How does Korea's rising household debt levels affect banks' financial stability?

There are no immediate concerns, says Moody's.

Moody's Investors Service says that high and rising household debt levels in Korea do not pose immediate financial stability concerns for the sovereign or the country's banks, because of the measures that the government has taken to mitigate the effects of income or interest rate shocks that would undermine the households' debt servicing capacity.

Here's more from Moody's:

Moody's notes that the rise in household debt in recent years has been significant and primarily in mortgages. Moody's points out that the structure of mortgages in the country poses unique risks for households, with the majority of mortgages (60%-70%) with floating rate or non-amortizing structures.

Such an arrangement exposes Korean households — and potentially banks and the sovereign — to income or interest rate shocks, which would undermine debt servicing capacity or constrain non-debt service consumption.

"The risks to the sovereign credit profile posed by a potential correction in residential prices or income and interest rate shocks are limited, and would mainly relate to lower GDP growth, because the government has taken and continues to introduce measures to mitigate the risks associated with financial instability," says Steffen Dyck, a Moody's Vice President and Senior Credit Officer for the Sovereign Risk Group.

"In particular, strict underwriting standards and low loan-to-value ratio curb risks to banking sector stability," says Sophia Lee, a Moody's Vice President and Senior Credit Officer for the Financial Institutions Group. "Furthermore, the linkage between banks and non-bank financial institutions is weak, reducing contagion risk should there be a significant decline in asset quality at non-banks," adds Lee.

Moody's analysis is contained in its just-released report titled "Rising Household Debt Poses Downside Risks to Growth, but No Immediate Financial Stability Concern," and is co-authored by Dyck and Lee.

Moody's report explains that Korean households have increased their borrowings over the past decade, with total household debt reaching 80.6% of GDP in September 2016, a rise of more than 10 percentage points since 2004.

The government aims, for instance, to shift the structure of household loans to fixed and amortizing loans from variable and bullet loans. According to the government's targets, by the end of 2017, the proportion of amortizing and fixed-rate loans will rise to 55% and 45% of outstanding mortgages respectively.

Moody's explains that the shift to fixed rate loans has not elevated asset liability mismatch risk for banks because most fixed-rate mortgages are transferred to the government-backed Korea Housing Finance Corporation.

This systemically important entity has nearly doubled in size since 2013 to almost 6% of GDP. The systemic risk associated with the increased concentration of mortgage loans on its balance sheet is mitigated somewhat by the low loan-to-value ratio of its mortgage loan portfolio and by strengthened prudential measures.

The Korean authorities have also tightened mortgage underwriting criteria and announced plans to expand prudential measures to non-bank financial institutions, and The Bank of Korea has tightened its monitoring and stress testing to identify households at risk of default.

For non-bank deposit taking institutions, which account for about 22% of household debt, mortgages accounted for about 40% of their household lending. Moody's estimates that the average loan-to-value ratio for such mortgages is about 10 percentage points higher than that of bank mortgages.

Nevertheless, this situation does not mean that all lending from non-banks is highly risky or pose a greater risk to the financial sector. Moody's explains that lending by public entities, securities companies and insurance companies are low risk, commonly backed by guarantees, securities or insurance policies.

Moody's report concludes by saying that overall, while an interest rate shock would have a marked effect on Korea's GDP growth, the government has the fiscal and monetary policy space to buffer against such a shock. Should indebted households retrench consumption significantly, the spillover effects to the broader economy and thereby the sovereign and banks could be material.