks that have not been revealed so far may surface, leading to a deterioration in loan soundness.

In fact, the delinquency rate and non-performing loan ratio for small and medium-sized enterprise loans have recently turned upward, indicating that the gap between soundness indicators and latent risks is narrowing due to factors such as last year's rise in market interest rates.

Accordingly, when the Bank of Korea examined how much the proportion of vulnerable companies?those with an interest coverage ratio (operating profit/interest expense) below 1?increases if companies actually bear higher interest costs reflecting real risks, it was found that the proportion of vulnerable corporate loans is higher than previously estimated.

Between 2020 and 2021, the proportion of vulnerable corporate loans increased by 3.1 percentage points and 2.7 percentage points for large corporations, and by 8.6 percentage points and 7.5 percentage points for small and medium-sized enterprises, respectively. The overall proportion of vulnerable corporate loans increased by 4.5 percentage points and 3.9 percentage points, respectively.

The Bank of Korea explained, "Results estimated using last year's corporate data also showed an increase in the proportion of vulnerable corporate loans," adding, "This means that latent risks have not yet been resolved and remain inherent."

Lee Chang-yong, Governor of the Bank of Korea, is answering reporters' questions at the "2023 First Half Price Stability Target Operation Status Review Briefing" held at the Bank of Korea Podium in Jung-gu, Seoul on the 19th. Photo by Joint Press Corps

Significant Bank Credit Losses if Economic Slowdown Occurs

If such latent risks in the corporate sector materialize in the future, it is estimated that the default rate on corporate loans will rise and credit losses will increase for banks.

According to the Bank of Korea's analysis, if latent risks in the corporate credit sector become apparent and the proportion of vulnerable corporate loans increases, the default rate on bank corporate loans as of the end of last year would rise by 0.24 percentage points. The resulting potential credit losses for domestic banks would require an additional 1.5 trillion won in loan loss provisions and an increase of 3.4 trillion won in unexpected losses requiring capital reserves.

In particular, if latent credit risks materialize and are compounded by a global economic slowdown or an expansion of risks in the financial sector, the proportion of vulnerable corporate loans would increase further, and banks would experience significant credit losses in the corporate loan sector.

Looking at the Bank of Korea's stress test results, under such risk scenarios, the default rate increased by at least 0.29 percentage points and up to 0.65 percentage points compared to the end of last year. The Basel Committee on Banking Supervision (BIS) capital ratio, which indicates bank soundness, is estimated to decline by 0.6 to 1.2 percentage points, reducing banks' resilience.

The Bank of Korea emphasized, "Considering banks' potential credit losses, the current corporate loan soundness indicators may be underestimating credit risk," and added, "Domestic banks need to expand loan loss provisions and capital reserves in preparation for the possibility of delayed economic recovery and the materialization of potential credit losses."