The Lex Newsletter: South Korean banks just got interesting

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Dear reader, 

The most interesting thing about boring stocks is that they are often undervalued. To have their day, they need someone to notice them. Best known for being unknown, South Korean banks are finally attracting some attention. Activists and foreign investors have them in their sights. At last, South Korea’s stolid lenders come with a dash of drama.

Asia’s financial services companies, especially the region’s lenders, have long needed a shake-up. Japan, China and Taiwan are among the countries with undervalued banking sectors on many measures. 

South Korean banks fare the worst, with an average price-to-tangible book value of just 40 per cent for the biggest names. That is just about half the ratio for regional peers HSBC and Singapore’s UOB. Now near historical lows, they are even below perennially undervalued Japanese peers. 

Meanwhile, capital ratios, balance sheets and net interest margins keep getting stronger. Non-performing exposures (NPEs) of South Korea’s four largest banks are among the lowest in the world at 0.2 per cent — a quarter of the global average. The sector’s average core equity tier one ratio of 12.3 per cent is well above its own and regulatory targets. 

For the biggest banks, CET1s rise to about 15 per cent. Return on equity of about 11 per cent is double that of regional peers. But few other countries have banks whose market capitalisations are so far below the value of their net assets. 

Line chart of Price to book values (X) showing South Korean banks have low ratings

Little wonder that Align Partners has taken stakes in seven financial holding companies. The Seoul-based activist fund has called for higher dividend payouts and generous share buybacks.

South Korean banks have an extraordinarily high proportion of shareholdings in the hands of foreign investors. Almost three-quarters of all the holdings of the largest lender KB Financial Group, for example, are held by foreigners. 

That is higher than the level for leading names in local tech, which is at 50 per cent for Samsung and 26 per cent for LG Electronics.

Foreign investors tend to pile into specific South Korean stocks on the back of local interest. Yet, for local lenders, the high proportion should be read as denoting the opposite. Local investors have fled, leaving foreign investors, such as passive funds, holding them for geographic and asset class exposure reasons. The reason for this is that the average rate of shareholder returns has been poor.

Competition is fierce in the banking sector. There are 12 local banks, three digital banks and eight financial institutions that offer banking functions. That does not even include the long list of mutual savings banks and global banks with operations in the country. 

The low NPEs of local banks are partly thanks to strict regulations on loans. This comes at a cost. Risk management of local banks is highly conservative. Most loans are given to companies and individuals with the highest credit ratings. That, combined with the abundance of banks, limits lenders’ ability to charge high interest rates, putting a cap on net interest margins. 

Moreover, banks face strict regulatory restrictions on how high the loan-to-value ratio and the borrower’s debt-to-annual income can be. These curbs were put in place by regulators whose concerns about financial stability can be traced back to the 1997 Asian financial crisis.

But a high ratio of foreign shareholders has an upside. Foreign funds are unlikely to toe the same consensual line of local investors content for banks to keep payouts conservative and retain their cash.

Shares of local banks — led by the four largest: Shinhan, Hana, KB and Woori — have gained more than a fifth this year. That reflects increased revenue from the repricing of loans, improving net interest margins and expectations of additional policy rate rises. Yet even those gains have not helped resolve the low valuations of the stocks.

The timing is right for shareholders to extract better terms from South Korean banks. Radical change, in the form of break-ups and consolidation, is unlikely given the regulatory constraints. But it should certainly be possible to squeeze out higher dividends.

Late last year, regulators said as long as banks had adequate capital, they would eschew intervention in dividend policy. Expect foreign activists to join in the battle for more payouts.

Enjoy the rest of your week,

June Yoon
Lex Asia editor

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