Front Matter Page

IMF Country Report No. 20/279

REPUBLIC OF KOREA

FINANCIAL SECTOR ASSESSMENT PROGRAM

TECHNICAL NOTE—SYSTEMIC RISK ANALYSIS, FINANCIAL SECTOR STRESS TESTING, AND AN ASSESSMENT OF DEMOGRAPHIC SHIFT IN KOREA

September 2020

This Technical Note on Systemic Risk Analysis, Financial Sector Stress Testing, and an Assessment of Demographic Shift in Korea for the Republic of Korea FSAP was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed in September 2020.

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Front Matter Page

REPUBLIC OF KOREA

FINANCIAL SECTOR ASSESSMENT PROGRAM

TECHNICAL NOTE

SYSTEMIC RISK ANALYSIS, FINANCIAL SECTOR STRESS TESTING, AND AN ASSESSMENT OF DEMOGRAPHIC SHIFT IN KOREA

September 1, 2020

The content of this Technical Note is based on information available as of end-June/December 2019, before the global intensification of the COVID-19 outbreak. It focuses on the Republic of Korea’s medium-term challenges and policy priorities and does not cover the outbreak or the related policy response, which has since become the overarching near-term priority.

Prepared By

Monetary and Capital Markets Department

Contents

• Glossary

• EXECUTIVE SUMMARY

• MACRO-FINANCIAL ENVIRONMENT, SYSTEM STRUCTURE, AND SCOPE OF THE SYSTEMIC RISK ANALYSIS

• A. Financial System Structure and Trends

• B. Macro-Financial Environment

• C. Korean Housing Market Structure and Dynamics

• D. Scope of the Systemic Risk Analysis

• RISKS, VULNERABILITIES, AND MACRO-FINANCIAL SCENARIOS

• A Risks, Vulnerabilities, and Macro-Financial Scenarios

• B. Fintech Developments in Korea

• FORWARD-LOOKING BANK SOLVENCY ANALYSIS

• A. Methodology

• B. Results

• C. Recommendations

• FORWARD-LOOKING BANK LIQUIDITY ANALYSIS

• A. Overview

• B. Current Liquidity Conditions and Banks’ Liquidity Profiles

• C. Methodology

• D. Results

• E. Recommendations

• RISK ANALYSIS FOR THE INSURANCE AND PENSION FUND SECTOR

• A. Insurance Sector

• B. Pension Fund Sector

• C. Recommendations

• NETWORK AND CONTAGION ANALYSIS

• A. Analysis

• B. Recommendations

• DEMOGRAPHIC DEVELOPMENTS IN KOREA

• BOXES

• 1. The Z-Score Methodology

• 2. Hybrid PD-Satellite-Z-factor Methodology and Dynamic Balance Sheets

• 3. Lifetime (LT-) ECL and Provision Stock and Flow Calculations

• 4. Fintech Overlay – Methodology

• FIGURES

• 1. Financial System Structure

• 2. Depository Institutions’ Business Models

• 3. Structure of the Insurance Sector

• 4. Financial System Performance

• 5. Bank Profitability (Significant Institutions): Key Trends

• 6. Korean Banks’ Asset Portfolio Structure, Liability Structure, and P&L Components

• 7. Solvency and Profitability of the Insurance Sector

• 8. Macrofinancial Environment

• 9. Housing Market

• 10. Demographics Shift and Household Debt

• 11. Baseline and Adverse Macro-Financial Scenario

• 12. Baseline and Adverse Scenario Paths for Real GDP in Historical Perspective

• 13. Cumulative Real GDP Deviations (Adverse Relative to Baseline)

• 14. Implications of Open Banking and E-Money Developments in Korea

• 15. Dependencies Captured in Top-Down Solvency Model Suite for Korean Banks

• 16. P&L Structure and Model Approaches Adopted for the Korea Solvency Analysis

• 17. Credit Risk Module Structure

• 18. Baseline and Adverse Scenario-Conditional PDs

• 19. Perfect Foresight and Risk Parameter Behavior after Initial 5-Year Horizon

• 20. Baseline and Adverse Scenario-Conditional LGDs

• 21. Effective Interest Rates for ECL Discounting Purposes

• 22. Banks’ Historical Effective Interest Rate Evolution for Korean Banks

• 23. Nonlinear Solvency-to-Funding Cost Feedback for Korean Banks

• 24. Solvency Stress Test Results: CET1 Ratios, Sub-Sector Aggregates

• 25. Changes in CET1 Capital Ratios from Starting Point to Low Point Under the Adverse Scenario

• 26. Capital Depletion Under the Adverse Scenario

• 27. Asset Exposure Shares vs. Credit and Market Loss Shares Under the Adverse Scenario

• 28. Fintech Overlay—Impact on Banks’ Capitalization Under Conservative Assumptions

• 29. Fintech Overlay—Impact on NIMs

• 30. Solvency-Liquidity Cost Feedback

• 31. Capital Ratios’ Sensitivity to Stronger House Price Shock for Residential Mortgage Portfolios

• 32. Mortgage Insurance Shares Across Korean Banks

• 33. Impact on Accounting Provision Stocks, Flows, and Risk Weights when Assuming that Mortgage Insurance was Absent

• 34. Capital Ratio Differentials under Different Static and Dynamic Balance Sheet Variants (Adverse Scenario

• 35. Loan Loss Coverage as of End-2018, Regulatory Provision-based vs. Top-down Model based (Adverse Scenario)

• 36. Impact of Regulatory Loan Loss Coverage on Capital Ratios and Depletion

• 37. Sensitivity of Capital Ratios to RWA Pass-Through Strength under the Adverse Scenario

• 38. Liquidity and Stable Funding

• 39. Liquidity Stress Test

• 40. Insurance Stress Test Sample—Fixed-Income Portfolio

• 41. Insurance Stress Test—RBC Coverage

• 42. Insurance Stress Test—Contribution of Individual Shocks

• 43. Insurance Profitability Projections After Stress

• 44. The National Pension Fund

• 45. Financial System Network Structure

• 46. Sector-Level Default Simulation: Capital Depletion

• 47. Network Centrality (Eigenvector Centrality)

• 48. Demographic Developments Proportion of Population Ages 65+

• 49. Old Age Poverty Across OECD Countries

• 50. Channels through which Demographic Developments May Impact the Financial System

• 51. Korean Financial System’s Total Asset Dynamics

• 52. Scenarios for Population Growth and Dependency Ratios in Korea until 2067

• 53. Demographics Scenario-Conditional Total Asset Dynamics

• TABLES

• 1. Main Recommendations

• 2. Financial System Structure

• 3. Core Financial Soundness Indicators, 2012–17

• 4. Selected Economic Indicators, 2017–24

• 5. Korean Banks In-Scope of the Systemic Risk Analysis and Stress Test

• 6. Insurance Firms Included in the Stress Test

• 7. Baseline and Adverse Macro-Financial Scenario—Main Features

• 8. Insurance Stress Test Scenario

• APPENDICES

• I. FSAP Risk Assessment Matrix (RAM)

• II. Solvency and Liquidity Stress Test Matrices for Banks and Insurers (STeMs)

• III. Liquidity Stress Test – Calibration Details

• IV. Solvency Stress Test – Mapping MR and CR Methodology

• V. Solvency Stress Test – Credit and Interest Income and Expense Models

Glossary