## 1korea2020004

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### Executive summary — main findings and vulnerabilities
- Past crises place systemic risk oversight at the core of Korea’s approach; authorities have:
  - amassed over a decade of experience with macroprudential policies;
  - put in place rigorous and sophisticated processes for risk monitoring;
  - published first-rate analysis;
  - actively developed measures to mitigate risks—notably from FX exposures, and from household indebtedness—as circumstances have changed.
- The system is highly complex, posing challenges for coordination, communication, and transparency; the macroprudential toolkit needs extension.
- Elevated household indebtedness is highlighted as a medium-term vulnerability; banks, including internet-only banks, and other depository institutions are heavily exposed to households.

### Institutional framework, mandates, and decision-making
- Macroprudential responsibility is shared across agencies:
  - Financial Services Commission (FSC): formal power to deploy macroprudential tools; broad regulatory macroprudential powers including designation of D-SIBs, setting loan standards for residential mortgages, and capital standards.
  - Financial Supervisory Service (FSS): on-going supervision and implementation/enforcement.
  - Bank of Korea (BOK): independent central bank responsible for price stability, financial stability, and emergency liquidity assistance; analytical capacity with a Financial Stability Department of around 100 staff under a Deputy Governor.
  - Ministry of Economy and Finance (MOEF): overall authority over foreign exchange policy and the ESF.
- Macroeconomic and Finance Meeting (MEFM):
  - Deputy-level body chaired by the First Vice Minister of Finance; convenes First Vice Minister of Finance, Vice Chairperson of the FSC, Senior Deputy Governor of the BOK, first senior Deputy Governor of the FSS, and President of the KDIC; secretariat in MOEF.
  - Established by Presidential Decree and set to run until 2020 under the most recent decree.
  - MEFM lacks formal statutory powers but effectively decides many macroprudential actions in practice.
- Governance concerns:
  - No single agency has financial stability as its sole primary objective; overlap of mandates may obscure ultimate responsibility and accountability.
  - Rapid turnover of FSC Chairmen since March 2013 (four Chairmen: Shin Je-Yoon (2013-15), Yim Jong-yong (2015-17), Choi Jongku (2017-19), Eun Sung-soo (2019-present)) noted as enabling government influence over leadership.

### Coordination between macroprudential and monetary policy
- Inter-agency cooperation is mostly good; working groups exist on household indebtedness, real estate, and credit union policy.
- BOK has responsibility for price and financial stability but no direct macroprudential powers; the system lacks direct means to resolve tensions between the Bank’s objectives via recourse to macroprudential measures.
- Monetary policy assessment:
  - Overall effect of monetary policy on crisis likelihood considered small; credit growth and asset price spirals respond little to interest rates.
  - Using monetary policy alone to address systemic vulnerabilities is generally costly and may damage central bank credibility.

### Systemic risk monitoring: models, data, and gaps
- Early warning systems and models in use:
  - BOK publishes a ‘financial stability index’ (FSI) with calibrated ‘warning’ and ‘crisis’ thresholds.
  - FSS has an early warning system for supervised institutions providing quarterly model-based assessments of capital shortfall likelihood.
  - FSC operates a monthly early warning system based on Kaminsky et al. (1998).
  - MOEF operates an early warning system for key external variables including the exchange rate and portfolio flows.
  - BOK implements CoVaR and SRISK approaches; conducts a biannual Systemic Risk Survey covering close to one hundred respondents.
- Stress testing:
  - BOK and FSS conduct annual joint stress tests; a suite of models includes the Systemic Risk Assessment Model for Macroprudential Policy (2012), Non-bank Financial Institution Stress Test Model (2019), Extensive Stress Test Model (2019), and FSS’s STARS (2017).
- Data strengths and gaps:
  - Licensed public credit registry Korea Credit Information Service (KCIS) exists under the Credit Information Use and Protection Act (2008).
  - Gaps: non-financial corporate exposures; FinTech/P2P lending information was limited until legislation passed in October 2019 requiring P2P platforms to disclose more and submit information to a credit agency.

### Key policy tools, gaps, and recommendations (summary)
- Authorities have emphasized borrower-based measures (LTV, DTI, DSTI/DSR) to limit household debt risks; used in concert they improve household resilience but may suffer diminishing effectiveness.
- CCyB framework:
  - Korea has implemented the CCyB framework but has yet to raise it above zero; Korea’s CCyB is currently set to zero.
  - CCyB decision process uses multiple indicators with the credit-to-GDP gap as the main indicator and five ancillary indicators (household debt-to-disposable income gap; house prices-to-GDP gap; direct financing-to-M2 gap; short term external debt-to-foreign exchange reserves gap; total credit gap). Measures of the ‘gap’ are constructed using a Hodrick-Prescott filter (Source: FSS).
- Sectoral Countercyclical Buffer (SCCyB):
  - Recommendation to introduce an SCCyB targeting household exposures as soon as is practical; proposed to cover all secured and unsecured household exposures (alternative: target real estate exposures to households and leasing businesses).
  - SCCyB benefits: allow banks to build/release capital as household risks wax and wane; provide releasable buffer; help mute pro-cyclicality in bank lending.
- Other broad-based tools recommended:
  - Consider an unweighted leverage ratio as a back-up to risk-weighted capital ratios.
  - Use forward-looking provisioning (IFRS9 implemented in 2018).
- Recommendations on CCyB design and governance:
  - Review quantitative guides used in deciding the CCyB to ensure indicators signal crises with at least one year lead-time and cover macro risk, credit risk, funding risk, and FX risk.
  - Publish core CCyB indicators and the considerations behind CCyB decisions.
  - Set a CCyB strategy with a quarterly review cycle; integrate CCyB and SCCyB decisions.
- Coordination and institutional recommendations (Table 1 highlights):
  - Recommendation 1: The MEFM (or an equivalent empowered body) should be assigned macroprudential oversight as its sole primary objective. Timing: ST. Priority: H.
  - Recommendation 2: Undertake a thorough review of the financial stability communication strategy to improve transparency. Timing: ST. Priority: M.
  - Recommendation 3: Establish an interagency team to synthesize, prioritize, and direct regular assessments to the MEFM. Timing: ST. Priority: H.
  - Recommendation 4: Strengthen formal mechanisms for coordination between monetary and macroprudential policies. Timing: ST. Priority: H.
  - Recommendation 5: Stock-take interactions between microprudential, macroprudential, fiscal, and regulatory measures. Timing: ST. Priority: M.
  - Recommendation 6: Review quantitative guides used for CCyB decisions. Timing: ST. Priority: H.
  - Recommendation 7: Introduce the SCCyB for household exposures as soon as practical. Timing: ST. Priority: H.
  - Recommendation 8: Introduce a framework to assess structural risks and develop mitigating measures. Timing: MT. Priority: M.
  - Recommendation 9: Develop an over-arching macroprudential strategy. Timing: ST. Priority: M.

### Communication, transparency, and accountability
- Multiple channels send financial stability messages:
  - BOK: biannual Financial Stability Report (FSR); June 2019 FSR was 138 pages (Korean) and 150 pages (English).
  - MPB: publishes minutes of quarterly Financial Stability Meetings.
  - MOEF: publishes summaries of MEFM meetings at least quarterly and announces FX regulation decisions.
  - FSC: announces macroprudential decisions via press releases; FSC commissioners’ minutes cover a broad range of topics.
- Issues:
  - Proliferation of forums complicates understanding and accountability; MEFM’s role is not well known externally.
  - Messages tend to be highly technical and expert-targeted; example: 79 media stories followed the June 2019 FSR.
  - Despite authorities’ messaging that household debt was unlikely to cause systemic risk, household debt consistently ranked high in the BOK’s Systemic Risk Survey (combined housing risk response frequency was 70 percent; US-China trade disputes 67 percent; slowing domestic economic growth 66 percent).
- Communication recommendations:
  - Review the financial stability communication strategy: identify stakeholders, choose channels, design comprehensible layered messaging, and clearly delineate agency responsibilities.
  - Link risk assessments to mitigating policy actions; disclose measures in force, targeted risks, and progress toward mitigation.
  - Consider revising disclosure practices for meetings (neither full minute disclosure nor total withholding is necessarily desirable).
  - Increase availability of English translations beyond the FSR.

### Household, housing, and borrower-based measure effects (selected empirical findings)
- Household and housing vulnerabilities:
  - Total non-financial private sector debt to GDP: close to 189 percent.
  - Core debt (owed to banks): 131 percent of GDP.
  - Household credit growth slowed to around 5 percent (as of 2019 Q1).
  - Corporate credit growth: a little under 7 percent.
  - Mortgage loans account for around a third of domestic banks’ assets.
  - Nationwide banks account for 52 percent of the total banking system in 2018, or 83 percent of GDP, and have the highest mortgage share at around two-fifths of their total assets.
  - Mutual credit cooperatives exposures to households around KRW300tn in 2018 (~70 percent of their total assets).
  - Loans amounting to some KRW100tn (~a little over 10 percent of domestic banks’ mortgage book) are partly guaranteed and carry zero risk weight.
  - Rapid growth in SME lending to real estate leasing businesses: loans to this segment amounted to a tenth of domestic bank total assets in 2018.
- Effects of tightening borrower-based measures:
  - HaR (Housing at Risk) simulations: a 10ppt tightening in both LTV and DTI reduces the probability of a real price rise greater than 5 percent from 21 percent to 16 percent (nationwide).
  - Seoul: baseline 5th percentile (5 percent HaR) = -7.5 percent; after 10ppt tightening in LTV and DTI = -6.6 percent.
- DSR policy impacts on banks (Table 6 results; Target refers to threshold levels to be achieved by 2021; Before refers to June 2018; After refers to 2019Q1):
  - Commercial banks (Target: 40): Average DSR Before 52.4, After 41.2; Percent of loans with DSR > 70: Target 15, Before 19.6, After 7.8; Percent with DSR > 90: Target 10, Before 15.7, After 5.3.
  - Special Purpose banks (Target: 80): Average DSR Before 128.2, After 68.6; Percent DSR > 70: Target 25, Before 40.1, After 24.6; Percent DSR > 90: Target 20, Before 32.8, After 18.1.
  - Regional banks (Target: 80): Average DSR Before 122.6, After 72.4; Percent DSR > 70: Target 30, Before 35.9, After 21.8; Percent DSR > 90: Target 25, Before 30.3, After 18.1.
  - All banks (aggregate): Average DSR Before 71.9, After 47.5; Percent of loans with DSR > 70 Before 23.7, After 11.5; Percent with DSR > 90 Before 19.2, After 8.2.

### Real estate valuation, regional dynamics, and model findings
- Regional valuation summary:
  - Broad conclusion: scant evidence of serious over-valuation in regional groups.
  - In the capital area, Seoul prices were around 10 percent above equilibrium in 2019Q1; surrounding areas not overvalued.
  - Nationwide apartment prices up 3 percent in real terms since 2014; regional disparities driven by non-capital declines.
- Appendix I empirical findings:
  - Correlations in real apartment price growth (June 2003–March 2019 averages of pairwise first differences):
    - Capital vs Capital: 0.74
    - Other metropolitan vs Other metropolitan: 0.47
    - Non-metropolitan vs Non-metropolitan: 0.50
    - Capital vs Other metropolitan: 0.16
    - Capital vs Non-metropolitan: 0.11
    - Other metropolitan vs Non-metropolitan: 0.50
  - Jeonse deposits typically 67 percent of property value on average, or 74 percent for apartments.
  - Model-based capital-area assessment: apartment prices around 5 percent above long-run level in 2019Q1.
- VAR-based regional model (monthly 2003–2019) key results:
  - Seoul: unit income elasticity (1.0); speed of adjustment per month -0.026; real long-term interest rates coefficient -0.075 (0.0089).
  - Incheon: spatially-weighted price long-run coefficient -1.0; speed of adjustment per month -0.030; real long-term interest rates coefficient 0.010 (0.0032).
  - Gyeonggi-do: spatially-weighted price long-run coefficient -1.0; speed of adjustment per month -0.076; real long-term interest rates coefficient -0.024 (0.00371).
  - Appendix I Table 2 reports cointegrating relations and tests (Number of cointegrating relations r*: Seoul 1, Incheon 2, Gyeonggi-do 3).

### FX liquidity, non-core funding, and structural resilience
- Historical FX stress:
  - 1996 BIS-reporting banks had foreign liabilities to assets ratio of 332 percent.
  - CIP deviations exceeded 1,000 bps during March 2008 turmoil.
  - FX swaps daily volumes around $17.8bn in 2016.
- FX macroprudential toolkit:
  - LCR-FX requirement in force in 2019 with floor at 80 percent (versus 100 percent local currency LCR); applies to domestic commercial banks with FX liabilities above a threshold and specialized banks, with exclusions noted (KEXIM; foreign bank branches; banks with foreign-currency debt below USD 0.5bn or foreign-currency debt/total debt < 5 percent).
  - LAR-FX maintained for insurers, other non-banks, small domestic banks, and KEXIM.
  - Net derivative position limits introduced 2010 and adjusted 2011, 2013, 2016.
  - Macroprudential Stability Levy (MSL): flat fee of 10 basis points on non-deposit foreign exchange denominated liabilities with remaining maturity ≤ 1 year; proceeds ring-fenced into the ESF.
- Empirical evidence of FX measures:
  - Choi (2014): sizeable reductions in short-term external borrowing after 2011.
  - Cho and Hahm (2014): MSL reduced non-core liability ratios by close to 10 percentage points.
  - Kim and Lee (2017) and Hwang (2017) find policies curtailed FX vulnerabilities without unduly restricting FX services to the real economy.

### Corporate sector exposures, SME lending, and rebalancing tools
- Corporate indebtedness and bank exposure:
  - Total non-financial corporate credit ~100 percent of GDP.
  - Of total corporate debt, KRW843tn (46 percent) was due to banks as of 2019-Q1.
  - Direct lending to large corporates ~KRW160tn (~one fifth of banks’ corporate book); ~KRW700tn (~20 percent of system assets) goes to SMEs.
- Government SME support:
  - Around 10 percent of SME lending backed by government loan guarantee.
  - Government spending worth 3 percent of GDP directed toward SMEs via procurement and subsidies.
- Banking composition and risks:
  - Nationwide banks and specialized banks are systemically significant; specialized banks’ regulatory capital ratios are somewhat below nationwide banks’.
  - FSAP stress tests show SME exposures imply loss rates exceeding portfolio shares for regional banks under scenarios considered; losses not sufficient to drive system insolvency under the scenario but knock-on effects may be under-captured.
- LTD rule changes (starting 2020):
  - Flat 100 percent LTD replaced by differential weights: 115 percent for household lending versus 85 percent for corporates; SOHO loans remain at 100 percent.
  - Assessment: change is of dubious value for sectoral rebalancing and should be revisited; SCCyB on household exposures could induce natural rebalancing.

### Strategic priorities and implementation considerations
- Develop a macroprudential policy strategy that:
  - Sets out stages of the policy cycle to ensure identified risks lead to policy action, implementation, monitoring, and review.
  - Accounts for complementarities between macroprudential measures and interactions with monetary policy via an established protocol ensuring FSC actions consider BOK’s price and financial stability roles.
- Assigning MEFM macroprudential oversight:
  - Rationale: MEFM decree already close to giving a financial stability objective; MEFM is focal point for systemic risk discussion and effective decision locus.
  - Implementation need not reassign formal powers; placing MEFM on a statutory basis and ensuring appropriate composition desirable.
  - Care needed to avoid impinging on crisis management tools (e.g., BOK emergency liquidity assistance, KDIC deposit insurance fund).
- Interagency synthesis team:
  - Establish an interagency team to synthesize, prioritize, and direct regular assessments to the MEFM; BOK well-suited to lead given legal reporting requirements.
  - Prioritize principal vulnerabilities by likelihood and systemic impact; identify amplifying factors and transmission channels.
- Coordination with monetary policy:
  - Strengthen formal mechanisms: agencies enacting macroprudential decisions should show due regard to BOK’s dual responsibilities; formal notification by MPB should be given when systemic risk constrains price stability.
  - Enhance BOK modeling capacity (develop BOKDSGE to include richer financial markets and institutions) to quantify macro-financial trade-offs and model macroprudential effects over policy horizons.

*Source: IMF Technical Note (Republic of Korea) — 1korea2020004.*

### EXECUTIVE SUMMARY __________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Main findings
- Past experience with financial crises places systemic risk oversight at the core of Korea’s approach to the financial system.
- The Korean authorities have:
  - amassed over a decade of experience with macroprudential policies;
  - put in place rigorous and sophisticated processes for risk monitoring;
  - published first-rate analysis;
  - actively developed measures to mitigate risks—notably from FX exposures, and from household indebtedness—as circumstances have changed.
- The system has evolved to be highly complex, posing challenges for coordination, communication, and transparency; the macroprudential toolkit needs to be extended.
- The FSAP highlights the elevated level of household indebtedness as a medium-term vulnerability. Banks, including internet-only banks, and other depository institutions are heavily exposed to households.

### Institutional framework and responsibilities
- Responsibility for macroprudential oversight is shared between financial regulators, supervisors, the central bank, and the government ministry; there is no single source of authority or concentration of macroprudential expertise.
- Formal power to deploy macroprudential tools rests with the Financial Services Commission (FSC); the Bank of Korea (BOK) has analytical resources to conduct system-wide risk assessments and shapes the financial stability narrative.
- A meeting of deputy-level officials—the Macroeconomic and Finance Meeting (MEFM)—convened within the Ministry of Economics and Finance (MOEF) effectively decides on macroprudential measures, but it possesses neither statutory status nor legal powers to act itself.
- Table 2 (Division of Systemic Responsibilities) indicates that the FSC, FSS, BOK, and MOEF all participate in identifying systemic risk and recommending macroprudential action, while deciding macroprudential policy action is assigned to the FSC and BOK; implementation, assessment, and reporting duties are shared.

### Coordination between macroprudential and monetary policy
- Inter-agency cooperation is mostly good, aided by working groups on household indebtedness, real estate, and credit union policy, and by the MEFM at policymaker level.
- Coordination between macroprudential and monetary policies needs to be strengthened. The BOK has responsibility for price and financial stability but no direct power over macroprudential tools. The system does not provide direct means to resolve tensions between the Bank’s objectives in the preferred manner—by recourse to macroprudential measures.

### Policy tools and gaps
- Authorities have focused on borrower-based measures (LTV, DTI, DSTI/DSR) to limit risks from household debt; used in concert they improve household resilience but may suffer diminishing effectiveness.
- A sectoral countercyclical buffer (SCCyB) targeting household exposures would:
  - allow banks to build up and release capital as household-sector risks wax and wane;
  - provide a buffer that could be released if risks crystallize;
  - help mute pro-cyclicality in bank lending.
- The toolkit needs extension to better handle structural risks and interactions with monetary policy.

### Key recommendations (from Table 1)
- Recommendation 1: The MEFM (or a body empowered for the equivalent purpose) should be assigned macroprudential oversight as its sole primary objective. Timing: ST. Priority: H.
- Recommendation 2: The authorities should undertake a thorough review of their financial stability communication strategy with the aim of improving transparency. Timing: ST. Priority: M.
- Recommendation 3: An interagency team should be established to synthesize, prioritize, and direct regular assessments to the MEFM. Timing: ST. Priority: H.
- Recommendation 4: The formal mechanisms for coordination between monetary and macroprudential policies should be strengthened. Timing: ST. Priority: H.
- Recommendation 5: A stock-take of the interactions between existing microprudential, macroprudential, and fiscal and regulatory policy measures should be undertaken. Timing: ST. Priority: M.
- Recommendation 6: A review should be undertaken of the quantitative guides used in deciding the level of the CCyB. Timing: ST. Priority: H.
- Recommendation 7: The sectoral countercyclical buffer for household exposures should be introduced as soon as is practical. Timing: ST. Priority: H.
- Recommendation 8: Introduce a framework in which to assess sources of structural risk and to develop mitigating policy measures. Timing: MT. Priority: M.
- Recommendation 9: An over-arching macroprudential strategy should be developed. Timing: ST. Priority: M.

### Strategic and communication priorities
- Develop a macroprudential policy strategy that:
  - sets out the stages of the policy cycle to ensure identified risks lead to policy action, effective implementation, monitoring of effects, and policy review;
  - accounts for complementarities between different macroprudential measures;
  - incorporates interactions with monetary policy via an established protocol to ensure FSC actions consider the BOK’s ability to fulfil price and financial stability roles.
- Revise the communication strategy to clearly delineate responsibilities of each agency and improve transparency, accountability, and predictability of policy decisions.
- Task an interagency team to synthesize, prioritize, and direct regular assessments to the MEFM to ensure policymakers are alerted to key risks in a timely fashion.

*Author: Roland Meeks (IMF), member of the FSAP 2019 team.*

### 6. The 2013 FSAP recommended that a dedicated macroprudential council be

### 6. The 2013 FSAP recommended that a dedicated macroprudential council be established

### Background and current institutional framework
- The 2013 FSAP recommended a dedicated macroprudential council with power to recommend actions to responsible agencies on a “comply-or-explain” basis. The FSAP also recommended a stronger role for the Bank of Korea (BOK), including regular assessments of systemic risk to the proposed council and proposals for policy action where appropriate.
- The authorities maintain a multi-agency system where key macroprudential responsibilities are shared. Principal agencies and roles:
  - Financial Services Commission (FSC)—the financial regulatory agency of the Korean government, with broad supervisory powers.
  - Financial Supervisory Service (FSS)—responsible for on-going supervision of financial institutions and markets.
  - Bank of Korea (BOK)—the independent central bank, responsible for price stability, financial stability, and emergency liquidity assistance, and has power to conduct bank examinations. It conducts foreign exchange operations in consultation with the MOEF.
  - Ministry of Economy and Finance (MOEF)—overall authority over foreign exchange policy, including FX-related macroprudential measures and the foreign exchange stabilization fund (ESF).
- The Technical Note excludes detailed consideration of the KDIC or SFC operations.

### Legal mandates and mandate overlap
- Legal mandates include a financial stability objective across principal agencies:
  - FSC and FSS share a legal mandate to “promote the stability of financial markets”.
  - BOK’s legal mandate requires it to “pay attention to financial stability”.
- Potential drawback: overlap between mandates may obscure ultimate responsibility and accountability for financial stability, risking delayed necessary actions.
- Financial stability is not the sole primary objective of any agency in Korea; it is one primary objective among others for the FSC/FSS and BOK. This can lead to trade-offs and potential inaction bias.

### Decision-making arrangements and appointments
- Formal macroprudential powers rest with the government-appointed FSC. FSC commissioners are ultimate decision-takers for most measures relating to regulated financial institutions, including macroprudential measures.
- FSC commissioners comprise: the FSC Chairperson and Vice Chairperson, the Vice Minister of the MOEF, the President of the KDIC, the Senior Deputy Governor of the BOK, the Governor of the FSS, and two financial experts and one business representative recommended by the FSC Chairperson and the Chairperson of the Korea Chambers of Commerce and Industry, respectively.
- The FSC Chairperson is a government appointee who nominates the FSC Vice Chairperson and the Governor of the FSS.
- Commissioners are appointed for a term of three years (renewable once) and cannot be dismissed except on serious grounds.
- Since March 2013 there have been four FSC Chairmen: Shin Je-Yoon (2013-15), Yim Jong-yong (2015-17), Choi Jongku (2017-19), and Eun Sung-soo (2019-present). The relatively rapid turnover has given the government ample opportunity to decide or influence key financial leadership roles since 2013.

### Central forum: the Macroeconomic and Finance Meeting (MEFM)
- The MEFM serves as the central forum for financial stability matters alongside the FSC meeting. It is intended to foster “close cooperation” between Korea’s main macroeconomic and financial agencies in:
  - Analysis and monitoring of macroeconomic and financial developments;
  - Foreign exchange market monitoring and policy;
  - Other elements affecting the economy, recently including global monetary policy, trade, and geopolitical developments.
- The MEFM is a deputy-level body within the MOEF, chaired by the First Vice Minister of Finance (who acts as chair), and brings together the First Vice Minister of Finance, the Vice Chairperson of the FSC, the Senior Deputy Governor of the BOK, the first senior Deputy Governor of the FSS, and the President of the KDIC. The MEFM secretariat is based in the MOEF.
- The MEFM is established by Presidential Decree and, under the most recent decree, will run until 2020.
- Multiple channels of government involvement exist with the MEFM; IMF guidance notes political influence as a risk factor for delays and compromised independence, but also that government involvement can be beneficial when legislative or fiscal measures are required.

### Ability to act (Principle 2)
- The FSC has broad regulatory macroprudential powers (“hard powers”), including:
  - Power to designate banks or bank holding companies as D-SIBs;
  - Power to set loan standards for residential mortgages;
  - Power to set various capital standards for banks and insurers.
- The FSC also exercises “soft powers”, for example in corporate restructuring recommendations. The FSS is responsible for implementation and enforcement.
- Agency capacity:
  - BOK financial stability department with a staff of around 100 under a Deputy Governor.
  - FSS has a dedicated department and specialized teams for macroprudential supervision.
  - FSC employs teams for macroprudential policy and teams specializing in housing, banks, and non-banks.
  - Resource constraints and wide-ranging briefs create challenges supporting the macroprudential policy process.
- The MEFM lacks formal powers (including semi-hard powers) but in practice its proposals are often enacted by relevant decision-making bodies. The MEFM decree describes deliberation, consultation, and a decision-making procedure, but does not specify powers such as a comply-or-explain semi-hard power.
- MEFM has been the locus of decisions on FX measures (for example, adoption of LCR-FX regulations) and discussions on borrower-based measures that were later taken up by FSC commissioners.

### Coordination and cooperation (Principle 3)
- Cooperation mechanisms:
  - Any agency may request materials from a sister institution under a presumption that requests will be granted (FSC Act, Art. 65).
  - Government is obliged to consult with the MPB when formulating important money and credit policies (BOK Act, Art. 93).
  - Confidential regulatory information held by the FSS is shared with the BOK on the basis of a MOU; BOK can request a joint bank examination with the FSS.
  - No cross-agency committee for oversight of data sharing presently exists.
  - For overseas cooperation, FSC and FSS have signed MOUs for exchange of financial information with forty-eight institutions in twenty-six out of the thirty-four overseas jurisdictions in which Korean financial companies are active (as of end-2018), including two international organizations.
- Topic-focused bodies and forums:
  - Macroprudential Analysis Council (MAC), introduced in March 2019, holds staff-level meetings to improve communication between agencies and incorporate external researchers and experts. MAC discussions have included repo markets, insurers’ foreign exchange hedging, and project finance loans; identified risks may be elevated to MEFM.
  - Household Debt Management Council has been an important forum for information-sharing prior to strengthening borrower-based measures.
  - BOK’s Financial Stability Forum provides outside perspectives and challenge to institutional views.

### Findings on willingness and safeguards
- Authorities have shown willingness to act on identified risks, notably on household sector measures in the past three years, often politically sensitive as they curb borrower access to credit secured against real estate.
- The macroprudential framework lacks formal safeguards to ensure independent decision-making and to prevent policy diversion from limiting systemic risk in future.

### Recommendations
- Assign the MEFM (or an equivalent empowered body) macroprudential oversight as its sole primary objective to:
  - Bring clarity to the institutional setting for macroprudential policy decision-making, strengthening decision processes and enhancing accountability.
  - Ensure safeguarding financial stability cannot be subordinated to other objectives, limiting the exercise of macroprudential powers absent systemic risk considerations.
- Specify interlocking intermediate objectives for macroprudential oversight (IMF, 2014a, ¶3):
  - Build resilience to shocks, for example by moderating the leverage available to borrowers and financial institutions and encouraging maintenance of buffers of high-quality loss absorbing capital.
  - Contain the build-up of vulnerabilities over time, for example due to excessive credit growth and maturity mis-match.
  - Mitigate structural vulnerabilities, for example due to interconnectedness.
- Secondary objectives may be combined with the macroprudential oversight objective but should not be too wide-ranging.
- Rationale for selecting the MEFM as the responsible body:
  - The MEFM decree already comes close to giving the body an objective to ensure financial stability, albeit insufficiently explicit.
  - MEFM is the focal point for systemic risk discussion and formulation of policy options; macroprudential matters are effectively decided at its meetings.
  - Under a revised arrangement the MEFM would continue to offer on-the-record recommendations for macroprudential actions to the FSC Meeting.
- Implementation considerations:
  - Recommendation need not entail reassignment of formal powers or new legal powers if not desired, though placing the MEFM on a statutory basis and ensuring appropriate composition would be desirable.
  - The recommendation pertains to macroprudential policy and should not impinge on crisis management tools such as BOK provision of emergency liquidity assistance or KDIC use of the deposit insurance fund.
  - Giving one body a sole primary financial stability mandate may have implications for laws governing other institutions; careful consideration should be given to whether other agencies should be assigned secondary financial stability objectives or retain co-equal objectives.

### Communication
- A supporting communication strategy is required for successful macroprudential policy. Communications must:
  - Ensure objectives of financial stability policy are understood by stakeholders.
  - Provide clear statements of policy intentions to improve effectiveness on activation and release of measures (IMF, 2014a, ¶50).
  - Enhance the authority’s reputation for predictable, consistent policymaking (CGFS, 2016).

*Source: IMF Technical Note (Republic of Korea).*

### 26. Financial stability messages are sent on multiple channels. The ability of the legislature

### 26. Financial stability messages are sent on multiple channels. The ability of the legislature and the public to hold agencies to account is aided by the publication of the minutes of key financial stability meetings. However, the proliferation of forums in which financial stability is discussed complicates the task of understanding policy, and of ensuring accountability.

### Communication channels, current practice, and limitations
- Multiple channels are used by agencies charged with financial stability:
  - The BOK publishes in-depth systemic risk analysis in its twice-yearly FSR.
  - The Monetary Policy Board publishes minutes of its quarterly Financial Stability Meetings.
  - Summaries of the inter-agency Macroeconomic and Finance Meeting (MEFM) are published by the MOEF-based secretariat after each meeting (at least quarterly).
  - The MOEF announces decisions on FX regulations.
  - Other macroprudential decisions are announced via FSC press release.
- Problems identified:
  - Proliferation of forums complicates understanding of policy and ensuring accountability.
  - Some channels mix financial stability messages with other topics (e.g., FSC commissioners’ minutes cover a broad range of micro- and macroprudential issues; MEFM covers a broad range of macroeconomic policy issues; financial stability issues appear in monetary policy communications). Combining conceptually distinct issues can obscure content or weaken impact.
  - Messages are often targeted at experts and specialized media; they are detailed and technical and are unlikely to reach beyond traditional consumers.
    - Example: 79 stories appeared across print, broadcast, and online media following the June, 2019 edition of the FSR.
    - The June 2019 edition of the FSR was 138 pages long in its Korean version, and 150 pages long in English.
    - Even among financial institutions consulted during the FSAP, few if any identified the key elements of the authorities’ policy strategy beyond “cooling the housing market”.
  - Despite authorities’ consistent message that household debt was unlikely to cause a systemic risk, household debt consistently featured near the top of those named by respondents to the BOK’s Systemic Risk Survey (e.g., combined housing risk response frequency was 70 percent, higher than “US-China trade disputes (67 percent) and slowing domestic economic growth (66 percent)”).
  - Much decision-making is invisible to those outside government because responsibilities are widely divided or shared, and because the MEFM and its role in the policy process is not well known.

### Recommendations on communication (summary)
- Undertake a thorough review of the financial stability communication strategy to improve transparency, considering:
  - Stakeholders that need to be reached by financial stability messages.
  - Channels through which messages should be sent.
  - Message design emphasizing comprehensibility, priority, and accountability.
- Specific recommendations:
  - Broaden the group of stakeholders reached by financial stability communications; introduce layers of messaging to help the general public relate to and act on messages.
  - Clearly delineate areas of responsibility for each agency under a revised strategy; rationalize the number of channels and prioritize dedicated channels. The body with sole primary responsibility for macroprudential oversight would naturally lead in communicating policy actions.
  - Link risk assessments to mitigating policy actions: provide information on macroprudential measures in force, a summary of the risks targeted by each measure, and an assessment of progress toward mitigating those risks. Ideally the body assigned sole primary responsibility for macroprudential oversight should own collation and disclosure of this information.
  - Review the appropriate level of disclosure for meetings that discuss, recommend, or decide financial stability policy actions: neither full disclosure of detailed minutes nor total withholding is necessarily desirable; timing and content of disclosure should foster accountability and guide private sector expectations.
  - Consider increasing availability of English translations of key documents beyond the FSR.

*Source: 1korea2020004 (IMF staff report excerpt).*

---

### SYSTEMIC RISK MONITORING

### A. Approach to risk monitoring — institutional roles and practices
- Wide-ranging monitoring activities are undertaken by the FSC, FSS, MOEF, and BOK; perimeter covers banks, nonbank depository institutions, other financial companies, public guarantee institutions, and others.
- High-frequency market monitoring is mainly overseen by the FSC and FSS.
- The BOK:
  - Is the principal agency charged with communicating risk assessments to stakeholders.
  - Is required by the BOK Act to conduct financial stability assessments and to publish a biannual Financial Stability Report (FSR).
  - Has the Financial Stability Department amassing data and analysis on credit and asset markets, financial institutions, capital flows, and financial market infrastructure.
  - Cooperates with FSC and FSS risk assessments via established processes.
- BOK analysis of financial institutions uses two parallel tracks:
  - ‘Desk-based’ analysis (around the FSR cycle) with broad institutional scope:
    - Bank and non-bank teams assess asset management, asset soundness, and profitability.
    - Vulnerabilities prompt internal reporting and in-depth follow-up analysis.
    - Matters can be elevated to the Financial Stability Meeting of the MPB.
  - ‘Bank examination’ track (annual cycle), focused on larger banks; can be individual bank-focused or sectoral with macroprudential focus.
    - Sectoral reviews approved by the MPB; recent topics included SOHO lending, household debt, and corporate loans.
  - Bank team risk analysis may be published in the FSR as in-depth topical issue boxes.

### A. Approach — early warning systems, models, and data
- Early warning systems in use:
  - BOK publishes a ‘financial stability index’ (FSI) in the FSR (e.g., June 2019, p. 3) with threshold values of ‘warning’ and ‘crisis’ calibrated on a broad range of indicators.
  - FSS has an early warning system for individual supervised institutions; it provides model-based assessments of likelihood of capital shortfalls quarterly.
  - FSC operates an early warning system for financial crises based on Kaminsky et al. (1998) signaling approach feeding monthly risk assessment.
  - MOEF operates an early warning system for key external sector variables, including the exchange rate and portfolio flows.
- Quantitative risk monitoring:
  - BOK implements CoVaR and SRISK approaches among other models.
  - Quantitative indicators are supplemented by qualitative information; BOK conducts a biannual Systemic Risk Survey covering close to one hundred employees and executives of domestic financial institutions, financial sector associations, research institutes, and foreign money managers.
  - Qualitative monitoring is bolstered by interactions with experts and market participants, including via the MAC.
- Stress testing:
  - BOK and FSS conduct annual joint stress tests; each agency also conducts its own tests.
  - Joint solvency stress test scenario is developed using inputs from BOK teams and aligns baseline with BOK MPB forecast used in monetary policy deliberations.
  - BOK has capacity for top-down solvency and liquidity tests; FSS conducts top-down and bottom-up tests.
  - A suite of analytical models supports stress testing:
    - Systemic Risk Assessment Model for Macroprudential Policy (2012).
    - Non-bank Financial Institution Stress Test Model (2019) covering insurance companies, credit cooperatives, savings banks, securities firms, and credit-specialized finance companies.
    - Extensive Stress Test Model (2019) integrating banks and non-banks; incorporates a contagion module analyzing spill-overs across financial sectors.
    - FSS’s STARS (2017) captures contagion and macro-feedback effects developed with the BOK.
  - Results from BOK stress tests are published in the FSR; joint BOK/FSS test results are shared with the MEFM.
- Data availability:
  - Generally very good; a licensed public credit registry, Korea Credit Information Service (KCIS), records and manages household and business loan information (Credit Information Use and Protection Act (2008)).
  - Gaps:
    - Non-financial corporate businesses’ financial exposures (relevant to solvency stress-testing).
    - FinTech/P2P lending: rapid growth but limited information on creditor base, risk exposures, or circumvention of macroprudential measures.
      - Legislation requiring P2P platforms to disclose more financial information is expected to be enacted; P2P lenders will be required to submit information to a credit agency to be used by banks to comply with DSR regulations.
      - The law was passed by the National Assembly in October 2019.

### B. Recommendations on systemic risk monitoring
- Establish an interagency team to synthesize, prioritize, and direct regular assessments to the MEFM to:
  - Bring together analysis of separate agencies.
  - Prioritize identified risks.
  - Deliver warnings targeted to responsible parties.
- Role and new elements proposed:
  - The BOK is well-suited to lead given existing legal reporting requirements and supporting processes (e.g., quarterly financial stability meetings).
  - Prioritization: clearly prioritize principal macroprudential vulnerabilities by likelihood of causing a systemic event and potential systemic impact; identify amplifying factors and transmission channels to strengthen rationale for macroprudential actions.
  - Designated recipient: synthesized and prioritized risk assessments and warnings to be directed to the body with sole primary responsibility for macroprudential policy.
  - The recommendation complements the proposed recommendation on monetary and macroprudential policy coordination.

*Source: 1korea2020004 (IMF staff report excerpt).*

---

### MONETARY POLICY AND FINANCIAL STABILITY

### Sources of policy interactions and assessment of trade-offs
- Monetary policy affects incentives for risk-taking, leverage, and liquidity creation through multiple channels:
  - Low interest rates can induce banks to grant riskier loans.
  - Short-term rate levels drive leverage and risk-taking by liability-driven investors (“search for yield”).
  - The extent of risk-taking behavior often depends on lenders’ underlying balance sheet strength, highlighting the importance of coordination between prudential and monetary policies.
- Quantitative assessment:
  - The overall effect of monetary policy on the likelihood of financial crises is considered small.
  - Evidence suggests the nexus of credit growth and asset price spirals responds little to interest rates; substantial reductions in crisis probabilities would require substantial hikes in interest rates.
  - Using monetary policy alone to address systemic vulnerabilities is generally viewed as costly relative to benefits; prolonged tighter-than-warranted monetary policy risks undershooting inflation and growth objectives and damaging central bank credibility.
  - These conclusions are tentative and actively debated.

*Source: 1korea2020004 (IMF staff report excerpt).*

### 41. Macroprudential policy should be used first to mitigate financial stability risks but is

### 41. Macroprudential policy should be used first to mitigate financial stability risks but is

### Macroprudential policy versus monetary policy: roles, limits, and interactions
- Macroprudential policy is recommended as the first line of defense against financial stability risks, especially when risks are sector-specific or structural rather than time-varying.
- Monetary policy is described as a particularly blunt tool for sector-specific or structural risks and should not be the primary instrument where targeted supervisory tools are available.
- Prudential tools have limitations:
  - Leakages, potential inaction bias, and political economy constraints.
  - Uncertainty over transmission and the risk that forms of risk-taking evolve faster than regulations.
  - Some vulnerabilities may be immune to effective remedy using macroprudential tools (example: deeply negative term premiums in bond markets).
- These limitations reinforce the need to strengthen macroprudential frameworks and for monetary policymakers to remain vigilant and ready to “lend a hand” when required, particularly when financial conditions tighten materially and threaten financial stability.
- Monetary policy may also be warranted to offset aggregate demand side-effects of some macroprudential actions.

### Bank of Korea (BOK) institutional responsibilities and practices
- Legal mandate:
  - The Bank of Korea Act (2011) instructs the BOK to pursue price stability while “paying attention” to financial stability.
  - The BOK interprets financial stability to be its (co-) primary mandate, although Art. 6 instructs the Bank to “do its best to achieve the price stability target”.
- Absence of direct macroprudential powers:
  - The BOK owns no direct macroprudential policy tools (it has power to set reserve requirements but has not done so for macroprudential purposes).
- How the Monetary Policy Board (MPB) discharges financial stability responsibilities:
  - Financial stability monitoring: the Board is briefed four times a year on financial stability matters and signs off on the analysis and recommendations in the Financial Stability Report.
  - Monetary policy strategy: the Board’s “General Principles of Monetary Operation” incorporate financial stability within its flexible inflation targeting framework and stress cooperation between monetary and macroprudential policy functions.
- Institutional configuration and functions:
  - The BOK acts as monetary policymaker, FX risk monitor, FX market agent, and a key participant in FX macroprudential measures through its seat on the MEFM.
  - Korea maintains a freely floating exchange rate and is among the most open advanced economies; trade is highly exposed to fluctuations in the US dollar exchange rate.
  - Around 20 percent of Korea’s exports are to the US, and more than 80 percent of them are invoiced in US dollars.
  - More than two-thirds of respondents to a recent BOK Systemic Risk Survey named trade tensions as a financial system risk factor.
- Organizational changes to meetings:
  - From 2017, the number of monetary policy meetings was reduced from twelve per year to eight, and four briefings dedicated to financial stability were added.

### Operational judgments, trade-offs, and examples from recent policy
- MPB responsibilities and actions when macroprudential measures are insufficient:
  - The MPB must judge when incentives for risk-taking are or are not being contained by current macroprudential measures.
  - Two possible actions when the trade-off is unfavorable:
    - Communicate the need for strengthening macroprudential policies (for example through the FSR) and influence the macroprudential process via participation in cross-agency forums.
    - Extend the policy horizon (bring inflation back to target more slowly) as an interim measure to avoid worsening financial imbalances.
  - If macroprudential limits are reached, monetary policy may be used to compensate to some degree, though trade-offs are likely unattractive.
- Examples:
  - BOK influence in 2019:
    - The BOK cut its base rate twice in 2019 in response to weak growth and below-target inflation.
    - To assuage debt concerns following easing, the BOK pushed (including at the MEFM) for strengthening the macroprudential framework through introduction of DSR limits. BOK analysis underpinned that push.
    - Pre-emptive macroprudential action opened some space for monetary policy to act on price stability, though trade-offs remain.
  - 2014 relaxation of housing macroprudential measures:
    - The government relaxed LTV and DTI limits and made technical adjustments aimed to boost housing demand.
    - This premature easing has been criticized for worsening the macro-financial trade-off at a time when easier monetary policy was needed and for appearing short-termist.
    - Using macroprudential tools to manage aggregate demand is likely to overburden them and should be avoided.

### Recommendations to strengthen coordination and analytical capacity
- Strengthen formal mechanisms for coordination between monetary and macroprudential policies. Key elements:
  - Agencies enacting macroprudential decisions should show due regard to the dual responsibilities of the BOK.
  - When the MPB judges systemic risk concerns materially constrain its ability to achieve price stability, formal notification should be given to the body responsible for macroprudential oversight.
  - The formal notification should be grounded in a risk assessment from the BOK’s monitoring activities and may include a recommendation for specific policy actions.
  - If the assessment includes mitigating action suggestions, these should be developed using inter-agency channels.
  - In implementing the recommendation, the independence of the Bank of Korea in monetary policy conduct is to be taken as absolute.
- Enhance BOK capacity to quantify the macro-financial trade-off and to model macroprudential policy effects over the policy horizon:
  - Structural models are needed to analyze the trade-offs, accounting for how policy settings may alter private agents’ behavior.
  - The BOK’s structural macroeconomic model (BOKDSGE) could be developed to include a richer set of financial markets, financial assets (in particular, housing), and financial institutions such as banks.
  - Developing such a tool would assist policymakers in balancing macroeconomic and financial stabilization goals when setting monetary policy.

### Systemic risks, current vulnerabilities, and macroprudential tools
- Broad financial vulnerabilities as of mid-2019:
  - Financial conditions (per IMF methodology) were close to historical averages after several years in easy territory.
  - Total non-financial private sector debt to GDP stood close to 189 percent.
  - Core debt (debt of the non-financial sector owed to banks) stood at 131 percent of GDP.
  - The credit-to-GDP gap was close to zero.
  - Credit growth:
    - Household credit growth slowed to around 5 percent (as of 2019 Q1), a level the government judges to be sustainable over the longer term.
    - Corporate credit growth stood a little under 7 percent, about double the average rate for recent years.
  - Real estate prices remain high, particularly in the capital area where some valuations may be stretched.
  - Banking system funding appears solid: banks exceed LCR and NSFR requirements and have little exposure to foreign exchange.
  - The economy continued to run a current account surplus despite weak external environment.
- Countercyclical Capital Buffer (CCyB) framework:
  - Korea has implemented the CCyB framework but has yet to ever raise it above zero; Korea’s CCyB is currently set to zero.
  - The CCyB’s purpose is to mitigate likelihood of crises from pro-cyclical movements in broad-based vulnerabilities and to attenuate cyclical build-ups in credit exposures.
  - An advantage of maintaining a positive buffer is the possibility of releasing it in stress, thereby reducing pro-cyclicality.
- CCyB assessment process and indicators:
  - Multiple indicators are used rather than a single guide; discretion is retained by policymakers.
  - The FSS provides recommendations for the CCyB setting to the FSC on a quarterly basis; the BOK provides a separate assessment.
  - Vulnerabilities assessment centers on a main indicator—the credit-to-GDP gap—and five ancillary indicators aimed to pick up accelerations in overall credit, household debt, house prices, non-core funding, and foreign currency debt.
  - On resilience, capital adequacy and asset quality are assessed.
  - Where indicators are below thresholds and resilience is sufficiently high, a zero buffer is recommended.

*Source: IMF staff analysis in the referenced chapter.*

### 52. The current approach to assessing the state of the credit cycle has a number of

### 52. The current approach to assessing the state of the credit cycle has a number of limitations.

### Limitations of current CCyB assessment approach
- Some indicators should be related to the incidence of banking system problems:
  - To be effective, the CCyB should be activated in the up-swing of a credit cycle that has the potential to lead to a crisis.
  - The chosen set of indicators may, or not, be systematically related to such events.
  - Authorities have developed a number of early warning models that could already provide useful model-based input to the decision.
  - An alternative to threshold-based EWMs is a binary classification model for crisis events.
- The scope of indicators should be sufficiently broad:
  - At present, all indicators are quantity- (rather than price-) based, making it hard to pick up mis-pricing of risks (for example, compressed lending spreads).
  - Desirable to define a set of risk buckets that encompasses all relevant risk categories and to select indicators within those.
  - Noted examples (without endorsement): Bank of England core indicator set contains 18 indicators in three categories: non-bank balance sheet stretch; conditions and terms in markets; and bank balance sheet stretch. ECB’s core indicator set includes categories: credit developments; property price over-valuation; external imbalances; private sector debt burdens; and the mis-pricing of risk.
- Computing ‘gaps’ using the HP filter has problems:
  - HP filter transformations introduce spurious dynamic relations (Hamilton, 2018).
  - Practitioners note a downward bias to the credit-to-GDP gap following credit booms, and undesirable increases from business cycle downturns.
  - Criticism extends to the one-sided filter; alternative detrending methods with firmer statistical basis exist (Harvey, 1990; Hamilton, 2018).
  - It is noteworthy that most countries that have activated the CCyB have a negative credit-to-GDP gap, and jurisdictions with a zero buffer include many whose credit ‘gap’ are well into positive territory.

### Indicators guiding calibration of the Counter-Cyclical Buffer (as reported)
- Key indicator:
  - Total credit-to-GDP gap
    - Total credit: financial institution loans to non-financial corporates and households, plus government loans
- Ancillary indicators:
  - Total credit gap
  - Household debt-to-disposable income gap
    - Household debt: aggregate loans extended by banks and other financial institutions.
  - House prices-to-GDP gap
    - House prices: National housing sales price index.
  - Direct financing-to-M2 gap
    - Direct finance: debentures, repos, certificates of deposit, bills sold, bills issued.
    - M2: M1 + term deposits, debentures, bills sold, bills issued.
  - Short term external debt-to-foreign exchange reserves gap
    - Short-term external debt: securities issued, borrowings, cash, deposits, trade credit, etc.
    - Foreign exchange reserves: gold, SDRs, IMF position, foreign exchange.
- Source note: Measures of the ‘gap’ are constructed using a Hodrick-Prescott filter. (Source: FSS.)

### Use and strategy for the CCyB
- The authorities have yet to set out how the CCyB will be used:
  - Increasing recognition that macroprudential policy should be guided by a strategy that sets out how risks map into actions, and how results of actions are assessed (see ¶97).
  - The CCyB is a useful place to trial such a strategy: it is reviewed on a quarterly basis and requires a holistic approach encompassing broad categories of vulnerabilities.
  - The quarterly review provides a focus for macroprudential risk assessment; making clear in advance when the buffer will be released should help reassure banks they do not need to hold “buffers-on-buffers”.
- Costs and benefits of a positive CCyB setting need fuller treatment:
  - Potential costs include spillovers to the real economy; these should be quantified.
  - Research suggests costs can be minimized by appropriate coordination between monetary and macroprudential policies (Meeks, 2017).
  - Potential benefit: activating the CCyB in a period of still-easy financial conditions would allow ‘insurance’ (additional capital) to be purchased cheaply against broad-based vulnerabilities from prolonged household indebtedness and the banking system’s sizeable exposure to real estate.
  - There exist circumstances where microprudential and macroprudential objectives conflict; risks arise from entrusting a microprudential supervisor with primary responsibility for CCyB recommendations.

### Other broad-based tools (complementary to CCyB)
- Unweighted leverage ratio:
  - Estimates of risk attending banks’ exposures are uncertain; risk-weighted schemes may fail to account for risks outside historical experience or when structure of financial system changes.
  - An unweighted leverage ratio provides a useful back-up to the standard risk-weighted capital ratio and protects against miscategorization or errors of commission.
  - Leverage limits disincentivize banks from shifting out of high-risk weight assets rather than raising additional capital.
- Forward-looking provisioning:
  - IFRS9 was introduced for Korean banks in 2018; banks are required to make provisions on the basis of expected losses rather than realized impairments.
  - Korean banks are active sellers of NPLs to AMCs.

### Vulnerabilities from housing and the household sector
- Elevated household indebtedness is viewed as a potential vulnerability:
  - Respondents to the BOK’s Systemic Risk Survey consistently place ‘household debt problem’ or ‘housing market instability’ among top five financial system risk factors.
  - FSAP identified pockets of at-risk debt owed by liquidity-constrained households, rollover risks associated with Korea’s rental system (jeonse), and potential medium-term stress among older age cohorts during demographic transition.
  - Historical episodes: Nordic banking crises of early 1990s saw GDP decline at almost 5 percent year-on-year in Sweden and more than 6 percent in Finland. Jordà and others (2016) report aftermath of mortgage booms marked by deeper recessions and slower recoveries.
  - Past Korean episode: 1999–2002 credit card lending boom—tripling of cards in issue and quintupling of outstanding balances—led to crisis in 2003 with heavy losses and negative spillovers.
- Size and composition of mortgage and household exposures:
  - Loans secured against housing collateral account for more than half of the assets of Korea’s nationwide banks.
  - Mortgage loans account for around a third of the assets held by domestic banks.
  - Nationwide banks account for 52 percent of the total banking system in 2018, or 83 percent of GDP, and have the highest mortgage share at around two-fifths of their total assets.
  - Jeonse (leasehold) deposits typically are 67 percent of property value on average, or 74 percent for apartments.
  - Loans amount to some KRW100tn, or a little over 10 percent of the size of domestic banks’ mortgage book—but are partly guaranteed and carry zero risk weight.
  - Rapid growth in SME lending to real estate leasing businesses: loans to this segment amounted to a tenth of domestic bank total assets in 2018.
- Non-bank and ODI exposures:
  - Mutual credit cooperatives had exposures to households of around KRW300tn in 2018, around 70 percent of their total assets.
  - ODI lenders historically applied lower lending standards to household loans than domestic banks.
  - Household lending by life insurance companies comprises just 3 percent of those companies’ total assets (median), with Samsung Life closer to 6 percent.
  - Internet-only banks have focused on consumer credit businesses and issued very few mortgages.

### Real estate market developments and regional risks
- Korea has not seen a real estate bust since 1997:
  - Nationwide nominal prices have not undergone significant decline since the Asian financial crisis.
  - In real terms, year-on-year price growth has been close to or below zero since the end of 2016.
  - Real-terms price declines largely driven by developments outside the capital city area.
  - In Seoul, Incheon, and Gyeonggi-do, prices have mostly grown above the rate of inflation; price growth in the capital area is only weakly correlated with other regions.
- Capital area is at greatest risk of over-valuation:
  - Capital area produces half of national GDP and contains half the country’s population.
  - Median apartment price in Southern Seoul is three times the national median, and eight times the price in the cheapest region (Gyeongsangbuk-do), per Kookmin Bank data.
  - Affordability in Seoul is very low.
  - Model-based valuation measures suggest Seoul prices are somewhat above their equilibrium level, while non-metropolitan areas are well below.

### Macroprudential measures addressing household and housing vulnerabilities
- Measures deployed have been broad and often targeted at the capital area:
  - Borrower-based measures have received most attention; tax measures and price caps have also been deployed.
  - Sustained policy action likely appropriate to avoid pro-cyclical effects of excess household credit; authorities should monitor net benefits as further tightening may be less effective and could have unintended side-effects (Alam and others, 2019).
- Borrower-based measures history and calibration:
  - Introduced in 2002 starting with a cap on loan-to-value (LTV) ratio; DTI limits on maximum repayments-to-income ratio for mortgages followed.
  - Current limits set conservatively— as low as 40 percent in speculation-prone metropolitan markets, with yet lower limits for owners of multiple homes.
  - Comparative examples: LTV limits of 75 percent in Croatia; above 90 percent in Finland; 75 percent in Indonesia. Limits in Bulgaria, Hong Kong SAR, and Singapore are comparably tight.
- Recent measures to strengthen borrower repayment capacity:
  - Loan underwriting tightened: October 2017 measures included stricter standards for calculating DTI ratios, eliminating anomalies for second mortgages, and improving income documentation; stricter income checks for cooperatives in June 2017.
  - Borrowers incentivized to take safer mortgages: easing LTV limits for fixed interest rate amortizing loans; stock of outstanding fixed-rate mortgages increased from less than 10 percent of all mortgages in 2011 to 45 percent in 2018; share of amortizing mortgages stood at a little over 50 percent in 2018.
  - Measures to address overall household indebtedness: rules restrict new lending at high-DSRs; fully implemented for banks in October 2018 and appear to have caused growth in non-mortgage lending to slow to close to zero in 2019Q1, and materially reduced the riskiest high-DSR lending.
- Minimizing regulatory leakage to non-bank lenders:
  - Alignment in LTV and DTI rules creates a level playing field and removes incentives for borrowers to migrate to lower-quality lenders.
  - In 2005 LTV limits for savings banks, mutuals, and finance companies were 80 percent in speculative zones compared to 40 percent for banks; LTV and DTI rates were unified at 70 percent and 60 percent (respectively) for all lenders in 2014.
  - Since 2017, LTV and DTI limits are again differentiated, but only by region and not by institutional form.
  - DSR targets differ for non-banks, reflecting diverse borrower base and loan types.

_Italic: Source: 1korea2020004 - 52. The current approach to assessing the state of the credit cycle has a number of limitations._

### 65. Tighter macroprudential measures crimped house price appreciation and lessened the

### 65. Tighter macroprudential measures crimped house price appreciation and lessened the risk of sharp house price corrections

### Effects of tighter borrower-based macroprudential measures on house prices and downside risks
- Objective and approach
  - Although affecting real estate prices is not a primary goal of LTV and DTI measures, research shows tighter measures have cooled the housing market.
  - Housing at Risk (HaR) measures the magnitude of house price declines that occur with a given probability and links macroprudential measures to household vulnerabilities and financial stability.
  - Figure 4 reports the impact of a 10ppt tightening in both the LTV and DTI ratios on the unconditional distribution of year-on-year real apartment prices (estimation sample runs 1992Q4-2019Q1).

- Key quantitative findings
  - Korea (nation as a whole, left panel): probability of a real price rise greater than 5 percent falls from 21 percent in the baseline to 16 percent when macroprudential measures are tightened.
  - Seoul (where policies were used most frequently, right panel): baseline 5th percentile (5 percent HaR) of the distribution is -7.5 percent; after a 10ppt tightening in LTV and DTI, the 5th percentile is -6.6 percent.
  - Interpretation: borrower-based macroprudential measures reduce the likelihood of rapid appreciations and can lessen downside risks, though real-terms declines cannot be ruled out.

- Methodological note
  - Computing HaR requires a statistical model linking house prices to determinants such as incomes, rents, and financial conditions; the FSAP’s model of real regional apartment prices is summarized in the Annex to the report.

### Selected borrower-based measures and bank DSR outcomes
- Timeline of selected measures to curb household lending risks (highlights)
  - 8/2017: LTV and DTI ratios on mortgages tightened for all loan types in overheated markets; additional tightening for multiple homeowners.
  - 10/2017: Tougher eligibility rules for calculating debt and income in DTI ratio.
  - 3/2018: Pilot limits on high DSR loans for banks (full roll-out to banks as of 10/2018).
  - 4/2018: Limits on leasehold deposit guarantees for high-income borrowers and multiple housing owners; cap on amount of deposit that can be guaranteed by KHFC and HUG.
  - 9/2018: LTV limits and underwriting limits on loans to housing rental businesses; limits on rental income-to-interest expense ratio for real estate rental businesses.
  - 7/2019: Limits on lending at high DSRs extended to loans from non-bank financial institutions.

- Impact of Household Debt Service Ratio (DSR) policy on banks (Table 6)
  - Commercial banks
    - Target: 40
    - Average DSR: Before 52.4, After 41.2
    - Percent of loans with DSR > 70: Target 15; Before 19.6; After 7.8
    - Percent of loans with DSR > 90: Target 10; Before 15.7; After 5.3
  - Special Purpose banks
    - Target: 80
    - Average DSR: Before 128.2, After 68.6
    - Percent of loans with DSR > 70: Target 25; Before 40.1; After 24.6
    - Percent of loans with DSR > 90: Target 20; Before 32.8; After 18.1
  - Regional banks
    - Target: 80
    - Average DSR: Before 122.6, After 72.4
    - Percent of loans with DSR > 70: Target 30; Before 35.9; After 21.8
    - Percent of loans with DSR > 90: Target 25; Before 30.3; After 18.1
  - All banks (aggregate)
    - Average DSR: Before 71.9, After 47.5
    - Percent of loans with DSR > 70: Before 23.7, After 11.5
    - Percent of loans with DSR > 90: Before 19.2, After 8.2
  - Source: FSC and FSS. Target refers to threshold levels to be achieved by 2021. Before refers to June 2018. After refers to 2019Q1.

### Sectoral Countercyclical Buffer (SCCyB) on household exposures: rationale and potential effects
- Purpose and design
  - SCCyB complements borrower-based measures by building capital buffers on demarcated segments of exposures (household exposures) that pose risks beyond Pillar I.
  - Proposed by the FSS; the FSC is reviewing plans to introduce it.
  - Authorities already impose higher time-invariant risk weights on some household exposures; SCCyB would allow time-varying capital build-up and release as household risks wax and wane.

- Potential benefits and trade-offs (summarized)
  - Enhance or maintain banks’ resilience to sector-specific risks by creating a cushion to absorb unanticipated losses and support continued lending.
  - Provide a targeted and efficient capital-based tool that affects relative cost of lending to borrower types and can be more efficient than a uniform CCyB.
  - Provide a releasable buffer to be released in incipient crises, with accompanying measures to ensure released capital is used to absorb losses rather than for distributions.
  - Complement borrower-based measures (e.g., maximum LTV ratios) and could slow household lending pace as an ancillary effect, though affecting credit growth/house prices is not its primary purpose.
  - Potentially improve policy mix: an active SCCyB may allow some borrower-based tools to be scaled back, reducing declining marginal benefits and rising costs of tightened borrower-based measures.
  - International experience to date: only Switzerland and Spain have introduced SCCyB frameworks; only Switzerland has used the buffer (Jahn and Pirovano, 2019).

- Implementation caveats
  - The effect on overall credit growth depends on banks’ responses to higher capital requirements; banks may undertake less risky lending which reduces risk-weighted assets but not necessarily total assets.

### Corporate sector exposures and bank risk implications
- Aggregate indebtedness and composition
  - Total non-financial corporate credit stands at around 100 percent of GDP, roughly unchanged from 2013.
  - This level is about 4ppt higher than the G20 aggregate and 6ppt higher than the advanced economy aggregate reported by the BIS.
  - Of total corporate debt in Korea, KRW843tn (46 percent) was due to banks (as of 2019-Q1); the remainder is capital market funding.

- Bank lending composition
  - Direct lending to large corporates is around KRW160tn, about one fifth of banks’ overall corporate book.
  - Most bank lending—some KRW700tn (20 percent of system assets)—goes to SMEs.
  - Spread between average SME loan rates and that of large firms has been less than 0.5 percent for the past five years (latest available figures are for 2017).
  - NPL rates on bank balance sheets are low, supported by comprehensive corporate restructuring provisions and specialized asset management companies.

- Government support for SMEs
  - Around 10 percent of total SME lending is backed by a government loan guarantee.
  - A little under 1 percent of SME lending is made directly from government.
  - Government directs spending worth 3 percent of GDP towards SMEs through procurement and subsidies.
  - Five specialized banks (three government-controlled) play a significant role in SME funding; e.g., some four-fifths of IBK’s loans were to SMEs in 2018.

- Stress-test results and vulnerabilities
  - FSAP solvency stress tests show SME exposures imply loss rates that exceed their portfolio shares, especially for regional banks, indicating heightened vulnerability under the scenario considered.
  - Losses are not sufficient to drive the banking system to insolvency under the scenario, but results should be viewed with caution because knock-on effects from large firm failures to SMEs may not be fully captured.
  - Specialized banks’ regulatory capital ratios are somewhat below nationwide banks’, and capital depletion under adverse scenarios is more sizeable for specialized banks.

### Liquidity, regulatory changes, and recommendations concerning sectoral rebalancing
- New loan-to-deposit (LTD) ratio rules (starting 2020)
  - The flat 100 percent LTD ratio will be replaced by differential weights: 115 percent for household lending versus 85 percent for corporates.
  - The weight on SOHO loans will remain at 100 percent.
  - If banks have approximately equal exposures to households and corporates, no immediate changes would be necessary; but the differential could incentivize more corporate lending under some circumstances.

- Assessment and policy recommendations
  - The change in LTD rules is of dubious value and should be revisited.
    - Macroprudential tools should target systemic resilience, not be used to achieve sectoral rebalancing as an end in itself.
    - If corporate lending risks are the concern, options include changing risk weights on SME lending or microprudential actions to bolster specialized banks’ capital.
    - If household exposure risk is the concern, implementing SCCyB on household exposures would likely induce a natural rebalancing toward SME loans.
  - Changing exposure weights for the LTD ratio is unlikely to materially increase SME lending and may have unintended consequences in liquidity stress given existing liquidity regulations (including the NSFR).

_Italic: IMF staff summary of chapter 65 from the provided PDF content._

### 75. A principal source of systemic liquidity risk is over-reliance on non-core funding. Core

### 75. A principal source of systemic liquidity risk is over-reliance on non-core funding. Core

### Historical episodes of FX liquidity stress
- 1997–98 Asian financial crisis:
  - BIS-reporting banks had a ratio of foreign liabilities to assets of 332 percent in 1996.
  - Much of the borrowing was short-term, exposing banks to rollover risk and losses on loans to troubled corporates.
- 2008 Global Financial Crisis:
  - Won-dollar carry trades and large-scale short-term dollar borrowing (particularly by foreign bank branches) contributed to stress.
  - Deviations from covered interest parity (CIP) exceeded 1,000 bps during March 2008 turmoil.
  - FX swap market dislocation, sizable outflows of foreign exchange, and large-scale intervention by the Korean government and central bank.
  - Swap lines (e.g., with the Federal Reserve) provided USD liquidity relief until 2010.
- FX derivative market scale:
  - FX swaps daily volumes around $17.8bn in 2016 versus $9bn per day for other derivatives.

### Institutional monitoring and coordination
- Authorities monitoring foreign exchange markets: MOEF and BOK, with MEFM as principal information exchange and policy discussion venue.
- MEFM convened as often as twice a week during periods of intensified global trade tensions in 2019.
- MEFM formulates measures to counteract emerging FX risks; implementation rests with the BOK and supervisory authorities.

### Policy toolkit deployed to limit systemic FX risks
- Key measures (summary of design and coverage described in text):
  - LCR-FX (Liquidity Coverage Ratio differentiated by foreign currency):
    - Adopted as a requirement alongside Basel III LCR; both fully in force in 2019.
    - Domestic commercial banks with FX liabilities above a threshold, and specialized banks, must hold HQLA in foreign currency sufficient to cover a 30-day net cash outflow.
    - Floor set at 80 percent (LCR-FX) versus 100 percent (local currency equivalent).
    - Exclusions: (i) KEXIM; (ii) foreign bank branches; (iii) banks with foreign-currency denominated debt below USD 0.5bn, or with a foreign currency-denominated debt to total debt ratio of less than 5 percent.
  - LAR-FX (replaced by LCR-FX for large domestic banks in 2017) maintained for insurers, other non-banks, small domestic banks, and KEXIM.
  - Net derivative position limits:
    - Require banks to hold capital against net FX derivative positions; introduced in 2010 and adjusted in 2011 (tighter), 2013 (tighter), and 2016 (looser).
    - Higher ratio to capital (looser) for foreign branches reflecting different business models and parent-bank access to FX.
  - Macroprudential Stability Levy (MSL):
    - Introduced in 2011 as a flat fee of 10 basis points on non-deposit foreign exchange denominated liabilities with remaining maturity of a year or less.
    - Design properties: targets source of vulnerability, acts as an automatic stabilizer as tax base varies over the cycle, and acts on financial vulnerability without impairing banks’ core intermediation.
    - Proceeds ring-fenced into the ESF to support FX liquidity in times of stress.
  - Other policy elements: limits on net open positions and forward positions; derivatives caps; modifications to liquidity rules; fiscal measures (e.g., exemptions for capital gains and interest on foreign investors’ bond portfolios between May 2009 and January 2011).

### Effects and empirical evidence of policy measures
- Complementary toolkit combining price-based measure (MSL) and quantity-based backstops (LCR-FX) implemented to limit maturity mismatches and short-term external borrowing.
- Empirical findings cited:
  - Choi (2014): sizeable reductions in short-term external borrowing attributable to measures after 2011, with virtually no reductions in longer-term borrowing.
  - Cho and Hahm (2014): MSL reduced non-core liability ratios by close to 10 percentage points.
  - Kim and Lee (2017): policies curbed FX market vulnerabilities; MSL effective at limiting foreign borrowings of domestic banks.
  - Hwang (2017): tighter derivative limits curtailed volatility of banks’ FX liabilities, especially among foreign branches; banks remained well inside prudential derivative exposure limits.
- Overall assessment: FX services to the real economy not unduly restricted; measures raise cost of activities that create systemic risk but do not impose residency-based discrimination.

### Structural and non-bank vulnerabilities
- Financial structure concentration and non-bank growth:
  - Largest four nationwide banks plus largest two specialized banks account for 60 percent of system assets.
  - Around 90 percent of system assets are held inside one of thirteen financial conglomerates.
  - Investment companies: 501 in 2018 (from 315 in 2013).
  - Credit-specialized finance companies: 105 in 2018 (from 76 in 2013).
- D-SIB regime:
  - FSC designated four financial groups (Shinhan FG, Hana FG, KB FG, NongHyup FG), their subsidiary banks, and Woori Bank as D-SIBs for 2019.
  - D-SIBs must meet a risk-weighted common equity tier 1 capital ratio that is 1ppt higher than other banks.
- Network and contagion analysis:
  - FSAP simulated bilateral exposures across 64 entities.
  - Nationwide banks are systemically significant; failure of that sector would cause sizeable direct losses in other sectors, particularly investment firms (whose capital would be fully depleted under assumptions).
  - Specialized banks as a group are about as systemic as nationwide banks and could significantly deplete core banking capital if they default.
- Principal structural risks identified:
  - Concentration of real estate exposures with high correlation across institutions.
  - Opaqueness and complexity in financial conglomerates (non-holding groups may limit supervisory insight).
  - Rapid growth of complex financial products (e.g., equity-linked securities) introducing step-in or reputational risks.
  - Structural shifts from FinTech increasing competition and potentially weakening bank earnings and resilience.
  - Interconnectedness and spillovers between regulated and unregulated entities.
  - Geographic concentration of exposures (regional banks and capital-area concentration).

### Policy recommendations (overview and intent)
- Ensure existing macroprudential tools are deployed in a consistent and predictable fashion.
- Close gaps in coverage to address evolving risks (specific operational recommendations follow from above analysis and include maintaining and calibrating LCR-FX, derivative limits, MSL, D-SIB buffers, and monitoring structural/interconnectedness risks).
- Maintain close FX market monitoring and rapid information exchange through MEFM to detect and counteract incipient FX pressures.

*Source: IMF staff report (Republic of Korea financial sector assessment excerpt).*

### 91. A review should be undertaken of the quantitative guides used in deciding the level of

### 1korea2020004 - 91. A review should be undertaken of the quantitative guides used in deciding the level of 

### Countercyclical Capital Buffer (CCyB): review and design
- Recommendation: A review should be undertaken of the quantitative guides used in deciding the level of the CCyB.
- Goal of the review: provide policymakers with an indicator that:
  - Signals a crisis with sufficient lead-time for the CCyB to be a relevant tool—at least a year in advance.
  - Has coverage that encompasses macro risk, credit risk, funding risk, and foreign exchange risk.
  - Covers instances where the buffer may be released (IMF, 2014b, ¶21-¶25).
- Operational guidance:
  - The process for setting the quantitative guides should allow relevant technical teams latitude to review and revise the guides as situations warrant.
  - A particular set of quantitative guides should not be prescribed in regulations.
- Information constraint: Powers of regulation and supervision do not currently extend to non-holding financial groups, making the information necessary to gauge risks harder to come by.

### Disclosure and communication
- Recommendation: Greater disclosure of the considerations behind CCyB decisions is desirable.
  - Present announcements are terse.
  - Disclosure consistent with the Recommendations for Communication would help guide expectations for CCyB settings and may make policy more effective.
  - Publish the core CCyB indicators (taking into account the recommendations in ¶91) along with the policy decision.

### Strategy, governance, and review cycle
- Recommendation: The FSC should set forth a strategy for its use of the CCyB.
  - Quarterly cycle for CCyB (and SCCyB, if implemented) decisions should be in the context of an improved, transparent overall strategy for activation and release.
  - Development of a CCyB strategy could anchor a broader review of the integrated use of the full range of macroprudential tools (see ¶97).

### Housing and household sector: stock-take and SCCyB introduction
- Stock-take: Undertake a stock-take of interactions between existing policy measures (examples noted):
  - Requiring longer-term mortgages slows the effect of changes in LTV and DTI ratios on the stock of outstanding loans.
  - DTI and DSR limits share common channels of transmission.
  - Tightening borrower-based and lender-based tools in concert has reinforcing effects on resilience via direct reductions in leverage and indirect reductions in PDs and LGDs.
- SCCyB: The SCCyB should be introduced as soon as practical; implementation should follow appropriate review by relevant agencies.
  - Objective: Primary objective of the SCCyB shall be to build lenders’ resilience to the unwinding of cyclical imbalances associated with household sector lending.
  - Exposures covered: All secured and unsecured household exposures should be subject to the SCCyB.
    - Alternative: Consider a SCCyB targeted at real estate encompassing exposures to households and leasing businesses, if complementary measures can effectively contain spill-overs to unsecured and other secured lending (for example, the DSR tool).
  - Activation and release: Authorities should set out considerations likely to lead to activation or release; devise a set of indicators emphasizing forward-looking measures associated with build-ups of system-wide risk.
    - Ideally, core indicators would be a sub-set of those used to inform the CCyB.
  - Interaction with CCyB: BCBS recommends using the SCCyB and the CCyB as additive complements (BCBS, 2019b).
    - SCCyB requirements are then the difference in the SCCyB and the CCyB rates applied to sectoral exposures.
  - Calibration: Review possible methods for calibrating the SCCyB with emphasis on meeting resilience objectives while minimizing imbalance and loss spillovers.
  - Implementation: Allow banks to meet higher requirements over a period of up to one year; relaxations of the buffer can apply with immediate effect.
  - Frequency of review: Review the SCCyB in concert with the broad buffer on a quarterly basis.

### Structural risks and nonbank monitoring
- Recommendation: Introduce a framework to assess sources of structural risk and to develop mitigating policy measures.
  - Structural risks are often poorly understood and hard to monitor.
  - A useful starting point: ongoing work on monitoring non-bank entities and activities, and the emerging FinTech sector.

### Over-arching macroprudential strategy
- Recommendation: Develop an over-arching macroprudential strategy.
  - Purpose: Set out how the stages of the policy cycle unfold to ensure identified risks lead to policy action, effective implementation, monitoring of effects, and policy review (ESRB, 2014).
- An overall approach should:
  - Be applied systematically across policy tools.
  - Be understood on common terms across agencies.
  - Set out how the set of tools should be set in concert.
  - Set out who is responsible for monitoring and review.
  - Be transparent about resource requirements for effective implementation.
- Governance proposal: Document a suitable strategy and make it available to the public (Recommendation, ¶30).
  - The body charged with sole primary responsibility for macroprudential oversight (Recommendation, ¶19) would naturally coordinate development and present a formal proposal to the FSC commissioners for adoption.

### Comparative table note
- A table compares active macroprudential tools in select countries (Korea, Japan, Australia, Singapore, Malaysia) across categories including broad-based tools, household sector tools, corporate sector tools, liquidity tools (banking sector), tools for systemic liquidity risk and nonbank sector, and tools for SIIs and interconnectedness.
  - Source: IMF-AREAER Macroprudential Survey (2018).

### Appendix I — Regional house price dynamics: key findings and background
- Purpose: Top-down assessment of valuation in Korea’s principal residential real estate markets; evolution of real (inflation-adjusted) apartment prices across regions; valuation measures based on incomes and rents; model-based analysis for equilibrium prices.
- Background and structural facts:
  - Korea has one of the highest population densities of any large country.
  - Number of dwelling units nearly doubled between 1985 and 2000.
  - Dwellings per 1,000 people: 395 in 2017 from 214 in 1995.
  - Loans secured by real estate total in excess of KRW700tn, roughly 43 percent of GDP, up from 12 percent of GDP in 1997.
  - Outstanding stock of government debt is a shade over 40 percent of GDP.
  - Real estate assets make up around two-thirds of household balance sheets.
- Policy context: Authorities have deployed a broad set of fiscal and macroprudential tools to prevent rapid growth in residential real estate prices, motivated by affordability, banking sector exposure to real estate collateral, and household balance-sheet risks.
- Regional differentiation:
  - Capital area (Seoul, Incheon, Gyonggi-do) produces half of national GDP and contains half the country’s population.
  - Median apartment price in Southern Seoul is three times the national median, and eight times the price in the cheapest region (Gyeongsangbuk-do).
  - Policy measures have tended to be targeted on the capital region.
- Valuation summary:
  - Broad conclusion: scant evidence of serious over-valuation in any of the regional groups considered.
  - In the capital area, Seoul prices were around 10 percent above their equilibrium in the first quarter of 2019; surrounding areas are not overvalued.
  - Internal migration, particularly out of Seoul and into Gyeonggi-do, likely provides a natural equilibrating force.
- Empirical observations:
  - Correlations in real apartment price growth (Appendix I Table 1):
    - Capital vs Capital: 0.74
    - Other metropolitan vs Other metropolitan: 0.47
    - Non-metropolitan vs Non-metropolitan: 0.50
    - Capital vs Other metropolitan: 0.16
    - Capital vs Non-metropolitan: 0.11
    - Other metropolitan vs Non-metropolitan: 0.50
    - Note: Figures are averages of pairwise sample correlations in the first difference of log real apartment prices. Sample runs June 2003 through March 2019.
  - Nationwide apartment prices are up 3 percent in real terms since 2014, with regional disparities and recent declines driven largely by areas outside the capital city area.
  - Since 2014, average prices have run behind incomes in all three regional groups; declines most marked in non-metropolitan areas.
  - Jeonse (lease) prices have been falling relative to sales prices over the past two years, led by declines in the capital area; jeonse prices are on average around two-thirds of the value of the property being leased.
- Model-based approach:
  - A model (similar to Holly and others, 2010, 2011) considers for each region: real income per capita; real jeonse prices; prices in adjacent regions; and the real long term interest rate.
  - Rationale: account jointly for multiple influences on prices and spatial linkages (e.g., price ripples from Seoul to nearby areas).

*Source: IMF staff report excerpts (Republic of Korea).*

### 13. Real apartment prices in the three regions in the capital area are modeled. Monthly

### 13. Real apartment prices in the three regions in the capital area are modeled. Monthly

### Model and methodology
- Monthly data from 2003 to 2019 is used, as 2003 is the earliest date for which data on Gyeonggi-do is available.
- The chosen model is a vector autoregression (VAR) that allows for a very general set of dynamic relationships between the likely determinants of equilibrium prices.
- System tests for cointegration are performed to uncover long-run relationships; when two or more trending variables are cointegrated, a linear combination of them is stationary.
- Additional variables considered but not retained due to unstable or implausible effects: number of dwelling units per household, net migration as a proportion of regional population, regional unemployment rates.
- Complications noted:
  - The jeonse implicit rental income depends on returns landlords earn on tenant cash deposits and is broadly linked to market interest rates, which have been low.
  - The share of jeonse leases has been declining relative to monthly rental payment arrangements in recent years, implying possible structural changes in the relationship between jeonse prices and sales prices.

### Main findings — Seoul
- There is one long-run relationship in the data for Seoul.
- Long-run elasticities and signs:
  - Prices have a unit income elasticity: a 1 percent change in Seoul GDP translates into a 1 percent change in Seoul prices.
  - Interest rates carry an unexpected positive sign, consistent with buyers moving into property assets when the returns that can be earned from tenant cash deposits are high.
- Speed of adjustment:
  - Adjustment to eliminate disequilibrium is estimated to occur at a rate of 2.6 percent per month (reported as -0.026 in Appendix I Table 2).
  - Illustration: if prices are initially 10 percent above equilibrium, then after a year they will on average have adjusted downward to be 3.6 percent above equilibrium.

### Main findings — Incheon and Gyeonggi-do (capital area outside Seoul)
- Spatial effects dominate after accounting for regional prices; regional incomes play no role in the long-run equilibrium for Incheon and Gyeonggi-do (though incomes matter for short-run dynamics).
- Long-run unit elasticity on spatially-weighted price index accepted by the data:
  - A 1 percent change in neighboring prices eventually translates into a 1 percent change in home region prices.
  - The region-specific fixed effects account for level differences (so unit elasticity does not imply convergence to the same median price level as Seoul).
- Bordering regions included:
  - For Incheon: Seoul and Gyeonggi-do.
  - For Gyeonggi-do: Seoul, Incheon, and three non-Metropolitan markets.
- Speeds of adjustment:
  - Incheon: 3 percent per month (reported as -0.030).
  - Gyeonggi-do: 8 percent per month (reported as -0.076).
- Observed dynamics:
  - Incheon prices have been running behind those in Seoul and Gyeonggi-do, and can be expected to rise in the long run.
  - Gyeonggi-do real prices have been growing at a similar pace to bordering regions and are estimated to be close to their equilibrium level.
  - The ‘ripple effect’ from Seoul to Gyeonggi-do is visible in close co-movement of valuation measures.
  - Possible underlying mechanism: net internal migration — Gyeonggi-do saw in-migration close to 10 percent of population in 2018-19, while Seoul saw out-migration of a similar magnitude over the same period.

### Valuation and overall assessment
- Capital region prices are not notably over-valued:
  - The model-based valuation measure for the capital area estimates apartment prices as running around 5 percent above their long-run level in the first quarter of 2019.
- Regional patterns:
  - Seoul: real apartment prices growing a little ahead of incomes.
  - Incheon: prices lagging relative to Seoul and Gyeonggi-do.
  - Gyeonggi-do: prices growing similarly to bordering regions and near equilibrium.

### Appendix I Table 2 — Real Apartment Prices, Long-Run Equilibrium (selected coefficients and statistics)
- Long-run cointegrating coefficients (unit elasticities and other variables reported):
  - Real apartment price: 1.0 (Seoul), 1.0 (Incheon), 1.0 (Gyeonggi-do).
  - Real income per capita: -1.0 (Seoul), 0 (Incheon), 0 (Gyeonggi-do).
  - Jeonse price: 0 (Seoul), - - (Incheon), (blank for Gyeonggi-do in table body).
  - Spatially-weighted apartment price: - (Seoul), -1.0 (Incheon), -1.0 (Gyeonggi-do).
  - Real long-term interest rates: -0.075 (0.0089) (Seoul), 0.010 (0.0032) (Incheon), -0.024 (0.00371) (Gyeonggi-do).
  - Constant: -7.32 (0.045) (Seoul), 0.67 (0.013) (Incheon), -0.072 (0.018) (Gyeonggi-do).
- Speed of adjustment (per month):
  - Seoul: -0.026 (0.0095)
  - Incheon: -0.030 (0.026)
  - Gyeonggi-do: -0.076 (0.028)
- Tests and statistics:
  - Test of over-identifying restrictions (p-value): 0.29 (Seoul), 0.55 (Incheon), 0.04 (Gyeonggi-do).
  - Number of cointegrating relations (r*): 1 (Seoul), 2 (Incheon), 3 (Gyeonggi-do).
  - Max eigenvalue statistic (r* ≤ r), p-value: 0.08 (Seoul), 0.06 (Incheon), 0.05 (Gyeonggi-do).
  - Trace statistic, p-value: 0.01 (Seoul), 0.02 (Incheon), 0.05 (Gyeonggi-do).
- Note: absolute value of standard errors in parentheses.

### Data sources and construction notes
- Regional coverage: 17 main administrative provinces (8 metropolitan including Seoul, 9 non-metropolitan). City of Sejong and Jeju-do excluded.
- Apartment price data sources: Korea Appraisal Board (KAB) and Kookmin Bank (KB).
  - KAB transaction price data comes in pre- and post-2012 vintages; these are spliced by rebasing as needed.
  - Spatially-weighted prices constructed by rescaling indexes by median house prices available from 2013 from KB, applying a spatial weighting matrix with unit entries for bordering or vertex-touching regions, and row-normalizing the weight matrix.
- Price deflation: nominal house prices deflated using regional CPI data; regional CPI is available monthly back to 1985.
- Monthly regional income: interpolated from annual regional GDP using monthly indices of production, employment and unemployment rates, and retail sales (Harvey, 1989; Ch. 6.3). Interpolated monthly regional income converted to per capita using regional population series interpolated monthly by cubic spline.

*Source: REPUBLIC OF KOREA, INTERNATIONAL MONETARY FUND*

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_Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1korea2020004.pdf_