The Korean Banking Sector: “Are we there yet?”

1. The Korean Banking Sector:“Are we there yet?” February 1, 2005

2. Origins of the System • A key part of the Korean economic miracle of the 1960s-90s. • Reliable source of cheap credit to targeted industries/companies. • Government allocation of credit is the centerpiece of national economic policy. • All is hunky-dory until ~1993.

3. The Big Bang • Overinvestment and poor allocation of capital lead to sub-par investments • Chaebols enter various uncomplementary businesses • Political favor counts for more than high potential returns • Corporate cash flow turns very negative • Banks with thin margins can not sustain bad debt write-offs

4. The Shakeout • Collapse of major Daewoo, Hyundai companies is the final blow. • More than half the banking industry fails; the remainder is badly shaken. • Major consolidation of bad banks (ex: Woori Financial) and bad assets (KDB, KDIC) takes place. • Commercial banks go from 33 in 1997 to 19 in 2004. • Merchant banks go from 30 to 2 over the same period. • Over $150bn in government funds injected.

5. The Double-dip • Having long shunned consumer lending for corporate loans which have proven lethal, Korean banks begin to throw credit at the consumer. • Average bankable Korean has 6+ credit cards by YE2003 • The credit cycle turns abruptly but inevitably after 4 years of 100%+ growth. • Virtually every credit card company goes bankrupt, including all of the big 3: Kookmin CC, LG Card, and Samsung Card.

6. Where are we now? • Four major domestic bank groups: • Kookmin • Shinhan/Chohung • Woori FG • Hana • Three large foreign-owned players: • KorAm (Citibank) • KFB (Standard Chartered) • KEB (Lone Star)

7. Competitive Pressure Rising • Citi and StanChart have largely clean entities to build on. • HSBC, DBS, JPM, and Barclay’s are also looking to buy in or start aggressive local operations. • Domestic banks’ product offerings & skills are still weak.

8. Financial Position • Domestic banks still distressed by global standards • Reported NPLs of 2.37% are probably close to 6% on an int’l standard basis • ROA of 0.74% (9mos04) is low vs global avg of 1.31% • Deposit rates still very high by Asian/world standards • 91d CD rate is 3.5% in Korea, vs. 0.25% in Sing., 0.01% in HK

9. Constrained Growth • Consumers remain over-geared • Strong exports will continue to create capital investment; however… • Business expansion is increasingly funded by internal cash flow or by borrowings in the international capital markets. • When banks fight the bond market, the banks lose • Low capital adequacy ahead of Basle 2 means that banks have limited capacity for expansion anyway.

10. What’s the way forward? • Banks must focus on “asset-light” activities: • Loan origination, not necessarily loan warehousing • Move excess deposits into investment products • Mutual funds • Insurance • Originate smarter products with more “value-add” for customers • Fixed rate and offset mortgages • Revolving credit cards

11. The way forward (cont.) • Higher capital efficiency will remove the threat of further involuntary consolidation • The presence of foreign banks will be a constant worry for laggards • Market share losses • Threat of acquisition

12. Some Final Thoughts • Don’t count out the non-banks • ITCs and brokers could also capture consumer investment dollars if banks stumble • Consumer finance, leasing, and cards will all be back….perhaps with foreign backing and management skill • Don’t automatically bet the foreign banks • Citi, HSBC, and StanChart have all stumbled before in new markets • Domestic banks will copy innovations and poach well-trained staff more quickly than anyone thinks

13. Contacts Paul Sheehan paul@asianbanks.net +852 9192-3105