Financial Supervisory Service Issues 'Management Caution' to 8 Banks: "Strengthen Loan Loss Provisioning"

Impact of Expanding Risks of Insolvency Including PF

Financial authorities have called for an enhancement of banks' loss absorption capacity. This measure comes in response to the expanding risk of insolvency across the entire financial sector, including real estate project financing (PF). In addition, the authorities plan to implement a series of measures to strengthen bank soundness, such as introducing the countercyclical capital buffer (CCyB) system this year.

Financial Supervisory Service, Yeouido, Seoul. Photo by Younghan Heo younghan@

According to the financial sector on the 22nd, the Financial Supervisory Service (FSS) recently issued management advisory measures to strengthen the loan loss provision calculation system to eight domestic banks (KB Kookmin, Shinhan, Woori, NH Nonghyup, Daegu, Gyeongnam, Gwangju, and Kakao Bank).

The authorities use the probability of default (PD) and loss given default (LGD), estimated by reflecting future economic conditions based on past default and loss rates, when banks estimate expected credit losses to calculate loan loss provisions. However, the authorities pointed out that recently, banks’ PD and LGD have appeared lower than actual measured values, failing to sufficiently reflect the possibility of expanding insolvency risks, raising concerns that loan loss provisions may be underestimated.

Additionally, each bank received various notifications regarding issues related to provision settings. In one bank’s case, it was pointed out that additional provisions were only set aside for loans classified as substandard or below in asset quality related to COVID-19 repayment deferrals and maturity extensions. According to the Korea Federation of Banks’ practical guidelines, if the loss risk calculated through the existing expected loss forecast model does not adequately reflect the possibility of insolvency for COVID-19 loans, additional provisions should be set aside; however, this was selectively applied.

Another bank was criticized for managing retail exposures by categorizing them according to risk characteristics into residential real estate, other retail, and eligible revolving transactions, and despite differences in the actual measured PD levels of each exposure, it developed a future outlook prediction model only for the entire retail exposure to estimate the predicted PD. The authorities pointed out that this could reduce the reliability of the predicted PD.

Regarding this, the FSS stated, "Banks should supplement their estimation methods so that elements estimating expected credit losses, such as PD and recovery rates, do not fall below recent actual default and loss rates in preparation for the possibility of expanding insolvency risks," and emphasized, "The adequacy of future outlook prediction models that forecast future macroeconomic changes should also be strengthened."

Meanwhile, the authorities plan to fully activate the three-pronged soundness enhancement measures this year: CCyB, stress buffer capital, and special loan loss reserves. The CCyB is a system that imposes an additional capital accumulation obligation within a range of 0 to 2.5% of banks’ risk-weighted assets, considering the impact of economic fluctuations on the financial system and the real economy. In May last year, the authorities decided to raise the CCyB accumulation level for banks and bank holding companies from the existing 0% to 1%, with a one-year grace period. Accordingly, from May this year, banks and bank holding companies must raise the CCyB accumulation level to 1%.

In addition, the authorities have introduced the special loan loss reserve accumulation requirement right, which allows them to require banks to set aside additional loan loss reserves, and are preparing to introduce the stress buffer capital system, which imposes additional capital accumulation obligations on underperforming banks based on stress test results.

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