The government introduced its plans to improve the management ofrisk exposure in real estate project finance on December 5.

Background

Project financing in real estate is a financing mechanism based onthe business value of the project and the expected cash flows of the project inthe future. Due to the recent financial deepening and continuing low yields,project financing has increased significantly. Project financing provides an efficientway to finance real estate or infrastructure development projects.

However, due to heavy reliance on the expected value of theproject, risk exposure is highly dependent on market conditions. Without propermanagement of risks, or in the case of a distortion of profits or risks, it maypose a threat to financial stability.

Risk exposure in project financing has continued to increase especiallyin non-bank sectors since 2013. The prevalence of high-risk project financingloans, such as bridge loans, has dropped whereas the level of exposure bysecurities companies and specialized credit finance companies increased. Debtguarantees in project financing also increased as the burden of credit exposureshifted from construction companies to financial institutions.

Recent Trends

At the end of June 2019, the total amount of debt guarantees inproject financing stood at KRW28.1 trillion, out of which KRW26.2 trillion issuedby securities companies. The outstanding loan balance in project financing stoodat KRW71.8 trillion, rising on average 11.6 percent a year from KRW39.3trillion at the end of 2013. By the end of June 2019, both the default rate andthe sub-standard asset ratio continued to decline since 2013 from 13.0 percentto 1.9 percent and 16.9 percent to 3.0 percent, respectively, due to anincreased volume in project financing loans.

Key Measures

I. Improvingthe Soundness of Debt Guarantees in Project Financing

► Establishing anupper ceiling on debt guarantees

Under the current system,securities companies face no upper limits on issuing debt guarantees. The newmeasure places an upper ceiling to 100 percent of equity capital and restrictssecurities companies from issuing debt guarantees over that limit.

For specialized creditfinance companies, the current regulation only limits their issuance of projectfinance loans to 30 percent of their credit assets, which include bonds, leaseassets, credit card assets and credit-based provisional payments. The newmeasure will place an upper ceiling on the issuance of combined amount of projectfinance loans and debt guarantees to 30 percent of their credit assets.

► Strengtheningcapital requirements & standards for bad debt reserves

Debt guarantees aregenerally categorized as off-balance sheet financing although they may becounted as on-the-balance based on market conditions. Despite regulations ondebt guarantees, such as capital requirements, asset quality classification andbad debt reserves, there still exists loopholes in regulations.

For securities companies, thecurrent regulation applies low capital requirements for debt guarantees,currently at 12 percent, for assessing credit risks. The new measure raises thecapital requirements for debt guarantees to 18 percent.

Specialized credit financecompanies will be required to set up bad debt reserves for project finance debtguarantees at an equivalent rate as those for project finance loans, whileapplying a 100 percent credit conversion factor.

► Managingliquidity risks

Securities companies arerequired to conduct stress test of their own and submit liquidity management plansto the regulatory authority. For securities companies whose adjusted liquidityratio falls below 100 percent, the Financial Supervisory Service will strengthenits risk management and supervision.

For specialized credit financecompanies, a new set of supervisory standards on liquidity risk management willbe established during the second half of 2020, which will include provisions fordebt guarantees in project financing.

II. Strengthening the Soundness in Project Finance Loans

► Eliminating inducementsthat contribute to an increase in project finance loans

1. Under the current system, the issued notes of payment or assets inmanagement are excluded when calculating a leverage ratio. However, the newmeasure will require that real estate investment assets in excess of 10 percentof the financing amount of the issued notes to be included when calculating aleverage ratio.

2. Real estate-related loans will be excluded from additional limitsto credit offering for companies (from 100% to 200% of equity capital).

3. The special exemption for real estate loans will be abolished andreal estate loans will be counted toward the amount of net working capital.

    

   ► Improving thecurrent bad debt reserve requirements

    

   Currently, there existdiscrepancies in bad debt reserve requirements for different sectors. Forsecurities companies, specialized credit finance companies and savings banks, thecurrent system allows lower reserve ratios when payment is guaranteed byqualified investment companies or that the related assets are apartments.However, the new measure eliminates this provision.

    

    (Unit: %)

*  When payment is guaranteed by qualifiedinvestment companies

**  Apartment assets

III. Establishing a Risk Assessment & Monitoring System inProject Finance

► Establishing a monitoringsystem on project financing risk management

The new measure is aimed at encouragingfinancial companies to strengthen risk management by establishing a periodic monitoringsystem – (i) select financial companies subject to closer monitoring in Q1every year, (ii) conduct supervision of risk exposure management trends in Q2every year, and (iii) share results with relevant financial authorities andinstitutions and apply remedies in H2 every year.

► Performingstress test to prepare for risks

The government plans to setup a system to perform stress tests – (i) develop methodology and framework forperforming stress tests in Q1 2020, (ii) select a risk scenario every year, and(iii) perform a stress test based on the risk scenario, and implement follow-upmeasures.

► Strengthening disclosurerules in project financing

From 2020, financialcompanies will be encouraged to disclose the following information in theirbusiness reports, such as the size and proportion of risk exposure in projectfinancing, proportions of project financing business sites by location,business purpose and credit worthiness of construction companies, as well as theresult of their own internal risk exposure assessment.

► Establishing acomprehensive system to manage risk exposure in project financing

Due to the lack of acomprehensive risk management system, detecting systemic risks has beendifficult, even though a routine monitoring system for both project financeloans and debt guarantees has been up and running.

The government plans toestablish a comprehensive risk management system on real estate financing in2020, which will also introduce provisions for a regular monitoring of riskexposure in project financing. The comprehensive system will include realestate financing in household, corporate and financial investment sectors. By selectingmajor indicators in each sector and developing methodologies for risk analysis,a database of risk exposure will be set up by different sectors.

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* Please refer to the attached PDF for details.