Korean regulatory change may expose banks to IFRS 9: Fitch

Less conservative loan-loss provisioning poses risk.

Proposed changes to loan-loss reserve regulations for Korean banks will boost their regulatory capital ratios in the short term, but could leave them less prepared for the introduction of International Financial Reporting Standard (IFRS) 9 in 2018, says Fitch Ratings.

Korea's regulatory accounting framework is substantially different from the IFRS financial accounting system used by the country's banks. Loan-loss reserves under IFRS are typically lower than the regulatory minimum loan-loss provision requirement, but banks currently have to set aside the difference as an additional loan-loss reserves (LLR) booked under retained earnings. These provisions are neither dividend-payable nor recognised as regulatory capital. Fitch has viewed this conservative loan-loss provisioning approach as positive for Korea's banking industry.

However, the Financial Services Commission (FSC) announced on 7 October that it is planning to recognise banks' additional LLR as common equity in regulatory capital calculations. The FSC has said the change is being made to bring local regulations into line with international standards.

According to the FSC, the new rules will boost the common equity tier 1 (CET 1) ratios of Korean banks by 90bp on average. There will be no immediate impact on Fitch's ratings because we use our own Fitch Core Capital calculation as the primary ratio in our assessments. Nevertheless, higher regulatory ratios could make Korean banks more attractive to equity and additional tier 1 (AT-1) instrument investors. Woori Bank (A-/Stable) is likely to be a key beneficiary. Woori's CET 1 ratio is expected by the FSC to rise by 1.2pp as a result of the rule change, increasing the regulatory capital buffer for an AT-1 coupon-skip trigger to around 200bp on a fully phased capital requirements basis, compared with the average of about 480bp for its close peers (Kookmin Bank, Shinhan Bank and KEB Hana Bank).

However, less conservative loan-loss provisioning could leave Korean banks less prepared for the implementation of IFRS 9 on 1 January 2018. IFRS 9 requires banks to switch to recognising and providing for expected credit losses (ECL) on financial assets, rather than the current practice of providing only when losses are incurred. Korean banks have shifted their loan portfolios toward secured loans - particularly mortgages - over the last few years, which is likely to reduce the potential impact of IFRS 9. Nevertheless, Fitch still expects the adoption of the new standard to put downward pressure on regulatory capital.

Korea's regulators have themselves argued since IFRS was adopted in 2011, that the additional LLR has been excluded from regulatory capital to ease the eventual transition to IFRS 9. Removing this buffer with IFRS 9 implementation just over a year away will create potential volatility in bank capital ratios.