Summary

36. Supervision lacks a legal mandate to regulate financial conglomerates which do not have a straightforward holding structure. By law the FSC/FSS are tasked with supervision of groups with a clearly defined head—a financial holding company. However, other financial groups— some of them systematically important—are not regulated on a group level, hence the authorities cannot assess and regulate risks emerging from the operations of their nonfinancial parts nor comprehensively supervise activities of their financial institutions. For a complete picture of supervisory analyses, the authorities must be mandated to reach a wider group with their information requests.

37. A set of regulatory measures incentivizing groups to streamline their group structures should be developed and the FSC/FSS’s mandate expanded. The FSC/FSS should also supervise financial conglomerates without a straightforward holding structure. A prudential framework for these “non-holding financial groups”, which is currently considered by the FSC, should be developed. Information disclosure of the group’s ownership structure would be an important upgrade. Group structures that do not impede effective supervision, recovery and resolution should be required. The supervisory authorities should have discretionary powers when designating heads of financial conglomerates (holding companies) to ensure that potentially systemic groups are under regulatory purview.

38. Korea has a solid, rules-based regulatory regime largely in line with international standards, which through regulation of individual sectors effectively supports the financial conglomerates framework. While capital requirements are in place at the holding company level, liquidity requirements currently apply only at banks and other financial subsidiaries. The lack of requirements at the holding company level is an important gap that should be addressed given the growth of non-banking activities in DSIB banking groups. In some areas, such as concentration and large exposure restrictions, the authorities are piloting some thresholds but are still considering the best approach for the Korean banking system. In insurance, implementation of the new K-ICS and IFRS 17 are important reforms. For capital markets, there is a need to accelerate the implementation of the IOSCO MMF Recommendations.

39. In terms of corporate governance requirements across financial institutions and groups, accountability of boards with respect both to meeting expectations for responsibilities related to fit and proper assessments and running the firm in a safe and sound manner is a major weakness. The FSC/FSS do not have the legal authority to evaluate board members and senior officers against specific qualification requirements and approve them for the positions; reviews in the context of regular supervisory assessments cannot fully replace these approvals as they miss the opportunity to formulate a concrete content of the accountability of board members and senior officers to supervisors at the beginning of their mandates. Additionally, on a group level, assessing responsibility of boards and senior managers for an issue that occurred on the level of a subsidiary can pose a challenge.

40. The authorities need to accelerate the implementation of the reforms to address risks of accounting and expand auditors’ obligations beyond the audits of financial statements. The planned financial statements review system should be put in place and linked with the audit and accounting oversight efforts so that there is a comprehensive assessment that can be made. Additional assignments to auditors can include the accuracy of regulatory reporting, or the effectiveness of internal control processes, including risk management, and systems—on enterprise and group level. The auditors should be required to report major flaws and failures to the FSC/FSS.

Financial Conglomerates

41. There are two regulatory frameworks established for supervision of financial conglomerates for two different types of group structures.³¹ The FHCA provides a legal basis for supervision of the groups meeting defined characteristics of a holding structure—HFGs. The Consultation Papers on the Supervision of Financial Conglomerates (CPFC), nonbinding recommendations, set standards for supervision of NFGs, groups with a complex structure, not headed by a holding company.

42. HFGs face a restrictive regulatory framework, determining less complex group structures, specificities in overall governance and a strong role of compliance based supervisory approaches. The aim is to prevent industrial conglomerates from establishing a bank as the treasury within the group. Law establishes a system of limits and restrictions to ring-fence banking operations and associated risks. First of all, a bank cannot be a member of a mixed conglomerate, but only of HFG, composed solely of financial institutions. Only financial companies or companies pursuing financial-related business are allowed to be incorporated into the group as the HFG’s subsidiaries, and only financial companies in related business can be incorporated as the holding company’s second-tier or third-tier subsidiaries.³² Regulation implies simple and hierarchic structures of HFGs, consisting of holding companies and two tiers of subsidiaries. The clarity of structures is also encouraged by supervisors with their close focus on compliance with these requirements.⁸ Regulations regarding intra-group transactions and investments are particularly strict for HFGs and include: prohibition of the investment among subsidiaries, restriction on the amount of credit granting among subsidiaries, and prohibition of the subsidiary’s granting credit to as well as stock investment in the holding company.

Korea: Example of Simplified HFG Map

Citation: IMF Staff Country Reports 2020, 275; 10.5089/9781513556970.002.A001

Source: IMF

• Download Figure
• Download figure as PowerPoint slide

View Full Size

Korea: Example of Simplified HFG Map

Citation: IMF Staff Country Reports 2020, 275; 10.5089/9781513556970.002.A001

Source: IMF

• Download Figure
• Download figure as PowerPoint slide

Korea: Example of Simplified HFG Map

Citation: IMF Staff Country Reports 2020, 275; 10.5089/9781513556970.002.A001

Source: IMF

• Download Figure
• Download figure as PowerPoint slide

43. A legal framework for NFGs on a group-wide basis is under gradual development, aiming to develop effective approaches that bring more transparency to these groups. These groups are defined as financial conglomerates by international standards, but application of the principles is challenging given complex structures of these groups and the lack of a legally binding regulatory framework.³³ The legislators proposed two bills largely inspired by the CPFC to the Parliament, where they have been pending for more than one year.³⁴ So currently, there does not exist a process by which the financial authorities can either approve of, or control, the change in the group structure for NFGs. The mentioned bills suggest provisions that could enable the financial authorities to exert sufficient influence over its affiliates, the level of which is similar to that of HFGs.

Korea: Example of Simplified NFG Map

Citation: IMF Staff Country Reports 2020, 275; 10.5089/9781513556970.002.A001

Source: IMF

• Download Figure
• Download figure as PowerPoint slide

View Full Size

Korea: Example of Simplified NFG Map

Citation: IMF Staff Country Reports 2020, 275; 10.5089/9781513556970.002.A001

Source: IMF

• Download Figure
• Download figure as PowerPoint slide

Korea: Example of Simplified NFG Map

Citation: IMF Staff Country Reports 2020, 275; 10.5089/9781513556970.002.A001

Source: IMF

• Download Figure
• Download figure as PowerPoint slide

44. Korea’s group-wide supervision forms together with sectoral supervision one system that has to be considered holistically. These sectoral laws define prudential requirements for consolidated supervision of HFGs. They include corporate governance rules, capital and liquidity rules, and risk management requirements. It means that sectoral laws do not only provide context to the group regulatory framework, but they are its inherent and inseparable component.

45. The legal definition of HFG can prevent group-wide supervision to reach relevant areas beyond the regulatory perimeter.³⁵ The definition is based on precise criteria not allowing any interpretation or discretion applied by supervisors. According to these criteria, an HFG is led by a FHC, which: i) controls at least 1 financial institution; ii) total assets are greater than or equal to 500 billion won; iii) the total amount of stock values of its subsidiaries exceed 50 percent of the total amount of its assets. This definition provides for a strong consistency of its application, providing high predictability of supervisory actions. However, there can be cases where supervision needs to employ additional quantitative or qualitative criteria to apply group level supervision to a holding company (and a group) which characteristics justify the exercise of financial conglomerate supervision, but it does not meet the strict quantitative limits. Such flexibility in qualifying criteria could support the enforcement of the conglomerate’s transparency.

46. The financial authorities cannot require HFGs to take on a specific legal form or a group structure, however the FSC/FSS have some powerful tools to enforce transparency of these groups. Transparency of group structure is regulated through a set of rules, rather than principles that would allow for broader discretion on side of supervisors. Nonetheless, the FSC/FSS do have quite strong tools to enforce these rules. Specifically, the FSC/FSS can restrict a subsidiary of an FHC from owning stocks of another subsidiary or can require a subsidiary to only control financial institutions in related business as its second-tier subsidiary. In the case of NFGs, the supervisory tools are more indirect and include capital adequacy requirements for financial affiliates.

47. Additionally, any change to the group structure of the HFG is reported to the FSC/FSS, and is subject to regulatory approval.³⁶ For HFGs, FHCs are required to either report to, or acquire the approval of, the FSC/FSS when they plan on newly incorporating a subsidiary into the group. FHCs need to report to the authorities when they no longer control a certain subsidiary. (Article 16 – 18 and Article 61 of the FHCA) For NFGs, a ‘representative company’³⁷ must report to the FSC on a quarterly basis on the current status of the group’s ownership and governance structure, and any other changes. (Article 17 of the CPFC)

48. The information on a wider group of nonfinancial corporations, primarily relevant for NFGs, can be reached only through cooperation with the FTC, which can limit the FSC/FSS’s authority towards groups. This is primarily relevant for supervision on the NFGs. In many cases this is sufficient, however the FTC has a specific mandate and information which it collects that may not always match the needs of supervision. Also, cooperation with the FTC is rather limited. Furthermore, there can be situations in which the FSC/FSS want to demonstrate their authority towards the conglomerates by directly requiring a specific piece of information, for the purpose of effective supervision. The proposal of the FSC/FSS to request such information through a ‘representative company³⁸ seems to be the most suitable, considering a possibility of potential enforcement.

49. The authorization of major shareholders provides a solid shield against a misuse of the financial system and safeguards soundness of the owners of financial institutions and groups. The qualifications for major shareholders are one of the evaluation criteria for authorization to establish a financial company.³⁹ Compliance with the qualifications after the establishment of the financial company is subject to a regular review. The FSC/FSS check information about major shareholders against corporate and securities registries, and other publicly available information. The FSC/FSS verify the source of major shareholders funds and get assurance that there is a clear separation of industrial and financial activities. The information on qualifying holdings is part of reporting. The FSS cross-checks information from reporting with information available to the FTC.

50. Prompt corrective actions can be effectively adopted only for HFCs, as NFGs at the group level are not regulated by law, which is a significant gap in the current framework. Considering that a wider range of supervisory judgement has to applied on a broader variety of situations in the case of NFGs, the lack of this enforcement tool can hamper the effectiveness of supervision, as prompt corrective actions can often be used to mark the limits of prudent practice. Currently, the FSC/FSS can only recommend that NFGs take measures to improve the soundness of the group, for instance through a submission of a non-binding management improvement plan.

51. The recovery and resolution framework should be applied to domestic systematically important banking groups, to support group supervision with additional tools. The complexity of financial conglomerates should be reflected in the application of the recovery and resolution framework. Also, despite the increasing strategic importance of the overseas activity of Korean banks and the significant share of foreign banks in the Korean system, little thought has been given to managing a failure of cross-border firms. An approach needs to be developed, including a strategy for engaging relevant authorities overseas.

52. The legally binding prudential regulation for HFGs prevents multiple gearing and leveraging, limits contagion and concentration risk, and ensures sufficient levels of capital and liquidity, as well as adequate governance standards, in line with international standards. The FHCA prohibits mutual stock ownership between the subsidiaries, places limits on the size of the credit exposures among the subsidiaries, etc., in an effort to prevent contagion risks that could be caused by intra-group transactions. Bank holding groups, in particular, are subject to additional regulations—in line with international standards, including Basel III. NFGs are expected to follow recommendations set in the CPFC, which proposes capital ratios calculated on an aggregate level for all financial institutions that are members of the same group.

53. Specifically, for NFGs, the FSC developed the minimum capital ratio that is broadly inspired by the 1999 Principles,⁴⁰ and represents a reasonable step in creating a backbone of prudential requirements for NFGs. It compares aggregated capital of group financial institutions and sectoral capital requirements, taking into account double/multiple gearing among these institutions. Also, the NFG must calculate capital requirements for contagion and concentration risk. The FSC is currently working on the calibration of these capital requirements. It is recommended that they reflect the complexity and size of the group (including a wider group). The recommendations assign a ‘representative company’ of the NFG with a similar role as a holding company.⁴¹ A representative company is designated by the FSC/FSS. It is responsible for compliance with prudential standards on a group level and it is a primary contact point for supervision. For instance, NFGs are required to establish a risk-management consultative body, comprised of the representative company and other constituent financial affiliates, to manage group-wide risks and to coordinate and arbitrate various risk-related issues and interests. (Article 9 of the CPFC)

54. Although the capital ratio for NFGs has several conceptual limitations, it can be an efficient tool to increase transparency of NFGs. The ratio cannot fully capture the complexity of intragroup relations. Also, it cannot guarantee that capital would be available or could quickly be made available in the part of the group where losses and capital needs might occur. Additionally, it can be a challenge to assure the appropriate quality of capital. Nonetheless, the ratio is a good tool to address the general nature of group-level risks and to enforce prudent behavior of NFGs. Already, signaling to NFGs from the perspectives of supervisors that these NFGs are considered by the FSC/FSS as groups, with all related group-level risks, is an important step forward. Considering all limitations of this ratio, it should be used to promote an increase in the transparency of NFGs by providing strong incentives to streamline relations within a financial part of NFGs and to shield financial institutions from the risks of a wider (e.g., nonfinancial) part of the group. Ultimately, NFGs should benefit from transforming their structure to a transparent holding financial arm of the group.⁴²

55. HFGs are required and NFGs are recommended to disclose a detailed set of information about the group, to support their transparency. The current regime provides a solid basis that can be further enhanced through the framework currently considered by the FSC, which includes information about ownership structure, corporate governing bodies, financial conditions, and risk management strategies, but also specific data about intra-group transactions, capital ratios, etc. It is recommended the FSC expands the disclosure requirement in the direction already being considered. Specifically, the information about group structures would be an important element of this upgrade, motivating groups to strengthen their organization. A similar strategy is already used by the FTC. Disclosures are available in the “Data Analysis, Retrieval and Transfer System” (DART).

56. FSC/FSS established regulations covering corporate governance,⁴³ applicable to all financial institutions and financial holding companies, applying a consistent standard across the financial system. The Corporate Governance Act (CGA) governs the corporate governance of banks, securities firms, insurers, credit card companies, MSBs, and financial holding companies, and is backstopped by the Commercial Act (CA). Where there are not specific provisions in the CGA, an area may be covered by the CA. Specifically, the CGA includes requirements for the composition and operation of the board, requirements with respect to roles and responsibilities related to internal controls and risk management, and prudential requirements for large shareholders.

57. In line with international standards and good practices, boards are required to have adequate representation of independent directors. At least 3 members must be independent directors, and these must represent a majority of board members. Additionally, the board must have risk and audit committees. This applies at both the legal entity and the holding company level. The corporate governance rules also require the board’s remuneration committee to deliberate and decide methods of determining and paying remunerations, ensure that no executive officer and employee take excessive risk when it creates a remuneration system, and defer the payment of remuneration payable to specific executive officers and employees. Each financial company is required to establish internal control standards by incorporating rules and integrity obligations with which the executive officers and employees should comply, for the soundness of business management and the protection of financial consumers. (Article 24 of the CGA).

58. The internal procedures of financial institutions (instead of supervisory reviews) on corporate governance are a basic instrument to ensure compliance with legal requirements, which represents a possible challenge for supervisory consistency and enforcement. The internal rules on corporate governance organize the corporate governance matters, including: the composition and management of the Board, establishment of a committee within the Board, the criteria for the expertise of executive officers, the evaluation of performance of executive officers, matters concerning succession to business control, such as the qualification for CEO. To ensure the sound management of financial conglomerates, the FSC/FSS require the board members (including persons who are not directors but who effectively conduct business affairs) to meet minimum qualifying prerequisites of integrity, while implementing various policy measures that secure the independence and expertise of the board members. Following the internal rules, financial companies are expected to submit to the financial authorities an annual report on the current status of the board management and operation, and to disclose it on relevant websites.⁴⁴ However, supervisors can be in a difficult position to achieve a uniform standard across the industry without their earlier involvement in the processes, benefiting from more intrusive approaches.

59. The FSC/FSS do not have the legal authority to evaluate board members and senior officers against specific qualification requirements and approve them for the positions, that substantially decreases accountability of boards with respect both to meeting expectations for responsibilities related to fit and proper assessments and running the firm in a safe and sound manner. Financial institutions, including FHCs, are required to develop their own internal fit and proper assessment processes. Financial institutions are responsible for reviews of the qualification requirements on on-going basis. The appointments do not require formal approvals by the FSC/FSS. Reviews in the context of regular supervisory assessments cannot fully replace these approvals as they miss the opportunity to formulate a concrete content of the accountability of board members and senior officers to supervisors at the beginning of their mandates. A similar logic applies to group level senior managers, where assessing their responsibility for an issue that occurred on the level of a subsidiary can pose a challenge, which is another critical weakness of the current framework.

60. The role of the FSC/FSS in assessments of major shareholders is complemented by the authority of the FTC, and these assessments would greatly benefit from enhanced cooperation between these agencies. The authority of the FSC/FSS to assess the financial soundness and the integrity of major shareholders is defined by the CGA and is applied to all supervised financial institutions and financial holding companies. The regulation also defines detailed requirements for FHCs. For NFGs, a periodic group-wide risk management assessment of the group is recommended, evaluating the overall safety and transparency of the ownership and governance structure of the group. The role of the FSC/FSS is complemented by the broader mandate of the FTC. Currently, the FSC/FSS benefit from information collected by the FTC, however the cooperation of the FSC/FSS have a greater potential which should be explored.

61. The FSC/FSS established the regulatory framework for the overall corporate governance and sound organization of risk management, in line with international standards, specifically:

• The board of the head of the group (an FHC or a ‘representative company’) is expected to be capable of understanding the group structure, management strategy and the material risks of the group. The board of the FHC deliberates and makes decisions on matters concerning the group’s business management, such as the formulation of the group’s management strategies, the realignment of the group’s organizational structure, and the management of group-wide risks. In the case of NFG, the board of the representative company should have a grasp over the group-wide issues and risks of the group. (Article 9 of the CPFC)

• The FSC/FSS require that the board of the FHC formulates capital management policies by identifying and assessing group-wide risks in a comprehensive manner. It includes risks of unregulated entities. The board of the FHC is required to review and approve whether risk management strategies and capital management policies are consistent with its management strategies. (Article 12(2) of the Detailed Supervisory Regulations on Financial Holding Companies) Based on this, financial conglomerates should design its capital management policies that include crisis-situation analysis. The FSC/FSS require that the board of the FHC and recommends that the board (or the Risk Management Committee) of the NFG proactively manages its capital.⁴⁵ The results of stress testing are expected to be reflected in capital planning and liquidity management processes, including as preparation for a crisis situation.

• Similarly, the head of the group (FHC/representative company) is required/recommended to develop a group-wide liquidity management processes and funding programs. These must be consistent with the group’s scope of business, risk factors, and restrictions. (Article 29 of the Supervisory Regulations on Financial Holding Companies and Article 9 and Appendix 1 of the CPFC) The liquidity management process takes into account factors such as limits on the group’s allowable risk size, managing an early warning system, conducting crisis-situation analyses, formulating contingency funding plans, diversifying funding channels and maturity periods, etc.

• The regulations also require the boards of financial conglomerates to set and implement risk management and internal control standards; financial institutions are requested to establish an independent risk management unit. The risk management and internal control standards delineate features such as the organization structure, the procedures and methods for group-wide risk management, including the administrative and accounting procedures of the group.⁴⁶ An internal control framework must be able to capture group-wide risks. Conglomerates are required to document the standards and processes, which broadly include matters such as the nature of business, issues related to various transactions, risks associated with the transactions and the interconnectedness of financial affiliates.⁴⁷

• However, the FSC/FSS has only limited tools for requiring firms to address qualitative weaknesses that may impact a financial company’s safety and soundness and should consider ways to strengthen incentives for banks to fix material risk management and control deficiencies. As a starting point, addressing to boards and senior management the assessments and expectations for rapid remediation of weaknesses in areas the FSS views as of the most critical importance would be a welcome development. Such areas could include those related to supporting financial resiliency and compliance with conduct-related rules.

62. The FSC/FSS uses its broad authority to require comprehensive regulatory reporting from supervised firms and receives an extensive set of reports, but potentially not always matching the needs of cooperative efforts of the FSC, FSS, KDIC and BoK related to financial stability. The FSC, FSS, KDIC and BoK all have responsibilities for financial stability-related objectives. This review indicated, however, that the flow of information could be enhanced. Moreover, the information collected by/reported to the FSS may not include the full suite of useful information for these purposes. The agencies should convene a working group to discuss their potential data/information needs over the next 5–10 years and consider revising reporting requirements if needed.

Banks

63. Korea has implemented capital requirements in line with Basel 3. The 2016 Basel Committee on Banking Supervision (BCBS) RCAP found the capital regime to be “largely compliant”. Two elements were found to not be compliant: transitional arrangements and definition of capital. Both of these areas have been or were in the process of being addressed during the recent mission.

64. For banks, the minimum CET1 capital ratio is set at 4.5 percent, minimum Tier 1 capital ratio at 6.0 percent, and minimum total capital ratio at 8.0 percent. For Domestic Systemically Important Bank (D-SIBs) there is a capital surcharge of 1 percent, except for one D-SIB that is government owned, which is not subject to the surcharge due to the existence of a government guarantee agreement to ensure sufficient capital to maintain operations. The capital conservation buffer is 2.5 percent. The FSC may also turn on a countercyclical capital buffer ranging from 0 to 2.5 percent. Currently this is not mandated.

65. Recovery and resolution efforts are still being considered and assessments of recovery planning at D-SIBs should be given more attention. Recovery preparedness and planning is an important part of promoting resiliency at systemically important banks (SIB). Such banks should be held responsible for identifying a range of options they could take into account. Banks typically have their own “self-rescue plans”, which are less comprehensive than recovery plans and are not automatically activated by deterioration toward a possible crisis situation. However, these could represent a basis for development of the recovery preparedness procedures.

66. The lack of liquidity regulations at the consolidated holding company level constrains the ability of FSC/FSS to effectively evaluate group-wide liquidity risks and group-wide processes for managing liquidity risks across the entire firm. There is no Liquidity-Coverage Ratio (LCR) or Net Stable Funding Ratio (NSFR) requirement at the holding company level, which should be addressed as soon as is practicably possible. Discussions with FSS supervisors indicated they understand the importance of this gap and are working to implement requirements at the consolidated group level.

67. There are a variety of liquidity position requirements in bank-level regulations, including LCR and NSFR requirements that have been or are being implemented in line with Basel 3 standards. The 2016 BCBS RCAP review of the LCR found the Korean LCR regime compliant. In addition to the LCR and NSFR, Korean banks are subject to loan to deposit requirements of 100 percent, an FX LCR requirement of 80 percent and a variety of maturity mismatch restrictions.

68. The LCR for highly liquid assets and highly liquid foreign assets was introduced by revising the Regulation on Supervision of Banking Business (RSBB) (Article 26 and Article 63) and the revised Detailed Regulation on Supervision of Banking Business (DRSBB) (Appendix 3–6) in Dec. 2014. Except under stressed conditions, banks are required to continuously comply with the LCR for highly liquid assets and highly liquid foreign assets (on US dollar basis) and report an average outstanding balance on a monthly basis by calculating the LCR for each working day.

69. Basel III minimum LCR requirements (at 100 percent) apply to domestic banks on a consolidated bank-level basis. Banks are required to submit Business Reports on maturity mismatches of assets and liabilities each quarter and on monthly average LCR, daily LCR, and contractual maturity mismatches every month to the FSC/FSS for their LCR management – Appendix 3–6 of the DRSBB. The FSC/FSS enforces a separate FX LCR regulation for FX assets in recognition of Korea’s unique characteristics as a small, open economy. There are also limits to FX maturity mismatches. For example, maturity mismatch requirements for mid-to long-term FX funding are as follows—all domestic banks (except those with less than US $50 million in FX loans outstanding) must maintain the stable foreign exchange funding ratio⁴⁸ at 100 percent or above (90 percent or above for the Eximbank) (article 65 of the RSBB and article 39 and Appendix 14 of the DRSBB).

70. Domestic banks excluding Eximbank and small-scale banks⁴⁹ are subject to an FX LCR requirement,⁵⁰ which is set at a minimum of 80 percent (60 percent for Korean Development Bank (KDB)), article 63–2 of the RSBB, article 39 and Appendix 3–6 of the DRSBB. Maturity mismatch requirements imposed on the Eximbank and small-scale banks are as follows—the FX liquidity ratio⁵¹ must be at least 85 percent and the mismatch ratio⁵² must be above -10 percent (article 64 of the RSBB and article 39 and Appendix 14 of the DRSBB).

71. Policy banks face almost identical prudential regulations as commercial banks, but a weaker position of bank supervision can hamper the effectiveness of the overall framework. The FSC which plays a primary role in enforcement towards all other financial institution, takes in this case a role of a majority shareholder, leading discussions about their business plans, budgets, headcounts and KPIs. Although, the goals of a shareholder and a supervisor are not necessarily in all cases conflicting, this setup decreases the overall effectiveness of the framework and represents a constraint for the FSS to act independently towards these institutions. In addition, policy banks are supervised by other institutions, including the Ministry of Economy and Finance (MOEF), the Presidential Board of Audit and Inspection, and the Parliament, which can undermine a leading role of the FSC/FSS in prudential supervision.

72. Banks are required to carry out regular stress testing of liquidity risk and FSC/FSS review the results and use check lists to ensure the stress test covers all areas that are expected. The results of the stress tests are expected to be used to guide liquidity risk management strategy, determine the liquidity risk appetite, adjust the holdings of high quality liquid assets, and design a contingency funding plan. The banks’ stress scenarios are required to incorporate each bank’s unique business characteristics and vulnerabilities so that the key liquidity risks can be adequately taken into account for each bank. The stress tests must use stress scenarios that incorporate both the bank’s unique positions (and potential stress conditions) and market-wide stressed conditions.

73. Internet banks benefit from a less stringent framework, with the view of gradually aligning it with traditional banks’ regulation in the majority of respects.⁵³ To support the development of this segment of banks, Korea decided to impose more favorable capital and liquidity requirements, following the Basel I framework. However, Basel III will be gradually implemented also for these banks, starting with 2020 (Appendix X). However, it is well understood that Korea wants to keep modernizing the banking system, the prudential framework should not be diluted and the level playing needs to be maintained. In this respect, the authorities are encouraged to proceed with the intended unification of prudential regulation for banks. Ultimately, the main difference in their prudential framework that remains is the requirements on the ownership structure, reflecting a specific business model that benefits from alliance with technological firms (that are permitted to hold more capital in internet banks than shareholders of traditional banks).⁵⁴

ODIs

74. The MSBs are required to hold a minimum 7 percent total risk-based capital (RBC) using a framework similar to Basel 1. For MSBs with KRW1 trillion or more in aggregate assets, the minimum capital adequacy requirement is 8 percent. It is recommended to impose the single limit of 8 percent and consider using the recent international capital standard as a basis for national legislation, implemented in a proportionate way. The rules can be simpler; however, the framework should not be less prudent in its result.

75. The MCCs calculate a net worth ratio relative to the aggregate assets, without applying risk weights. MCCs follow different limits of net worth ratio depending on the segment. Credit unions, fisheries cooperatives and forestry cooperatives must comply with 2.0 percent limit, while agricultural cooperatives are subjected to 5.0 percent limit, and community credit cooperates are required to stick to 4.0 percent limit. The underlying logic of different limits is not obvious. However, none of them reaches levels recommended as good practice by international organizations of cooperatives and their regulators.⁵⁵

76. Additional ratios are in place to steer prudential requirements, including liquidity ratio and loan-to-deposit ration.⁵⁶ Simple liquidity ratio is applied to MSBs and MCCs, focusing on short term liquidity. MSBs shall maintain their liquidity ratio (liquid assets and liquid liabilities that mature within three months) above 100 percent pursuant to Article 40–4(3) of the Regulation on Mutual Savings Bank Business. The ratio for MCCs is identical, but no limit exists for them. This basic liquidity ratio requirement does not accurately reflect the extent to which an institution engages in asset-liability mismatch and liquidity/maturity transformation. It is recommended to develop more accurate measure taking into account a specific structure of MSBs/MCCs’ balance sheets. For MCCs, the limit should be applied, although national federations of MCCs follow their own frameworks supporting liquidity risks management considering liquidity status of individual cooperatives. While for MCCs, the loan-to-deposit ratio is in place, MSBs should comply with a similar set of rules from 2020, with a phase-in-period. The efficiency of the loan-to-deposit ratio is decreased by the fact that it combines a prudential perspective with government’s social policy goals (certain loans are exempted from calculation). Asset classification and minimum reserve requirements are harmonized from 2020 on, as well.

77. However, the upgrades of regulation resulting in a more prudent and consistent framework should continue beyond 2020. The authorities have been gradually converting the framework for MCCs and MSBs to achieve more convergence in regulations for individual segments of ODIs. The current program of regulatory reforms contains initiatives that go until 2020. The authorities are encouraged to continue this program and to adopt a new medium term strategy of reforms, to enhance level playing field across deposit taking institutions and to increase prudence of regulatory requirements, including their alignment with international good practice.

Insurance

78. The objectives of insurance supervision are defined in the IBA. According to article 1 IBA, the objectives are: (i) ensuring the sound management of insurance companies; (ii) protecting the rights and interests of policyholders and other interested parties; (iii) promoting the insurance industry; and (iv) contributing to the balanced development of the national economy. Details on the FSC’s and FSS’ responsibilities and powers are further laid out in the Enforcement Decree of the Insurance Business Act (EDIBA), the Enforcement Rules of the Insurance Business Act (ERIBA), the Regulation on Supervision of the Insurance Business (RSIB), and the Detailed Regulation on Supervision of the Insurance Business (DRSIB).

79. The valuation of liabilities under the RSIB is based on current international accounting standards, meaning that liabilities are measured at cost in accordance with International Organization of Securities Commissions (IFRS) 4. A fair value measurement of liabilities will be introduced when IFRS 17 replaces IFRS 4, currently scheduled for 2022. As Korea is committed to the full adoption of IFRS, FSC/FSS are expected to fully implement IFRS 17 and revise the RISB accordingly once the International Accounting Standards Board (IASB) decides on the implementation details. In order to complement the cost accounting method under the existing standards, insurance companies are required to assess the adequacy of liability reserves. Insurance companies should calculate the current estimates of future cash flows from insurance contracts (similar to fair value) and additionally set aside any difference with the liability reserves calculated at cost in order to better reflect the impact of changing economic conditions on the value of liabilities.

80. Asset values are determined based on IAS 39 and therefore broadly incorporating an economic valuation. However, after the implementation of IFRS 17, the measurement will be based on IFRS 9. As assets are measured in accordance with international accounting standards that adopt the fair value approach, economic conditions are reflected in the measurement of assets.

81. The FSC/FSS has introduced and subsequently strengthened an RBC regime for solvency purposes. Pursuant to Appendix 22 of the DRSIB, insurance companies are required to calculate their available capital and required capital based on consolidated financial statements in accordance with K-IFRS. RSIB requires insurers to compute available capital by considering the quality and permanent nature of capital resources and accordingly measure tier 1 capital, tier 2 capital, deduction items, and others. Several reforms of the RBC were introduced since the last FSAP, amongst others, the charges for interest rate risk and credit risk were raised in July 2015, and a group capital regime, were introduced in 2016.

82. The RBC level determines the need for corrective actions. In case the RBC ratio falls under 100 percent, prompt corrective action is triggered in order to help insurance companies improve their financial soundness through a set of means such as capital increase. The FSC imposes a management improvement recommendation (MIR) to insurance companies with the RBC ratio ranging between 50 percent and 100 percent. A management improvement demand (MID) is imposed to insurers with the RBC ratio ranging between 0 percent and 50 percent. Finally, a management improvement order (MIO) is imposed by the FSC to companies with the RBC ratio below 0 percent.

83. When calculating the required capital, a standardized approach is in place which covers insurance risk, interest rate risk, credit risk, market risk, and operational risk. Internal model approaches using insurers’ own statistical data are currently not allowed, but from 2020 onwards, insurers can apply for the use of such models.

84. The solvency regime is currently being updated with an implementation date scheduled for 2022, together with IFRS 17, which will determine the valuation of insurance liabilities. The FSS has run two quantitative impact studies on the new fully risk-based solvency regime, the K-ICS. Results of these field tests are not publicly available but will determine the calibration of the RBC and the need for a phase-in approach.

85. The Governance Act and the IBA require insurance companies to have effective systems of risk management and internal controls, including on a group level. Key control functions are prescribed for risk management, compliance, actuarial matters, and internal audit. Internal control standards include: (i) segregation of duties; (ii) establishment of an organizational structure; (iii) clarification of the roles of the BoD, executives, and compliance officers in relation to internal control; (iv) establishment of an effective reporting system for managerial decision making; (v) enforcement against employees who violate internal control standards; (vi) processes or standards for prevention of violation of finance-related laws and regulations; and (vii) methods and procedures to manage conflicts of interests.

86. Insurance companies are required to establish an ORSA. It aims at identifying, assessing, monitoring, and controlling risks arising in the course of insurance business operations, asset management, and any other business activities, in order to adequately manage risks and assess internal capital. The ORSA—implemented in 2016, but not applied yet by all companies as the FSC/ FSS has granted a phase-in—requires insurers to measure and manage major risks that arise from their transactions such as insurance risk, interest rate risk, market risk, credit risk and operational risk. Insurers should set and comply with risk tolerance limits and transaction limits by risk covered, transaction, division (trading unit), and employee.

87. In order to ensure prudential asset management, FSC/FSS regulates investment activities of insurance corporations with a set of limits and restrictions. Article 104 of the IBA requires insurance companies to ensure stability, liquidity, profitability, and public interests when they manage assets. Limits are in place with regard to certain asset classes, credit extensions and trading with large shareholders. Insurers should also keep liquidity ratios above certain levels. Under Risk Assessment and Application System (RAAS), investment risk is managed and supervised by evaluating quantitative indicators such as investment risk ratio, non-performing asset ratio, and coverage ratio.

88. The Korean effort to implement the long overdue fully risk-based solvency regime in line with international best practices is a welcome prudential enhancement. While much of the public discussion on the K-ICS focuses on the perceived capital shortfall and the necessity of transitional measures to phase in the new regime, this discussion should not overshadow the need for structural adjustments in the life insurance sector. The FSC/FSS should assess the long-term viability of business models and, for companies with a weak solvency position and low or negative profitability, also evaluate the financial strength of shareholders as well as the possibility of capital injections. Consideration should also be given to deal with high-guarantee legacy business, e.g. by evaluating the legal basis for portfolio transfers, run-offs and conversion offers. For companies with a very distinct risk profile and weaknesses in governance structure or internal control functions, the possibility of explicit Pillar 2 capital add-ons should be considered. Longevity risks, which are expected to rise in the future, should be addressed with a prudent calibration of the respective capital charge which should not only build on historic experience but also incorporate expected changes in policyholder behavior.

Asset Management and Collective Investment Schemes (CIS)

89. The overall regulatory structure governing CIS is robust and based on international standards. It is broadly compliant with the IOSCO principles and standards although there are still some areas that are presently in the pipeline for introduction. There are relevant standards in place for the eligibility, governance, organization and operational conduct of those who wish to market or operate a CIS.

90. The main legal framework for CIS is the Financial Investment Services and Capital Markets Act (FSCMA), which consolidated the Securities and Exchange Act, the Trust Business Act, and the Indirect Investment Asset Management Business Act, and took effect in February 2009. Among others, the FSCMA provides for a “negative list” system, introduces function-based regulation, and strengthens investor protection. In addition, the CGA that integrated corporate governance laws in different financial sectors was introduced in 2016 in response to calls for enhanced role of the board and the audit committee in improving corporate governance and stricter rules for corporate governance.

91. In Korea, funds are classified according to the number of investors who receive investment solicitations and the number of investors who participate in the investment. If the number of solicited retail investors and the number of participating retail and professional investors (excluding institutional investors) are each 49 or fewer, the fund is classified as a privately offered fund. If both numbers are 50 or more, the fund is classified as a publicly offered fund. Publicly offered funds are regulated under the FSCMA, and privately offered funds are subject to special provisions and regulated by way of exempting certain regulatory provisions that are applicable to publicly offered funds.

92. There are specific requirements on governance and ownership structure of the asset management companies including for those that are part of conglomerate groups. There are currently five asset management companies that are part of conglomerate groups in Korea. One of the regulatory concerns is preventing any person not meeting the requirements for a large shareholder from operating a financial investment service business by acquiring shares. In this regard, the CGA provides that a person who seeks to become a large shareholder of a financial investment service provider by acquiring or obtaining shares issued by the provider must satisfy conditions for a change in large shareholder and apply for pre-approval from the FSC. The FSC has the authority to order a large shareholder to dispose of shares acquired without FSC approval within a six-month period. A large shareholder who has acquired shares without FSC approval may not exercise voting rights attached to the unapproved shares. All asset managers including hedge fund managers are prohibited from trading with their large shareholders such as acquiring securities issued by them and extending credit to them. The eligibility assessment of large shareholders is conducted every two years

93. Asset managers managing publicly offered funds are required to keep their capital above the minimum operating capital as a prudential measure. Minimum operating capital for each licensed business is the sum of capital required to be maintained, capital required for managing investor assets, and capital required for managing proprietary assets. The specific calculation methods for each class of the capital are set forth in the Regulation on Financial Investment Business and the Detailed Regulation on Financial Investment Business. Asset managers are required to set up a risk management system including a risk management team (or group) and risk management guidelines designed to identify, assess, monitor and control all risks arising from trading. The FSCMA does not impose restrictions on investment in foreign assets by asset managers, and according to the FSS, there are no segments within the overall financial system which manages pools of money but are not subject to direct oversight by the FSC/FSS.

94. A trust business entity of a CIS manager checks whether the CIS manager complies with regulations such as leverage limits, limits on the risk amount from derivatives trading, and the use of securities financing. If the trust business entity finds a violation, it should demand corrective measures from the CIS manager. If the manager does not carry out the corrective measures within three business days, the trust business entity should report it to the FSC.

95. There are relevant requirements in place for the custody and management of CIS assets. The custody and management of the CIS assets should be entrusted by the CIS manager to a trust business entity. A trust business entity owes investors the fiduciary duty of due care in managing CIS assets. Accordingly, it must carry out the business in good faith for the purpose of protecting investor interests and segregate its proprietary assets and CIS asset. The affiliates of a CIS manager are not allowed to be the trust business entity that manages and holds the custody of CIS manager’s CIS assets.

96. The general basis of valuation of CIS assets in Korea is in compliance with the IOSCO principles but there is a need to accelerate the implementation of the IOSCO MMF Recommendations. This is an important area that requires a proper and disclosed basis for asset valuation, pricing and redemption of units in CIS. The Korean regulators have generally ensured that the key aspects are in place. However, the valuation of MMF should use market value or fair value as required by the IOSCO Policy Recommendations on MMF.⁵⁷ The authorities have informed the mission that this is in the process of being implemented. Korea also has been rather slow in introducing the reforms which was a point that was also previously highlighted in the last FSAP.

97. The CIS framework in Korea includes a range of safeguards to promote liquidity management. There are investment limits imposed at the portfolio levels (such as diversification limits both by asset type and issuer); relevant policies and procedures for liquidity risk management and stress testing; and specific disclosure and regulatory reporting on liquidity.

98. The FSCMA has requirements for each fund category, that specifies the types of assets that can be invested, investment limits on similar asset class, and restrictions on the level of derivatives trading. It should be noted that the FSCMA imposes investment limits by asset class, not by type of CIS. In addition, there are separate regulations for MMFs. The regulations applied for privately offered funds are much less onerous than those applied on publicly offered funds. Given the importance of liquidity management for MMFs, the level of restrictions is even stricter for MMFs. Asset managers are also required to divide MMFs into MMFs for retail investors (“retail MMFs”) and MMFs for legal entities (“institutional MMFs”) and have them managed accordingly.

99. There is clear recognition of potential risks to financial stability from a liquidity crisis emanating from large sell-off orders by MMFs. Given the sensitivity of institutional MMFs to situations of severe market stress, selling by institutional MMF investors may trigger a major run further precipitating a decline in asset prices. In order to prevent a potential spread of systemic risk from such a run on the funds, the FSC/FSS has proposed⁵⁸ rule changes requiring asset managers to periodically conduct stress testing on MMFs and require marked to market valuations for institutional MMFs.

100. There are relevant regulatory requirements and limits on the use of leverage with reporting requirements to the regulators. Borrowing is allowed only for hedge funds; it is not allowed for publicly offered funds (excluding real estate funds). Borrowing limits are determined by the leverage ratio with leverage determined as the sum of the amounts borrowed, risk amount from derivatives trades, and debt guarantee or the amount of collateral provided. Derivatives-based leverage is primarily used for FX hedging and other hedging purposes.

Audit Framework

101. The audit framework is a very relevant component of conglomerates supervision, with the focus on assurances on the group level.⁵⁹ In this sense, FSAP identified a gap in the current regulatory framework, as group auditors are not required. Also, the regulation does not require a cooperation and information exchange among auditors of the financial conglomerate’s companies that could supplement the group auditor requirement. Such requirements are important for efficient conglomerates supervision, as they can provide additional checks on relations across groups, and above all on the quality of capital in financial institutions. The authorities are recommended to consider a group level audit framework, compliant with the overall legislative framework.

102. The 2013 FSAP identified some gaps in the overall oversight of the auditors. The current FSAP did not conduct a full scope review of the audit and auditor oversight regime, but as there were some gaps identified in the previous FSAP, a questionnaire was sent to the authorities and based on the responses and a discussion with the authorities mainly FSC and FSS, the review below is presented. Among the areas identified by the 2013 FSAP was the need to strengthen the quality control requirements for audit firms that audit listed companies and financial institutions; the requirement that audit oversight programs should be sufficiently comprehensive and address the risks of non-compliance with the market rules; and that there is enforcement of any violations of the independence and quality control requirements.

103. An overall review of the structure in Korea shows that Korea has the requisite requirements for independence of auditors and accounting and auditing standards that are aligned to international standards. Accounting standards used by issuers to prepare financial statements since 2011 have been based on international standards with the adoption of IFRS. This is reflected in the relevant provisions in the Enforcement Decree of the FSCMA and the Enforcement Decree of the Act on External Audit of Stock Companies. The Act on External Audit of Stock Companies stipulates the scope of companies, which are subject to external audits and the threshold criteria for small sized companies that are not required to have external audits.

104. Auditors are subject to adequate levels of oversight but there is a need to continue strengthen the oversight regime and accountability of auditors as well as the enforcement and sanctions regime to address the risks of accounting and audit fraud. Several reforms have been introduced at the end of 2018 to the Act on the External Audit of Stock Companies and are in the pipeline for implementation. It remains to be seen how effective the actual implementation efforts will be to enhance the quality of audits for listed firms as well as regulated entities and provide a credible deterrence against accounting fraud and poor audit quality. While the authorities are to be commended for introducing the various reforms in the area, it is recommended that the authorities intensify efforts to implement these provisions and address the issues of accounting fraud and audit quality that continues to exist in Korea.

105. The authorities have worked towards strengthening the enforcement of violations on independence and quality control requirements. The amendments to the Act on External Audit in November 2018 was also done to further raise auditors’ quality control standards and practices. Specific provisions on enforcement have been provided for the CEO and the audit quality control officer of an audit firm for negligent audits when a serious audit flaw is uncovered in a publicly traded company. In addition, as mentioned above a new registration regime has been introduced for audit firms performing audit of publicly traded companies so that only accounting firms satisfying certain levels of physical facilities and quality control standards can be permitted to perform audit of publicly traded companies. There are also plans under consideration to publicly disclose quality control recommendations by supervisors following audit reviews and the names of auditing firms that fail to comply with supervisor-issued recommendations.

106. The authorities should accelerate the implementation of the reforms to address risks of accounting and audit fraud. The initiatives to strengthen the audit and accounting oversight should continue to achieve a comprehensive quality assessment of audits.

107. The authorities are also encouraged to expand auditors’ obligations beyond the audits of financial statements. This is particularly important for supervision of financial institutions. It is good practice to assign auditors with additional tasks related to their annual audits. These assignments can contain the accuracy of regulatory reporting, or the effectiveness of internal control processes, including risk management, and systems. The auditors should be required to report major flaws and failures to the FSC/FSS. These obligations should be also established on a group level.

Summary

108. As an integrated supervisor, the FSC/FSS is well positioned to carry out strong, group-wide supervision. The current supervisory approach for financial groups is organized around legal entities, with a relatively small team of “group-level” supervisors. Given the systemic importance of these groups and that growth is being driven largely by non-bank activities, the authorities will need to continue to develop and implement more group-wide supervision practices. The authorities should further elaborate their supervisory approaches to capture additional dimensions of group organizations’ risks. Multilayer analyses of conglomerate maps, which captures the relationships between the group structure, the quality of capital and risks’ dynamics within the groups, including for the cases of crisis situations, would significantly elevate supervisory outcomes.

109. The reliance on a rules-based approach may hamper the FSS’ supervisory ability to proactively address new and emerging risks in the financial sector. When rules restrict financial institutions from certain activities and risks, they may find ways that are not directly constrained by regulation. Supervisors play a key role by identifying such behaviors and requiring effective internal practices at financial institutions to identify and incorporate them into their assessments of capital and liquidity needs.⁶⁰ The FSC/FSS should consider greater use of forward-looking approaches and measures which requires significant changes to laws and regulations that currently are not particularly supportive of ex ante actions when institutions’ risk management practices are deemed to be less than adequate, but no violation of rules and regulations has occurred. ⁶¹

110. There should be greater emphasis on in-depth qualitative assessments of critical group-wide practices. These include Credit Risk Management, Internal Capital Adequacy Assessment Process (ICAAP), Internal Liquidity Adequacy Assessment Process (ILAAP) and recovery planning. To support this, the Korean supervisors need the authority to put in place meaningful requirements and expectations/guidelines in these areas on a group-wide basis. While the FSS has implemented ICAAP requirements for capital planning and stress testing requirements for liquidity risk management, reviews of these practices could be strengthened and forward-looking measures of financial condition could be better integrated into the rating framework and supervisory outcomes interactively communicated with banks, and most importantly for DSIBs at the consolidated group level. Evaluations of banks’ internal capital assessments can play an important role in promoting bank resilience and feed into Pillar 2 assessments framed by a formal annual supervisory review process, at least for large banks, as done in other jurisdictions. Similarly, in insurance, annual ORSA reports should be used to provide systemic feedback in the form of a risk dialogue to individual insurance corporations.

111. Supervision of corporate governance requires further enhancements, particularly at the holding company level. As discussed in the previous sections, a lack of direct assessments of the effectiveness of holding company and bank level boards and senior management in the current framework is a significant gap of the current framework.

112. Supervisors need to strengthen their supervisory approaches towards external auditors across groups. A qualitatively rich exchange of views with external auditors, corresponding with crucial phases of audits of systematically important financial institutions and groups, should be further developed. It is important to give auditors regular feedbacks and discuss cross cutting issues relevant for multiple types of financial institutions, to promote consistency of external auditors’ approaches and to get additional assurance of the financial system’s soundness. A group level perspective should be included in dialogues with relevant external auditors.

113. The prudential supervisory approach for state-owned banks, mutual savings banks and ODIs is a concern, with potential consequences for financial conglomerates. The FSS’s ability to promptly act in an even handed and prudential way is limited by a lack of competent jurisdiction and/or delegation and freedom to take prompt supervisory action towards these institutions, which in a number of cases operate within groups. Furthermore, pursuing economic and social goals via commercially oriented financial institutions erodes the soundness of the system and hampers the level playing field across the financial sector.

114. Although Korea has established an overall well-functioning securities markets supervisory structure, instances of mis-selling and misconduct have begun to rise, negatively influencing the reputation of some groups. The underdeveloped consumer and investor protection framework in Korea could impact market confidence, if risks related to severe redemption and liquidity pressures in the funds and asset management industry are not recognized and addressed. The authorities should: (i) fully implement the key IOSCO Money Market Funds (MMF) recommendations; (ii) conduct stronger surveillance of capital market and nonbank risks accompanied by a more regular inspection program; (iii) develop a systemic risk framework that incorporates the securities sector and features stress tests on the asset management industry particularly for MMF funds; and (iv) accelerate the implementation of the reforms to address risks of accounting and audit fraud.

Financial Conglomerates

115. The FSAP focused on supervisory practices towards holding financial groups (HFGs), as supervision of nonholding financial groups (NFGs) is only just now being launched. The FSAP identified a solid standard of the supervisory framework for HFGs and the commitment of supervisors to implement the framework for NFGs.

116. The supervisory practices for financial conglomerates need to be enhanced to be able to capture and address potential systemic risks for the financial system, and to increase compliance with international standards. Recovery and resolution efforts are still a work in progress and assessments of recovery planning at large groups has not been introduced. An emphasis on evaluations of key forward-looking practices at the group-wide level could enhance the supervision process, as well as greater focus on group-wide risks and group-wide practices for controlling and managing them. Supervisory activities for assessing the effectiveness of the group level governance—including boards of directors and senior managements—remain underdeveloped, a greater emphasis on in-depth qualitative assessments of critical group-wide practices such as Credit Risk Management, ICAAP, ILAAP needs to be established. The overall group supervision framework shall be developed to cover all financial conglomerates, including non-holding financial groups. It should incentivize groups in maintaining transparent and robust group structures and empower supervisors through legally binding prudential requirements applicable to all financial conglomerates.

117. Enhanced cooperation of the FSC/FSS with the FTC, which is assigned with a specific role in conglomerates supervision, could expand the FSC/FSS’s perspective. The FTC regulates a wider range of significant conglomerates, beyond financial groups. Although it is primarily mandated to supervise antitrust rules, its focus is broader and includes transparency of groups or consumer protection. The FTC has a complete picture of conglomerates structures. These structures are published annually, to encourage their transparency.⁶² The FTC monitors intragroup large transaction,⁶³ including guarantees, to prevent multiple gearing and hidden leverage. The FTC has power to file criminal charges against the members of BoDs, in the case of inaccurate information reported to the FTC (qualified as a criminal act). The FTC regularly meets BoDs of conglomerates to discuss its views. The cooperation with the FSC/FSS is rather limited although all authorities could significantly benefit from such cooperation and leverage their positions towards conglomerates.

118. The state policy functions which are entrusted to many financial institutions and groups can pose some additional challenges for supervision. These policy mandates of financial institutions extend their roles in financial intermediation and bring another layer of complexity to the organization of their activities and processes, including risk management. In some cases, these additional complexities apply to a group level. Policy institutions are typically related to the underlying activities, which are supported by a respective policy function, not only through their mandates, but also through relations to their groups and/or beneficial owners.⁶⁴ Although, the FSC/FSS adopted a set of measures to ringfence FHGs from the most prominent risks, some structural weaknesses prevail. All these circumstances put supervision in a very delicate position. It is important for supervisors to stick to their traditional roles, apply conventional tools and approaches, and safeguard a level playing field. This applies to both enterprise-and group-level supervision.

119. An emphasis on evaluations of key forward-looking practices at the group-wide level (for bank-led FHCs) could strengthen the supervision process for FHCs through periodic in-depth examinations of these practices. Specific practices warranting such reviews could include credit risk management, ICAAP and capital planning, ILAAP and liquidity planning and recovery planning. Supervisory emphasis on forward-looking practices and techniques can play an important role in promoting financial resiliency by making clear to boards and senior managers of FHCs that ensuring effective group-wide practices in these areas are important elements of their roles and responsibilities and that they will be assessed against these responsibilities. These periodic assessments should factor into evaluations of board and senior management effectiveness.

120. As an integrated supervisor, the FSC/FSS is well positioned to carry out strong, group-wide supervision of HFGs, and should take full advantage of this by further enhancing its focus on group-wide risks and group-wide practices for controlling and managing them. The current approach to supervision of banking and insurance groups is primarily organized around supervision of legal entities, with a relatively small team of “group-level” supervisors.⁶⁵ Given the systemic importance of these groups and that growth is being driven largely by non-bank activities, the FSS will need to continue to develop and implement more group-wide supervision practices. As with all financial conglomerates, understanding group-wide risks and vulnerabilities—including those stemming from intercompany transactions—is critical for effective supervision.

121. The FSS collects conglomerate maps and other data and information on financial conglomerates providing some crucial insights, if connected to a holistic picture of the group level risks. A comprehensive approach that could enhance the existing analyses should encompass these areas: ownership structure, control established by contractual arrangements, profit/loss sharing arrangements within the group, guarantees and other instruments transferring risks between entities of the group important capital and liquidity flows (including smaller but frequent amounts), other arrangements potentially establishing major dependencies among members of the group, potential recovery and resolution arrangements. These pieces of information analyzed and assessed altogether—as dimensions of conglomerate maps—can improve the understanding of relations within the group, and the identification of additional weaknesses and hot spots.

122. The currently underdeveloped approach to consolidated supervision represents a lost opportunity given the FSC/FSS’ role as an integrated supervisor covering all financial sectors. With supervisory responsibility for all major financial system sectors, the FSS is well positioned to implement a comprehensive and effective consolidated supervision program with heightened emphasis on recently designated D-SIBs at the group level. Efforts to enhance its group-wide approach should be continued and strengthened, including putting in place more resources specifically focused on group-level risks and practices. Current approaches involve input and collaboration from a number of different stakeholders within the FSS. These include teams from the Bank Supervision Department, the Bank Examination Departments, the Bank Risk Office and the Financial Group Office. However, the collaborative efforts, in the absence of a stronger focus on the group level, may also create unnecessary complexity and heighten the risk that important issues arising at subsidiaries could be lost in the communication.

123. For oversight at the holding company level, participants from the different supervision sectors – e.g., banks, insurance and securities firms – have a variety of systems for sharing information and come together as a group when planning comprehensive examinations. However, examinations are typically carried out within the subsidiaries by supervisors from the sectoral departments of each subsidiary. Greater cross-sector focus of key risks and risk management and control tools would enhance FSS supervision of groups.

124. For bank led HFGs the FSS uses the RFI assessment framework, which guides reviews organized in 2–3 years cycles depending on the size of the group. FSS assesses FHC’s using RFI assessment framework, which reviews three elements – i.e., Risk Management (R), Financial Condition (F), and Potential Impact (I). Considering the assessment results of the three elements and overall management condition, a composite rating is calculated based on specific weightings for each category. The RFI is built largely on inputs from sectoral supervisors, who participate in preparatory work for RFI examinations. The FSS directly requests and meets with the FHC’s representatives, for instance group-level audit committee. Outside of the 2–3-year cycle, the rating is generally not up-dated. The cycle is not synchronized across institutions. The communication of results to the institutions is not formalized.

125. Over recent years the FSS has increased the use of thematic cross-sectoral reviews to focus in on key risks and risk management practices. A recent review—the first of its kind— applied this cross-sectoral approach, looking at a specific activity across HFG’s subsidiaries in different sectors that were identified as posing the greatest risk. This activity-based approach is good practice and the reviewers encourage greater use of it. We would recommend that firm-specific examinations also take a cross-sectoral perspective to enhance the overall understanding of the vulnerabilities across entities within HFG. In addition to offsite monitoring and analysis efforts, FSS supervision emphasizes periodic onsite “comprehensive examinations” and targeted/thematic reviews. The FSS has significantly increased the use of risk—or activities—focused thematic and/or targeted reviews since the prior FSAP and the reviewers encourage them to continue to build on this progress.

126. There may be opportunities to enhance overall effectiveness of FSS’ supervision by either increasing total staffing levels for large financial conglomerates directly or rebalancing resource allocation across different parts of the framework. In particular, for large institutions, including DSIBs, supervisory intensity should be increased, and more focus could be given to top-to-bottom reviews of critical practices for promoting financial resiliency. These should include reviews of group wide ICAAP/ORSA and capital planning to provide for concrete assessments of important supporting practices such as risk identification, management and controls. This would allow the FSS to assess all aspects of that groups’ practices from identifying and measuring risks, to ensuring full and timely capture of all positions, internal controls around key risk data and information, reporting to management and the board and the role of internal audit in providing boards with a solid understanding of the strengths and weaknesses of the critical processes supporting their decision-making about capital needs.

127. The group-wide internal capital processes (ICAAP/ORSA) should be fully integrated across groups and weaknesses at any subsidiaries should be required to be addressed by group-level boards and management. As recommended by the 2013 FSAP, the FSC/FSS introduced a rule to require ICAAP at the subsidiary and group level in 2016 and should ensure effective comprehensive and integrated group-wide ICAAPs at D-SIBs are being carried out and assessed by supervisors. ICAAP ‘reviews’ are a key part of the annual Risk Assessment process done by the FSS. These reviews consist largely of reading and analyzing the required annual ICAAP report required of banks and the holding companies. The process to date is still under development at the group level. Banking groups’ legal entities carry out some entity-level analysis and the holding companies consolidate those. Similarly, in insurance, the ORSA was introduced in 2016, and while all companies have developed implementation plans, the FSC/FSS has granted a phase-in for many companies. For those companies that already submit an annual ORSA report, findings from the review of these are incorporated into the risk assessment, but no systematic feedback in the form of a risk dialogue is provided to the companies.

128. Supervisory efforts for the assessment of banks’ internal capital assessments and capital planning should be enhanced by conducting periodic in-depth supervisory reviews of these processes. Currently, in depth oversight of ICAAP at banks is largely carried out by internal audit departments at the subsidiary level, with reporting on their assessments going to the FSS annually. Group-wide ICAAP should be an integrated process and the FSS should evaluate that firms capture all material risks across the group and incorporate them into considerations of capital needs. This should include an assessment of whether the BoD is getting the information it needs to make informed decisions about capital needs at ach subsidiary and on a consolidated group level.

129. FSS supervisors does not directly assess group-level liquidity risk management for HFGs. Group level liquidity risk management is critical for large banking organizations that may be active in a variety of businesses through different legal entities and in different jurisdictions. Given large Korean banks’ and insurance corporations’ plans to continue expanding overseas operations and expand other financial intermediation activities, lack of group level liquidity risk requirements and supervision is a significant shortcoming in the oversight of the financial system, even if sector-level requirements may appear to be effective for each subsidiary.

130. Supervision of corporate governance remains a work in progress, particularly at the holding company level. It may be hampered by a lack of direct assessments of the effectiveness of holding company and bank level boards and senior management in the current rating framework. Currently, for bank-led holding companies the supervisory focus continues to be on the primary legal entities individually – e.g., bank, insurance company, securities firm and asset manager, etc., though group level governance is covered by regulation as noted below.

131. Emphasis should be increased on the roles of group-wide internal audit and the group board’s audit committee, including direct assessments of group-level audit effectiveness. For instance, supervisory coverage on internal audit at banks is typically part of the CAMEL-R assessment process and the comprehensive examinations. In addition, supervisors may review bank-level internal audit work as part of a targeted or thematic review. The FSS does not make an explicit assessment of whether internal audit can be relied upon to cover prudential issues; the FSS makes these assessments itself.

132. As noted above, the FSS should work to enhance its capacity to take a more forward-looking perspective in assessments of the quality of banks’ risk management practices. Current practices are largely reactive to issues and events that are captured through offsite monitoring or carried out as part of the periodic comprehensive exams. A review of Board minutes and reporting is a core element of the onsite review. The process to confirm that a Board and senior management remain effectively engaged and informed of the changing risk profile of the bank and take appropriate action does not appear well developed.

133. There should be more emphasis by the FSC/FSS on corporate governance to embed better corporate governance standards and practices in the capital market. The area of corporate governance has received attention from the policymakers in Korea. Regulations on Supervision of Corporate Governance of Financial Companies and the CGA governs the corporate governance of capital market entities and other financial institutions supplemented by provisions in the CA.

134. As part of the overall efforts to strengthen corporate governance, there must be greater accountability placed on boards and senior managers which could include putting in place a senior managers regime of the type that exists in several developed markets. There must also be higher levels of supervisory engagements with the boards and senior managers. While there are some elements of this that exist in Korea, the discussions with the supervisors indicate that there is still significant room for improvement. An elevation of the overall efforts in respect of addressing governance and culture at firms as well as levels of engagements and accountability being placed on boards and senior managers in the regulatory and supervisory approach adopted is needed. At the heart of every major crisis in financial markets there is an element of governance failure. Strengthening governance, culture and conduct must appear more deeply in the supervisory philosophy adopted.

135. A dialogue between supervisors and external auditors should be intensified. Currently, supervisors do not meet regularly external auditors to discuss their findings. It is good practice to meet auditors at least annually. For systematically important or troubled institutions, it is also recommended to meet external auditors in a preparatory phase. The results of auditors should be regularly reviewed by supervisors, and in the case of failures, enforcement actions should be taken against respective auditors (and partners of audit firms). A relationship should be also established with professional association of auditors, to communicate expectations of supervisors.

Banks

136. Well-developed practices for FSS monitoring of bank compliance with laws and rules, benefit from a generally strong regulatory framework for banks. The approach makes extensive use of continuous offsite monitoring, which provides for a comprehensive process for assessing compliance with rules and laws. Follow-up assessments through examination activities are carried where deemed warranted, which may be the result of a firm failing to comply with requirements or other issues identified through the monitoring process. In addition, each bank is in practice subject to a periodic comprehensive examination every 2–3 years, depending on size.

137. The FSS’ banking supervision approach appropriately includes extensive use of offsite monitoring of compliance with laws and regulations. This involves monitoring for compliance with regulatory limits and minimum requirements, as well as continuous monitoring of business activities and associated risk profiles. Offsite supervision includes a variety of processes for monitoring firm-specific performance and financial condition, as well as the operating environment and macro-economic or systemic developments. Supervised firms are required to report on a variety of indicators of compliance with requirements; supervisors review and assess these reports and determine if follow up, including via examinations, is warranted.

138. For banks, the supervisory assessment is built on the CAMEL-R framework and the supervision process focuses primarily on traditional assessments of CAMEL factors and a Risk Assessment at the bank level. The CAMEL-R rating includes both quantitative and qualitative factors. The CAMEL ratings are updated biannually as a result of the comprehensive exams. The quantitative elements of the Risk Assessment are carried out annually, with qualitative factors assessed during onsite exams as warranted in the biannual exam based on a comprehensive planning process. Qualitative factors are largely assessed through the use of manuals and checklists for risk management and control practices used by onsite examiners.

139. The CAMEL-R assessment is used to determine the level of supervisory scrutiny and help identify areas that warrant supervisory attention. However, other than increased scrutiny, there are no binding restrictions driven by the rating process such as exist in other jurisdictions. While this may give the FSS flexibility, it undermines the use of the rating to serve as a strong incentive for banks to address any failures to meet supervisory expectations, including with respect to key risk management and controls weaknesses.

140. As noted, the FSS has been increasing the share of work carried out through on-site supervision in line with the previous FSAP recommendations, but the balance still tilts toward monitoring against rules-based requirements. There is no requirement to carry out periodic “comprehensive onsite examinations”. In practice, however, the large banks and DSIBs are subject to these reviews biannually, while the smaller banks are generally examined every three years. The comprehensive examinations are risk-focused and cover a reasonably broad swath of banks’ risk management and internal controls processes, as well as consumer compliance and protection areas.

141. The current mission continues to find that the FSS could enhance its effectiveness by increasing the intensity of supervision, particularly for the D-SIBs, as the previous FSAP recommended. The extensive rules-based requirements and reporting against these by the banks provides a strong base from which to assess the firms. However, it does not necessarily encapsulate the type of qualitative evaluations that are critical for informing meaningful assessments of SIB groups. For those firms deemed to represent systemic risk to the Korean economy and financial system, more resources should be spent carrying out analyses and examinations, as well as in communicating the need for these banks to meet the highest standards and rapidly address any material prudential weaknesses.

142. Notably, the value of a Pillar 2 add-on process for banking groups that already hold capital in excess of regulatory minima is limited in its ability to provide an incentive to address the underlying weaknesses resulting in the add on charge. This has not been recently tested as supervisors are still refining respective processes to calculate a Pillar 2 add on and it has not been used. A Pillar 2 assessment could be a more significant part of the supervisory process if framed by a formal annual supervisory review process, at least for large banks, as done in some other jurisdictions. This formalization would foster greater the structure of the supervisory process, increase transparency for banks, and also provide an opportunity to support supervisory views on risk management challenges at the firms. The outcomes of these review should articulate qualitative and quantitative assessments. Although, banks are perhaps well above potential minimums, their position would be different, if decisions about capital levels would be limited by supervision requirements.

143. The strength of Korea’s capital requirements is tempered by reliance on internal models-based approaches to risk-weighted asset (RWA) calculation combined with a leverage ratio backstop. While it should be noted that the RWA/Total Asset density of Korean banks is not as low as some other jurisdictions, the use of the leverage ratio as a backstop to an internal ratings-based (IRB) approach does create conflicting incentives for banks. On the one hand, banks may increase their holdings of risky assets to maximize returns relative to the leverage ratio constraint, while at the same time seeking to minimize the contribution of these positions to RWA calculations using their internal models. This increases the importance of supervisory reviews of firms’ modeling approaches, as well as in-depth reviews of the risk measurement practices and controls around both the identification of risks and the data used to report those risks. A particular area of focus for FSS supervisors should be risk identification and D-SIBs group-wide capacity to capture and report all risks across the group to ensure the comprehensiveness of the risks captured in models used for RWA calculations and for internal and FSS stress testing.

144. The FSS should increase the importance placed on stress testing for assessing capital adequacy. This should include both top down and bottom up stress tests run by the banks and FSS. While the current approach gives some attention to stress testing practices and results, that weighting should be increased, and strong consideration should be given to requiring D-SIB groups to meet post-stress minimum capital thresholds. In addition, internal stress tests run by banking groups for ICAAP and capital planning purposes should face greater supervisory scrutiny and serve as a key window into FSS assessments of risk management and internal controls at these firms.

145. Comprehensive off-site analyses of group level liquidity will benefit from implementing LCR or NSFR requirement at the holding company level. Additional data about relevant cash-flows among entities within banking groups could assist in identifying important inter-group dynamics and the roles of various subsidiaries, which will benefit both day-to-day supervision monitoring in crisis situations.

146. Supervision of liquidity risk management is focused on the bank level for all commercial banks. A key aspect of supervising liquidity risk management is offsite monitoring of liquidity positions on a bank consolidated basis using required regulatory reports on all limits and restrictions. The monitoring process includes reviewing banks’ ‘Business Reports’, monitoring market indicators and banks’ internal early warning systems for liquidity risk. Banks are required to submit data in the form of Business Reports for calculation of regulatory liquidity requirements such as LCR, FX LCR, loan-to-deposit ratios (denominated in KRW), FX liquidity ratios, and the NSFR. FSS supervisors also receive data on contractual maturity mismatches, concentrations of funding, and available unencumbered assets in the form of Business Reports.

147. Qualitative assessments of liquidity risk management would be carried out as part of the onsite examination process, primarily through the biannual ‘comprehensive examinations’, should the planning process find that a focus on liquidity is warranted. Examiners are provided with check lists for the assessment of qualitative factors to support their assessments. Such an examination would focus on key aspects of liquidity risk management, measurement and compliance with limits, key inputs into required stress tests, etc. Between biannual comprehensive exams, supervisors receive quantitative data on a quarterly (and often more frequent) basis for liquidity, as noted above.

148. The primary efforts to assess risk management is the annual risk assessment process and the biannual comprehensive examination used to develop the CAMEL-R rating. As noted above, the FSS also increasingly uses thematic and targeted reviews to assess specific practices and/or activities deemed to warrant follow up.

ODIs

149. The supervisory approach for MSBs and MCCs, including supervisory and enforcement tools, contain all important elements. Off-site supervision monitors various indicators on a frequent basis and performs regular CAEL assessments, using business and regulatory reports. The outcomes of supervisory assessments are used for prompt corrective actions, such as MIR, MID and MIO. The FSC/FSS has sufficient powers also towards national federations of mutual cooperatives. The composite ratings of the assessments (CAMEL) are calculated by examination departments, using information from on-site inspections. The FSS may also request auditors of MSBs to submit information for the purpose of supervision. The FSS holds no power to make a similar request in the case of MCCs, which represents one of the gaps of the current framework.

150. ICAAP or ILAAP are not part of the framework of either MSBs or MCCs. With the modernization of the regulatory framework, ICAAP and Pillar 2 should be considered for MSBs.

151. Although the sector of MSBs has gone through the gradual process of stabilization, it still requires a close attention of supervisors. Since 2011, MSBs have experienced a wave or restructuring, followed by tightening of regulatory standards and continuous improvement of the indicators of financial soundness. Their business model is primarily oriented on unbanked or financially underserved individuals and small businesses with a higher risk profile. For that reason, supervisors are encouraged to continue the implementation of more stringent requirements fostering the capital and liquidity position of these institutions, followed by diligent supervision and strong enforcement—all anchored by a strategic supervisory plan. Supervision should consider changes in the business environment influenced by new technologies, impacting the customer base of some MSBs.

152. Several MSBs are members of financial conglomerates, including NFGs. Although, their balance sheets are currently relatively small, comparing to the overall financial groups’ balance sheets, their growth is quite substantial and their position in the groups can become more significant (also, thanks to benefiting from a less stringent framework). It will require supervisors to align their approaches with supervision of other institutions, primarily with banks. A special attention will be required by MSBs which are members of NFGs, where regulatory framework is less efficient.

153. Volatile market conditions can also create new challenges to MCCs, which may require well-orchestrated responses from the currently fragmented group of multiple supervisors. Credit cooperatives play an important role in the Korean financial system representing more than 16 percent of the total assets of deposit taking institution and serve primarily or exclusively some communities. This increases pressures on supervisors in taking well targeted, effective actions. To succeed, all institutions mandated by regulation and supervision of MCCs must cooperate closely,. In the current institutional arrangements, it can pose certain challenges. In the context of potential pressures on MCCs, preventing contagion spreading to financial groups from related MCCs creates additional demands on supervision. This is another argument why the supervisory system needs a firmer guiadance by the FSC/FSS. MCCs do not belong to any financial group as they are independent legal entities with a diversified shareholders structure.

Insurance

154. As in banking, the insurance supervisory approach remains largely rules based. The FSS supervises the soundness of insurance companies by evaluating their business operations and risks through the RAAS, a supervisory evaluation and rating regime which comprises a qualitative and quantitative evaluation. A quantitative evaluation of the components is conducted quarterly or ad-hoc if deemed necessary, while qualitative evaluations are conducted during on-site examinations.

155. RAAS involves an analysis of management risk, insurance risk, interest rate risk, investment risk, liquidity risk, capital adequacy, and earnings. RAAS consists of quantitative and non-quantitative factors, and the quantitative factors have 17 assessment indices. The FSS also utilizes business reports that insurance companies submitted to the FSS quarterly. The FSS applies different weights to evaluation components in consideration of the different risk nature between life and non-life companies and differences in business characteristics. Depending on business characteristics, some components may be excluded from evaluation.

156. The examination cycle is, to a large degree, determined by the RAAS score of each undertaking. The FSC and FSS have determined four categories of supervisory intensity: (i) autonomous, (ii) regular, (iii) intensive, and (iv) emergency. According to the category, the examination cycle ranges from every three to four years for autonomous monitoring to every one to two years for intensive monitoring. Companies falling in the emergency category are deemed to be examined immediately.

157. The FSS reviews the adequacy of insurance companies’ risk management process and financial conditions based on ORSA results submitted by them. In addition, the FSS may request insurance companies to submit materials detailing the calculation methods for risks used in the ORSA. The adequacy of an ORSA is reviewed during the RAAS evaluation and may result in requests to strengthen risk management or capital adequacy.

158. Insurance companies are required to conduct stress test for major risks at least semiannually and comprehensive stress testing at least annually. The FSC/FSS develops scenarios for different risk factors depending on macroeconomic and financial market indicators. Stress test outcomes are reviewed by the FSS at least once a year. The scope of the tests extends to the impact on the balance sheets, income statements, RBC ratios, and liquidity. The time horizon for the stress tests is set in accordance with the expected duration of the stress, the risk characteristics of assets and liabilities, but it is usually set at a year or longer. At a minimum, insurance companies must include their insurance risk, interest rate risk, market risk, credit risk, operational risk, and liquidity risk. When conducting comprehensive stress tests, insurance companies are required to consider the diversification impact arising from the correlation of risk factors and provide to the FSS appropriate explanation and rationale for such correlations.

159. The FSAP considers a higher supervisory intensity and a more forward-looking perspective imperative. Aging, the low-yield environment and intense competition will shape the insurance sector for the years to come. This requires an intensified supervisory focus on companies’ business models and risk management practices. The FSS should therefore exploit the full potential of the ORSA and incentivize an earlier implementation by all insurance companies. Furthermore, the FSS should deepen its risk dialogue with companies’ senior management and internal control functions. Aggregated findings from this dialogue should also feed into macroprudential surveillance and horizontal analysis of the sector.

160. Like in banking, supervision must step up its focus on corporate governance, and the supervision of overseas insurer activities. Insurers’ corporate governance needs to be strengthened further and Boards of Directors held accountable. The FSS should consider more forward-looking and qualitative components in the RAAS process (incl. changes to business models). While overseas operations are small compared to domestic business in Korea, growth rates are considerable and, concentrated in a few markets, Korean insurers hold non-negligible market shares. Closer and intensified monitoring of overseas expansion, further strengthening working level cooperation with host authorities, and setting up supervisory colleges are some of the other desired actions.

Asset Managers and CIS

161. There is a need to enhance the supervision of the asset management industry with a more comprehensive and frequent inspection program. In light of the significant deregulation of the private funds’ markets and the growth of smaller asset managers, including hedge funds, the authorities should enhance their supervisory efforts including an expanded program of on-site examinations. There needs to be also a greater focus on mis-selling and misconducts risks in light of recent experiences. Additionally, investment products are seen by financial groups as business lines with a substantial growth potential, and similar cases could have implications for larger institutions as well.

162. Instances of mis-selling and misconduct have begun to rise and may pose reputational risk for financial conglomerates. With elderly households and younger Koreans seeking ‘higher yields’, this practices could impact market confidence, if risks related to severe redemption and liquidity pressures in the funds and asset management industry are not recognized sufficiently. The processes to monitor systemic risk should continue to further acknowledge the increasing potential for systemic risk arising from the securities sector, while certain deficiencies in the regulators’ arrangements to manage defaults should be taken into account.

163. Misconduct and mis-selling concerns have already been the subject of investigation by the authorities, including within large financial institutions, following some highly publicized and damaging losses associated with the equity linked securities (ELS) and derivative linked securities (DLS) products sold by several securities firms. In an environment of investor fragility, loss in confidence and pressures to manage growing demands on retirement savings for an aging society any major misconduct or governance failure can have significant long-term damage to investor psyche with consequential systemic effects across the markets.

164. The FSC/FSS has received filed complaints alleging that the institutions selling DLS and related products were doing so in an “irresponsible” manner with mis-selling being alleged. The matter has received widespread attention in the media and marketplace. The financial authorities have been conducting their investigations to look into the matter to determine how the products were designed and sold to the clients.

165. The experience with DLS/Derivative Linked Funds (DLFs) clearly shows how misconduct risks can damage the trust and confidence of investors and undermine the efforts that are being made to grow the Korean capital markets. While taking the appropriate enforcements actions against those responsible would be critical to send a strong signal of credible deterrence, it is equally important for the authorities to look at how the supervisory efforts against misconduct risks can be enhanced, including an assessment of the underlying culture within the firm and the role of the firms and their boards and senior managers, in ensuring that there are internal governance arrangements, controls and appropriate incentive structures to prevent these sorts of problems from damaging investor confidence.⁶⁶

166. What could the Korean authorities do about this to avoid any unintended and reputational and investor protection spillovers?

• First, the authorities should fully implement the key IOSCO MMF recommendations.⁶⁷ Ensuring that MMF fund valuations adopt fair value and are marked to market is important and should be in place expediently. The authorities should consider putting in place properly structured stress tests to be conducted on the asset management industry with clearly defined parameters on size and type of funds which is particularly important for MMF funds.

• Second, stronger surveillance of capital market risks accompanied with a more regular inspection program. Market surveillance should cover both off-site monitoring and thematic assessments. Frequency of on-site inspections should be scaled up along with external audits for entities which may in isolation appear relatively small but could pose risks to the integrity of the markets.

• Third, develop a systemic risk framework that incorporates the securities sector. This could be done as a joint exercise with other parts of the FSS and the BoK to better capture cross sectional and macro financial risks emanating from the securities market. Conduct stress tests on the asset management industry with clearly defined parameters on size and type of funds, particularly for MMF funds.

• Finally, implement an integrated approach to supervision, focusing on products offered across the financial system. The products are often distributed by multiple types of financial institutions (distribution channels), where an appropriate supervisory framework is not in place. The FSC/FSS should take an initiative to close these gaps.⁶⁸