## _cr14126 ## Source details **Canonical URL:** [_cr14126](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14126.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14126.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14126.pdf.json) --- ### Macroeconomic outlook and micro-financial linkages - GDP growth projections: - Rebound to 2.8 percent in 2013 (from 2 percent in 2012). - Strengthen to 3.7 percent in 2014. - Inflation: - Fell to 0.7 percent in October 2013 from 4.2 percent in 2011. - Target band: 2½–3½ percent. - External position: - Current account surplus expected to reach around 5.5 percent of GDP in 2013, exerting upward pressure on the exchange rate. - Key near-term risks: - Sharply slower growth in Korea’s main trading partners. - Severe global financial market stress. ### Financial sector soundness, resilience, and vulnerabilities - Improvements since 2008: - Banking sector capitalization improved; CARs: - 12.3 percent at end-2008. - 14.3 percent at end-2012. - Foreign currency liquidity profiles strengthened. - Active disposal of bad assets resulted in low NPL levels: - NPLs of commercial banks: 1.2 percent of total loans at end-2012. - Total financial sector assets: 312 percent of GDP at end-2012. - Banking sector share: 48 percent of aggregate financial sector assets at end-2012; lending constituted 73 percent of commercial banks’ total assets. - Remaining pressures and exposures: - Bank profitability weak; ROA of commercial banks in 2012 about 0.5 percent. - Conservative provisioning standards (up to about 150 percent of expected losses). - Corporate sector: aggregate debt-at-risk ratio comparable to 2008 crisis; leveraged relative to OECD peers. - Household debt: 136 percent of disposable income at end-2012. - NDFIs accounted for 20 percent of household credit at end-2012; all NBFIs accounted for 45 percent. - Household borrowers with high DSR (>40 percent) and high LTI (>400 percent): 35 percent in July 2010 (up from 30 percent in July 2009); share with high DSR (>40 percent) alone estimated at 33 percent at end-2012. - Sectoral asset shares at end-2012: - Insurance companies: 19 percent of aggregate financial sector assets. - Asset management companies: 8 percent. - Securities companies: 7 percent. - Bond market: - Outstanding securities accounting for 123 percent of GDP at end-2012. - Domestic debt securities: corporate issuers 43 percent of GDP; financial institutions 32 percent of GDP. - Derivatives market: - Daily turnover of equity-linked derivatives at the Korea Exchange second highest globally behind the CME. ### Stress testing — solvency, liquidity, FX, and NBDIs - Banking system stress-test findings: - Capital adequacy ratios remain at about or above 10 percent even under the most severe stress test scenario. - System-wide capital ratios remain considerably above the Basel III requirement even under a very adverse macro scenario. - By end-2017, under the severe scenario: - Aggregate CAR would decline to 12 percent taking into account contagion effects, against 13.6 percent without such effects. - Market risk exposures at end-2012 were about eight times smaller than credit risk exposures. - Under the most adverse scenario, market risks would account for up to 0.3 percent of risk-weighted assets in 2014 (BU exercise) and 0.8 percent in 2013 (TD exercise). - TD estimates: a market shock would reduce the CAR of the top seven banks by about 1.3 percent. - Solvency scenario examples (five-year horizon): - Severe global double-dip: real GDP growth could be -3.8 percent in 2013 and -2.7 percent in 2014 with gradual recovery by 2017. - Prolonged low growth: real GDP growth 2.5 percentage points below projected baseline over the 5-year horizon. - Interest rate spike: interest rates increasing by 250 basis points over 2½ years starting in H2 2014. - Additional sensitivities: - Interest rate shocks: extreme 300 basis points and moderate 200 basis points. - Exchange rate depreciation: extreme 50 percent and moderate 30 percent. - Fall in real house prices: extreme 20 percent and moderate 15 percent. - FX liquidity stress tests: - Under a shutdown of global wholesale funding, aggregate gap for all commercial banks around US$3.8 billion without committed credit lines (about 1.2 percent of Korea’s international reserves). - After committed credit lines, gap turns into a small surplus of around US$155 million. - Authorities’ estimate (end-September 2013 data): decline in FX liquidity gap to US$1.5 billion before credit lines and a surplus of US$3.1 billion after credit lines. - NBDIs (including MSBs and credit unions): - Some NBDIs could only handle up to a 6–8 percentage point increase in NPLs before capital drops below minimum required threshold. - Design of NBDI stress tests used a simple balance-sheet framework due to lack of data (except MSBs). ### Macroprudential framework, measures, and institutional arrangements - Tools and effects: - LTV introduced in 2002; DTI limits in 2005. - Current LTV limits: - 50–60 percent for banks. - 60–70 percent for nonbanks. - DTI ratio limit: between 50 percent and 65 percent. - Average actual LTV in Korea around 50 percent (comparatives: 74 percent in Germany, 75 percent in the U.S., 80 percent in the United Kingdom). - Result: Low average LTV helped keep mortgage default rates below 1 percent into 2012. - Loan-to-deposit (LTD) ceiling enforcement: prior LTD around 120 percent; after enforcement (June 2012) LTD came down to around 95 percent (as of April 2013) on average for commercial banks. - FX derivative position ratios: - Introduced October 2010 at 250 percent for foreign branches and 50 percent for domestic banks. - Tightened July 2011 and January 2013 to 150 percent and 30 percent for foreign branches and domestic banks, respectively. - Macroprudential Stability Levy since August 2011: 20 basis points of the dollar amount of short-term FX funding with maturity of less than one year (lower rates for longer maturities). - Effects observed: - Average FX leverage ratio of foreign branches fell from over 260 percent to around 90 percent on average in late 2013. - Share of short-term FX funding in all FX funding fell from around 50 percent in 2008 to less than 20 percent in April 2013. - Institutional arrangements: - Macroprudential Economic and Financial Meeting (MEFM) replaced prior interagency meetings on July 20, 2012. - MEFM meets at least quarterly at deputy level and comprises BOK, FSC, FSS, and MOSF (MOSF chairs and prepares the agenda). - Decisions at MEFM are not binding; each agency remains ultimately responsible for policy in its domain. - Recommendation: Establish a dedicated and formal macroprudential council with: - Stronger role for the BOK. - Power to recommend regulatory action with a “comply or explain” mechanism. - Mandated regular BOK systemic risk assessments and public reporting of deliberations. - Safeguard: Monetary policy should remain independent; monetary policy explicitly excluded from council discussion or BOK veto. ### Crisis preparedness, crisis management, and deposit insurance - Suggested institutional improvements: - Establish a dedicated apex committee for leading and coordinating crisis preparedness and crisis management distinct from macroprudential council. - Periodic crisis simulation exercises. - Formally designate crisis management teams in each supervisory authority and establish multi-agency institution-specific crisis management groups. - Develop a crisis management handbook. - Deposit insurance and KDIC: - Recommendation: Replenish the deficit in the deposit insurance fund; assure KDIC back-up funding (explicitly assured and irrevocable line of credit from the Government recommended). - Discontinue practice of allowing insolvent banks to accept fresh deposits and repay existing deposits. - Review processes to reduce timelines for depositor repayment, financial assistance, and resolution decisions. - Public funds and moral hazard: - Review public funds established after GFC and late 1990s to address potential moral hazard and avoid distorting incentives. - ELA and BOK role: - BOK has significant capacity including foreign reserves and swap lines; at end-March 2013 BOK held US$327.4 billion of reserves (28 percent of GDP). - Bilateral swap lines with PBOC, CMI, BOJ and multilateral swap via Chang Mai Multilateral Initiative. - Recommendation: Ensure ELA framework robust and understood; BOK crisis management contingency plan should adequately cover ELA-related decisions. ### Regulation, supervision, legal framework, and enforcement - Structural and legal observations: - Progress since 2003 FSAP; moderate compliance with BCPs (as revised in 2012). - Overarching supervisory concerns: governance, mandate, risk-sensitive approaches, and perceived independence from political influence. - Legal framework solid but gaps include a prosecution-centric enforcement approach and relatively narrow/low pecuniary administrative sanctions. - Recommendation: Strengthen independence of FSC and FSS from political process; broaden administrative and civil penalties and increase fines. - Institutional roles: - MOSF: FX policies and financial/economic coordination. - FSC: financial sector policy, prudential policy, supervision, enforcement, sanctions, and resolution. - SFC (within FSC): monitors and supervises capital market activities. - FSS: inspection and supervision under FSC/SFC guidance. - KDIC: deposit insurance and resolution under FSC guidance. - KOFIU: financial intelligence under FSC oversight. - Sectoral supervisory takeaways: - Banking: - ICAAP importance; average CAR about 13.8 percent. - Basel II applies to commercial banks; FHCs subject to Basel I but plans to apply Basel II to FHCs by December 2013; FSS plans to implement Basel III in December 2013. - Apply bank-consistent regulatory framework to larger non-bank deposit-takers. - Enhance risk-sensitive supervision, more frequent onsite exams, stronger corporate governance assessments. - Insurance: - High observance of ICPs; total premium KRW 149.9 trillion (USD 134 billion) in 2011. - Insurance penetration 11.6 percent; insurance density USD 2,660 per person. - Profitability and capital sound; negative interest rate spread risk mitigated but requires ongoing monitoring. - Securities: - Good overall compliance with IOSCO Principles; K-IFRS applied since 2011. - Complex decision-making structure; recommend greater transparency on responsibilities. - Expand on-site exams for smaller entities, auditors, and asset management companies. - Enforcement hampered by lack of sufficiently dissuasive administrative sanctions and criminal process length. ### Financial Market Infrastructures (FMIs) and market liquidity - Payment, clearing, and settlement: - BOK-Wire+ is the real-time interbank gross payment and settlement system; finality and irrevocability applied to settled transactions. - KRX operates KOSPI, KOSDAQ, and DM and offers CCP services; planned CCP for OTC derivatives intended to comply with PFMI before launch. - BOK-Wire+ recommendations: - Improve collateral risk management by regular testing of haircuts and annual independent validation. - Clarify regulations on settlement finality and queue management. - Fully implement disclosure framework, including English rules/regulations. - Strengthen BOK oversight powers over linked payment FMIs and participants. - KRX CCP recommendations: - Collect risk-based collateral (daily margin) to cover exposures between transaction and settlement days. - Reconsider design of joint compensation funds (remove fixed size requirement). - Increase criteria for settlement banks and custodians. - Independent review and validation of margin model. - Improve independence and staffing of risk management committee; increase staff for credit and liquidity risk. - Market liquidity structure and vulnerabilities: - Structural liquidity overhang around KRW 230 trillion (about 20 percent of GDP). - Money market: active secondary markets mostly up to one week maturities; longer-term markets shallow and dominated by buy-and-hold investors. - Absence of active secondary markets increases prominence of BOK as backstop in stress. - Recommendation: boost secondary market liquidity (Basel III LCR implementation and repo market improvements), and ensure ELA procedures are well honed and practiced. ### Household debt, housing, and related vulnerabilities - Household debt dynamics and asset composition: - Household debt as share of disposable income increased from 116 percent in 2004 to 156 percent at end-2011. - Household debt 136 percent of disposable income at end-2012. - Median household debt to disposable income across OECD countries in 2011: 128 percent. - At end-2012 households’ net assets accounted for 115 percent of household debt. - Currency and deposits accounted for more than 45 percent of financial assets; real estate accounted for 75 percent of total household assets. - LTV values currently around 50 percent. - Banks’ collateral recovery up to 120 percent of loan values. - Share of bullet loans declined from 41.3 percent at end-2010 to 33.6 percent in March 2013. - Share of fixed rate loans increased from 5.1 percent at end-2010 to 39.5 percent in May 2013. - Debt of multiple loan borrowers rose from KRW 262 trillion in June 2010 to KRW 306 trillion at end-2012. - Sensitivity analysis (KIF based on IMF FSAP framework): - Baseline: aggregate level of debt at risk not covered by all assets stands at 0.7 percent. - If absorptive capacity of financial assets only is taken into account, debt at risk stands at 21.9 percent. - Policy recommendations to address household and nonbank vulnerabilities: - (i) Tighter regulation of NBFIs to curb further credit expansion via regulatory arbitrage. - (ii) Further transformation of household debt structure towards fixed rate amortizing loans, ensuring pricing reflects risks. - (iii) Expanded availability of debt counseling services, providing budget and legal advice to households. - Support gradual household deleveraging to balance growth momentum and financial stability. ### High-priority recommendations (selected items and timing) - Establish a dedicated and formal macroprudential council with stronger BOK role and transparency — Medium-term. - Strengthen independence of FSC and FSS and clarify allocation of decision-making responsibilities — Short to Medium-term. - Broaden administrative and civil penalties and increase amount of fines — Medium-term. - Enhance coordination among agencies involved in stress testing (FSS and BOK) — Short-term. - FSS to carry out comprehensive validation of banks’ stress testing exercise — Short-term. - Disclose to the public the results of the stress tests conducted by the authorities — Short-Term. - Empower supervisors to set capital ratios above Basel II minimum; implement Pillar-2 principles; extend Basel II capital to group holding companies — Short-term. - Apply bank-consistent regulatory framework to all NBDIs; subject larger entities to stricter supervision — Short-term. - Implement risk-based approach to AML/CFT supervision; expand supervisory activities to all deposit-taking institutions and designated non-financial businesses and professions — Short-term. - Ensure comprehensive audit oversight and introduce minimum standards for appointing external auditors of banks — Medium-term. - Enhance risk-sensitivity of supervision via more flexible and frequent examinations, covering smaller supervised entities and enhancing judgmental assessments — Medium-term. - Establish dedicated apex committee for crisis preparedness and management; undertake periodic crisis simulation exercises — Short-term. - Replenish deficit in deposit insurance fund; assure KDIC back-up funding — Short-term. - BOK to ensure crisis management contingency plan adequately covers ELA-related decisions — Short-term. - Put in place an MOU to ensure effective coordination between BOK and FSC in FMI matters and provide BOK with more enforcement tools — Short-term. - Reform credit risk and management framework for securities market; increase number of KRX staff managing companywide and CCP-related matters — Short-term. ### AML/CFT, monitoring, and enforcement gaps - Progress since FATF November 2008 assessment, but deficiencies remain: - Supervisory sanction regime primarily targets staff rather than financial institutions; sanctions mostly non-pecuniary. - AML/CFT regulation and supervision of designated nonfinancial businesses and professions currently encompass only casinos. - Shortcomings in terrorist financing offence remain. - Draft bill to amend the Prohibition of Financing for Offences of Public Intimidation Act is being drafted; expected submission to National Assembly later this year. - Bill amending Financial Transaction Reports Act submitted to National Assembly to abolish threshold for suspicious transaction reports and require full originator information to travel with wire transfers. - FATF tentatively scheduled Korea for assessment against revised AML/CFT standard in 2016. ### Supervisory intensity, onsite/on-line practices, and capacity - FSS supervisory model: - Two-tiered approach: relationship manager model and centralized subject matter expert teams. - Offsite data collection: FSIs quarterly; liquidity data monthly; CAEL risk rating tool used. - Onsite examinations: - Full-scope onsite normally every two years; team takes ~one month; uses CAMEL-R framework. - Partial onsite normally every other year, focused on single thematic issues. - Best-practice: more frequent onsite exams for larger systemically important banks; meetings with full boards recommended. - Nonbank deposit-takers and MSBs: - As of March 2013: ~2,338 Credit Unions and Cooperatives and 93 Mutual Savings Banks. - Credit Unions and Cooperatives combined total assets: KWR 352.1tr representing 9.9 percent of the financial system and KWR 10.7 percent of lending by the financial system. - Average assets: KWR 150.6 billion; average lending: KWR 87.4 billion. - Largest Credit Union by assets: KWR 600 billion; largest Cooperative: KWR 2 trillion (Agricultural sector). - Agricultural Cooperatives market share almost 80 percent at KWR 272.6 trillion. - FSS-FSC rely upon Federations for sharing supervisory responsibilities; scope exists to apply consistent minimum requirements across banks and nonbank deposit-takers. - Staffing and enhancements: - FSS-FSC described as skilled with detailed offsite processes. - Enhancements recommended: more frequent assessments of risk management information, intrusive board assessments, targeted thematic and deep-dive exams, and resource allocation to highest-risk institutions. *Source: EXECUTIVE SUMMARY and extracted IMF staff report content for _cr14126* ### EXECUTIVE SUMMARY ___________________________________________________________________________ 7 ### _cr14126 - EXECUTIVE SUMMARY ___________________________________________________________________________ 7 ### Macroeconomic Outlook and Micro-Financial Linkages - GDP growth is expected to rebound to 2.8 percent in 2013 (from 2 percent in 2012), and strengthen further to 3.7 percent in 2014, in view of the projected global recovery and a gradual pickup in domestic demand. - Inflation has fallen to 0.7 percent in October 2013 from 4.2 percent in 2011, well below the target band of 2½–3½ percent. - The current account surplus is expected to reach around 5.5 percent of GDP in 2013, putting upward pressure on the exchange rate. - Main near-term risks are external: sharply slower growth in Korea’s main trading partners or severe global financial market stress. ### Soundness of the Financial Sector and Potential Risks - System vulnerabilities have diminished since the 2008 crisis: banking sector capitalization has improved, foreign currency liquidity profiles have strengthened markedly, and active disposal of bad assets has resulted in low levels of nonperforming loans. - Profitability of banks has remained weak; further economic weakness could impair the soundness of corporate and household sectors. - Macroprudential policies slowed the growth of banks’ lending to households but spurred household exposures to less regulated nonbank financial institutions (NBFIs). - Banking system stress tests: - Capital adequacy ratios remain at about or above 10 percent even under the most severe stress test scenario. - Banks’ foreign currency liquidity positions are robust; only under a very severe scenario would the system face a small but manageable liquidity shortage. - Nonbank depository institutions (NBDIs) are more vulnerable: stress tests reveal some NBDIs have thin buffers against credit risk. - Recommendation: Apply a regulatory framework consistent with that for banks to all NBDIs, with larger entities also subjected to stricter supervision. ### Macroprudential Framework and Institutional Arrangements - Korea has been effective in articulating and applying macroprudential policies, but would benefit from the establishment of a macroprudential council. - Rationale for a council: - High degree of capital account openness and increasing financial integration, - Greater sophistication of the financial sector and potential for regulatory arbitrage, - Need for enhanced ability to detect emerging systemic risks and initiate timely responses. - Benefits of formal arrangements: - Enhanced transparency and accountability, - Greater degree of independence from the political process, - Clarification and strengthening of the role of the BOK in financial stability, - Separation of the macroprudential policy function from crisis management. ### Crisis Preparedness and Crisis Management - Recommendation: Establish a dedicated apex committee for leading and coordinating crisis preparedness and crisis management. - Authorities should undertake periodic crisis simulation exercises; strengthen the ability of the deposit insurance and resolution authority to play a more effective role; bring the financial institutions resolution framework in line with international best practice, particularly for financial conglomerates and SIFIs. - Deposit insurance: replenish the deficit in the deposit insurance fund; assure KDIC back-up funding. - Address potential moral hazard risks by enhancing banks’ risk management and ensuring that government support is not assured or open-ended. - BOK emergency liquidity assistance (ELA): - BOK has significant capacity to respond to foreign and domestic currency liquidity pressures although tensions may arise in times of heightened stress. - Recommendation: Ensure the ELA framework is robust and understood by stakeholders; ensure BOK crisis management contingency plan adequately covers ELA-related decisions. ### Regulation, Supervision, and Legal Framework - Building on 2003 FSAP recommendations, authorities have taken resolute steps to strengthen regulation and supervision; assessments identified gaps to be addressed. - Overarching supervisory concerns: governance, mandate, and risk-sensitive approaches that could undermine supervisory effectiveness. - Legal framework: provides a solid foundation for oversight but gaps remain, notably the narrow range and level of pecuniary administrative sanctions compared with a prosecution-centric focus. - Regulatory architecture concerns: - Independence from political influence (or perception thereof), - Multiple objectives that dilute focus on core supervisory mandate, - Overlapping responsibilities and complex processes requiring intense inter-agency communication. - Recommendation: Further strengthen the independence of the FSC and FSS from the political process to facilitate greater focus on promoting safety and soundness and sound supervisory and enforcement decisions. - AML/CFT: - Authorities have undertaken various initiatives but key shortcomings persist: - Lack of a sound and effective risk-based approach to AML/CFT supervision, - Slow progress in amending the legal framework, - Absence of supervision for a subset of deposit-taking institutions. - Recommendation: Implement a risk-based approach to AML/CFT supervision and expand supervisory activities to all deposit-taking institutions and the designated non-financial businesses and professions. ### Systemic Liquidity and Financial Market Infrastructures (FMIs) - High levels of KRW liquidity provide confidence in financing longer term assets from short-term funding markets, but thin secondary markets for fixed-income securities are a weakness in times of stress, implying a prominent BOK role to backstop markets. - Recommendations: - Support secondary markets development, - Enhance cooperation between the BOK and the FSC regarding regulation, supervision, and oversight of FMIs, - Develop a Memorandum of Understanding to ensure effective coordination between the BOK and FSC covering both technical and management levels, - Develop and test a crisis management plan for FMIs, - Increase powers of the BOK and resources of the FSC. - Reform the credit risk and management framework for the securities market, and increase the number of KRX staff managing companywide and CCP-related matters. ### High-Priority Recommendations (excerpted items and timing) - Establish a dedicated and formal macroprudential council, with a stronger role for the BOK, the power to recommend regulatory action from other bodies, and transparency over policy deliberations. — Medium-term - Strengthen the independence of the FSC and FSS and increase transparency of the allocation of decision-making responsibilities among the two authorities. — Short to Medium-term - Enhance enforcement effectiveness by broadening the range of administrative and civil penalties and increasing the amount of administrative fines and civil penalties. — Medium-term - Enhance coordination among agencies involved in stress testing (FSS and BOK). — Short-term - FSS should carry out a comprehensive validation of banks’ stress testing exercise. — Short-term - Disclose to the public the results of the stress tests conducted by the authorities. — Short-Term - Empower supervisors to set capital ratios above the Basel II minimum, implement all principles of Pillar-2 of Basel II, and extend calculation of Basel II capital to group holding companies. — Short-term - Apply regulatory framework consistent with that for banks to all NBDIs, with larger entities also subjected to stricter supervision. — Short-term - Implement a risk-based approach to AML/CFT supervision, and expand supervisory activities to all deposit-taking institutions, and the designated non-financial businesses and professions. — Short-term - Ensure sufficiently comprehensive audit oversight and introduce minimum standards for appointing external auditors of banks over and above existing requirements, reflecting expectations of experience and expertise. — Medium-term - Enhance risk-sensitivity of supervision via more flexible and frequent examinations that also provide sufficient coverage of the smaller supervised entities and enhancement to the judgmental component of the assessments. — Medium-term - Establish a dedicated apex committee for leading and coordinating crisis preparedness and management work; undertake periodic crisis simulation exercises. — Short-term - Replenish the deficit in deposit insurance fund; assure KDIC back-up funding. — Short-term - BOK to ensure that its crisis management contingency plan adequately covers ELA-related decisions. — Short-term - Put in place a Memorandum of Understanding to ensure effective coordination between BOK and FSC in FMI matters, and provide BOK with more enforcement tools. — Short-term - Reform the credit risk and management framework for the securities market, and increase the number of KRX staff managing companywide and CCP-related matters. — Short-term *Source: EXECUTIVE SUMMARY, _cr14126* ### 2. Against this background, the Korean authorities’ response has been timely and ### _cr14126 - 2. Against this background, the Korean authorities’ response has been timely and ### Policy response and macroeconomic stance - The government issued a supplementary budget in April 2013 (of 1¼ percent of GDP) to make up for a potential revenue shortfall and provide modest stimulus. - The fiscal deficit (excluding social security funds) is projected to widen to around 2.1 percent of GDP in 2013. - The previously committed fiscal consolidation path has been delayed in view of the prevailing negative output gap. - The BOK cut the policy rate by 25 bps in May 2013 to 2.5 percent, after pausing since October 2012. - In April 2013, the government launched a comprehensive policy package to stimulate the property market. - Key short-term risks to the outlook identified: - An abrupt and premature exit from quantitative easing in the United States. - A re-intensification of the euro area crisis. - A deeper-than-expected slowdown in emerging markets, particularly China. ### Recent market turbulence and Korea’s resilience - Korea was affected only mildly by recent global market turmoil and was viewed as a safe haven. - After an initial short-lived fall in the won, Korea proved resilient to large capital outflows and sharp currency depreciations following the announcement of the eventual tapering of U.S. unconventional monetary policy (UMP) in May. - Despite tighter global conditions: - Korean bond yields have risen only modestly. - The Korean won and stock market have actually been appreciating. - Korea’s relative resilience reflects strong fundamentals, particularly reduced short-term external debt, low inflation and public debt, and rebounding growth. - Susceptibility to capital flow volatility remains a key concern; measures have been taken to mitigate this volatility. ### Financial crisis experience and stabilization policy measures - Prompt policy actions supported a relatively rapid recovery of the financial sector and the broader economy after the 2008 crisis. - Net capital outflows amounted to 4½ percent of annualized GDP in the fourth quarter of 2008, compared to about 3¾ percent of annualized GDP in the fourth quarter of 1997 during the Asian financial crisis. - The shortage of dollar funding spilled over into domestic money markets; perceived default risk of Korean banks increased more than anywhere else in the region. - Comprehensive policy responses prevented disruption to the flow of credit to the economy. Box 1 — Global Financial Crisis: Korea’s Stabilization Policy Measures (measures mostly phased out except SME support) - Providing generous liquidity support in both won and U.S. dollar: - BOK broadened eligible counterparties and collateral in won repo operations and supplied liquidity of KRW16.8 trillion through long-term repos. - Set aside KRW 5 trillion (KRW 2.1 trillion were used) to purchase corporate bonds and CPs under the Bond Market Stabilization Fund. - Used foreign reserves and entered into currency swap deals with major central banks to provide up to US$56 billion to banks and trade-related businesses. - Guaranteeing banks’ external debt: - Government guaranteed banks’ foreign debt in 2009; by end-2009 several banks accessed international capital markets without the guarantee. - Establishing recapitalization and restructuring funds: - In December 2008 a Bank Recapitalization Fund of up to KRW 20 trillion was set up; a one-time injection of KRW 4 trillion into eight banks was carried out in March 2009. - KAMCO stood ready to issue up to KRW 40 trillion government-backed bonds to purchase corporate NPLs (only a fraction was used). - Ensuring SMEs’ access to credit: - SME credit guarantees were raised and coverage increased up to 100 percent; banks were guided to roll over SME loans falling due in 2009. - Subsidized lending facilities for SMEs expanded, with the BOK raising the Aggregate Credit Ceiling by KRW 3.5 trillion to KRW 10 trillion. - Actively using macroprudential tools to contain systemic liquidity risks in the banking sector. - The interbank market stabilized quickly after a roughly 150 basis point spike in interbank market spreads in December 2008. - With banks able to fund themselves, private domestic credit continued to grow healthily. ### Financial sector structure and key statistics - The total assets of the financial sector amounted to 312 percent of GDP at end-2012. - The banking sector accounted for 48 percent of aggregate financial sector assets at end-2012; lending constituted 73 percent of commercial banks’ total assets. - The nonbank sector’s share rose to 52 percent at end-2012 from 41 percent at end-2000. - Credit cooperatives accounted for about 11 percent of aggregate financial sector assets at end-2012. - Non-deposit-taking institutions’ shares of aggregate financial sector assets at end-2012: - Insurance companies: 19 percent. - Asset management companies: 8 percent. - Securities companies: 7 percent. - As of end-2012, there were 12 FHCs in Korea: 10 bank and 2 nonbank holding companies. - The bond market: outstanding securities accounting for 123 percent of GDP at end-2012. - In Korea, outstanding domestic debt securities at end-2012: - Corporate issuers: 43 percent of GDP. - Financial institutions: 32 percent of GDP. - Daily turnover of equity-linked derivatives at the Korea Exchange was the second highest globally, only behind the CME. ### Financial sector vulnerabilities and resilience - Banks’ liquidity profiles improved, reflecting lower FX liquidity mismatches and less reliance on wholesale funding. - Capital adequacy ratio (CAR) of the banking system: - 12.3 percent at end-2008. - 14.3 percent at end-2012. - Exposure to intensification of global financial market risks has been muted but remains largely untested: - Banks decreased dependence on short-term wholesale funding, but remain exposed if global risks rise sharply, particularly via euro area stress. - A disorderly UMP exit and sudden reversal of capital flows could impair business sentiment and investment. - Tighter financial conditions could raise funding costs for banks and corporates, hurting domestic growth. - Banks’ profitability pressures: - Low interest rate environment compressing net interest margins. - Increased credit risk from deteriorating macroeconomic conditions. - Conservative regulatory provisioning standards (up to about 150 percent of expected losses). - Return on assets (ROA) of commercial banks in 2012 was about 0.5 percent. - Share of non-interest income has remained low. ### Corporate sector vulnerabilities - Corporate financial conditions deteriorated in 2011 and have remained weak due to lower profitability. - Aggregate debt-at-risk ratio is at a level comparable to that in the midst of the 2008 crisis. - Corporate leverage has continued to decline after 2008, but Korean firms remain more leveraged than OECD peers. - Sectors with acute vulnerabilities: construction and real estate development; shipbuilding and transportation. - SMEs vs large corporations: - SMEs’ return on assets in 2011 was 2 percent, about 0.5 percentage points below that of large corporations. - SMEs’ leverage ratio at end-2011 was 35 percentage points higher than the 145 percent for large corporations. - Government support may have propped up potentially unproductive and financially weak SMEs. ### Household sector risks and debt dynamics - Household debt accounted for 136 percent of disposable income at end-2012 and has been rising, albeit at a slower pace. - The share of household debt owed by borrowers with high DSR (>40 percent) and high LTI (>400 percent) was 35 percent in July 2010, up from 30 percent in July 2009. - At end-2012, the share of debt owed by borrowers with high DSR (>40 percent) alone is estimated to be 33 percent. - NDFIs accounted for 20 percent of household credit at end-2012, while all NBFIs accounted for 45 percent. - Near-term risks related to household lending are relatively limited due to: - Conservative macroprudential limits. - Robust process for collateral collection. - High household net wealth. - However, macroprudential requirements on bank household exposures appear to have increased credit risk at some NBFIs. - Sensitivity analysis (KIF based on IMF FSAP framework) indicates household debt-related vulnerabilities are tightly linked to housing prices: - Under the baseline scenario, aggregate level of debt at risk not covered by all assets stands at 0.7 percent. - If absorptive capacity of financial assets only is taken into account, debt at risk stands at 21.9 percent. - Box 2 — Household Debt-Related Risks (key figures and features): - Household debt as a share of disposable income increased from 116 percent in 2004 to 156 percent at end-2011. - Median household debt to disposable income across OECD countries in 2011 was 128 percent. - At end-2012, households’ net assets accounted for 115 percent of household debt. - Currency and deposits accounted for more than 45 percent of financial assets. - Real estate accounted for 75 percent of total household assets. - Loan-to-value (LTV) values are currently at around 50 percent. - Banks’ collateral collection recovery of up to 120 percent of loan values. - Share of bullet loans declined from 41.3 percent at end-2010 to 33.6 percent in March 2013. - Share of fixed rate loans increased from 5.1 percent at end-2010 to 39.5 percent in May 2013. - Debt of multiple loan borrowers rose from KRW 262 trillion in June 2010 to KRW 306 trillion at end-2012. ### Policy recommendations to address household and nonbank vulnerabilities - Support continual gradual household deleveraging to ensure adequate growth momentum without fueling financial stability concerns, including: - (i) Tighter regulation of NBFIs to curb further credit expansion via regulatory arbitrage. - (ii) Further transformation of the structure of household debt towards fixed rate amortizing loans, while ensuring such loans are priced to fully reflect risks. - (iii) Expanded availability of debt counseling services, providing budget and legal advice to households. _ REPUBLIC OF KOREA INTERNATIONAL MONETARY FUND_ ### 17. Overall, banks’ NPL levels are low, reflecting a practice of active disposal of bad assets, ### _cr14126 - 17. Overall, banks’ NPL levels are low, reflecting a practice of active disposal of bad assets, ### Nonperforming loans (NPLs) and asset disposal - NPLs of commercial banks accounted for 1.2 percent of total loans at end-2012. - Banks write off or sell about 1 percent per year of loans to Asset Management Companies (AMCs). - Most distressed assets are purchased by private entities, which fund purchases via the issuance of corporate bonds. - Collateral recovery is described as robust: - Recovery rates reportedly high, with lenders legally having senior claims on up to 120 percent of the value of a loan. - Caveat: The robustness of disposal and recovery mechanisms in the context of a sharp decline in housing prices has not been tested. ### Financial-sector distortions and bank behavior (policy-relevant findings) - Identified distortions and needed actions: - Ensure banks have full operational autonomy to undertake risk-based allocation of credit. - Develop risk pricing skills to provide non-guaranteed funding to a broader range of viable SMEs. - Enhance banks’ risk management. - Curb pressures on banks to cut interest rates and fees to avoid depressing bank profits and limiting credit availability for higher risk borrowers. ### Stress tests — commercial banking system solvency - Overall resilience: - The commercial banking system would remain sound even under extreme macro shocks or protracted sluggish growth. - High initial capital buffers and conservative capital management support resilience. - System-wide capital ratios remain considerably above the Basel III requirement even under a very adverse macro scenario. - All banks meet the Basel III capital requirements, with CARs remaining at about or above 10 percent. - Contagion/second-round effects: - Banks remain solvent if potential second-round spillovers are taken into consideration. - By end-2017, under the severe scenario: - Aggregate CAR would decline to 12 percent taking into account contagion effects, against 13.6 percent without such effects. - Modeling caveats: the macro model does not explicitly capture some linkages (particularly between higher interest rates and DSR); an exogenous consumption shock was applied to correct for this and model limitations may have underestimated potential impact. - Market risk exposures: - Market risks at end-2012 were about eight times smaller than credit risk exposures. - Market risks were mostly in the form of debt securities holdings. - Under the most adverse scenario, market risks would account for only up to 0.3 percent of risk-weighted assets in 2014 under the BU exercise, and 0.8 percent in 2013 under the TD exercise. - TD estimates suggest a market shock would reduce the capital adequacy ratio of the top seven banks by about 1.3 percent. ### Stress tests — scenarios, liquidity, and FX - Solvency stress-test scenarios (five-year horizon) included: - Mild and severe global double-dips; severe could result in real GDP growth of -3.8 percent in 2013 and -2.7 percent in 2014, with gradual recovery by 2017. - A prolonged period of low growth: real GDP growth 2.5 percentage points below projected baseline over the entire 5-year horizon. - A spike in interest rates from a potential disorderly U.S. exit from UMP: interest rates increasing by 250 basis points over 2½ years, starting in the second half of 2014. - Additional sensitivity analyses: - Interest rate shocks: extreme 300 basis points and moderate 200 basis points. - Exchange rate depreciation: extreme 50 percent and moderate 30 percent. - Fall in real house prices: extreme 20 percent and moderate 15 percent. - FX liquidity stress tests: - Under a shutdown of global wholesale funding, the aggregate gap for all commercial banks amounts to around US$3.8 billion without committed credit lines from international banks (about 1.2 percent of Korea’s international reserves). - After taking committed credit lines into account, the gap turns into a small surplus of around US$155 million. - Authorities’ estimate (using end-September 2013 data and identical assumptions) shows a decline in the FX liquidity gap to US$1.5 billion before credit lines, and a surplus of US$3.1 billion after accounting for credit lines. - Won liquidity stress tests suggest individual banks have sufficient liquid assets to handle potential outflows under extreme shocks. ### Stress-testing process, coordination, and gaps - Institutional practices: - The FSS requires banks to carry out stress tests twice a year for solvency and monthly for liquidity. - The BOK conducts TD stress tests of the banking sector using supervisory information. - Coordination and validation issues: - Lack of cross-agency coordination to discuss relevant risk factors and reconcile results. - The FSS and the BOK do not share results with each other and thus lack a channel to validate respective results. - Divergent results between TD exercise (BOK) and BU exercise (banks validated by FSS) on market risks. - The FSS does not appear to fully validate BU results received from banks (e.g., methods banks use to estimate losses). - Banks largely follow scenarios provided by the FSS and do not appear to run event-specific tests aligned with their internal operational needs. - Recommendation (implied by findings): - Enhance interagency coordination, data and result sharing, and validation between FSS and BOK; consider making stress-test results public to encourage coordination. ### Nonbank depository institutions (NBDIs) stress assessment - Reverse stress-test findings: - Some NBDIs have thin buffers against potential credit risk. - Some NBDIs—including mutual savings banks and credit unions—could only handle up to a 6–8 percentage point increase in nonperforming loans before their capital drops below the minimum required threshold. - Design and assumptions: - Stress tests used a simple balance-sheet framework due to lack of data (except for MSBs). - Assumed pre-loss profitability at lowest levels historically and more conservative provisioning than rules enforced by Korean supervisors. - Spillover assessment: - Even if NBDIs face difficulties, spillovers to other parts of the financial sector are likely to be minimal because their funding is mostly in deposits. ### Macroprudential measures, effectiveness, and institutional arrangements - LTV and DTI tools: - LTV ratios introduced in 2002; DTI limits in 2005. - Limits adjusted actively over time—tightened and loosened several times—with cumulative effect amounting to considerable tightening relative to initial levels. - Limits extended to nonbank mortgage providers (with some delay). - Current ranges (as stated): - Limits on the LTV ratio range between 50 and 60 percent for banks and between 60 and 70 percent for nonbanks. - The DTI ratio limit is between 50 percent and 65 percent. - Average actual LTV ratio in Korea is around 50 percent (comparative figures cited: 74 percent in Germany, 75 percent in the U.S. and 80 percent in the United Kingdom). - Result: Low average LTV may have dampened house price growth and household credit growth and helped keep mortgage default rates below 1 percent into 2012 despite softening housing prices since 2008. - Loan-to-deposit (LTD) ceiling: - Prior LTD around 120 percent when a ceiling of 100 percent was announced. - After enforcement (June 2012), LTD came down to around 95 percent (as of April 2013) on average for commercial banks. - FX-related measures: - Regulation on ratio of FX derivatives positions introduced October 2010 at 250 percent for foreign branches and 50 percent for domestic banks; tightened in July 2011 and January 2013 to 150 percent and 30 percent for foreign branches and domestic banks, respectively. - Macroprudential Stability Levy since August 2011: 20 basis points of the dollar amount of short-term FX funding with maturity of less than one year (lower rates for longer maturities). - Effects observed: - Average FX leverage ratio of foreign branches fell from over 260 percent to around 90 percent on average in late 2013. - Share of short-term FX funding in all FX funding fell from around 50 percent in 2008 to less than 20 percent in April 2013. - Shift in maturity structure of external funding of foreign branches toward longer-term funding; may have reduced sensitivity of interbank capital flows into Korea to global financial conditions since June 2010. - Institutional coordination: - Macroprudential policy discussed historically in various interagency meetings; replaced on July 20, 2012 by the Macroprudential Economic and Financial Meeting (MEFM). - MEFM convened at least quarterly at deputy level; comprises the BOK, the FSC, the FSS, and the MOSF (which chairs and prepares the agenda). - Decisions at MEFM are not binding; each agency remains ultimately responsible for policy in its domain. - Interagency coordination is strong at working levels, especially among MOSF, FSC, and FSS. - A revised Memorandum of Understanding (2009) improved information exchange, especially supervisory data sharing. *Source: IMF staff report content provided in the supplied PDF excerpt.* ### 33. Korea has done well in applying macroprudential tools and should consider a further ### _cr14126 - 33. Korea has done well in applying macroprudential tools and should consider a further ### Macroprudential policy: institutional framework and recommendations - Korea has applied macroprudential tools well but should further strengthen the institutional framework for macroprudential policy. - Key desirable attributes: - Formal and well-focused institutional framework. - Enhanced transparency and accountability. - Greater degree of independence from the political process. - Clarification and strengthening of the role of the BOK in financial stability. - Separation of functions: - Macroprudential policy arrangements should be separated from crisis management and preparedness to allow each function to benefit from separate institutional frameworks, greater transparency, and greater political independence. - Separation would facilitate establishing a stronger role for the BOK in macroprudential policy. - Macroprudential policy council (legislative basis and functions): - Objectives, functions, and powers should be articulated in primary legislation. - Council should have broad power to make recommendations to regulatory agencies, coupled with a “comply or explain” mechanism. - Law should require the BOK to provide regular assessments of systemic risk to the council and to formulate draft policy responses for council consideration. - A record of the council’s deliberations should be made public; periodic reports should ensure further accountability to parliament and the public. - Possible chairing and composition: - The council could be chaired by the BOK or the MOSF and should also comprise the financial regulatory and supervisory agencies. - The council should meet at least quarterly with all participating agencies represented at the top level. - Monetary policy safeguard: - Arrangements must not impinge on the continued independence of the BOK in conducting monetary policy. - Monetary policy should be explicitly excluded from the scope of council discussion, or alternatively the arrangements could assign the BOK a veto power over council policy decisions. ### Financial sector supervision: legal underpinning and structure - Legal framework developments and gaps: - Financial sector related laws and subsidiary legislation have been continuously updated and benchmarked against international standards and multiple legal traditions. - Gaps remain: enforcement approach is predominantly prosecution-centric, and administrative pecuniary sanctions are relatively small compared with other jurisdictions. - Introducing a regime for imposition of administrative penalties in respect to a broader range of offences would enable financial regulators to implement a more effective enforcement system. - Institutional arrangements (multiple agencies): - Agencies include: - MOSF: responsible for FX policies and financial and economic coordination. - FSC: responsible for financial sector policy, prudential policy, supervision, enforcement, sanctions, and financial institution resolution. - SFC (within FSC): responsible for monitoring, supervising and investigating capital market activities. - FSS: responsible for inspection and supervision of financial institutions under guidance and oversight of the FSC and SFC. - KDIC: operating the deposit insurance function and performing resolution functions under the guidance and oversight of the FSC. - KOFIU: established under FSC oversight, performing the financial intelligence function. - Inter-agency mechanisms and coordination: - Established mechanisms facilitate policy coordination and conflict resolution, including cross-representation at key decision-making levels. - Examples: - FSC, FSS, BOK, MOSF, and KDIC signed a joint MOU providing for sharing periodic and non-scheduled financial information submitted by financial institutions to the BOK, FSS, and KDIC. - BOK and KDIC can request the FSS to undertake joint examinations and share examination reports. - Following joint BOK/FSS examinations, the BOK may request the FSS to take corrective measures in areas under its mandate. - The BOK’s Monetary Policy Committee (MPC) may request the FSC to reconsider a decision if it has a direct bearing on monetary and credit policies; Article 89(2) of the BOK Act notes that the FSC, if requested by the BOK to review a decision, needs a two thirds majority to retain its original decision. ### Sectoral regulation and supervision — Banking - Progress and compliance: - FSC and FSS have made considerable progress since the 2003 FSAP and achieved moderate compliance with the BCPs as revised in 2012. - Structural changes and regulatory reforms strengthened the supervisory framework; conservative requirements for capital, liquidity and loan loss provisioning helped banking sector resilience during the 2008 crisis. - Supervisory approach and enhancements needed: - Further emphasis on a more risk-sensitive approach would be beneficial. - The FSC-FSS uses detailed off-site supervisory processes; on-site examinations would benefit from more flexible and frequent examinations tailored to relevant risks. - Enhancements needed: stronger judgmental components, appointment of a point of contact for each bank/group, more intrusive assessment of corporate governance and Board oversight of risk management. - ICAAP and capital framework: - Internal Capital Adequacy Assessment Process (ICAAP) is important for integrated capital planning and risk management. - The average CAR for the banking sector, at about 13.8 percent, provides a healthy buffer over prudential minimums. - Basel II applies to commercial banks; FHCs are subject to Basel I. Plans to apply Basel II to FHCs by December 2013 will improve consistency and comparability. The FSS plans to implement Basel III in December 2013. - Group supervision: - FHC Act enacted as a first step; further work needed to consistently apply minimum requirements for capital, liquidity and risk management on a group-wide basis. - Loan loss provisioning and liquidity: - Prudential regulations for provisioning strengthened; a reserve for Credit Loss was introduced in transition to IFRS. - Non-performing loan ratios for domestic banks remain low by international standards, but provisioning practices need improvement when loans return from default to performing status. - Banks operate with strong liquidity ratios, especially for foreign currency liquidity which are more conservative than domestic liquidity. - One-to-one loan-to-deposit ratio restricts leverage; scope exists to enhance liquidity risk management of won-denominated asset-liability. - Transition to Basel III Liquidity Coverage Ratio (LCR) framework will be useful; banks are currently required to report LCR ratios on a quarterly basis. - Authorization and non-bank deposit-takers: - Authorization processes are thorough, but some major acquisitions and transfers rely on notification rather than explicit supervisor approval; requiring approval would enable earlier supervisory action. - Regulatory and supervisory framework consistent with banks should be applied to larger non-bank deposit taking institutions (e.g., mutual savings banks) to strengthen resilience. - Capital framework for non-bank deposit takers is a net capital ratio of equity over the sum of total assets and loan loss provisions; for large non-bank deposit-takers, capital should be strengthened using Basel computations and definitions. - Supervisory intensity (Box 5) — main features: - Onsite examination by FSS is intensive and comprehensive; larger systemically important banks would benefit from greater frequency of onsite examinations. - Greater use of supervisory tools to differentiate banks’ risk profiles will help allocate resources to the riskiest banks. - Systematic meetings with full bank boards during onsite exams would allow better assessment of Board’s understanding of structure and risks. - FSS has increased frequency of onsite supervision of MSBs and strengthened corporate governance requirements; a more intrusive approach to Board assessment is recommended. - FSS relies on highly skilled staff and detailed off-site processes; more frequent assessments of risk management information would yield a comprehensive view of risk. ### Sectoral regulation and supervision — Insurance - High observance and proactive reforms: - Insurance supervisory system shows a high level of observance of the Insurance Core Principles (ICPs). - Reforms are proactive and timely; IFRS accounting standards, updated capital regime, and other regulatory requirements have been implemented. - Authorities developed a sound Risk Assessment Application System (RAAS); attention to insurance fraud is notable. - Market size and indicators: - Total premium stood at KRW 149.9 trillion (USD 134 billion) in 2011, ranking it the eighth largest in the world. - Insurance penetration stood at 11.6 percent and was ranked 5th in the world. - Insurance density stood at USD 2,660 per person ranked 23rd in the world. - Insurance market concentration indicates an open and competitive market; large insurers are substantially domestic with both assets and premiums attributable to domestic business well above 90 percent. - They do not currently meet the expected criteria for either IAIS Global Systemic Insurers or ConFrame IAIG supervision. - Risks and capacity building: - Negative interest rate spreads remain an issue but have been mitigated substantially through earlier recognition and corrective actions since the late 1990s crisis. - Active stress testing and insurer actions have reduced negative spread risk, though ongoing monitoring is required. - Insurer profitability and capital are sound for both life and non-life insurance. - Industry capacity for enhanced enterprise risk management will take time to mature; ongoing initiatives to enhance requirements should continue. - G-SIFI and ComFrame could be relevant for Korea as a host supervisor in the short term. - Becoming a signatory to the IAIS Multilateral Memorandum of Understanding (MMoU) is in progress. ### Sectoral regulation and supervision — Securities - Progress and compliance: - Significant progress since the last FSAP; current framework achieves good overall compliance with IOSCO Principles. - Earlier legal impediments to international cooperation and exchange of information have been removed. - Since 2011, Korea applies K-IFRS that follow the IFRS. - Governance, complexity, and transparency: - Although responsibilities are defined in legislation, the complex structure obscures transparency of decision-making. - Responsibility for supervisory or enforcement actions can lie with FSC, SFC, or FSS depending on nature and gravity; it is not always clear which is ultimately in charge. - Use of pre-deliberation committees and roles for self-regulatory organizations (KRX, KOFIA, KICPA) further complicate processes. - Publication of additional information on decision-making structure and processes would be beneficial. - Powers, examinations, and enforcement: - Authorities have a broad set of powers used effectively; on-site examination program could be expanded to ensure coverage of smaller entities, especially asset management companies and auditors. - Improved oversight of small auditors is important for enforcing auditor independence and quality control requirements. - On-site inspections should continue to focus on proper handling of customer securities and funds. - Challenges remain in enforcing unfair trading/market abuse provisions of FISCMA due to lack of sufficiently dissuasive administrative sanctions and the length and less than optimal outcome of the criminal enforcement process. - Authorities, jointly with the public prosecutor’s office, should continue to seek ways to improve both administrative and criminal enforcement powers and processes. - Disclosure and CIS custody/valuation: - Comprehensive disclosure requirements apply to issuers and collective investment schemes (CIS); rules prescribe content of primary market, periodic and ongoing disclosures. - Authorities are encouraged to monitor whether ongoing disclosure requirements for issuers best serve investor interests and market evolution while maintaining a manageable compliance burden. - Given risks to investors from any CIS custody and valuation shortcomings, focus on monitoring compliance and requiring the use of market or fair value for all CIS is important. *Republic of Korea — IMF Staff Report (extracted content unit).* ### 58. The current processes to monitor systemic risk do not appear to sufficiently ### _cr14126 - 58. The current processes to monitor systemic risk do not appear to sufficiently ### Financial Markets Infrastructures - Korea has a well-developed payment, clearing, and settlement infrastructure: - BOK-Wire+ is the real-time interbank gross payment and settlement system and the backbone of the infrastructure where the final payments of various markets are settled. - The KRX operates three exchanges (KOSPI, KOSDAQ, and DM) and offers CCP settlement services for all securities and derivatives traded on the KRX. - A planned CCP for OTC derivatives is intended to be established at a future date; discussions are ongoing on transforming current trade reporting systems into full-fledged trade repositories (TRs). - The planned CCP for OTC derivatives should ensure full compliance with the PFMI before being launched, taking into account lessons learned from the assessment of the CCP for exchange-traded products. - BOK-Wire+ compliance and features: - Largely compliant with the Principles for Financial Markets Infrastructures (PFMI). - Subject to comprehensive and transparent risk management frameworks including clear policies and guidelines, governance arrangements, operational systems, and regularly tested default and business continuity procedures. - All transactions once settled in BOK-Wire+ are deemed final and irrevocable, as well as bankruptcy remote. - Recommended improvements for BOK-Wire+ to enhance PFMI compliance: - Improve the collateral risk management framework by adopting regular testing of haircuts and putting in place an annual independent validation of the haircut procedures adopted. - Provide more clarity in the regulations on settlement finality and queue management, particularly regarding revocation of queued transactions. - Fully implement the disclosure framework, including disclosure of relevant rules and regulations in English. - Strengthen BOK’s powers of oversight over linked payment FMIs and participants, particularly to obtain authentic information and enforce compliance by FMIs with its observations and findings. - KRX CCP status and recommendations: - The KRX CCP broadly complies with the PFMIs and contributes to safety and efficiency but concentrates systemic risk. - Recent steps include introduction of intraday margin calls, back testing, sensitivity analysis, increased sizes of joint compensation fund and settlement reserves, and an operational risk management system introduced in January 2013. - Additional credit risk management measures warranted: - Collect risk-based collateral (margin) on a daily basis to cover KRX’s exposures towards clearing members between transaction and settlement days. - Reconsider the current design of joint compensation funds, including removing the fixed size requirement to better adapt to increased exposures. - Increase KRX’s criteria for settlement banks and custodians. - Have KRX’s risk management framework, particularly its margin model, reviewed and validated by an experienced and independent entity (e.g., an academic or a consultant). - Governance and staffing recommendations: - Improve independence of the KRX risk management committee (currently chaired by an executive director who is also responsible for strategy and planning). - Increase the size of staff responsible for management of credit and liquidity risk; current staffing is small compared to responsibilities. - Increase KRX focus on safety and efficiency of the CCP in company objectives. - Regulation, supervision, and oversight of FMIs: - Cooperation between the BOK and the FSC should be formalized by: - Developing an MOU with a sound legal basis to ensure effective coordination where roles overlap, enhancing cooperation at technical and management levels and improving efficiency and effectiveness of regulation, supervision and oversight (notably KRX-CCP and KSD). - “Speaking with one voice” to avoid inefficiencies in BOK and FSC communication with KRX and KSD. - Agreeing on specific arrangements for frequency of information exchanges and holding joint meetings with the FSS, KRX and KSD. - Developing and testing a crisis management plan for timely and effective cooperation in crises. - To further improve regulatory structure for FMIs: - Amend existing legislation to provide the BOK with enforcement tools to effectively discharge its oversight responsibilities. - Increase human resources at the FSC to support a proactive policy approach and effective guidance by the FSC to the FSS. ### Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) - Progress made since the November 2008 FATF assessment: - Korea was assessed by the FATF in November 2008; at that time the AML/CFT framework had significant deficiencies. - Authorities have made regular and steady progress, notably by amending existing legislation. - Additional resources have been allotted to the FSS and KoFIU to enhance AML/CFT supervision and examination capacity. - Regular training provided to law enforcement agencies to improve implementation of sanctions for money laundering. - Remaining deficiencies and actions underway: - Main concerns: - Supervisory sanction regime primarily targets staff rather than financial institutions, and sanctions are mostly non-pecuniary. - AML/CFT regulation and supervision of designated nonfinancial businesses and professions currently encompass only casinos. - Shortcomings in the terrorist financing offence remain a concern. - A draft bill amending the Prohibition of Financing for Offences of Public Intimidation Act is being drafted to expand the scope of the offence and is expected to be submitted to the National Assembly later this year. - The FATF has tentatively scheduled Korea for an assessment against the revised AML/CFT standard in 2016. - Additional legislative steps: A bill amending the Financial Transaction Reports Act has been submitted to the National Assembly for approval to abolish the threshold for reporting of suspicious transactions and require banks to ensure that full originator information travel with wire transfers. ### Conclusions and Recommendations (Governance and Supervisory Structure) - Key concerns about the supervisory structure: - Current governance, decision making, and accountability arrangements promote consensus building and coordination but may compromise supervisors’ independence. - Presence of industry nominees on governance structures could give rise to “regulatory capture.” - Supervisory responsibilities include financial policies and market development, creating potential conflicts of interest and dilution of supervision. - Recommended characteristics for future reforms to supervisory institutional framework: - The new arrangement should: - Have well identified objectives and responsibilities that clearly and transparently define responsibilities of various authorities in prudential and conduct of business supervision and enforcement. - Be free of political influence and interference, or the perception of it. - Be able to set and enforce prudential requirements at system level and for individual institutions in accordance with risk profile and systemic importance. - Have explicit powers to take timely supervisory response measures, including a range of sanctions, enforcement actions, and revocation of license. - Be familiar with the market and market practices, but independent of market influences. - Have efficient internal systems that eliminate administrative layers. ### Systemic Liquidity - Structural liquidity and FX funding: - The Korean financial system’s structural liquidity overhang is around KRW 230 trillion (about 20 percent of GDP), supporting markets in normal times. - Steps to more closely manage funding risks associated with exporters’ and multinationals’ medium to long term foreign currency needs have led to declining FX liquidity exposures since the GFC period. - Money market vulnerabilities: - Much of the money market lacks active secondary markets; most active are unsecured cash and repo markets of maturities up to one week. - Markets for longer term instruments are relatively shallow, dominated by buy-and-hold investors, and lack market makers. - Role of the Bank of Korea (BOK): - Absence of active secondary markets makes the BOK a prominent backstop in stress situations. - Banks hold few assets usable to raise liquidity from secondary markets in stress, increasing reliance on BOK. - BOK’s capacity to respond includes significant foreign reserves and swap lines along with wide-ranging ELA powers broadened after the GFC. - Specific data: At end-March 2013, the BOK held US$327.4 billion of reserves (28 percent of GDP), and had bilateral swap lines with the Peoples Bank of China (PBOC), the Chang Mai Initiative (CMI), and the Bank of Japan (BOJ), as well as a multilateral swap line via the newly introduced Chang Mai Multilateral Initiative. - Recommendations to strengthen market self-reliance and preparedness: - Boost secondary market liquidity (Basel III LCR implementation and repo market improvements are helpful). - Ensure ELA procedures are well honed, developed, practiced, understood and accepted by key stakeholders to smooth decision making and guide expectations and accountability. ### Crisis Management and Resolution Framework - Financial safety net and crisis tools: - Well-established deposit insurance scheme and central bank ELA, supported by a well-developed financial sector supervision framework. - Available crisis tools include: influence on systemic liquidity in money and securities markets; broad deposit insurance and investor protection (including full guarantee); public funds to support institutions and markets under stress; and mechanisms to intervene and resolve troubled financial institutions. - Recommendations to formalize crisis management: - Consider establishing a dedicated apex forum for leading inter-agency cooperation and coordination on crisis preparedness and management, distinct from macroprudential council. - Formally designate crisis management team(s) in each supervisory authority. - Develop a crisis management handbook. - Establish multi-agency institution-specific crisis management groups. - Periodically conduct crisis simulation exercises to test contingency plans and arrangements. - KDIC (Korea Deposit Insurance Corporation) improvements to reduce exposure to avoidable losses: - Replenish the deposit insurance fund, which is currently in deficit. - Establish an explicitly assured and irrevocable line of credit from the Government to provide back-up funding to KDIC to improve prompt depositor pay-outs and financial assistance capabilities in times of crisis. - Discontinue the practice of allowing insolvent banks to continue to accept fresh deposits and repay existing deposits. - Review processes to reduce timelines for decisions on depositor repayment, providing financial assistance, and resolving troubled banks. - Public funds and moral hazard: - Korea established several funds after the GFC and in the late 1990s to provide financial assistance; these can potentially distort incentives and should be reviewed to address moral hazard. - Resolution framework assessment: - The legal framework establishes a special resolution regime for distressed financial institutions (Act on Structural Improvement of the Financial Industry (ASIFI)). - Resolution authorities’ powers are comprehensive but scope for improvement exists to assure certainty and avoid delays, particularly for financial conglomerates and SIFIs, including cross-border operations. ### Appendix I — Main Recommendations of the 2003 Financial Sector Assessment Program (Selected entries and implementation status) - Overall Financial Sector Oversight: - Strengthen supervisory independence to improve ability to provide authoritative guidance and interpretation — Partly done. - Strengthen legal protection of supervisors — Partly done. - Clarify division of responsibilities between MoFE, FSC and FSS — Done. - Tighten supervision of NBDIs — Partly done. - Banking Supervision: - Increase supervisor's capacity for new tasks (off-balance sheet, Basel II) — Done. - Pay greater attention to differing risk levels when setting minimum capital levels — Partly done. - Broaden coverage of fit and proper criteria — Done. - Enhance ability to stress test banks' balance sheets — Partly done. - Insurance Supervision: - Strengthen solvency framework for life insurers — Done (new capital regime implemented). - Securities Regulation: - Improve regulatory transparency and enforcement — Partly done. - Enhance volatile market framework by more frequent calculation and reporting of capital requirements — Partly done. - Tighten regulations of securities firms to curb excessive risk-taking — Partly done. - Payments System: - Establish role of Bank of Korea in overseeing payments system in legislation — Done, but BOK powers need to be strengthened. - Address settlement practices in debt securities trade and mitigate risks from checks for large value payments — Done. - Legal Framework: - Adopt a strong insolvency framework — Done. - AML/CFT: - More resources to KoFIU — Done. - Remove limitation to access customer information for international cooperation — Done. - Abolish threshold for suspicious transaction reports — Amendment to enter into force in October 2013. - Market Development: - Develop a benchmark yield curve and reduce market segmentation — Partly done. - Remove impediments to foreign participation — Done. *Source: _cr14126 - 58. The current processes to monitor systemic risk do not appear to sufficiently* ### Appendix II. Korea: Supervisory Intensity ### Appendix II. Korea: Supervisory Intensity ### Supervisory intensity—context and objectives - The quality of financial sector supervision must be "intrusive, adaptive, proactive, comprehensive, and conclusive." - Supervisory intensity represents both the ability to act and the demonstrated willingness of the supervisor "to ask questions, dig deep and to act if issues are identified." - The key purpose is to illustrate examples of best practice and identify potential areas of improvement. ### FSS supervisory framework: offsite surveillance and data collection - Two-tiered approach: - Relationship manager model focusing on individual banks. - Centralized teams of subject matter experts responsible for industry analysis of specific risk issues (e.g., FX risk, concentration risk). - Integrated data collection and offsite surveillance: - A comprehensive suite of Financial Soundness Indicators (FSIs) are collected on a quarterly basis and more regularly if required. - Liquidity data are collected on a monthly basis. - Offsite analysis results are captured in the CAEL risk rating tool (Capital, Asset Soundness, Earnings and Liquidity). - Offsite surveillance tools inform and enable adjustments to the onsite supervision program. ### Onsite examinations: scope, frequency, methodology - Dedicated specialist teams perform onsite examinations across the banking sector. - Full-scope onsite examination: - Normally performed every two years. - Encompasses a thorough evaluation of the entire spectrum of risk management and compliance programs. - Consists of a team of examiners, takes approximately one month, and produces a risk assessment using the CAMEL-R framework (CAMEL-R is similar to CAEL with the addition of an assessment of Business Management and Risk Management). - Partial onsite examination: - Normally performed every other year. - Typically focused on a single thematic issue (example: corporate governance in 2012). - Best-practice elements of onsite work: - Challenging the quality of risk management staff. - Intrusive evaluation of the application of policies and processes not evident in quantitative indicators (e.g., relationship between front and back office in credit approval, effectiveness of credit hind-sighting, risk culture). - Meetings with senior management and Board representatives, file reviews, and analysis of key documentation. - For larger, more complex, and systemically important banks, "greater frequency of onsite examinations would enable supervisors to act more proactively in detecting emerging risks." ### Resource allocation and targeted examination approaches - Increasing onsite frequency involves resource implications. - Effective differentiation of bank risk profiles is needed to allocate scarce supervisory resources to the riskiest banks and highest priority risks. - Thematic examinations: - Target a specific portfolio or business line. - Conducted over a two-to-five day period. - Good practice for comparing risk management practices and identifying industry outliers. - Deep-dive examinations concentrating on specific risk areas improve timeliness of risk management assessments and strengthen the link between onsite and offsite supervision. ### Corporate governance assessment practices and recommendations - Current FSS onsite corporate governance verification includes: - Verification of Board resolutions, Board minutes, meeting agendas, and assessment of management structure adequacy. - Meetings with the Board to discuss risk management issues prior to, and at the conclusion of, full-scope onsite examinations. - Typically engages executive directors; meetings with the full board of independent (outside) directors occur only in exceptional circumstances. - Recommended best practice: - Meeting with the full board of directors to effectively assess the board’s oversight of the bank by challenging its understanding of risk management processes. - Such meetings assist in assessing the Board’s understanding of the banking group’s operational structure and risks, including those from structures that impede transparency (e.g., special-purpose or related structures). - Extending meetings to boards of subsidiaries supervised by the FSC-FSS to help ensure consistent corporate governance standards across the group. ### Nonbank deposit-taking institutions and Mutual Savings Banks (MSBs) - Sector composition and scale (as of March 2013): - Approximately 2,338 Credit Unions, Cooperatives and 93 Mutual Savings Banks. - Credit Unions and Cooperatives combined total assets: KW352.1tr representing 9.9 percent of the financial systems and KWR 10.7 percent of lending by the financial system. - Average assets: KWR 150.6 billion. - Average lending: KWR 87.4 billion. - Largest Credit Union by assets: KWR 600 billion. - Largest Cooperative by assets: KWR 2 trillion (in the Agricultural sector). - Market share for Agricultural Cooperatives is almost 80 percent at KWR 272.6 trillion. - Supervisory approach: - FSC-FSS employ the same supervisory tools as used with banks (mainly CAEL and CAMEL). - For Credit Unions and Cooperatives, the FSS-FSC rely upon Federations representing their immediate membership to share onsite and offsite supervision responsibilities. - Where nonbank deposit-taking institutions are of sufficiently significant size, there is scope to apply a consistent standard of minimum requirements across banks and nonbank deposit-taking institutions. ### Mutual Savings Banks: post-crisis initiatives and outstanding gaps - Since the Mutual Savings Bank crisis, FSS-FSC initiatives include: - Heavily increased frequency of onsite supervision of MSBs. - Changes to corporate governance requirements to raise standards. - Forced exits of a number of MSBs from the industry. - Strengthened offsite surveillance via a loan examination support system where MSBs submit loan reports containing asset classification data on a monthly basis. - Remaining gaps: - A more frequent and intrusive approach to assessing the effectiveness of the Board in the MSB sector is yet to be implemented. ### Staff capacity, data, and supervisory effectiveness - The FSS-FSC "boasts skilled staff and a strong commitment to their mandate." - Strengths: - Detailed off-site supervisory process supported by a broad range of financial soundness indicators reported in a timely manner. - Enhancements: - More frequent assessments of risk management information to complement offsite processes and produce a comprehensive view of risk. - Applying an intrusive approach to assessing boards and challenging board oversight of risk management to encourage higher standards of corporate governance essential to a resilient banking sector. *Source: Appendix II. Korea: Supervisory Intensity, IMF staff report content.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14126.pdf_