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 countries such as the United States and Japan remain at elevated levels, banks are voicing concerns about a potential increase in marginal borrowers and the worsening of asset quality due to rising interest rates. The risk is heightened as signs of economic recovery are concentrated mainly in certain sectors like semiconductors, intensifying a 'K-shaped polarization.' If small and medium-sized enterprises (SMEs) and individual entrepreneurs, already facing the dual challenges of an economic slowdown and high interest rates, become less able to repay their loans, the resulting defaults could spill over into the banking sector. Consequently, banks plan to scrutinize the repayment capacity and credit health of vulnerable borrowers more closely.

According to the financial industry on September 4, executives in charge of risk management at major commercial banks have recently become wary of the repercussions that could arise from the sharp rise in long-term government bond yields in key markets like the United States and Japan. They are particularly focusing on the credit soundness of marginal borrowers who are directly affected by high interest rates. As interest rates rise, the interest burden on both corporations and households inevitably increases, and prolonged sluggishness in certain sectors due to the economic slowdown raises the possibility of borrower delinquencies and defaults.

An executive from the risk management division at a leading commercial bank said, "Economic growth is being concentrated in a few sectors, such as semiconductors, which could widen the gap in borrower credit quality. In particular, we need to closely examine the repayment capacity and default risk of SMEs and sole proprietors who are simultaneously affected by economic slowdown and high interest rates." In fact, the delinquency rates on SME loans within the banking sector have remained high. According to the Financial Supervisory Service, as of the end of May this year, the delinquency rate on SME loans at domestic banks was 1.00%, reaching its highest point in 11 years since May 2015 (1.11%). By the end of June, the rate fell to 0.82% due to the banks clearing overdue loans at the end of the quarter, but this figure was still 0.08 percentage points higher than the same period last year.

The indicator that banks are particularly monitoring is the 'non-performing loans.' Non-performing loans are those where the bank no longer recognizes interest as income or where the repayment of principal and interest has been overdue for more than three months, making it difficult to expect normal interest income. An increase in non-performing loans signals a growing volume of delinquent debt within the banking sector.

As of the end of the second quarter this year, the outstanding balance of non-performing loans among the top five banks stood at 6.4108 trillion won, up 28% from 5.0065 trillion won at the end of last year. The general view among banks is that, if high interest rates and the economic slowdown persist, delinquencies could rise further among vulnerable borrowers, potentially leading to a continued increase in non-performing loans.

One positive factor for capital ratios is the recent stabilization of the exchange rate. Most major banks manage significant assets overseas, so a higher won-dollar exchange rate increases risk-weighted assets (RWA) when recalculated in won, putting downward pressure on capital ratios. As the exchange rate has eased recently, banking officials say conditions for managing capital ratios have slightly improved compared to the first half of the year.

However, whether the current exchange rate trend will continue into the third and fourth quarters remains to be seen. Rising market interest rates could decrease the valuation of certain held bonds, adversely affecting capital ratios. If the exchange rate rises again and increases RWAs, this could impose a dual burden on capital ratios.

Given these developments, the main challenge for the banking sector in the second half of this year will be to monitor the potential for increased defaults among vulnerable borrowers due to rising interest rates, while also ensuring stable management of capital ratios. The Financial Supervisory Service has also indicated its intention to closely monitor banks' asset quality, taking into account the global trend of rising interest rates and internal and external uncertainties, and to encourage banks to proactively strengthen their loss-absorbing capacity.

Nonetheless, some analysts believe that the additional shock to bank capital ratios from rising interest rates could be more limited than expected. This is attributed to the fact that domestic banks primarily operate with relatively short-term bonds, and concerns about rate hikes have already been largely priced into government bond yields after the base rate hikes in July and August and ongoing discussions about further increases. Recently, the yield on three-year government bonds has been fluctuating around 3.9% per annum.

Another executive from a commercial bank noted, "If the yield on three-year government bonds does not rise significantly above 4%, then the further impact of declining securities values on capital ratios due to higher interest rates will likely be limited."

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