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.
IV. Lessons and Policy Recommendations from the Financial Crisis 32
A. Introduction
71. The ongoing global financial crisis has thus far had only a small direct and moderate indirect impact on Korea, reflecting the overall soundness of the Korean financial system. However, the crisis has proven to be, at times, powerful and fast moving. In this light, lessons from the causes and impacts of the turmoil could serve as useful advice to help inform Korea’s financial markets as well as their regulatory and supervisory authorities. This is especially true as Korea attempts to promote major changes to its financial sector through regulatory reform.
72. In 2007, turmoil in the U.S. subprime mortgage market began spreading into other market segments and reaching across borders into other regions. A credit crunch swept internationally across the interbank lending market. Similarly, key over-the-counter (OTC) markets in securities and derivatives began suffering from a lack of trading if not outright illiquidity. Of the cross-border impacts, European banks were especially hard hit, first by losses on subprime-related assets and then by a contraction in wholesale funding through the interbank market.
73. Emerging market financial systems were not immune from the financial crisis, although they experienced less severe outcomes. One reason emerging economies were spared from the worst of the crisis is that they were treated by international investors as a safe haven from the sharp downturn in developed country financial markets. For Korea, there are two other factors that have contributed to its resilience. First, while it is an advanced economy, it has a relatively less developed—and thus less complex—financial system. And, second, its financial regulatory framework is based on a rules-based approach where permitted activities are prescribed by law, resulting in more gradual and careful market changes.
74. Upcoming changes in Korea’s financial markets will likely result in larger, more complex financial firms, and new markets in more sophisticated financial instruments. By February 2009, Korea will have implemented new legislation intended to promote financial market development through changes in market regulation.33 One main feature is to permit the formation of larger, multi-service financial firms, modeled along the lines of the major U.S. broker-dealers such as Goldman-Sachs, which will be more capable of introducing financial innovation into the marketplace. The law will also promote the further development of the asset-backed securities (ABS) market, and encourage more growth and market participation in OTC derivatives markets. Other aspects of the financial reforms will weaken the existing separation between banks and commercial firms.
75. As part of this process, Korean authorities will need to consider the most recent recommendations on financial policy reforms from international organizations.34 Since the financial reform legislation was passed in July 2007 the global financial situation has changed significantly. During this period of change, both regulators and financial firms will need to consider the lessons of the financial crisis and adopt the relevant policy recommendations in order to avoid similar troubles. This will be especially important as the financial system faces risks from the new large complex financial firms, new lines of business, new governance challenges to address potential conflicts of interest, and new financial instruments.
B. General Lessons from the Financial Crisis
76. The subprime market turmoil has highlighted several shortcomings in the functioning of the U.S. mortgage market. It is widely viewed that underwriting standards were too lax, especially in relation to the mortgage interest rates. Furthermore, these low standards were inadequately disclosed by originators as the mortgages were sold or distributed through secondary markets. The originate-to-distribute model facilitated conflicts of interest and lax market discipline as credit risks were quickly passed along from origination to securitization and re-securitization. Moreover, gaps in the U.S. regulatory and supervisory framework left many of the financial firms involved in this process out of the supervisory network.
77. OTC securities and derivatives markets proved to be lacking in resilience in the face of the turmoil. The FSF, the NYFRB, and others have pointed to weaknesses in OTC markets and the need to develop better market infrastructure to confirm and settle transactions and improve price transparency. When the crisis hit, key market participants failed or quit trading and dealers ceased acting as market makers. As a result, markets “froze” or became illiquid. This not only locked investors into losing positions and impaired efforts to hedge new risks, but also left the wider marketplace without prices to mark positions to market. This in turn led to accounting and valuation problems. The sudden lack of liquid markets further diminished the values of these assets and contributed substantially to the massive writedowns by banks and securities firms.
Summary of Recommendations by International Financial Organizations
| Mortgage Market | ||
| Improve underwriting standards | PWG | |
| Improve disclosure requirements and practices | PWG | |
| Remove conflicts of interest & restore market discipline in O2D model | BIS, IIF, PWG | |
| Prevent fraud and consumer abuse | PWG | |
| OTC Market Reforms | ||
| Establish OTC Registry | NYFRB, FSF, PWG | |
| Establish clearing house for OTC derivatives | NYFRB, FSF, PWG | |
| Improve counterparty risk for OTC derivatives | BIS, FSF, PWG | |
| Liquidity | ||
| Higher standards for liquidity management | BIS, FSF, PWG | |
| Liquidity cushion and contingent funding plan | BIS | |
| Internal controls and risk management | BIS | |
| Complexity | ||
| Higher standards for disclosure | IOSCO, BIS | |
| Modeling problems—errors with existing models, dangers of relying on one model or methodology | BIS, PWG, IASB, IOSCO | |
| Reform accounting and valuation methods | PWG, IOSCO, BIS | |
| Reform credit rating agencies | PWG, IOSCO | |
| Promote greater due diligence, sophistication & obtaining disclosures | BIS | |
| Suitability | FSF | |
| Inadequate Prudential Regulation | ||
| Need to adequately govern leverage | BIS, IMF | |
| Need greater capital requirements for off-balance sheet exposures, including liquidity obligations to | SIVs BIS, FSF, IMF, PWG | |
| Need greater capital requirements for liquidity risks | BIS | |
| Need greater capital requirements for complex assets | BIS, FSF, PWG | |
| Eliminate regulatory gaps ‑ prevent financial firms from operating outside the prudential regulatory framework | FSF, IMF, PWG | |
| Special supervisory attention to firms such as monoline insurers that serve critical role in multiple financial markets | FSF | |
| Executive compensation reform | IMF | |
| Policy Response Measures | ||
| Central bank provision of liquidity, including new procedures | FSF, BIS, IMF | |
| Managing failures through receivership, purchase and acquisitions, nationalization | FSF | |
| College of supervisory for global financial firms | FSF | |
| Mortgage Market | ||
| Improve underwriting standards | PWG | |
| Improve disclosure requirements and practices | PWG | |
| Remove conflicts of interest & restore market discipline in O2D model | BIS, IIF, PWG | |
| Prevent fraud and consumer abuse | PWG | |
| OTC Market Reforms | ||
| Establish OTC Registry | NYFRB, FSF, PWG | |
| Establish clearing house for OTC derivatives | NYFRB, FSF, PWG | |
| Improve counterparty risk for OTC derivatives | BIS, FSF, PWG | |
| Liquidity | ||
| Higher standards for liquidity management | BIS, FSF, PWG | |
| Liquidity cushion and contingent funding plan | BIS | |
| Internal controls and risk management | BIS | |
| Complexity | ||
| Higher standards for disclosure | IOSCO, BIS | |
| Modeling problems—errors with existing models, dangers of relying on one model or methodology | BIS, PWG, IASB, IOSCO | |
| Reform accounting and valuation methods | PWG, IOSCO, BIS | |
| Reform credit rating agencies | PWG, IOSCO | |
| Promote greater due diligence, sophistication & obtaining disclosures | BIS | |
| Suitability | FSF | |
| Inadequate Prudential Regulation | ||
| Need to adequately govern leverage | BIS, IMF | |
| Need greater capital requirements for off-balance sheet exposures, including liquidity obligations to | SIVs BIS, FSF, IMF, PWG | |
| Need greater capital requirements for liquidity risks | BIS | |
| Need greater capital requirements for complex assets | BIS, FSF, PWG | |
| Eliminate regulatory gaps ‑ prevent financial firms from operating outside the prudential regulatory framework | FSF, IMF, PWG | |
| Special supervisory attention to firms such as monoline insurers that serve critical role in multiple financial markets | FSF | |
| Executive compensation reform | IMF | |
| Policy Response Measures | ||
| Central bank provision of liquidity, including new procedures | FSF, BIS, IMF | |
| Managing failures through receivership, purchase and acquisitions, nationalization | FSF | |
| College of supervisory for global financial firms | FSF | |
78. In addition, there was excessive leverage at some of the key financial firms in the mortgage market. The unregulated mortgage originators—often the subsidiaries of regulated and well-capitalized banks and securities firms—operated with little capital and relied heavily on wholesale funding markets to finance their holdings of mortgages until they could be sold in the secondary market. The structured investment vehicles (SIVs) and conduits—which were sponsored by major banks but not consolidated for accounting or regulatory purposes—financed over 90 percent of their assets with asset-backed commercial paper and medium-term notes. Some hedge funds (the primary broker clients of the same banks and securities firms) operated with even greater leverage. High degrees of leverage led sometimes to crippling losses for the enterprise, and at other times it resulted in their inability to maintain operations in the face of margin or collateral calls. In the case of SIVs and conduits, it triggered liquidation provisions that led their bank sponsors to take the assets onto their balance sheets.
79. The subprime crisis has revealed that innovations involving new or higher levels of complexity can result in mispricing and inadequate risk management. Investors often relied too heavily on existing market prices and credit ratings as the low-cost alternative to investing heavily in the time and techniques required to conduct proper due diligence.
80. Yet another lesson is that gaps in regulation can amplify risks, in particular during a crisis. While regulated banks and securities firms formed the core of the major developed financial markets, there were many unregulated firms that played critical roles in the mortgage and overall financial markets and these often proved far less resilience to the market turmoil.
81. Finally, the crisis has highlighted the role that large, diversified financial firms can play in spreading turmoil across market segments and borders. The funding illiquidity experienced among major banks in the U.S. subprime mortgage market quickly spread to other banks and securities firms in the United States and Europe through wholesale interbank markets. The subprime mortgage turmoil, by inflicting severe losses on monoline insurers, was also transmitted into refunding crises in auction rate securities and tender option bonds backed by U.S. municipal bond and student loan ABS.
C. Lessons for Korea’s Mortgage Market
82. Korea’s mortgage market is characterized by strong underwriting standards and some encouraging developments. Mortgages in Korea are usually originated with at least a 60 percent loan–to-value (LTV) ratio. This implies a 167 percent collateralization rate on mortgage loans and provides mortgage lenders, offering a substantial degree of protection against declining home prices. One important positive development is the increasing use of long-term mortgage contracts. There is also a small but growing share of fixed-rate mortgages, but at present the market still consists of over 90 percent adjustable rate mortgages (ARM).35 The market for mortgage-backed securities (MBS) is small but growing, and as in the United States, it is dominated by a government-sponsored firm, Korean Housing Finance Corporation (KHFC), but also includes private sector issuers. Moreover, the regulatory authorities have dampened growth in the market when it was viewed that the growth in household mortgage debt and the pace of growth of housing price was excessive.
83. Nevertheless, some concerns regarding the mortgage market should be addressed based on the lessons of the financialcrisis. One issue is the recent use of grace periods in long-term amortized mortgages. The grace period is usually for 2 to 3 years and allows for only interest payments to be made during that time. This raises concerns both about underwriting quality—since initial interest-only payments may be used as an affordability provision to qualify borrowers—and the consequences for the ability of homeowners to pay their mortgages when the grace period ends.36 Such payment problems could be to limited in the future by limiting the use of grace periods to mortgages with long maturities or by limiting tax incentives for such loans. Mortgage risks may also be exacerbated by the predominant use of variable rate mortgages in Korea, which transfer interest rate risk to household, and continued efforts to develop fixed-rate mortgages would be advisable. In fact, in the U.S. market turmoil a sharp rise in delinquency and foreclosure rates of U.S. ARM mortgages has been observed as a consequence of the rise in short-term rates.
U.S. Delinquency and Foreclosure Rates
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A004
Source: Mortgage Bankers Association.U.S. Delinquency and Foreclosure Rates
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A004
Source: Mortgage Bankers Association.U.S. Delinquency and Foreclosure Rates
Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A004
Source: Mortgage Bankers Association.84. The growth in MBS issuance may also raise concerns about the originate-to-distribute business model for mortgage financing. At present, the vast majority of MBS are issued by the state-owned KHFC. They guarantee interest and principal payments and issue pass-through type MBS, as do Fannie Mae and Freddie Mac. The KHFC’s low and declining delinquency rates on the mortgage pools indicates strong underwriting standards. However, there is also a small but growing market in MBS issued by banks and other private sector financial firms. This is likely to grow more rapidly as the Capital Markets Consolidation Act (CMCA) is implemented and larger nonbank financial firms expand their securitization business. As private, independent MBS issuance grows, so will concerns about potential conflicts of interest and the lack of market discipline as credit risk is passed along in the securitization process. The IIF37 recommends that firms involved in the originate-to-distribute process should apply the same credit due diligence standards at all stages regardless of whether assets are to be held on the books or distributed.
D. Lessons for Korea’s OTC Financial Markets
85. As noted, another lesson from the financial crisis is that some OTC markets have weak market structures. The most serious consequence was the loss of market trading liquidity in some securities and derivatives markets. It not only prevented investors from adjusting their positions, but also hampered proper asset valuations by eliminating the use of liquid market prices for marking to market.
86. In response, the international financial policy organizations have made the following recommendations:
Establishment of an OTC registry or depository to record OTC trade confirmations and to make prompt public reports of market prices so as to improve the efficiency of price discovery and dissemination.
Establishment of a clearing house or similar facility to handle post-trade infrastructure including prompt trade confirmation, resolution of trade errors, and settlement.
Improvement of counterparty risk management through high standard and more efficient practice for the use of collateral for derivatives and lending transactions.
87. A key concern in Korea is that rapid financial sector reforms stemming from the CMCA will lead to expansive growth in financial transactions conducted in nontransparent OTC markets. The reforms will likely result in more financial transactions occurring in markets beyond the reach of Korea’s current regulatory framework. In addition to gaps in reporting requirements, there are no prudential regulations governing the use of collateral to reduce and otherwise manage counterparty credit risks in derivatives trades.
88. In order to mitigate these problems, an OTC registry can reduce operational risk and improve pricing. By requiring market participants to report OTC transactions to a designated registry, it can improve operational risk by reducing post-trade uncertainty and other costs. As an example, the regulatory framework in Brazil has established such requirements, and the function of the registry is provided by two institutions, the BM&F exchange and the CETIP depository.38 In the OTC market for corporate bonds and municipal bonds in the United States, participants are required to report within 15 minutes to a public access facility for posting prices.39 A registry can provide greater market transparency for competitive pricing during normal times, and help to mark-to-market less liquid securities during tumultuous times. Accounting and reporting requirements also improve with the enhanced availability of market prices.
89. Korea’s OTC markets for bonds already satisfy some of the recommendations.40 The bond market is regulated by the Korean Securities Dealers Association (KSDA), a self-regulatory organization. Trading in government bonds, corporate bonds and ABS are covered under the current KSDA rules, which require that all OTC bond and ABS transactions be reported within 15 minutes, to a central OTC registry and the information is then made available to the public. Korea’s Bond Quotation System also improves pre-trade transparency in the bond market by offering a centralized quotation system. However it is not required of other OTC securities or derivatives transactions.
90. Korea’s OTC securities and derivatives markets would be further improved by market-wide price reporting requirements, the use of a clearing house to reduce counterparty risk, and the establishment of minimum standards for the use of collateral in derivatives transactions. Korea’s price reporting requirements, which already applies to corporate bond transactions, should be extended to dealers and other market participants in OTC derivatives and other OTC securities markets in order to strengthen the structure of those markets and help to ensure liquidity. The use of a clearing house and the establishment of collateral standards would also help maintain market liquidity by reducing counterparty risks. The clearing house would also enhance liquidity by allowing a larger number of firms to participate in the market. Towards this end, Korean authorities might be encouraged by recent successes by the NYFRB to convince major OTC derivatives dealers to undertake a voluntary commitment to meet similar requirements.41
91. Alternatively, securities and derivatives are traded on the Korea Exchange (KRX) and this public market provides an even higher standard of transparency and trading liquidity for the price discovery process. The IFPO recognized that exchanges did not suffer the disruptions and trading illiquidity costs that befell many OTC markets. This is an important lesson to financial authorities, and the KRX offers a high standard for price transparency, efficient procedures for trade confirmation and clearing, and improved opportunities for market surveillance by financial system supervisors. Korean authorities have encouraged more government securities trading to occur on the exchange, and such efforts could be expanded to include other securities and derivatives instruments.
92. Korea lacks designated market makers in some OTC markets. Although not explicitly spelled out as a recommendation, OTC markets sometimes need designated dealers to serve as market makers to maintain liquidity. The role of the market maker is more costly when volatility rises, and OTC market have recently experienced dealers withdrawing from markets. This is an important issue because of Korea’s reliance on OTC trading for trading for bonds, structured securities and derivatives contracts. One potential policy measure to help prevent this is a requirement for dealers to maintain a liquid and orderly market by posting binding bid and offer prices throughout the trading day. Indeed, the KRX has designated dealers on the exchange, and the 20 designated primary dealers in government securities are also obliged to maintain price quotes on benchmark issuances. In a comparable manner, designated OTC foreign exchange dealers in Chile are required to act as market makers, Brazilian authorities have proposed market making requirements for OTC dealers, and primarily dealers in the OTC markets for U.S. Treasury securities are also required to act as market makers.
E. Dealing with Liquidity Risk
93. The credit crunch in the interbank markets was one key way in which subprime mortgage problems grew into a financial crisis. It resulted from heightened counterparty risk and a surge in the demand for interbank borrowing to fund assets being brought back onto banks’ balance sheets. In this context, the following recommendations have been made by the IFPOs:
Higher regulatory standards for liquidity risk management,42
Greater regulatory incentives to maintain an adequate liquidity cushion and other contingency provisions,
Improved internal controls and risk management.
94. The current international financial regulatory framework does not fully address the need to provision for funding liquidity. Requirements for cash in hand and deposits with the central bank were designed to meet the threat of a loss of confidence by depositors. However, the liquidity problem that has recently emerged pertains to threats from disruption of wholesale funding markets. These include not only interbank markets, but also wholesale markets for money market instruments such as asset backed commercial paper and auction rate securities. Another source of recent liquidity problems stems from off-balance contingent obligations to provide liquidity to affiliated but often unconsolidated entities such as SIVs and conduits.
95. Korean banks face liquidity funding risks by operating with a high loan-to-deposit ratio. The prudential regulatory framework currently maintains higher than usual standards for bank liquidity, requiring minimum proportions of liquid assets over a specified short-term time horizons (7, 30 and 90 days). While the measures have proven adequate to address issues of depositor confidence, they may not be adequate to address risks from wholesale market disruptions that can strike at the roll-over dates of three month to one year maturities. This issue is accentuated by the increased reliance of funding from asset management companies who fund banks through certificate of deposit (CD) instruments and intermediate term notes. 43 Foreign currency borrowing from wholesale markets faces similar liquidity risks.44
96. Recent disruptions in foreign currency funding at Korean banks illustrated the vulnerability to liquidity risk. In November-December 2007, major money center banks in the United States were faced with a serious credit crunch. As a result, Korean banks experienced difficulties in rolling over foreign currency loans in the wholesale interbank market and switched to the foreign exchange swap market for U.S. dollar credit. Korean banks were successful in using these derivatives instruments as a substitute to fund their dollar assets and derivatives, but the shift led to a reduction in transparency (financial statements became less representative of underlying activities) and it also reduced regulatory capital requirements for equivalent economic activity.45
F. Complexity of Financial Products
97. Although small compared to other OECD financial systems, Korea is already a regional leader in the issuance of ABS. Korean ABS are issued on car loans, home equity loans, credit card receivables and student loans. They are also used for real estate project financing. Despite the subprime crisis in the United States, the issuance of ABS in Korea for the first quarter of 2008 was up sharply (by 42 percent) over the same period in 2007. Compared to the first quarter of 2006, however, it amounted to a small decrease due largely to a sharp decline in real estate project financing and the securitization of those assets. The growth of the ABS market is expected to benefit from the implementation of the new deregulatory measures, as is the market for derivatives and other structured instruments
98. The IFPO identified the complex nature of financial innovations such as CDO, credit derivatives indices and SIVs as one source of the financial crisis. The following recommendations are especially relevant to Korean authorities:
Higher standards for disclosure,
Promote greater due diligence and sophistication,
Suitability requirements for the full range of financial instruments,
Better modeling—using more than one model and methodology,
Reform of accounting and valuation methods.
99. ABS issuance by mutual savings banks in Korea does not meet the highest standards of IFPO recommendations. The underlying assets of mutual savings bank issued ABS are largely loans to construction projects, and the ABS carry credit enhancements in the form of a guarantee. The concern is that investors are not fully aware that the guarantees on the ABS are provided by the construction companies that are the recipients of the project loans that form the underlying assets. Unless investors are fully informed of the content of the underlying assets and the details of the structure of the securitization process, the asset will not be efficiently priced.
100. As Korea’s financial markets engage more and more in modern, complex market activities it may increasingly involve legal structures such as special purpose entities. 46 The treatment of SPEs in the regulatory framework will need to be updated accordingly. The IFPO recommends strengthening capital requirements to properly reflect the risks involved with sponsoring and making funding commitments to such SPE.
101. Suitability is another source for potential problems with complex financial instruments. Financial sophistication is required in order to properly price complex financial transactions, in particular those that are not standardized and/or trade in illiquid markets. Financial firms that are sophisticated and trade regularly in these products face a conflict of interest in dealing with less sophisticated customers or clients and should be held accountable to “know thy customer” and suitability requirements.
102. Certain financial structures are unsuitable for issuers. One of the factors that led to the financial crisis in the U.S. municipal securities market and the student loan ABS market was the use of inappropriate financing structures. Auction rate securities, variable rate debt obligations and tender option bonds, which were putable debts, proved vulnerable to counterparty risk and liquidity risk. Auction rate securities were designed to add trading liquidity in order to attract money market investors. They depended upon dealers to assure liquidity, but there were no obligations for dealers to act as market markers. When troubles at the monoline insurers threatened the creditworthiness of these securities, investors tried to pull out, dealers abandoned their market making role and auctions failed to clear. The lesson is that these were not safe and sound innovations, and they proved unsuitable for investors as well as issuers.
103. Korean authorities will need to increasingly focus on suitability issues. Regulators will need to monitor innovations under the new negative list system and exercise appropriate authority in order to avoid similar problems in the modernization of Korea’s financial system. While the CMCA includes new investor protection laws, suitability requirements should also apply to all clients, customers and counterparties even if they are selling or issuing securities. In fact, some suitability problems have recently emerged in Korea. Domestic banks have recently sold “knock-in knock-out” options to nonfinancial (largely small and medium-sized) firms that were seeking to hedge their foreign exchange risk. These types of options are less expensive than “vanilla” options because they are comprised of several partially offsetting long and short options transactions. Hedgers were likely attracted to their lower costs, however they proved inadequate as a hedging strategy because they left the hedger exposed to large changes in the exchange rate that would knock-out any gains otherwise captured from the transaction.
G. Addressing Regulatory Gaps
104. Several recommendations on regulatory gaps from the IFPO could prove useful for regulatory authorities in Korea:
The regulatory framework should encompass the range of financial service firms and financial instruments in the marketplace and not leave regulatory gaps.
Greater capital requirements are needed for complex assets as incentives to adequately provision for liquidity cushions.
Special supervisory attention is needed for large, complex financial firms, especially when the firms play critical roles in several financial markets.
105. Korean regulatory reforms are moving from a “positive” list to a ‘negative’ list. While negative lists can speed the pace of innovation, they also risk the creation of gaps or regulatory arbitrage as new financial products are developed to circumvent existing regulations, accounting rules or tax provisions.
106. CMCA reforms will allow hedge funds to raise capital from domestic investors, and over time to accept funds from retail investors. The regulatory plan does not require reporting requirements for hedge funds, but instead plans to regulate them indirectly through the regulation of managers and investment advisors. While the fiduciary integrity and investment records of these managers are important, so too is the ability to maintain market surveillance and if larger amounts of investments are being channeled through such nontransparent financial firms then the effective market monitoring will become more challenging.
107. Korean authorities also need to ensure that financial firms maintain capital commensurate with risk exposures from complex financial instruments and commitments for liquidity funding. Korea has already adopted Basel II capital requirements and should be ready to adopt efforts by the Basel Committee on Bank Supervision to update those financial policies according to the new recommendations. The areas of Korea’s financial regulatory framework applying to nonbanks should be similarly updated, where appropriate, to better govern risk taking in light of the greater risks exposed by the financial crisis.
H. Policy Response Measures
108. The U.S. financial crisis illustrates the importance of a central bank’s ability to exercise their authority to provide funding liquidity to the financial system. In response to the financial turmoil, the Federal Reserve expanded the range of assets that it allowed to be used as collateral for discount window borrowing and repurchase agreements. It also created a new asset swap facility in which general collateral U.S. Treasury securities could be obtained in a repo-like transaction in exchange for posting high quality but illiquid assets. Furthermore, the Federal Reserve expanded the range of financial institutions eligible for discount window lending by including all the designated primary dealers in U.S. Treasury securities. These measures succeeded in adding needed funding liquidity to the financial markets.
109. Korea’s central bank has the capacity to add liquidity to the financial system through outright loans and repurchase agreements. The Bank of Korea has the emergency authority, for the purpose of assuring financial stability, to provide direct loans and credit through repurchase agreements to banks and nonbank financial firms. Normally, government bonds, government guaranteed bonds, and monetary stabilization bonds can be used as collateral, but under emergency authority the central bank can accept other assets. Korean banks have pursued an aggressive loan growth policy in recent years, and as a result their balance sheets are proportionally less liquid. Korean authorities should take a careful look at the experience of the U.S. Federal Home Loan Banks in providing liquidity during the 2007 credit crunch by accepting home mortgages as collateral in exchange for making direct loans to banks and similar depository institutions.
110. Finally, it is important to point out that private repo markets in the United States and EU continued to function effectively throughout the credit crunch. This securitized credit market facilitated central bank actions, such as the Federal Reserves’ security swap program, and augmented the provision of credit to financial and nonfinancial firms alike. Korea’s repo market has remained underdeveloped, and reliance remains heavy on unsecured call loan transactions; such unsecured transactions proved to be the weak point in the credit crunch that hit the Eurodollar market in 2007 when counterparty risk jumped to critical levels. In light of this, the Korean authorities should complete their plans to deepen their repo market.
Prepared by Randall Dodd.
A fuller discussion of the Financial Investment Services and Capital Markets Act of 2007 can be found in Republic of Korea: Selected Issues, 2006, IMF Country Report No. 06/381; and Chapter III of this Selected Issues paper.
See Box IV.1 for a selected list of recommendations from the major International Financial Policy Organizations (IFPO). These include the Bank for International Settlements (BIS), the Financial Stability Forum (FSF), the International Accounting Standards Board (IASB), the International Monetary Fund (IMF), the International Organization of Securities Commissions (IOSCO), the Institute for International Finance (IIF), and the Organization for Economic Cooperation and Development (OECD). The New York Federal Reserve Bank (NYFRB) and the President’s Working Group (PWG) on Financial Markets are U.S. organizations, but with an international focus and presence.
As of April 2007.
For further details, see Chapter IV of Republic of Korea: Selected Issues, 2007, IMF Country Report No.07/345; and Chapter II of this Selected Issues paper.
Institute of International Finance, Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations, July 17, 2008.
The Brazilian Futures Exchange (BM&F) is one of the largest and most sophisticated derivatives exchanges in the world, and it also serves as a clearing house for bonds and a registry for OTC derivatives. CETIP is the central securities depository and a derivatives registry in Brazil.
The service is provided by the TRACE and the Municipal Securities Rulemaking Board, a self-regulatory organization for the municipal securities market.
The vast majority of bond trading in Korea is conducted OTC. The KSDA reports that 80.5 percent of bond trading volume was OTC in 2007, down from 99 percent in 2001.
See July 31, 2008 open letter to NYFRB President Geithner from 17 dealers, key buy-side asset management firms, and three related trade associations.
See Chapter III of this Selected Issues Paper for a discussion of stress testing in regard to liquidity risk.
The use of longer maturity notes mitigates the wholesale funding risks as the frequency of the roll-over decreases and roll-over events are staggered over time.
While a substantial share of this foreign currency borrowing is from parent or headquarter banks abroad, those banks may face their own liquidity risks during periods of global turmoil, and may not necessarily be capable of maintaining lines of credit to all areas of the global enterprise.
The foreign exchange swap transaction is very much like a similarly dated foreign currency loan, but has different regulatory and accounting implications. The swap is booked through the bank’s derivatives desk and is reported as an off-balance sheet item. The offsetting value of the exchange of currencies at the spot exchange rate in the start leg of the transaction means that there is no initial credit exposure on the transaction. If it were instead structured as a back-to-back loan, it would appear on the balance sheet as matching (won) asset and (dollar) liabilities.
These entities are also known as QSPEs, special investment vehicles, special purpose vehicles, and conduits.
