This Selected Issues paper focuses on some of the key stylized facts of Korean business and export cycles over 1960–2001, and calculates a chronology for the classical cycle in these series by applying a variant of the Bry and Boschan (1971) cycle-doling algorithm. It highlights that the Korean classical business cycle and exports cycles are extremely asymmetric, as they exhibit long-lived expansions and much shorter-lived contractions. The results also indicate that the probability of ending a contraction or expansion phase in Korean industrial production and Korean real exports is independent of their duration.


This Selected Issues paper focuses on some of the key stylized facts of Korean business and export cycles over 1960–2001, and calculates a chronology for the classical cycle in these series by applying a variant of the Bry and Boschan (1971) cycle-doling algorithm. It highlights that the Korean classical business cycle and exports cycles are extremely asymmetric, as they exhibit long-lived expansions and much shorter-lived contractions. The results also indicate that the probability of ending a contraction or expansion phase in Korean industrial production and Korean real exports is independent of their duration.

VI. Bank Privatization In Korea: Developments and Strategies1

There has been only limited progress in privatizing banks that were nationalized in the aftermath of the 1997 financial crisis in Korea. With the gradual improvement in the health of nationalized banks and increased consolidation of the banking system, the government’s privatization efforts are moving into higher gear in 2002. For success, a clear strategy is needed to oversee and coordinate the privatization process for all institutions. This paper discusses the challenges of defining such a strategy, with emphasis on the trade-offs between multiple objectives of privatization, the constraints imposed by the existing condition of banks to be privatized, and the choice of privatization methods that could be adopted.

A. Introduction

1. The restructuring of the Korean financial sector has resulted in an significant increase in government ownership of banks. The conflicting role of the government as owner and supervisor of banks is stalling the pace of restructuring the corporate sector as it raises the risk that creditors do not make decisions based on their own commercial interests and inappropriately prop up failing companies. With the substantial headway made in recapitalizing and restructuring of the financial sector, the Korean authorities’ priorities are rightly shifting to the return of these institutions to the private sector. This process presents unique challenges and opportunities and will affect the future structure of the financial sector.

2. The paper is organized as follows: Section B describes the emerging structure of Korean banking sector and Section C summarizes the privatization efforts of the Korean government since 1999. Section D discusses the remaining challenges in privatization of government-owned banks, while Section E concludes.

B. Emerging Structure of Korean Banking Sector

3. Financial restructuring of the Korean banking sector resulted in a significant change in the ownership structure and concentration in the sector.2 Prior to the crisis, the presence of foreign capital in the sector was limited to small portfolio investments and government ownership was significant only for specialized and development banks. In the process of financial restructuring the government injected W 85 trillion into 14 commercial and three specialized policy banks, increasing its control in the sector from 33 percent of banking sector assets at end-1996 to 54 percent at end-2000 (Table VI.1). Foreign ownership also increased through debt/equity swaps, the sale of 51 percent of a nationalized bank, and common stock and GDR sales in capital markets. At end-2000, foreigners held 32 percent of commercial bank assets. Concentration in the sector has also increased through the purchase and assumption of assets and liabilities of closed banks, forced mergers by the government in intervened banks, and voluntary mergers that followed government’s pronounced preference for larger banks in the sector.

Table VI.1.

Korea: Change in Ownership in the Banking Sector 1/

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The subtotals for government ownership are calculated as the sum of products. of individual shareholdings and total assets.

Includes shares in Commercial and Hanil banks that merged to become Hanvit Bank in 1997.

Includes shares in Boram bank previous to its merger into Hana Bank.

Through cross-ownership in other other banks.

Kookmin and KHCB merged on November 1, 2001 diluting the shares of the government in the New Kookmin bank to 9.64 and increasing that of the foreigners to 70 percent.

4. Financial sector consolidation has gained momentum in 2001 following the example set by the government. The government established Woori Financial Holding Company (FHC)—which comprises Hanvit, Peace, Kyongnam and Kwangju banks, and a merchant bank, all state-owned—in April, 2001. This was followed by the voluntary merger of two privately owned banks—Kookmin and Housing and Commercial Bank—creating the largest bank in Korea in November 2001. Shinhan Bank followed suit by launching its own FHC at end- 2001 and assuming management responsibility of another nationalized small bank with a strategic regional network. As a result of these developments concentration in the sector increased significantly (Table VI.2).

Table VI.2.

Korea: Concentration in Commercial Banking

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Sources: FSS and staff calculations.

Includes Woori FHC as one bank and New Kookmin.

5. The consolidation trend is likely to continue in 2002 with the government as a precursor to the government’s privatization strategy. The government, in an agreement with the labor unions, had postponed possible mergers under the Woori FHC until 2002, which also delineates the self-imposed deadline to begin the privatization of government-owned banks. Under political pressure to maximize the recovery of injected public funds, the merger of the smaller banks under Woori FHC into Hanvit bank may emerge as a means to increase the market value of the merged bank. In addition, Seoul and Chohung banks, and Korea Exchange Bank (KEB) have recently indicated interest in several merger combinations involving these three banks.

6. In this transformation process, a two-tier banking structure is starting to emerge that can be broadly differentiated along the lines of ownership, scale, and profitability. Out of the remaining 16 commercial banks, seven are under the ownership of dispersed private owners, while the remaining nine banks are either majority government owned or co-owned by the government and private owners (Figure VI. 1). Among national commercial banks, this two-tier structure is even more pronounced with only four banks (Kookmin, Shinhan, Hana, and Koram) under dispersed private ownership, while four banks (Hanvit, Chohung, Seoul and Peace) remain under full government control, and the remaining two (KEB and Korea First Bank (KFB)) are jointly owned by the government and foreign private owners. In terms of scale, the two large banks that emerged after the establishment of Woori and the merger of Kookmin/HCB dominate the market with a combined market share of about 50 percent both in deposit and loans, while the second-tier banks lag the two market leaders by a considerable margin in terms of scale. Profitability differences provide yet another dimension along which commercial banks are divided into a two-tier structure. Among the four privately held national commercial banks, only Koram Bank has reported negative return on equity (ROE) in 2001Q1, whereas all banks under majority government-ownership registered a negative ROE, although significant performance differences prevail within this group.

Figure VI.1.
Figure VI.1.

Korea: Two-Tier Structure in Commercial Banking

(end-March, 2001)

Citation: IMF Staff Country Reports 2002, 020; 10.5089/9781451822069.002.A006

7. Another byproduct of the financial restructuring process has been the increasing importance of government-owned specialized banks in financial intermediation. Since their establishment in the 1960s the role of specialized banks was limited to providing funds to sectors that were given priority in Korea’s successive development plans and complement commercial banks in areas where they could not supply enough funds due to limitations in funding, profitability and expertise.3 With subsequent changes in the financial environment, however, the specialized banks were allowed to expand their business into commercial banking areas, including lucrative consumer banking and credit card operations, although their balance sheets still maintain a structure consistent with their establishment goals. For their funding they rely heavily on public funds and the issue of domestic and foreign debentures, but they compete with commercial banks for deposits. In the recovery process from the crisis they became instrumental in successfully avoiding a liquidity crunch in the corporate bond market and providing credit to small and medium enterprises, which otherwise would have been priced out of the market due to the inexperience of commercial banks and other financial intermediaries in pricing and accepting risk in an environment of high uncertainty. Notwithstanding their success in these areas, their encroachment into commercial banking with the backing of public funds and under the full ownership of government creates an uneven playing field in the otherwise competitive commercial banking sector.

C. Privatization Efforts in 1999–2001

8. Mindful of the inefficiencies generated by the dominance of the government in the banking sector, the Korean authorities have committed to return government-owned banks to private ownership. This commitment was present starting in the immediate aftermath of the crisis. The government offered Seoul Bank and KFB, the first two banks nationalized in the aftermath of the crisis, for sale in 1999. A majority stake of KFB was sold to Newbridge Capital in 1999, but attempts to sell Seoul Bank to strategic investors proved to be unsuccessful, prompting additional restructuring measures4. These measures included a management agreement with Deutsche Bank, which was hoped to end in an eventual equity partnership, and additional capital injections to reduce the overhang of impaired assets. At end 2001, new potential buyers, including some domestic industrial groups, have entered into negotiations to buy Seoul bank.

9. Following these initial attempts, the Korean government announced in mid-2000 its plans to sell commercial bank shares acquired since the crisis. The plan included (i) a redemption schedule of preferred shares in five banks that received funds in return for their P&A of five closed banks; and (ii) a flexible approach for the sale of common stock in five intervened banks (Hanvit, Seoul, Chohung, KFB, and KEB) that was conditional on the return of these banks to profitability, a thorough clean-up of their balance sheets, and market conditions. When the plan was announced it was hoped that these preconditions could be met in early 2002. The redemption of preferred shares have been continuing according to schedule, and it is excepted that all shares will be redeemed before the 2004 deadline. The government expects to recover W 1.3 trillion from this operation.

10. Additional capital deficiencies that emerged after the Daewoo crisis stalled privatization efforts. The fallout from Daewoo crisis and other work-out cases revealed additional capital deficiencies in the banking sector, concentrated mostly in banks that had already received public funds and some smaller private banks. As a result, the government nationalized Hanvit Bank and four smaller banks and provided additional capital injections to reduce impaired assets at these banks.

11. With the approach of their target date to begin privatization, the government issued so-called OPERA bonds for Woori FHC and Chohung Bank to stress its commitment to privatization.5 Despite their complex structure, the four-year OPERA bonds issued by the KDIC in December 2001 are in essence bonds that may become exchangeable into common shares of either institution if the government succeeds in meeting a free float condition by 2004 (see Section D). The issuance of the bonds does not achieve an immediate change in ownership, and is likely to result in increased private ownership in only one bank. Nevertheless, it provides incentives to the government to increase private ownership in order to meet the float requirement.

12. A specific privatization strategy for KEB and KFB has not been identified yet. These banks have been capitalized jointly by the government and foreign strategic partners in the aftermath of the crisis. A privatization strategy of government’s stake in these banks will have to take into account the foreign partner’s business strategies and may require a joint decision with the respective foreign partners for the privatization method. The presence of a capital fund as the strategic partner in KFB instead of a banking group, as in KEB, may provide more options for the sale of government’s shares in this bank.

D. Remaining Challenges in Bank Privatization

13. Past experience in privatization of state-owned banks highlight the challenges confronting the Korean government. These challenges can be broadly described in terms of a constrained optimization problem that includes: (i) a multiplicity of objectives; (ii) the constraints imposed by the existing condition of the banks to be privatized and the overall economic and political conditions; and (iii) the choice of privatization methods that can address the objectives within the unique political and economic context of the country. Accordingly, three well-defined stages in a privatization process can be outlined: (i) a mechanism for strategic choices; (ii) preparation of the state-controlled banks for privatization; and (iii) the mechanics of disposal. This section discusses these challenges within the Korean context and assesses the recent privatization efforts of the government.

Multiplicity of Objectives

14. Most privatization programs are identified with explicit or implicit multiple objectives that can potentially be in conflict with each other; a mechanism for strategic choices is needed to address these conflicts. The plethora of objectives includes revenue generation for the state, capitalization of banks, improvement of corporate governance and transparency, development of capital markets, improvement of managerial and technical know-how, and economic efficiency and competition.6 The potential trade-off between these different objectives necessitates an overall privatization strategy that defines the relative priority attached to each objective and a decision-making mechanism that will identify the feasible options and make the strategic choices, while remaining accountable to elected representatives of the taxpayer within the context of defined goals. The “success” of a privatization program can only be defined with respect to clearly defined policy objectives and without them it is likely to remain a politically contested issue.

15. The extensive public focus on revenue generation in Korean privatization efforts may have overshadowed other important objectives. As in other systemic crisis episodes, the restructuring of banks involved significant injections of public funds to ailing institutions (Box VI.1). The strong tradition of fiscal prudence and the political cycle are dictating a fast and substantial recovery of public funds, to which the Korean government responded with deadlines to return government-owned financial institutions to private ownership. However, the focus on revenue generation has created public expectations that would be hard to fulfill under the existing condition of the institutions that are targeted for privatization. Although the recovery of public funds should remain an objective in the privatization process, management of expectations is equally important to deter a public perception of fire-sales.

Use of Public Funds and Recovery Prospects

Substantial public funds have been used to facilitate financial sector restructuring. As of end September 2001, gross of recoveries, a total of W 148.3 trillion (27½ percent of 2001 GDP) has been spent, out of which 60 percent was used for the banking sector. Two government agencies conduct most of the injection of public funds. KAMCO is responsible for the purchase of impaired assets whereas KDIC is charged with recapitalization of financial institutions, loss coverage and depositor protection. As a result of its function, KDIC become the largest single owner of commercial bank equity in the sector.

Of the total injections, 25 percent has been recovered as of end-September 2001. KAMCO and KDIC had widely different recovery rates reflecting the differences in their methods of public funds injections; KAMCO has recovered 63 percent of total funds it has injected, through various methods of disposing impaired asset it has purchased from financial institutions1, whereas KDIC recoveries amounted to only 14 percent of total funds it has injected, mostly through dividends recovered in the liquidation process.

The recovery prospects of KAMCO and KDIC may shift significantly with the decline in asset value in KAMCO’s portfolio and the start of the privatization process. Although KAMCO succeeded in rapid recovery of public funds so far, its remaining portfolio includes loans, including those of Daewoo that are more difficult to dispose with lucrative returns. KDIC, on the other hand, has an improving prospect to recover funds through the sale of its equity stakes in financial institutions.

Korea: Use and Recovery of Injected Public Funds

(end-September 2001, in trillion W)

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Expectations of high recovery rates of pubic funds injected into the banking sector may be overstated. Out of the W 85 trillion injected into banking system, only W 34 trillion was spent to acquire equity and W 14 trillion was used for capital contributions. A large portion of these capital contributions may not be recovered in full, since they were used (i) to increase the capital of banks that acquired the five closed banks, in return for small preferred shares redeemable at par value; (ii) post-sale settlement of Korea First Bank and (iii) to recapitalize nationalized banks whose capital had to be written down due to past losses. Although bank stock prices have outperformed the market in 2001, a full recovery of funds injected into the banks may necessitate even higher price-to-book value ratios than those observed so far.

1 For a summary of asset disposal methods used by KAMCO see Chopra et al (2001).

16. Equally relevant goals for the Korean banking sector are the improvement of corporate governance and transparency, development of managerial know-how, and maintaining efficiency and competition. Although the restructuring process led to a paradigm shift in the banking sector with stronger prudential regulations that also stress transparency and corporate governance, and a management culture that increasingly focuses on shareholder value rather than asset growth, much remains to be done. Privatization, depending on the choice of divestment method, could be a driving force in entrenching this emerging management culture. Despite the sharp increase in concentration, no clear signs of lack of competition have emerged in the sector. This is perhaps attributable to the leading role of the government in the consolidation process. If anything, there is increasing competition in the new growth areas, such as retail banking and credit cards, in an attempt to reduce exposure to large business groups and improve profitability. However, the privatization of large banks in a concentrated market may have significant implications for competition, economic efficiency, and future stability of the system. Although anti-trust policies should be the main policy tool to maintain a competitive market, the privatization method adopted may also be conducive to balancing the concentrated market structure with a dispersed ownership structure to mitigate risks of financial monopolies by a handful of owners.

17. Korea took steps to centralize the decision making process for the use of public funds; a similar mechanism is needed in the privatization process to balance these goals and the available privatization options. The efforts to privatize some banks and other NBFIs have been somewhat isolated efforts without a sufficiently clear strategy. With significant amounts at stake during the privatization process and the need to balance the above-mentioned objectives, a decision making mechanism is needed to establish a privatization program to oversee the sale of all state-owned financial institutions in a transparent manner, and take strategic decisions on timing and method of privatization consistent with established goals of the program. An example of such a decision making process has been successfully used by the Korean authorities in the use of public funds. The Public Funds Management Committee (PEMC) established under the Ministry of Finance and Economics (MOFE) consists of government officials, academics and private sector participants and oversees the injection of public funds into the financial sector under clearly established guidelines for conduct and transparency. One possibility, therefore, would be to extend the PFMC’s responsibilities to include decision making and oversight for the privatization process.

Preparation of Banks for Privatization

18. The preparation of state-owned banks for privatization is dictated by the financial conditions of the banks. Political and economic constraints, however, may turn this necessary step into a costly and drawn-out process. Most restructuring efforts include a combination of a clean-up of banks’ asset portfolios, recapitalization, and cuts in operational costs. These measures are necessitated by the accumulated losses and the lack of profitability at these banks and usually justified as necessary steps to return them to private owners. However, the constraints—such as labor’s resistance to some restructuring measures and privatization, the lack of political consensus on privatization or its timing and method, and the cyclical or structural weaknesses in demand by potential buyers—imposed by the overall economic and political conditions may also lead to misguided and costly pre-privatization restructuring, delays in privatization, and ultimately a reduction in the recovery rate of injected public funds.

19. In Korea’s case, despite significant restructuring of government-owned banks, delays in corporate restructuring have led to concerns about the quality of banks’ asset portfolios. All banks that were recapitalized by public funds implemented deep operational cuts that included labor shedding and branch closures and significantly reduced their impaired assets, first by direct sales to KAMCO and more recently by securitization of impaired assets. Despite these efforts, most of these banks recorded negative ROEs as of March 2001, although their performance has been on an upward trend since 2000. Also, their significant exposure to large work-out companies, whose restructuring has been delayed, and possible large gaps in classification and provisioning of these exposures by privately-owned- and government-owned banks are raising concerns about the true valuation of government-owned banks and adversely affecting market sentiment. Continued efforts to strengthen the balance sheets of government-owned banks, especially Chohung and Woori FHC, are therefore an essential prelude to privatization.

20. Consolidation of state-owned banks cannot address these underlying weaknesses and may prove counterproductive in the privatization process. The government’s decision to consolidate Hanvit and three smaller banks under the Woori FHC may be a useful instrument of financial sector policy that favors large banks, but the concentration trend set into motion by Woori may also increase moral hazard in the system by creating banks that are considered to be too big to fail after privatization. In addition, sale of larger banks with questionable asset quality may require costly concessions to potential buyers to limit their downside risks. The restructuring measures enforced at Woori banks are also likely to entail additional costs without clear benefits for increasing the recovery rate of injected public funds. For instance, Woori banks are in the process of consolidating different business lines of the group banks to benefit from economies of scale. Functional merger of activities may be helpful in reducing costs further, but the main concern about the asset quality of Hanvit Bank arising from its exposure to the corporate sector will remain the dominant issue in the privatization of the Woori FHC. Further, most government-owned banks, including Woori banks, engaged in costly overhauls of their image, including establishing new brand names and new business strategies. Although useful in laying the groundwork for a more profitable business, these measures may also reduce the base of potential suitors by pre-committing the banks to a certain business strategy that would be costly to redesign.

Methods of Privatization

21. The increasing sophistication of financial products provides several options for the sale of state-banks, but not all of them may be feasible for the objectives of privatization (Box VI.2). In addition to the trade-offs they pose for the attainment of various privatization goals, the feasibility of some disposal methods may be restricted by global macroeconomic conditions, the depth of domestic capital markets, and other regulatory restrictions.

Privatization Methods

Public Share Offerings

There are three methods that have been utilized in public share offerings: Initial Public Offering (IPO), seasoned equity offerings (SEO), and private placements. In most privatization cases, the disposal involves a process that combines different issue types at different points in time depending on the depth and the performance of the stock market and the overall macroeconomic conditions.

This method can provide new capital to the privatized institutions or revenue for governments and contribute to the development of capital markets through dispersion of equity ownership. It may also help improve transparency, since stock exchange listings require strict disclosure measures. However, this method does not necessarily provide new managerial expertise and improve management accountability. Unless supported by strong corporate governance measures and rights for minority shareholders, agency problems between managers and dispersed owners may create incentives for excessive risk taking behavior by managers. These risks can be mitigated if there is a strong institutional investor base able to oversee the management and impose market discipline.

Sale to Strategic Investors

Sale to strategic investors can be accomplished either by trade sales through one-to-one negotiations or by tender auctions. Although their implications for attaining the goals of improved corporate governance, competition and profitability are similar, these methods may produce significantly different outcomes for revenue generation. Trade sales are more likely to include special provisions, such as option clauses designed to limit the downside risks to the investor.

Sale to strategic investors may provide gains in managerial and technical know-how, profitability, and improved corporate governance, because the sought-after strategic investor in most cases has sufficient experience and stature in running a bank and must have a convincing business strategy to improve the bank. However, for most emerging economies, this description often implies foreign strategic partners due to the absence of such managerial know-how domestically and may be shunned due to a national bias for domestic ownership.

However, securing the interest of a strategic investor is not always easy. Both domestic and international market conditions are critical for the success of privatization through this method. The financial health of the bank, its market share in the sector, the potential for growth of the sector and the bank are significant factors in attracting strategic investors. For foreign investors the ease of conducting business in the country, including the quality of the legal and supervisory frameworks in providing a well-supervised but business friendly and rule based environment, level of development of capital markets and openness of the capital account, the global consolidation trends in the banking sector may also play a role.

Hybrid Methods

Hybrid methods include a combination of the above methods for the sale of common stock or other forms of securities convertible to common stock (e.g., convertible bonds, and bonds with warrants). Although they can be useful to fine tune the offer to market conditions to optimize revenue generation, these methods may also dilute the advantages of pure methods of disposal they include. If convertible securities dominate the offer the transfer of ownership may be delayed postponing any gains in profitability, improved corporate governance and managerial know-how that may come with new owners. In addition, the valuation of different securities in the hybrid method may create transparency and marketing problems along with potential conflicts among targeted investor groups.

22. The global downturn in 2001 and 2002 and the lack of a strong institutional investor base domestically are significant constraints on the Korean authorities’ choice of disposal method. With the global downturn, expansion plans of major international players in the financial sector are likely to be postponed to focus instead on managing their existing risks in order to maintain profitability and shareholder value. This limits the possibilities for direct sale of banks to foreign strategic investors, who would be less eager to take over Korean banks that still retain under-provisioned exposures to work-out companies. Further, the continuing weaknesses in the insurance and ITC sectors limit the capacity of these sectors to provide institutional capital for privatization, leaving public share offerings as the other viable alternative.

23. Although these constraints point to public share offering as a viable privatization method, the Korean government, instead, opted for a strategy that buys time to overcome some of the constraints. The Korean stock market has sufficient liquidity and depth to absorb well-planned share offerings of government-owned banks. However, the concerns about the asset quality of banks and the stock market valuations that are likely to fall below expectations of the recovery of public funds made this option unattractive in the pre-election environment. In addition, the perception that the lack of strong ownership in the banking sector contributed to its malaise created a bias for either strategic or institutional investors to create a concentrated ownership structure. As a result, the Korean government chose a complex hybrid method to prepare for the privatization of Woori FHC and Chohung Bank while maintaining its approach of negotiating with strategic investors for direct sale or merger of the remaining banks.

24. The issuance of the so-called OPERA bonds that may become exchangeable into either Woori or Chohung Bank shares is a nonbinding pre-commitment to privatization that may push strategic decisions into the future. The structure of the OPERA bonds comprise a fixed coupon bond for the first two years, which will afterwards transform into an exchangeable bond with an 18 percent conversion premium if a US$1 billion free float threshold for Woori FHC or Chohung Bank can be achieved. Despite its complicated structure, the bond provides flexibility to the government to pursue other privatization options other than the free float while providing protection to the investor.7 The OPERA bond issue includes a nominal upfront equity option premium reflecting the risk that a conversion into an exchangeable bond may not take place if the government fails to meet the free float requirement. If the buoyant performance of bank shares in 2001 does not continue in 2002–04, the free float condition may require the government to sell shares at a price that they consider is not advantageous. However, even if a qualifying float can be achieved in the next two years, the structure of the bond suggests that would be a substantial increase in private ownership.

25. In the meantime the Korean authorities are taking steps to expand the domestic institutional investor base eligible to own banks. These steps include relaxation of bank ownership limits imposed on domestic investors and equity-investment limits on pension funds. Although the latter may help create a viable institutional investor base, the former has created concerns that bank ownership by chaebol may lead to abuse of banks through connected lending practices (Box VI.3). Prior to the crisis, the ownership restrictions separated industrial capital from financial capital, but failed to protect the financial sector from the abuse in the absence of strong limits on connected lending and large exposure, and also poor corporate governance. The government’s proposal includes provisions to strengthen the connected lending limits, and a divestment requirement from industrial activity for chaebol to become eligible to own at least 10 percent of a commercial bank. Although these are significant steps to prevent abuse of banks by owners, the proposal could be strengthened further by including shares owned by all affiliated group companies in the calculation of the ownership ratio and the aggregate credit limits to connected parties.

Bank Ownership Limits in Korea

Prior to the crisis, regulatory restrictions were instrumental in defining the ownership structure in the Korean banking sector. In order to discourage entry of chaebol into the banking sector in the course of bank privatization in early 1980s, ownership in Korean banks has been restricted since 1982. The stock holding limit for domestic investors was reduced from 8 percent in 1982 to 4 percent in December 1994 in nation-wide commercial banks, and was set at 15 percent for regional banks. However, during the restructuring process, holdings by the government and the KDIC as well as domestic shareholdings at merged banks were exempted from these restrictions. For foreign investors, the limit was set at 10 percent (15 percent for regional banks), but exemptions were possible with approval of the Financial Supervisory Commission/ Service (FSC/FSS) each time holdings exceeded 10 percent (15 percent for regional banks), 25 percent, and 33 percent. Domestic entities could also be granted similar exemptions as those applied to foreigners, but the subsidiaries of the top-30 chaebol could exceed the holding limits only in one bank.

Ownership restrictions served their purpose in form but not in gist. The main objectives of regulatory limits over bank ownership are to prevent abuse of the banks by large shareholders and other connected interests, protect depositors and safety nets, and ensure the stability of the financial system. In Korea, the restrictions were successful in deterring bank ownership by chaebol, but did not prevent abuse of the banks by large industrial groups.

Recently, the government announced plans to relax bank stock holding limits to remove reverse discrimination against domestic entities and to facilitate the sale of nationalized banks. The proposed amendment to the banking law will allow any single entity to own 10 percent of a commercial bank without advance reporting requirement. However, chaebol with more than 25 percent of capital invested in nonfinancial activities will not be able to exercise voting rights above 4 percent ownership, unless they spin off their affiliates in nonfinancial sector or commit to transform themselves into a financial chaebol within two years.

Although the proposal includes new measures to prevent abuse of banks by large shareholders it falls short of best practice. The proposed amendment includes the following measures: (i) a yearly fit and proper test; (ii) an aggregate credit limit of 50 percent of bank capital for large stockholders; (iii) a limit of 3 percent of bank capital on the acquisition of stocks affiliated to large stockholders; (iv) prohibition of cross-lending to other bank stockholders; (v) public reporting requirement of connected transactions above a certain size, which must be supported by at least two-thirds of the board of directors, and (vi) several other measures that increase the powers of supervisors in examining large stockholders and an amendment to the criminal law to strengthen penalties of noncompliance. Notwithstanding these useful steps, the high aggregate credit limit to large stockholders, and the exclusion of connected parties from the calculation of this limit falls short of best practice. Also, the 10 percent ownership limit does not include ownership through affiliated companies, except for securities firms under the group. This may become the Achilles heel of the law, as chaebol may exert power over banks through their cross-share holdings in other financial affiliates.

E. Conclusion

26. The Korean authorities have stated that they are committed to privatizing government-owned banks. This is important, not least because a market driven corporate restructuring process will be greatly facilitated if it is led by sound and privately-owned banks. The privatization efforts since 1999 have, however, had only limited success, and the government faces several challenges as it strives to reinvigorate the process. An overall privatization program is needed to identify the goals of privatization, oversee the privatization of all state-owned financial institutions in a transparent manner, establish a consistent mechanism for the valuation of banks, and decide on the disposal methods. In defining the goals, the recovery of injected public funds, although important, should not overshadow equally relevant goals of bank privatization, including the entrenchment of a management culture that favors shareholder value over asset growth. It should be recognized that managers will not be responsive to the market unless there is a market for the bank stocks.

27. In the period ahead, priority should be given to increase the free float of Chohung Bank and expedite the listing of Woori FHC to complete the process that started with the issuance of the OPERA bonds. This, however, is likely to require further clean-up of the balance sheets of these banks to convince markets and potential investors that known credit costs have been met. Indeed, until nationalized banks can demonstrate a capacity to earn sufficient profit to remunerate their capital and meet new credit costs in the future, privatization will remain difficult. The privatization strategy for Seoul bank, which is much smaller and apparently has a stronger balance sheet, could include an initial public offer and efforts to attract strategic investors.

28. The focus on the privatization of majority government-owned banks should not overshadow the sale of minority stakes in KEB, KFB and Kookmin Bank. The performance of Kookmin Bank and its improved potential after its merger present an excellent opportunity to divest the government’s shares in the local market, and would send a strong signal of the government’s commitment to privatization. For KEB and KFB, the approach chosen will need to take account of the business strategies of the existing strategic partners in these banks. If the current partners are not interested in increasing their share in these banks, a well-planned initial public offer presents a viable alternative.


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This paper was prepared by Meral Karasulu (MAE).


For a detailed discussion of the structure of the financial sector before and after the crisis and a description of financial institutions in Korea, see Karasulu (2001) and Chopra et al. (2001).


For a detailed description of specialized banks see Financial Supervisory Service (2000).


Negotiations to sell Seoul Bank to Hong Kong and Shanghai Banking Corporation (HSBC) broke down in mid-1999. HSBC’s preference to focus on retail banking and reduce large corporate exposure by having the government assume a hefty share of the loan portfolio contributed to the failure of the deal. Talks between the government and the Deutsche Bank Capital Partners also ended in failure in September 2001.


OPERA is an acronym for “Out-performance Equity Redeemable in any Asset.” Similar bonds were used first in China in early 1990s and most recently in Italy for privatization and to raise funds.


See, for example, Heald (1985) and Braz (1999).


If more than 25 percent in either bank is sold through a strategic sale or depository receipt issues, the notes can be put back.