## 1korea2020001

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### Context and scope
- Prepared by IMF staff for Executive Board consideration on Friday, March 27.
- Based on information available as of end June 2019; staff discussed with Korean authorities in September and December 2019.
- FSAP mission visits: August 20–September 6, 2019 and December 4–19, 2019.
- Assessment focuses on Korea’s near and medium-term financial stability challenges and policy priorities and was prepared before COVID-19 became a global pandemic; it therefore does not reflect the implications of COVID-19 and related policy priorities.
- Findings discussed with authorities at the end of the second mission.

### Main findings: resilience and vulnerabilities
- Financial system characteristics:
  - Among the most developed and internationally connected in Asia; operating within a trade dependent open economy.
  - Rules-based oversight system maintained by authorities.
- Aggregate resilience:
  - Overall system appeared resilient for the present, but with growing vulnerabilities.
  - Stress tests suggested banks and insurers, in aggregate, can weather severe macro financial shocks, although some banks would make use of capital conservation buffers.
- Key vulnerabilities and risks:
  - Growth-related uncertainties given global macroeconomic conditions and the COVID-19 crisis.
  - Elevated household debt.
  - Low interest rates, rising competition from fintech and nonbanks, and adverse demographics inducing shifts in household financial behavior.
  - The leasehold deposit market (Jeonse) presents potential vulnerability for the real estate market.
  - Financial conglomerates are not under adequate oversight.
  - Need for stronger monitoring of transmission channels between securities markets and banks, and across asset classes.
  - Systemic risks from securities market activities that can amplify contagion, including sudden redemption and liquidity pressures in funds and asset management.

### System structure, size, and key statistics
- Growth since 2013 FSAP: financial system grew by about 40 percentage points of Gross Domestic Product (GDP).
- As of 2018Q4, total assets of financial institutions reached about 300 percent of GDP.
- Asset management industry: privately placed funds, derivatives-linked securities and products such as equity-linked securities amount to about KRW 500 trillion, roughly 30 percent of GDP.
- State presence:
  - KHFC: Loans, securities and guarantees issued and provided in 2017 amounted to about 7% of GDP; total MBSs issued and guaranteed by KHFC amounts to KRW 116trn.
  - KAMCO acquired about USD 100bn of bad loans after the Asian crisis and bought substantial amounts of NPLs after subsequent crises.
  - NPS manages USD 600bn in assets.
  - KIC has about USD 130bn assets under management.
- Financial holding companies:
  - As of end-2018, nine FHCs held about 40 percent of total financial institutions’ assets (114 percent of GDP).
  - Four FHCs identified as D-SIBs.
- Banking and lending:
  - Bank loans split roughly equally between households and firms; about 80 percent of the stock of corporate bank loans is to SMEs.
  - Share of foreign business in total assets about 6 percent (up from 4 percent in 2013).
  - Nationwide banks’ largest exposure to China: 1.7 percent of total assets in 2018 (1.1 percent in 2013).
- Capital markets:
  - Equity market capitalization around $1.8 trillion with foreigners holding around 35 percent of listed Korean stocks.
- Macrofinancial leverage and household debt:
  - Total non-financial private sector debt to GDP: close to 200 percent.
  - Core debt (debt of the non-financial sector owed to banks): about 130 percent of GDP.
  - Household debt as ratio of disposable income: about 180 percent.
  - Household debt-at-risk indicators: around 15 percent of total household debt currently registered ‘at-risk’ and around 11 percent at solvency risk; around 4 percent both at solvency risk (debt-to-asset ratio above 100) and liquidity constrained.

### Stress testing and systemic risk analysis
- Banking solvency stress test:
  - Top-down dynamic balance sheet solvency analysis for 24 banks covering 95 percent of banking system assets at end-2018; five-year horizon.
  - CET1 ratios of nation-wide, regional, and specialized banks fall by 3.4, 3.4 and 4.7 percentage points up to the low point.
  - All banks’ capital ratios would stay above regulatory minima when allowing consumption of the capital conservation buffer (CCB).
  - Banking system-wide loss shares under the adverse scenario:
    - corporates: 60 percent
    - households: 30 percent
    - sovereign: 2 percent
    - residual category: 8 percent
- Liquidity stress tests (LST):
  - LCR introduced to 100 percent for all currency and 80 percent for FX in 2019, together with NSFR of 100 percent.
  - Most banks’ liquidity exceeded regulatory requirements in 2019Q1; systemic liquidity coverage falling from 121 percent to 120 percent under asset price shocks.
  - Retail funding shocks: average liquidity coverage of nationwide banks falling to 98 percent.
  - State-owned banks’ FX liquidity coverage could fall from 112 percent to 85 percent under wholesale funding shocks.
- Insurance solvency stress test:
  - Top-down ST for seven life and six non-life insurers covering about 75 percent of the market, instantaneous shock.
  - Median RBC coverage:
    - Life: declines from 239 to 169 percent.
    - Non-life: declines from 214 to 158 percent.
  - Two life insurers and one non-life company fall slightly below the recommended level of 150 percent, though still above the 100 percent regulatory threshold.
  - Net income before tax would drop by 42 percent in the first year of the projection horizon under the scenario assumptions.
- Growth-at-risk (GaR) analysis:
  - Points to sizable downside risk over the next few years; adverse scenario calibrated such that 1-year ahead real GDP fall matches 5 percent GaR.
- Recommendations to augment stress-test reliability:
  - Use advanced methods and system-wide monitoring.
  - Test overall leverage related to residential properties.
  - Test households’ resilience to adverse shocks.
  - Test sovereign contingent liabilities.

### Adverse macro-financial scenario and COVID-19 note
- Adverse scenario narrative:
  - Escalation of global trade tensions causing a broad-based, world-wide sell-off in equity markets; significant capital outflows; strong currency depreciation; widening of term and risk premia; material house price drops; severe recession with a deep downturn spanning over two full years before normalizing.
  - Scenario built on October 2019 WEO forecast and Korea-specific modelling (regime-switching structural VAR).
- COVID-19:
  - Rapid rise in COVID-19 cases since February 2020 likely implies a significant, though hopefully only temporary, drag on economic activity.
  - Authorities proposed KRW 11.7trn (0.6 percent of GDP) supplementary budget to mitigate macroeconomic impact.
  - FSAP team’s assessment: the adverse FSAP macro-financial scenario is severe enough to encapsulate a COVID-19 implied fallout in both depth and duration.

### Household debt, housing finance, and Jeonse market risks
- Household debt structure and vulnerabilities:
  - Around 50 percent of household debt linked to floating interest rates and structured as bullet payments.
  - Over 30 percent of debt held by households with a debt service ratio above 40 percent (KOSTAT data).
  - Around one-quarter of total stock of debt held by households retired or close to retirement.
  - Significant share of household debt secured against a non-primary residence.
  - Household stress-test impact: debt held with liquidity constrained insolvent households will rise following an adverse income (house price) shock from around 4 to 5.3 (6.6) percent of GDP.
  - Impact of shocks on household balance sheets grows with age; retiree households most at risk from interest rate hikes.
- Jeonse market specifics:
  - Jeonse deposits average about 50-70 percent of the house value ("Jeonse price") paid to landlords and repaid at the end of two-year contracts if not extended.
  - BoK study: 78 percent of landlords could cover the financing gap from a 20 percent fall in Jeonse deposit price with other financial assets while 22 percent would need additional loans.
  - Policy vigilance needed on rollover risk, potential claims on the state in case of wide-spread defaults and social pressure, and amplification of house price shocks via Jeonse market.
  - Mitigation option: policy measures limiting the combined value of mortgage and Jeonse deposits.

### Non-financial corporate vulnerabilities
- Corporate debt:
  - Non-financial corporate debt about 100 percent of GDP, higher than G20 average; one quarter appears “at-risk,” mostly SMEs.
  - SMEs account for about 35 percent of total corporate debt and are largely funded by bank credit.
  - Since the GFC, increases in firms reporting negative ROA, negative revenue growth, insufficient liquidity, and interest coverage ratio below 1.
  - Stress tests show rise in corporate debt-at-risk under the adverse scenario, though total credit losses likely contained due to large cash buffers.
- Insolvency framework:
  - Seoul Bankruptcy Court established in 2017; challenges include filing delays and post-commencement financing difficulties.
  - Possible reform: establish an insolvency practitioner profession to prevent gridlock in a crisis.

### Fintech, market structure, and payment risks
- Fintech developments:
  - Entry of large technology companies into financial services creates profitability and disintermediation pressures on banks and may incentivize banking consolidation.
  - Authorities introduced an “open banking” system requiring commercial banks to open payment networks to fintech providers upon customer consent; parallel legal clarifications for electronic financial transactions and personal data use.
- Risks from fintech and open banking:
  - Increased interconnectedness and complexity, greater operational risk, negative impact on incumbent banks’ profitability, higher market concentration in payment system, potential crowding out of innovative business models.
  - Liquidity risk via immediate customer reactions ("electronic deposit run") and re-depositing by e-money providers, leading to concentration risk.
- Fintech Overlay to bank solvency analysis:
  - Baseline overlay strength set to 50 percent; lower and upper bounds 10 percent and 100 percent respectively.
  - Capital depletion under the adverse scenario may move from 2.9 percent of GDP when overlay is off to 3.9 percent when overlay strength at 90 percent.
- Recommendation: conduct impact assessment of “open banking system” and e-money on security and operational risks and market structure (FSC/FSS and BoK, timing: I).

### Macroprudential and supervisory framework: strengths and gaps
- Macroprudential measures:
  - Authorities have implemented many measures; as many as 18 macroprudential and other measures taken to curb credit to households and house price growth.
  - Existing toolkit includes leverage limit on net derivative positions, macroprudential stability levy on short-term FX exposures, foreign currency LCR and minimum foreign currency LAR.
- Institutional and framework gaps:
  - Macroprudential framework needs enhancements for predictability and to minimize undesired spillovers.
  - Oversight of corporate governance and Pillar 2 for D-SIBs is work in progress.
  - Group-level supervision absent for many financial conglomerates; definition of financial holding company should be widened.
  - State-owned banks, smaller depository entities, and securities market activities need stronger supervisory attention.
  - Rules-based supervision limits forward-looking/preemptive actions; greater use of qualitative, judgmental assessments recommended.
- Recommendations (selected, with timing indicators I = Immediate, NT = Near-Term, MT = Medium-Term):
  - Assign the MEFM (or equivalent body) macroprudential oversight as its sole primary objective (MOEF, FSC and BoK, timing: I).
  - Implement a Sectoral CCyB framework for secured and unsecured household exposures of the banking sector (FSC/FSS and BoK, timing: NT).
  - Conduct enhanced stress testing on NPL sales, FX and domestic household liquidity, SME loans, securities intermediaries activities, and sovereign contingent liabilities (BoK and FSC/FSS, timing: MT).
  - Review role of state-controlled banks to ensure conformity with prudential requirements for nationwide banks (FSC/FSS, timing: I).
  - Widen definition of financial holding company and enhance legal powers to cover all financial conglomerates, including group-wide liquidity risks and contingency plans (MOEF and FSC/FSS, timing: I).
  - Focus FSC on strategy, nonbank data gaps, market development and crisis preparedness; assign greater operational and enforcement authority to FSS (MOEF and FSC/FSS, timing: NT).
  - Support development of pension and contractual savings products introducing multi-employer pension schemes and build oversight capacity (FSC/FSS / MOEL, timing: MT).
  - Include cross-border activities and overseas operations of financial conglomerates in resolution plans and clarify ELA-resolution funding relationship (FSC/FSS, timing: NT).
  - Strengthen insolvency and creditor’s rights regime through well-resourced courts and a functioning insolvency practitioners’ profession (MoJ, timing: MT).

### Crisis management, resolution, and safety nets
- Safety net and resolution:
  - Korea has a well-established financial safety net and a resolution regime with many elements of the FSB Key Attributes.
  - ASIFI provides a special resolution regime including transfer powers and bridge institution powers.
  - KDIC: DIF returned to surplus; KDIC succeeded in turning DIF into KRW 500 billion in late 2017, and KRW 2.5 trillion at end-2018.
- Key challenges:
  - Preparing for failure of a financial group including cross-border activities and ensuring orderly resolution of D-SIBs without public solvency support.
  - Need to include cross-border activities and overseas operations in resolution plans.
  - Funding for resolution: current arrangements have all funding for firms in resolution met from deposit insurance fund — may be unsustainable for D-SIB resolution.
  - Recommendation: consider statutory bail-in powers and enable BoK to provide liquidity to an institution considered systemic and viable in context of a realistic, time-bound resolution plan (subject to safeguards and determination of viability).
- Domestic crisis cooperation:
  - Roles of MOEF, BoK, FSC, FSS, and KDIC are clear in statutes; MEFM coordinates risk assessments and interventions.
  - Recommendation: formalize arrangements via an apex group or MEFM crisis management subgroup (coordination only) including KDIC to anchor interagency coordination on crisis preparedness and management.

### Securities markets, asset management, and nonbank risks
- Capital markets developments:
  - Private funds market registration increased; alternative investments including real estate on the rise; increase in hedge funds.
  - Savings channeling via securities to cross-border locations and assets.
- Risks:
  - Mis-selling and misconduct rising; investor protection framework underdeveloped.
  - Potential for severe redemption and liquidity pressures in funds and asset management to amplify systemic risk.
- Recommendations:
  - Fully implement key IOSCO MMF recommendations.
  - Strengthen surveillance of capital market and nonbank risks with regular inspection program.
  - Develop systemic risk framework incorporating securities sector and stress tests on asset management industry, particularly MMFs.
  - Accelerate reforms to address accounting and audit fraud risks.

### Insurance sector and pension system challenges
- Insurance:
  - Insurers well capitalized but low interest rates weigh on profitability.
  - Life insurance ROA: 0.3 percent in 2018.
  - Median return on assets for non-life: 1.3 percent in 2018.
  - Implementation of K-ICS and IFRS 17 are important reforms; K-ICS to be introduced in 2022.
  - Recommendation: FSS should assess long-term viability of business models and consider capital injections where needed; address high-guarantee legacy business via legal basis for portfolio transfers, run-offs, conversion offers; calibrate capital charge for longevity risks prudently.
- National Pension Service (NPS):
  - Accumulation phase expected to grow until 2041 when benefit payments start exceeding contributions.
  - Projection under unchanged parameters: fund will be depleted by 2057.
  - Current portfolio: 60 percent domestic assets; expanding overseas portfolio and exposed to currency risk largely unhedged.
  - Options to address sustainability: reduce benefits, increase contribution rates, increase retirement age, broaden membership, increase targeted investment returns.

### Cross-border supervision, climate risk, and AML/CFT
- Cross-border supervision:
  - Large financial institutions plan overseas expansion; closer cooperation with host authorities and supervisory colleges warranted.
- Climate risk and green finance:
  - BoK joined the Network for Greening the Financial System (NGFS) in 2019; first ESG foreign currency bonds issued in 2013.
  - Recommendation: comprehensive action plan and interagency coordination on climate risk for disclosure, stress testing, and capital market reforms.
- AML/CFT:
  - Korea’s AML/CFT regime assessed by FATF and APG; onsite assessment June/July 2019; draft report adopted by FATF plenary in February 2020; scheduled for APG plenary adoption in July 2020.

### Risk Assessment Matrix — selected risks
- Sharp rise in risk premia: Overall Level of Concern — High; Relative Likelihood — Medium.
- Rising protectionism and retreat from multilateralism: Overall Level of Concern — High; Relative Likelihood — High.
- Weaker-than-expected global growth: Overall Level of Concern — High; Relative Likelihood — High.
- Surge in external competitive pressures: Overall Level of Concern — Medium; Relative Likelihood — High.
- Sharp domestic house price correction: Overall Level of Concern — Medium; Relative Likelihood — High.

### Implementation status of prior FSAP recommendations (selected)
- Empower supervisors to set capital ratios above Basel II minimum, implement Pillar-2 principles, extend Basel II capital to group holding companies — Status: PD.
- Apply regulatory framework to NBDIs with larger entities subjected to stricter supervision — Status: PD.
- Risk-based approach to AML/CFT supervision and expansion — Status: PD.
- Enhance audit oversight and external auditor appointment standards — Status: LD.
- Establish dedicated apex committee for crisis preparedness and management; periodic crisis simulation exercises — Status: PD.
- Replenish deposit insurance fund and assure KDIC back-up funding — Status: LD (DIF returned to surplus; back-up funding arrangements remain loose).

*Financial System Stability Assessment (FSSA), IMF staff report prepared for the Republic of Korea FSAP (information as of end June 2019).*

### 2019. It focuses on Korea’s near and medium-term financial stability challenges and policy

### REPUBLIC OF KOREA FINANCIAL SYSTEM STABILITY ASSESSMENT — KEY ISSUES

### Context and scope
- The FSSA was prepared by IMF staff for the Executive Board’s consideration on Friday, March 27.
- The staff report reflects discussions with the Korean authorities in September and December 2019 and is based on the information available as of end June 2019.
- The assessment focuses on Korea’s near and medium-term financial stability challenges and policy priorities and was prepared before COVID-19 became a global pandemic; it therefore does not reflect the implications of COVID-19 and related policy priorities.
- The FSAP mission visited Korea in August 20–September 6, 2019 and December 4–19, 2019; findings were discussed with the authorities at the end of the second mission.

### Main findings: resilience and vulnerabilities
- Operating within a trade dependent open economy, Korea’s financial system is among the most developed and internationally connected in Asia.
- The authorities maintain a comprehensive, rules-based oversight system.
- The overall financial system appeared resilient for the present, but with growing vulnerabilities.
- Stress tests suggested that banks and insurers, in aggregate, can weather severe macro financial shocks, although some banks would make use of capital conservation buffers.
- Key vulnerabilities and risks:
  - Growth-related uncertainties in view of the global macroeconomic conditions and the COVID-19 crisis.
  - Elevated household debt.
  - Low interest rates, rising competition from fintech and nonbanks, and adverse demographics inducing shifts in household financial behavior.
  - The leasehold deposit market (Jeonse) presents a potential vulnerability for the real estate market.
  - Financial conglomerates are not under adequate oversight.
  - Need for stronger monitoring of transmission channels between securities markets and banks, and across asset classes.
  - Systemic risks from securities market activities that can amplify contagion, including sudden redemption and liquidity pressures in funds and asset management.

### Systemic risk analysis and stress testing
- Stress tests indicate the banking system is broadly sound; largest adverse capital impacts are estimated for a few regional, mutual savings, and state-owned banks.
- Growth-at-risk (GaR) analysis points to sizable downside risk over the next few years, but risk of systemic contagion within the financial system appears presently contained.
- Recommendations to augment reliability of stress tests:
  - Use advanced methods and system-wide monitoring.
  - Test overall leverage related to residential properties.
  - Test households’ resilience to adverse shocks.
  - Test sovereign contingent liabilities.
- Box: Fintech overlay to the bank solvency analysis is considered for rationale and results (document contains a Box 1 on this topic).

### Fintech and market structure risks
- Fintech developments offer benefits but could be disruptive without a comprehensive approach.
- Entry of large technology companies into financial services is creating profitability and disintermediation pressures on banks and may increase incentives for banking consolidation.
- Intensified search for yield by depositors and households is leading to retailing of risky wealth management and less transparent derivative securities products.
- Recommendation: Conduct an impact assessment of the “open banking system” and e-money on security and operational risks and market structure (FSC/FSS and BoK, timing: I).

### Household debt, housing finance, and pension markets
- Elevated household debt is a key vulnerability to financial stability.
- The Jeonse leasehold system implies potential rollover risk and connectedness to securities companies; assessment recommended (FSC/FSS and BoK, timing: NT).
- Recommendation to review housing market financing structures and implicit subsidies, and the pension funds market.

### Macroprudential and supervisory framework
- Authorities have implemented many micro and macroprudential measures; as many as 18 macroprudential and other measures have been taken to curb credit to households and house price growth.
- The macroprudential framework needs enhancements to make policy processes more predictable and to minimize undesired spillovers.
- Supervision is rules-based with good transposition of international regulations, but gaps remain:
  - Oversight of corporate governance and Pillar 2 for D-SIBs is work in progress.
  - A systematic application of group-level supervision covering all types of financial conglomerates is absent.
  - State-owned banks, smaller depository entities, and securities market activities require stronger supervisory attention.
- Recommendations include widening the definition of financial holding company and enhancing legal powers to cover all financial conglomerates, including group-wide liquidity risks and contingency plans (MOEF and FSC/FSS, timing: I).

### Policy recommendations (selected, with timing)
- Strengthen the institutional framework for financial stability by assigning the MEFM (or equivalent body) macroprudential oversight as its sole primary objective (MOEF, FSC and BoK, timing: I).
- Implement a Sectoral CCyB framework for secured and unsecured household exposures of the banking sector (FSC/FSS and BoK, timing: NT).
- Conduct enhanced stress testing practices to better estimate vulnerabilities relating to NPL sales, FX and domestic household liquidity, SME loans, securities intermediaries activities, and sovereign contingent liabilities (BoK and FSC/FSS, timing: MT).
- Review the role of state-controlled banks and ensure their commercial lending and investment activities conform to prudential requirements for nationwide banks (FSC/FSS, timing: I).
- Increase risk-based supervisory intensity of insurers, ensure prudent and proportionate implementation of K-ICS, and design of the capital charge for longevity risks (FSC/FSS, timing: I).
- Focus the role of FSC towards strategy, nonbank data gaps, market development, and crisis preparedness while assigning greater operational and enforcement authority to the FSS (MOEF and FSC/FSS, timing: NT).
- Support development of pension and contractual savings products by introducing multi-employer pension schemes and building oversight capacity for pension funds (FSC/FSS / MOEL, timing: MT).
- Include cross-border activities and overseas operations of financial conglomerates in resolution plans, clarify resolvability and the relationship between ELA and resolution funding (FSC/FSS, timing: NT).
- Strengthen the insolvency and creditor’s rights regime through well-resourced courts and a functioning insolvency practitioners’ profession (MoJ, timing: MT).

### Crisis management, resolution, and safety nets
- Korea has a well-established financial safety net and a resolution regime with many elements of the FSB Key Attributes.
- Key challenges:
  - Preparing to deal with the failure of a financial group, including cross-border activities.
  - Ensuring orderly resolution of D-SIBs.
  - Resolution plans should explicitly include cross-border activities and overseas operations of financial conglomerates.

### Data points, missions, and administrative details preserved from source
- Report date references: March 27 (Executive Board consideration), March 10, 2020 (document footer).
- FSAP mission dates: August 20–September 6, 2019 and December 4–19, 2019.
- Team lead and contributors listed in the source (Udaibir Das; Thomas Harjes; Zsofia Arvai; Farid Boumediene; Marco Gross; Roland Meeks; David Rozumek; Jess Cheng; Anjum Rosha; Sohrab Rafiq; Timo Broszeit; Tim Clark; Andrew Gracie; Ranjit Singh; Elizabeth Mahoney; Vanessa Guerrero).
- Senior officials met: FSC Chairman EUN Sung-soo; BoK Governor LEE Juyeol; 1st Vice Minister of Economy and Finance KIM Yongbeom; FSS Governor YOON Suk Heun.
- The Republic of Korea is deemed by the Fund to have a systemically important financial sector under Mandatory Financial Stability Assessments Under the Financial Sector Assessment Program—Update (11/18/2013).

*Financial System Stability Assessment (FSSA), IMF staff report prepared for the Republic of Korea FSAP (information as of end June 2019).*

### 1.      The Korean financial system is one of the largest and most developed in Asia (Figure 1,

### The Korean financial system is one of the largest and most developed in Asia

### Structure, size, and market composition
- Since the 2013 FSAP, Korea’s financial system has grown by about 40 percentage points of Gross Domestic Product (GDP).
- As of 2018Q4, total assets of financial institutions reached about 300 percent of GDP.
- Real estate is the central asset class where leverage is high.
- Banks and other depository institutions (ODIs) hold most financial institutions’ assets, alongside a sizeable insurance sector.
- The asset management industry is small but growing; privately placed funds, derivatives-linked securities and products such as equity-linked securities amount to about KRW 500 trillion, roughly 30 percent of GDP.
- Growth in the onshore FX derivatives market lags cross-border investment flows while the offshore non-deliverable forward (NDF) market in Korean won (KRW) remains large and liquid.

### State presence and public financial institutions
- The state has a significant footprint through three large (“specialized”) state-owned banks, the Korea Asset Management Corporation (KAMCO), and the Korean Housing Finance Corporation (KHFC).
- KHFC provides mortgage insurance and issues fully guaranteed mortgage-backed securities composed of “conforming” loans for which it sets the maximum amount, maturity and interest rates in advance.
  - Loans, securities and guarantees issued and provided in 2017 amounted to about 7% of GDP.
- KAMCO acquired about USD 100bn of bad loans from the banking system after the Asian crisis and bought substantial amounts of NPLs after the credit card crisis (2003), global financial crisis (2008), and household debt crisis (2013).
- The National Pension Service (NPS) manages USD 600bn in assets and is the largest on-shore investor in Korea.
- The Korean Investment Corporation (KIC) has about USD 130bn assets under management.

### Financial holding companies and systemic importance
- As of end-2018, nine Financial Holding Companies (FHCs) held about 40 percent of total financial institutions’ assets (114 percent of GDP) through complex networks of subsidiaries.
- Four FHCs have been identified as D-SIBs.
- Firms belonging to bank holding companies operate across insurance, capital markets and asset management businesses.

### Depository institutions — business models and exposures
- Banks and Other Depository Institutions (ODIs) are primarily funded by retail deposits; assets are concentrated in loans often related to real estate.
- Bank loans are split roughly equally between households and firms; about 80 percent of the stock of corporate bank loans is to SMEs.
- Most SME loans are collateralized against real estate and linked to floating rates.
- Commercial banks have a relatively diversified loan portfolio and securities holdings; state-owned banks focus lending on SMEs and the shipbuilding sector.
- The share of foreign business in total assets is about 6 percent, up from 4 percent in 2013.
- Nation-wide banks’ largest exposure is to China, amounting to 1.7 percent of total assets in 2018 (1.1 percent in 2013).

### Insurance sector structure and role
- Insurance penetration (premiums to GDP) is one of the highest in the world, exceeded only by Taiwan Province of China and Hong Kong SAR.
- Life insurance has been a central conduit of savings; life insurance reserves represent a significant share of household financial assets.
- The market is dominated by large firms owned by FHCs and Korea’s large conglomerates; the top 3 life insurers hold over 50 percent of the life sector’s assets, and the top 3 non-life insurers hold over 50 percent of non-life assets.
- Assets are concentrated in bonds, but loans are also sizeable.
- The bancassurance market is well developed; 50 percent of new business in life insurance is sold via banks.

### Capital markets and asset management
- The equity market has a market capitalization of around $1.8 trillion with foreigners holding around 35 percent of listed Korean stocks.
- The five large conglomerates account for over 50 percent of market capitalization; Korean companies display significantly lower price-to-book and price-to-earnings rates relative to major comparators (the “Korea discount”).
- The bond market is dominated by government and other public debt and includes green or ESG bonds.
- The asset management industry has experienced robust growth reflecting changing saving patterns and a search for yield.

### Macrofinancial developments and vulnerabilities
- Korea’s export-oriented manufacturing sector accounts for approximately a quarter of GDP; growth slowed to about 2 percent last year due to a cyclical slowdown in semiconductors.
- The KRW has depreciated partly on the back of trade tensions between the United States and China.
- The financial cycle has reached an advanced phase with household debt among the highest for OECD countries:
  - The ratio of total non-financial private sector debt to GDP has reached close to 200 percent.
  - Core debt (debt of the non-financial sector owed to banks) amounts to about 130 percent of GDP.
  - Household debt as a ratio of disposable income stands at about 180 percent.
- After some deleveraging, corporate credit has picked up, particularly to the SME sector, often secured by real estate.
- Household lending growth (primarily housing-related) has slowed but remains above nominal GDP growth.
- Financial conditions have slightly tightened and the credit gap has turned slightly positive again (referenced indicators in Figure 4).

### Demographic rotation — channels and projected effects
- Korea faces one of the most adverse demographic rotations worldwide; old-age poverty in Korea is highest among OECD countries.
- Demographic change raises concerns of low capital formation, prolonged low growth and inflation, and erosion of financial buffers.
- Potential channels of impact on financial stability include:
  - Lower interest rates and a flatter yield curve, exerting structural downward pressure on net interest income for banks.
  - Reduced demand for long-duration loans (mortgages) due to a shrinking young population cohort.
  - Rising share of debt held by older households, including through reverse mortgages promoted by the KHFC, increasing the debt service-to-income ratio of older cohorts.
  - Banks may need to shrink branch networks to reduce costs and offset falling interest income and increased nonbank activities.
- Long-term scenario findings:
  - All financial sector components except pension funds are likely to shrink or stagnate eventually.
  - Nation-wide, regional and specialized banks are expected to move sideward in terms of size.
  - Non-life insurers and pension funds are most dependent on demographic scenario assumptions and may still grow somewhat.
  - The proportion of debt held by older households will increase and the debt service-to-income ratio of older cohorts will rise significantly.

*Source: IMF staff analysis (excerpts from 1korea2020001).*

### 12.      Several vulnerabilities could amplify shocks in Korea. The FSAP analysis points to  five

### 12.      Several vulnerabilities could amplify shocks in Korea

### Major identified sources of vulnerability
- Five sources: (i) high household leverage and housing market structure; (ii) corporate debt; (iii) liquidity risks including for FX; (iv) structural shifts towards digital finance and technology; and (v) longer-run risks from demographic transition on life insurers and real estate market.

### Adverse scenario and triggers
- Potential shocks stem from spillovers from trade tensions, a protracted global growth slowdown, and tightening of global financial conditions.
- FSAP quantitative risk assessment based on the October 2019 WEO forecast and an adverse scenario over a five-year horizon.
- Scenario narrative: assumed escalation of global trade tensions causing a broad-based, world-wide sell-off in equity markets, significant capital outflows, strong currency depreciation (Korea close to epicenter due to ties with China), marked widening of term and risk premia, material house price drops, exchange rate depreciation, and a severe recession with a deep downturn spanning over two full years before normalizing.
- The rapid rise in COVID-19 cases since February 2020 likely implies a significant, though hopefully only temporary, drag on economic activity; authorities proposed a KRW 11.7trn (0.6 percent of GDP) supplementary budget to mitigate the macroeconomic impact.
- FSAP team’s assessment: the adverse FSAP macro-financial scenario is severe enough to encapsulate a COVID-19 implied fallout on economic activity in both depth and duration.

### Household debt and housing market vulnerabilities
- Around 50 percent of household debt is linked to floating interest rates and structured as bullet payments.
- Over 30 percent of debt is held by households that have a debt service ratio above 40 percent (KOSTAT data).
- Household balance sheets have weakened since 2010 as leverage and debt service ratios have risen.
- Household balance sheets are vulnerable via both asset (real-estate investments) and liability (Jeonse deposits) channels to real-estate price fluctuations.
- Around one-quarter of the total stock of debt is held by households who are retired or close to retirement.
- A significant share of household debt is secured against a non-primary residence.
- House prices at the national level: price-to-income and price-to-rent measures do not suggest overvaluation, but model-based regional valuation points to some overvaluation in the Seoul market.
- Around 15 percent of total household debt is currently registered ‘at-risk’ and around 11 percent at solvency risk.
- Around 4 percent of household debt is held by households who are both at solvency risk (debt-to-asset ratio above 100) and liquidity constrained.
- Household stress tests: debt held with liquidity constrained insolvent households will rise following an adverse income (house price) shock from around 4 to 5.3 (6.6) percent of GDP.
- The impact of shocks on household balance sheets grows with age; retiree households are most at risk from a hike in interest rates.

### Jeonse (leasehold deposit) market specific risks
- Jeonse deposits average about 50-70 percent of the house value (“Jeonse price”) paid to landlords and repaid at the end of two-year contracts if not extended.
- Landlords rely on rising house prices and financial returns from investing Jeonse deposits instead of rental income; some use Jeonse deposits to finance the property.
- BoK study: 78 percent of landlords could cover the financing gap resulting from a 20 percent fall in the Jeonse deposit price with other financial assets while 22 percent would need additional loans.
- Policy vigilance needed on: (i) rollover risk of Jeonse contracts; (ii) potential claims on the state in case of wide-spread defaults and social pressure; and (iii) potential amplification of house price shocks through adverse conditions in the Jeonse market.
- Mitigation option: policy measures limiting the combined value of mortgage and Jeonse deposits.

### State backstops and contingent liabilities
- KHFC securitizes long-term mortgages; total MBSs issued and guaranteed by the KHFC amounts to KRW 116trn.
- KHFC offers guarantees on housing related loans and reverse mortgages to low-income pensioners.
- Contingent liabilities could amplify under an adverse scenario featuring a severe correction of house prices.
- General lack of transparency regarding the state’s total contingent liabilities related to the housing market makes it hard to determine whether current capital buffers are adequate.

### Heterogeneity, demographics, and household risk distribution
- Household balance sheet vulnerabilities have grown heterogeneously across age cohorts.
- Almost one-fifth of household debt is held by retirees.
- As households age, income volatility tends to rise while seniors experience a large fall in income.
- Figures indicate: younger cohorts saw fastest HH debt growth since 2011; net worth has risen greatest for younger households and fallen most for older households; around 50 percent of loans are structured as bullet payments and concentrated in older cohorts.

### Non-financial corporate sector vulnerabilities
- Non-financial corporate debt about 100 percent of GDP, higher than the G20 average; one quarter appears “at-risk,” mostly with SMEs.
- SMEs account for about 35 percent of total corporate debt and are largely funded by bank credit; larger firms’ debt concentrated in market-based instruments.
- Since the GFC, increases in firms reporting negative ROA, negative revenue growth, insufficient liquidity, and interest coverage ratio below 1.
- Corporates most vulnerable to a slowdown in global growth coupled with higher funding costs.
- A weaker exchange rate would have limited impact on corporate balance sheets given low FX debt and natural hedges.
- Balance sheet stress tests show a rise in corporate debt-at-risk under the adverse scenario, although total credit losses would likely remain contained reflecting large cash buffers.
- Statutory framework improvements: Seoul Bankruptcy Court established in 2017; challenges include delays in filing and difficulties securing post-commencement financing.
- Possible reform: establish an insolvency practitioner profession to prevent gridlock in a crisis.

### Fintech and payment system risks
- Payments innovation driven by large technology firms; authorities introduced an “open banking” system requiring commercial banks to open payment networks to fintech providers upon customer consent.
- Parallel initiatives to clarify and relax legal frameworks for electronic financial transactions and use of personal data.
- New risks: increasing interconnectedness and complexity, greater operational risk, negative impact on profitability of incumbent banks, higher market concentration in payment system, potential crowding out of innovative business models.
- Monitoring priorities: solvency, systemic liquidity, and system-wide operational risks; security and operational risks associated with greater data sharing and connectivity.

### Banking sector solvency and asset quality
- Banks’ aggregate capital ratio at about 16 percent of risk-weighted assets.
- NPL ratios are structurally low but must be interpreted cautiously because banks sell NPLs swiftly into a liquid market for distressed assets.
- Korean banks underperform regional peers in profitability.
- Nationwide banks’ asset exposures are diversified; regional banks and mutual savings banks’ exposures concentrated in SME lending; ODI’s lending concentrated in consumer credit.

*Sources: BoK, and IMF staff calculations/projections.*

### 26.      The banking system appears resilient under an adverse macro-financial scenario. The

### 26.      The banking system appears resilient under an adverse macro-financial scenario.

### Solvency stress test: methodology and headline results
- Top-down dynamic balance sheet solvency analysis with a five-year horizon for the Korean banking system using public and supervisory data for 24 banks, covering 95 percent of banking system assets at end-2018, with sub-aggregates for the ODI category (Credit Unions, MSBs, credit cooperative banks).
- A few regional, specialized banks and ODIs face the biggest capital losses (Figure 15).
- All banks’ capital ratios would stay above regulatory minima when allowing the consumption of the capital conservation buffer (CCB).
- CET1 ratios of nation-wide, regional, and specialized banks fall by 3.4, 3.4 and 4.7 percentage points up to the low point.
- Banking system-wide loss shares under the adverse scenario amount to:
  - corporates: 60 percent
  - households: 30 percent
  - sovereign: 2 percent
  - residual category: 8 percent
- The lower household loss share partly reflects mortgage insurance schemes that protect banks’ capital and provide relief in terms of risk weight densities.

### Profitability, structural pressures, and scenarios
- Pressure on bank profitability and capital ratios may grow as competition with Fintech intensifies and demographic rotation becomes firmer.
- A “Fintech Overlay” (Box 1) to the solvency analysis finds:
  - Regional banks, ODIs and selected specialized banks would be most adversely affected by intensifying competition due to “Open Banking” and e-money developments.
  - Regional banks’ capital ratios fall by 0.6 to 1.3 percentage points below the baseline under the overlay.
  - In the longer term, an aging population may require further adjustment of bank business models and possibly more consolidation as savings and lending patterns change.

### Fintech Overlay: rationale, parameters, and quantitative impacts
- Rationale:
  - Fintech and Open Banking imply rising competition for banks.
  - E-money providers may compete for commercial bank deposits enabled by de-regulation; mobile applications enable swift transfer of deposits/lending to most competitive providers, putting downward pressure on interest margins.
  - Banks with lower deposit rates and higher household deposit shares, and banks with higher loan interest rates and high household loan shares (the two largest specialized banks and most Mutual Savings Banks) would be affected the most.
- Overlay strength parameters and bounds:
  - Baseline overlay strength set to 50 percent.
  - Upper and lower bounds reflect strength set to 10 percent and 100 percent, respectively.
  - The “strength” parameter describes the assumed degree of competitive pressure; a strength parameter at 1 implies maximal impact in terms of upward (downward) pressure on retail deposit (loan interest) rates.
- Quantitative results:
  - Capital depletion under the adverse scenario may move from 2.9 percent of GDP when the overlay is off to 3.9 percent when the overlay strength is at 90 percent (Figure B, lower part).
- Liquidity risks from Fintech:
  - Open Banking and growing popularity of e-money service providers could raise liquidity risks via immediate customer reactions (an ‘electronic deposit run’) and re-depositing by e-money providers in few banks, leading to concentration risk.

### Banking sector liquidity framework and LST results
- Regulatory liquidity frameworks introduced and requirements:
  - Liquidity coverage ratios (LCR) introduced to levels of 100 percent for all currency and 80 percent for FX in 2019, together with a Net Stable Funding Ratio (NSFR) of 100 percent.
  - Most banks’ liquidity exceeded these regulatory requirements in 2019Q1.
- Funding structure and maturities:
  - Banks’ funding mix is diversified; FX funding structure more stable with short-term FX funding now mostly reflecting FX deposits by domestic corporates.
  - Retail deposits still account for most KRW funding.
  - NSFR funding structure appears more diversified with retail and SME deposits, corporates, other financial institutions and sovereigns being more balanced.
  - Maturities of assets and liabilities are generally well matched except some short-term maturity mismatch for regional banks and internet banks in KRW.
- Liquidity Stress Test (LST) design:
  - Used regulatory data from 2018Q4; included 18 domestic banks and foreign bank branches (KRW liquidity only).
  - Hurdle rate set to 100 percent.
  - LST considers ability to withstand net-cash outflows under even more severe crisis assumptions than the LCR’s.
- LST outcomes and vulnerabilities:
  - Asset price shocks consistent with the bank solvency stress test would have little effect on liquidity: liquidity coverage decreasing from 121 percent to 120 percent.
  - Retail funding shocks mainly affect KRW liquidity: average liquidity coverage of nationwide banks falling to 98 percent (implying only a marginal liquidity shortfall); FX liquidity coverage would remain above 100 percent.
  - Overall, the banking system is likely to maintain adequate liquidity following a wholesale funding shock.
  - State-owned banks’ reliance on unsecured wholesale funding would lead to a fall in FX liquidity coverage from 112 percent to 85 percent.
- Recommendations to strengthen liquidity monitoring and stress testing:
  - Improve bank LST for domestic currency and develop FX LST by major currencies.
  - Expand the methodology of the joint BoK and FSS FX liquidity stress test to include FX LCRs.
  - Add an NDF stress scenario in different types of stress tests.
  - Periodically survey resident NDF FX market participants for any potential macroprudential effects as global shifts take place in currency and interest rate markets.

### Insurance and pension fund sector snapshot
- Insurers:
  - Insurers are currently well capitalized but low interest rates are weighing on profitability.
  - Life insurance: return on assets stood at 0.3 percent in 2018.
  - Life insurers have extended asset durations (through foreign investments) and offer more ‘protection’ instead of savings products.
  - Profitability is low; growth prospects limited, triggering foreign expansion and cooperation with fintech providers.
  - Non-life companies have material exposure to long-term saving and protection business; median return on assets was 1.3 percent in 2018.
  - Profitability in non-life is impacted by underwriting losses, especially in health insurance where the government aims for lower cost of private coverage.

*Sources: Supervisory data from the FSS, publicly available data for banks (FISIS), Korean Ministry of Economy and Finances, and IMF staff calculations.*

### 32.      Under stress, insurers’ available capital declines substantially—still all companies stay

### 32.      Under stress, insurers’ available capital declines substantially—still all companies stay above regulatory thresholds

### Insurance solvency stress test: design and headline results
- FSAP conducted a top-down solvency ST for seven life and six non-life insurance firms covering about 75 percent of the market.
- Scenario narrative and severity were adopted from the banking solvency ST, with more emphasis on instantaneous market shocks.
- Under the current accounting regime held-to-maturity designation is still allowed—and widely used among life insurers—hence around 23 percent of the sample’s investments were shielded from market price changes.
- Median RBC coverage:
  - Life: declines from 239 to 169 percent.
  - Non-life: declines from 214 to 158 percent.
- Two life insurers and one non-life company fall slightly below the recommended level of 150 percent, though still well above the 100 percent regulatory threshold.
- The largest impact on available capital stems from shocks on equity prices and corporate bond yields.
- Assumption: no recovery after the instantaneous stress in financial markets.

### Impact on profitability and business-model implications for life insurers
- Recent trend: declining premium income pressured underwriting results of life companies, turning negative in 2018.
- Top-down ST model assumes no recovery of asset prices after the instantaneous shock.
- Net income before tax: would drop by 42 percent in the first year of the projection horizon, recovering afterwards.
- Policy/strategic implication: urgency for life companies to restructure business to increase underwriting profitability—shifting further from guaranteed savings products into lower guarantees and protection business.

### National Pension Service (NPS): medium- and long-term challenges
- NPS is still in an accumulation phase and expected to grow until 2041 when benefit payments would start exceeding contributions.
- Projection under unchanged parameters: the fund will be depleted by 2057.
- Options to cope with long-term sustainability concerns include:
  - Reducing benefits.
  - Increasing contribution rates.
  - Increasing the retirement age.
  - Broadening the membership (e.g., through an increase in female labor force participation).
  - Increasing targeted investment returns.
- Current portfolio and risk exposures:
  - NPS is still mostly invested in domestic assets (60 percent), but gradually expanding its overseas portfolio.
  - With increasing foreign investments, NPS is exposed to higher currency risk—currently largely unhedged—and will have to develop its risk management capacity accordingly.
  - Historical note: the KRW/USD exchange rate tended to co-vary negatively with foreign asset prices, especially in the long term.
- Recent performance: after a negative performance in 2018, NPS recorded an almost double-digit yield in the first three quarters of 2019 (2019 performance for the first nine months only).

### Interconnectedness and contagion: network and default-simulation findings
- Analysis uses a network approach based on on-balance sheet cross-exposures for 64 large financial institutions across financial sectors (banks, insurance, investment firms, and credit-specialized firms).
- Network visualization and default simulation follow Espinosa-Vega and Solé (2010); assumed LGD equal 100 percent in simulations.
- Key systemic linkages and vulnerabilities:
  - Specialized banks are about as systemic as nationwide banks.
  - Nationwide banks are net lenders to specialized banks and hence more vulnerable to specialized banks than vice versa.
  - Life and non-life insurance firms are not as systemic, but are vulnerable to stress in specialized banks and nationwide banks.
  - Insurers are net lenders to all other subsegments of the Korean financial system.
- The banks and insurance firms hardest hit on capital under the adverse solvency scenario are not tightly linked with the rest of the financial system; the spillover potential from such firms appears sufficiently contained at the current juncture.
- Caution: confidence effects can imply spillover effects beyond the direct financial linkages between firms.

### Macroprudential framework: strengths and recommended institutional reforms
- Korea has over a decade of experience with macroprudential policies and a rigorous process for risk monitoring.
- Existing toolkit includes:
  - A leverage limit on net derivative positions.
  - A macroprudential stability levy, or tax, on short-term FX exposures.
  - Prudential liquidity measures, including a foreign currency-denominated LCR and a minimum foreign currency-denominated liquid asset ratio (LAR).
- These measures differ in institutional coverage and transmission mechanisms but are viewed by authorities as mutually reinforcing.
- Remaining vulnerabilities and areas for improvement:
  - Household indebtedness is high; mortgage loans account for around a third of loans outstanding at domestic banks; leasehold deposit lending is around a tenth the size of domestic banks’ mortgage lending.
  - Borrower-based prudential limits (LTV and repayment-to-income ratios) are tight—“as low as 40 percent in speculation-prone metropolitan markets areas.”
  - Recommendation: implement a sectoral countercyclical buffer (SCCyB) targeting secured and unsecured household exposures to allow banks to build and release capital as sector risks wax and wane; implementation should follow appropriate review and international guidelines (Basel Committee on Banking Supervision (2019): “Guiding principles for the operationalization of a sectoral countercyclical buffer”).
- Institutional recommendations:
  - Priority should be given to macroprudential objectives by assigning the MEFM (or an empowered body) the task of ensuring financial stability as its sole primary objective—perhaps along with a limited number of secondary objectives.
  - Establish an interagency team (possibly at the BoK) to synthesize, prioritize, and direct regular risk assessments to the MEFM.
  - Develop a macroprudential policy strategy to ensure risks lead to policy action, effective implementation, monitoring, and review.
  - Revise communication strategy to improve transparency, accountability, and predictability of policy decisions; broaden stakeholders reached, clarify agency responsibilities, and link risk assessments to mitigating actions.
  - Establish a protocol to account for interactions between monetary and macroprudential policies and to ensure MPMs consider the BoK’s ability to fulfil its price and financial stability roles.

### Microprudential framework: assessment and suggested enhancements
- Oversight is broadly effective; FSC and FSS have regulatory and supervisory regimes broadly in line with international standards with only few remaining gaps.
- Operational considerations and gaps:
  - The rules-based system lacks a sufficiently forward-looking character, hampering supervisors’ ability to proactively address risk build-up.
  - Remit of financial conglomerates supervision covers only groups dominated by banking business, leaving significant nonbanking-related risks not fully covered.
  - Group-level supervisory approaches lack consistent application across financial holding groups.
  - Non-existence of a modern resolution and recovery framework increases costs for handling financial stress in complex groups and implies significant fiscal risks.
  - Prudential and supervisory regime should evolve to emphasize risk management capabilities in firms, target on-site examinations at key risks, and strengthen the judgmental component of assessments.

*Source: IMF staff calculations and analysis based on FSS, company, and NPS data contained in the referenced chapter.*

### 49.      Given the plans of   large Korean financial institutions to continue overseas expansion,

### 1korea2020001 - 49.      Given the plans of   large Korean financial institutions to continue overseas expansion,

### Cross-border supervisory cooperation
- Large Korean financial institutions plan continued overseas expansion; cross-border supervisory activities would benefit from enhanced cooperation.
- The FSC/FSS perform examinations of foreign branches and subsidiaries of banks and insurers and organize visiting programs and conferences for foreign supervisors.
- Recommendations:
  - Closer and intensified monitoring of overseas expansion.
  - Closer cooperation with host authorities at the working level.
  - Setting up supervisory colleges is warranted.

### Climate risk and green finance
- Awareness of climate risk is rising.
- First ESG foreign currency bonds were issued in 2013 and Korea has reportedly become a large supplier of such bonds.
- Banks and financial groups have subscribed to the ESG principles and founded the Sustainable Climate Finance Forum in Korea.
- The BoK joined the Network for Greening the Financial System (NFGS) in 2019; other authorities are considering membership.
- The FSC/FSS focused on climate risk in its latest survey of the banking system; the BoK included climate risk in its estimates of potential losses.
- Recommendation: Korea would benefit from a comprehensive action plan and interagency coordination on climate risk to assess climate or green finance trends, disclosure aspects, stress testing, and climate-related capital market reforms.

### Banking supervision: strengths and gaps
- Korea has a solid, rules-based regulatory and supervisory regime largely in line with international standards.
- Credit risk management is a key focus for bank supervisors; offsite monitoring of banks’ credit risks is adequately robust, including verification of provisioning levels.
- Capital requirements are in place at the holding company level; liquidity requirements currently apply only at banks and other financial subsidiaries — identified as an important gap given the growth of non-banking activities in DSIB banking groups.
- In some areas (e.g., concentration and large exposure restrictions) authorities are piloting thresholds but are still considering the best approach for the Korean banking system.
- Approaches like Pillar 2 or an Own Risk and Solvency Assessment (ORSA) are not fully adopted in supervisory practice. The tools used by supervisors tend not to have a preemptive effect and only provide ex-post follow up on identified risks and shortcomings. 22 23
- The rules-based approach may hamper the FSS’ ability to proactively address new and emerging risks; supervisors should identify behaviors not directly constrained by regulation and require effective internal practices to incorporate such behaviors into capital and liquidity assessments.
- The FSC/FSS should consider greater use of forward-looking 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 less than adequate but no violation has occurred. 24
- Recommendation: Greater emphasis on in-depth qualitative assessments of group-wide practices (Credit Risk Management, ICAAP, ILAAP, recovery planning); supervisors need authority to set meaningful group-wide requirements and expectations/guidelines.
- The FSS has implemented ICAAP requirements for capital planning and stress testing requirements for liquidity risk management, but reviews could be strengthened and forward-looking measures better integrated into rating frameworks and supervisory outcomes, especially for DSIBs at the consolidated group level.
- Evaluations of banks’ internal capital assessments can promote bank resilience and feed into Pillar 2 assessments framed by a formal annual supervisory review process for large banks.

### Prudential approach to specific institutions
- The prudential and/or supervisory approach for state-owned banks, mutual savings banks and ODIs is a concern: the FSS’s ability to act promptly and even-handedly is limited by lack of competent jurisdiction and/or delegation.
- Pursuing economic and social goals via commercially oriented financial institutions erodes system soundness, builds contingent liabilities for the public balance sheet, and sends mixed signals.

### Insurance sector reforms
- Implementation of the new K-ICS and IFRS 17 are important reforms.
- The FSS has run two quantitative impact studies on the new fully risk-based solvency regime, the K-ICS to be introduced in 2022 together with the valuation of insurance liabilities based on IFRS.
- Public debate has focused on perceived capital shortfalls; there is a clear need for structural adjustments in the life insurance sector.
- Recommendation: FSS should assess long-term viability of business models and, for companies with weak solvency and low profitability, the need for capital injections.
- High-guarantee legacy business could be addressed by evaluating the legal basis for portfolio transfers, run-offs, and conversion offers.
- Rising longevity risk should be addressed with prudent calibration of capital charges.

### Securities and capital markets risks
- Korea has a functioning securities markets regulatory and supervisory structure, broadly aligned with international standards.
- Deregulation and liberalization efforts since the last FSAP are maturing; securities market oversight faces new challenges:
  - Private funds market registration has increased; alternative investments including real estate are on the rise.
  - Rise in new investment firms, particularly hedge funds in Korea.
  - Korean savings channeling via securities/capital markets to cross-border locations and asset classes.
- Current processes to monitor systemic risk could be enhanced to fully account for data gaps and new risks from the nonbanking sector.
- Instances of mis-selling and misconduct have begun to rise, amplifying an underdeveloped consumer and investor protection framework and potentially impacting market confidence if severe redemption and liquidity pressures in funds and asset management are not recognized.
- Recommendations:
  - Fully implement key IOSCO Money Market Funds (MMF) recommendations.
  - Conduct stronger surveillance of capital market and nonbank risks with a more regular inspection program.
  - Develop a systemic risk framework that incorporates the securities sector and includes stress tests on the asset management industry, particularly for MMF funds.
  - Accelerate implementation of reforms to address risks of accounting and audit fraud.

### Supervision of financial conglomerates
- Supervision lacks a legal mandate to regulate financial conglomerates without a straightforward holding structure.
- By law the FSC/FSS supervise groups with a clearly defined head—a financial holding company. Other financial groups, some systematically important, are not regulated on a group level, preventing assessment and regulation of risks from nonfinancial parts and comprehensive supervision of their financial institutions.
- Recommendation: Authorities must be mandated to reach a wider group with information requests; develop a prudential framework for “non-holding financial groups” and expand the FSC/FSS mandate.
- Information disclosure of group ownership structure should be upgraded.
- Group structures that do not impede effective supervision, recovery and resolution should be required.
- Supervisory authorities should have discretionary powers when designating heads of financial conglomerates to ensure potentially systemic groups are under regulatory purview.
- As an integrated supervisor, the FSC/FSS is well positioned to carry out strong group-wide supervision but currently organizes supervision around legal entities with a relatively small “group-level” team.
- Given systemic importance and growth driven by non-bank activities, authorities need to develop and implement more group-wide supervision practices, including multilayer analyses of conglomerate maps capturing relationships between group structure, capital quality, and risk dynamics, including crisis cases.

### AML/CFT assessment
- Korea’s AML/CFT regime is being assessed by the Financial Action Task Force and Asia/Pacific Group (APG) on Money Laundering.
- The onsite assessment took place in June/July 2019; the draft report was adopted by the FATF plenary in February 2020 and is scheduled for adoption by the APG plenary in July 2020.

### Crisis management, resolution, safety nets, and financial integrity
- Korea has a well-established financial safety net: a special resolution regime, an ELA facility at the central bank, a deposit insurance system, a policy-holder protection scheme for insurance products, and an investor protection scheme for household holdings in investment and trust funds.
- Several legacy funds established during past crises exist and their continued existence should be reassessed given potentially distortionary and moral hazard effects.
- The resolution regime contains many Key Attributes elements; ASIFI provides a special resolution regime including transfer powers and bridge institution powers.
- Since the 2013 FSAP, operational arrangements were strengthened (crisis manuals and simulation exercises). Planned amendments to ASIFI would introduce a power to impose a temporary stay on early termination rights and formalize requirements for recovery and resolution plans (RRPs).
- Recommendation: Consider additional legal amendments to introduce statutory bail-in powers and ensure resolution can be triggered sufficiently early and well before insolvency.
- Key challenges:
  - Preparing to deal with failure of a financial group and ensuring orderly resolution of D-SIBs without public solvency support.
  - RRP exercises should incorporate intra-group dimensions; resolution strategies for D-SIBs are critical to deliver financial stability objectives without public bail-outs. 25
  - Need to enhance mechanisms for providing liquidity in resolution: under current arrangements, all funding for firms in resolution is met from the deposit insurance fund, which may be unsustainable for D-SIB resolution.
  - The BoK should be able to provide liquidity, subject to safeguards, to an institution whose current solvency may be in doubt but which is considered systemic and viable in the context of a realistic, time-bound resolution plan. Resolution and/or supervisory authority should make a positive determination of viability; central bank then decides on liquidity provision, backed by an indemnity from the government.
- Deposit Insurance Fund (DIF) replenishment:
  - KDIC succeeded in turning the DIF into a positive balance of KRW 500 billion in late 2017, and KRW 2.5 trillion at end-2018. 26

### Domestic crisis cooperation and cross-border considerations
- Domestic cooperation in crisis management relies on existing statutory arrangements; roles of MOEF, BoK, FSC, FSS, and KDIC are clear in respective statutes.
- Cooperation is facilitated informally through the MEFM, responsible for coordinating assessments of systemic risks and financial policy interventions.
- Recommendation: Formalize arrangements via an apex group separate from the MEFM or a new MEFM crisis management subgroup (coordination function only, decision making remaining with member agencies) that would include KDIC to anchor interagency coordination on crisis preparedness and management and oversee crisis simulation exercises.
- Recovery and resolution framework should be applied to domestic systematically important groups; complexity of financial conglomerates should be reflected in framework application.
- Little thought has been given to managing failure of cross-border firms despite increasing overseas activity of Korean banks and significant share of foreign banks in the Korean system.

### Appendix I — Selected risks (Risk Assessment Matrix)
- Sharp rise in risk premia: Overall Level of Concern — High; Relative Likelihood — Medium; Expected Impact — Less favorable borrowing conditions could weigh on private and public balance sheets, valuation losses on financial institutions’ assets, reduced value of collateral, negative impact on FX liquidity.
- Rising protectionism and retreat from multilateralism: Overall Level of Concern — High; Relative Likelihood — High; Expected Impact — Weaken Korea export growth, trigger capital outflows and depreciation pressures, higher equity volatility.
- Weaker-than-expected global growth: Overall Level of Concern — High; Relative Likelihood — High; Expected Impact — Significant vulnerability due to China slowdown; financial contagion risk as Korean assets and the Won are used as “proxy trades” for Chinese and other smaller regional asset markets.
- Surge in external competitive pressures: Overall Level of Concern — Medium; Relative Likelihood — High; Expected Impact — Pressure on major Korean nonfinancial corporates, spillovers via corporate investment networks, rising unemployment.
- Sharp domestic house price correction: Overall Level of Concern — Medium; Relative Likelihood — High; Expected Impact — Deteriorating asset quality related to mortgage lending and real estate financing, contagion to markets that fund mortgage lending, increase in government contingent liabilities through mortgage insurance claims.

### Key recommendations and implementation status (selected)
- Establish a dedicated and formal macroprudential council, with a stronger role for the BOK and the power to recommend regulatory action — Status: PD.
- Strengthen independence of the FSC and FSS and increase transparency of decision-making allocation — Status: PD.
- Enhance enforcement effectiveness by broadening administrative and civil penalties — Status: PD (eleven laws amended; higher levies went into effect on 19 October 2017).
- Enhance coordination among agencies involved in stress testing (FSS and BOK) — Status: D (working group set up in 2015; regular meetings).
- FSS should carry out comprehensive validation of banks’ stress testing exercise — Status: D (internal assessment conducted regularly).
- Disclose to the public results of stress tests conducted by the authorities — Status: D (BOK conducts macro stress tests regularly and publishes results in its Financial Stability Report).

*IMF — Republic of Korea Financial Sector Assessment (excerpts)*

### Appendix I

### 1korea2020001 - Appendix I

### Implementation of 2013 FSAP Recommendations
- Key recommendations status legend: D—Done / LD—Largely Done / PD—Partly Done / NA—No Action.
- Empower supervisors to set capital ratios above the Basel II minimum, implement all principles of Pillar-2 of Basel II, and extend calculation of Basel II capital to group holding companies.
  - Status: PD
  - Since the 2013 FSAP the FSC has implemented regulations for Basel II capital requirements at the FHC level.
  - Pillar 2 principles have been included in FHC regulations since 2016.
  - The supervision process for Pillar 2/ICAAP at FHCs is still a work in progress. The FSC can request banks and FHCs to hold capital above regulatory minima based on weaknesses in risk management and ICAAP.
- Apply regulatory framework consistent with that for banks to all NBDIs, with larger entities also subjected to stricter supervision.
  - Status: PD
  - Prudential regulatory standards for Mutual Savings Banks (MSB) and Mutual Credit Cooperatives (MCC) have been strengthened in the areas of asset classification standards and provisioning standards.
  - Standards in these two key areas for banks, MBSs and MCCs are now equivalent.
- Implement a risk-based approach to AML/CFT supervision and expand supervisory activities to all deposit-taking institutions, and the designated non-financial businesses and professions.
  - Status: PD
  - Update will be provided to the Board on progress made and the findings of the ongoing FATF mutual evaluation.
- Ensure sufficiently comprehensive audit oversight and introduce minimum standards for appointing external auditors of banks over and above existing requirements, reflecting expectations of experience and expertise.
  - Status: LD
  - The Act on External Audit of Stock Companies was amended in October 2017 to reinforce appointment of external audit standards for financial institutions to make them equivalent to listed companies.
  - Requirements include evaluation standards for the independence and expertise of external auditors.
  - Publicly traded financial institutions must appoint a qualified external auditor approved by the FSC.
- Enhance risk-sensitivity of supervision via more flexible and frequent examinations that also provide enough coverage of the smaller supervised entities and enhancement to the judgmental component of the assessments.
  - Status: PD
  - For banking supervision, the FSS has moved to include greater use of thematic/targeted reviews in its supervision process.
  - Determination of reviews and firms comes out of a risk-focusing process.
  - Supervision broadly continues to be largely based on assessments of compliance with rules and regulations, rather than a more principles-based approach; supervisory ratings include significant qualitative elements requiring subjective judgments.

### Crisis Preparedness and Crisis Management Framework
- Establish a dedicated apex committee for leading and coordinating crisis preparedness and management work; undertake periodic crisis simulation exercises.
  - Status: PD
  - As part of the introduction of RRP, the authorities plan to establish an RRP Assessment Committee to act as a focal point for coordination of resolution planning among authorities; its broader coordination role for contingency planning is still to be defined.
- Replenish the deficit in deposit insurance fund; assure KDIC back-up funding.
  - Status: LD
  - The DIF has been returned to surplus though there are still sizeable deficits in some accounts (e.g. for MSBs).
  - Arrangements for back-up funding for DIF remain loose.
- Address potential moral hazard risks by enhancing banks’ risk management; and ensuring that government support is not assured or open-ended.
  - Status: PD
  - The legal power to bridge banks in resolution at holding level in principle could be used to affect a bail-in and avoid public solvency support but this is not currently feasible or credible given the lack of gone concern loss absorbency requirements.

### Systemic Liquidity Management and Financial Market Infrastructures (FMIs)
- BOK to ensure that its crisis management contingency plan adequately covers ELA-related decisions.
  - A contingency plan has been developed for ELA but it needs to be more closely integrated with the approach to funding in resolution.
- Put in place a Memorandum of Understanding to ensure effective coordination between BOK and FSC in FMI matters, and provide BOK with more enforcement tools.
  - Status: LD
  - Information-sharing arrangements for FMIs exist between BOK and FSS but enforcement powers for BOK have not been strengthened.
- Reform the credit risk and management framework for the securities market and increase the number of KRX staff managing company-wide and CCP-related matters.
  - Status: PD
  - An exchange margin scheme to address price volatility has been adopted.
  - Calculation method for margin assessment ratio restructured with conditions on qualified collateral and collateral concentration limit.
  - The cap for Joint Compensation Fund (JCF) has been repealed with the amount set based on the risk exposure calculated by stress test.
  - Additional intraday margins on clearing members are imposed when necessary to reduce settlement risks.
  - A scheme to manage credit risks levies additional margins for credit risk if net risk margin exceeds credit risk limit (three times the net capital) of each member.
  - The Risk Management Committee for Clearing and Settlement was expanded and restructured to the Deliberation Committee to increase independence.
  - A Working-level Committee for CCP Risk Management was formed to strengthen CCP risk management.

### Banking Sector: Solvency Stress Test — Institutional Perimeter, Horizon and Main Data Inputs
- Institutions in-scope:
  - 24 banks in total. Composed of 19 banks and five groups of aggregate ("consolidated") banks: four nation-wide commercial banks, two foreign subsidiaries, two internet-only banks, six regional banks, five specialized ("policy") banks.
  - Five groups of aggregate ("consolidated") banks: Credit Unions (929 underlying entities), Mutual Savings Banks (79 entities), Agricultural Cooperative Banks (1,122), Fisheries Cooperative Banks (90), Forestry Cooperative Banks (137).
- Banking system coverage:
  - About 95 percent of the banking system as of 2018Q4 in terms of total assets, with “banking system” being defined as all institutions listed above plus Community Credit Cooperatives (5 percent). The latter are excluded due to insufficient data availability.
  - Note: coverage as described here would amount to 89 percent of total banking system assets when foreign bank branches were part of the aggregate banking system.
  - “Banking system” excludes foreign bank branches for what concerns the solvency stress test scope.
- Cut-off date and scenario horizon:
  - Cut-off date 2018Q4.
  - Scenario horizon five years. Banks’ solvency position will be reported as of their “low-point” along the scenario horizon.
- Scope of banks' operations:
  - Emphasis on banks’ domestic, Korean exposures; as of 2018Q4 the bank sample’s foreign exposures in terms of loans and security holdings outside Korea amounted to 5.4 percent.
- Main data sources:
  - Regular supervisory reporting + ad-hoc data request to all banks + public data sources (e.g., Bloomberg, public disclosures of banks through annual and financial reports, etc.)

### Banking Sector: Solvency Stress Test — Methodology and Assumptions
- Credit risk – accounting:
  - Compatible with K-IFRS 1109 (Korean version of IFRS 9).
  - Satellite models for PDs employing a “hybrid” methodology that combines scenario-conditional PD forecasts with a Z-factor methodology to project bank-portfolio-specific transition flow matrices.
  - Structural LGD model for real estate collateralized portfolios.
- Credit risk - regulatory risk weight treatment:
  - Risk weights for STA portfolios constant.
  - Risk weights for IRB portfolios conditional on scenarios through link to point-in-time default rates consistent with weighted average of two (S1 and S2's) default rates from the transition matrices.
  - Smoothing factor to be employed for that link to reflect a through-the-cycle rationale of regulatory risk parameters (modeled through Basel risk weight formulas).
- Credit risk – provisioning:
  - Both regulatory provisioning rules as well as accounting provisioning principles to be employed in parallel (results will be presented separately and in conjunction).
- Interest rate risk:
  - Wholesale funding stress consistent with scenario.
  - Pass-through to asset side captured through cross-bank portfolio-specific panel models.
  - Model suite considered: net interest margin-based, vs. individual models on interest income and expense rates separately.
- Feedbacks:
  - Feedback from interest rate risk to credit risk accounted for through incorporation of interest rates in the Z-factor models; interest income is a function of credit risk (only performing loans generate interest income by assumption).
  - Feedback from banks' solvency to funding conditions accounted for by incorporation of banks' capital adequacy metrics in funding cost satellite models (lagged at quarterly frequency).
- Market risk (other than interest rate risk):
  - Trading book equity positions revalued in line with equity market price trajectories in scenario.
  - Bond holdings in the trading book revalued in line with maturity-corresponding bond yield (and implied price) paths from the scenario.
- Other P&L:
  - Satellite models for net fee and commission income.
- Balance sheet dynamics:
  - Two cases: static balance sheet vs. dynamic balance sheet.
  - Under dynamic balance sheet scenario, corporate and retail loan book may grow at different rates; write-offs and asset sales will be allowed and optionally dis-allowed.
  - Asset sales are important and sizable for Korean banks given their continuous NPL selling to the NPL market.
- Tax assumptions:
  - Statutory tax rates.
- Dividend payout assumptions:
  - Dividend payout ratios kept constant at their ratios as observed at the bank-level at end-2018.
  - Net income after tax turning negative implies zero dividends by assumption.
- Capital ratio thresholds:
  - Basel III min capital requirements for CET1 and total capital (T1+T2) ratios including CCB, and incl. capital surcharge for D-SIBs of 1 percent (Kookmin Bank, Shinhan, KEB Hana, Woori, Jeju Bank, NongHyup Bank).
  - For D-SIBs, the CET1/RWA and total capital/RWA thresholds stand at 5.5 and 9 percent; for non-D-SIBs other than ODIs, they are 4.5 and 8 percent, all inclusive of the 2.5 percent CCB.
  - Mutual Savings Banks subject to total capital ratio threshold only.
  - All other mutual credit cooperatives (credit unions and cooperatives) subject to risk-unweighted net worth ratio constraint at their respective minima as stipulated through regulation.
  - CCB allowed to be depleted under adverse scenario.

### Banking Sector: Solvency Stress Test — Macrofinancial Scenario
- Adverse scenario narrative:
  - Developed along G-RAM and Korea-specific structural features and vulnerabilities.
  - Sudden spread of trade protectionism; material drop in activity in China; material drop in Korea's exports; broad-based world-wide sell-off in equity markets reflecting general fall in investors' risk appetite; significant capital outflows from Korea coupled with strong depreciation of its currency; potential defaults of export-oriented and FX-indebted non-financial firm conglomerates; cascade effects through Korea's strongly interconnected supply chain; rising unemployment rate; depressed confidence and drag on consumption and investment; spillover to housing and mortgage market through less demand and rising unemployment.
- Number of scenarios:
  - Two scenarios: One baseline (WEO) and one adverse scenario.
- Quantification / methodology:
  - Regime-switching structural VAR model based on Korean data (1990Q1-2018Q4), to simulate structurally identified external demand shock (sign constraints).
  - Conditional on recession regime identified by the model to capture dependencies across macro-financial variables as observed in crisis/recession times.
  - Shock scenario profile scaled such that 1-year ahead real GDP fall matches 5 percent GaR.
- Macro-financial feedback effects:
  - Accounted for by allowing macro-financial feedback at the scenario generation stage in the regime-switching SVAR (banking system credit endogenous, two-way feedback with GDP and other variables).
- Scenario variables:
  - Real GDP, nominal GDP, unemployment rate, CPI inflation, CPI core inflation, residential property prices, commercial property prices, equity prices, USD-KRW exchange rate, long-term interest rate (benchmark sovereign bond yield), short-term money market interest rate, MSCI World Equity Index, gross banking system credit, corporate bond spread, real and nominal GDP components.
- Sensitivity analysis:
  - Sensitivity analysis to be conducted with respect to house prices.

### Banking Sector: Liquidity Test — Institutional Perimeter and Coverage
- Institutional perimeter / Banking system coverage:
  - 18 banks are included: six nation-wide commercial banks, two internet-only banks (KRW only), six regional banks, and four specialized ("policy") banks. In addition, foreign bank branches are included (KRW only).
- Market share:
  - About 90 percent of the banking system as of 2018Q4 in terms of total assets, with 'banking system' defined as the institutions listed above.
- Cut-off date:
  - Cut-off date 2018Q4.

### Banking Sector: Liquidity Test — Methodology and Scenarios
- Methodology:
  - Assesses banks’ ability to use counterbalancing capacity to withstand net cash outflows, accounting for contractual and behavioral flows.
  - Asset price haircuts based on the macrofinancial scenario used for the solvency stress test.
  - Retail and wholesale funding run-off rates consider Korean specific liquidity factors and are calibrated conservatively.
  - Capital shortfalls measured as percentage of counterbalancing capacity.
- Stress test horizon:
  - The stress test horizon is 30 days. The funding gap calculations use horizons of between 1 month and 10 years.
- Scenario analysis:
  - Four scenarios: (i) asset price falls, (ii) a run on retail deposits, with higher run-off rates for retail deposits, (iii) a run on wholesale funding, with higher run-off rates for corporate deposits and other wholesale funding, and (iv) an “extreme” scenario with combination of runs on retail deposits and wholesale funding (scenario ii and iii).
  - For the cash-flow analysis, a series of scenarios consistent with the solvency stress test and the adverse macro-financial scenario are considered, with a range from mild to severe liquidity conditions.
  - Capital shortfalls are calculated for twenty different gradually more severe scenarios, where the least severe assume the run-off rates used in LCR calculations and the most severe assumes the run-off rates in the “extreme” scenario (iv).
- Buffer assumptions:
  - Funding liquidity risk reflected in funding run-off rates and asset roll-over rates.
  - Market liquidity risk reflected in asset haircuts.
- Other behavioral assumptions:
  - Liquidity from the central bank’s emergency lending assistance (ELA) is not considered.
- Regulatory and market-based standards and parameters:
  - An LCR above 100 percent or a non-negative cash balance for the cash-flow analysis is required to pass.
- Reporting format for results:
  - Output presentation for all currency, KRW and FX, includes changes in the system-wide liquidity position, distribution of banks’ and bank categories liquidity positions, and amount of liquidity shortfalls.

### Insurance Sector: Solvency Risk (Top-Down by IMF)
- Institutional perimeter:
  - Institutions included: Seven life insurers, and six non-life insurers.
  - Market share: Life: 73 percent (balance sheet assets); Non-life: 76 percent (balance sheet assets).
  - Data: Regulatory reporting.
  - Reference date: December 31, 2018.
- Channels of risk propagation:
  - Investment assets: market value changes of available-for-sale securities after price shocks, increase in the default rate for corporate and mortgage loan exposures.
  - Insurance liabilities: unaffected by change in interest rates as discount rates are based on historic cost accounting.
  - Sensitivity analysis: effect on available capital and solvency position.
  - Time horizon: Instantaneous shock.
- Tail shocks — Adverse scenario:
  - Short-term KRW sovereign bond yield -20 basis points, long-term KRW sovereign bond yield +250 basis points;
  - Stock prices -39.0 percent (Korea), -35.0 percent (other advanced economies), mutual funds -12.5 percent;
  - Korean corporate bond spreads between +120 basis points (AAA) and +400 basis points (BB and lower), foreign corporate bond spreads between +70 basis points (AAA) and +300 basis points (BB and lower);
  - Haircut on unsecured loans -1.5 percent, haircut on sub-standard loans -30 percent;
  - 37 percent appreciation of KRW against USD.
- Sensitivity analysis:
  - Variations of short- and long-term sovereign bond yields.
- Risks and buffers:
  - Risks/factors assessed: Market risks — interest rates, share prices, property prices, credit spreads.
  - Summation of risks, no diversification effects.
  - Buffers: Accounting designation (23 percent of assets in the general account held to maturity).
  - Behavioral adjustments: None.
- Regulatory standards and parameters:
  - Regulatory/accounting standards: Korean Risk-Based Capital (RBC); National GAAP.
- Reporting format for results:
  - Impact on solvency ratios.
  - Contribution of individual shocks.
  - Dispersion measures of solvency ratios and net income.

*Source: 1korea2020001 - Appendix I*

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_Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1korea2020001.pdf_