Regulatory detonator emerged as a new threat to explode a bomb of South Korea's excessive household debts. Follow-up measures adopted by the financial watchdog to curb non-bank financial institutions' lending to households were paradoxically feared to drive borrowers with bad credit to rely more on lenders that demand much higher lending rates.

In late February, South Korea's Financial Services Commission ( FSC) announced its plan to tighten rules on lending by non-banking financial institutions such as mutual credit institutions and insurers. Mutual credit institutions are non-banking financial institutions that hold deposits, including agricultural cooperatives, fisheries cooperatives, forestry cooperatives, credit unions and community credit cooperatives.

The February action was a follow-up measure taken after the FSC introduced comprehensive countermeasures against excessive household debts in the banking sector last June. The regulator targeted non-banking institutions this time as lending growth in the non-banking sector surpassed the one in the banking sector following the June action.

According to the Bank of Korea (BOK), household debts extended by mutual credit institutions amounted to 175 trillion won (155.9 billion U.S. dollars) as of the end of 2011, up 13.1 percent from a year earlier and around quadruple from 45.7 trillion won nine years before. Debts owed by households to insurers expanded 9.3 percent on-year to reach 74.7 trillion won as of end-2011, much faster than a 3 percent growth tallied in 2010.

Debt growth accelerated in the second half of 2011 following the June action. Household debts by mutual credit institutions grew 7.6 percent in the second half of last year, faster than a 5. 5 percent expansion six months earlier. Insurers' debt growth rate jumped to 7.7 percent in the second half from 1.6 percent in the first half, while the one for banks fell from 3 percent to 2.7 percent over the cited period.

The paradoxical phenomenon reflected the balloon effect arising from the financial watchdog's tighter rules on banks' household loans that triggered faster growth in household debts by non- banking institutions. As was the case, the pressure on the non- banking sector was feared to push the loan demand into other money lenders that demand much higher lending rates.

TIGHT GRIP ON NON-BANK SECTOR

Under the newly adopted regulation, mutual credit institutions will be required to keep their loan-to-deposit ratio below 80 percent. Those currently in breach of the ceiling will be required to comply within next two years. The sector's average loan-to- deposit ratio was reported to hover around 70 percent, while about 14 percent of the sector's institutions saw its ratio breach the new requirement.

The institutions in breach of the limit were expected to reduce their lending to households, driving borrowers with low credit rating to lenders that demand higher borrowing costs. "Companies that have breached, or are close to breaching the new requirements, have to reduce their exposures or promptly slow down their growth, while others are likely to change their business strategies. Households could look for less-regulated lenders to satisfy their funding needs," said Ryan Tsang, a credit analyst at Standard & Poor's in Hong Kong.

In addition, mutual credit institutions were required to tighten their underwriting practices for high-risk loans such as bullet payment loans and "multiple-loan" borrowers' loans. The new rule required the institutions to set aside additional loan loss provisions if they offer fresh high-risk loans or extend the maturity of risky loans.

Bullet payment loans have been picked as a vulnerability of the country's household debt structure as such loans, which require only interest payment until maturity, will pressure borrowers with principal payment if banks deny extensions amid bad economic conditions.

Multiple-loan borrowers have been also a headache for the policymakers as they take out loans from more than one financial institution such as banks, mutual credit institutions, savings banks, insurers and credit-specialized financial companies. Those who banks deny lending to tend to become multiple-loan borrowers as they inevitably turn to lenders that demand higher lending rates after the denial.

Those whose borrowing is denied by even mutual credit institutions may seek to rely on money lenders that demand much higher lending rates, or declare default. "The risk is that this will lead to higher household defaults, especially among the high- risk borrowers that mutual credit institutions tend to focus on, particularly so-called multiple-loan borrowers," said Park Hyun Hee, a credit analyst at Moody's.

Meanwhile, the FSC required insurance companies to raise loan- loss provisions and risk weightings on high-risk loans as well as home-backed loans when calculating risk-based capital (RBC) ratio, while restricting what the regulator views as aggressive marketing activities.

The FSC estimated that mutual credit institutions and insurers would cut lending by 1.21 trillion won and 480 billion won respectively if the new rules are observed stringently, but the similar, or additional, amount of loan demand with the reduced loans in the sector may move to money lenders that demand higher lending rates.

HOW LARGE, HOW FAST, HOW SERIOUS

The country's household credit, including loans from banks and non-banking financial institutions as well as credit purchases, reached a fresh record high of 912.9 trillion won (808.23 billion U.S. dollars) as of the end of 2011, up around 700 trillion won from 12 years earlier. It topped the 900 trillion won mark six quarters after breaching the 800 trillion won level.

The household credit grew at an average annual rate of 12.9 percent during the 1999-2011 period, much faster than the one for the country's nominal gross domestic product (GDP) over the same period. The ratio of household debts to GDP advanced to 73.3 percent as of end-2011 from 38.8 percent 12 years before, with the rate of household debts to disposable income jumping to 135.9 percent from 61.3 percent over the cited period.

Adding to concerns, household debt burden became increasingly heavier. According to the BOK report, the debt service ratio (DSR), which gauges households' burden to repay principal and interest of debts, advanced to 12.9 percent in 2011 from 11.4 percent a year earlier. The ratio is calculated by diving payment of debt principals and interests by disposable personal income.

The BOK said that the proportion of households with excessive debts, which means their DSR above 40 percent, rose to 9.9 percent of the total in 2011 from 7.8 percent in 2010, warning that households' burden would be heavier as around 46 percent of mortgage loans will be due before 2013.

In addition, loan demand moved to non-banking financial institutions, boosting worries that credit quality of household lending may worsen amid rising burden for higher interest payment.

Household debts, excluding credit purchases, reached 858.1 trillion won as of end-2011. Among them, loans extended by non- banking depository corporations, including mutual credit institutions and savings banks, as well as other institutions, including insurers and credit-specialized financial companies, amounted to 402.2 trillion won at the end of last year, nearing to 455.9 trillion won by banks. Household loans by non-banking institutions stood merely at 193.8 trillion won as of the end of 2004, much lower than 276.3 trillion won for banks.

Global credit rating agencies picked the country's excessive household debts as a major risk factor. Moody's revised up Monday its outlook for South Korea's sovereign credit rating "A1" to positive from stable, but the rating appraiser noted that "rising household debt is another concern. If unchecked, this trend could impair bank asset quality and introduce a drag on private consumption expenditure as an important source of GDP growth." (1 U.S. dollar equals 1,123 won)