Korea’s Financial Reform: A Systemic Risk Approach

Jang-Yung Lee

Senior Counselor to the Deputy Prime Minister

Ministry of Finance and Economy

Republic of Korea

November 2002

Korea’s Financial Reform : A Systemic Risk Approach

• Overall Assessment of Reforms

• Financial Restructuring: Banking vs. Non-banking financial sector

• Corporate sector vulnerability

• Conclusion : Remaining reform agenda

2

Questions to be answered

• What are the lessons to be drawn from Korea’s post-crisis reforms?

• Were the sequence and pace of the reforms appropriate?

• Were Korea’s reform strategy properly formulated to deal with the systemic risks?

• How serious is the systemic threat currently posed by weak corporate sector?

3

Initial policy responses

• Liquidity support by the BOK• A blanket guarantee for depositors• Institutional Infrastructure: => FSC, KDIC, KAMCO• Resolution strategy consulted with IMF and

IBRD• Socio-political consensus on financial reforms

and fiscal support plan

4

A Systemic Risk Approach

• Prioritize the government-led restructuring of financial institutions, based on their systemic importance

• Deposit-taking intermediaries first:

=>a greater risk to the payment system

• Prioritize the banks with the greatest systemic importance

5

Resolution of weak banks

• Two large commercial banks: Jan.’98

• Five small banks: July.’98

• Remaining seven undercapitalized banks: Jan.’99-Sep.’99

• Various forms of restructuring in the banks that were not undercapitalized

6

Speed of banking sector restructuring

• Swift move to recapitalize: meet the 6% CAR by Mar.’99, and 8% CAR by Mar.’00

• Adhered to the tighter CAR even when the banking system returns to normalcy

• Prompt mobilization and injection of the public funds: W 137.5 trillion

7

Use of Public Funds in Financial Restructuring

Re

Capitalization

Deposit Repayment

Asset

Buy

NPL

Buy

Total

Amount Total

Banks 44.3 - 13.2 24.0 81.581.5 59.3

Non-banks

Securities& ITCs

Insurance Companies

Merchant Banks

Mutual Savings

Credit Unions

Sub Total

 

7.7

10.4

2.7

0.05

-

20.9

 

0.01

-

12.2

5.8

2.0

20.0

 

-

0.4

–

0.5

–

0.9

 

-

0.4

–

0.5

–

0.9

 

16.0

12.6

16.5

6.6

2.0

53.7

 

11.5

9.2

12.0

4.8

1.5

39.0

Offshore Institutions - - - 2.3 2.3 1.7

Total 65.2 20.0 14.1 38.2 137.5 100

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Restructuring of non-banking financial sector

• Priority given to the closure of 17 merchant bank sector: large exposure to FX risk

• A tightening of investment guidelines for insurance companies

• Relatively lax supervisory framework for investment trust companies(ITC), even though the weakest among the non-banks

=> posed the significant systemic risk

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Asymmetric Restructuring

• Regulatory forbearance for the non-bank financial institutions

• Exceptional growth of ITC’s trust assets: July ’98- August ’99

<= Driven by a sharp fall in interest rates + by the lax supervisory oversight

• Continued to be used as a financing vehicle by the large companies => reduced the pressure on corporate sector restructuring

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Figure 1. Trust Assets of Investment Trust Companies

(Unit: W100 billion)

0

500

1,000

1,500

2,000

2,500

3,000

9701 9703 9705 9707 9709 9711 9801 9803 9805 9807 9809 9811 9901 9903 9905 9907 9909 9911

Stock-type Bond-type Total

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ITC’s liquidity problems

• Triggered by Daewoo’s debt servicing problems in mid-1999: held 80% of Daewoo’s domestic bonds

• Public confidence further damaged by illegal marketing practices, poor accounting standards, and maturity mismatch

• Redemption pressure increased

12

Stabilization of ITC industry

• Restrict ITC fund redemption: could receive only 50% of Daewoo portion of their investment if withdrawn before Nov.’99

• Create bond market stabilization fund• Public bail-out of two largest ITCs• Intervention justifiable based on the market’s f

ailure to respond appropriately• Systemic risk: event risk or refinancing risk

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Corporate Sector Restructuring

• Pursued simultaneous restructuring of the financial and corporate sector

• Slow pace of corporate restructuring, due to weakened reform momentum in early 2000

• Weak accounting and disclosure standards• Poor risk management in both firms and banks• Inadequate legal and judicial framework for

court-supervised insolvency procedures

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Macroeconomic vulnerability

• Smooth macroeconomic adjustment• Success of IMF-supported stabilization

program-> external position no longer a systemic threat by early 1999

• Evidence of reduced vulnerability: no exchange rate misalignment, balance between foreign exchange reserves and domestic money, and normal rate of credit growth

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Figure 2. Credit Ratings of Korean Firms (Share by the Ratings)

(Unit: percentage)

35.2

27.2

22.9 22.5

27.7

20

41.8

39.638.8

33.1

30.8

37.535.8

39.3

44.8

20

30

40

50

1997.12 1998.12 1999.12 2000.12 2001.1

%

A Grade BBB Grade Speculative Grade

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Renewed credit crunch in the last quarter of 2000

• Collapse in corporate bond market-> increased refinancing risk

• Heavy concentration of maturing corporate bonds in early 2001 (W 65 tril. 13 % of GDP)

• Demise of merchant banks and shrinkage of ITC as the main investors

• Absence of active high-yield (junk bond) market• Perception of high credit risk -> almost 70 % of m

aturing corporate bond not renewable

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Quick underwriting scheme

• Primary CBO market to facilitate the revolving of the sub-investment grade bonds

• Let the KDB underwrite 80% of the maturing corporate bonds with sub-inv. grade

• WTO issue: no specificity => non-actionable subsidies

• Assistance strictly limited to economically viable companies: importance of solvency analysis by the main creditor bank

• Penalty rate (260 bp) to avoid moral hazard

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After the quick underwriting scheme

• Market sentiment improved-> Bond market ceased to be a systemic concern

• Liquidity pressure not likely• =>Absorptive capacity of the primary CBO

(W 6.0 tril.) large enough to deal with the maturing sub-investment grade bonds (W 5.3 tril.)

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Corporate vulnerability

• Profitability still constrained by large debt burden• Recessionary shock will lead to further strains • 29 % of manufacturing companies have an ICR of less t

han one• Chronically insolvent companies (ICR of less than one f

or three consecutive yrs): 4 % of Korean companies• Total liabilities issued: W 10 trillion, only 2.7 % of ban

king system’s asset• Do not pose a systemic threat to the rest of the economy

=> calls for acceleration of corporate restructuring

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Remaining challenges

• Orderly exit of the insolvent firms• Need insolvency reform to harmonize three

bankruptcy-related laws • Make the Constant Restructuring System work more

forcefully => Early privatization of the nationalized banks => Promote active M&A market; => Strengthen corporate governance; => More rigorous bank accounting standards;

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Table 1. Public Funds Injected (Nov.1997~Jun.2002)

Support type

SourcesRecapitalize

Loss

Cover

Deposit

Repay

Asset

Buy

NPL

DisposeTotal

Bond issuance 42.2 15.2 20.0 4.2 20.5 102.1

Recovered funds 3.9 1.2 6.0 4.4 16.7 32.2

Other fiscal resources 14.1 - 0.5 6.3 1.5 22.4

Total 60.2 16.4 26.5 14.9 38.7 156.7

Source : Ministry of Finance and Economy, Public Fund Management Committee(August 2002), White Paper on Public Fund Management

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Table 2. Estimate of Recollectable Fund (unit: tril.KRW)

Recollection (B)Spent (A) Recollection Ratio (B/A)

TotalSpent

156

Already recollected(’02.3) : 42

FiscalA/C

-Subordinate Debt value held by gov’t (100% recollectable) : 6.4-Book-value of equity-stake at Specialized banks : 10.3 (KDB, KEXIM, IBK)-Sub total : 16.7

-Sale of equity-stake : 13.1~18.4 -Bankrupt asset sales : 3.1~ 3.3-Sale of NPLS : 7.8~10.3

-Sub total : 28.0(24.0~32.0)

KDIC.

KAMCO

Recollectable in Future : 45(41~49)1)

Total Recollection : 87

Non Recollectable(A-B) : 69

26.1%+31.2%

26.9%

55.6%

+ +

1) Present discounted

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Table 3. Closures and Mergers of FIs (1997-2002)

Number of Institutions as of end of 1997(A)

RestructuredNewly

established

End of

Mar. 2002Exit Merger

Banks 33 5 9 1 20

Securities 36 6 2 16 44

Insurance 50 9 6 9 44

Others 1) 1,982 447 136 32 1,431

Total 2,101 467 153 58 1,539

Note: 1) Merchant Banks, Investment Trust Funds, Mutual Funds, Credit Unions, Lease companies, etc.

Sources : Financial Supervisory Service(FSS)

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Figure 3. Bank Restructuring flow

BIS Capital Ratio>8%13 Banks

SB/KFB

Rehabilitation PlanDiagnostic Review

Diagnostic Review

Rehabilitation Plan

Disapproved

Approved

Resolution

P&A

M&A

SoundBanks

Dispose NPLs

Recapitalize

Asset Assessment

Lead Manager

Bidding Privatize

BIS Capital Ratio<8%12 Problem Banks

PublicResources

Evaluation

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