Foreign investors are being lured back to South Korean banking shares, attractedby the sector's robust earnings and increasing dividend pay-outs.

The country's banking shares drew little attention last year, overshadowed by big initial public offerings of Chinese banks such as Industrial and Commercial Bank of China, and the stellar performance of Indian banks such as ICICI.

But this year foreign investors have bought a net Won543.2bn ($579m) worth of Korean banking shares, pushing the banking stock index up 11.27 per cent higher. Foreign ownership of the sector has reached 70 per cent.

And even given this year's strong growth, analysts say the sector had room for further gains given its cheap valuation and low risk.

"Korean banking shares are still much cheaperthan those of their Asian rivals," says Kim Jin-sangat Nomura International.

"They are undervalued compared with their sound asset quality, strong returns on earnings and management transparency."

Analysts say Korean banking shares used to be discounted by more than 20 per cent compared with their Asian rivals. But the valuation gap had narrowed, with foreign investors increasing their exposure to Korean banks as they cashed out of Chinese lenders amid a correction in the Chinese stock market.

Korean banks are trading at an average price to 2007 estimated earnings ratio of9 per cent, while Asian banks trade at an average of 12 times estimated 2007 profit.

Kookmin Bank, the country's largest lender, is trading at only 2.08 times 2007 book value compared with 4.78 times book value for ICBC, China's top lender.

"Korean lenders are in a strong uptrend on the back of rising demand and robust earnings. There could be a short-term correction, butI think there is still a 20 per cent upside potential," says Sung Byung-soo at Prudential Financial.

Big Korean lenders reported record earnings last year after rapid asset growth and one-off investment gains. Kookmin last week said profits rose 9.3 percent to Won2,472bn in 2006, while second-ranked Shinhan Financial Group boasted a 17 per cent jump to Won1,833bn.

Korean banks also surprised by offering to return more cash to shareholders, which added fuel to thesector's rally.

Korea Exchange Bank, controlled by US private equity fund Lone Star, unveiled its first pay-out plan in a decade.

Meanwhile, Kookmin plans to return half of its 2006 profit to shareholders and to pay out about a third of earnings in the future.

"The proposed pay-back will raise expectations on smart capital management by banks, addressing the current discount argument towards Korean banks," Bryan Song at Merrill Lynch said in a recent report.

Analysts expect Korean banks to continue to return cash to shareholders in coming years, with 2007 likely to be another record year for Korean banks' earnings.

The banks are helped by continued one-off invest-ment gains, in spite of slowing growth in their core businesses.

Shinhan, for example, is expected to gain from its acquisition of LG Card, while Woori Financial Group, which is 78 per cent owned by the government, is planning to offload a 28 per cent stake this year and eventually sell the remaining 50 per cent to a strategic investor.

Kookmin and Hana remain interesting plays, given the pending sale of Korea Exchange Bank.

Lone Star cancelled a $7.3bn deal to sell the country's fifth-largest lender to Kookmin last year due to an extensive probe into suspicions surrounding its 2003 purchase of Korea Exchange Bank. But it is expected to resume efforts to sell the bank next year once the investigation is concluded.

Kookmin and Hana remained the most likely buyers for Korea Exchange Bank, as the governmentdid not want to see it fall into foreign hands, analysts say.

Despite all their merits, investing in Korean banks carries risks. Their profits fell by a third in thefourth quarter after thegovernment tightened provisioning rules in prepar-ation for tougher inter-national requirements onbank capital.

It also strengthened rules on mortgage lending in a bid to cool the property market.

"Credit risks may increase amid an economic slowdown. And the growth rate in household lending will slow due to the tougher rules," says Daniel Baekat Woori Investment and Securities.

"But those factors are not likely to hurt banks' profit-ability much as competition for asset growth eases."