This note is on Korea’s transition to a knowledge-based economy, the prospects and challenges ahead, and the development of its financial sector. Assessment of recent government initiatives to develop capital markets has been presented. The note discusses restrictions on Chaebol ownership of Korean banks and strategy for restructuring the small and medium-sized enterprise sector in Korea. This note describes the key fiscal challenges and discusses possible ways to address them, arguing that there is already a great need to start taking remedial action.


This note is on Korea’s transition to a knowledge-based economy, the prospects and challenges ahead, and the development of its financial sector. Assessment of recent government initiatives to develop capital markets has been presented. The note discusses restrictions on Chaebol ownership of Korean banks and strategy for restructuring the small and medium-sized enterprise sector in Korea. This note describes the key fiscal challenges and discusses possible ways to address them, arguing that there is already a great need to start taking remedial action.

II. A Financial Big Bang in Seoul? The Development of the Financial Sector in Korea24

A. Why is the Development of the Financial Sector so Important for Korea?

1. The development of the financial system is very important for Korea as its economy matures, becomes more open and integrates with the region. With growth becoming increasingly dependent on productivity, raising the efficiency of capital allocation in the economy is key to boosting long-term prospects. The development of the financial system is needed to respond to the needs of a modern Korean economy and to reflect the type of financing required for high-tech firms to emerge and prosper. At the same time, the aging of the population will require the provision of sophisticated financial products. Finally, as its economy becomes more open and integrates with its neighbors, Korea may have a role to play in intermediating savings from the region. Indeed, the ambition of the government is to have Korea become an important trade and financial center in Northeast Asia and benefit from the rise of China.

2. This paper gives an assessment of recent government initiatives to develop capital markets. In Section B, the paper describes the state of the financial sector, and points to the need for capital markets to be developed in order to complement an already large and vibrant banking sector. In Section C, it introduces the recent initiatives that have been adopted in the past few years by the authorities to deal with it. In Section D, it presents the government’s first pillar: the deregulation of capital market activities and shows (in Section E) how it differs from global trends. Some lessons from the experience of Europe and the United States in dealing with the elimination of barriers between different financial activities are introduced in section F. The paper provides in Section G and H some recommendations on how to deal with potential risks that may arise during the liberalization process in Korea based on international experience. Section I presents the second pillar: the development of the foreign exchange market suggesting in Section J some ways to foster the development of the money and bond markets, prerequisite for an active foreign exchange market.

B. Why Is The Development of Capital Markets Lagging Behind that of the Banking Sector?

3. Since the financial crisis, the Korean banking system has been restructured and stabilized. The banking sector has consolidated into seven large banks. Banking system capitalization has improved with the BIS capital adequacy ratio now reaching 13 percent. Non performing assets have been cut to only one percent of total loans and banking profitability has risen to world-class levels. As a result, credit ratings of Korean banks have been upgraded with most now benefiting from A- ratings, and banking shares have rallied over the past few years in tandem with the rise in the KOSPI.


BIS Capital Adequacy Ratio

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: Financial Supervisory Service.

KSE Banking Index

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: CEIC Data Company Ltd.

SBL ratio

(Substandard and lower loans; in percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: Financial Supervisory Service.

Return on Equity and Assets

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: IMF, Corporate Vulnerability Utility.

S&P LT Local Issuer Rating At End Period

article image
Source: Bloomberg LP.

4. To a large extent, foreign capital has helped this transformation. There were two waves of entry of foreign capital into the Korean banking system. First, from 1999 to 2003, foreign private equity funds acquired three banks that failed during the financial crisis and restructured them. Foreign capital helped restructure the failed banks through large capital injections and reduction of NPLs. It also helped turn around the operations of the banks and introduced new financial products, such as mortgage-backed securities, thereby contributing to the development of capital markets. Once the banks became profitable, foreign private equity funds sold their stakes to banking groups, allowing, in a second wave, two major international banks, Citigroup and Standard Chartered to expand quickly in the Korean banking market. In addition, following the complete liberalization of portfolio investment into the equity market in 1998, foreign investors have acquired significant stakes in domestically-controlled banks, encouraging them to upgrade corporate governance and to focus on profitability.

Korean Banking System

(as of end 2005)

article image
Source: Financial Supervisory Service.

Includes data for Chohung bank.

KEB is in the process of being acquired by Kookmin.

5. The development of Korean capital markets, however, has remained behind that of the banking system. During the high growth period (from the 1960s until the mid-1990s), the banking system was deliberately favored as the main channel of intermediation of savings to the corporate sector. Banking activities and capital market activities were kept separate. As a result, the development of non-bank financial firms has lagged that of banks, and securities firms are of relatively small size: the total assets of securities firms represent only six percent of assets of banks. At the same time, the sector suffers from fragmentation and the coexistence of 56 small securities houses acting mostly as brokers.


Financial Sector Assets, at end-2005

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: Financial Supervisory Service.

6. Even within different segments of capital markets, development is uneven. While equity markets are already relatively developed, sizable and active, the bond market has remained largely underdeveloped and inactive. It is large in size, representing almost 50 percent of GDP, but suffers from a lack of an active secondary market: the turnover ratio is one of the lowest in Asia and bonds acquired through the primary market are usually held onto maturity.25 The money market is also unevenly developed: the overnight market is very active, but the market for longer maturities is not liquid and the repo market is underdeveloped.


Asia: Stock Market Capitalization

(In billions of U.S. dollars, end-March 2006)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: CEIC Data Company Ltd.

Asia: Stock Market Turnover

(In percent of market capitalization, end-March 2006)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: CEIC Data Company Ltd.

7. Foreign exchange markets are not very active for such a large open economy. Despite being a sizable economy with a large tradable sector, Korea’s foreign exchange markets are relatively small. The daily market turnover on onshore spot transactions at around $6 billion or about 2 percent of GDP is still below that of its peers in the region. Half of the transactions are in cash and the share of trading done through swaps is much lower than in other regional financial centers. Another important feature is the large share of trading being done off-shore through the Non Deliverable Forward (NDF) market.26 To some extent, this is due to the persistence until very recently of significant capital account regulations and extensive reporting requirements on foreign exchange transactions, which were seen as intrusive and raising transactions costs.


Average Total Foreign Exchange Daily Transaction

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: BIS.

Share in Total Foreign Exchange Transactions

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: BIS.

C. What are the Authorities’ Plans for Developing Financial Markets?

8. In order to remove impediments to the development of capital markets, the government has launched a two-pillar strategy under the Financial Hub Strategy. This plan aims to establish Korea as a major financial center in Asia by 2011 and it is part of the government’s vision to have Korea become an important trade and economic center in Northeast Asia. The government also sees Korea as having a natural comparative advantage in developing an advanced financial industry because equity and bond markets are large and their scope for growth is significant given the increasing need for developed financial services in Korea as the population ages rapidly. Moreover, the authorities stress that Seoul benefits from a well-established legal and institutional framework and there does not seem to be any obvious financial center in Northeast Asia.

9. This program was actively kicked-off in 2005. The idea of a financial hub started actually in 2002. It was, however, limited mostly to the ambition of becoming an Asset Management Hub. The plan was revitalized and expanded on June 2005 by the 1st National Economic Advisory Council Meeting on the Financial Hub chaired by President Roh Moo-Hyun. There are now seven goals: (i) foster asset management business; (ii) advance financial markets; (iii) develop specialized financial services; (iv) strengthen global networks; (v) establish the Korea Investment Corporation (KIC) to manage actively a share of the foreign exchange reserves; (vi) innovate the regulatory and supervisory systems; and (vii) improve management and living conditions.

10. To achieve these goals, the government envisages the twin objectives of easing barriers between financial activities and the complete liberalization of the capital account. The logic of the two-pillar strategy is straightforward. Developing the financial system will require both addressing domestic impediments, as well as promoting crossborder transactions. Both are connected, as there won’t be much cross-border transactions as long as domestic capital markets remain underdeveloped and illiquid; and there won’t be much development of capital markets without active involvement of non-residents.

11. The deregulation of capital markets is the first pillar. Under the Financial Investment Services and Capital Market Act (FISCMA), the government plans to remove the current restrictions that strictly separate securities, futures, asset management, trust services and other financial services businesses (excluding banking) and move the Korean financial system into a three-pillar system divided into banks, insurance and investment banks by 2008. Already, financial holdings companies have been allowed since 2004 and banks are leading the way in setting up holdings.27

12. As a second pillar, the government is pursuing a range of initiatives to liberalize the capital account framework and the foreign exchange system. Under the “Foreign Exchange Master Development Plan” the government has launched a program to achieve the complete liberalization of foreign exchange transactions by 2009. The objective is to increase the depth and liquidity of the domestic foreign exchange market and bring the offshore NDF market onshore.

D. What are the Authorities’ Plan to Upgrade Capital Markets in Korea?

13. The FISCMA will allow the consolidation of a fragmented non bank financial system and lead to the emergence of strong financial investment companies.28 The law will be introduced in the second half of 2006, with its implementation currently planned for 2008. It provides for the easing of barriers between different capital market activities, i.e. securities, asset management and derivatives, and the setting up of financial investment companies which will be able to deal in these different activities.

14. The law will radically alter the regulatory landscape for financial activities. It will modify the current regulatory framework and shift it to one by functions. Therefore, financial functions of the same nature will be brought under one regulation, regardless of the type of financial institutions engaged in the transaction. Regulation for financial investment companies is also expected to move from a positive list system into a negative list system, whereby financial products not explicitly prohibited will be allowed.

15. It will also contribute greatly to the development of financial services in Korea. Not unlike the U.K. “big bang” approach of the late 1980s, the FISCMA, by eliminating barriers between different financial activities, will contribute to a major upgrading of capital markets in Korea. This is first and foremost because it will allow greater competition among financial firms. This could result eventually in the consolidation of financial firms and lead to the emergence of several strong and well-capitalized investment banks. Having greater capital, these investment banks, unlike current securities houses, should be in a better position to engage in market-making activities. But also, given that they will be subject to a negative list system type regulation, they will be able to develop new products, which should ultimately lead to greater financial innovation and improved financial intermediation.

16. The level of investor protection will be raised. Transparency requirements will be raised and financial investment companies will be obliged to provide investors detailed explanations on the products offered and the risks entailed in dealing in these products. Financial investment companies will be held responsible for losses and damages imposed on investors in case of incomplete disclosure or fraudulent sales.

17. Provisions for dealing with potential conflicts of interest will also be introduced. Conflicts of interests will be prohibited by law and made subject to sanctions. In addition, the law will provide mechanisms to prevent conflicts of interest, by obliging financial investment companies to set up internal control systems and impose organizational separation or personnel restrictions when potential conflicts of interest exist. Potential conflicts of interest will also have to be disclosed to investors.

E. How does this Plan Compare to Global Trends?

18. In many ways, the proposed plan reflects developments in advanced countries. The deregulation between different financial activities, and the conglomeration of financial institutions is a global trend.29 This phenomenon started in Europe, following the easing of barriers between financial institutions and banks (and insurance) during the late 1980s: in 1989, the German system of universal banking was extended through-out Europe following the adoption of the Second Banking Directive by the European Commission. More recently, the move toward conglomeration has accelerated in the United States, as the Glass-Steagall Act of 1933, which separated commercial banking from the securities business, was repealed in 1999. It was replaced by the Gramm-Leach-Bliley Act, which opened up competition between banks, securities and insurance firms. In Japan, the movement started in 1993 as banks and insurance companies were allowed to enter each other’s business through subsidiaries and it deepened in 1998 with the authorization to set up holding companies.

19. Given the size of their balance sheets and capital, banks in advanced economies are leading the way in conglomeration. In response to customer demands for a large selection of financial services, banks are expanding into various financial areas. With the easing of barriers, banks have taken the initiative, taking over securities firms, asset management activities and insurance companies. As a result, the share of conglomerates among the world’s major banks has risen to more than four-fifths by asset, three-fifths by number. At the same time, given the size of their assets and their ability to provide a whole range of financial services and credits to corporates, banks have increased their market share in investment banking activities. This is not only true of Europe, but also of the United States following the repeal of the Glass-Steagall Act in 1999.


Financial Conglomerates in Top 500 World Financial Institutions

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A002

Source: BIS.

20. However, the FISCMA differs from global trends in two important ways. First, while global trends push toward the total elimination of barriers between different financial activities, the FISCMA will not remove the barriers between banks, securities firms and insurance companies. Only through subsidiaries will financial holdings companies be able to operate in different financial activities. At the same time, while international evidence shows that universal banks tend to increase their market share of investment banking activities, the FISCMA is pushing for the development of investment banks, separate of banking groups.

F. What Lessons can be Drawn from the Experience of Advanced Countries?

21. There are a number of important lessons that can be drawn from the experience of advanced countries in dealing with financial deregulation and the easing of barriers between financial activities. In general, conglomeration is beneficial for the efficiency of the financial system. Allowing conglomeration helps to reduce the “asymmetric information” problem and improves the information collection and production mechanism: a conglomerate can offer a wider diversity of financial products than a specialized entity and it is therefore in a much better position to expand its relationship with its customers, thereby gaining access to more varied and deeper information.30 As such, it has a comparative advantage in allocating capital to its most productive use and generating higher returns than a specialized entity. At an aggregate level, this is reflected in increased efficiency of the financial intermediation process.

22. Allowing banks direct access to capital market activities has also facilitated the development of financial markets. The experience of Europe shows that eliminating barriers preventing commercial banks from entering capital market activities directly can spur effectively the development of financial markets. This is because commercial banks in Europe had a significant edge over other financial firms in terms of asset size and access to an investor base. Therefore, once financial barriers were lifted, banks were quickly able to invest sizable resources into capital market activities. In addition, providing banks access to capital market activities gives them a strong incentive to foster the diffusion of non-deposit financial products, thereby helping to shift savings away from deposits to capital market-based financial products. Following the elimination of barriers for banks to enter capital market activities in Europe, capital markets have developed rapidly.

23. However, the experience of Europe and the United States shows that easing barriers between financial activities can lead to a new set of risks. Conglomerates are exposed to higher financial market risks and counterparty exposure to market risk and liquidity risk than non diversified financial institutions. Easing barriers and allowing firms to integrate a number of activities under one roof also gives rise to numerous potential conflicts of interest. There are several possible different conflicts of interest, such as conflicts of interest between asset management activities and securities firms, conflicts of interest between M&A activities and the proprietary trading arm of the same group, or between corporate finance activities and research. Conglomeration may finally allow contagion within the group as reputational risks between different activities become correlated.

24. While there is ample evidence that financial deregulation improves the intermediation process, some empirical studies have shown that conglomerate firms exhibit levels of risk-taking higher than smaller and specialized firms. Lown et al. (2000) show that U.S. banks’ mergers with securities firms have increased risk modestly. A more recent study by De Nicolo et al. (2003) show that larger and conglomerate firms did not achieve higher levels of profitability than smaller and specialized firms.31 At the same time, the study found that firms with a wider scope of activities are more leveraged and do not attain a lower volatility of returns than smaller and specialized firms. This is consistent with a finding that as financial firms grow in size and complexity, internal risk becomes more difficult to assess.

25. Conflicts of interest between asset management and securities activities are among the most serious threats to the credibility and development of financial markets. With the move toward conglomeration of activities in the financial industry and the development of universal banking, the possibilities for conflicts of interest between asset management activities and underwriting divisions of securities houses have increased, as asset managers may sometimes feel pressured to invest in companies whose securities have been underwritten by the investment banking arm of the group. These pressures may be especially strong in the case of failed issuance.

26. Serious violations to these rules occur even in countries with very developed financial systems and experienced regulators. There have been indeed many cases where the investment banking arm of a financial firm put pressure on the asset management arm. In one of the most notorious cases, on March 12, 2003, the Wall Street Journal reported that the Chief Investment Officer at a major investment bank’s asset management unit was asked by an underwriting executive to buy some of the shares in a struggling media company it helped bring public. There have also been numerous cases of conflicts of interest between research activities and underwriting division uncovered in the United States in the late 1990s. In many cases, analysts were under strong guidance or financial incentive to provide favorable research to ensure the success of underwriting. This was remedied in December 2002 through the “Global Settlement” reached by the Securities and Exchange Commission (SEC), the New York Attorney General and the ten largest investment banks forcing banks to sever the links between research and other investment banking activities.

G. How Advanced Countries Deal with Potential Conflicts of Interest

27. Market discipline helps prevents potential conflicts of interest. In theory, most advanced economies do not bar securities firms from directly managing assets. In the United States, the SEC does not require asset management activities to be legally separate from other securities lines. Rather, firms must disclose potential conflicts of interest prior to the completion of a securities transaction. In the EU, legal separation of asset management from securities firms is also not required, but disclosure rules are imposed on potential conflicts of interest. In practice, however, most asset management activities are usually kept as separate legal entities in response to both customer desires for improved governance and firms’ concerns about liabilities under civil litigation. Another result of the increased consumer demand for transparency and efficiency in asset management activities has been the growth of independent asset management companies, such as PIMCO, Fidelity or Templeton.

Investment Banks and Asset Management Arms

article image
Source: Companies’ annual reports.

28. Market discipline requires transparency, strong disclosure rules and enhanced customer protection. Thanks to the transparency requirements of advanced countries, customers are in a strong position to impose market discipline on financial institutions. To do so, many countries have adopted laws protecting financial investors. Australia introduced such legislation in 2001 with the Financial Services Reform Act (FSRA). The FRSA was designed to contribute to the development of a transparent and competitive framework for the financial industry in Australia. It helped changed the emphasis of looking at the industry from being product based to looking at “financial services”. By requiring the providers of all financial products and services to undertake the same licensing and disclosure practices, it strengthened consumer protection through better understanding, ease of comparison, as well as through ensuring that all market participants have the key financial and organizational capability requirements to hold a license and fostered competition between financial service providers.

29. In countries with weak transparency and disclosure requirements or in transition toward meeting such requirements, however, market discipline can not function effectively and regulation needs to step in. Avoiding conflict of interests is then best achieved through regulation, either by forcing the separation of functions so that agents are not in a position to respond to multiple principals (“Chinese walls”) or more stringently by separating legally different activities.32 These “Chinese walls” can take several forms: a formal separation of powers between management and business decision makers on the one hand and administrative functions on the other hand; a physical separation and limited contacts between personnel from different parts of the institution where there are potential conflicts of interest.

30. A strong system of penalties for those who commit violations is required as a deterrent against possible violations. In many advanced countries, the regulator can impose severe penalties for those who breach rules against conflict of interest. These penalties are often of a financial nature, but in some cases, individuals found guilty of committing severe violations can be barred for life from the financial industry.

H. What Does the International Experience Imply for Korea?

31. Allowing banks to acquire investment bank activities could allow a more rapid development of financial market activities in Korea, but a gradual and cautious approach is appropriate. Initially, keeping banks away from direct involvement in capital market activities while safeguards to deal with the risks of deregulated financial activities in terms of supervision and market discipline are being strengthened is reasonable. But once these safeguards are in place, allowing banks to directly enter capital market activities could be envisaged.

32. Easing barriers will create new demands on financial supervision. As this deregulation will create larger and more-complex financial institutions, consolidated, riskbased and functional supervision will become even more important.33 At the same time, the move toward a more open and market-based financial system will raise the need for a fully transparent regulatory regime.

33. Given Korea’s nascent capital markets, the risks of potential conflicts of interests are significant and any problem could impact the development of the capital markets. Korea’s recent initiatives to develop capital markets will very likely transform the financial landscape and raise the potential benefits firms can gain from conflict of interests. Preventing those violations will require strong supervisory and legal regimes, as well as effective market discipline. Korea is very well-placed to develop these mechanisms, but the experience of other advanced economies shows that in the initial stages of market development and deregulation, accidents and violations do occur. Should any such problems also happen in Korea, the credibility of Seoul as a financial center could be seriously impaired thereby derailing the reform momentum.

34. Keeping the securities business separate from asset management helps to minimize those risks. In the transition to a strong supervisory and legal regime, and to an effective market discipline, Korea could keep asset management and securities activities legally separate. This does not preclude, however, that securities firms be allowed to own asset management arms as their subsidiaries so as to free up the synergies between those two activities and enable securities firms to offer savings products to their client base. But such a scheme, by establishing separate balance sheets and governance structure for asset management activities would guarantee some degree of transparency for asset management activities thereby allowing market discipline to flourish. This would also minimize the risks of coercion of asset managers by investment bankers as these would operate under different management and according to different financial incentives.

35. Moreover, this separation should not be a major impediment to the development of capital market activities. The current initiatives to deregulate the financial industry and promote the foreign exchange market are very likely going to lead to the transformation and modernization of the capital markets. All segments of the capital markets, including the bond, equity and derivatives markets will benefit from these initiatives, and their development will allow securities firms and investment banks to develop and prosper. Limiting securities firms to operate asset management arms only in the form of a subsidiary is not expected to be a major drag on their revenues, and would in any event bring Korea in line with international practices.

36. Finally, the projected increase in capital market activities calls more generally for stronger measures to secure market integrity. Since the current level of penalties for financial fraud such as insider trading or accounting fraud may no longer be commensurate with possible profits, the level of penalties for financial fraud could be raised significantly.

I. What are the Authorities’ Plans for Developing the Foreign Exchange Market?34

37. The development of the foreign exchange market will help foster cross-border transactions and develop the financial sector. To this aim, the government has developed an ambitious plan to liberalize the foreign exchange market, with a roadmap which should in three stages help it reach the level of advanced forex markets.

38. Already, several measures have been taken. Since January 2006, a reporting system has replaced the existing permit system for all capital transactions, and related regulations such as the reporting form that includes the purpose of transaction have been streamlined. Foreign currency borrowing by foreign exchange banks has also been eased. For foreign currency borrowing which requires a quick decision, a post facto reporting has been allowed. Asset management companies have also been allowed to issue foreign currencydenominated investment securities.

39. There are further plans to eliminate most of the remaining controls on capital account transactions and foreign exchange trading. Under the plan, remaining controls on nonresidents transactions in won will be removed. This should help grow the foreign exchange market, but would still leave two significant impediments to foreign exchange transactions: the current requirement to provide underlying documentation for foreign exchange transactions from non residents and the prior notification requirements for some transactions.

40. At the same time, the development of the foreign exchange market won’t be possible without an active money market. The money market is an important element in the development of the foreign exchange market as it provides a pricing mechanism for forward transactions between won and foreign currencies and helps ensure liquidity of the foreign exchange market. But in Korea, the money market, outside of the uncollateralized overnight call market, is largely illiquid.

J. How can the Repo and Bond Markets Help?

41. The repo market is an important element of the money market in many advanced countries.35 Repo transactions serve two important functions for central banks: they provide a monetary policy instrument which is attractive given the low credit risk it carries.36 At the same time, repo transactions are a useful instrument for signaling market expectations. In addition, repos have the advantage of providing a lower cost of funding compared to the uncollateralized market given the collateral. But of course, ensuring the smooth functioning of repo markets requires having in place an adequate legal framework and settlement system.

42. The repo market also helps to improve the liquidity of the money and bond markets. Unlike unsecured transactions, repo transactions facilitate the development of a whole range of financial markets: they can serve as a source of demand for the underlying securities that may include short-term paper, corporate bonds or mortgage backed securities. At the same time, repo transactions facilitate arbitrage along the yield curve, thereby helping to develop an efficient yield curve.

43. To improve the functioning of the money market, the authorities are trying to develop the repo market. Some progress has already been made, notably by amending bankruptcy laws so as to protect collateral from the freezing of assets in the case of corporate or banking bankruptcy. Some other measures could be pursued. In particular, the access to the call market could be limited to banks, as it is the case in many advanced countries. This would force other financial institutions to go to the repo market for short-term financing. But at the same time, fostering the development of credit risk awareness among financial institutions and easing current maturities mismatch limits would enable the development of the full spectrum of the money market.

44. The authorities are also trying to foster the bond market so as to develop a yield curve beyond the money market. Currently, the secondary market for bond transactions is not very active as liquidity is limited, except for a few treasury issues.37 One particular problem with the bond market is the absence of market making activities: the current system resemble more one of brokered transactions between securities firms, with ex-post notification of the transaction to the Stock Exchange, often with a significant lag.

45. Many countries have adopted a system of primary dealers to develop the government bond market.38 Under this system, primary dealers play the role of exclusive financial intermediary for government issuance. By being primary dealers, financial institutions benefit from exclusive access to auctions of government securities, and sometimes the right to be counterparty to central bank market operations, and to have access to credit lines from central banks. Of course, this privileged status does not come without obligations: primary dealers are obliged to participate in the primary market in a consistent and sizable manner and to serve as market maker in the secondary market by providing two-way quotes on a transparent and continuous basis.

46. The primary dealer system is especially useful in countries in need of developing market-making capacity and liquidity in the secondary market. Given their obligations to provide two-way quotes on government bond securities, primary dealers are forced into developing their market making capacity and internal risk pricing models. At the same time, the secondary market becomes more active as transactions for sizable amounts can be done rapidly through market makers thereby improving the liquidity of the market.

47. Improving the primary dealer system in Korea could be central in a strategy to foster market-making activity and the transparency of the bond market. The primary dealer system was first introduced in 1999 in Korea.39 Often, however, primary dealers do not provide two-way quotes on which they are willing to trade, and pricing is not fully transparent. The current primary dealer system could be made more attractive by notably introducing the non-competitive bid system for primary dealers. Under such system, primary dealers could acquire additional amount of bonds at the price set at the previous auction. Also, primary dealers should also respect current rules, including the trading rules. As such, they should report to the Stock Exchange their transactions quickly after completion of trading, so as to ensure the transparency of the bond trading system.

K. Conclusions

48. Since the crisis, Korea has achieved a major transformation of its economy. The banking sector, through its restructuring and opening up to domestic and foreign competition played a central part in this transformation. However, the challenge of a maturing economy with an aging population, as well the opportunities offered by the emergence of China put into question the adequacy of the current bank-centered financial system and calls for the development of capital markets, as a complement to bank finance.

49. Cognizant of these challenges, the authorities have embarked on an ambitious plan to develop the foreign exchange market and ease barriers between financial activities, so as to transform the financial system. This plan contains several important elements, which could usefully be complemented by supporting measures to develop the money and bond markets, as well as facilitate foreign exchange transactions, as this paper has suggested. Such a major endeavor is of course not without risks, especially during the transition process of liberalization where accidents can be costly in terms of market credibility. This is why, giving proper consideration to balancing the benefits of a speedy liberalization (“Big Bang” approach) against assurances that mechanisms to deal with the risks are in place and running is appropriate.


  • Arnone, Marco and George Iden, 2003, “Primary Dealers in Government Securities: Policy Issues and Selected Countries Experience,” IMF Working Paper No. 03/45 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Bank of Japan, 2005, The Expansion of Corporate Groups in the Financial Services Industry: Trends in Financial Conglomeration in Major Industrial Countries, December.

    • Search Google Scholar
    • Export Citation
  • Bank for International Settlements, 1999, Implication of Repo Market for Central Banks, Report of the Working Group established by the Committee on the Global Financial System of the Central Banks of the Group of Ten Countries.

    • Search Google Scholar
    • Export Citation
  • Bank for International Settlements, 2001, Group of 10—Consolidation in the Financial Sector.

  • De Nicoló, Gianni, Philip F. Bartholomew, Jahanara Zaman and M.G. Zephirin, 2003, “Bank Consolidation, Internationalization and Conglomeration: Trends and Implications for Financial Risk,” IMF Working Paper No. 03/158 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2003, Republic of Korea: Financial System Stability Assessment, including Reports on the Observance of Standards and Codes, IMF Country Paper No. 03/81 (Washington).

    • Search Google Scholar
    • Export Citation
  • Kang, Kenneth, 2004, “Developing the Government Bond Market in Korea: History and Challenges” (unpublished; Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Lee, Myong-Jong and Soo-Ho Kim, 2006, “Developing the Corporate Bond Market: The Korean Experience,” in Developing Corporate Bond Markets in Asia, BIS Papers, No. 26.

    • Search Google Scholar
    • Export Citation
  • Lown, C.S., C.L. Osler, P.E. Strahan, and A. Sufi, 2000, “The Changing Landscape of the Financial Services Industry: What Lies Ahead?” FRBNY Economic Policy Review, October.

    • Search Google Scholar
    • Export Citation
  • Mishkin, Frederic, 2003 “Policy Remedies for Conflicts of Interest in the Financial System,”in Macroeconomics, Monetary Policy and Financial Stability: A Festschrift for Charles Freedman (Bank of Canada).

    • Search Google Scholar
    • Export Citation
  • Soueid, Mazen and Harm Zebregs, 2004, “Development of the Corporate Bond Market in Korea” (unpublished; Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • White, Eugene N., 2004, “Can the Market Control Conflicts of Interest in the Financial Industry?” in Current Development in Monetary and Financial Law (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

Prepared by Romuald Semblat.


See Soueid and Zebregs (2004) and Lee and Kim (2005).


Daily transactions on the NDF market are estimated at around $2 billion.


Already, three of the four big domestically-controlled Korean banks have set up financial holdings company: Hana Bank, Shinhan Bank and Woori Bank.


Based on the proposed bill “Financial Investment Services and Capital Market Act” announced on Feb. 17, 2006 and posted on MOFE’s website on May 8, 2006.


See International Monetary Fund: “Republic of Korea: Financial System Stability Assessment” (2003).


This section includes findings and recommendations from an IMF Technical Assistance Mission (MFD) that visited Seoul on March 30-April 13, 2006 to discuss the reform and development of the foreign exchange market in Korea.


Repurchase agreements are contracts whereby one party sells securities to another party with the agreement to buy them back after a certain period of time.


There are currently 20 primary dealers, half of which are banks and the other half securities firms.

Republic of Korea: Selected Issues
Author: International Monetary Fund