[1mm Financial Talk] FSC Urges More 'Loan Loss Provisions'... Is It a Signal to Restrain Dividends?

Financial Supervisory Service Recommends Banks to Increase Loan Loss Provisions
Preparing for Extension of Financial Support Measures Amid Geopolitical Risks
Loan Loss Provisions Are Capital but Cannot Be Used for Dividends
Dividend Capacity Inevitably Decreases Depending on Additional Provision Amount

[Asia Economy Reporter Song Seung-seop] The Financial Supervisory Service (FSS) has advised commercial banks to increase their "loan loss reserves." This measure comes in response to growing geopolitical risks due to Russia's invasion of Ukraine, as well as the six-month extension of loan maturity extensions and interest repayment deferrals for small and medium-sized enterprises and small business owners.

According to financial circles on the 8th, the FSS sent an official letter to all banks the previous day, urging them to set aside additional loan loss reserves.

The financial authorities have originally demanded that banks increase the size of their loan loss provisions. On January 1, following a meeting with economic and financial experts, Financial Services Commission Chairman Ko Seung-beom stated, "It is important for banks to accumulate loan loss provisions to a level that provides crisis response capacity." FSS Governor Jung Eun-bo also argued in the same month, "We need to accumulate more provisions to expand the capacity of financial institutions to absorb losses."

The reason for the change in the financial authorities' demand lies in the difference between loan loss provisions and loan loss reserves. Banks accumulate both loan loss provisions and loan loss reserves to prepare for bad debts. Loan loss provisions are set aside by banks based on their own assessments according to International Financial Reporting Standards (IFRS 9) from a portion of their profits. If these provisions are less than the loan loss provisions specified in the Banking Supervision Regulations, the shortfall is accumulated as loan loss reserves.

Banks classify loan receivables into categories such as normal, watch, substandard, doubtful, and estimated loss. The FSS has set minimum loan loss provision standards for each asset category in the Banking Supervision Regulations at 0.85%, 7%, 20%, 50%, and 100%, respectively. There are slight differences depending on whether the loan is personal or corporate and the industry type. Typically, loans overdue by more than three months or those under workout are classified as substandard or lower, requiring at least 20% loan loss provisions.

Increasing Loan Loss Reserves Inevitably Reduces Distributable Profits

Loan loss provisions are treated as accounting expenses, while loan loss reserves are treated as capital. Since loan loss provisions are expenses, they are not counted as profits and cannot be used for dividends. Although loan loss reserves are created from retained earnings, they are statutory reserves and thus cannot be used for dividends either. Consequently, distributable profits decrease accordingly.

A financial industry insider said, "Although the financial authorities have urged banks to increase loan loss provisions since January this year, banks seem not to have accumulated as much as the authorities wanted, citing that delinquency rates have not risen." According to the FSS, as of the end of December last year, the delinquency rate on won-denominated loans (based on principal and interest overdue by one month or more) at domestic banks was 0.21%, the lowest ever recorded. This is analyzed as a distortion effect due to the financial authorities' COVID-19 loan support measures, such as loan maturity extensions.

Since banks did not accumulate many provisions, profits increased, creating room for dividends. The insider explained, "Because loan loss reserves are the amount remaining after subtracting the loan loss provisions that banks have set aside on their own from the standards set in the supervision regulations, it is ambiguous what it means to ask banks to accumulate more loan loss reserves. It seems that the authorities intend to raise the standards in the supervision regulations to require banks to accumulate more loan loss reserves." He added, "If banks are made to accumulate more loan loss reserves in this way, it appears to be an effort to reduce distributable profits and thereby curb dividend payouts as much as possible."

Meanwhile, it has been revealed that the amount of money banks have set aside (loan loss reserves + loan loss provisions) during the COVID-19 pandemic is significantly lower than during the 2008 financial crisis.

According to FSS data, banks had set aside up to more than 1 trillion won more in preparation for crises as of 2010, when the shock of the financial crisis persisted. For example, KB Kookmin Bank had accumulated up to 5.0059 trillion won as of the end of September 2010. Woori Bank had 4.5626 trillion won as of March 2011. In contrast, as of September last year during the COVID-19 pandemic, these amounts were 3.8691 trillion won (KB Kookmin) and 3.3057 trillion won (Woori), respectively, showing decreases of 1.1368 trillion won and 1.2569 trillion won.

Looking at loan loss provisions alone by bank, they also decreased last year compared to 2020. As of the end of December last year, loan loss provisions by bank were 1.4352 trillion won for Kookmin Bank, 1.3540 trillion won for Shinhan Bank, 1.1890 trillion won for Woori Bank, and 1.2410 trillion won for Hana Bank. Only Hana Bank increased by 41.5 billion won compared to the previous year, while Kookmin Bank, Shinhan Bank, and Woori Bank decreased by 5.3 billion won, 90.4 billion won, and 127 billion won, respectively.

This content was produced with the assistance of AI translation services.