Fitch Ratings said that Korea's banks will continue to face challenges to their profitability due to higher than usual credit costs sustained through a slowdown in the domestic economy amid the global downturn, albeit tempered by the Korean government's wide-ranging fiscal stimulus efforts. Nevertheless, the capitalisation of the banks remains satisfactory, which should continue, as aided by government support if necessary. Both foreign and local currency liquidity for the banks have also eased amidst central bank support and are in line with general liquidity trends globally - although liquidity to the real economy is likely to remain tight for some time to come, which could compound credit costs to an extent.

Fitch notes in a published report that, in the lead-up to the global credit crisis, Korea's banking system grew quite strongly, partly due to excessive competition among the banks for market share and leadership size. Loan growth was particularly strong to construction/property companies, which, due to overbuilding, were already showing signs of stress before the crisis arose. This, together with the challenges Korea's trade/export-oriented economy is already facing due to a fall in demand from US and European consumers - which could be prolonged - has and will continue to result in higher credit costs for the banks.

These challenges have been, and may well continue to be compounded by various one-off costs, particularly in relation to customers being unable to meet their obligations to the banks under foreign exchange derivative contracts, which became very onerous due to a sharp depreciation of the Korean won during 2008 and early 2009.

Furthermore, net interest margins are under significant pressure due to record low interest rates and a mismatch in asset and liability maturities (although there may be some improvement in H209), and fee income is down due to lower sales of wealth management products. In 2008 and Q109, the profitability of Korean banks was very limited (ROA of 0.5% and 0.1% respectively) and this is likely continue for the rest of 2009 and 2010, with higher credit costs the main factor. Losses cannot be ruled out.

In recognition of this, the banks are raising capital, particularly from the Korean government's KRW20trn Bank Recapitalisation Fund, which was established in March 2009 for the purchase of hybrid Tier I and subordinated debt only. Overall, balance sheet strength should remain satisfactory (with Tier I and Total CARs currently around 9% and 13% respectively), although there is some downside risk here.

After the collapse of Lehman Brothers in September 2008, Korea's banks faced acute liquidity tightening in both Korean won and US dollars, requiring substantial liquidity support from Korea's central bank. This, along with a general loosening of global liquidity since March 2009, has eased liquidity for Korea's banks.

Nevertheless, Fitch remains concerned that business borrowers in Korea may still find it difficult to secure funding from the banks in the future, resulting in unnecessary credit costs. Towards this end, the government is endeavouring to ensure ongoing funding support to SMEs through moral suasion of the commercial banks, and directions to the policy banks and state-owned credit guarantee corporations. Although generally supportive of these measures, Fitch notes that they need to be carefully managed, recognising that loans to businesses that are ultimately not viable would be wasteful in terms of bank and taxpayer funds.

The agency also notes that, given the increased role of Korea's policy banks as a result of the crisis, they are unlikely to be privatised for some time yet, in contrast to the government's original plan of speeding up their privatisation.

In November 2008, Fitch put almost all its long-term Korean bank ratings (and the sovereign rating of 'A+') on Negative Outlook. Fitch believes that the Outlooks will remain in place for some time, with capitalisation a key point in its review of these banks. Notably, given that the banks' ratings are to varying extents linked to the sovereign's rating, a change in the sovereign rating would have direct implications for the sovereign-linked banks' ratings, and possibly indirect implications for those that are not.