Banks asked to beef up loss absorbing capacity amid growing uncertainty

South Korean financial authorities unveiled updated regulations on strengthening loss absorbing capacity at domestic banks to prepare for potential unrest at home and abroad, including the recent Israeli-Hamas conflict and an alarming rise in bank delinquency rates, so that they can avert a future crisis while saving at a time when they benefit from high interest rates.

The Financial Services Commission (FSC) approved an amendment to the banking supervision regulations on Wednesday, stating, “There are concerns over bank soundness as internal and external uncertainties grow, such as rising interest rates.” The commission also underscored the need to enhance crisis response capabilities across the banking sector, especially in the wake of the bankruptcy of Silicon Valley Bank (SVB) in the United States in April 2023.

Reserves for credit losses are a “rainy day fund” for unexpected losses and are expected to act as a bulwark in an economic downturn.

Korean banks have been accumulating loan loss reserves according to their accounting standards, but financial authorities saw that the level of provisions at domestic banks is insufficient compared to those in the United States and Europe. According to the FSC, the provisioning ratio as a percentage of total loans was 0.93 percent at the end of June this year, falling short of 1.51 percent in Europe and 1.67 percent in the United States.

In particular, the domestic banking sector is facing a double whammy of rising delinquency rates on loans in local currency and market risks from global geopolitical uncertainties. According to the Financial Supervisory Service, the delinquency rate of loans in Korean won that are overdue for more than a month at local banks was 0.43 percent, the highest in three years and six months since February 2020.

The revision of the supervisory regulations is a catalyst to introduce three measures for enhancing loss-absorbing capacity at banks. Along with reserves for credit losses, authorities are preparing to introduce a “countercyclical capital buffer,” a mechanism to build up additional capital during periods of high growth, and a “stress buffer capital,” capital cushions that banks are required to hold according to their level of risk management. In May 2023, the countercyclical capital buffer was raised to 1 percent from 0 percent, and domestic banks and bank holding companies must meet this requirement from May 2024. The stress capital buffer requirement will also be effective starting next year.

The new supervisory regulations are a signal from the authorities to banks to proactively raise their capital ratios. The base capital ratio requirement is 8 percent, but the minimum required capital ratio for banks reaches 11 percent after accounting for 1 percentage point for the countercyclical buffer and 2 percentage points for the internal capital buffer. When additional 2 percentage points for the stress buffer requirement is introduced next year, the capital adequacy ratio for the Korea’s four banks will rise to 13 percent.

Banks are already scrambling to raise capital. The capital adequacy ratio of domestic banks is currently at 12.98 percent at the end of June 2023, and banks are unlikely to meet the minimum capital ratio requirement next year at this rate. Banks will have to take preemptive steps to raise capital through measures such as limiting dividends.