Moody's Investor Service said in a report from New York that "the asset quality picture is bleak, liquidity remains tight, profitability thin, and most urgently -- capital is scarce."

"Although the government is making earnest efforts to reform the system, it is waging a difficult battle against entrenched socio-political resistance, especially that of staff reduction, during a period of extreme economic stress."

Last month, a threatened nationwide banking strike was averted when management at banks undergoing restructuring agreed with their unions to fewer job cuts.

"Dismantling `Korea, Inc' will take much time and the credit standing of the banks will be pressured throughout the process," Moody's said.

The assessment is a blow to the government, which has said it hasbasically turned the corner on its financial restructuring efforts and has invited Moody's to come here next month to review South Korea's country rating.

The world's major credit rating agencies downgraded South Korea's sovereign to below investment grade and that of its banks to virtual junk bond status when the country plunged into financial crisis late last year.

That has considerably raised borrowing costs for the country and its banks.

"With the banking system technically insolvent, capital levels among Korean banks is a key credit consideration," Moody's said.

The removal of problem loans -- and reforming the credit-making process -- is key to getting capital to start flowing back into the country, analysts said.

Merrill Lynch said in a report on the Korean banks issued this week that "unless banks' credit process is fundamentally altered, the sector could potentially repeat some of the mistakes that led to the current crisis."

The debt-driven growth of the industrial sector, with creditallocation often directed by the government, is widely viewed as a key factor in tipping the country into economic crisis.

Merrill said the government's estimate of 64 trillion won ($48 billion) to recapitalise the banking system was optimistic, estimating it could well be more than 100 trillion won.

South Korea's non-performing loans (NPLs) could reach 100-120 trillion won by the end of the year.

The Korea Asset Management Corp, a state agency charged with buying up problem loans and disposing of the assets behind them, has so far purchased NPLs with a book value of 39 trillion won at an average discount of 55 per cent, Merrill said.

It plans to purchase another 25-30 trillion won in the fourth quarter of this year and a further 12-17 trillion during the first half of next year.

"We see KAMCO's ability to dispose of the assets it has acquired and to become self-funding as among the major challenges for the authorities," Merrill said.

The privatisation of Korea First Bank and Seoulbank, expectedby the end of the year, looms as another test.

On Monday, the government said it would buy the future bad debts of both banks over the next three years and remain a major shareholder in them to bolster their credibility.

The offer came after months of fruitless efforts to sell the two banks, which were nationalised early this year after collapsing under a mountain of bad loans.

The Financial Supervisory Commission said the government would spend up to 7.8 trillion won to buy 60 to 80 per cent of the bad loans of the two banks over the next three years.