Moody's Investors Service says that its negative outlook for the Korean banking system reflects its assessment that the overall creditworthiness of Korean banks will deteriorate over the next 12-18 months.

Moody's outlook on the Korean banking system has been negative since May 2016.

"Weak domestic consumer sentiment and rising policy risk at home and abroad have extended a period of subdued economic growth and revenue pressure on large corporates," says Sophia Lee, a Moody's Vice President and Senior Credit Officer.

"Our baseline scenario is for real GDP growth to slow to 2.5% in 2017 and 2.0% in 2018 from 2.7% in 2016, while the upcoming change in administration introduces uncertainty around policy direction on household debt and corporate sector restructuring," adds Lee.

Moody's conclusions are contained in its just-released report titled, "Banking System Outlook — Korea: Negative Outlook Reflects Challenging Operating Environment and Deteriorating Corporate Asset Quality".

The negative outlook is based on Moody's assessment of five drivers: Operating Environment (deteriorating); Asset Quality and Capital (deteriorating); Funding and Liquidity (stable); Profitability and Efficiency (stable); and Systemic Support (stable).

Moody's expects asset quality to deteriorate as corporate loans come under pressure from declining revenue amid a slowing economy and rising market interest rates.

In addition, the prolonged restructuring of sectors with overcapacity, such as shipbuilding, will increase problem loans and contingent liabilities, particularly for policy banks.

Capital ratios may decline over this outlook, with downward pressure from low profitability, the phasing out of debt capital securities and the adoption of IFRS9 in 2018.

Profitability, however, will remain stable in 2017, as net interest margins have stabilized and may even improve on rising interest rates on new loans. Moody's also expects banks to maintain cost discipline, which will lead to an improvement in their cost to income ratio, thereby reversing the deteriorating trend that began in 2010.

Government support will remain very high, says Moody's, with pre-emptive capital injections likely to remain the preferred method to resolve distressed banks in Korea. The regulators will review the implementation of a resolution and recovery plan by 2018.

Moody's rates 17 banks in Korea which together account for 100% of total system assets.