UPDATE 1-S.Korea banks' capital ratio lowest in 7-½ years

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SEOUL, Nov 11 (Reuters) - South Korean banks' capital ratio fell to the lowest in seven and a half years due to investment losses sparked by the global financial turmoil and an increase in risky assets, the financial regulator said on Tuesday.

The Financial Supervisory Service (FSS) said it would encourage banks to boost their capital and increase profits retained. It also called for banks to prepare for a possible rise in bad debt amid the economic downturn. The capital adequacy ratio guided by the Bank for International Settlements (BIS), a measure of banks' financial soundness, fell to 10.79 percent at the end of September, down from 11.36 percent at end-June, the FSS said.

It was the lowest reading for the quarterly data since end-March, 2001. At the end of 2007, the ratio stood at 12.31 percent.

Separate FSS data showed the ratio of bad debt to total loans at domestic banks rose to 0.81 percent at end-September from 0.70 percent at end-June.

"The ratio of bad debt is turning higher, although still at a low level, as the economy slows following the global financial crisis," the regulator said in a statement.

"(The FSS) will guide banks to dispose of non-performing debt, strengthen risk management and increase capital to prepare for a rise in bad debt."

To boost capital the FSS said banks would be encouraged to issue hybrid bonds and adjust dividend payments.

Hybrid bonds combine features of debt and equity, paying higher returns to investors than standard debt but ranking lower down the repayment chain than senior debt in a bankruptcy.

The BIS capital ratio represents the net worth of banks in the form of issued capital, retained profits and some hybrid debt divided by risk-weighted assets. Korean banks are usually expected to meet a 10 percent ratio to be considered healthy.

Of 18 domestic banks, including foreign-owned and state-run institutions, 11 saw their capital ratios fall from end-June. Kookmin Bank, Citibank Korea and the Export-Import Bank of Korea registered BIS capital ratios below 10 percent, according to the FSS. (Reporting by Rhee So-eui; Editing by Keiron Henderson and Jonathan Hopfner)