Despite the challenging business environment primarily impacted by the prolonged economic downturn, Kyongnam Bank turned in an impressive performance in overall operations in 2004. Total assets in 2004 expanded 11.2% over the prior year; total deposits 10.6%; and total loans 13.1%. Of significant note, net income surged 28.2%, year-on-year, amounting to a record 109.2 billion won.

Buoyed by its notable profit performance, the bank was able to attain a stable BIS capital adequacy ratio of 11.3%. Return on assets (ROA) recorded a gain of 0.18 percentage points, or from 0.80% to 0.98%. Return on equity (ROE), backed by the significant profit growth, grew significantly to 19.18% compared to 17.94% a year earlier.

In fiscal 2004 (Jan. 1, 2004 to Dec. 31, 2004), net income amounted to 109.2 billion won, up 28.2% from a year earlier, driven by the growth of 606 billion won in interest-bearing assets and a reduction in loan loss provisions.

In order to address the changing needs of customers, the bank put in operation a customeroriented business structure. The bank shut down 13 branches with limited growth potential, while establishing three new branches in strategically important business areas. The branches are now broadly categorized into four types-retail banking-oriented, corporate banking-oriented, multiplebusiness- oriented, and depository branches for municipal and local governments funds.

The bank also strove to improve its profile as a community bank with generous donations to various social, cultural and sports entities, as well as to those in need.

In 2005, the bank¡¯s primary goal is to achieve a more than 7.2% growth in total assets. During the past two years, total assets recorded average annual growth of 10.9%. As for total deposits, the bank seeks to attain growth of more than 7.8%, much lower than the average growth of 11.0% during the past two years. Total loans are also expected to continue to show robust growth in 2005 if the bank¡¯s target is met. Total loans are projected to grow 9.3%, lower than the average annual growth rate of 13.1% of the past two years.

Backed by an impressive growth of interest-bearing assets, net interest income in 2004 grew 11.8% over the previous year to 353.1 billion won. Interest income on securities, mainly public bonds, rose by 21.8 billion won, year-on-year.

Primarily due to fall-offs in interest rates on deposits, interest on deposits fell by 23.2 billion won, which contributed to the significant growth of net interest income in 2004. Interest-bearing assets expanded by 606 billion won, which was responsible for a 19.4 billion won rise in interest income.

Non-interest income in 2004 decresed 13.9% over the previous year to 43.5 billion won. However, given the fact that there was the reversal of bad loan write-offs amounting to 12.8 billion won in 2003, non-interest income in 2004 posted a healthy increase of 11.5%. The sale of LG Card bonds generated income of 7.8 billion won. In addition, the reduction of 23.1 billion in loan loss provisions helped to substantially increase net income for the year under review.

Selling, general and administrative (SG&A) expenses were up 15.5% year-on-year to 170.6 billion won, backed by an increase of 14.8% in personnel expenses and a sharp 22.5% rise in IT-related expenses. Personnel expenses, which amounted to 99.0 billion won in 2004, included 3.1 billion won in incentives. In contrast, operating income rose by 30.6 billion won to 124 billion won, a dramatic expansion of 32.8%.

Due to the growth of quality assets, the proportion of net interest income is expected to drop to 88.5% in 2005 from 89.0% in 2004. Commissions and fees, as a result, are likely to expand to 55 billion won from 53 billion won, thanks to increases in credit card and other fees.

The average balance of deposits denominated in the local currency grew 5.0% in 2004 over the prior year to 8,344.6 billion won. Deposits in foreign currency, however, fell 33.8% to 99.8 billion won. These deposits include non-interest-bearing funds.

By type of depositors, individual clients accounted for 47.2% of total deposits in bank accounts in 2004, a drop of 1.4% points over the previous year. The proportion of corporations, meanwhile, edged up to 31.7% in 2004 from 28.5% a year earlier. This year, the bank intends to strengthen retail banking, along with its stepped-up efforts to increase the management of public funds.

* 47.2 %
individual clients accounted for 47.2% of total deposits in bank accounts in 2004.

As the bank¡¯s fund-raising activity, interest-bearing funds in 2004 amounted to 10,149 billion won, a gain of 473 billion won (4.9%) over a year earlier. Borrowings in Korean won dipped 6.1%, year-onyear, while foreign currency borrowings expanded by 65.2 billion won to 353.6 billion won.

As expected, the manufacturing sector accounted for the largest portion (35.3%) of loans outstanding at the end of Dec. 31, 2004, followed by loans extended to households (26.6%), loans to retail & wholesale (11.5%) and loans to real estate/home rental business (6.2%). Loans to financial and insurance services amounted to 34.5 billion won, representing a 0.5% share of total loans denominated in Korean won.

By type of collateral, real estate accounted for 42.3% in 2004, slightly lower than in the previous year. Credit and other unsecured loans constituted 38.1%, slightly up from 36.8% a year earlier.

In 2004, substandard & below loans surged 32.7% over the previous year to 151.2 billion won, because there were no sales of bad loans. The bank¡¯s write-offs of NPLs in 2004 amounted to 84.4 billion won. In contrast, sales and write-offs of NPLs, aggregated to 165.9 billion won. Meanwhile, total credit expanded 11.8% year-on-year. Consequently, the ratio of substandard & below loans deteriorated to 2.05% from 1.73% a year earlier. The coverage ratio also dipped to 81.5% from 82.3%, while the balance of loan loss provisions rose by a significant margin of 31.6%. Nonperforming loans, as a result, rose to 147.1 billion won, resulting in an NPL ratio of 2.0%.

The bank is determined to reduce its substandard and below loans through the disposal of bad loans valued at 42 billion won during the first half of 2005. This action will likely to reduce the substandard & below loan ratio to 1.8% during the first quarter of 2005. The coverage ratio is also expected to rise to 97.5%, a notable improvement over the previous year.

The bank will seek to prevent the emergence of bad loans by tightening its credit screening and strengthening the evaluation of borrowers¡¯ creditworthiness. In 2004, the bank implemented an innovative credit risk management system that will be instrumental in reductions of bad loans.

In 2004, the bank sold bancassurance products amounting to 7.5 billion won, compared to 15.6 billion won a year ago. However, commissions recorded a more than five-fold increase to 4.2 billion won. Since commencing the cross-selling of bancassurance products, the bank has forged tie-ups with eight major insurers, including Samsung Life, Hungkuk Life and Korea Life.

Kyongnam Bank will aggressively move to increase cross-selling activities in order to expand its fee-based services. The bank also decided to take various initiatives to ease inconveniences for those who subscribe to bancassurance products.

The bank¡¯s BIS capital, driven by a significant growth of net income, grew 6.1% in 2004 over a year earlier, amounting to 729 billion won. Risk-weighted assets also rose 9.4%, year-on-year, due to the increased risk-weighted assets which were primarily derived from the substnaitl increase of assets. As a result, the BIS capital adequacy ratio reached 11.34%, still much higher than the 8% range mandated by the Financial Supervisory Board.

Capital adequacy is measured by risk-weighted capital ratios, which are computed by dividing Tier 1 and Tier 2 capital by risk-weighted assets. Tier 1, or core capital, includes paid-in capital, capital surplus, retained earnings and minority interests accounted on a consolidated basis. Tier 2 capital, or supplemental capital (up to a maximum of 100% of Tier 1 capital), includes allowances for loan losses for credit classified as normal or precautionary up to 1.25% of total risk-weighted assets, and subordinated debt with an initial maturity of at least five years.

The bank has attained all six of the targeted financial indicators specified in the MOU in effect with the Korea Deposit Insurance Corp. Although selling, general and administrative (SG&A) increased 15.5% in 2004, the ratio of SG&A expenses to adjusted operating income dropped to 43.0%, thanks to robust growth of 32.8% in operating income. The substandard & below loan ratio of 2004 was considerably lower than the year¡¯s target of 2.3%.

In 2004, Kyongnam Bank tightened risk management as part of its efforts to reduce bad loans. Outstanding loans were reclassified in a measure primarily aimed at the reduction of risky loan and continued expansion of high-quality credit.

The bank¡¯s reclassification of outstanding loans was based on the credit ratings of borrowers. The reclassification involved borrowers of 1 billion won or more in May 2004 and 500 million won or more in November 2004. As of January this year, the classification affected borrowers of 100 million won or more. Compared to March 31, 2004, risky loans fell by 106 billion won.

As of the end of December 2004, 668 borrowers were declared excellent clients and were allowed to enlarge their borrowing from the bank, while 1,937 borrowers were permitted to maintain their present level of borrowing. In contrast, the bank decided to curtail loan exposures to 336 borrowers of precautionary classification and gradually terminate lending activity to 89 clients. The bank will actively push ¡°de-marketing¡± for the 89 borrowers through interest rate hikes and other measures.

* 668 excellent clients
668 borrowers were declared excellent clients and were allowed to enlarge their borrowing.

The bank also streamlined its loan asset structure in a stepped-up effort to strengthen risk controls. Since March 2004, the bank¡¯s outstanding exposure to corporations expanded by 499 billion won, of which 468 billion won (93.8%) involved companies with credit ratings with 7 or above. Meanwhile, loan exposure to companies with credit ratings of below 10 decreased by 430 billion.

LIMITS TO TOTAL EXPOSURE AND LARGE EXPOSURE
Since November 2004, the bank has set the loan limit per customer and this system prohibits any significant loss from a particular customer. The limits on total exposure were set through calculation of borrowers¡¯ corporate value, which involved loans, securities, acceptances and guarantees, etc. This total exposure limit system affects borrowers of more than 5 billion won. The bank also sets the limit on large exposure, based on corporate credit ratings that are made by independent credit rating agencies. This system is applied to borrowers of more than 10 billion won.

Credit Risk Management
The bank implemented an innovative credit risk management system (CRMS) in mid-2004 to ensure efficient management of credit risk and to lay the foundation for strategic decision-making in asset management. Under the CRMS, the bank upgraded the credit ratings of corporate borrowers, especially smaller firms, restructured the database on collateral, created a data mart, and established a Credit VaR System for efficient management of loan portfolios and analytical forecast of crisis situations.

MARKET RISK MANAGEMENT
Market risk involves exposure to potential losses that can result from changes in interest rates, equity values and foreign exchange rates. This risk is managed primarily by VaR (value at risk) monitoring, which uses statistical models to estimate the potential loss in market value.

LIQUIDITY RISK MANAGEMENT
The bank is involved in liquidity risk management in order to withstand sudden large-scale deposit withdrawals due to worsening of its credit rating or other contingencies. Liquidity risk is mainly measured by the bank¡¯s limited GAP, liquidity ratios of the Korean won and foreign currencies and the ratio of short-term credit to total credit.