Risk Exposure and Risk Management at Korea First Bank

1. Risk Exposure and Risk Management at Korea First Bank George Allayannis Darden Graduate School of Business, University of Virginia World Bank Conference Washington DC, May 2003

2. KFB’s Overall Performance • Assets have been declining over time from 46,115 to 33,498 (Ex. 1) • A large part of the decline in assets is due to the decline in loans from 20,208 (‘96) to 15,025 (‘98), as well as Customers Liabilities on Guarantees [4,475 (‘96) to 1,466 (‘98)] • Not surprisingly, Deposits are down from 26,910 (‘96) to 22,478 (‘98) • Retained Earnings have declined precipitously from 446,446 (‘96) to (1,914,597) (‘98)

3. KFB’s Overall Performance • Large decline in stock market price (see Figure 1); significant decline that cannot be explained by decline in Korean market (or the Korean Finance index) during the same period (see Figure 1 and 2) • Consolidated net loss increase from (39,511) in ‘96 to (2,731,029) in ‘98 (Ex. 2) • Interest expense went up from 2,718,878 in ‘96 to 3,158,489 in ‘98 • Other operating expenses shot up as well from 726,742 in ‘96 to 2,932,784 in ‘98 • Large decline in interest and dividends on securities for sale from 1,207,088 in ‘96 to 356,054 in ‘98

4. KFB’s Credit Risk (A) • KFB’s main exposure to business loans • In ‘98 KFB has a slightly more diversified loan portfolio (% of total loans in the top 5 industries down to 37.4% from 44.3% in 96) (Ex. 4) • In ‘98 KFB has a smaller percent of loans denominated in foreign currency than in ’97 (32.4% vs. 41.2%); FX loans could provide some diversification from Korean market, but at the same time, potential FX risk

5. KFB’s Credit Risk (B) • However, top industries of KFB’s loan portfolio highly correlated (e.g., correlation between chemicals and textile (construction) 0.95 (0.92); wholesale and construction: 0.97) (Ex. 5) (see also Figure 3) • Bad loans and non-performing loans as a percent of credits have increased significantly from 1.2% (6.7%) in 96 to 8.7% (20.4%) in 1998 (Ex. 6) • BIS capital ratio significantly higher than competitors (e.g., in ‘98 (1.27%) versus 7.92% for Hanvit Bank and 7.9% for Hana Bank)-NPL have shot up to 20.4%, way out of line with competitors [5.5% for Cho-Hung Bank and 0.7% for Summit Bankcorp (US)] (Ex. 8)

6. Relative Performance of Korean Industry Specific Stock Indices

7. KFB Credit Risk (C) • Hanbo Steel: large exposure to a chaebol; loaning large amounts to a chaebol risky; “Connections with industrial groups increased the likelihood of distress for East Asian financial institutions during the East Asian crisis (Claessens, Bongini, and Ferri, JFSR 2001) • Country rating decline during the Asian crisis by international agencies affected all Korean firms regardless of their individual performances (country-risk)

8. KFB’s Market Risk • KFB has reduced the % of corporate exposure to Korean market to 36.4% from 45.2% in ’96 (Ex. 9) • However, their equity investments still high (and volatile) from 1268.4 in ’96 to 868.9 in ’97 to 1366.2 in ’98. • As investment in foreign currency goes down over time, (from 802.9 to 683) there is slightly more vulnerability to Korean equity/bond markets • Of course, compared to US banks (with no equity investment) KFB has higher risk.

9. KFB’s Interest Rate Risk (A) • In ’97, 4rth stage of interest rate liberalization by Korean government (Fig 4); significant negative impact on the bank: interest rates on deposit adjusting upwards instantaneously, whereas interest rates on loans take a while to adjust • As a result of increasingly intensified competition among banks, interest on deposits increased causing downward pressure on average spreads • KFB significant mismatch between loans and deposits (58.3% vs. 73.1%)- a lot different than Hana Bank (60.9% vs. 61.7%). Hana Bank the best performer in the group (Ex. 8) • The one year accumulated gap between assets and liabilities in local currency was negative (1,971.6) bKW (Ex. 10)– and higher than in 1997 (1,707.7); significant risk in the event of rising interest rates

10. KFB’s Interest Rate Risk (B) • Mismatch in Interest rate earned from Foreign loans (6.7%) and interest paid in deposits (9.4%) in 1998. Significant exposure to FX/Interest rate risk (Ex. 11)

11. KFB’s Exchange Rate Risk (A) • Foreign loans in ’98 a lot smaller than ’97; foreign companies did not want much business with Korean banks during crisis (Ex. 11) • The percent of interest payout in foreign deposit dramatically hurt profitability of KFB [up to 9.4% from 5.2% in ’96]; as a result also spreads have gone down dramatically from 2.2% in ’96 to 0.2% in ’98 (Ex. 11). • Foreign loans are down to 5,529.3 [from 6,773.1 in ’97] but foreign deposits are up from 2,626.8 to 7,200 (Ex. 11); mismatch in foreign assets and liabilities (when the Korean won depreciates you want fewer deposits, more loans, as you now need more won to pay interest on deposits).

12. KFB’s Exchange Rate Risk (B) • Relative to competitors (Hanvit Bank and Cho-Hung Bank), KFB has similar percentages of foreign currency denominated assets to total assets (around 40%), but relative to Hana Bank, all of these banks have a lot higher foreign currency exposure. Hana Bank has the lowest percentage of foreign currency assets (13.6% in ’98)-and also has the highest average rate and spread out of the group [2.8% spread in ’98, compared to 2.2% for Cho-Hung, 1.7% for Hanvit Bank and 0.2% for KFB] (See Ex. 8)

13. KFB’s Liquidity Risk • Significant shortage of assets in short maturities. The gap is even larger (and more serious for the Bank’s operations) in the short-term currency accounts (1,914) billion Kwon (Ex. 13)

14. KFB’s Operational Risk • Transparency of loan issuance; past mishandling of loan process (see Hanbo) have put the bank into jeopardy. Does this belong in the past?

15. Which Risks Should Be Managed at KFB and Why? • Credit risk-major problem • Interest rate risk-significant • FX risk-another major devaluation in the future could be devastating • Liquidity risk • Market risk • Operational risk-market would not tolerate another scandal-but under KFB’s control

16. Credit risk measurement-KMV • V: Asset Value • σ: annual volatility of asset value • D: total obligation • t: time horizon

17. Credit Risk Measurement-KMV

18. Credit Risk Measurement-KMV

19. How Should Risks Be Managed? • Put new, efficient, transparent credit risk policies into place-ensure the diversification of the loan portfolio [for example loans to industries with low correlations such as insurance and transport equipment or machinery; medical and wholesale/financial]-(Ex. 5) • To improve the one-year negative gap, KFB should make efforts to increase short-term loans and expand its investment portfolios-use sophisticated profit/loss simulations to forecast impact of interest rate movements on bank spreads • Try to sell high-risk assets and engage government participation to improve liquidity problem-also set liquidity targets for each maturity level • Cut investment in high-risk securities – use VAR to evaluate and monitor market risk

20. What Should KFB do? • KFB should articulate a comprehensive Risk Management Strategy-Make it a Key Priority of CEO/Establish Position of Chief Risk Officer and give him/her decision making power • Strengthen controls; employ all risk management tools at its disposal; establish risk limits and obey them for each risk category • Allocate total risks among different departments (e.g. Funds and Securities, Int’l Banking, etc.) • Most critical for KFB to update the credit policies (built databases to better assess and quantify credit risk (KMV)), increase transparency in the loan issuance process (establish an independent Loan Committee) and convince regulators and the markets that new, efficient and transparent processes are in place. This process will also help improve asset quality problem (improve BIS ratio) • Monitor risks on a frequent basis; decide the frequency based on nature of risks (e.g., FX/market on a daily basis)-cut high risk equity investment

21. What Should KFB do? • Examine what Korean competitors do with respect to risk management-also comparable banks in the US/Japan

22. Role of Korean Government and International Regulators? • Oversee the step-by-step implementation of risk management policies • Strong measures against non-transparency • Remove the “implicit” guarantees-”too-Big to Fail”