As Korean asset owners keep looking for overseas alternative investments, Korean securities companies will continue to broker these deals. But in the process, they will have to increase their skin in the game, according to a new report from financial institutions group Moody's Investors Service.
Moody's Investors Service has changed its outlook for securities companies in Korea to negative from stable. It reckons that difficult operating conditions over the next 12-18 months will encourage these companies to take on more risk by focusing more on non-traditional businesses, in particular overseas real assets such as commercial real estate and infrastructure equity as well as debt.
The securities companies are indeed supplying what the asset owners are looking for, according to Ok Tae-Jong, analyst at Moody's Investors Service’s.
“We expect [that] demand from both institutional and retail investors for higher yielding products in a prolonged period of low interest rates will remain robust. Retail and institutional investors' investment in overseas real estate funds have grown by more than 30% per year in the past three years and we expect this trend to continue for the next 12-18 months,” Ok told AsianInvestor.
As an example, another ratings agency believes that both Korean life and non-life insurers will continue to increase their exposures to alternative investments and overseas securities, especially long-tenor bonds, according to Siew Wai Wan, senior director of insurance at Fitch Ratings.
“Such assets still provide Korean insurers with higher yields against a low interest rate environment of the domestic market. Insurers have gradually shifted their allocation towards alternative and overseas assets to 24% of their total investment portfolio as of June 2019,” Wan said.
Moody's explains that Korean securities companies have insufficient stable sources of funding that will be available to them even during times of stress. This is especially true for foreign-currency funding, where most Korean securities companies lack committed credit lines or long-term funding, and rely instead on swaps and bank lines.
Moody's also says that the companies' profits will stay stable, but capital pressure will intensify. In particular, the industry's brokerage fee income will remain weak but offset by higher revenue from diversified revenue sources such as corporate securities exposures, real estate investment and sales of alternative assets.
Despite stable profit, however, capitalisation will be strained because of high asset growth, due to ongoing growth in the companies' short-term financing business and corporate lending.
Diversification and a sluggish domestic economy are the main reasons for this push from asset owners. Moody's baseline scenario assumes slower economic growth for Korea of 1.9% in 2020 and 2.6% in 2021, with disruptions caused by the coronavirus outbreak adding risk to growth.
As previously described, competition has become fierce within the industry's brokerage business. This is reflected in the continuing declines in brokerage commission rates, and the derived hunt for higher yields, for instance in Eastern Europe.
“The securities companies also need to be able to earn a fee, so that increases the need for high-yielding investments,” an investment professional at a Korean securities company said.
The key funding risk will come from the use of short-term borrowings to fund asset accumulation, according to Ok. And the industry will face challenges in liquidity management when the portfolios of illiquid assets pile up.
The investment professional explains that the sourcing model has worked because some Korean asset owners prefer direct ownership of assets, rather than investing in a commingled fund vehicle with an asset manager as a general partner.
“Key liquidity and funding risks associated with acquiring and selling overseas assets to domestic customers could arise when securities firms are unable to sell their acquired assets and are required to roll over their foreign currency funding for the duration of the investment, especially during times of global liquidity stress,” Ok said.
“Failure to sell down acquired assets may arise for various reasons including the failure of securities firms to assess investors’ demand adequately, a sudden market event that results in lower investor risk appetite and inadequate due diligence that results in unexpected problems arising from the acquired assets," he elaborated.
The ability of the securities firms to control these risks depends on the robustness of their internal controls andadequate employee compensation which balances both opportunities and risks. Given the relatively short track record of the Korean securities firms in this business, their ability to manage risk through a credit cycle is somewhat untested.
Although Korean asset owners continue to demand overseas alternative investments, the supply from eager securities companies might lead to saturated balance sheets. And that can become a liability if these assets sit on the balance sheets longer than the short-term lending used to secure them.
After the market to sell down these assets to institutional asset owner vehicles became saturated last year, some securities companies began to offer them via retail vehicles.
According to the Korean securities investment professional, one example of this is three Amazon-leased European real estate assets that did not receive enough interest because they were perceived as overpriced in the eyes of Korean asset owners. A share of the portfolio worth around $200 million was instead offered as a Korean retail investor product and was sold in two days, according to the investment professional.
Securities firms could potentially offload their unsold acquired assets in multiple ways, including selling at discount to overseas or local investors, or carrying the book in the company’s own investment book, Ok said.
“If assets are sold at a discount, the scenario will be negative on profitability while decision to carry on the company’s own book may entail heightened credit and liquidity risks,” he elaborated, emphasising that to minimise risk of failure to sell down acquired assets, Korean securities firms have established internal limits on aggregate unsold balance.
Moody's rates seven securities companies in Korea. These firms accounted for 59% of consolidated system assets at 30 September 2019.