For Korean bank treasuries, liquidity trumps profits

Korean banks are unlikely to take on new risks when it comes to managing their assets this year.

"The first priority is liquidity," says Lee Sangwook, senior vice-president and manager of the international fixed-income portfolio at Shinhan Bank in Seoul. "The second is the quality of assets. The third is earning a return on investment."

Since last year, banks' risk managers have focussed on safety, not profitability, when it comes to managing their treasury desks. Some of this is a backlash against the widespread exposures among Korean financial institutions to complex products, such as collateralised debt obligations and credit-linked notes, which caused losses in late 2008.

The regulation around the banking world is also requiring tighter controls on how banks invest their assets. The Basel 3 code puts an emphasis on banks' capital adequacy, their liquidity and the need for limiting exposures to debentures with high credit ratings.

Moreover, in 2012, Korea will implement adherence to IFRS accounting standards, which will require banks to mark assets to market on the balance sheet. This will force banks to shift more towards plain-vanilla bonds and simple structured products that are transparent and easy to value, such as range-accrual notes.

That said, this year banks are taking a little more risk than in 2009. In their favour is the fact they don't generally need to hedge their international exposures (unlike insurance companies); most of their international fixed-income assets are funded by the same currencies and their average duration exposure is short, no more than five years.

The collapse of Lehman Brothers in 2008 put a squeeze on liquidity, but conditions in the market have since eased. Last year provided a boost from credit exposure. But credit spreads on single-A-rated bonds are likely to tighten a little further this year, perhaps by 10-20 basis points by the end of the year, and that will help investors, says Shinhan's Lee.

He reckons Korean banks' international bond exposures shrunk by 10-15% in 2008-2009, and will remain flat this year. But if market conditions remain favourable, he believes banks can resume growing their international exposures, from 2011, by 5-10% a year.

Commercial banks mainly hold short-term notes, deposits and interbank money-market funds, all of which provide ultra-low yields. They also hold loans on their books, which provide high yields, but poor liquidity, so these exposures haven't been increased. Fixed income offers the best compromise, providing both liquidity and a chance to earn a return. For now, the portfolio can't grow, but Lee says banks will begin to add to bond positions starting next year.

For international holdings, banks are highly exposed to US dollar-denominated securities. Banks are most exposed to Korean paper (KP), dollar-denominated issues by Korean entities, but during the crisis liquidity dried up. They are now looking to decrease the proportion of KP holdings.

Shinhan is sticking with short-duration bonds and minimal interest-rate risk. It seeks to buy quasi-sovereign paper and debentures from highly rated financial groups.

In the meantime, it is going overweight Asian and Australian bank bonds. "This gives us indirect exposure to China and can provide us with some out-performance," Lee says. "And most high-grade Asian banks are tightly regulated."

These instruments are mostly dollar-denominated. For euro exposure, Shinhan prefers supranationals or AAA-rated bonds from European financial institutions. It has been avoiding sovereign debt, particularly from countries with financial problems, such as Greece, Italy and Spain.

Shinhan Bank manages its international exposures entirely in house.