Best Practices in Preventing and Monitoring Systemic Risk

Best Practices in Preventing and Monitoring Systemic Risk July 9, 2009 The Bank of Korea Ilhwan Kim

Introduction Ⅰ Business activities of non-bank financial institutions, and the policy authorities' measures in response. Ⅱ Some pointers and best practice Ⅲ Contents

Ⅰ. Introduction • Among the causes of the recent global financial crisis, we may single out the lax regulation of hedge funds and large unregulated non-bank financial institutions (hereafter 'NFIs'). • In Korea, only a few hedge funds have a domestic market presence and their way of doing business has had little influence on the financial market. • Things have not yet reached such a pitch as to give cause for concern. • Recently, the「Capital Market and Investment Services Act」came into effect. • It provided a platform for the introduction of hedge funds.

Ⅰ. Introduction • It put in place a legal foundation for setting ceilings on derivatives investment and borrowing of money. • We had experience of system risk arising owing to the relatively more relaxed regulatory regime applied to large NFIs. • Examine the systemic risk generated by the reckless way in which merchant banking corporations (hereafter 'MBCs') and credit card companies (hereafter 'CCCs') operated in Korea. • Look at the measures adopted bythe policy authorities in response. • Draw on it in order to consider best practices in preventing and monitoring systemic risk arising from large NFIs rather than hedge funds.

Ⅱ. Business activities of non-bank financial institutions, and the policy authorities' measures in response. 1. Merchant Banking Corporations • MBCs, as the highly-leveraged non-banking financial institutions in Korea before the 1997 currency crisis, had carried out businesses similar to those of banks. • MBCs' business : Discounting commercial paper, Medium and long-term lending, Leasing, Securities brokerage, International financing, and Factoring. • MBCs are believed to have triggered the currency crisis, due to the following factors; • Severe maturity mismatches

1. Merchant Banking Corporations • MBCs Borrowed short-term capital at high interest rates in the international financial markets, and used the funds to extend long-term credit or invest in illiquid bonds in emerging markets. • This resulted in severe maturity mismatches between their foreign currency liabilities and assets. • In these circumstances, MBCs had troubles in short-term foreign currency borrowing and roll-overs due to the worsening international financial market conditions. • Following defaults on EME bonds in which they had invested, they faced foreign currency liquidity shortages.

1. Merchant Banking Corporations • Expansion of their domestic business scopes into more risky areas. • Despite lacking credit rating and analysis abilities, MBCs had extended non-secured loans to corporations with low credit ratings, by discounting CP. • As a result, MBC asset soundness was much aggravated due to the defaults of such corporations from 1997. • As MBCs started to withdraw their loans from faltering firms in response, a vicious spiral of accelerating firm bankruptcies and increasing MBC weakness occurred.

1. Merchant Banking Corporations • The loosening of regulations also triggered the currency crisis in some sense, causing MBCs' deterioration. • Financial supervisory and regulatory frame not systemically established • Although the policy authorities had the right to regulate the MBCs, it had no infrastructure for supervision such as supervisory experts and organizations. • Their function in systemic and comprehensive coordination of MBCs supervision turned out to be weak.

1. Merchant Banking Corporations • Negligent MBC business activity regulation • For the purpose of easing regulation of financial institutions, the new market entry of MBCs was allowed without any setting of required principles. • To attract foreign capital, establishment of new MBCs and conversion of all the existing investment finance companies into MBCs were allowed. • The rapid increase in number of MBCs caused excessive competition and lowering of business quality. • The government ignored the MBCs' herd behavior, such as crowded establishment of overseas branches. • This led to reckless foreign currency borrowing, increased funding costs and unsound asset management.

1. Merchant Banking Corporations • Insufficient regulation • The capital adequacy regulatory system was underdeveloped. • Before the currency crisis, the government regulated MBCs by means of a naive financial gearing ratio standard. • MBCs conducted careless asset management without considering the related risks. • The regulations on MBC credit concentration were loosened. • The permitted ceiling on MBC credit to conglomerates was three times that for commercial banks. • Loans and leases made to 'dispersed ownership companies' were excluded from ceiling calculation.

1. Merchant Banking Corporations • Although MBCs' loans, mostly unsecured, should have been more strictly regulated than those of banks, they were relatively loosely regulated. • As a result, the troubles at MBCs worsened rapidly. • There were imbalances between the regulations on MBCs' short-term and their long-term foreign currency borrowings. • In cases of medium and long-term (over 1-year maturity) foreign currency borrowing, MBCs were required to declare the transactions to the government. • For transaction amounts more than 10 million US dollars, they had to notify the government beforehand. • Short-term (less than 1-year maturity) borrowings were not only unrestricted but also excluded from the application of ceiling on total short-term borrowings. • MBCs enormously expanded their short-term borrowings which were more risky.

1. Merchant Banking Corporations • Overseas securities investment was unregulated. • The ceiling on investment in local securities had been regulated. • However, investment in overseas securities, had been excluded from application of the ceiling. • Without making any provision for risk, MBCs had continued to borrow short-term foreign currency and invest it in emerging-market bonds. • There were characterized by high risk and low liquidity. • The policy authorities worked to overcome the financial turmoil through restructuring, such as forcing the market exits or M&As of bad MBCs. • Only two MBCs are currently in business in Korea and their scope of business reduced. • They are regulated in accordance with the same criteria as banks.

2. Credit card companies • After the 1997 currency crisis, the number of CCCs increased substantially. • The reasons were • the growth of retail financing thanks to the rapid domestic economic recovery and continuing low interest rate level, and • the belief that credit card market would achieve higher returns. • In particular, certain measures by the policy authorities', including a tax deduction, elimination of both the administrative ceiling on monthly cash advances and the leverage limit on credit card issuers, and application of relatively light capital adequacy ratio, contributed to a boom.

2. Credit card companies • From 1999 to 2002, the number of credit cards in use tripled, while the volume of total credit card transactions expanded sevenfold. • During the same period, the total assets of CCCs also rose more than fivefold. • These institutional support and financial deregulation resulted in the generation of a credit card bubble. • Fierce competition for market share between CCCs, caused by the easing of market entry regulations, led to a relaxation of lending standards and risk management. • The limited infrastructure for reporting and sharing of credit information led to insufficient evaluation and investigation of the credit conditions of card applicants.

2. Credit card companies • Credit cards were excessively issued even to households with low credit and they were given credit limits beyond their repayment capacities. • CCCs ignored the importance of risk management. On the contrary, they concentrated their efforts on high-risk, high-return areas of businesses including card loans and cash advances. • Herd behavior appeared in the credit market, as some CCCs focused on expansionary strategies and others followed the same strategy to avoid losing their market share.

2. Credit card companies • The credit card bubble burst in 2003, so the financial conditions of CCCs deteriorated dramatically. • The volume of delinquent card loans rose sharply due to the lowered debt-servicing capacity of households. • CCCs became more cautious in issuing new credit cards and making card loans, and carried out follow-up measures including calling in of loans to lower-rated borrowers, prohibition of balance transfers, and reductions of loan ceilings. • Household and credit company soundness deteriorated further with the soaring volume of delinquent loans and appearance of a credit crunch.

2. Credit card companies • To prevent the deterioration at CCCs from spreading to systemic risk, the policy authorities took the measures. • They upgraded credit card asset classification standards, strengthened loan loss provisioning requirements and began to apply Prompt Corrective Action measures. • They raised the minimum capital adequacy ratio for card issuers, from 7 percent to 8 percent. • They also banned aggressive street marketing practices and established a cap on cash advances of less than 50 percent of total CCC assets. • However, these measures did not calm market participants' unrest as expected, but led to a worsening credit crunch among CCCs.

2. Credit card companies • The policy authorities changed their tactics to more active intervention. • They provided a large volume of liquidity to support troubled CCCs and thus enhance financial market stability. • They pressured CCCs to undertake self-rescue efforts and to take some measures to improve their balance sheet conditions, including injections of capital by their majority shareholders. • They allowed CCCs to roll over their delinquent credit card loans by exercising de facto regulatory forbearance on ancillary business ratio regulations.

2. Credit card companies • They made the conditions necessary for exercising Prompt Corrective Action more realistic and helped CCCs repay or dispose of their delinquent loans. • To ease the liquidity crunch of CCCs and the money market distress, they also extended maturities of credit card receivables indefinitely. • The financial market returned to stability, on the back of expectations that the short-term liquidity problems of CCCs would be resolved.

Ⅲ. Some pointers and best practice • The irresponsible business models and ways of running operations of large unregulated NFIs may lead to systemic risk . • It can bring about heavy social costs in that the resulting financial market unrest can give rise to financial crisis or financial panic. • In the light of our experience related to systemic risk arising from large unregulated NFIs’ deterioration in Korea, the following best practices can be considered.

Ⅲ. Some pointers and best practice • Construction and operation of internal control systems based on risk management • It is very important to bring about recognition of risk management. To this end, NFIs’ routine construction of risk management systems should be encouraged and a regime put in place to confirm compliance at regular intervals. • What is more, a risk management department should be set up as an independent organization, and reporting systems put in place that constantly report back to top managers. • In addition, stress tests analysis should be undertaken to guard against overly optimistic expectations as to the future management environment.

Ⅲ. Some pointers and best practice • Strengthening of prudential supervision and regulation of NFIs’ soundness • A risk-based supervisory framework should also be introduced and brought into operation for the NFIs like that for the bank. • NFIs that have been in a comparatively relaxed prudential supervisory and regulatory regime, should in future be subject to the same level of supervision as banks. • Heightening the transparency of NFIs’ management information • The scope for disclosure of NFIs' management information should be expanded, and accounting standards revised on a systematic basis.

Ⅲ. Some pointers and best practice • The information should be promptly made available to market participants. • Moreover, the financial supervisory authorities should disclose within a certain range the findings concerning NFIs’ evaluated in the course of on-site examination. • Imposing liability on the majority shareholder of NFIs • In order to avoid moral hazard on the part of market participants, the majority shareholders should bear the liability for failed NFIs. • A system should be established whereby majority shareholders of NFIs make up a considerable part of management losses.

Ⅲ. Some pointers and best practice • The policy authorities' direct intervention in order to safeguard the financial system stability by acting as an orchestrator. • If NFIs failed, the policy authorities should swiftly divide them into those that are systemically important and those that are not. • In order to prevent contagion effects, support for a turnaround can be given to those paths of systemically important through the supply of liquidity whereas the remaining institutions should exit the market.

Thank you.

Best Practices in Preventing and Monitoring Systemic Risk