Korean banks: no joy in sight

As long as banks continue to be pressured into bailouts, investors should avoid the sector.

Euphoria now surrounds the Korean banking sector following the announcement that Kookmin and Housing & Commercial Bank (H&CB) have reached a successful merger agreement following marathon talks. This euphoria will probably be short-lived, however, because the sector is unlikely to enjoy any recovery in basic operating circumstances. The current situation facing the Korean banks as a whole is depressing, with many of the banks having to face the prospect of increasing levels of non-performing loans to faltering chaebols such as Hyundai, Daewoo and Ssangyong.

The Korean government promoted bank mergers in the apparent belief that in terms of assets, Korean banks were simply too small to compete. Being significant in asset scale can have advantages of course, but combining Korean banks simply to achieve scale in asset size ignores the multitude of problems that Korean banks will face as they meld together disparate corporate systems.

Take the Kookmin and H&CB merger. You have all the ingredients for a colossal climb-down in the quality of the merged bank versus the operational levels of the two banks prior to the merger. In the Korean way of banking, there will not be any significant across-the-board redundancies or departmental rationalization. Staff departures will primarily be by natural attrition. The merged bank, which may retain the Kookmin name, will have two of everything: two personnel departments, two credit analysis departments, two administration and settlements departments, two trust departments, etc. The same goes for the over-900 retail branches of the two banks, which are often only feet apart on the same street. Merging branches will take time, and will retain nearly all of the original staff.

But the real costs to virtually all of the Korean banks continue to be the opportunity costs involved in participating in dubious bailouts apparently organized by the Korean financial authorities. This seems to be the case in the refusal of the senior management of Korea First Bank (KFB) to commit to one of the special financial rescue packages arranged on behalf of the Hyundai group by the Financial Supervisory Service (FSS).

The working level officers of the FSS were extremely displeased with the refusal of KFB's management to commit to the emergency financing for Hyundai Engineering & Construction, KFB’s president has said. He won an agreement that KFB did not have to participate in the bailout only through an appeal to the highest levels of the Korean government and by explaining carefully why participating in a risky financial bailout for Hyundai would not be beneficial to KFB and its shareholders, including the Korean government, which owns 49%.

This drama suggests that government influence over the credit decisions of the Korean banks will continue to influence the earnings, or the lack of earnings, of most Korean banks.

After all, what possible incentive could the group of Korean creditor banks have for continuing to prop up Daewoo Motors to the tune of $300 million per month when there is very little probability that any of this can be recovered, even if General Motors actually makes a bid for the company? Even if GM does take over Daewoo Motors, it is very doubtful that GM would agree to take on any of Daewoo's debts.

So the only reason that Korean creditor banks would continue lending to Daewoo seems to be a political one, allowing politicians to tell the voters, especially the Daewoo staff, that they kept the company afloat by forcing the banks to lend to it. This is not market economics. It can more properly be called social policy economics.

The recent decision by a group of Korean creditor banks to the Hyundai group to convert a large element of Hyundai Engineering & Constructions (HE&C) debts to equity was again an intervention to stave off HE&C's impending insolvency. This intervention has the look of a stage-managed intervention again, and one that is probably not in the long term interests of the banks involved.

The neat solution that was hit upon here was the process of eliminating some of HE&C's loans, which the banks would soon have had to begin writing off their books and taking losses as a consequence, by converting these debts to equity ownership in HE&C.

HE&C's equity is probably as valueless as its debts were as far as the banks are concerned. If the company is in such bad shape that it cannot pay off on its debts when due, how can it pay dividends on equity or how can it earn income so that the value of the equity would be maintained or increased? The answer is that it probably cannot make a commercial return on the "equity" and so this equity will likely soon be of as little value as the loans that Hyundai could not repay.

Debt forgiveness in most cases won’t let banks improve their results; it only forestalls a day of reckoning. Banks tried this route with Dong Ah Construction, which was declared too important to be permitted to collapse in 1998 and was permitted to begin a debt workout program. But even if Dong Ah had the best managers in the world it was probably beyond saving. This was recently recognized by the bankruptcy court in Seoul, which declared that Dong Ah could not be redeemed and that the company should be dissolved. If the Korean banks had not had to support Dong Ah during its abortive workout process, they would not have had to encumber themselves with additional rescue loans.

As long as the Korean banks as a group continue to be used for corporate sector bailouts there will not be any effective restructuring of the Korean banks along market-oriented lines. They will almost certainly suffer increasing levels of non-performing loans, further weakening their capital structures. The Korean government may have to make further equity investments in banks to prevent them from falling below capitalization ratios prescribed by the Bank for International Settlements.

This does not sound like a sector in which investors will find much joy in the near term. Most of the banks will be dragged down in share price terms below the performance levels of the overall market. Clearly, these problems could endure well beyond a recovery in exporting prospects for next year, which could send industrial companies' share prices up again as early as the second half of this year. In short, investors should be wary of the Korean financial sector, and especially of the banks.

Hank Morris is director of Industrial Research & Consulting and a long-time resident of Seoul.

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