The paper discusses potential output, the output gap, and inflation in Korea. The paper explores the information content of potential leading indicators of inflation. A broadly balanced current account has been the suggested norm for Korea over the medium term. The challenge is to help build a more robust bond market that prices risk appropriately. The features of pension schemes in Korea and the problems they face are outlined. The paper reviews pension reform, banking sector, corporate sector, and foreign exchange crises with respect to Korea.


The paper discusses potential output, the output gap, and inflation in Korea. The paper explores the information content of potential leading indicators of inflation. A broadly balanced current account has been the suggested norm for Korea over the medium term. The challenge is to help build a more robust bond market that prices risk appropriately. The features of pension schemes in Korea and the problems they face are outlined. The paper reviews pension reform, banking sector, corporate sector, and foreign exchange crises with respect to Korea.

VI. The Profitability of the Banking Sector in Korea1

This chapter analyzes the profitability of Korean banks. Low interest margins and high provisioning costs due to low asset quality have resulted in poor performance. Despite an apparent increase in concentration, competition for market share remains fierce. There has been an effort to diversify portfolios and improve margins, and also contributed to improvements in risk management. Further consolidation in the sector through the merger of unsound banks with similar banking franchises is not likely to contribute to profitability unless significant reductions in overhead costs can be achieved.

A. Introduction

1. The banking sector in Korea has undergone a significant transformation since the financial crisis of 1997-1998. The changes have been most notable in relative market shares, ownership structure, financing sources, management, and attitudes toward risk. In the aftermath of the crisis the immediate reform efforts focused on an early restoration of the solvency of the financial system, and a correction of the major structural weaknesses revealed by the crisis. The resolution of troubled financial institutions has benefitted from significant improvements in prudential regulations and supervision, and overall governance. The restructuring of Korean banks entailed increased market concentration through closures and mergers, significant capital injections, one of the highest and fastest disposal rates of non-performing loans (NPL) in the region, and reductions in operational costs through retrenchment of branches and employees.2

2. Throughout this transformation, Korean banks, plagued with low profitability even before the crisis, remained relatively poor performers. In the 1992-96 period, the return on assets (ROA) of Korean commercial banks averaged around 0.4 percent, significantly below the OECD average. The onset of the crisis led to a considerable deterioration in profitability in 1997 (Tables VI.1 and VI.2). Despite the restructuring measures, weaknesses in the corporate sector, especially the unraveling of the Daewoo group in 1999, revealed the persistence of underlying vulnerabilities of the Korean banks that continue to affect their profitability adversely. Three years after the crisis, Korean banks in aggregate were still unable to remunerate their shareholders with a positive return on their equity.

Table VI.1.

Korea: Bank Profitability: Selected Countries

(as of end-1997, in percent)

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Sources: World Bank database on Financial Development and Structure: Beck, Demirguc-Kunt, and Levine (1999): Bank Profitability-OECD financial statement of banks (1999).Definitions:Net interest margin (NIM) = Net interest revenue/total assetsROA = Profit after tax/total assetsROE = Profit after tax/total capital
Table VI.2.

Korea: Bank Profitability in Asian countries Before and After the crisis

(In percent)

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Sources: FSC various Staff Reports, Selected lssues papers, and Fund staff estimates.

Data for 13 largest banks representing 78 percent of total bank liabilities, annualized for first half 2000.

Commercial banks.

End-1999, the numbers given correspond to the number of listed financial companies used in the calculation of ROA and ROE.

3. The Korean government launched a second stage restructuring process in June 2000 that focuses, among other things, on improving the profitability of the banking sector. These reforms include; (i) a further clean-up of bank balance sheets by a realistic application of the forward looking asset classification (FLC) and provisioning rules to workout companies and other restructured loans, (ii) additional capital injections into banks that are most affected by the recognition of these losses, and most recently (iii) an increased emphasis on encouraging consolidation in the sector through voluntary mergers and acquisitions, and also through the use of recently-allowed financial holding company structures. The government expects the consolidation in the sector to improve profitability through realization of scale economies. In the recapitalization process, the Korean government acquired control of a significant portion of banking sector assets and plans are underway to sell government holdings and recover the public funds injected into banks. The necessary precondition for reasonable recovery rates is a return to profitability by these banks.

4. A thorough understanding of the underlying reasons behind the low profitability of the Korean banks is of paramount importance to guide the policy choices that are being considered. This paper will attempt to analyze the structure of the banking system in Korea, how its profitability has evolved since 1997, where the weaknesses remain and how they can be addressed. Section B describes the structure of the financial sector in Korea and summarizes its evolution since the 1997 crisis. Section C reviews the capital structure and asset quality of commercial banks. Section D analyzes the determinants of commercial bank profitability with the use of profitability indicators and regression analysis, and discusses the implications of these findings in the light of the restructuring efforts being pursued. Section E outlines two merger case studies to provide evidence of the impact of mergers on the profitability of the banks involved. Section F summarizes and concludes.

B. Evolution of the Financial Sector Since the Crisis

The changing structure of the financial sector

5. Since 1997, the role of the banking sector in financial intermediation has increased significantly while that of the nonbank financial sector has declined (Box VI.1). After closures and mergers, the share of the banking sector (including trust accounts) in total financial sector assets has increased from 66 percent at the end-1996 to 71 percent at mid-2000 (Figure VI.1). The decline in the number of small saving institutions and other nonbank depository institutions has been the main driving force behind this change. These systemically insignificant institutions experienced the highest closure rates following the crisis losing more than 9 percent of their market share. The shrinking market share of smaller nonbank financial institutions (NBFI) benefited banks, investment trust and securities companies. Commercial banks experienced the largest gain of market share from this change. Their share in the financial sector increased by 4 percentage points although they experienced a significant decline in their trust business in the face of strengthening competition from investment trust companies (ITC) that specialize in comparable equity and stock investments, and as improved supervision diminished the attractiveness of bank trust accounts.

Types of Institutions

The Korean financial system includes three main types of institutions: commercial banks; the specialized and development (S&D) banks; and nonbank financial institutions (NBFIs).

Commercial banks

Commercial banks engage in traditional short-term financing of the corporate and the household sector. Since 1985 all commercial banks were also allowed to operate trust accounts which are maintained separately from their banking business, but managed as one entity. Although trust accounts were operated on client’s own accounts, for all practical purposes, they were treated like deposits.1 With the improvements in the regulatory framework, the management of trust accounts are now separated from the bank’s core business. The application of the CAR ratio to all guaranteed trusts eliminated any remaining incentives to offer trust accounts to customers and reduced their role to pure fiduciary services. Commercial banks can engage in very limited securities business and are not allowed to engage in insurance business on their balance sheets, but they are allowed to own securities and insurance companies. Most banks have also leasing and credit card operations.

As of October 2000, the commercial banking system comprised 11 nationwide commercial banks, 6 regional banks, and 44 foreign bank branches. National banks are licensed to establish branches and conduct banking business in Korea, whereas regional banks are restricted to smaller geographic areas in their branch networks and their business is oriented to regional small and medium size enterprises (SMEs). Foreign banks are largely engaged in wholesale banking.

Specialized and development banks

S&D banks were established in the 1950s and 1960s to provide funds to specific strategic sectors. With subsequent changes in the financial environment, however, they were allowed to expand their business into commercial banking areas, but their balance sheets retain a longer term maturity structure. For their funding they rely heavily on the issue of domestic and foreign debentures and borrowing from the government in addition to deposits from the public.

There are four specialized banks and two development banks in Korea and they are partly or wholly owned by the government. Specialized banks include the Industrial Bank of Korea, which finances small and medium enterprises; and three cooperatives that specialize in agricultural, livestock and fisheries loans. The two development banks are the Korea Development Bank that finances key strategic industries and the Export-Import Bank of Korea specializing in financial support to export and import industries, and overseas investment projects.

Nonbank financial institutions

Nonbank financial institutions can be broadly classified into nonbank depository institutions and other specialized institutions. Nonbank depository institutions consist of merchant banking corporations, securities investment trust companies, mutual savings and finance companies, credit co-operatives, and a postal savings bank. Merchant banking corporations can engage in almost all financial business except securities brokerage and insurance business. The securities investment trust companies (ITCs) invest capital raised from retail and institutional investors in stocks, bonds and short term hybrid money market funds. Mutual savings and finance companies specialize in loans for small enterprises and households. Credit institutions such as credit unions, mutual credit facilities, and community credit cooperatives focus on mutual deposit and lending operations between members. Postal savings bank handled by the post offices, is a public financial institution.

The nonbank financial sector also includes a wide variety of nondepository financial institutions and specialized finance companies. These include securities companies, insurance companies, the Korea Securities Finance Corporation, mutual funds, futures companies, money broker companies, investment advisory companies, asset-backed securitization companies, and corporate restructuring companies.

1 These accounts were not counted in the calculation of the CAR ratio, but most of them offered a guarantee on the principal and the yield and were covered by the blanket deposit guarantee until end-2000.
Figure VI.1.
Figure VI.1.

Korea: Financial Sector Developments, 1996 - June, 2000

(Share of Assets)

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A006

Source: Financial Supervisory Commission/Services.

6. The collapse of merchant banks has been a major reason for the growing importance of commercial banks in financial intermediation. Over the past three years, merchant banks have seen a steady erosion of their core lending business, which was exacerbated by the recent collapse of the Daewoo Group. Between 1997 and 2000, total loans of merchant banks fell by 90 percent and total deposits declined by over 80 percent.

7. Several factors contributed to the decline of the merchant banks. First, the high share of merchant banks prior to the 1997 crisis was mainly due to artificial incentives, including weak supervision relative to that exerted on banks. The strengthening of the regulatory framework reduced these incentives. Second, after the government allowed banks and securities companies to discount commercial paper (CP), commercial banks rapidly encroached on the merchant banks’ core business area. Third, and perhaps most importantly, a sharp increase in nonperforming loans related to the Daewoo Group and other workout companies led to the failure of the larger merchant banks and undermined investor confidence. As a result, merchant banks suffered steep losses following a mandated increase in loan loss reserves; further failures followed. Finally, in advance of the reduction in the coverage of deposit insurance from January 2001, merchant banks and smaller saving institutions suffered from a sharp rise in withdrawals of deposits by customers looking to place their money in commercial banks perceived as more secure institutions.

8. Within the banking sector, nationwide commercial banks gained market share both in the deposit and loan markets. Since 1997 four regional banks and nine foreign bank branches have been closed. In addition, consolidation in the banking sector and the downturn that affected small and medium sized enterprises disproportionately reduced the customer base for regional banks that specialize in this segment of the market. As a result the national commercial banks increased their market share both in deposit and loan markets (Table VI.3).

Table VI.3.

Korea: Market Share in the Banking Sector

(In percent)

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Source: BOK Monthly Bulletin.

Concentration and ownership in the commercial banking sector3

9. The restructuring process led to a significant consolidation in the Korean banking sector. At the end of 1997 there were 27 commercial banks in Korea. In the restructuring process, 5 banks have been closed and their businesses transferred, through purchase and assumption (P&A) transactions, to other banks. Two systemically important banks were nationalized soon after the crisis erupted. In four different sets of transactions, a total of 9 banks merged into 4 new banks, so reducing the number of commercial banks to 17 by the end of 1999 (Table VI.4).

Table VI.4.

Korea: Total Assets of Commercial Banks

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Source: FSC.

10. Mergers have been a key factor in the consolidation of the banking sector. Two of the mergers have involved relatively sound banks and were voluntary transactions. One of these involved two smaller-sized banks, Hana and Boram. The second involved Korea Long-Term Capital (KLTB)—a development bank—and Kookmin Bank, and created the largest bank in Korea. Two mergers were also undertaken to restructure unsound banks that had received conditional approval from the supervisory authority in the aftermath of the crisis. These transactions involved the purchase of NPLs of the merged banks by the government in exchange for equity ownership. The first was between Hanil Bank and Commercial Bank, creating Hanvit Bank, which became the second largest bank in Korea with 95 percent government ownership. The second involved the merger of three small banks with the fourth largest bank in Korea, Chohung Bank, resulting in 90 percent government ownership.

11. Concentration before the crisis was moderate, but increased considerably with the consolidation in the sector (Table VI.5).4 The Herfindahl-Hirshman index5 increased from 0.08 to 0.1, a 25 percent jump, due to the impact of the restructuring process on the number and the size distribution of banks (Figure VI.2). At the end of 1998 there were 10 small banks comprising 13 percent of the banking sector assets. Through mergers and P&As the number of smaller and medium sized banks in the sector has declined in favor of larger sized banks, although the lower end of the market still contains 7 banks accounting for 10 percent of banking sector assets. The merger of Hanil Bank and Commercial Bank, which generated the second largest bank in Korea, diffused the concentration of medium-sized banks in the market, reducing their share from 55 percent with 8 banks to 31 percent with 5 banks. As a result, the share of large size banks in total sector assets increased from 32 percent with 3 banks to 59 percent in 2000 with 5 banks. The C3 and C5 concentration ratios (defined as the share of the three or five largest banks) increased accordingly.

Table VI.5.

Korea: Concentration in the Korean Banking Sector 1/

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Sources: FSC and Fund staff calculations.

Includes only commercial banks.

Figure VI.2.
Figure VI.2.

Korea: Size Distribution of Banks

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A006

Sources: FSC and Fund staff calculations.

12. Despite the increase in size concentration, the market structure in Korea remains very competitive both in the loan and deposit markets. On the lending side, out of 11 national banks, 6 account for more than 70 percent of corporate lending with very similar market shares. Only two of the largest banks, Kookmin Bank and Housing and Commercial Bank have large market shares in retail and mortgage lending, but this is mostly due to historic reasons. These banks were established by the government in early 1960s with the purpose of providing credit to individuals and small and medium sized enterprises (SME), and for mortgage finance for low and medium income households. Both banks were privatized only in the mid-1990s and since then they have gradually diversified their portfolio, reducing their leadership in this segment of the market. This, along with the shift in the loan portfolio mix of other banks reduced the specialization in the loan market and has kept the level of competition high. For example, before the crisis the corporate lending market was dominated by six banks; now the ten largest banks are all seeking a broadly based corporate lending business, and most of them are also seeking to increase market share in the retail and consumer sector. On the deposit side, 6 banks account for 68 percent of total deposits but the market share of the three largest is significantly higher than before. Concerns over maintaining market share ahead of further consolidation in the sector have led banks to continue to compete for deposits in the face of declining good quality loan demand, keeping loan-deposit spreads low. In the months preceding the return to partial deposit insurance at the end of 2000, the larger banks saw a more rapid increase in their deposits as depositors shied away from ITCs and smaller NBFIs.

13. An international comparison suggests that the concentration in Korea is not high relative to other OECD countries. Although data deficiencies did not enable an up-to-date analysis for the commercial banking sector, the-three-bank concentration ratio for all deposit taking institutions in 1997 was low in Korea when compared to the OECD average and to other regional economies. Also, the number of bank branches per 1000 capita does not suggest that Korea is over banked relative to other OECD or Asian economies (Table VI.6).

Table VI.6.

Korea: Concentration in the Banking Sector: Selected Countries

(As of end-1997, in percent)

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Sources: World Bank database on Financial Development and Structure: Beck, Demirguc-Kunt, and Levine (1999), Bank Profitability-OECD Financial Statement of Banks (1999), and World Economic Outlook.

Includes thrift banks, rural banks, and small saving institutions.

Deposit Money Bank Assets to Total Financial Assets = total claims on nonfinancial sectors by deposit money banks as share of total claims on nonfinancial sectors by central bank, deposit money banks and other financial institutionsDeposit Money Bank Bank Assets to GDP = total claims on nonfinancial sectors by deposit money banks as share of GDP Concentration = share of the three largest banks’ assets as share of total banking assets

14. The restructuring process led to an increase in government ownership of commercial banks. Before the crisis, the Korean government had equity shares in three banks for historic reasons, accounting for less than 18 percent of total banking sector capital. The recapitalization of commercial banks with public funds, however, resulted in a significant increase in government ownership in the sector. As of mid-2000, the Korean government owned 58 percent of commercial bank capital. Despite this increase, the government has controlling shares in only 3 large corporate lending banks accounting for 24 percent of commercial banking sector assets and 9 percent of total financial sector assets. The second stage restructuring process is likely to increase government ownership in the sector somewhat, as the proposed measures include the recapitalization of three smaller banks that previously did not have significant government ownership.

15. The restructuring of banks has also entailed an increase in foreign ownership. Until 1999 individual foreign ownership in commercial banks was limited to 50 percent of equity capital. This restrictions and the heavy government interference in the banking sector, limited foreign ownership in Korean banks to small portfolio investments with no management involvement. In the aftermath of the crisis, banks being restructured were exempted from these restrictions. The sale of 51 percent of Korea First Bank—one of the two banks nationalized early in the crisis—to Newbridge Capital, at the end of 1999, led to the first majority foreign interest in a large Korean bank that comprises 10 percent of banking sector assets. In the restructuring of the Korea Exchange Bank, another bank with historic public sector ownership, Commerzbank converted its credit exposure to equity, acquiring a 30 percent equity stake, and began to participate in the management of the bank. The International Finance Corporation invested in Hana Bank and in KLTCB before the respective mergers of these banks.

16. Foreign investment contributed to the recapitalization of relatively more sound banks as well. In 1999, ING Group and Goldman Sachs acquired 10 percent and 17 percent of Housing and Commercial Bank and Kookmin Bank respectively. Shinhan Bank raised capital in foreign markets through the issue of global depository receipts. Combined with other noncontrolling shares, total foreign ownership at end-1999 stood at 22 percent of outstanding bank shares, representing 30 percent of total banking sector assets. Recently, the Korean government exempted banks from the ownership restrictions, subject to approval by the Financial Supervisory Commission (FSC) on prudential grounds when ownership increases above certain predetermined levels.

C. Financial Structure of Commercial Banks

Capital structure

17. The full implementation of the Basel capital requirements and the recapitalization process, have led to a significant change in the capital structure of commercial banks. The average capital of commercial banks after mergers, closures, and recapitalization was 10.8 percent of risk-weighted assets at mid-2000 (Table VI.7).6 The recapitalization of banks with public funds was implemented through cash injections, the exchange of government guaranteed bonds for equity, subscription for subordinated debt, and nonperforming asset purchases (Lindgren et al.,1999). Following the initial recapitalization drive by the government, viable commercial banks raised new capital, mostly through issuance of subordinated debt as equity financing proved difficult due to the sluggish profitability of the banks. As a result, the share of Tier 1 capital in total capital, declined from a system-wide 71 percent in 1997 to 62 percent in mid-2000.7

Table VI.7.

Korea: Microprudential Indicators of Commercial Banks

(In percent)

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Sources: FSC and Fund staff calculations.

FSC definition.

Old criteria.

FLC criteria.

Loans and discounts in won.

18. Despite the overall improvement in CAR ratios, the extension of FLC to workout companies and other restructured loans has revealed additional capital deficiencies. In 2000, three national and two regional banks reported CAR ratios below the mandated 8 percent. These banks represent 22 percent of banking sector assets. Following an evaluation of the self-rescue plans of these banks, the FSC announced that the banks were insolvent and introduced restructuring measures that include further injection of public funds and consolidation of the banks under a holding company, and subsequent operational restructuring.

Balance sheet structure and asset quality

19. There has been a shift in the asset composition of Korean banks following the crisis and the subsequent changes in prudential regulations. There is ample evidence in the literature that binding capital requirements affect the portfolio decisions of banks with implications for profitability. The implementation of the Basel capital adequacy requirements and better enforcement of supervisory regulations have been cited as likely triggers for significant shifts in asset composition of banks in the U.S., and elsewhere (Peek and Rosengreen (1995), and Shrieves and Dahl (1995)). In Korea, the recognition of large volumes of nonperforming loans and the consequent deterioration in capital adequacy ratios has been cited as one of the reasons for the decline in bank lending following the crisis (Ferri and Kang (1999), and Choi (2000)).

20. Faced with capital constraints as a result of large loan losses, banks have shifted their portfolio to less risky assets that carry lower regulatory risk-weighting. The Basel risk-weighted capital requirements were introduced before the crisis with a deadline for compliance at end-1997. As a result, most of the adjustment in asset compositions to reduce the capital charges had taken place prior to the crisis. Since 1997 there was an additional decline in the average risk-weight of bank assets. There were other significant shifts in the asset composition (Figures VI.3 and VI.4).

Figure VI.3.
Figure VI.3.

Korea: Asset and Liability Structures

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A006

Sources: FSC and Fund staff calculations.
Figure VI.4.
Figure VI.4.

Korea: Income and Expenditure Structure

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A006

Sources: FSC and staff calculations.
  • The share of non-earning assets in total assets declined by 12 percentage points to 10 percent since 1998, whereas the share of earning assets increased by a similar amount.

  • Within earning assets, the share of securities investment increased by five percentage points to 27 percent between 1998 and 2000. Within the investment portfolio, the share of government securities increased from 20 percent to 34 percent. The recapitalization of banks with public funds, and the acquisition of NPLs by the Korea Asset Management Corporation (KAMCO) contributed to the increase in government securities holdings.

Although the government guaranteed bonds acquired in these transactions were tradable, banks had ample incentive (in addition to the zero risk weighting for capital adequacy purposes) to hold on to their government securities portfolio as the decline in interest rates brought substantial gains.

  • The size and composition of the loan portfolio changed as well. The share of the loan portfolio in total assets increased by eight percentage points to 56 percent and its composition shifted away from foreign currency loans towards won loans. The decline in foreign currency lending was due to the increasing funding costs in the aftermath of the crisis as well as stricter supervision of foreign currency liquidity.

21. The main funding source of Korean banks, excluding trust accounts, is customer deposits. This trend has not changed since 1997. The introduction of blanket guarantees at end-1997 helped maintain a stable deposit base in the aftermath of the crisis, while the flow of funds from ITCs and smaller saving institutions to commercial banks following the Daewoo crisis in 1999 increased the attractiveness of bank deposits. The continued fall out in the merchant banking sector and the failure of several small mutual savings and finance companies (MSFC) before the return to a partial deposit insurance at end-2000, exacerbated the flow of deposits into commercial banks. The increase in deposit funding was larger for regional banks who are closer substitutes for traditional MSFC customers, especially outside of Seoul.

Nonperforming loans

22. The seemingly benign level of pre-crisis nonperforming loans was a reflection of the deficiency in prudential standards on asset quality. In particular, the classification and provisioning rules were based on the loan’s past servicing record, and on collateral availability, including third party guarantees, without much regard to the borrower’s future capacity to repay. Also, loans were considered nonperforming only if they were in arrears for six or more months, and the published figures for nonperforming loans included only the “doubtful” and “loss” categories, and not the much larger volume of “sub-standard” loans. In this lax regulatory environment, banks did not develop strong credit risk management systems and under-provisioning was common practice.

23. To address this deficiency, more stringent procedures for the valuation, classification, and provisioning of impaired assets have been introduced. In 1998 the definition of a nonperforming loan was changed to include all loans overdue by more than 90 days and all such claims were classified as “sub-standard” or lower. The provisioning rate for “precautionary” assets was increased from 1 percent to 2 percent. The practice of including specific provisions within Tier 2 capital was abolished, except for those in respect of “precautionary” and “normal” assets. As a result, provisioning for nonperforming loans increased in line with the growth of NPLs, and the strengthening of loan classification and provisioning standards.

24. The backward looking asset classification rules proved less than satisfactory in an underdeveloped lending culture. The banks lacked credit risk management and credit analysis skills; banks could avoid classifying loans to weak companies by simply expanding lending sufficiently to allow the borrower to service its debt. Lending decisions tended to be centralized in senior management, credit reviews were scarce, limits on banks’ risk concentration were loose. The improvements in the loan classification rules did not provide sufficient incentives to change this lending culture. The collapse of Daewoo group in 1999 provided a good example for the shortcomings of the system; prior to the collapse, most Daewoo debt was classified as normal or precautionary and severely under-provisioned.

25. In order to encourage reform and progress in lending practices the FSC introduced the so-called “forward-looking criteria” (FLC) to classify assets with effect from end-1999. Under the FLC, which require each bank to develop an individual loan grading system, to assess the capacity of borrowers based on expected cash flows with due regard to other risks, such as industrial, managerial, operational and financial risks. The introduction of the FLC led to a substantial increase in the amount of classified loans; NPLs more than doubled, reaching 12 percent of total loans by end-1999. However, this increase merely reflected the fact that the FLC have led to better identification and valuation of credit risk already on the books of the banks. While the new rules took effect from end-1999, the new approach will require considerable improvement in credit assessment by banks and new skills by examiners. Borrowers will also need to provide much more information, for example about their expected cash flows. Thus the full effect of the new arrangements will take several years to be fully reflected in asset valuations.

26. In line with the new classification standard, the FSC has modified the definition of nonperforming loans (NPLs) to include all loans overdue more than three months and “non-accrual” loans.8 This modified definition is strictly for a comparable presentation of system-wide NPL ratios. According to the FLC, a borrower who is not in arrears or bankruptcy may be classified as substandard by one bank while an identical borrower may receive a different rating from another bank. According to the previous definition, the NPLs were defined as loans classified as substandard, doubtful and estimated loss. Due to this change in definition, the data for 1998 are not comparable to 1999 and 2000 figures. To circumvent this problem the old definition has been used in all tables and regression analyses.

27. The extension of the FLC in 2000 to restructured loans increased required provisions of banks. In recognition of the linkages between corporate and financial restructuring, the FSC instructed banks to reclassify their restructured loans, including those to work-out companies, using the FLC so as to reflect not only the weaknesses that gave rise to the need for restructuring, but also doubts that remain about the ability of the borrower to repay.9 This is expected to expedite the exit of non-viable companies, lead to faster restructuring of viable companies and greater recognition of the true losses of corporate restructuring to the financial sector. The banks are to book these provisions no later than December 31, 2000.

D. Profitability in the Banking Sector

28. Despite a return to positive operational profits in 1999, the recognition of high NPLs continue to produce net losses (in aggregate) on a post-provision basis. Following the large losses at the vortex of the crisis, Korean banks reported profits before provisions in 1999 and the first half of 2000 mainly due to a large decline in operational expenses and other noninterest expenses. Despite this improvement, the net income of Korean banks after taxes and provisions remained negative in 1999 as required provisions doubled following the implementation of the FLC.10

29. Efforts to reduce NPLs, although necessary for an eventual return to profitability, are likely to erode profits in the near term. Both healthy banks and those still under restructuring are making a significant effort to reduce their NPLs through asset sales to KAMCO and other buyers and by the issuance of asset-backed securities (ABS).11 Although this would reduce the NPL overhang, the immediate impact on profits is likely to be negative. The sale of NPLs requires the recognition of the market value of the loans and involves the booking of credit losses to the extent that provisions are inadequate. Provisions may also be needed to cover potential losses on loans sold to KAMCO on a “with-recourse basis” (i.e. where banks have an obligation to repurchase loans from KAMCO under certain circumstances). Until now, banks’ balance sheets did not always reflect the potential losses that might arise on buying back loans from KAMCO. The extension of the FLC to restructured loans and additional failures in the corporate sector are also likely to contribute to increased loan losses and to require higher provisions. A return to profitability does not appear likely before the full effect of the FLC and corporate restructuring is accounted for the in the books of the banks.

30. Besides the NPL overhang, the underlying income and expenditure structure and the banking culture have also contributed to poor performance. Although, the pace of return to profitability after a financial crisis is largely a function of how fast the NPL overhang can be eliminated, other significant determinants of this process include a change in the banking culture to improve the income and expenditure structures of a banking sector that historically focused on growth of assets as opposed to profitability. An analysis of these factors in conjunction with various profitability indicators reveals continuing weaknesses in the profit structure of Korean banks, but also some positive changes that will take time to be reflected in bank profitability.

Profitability indicators

31. Korean banks recorded negative levels of ROA and ROE since the crisis, although a slight improvement has taken place since 1999. Decomposition of these profitability measures into their constituent parts reveals the main reasons behind this poor performance (Table VI.8).

Table VI.8.

Korea: Profitability Ratios

(In percent)

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Sources: FSC and Fund staff calculations.

Operating revenue / Total Assets

Total Assets/Equity

(Overhead + Provisions+ Taxes)/T, Assets

Adm in, Expenses/T. Assets

Provisions/Total Assets

Net Operating Income/Number of employees

32. The poor profit performance is mainly due to the low interest margins, and the high provisions necessitated by low asset quality. Although operating revenues of Korean banks almost tripled since 1997, mainly due to a reduction in losses and a significant cut in operating expenses, the drastic increase in provisions reduced net profit margins.

33. The low net interest margin on the loan portfolio is a reflection of deficiencies in pricing credit risk. In the past, directed policy lending on the basis of implicit government guarantees biased banks to favor growth of assets over profitability. Lacking incentives to develop risk management systems to price credit risk appropriately, banks favored large corporate loans backed with chaebol guarantees and collateral. The competition for large corporate customers kept ex ante loan yields low. In the aftermath of the crisis, corporate failures led to high non-accrual rates and reduced the effective ex post yield on the loan portfolio of banks that had large exposures to chaebol and other large borrowers.12

34. The net interest margin is also affected by related funding costs. This is driven by two factors; (i) stickiness in deposit rates due to high competition in deposit markets to retain market share, and (ii) the change in the composition of deposits and the associated pricing structure. Due to financial innovation, the share of demand deposits in bank deposits since 1980s has been on a declining trend for almost all developed countries, including Korea. An additional contribution to the increase in time deposits in Korea has been the declining yield differentials with ITC products, especially since funds in ITCs have been marked-to-market. In a period of declining market interest rates, the lagged price setting structure on time deposits has contributed to the low net interest margins since time deposits bear higher rates than demand deposits.

35. Despite a sharp reduction in operational expenses, financial intermediation expenses remain high mainly due to high provisioning costs. The reduction in operational expenses has been achieved through rationalization of personnel and branches (Table VI.9). Since 1997, 22 percent of bank branches has been closed and 35 percent of the workforce in the banking sector has been cut, reducing operating expenses by more than one third. Mergers contributed significantly to the decline in operational expenses, but most of the operational savings from these mergers have been realized only in 2000.13 A commonly used operational efficiency indicator-the ratio of operational costs to operational income—suggests a marked improvement in the efficiency of Korean banks since 1998. The employee productivity indicator seems to have stabilized at a high level as well. Despite these operational savings, the increase in provisioning costs, following the introduction of FLC, has kept financial intermediation expenses high, thus contributing significantly to the negative ROA performance.

Table VI.9.

Korea: Number of Branches and Staff, and Operational Expenses

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Sources: FSC and Fund staff calculations

36. The post-crisis data reveal the painful adjustment process in income and balance sheet structures of banks that is still in progress. The earning base of Korean banks has increased by more than 16 percent since 1998, while the earning spread declined by 57 percent. This suggests an inefficient intermediation function in borrowing and lending, considering the disproportionate decline in earning spread relative to the base. This appears to be related to a change in both the balance sheet and income structure of banks that led to an inefficient portfolio mix that is skewed towards income sources with lower profit margins.

37. The decline in trust business has been one of the main driving forces of the change in the income structure of banks. Until 1998, interest and noninterest income had similar shares in the revenues of the Korean banks. Fees generated by the trust business of the banks has been the main contributor to the high share of noninterest income in revenues, and more traditional sources of noninterest income such as commission and fees from banking services have been negligible. The assets in trust accounts accounted for 42 percent of the total assets in 1996, but by mid-2000 this ratio had dropped to 32 percent. Consistent with this decline, the share of trust fees in revenue dropped by 23 percentage points to 14 percent. By contrast, the portfolio share of loans increased by eight percentage points to 56 percent over the same period contributing to a 27 percent increase in the share of interest income in revenues. However, the changing structure of income sources is not commensurate with the margins in these operations. Between 1998 and mid-2000 the net interest margin declined significantly, while the noninterest margin more than doubled.

38. Notwithstanding these weaknesses, profitability indicators have improved somewhat since 1999 mainly due to a pick-up in the noninterest and the nonoperating margins. Banks have recently extended their efforts to increase their fee based income, including through diversification of their fee-based customer services and also by increasing merchant banking activities following the exit of several merchant banks. As a result, the share of commission and fee income in gross income has recorded a 2 percentage point increase since 1998. Although the full effect of this change is likely to take some time before its impact on the income structure and margins can be felt, it appears that the banks are increasingly appreciating this source of income as an important contributor to their profits. A cause for concern is the relatively high share of securities in the portfolio of banks that increased throughout 1990s and stabilized at 27 percent of their portfolio since the crisis. Although noninterest margins benefited from a positive contribution from securities gains in 1999, the high volatility of this source of income may erode noninterest income in the future.

39. The restructuring of the financial sector shook the management culture and is changing the business structure of banks with positive implications for future profitability. The government’s recent restructuring measures include the consolidation of unsound government-owned banks under a holding company, which will create larger bank franchises with significant market shares. These measures are providing incentives for private banks to follow suit with voluntary mergers. The expectation of further consolidation in the sector, along with the introduction of FLC, improved supervision and strengthened accounting and disclosure standards, has kept competition strong as banks attempt to retain their market shares. In this environment bank managements are placing an increasing emphasis on rationalizing their income structure to improve profitability.

40. Most banks now have a formal risk management system in place, although the entrenchment of these techniques into banking operations will take time. Further, there does not appear to be a significant differentiation in loan pricing yet. However, a visible shift is underway in the composition of the loan portfolio. Recently, the banks seem to have adopted a more retail oriented marketing strategy, increasing the share of loans to households, and to smaller customers. As a result, the share of loans to enterprises declined from 75 percent in 1996 to 60 percent in mid-2000, whereas over the same period loans to households increased from 19.5 percent to 26 percent (Table VI.10). If the relative credit risks are managed properly, this shift is likely to have a positive effect on profitability as margins in retail banking tend to be higher.

Table VI.10.

Korea: Composition of loan Portfolio

(As percent of total loans)

article image
Sources: FSC and fund staff calculations.

41. The substantial cut in branches and staff suggests that room for cost savings through further cuts may have been exhausted. Any additional contribution of cost cutting measures to net profits in the near term is not likely to be significant. Future improvement in profitability has to come from improved portfolio efficiency, by optimizing both net interest and net noninterest components of the portfolio in line with the yields they offer. Given the increasing share of loans in total assets, the improvement of lending margins will be critical in this respect. The increase in asset utilization ratios, derived from the ratio of operational revenues to assets suggests, a movement in the right direction in improving portfolio management policies in choosing the optimal yield and asset mix; a reflection of the changes discussed above.

Determinants of profitability

42. This section reports regression estimates for the determinants of profitability for commercial banks in Korea. The data is based on balance sheet and income statements of 17 commercial banks between 1998 and mid-2000. During this period there were significant changes in the regulatory environment and the financial structure of banks that are still in progress. These changes are likely to have reduced the ability of panel data in such a short span to pin down the underlying determinants of profitability. Due to these deficiencies the results of the regressions reported in this section should be considered as only indicative. Only pooled regression result are reported. As determinants of profitability the following variables were considered.

Equity capital/total assets (EQR):

43. The regression includes the equity ratio to capture the impact of leveraging on banking activity. Ceteris paribus, a bank with a higher equity ratio should have a higher return on assets and a lower return on equity, necessitating the use of equity ratio as a conditioning variable.

Ownership (OWN):

44. To capture differences in managerial efficiency under different ownership structures, the regression includes a dummy for government ownership. Although foreign ownership has also been cited as a significant determinant of profitability, a foreign ownership dummy has not been included as the data lack sufficient variation in this variable to identify its effect.14 In Korea, the increase in foreign ownership led to a management change in only one bank, Korea First Bank, which was acquired by a foreign investor, and which has signed a special agreement with government that includes put-back options of NPLs until end-2002. This agreement expedited the removal of NPLs from the balance sheet and might have contributed to an improvement in profitability. Although this is directly related to the sale of the bank, it is not really an indicator of foreign managerial efficiency. This single observation is insufficient to identify the effect of foreign ownership in the sample. Although the two largest banks in Korea have significant foreign participation, these are of a portfolio nature and the banks are operated under Korean management.

Loans/total assets (TLTA) and deposits/total assets (TDTA):

45. To capture the impact of portfolio shifts on profitability, TLTA and TDTA have been included in the regression analysis. Loans are the largest segment of interest earning assets with a direct impact on bank profitability. Assuming perfect competition in loan markets, loan prices will be market determined, leaving the quantity and type of loans as the choice variable for asset management. Deposits represent the largest source of funding for Korean banks with straightforward implications for profitability.

Nonperforming loans (NPLR):

46. Asset quality has a significant affect on net profit margins and hence profitability. As loans represent the highest portion of earning assets, the nonperforming loans ratio was included in the analysis as a proxy for asset quality.

Operational efficiency (OPEXBR):

47. The effect of operational efficiency on profitability is investigated by using operational expenses per branch as one of the independent variables. Branches and employee wages constitute the largest portion of noninterest expenses for Korean banks.

Since 1997, there has been significant retrenchment in branch networks and the number of employees due to mergers and restructuring. These improvements are expected to have made a positive contribution to profitability.

Tax management (TAT):

48. Although the tax rate on corporate profits is not a choice variable for banks, the differences in tax management may be an important factor affecting profitability. The ability of the bank management to allocate its portfolio to minimize its taxes can be captured by the ratio of taxes to before-tax profits. This ratio represents the effective tax rate faced by the bank.

Interest rate policy (CALL):

49. It has been proposed in the banking literature that the profitability of banks may be restricted during periods of rising interest rates. This is associated with concerns for the soundness of smaller banks, which are commonly thought to hold a large portion of their portfolios in longer term fixed-rate loans and thus face a considerable interest rate risk. According to this hypothesis, the higher the interest-paying liabilities relative to interest earning assets, the lower will be the net interest margin and hence the return on assets, when interest rates rise. This effect is accentuated if the interest spreads do not adjust following a rise in interest rates. The empirical evidence is mixed. Demirguc-Kunt and Huizinga (1999) present empirical evidence to the contrary suggesting a positive relationship between interest rates and profitability. Hanweck and Kilcollin (1984) report a positive relationship between interest rates and profitability for small banks, whereas for larger banks no significant effect is reported (Flannery, 1981). Hancock (1985) provides evidence for U.S. banks that interest rate increases tend to increase profits, irrespective of their effect on the spread.

50. To investigate the validity of this hypothesis in the case of Korea, the overnight call rate is included in the regression analysis. With the decline of interest rates following the crisis, the loan-deposit spread declined significantly. However, this does not take into account the effect of NPLs which reduce the effective spread on the loan side as the share of non-accrual loans increase as NPLs rise. In addition, the high level of competition in the deposit market led to the sluggish adjustment of deposit rates squeezing margins further. Hence the effect of interest rate decline may not have contributed significantly to profits.

Concentration and Market Share (CON and MS):

51. High market concentration has been identified as a factor that may affect bank profitability through price setting behavior and above normal profits (see Molyneaux, 1994, among others). This hypothesis posits a positive relationship between a proxy of market concentration (such as the three bank-concentration ratio) and the performance measure. Proponents of the efficient structure hypothesis, on the other hand, maintain that the observed high profitability in high concentration markets may be a reflection of the more efficient management that led to an increase in the market share. These two hypotheses can be tested by including both the three-bank concentration ratio and the market share of each bank in the analysis. If the coefficient of the concentration variable is positive and that of the market share variable is insignificant this would suggest that concentration in the sector is a determining factor of profitability.

Regression results

52. Regression results reveal the following tendencies (Table VI.11):

Table VI.11.

Korea: Regression Results

article image
Source: Fund staff calculations.
  • As expected, the share of NPLs, along with government ownership, operational and tax management efficiency, and capital asset ratio are statistically significant determinants of profitability.

  • The interest rate does not seem to exert a significant effect on the ROA.

  • The increasing concentration in the sector does not appear to have affected profitability.

  • After controlling for concentration, a higher market share has a positive effect on profitability, validating the efficient structure hypothesis. This is consistent with the circumstances in the Korean banking sector. First, the increase in concentration has been mainly due to mergers among unsound banks. These are the least profitable banks and they are not best suited to exert market power. Second, despite the increase in concentration, competition in the sector remained high as banks attempted to retain their market share before further consolidation in the sector. In this environment the banks that have managed to increase their market share are likely to be those that have better management practices with positive implications on their profitability. Hence, the increase in concentration did not contribute to profitability of the sector, and the positive relationship between market share and profits is a reflection of the more efficient structure of those banks that were able to increase their market share.

E. Can Mergers be a Solution for Low Profitability?

53. The second stage restructuring measures of the government have encouraged consolidation in the banking sector as a means of improving profitability. This premise assumes that there are economies of scale in the banking sector that can be realized with mergers that spread the overhead costs and provide better diversification. The literature provides mixed evidence for scale economies in U.S. banks, and the effects of consolidation on profitability in financial service companies.15 The regression results above also suggest that concentration in the sector did not have a significant effect on profitability. However, these results may be confounded by the effects of the crisis and the many regulatory changes that took effect over the same period.

54. Two merger cases are examined to shed light on the possible benefits that may emerge in future consolidations. In 1998 there were four mergers in Korea, of which two were not voluntary and were engineered by the government to restructure relatively unsound banks. To gain a better understanding of the effect of mergers, this section will focus on the involuntary merger of Commercial Bank and Hanil Bank and the voluntary merger between Hana Bank and Boram Bank.

55. The validity of several merger motives listed in the literature are discussed in light of the pre- and post-merger performance of the banks. These motives include the following:16

  • The acquirers may be motivated by the potential to diversify their funding sources and earnings. Those that rely on purchased funds may be especially interested in banks that have core deposit funding bases. Shareholders may also gain from diversification of the loan portfolio.

  • If merged banks share similar franchises and service similar markets, consolidation of these services, especially the branch network, would reduce overhead costs and may improve operating efficiency;

  • A third reason may be that acquirers perceive gains from an increased size and market share, and associated economies of scale.

  • Finally acquirers may have better management than the target bank and one reason for the merger may simply be to improve the target bank’s financial performance.

Hana-Boram merger

56. In the Hana-Boram merger, the target was the Boram Bank. In terms of size, Hana and Boram were the two smallest banks among national banks with market shares of 4 and 2 percent of total commercial banking sector assets, respectively. More recently, the enlarged Hana Bank accounted for 7½ percent of banking sector assets.

57. The balance sheet composition of both banks was very similar (Table VI.12). On the funding side, both banks relied on core deposits, but Boram Bank had a slightly higher share of purchased funds in its portfolio. The diversification of loan portfolio was similar, as well. Both banks allocated more than SO percent of their loan book to enterprises and the remainder to household loans (Figure VI.5).

Table VI.12.

Korea: Evolution of Asset and Income Structure in Hana-Boram Merger

article image
Source: FSC and staff estimates.
Figure VI.5.
Figure VI.5.

Korea: Loan Portfolios

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A006

Sources: FSC and Fund staff calculations

58. The balance sheet structure of the merged bank suggests that the increase in size was used as a means to increase diversification and market share. After the merger, Hana Bank expanded its loan portfolio significantly and reduced the share of nonearning assets in its portfolio, gaining market share in the loan market. In the process it reduced its exposure to corporate loans and increased the share of household loans in its portfolio. Compared with the trend in the industry, the loan portfolio shift of Hana Bank was more pronounced. As a result, the bank’s share in the household loan market increased by 3 percentage points in 2000 over the combined share of the two banks in 1998 (Table VI.13). The funding sources of the merged bank exhibited an increasing reliance on deposits and a decline in the share of noninterest bearing liabilities. This also led to an increased market share in the deposit market.

Table VI.13.

Korea: Evolution of market Share in Hana-Boram Merger

(As percent of total banking sector)

article image
Sources: FSC and Fund staff calculations.

59. Hana Bank’s desire to expand its branch network was achieved with the merger. The branch network of both banks were the smallest in the industry even when compared with most regional banks (Table VI.14). However, Hana bank was increasing its branch network aggressively in the two years prior to the merger. In this period Hana increased its number of branches by 75 percent and its staff by 28 percent. Both banks’ branch size (measured in terms of assets and staff per branch) was similar to the industry average, but Hana Bank had better operational efficiency in its branch network with lower overhead costs despite a larger branch size. After the merger, Hana bank extended its branch network and increased staff relative to the respective combined figures of the two banks in 1998. The average branch size in terms of total assets per branch increased by more than the two combined banks and the industry average. The overhead costs per staff also rose significantly in 1999 but this increase is not significantly above the increase in the combined statements of the two banks and possibly reflects the costs of the merger. In 2000 there was a 45 percent decline in overhead per staff, similar to the trend in the rest of the sector. This substantial cut in expenses did not come from further branch and staff reductions, and possibly reflects the gains from centralization of some operations, such as accounting, information technology, and account processing.

Table VI.14.

Korea: Evolution of Branch Network and Staff Expenditures in Merger Cases

article image
Sources: FSC and Fund staff calculations.

60. After the merger the bank’s profit performance deteriorated but it is still the second most profitable bank in the sector. Prior to the merger, Hana Bank outperformed most industry peers with positive profits and a high ROE and ROA (Table VI.15). In fact, Hana Bank was the most profitable bank among national banks. By contrast, among the banks that were deemed relatively sound based on their CAR ratios at the end of 1997, Boram Bank had the highest losses in the sector relative to its assets and equity. A formal analysis of scale economies that employs widely used concepts in the literature, such as ray scale and expansion scale economies could not be conducted due to lack of detailed data for the merged banks. However, a simple comparison of the operational expenses relative to net operating income before and after the merger suggests that scale economies were present in this case. This ratio declined by 29 percent in 1999 over the combined ratio of the merged banks in 1998. The relative efficiency of Hana Bank in reducing operational expenses despite the expansion of the branch network seems to be the main reason for this gain. The strikingly different performances of the two banks before the merger, and the relatively high profitability of the bank after the merger, also suggests that the acquiring Hana Bank saw the potential for realizing superior managerial efficiency through a merger with Boram Bank.

Table VI.15.

Korea: Evolution of Profitability Indicators in Hana-Boram Merger

(in percent)

article image
Sources: FSC and staff calculations.

Hanil-Commercial merger

61. The merger of Hanil Bank and Commercial Bank of Korea created Hanvit Bank, the second largest bank in Korea, with 14 percent of banking sector assets. Before the merger at end-July 1998, both Commercial Bank and Hanil Bank had sizable market shares, comprising 8 and 12 percent of total banking sector assets, respectively (Table VI.16).

Table VI.16.

Korea: Evolution of Market Share in Hanil-Commercial Merger

(As percent of total banking sector)

article image
Sources: FSC and Fund staff calculations.

62. The merger did not produce gains in portfolio diversification, nor in market share. The balance sheet composition of these banks was very similar, as in the case of the Hana-Boram merger. Both banks relied on core deposits in their funding, and half of their loan portfolio was allocated to corporate loans (Table VI.17, Figure VI.6). Hanvit Bank expanded its loans to enterprises and reduced the share of household loans in its portfolio.

Table VI.17.

Korea: Evolution of Asset and Income Structure in Hanil-Commercial Merger

article image
Sources: FSC and Fund staff calculations.
Figure VI.6.
Figure VI.6.

Korea: Loan Portfolios

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A006

Sources: FSC and Fund staff calculations.

63. The reduction in operational costs appears to be the main gain realized through this merger. The branch network of both banks were the second and third largest in the industry before the merger, with almost identical number of branches and staff. Their operational costs per staff were similar as well, and were 11 percent above the industry average. After the merger, Hanvit Bank reduced its branch network by 17 percent over the combined branch network of the two banks before the merger. However, the combined staff of the two banks was reduced by only 4 percent in 1999, reflecting operational difficulties in a merger process that take time to be resolved. Hanvit Bank managed to cut operational costs by 52 percent in 2000, as the number of branches and staff were reduced by an additional 5 and 2 percent, respectively. Despite these cuts, Hanvit Bank still has the largest branch network.

64. After the merger the Hanvit Bank recorded some improvement in operating profits, mainly due to the reduction in operating expenses and in noninterest losses. Before the merger, both banks recorded almost identical negative ROA and ROE figures in 1998 (Table VI.18). Like their industry peers, Hanil and Commercial suffered from low interest margins and high losses on their noninterest and nonoperating business. Following the merger, both profitability measures improved in 1999, as cost cutting measures raised the operating margins. The ratio of operational expenses to net operating income declined by 77 percent. Hanvit also benefited from a significant reduction in nonoperating costs. However, this turn around in nonoperating losses appears to be cosmetic, since the earlier losses in 1998 reflected the write-off of large loan losses before equity injections by the government in the merger process.

Table VI.18.

Korea: Evolution of Profitability Indicators in Commercial-Hanil Merger

(In percent)

article image
Sources: FSC and Fund staff calculations.

65. The analysis of two merger cases sheds light on the possible benefits that may emerge in future consolidations. In the Hana-Boram merger, which involved two relatively sound banks, the increase in market share and the associated diversification in the balance sheet appears to have been a key motive for the merger. The merged bank appears to have realized economies of scale by rationalizing its operations rather than its branch network and staff. The second merger case involved two government-owned banks that were under restructuring. These banks had similar asset compositions, branch networks, and similarly low profitability. The merger of these banks appears to have generated a significant reduction in overhead costs, mostly due to the rationalization of branch network and staff. However, profitability of the merged bank remains elusive.

F. Conclusions

66. The poor performance of Korean banks is mainly due to low interest margins, high losses on noninterest earning accounts, and high provisioning costs. Past reliance on chaebol guarantees and collateral, did not encourage banks to focus on pricing credit risk appropriately or to develop fee-based services to improve their noninterest income. With the crisis, the ex-post yields on loans declined as the rate of nonperforming loans increased thus squeezing interest margins. The strengthening of loan classification and provisioning standards revealed the deficiencies in asset quality leading to substantial increases in required provisions.

67. In an environment where the focus is shifting to profitability from asset growth, bank balance sheets in Korea are undergoing a process of rationalization. Banks are reducing non-earning assets and shifting their loan portfolio away from corporate lending toward household loans. Most banks now have a formal risk management system in place, although the impact of these techniques on profitability will take time to materialize. Despite these changes, interest margins have not yet improved. This is a reflection of deficiencies in pricing credit risk and the high share of nonperforming loans in the portfolio which reduces effective loan yields. Furthermore, heavy competition in the deposit market, and attempts to preserve market share before further consolidation in the sector, has tempered downward pressure on deposit rates and contributed to low interest margins.

68. A pooled regression analysis confirms the importance of asset quality in explaining the poor performance of Korean banks. The results also suggest that concentration in the market does not appear to be a determining factor in explaining the change in the return of assets. Increasing market share of banks, however, does explain the variation of returns across banks. Other significant determinants of bank profitability are operational expenses and tax management efficiency. The level of interest rates does not appear to exert a significant effect on return on assets in the short sample period specified.

69. The government is placing an increasing emphasis on consolidation in the sector to improve the profitability of Korean banks through realization of economies of scale. Although this study did not include elaborate techniques to estimate economies of scale in the sector, this policy emphasis may need to be reviewed based on available evidence. First, mergers tend to produce economies of scale when they involve banks that operate in different market niches. However, most commercial banks in Korea compete in the corporate loan market with similar market shares. Hence realization of scale economies through loan and funding diversification appears to be less likely, especially if it involves similar-sized banks. Given the similar branch networks of banks, the largest scale economies can be obtained by rationalization of branch networks and staff of merged banks, and centralization of some functions, such as accounting, information technology and account processing. The merger of two-government owned banks also demonstrates that mergers are not a sufficient condition for improved profitability if the underlying banks are unsound.


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This chapter was prepared by Meral Karasulu.


The discussion of the restructuring process is beyond the scope of this paper. For a detailed discussion of restructuring measures in Asian economies, including in Korea, see Lindgren et al., 1999, Baliño and Ubide, 1999, and SM/99/285).


Hereafter commercial banks and banks will be used interchangeably, unless specified otherwise.


These comparisons need to be interpreted with caution. Theory does not offer clear guidance for an appropriate indicator of market structure, nor for the optimal number and size distribution of banks. See Rhoades (1993) for a discussion of these issues, including the use of concentration ratio and other measures of concentration.


The HH index is a measure of market concentration given by H =Σisi2 where sf is the market share of the ith firm. The H-index takes into account both the number of firms in an industry and their size differences. The value of H will equal 1 when there is only a single firm in the industry and will tend towards 1 when there are fewer firms and/or greater degree of dispersion in market shares.


The capital ratio at end-1997 was reported to be 7 percent of risk-weighted-assets, but given the weak accounting standards and supervisory requirements, this overstated the true amount of capital in the banking system.


Under the Basel Capital Accord, Tier II capital can not exceed 100 percent of Tier I capital, and subordinated debt is limited to 50 percent of Tier I capital.


“Non-accrual” loans include (i) bankrupt loans, (ii) loans to borrowers whose capacity to repay have weakened, and (iii) nonperforming restructured loans.


Previously, banks had been required to classify restructured loans as precautionary or substandard and provisioned them in the 2-20 percent range.


Although net profits after taxes and provisions in mid-2000 are positive, they do not include all the additional provisions that will be booked at the end of the year due to the extension of the FLC to restructured loans.


As of end-September 2000, KAMCO had purchased loans from the banks with a face value of W 47 trillion at an average discount of 59 percent.


A decline in interest margins has been documented for other countries following a financial crisis (see Demirgüc-Kunt, et al., (2000)).


An estimated 20 percent of the decline in bank branches is accounted for by the mergers. The P&A transactions do not appear to have contributed significantly to the decline in branch and personnel numbers as all the closed banks had limited branch networks.


Among others, see Beck et al. (1999)


Among others, see Hunter and Wall (1989).

Republic of Korea: Selected Issues
Author: International Monetary Fund