Bank of Korea Rate Hikes Lift Bank Interest Income but Squeeze Margins

Two hikes so far, and a third under discussion

The Bank of Korea raised its base rate by 25 basis points in August, taking it to 3%. That followed another quarter-point increase in July. It was the first time since early 2023 that the bank had raised rates at two meetings in a row1. The July move was the first increase since January 2023 and ended a long run of holds at 2.5%. Headline inflation had climbed to 3.2% in June, pushed up by expensive oil and a weak won1. Governor Shin Hyun-song has called the back-to-back increases "unprecedented" and says they sent the market a strong signal3.

The latest data explain why the bank does not think it is finished. Consumer prices rose 2.9% from a year earlier in September, down from 3.1% in August. Core inflation, which strips out food and energy, fell from 3.4% to 2.8%4. The direction of that core number is read in different ways. Some coverage stresses that it eased sharply from August6. Seoul Economic Daily describes 2.8% as effectively the highest level of the year and argues that the underlying pace of inflation actually picked up5. Either way, core inflation is still clearly above the 2% target. Transport prices rose 7.7%, the largest single contributor4. Expensive oil has fed into airfares, car repairs and package tours, and higher chip prices are being passed on to computers and other electronics6.

At a parliamentary audit on October 12, Shin said moving before the U.S. Federal Reserve's September hike had "bought time." In his view, acting early costs the economy far less than being forced into defensive hikes later by market pressure2. He expects inflation to stay above target for a considerable time, as built-up cost pressures keep feeding through and demand pressure slowly builds2. The bank's next rate meeting is on October 223.

Most economists expect a pause in October, then a move in November that would take the rate to 3.25%4. Citi's Kim Jin-wook expects hikes in November and February, ending at 3.5%5. Analysts at Meritz Securities and Shinyoung Securities also see two more increases. Both say the Fed's tightening has raised the chance of a higher top end to the rate path10. Our reading is that a pause in October, with a strong signal of more to come, is the most likely outcome. Markets should not treat a hold as the end of the cycle.

Why the economy can take higher rates

The reason for tightening is not only inflation; growth is also strong. A semiconductor boom driven by global AI demand pushed second-quarter gross domestic income up 15.6% from a year earlier, the fastest growth in more than 38 years1. The central bank raised its 2026 growth forecast to 3.3% from 2.6% and expects 2.9% growth in 20271. Exports hit a record $120.9 billion in September. Semiconductor exports alone jumped 263% to $60.3 billion4.

Fiscal policy is pushing in the other direction. Opposition lawmakers argued at the audit that the government's expansionary budget could work against the bank's efforts. Shin estimated the budget would add 0.5 percentage point to growth and 0.06 percentage point to inflation7. He also acknowledged that higher rates hit lower-income borrowers hardest7.

Banks earn more interest but make less profit

For lenders, the obvious expectation is that higher rates mean higher profits. The first-half figures show something more complicated. The Financial Supervisory Service reported that Korea's 20 domestic banks earned a record 32.2 trillion won in interest income in the first half of 2026, up 8.3% from a year earlier1215. Interest-earning assets grew 6.4% to 3,628.1 trillion won, and the net interest margin widened 4 basis points to 1.56%16.

Net profit still fell 6.4% to 13.8 trillion won12. Coverage agrees on the cause: rising market rates cut the value of the bonds banks hold. Securities-related results swung from a 3.2 trillion won profit to a 2.5 trillion won loss. Valuation results alone moved from a 1.3 trillion won gain to a 3.2 trillion won loss12. Non-interest income fell 43.4% to 2.9 trillion won15. Several outlets linked part of the losses to the KOSPI stock index1314. Supervisory data focus more on bond valuations hit by higher yields17. Return on assets fell to 0.65% and return on equity to 8.89%17.

The pattern was already visible in the first quarter. Interest income rose 6.4% then, but net profit fell 3.9% because of bond valuation losses. At the time, analysts warned that bank earnings were becoming more sensitive to swings in interest rates20.

Not every report fits this picture. One market commentary says the four big financial groups (KB, Shinhan, Hana and Woori) together earned about 9.8 trillion won in the first half, more than in all of 2024. It credits record lending spreads18. That account also says deposit rates fell under an easing cycle, which does not match a central bank that started hiking in July18. Group-level figures also include non-bank units. The regulator's sector-wide data are the firmer basis, and they show strong core lending income offset by losses on bond holdings.

Lending spreads are moving both ways

The key question is whether lending margins can keep growing as the cycle goes on. The evidence points both ways. After the July hike, banks raised deposit rates faster than loan rates. Five major lenders saw their average household loan-deposit spread shrink from 1.512 percentage points in March to 1.298 in July. Spreads narrowed even more at regional and internet-only banks. Across the banking system, the spread on new loans fell to 1.06 percentage points in July, its sixth monthly decline in a row28. Cheap funding is also shrinking. Fixed deposits at the five big banks rose by nearly 60 trillion won between late June and mid-September, while low-cost demand deposits fell by about 51.5 trillion won28.

August brought a partial reversal. The spread on new loans widened by 0.13 percentage point to 1.19, the first increase in seven months. The spread on existing balances narrowed slightly to 2.2225. Loan rates are now catching up with funding costs. The average new mortgage rate at banks reached 4.66% in August, the highest since November 202223. Unsecured loan rates rose to 6.33%25. Among the five biggest lenders, new mortgage rates averaged 4.94%. That was a 0.28-point jump in a single month, and only a small further rise in September would push the average above 5%21.

Funding costs keep climbing. One-year corporate deposit rates at major banks have passed 4%; Woori Bank offers 4.09%. Corporate clients supply about 80% of bank deposits22. Five-year bank bond yields, the benchmark for fixed-rate mortgages, rose to about 4.6% from 3.49% at the end of last year24.

What it means for bank earnings

Our reading is that the rate cycle helps banks' interest income but is not a clean gain for overall profits. Loan books keep growing despite higher rates. Household loans at the five big banks increased again in early October, helped by autumn moving-season demand21. That growth, together with lending rates catching up to deposit costs, should keep interest income near record levels. But each further rise in bond yields brings more mark-to-market losses. Credit quality is the bigger long-term risk. Loan-loss expenses rose 8.6% in the first half11, and the regulator has named rising delinquencies and the Middle East conflict as risks to bank soundness13.

Borrowers are in a tougher position. New mortgages at the five big banks with rates of 5% or more rose 14-fold between December and August, to 2.34 trillion won29. A simple calculation shows that a 0.1-point increase across household bank loans adds about 1 trillion won a year in interest costs24. Regulators have reportedly signaled concern about bank profits earned at borrowers' expense18. That raises the political risk that the strongest part of bank earnings, interest income, becomes a target for intervention.

As the October 22 meeting approaches, bank shareholders are better off if the central bank stays hawkish but keeps its message clear and predictable. Steady guidance helps keep bond yields in check, as Shin argues3. It would also limit the valuation losses that wiped out this year's record interest income.