The Korean Banks in trouble.

By Miyoung Kim and Rhee So-eui - Analysis

SEOUL (Reuters) - As the global financial crisis picks off victims among U.S. and European financial institutions, analysts fear South Korea's banks could be the next casualties.

The concerns have come as something of a shock to ordinary South Koreans, repeatedly told by officials that the prudence born from the misery of the Asian financial crisis a decade ago had largely inoculated what is now Asia's fourth-largest economy from another economic catastrophe.

Officials are backing words with deeds, offering to provide access to hefty foreign exchange reserves and additional funding support if necessary to ride out the crisis, efforts analysts expect to avoid a meltdown.

"We expect the Korean government to step up its efforts to alleviate the dollar funding problem, which would provide some relief to the market," Standard Chartered analysts said on Thursday, maintaining their stable outlook on the Korean banks.

But signs are growing that the banking system faces tough times and the finance minister has already warned that South Korea's banks are having difficulty raising foreign currency because of a tightening global credit squeeze.

At the heart of the problem is a banking sector with inadequate funding structures, an inflated loan book and deep exposure to the wobbly property and construction sectors and struggling small- and medium-sized companies, which could sour loan portfolios rapidly in a sharp economic slowdown.

"Banks have overly expanded their lending assets for years in spite of a tough funding environment ... their unabated growth has finally boomeranged and is now squeezing their profitability and borrowers' liquidity as well," said Jun J. Lee, an analyst at Korea Investment & Securities.

The loan-to-deposit ratio of commercial banks, including certificates of deposit, reached 103 percent at end-September as they lent money at a staggering pace during the last few years, even though South Koreans increasingly switched their savings into property and stocks from banks.

It is far above the around 80 percent in most other Asian economies, according the Merrill Lynch data.

At the four biggest Korean banks -- Kookmin (060000.KS: Quote, Profile, Research, Stock Buzz), Woori (053000.KS: Quote, Profile, Research, Stock Buzz), Shinhan (055550.KS: Quote, Profile, Research, Stock Buzz) and Hana (086790.KS: Quote, Profile, Research, Stock Buzz) -- the ratio ranged between 149 and 181 percent in the second quarter of 2008, according to Moody's Investors Service.

The high ratio means lending at these banks was far higher than the pace at which deposits grew, leaving them reliant on the fickle short-term money markets where liquidity has dried up and cost of borrowing continues to soar.

As they struggle to refinance existing debt and fund dollars for an economy that relies heavily on global trade, their fundamental strength such as strong asset quality and small delinquencies provide little help.

"A higher dependency on wholesale funding instruments has negatively affected Korean banks' fundamental strength in terms of earnings and funding structures," Standard & Poors' Ratings Services said on Tuesday.

"Failure to address the issue (of foreign liquidity funding) in a timely manner could deteriorate banks' credits."

Shares of Woori, Shinhan and Hana have all tumbled more than 30 percent in the past month, compared to an 11 percent fall in the broader market.

South Korea might have mitigated the current dollar squeeze if it had gone ahead with a planned sovereign bond when the credit market was more forgiving and demand was still strong.

But last month it shelved a $1 billion sovereign bond because of a global rise in risk aversion. Many domestic banks followed suit, delaying bond sales over high borrowing costs.

South Korea's risk premium, however, has since risen further, with the cost of protection against a default on Korea's 5-year sovereign debt soaring nearly eight-fold this year to 310 basis points. An investor would need to pay $310,000 a year to insure $10 million of South Korean bonds against default.

By comparison, insuring similar bonds in Malaysia, rated one notch below South Korea at A-minus, costs around $200,000.

"Banks could have raised more funds earlier this year. They missed the opportunity... We do need to see whether the situation improves or not. But it's more likely to deteriorate," said Leo Wah, senior analyst at Moody's Financial Institutions Group.

Investors are now closely watching the property market and small- and medium-sized firms for any signs of further distress in the system that might trigger capital outflows and more currency selling.

Analysts pointed out that more than 250 construction companies went bust in January-August, while the number of unsold homes is rising and consumer debt is high.

MEASURES IN PLACE?

To address banks' liquidity problems, the government has so far allocated $15 billion to the foreign exchange swap market and state-run Export-Import Bank of Korea (KEXIM) and also pledged to allow banks access to the country's foreign exchange reserves, the world's sixth-largest at nearly $239 billion.

Top policy makers also rushed to calm investors, saying local banks would have few problems raising funds through selling their foreign currency assets and their asset quality remains solid.

"We think banks have the ability to deal with the current situation," said Joo Jae-seong, head of the banking service division at the Financial Supervisory Service.

Despite repeated reassurances, the won, one of the world's worst performers, has plunged over 30 percent this year and money market rates are still soaring.

"Investors are nervous," said Alaistair Chan, a Moody's Economy.com analyst.

"Government words and action, in an attempt to calm financial markets, have lately had the opposite effect, and may risk creating a self-fulfilling downward cycle."

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