High Interest Rates and K-Shaped Polarization: Banks Focus Risk Management on Marginal Borrowers

Banks on High Alert as Major Economies' Bond Yields Rise
Close Watch on Repayment Capacity of SMEs and Individual Business Owners Amid Economic Slowdown
Non-Performing Loans at Five Major Banks Reach 6.4 Trillion Won, Up 28% in Six Months
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As government bond yields in major economies such as the United States and Japan remain elevated, banks are increasingly concerned about a rise in marginal borrowers and a potential deterioration in asset quality due to interest rate hikes. With the so-called 'K-shaped polarization' intensifying as economic growth is concentrated in certain sectors like semiconductors, there is growing risk that bad debt could spill over into the banking sector if the repayment capability of small and medium-sized enterprises (SMEs) and sole proprietors—who are already dealing with both an economic slowdown and high interest rates—deteriorates further. Banks are therefore committed to more closely monitoring the repayment capacity and asset quality of vulnerable borrowers.

According to the financial sector as of September 4, risk management executives at major commercial banks have recently become wary of the aftershocks likely to result from the sharp rise in long-term government bond yields in major economies, such as the United States and Japan. They are especially focused on the asset quality of marginal borrowers, who are directly affected by high interest rates. As rates rise, both businesses and households inevitably face increased interest payment burdens, and with certain sectors continuing to underperform due to the economic downturn, banks believe the risk of delinquencies and defaults among borrowers may grow.

One executive in the risk management department at a commercial bank observed, "As economic growth becomes more concentrated in sectors like semiconductors, the disparity in asset quality among borrowers could widen. In particular, close attention should be paid to the repayment capacity and possibility of default among SMEs and sole proprietors who are simultaneously affected by the economic slowdown and high interest rates." In fact, the SME loan delinquency rate in the banking sector has remained at a high level. According to the Financial Supervisory Service, as of the end of May this year, the delinquency rate on SME loans at domestic banks stood at 1.00%, the highest since May 2015 (1.11%)—an 11-year high. By the end of June, the figure dropped to 0.82% as banks cleared delinquent loans at the end of the quarter, but this was still 0.08 percentage points higher than the same month last year.

Banks are also paying close attention to the so-called “non-performing loans” (NPLs). These are loans for which banks do not recognize interest as income or for which principal and interest repayments have been delayed for more than three months, making it unlikely that normal interest income will be collected. An increase in NPLs signals a growing scale of problematic debt within the sector.

As of the end of the second quarter this year, non-performing loans at the five largest banks totaled 6.4108 trillion won, a 28% increase from 5.0065 trillion won at the end of last year. From the banks' perspective, if high interest rates and the economic downturn persist for an extended period, it is difficult to rule out the possibility of further increases in delinquencies—and thus NPLs—especially among vulnerable borrowers.

One relatively positive factor for capital ratios is that the exchange rate has recently shown signs of stabilization. As most commercial banks manage a significant share of their assets overseas, an increase in the won-dollar exchange rate raises risk-weighted assets (RWA) when converted into won, thereby putting pressure on capital ratios. According to bank officials, the recent fall in the exchange rate has made capital ratio management somewhat easier than in the first half of the year.

However, whether the exchange rate will continue its current trend into the third and fourth quarters remains to be seen. If market interest rates rise, the mark-to-market value of some bonds could fall, putting pressure on capital ratios. Furthermore, should the exchange rate climb again and boost RWAs, banks could face a double burden on their capital ratios.

Accordingly, the banking sector is expected to focus on two main priorities in the second half of this year: assessing the potential for increased bad debt among vulnerable borrowers as interest rates rise, and maintaining stable capital ratios. The Financial Supervisory Service also plans to closely monitor banks’ asset quality and encourage a proactive strengthening of their capacity to absorb losses, considering ongoing global interest rate increases and uncertainties both at home and abroad.

However, some analysts believe that any additional shocks to banks’ capital ratios caused by rising interest rates may prove more limited than initially feared. This is because domestic banks primarily manage bonds with relatively short maturities, and much of the concern over rate hikes has already been priced into government bond yields following policy rate increases in July and August, as well as the prospect of further hikes. Currently, the yield on three-year government bonds is hovering around 3.9% per annum.

Another executive at a commercial bank remarked, "If three-year yields do not rise significantly above 4%, the impact of value declines in marketable securities on capital ratios should remain limited despite the increase in interest rates."

This content was produced with the assistance of AI translation services.