Republic of Korea
Financial System Stability Assessment, including Reports on the Observance of Standards and Codes on the following topics: Monetary and Financial Policy Transparency, Banking Supervision, Securities Regulation, Insurance Regulation, Corporate Governance, and Payment Systems

This paper presents key finding of the Financial System Stability Assessment for the Republic of Korea, including Reports on the Observance of Standards and Codes on Monetary and Financial Policy Transparency, Banking Supervision, Securities Regulation, Insurance Regulation, Corporate Governance, and Payment Systems. Korea has achieved a high degree of observance of key standards and codes through newly revised laws and competent supervision. However, supervisory independence could be strengthened to improve the ability to provide authoritative guidance and interpretation. Reform of the banking sector has restored profitability and improved its strength and resilience.


This paper presents key finding of the Financial System Stability Assessment for the Republic of Korea, including Reports on the Observance of Standards and Codes on Monetary and Financial Policy Transparency, Banking Supervision, Securities Regulation, Insurance Regulation, Corporate Governance, and Payment Systems. Korea has achieved a high degree of observance of key standards and codes through newly revised laws and competent supervision. However, supervisory independence could be strengthened to improve the ability to provide authoritative guidance and interpretation. Reform of the banking sector has restored profitability and improved its strength and resilience.

Section I—Staff Report on Financial System Stability

I. Summary and Overall Stability Assessment

1. Korea’s macroeconomic performance since the 1997–98 crisis has been impressive. Real GDP growth has averaged 7¼ percent annually during 1999–2002, and inflation has remained low. A downturn in 2001, which resulted from external shocks, appears to have been overcome following the recent expansion of both domestic and external demand, and real GDP is now estimated to have grown by 6 percent in 2002. Core inflation has remained within the 2–4 percent target range, partly due to the 10 percent nominal appreciation of the won against the dollar since late 2001. Foreign exchange reserves are expected to reach almost twice short-term debt this year. Reflecting these positive developments, major rating agencies recently upgraded Korea’s credit ratings (to A- by S&P). Because of these upgrades, Korea is no longer included in the EMBI+ index.

2. Since the crisis, Korea has made major progress in financial and corporate sector reform: the supervisory and regulatory regime for the financial sector has been substantially strengthened, and recent reforms have helped achieve a high degree of observance of international standards and codes. The problem of non-performing assets and widespread insolvency of financial institutions has been largely addressed—especially for the banking sector. This sector has undergone significant consolidation: banks have become more profit oriented, cutting costs, streamlining their operations, shedding staff, and consolidating branches. As a result, in 2001 the sector registered a profit for the first time since the crisis. Foreign participation in the banking sector has tripled since 1996.

3. The recovery of the financial sector has taken place in an overall favorable macroeconomic environment, which greatly facilitated the improvement of measured financial sector soundness. However, while much has been achieved since the crisis, there are still some substantial gaps to be filled. In particular, there remain some important reform measures in the insurance and securities sectors, the adaptation of the insolvency framework, and the completion of corporate restructuring. The challenge is now to complete the unfinished reform agenda, to fully implement the revised supervisory and regulatory regime, and to address the reform needs related to domestic and global developments.

4. Despite notable progress in prudential supervision, concerns remain about the supervisor’s ability to fully supervise the management of certain risks and respond to new challenges. Examples of such risks include the rapidly growing off-balance sheet positions of banks, the capital position of insurance companies, and the derivative activities of securities firms. Also, despite the important role of connected lending and cross ownership in the financial crisis, disclosure and monitoring of these issues remains weak. Additional concerns include the implementation of asset classification and low provisioning rates, given remaining weaknesses in the corporate sector. Off-site supervisory practices should be enhanced: The supervisory agency does not yet analyze the results of stress-tests of individual institutions in a systematic manner, which would allow a better assessment of individual and systemic risk. Finally, making the division of responsibilities between MOFE, FSC, and the FSS more transparent, and reassuring markets about the independence of the regulator would be important.

5. Recapitalization of commercial and specialized and development banks is largely complete. Stress tests on the banking sector’s loan portfolio suggest that it can handle isolated shocks without compromising its soundness, although a combination of shocks could be problematic for at least some institutions. The rapid growth in off-balance sheet positions requires improvements in banks’ risk management capabilities and adaptations to supervisory oversight. Banks are also increasingly exposed to potential adverse developments in household income, as lending to the household sector has been increasing rapidly. Recent measures to strengthen provisioning for household lending are welcome.

6. The forthcoming Basel II Capital Accord, the introduction of bancassurance, and the growth of derivatives and other off-balance sheet activities will pose even greater demands on both financial institutions and supervisors, including requiring more sophisticated systems to assess and price inter-related risks. The FSC/FSS will need to evaluate the adequacy of its resources, especially staff, to deal with these issues.

7. The insurance sector remains financially weak with most life insurance companies undercapitalized. The capital adequacy requirement also needs to be redefined. Stress tests show the vulnerability of the sector to shocks to interest rates and equity prices. Greater transparency of the ‘quasi-insurance’ sector would enhance competition. Pension reform is another important pending topic, since under current policies Korea’s partially funded public pension system will not be able to deliver the promised benefits to the rapidly aging population.

8. Nonbank deposit taking institutions face soundness problems and some parts seem inadequately supervised. This is particularly worrisome given the sector’s size and the reputational consequences should there be runs on these institutions. The FSC/FSS should continue to strengthen the oversight of these institutions and resolve promptly any that are insolvent. Securities markets are highly volatile. Tighter supervision of the securities houses—particularly to curb excessive risk-taking by weakly capitalized institutions—seems warranted. Three investment trust companies are financially weak.

9. Money, bond, and foreign exchange markets are still less developed than could be expected in a market of Korea’s size and income level. The observed lack of depth is, in part, related to segmentation in the government debt market and a lack of key maturities. Consolidation of government and government-guaranteed debt will help to enhance transparency and reduce market segmentation. Further necessary steps include the introduction of short-term securities—to provide a benchmark to the market and to allow the use of MSBs solely for liquidity management—and the removal of some remaining impediments to foreign participation. Measures to increase institutional investor participation and more regular and larger issues of long-term bonds would also foster market development.

10. Corporate governance and disclosure have improved but further steps are needed. Accounting and auditing reform should continue, to align Korea with evolving international best practice. Audit committees need to become more effective. Other reform areas include improved corporate disclosure, particularly with regard to related party transactions, strengthening of shareholder rights, and a clearer role for and professional training of outside directors.

11. Corporate restructuring has made significant progress, but up to a quarter of Korean corporations remain unprofitable and highly leveraged. Exposure of banks to such companies remains a concern. While current proposals to modernize the insolvency regime go in the right direction, the delay in completing this work is unfortunate as it remains a key step to give Korea an appropriate framework to deal with corporate distress. Passage of the new draft insolvency law that has recently been issued is therefore of key importance.

12. Korea has made considerable strides towards observance of the Financial Action Task Force’s (FATF) recommendations on combating money laundering and the financing of terrorism, but some measures detailed in this report remain to be taken to achieve full observance of the applicable international guidelines.

II. Macroeconomic and Financial Sector Context

A. Current Macroeconomic Environment

13. Korea’s macroeconomic performance since the 1997–98 crisis has been impressive but the near-term outlook depends on continued global recovery. Real GDP growth has averaged 7¼ percent annually during 1999–2002, and inflation has remained low. Vulnerability to a balance of payments crisis has been sharply reduced, with Korea operating a floating exchange rate and with foreign reserves reaching almost two times short-term debt. Reflecting such positive developments, Korea has been the first country to graduate from the EMB1+ index following credit rating upgrades by all the major rating agencies. Korea’s ratings have almost regained pre-crisis levels.

14. Recent developments in capital markets have reflected diminished confidence in the global recovery, and risks of a further run up in oil prices. The KOSPI and KOSDAQ have given back the significant gains recorded earlier in 2002, and bond yields have moved in a similar fashion. The real estate market, however, has remained buoyant. While overall house price inflation on a 12-month basis slowed slightly from a peak of 17.7 percent in April to 17.1 percent in November, apartment price increases in Seoul remained high at 31 percent overall, and higher increases in some districts, fueling concerns about a real estate bubble. Such concerns have abated in late 2002 as house price increases have slowed notably as a result of policy measures adopted in October 2002, with small price declines in the areas with the highest previous increases.1

B. The Financial Sector Context

15. Korea’s financial sector is large and diversified, including banks, various non-bank deposit taking institutions, securities firms and insurance companies (Table 1). Pension schemes are still in their infancy. In international comparison, given Korea’s size and level of development, the sector seems heavily focused on bank intermediation, with a comparatively smaller role of securities and equities markets.

Table 1.

Korea: Structure of the Financial System, 1997–2002.6

(As of the end of period, trillion won and in percentage)

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Sources: The Bank of Korea, Monthly Statistical Bulletin, and Financial System in Korea, February 15, 2002, and The Financial Supervisory Service, Monthly Financial Statistics Bulletin.

Number of foreign bank branches (in the banking institutions) is as of September 1997.

Including investment and finance companies.

Domestic companies only.

The figures in 1995 are for investment trust companies.

Assets in trust accounts of banks is defined as total trust assets minus securities investment trust of investment trust management companies.

The banking sector

16. As of mid-2002, the banking sector included nine nationwide commercial banks, six regional banks, five specialized and development banks, and 42 foreign bank branches. Commercial banks primarily engage in traditional financing of the corporate and the household sectors, but they also have limited activities in securities business and factoring, and in derivatives—an area of recent rapid growth. Most banks have leasing and credit card operations. It is expected that bancassurance will become permissible in 2003. Commercial banks are banned from owning real estate other than for business purposes. Specialized and development banks include the Industrial Bank of Korea (IBK), the Korean Development Bank, (KDB), and the Korea Export Import Bank (KEXIM), and the banking arms of two federations of cooperatives. These banks were founded initially to provide funds to strategic sectors but they now also undertake significant commercial banking activities.

17. Key characteristics of the Korean banking sector are a high share of government ownership and increasing concentration. As part of the restructuring efforts following the crisis, government and foreign ownership increased significantly. Prior to the crisis the government held equity in only three banks, amounting to less than 18 percent of total assets. After the restructuring, eight out of 15 commercial banks are now either majority government owned or co-owned by the government and private owners. When combined with government-ownership in specialized and development banks, in mid-2002 nearly 60 percent of the assets of the Korean banking sector is government-controlled. Foreign ownership increased from about 10 percent in 1998 to more than 30 percent in 2002.2 Concentration before the crisis was moderate, but increased considerably with consolidation in the sector.3 The share of the three and five largest banks stood at 51 and 69 percent of total sector assets, respectively. Following the merger of Hana Bank and Seoul Bank in 2002, three large banks now dominate the market.4 The structure of the banking sector continues to evolve in response to the government’s ongoing privatization efforts.

18. The restructured banking sector has demonstrated improved asset quality, higher earnings, and in 2001 showed profits for the first time since the crisis. Aggregate capital adequacy levels are close to 11 percent, although shareholders’ equity capital remains relatively low compared to total (non-risk weighted) capital. Liquidity of commercial banks is adequate. Assets reached nearly W 900 trillion at the end of 2002, amounting to about 160 percent of GDP (Tables 2 and 3).

Table 2.

Korea: Selected Financial Soundness Indicators for Commercial Banks, 1997–2002(June)

(In trillions of won and in percentage)

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Sources: FSS/FSC, Bank of Korea, and staff calculations.

Non-performing loans are defined as loans overdue for more than three months plus non-accrual loans.

Large credit exposure is defined as credit exposure larger than ten percent of bank’s capital.

The loans for housing is the sum of housing loans (to corporations, households, public and others) and loans with National Housing Fund.

Total Credit Exposure to top 30 Large Business Groups.

Gross income is defined as the sum of interest income, non- interest income, and non-operating income.

Spread between reference loan and deposit rates.

Total liquid assets is defined as the sum of cash and check, foreign currency, due from banks, traded securities, call loans and bills bought.

Short term liabilities is defined as the sum of deposits, CDs, due to banks, due to BoK, and borrowings.

Turnover ratio is defined as trading volume divided by market capitalization.

Table 3.

Korea: Consolidated Summary Balance Sheet of the Banking Sector, 1999–2002.6 1/

(In trillion won and in percentage)

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Source: FSS, Monthly Financial Statistics Bulletin and IMF staff calculations.

Includes commercial banks and specialized banks and covers only the banking accounts.

Acceptances and guarantees outstanding were moved from on-balance sheet items to off-balance sheet items from 1999.

Unpaid spot exchanges were removed from off-balance items from March 2000.

Capital is defined as sum of Tier I and Tier II capital.

Nonbank deposit taking financial institutions

19. Nonbank deposit taking institutions hold more than one quarter of the assets of the total deposit taking system, or about 15 percent of total financial sector assets. The sector is diverse, including merchant banking corporations, mutual savings banks, a postal savings bank, credit unions, mutual credit facilities and community credit cooperatives. Each type of institution is specialized, and all have important limitations on their business activities.

20. Strength varies across types of institutions, but there remain concerns about weaknesses in the sector. Most notable are credit unions, which sustained aggregate net losses of W 6.6 billion in 2001: 15.2 percent were insolvent as of end-June 2002. Provisioning is low, and 22 percent of these institutions have been closed since 1999. The federation of credit unions (which assists in their oversight) has also reported significant losses in reserves due to low-yielding assets. Other institutions, most notably mutual savings banks, posted a decline in NPLs, even though weaknesses in different areas remain. The FSC/FSS recently suspended operations of 122 credit unions, of which 100 have been closed. In addition, improvements in supervision over the sector have been implemented.

Securities and fund management industry

21. Three modern exchanges operate in Korea, trading equities and a wide range of securities and derivative instruments. Foreign and individual retail investors participate heavily in these markets, which exhibit comparatively high volatilities in returns. There is a lack of actively trading institutional investors, as private pension plans are still rare. Among instruments traded, derivatives have grown the fastest.

22. Korea’s securities and collective investment sector represents about 63 percent of GDP. Collective investment schemes include more than 260 institutions but are dominated by the ITC sector, which includes 31 funds managers managing W 165 trillion assets (29 percent of GDP) and 19 trust accounts of banks which manage about W 130 trillion (about 23 percent of GDP). Sixty securities firms manage assets of about W 50 trillion (about 9 percent of GDP).5 Some corporate-style investment funds were introduced in 1998, but have not been very successful. Foreign participation in ten investment trust companies, mostly through minority shares, has gradually increased to 19 percent of assets. Given concerns about the soundness of the fund management industry, investors prefer to establish their own funds and roll over investments annually.6

Insurance sector

23. Korea’s insurance market is large in world and regional terms, ranking seventh by premium behind the United States, Japan, the United Kingdom, Germany, France, and Italy. Gross premiums as a percentage of GDP, commonly referred to as “insurance penetration,” stood at 13.1 percent, the third highest in the world after South Africa and the United Kingdom. Life insurance makes up the largest segment of the market, with 22 companies in operation. The sector was particularly affected by the crisis and the subsequent economic conditions, which exposed past product weaknesses, poor quality assets, and management focused largely on growth.7

24. Notwithstanding improvements in regulation and supervision, insurance companies currently face important financial challenges. Most companies have issued contracts with guaranteed rates of return above current market levels, and therefore depend on capital appreciation and other underwriting profits to overcome the losses arising from outstanding contracts still in force. Companies also carry a very substantial mismatch risk between assets and liabilities as a result of this business line. Existing business continues to be written with relatively strong guarantees, although at lower rates than in the past.

25. The non-life insurance sector has been stable over the last 15 years. The combined ratios for the 19 companies in the sector indicate marginal but improving profitability. Non-life insurance companies have faced less serious asset liability mismatch issues than the life insurance companies.

Pension sector

26. The emergence of the pension sector is a recent development in Korea. It is widely expected to require reforms to properly serve the population in a demographically ageing environment. Occupational pension schemes are expected to emerge through reform of the current retirement allowance system, although the precise form of the new arrangements is undecided. The current National Pension Scheme which holds assets amounting to 15 percent of GDP is facing its own challenges as it attempts to achieve actuarial balance. These pressures arise from benefits accruing at a rate and value in excess of current contributions and an imperative to recover much of the intergenerational subsidy built into the scheme owing to lower past contributions. A small but growing tax-favored voluntary pension sector has emerged over the last five years.

C. Market Infrastructure

Money and bond markets

27. Money and bond markets remain partially fragmented and, at least in certain maturities and instruments, insufficiently deep. Unlike comparable markets, there is no core “interbank” market, which would be more efficient in terms of liquidity redistribution. Instead, the call money market encompasses more than 600 financial and non-financial institutions that can also participate in the repo market. While the market is liquid for maturities below 90 days, liquidity dries up quickly beyond that maturity given the difficulties of pricing such deals in the absence of a suitable yield curve. The BOK conducts repo operations, using its monetary stabilization bonds (MSBs) of different maturities.

28. The bond market encompasses corporate and government bonds of different maturities. The government bond sector includes a range of different instruments, including bonds issued in the restructuring process (KAMCO and KDIC bonds), Exchange Stabilization Bonds, National Housing Bonds and MSBs. There have also been small issuances of 10-year treasury bonds. The multiplicity of instruments, the absence of a short term benchmark government bond (issued at regular intervals) and the insufficient volume of ten-year government bonds all constrain the market’s ability to price risk, and hinder the further development of money and bond markets. The market for corporate bonds is deep but not particularly active, especially relative to its potential.

Foreign exchange market

29. The trading volume in Korea’s foreign exchange market has grown significantly since the crisis, when shallowness was a concern.8 Trading grew due to the two-stage foreign exchange liberalization program that started in April 1999, and the accompanying increase in inflows of foreign direct investment (FDI) and portfolio investments. Exchange markets also grew as a result of increases in exports and imports. There has been a notable jump in foreign exchange forward and swap transaction volumes since 1999 following the removal of the bona-fide (real demand) principle in the use of foreign exchange forward and derivative transactions, and the authorization for onshore financial institutions to transact in offshore non-deliverable forward contracts (NDF).9 Some of the increase in foreign exchange derivative activities reflects increasing hedging activities.

30. Notwithstanding the sharper increase in foreign exchange forward and swap transactions, spot trading still dominates, because of various restrictions and documentation requirements.10 In addition, Korea’s foreign exchange market is more end-user-and domestically-oriented, with cross-border transactions accounting for about a quarter of total foreign exchange volume in 2001, compared with about 70 percent in the comparator countries. The authorities plan to further liberalize the capital account in three phases over the period 2002–11 and to implement measures to broaden and deepen the foreign exchange market.

D. Regulation, Supervision, and Compliance with Standards and Codes

31. To improve financial supervision and regulation, the authorities reorganized the sector’s regulatory agencies in 1998. The FSC was created to oversee regulation of Korean financial institutions and markets. It is a statutorily independent government agency under the general authority of the President who appoints its nine-member Board.

32. The FSC is responsible for policy formulation for the financial markets and is the supervisory and regulatory authority for all banks and non-bank financial institutions. The agency’s powers include the authority to issue and revoke licenses for financial institutions. It is responsible for coordinating the activities of and setting policy for the Financial Supervisory Service (FSS) and the Securities and Futures Commission (SFC). The FSS is the executive arm of the FSC. MOFE is required to consult with FSC on all proposed legislation pertaining to financial markets that it submits to Parliament. MOFE, the BOK, and the Korea Deposit Insurance Corporation (KDIC) continue to have some involvement in the policymaking, examination, and supervisory process for the financial sector. As a result of the crisis, FSC was also given some responsibilities for corporate sector restructuring.

33. Korea broadly observes international standards and codes across all segments of the financial industry but full implementation is still in progress. The legal framework for financial institutions and supervision is well established in a number of laws.11 The main findings of the standards assessments are summarized in Box 1.

III. Short-Term Vulnerabilities

34. This chapter discusses the extent to which the balance sheet exposures of the Korean financial sector alone or in conjunction with other structural weakness could imply short-term vulnerabilities. Korea’s banking sector seems broadly resilient to isolated macroeconomic shocks of a plausible size based on the experience over the last five years. However, a combination of shocks could be problematic to at least some institutions. Stress tests for the insurance sector yield more worrisome results, showing that some companies could suffer unsustainable losses even from moderate changes in interest rates and stock prices. In addition to those quantifiable risks, the chapter also discusses structural risks—including the exposure of banks to off-balance sheet risks, weaknesses in the securities and ITC sectors, and recent capital losses in non-bank financial institutions. The latter risks deserve careful monitoring, as they could cause serious problems in the financial sector, even in the short-run.

Main Findings of the Assessment of Observance of Key International Standards and Codes

The FSAP team conducted assessments of Korea’s observance of the following key international standards and codes:

  • The review of the Basel Core Principles (BCP), IAIS, and IOSCO shows that the FSC/FSS, the unified supervisory agency, is a competent regulator. Assessors felt though that the supervisory framework and implementation should be reviewed to strengthen the supervisor’s independence, including its ability to provide authoritative guidance and interpretation. Legal protection of supervisors should be strengthened.

  • Basel Core Principles. There is a high degree of compliance with best international supervisory practices in banking supervision. Measures needed to further strengthen compliance with the BCP would include: (i) increasing staffing in key areas: this will also help to address the challenges of new supervisory tasks related to off-balance sheet activities, Basel II, and AML; (ii) paying greater attention to differing risk levels when setting minimum capital levels; (iii) broadening the coverage of fit and proper criteria; and (iv) giving more attention to qualitative criteria in supervision.

  • IAIS. There is also a high degree of compliance with the IAIS. Measures initiated to strengthen the insurance sector go in the right direction but may need to go further. In particular the new capital requirements for life insurance companies, even when fully phased-in may not be adequate given Korea’s structural and financial framework. In addition, a withdrawal of the government from direct insurance business, facilitating the listing of insurance companies on the stock exchange, further price and product liberalization and further deepening of the capital markets would all help to further strengthen the insurance sector.

  • IOSCO. Korea has achieved significant observance of the IOSCO principles, but some critical issues remain. They include: (i) the need to improve regulatory transparency, (ii) in the volatile market framework, regulators should require more frequent calculation and reporting of capital requirements, and (iii) extended enforcement of prudential rules could increase market confidence.

  • CPSIPS. BOK-Wire, Korea’s RTGS payment system, is efficient and compliant with all CPSIPS principles, but the BOK’s role in the payments system should be explicitly set out in the legislation, and accompanying legislative powers should also be introduced. In addition, the check system remains important, including in OTC settlement. The BOK is aware of the systemic risks implied in the use of checks for large value payments. However, there are efforts to encourage a broadening of the use of BOK-Wire for large transfers, especially for payments related to OTC trades. It appears though that there are some significant obstacles, including the (t+0) settlement practice in debt securities trade. Other important obstacles to reducing the role of checks are related to the widespread use of cashiers’ checks as a substitute for cash, encouraged further by the low value of the largest denomination bill.

  • Code of Good Practices in the Transparency of Monetary and Financial Policies. All assessed financial institutions in Korea practice a high degree of transparency. The practice could be improved through better information sharing arrangements, wider consultation on technical changes to regulations and better disclosure of internal governance procedures.

  • OECD Principles of Corporate Governance. Corporate governance rules are close to those in other OECD countries, but actual practice remains an issue. Efforts will be needed to improve the transparency of business practices and ensure adequate disclosure for chaebols.

  • AML/CFT. Korea has put in place the legal and institutional framework necessary for an effective framework for anti-money laundering (AML) and combating the financing of terrorism (CFT) but more focus needs to be given to implementation. To make the framework operational, more staff resources should be devoted to the Korea Financial Intelligence Unit (KoFIU). The FSS/FSC should fully exercise its mandate in this area, avoiding the need to build up a parallel structure within the KoFIU.

A. Exposures of the Banking Sector

35. Short-term risks may arise from the direct effect of shocks to interest and exchange rates on bank balance sheets, and from indirect effects through corporate and household balance sheets, and from off-balance sheet items. This risk may be sizeable as bank lending remains a principal source of corporate financing, and, going forward, the quality of household credit is also likely to suffer. Given the recently rising level of household debt, increases in interest and exchange rates could significantly undermine household debt servicing capacity. Loans to households grew at an annualized rate of 34 percent in the first half of 2002, and, starting from low levels, total household debt has now reached average G-7 levels, but with a lower share of mortgages. Off-balance sheet exposures of banks have also been growing rapidly in the past two years.12

36. In examining vulnerabilities, the guiding rod has been the size of shocks experienced since 1998, which are smaller than those experienced during the crisis. This approach was chosen for two reasons: (i) Shocks of the magnitude experienced in 1997-98 would most likely lead to structural breaks in the relationships underlying the stress tests. The results based on models estimated in calmer times may therefore not be able to give adequate quantitative guidance for what would happen in a crisis situation, (ii) Since the crisis, Korea has put in place safeguards that would make a reoccurrence of shocks of the 1997-98 magnitude very unlikely.

Bank exposure to interest and exchange rate shocks

37. Banks appear resilient to the direct effects of interest and exchange rate shocks on the balance sheet items considered in the tests, mainly because of the absence of large currency and maturity mismatches. Present Basel capital ratios show little change in the face of a modest increase in interest rates (a permanent rise in interest rates by two percentage points), and virtually no change in the face of either a temporary or a permanent depreciation of the exchange rate (of 20 percent, in the temporary case reversed after one year).

Exposure to the corporate sector

38. Exposure to interest rate risk and earnings risk are the main source of vulnerabilities for the corporate sector, despite historically low interest rates and strong growth in the economy. Given the reduced direct foreign borrowing of corporations and the increase inhedging, the corporate sector appears less sensitive to foreign exchange rate risk than at the time of the crisis. However, many companies appear not to hedge consistently. Moreover, given the differences in the quality of hedges available in the Korean market, even those that do hedge may face risks. Stress tests suggest that a deterioration in corporate sector balance sheets from higher interest rates or lower operating income would worsen the quality of bank credits. As a result, capital ratios of banks would decline by less than one percentage point for the banking system as a whole, although for individual banks the fall could be higher. Given the still comfortable levels of capital, the banking system is therefore likely to be able to absorb each of these shocks individually. However, if a series of simultaneous shocks were to occur together, the potential impact on individual banks could bring capital ratios under pressure for some of the smaller, less well-capitalized institutions.

Exposure to the household sector

39. Stress tests were also conducted to assess the effects of changes in interest rates on the household debt burden and the implied feedback effects on nonperforming loans and on capital ratios. From the baseline, three variations of the shocks are presented. The first allows for no reaction from interest rates. The second treats the shock as a demand shock, and allows for a 150 basis point reduction in interest rates. The third treats the shock as a supply shock, requiring a 50 basis point increase in interest rates.

40. Stress tests for household credit indicate that the shocks used could generate very small loan defaults if they are demand shocks, but defaults as large as 8-9 percent of household credit outstanding if they are supply shocks. The Basel capital ratio of the banking sector could decline by around 1.5 percentage points. The results of the stress test show that the banking system as a whole could be at risk of possible capital losses from their exposures to households. The risk is accentuated by the higher credit risk of new lending, and by the fact that the particular loan structure of most household loans (three-year bullet loans with only interest due in the interim) is likely to lead to an understatement of problem loans in the household sector. Against this background, added vigilance is necessary and the measures announced by the authorities in October 2002 to curb the growth in household lending are steps in the right direction. There has also been some active provisioning against such risks.

B. Exposure of Insurance Companies to Macroeconomic Shocks

41. The insurance sector suffers from weaknesses that might endanger its own financial standing and the wider confidence in the financial sector. The life insurance sector carries considerable mismatch risk. Industry participants advised that the mean term of their liabilities is of the order of seven years and the mean term of their assets is, at best, three years. In such a situation, falls in interest rates will be unfavorable to the companies. Insurance companies are also invested in equity markets, linking their solvency to equity price moves. Finally, insurance companies are allowed to invest up to 20 percent of their assets abroad.

Table 4.

Balance Sheet Sensitivity of Korean Banks, June 2002

(In percent of risk weighted capital)

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Sources: Staff estimates.

Basel capital ratio: Defined as Tier 1 plus Tier 2 capital to risk-weighted assets, at end-June 2002.

Interest rate shock: A 2 percentage point increase in domestic interest rates.

Exchange rate shock: A 20 percent increase in the won value of foreign currency denominated assets and liabilities, reversed after one year.

Open foreign exchange position shock: A depreciation of the won against currencies composing the open position in the amount of the mean depreciation over 1997-2002 plus two standard deviations of the series.

Foreign interest rate shock: A 2 percentage point increase in foreign interest rates.

42. Stress tests for the insurance industry suggest that the insurance sector could suffer from changes in interest rates, stock or foreign exchange values. As a result, for the life sector in particular, the risk of a repeat of the need for government intervention in some ways remains material. In contrast, based on an analysis of its balance sheets, the non-life sector is better placed with a stronger valuation basis for liabilities, more closely matched assets and liabilities, and excess capital generally sufficient to enable it to cope with foreseeable adversity in the economic environment. A continued strengthening of the operating framework for life insurance will be critical to reduce the sector’s vulnerability.

Table 5.

Impact of Macroeconomic Shocks on the Corporate Sector and Implied Effects on Banking Sector 2001 Base

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Source: Staff estimates.Notes:-Interest rate shock: 2 percentage point increase in call rate and 1.24 percentage point increase in 3Y bond yield.-Exchange rate shock: 20 percent decline in the net gains on foreign currency transactions and translations.-Earnings shock: 20 percent decrease in operating income.-Uncovered Borrowing Ratio (UBR) is the proportion of total industry debt for which the interest coverage ratio (ICR = EBITDA to interest expenses) is less than 0.75. A threshold of 0.75 was used instead of the standard cutoff of 1.0, since some Korean firms earn substantial interest income, and the threshold of 0.75 had greater explanatory power for describing corporate performance.-Bank SDL ratio: The impact on the ratio of substandard, doubtful, and loss loans to total loans is calculated based on cross-sectional regression for 30 industry categories (for lower bound) and a regression of the total SDL ratio with the uncovered bank borrowings ratio (for upper bound).

C. Other Short-Term Risks

43. In addition to the directly quantifiable risks discussed above, parts of Korea’s financial sector can—even in short-term—suffer significant losses from structural weaknesses. In particular, the following areas would need to be highlighted:

  • Derivatives. The Korean derivatives market was established only in 1996 but has since grown very rapidly.13 Benefits include improved price formation, larger market liquidity, and more hedging possibilities. While the nature of instruments used and the level of exposures do not indicate at present any systemic risk, continued, rapid growth and prevailing market practices have raised concerns about additional risks for institutions that are engaging in this market (Box 2). While market participants have put in place reasonable risk management systems, the extent to which these have been sufficiently adapted to the Korean markets remains an issue. The need to supervise the rapidly growing area of derivatives and to adapt to the increasing level of sophistication is straining the FSS’ scarce resources. Current low levels of close-out netting—a key instrument to reduce counterparty risk—are likely to increase following the authorities’ efforts to clarify the legal basis.

Main Features of Korea’s Derivative Markets

Korean derivatives markets have grown rapidly but their overall size remains below OECD average. Notional volumes in Korean over-the-counter (OTC) derivative markets have tripled from December 2000 to September 2002 to reach KrW 756 trillion (130 percent of GDP). Growth of exchange-traded derivatives (ETD) was even faster. Trading volumes in ETD instruments in the frist half of 2002 exceeded KrW 1100 trillion, equally shared between equity and interest risk derivatives. Korean equity derivatives are now the largest in the world by number of contracts and rank among the top five by trading value. Retail investors account for 48 percent and securities firms for thirty eight percent of trading in equity derivatives markets.

The main features of OTC and ETD markets are as follows: The market for OTC derivative instruments in Korea is mainly made up of interest rate swaps in Korean won (KrW), cross-currency swaps and to a smaller extent, currency options, and credit derivatives. ETDs in Korea consist mainly of stock index (KOSPI 200) futures and options which are traded on the Korea Stock Exchange (KSE), and Korea Treasury Bond (KTB) futures and won/dollar futures which are traded in the Korea Futures Exchange (KOFEX). Trading is about four times of cash markets, and turnover is three times in equity and six times in bond markets.15 The average number of daily KTB futures transactions rose from 6,300 in 2000 to 37,900 in 2001. Over the same period equity derivatives transactions increased by over eighty percent in trading volume.

Korea’s derivative markets may be subject to specific risks but efforts toward risk management are well advanced. Large differences among individual banks and risk factors specific to emerging nature of the Korean derivative markets indicate that overall risks might be higher than OECD averages. Aggregate credit exposures of Korean banks’ derivatives business are three percent of notional amounts as compared to one percent BIS average and 1.4 percent for Japanese banks. This could be due to structural differences in the portfolio composition of derivatives that point to Korean derivatives having a greater net market value sensitivity to changes in market parameters (such as exchange and interest rates), or higher net exposures because of differences in portfolio netting characteristics. Also Korea has a large share of (generally more volatile) currency derivatives that account for 38 percent of total outstanding notional amounts as compared to a BIS average of 14 percent, although currency forwards (that typically have maturities less than a year, and less exposure implications compared to longer-term currency swaps) account for a relatively large 22 percent share in Korea. Market participants have put in place reasonable risk management systems and are in the process of adapting them to the Korean market environment. Most OTC deals are undertaken based on ISDA master agreements and the authorities are undertaking efforts to clarify the legal validity of close-out netting to increase the current low level of reported netting.


Commercial Banks’ Leverage

Citation: IMF Staff Country Reports 2003, 081; 10.5089/9781451822151.002.A001

Source: FSS monthly statistic (table 13)

Securities Firms Revenues

Citation: IMF Staff Country Reports 2003, 081; 10.5089/9781451822151.002.A001

Source: FSS monthly statistic (table 25)

Equity Derivatives Trading

Citation: IMF Staff Country Reports 2003, 081; 10.5089/9781451822151.002.A001

Source: KSE monthly statistics KOSPI200 futures & options
1 There are five companies with listed options on the exchange.
Table 6.

Impact of Macroeconomic Shocks on Household Credit

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Assuming a reduction in BOK target call rate of 150 basis points to moderate growth reduction.

Assuming a rise in BOK target call rate of 50 basis points to prevent inflation rising.

Financial liabilities of the individual sector are projected to rise 30 percent, and disposable income by 7 percent compared with 2001, and the effective interest rate is assumed to fall by 50 basis points.

The effective interest rate is estimated to respond with an elasticity of 0.4 to changes in the policy rate after two years.

Assuming 1/3 of non-performing household loans are charged off against capital.

  • Yen “carry trade.” Interest rate differentials between yen and won and a degree of exchange rate stability have induced increased interest in yen borrowing. The FSS has taken important steps to ensure that banks adequately moniotr implied credit risk and promote hedging. The authorities will also need to be mindful of the possible risks that might arise from short-term borrowing abroad by the corporate sector.

  • Securities firms. The securities sector, which accounts for slightly more than 3 percent of financial sector assets, is structurually weak. Capital levels of some companies are low and securities firms appear pressured by declining brokerage income. In this environment, they take mostly similar leveraged positions, in part due to high usage of “program-guided trading.” Systemic risks could arise if the rapid growth of leverage continued amid high volatility, and if leading securities firms were to become dominant players, with all institutions having high risk exposures of a similar type. The authorities’ recent decision to extend OTC derivative trading to only three well capitalized securities firms is a first step in the necessary process of strengthening prudential regulations and supervision over the sector.

  • Supervisory challenges: While adequate in most places, some areas in the prudential oversight process seem stretched which could leave important risks undetected. Examples include the FSS’s apparent difficulties in monitoring off-balance sheet exposures, which have grown rapidly in the recent past. Insufficient information is available on connected lending and related party transactions, which were a major problem at the time of the crisis. Other issues include instances of late or incomplete availability of core supervisory data.

  • Residual risks from asset-backed securities (ABS). A significant amount of NPLs in Korean banks’ balance sheets have been securitized using ABS issues, some of which included credit enhancements provided by banks in case the security performed worse than expected. Appropriate disclosure and supervisory vigilance on the valuation and provisioning practices in the ABS market will be needed to monitor remaining bank exposures.

  • The weaknesses in the non-bank deposit taking financial sector are of concern. While neither individually nor as a group systemically important, an eventual open crisis in that sector might nevertheless tarnish the reputation of the Korean financial system.

  • Weak ITCs. Public awareness of the financial difficulties and the negative capital ratios of some large ITC companies are increasing. The main danger could lie in the loss of market confidence and, additionally, possible contagion to other segments of the financial market, in particular since the securities sector as a whole remains weak.

  • Delays in completing corporate restructuring. Despite the progress made, corporate restructuring has failed to address the problems of about a quarter of the corporations, many of which have negative cash flow, are unprofitable and overleveraged, and are likely to fail. While those potential failures are probably smaller than the Daewoo and Hynix cases, they could be substantial in the aggregate, unsettle capital markets, and increase credit losses in financial institutions. The FSS mandated semi-annual review of “potentially ailing” companies based on EBIT/interest rate criteria needs to be implemented rigerously to further improve provisioning and to avoid “evergreening” and speed up restructuring.

IV. Medium-Term and Structural Issues

44. The medium-term challenge for Korea’s financial sector is to deepen markets, while ensuring that the supervisory and regulatory framework is capable of addressing any associated risks. This section highlights the main areas that might need attention. In the legal and regulatory area there are important challenges such as ensuring the full independence of the regulator and providing a more efficient and predictable framework for insolvency. Medium-term financial stability will also require addressing structural soundness problems especially in the insurance and securities sectors. Furthermore, impediments to market development are an issue of concern. The further deepening of money, foreign exchange and bond markets all appear closely linked to supportive government debt management practices. Finally, improving corporate governance practices will enhance investor confidence—critical to all other areas discussed.

A. Financial Sector Supervision and Regulation

45. The FSC/FSS/SFC have established a track record of issuing rules and regulations, which have generally been appropriate and timely, but concerns about some aspects of the regulatory process remain. In particular, market participants have questioned the quantity and quality of such regulations, the opaque way in which some of them have been introduced, their interpretation, and the fact that prudential regulators lack the unfettered right to issue new regulations when they perceive a need to do so. There is also a perception in the market that violations of applicable regulations are often overlooked or weakly sanctioned. Weak implementation of regulations or inadequate sanctions for violations undermine the integrity of the regulatory process and encourages further inefficient and inappropriate market behavior.

46. Given the scope and power of the FSC/FSS/SFC, their independence is a matter of great importance. Although embodied in the law, in practice independence has been called into question. Concerns arise because of the role taken by MOFE in interpreting laws and supervisory regulations, giving FSC/FSS/SFC only limited freedom in implementing supervision. In addition, the rapid turnover of the FSC chairman (who also is the governor of the FSS) and the policy where FSC staff would sometimes be moving to and from MOFE has a potential to undermine the credibility of supervisory independence.

47. Supervisory effectiveness may also be hampered by the insufficient legal protection for FSC/FSS/SFC staff against lawsuits for supervisory actions. While there are to date no reported difficulties, this could become an issue as Korea integrates more into the global financial system and participants become less bound by traditional Korean legal customs and procedures. Appropriate legal protection for supervisory staff would help to ensure that fear of retribution does not constrain supervisors when exercising their professional responsibilities.

48. The FSC was also given, in addition to its role as regulator, responsibility for overseeing the restructuring in the corporate and financial sectors in the wake of the financial crisis. As a result, it has been put in a position of having to compromise on occasion with what might be appropriate from a purely prudential perspective. Whatever the merits of this assignment of responsibility at the time, corporate and financial restructuring should now be carried forward by the private sector or in the case of government-owned entities by the agency holding the shares.

49. The FSC/FSS/SFC appear to have sufficient well-trained staff to carry out their responsibilities, but there are indications of shortages of expertise in a few key areas. Additionally, there are some concerns about the ability of the supervisor to maintain the technical capacity of staff through ongoing recruitment and training in an increasingly complex and competitive financial system. This situation also reflects a national shortage of key professionals. Some efforts are under way to reduce these shortages over time, and other efforts might be considered.

50. Some market participants have voiced concern that prudential supervision is not applied equally, and that there is excessive intervention of the supervisor in day-to-day management. Market participants also note that the complex regulatory framework makes full compliance with all requirements impossible, leaving them exposed to inconsistent application of fines and retribution. The authorities should continue their efforts to make the sanctions process open and transparent, and be mindful of the need to avoid perceptions of unequal treatment and of unjustified retribution.

B. Legal Infrastructure

51. Korea has established a sound and respected judiciary and judicial system. Judges are well regarded and considered competent and impartial. In the area of commercial disputes including insolvency, the authorities have strengthened the ability of the courts to respond to the needs of the financial and corporate sectors. Court procedures have been streamlined, although further reforms would help to overcome some concerns regarding perceived delays in the court system, the ability of a creditor to issue attachment proceedings on an ex parte basis, and the relatively unfettered right of any party to appeal or to seek adjournments.

52. The scope and pace of legislative reform following the 1997-98 financial crisis has been extraordinary. New laws dealing with particular aspects of financial and corporate restructuring and other specialized areas of financial sector reform have been introduced and new institutions were created. Several of these laws have been amended, reflecting the authorities’ readiness to fill identified gaps in the legislative and regulatory framework. However, the framework in place is, in certain areas, complex and has resulted in some overlapping responsibility and uncertainty as to lines of authority—particularly in relation to regulatory supervision—and in some tension between regulatory bodies.

53. The legal framework for secured transactions is generally sound. Company, movable and immovable property registers work well and debt enforcement mechanisms are relatively straightforward. However, there is no provision for non-possessory pledges such as the right to secure inventory and accounts receivable. The introduction of such rights together with a comprehensive review of the secured transactions regime as an alternative to insolvency should be considered.

54. A preliminary assessment of the proposals for insolvency reform confirms that the authorities are moving in the right direction. However, the delay in adopting this reform is unfortunate. The adoption of a single unitary law which also addresses consumer rehabilitation and cross border insolvency would be a welcome development. However, an improved legal framework is desirable but not sufficient. Of perhaps even greater importance will be the attitude that creditors take to the new regime and whether they will use it effectively to restructure weak companies and promote solid corporate financial health.

C. Sectoral Issues

Banking sector

55. The government has made encouraging strides to return banks under its control to private ownership. It has found creative ways to place parts of Woori and Chohung in the market and make a number of contingent sales. However, the process remains to be completed. The merger of Hana Bank with Seoul Bank has left the government with a 31 percent equity stake in the merged bank, which accounts for 12 percent of banking sectorssets. In addition to selling this stake, the sales of Woori, Chohung and minority stakes in KEB, KFB, and Kookmin Bank are still pending. Full divestiture would eliminate potential conflicts of interest arising from the government’s role of both regulator and owner of banks.

56. As part of its restructuring policy, banking concentration was actively pursued by the government since 2000. These efforts helped increase efficiency and reduced the number of non-viable banks in the system. However, against the background of a now profitable sector, the market, rather than the government, seems better placed to determine the structure of the banking system over time. Despite the increased concentration in the sector, competition in both deposit and loan markets remain healthy. Consumer protection and competition policy should remain important concerns for the authorities, but they should be implemented in a way that allows for innovation.

57. Special privileges granted to some specialized and development banks undermine market competition. For instance the IBK, the KDB, and the banking sections of the National Agriculture Credit Federation (NACF) and National Forestry and Fisheries Corporation (NFFC) carry out operations typical of commercial banks, such as deposit taking, lending, trust business, and credit card operations. They enjoy benefits that include some combination of low cost funding through government guarantees, borrowings from the government and the BOK, as well as preferential treatment regarding some prudential ratios, such as liquidity. The IBK is a main competitor in its SME lending business with many midsized commercial banks who do not share the same funding and guarantee privileges. It would be appropriate to level the playing field by phasing out any privileges that differentiate across financial institutions.

Insurance and pensions

58. The principal concern for the insurance sector is the capitalization of the life insurance companies. The industry is, at best, marginally capable of meeting the current minimum capital requirements once they are fully phased in. A more robust valuation of liabilities, exclusion of double counting of regulatory capital in subsidiaries, and an additional margin for the substantial market risk arising from the asset liability mismatch and exposure to equities would place many companies in a marginal situation. Many of them will have access to capital from their parent, and the regulatory and supervisory regime should require the allocation of this capital to the life insurance business. Others may need closer supervisory intervention. The prudential status of companies would also be enhanced if the impediments to listing were overcome.

59. The role of the Korean Insurance Development Institute (KIDI) raises some concerns. While useful in the ongoing development of the sector, the extent of the continuing role in, for example, product development and approval may discourage individual company innovation and company development of in-house technical expertise. The procedures and basis for decisions within the KIDI are not transparent to industry participants The functions and operations of the KIDI should be refined and refocused to enhance their transparency and flexibility, in concert with a system that further encourages companies to develop advanced risk management systems.

60. The government is involved in the insurance sector through its continuing part ownership of Korea Life via the KDIC, and the operations of the ‘quasi-insurance’ sector.14 The marked lack of transparency in the “quasi-insurance” sector operations contributes to suspicion from the commercial sector. More transparency would be consistent with the stated public benefit objectives of the “quasi-insurance sector” and facilitate a more soundly based consideration of the merits of its continued operation in its present form.

61. Pension reform is recognized as necessary given the aging of Korea’s population and the general level of funding of the current arrangements. The authorities are to be commended for the priority they have attached to these initiatives to date and should continue these efforts, both in terms of the proposals for an occupational pension system in the private sector and for the continued careful consideration of the role and sustainability of the national pension system. The introduction of an occupational pension system will require the establishment of a well considered regulatory and supervisory regime. The effort needed to achieve such a regime should not be underestimated.

62. Regulators should devote close attention to the introduction of bancassurance. Early attention will need to be given to the potential existence of capital and other regulatory arbitrage and differential taxation treatment of product providers. This would ensure that any refinements can be made whilst transitional issues are at a minimum.

Fund management and securities

63. Securities markets are characterized by high retail participation and significant trading by securities firms on their own account. In contrast, sizeable actively trading institutional investors are all but absent. This market structure has contributed to high volatility in equity markets and rapid growth in speculative derivates trading. There are also weaknesses in the investment trust industry, where some companies have negative capital.

64. Higher participation of institutional investors in Korea’s security markets would greatly benefit the stability and development of that market. Such investors promote long-term savings, enhance productivity and innovation, emphasize trust and corporate governance, and often become strategic investors. Although Korea has introduced a variety of collective investment vehicles (including bank trust accounts, investment trust and management companies, investment advisory firms, corporate-style mutual funds, and contractual savings) the fund management industry has not yet been able to rebuild investor trust. Industry experts suggest that the form of investment trusts (ITC) is suitable for Korean markets, but that corporate governance must be enhanced emphasizing independence, both from government and corporate or sell-side pressures15. Moreover, the market requires substantial consolidation. In addition, new legislation on fund management should emphasize market principles and provide safeguards for independence, such as mandatory monthly disclosure of assets, and strict separation between managers and trustees.

Corporate restructuring

65. While the corporate failures associated with the 1997-98 crisis prompted several waves of corporate restructuring, the agenda remains unfinished. Korea has succeeded in increasing overall profitability of the corporate sector, in addressing long-term moral hazard issues, financially stabilizing distressed companies, in initiating follow-on operational restructuring, and in improving transparency in financial disclosure and corporate governance. However, three main risks remain: (i) In 2001, the bottom quartile of Korean companies showed very high leverage ratios, large net losses, and low interest coverage. Although Hynix and other large companies are being restructured by creditors, they remain exposed to the risk of further losses, (ii) The prospects for many of the smaller companies emerging from workouts are uncertain. Almost half of the smaller public companies in workouts remain unprofitable and most are still highly leveraged, (iii) Weaknesses in financial disclosure and corporate governance may permit insiders in Korea’s largest chaebols to channel financial support from strong to weak affiliates, at the expense of the stronger affiliates (and outside shareholders).

66. Given the risks associated with delays in corporate restructuring, care needs to be taken to minimize possible spillover effects on the financial sector. Measures in that regard include encouraging efforts by financial institutions to identify emerging cases of corporate distress and initiate needed financial and operational restructuring in a timely manner, based on forward-looking criteria for the classification. Financial institutions will need to move forward aggressively with restructuring of distressed-but-viable companies, and to pursue prompt sale or liquidation of non-viable companies. Owners and supervisors will need to prevent financial institutions, especially state-owned banks, from delaying loss recognition on over-valued corporate assets. The FSC/FSS should ensure that financial institutions value workout companies at market value. Efforts to strengthen corporate governance and the insolvency regime will support the financial sector’s ability to engage in new corporate lending activities.

D. Market Development Issues

67. Korea has active money, bond and foreign exchange markets, but further market development hinges upon overcoming some related structural problems. These include insufficient ability to build a yield curve in won assets, which reduces the liquidity of money markets, with possible effects also on investors’ ability to hedge activities in the foreign exchange market. In addition, the insufficient volume of longer term government bonds constrains the deepening of the corporate bond market. Government debt management practices, including the choice of types and maturities of instrument offered, can play a critical role in market development.

Money and foreign exchange markets

68. Korea’s short-term money market suffers from some shortcomings. A lack of instruments prevents the determination of the short-term end of the risk-free yield curve between the overnight and one-year maturities. This complicates the determination of a prime rate that could use for pricing of loan contracts and forward foreign exchange transactions. In addition, it impedes the effective transmission of monetary policy to the longer end of the yield curve. Regular issuance of three-month Treasury bills would help to meet these needs without constraining the use of MSBs for monetary purposes.

69. One problem recognized at the time of the financial crisis was the lack of liquidity in Korea’s foreign exchange markets. The authorities should be commended for the substantial efforts that they have taken since then to develop and deepen the liquidity in the foreign exchange market. Indeed, this market has improved significantly over the last three years in terms of liquidity and available instruments. Nonetheless, further steps to deepen it should be considered.16

Public debt management issues

70. Despite important improvements in government debt management, the market remains fragmented. In addition, maturities demanded by the markets—most notably a three-month bill that would help deepen money markets, and a longer term bill that is in high demand by institutional investors—are not issued or issued in insufficient amounts. A review of debt management practices suggests that there may be room to further lower the cost of government borrowing, while at the same time supporting the development of deeper money and corporate bond markets.

71. On the whole, public debt management is in line with the Guidelines for Public Debt Management. The risk management framework has been strengthened with the implementation of a simple, yet powerful system. The authorities may now wish to consider broadening the risk management framework towards an asset-liability management (ALM) approach.

72. The government bond market modernization plan launched two years ago has had important results. The introduction of a fungible issuance system and the buy-back operations have increased the average issue size and liquidity. The government has also launched a new 10-year Korean Treasury Bond (KTB). Furthermore, interest rate swaps and a futures contract based on the 3-year KTB have been introduced as hedging instruments for KTBs.

73. There is scope to develop the long end of the government bond market. In the long run, such lengthening can lower the government’s borrowing costs, and more importantly, facilitate the emergence of a fully developed and liquid corporate bond market. Consolidating Foreign Exchange Stabilization Bonds and National Housing Bonds with KTBs would help in reducing market fragmentation, starting in 2003 with KDIC and KAMCO bonds.

74. On the demand side, there is a clear need for more heterogeneous investors with different investment horizons and risk preferences. The National Pension Fund with its growing demand for assets could be a major force in the market. In addition, more active participation of foreign investors would also be helpful. This would have two main benefits: higher long-term demand for Korean government bonds and enhanced market liquidity from more active trading. The fact that foreign investors presently hold only 1 percent of the outstanding stock of government bonds suggests the existence of impediments to foreign investor participation in the market. Such impediments could include the withholding tax on interest income and the restrictions a foreign investor meets when trying to hedge foreign exchange exposure. Constraints related to the still relatively shallow secondary market may, however, be the most important disincentive.

E. Financial Safety Nets and Crisis Management Capabilities

Liquidity support in normal times

75. Short-term money markets are sufficiently liquid to allow banks access to market liquidity in normal times. In addition, the BOK has adequate facilities to manage overall liquidity and assist banks in meeting temporary shortfalls. It intervenes in the money market through repo transactions or the issuance/redemption of MSBs. Reserve requirements averaging also helps banks’ liquidity management. Finally, the BOK has a number of credit facilities to complement open market operations.

Emergency liquidity

76. The BOK Act provides sufficient flexibility for the BOK to provide emergency liquidity assistance (ELA) to financial institutions in periods of instability. It allows for collateral to be “temporarily defined as acceptable” and gives the BOK authority to restrict the activities of the borrower while there is ELA outstanding.

77. The BOK provided extensive ELA during the financial crisis but operations in the post-crisis framework remain untested. During the crisis, ELA assistance proved critical in containing the systemic liquidity crisis. However, the BOK’s ELA operations at that time were conducted when the government blanket guarantee on bank liabilities was still in effect, which is no longer the case. Looking forward, therefore, there could be new challenges for the BOK ELA operations, should a need for such lending arise again. The BOK is aware that any ELA operations in an environment of partial deposit insurance would subject the central bank to higher credit risks.

78. Given the separation of banking supervision from the BOK, assessing the systemic implications of a bank failure may be harder. Thus, there is a need for the BOK and the FSS to strengthen their information sharing arrangements. While the recent memorandum of understanding (MOU) between the BOK and the FSS is a useful step in that direction, care needs also to be taken not to duplicate on-site inspections.

79. On-going market consolidation will produce large financial institutions with complex organizational structures, where banks and non-bank financial institutions have inter-linkages and share common reputational risks. How to deal with such large and complex financial institutions in ELA operations should receive due attention. Moreover, as capital markets develop further, the liquidity situation of non-bank market intermediaries could have significant impact on overall market stability. Dealing with such potential contingencies is also a challenge for the authorities. The MOU between the FSS and the BOK is a welcome step in this process.

Deposit insurance and resolution of financial institutions

80. The Korea Deposit Insurance Corporation (KDIC) in cooperation with the Korea Asset Management Company (KAMCO) has been instrumental in resolving distressed financial institutions, and in paying depositor claims. This was done under the blanket Deposit Protection System that was put temporarily in place during the crisis. With the reinstatement of the Partial Deposit Protection System from January 1, 2001, KDIC’s role has broadened, from ex post facto deposit insurance provider, repaying deposits in the event of default, to include expanded responsibilities in monitoring and safeguarding the financial stability of insured deposits and the Deposit Insurance Fund.

81. The KDIC has already significantly improved its organizational structure to address its changing role. To safeguard the insurance fund it is considering the introduction of risk-based premiums and the development of risk assessment models to detect potential problems at individual institutions and the system as a whole. While in principle welcome—once preconditions have been met—the introduction of risk-based premiums is a demanding exercise and should be approached with caution, since inadequate implementation could have undesirable consequences.

82. The KDIC has proposed an amendment to the Deposit Protection Act to cease insuring credit unions. The National Credit Union Federation of Korea plans to establish a private deposit insurance system for its members. The authorities should proceed with caution until all nonviable institutions are resolved, to avoid the possibility of runs.

83. The existing safety net and resolution arrangements date from the 1997-98 crisis. In light of the changed environment, the roles of the different institutions concerned may now need to be reviewed, to set clear responsibilities to all those institutions and establish contingency planning for crisis management. The Financial Policy Coordination Committee could serve to identify priorities and establish guidelines for such planning. In assessing the respective roles of FSC/FSS, BOK, MOFE, and the KDIC arrangements for crisis management, coordination and frequent information sharing between these institutions should take precedence, perhaps through committees that establishes guidelines and procedures for early action, and meets regularly should symptoms of a systemic crisis emerge.

F. Corporate Governance

84. In the last few years, Korea has laid a solid foundation for good corporate governance. However, while formal corporate governance rules may now be substantially similar to other OECD countries, practices often fall short of the spirit, if not the letter, of the OECD principles. The challenge now lies in implementation and effective enforcement of legislative changes to improve the corporate culture and practices. The government and the business community should take additional steps to change incentives and further promote transparency of business practices, particularly among chaebol groups; to strengthen competition policies, in order to subject chaebol and firms to stricter market discipline; to enhance and enforce shareholder rights; and to improve disclosure and monitoring of related-party transactions.

85. To deepen its equity market, Korea needs to continue improving corporate governance practices in a manner consistent with other OECD countries and international best practice. While there has been good progress in upgrading accounting and auditing standards, efforts should continue to further improve accounting standards and their implementation to make them fully consistent with evolving international practices. Efforts in 2002 to step up enforcement of accounting and disclosure standards and the preparation of a draft accounting bill are welcome steps. In addition, Korea should also continue to improve the effectiveness of audit committees, including measures to clarify and strengthen the role and function of such committees; replace statutory auditors with audit committees for smaller companies over time; and upgrade the skills of audit committee members.

86. Holding companies, which would be more transparent than chaebol, are allowed, but not many have been established. To improve transparency of large chaebol, several measures could be considered, including some that may provide incentives for such entities to transform into holding companies.

87. Shareholder rights have been improved significantly to allow reduced levels of shareholding for assertion of certain rights, but further improvements are required. While derivative actions are allowed, these are costly and therefore have been limited so far to only a few. Shareholders lack a cost-effective way to seek redress. There is an urgent need to introduce class action lawsuits by shareholders and investors against directors, managers, and auditors for breaches of duty and violations of the law. The draft law submitted to the National Assembly to allow class action lawsuits should be enacted as soon as possible.

88. The concept of independent (outside) directors is new and still not well rooted in Korea. Directors may not know what is expected of them and how they should exercise their duties. There is an urgent need to establish an institute of directors to train directors on their duties, responsibilities, and accountabilities.17 Additional efforts could include measures to expand the fiduciary duty of directors to shareholders and make it explicit under the law; further expand and clarify the right of directors to access all corporate information necessary to perform their duties; and limit liability of independent directors in cases in which they have acted in good faith.

G. Combating Money Laundering and the Financing of Terrorism

89. Korea has made considerable strides towards observance of the Financial Action Task Force’s (FATF) recommendations on combating money laundering and the financing of terrorism. Korea’s Financial Intelligence Unit (KoFIU) joined the Egmont Group in June 2002, and its computer database became recently operational. A system for the strategic analysis of suspicious transactions will also become operational this year. Underscoring Korea’s commitment to AML/CFT, it submitted in August of 2002 to an on-site examination by the Asia Pacific Group of the framework it has set in place to combat these activities. Nonetheless, further efforts are warranted among others in the following areas: First, expediting the enactment of the Anti Terrorism Bill, consistent with the United Nations International Convention for the Suppression of the Anti- Terrorism of 1999. Second, the limitation of the Real Names Act on access to customer information should be addressed in order to facilitate international cooperation in the investigation of money laundering and financing of terrorism cases. Third, the monetary threshold for suspicious transaction reports should be abolished as soon as is practicable.

Section II—Report on Observance of Standards and Codes

I. Summary Assessment of Observance of the Basel Core Principles for Effective Banking Supervision

A. General

90. This assessment of the bank supervisory system in Korea was performed on the basis of the Basel Core Principles for Effective Banking Supervision and the Basel Core Principles Methodology.18 It was based on a review of the legal framework governing banking and bank supervision and extensive discussions with government and supervisory agencies, representatives of financial institutions and financial sector associations. The assessment also drew upon a partially completed self-assessment prepared by the Korean authorities.

91. Bank examination reports and other bank-specific analysis were not made available to the assessment team at the time of the mission, due to the Financial Supervisory Commission (FSC) and the Financial Supervisory Service (FSS) concerns regarding confidentiality. In subsequent discussions after the BCP mission, the staff of the FSC/FSS offered to provide access to confidential materials.

B. Institutional and Macroprudential Setting, Market Structure—Overview

92. As of mid-2002, the banking sector included nine nationwide commercial banks, six regional banks, five specialized and development banks, and 42 foreign bank branches. The Korean banking sector is highly concentrated and at present, following crisis- related interventions, dominated by the government. The share of the three and five largest banks stood at 51 and 69 percent of total sector assets, respectively. Eight out of 15 commercial banks are either majority government owned or co-owned by the government and private owners. When combined with government-ownership in specialized and development banks, in mid-2002 nearly 60 percent of the assets of the Korean banking sector is government-controlled. The government is pursuing active efforts towards privatization.

C. General Preconditions for Effective Banking Supervision

93. Presently, Korea’s macroeconomic management has delivered sound and sustainable policies, and the public sector infrastructure is well-developed, with a significant body of recently-revised laws covering the financial sector. The FSC, with the associated FSS and SFC, is an integrated supervisor, responsible for the regulation and supervision of the financial sector. Its powers include the authority to issue and revoke licenses for financial institutions. In addition, it has some responsibilities for corporate sector restructuring.

94. The power to define the scope of banking activities is vested in the Ministry of Finance and Economy (MOFE). Decisions regarding corrective action for problem banks rests with the FSC, the policy body, and not the FSS, the executing body. Once decisions are taken by the FSC and a framework for remedial action is developed, it is implemented at the operational level by the FSS. Under the general direction of the FSC, the FSS supervises financial institutions (via on-site examinations and off-site monitoring) and other participants in the financial markets. In addition to FSC/FSS, the MOFE, the Bank of Korea (BOK) and the Korea Deposit Insurance Corporation (KDIC) also have some involvement in the examination/supervisory process.

95. The legal machinery in place in Korea to support banking activities includes a relatively efficient court system. Korea is not fully compliant with International Accounting Standards (IAS), with differences due to the absence or incompleteness of rules governing related party disclosures and disclosures by banks and similar financial institutions. A new accounting standard for the banking industry is being drafted, which will be fully consistent with IAS. With respect to corporate governance, there is scope for strengthening market discipline by implementation of IAS and enhancing financial transparency for corporations. The Korean financial system is supported by a comprehensive public safety net and an explicit deposit insurance system.

D. Main Findings

96. Objectives, Autonomy, Powers, and Resources (CP 1). The operational independence of the FSC/FSS is embodied in law, however in practice several factors have called that independence into question. To protect the operational independence of FSC/FSS, the MOFE should allow laws in the financial sector to be implemented by regulation, to the greatest extent possible, and refrain from issuing its own interpretations of those regulations. The FSC’s responsibility for overseeing the financial restructuring program compromises its primary role as bank supervisor, and should, therefore, be vested with another agency. Measures should be taken to clarify responsibilities between the FSC and the FSS and between the FSC/FSS and the BoK and KDIC and. Finally, the FSC and the FSS should address key staffing issues that could potentially undermine their effectiveness, i.e., the lack of statutory protection for the FSC/FSS and their staff against lawsuits; the frequent turnover of the Chairman of the FSC; and the lack of adequate examination staffing resources to carry out supervision duties.

97. Licensing and Structure (CPs 2–5). The FSC/FSS lacks regulatory authority to determine the scope of permissible banking activities. Additionally, the legal framework and supervisory powers with respect to the licensing processes should be strengthened. The FSC/FSS should apply fit and proper test to employees below Board level, corporate ownership of banks should be subject to rigorous fit and proper tests, and the licensing of banks should be void of political interference.

98. Prudential regulation and requirements (CPs 6–15). Capital requirements for banks are broadly in line with the Basel capital standard, but there is need for the FSC/FSS to use flexibility in the application of capital adequacy ratios above the defined minimum. For banks, there is scope for strengthening and clarifying comprehensive loan evaluation methodologies and adherence to provision criteria, large exposure and concentration limits and transactions between insiders. The FSC/FSS also needs to strengthen their supervisory practices and banks’ capital and risk management techniques for off-balance sheet derivative exposures, and other risks. In terms of anti-money laundering legislation, the FSS needs to finalize and fully implement its internal procedures for ensuring compliance with the new legislation. The FSC/FSS needs to strengthen the prudential rules such as capital and asset classification norms for nonbank deposit-taking institutions, to bring them in line with rules for banks.

99. Methods of ongoing supervision (CPs 16–20). There is a need to further develop risk-focused supervision examination techniques (scope and periodicity) for each type of bank and other nonbank deposit-taking institutions, consolidated supervision of financial holding companies, and improve the quality of supervisory data management.

100. Information Requirement (CP 21). The quality of auditing, accounting, and financial and non-financial disclosure needs to be further improved in order to be consistent with best international practices.

101. Formal Powers of Supervisors (CP 22). There is a full range of remedial actions that can be taken against banks. However, there is scope to strengthen and clarify the FSS’ powers to initiate enforcement actions.

102. Cross-Border Banking (CPs 23–25). While the FSC/FSS undertake consolidated supervision on a global basis, provisions of the Real Name Transactions Act have the potential to prevent an unimpeded exchange of information with foreign supervisors.

Table 1.

Recommended Action Plan to Improve Observance of the Basel Core Principles

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E. Authorities’ Response

103. While the authorities recognize shortcomings with compliance with other BCPs, they believe that measures are in progress to strengthen compliance. In some cases, they note that existing practices limit potential exposures that could result from weaknesses identified through the BCP assessment. With respect to operational independence of the FSC/FSS, the authorities indicated that the lack of clarity in the roles of agencies overseeing the financial sector promotes an effective system of checks and balances. On legal protection for supervisors, the FSS also noted that it covers legal expenses for both civil and criminal lawsuits brought against FSS officers and staff for actions taken while lawfully discharging their official duties.

II. Summary Assessment of Observance of the Insurance Core Principles

A. General

104. This assessment of Korea’s observance of the International Association of Insurance Supervisors (IAIS) Insurance Core Principles involved the review of the self assessment prepared by the Financial Supervisory Commission (FSC) and the Financial Supervisory Service (FSS), comparison with the Core Principles and the Core Principles Methodology, and a review of parts of the insurance laws in Korea.19 In addition, a series of meetings and presentations were held in Seoul with the FSS and the FSC, including discussions on all aspects of their operations relevant to insurance supervision. Meetings and discussions were also held with representatives of the Ministry of Finance, selected larger and smaller insurers, both locally incorporated and branches. Industry groups were also consulted including the insurance industry bodies, the Korea Insurance Development Institute (KIDI), the actuarial body, auditors and academics. Assistance provided by these organizations is gratefully acknowledged.

105. The supervisory staff at the FSS and the FSC cooperated fully in the assessment.

B. Institutional and Macroprudential Setting—Overview

106. In 2000, the Korean insurance market had total premiums of $58.3 billion, representing 2.3 percent of the world market, placing Korea as the seventh largest insurance market by premium in the world. Premia as a percentage of GDP stood at 13 percent—well above most other countries and third behind South Africa and the United Kingdom. The comparisons of these figures with other countries are, however, complicated by the substantial savings element in non-life insurance business in Korea and the existence of relatively short-term life insurance policies.

107. The sector has emerged from a difficult period after the crisis. The life insurance sector, in particular, was hard hit by the effects of the crisis and the extensive exposure to negative spreads on in-force business. A number of companies left the market as a consequence, and one company converted to state ownership. Current circumstances are more positive as a result of restructuring, improved regulation, and increased profitability arising from restored consumer confidence and the asset price appreciation. It is cautionary to note that the structural issue that gave rise to negative spreads has been mitigated but not eliminated, and therefore continued prospects for the sector rely on continuing economic strength and asset growth.

108. The Korean non life insurance market is the tenth largest in the world. There are 22 companies operating as at December 2001, made up of 14 domestic and 8 foreign companies. Premium income in the year to March 2001 was W 16,478 billion. The market writes most classes of business, with the largest proportions of premia written in long-term insurance (42 percent in 2000) and automobile (39 percent).

109. The Korean life insurance market is also large in size and ranks sixth in the world. Life insurance premiums were just under 10 percent of GDP in 2000. The main products written are traditional endowment and whole of life insurances and various types of rider benefits. Unit linked insurance has recently been introduced and is growing. There are 22 companies operating in this market as at December 2001 made up of 12 domestic companies, 8 foreign companies and 2 joint ventures. The sector has been improving in its performance after a severe setback in 1997. Improved investment performance and a focus on productivity improvement, both in administrative operations and in distribution, have contributed. Companies are, however, still conscious of the need for further improvement including the need to prepare for the introduction of bancassurance.

C. General Preconditions for Effective Insurance Supervision

110. In Korea, the supervision of insurance falls under the ESC and the FSS. The principal legislation for the supervision of insurance is the Insurance Business Act. The legal structure in Korea operates effectively and the supervisor is able to make use of the general corporate laws and accounting standards.

111. Both the accounting and actuarial professions exist in Korea. The accounting and audit profession is more developed than the actuarial profession, where membership is small and technical capacity is still developing. As a result, the KIDI plays a role in carrying out extensive research projects which would otherwise fall to the actuarial profession. There is scope for the actuarial profession to make greater use of more sophisticated financial techniques, and they should be encouraged to do so. In addition, the reputational standing of the actuarial profession could be enhanced through greater use of actuarial approaches and advice by companies.

D. Main Findings

112. The Korean authorities have made considerable strides in the development of their regulatory and supervisory structure since the 1997 crisis. A high level of observance is achieved in the regulatory regime, reinforced by active supervision and enforcement on the part of the FSS and FSC.

113. Organization of an Insurance Supervisor. The insurance supervisory function is organized under the FSS and the FSC. This structure is adequately and flexibly resourced, operates clear lines of reporting and day to day decision making, and has established confidentiality and ethical requirements.

114. The operation of MOFE and the Regulatory Reform Committee in interpreting and reviewing decrees, regulations, and rules has the potential to reduce the operational independence of the FSC and the FSS, by clouding its autonomy and the ultimate responsibility for supervision and regulation. While it is appropriate to have some government body act as the ultimate reviewer of the regulatory and rule-making process, care is needed to ensure that any such review does not impinge on the operational independence of the FSC and the FSS.

115. In line with international best practice, consideration should be given to providing legal protection for the FSC/SFC/FSS and their staffs against lawsuits when carrying out their duties in good faith and without negligence.

116. Licensing and Changes in Control. The FSS and FSC operate a sound licensing regime which addresses all the IAIS criteria. The ‘fit and proper’ tests are formally applied to directors but could be more formally applied to senior management, and the inclusion of a 5-year ban could be altered to permit lifetime bans when relevant. Consideration could be given to removing the time limit for approval of applications. A regime for advice of change of control is in place but the requirement for approval is not in place but being given active consideration.

117. Corporate Governance and Internal Controls. With respect to corporate governance, the requirements for audit committees are relatively new and, whilst in place, have not been through a full cycle to ensure that the desired results are being achieved. Initial experience, particularly with respect to external directors, has indicated companies will need some time to gain experience in working with these requirements. Consideration may also be given to requiring separation of roles between chairmen, chief executives, and actuaries with official responsibilities. In addition, it may be useful to consider a mechanism for filling casual vacancies of non executive directors so as to ensure that the relevant effect and intention of the regulations were able to be maintained continuously rather than having to await a general meeting to be convened.

118. Prudential Rules. A comprehensive set of prudential rules has been developed since the crisis. Asset rules provide for asset management, financial derivatives, the mixture and diversification of assets, credit risk limits, and the treatment of particular types of assets. Assets are generally valued at market value for the purpose of financial reports. Pledging of assets is not permitted. The supervisor assesses the adequacy of liabilities and technical provisioning through off site analysis and on site inspections and assesses reinsurance recoveries being claimed against gross provisions. Particular attention is also given to catastrophe type provisions. KIDI prepares technical information to assist companies, particularly for incurred but not reported provisions for non life insurance companies. The provisioning for liabilities in Korea is consistent with a market value based environment and, therefore, the value of the assets on balance sheets.

119. The legislation and regulations on the supervision of insurance business imposes an EU modeled solvency regime. With respect to the non life insurance sector, higher parameters have been adopted than applies in the EU, which is appropriate given the other financial and institutional aspects in Korea. With respect to the life insurance sector, the parameters adopted are the same as applies in the EU directives and are being phased in over a period. Solvency is monitored actively and control levels are identified. There is no specific attention under the solvency regime to the question of double gearing in groups, but there are cases in practice where this situation arises.

120. Requirements with respect to derivatives and reinsurance show a high level of observance of both the essential and additional criteria.

121. Monitoring, Inspection, and Sanctions. Insurance distributors are required to be authorized and be fit and proper. The fair dealing with customers is elaborated extensively with regard to the taking out of contracts, point of sale disclosure and illustration, and anti-twisting rules. The supervisor encourages companies to establish customer complaint handling procedures and, through an office within the FSS (the Customer Protection Center), also deals with and resolves customer complaints.

122. Financial reporting to the FSS is satisfactory and all information is systematically analyzed off-site and subject to verification as part of the on-site inspection processes. The legal basis for on-site inspections is set out in the law, including an obligation to carry out such inspections and request and obtain information. Inspections are conducted on a full scale basis as well as on specific matters.

123. The FSS and FSC have the power to issue fines, limit business activity, force dealing with assets, and require the transfer of assets and liabilities to others or impose conservatorship. A range of sanctions are available; licenses can be denied or revoked; and Boards of directors or management can be dismissed and replaced. There is a regime of prompt corrective action requirements in place.

124. Cross-Border Operations, Supervisory Coordination and Cooperation, and Confidentiality. It is permissible for overseas companies to operate through distribution in Korea with only limited requirements. As such the local authorities are reliant on the quality of the home supervisor. Consultation with home supervisors is practiced. The exchange of information with anti money laundering authorities is in its infancy and is developing. The Act on the Establishment of the Financial Supervisory Organizations includes a broad confidentiality clause that covers the essential criteria. There are, however, no specific exclusions or permissions included that address the exchange of information with other supervisory or legal authorities.

E. Authorities’ Response

125. As a way to ensure soundness of the insurance sector and enhance the transparency in the insurance market, the FSC/FSS has incorporated much of the IAIS core principles into the insurance regulations and has been enforcing them. In October 2002, the FSC/FSS adopted the consolidated solvency margin rule and has been taking other steps as part of our broad efforts to ensure prudential regulation of the domestic insurance industry. The FSC/FSS is also looking into ways to seek greater accountability from the officers of insurance companies.

126. In response to the recommended actions in Table 2, the assessment of officers is included in the revised Insurance law, which is currently pending at the National Assembly. Abolishing time-based restrictions on licensing approvals along with banning industry participation indefinetely will be given careful review taking into account relevant laws and circumstances.

Table 2.

Recommended Action Plan to Improve Observance of IAIS Insurance Core Principles

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III. Summary Assessment of Observance of the Iosco Objectives and Principles of Securities Regulation

127. This assessment of Korea’s observance of the IOSCOObjectives and Principles of Securities Regulation20 is based upon interviews with the Financial Supervisory Commission (FSC), the Securities and Futures Commission (SFC), and the Financial Supervisory Service (FSS), as well as discussions with Korean governmental officials, representatives of securities self-regulatory organizations (SROs) and members of the Korean securities industry. These interviews were supplemented with a self-assessment prepared by the FSC and additional reference materials, including copies of applicant laws, decrees, reports, and regulations. The FSC/SFC/FSS cooperated fully with the assessment.

A. General

128. There are two main markets for equities in Korea: the Korean Stock Exchange (KSE), and the KOSDAQ. At the end of 2001, 689 companies were listed on the KSE, with a total market capitalization of W 255 trillion and a daily trading volume of approximately 610 million shares, with 66 percent of trading from on-line customers. Foreign investment in KSE companies is more than 36 percent. The KOSDAQ market has 721 listed companies with a market capitalization of W 52 trillion and daily trading volume of 367 million shares, predominantly short term on-line trading by individual (domestic) investors. In addition to these two markets, there is the the KOSDAQ OTC Bulletin Board system to enable trading in very small companies; the Korean Futures Exchange (KOFEX), a independent SRO; and Korea ECN Securities, a communications network that provides after hours trading in 200 KSE listed companies and 50 KOSDAQ listed companies. Korean markets function through direct interaction of orders. There are no market-makers or specialists acting as intermediaries. This may be a contributing factor to the high volatility in the Korean securities markets.

129. There are 60 securities companies licensed by the FSC to operate in Korea, including 17 foreign companies, with 52 of these companies being members of the KSE. The Korean securities industry is heavily concentrated, with the largest brokerage company controlling 14 percent of the market; its affiliated investment trust company and insurance company are also dominant. As of December, 2000 there were 79 investment advisory companies registered with the FSC. Banks and insurance companies, upon registration with the FSC, may only engage in underwriting and dealing in government bonds.

130. The bond market in Korea is small. Government bonds totaled W 296 trillion in value (year 2000) and corporate W 133 trillion (2000). While over 80 percent of debt is listed on the KSE, over 95 percent of trading occurs in the over the counter market, dominated by a small number of specialized dealers. The secondary market for corporate debt is also very thin. The OTC market in debt is heavily concentrated in five securities companies. There is little transparency, primarily because of a lack of active trading (prices are published daily based on valuation by the KSDA) and limited liquidity. Because of the tradition of holding debt to maturity, price discovery is difficult, as is locating contra parties. Although the KSE has just begun trading in repos, the market is restricted. ITC’s are only permitted to engage in repos, not reverse repos.

131. Private pension plans are uncommon and have limited assets to invest in equities. Insurance companies invest only a small proportion of their assets in equities. Collective investment schemes and investment trusts are relatively small players in the Korean market, with the bulk of funds under management invested in government debt. There are two types of investment trust products offered in Korea, investment trusts (ITC) and investment companies (ITMC). The ITC’s are contractual agreements and account for approximately 96 percent of all assets controlled by collective investment schemes. The limited effective life of most ITC’s and ITMC’s is a significant factor in the investment strategy for investors and, in turn, for the funds. Following the l997 financial crisis, most Korean investors consider ITC’s and ITMC’s to be short-term investments. Under Korean law, the standard trust agreements impose a redemption penalty on investors who withdraw any invested funds from an open-ended IT within three months or six months for a closedend fund. The remaining 50 percent may not be withdrawn for another three months. There is a tendency for Korean investors to regard this period as the maturity date of the fund. Because of the volatility of the Korean market (among the highest in the world), most Korean investors immediately withdraw funds as soon as possible. The result is an institutional investment sector that is focused on the short-term and a contributor to volatility rather than stability.


132. The FSC was created by the Act on Establishment of Financial Supervisory Organizations in 1998 to oversee regulation of Korean financial institutions and markets. It is a statutorily independent agency, under the general authority of the President, responsible for coordinating the activities of and setting policy for the SFC and FSS. It has a small staff of approximately 65, supplemented with staff on loan from the FSS. The FSC is responsible for issuing and revoking licenses of financial institutions. The SFC was created under the Act with specific responsibility for investigating market abuses and for accounting and auditing standards. It, too, is a governmental entity with a small staff. The FSS, headed by a Governor who is concurrently the Chairman of the FSC, is the principal operational financial system regulator. Unlike the FSC and SFC, it is technically not a government agency and its budget is funded through annual fees imposed upon regulated entities. As such, it is not bound by Korean government civil service standards and salaries. The FSS has a staff of nearly 1500. The FSS has the authority to examine and inspect the operations of all Korean financial institutions. It may compel testimony and the production of documents from persons and entities subject to its regulation and may recommend to the FSC disciplinary action against financial institutions and associated persons.

133. The Korean Ministry of Finance and Economy (MOFE) is the principal governmental institution charged with management of the Korean fiscal system and economy. Until the 1998 reorganization, it was the agency responsible for regulation of banks and non-bank financial institutions. MOFE continues to have primary responsibility for drafting legislation and submitting it to Parliament and for official interpretation of Korean financial laws and related Presidential Decrees. The Vice-Minister of MOFE is an ex officio member of the FSC.

B. Main Findings

134. Principles relating to the regulator. When viewed as a consolidated regulator, the FSC/FSS/SFC has sufficient authority to perform its regulatory duties. However, the trifurcated structure appears cumbersome and has the potential to impinge on regulatory effectiveness. While the FSC appears to make a concerted effort to solicit industry input into its policy deliberations, adoption of a formal public notice and comment procedure for proposed regulatory actions would enhance its ability to develop high-quality, cost-effective regulatory policies. In addition to enabling it to obtain the broadest possible range of public opinion, it would dispel any perception that some entities or components of the financial industry have an inordinate influence in the development of policy. A second concern is the overlap in interpretive responsibilities between the FSC/FSS and the MOFE. While the FSC/FSS has the authority to interpret its rules, the MOFE has the authority to interpret the law. This situation has the potential to reduce the operational independence of the FSC and the FSS, by clouding its autonomy and the ultimate responsibility for supervision and regulation. While it is appropriate to have some government body act as the ultimate reviewer of the regulatory and rule-making process, care is needed to ensure that any such review does not impinge on the operational independence of the FSC and the FSS.

135. Principles of self-regulation. Korean SRO’s have sufficient authority and appear to utilize it effectively in enforcing listing standards, but their exercise of authority is limited in some other key areas. They do not inspect or monitor member securities firms for compliance with capital adequacy standards (monthly reports to FSS are jointly filed with the appropriate SRO) or other regulatory requirements. Also, SRO disciplinary programs are limited in size and scope.

136. Principles for the enforcement of securities regulation. The FSC/SFC/FSS combination has sufficient comprehensive regulatory authority, and recent actions suggest a commitment to the effective use of this authority. While the SFC has statutory authority to oversee market misconduct, it relies upon FSS staff to perform much of the function. It may be useful to clarify the respective responsibilities of the two organizations.

137. Principles for cooperation in regulation. Because of the substantial infusion of foreign capital into Korean securities markets in recent years, it is highly likely that the FSC/SFC/FSS may have to investigate activities on the Korean markets that involve conduct by foreign investors. This will likely require the assistance of foreign regulators. However, foreign regulators as a general matter may not provide such assistance unless there is a memorandum of assistance that provides for reciprocity. Provisions of the Real Name Transactions Act have the potential to prevent an unimpeded exchange of information with foreign supervisors. Thus, the inability of the FSC to reciprocate may ultimately impede its ability to regulate its own markets effectively.

138. Principles for issuers. Korea has made a concerted effort to improve the quality of corporate disclosure through improved requirements, combined with an initiative to improve corporate governance and the quality of Korean accounting standards. Korean accounting standards are now approaching International Accounting Standards (IAS), and auditing standards are now fully consistent with international standards. The regulators have also strengthened enforcement by imposing sanctions on accountants for violations of standards or rules. Effective implementation of these standards and the quality of auditing, accounting, and financial and non-financial disclosure needs to be further improved in order to be consistent with practices in other advanced industrial countries. A major impediment to complete implementation of Korean GAAP and GAAS is a shortage of properly trained accountants, auditors and corporate financial officers. A second impediment may be the historically low audit fee paid by Korean companies, estimated to be roughly 20–25 percent of the comparable audit fees paid in Japan and the United States.

139. Principles for collective investment schemes. There is an established system for regulation of collective investment schemes, which do not play a major role in the Korean financial system. The requirement that the management company invest a minimum of W 100 million on in the start up of an ITMC may be a contributing factor in the limited use of ITMCs, given that they have a typical life span of less than two years.

140. Principles for market intermediaries. Korea has a comprehensive regulatory structure for brokerage firms. Its system for overseeing capital adequacy of firms should be carefully monitored to ensure that it can identify firms with capital deficiencies in a timely manner. For example, the FSS could impose a more frequent computation and reporting requirement. Close oversight of firm capital adequacy is particularly important given the volatility in the Korean market and the generally low capital levels of all but the largest firms. The requirement that underwriters act as market stabilizer for 30 days after an offering of securities may also create risk exposure as well as depressing the offering price, as it creates a contingent liability for underwriters for the entire offering.

141. Principles for the secondary market. Korea’s regulatory structure provides all necessary authority for adequate regulatory oversight. In fact, it may not be necessary for Korean regulators to actively involve themselves in detailed decision making on market products, and consideration could be given to granting Korean markets greater latitude in making such business decisions. Conversely, it may be appropriate for the FSS to increase its direct surveillance of the markets, given the limited amount of direct enforcement performed by the SRO’s.

Table 3.

Recommended Action Plan to Improve Observance of the IOSCO Objectives and Principles of Securities Regulation.

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C. Authorities’ Response

142. The FSC/FSS has been observing the international standards in most areas including capital adequacy an internal control. Especially, the FSC/FSS is reviewing the internal control standard on a regular basis to ensure that the compliance officer system and Internal Control System (ICS) take root. Both systems were initiated in 2000 and the FSC/FSS is evaluating the ICS of securities companies when performing on-site examinations.

IV. Summary Assessment of Observance of the Cpss Core Principles for Systemically Important Payment Systems21

A. General

143. The Korean payment system consists of a central high-value funds transfer system, the Bank of Korea Financial Wire Network (BOK-Wire), which is operated by the Bank of Korea (BOK), and several other paper-based and electronic systems operated by the Korea Financial Telecommunications and Clearings Institute (KFTC), a company owned by payment system participants, including the BOK. BOK-Wire is a wholesale funds transfer system that accounts for around 70 percent of the total value of cleared payments in Korea. All BOK-Wire transactions are settled on a real-time gross settlement (RTGS) basis across participants’ settlement accounts at the BOK. A minimum transaction value of W 1 billion for customer payments is enforced, but there is no limit on funds transfers between BOK-Wire participants. Any financial institution holding a settlement account at the BOK is eligible to participate in BOK-Wire. Currently, banks, including all foreign bank branches, and non-bank institutions such as securities companies and merchant banking corporations participate in the system. As at end-2001, there were 132 members of BOK-Wire, of which 65 were banks and 67 were non-bank financial institutions.

144. The KFTC-operated systems include a variety of interbank electronic payment systems. The KFTC also operates a check clearing system and a paper-based bank giro system. Each of the KFTC-operated systems settles on a multilateral net basis through BOK-Wire at designated times (currently 2:30 p.m. for checks and 11:30 a.m. for all other KFTC systems). BOK-Wire is also used to settle high-value cash transfers between participants, BOK loans and discounts to banks, Korean Government treasury payments and receipts, and the cash leg of some securities settlement transactions. These securities transactions relate to over-the-counter (OTC) trades in debt securities markets. At present, the BOK estimates that up to 40 percent of the total value of debt securities trades are settled on a delivery-versus-payment (DvP) basis via a link between BOK-Wire and the KSD.22 Cash payments relating to the remaining 60 percent are made using other payment mechanisms, such as the Electronic Banking System and cashiers’ checks (i.e., a check drawn by a bank on itself). These transactions are not settled on a DvP basis. It is possible that the existing market practice of settling debt securities trades on the day the trade occurred (i.e., T+0), which exceeds current international best practice, may be impeding BOK’s attempts to encourage DvP settlement.

145. The check clearing system is the second most important clearing system in Korea in terms of the value of transactions cleared, accounting for a little under 19 percent of the total value of cleared payments. There are a number of reasons for this. First, promissory notes (which are cleared in this system) are actively used as a means of payment for commercial transactions. These instruments account for around 40 percent of the total value of items cleared in the check system. Second, cashiers’ checks are widely used as a means of paying for larger-value commercial transactions between individuals (e.g., car and house purchases) and between companies. These instruments are also used as a substitute for higher-value currency notes. (The largest currency note on issue in Korea is the W 10,000 currency note, which is worth approximately $8 dollars.) However, data provided by the BOK indicate that the substitution of cashiers’ checks for higher-value currency notes has a significant influence on the volume, but not the value, of checks exchanged in the Korean payments system. Third, cash payments relating to the settlement of some OTC debt securities trades and exchange-traded equities transactions are made using cashiers’ checks. This is less than optimal as the rules of the check system allow checks drawn on a failed bank to be unwound.


146. The BOK is the public sector agency responsible for the oversight of the Korean payment system. Under the Bank of Korea Act, the BOK has the authority to operate and manage payment systems for the purposes of implementing its monetary and credit policies. Since 1994, the BOK has operated BOK-Wire. The BOK performs other payments-related activities, including issuing currency and providing current accounts for the settlement of interbank obligations among financial intermediaries.

147. In December 2001, the BOK’s Monetary Policy Committee (MPC) passed a new regulation—the Regulation on the Operation and Oversight of Payment Systems—that, among other things, sets out BOK’s oversight objectives and requires the Governor to submit an annual report to the MPC on the BOK’s oversight activities.

B. Main Findings

148. BOK-Wire has a high degree of compliance with the Core Principles. There is one issue, relating to the ability of the BOK to oversee private sector systems’ compliance with the Core Principles that could be significantly improved.

149. Central Bank Responsibilities in applying the CPs. Under the current arrangements, the BOK is not explicitly responsible for ensuring that risks are controlled in private sector payment systems, nor does it have powers defined in legislation to intervene in circumstances where it believes that private-sector payments arrangements may compromise the stability of the Korean payment system. In these circumstances, the BOK’s payment system policy objectives may not always be fully achieved, or achieved within an acceptable time frame. This is not optimal given the potential for poorly designed payment systems to quickly transmit financial shocks, such as the insolvency of a payment system participant, throughout the financial system.

150. Emerging best practice around the world is for central banks to have an explicit legislative mandate for the stability, and sometimes also the efficiency of the payment system, and associated powers to ensure that this mandate can be carried out. These powers often include the ability to require data, set risk control and other standards and issue directions to payment system operators. It is also common for the central bank to have to provide an annual report to the Government outlining key payment system issues and the actions it has taken to achieve its policy objectives.

151. Efficiency and practicality of the system (CP VIII). The BOK-Wire system provides a low cost and effective service to its participants. At present, there is no limit on the minimum value of interbank payments. However, Article 21 of the Working Regulation on the Operation and Oversight of Payment Systems requires that customer payments must have a value of at least one billion won.

152. It is recommended that steps be taken to reduce the value of payments cleared through the check system. To promote this objective, it is recommended that the minimum transaction value of W 1 billion for customer payments through BOK-Wire be lifted, provided there is sufficient excess processing capacity to cater for the likely increase in transaction volumes. In addition, the exchange of higher-value promissory notes through the check system should be discouraged; BOK-Wire payments could be used as an alternative means of transferring funds to the presenters of these notes.

153. Further steps should also be taken, in concert with the KSD and financial market regulatory authorities, to ensure that cash payments forming one side of a securities settlement transaction take place through a payments mechanism that complies with the Core Principles; that interbank obligations arising from these cash payments are settled via BOK-Wire; and that all securities settlements occur on a DvP basis.

Table 4.

Recommended Action Plan to Improve Observance of CPSS Core Principles and Central Bank Responsibilities in Applying the CPs

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C. Authorities’ response

154. The BOK was in broad agreement with the assessment. With regard to having an explicit legislative mandate specifying the responsibilities and powers of the BOK for payment system operation and oversight, the BOK will strive to have these provisions inserted into the BOK Act at some future date when a review of the Act or other relevant legislation is undertaken.

155. The BOK and the Korean Government have already introduced various arrangements for the substitution of promissory notes, such as Corporate Procurement Loans, Electronically-Processed Secured Receivables Loans, Corporate Procurement Cards, and Electronic Receivables System for Business-to-Business transactions. The BOK will continue to support these arrangements for a further substitution of checks and bills, including promissory notes. Serious consideration will be given to implementing the recommended actions, in order to reduce the value of payments cleared through the check system.

V. Summary Assessment of Observance of the Code of Good Practices on Transparency in Monetary and Financial Policies

A. Transparency of Monetary Policy23


156. The Bank of Korea Act defines the objectives and responsibilities of the Bank of Korea (BOK), and requires the BOK to set a price stability target each year in consultation with the Government, and to formulate and implement an operational plan to achieve this target. The BOK is required to publish monthly balance sheets and an annual balance sheet, as well as an annual report. The BOK is required to submit a report to the National Assembly at least once a year on the implementation of monetary and credit policies, and the Governor is required to appear before the National Assembly to discuss the report. The internal auditor of the BOK is required to submit a comprehensive audit report to the Government and to the MPC on an annual basis, and the BOK must be audited by the National Board of Audit and Inspection (the official government auditing body) each year.

Main findings

157. Clarity of roles, responsibilities, and objectives of the central bank for monetary policy. In general, the BOK practices a high degree of transparency in most aspects of its operations. There are a few areas where further steps could be taken to improve transparency, as discussed below. The BOK has a set of internal procedures in place that govern procurement, which are not publicly disclosed, but are provided to prospective bidders and are available to interested parties upon request.

158. Open process for formulating and reporting monetary policy decisions. While the BOK Act requires an annual target for inflation, in practice, the operating horizon of monetary policy is often outside the target period, because monetary policy decisions will have limited impact on inflation in the remainder of the year, but a potentially significant impact on inflation next year. The adoption of a medium-term target by the MPC partly compensates for this problem. This complexity in the inflation targets and the resulting potential for public misunderstanding is a consequence of the BOK Act rather than BOK practices, and the BOK is seeking to improve the Act in due course. The BOK consults with commercial banks and other financial institutions on a consistent basis, providing them with a broad description of the proposed changes. These consultations usually occur within one to three months prior to the enactment of the change.

159. Public Availability of Information on Monetary Policy. The statistical releases of the BOK meet almost all of the requirements of the IMF’s Special Data Dissemination Standard (SDDS) for the coverage, periodicity, and timeliness of data and for dissemination of advance release calendars, with the exception of the international investment position. The BOK intends to publish international investment position data for 2002 by June 30, 2003. The balance sheets presented in the BOK’s Annual Report are in summary form only, and do not provide a detailed picture of the balance sheet. The accounting rules followed by the BOK in preparing its balance sheets are not publicly disclosed.

160. Accountability and assurances of integrity by the central bank. The BOK also has its own internal administrative rules regarding organizational and personnel matters, accounting, and welfare issues. These internal administrative procedures are not published or available to the public. There are no general legal protections for BOK staff.

Table 5.

Recommended Action Plan to Improve Observance of IMF’s MFP Transparency Code Practices-Monetary Policy

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Authorities’ response

161. The BOK was in broad agreement with the assessment, and intends to take appropriate measures to heighten transparency in monetary policy. Regarding the process for formulating monetary policy, the BOK Act requires the BOK to set an annual inflation target. Although the medium-term target is not required by law, it has been established and operated since 2000. According to the BOK, the medium-term target is intended to compensate for the limitations of the annual target. Currently, the mid-point of the annual inflation target is within the range of the medium-term target. The BOK provides a detailed background explanation of the annual and medium-term inflation targets in its various publications, including the Annual Report, the Monetary Policy Report, and press releases.

162. Regarding changes to regulations, the BOK consults with commercial banks and non-bank financial institutions in most cases, and reflects their suggestions and ideas when amending monetary policy related regulations. In the opinion of the BOK, when major matters are to be amended, it follows reasonable procedures for gathering the opinion of the financial community. The BOK plans to publish the accounting rules, policies, and footnotes relating to financial statements from fiscal year 2003.

B. Transparency of Payment System Oversight24


163. The BOK is the public sector agency responsible for the oversight of the Korean payment system. Under the Bank of Korea Act, the BOK has the authority to operate and manage payment systems for the purposes of implementing its monetary and credit policies. In December 2001, the BOK’s Monetary Policy Committee (MPC) passed a new regulation—the Regulation on the Operation and Oversight of Payment Systems— that, among other things, sets out BOK’s oversight objectives and requires the Governor to submit an annual report to the MPC on the BOK’s oversight activities.

Main findings

164. Clarity of roles, responsibilities, and objectives of financial agencies. The institutional framework for payment system oversight is largely defined in the Bank of Korea Act and the Regulation on the Operation and Oversight of Payment Systems. The Regulation sets out the BOK’s payment system objectives and reporting requirements. It also seeks to provide a legal basis for the BOK to require data and reports from payment system participants, conduct inspections, and impose sanctions or corrective measures on payment system operators or participants that violate its regulations or rules. However, this regulation is not underpinned by legislation.

165. Accountability and assurance of integrity by payment systems oversight agencies. The BOK has its own internal administrative rules regarding organizational and personnel matters, accounting, and welfare issues. These internal administrative procedures are not published or available to the public. The accounting rules of the BOK are also not published. They follow the general accounting rules in place for government agencies. There are no general legal protections for BOK staff, and no disclosure of this lack of protection.

Table 6.

Recommended Action Plan to Improve Observance of IMF’s MFP Transparency Code Practices-Payment Systems Oversight

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Authorities’ response

166. The BOK was in broad agreement with the assessment. With regard to having an explicit legislative mandate specifying the responsibilities and powers of the BOK for payment system operation and oversight, the BOK will strive to have these provisions inserted into the BOK Act at some future date when a review of the Act or other relevant legislation is undertaken. The BOK plans to publish the accounting rules, policies, and footnotes relating to financial statements from fiscal year 2003. The BOK will also expand the public disclosure of internal governance procedures that are considered necessary to assure the public of the integrity of its operations.

C. Transparency of Banking, Insurance, and Securities Supervision25


167. The Act on the Establishment of Financial Supervisory Organizations (AEFSO) establishes the Financial Supervisory Commission (FSC)/Securities and Futures Commission (SFC)/Financial Supervisory Service (FSS) as a unified regulator for Korean financial markets, covering banking, insurance, securities markets, and nonbank financial institutions. The Act states that the objective of the FSS is to examine and supervise financial institutions under the directions of the FSC or the SFC. The relationships between the key financial agencies (the FSC, the SFC, the FSS, the BOK, the KDIC, and the MOFE) are also defined in the AEFSO.

Main findings

168. Clarity of roles, responsibilities, and objectives of financial agencies. The broad objectives for the FSC and the FSS are clearly defined in the AEFSO. Procedures for appointment, terms of office, and any general criteria for removal of the heads and members of the governing bodies of financial agencies are defined in AEFSO. The objectives are elaborated in speeches, articles and public documents issued by the FSC and the FSS. The FSC and FSS submit to an annual audit and inspection by the National Assembly and receive National Assembly requests for information and testimony from officials. The AEFSO is available from the FSS in hard copy and on its website.

169. For insurance, the FSS and the Korean Insurance Development Institute work closely together on aspects of product supervision although the KIDI is not a fully authorized self-regulatory organization. The KIDI produces an annual report on its operations with respect to these and other aspects of it’s work.

170. Open process for formulating and reporting of financial policies. The regulatory framework governing the conduct of financial policies is outlined in the AEFSO, with operating procedures specified in the regulations issued by the FSS and made available in hardcopy and on the website. Policies, objectives, and changes to regulations are explained in a variety of publications available from the FSS in hard copy and on their website. For proposed substantive technical changes to the structure of financial regulations, industry consultation is conducted, although the FSS could consider consulting with a wider range of potentially interested parties by inviting public comments within a specified time period, for all proposed changes. The FSC discloses the existence of memoranda of understanding with foreign supervisory authorities in the weekly newsletters and on its website.

171. Public availability of information on financial policies. The FSS maintains an extensive public information service that publishes and disseminate press releases and reports on financial supervisory policies to the public. The FSS publishes an Annual Report, which provides a broad overview of developments in the industry; a Weekly Newsletter, which contains articles discussing broad trends in the industry; press releases about specific developments in the financial sector; and a Monthly Financial Statistics Bulletin with aggregate data on financial institutions. All of these publications are available in hard copy and on the extensive FSS website. Senior officials hold press conferences, deliver lectures, give interviews and attend public meetings of industry bodies, with the text of these public addresses generally made available on the FSC or FSS website.

172. Accountability and assurances of integrity by financial agencies. The FSC/FSS report to the National Assembly twice a year (at the beginning of the year and during the regular session of the National Assembly) and exchange views with members of the Assembly on the state of the financial system. The FSS is audited every year by the National Board of Audit and Inspection, an independent government agency. The FSS does not publish audited financial statements but they do follow the general accounting rules in place for government agencies. The FSS discloses a summary balance sheet and income statement in its Annual Report. It also has its own internal administrative rules regarding organizational and personnel matters (including rules governing conflicts of interest), accounting, and auditing arrangements. The full range of internal administrative procedures are not published or available to the public. There are no legal protections for officials and staff of government agencies. The Legal Affairs Office of the FSS defends lawsuits brought against the FSS and its staff pertaining to the official conduct of their duties.

Table 7.

Recommended Action Plan to Improve Observance of IMF’s MFP Transparency Code Practices—Banking, Insurance, and Securities Supervision

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Authorities’ response

173. The FSC/FSS has been trying to establish the market-driven supervision system by encouraging the voluntary participation of all the interest parties in the market. In order to achieve this objective, the FSC/FSS has established the appraisal system to measure the effectiveness of supervision policy and the advisory committee for financial soundness. The fairness and efficiency of supervision policy have been enhanced by reflecting their feedback. In addition, the FSC/FSS will implement a new system to receive consultation papers from the market participants and scholars whenever the FSC/FSS try to set out new financial measures or strengthen the current ones.

174. The FSC, as a government agency, sets up its budget through legal procedures. Plus, at the end of each fiscal year, the FSC is obliged to submit financial statements to the National Audit Committee for audit and file the audit result to the National Assembly before the beginning of the following fiscal year. SFC operates on the FSC’s budget since they are not separate administrative entities.

175. The FSS, in accordance with relevant regulations, requires and approval by the FSC. In addition, the FSS is already getting an annual audit by a private audit firm and discloses, or a regular basis, financial and budget information, including its financial statements on the web site.

176. Therefore, it should be noted that the FSC/SFC/FSS strictly observe accounting rules and the auditing and disclosure of the internal operations are being practiced in a transparent manner.

D. Transparency of Deposit Insurance26


177. The KDIC was created under the Depositor Protection Act (DPA) of 1995 with the objective of operating the deposit insurance system prescribed in the Act. The broad objectives, institutional framework, modalities of accountability, and procedures for appointment and removal of senior officials are defined in the DPA and in the Public Fund Management Special Act (PFMSA). Copies of the DPA and PFMSA are included in the Annual Report, which is available in hardcopy and on the website. The regulatory framework governing the operations of the KDIC is specified in the DPA and PFMSA and their associated enforcement decrees. Major policy changes are announced and explained via press releases at the conclusion of meetings of the Policy Committee, and in regular interviews and speeches by the President of the KDIC. The KDIC also describes its objectives, performance, and policy changes in its Annual Report. The KDIC provides extensive, detailed information on financial support provided to insured institutions on its website and in its Annual Report, disaggregated by type of financial institution, by type of financial support, by month, and by individual institution.

Main findings

178. Public availability of information on financial policies. Senior officials of the KDIC appear in the media and give speeches and interviews. The transcripts of such interviews are disclosed in some instances on the KDIC website. A presumption in favor of disclosure of the text of public statements by senior agency officials would be helpful to ensure equal access to the statements of senior officials.

179. Accountability and assurances of integrity by financial agencies. The accounting rules of the KDIC are not published. The accounting principles and rules utilized by KDIC are basically the same as the Korean GAAP with minor discrepancies. Additional information on discrepancies between the KDIC’s accounting rules and Korean GAAP accounting rules and policies would be helpful. A more detailed breakdown of operating expenses and more extensive use of accompanying notes in the financial statements would enhance the transparency of operations.

180. In general, the KDIC does not provide legal protection for the executives and staff. However, in respect of specific circumstances related to staff of KDIC assigned as trustees of bankruptcy estates or management supervisor of failed financial institutions, the KDIC does provide legal protection as they conduct relevant business under the guidance of the KDIC even though the business is conducted outside of KDIC. The internal regulations regarding KDIC staff, such as the code of conduct for KDIC employees are not publicly disclosed.

Table 8.

Recommended Action Plan to Improve Observance of IMF’s MFP Transparency Code Practices—Deposit Insurance

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Authorities’ response

181. In terms of basic accounting rules or “Criteria for Account Settlement,” they have been disclosed in the Annual Reports since 2000. As the governing accounting principles and rules utilized by KDIC are basically the same as the Korean GAAP with minor discrepancies, KDIC does not necessarily believe that any further disclosure is necessary for enhancement of public’s understanding of the KDIC accounting practices. In terms of internal governance procedures, the KDIC is considering limited disclosure of some internal governance procedure and auditing arrangements. Furthermore, KDIC views the two items as rather proprietary to each individual organization. In terms of standards of conduct for employees, the KDIC does have a “code of ethical conduct” and will consider posting it on its website. In terms of legal protections for staff, the KDIC is considering disclosure the extent of specific circumstances where legal protection is provided for staff of KDIC assigned as trustees of bankruptcy estates or management supervisory of failed institutions.

VI. Summary Assessment of Observance of the Oecd Principles of Corporate Governance

182. This assessment of the quality of corporate governance in Korea was performed as part of the joint IMF/World Bank Financial Sector Assessment Program (FSAP), conducted during April 11–23 in Seoul.27 The assessment was conducted by determining the levels of observance with the Organization for Economic Cooperation and Development (OECD) Principles of Corporate Governance (the “OECD Principles”). The assessment also identified areas where further development may be appropriate.

A. General

183. For the purpose of the OECD Principles, corporate governance is “that structure of relationships and corresponding responsibilities among a core group consisting of shareholders, board members, and mangers designed to best foster the competitive performance required to achieve the corporation’s primary objective.”28

184. Korea’s corporate ownership structure has been characterized by affiliation and cross-ownership among firms. Families that run chaebol own far less than 50 percent of related companies, but they have had almost total control over the combined business group. Prior to 1998, ownership concentration combined with weak protection of outsider shareholders, an uncompetitive financial system, and opportunities for malfeasance and corruption by powerful insider shareholders, had led to corporate inefficiencies. In many instances, there had been little distinction between managers and owners. Collusion between chaebol and the government had further exacerbated failures of corporate governance. Large shareholders had been reluctant to install mechanisms that could erode their control and the benefits it brings.

185. Since 1998, Korea has taken important steps to address corporate governance weaknesses. The corporate governance framework has been strengthened significantly. Duties of directors on the boards of listed companies have been clarified. A Code of Best Practices for Corporate Governance has been issued. Minority shareholders rights have been strengthened through the reduction of thresholds for the exercise of certain rights. There has been good progress in upgrading accounting and auditing standards and practices and strengthening underlying institutions responsible for setting standards and ensuring compliance: accounting and auditing standards have been improved significantly and are now largely consistent with international standards, and the KASB, an independent standard-setting organization, has been established and is developing and issuing standards. The FSC/FSS have been established, and the role of the Korean Institute of Certified Public Accountants has been strengthened. While significant improvements have been made, efforts should continue to further improve accounting standards as well as accounting and auditing practices.

B. Main Findings

186. The reform agenda for corporate governance remains unfinished. In order for Korea to deepen and strengthen its equity market, it needs to build on the excellent progress made to date and continue to improve corporate governance practices in a manner consistent with other OECD countries and international best practices. Going forward, Korea needs to deepen the progress made in improving financial transparency and shifting corporate culture in two directions: the separation of management from ownership, and the maximization of shareholder value rather than corporate size.

187. While formal corporate governance rules may not now be substantially different from other OECD countries, corporate governance practices often fall short of the spirit, if not the letter, of the OECD Principles. The challenge now lies in implementation and effective enforcement of legislative changes to improve the corporate culture and practices. Beyond the changes in legislation affecting corporate governance, the Government and the business community should take additional steps to change incentives and further promote transparency of business practices, particularly among chaebol groups; to strengthen competition policies, in order to expose chaebol and firms to stricter market discipline; to increase and enforce shareholder rights; and to improve disclosure and monitoring of related party transactions. While significant improvement has been made to improve accounting and auditing standards, efforts should continue to further improve accounting standards and improve accounting and auditing practices.

Rights of shareholders

188. Shareholder rights have been strengthened significantly to allow reduced levels of shareholdings for assertion of certain rights such as demanding removal of directors and auditors, seeking injunctions against directors, initiating a derivative lawsuit, convening a general meeting of shareholders, and inspecting the account books of a company. Cumulative voting is now permitted, unless explicitly revoked in a company’s articles of incorporation. While significant improvements have been made to increase minority shareholder rights (e.g., by lowering or eliminating threshold ownership requirements) and the ease with which shareholders exercise those rights, further improvements are required. These could include changing the incentives to make cumulative voting more appealing for large listed companies as a means of allowing minority shareholders a greater voice in the selection of directors (where a certain percentage of shareholders request it). Currently, more than 80 percent of listed firms have opted out of cumulative voting. Additionally, further steps should be taken to improve the process for nomination of independent directors by, for instance, requiring that at least two-thirds of members of outside nomination committees be independent directors.

Equitable treatment of shareholders

189. While derivative actions are allowed, these are costly and therefore have been limited so far to only a few cases. The redress available to shareholders if their rights are violated remains limited. There is no cost-effective way for shareholders to seek redress. There is an urgent need to introduce class action lawsuits by shareholders and investors against directors, managers, and auditors for breaches of duty and violations of the law.29 The draft law submitted to the National Assembly to allow class action lawsuits should be enacted as soon as possible. Related party transactions are widespread in Korea, but since they involve controlling shareholders, or more often affiliated persons, rather than directors, they are not covered by the Commercial Code. Further steps should be taken to ensure that directors, controlling shareholders and other related parties make full disclosure to the board on related party transactions. Additionally, the accounting standard concerning related party transactions need to be made fully consistent with international standards.

Role of stakeholders in corporate governance

190. The role of institutional investors, who play a key role in corporate governance in many OECD countries, is an area that should be further developed. This could be achieved, for example, through pension system reform to encourage further capital market development. Further consideration should be given to how to better ensure the rights of stakeholders and their protection in the corporate governance framework.

Disclosure and Transparency

191. Large chaebol have been required to prepare combined financial statements since the year 2000. However, the transparency of related party and conflict-of-interest transactions within the chaebol, particularly between unlisted subsidiaries and third parties that may not be at arms-length, remains a challenge. While combined financial statements for large chaebol attempt to capture accounting information, non-accounting information may not be easily available or reliable. While holding companies are allowed, only a few have been established. In order to improve transparency and disclosures of chaebol-affiliated operations, several measures could be considered, including changing the incentives for large chaebol to establish holding companies (e.g., through lower taxes), and a shortening of the period for preparation of combined financial statements after the close of a financial year.

192. Listed companies are now required to produce quarterly reports. Further efforts will be required to ensure that listed companies report regularly to shareholders on the extent to which their corporate governance practices conform to the standards established by the Code of Best Practice for Corporate Governance.

Responsibilities of the Board

193. Large listed companies have been required to establish audit committees of the boards of directors. However, the concept is new and audit committees are generally perceived to be neither effective nor adequately equipped to effectively discharge their oversight responsibilities. Efforts should continue to improve the effectiveness of audit committees, including measures to clarify and strengthen the role and function of audit committees consistent with international best practices; replace statutory auditors with audit committees for smaller companies over time; and upgrade the skills and knowledge of audit committee members.

194. Securities laws have been amended to require that at least 25 percent of boards of directors of listed companies be outside directors. The statutory minimum is fifty percent (three outside directors at a minimum) for financial institutions and large listed companies. However, the concept of independent (outside) directors is new and still not well rooted in Korea. Directors may not know what is expected of them and how they should exercise their duties. There are efforts to establish an institute of directors to train directors on their duties, responsibilities, and accountabilities. There is an urgent need for such an organization and training of directors, and these efforts need to be expedited. Additional efforts could include measures to: expand the fiduciary duty of directors to shareholders and make it explicit under the law; further expand and clarify the right of directors to access all corporate information necessary to perform their duties; and limit liability of independent directors in cases in which they have acted in good faith.

Table 9.

Recommended Action Plan to Improve Observance of OECD Principles of Corporate Governance

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