What banks?

The banks in question, and subject to the investigation, are the Bank of China Ltd., Industrial and Commercial Bank of China (HKG:1398) (SHA:601398) and China Construction Bank Corporation (HKG:0939) (SHA:601939), as well as Barclays PLC (NYSE:BCS) (LON:BARC).

Barclays Banks

It’s believed that the banks in question are having their books looked over due to a rise in yuan-denominated deposits which worry officials in Seoul. South Korea worries that the country’s exposure to foreign exchange volatility is growing too fast and in the case of rapid capital outflows could leave Korean depositors exposed.

According to Lee Jong-uk, the FSS director of the investigation, the probe will continue until at least the end of March. While no details of the investigation were forthcoming, it did come with a request from the South Korean central bank.

If malfeasance is found, the FSS has a number of sanctions at its disposal ranging from fines, restrictions, or in the most extreme cases, and certainly not in this investigation, the termination of operating licenses.

Why the investigation?

It’s not difficult to see the reason for the investigation. A report from the Bank of Korea shows Yuan deposits hit a record high of $7.62 billion at the end of February 2014, and this is a massive number given a comparable $170 million at the end of 2012.

South Korean investors and residents have begun to buy offshore yuan structured products offering a yield of 6-7%, according to a recent report from analysts at Deutsche Bank AG (NYSE:DB) (FRA:DBK) (ETR:DBK). That’s all well and good if the yuan appreciates, but on the downside these derivative packages are dangerous given a depreciating yuan. So far this year, due to the Chinese banks’ efforts to stem capital inflows, the yuan has already dropped 2.3% against the dollar compared to a gain of 2.9% in 2013.

Due to trade ties between China and South Korea, the Korean won has also lost value against the dollar. While only down 1.4%, it is a cause of worry in a country that calls China its biggest trade partner and whose export exposure represents a double digit percentage of its gross domestic product.

In most analysts’ opinions this investigation is little more than a continuation of a policy begun in 2010 to slow capital inflows, which has also included the capping of banks’ foreign exchange forward positions.