In this blog post, we’ll break down the true nature and hidden risks of subordinated bonds, which lure investors with high interest rates.
Banks and Savings Banks Are Different
When you hear about a “product that pays high interest,” what’s the first thing that comes to mind? Most people probably think, “Wow, that sounds like a great product.” However, in reality, a product that pays high interest is often a “risky product.” We can see a classic example of this in the subordinated bonds issued during the savings bank crisis.
In May 2012, four savings banks in Korea—Solomon, Mirae, Korea, and Hanju—had their operations suspended. Subsequently, not only bank presidents but also key figures in the political sphere were arrested one after another for various illegal lending practices and the creation of slush funds. One of the causes of these incidents can be traced back to the amendment of the “Mutual Credit Union Act” to the “Mutual Savings Bank Act” in March 2001. With this law, existing mutual credit unions were renamed “savings banks,” resulting in significant changes to their outward appearance.
Concerns were raised that the term “savings bank” made it easy for the public to confuse them with banks in the primary financial sector. Although legal measures were taken, such as prohibiting the use of spaces in the signage, it is practically impossible for the general public to distinguish between “savings bank” and “savings bank.” Song Seung-yong, a director at Hope Financial Planning, explained it this way.
“Originally, they were credit unions. Simply put, they are private financial institutions, no different from small financial companies like Saemaul Credit Unions. However, once the word ‘bank’ was added to their name, people began to confuse them with regular banks, leading them to mistakenly believe that ‘it would be safe to deposit large sums of money there.’”
Cases of Losses Due to Subordinated Bonds
People began depositing their hard-earned money in savings banks because they were told these institutions offered higher interest rates than primary financial institutions. However, that money gradually flowed into illegal loans, slush funds, and even embezzlement for the personal benefit of bank presidents. As a result, the banks faced business suspensions, and the burden of the losses fell on ordinary citizens.
Subordinated bonds were a particularly problematic product in this process. Many people were lured by the promise of “high interest rates” and rushed to purchase these products without understanding their true nature. Looking at the cases of victims from Daejeon Savings Bank, which had its operations suspended in February 2011, many suffered significant losses due to subordinated bonds. According to the Association of Financial Victims, the total losses for just 67 victims alone amounted to 8 billion won.
Oh In-yong, Vice Chairman of the Financial Victims Association, shared a real-life example and said the following.
“Take the case of one individual who was a deposit account holder. A teller asked if they would like to invest in a good product. The person replied, ‘I don’t have any money.’ The teller then explained, ‘You can just close the savings account you currently have and use that money to invest.’ When the customer asked why they should cancel the account and lose the interest calculated at the agreed-upon rate, the clerk persuaded them by saying, ‘We’ll pay you the agreed-upon interest.’ So, the customer canceled the deposit and ended up purchasing subordinated bonds. However, there was absolutely no mention that this investment product was a ‘bond.’ They didn’t know it was a bond; they described it as a ‘deposit conversion.’”
The Structure of Subordinated Bonds and BIS Loopholes
So, what exactly are subordinated bonds? When a company issues bonds, they represent the company’s debt. If the company is financially sound, there is no issue, but if the company goes bankrupt or fails, there is a priority order for repaying creditors. General creditors are paid first, followed by holders of subordinated bonds. In other words, subordinated bonds are those that are lower in the priority order for debt repayment when the company goes under. Money is repaid in the order of senior bonds, subordinated bonds, and then shareholders.
In the case of savings banks, liabilities often exceed assets, making it difficult to repay all creditors. Consequently, holders of subordinated bonds find it hard to recover their money. Director Song Seung-yong explained the characteristics of subordinated bonds as follows.
“Subordinated bonds offer higher interest rates than regular bonds. They pay more because they’re riskier. The interest rates on subordinated bonds are significantly higher than those on senior bonds. Not only are the interest rates high, but the maturities are also long. Typically, you have to hold them for a long time—about five and a half years.”
So why did savings banks sell subordinated bonds? Behind this lies a “loophole” that the general public is largely unaware of. The key lies in the BIS ratio. The BIS ratio is a key indicator of a bank’s asset soundness; if it falls below a certain threshold, the bank receives recommendations, requests, or orders from regulatory authorities to improve its management.
Converting deposits into subordinated bonds reduces liabilities on the balance sheet, which in turn raises the BIS ratio, allowing the bank to receive an evaluation of “sound assets” from external regulators. Oh In-yong, Vice Chairman of the Financial Victims Association, explained this as follows.
“Banks issue subordinated bonds to raise their BIS ratio. From the bank’s perspective, deposits are debt. Since they must eventually be returned to customers, they are recorded as liabilities. However, bonds are not recorded as liabilities. This is why they can be used to raise the BIS ratio.”
High Returns Mean High Risk
In essence, this amounts to trying to plug a leaky bucket with the money of ordinary people. If a bank promises customers high interest rates, it must invest in somewhat risky ventures to generate the necessary funds, which increases the likelihood of losses. When losses from risky investments materialize, the damage inevitably falls directly on the customers. Director Song Seung-yong issues this warning:
“There is something financial consumers must understand: wherever high interest rates are offered, risk is inevitably lurking. For example, savings banks offer higher interest rates because they are more likely to fail than commercial banks. If a specific product offers high interest, it also means the probability of failure is correspondingly high. However, one must not assume, ‘If the interest is high, it must be a good product,’ without understanding this.”
We sometimes lose money because we are too ignorant, too trusting, or too naive. Mark Twain said this in ‘The Adventures of Tom Sawyer’:
“Banks lend you an umbrella on a sunny day, but take it back when it rains.”
Even today, many bank presidents say upon taking office, “I won’t take away your umbrella on a rainy day.” While individuals may hold onto that hope, a bank is a company that must consistently generate profits. There is an incentive to steer customers toward risky products in pursuit of greater profits. Financial institutions tend to shift the blame for risks onto customers, meaning the actual burden falls on them.
Furthermore, in an era of low interest rates, phrases like “8–10% interest” naturally catch everyone’s attention. However, simply knowing that deposit insurance covers only up to 50 million won—including both principal and interest—in the event of a savings bank’s bankruptcy might have helped minimize the scale of losses. Director Song Seung-yong points out that the more complex a product is, the more explanations and precautions are required; if it is sold without the consumer’s full understanding, it can lead to mis-selling.
It’s time to be aware. When a bank says it “treats you like family,” don’t rely on a vague sense of reassurance. Because sometimes, the bank may not be on your side “at all.”
