Abstract
This Selected Issues paper for the Republic of Korea focuses on the role of monetary policy in the current context of slowing growth and rising inflation pressures. Korea has not remained immune to the global slowdown, and with the cycle turning downward, the trade-off between inflation and growth is deteriorating. Subprime-related turbulences in financial markets add an extra element of uncertainty to the economic outlook, and have led to a noticeable increase in Korea’s stock market and exchange rate volatility.
III. Korea’s Banking Sector—Liquidity Risk Management in the Face of Structural Trends and Deregulation 13
A. Introduction
40. While Korea’s financial system is generally healthy, the need for further financial sector development is well recognized. Indeed, this recognition underlies reform plans, including for deregulation and bank privatization. The Financial Investment Services and Capital Market Act, also referred to as the Capital Markets Consolidation Act (CMCA), comes into effect in February 2009. It is expected to lead to consolidation of the securities industry and the emergence of domestic investment banks, and bring important benefits.
41. This deregulation will put a premium on efforts by banks and supervisors to limit liquidity risk. A trend decline in household deposits and an interest-income/asset-expansion based banking model have raised wholesale funding dependence and liquidity risk—particularly in the context of global credit market stresses. The planned deregulation is likely to increase the rate of disintermediation away from deposits and increase competition for funding, thus further narrowing net interest margins and raising wholesale funding dependence. In the face of these challenges, banks and regulators will need to improve liquidity risk management (LRM) and adapt banks’ business models. Further deregulation may be warranted beyond 2009 and banks’ business models will depend in part on the how financial oversight evolves. This chapter examines Korean banks’ increasing wholesale funding dependence, and the associated need for improving LRM and adapting banks’ business models, drawing on some lessons from international experience. The next chapter considers broader lessons from the ongoing financial turmoil.
B. Banks’ Increasing Wholesale Funding Dependence and Liquidity Risk
Funding Developments of Korean Banks in International Perspective
42. Korean banks have some of the highest loan-to-deposit ratios (LDRs) in the region, reflecting the shift away from bank deposits by households and the interest-income-focused business model of banks. These factors have increased banks’ reliance on wholesale financing to fund lending operations. Elevated global credit strains and the experience with Northern Rock have drawn attention to banks reliant on wholesale financing as vulnerable to heightened liquidity risk.14 Indeed, such concerns are manifest in the relative performance of Korea’s banking stocks and credit default swap spreads (Figure III.1).15
Liquidity Risk in the Banking Sector
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Liquidity Risk in the Banking Sector
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Liquidity Risk in the Banking Sector
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
43. There has been a trend shift of household assets away from deposits to other assets, mainly securities. Factors driving the rebalancing of household assets away from deposits include: (i) further liberalization of outflows and tax benefits in 2006; and (ii) portfolio rebalancing in the context of declining home-bias, increasing risk tolerance, and search for yield. There has been some return to deposits recently with active efforts being made by banks to attract deposits, and as a safe haven in the context of the global financial turmoil. The trend decline however is unlikely to reverse in the longer term (see below).
44. The focus of Korean banks on interest income and asset expansion has contributed to increasing wholesale funding dependence. Korean banks’ returns on average assets and average equity are in line with the rest of Asia and similar to those of the G-7 countries (Table III.1) Korean banks’ reliance on interest-income increased sharply between 2001 and 2005, but has declined since.16 The interest-income share in total income is higher in Korea than that of the OECD countries considered. Korea’s interest-income share is however similar to non-OECD Asia, consistent with the bank-centric and lending-based nature of most financial systems in Asia.17 Competition and more recently the global credit market stresses have pushed up funding costs and net interest margins (NIMs) and profitability (net of one-offs) have trended downward.18 Korean banks’ reliance on interest income and their attempts to maintain profits and compete for market share mean that declining deposits together with continued rapid asset expansion have resulted in increasing wholesale financing dependence. The main sources of the increased wholesale financing have been debentures and CDs.
Indicators of Commercial Banks’ Performance and Business Models in OECD and Asia
(2006 averages) 1/
2006 data are more consistently available than 2007 and so the averages are more representative; ratios are simple averages, unless otherwise stated.
Calculated as the sum of interest income of all banks relative to the sum of total operating income of all banks.
Non-OECD Asia includes: China, Hong Kong SAR, India, Indonesia, Malaysia, Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam.
The very large number of small US banks can distort the averages.
Indicators of Commercial Banks’ Performance and Business Models in OECD and Asia
(2006 averages) 1/
| Return on average assets | Return on average equity | Impaired loans/gross loans | Net interest income/operating income2/ | Total Assets | ||
|---|---|---|---|---|---|---|
| (In percent) | (In billion of U.S. dollars) | |||||
| OECD and Asian commercial banks 3/ | 1.13 | 10.55 | 0.97 | 0.54 | 8 | |
| OECD commercial banks excl. United States 4/ | 1.19 | 11.27 | 3.49 | 0.50 | 37 | |
| OECD | 1.14 | 10.65 | 0.84 | 0.51 | 7 | |
| Asia (excl. Japan and Korea) | 0.89 | 7.99 | 4.90 | 0.77 | 23 | |
| G-7 Countries | 0.92 | 9.33 | 3.24 | 0.48 | ||
| United States | 1.10 | 10.52 | 0.61 | 0.56 | 2 | |
| Japan | 0.36 | 2.78 | 4.46 | 0.67 | 51 | |
| Germany | 1.11 | 8.27 | 3.60 | 0.40 | 32 | |
| United Kingdom | 0.49 | 9.97 | 3.34 | 0.48 | 86 | |
| France | 1.51 | 13.18 | 5.75 | 0.28 | 58 | |
| Canada | 0.85 | 9.88 | 0.57 | 0.41 | 54 | |
| Italy | 0.99 | 10.72 | 4.35 | 0.57 | 27 | |
| Korean Commercial Banks (incl. foreign banks) | 0.93 | 7.95 | 0.90 | 0.80 | 64 | |
| Major Korean Commercial Banks 4/ | 1.17 | 17.59 | 0.91 | 0.79 | 172 | |
2006 data are more consistently available than 2007 and so the averages are more representative; ratios are simple averages, unless otherwise stated.
Calculated as the sum of interest income of all banks relative to the sum of total operating income of all banks.
Non-OECD Asia includes: China, Hong Kong SAR, India, Indonesia, Malaysia, Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam.
The very large number of small US banks can distort the averages.
Indicators of Commercial Banks’ Performance and Business Models in OECD and Asia
(2006 averages) 1/
| Return on average assets | Return on average equity | Impaired loans/gross loans | Net interest income/operating income2/ | Total Assets | ||
|---|---|---|---|---|---|---|
| (In percent) | (In billion of U.S. dollars) | |||||
| OECD and Asian commercial banks 3/ | 1.13 | 10.55 | 0.97 | 0.54 | 8 | |
| OECD commercial banks excl. United States 4/ | 1.19 | 11.27 | 3.49 | 0.50 | 37 | |
| OECD | 1.14 | 10.65 | 0.84 | 0.51 | 7 | |
| Asia (excl. Japan and Korea) | 0.89 | 7.99 | 4.90 | 0.77 | 23 | |
| G-7 Countries | 0.92 | 9.33 | 3.24 | 0.48 | ||
| United States | 1.10 | 10.52 | 0.61 | 0.56 | 2 | |
| Japan | 0.36 | 2.78 | 4.46 | 0.67 | 51 | |
| Germany | 1.11 | 8.27 | 3.60 | 0.40 | 32 | |
| United Kingdom | 0.49 | 9.97 | 3.34 | 0.48 | 86 | |
| France | 1.51 | 13.18 | 5.75 | 0.28 | 58 | |
| Canada | 0.85 | 9.88 | 0.57 | 0.41 | 54 | |
| Italy | 0.99 | 10.72 | 4.35 | 0.57 | 27 | |
| Korean Commercial Banks (incl. foreign banks) | 0.93 | 7.95 | 0.90 | 0.80 | 64 | |
| Major Korean Commercial Banks 4/ | 1.17 | 17.59 | 0.91 | 0.79 | 172 | |
2006 data are more consistently available than 2007 and so the averages are more representative; ratios are simple averages, unless otherwise stated.
Calculated as the sum of interest income of all banks relative to the sum of total operating income of all banks.
Non-OECD Asia includes: China, Hong Kong SAR, India, Indonesia, Malaysia, Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam.
The very large number of small US banks can distort the averages.
Korean Banks: Trends in Income Sources, 1992–2007
(Average share)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Korean Banks: Trends in Income Sources, 1992–2007
(Average share)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Korean Banks: Trends in Income Sources, 1992–2007
(Average share)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Sources of Revenue, 2007
(In percent of total operating revenue)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Sources of Revenue, 2007
(In percent of total operating revenue)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Sources of Revenue, 2007
(In percent of total operating revenue)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Net Interest Income, 2006
(Percent of total operating income)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Source: Bankscope.Net Interest Income, 2006
(Percent of total operating income)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Source: Bankscope.Net Interest Income, 2006
(Percent of total operating income)
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Source: Bankscope.45. The potential advantages of debentures may also explain in part their increasing share of wholesale funding. Debentures do not require deposit insurance or incur reserve requirements, and have relatively low overhead costs. These can shave off more than 50 basis points on funding costs. However, deposits are still important from the perspective of creating a customer base and relationship building from the longer-term perspective.
46. International comparisons of loan-to-deposit ratios and wholesale funding dependence may be misleading for a number of reasons. Firstly, there has been relatively little securitization of assets by Korean banks, so loans have largely stayed on their balance sheets, which makes comparisons—particularly with U.S., European, and Australian banks—less straightforward. Secondly, as Korean banks have moved to financial holding company structures, declines in the banks’ deposits may in part end up with subsidiaries under the bank holding companies (such as AMCs), and these could provide funding if necessary.19 Finally, a large part of the recent growth in lending reflects mortgage loans, including the new amortizing mortgages with 3 year grace periods. As the grace periods expire, principle repayment should work to reduce these outstanding loans. Thus banks’ loan-to-deposit (and wholesale funding) ratios should be used cautiously in cross-country comparisons.
Pressures on Bank Financing and NIMs are Likely to Continue
47. Portfolio rebalancing by households seems likely to continue in the longer-run, if major OECD countries provide a useful reference point. The share of Korean household financial assets in the form of cash and deposits has already declined from 54 percent in 2002 to 43 percent in 2007. If Korean households continue to rebalance their portfolios towards the G-7 average, this would imply a fall in share of deposits to 29 percent. In 2007, the average G-7 ratio of cash and deposits for Korean households would have meant that wholesale financing—holding the asset size constant at the actual end-2007 level—would have been around 60 percent of total funding (compared to the actual 40 percent).
Household Financial Asset Allocation: Korea and the G-7 1/
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Sources: OECD Database, Bank of Korea, U.S. Federal Reserve; and Fund staff calculations.1/ Data for Korea and the United States are for end-2007; data for other countries relate to end-2006.Household Financial Asset Allocation: Korea and the G-7 1/
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Sources: OECD Database, Bank of Korea, U.S. Federal Reserve; and Fund staff calculations.1/ Data for Korea and the United States are for end-2007; data for other countries relate to end-2006.Household Financial Asset Allocation: Korea and the G-7 1/
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A003
Sources: OECD Database, Bank of Korea, U.S. Federal Reserve; and Fund staff calculations.1/ Data for Korea and the United States are for end-2007; data for other countries relate to end-2006.48. The adoption of the CMCA is likely to increase wholesale funding dependence of banks. The CMCA is expected to bring important benefits (Semblat, 2006) and is in the direction of global trends towards financial sector conglomeration and deregulation (Box III.1). The likely increased competition for funds suggests increased wholesale funding dependence of banks and lower NIMs. Experiences from other countries such as the United Kingdom and Australia (that introduced comprehensive definitions of financial products and services and functional regulatory frameworks, similar to the CMCA), corroborate the expected weakening of banks’ deposit bases and increases in wholesale funding reliance.20 Increasing wholesale funding is also a global trend among developed countries (De Nicolo and others, 2003; IMF, 2008).
Global Banking Sectors Trends
Deregulation between different financial activities and financial institutions is a global trend. The trend began in Europe in the late 1980s, following the adoption of a European Commission Directive that extended the German system of universal banking throughout Europe. In 1993, Japan allowed banks and insurance companies to enter each others’ sectors through subsidiaries, and financial holding companies were permitted in 1998. The global trend accelerated in the United States when the Gramm-Leach-Bliley Act replaced Glass-Steagall in 1999 which opened up competition between banks, securities firms, and insurance companies (Semblat, 2006). An associated trend has been the consolidation of financial sector regulatory/supervisory agencies.
There are also well-documented trends of bank consolidation, conglomeration and internationalization (De Nicolo and others, 2003). The financial consolidation trend has been driven by real and financial sector globalization, deregulation, technological developments, increased performance pressures from shareholders, bank privatization, and in some cases (such as Korea) banking crises. Consolidation has been contributing to greater banking sector concentration, although the concentration trend presents uneven patterns across different regions and/or countries. Internationalization, as evidenced by the number financial institutions that operate across national borders and the ratio of foreign-controlled assets to total assets, also exhibits uneven trends but has increased markedly.
Banks in developed countries have been increasingly reliant on wholesale funding and liquid asset ratios have been declining, IMF (2008). Rather than retail deposits, banks have increasingly been relying on interbank borrowing, short- and long-term debt, or the sale of marketable securities. Evidence for the period 1995-2000 shows that banks in developed countries relied mainly on wholesale deposit or nondeposit liabilities to fund asset growth. In contrast, major emerging markets showed greater reliance on deposit funding. (De Nicolo and others, 2003).
Globally, banks are increasing reliance on nontraditional activities that generate fee, trading and other types of non-interest income. This trend might be explained in large part by new technologies (such as the introduction of ATMs and associated fees), and regulatory changes (including deregulation which has created greater competition and reduced net interest margins, creating a push for new areas of income growth). Banks may also have been attempting to benefit from diversification of income sources. However, some empirical evidence suggests that expansion into nonbanking activities may increase the variability of profits and thus offset some of the benefits of diversification; and the benefits may decline as the share of non-interest income grows.1
1Stiroh (2002) finds for U.S. banks that declining volatility of net operating income reflects reduced volatility of net interest income and is not a benefit of diversification as non-interest income has been quite volatile and is increasingly correlated with interest income. Also, reliance on non-interest income such as trading income, is associated with higher risk and lower risk-adjusted returns.C. Liquidity Risk Management—Recent Developments and Next Steps
49. In recognition of the elevated liquidity risks, regulators have strengthened their monitoring of short-term liquid asset ratios and other indicators of possible liquidity strains. Banks and financial regulators have been pushing to diversify funding sources, revenues, and scope of operation. Recent international experiences provide an opportunity for Korea to learn from shortcomings in LRM elsewhere.
Key Elements of LRM in Korea
50. Beyond reserve requirements, the main liquidity risk management (LRM) mechanisms are the statutory won and foreign currency liquidity ratios. Banks are required to ensure that their won liquidity ratio (the ratio of their assets and liabilities with maturities of 3 months or less) is at least 100 percent; and banks are subject to 7, 30, and 90-day liquidity ratios in foreign currency.21 Nonquantitative aspects of regulators evaluations of liquidity risk include assessing the adequacy of banks’ LRM and the reasons for changes in liquidity; and the reasonableness of fund raising and operation structures. Reporting intervals for the won liquidity ratio were shortened in September 2007 from a quarterly to a monthly basis and regulators have stepped up monitoring of liquidity indicators on a daily basis.
51. Banks are also required to undertake stress tests on a regular basis and prepare contingency plans. How the stress tests are conducted and whether senior management develop effective contingency plans are also non-quantitative elements of the risk assessment system. Stress testing is also a minimum requirement for banks applying to use the internal-ratings based (IRB) approach in the move to Basel II. However, stress tests focus on credit and market risks.
52. If banks face liquidity difficulties, the BOK can provide liquidity support. Banks can access BOK’s standing facility using eligible collateral (government bonds, government guaranteed bonds, and monetary stabilization bonds). BOK can, if required, relax collateral requirements and under exceptional circumstances, could extend liquidity to individual banks or financial companies.
What Does Recent International Experience Suggest for Korea’s LRM?
53. The global financial turmoil has revealed that liquidity risk is far more pervasive than previously thought—liquidity can dissipate very quickly and stresses can persist forlong periods. With the central importance of liquidity to the functioning of financial markets re-emphasized, various international institutions and fora have issued preliminary guidance for improving LRM and supervision in light of recent events (as listed in the next chapter).
54. Lessons point to the importance of Korean banks:
Establishing funding strategies that provide effective diversification in sources and tenor of funding. Issuance of longer-term notes, securitization, and covered bonds could help match the associated asset’s maturity and thus reduce liquidity risk (see below).
Strengthening stress testing. In particular, these test should allow for the possibility of large and multiple shocks and account for the possible evaporation of liquidity in some asset classes during a crisis; closure of multiple wholesale markets; and widespread calls on liquidity commitments, taking into account commitments to off-balance sheet entities.
Establishing formal contingency plans, closely linked to stress tests.
Greater transparency and disclosure of LRM policies and practices. Sufficient details should be regularly disclosed to allow market participants to assess banks’ LRM, including funding sources, liquidity commitments (especially to off-balance-sheet entities), maturity mismatches, assumptions made over deposit withdrawal prospects, contingency plans, and stress test (assumptions and results).
55. Financial regulators and supervisors should ensure Korean banks make progress towards “best practice” in their LRM. This could involve, regular and comprehensive assessments of banks’ overall LRM frameworks, particularly their stress-tests and contingency plans; and guidance should be provided or remedial actions required, as necessary. (IMF (2008) provides a more general discussion of the options).
56. BOK, regulators, and government could also strengthen their own system-wide analysis, contingency planning and cooperation. BOK and financial regulators should ensure their own stress-tests adequately account for the possibility of extreme and multiple shocks (tail events), contagion between institutions, and macroeconomic effects, and are linked closely to their contingency planning. Communication and coordination between supervisors, the BOK and the government should be reviewed to ensure the necessary procedures exist for effective coordinated responses under stress scenarios.
57. Central banks in the most affected countries seemed less than fully prepared for the extent of the liquidity stresses. Central bank actions have limited wider damage, yet the extensive, sudden and, in some cases, ad hoc nature of the changes to their operational frameworks suggest the extent of the liquidity problems were not anticipated. BOK (as ultimate provider of liquidity) may need to review its range of counterparties, the maturities of their facilities, and what is acceptable as collateral. However, while it is expedient during a crisis to be able operate with wide ranges of counterparties/collateral, this creates difficult trade-offs, such as reducing the incentives for banks to hold or provide high-quality collateral (IMF, 2008).22 Well functioning repo markets were also demonstrated to be particularly important under stress conditions and so the strategy to deepen Korean money markets and increase secured lending should be expedited.
Efforts to Diversify Funding Sources and Income Sources
58. There has been some movement by Korean banks to diversify funding sources and currencies. Korean banks have recently tapped the Malaysian ringgit and Brazilian real markets; and started to offer structured deposits.23 Two major Korean banks have also recently issued securitized bonds; and banks are also looking towards alternative forms of funding (such as covered bonds once these are permitted—see below).
59. There are encouraging signs of Korean banks diversifying their income sources. Korean banks’ non-interest income has been increasing as a share of overall income in recent years, mainly benefiting from the fast-growing wealth management industry. Their ability to generate fee and other non-interest income, however, seems to be lagging behind banks in more developed markets (Fitch Ratings, 2008).24 While the evidence internationally on the benefits of banks’ diversifying income sources is mixed, a recent study (BOK, 2006) found that expanded nonbanking activities of Korean banks led to improved profitability and lower volatility of profits. This could be because the scope of nonbanking activities is still relatively limited, and because Korean banks have focused on relatively stable income sources such as fee income and credit card businesses.
60. Korean banks have also been expanding internationally, but from a low base. Korean banks’ overseas assets have been steadily increasing since 2001 and the number of overseas networks is also increasing.25 The drivers include competition and narrowing scope for domestic expansion; the substantial growth potential in regional neighbors; and the increasing need/demand for integrated regional and global services from existing customers also operating internationally. Korean banks are still largely domestically oriented—with overseas assets accounting for only 4 percent of total assets, compared with 30 percent for DBS, and nearly 60 percent for Citi and HSBC (Noh, 2007).
61. Regulators have been encouraging Korean banks to further diversify their funding and revenue sources, and to explore global opportunities:
Financial regulators recently announced they will permit banks to issue covered bonds. Covered bonds—which are debt securities backed by cash flows from mortgages or other loans—are usually highly rated and it is hoped these will help banks lower funding costs, and generally improve their liquidity conditions. (The timeline for permitting issuance of covered bonds has yet to be confirmed).
Regulators will also allow banks to trade derivatives from August 1, 2008. Trading of derivatives is currently allowed only as a hedging tool. This could help support income diversification, but could also increase risk.
Regulators have indicated intentions to: (i) allow banks to issue Derivatives-Linked Securities and Credit-Linked Notes (the planned deregulation is at the review stage); (ii) allow banks to provide asset management advisory services; and (iii) simplify the process for banks to enter offshore markets.
D. Deregulation, Competition, and Banks’ Business Models
62. Korean banks are preparing for the adoption of the CMCA next year. Banks’ seem to be diversifying their sources of income as evidenced by the increase in the share of non-interest income in recent years; and there has been some move towards greater global operations by Korean banks. This section considers the international experiences of banks post-deregulation and draws some tentative lessons for Korea going forward.26
International Experience Post-Deregulation
63. The global financial policy direction has been towards deregulation between financial activities. Despite concerns about risk, this deregulation trend reflects the general belief that there are net benefits from financial sector consolidation and conglomeration. These can come from improved information (from wider and longer-term customer relationships), economies of scale and scope (e.g., the sale of mutual funds through bank branches), the development of capital markets (if banks have direct access to capital markets), and providing a one-stop-shop for customers (reducing their transactions cost). Allowing banks access to capital market activities provides a strong incentive for them to foster the diffusion of nondeposit financial products. While this helps the shift of savings from deposits to capital market-based financial products, adding to funding risks, it also permits banks to reduce reliance on interest-income.
64. However, easing of barriers can create new risks. The experience of Europe and the United States shows that conglomerates are exposed to higher financial markets risks and counterparty exposure to market and liquidity risk than nondiversified financial institutions. Allowing a number of activities under one roof can create numerous conflicts of interest. Conglomeration may also contribute to the contagion within a group (e.g., reputational risk becomes correlated). Lown and others (2000) found that U.S. banks’ mergers with securities firms increased risk modestly; and De Nicolo and others (2003) finds that large and conglomerate firms exhibited higher risk-taking than smaller firms.
Financial sector deregulation and denationalization in Korea during the 1980s
65. Gilbert and Wilson (1998) found that Korean banks responded to privatization and deregulation by dramatically altering their mix of inputs and outputs, which yielded large productivity gains. Deregulation in the 1980s included: abolishing or simplifying regulations; relaxing direct controls on interest rates; easing restrictions on bank entry; and broadening the scope of banks’ business activities (see details in Gilbert and Wilson, 1998). At the same time, IT developments allowed banks to sell more sophisticated financial services. Entry barriers were also lowered substantially for nonbank financial institutions. Banks thus faced increased opportunities but also increased competition, and still had high levels of nonperforming loans. This combination of having to write off bad loans out of current earnings while facing competition may explain the strong incentives to cost-cut: during 1980-94, banks increased their assets substantially while reducing average employment.
Financial deregulation in the United States during the 1990s
66. U.S. banks during the 1990s seem to have maintained productivity through providing additional services or higher quality service, which may have raised costs, but also raised revenues by more than costs (Berger and Mester, 2003). The Gramm-Leach-Bliley Act (GLB) of 1999 repealed the Glass-Steagall Act of 1933, allowing banks, brokerage firms, and insurance companies to merge. GLB to some extent simply ratified what was already being practiced in the context of a gradual liberalization of Glass-Steagall. There is thus mixed evidence on the benefit of GLB for banks, although Al Mamun and others (2004) find commercial banks, brokerage firms, and insurance companies all benefited from the introduction of GLB, with commercial banks and large firms benefiting the most. Berger and Mester (2003) note that, due to consolidation and deregulation, the banking sector has become more competitive; and examine the effects of technological change, deregulation and dynamic changes in competition, on the performance of U.S. banks. They find that during 1991-97, cost productivity (the predicted cost of producing a given level of output annually, controlling for business conditions) increased and profits (controlling for business conditions) improved dramatically over the period.27
Performance of Japanese banks post-Big-Bang reform
67. Selected elements of Japan’s financial sector reform and deregulation during 1998-99 include: permitting of financial holding companies; a new regulatory framework; an improved framework for securitization; the shift from licensing to registration for entry of securities businesses; permitting the sale of mutual funds by banks; permitting securities firms to offer asset management services; and the abolition of the fixed commission system for securities brokers.28 Loukoianova (2007) examines the efficiency and profitability of Japanese banks during 2000-06, and finds banks’ performance has steadily improved since 2001, but profitability and NIMs were low compared to other advanced countries. Banks would likely benefit from greater diversification of their products and activities, further deepening of capital markets,29 and from cost-sharing arrangements.30 Hence, further deregulation and development of the capital market would likely increase business opportunities and improve the performance of banks.
Lessons from International Experience for Korea Post-CMCA
68. The international evidence seems to suggest that banks have effectively adapted their business models to competitive pressures and revenue opportunities in post-deregulation environments. Korea’s own experience points the potential for large productivity gains from restructuring and cost-cutting. The experience in the U.S. post-GLB suggests that the model of providing new, innovative, and higher quality financial services can support profitability despite involving higher costs (such as more skilled staff and more extensive investment in IT-capital). Japan’s experience highlights the potential benefits of further relaxing regulations between banks and securities companies, and the associated development of the capital market.
69. In the longer term, beyond the CMCA, universal banking may be an appropriate goal. Korea’s CMCA differs in one important dimension from the global trend towards the elimination of barriers between banks, securities firms, and insurance companies. In Korea, only through subsidiaries are financial holdings companies able to operate in these different financial activities. The idea is to develop investment banks separately from commercial banks, while elsewhere, the share of investment bank activities in universal banks has increased.31 The choice of regulatory structure and the extent of easing of barriers between financial activities depend on a host of factors, including countries’ differing assessments about the net benefits and risks. Allowing banks to undertake investment bank activities could hasten the development of capital markets in Korea but a gradual approach is appropriate. In particular, some separation of these activities may be appropriate until supervision and market discipline are in place to deal with the risks of deregulated financial activities. With these in place, further easing could be appropriate (Semblat (2006) discusses the benefits and challenges of further easing barriers).
E. Conclusions
70. Korea’s wholesale funding dependence will likely continue to increase with the shift of households portfolios away from deposits, particularly in the context of the deregulation next year and underlying structural factors (such as the interest-income focused model of banks). Liquidity stresses in Korea have not yet been very disruptive. Recent international experience demonstrates how quickly and unexpectedly liquidity problems can manifest (particularly in the context of high wholesale funding dependence), and how severe the consequences can be. Korean policymakers have acknowledged the increasing liquidity risk concerns and have taken measures, such as enhancing monitoring of liquidity indicators, and expanding the options for banks to diversify funding and income sources. Regulators should also push to move Korean banks towards international LRM best practice (as recently revised in light of the subprime crisis). Korean banks’ business models have evolved—and will likely continue to evolve—in preparation for increased competition under CMCA. There are likely to be net benefits from continued diversification of income for Korean banks; but scope to do so depends in part on the extent to which banks are allowed to operate in investment banking activities. Ultimately a move to universal banking could be appropriate for Korea, once the key safeguards are in place.
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Semblat, Romuald, 2006, “A Financial Big Bang in Seoul? The Development of the Financial Sector in Korea,” in Republic of Korea: Selected Issues, IMF Country Report No. 06/381 (Washington: International Monetary Fund).
Stiroh, Kevin J., 2002, “Diversification in Banking: Is Noninterest Income the Answer?” Federal Reserve Bank of New York Staff Report No. 154, November (New York).
Prepared by Yougesh Khatri.
Wholesale funding here refers to funding sources of banks other than deposits, such as CDs, bonds/debentures, money market and borrowing. Liquidity risk, broadly, refers to vulnerabilities on liabilities side of an institutions balance sheet. The focus here is on funding liquidity risk more than market liquidity risk but the two are integrally related.
Foreign currency borrowing by banks remains modest (around 7 percent of their total funding), and only part of this is related to their onlending in foreign currency.
The ratio of net interest income to operating income shot up from 50 percent in 2001 to almost 80 percent in 2005. This could reflect a number of factors including tighter post-crisis bank regulation; consolidation and increased competition in the banking industry (affecting fees and other charges); and the move to financial holding company structures (with some of the banks’ non-interest income shifting to affiliates).
Financial disintermediation in most Asian countries lags that in Korea and thus asset growth of banks elsewhere in Asia has not been associated with similar degrees of wholesale financing reliance seen in Korea.
NIMs were 2.81 percent in 2005, 2.64 percent in 2006, and 2.45 percent in 2007. Helping to support profitability were stronger sales of wealth management products (Fitch Ratings, 2008).
An affiliates’ extension of credit to another affiliate must be fully secured and cannot exceed 10 percent of its capital; and extension of credit to all affiliates combined cannot exceed 20 percent of its capital.
BOK’s April 2008 Financial Stability Report (Box IV-1) describes the experiences in the United Kingdom and Australia.
The ratio of asset/liabilities with residual maturity of three months should be at least 85 percent. The ratio of assets exceeding liabilities to total assets, when the residual maturity is 7 days and 30 days should be zero and 10 percent respectively. There is also a requirements that banks foreign currency loans of one year or longer should be at least 80 percent funded by foreign currency borrowing with a maturity of one year or more (unless the outstanding foreign currency loans are less than $50 billion).
Other key issues include the balancing of a central banks role with respect to macroeconomic stability (through monetary policy) and financial stability (including through liquidity provision); and the need for international coordination of emergency arrangements and convergence of practices (IMF, 2008).
Structured deposits are basically an interest rate derivative product where the principal is protected and the interest received varies depending on some underlying financial instrument. These may help to increase the deposit base but may also raise concerns about “suitability”.
Fitch Ratings reports a doubling of the share of net non-interest income between FY2005 and FY2007 (from 13 percent to 26 percent of net revenue).
KEB has 26 overseas networks, Woori Bank has 18 and Shinhan Bank has 16.
Discussions of the broader experiences with deregulation in advanced countries and lessons for Korea can be found in KDI (2006) and Semblat (2006).
Over time, banks have provided a wider variety of services and offered additional convenience (ATMs, proliferation of credit/debit cards, and online banking). These seem to have increased costs but seem to have been necessary expenditures to maximize profits.
KDI (2006) provides a fuller discussion, including other important legislation passed in 2000.
In Japan (as in Korea but in contrast to other industrial countries), corporations rely less on capital markets for financing and individual investors hold a larger share of their wealth in bank deposits. Banks in other countries engage in a wider range of activities, including greater securitization of their loan books, and more sophisticated deposit and savings products (also ABS and REITs are growing in Japan).
Japan’s regional banks have already been taking steps to reduce costs by sharing computer systems, pooling risk management, and joint outsourcing.
Investment bank businesses at major global commercial banks generate 30–40 percent of their total profits, compared to less than 5 percent currently in Korean commercial banks
