Bank debt restructuring reclassified as normal after 6 months, masking potential insolvency

Korean financial authorities are moving to ease the requirement for upgrading the soundness classification of loans to borrowers who received banks' own debt restructuring from 'precautionary' to 'normal.' The aim is to encourage expanded inclusive finance to rescue vulnerable borrowers pushed to the brink by prolonged high interest rates, but concerns are rising that the capital regulation easing could mask potential insolvency risks in the banking sector.

According to financial industry sources on Nov. 6, financial authorities are considering shortening the required diligent repayment period for banks' own debt restructuring loans to return to normal status from the current one year to six months. Under current Financial Supervisory Service supervisory regulations, household loans that have gone through the Credit Counseling & Recovery Service's pre-workout can be reclassified as normal after fulfilling the repayment plan for just six months. In contrast, banks' own debt restructuring requires one year of repayment. Authorities plan to align the two systems to increase banks' incentive to participate in inclusive finance.

When the soundness classification is upgraded from precautionary to normal, the loan-loss provision burden on banks drops sharply. Under current asset soundness classification standards, the minimum provisioning rate for normal loans is 0.5%, while precautionary loans require 10%. The classification upgrade alone reduces provisions to one-twentieth of the previous level. This leads banks to immediately cut credit costs, defend net profit, and maintain key soundness indicators such as the common equity tier 1 (CET1) ratio at high levels.

The problem is that such regulatory easing could create an illusion that conceals borrowers' actual credit risk. Typically, the first six months of debt restructuring is a period when borrowers receive principal repayment deferrals or significant maturity extensions, artificially reducing their monthly principal and interest burden. Just because no delinquency occurred during this period does not necessarily mean the borrower's fundamental income-generating ability or debt repayment capacity has recovered.

In particular, re-default that occurs when the principal and interest repayment deferral period ends and the full principal amortization schedule begins is considered a chronic risk factor in the debt restructuring market. If soundness grades are easily upgraded based on only six months of repayment history, the risk increases that insolvencies submerged below the surface could erupt all at once during a future economic slowdown or macroeconomic shock.

The difference in screening intensity between the Credit Counseling & Recovery Service, a public debt restructuring agency, and banks' own programs is also a key issue. The CCRS objectively verifies borrowers' repayment capacity through strict asset screening and joint creditor adjustment. In contrast, banks' own debt restructuring relies heavily on each bank's individual screening and discretion. If the same soundness upgrade exception as the public agency is uniformly applied to banks' own programs with relatively lenient screening standards, it creates an incentive to easily normalize nonperforming loans.

In fact, the possibility cannot be ruled out that banks may abuse debt restructuring with easy terms for borrowers showing signs of distress to manage quarter-end delinquency rates or reduce provisions. If bad loans are quickly laundered into normal receivables and only accounting soundness is packaged, financial markets and investors will find it difficult to grasp the exact scale of banks' vulnerable loans and their underlying strength.

Behind the inclusive finance expansion encouraged by policy authorities lies the financial cost of deferring and accumulating risk. Easing capital regulations first while borrowers' repayment stability has not been substantively proven over the long term could boomerang and undermine the soundness of the entire financial system.

Therefore, to prevent the regulatory overhaul from degenerating into a shortcut for banks to preserve short-term earnings, tight safeguards are essential. Along with the shortened repayment period requirement, penalty clauses for borrower re-default and measures to forcibly maintain loss-absorbing capacity at each soundness stage must be designed together to ensure the system's effectiveness.

※ This article is an AI translation of the Korean original published by Korea Credit News; it was checked by automated quality guards and published by the English edition desk.