## _cr14310 ## Source details **Canonical URL:** [_cr14310](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14310.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14310.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14310.pdf.json) --- ### Summary, key findings, and overall assessment - Republic of Korea assessed as having a "moderate level of compliance" with the Basel Core Principles for Effective Banking Supervision (BCP). - Key strengths: - Strong—but described as "overly complex"—regulatory framework and thorough supervisory practices. - Sophisticated offsite monitoring capabilities and extensive onsite capability. - FSC-FSS collects and analyzes detailed financial and management information. - Supervisory approach relies heavily on off-site monitoring, notifications of exceptions, and biannual full-scope on-site examinations. - Main gaps and required actions: - Need broader powers to apply minimum capital requirements to individual banks. - Full implementation of Pillar 2 and ICAAP is incomplete. - More comprehensive approach to conglomerates and group-wide supervision required. - Basel II not fully applied to Financial Holding Companies (FHCs); FHCs still calculate capital using Basel I. - Strengthen independence of FSC-FSS from political process and reduce overlapping responsibilities and complex inter-agency processes. - Post-examination communication processes are lengthy and weaken supervisory effectiveness despite recent improvements. - Multiple autonomous subject-matter teams complicate a consolidated risk view of institutions. - Systemic resilience observations: - Vulnerability diminished since 2008 crisis with stronger capitalization across sector. - Non-performing ratios for domestic banks remain relatively low by international standards. ### Regulatory and supervisory framework — structure, mandates, and resources - Institutional architecture: - Integrated supervisory approach via Financial Services Commission (FSC) and Financial Supervisory Service (FSS). - FSC: policy and supervision; FSS: inspection and supervision under FSC direction. - Five organizations share stability mandate: FSC, FSS, MoF, BoK, KDIC. - Legal and operational features: - Establishment Act objectives include: (i) promote advancement of the financial industry; (ii) promote stability of financial markets; (iii) establish sound credit order and fair financial transaction practices; and (iv) protect depositors, investors and consumers. - Article 40 Establishment Act and Article 43–2 Banking Act grant FSS broad reporting and information powers. - Changes to banking regulations frequent; Banking Act last updated September 2011; Presidential Decrees last as of February 2012. - Resources, governance and protections: - FSS funded by fees to regulated institutions; budget approved by FSC; may borrow funds upon FSC approval. - Staff are government officials; managerial-level employees have a "2 year cooling off period" before joining private companies previously supervised (exceptions possible). - Legal protections exist but assessors conclude legal protection for supervisors needs enhancement; FSC/FSS notes de facto protections and avenues for defense (Litigation Support Committee). ### Consolidated supervision and group-wide issues (CP12 and related) - Progress and limitations: - FHC Act and RFI key steps toward consolidated supervision; FSS has implemented consolidated reporting and prudential consolidated standards for FHCs (e.g., capital adequacy 8 percent based on 1988 Accord). - Several large banks are conglomerates with wide variety of entities; current framework does not fully permit in-depth forward-looking group analysis. - Monitoring relies on consolidated financials and assessment of FHC internal controls; group monitoring focuses mostly on banking side via stand-alone supervision. - Specific shortcomings: - FSS lacks systematic procedures to assess contagion and reputation risks from non-banking group entities. - Non-financial entities often not consolidated and information limited; no power to require FHC to distribute capital across group. - Fit-and-proper tests and other governance checks do not fully extend to all large shareholders and related parties. - Assessment: - Principle 12 rated: Materially Non-Compliant (MNC). - Recommendations: - Develop framework to systematically assess risks of non-financial businesses within groups. - Enhance qualitative assessment of group strategy and risk appetite and incorporate information across departments. - Expand fit-and-proper tests to related parties of all large shareholders and eliminate Board-approval loopholes that permit exceeding related-party lending limits. ### Capital adequacy and ICAAP (CP16) - Current regimes and discrepancies: - Basel II (BII) applied to commercial banks; Financial Holding Companies (FHCs) apply Basel I. - Authorities planned to apply BII and BIII to FHCs "by December 2013". - Minimum legal capital requirements: W 100 billion for a nationwide commercial bank; W 25 billion for a regional commercial bank. - Minimum capital requirement is "8 percent" risk-weighted assets (RWAs). - Average CIS ratio for domestic banks as at December 2012 was 14.30 percent. - Composition and limits: - Tier 1 and Tier 2 components defined in detail; Tier 2 limited to "100 percent" of Tier 1; hybrid securities inclusion limited to "30 percent" of equity capital. - Maximum allowance for credit losses included in supplementary capital: "1.25 percent" for standardized banks; IRB banks maximum "0.6 percent" of RWAs if EP>EL. - Pillar 2, supervisory powers and internal models: - Pillar 2 of BII not fully implemented; FSS cannot set individual minimum capital ratios above the Basel "8 percent" floor. - ICAAP implementation is at early stage; FHCs had not submitted ICAAPs for a full assessment cycle (guidance circulated 2012; 2013 first year receiving ICAAPs for FHCs). - Internal model validation is performed annually by banks but there is "no requirement" for validation results to be assessed by FSS prior to updating model estimates used in RWAs. - Assessment drivers: - Inconsistent application of BII between banks and FHCs. - Lack of legal powers for supervisors to impose higher capital on individual banks based on risk profile. - ICAAP and Pillar 2 processes not fully embedded. - Recommendations: - Fully implement ICAAP across deposit-taking institutions. - Implement Pillar 2 for all banks and enable supervisors to set individual capital requirements. - Require supervisory assessment/approval of model validation results prior to use in capital calculations. ### Credit risk, problem assets, provisioning and collateral (CP17–CP18) - Credit risk governance: - Credit risk is the most relevant risk; FSS monitors vulnerabilities on a quarterly basis. - CAMEL-R onsite assessments and off-site data used; full-scope on-site examinations are biannual for all banks. - File sampling during full-scope exams: approximately 20–30 percent of total loans (review of 80–90 borrowers); examiners onsite about 20 days. - Asset classification and provisioning schedules: - Five loan categories: normal, precautionary, substandard, doubtful, presumed loss. - Provisioning schedule (Article 29): Normal "0.85/100" (residential mortgage normal "1/100"); Precautionary "7/100"; Substandard "20/100"; Doubtful "50/100"; Presumed loss "100/100". - Credit card provisioning: Normal "1.1/100"; Precautionary "40/100"; Substandard "60/100"; Doubtful "75/100"; Presumed loss "100/100". - Reserve for Credit Loss introduced to preserve banks’ loss absorbent capacity under KIFRS. - Reclassification and supervisory concerns: - Regulations permit reclassification to performing status "without the borrower having proved repayment capacity under revised terms"; FSS does not meet EC9. - FSS increased oversight but greater supervisory attention required, "especially at this point in the cycle." - Independent valuation of collateral is often performed by internal bank officers; FSS processes to assess collateral valuation practices are uneven across major banks. - Default definition inconsistency: - Domestic banks default defined as "90 days" past due; non-banks default defined as "180 days" past due. FSS plans to harmonize non-bank definition by 2017. - Assessment: - Principle 18 rated: Materially Non-Compliant (MNC). - Recommendations: - Increase frequency of onsite credit risk inspections for larger systemic banks. - Require independent collateral valuation for defaulted exposures and conservative valuation practices (net realizable value with appropriate haircuts). - Tighten reclassification criteria to require proof of repayment capacity under revised terms. ### Concentration risk and large exposures (CP19) - Regulatory design: - Large exposure (LE) defined as "Ten per cent or more of a bank’s capital". - LE limits: single name "20 percent" of capital; enterprise group "25 percent" of capital; sum of large exposures across borrowers must not exceed "five times the bank’s capital". - LEs measured at month end and reported quarterly. - Gaps identified: - Framework focused on name risk; broader concentration dimensions (industry, economic sector, geographic region, market/asset classes) not systematically incorporated. - Appendix 2 contains exclusions that reduce visibility of certain exposures; LE monitoring not continuous and lacks delegation/approval framework (no requirement for Senior Management or BoD approval of LE). - Assessment: - Principle 19 rated: Materially Non-Compliant (MNC). - Recommendations: - Issue guidance/regulation covering the whole spectrum of concentration risk as per revised CP. - Narrow exceptions and tighten connected-counterparty definitions; require LE approvals by senior management/Board and notify FSS of exposures above "10 percent". - Ensure consistent application of LE limits on both solo and consolidated basis. ### Market risk, IRRBB and liquidity (CP22–CP24) - Market risk: - Trading Book (TB) may be excluded from market risk capital calculation if (i) ratio of TB to total assets on consolidated balance sheet is "less than 5 percent maximum per day"; and (ii) TB is "less than W 100 billion maximum per day". Thresholds considered excessive by assessors. - TB composition (end of June 2012): "52.7 percent" OTC derivatives trading; "42.9 percent" securities trading. - Seven banks authorized to use internal models for market risk; others use standardized approach. - Recommendation: amend exemptions thresholds and codify valuation/model governance expectations. - Interest rate risk in banking book (IRRBB): - Regulations require measurement "at least quarterly"; in practice banks calculate monthly. - Combined EaR for domestic banks was "1.6 trillion Won" or "1 percent of capital" as of end-December 2012. - VaR reporting threshold: file to FSS if IRR VaR exceeds "20 per cent of equity capital". - Assessment: Principle 23 rated: C. - Liquidity risk: - Won liquidity rules: current assets to current liabilities "1:1 or more"; loan-to-deposit ratio "1:1 or more" (end-of-month compliance). - FX liquidity rules include minimum "85 percent" for A/L with maturity of less than "3 month". - FSS monitors LCR data quarterly and Korea intended to adopt LCR starting in 2015; FSS indicated banks’ average LCR approximately "130 percent". - Key shortcomings: liquidity ratios required only at end-of-month; stress test specifications not prescriptive; one-month mismatch metric may incentivize short-term asset purchases. - Assessment: Principle 24 rated: LC. - Recommendations: - Require continuous compliance with liquidity ratios; develop prescriptive liquidity stress test guidance (severity, inputs, horizons); define HQLA quantitatively in Regulations. ### Supervisory approach, reporting, techniques and corrective powers (CP8–CP11) - Supervisory approach: - Heavy reliance on off-site monitoring and biannual full-scope on-site examinations for all banks. - Multiple autonomous teams limit a consolidated risk view; recommend establishing a point of contact for each bank/group to consolidate on- and off-site information. - Consider mixed partial on-/off-site examinations targeted at specific risks. - Supervisory reporting and data quality: - FSS receives data on daily, monthly, quarterly, semiannually, annually, and ad-hoc basis; no systematic procedures to check data reliability or quality control. - No formal process to assess suitability of external experts or require prompt reporting of material shortcomings by external experts. - Recommendation: amend legal framework to access all relevant data from non-financial entities within a group and require external auditors to review quality of regular reports submitted to FSS. - Corrective and sanctioning powers: - Broad range of statutory powers (warnings, corrective orders, suspension, revocation, personnel actions, fines). - However, no explicit legal power to impose more stringent prudential limits on individual banks, bar individuals from the sector, or replace/restrict Board powers collectively. - Post-examination communication historically lengthy; since January (year unspecified) FSC/FSS sends examination findings within five months for full-scope exams and within four months for partial exams; CAMEL-R results can be notified separately prior to final report. - Assessment: Principle 11 rated: LC. - Recommendations summary: - Enhance post-examination and sanctioning processes; grant legal powers to impose bank-specific prudential measures and to bar/restrict individuals where appropriate. - Strengthen standard rules for hiring third parties, quality control and conflict-of-interest safeguards. ### Corporate governance, internal control, audit, external audit and disclosure (CP14, CP26–CP28) - Corporate governance: - Regulations require majority outside directors on Boards and Audit Committees; FSS has Model Guidelines for compensation and independent directors. - Shortcomings: no regulatory requirement for subsidiary boards to have independent directors; limited supervisor power to remove directors unilaterally. - Assessment: Principle 14 rated: LC. - Internal control and audit: - Regulations comprehensive; Audit Committee composition requirements and internal audit responsibilities specified. - Supervisory practice: onsite CAMELR every two years with variable depth of partial examinations for IA. - Assessment: Principle 26 rated: C. - Financial reporting and external audit: - K-IFRS adoption required (Article 32); some exceptions (KEXIM, Suhyup Bank transitioning). - FSS lacks power to set external audit scope, reject/rescind auditor appointments, or mandate auditor work on specific supervisory issues. - Assessment: Principle 27 rated: LC. - Disclosure and transparency: - Uniform Disclosure Standards and Pillar 3-like disclosures exist but Pillar 3 framework not fully developed for solo disclosures; quarterly business reports to FSS need not be audited or prepared by an independent officer. - Assessment: Principle 28 rated: LC. - Recommendations: - Enhance corporate governance regulation (Board review frequencies, independent directors at subsidiaries). - Strengthen FSS role vis-à-vis external auditors (scope, appointment, access to workpapers). - Strengthen Pillar 3 disclosures, including solo disclosure for material banking subsidiaries. ### Non-bank financial institutions, AML/CFT and other cross-cutting issues (CP29 and NBFIs) - NBFIs capital and default definitions: - Current capital framework for NBFIs: net capital ratio of equity over total assets subtracting deductions and loan loss provisions. - For deposit-taking NBFIs of size equivalent to banks, capital framework should be strengthened and calculated using the Basel Accord. - Definition of default inconsistent: banks "90 days"; non-banks "180 days" (harmonization planned; mutual savings banks to "120 days" July 2014; credit cooperatives/unions changed to "120 days" July 2013 and will become "90 days" July 2014). - AML/CFT (Principle 29): - KoFIU is AML/CFT authority (part of FSC); FSS conducts onsite exams under KoFIU guidance. - Supervisory approach not fully risk-based; FIU exploring a methodology. - Reporting threshold for suspicious transactions remains "10m Won"; a Bill proposed to repeal threshold. - Assessment: Principle 29 rated: LC. - Recommendations: - Apply Basel-consistent capital framework to large NBFIs. - Implement a risk-based AML/CFT supervisory methodology across deposit-taking institutions and extend FIU focus to securities, insurance and smaller non-banks. ### Selected consolidated list of recommended actions (as provided) - Clarify priority of safety and soundness duties and segregate from other supervisory objectives. - Amend legal framework to enable supervisors to increase prudential requirements for individual banks and banking groups based on risk profile and systemic importance. - Revise composition/functioning of Commission to reduce conflicts of interest and strengthen legal protection for supervisors. - Amend licensing criteria to cover ultimate beneficial owners, detection/prevention of criminal activities, oversight of outsourcing, and require home supervisor no-objection for foreign bank subsidiaries. - Require approvals for transfers of ownership that can change effective control; expand definition of large shareholder. - Require prior approval for major acquisitions and cross-border subsidiary establishment; ensure host country provides needed information flows. - Establish point of contact for each banking group to consolidate surveillance; increase targeted partial examinations; develop judgmental qualitative assessment capacity. - Strengthen data reliability controls; require external auditors to review regular supervisory reports; formalize third-party engagement rules. - Strengthen consolidated supervision, harmonize default definitions, require independent collateral valuations, and tighten concentration and related-party rules. - Implement Pillar 2 and fully embed ICAAP; adopt D-SIB framework and apply systemic capital buffers as needed. - Amend liquidity regulations to require continuous compliance, define HQLA quantitatively, and prescribe liquidity stress testing parameters. - Develop an explicit, risk-based AML/CFT supervisory methodology and extend coverage. *Source: IMF staff and World Bank assessment as presented in the provided content unit (_cr14310)._ ### 1. The 2012 Revised Core Principles _______________________________________________________________ 9 ### _cr14310 - 1. The 2012 Revised Core Principles _______________________________________________________________ 9 ### Summary, key findings, and overall assessment - The Republic of Korea has a "moderate level of compliance" with the Basel Core Principles for Effective Banking Supervision (BCP). - Strengths: - A strong—albeit "overly complex"—regulatory framework and thorough supervisory practices. - Sophisticated offsite monitoring capabilities and an extensive onsite capability. - The FSC-FSS collects and analyzes a broad suite of information including detailed financial and management information. - Supervisory approach relies heavily on off-site monitoring, notifications of exceptions, and biannual full-scope on-site examinations. - Main gaps and areas requiring attention: - Broader powers are needed to apply minimum capital requirements to individual banks. - Full implementation of Pillar 2 and ICAAP is incomplete. - A more comprehensive approach to conglomerates is required. - Application of Basel II to Financial Holding Companies (FHCs) has not yet been completed. - Need to strengthen independence of the FSC-FSS from the political process and reduce overlapping responsibilities and complex inter-agency processes. - The process to communicate results of supervisory activities (e.g., recommendations from on-site examinations) is lengthy and weakens effectiveness, despite recent improvements. - Coordination challenges stem from multiple points of responsibility among subject matter experts, complicating an overall risk view of institutions. - Systemic resilience observations: - Overall vulnerability of the Korean banking system has diminished since the 2008 crisis with stronger capitalization across the sector. - Non-performing ratios for domestic banks remain relatively low by international standards. ### Regulatory and supervisory framework issues - Capital and group supervision: - Basel II (BII) applies to commercial banks but has not been extended to FHCs where capital is calculated using Basel I. - The FSC-FSS plans to apply BII and BIII to FHCs "by December 2013" to strengthen the quality of regulatory capital. - Implementation of ICAAP is cited as an important step toward integrated capital planning and higher standards of bank risk management and toward full implementation of Pillar 2. - Powers, timing, and follow-up: - FSC-FSS has a broad range of powers, measures and tools to address threats, but the time to communicate supervisory results needs to be enhanced. - Follow-up processes have been recently enhanced but still need improvement. - Concentration risk and large exposures: - The regulatory framework for concentration risk is mostly focused on large exposures and "name risk" and should be expanded to incorporate a broader definition (industry, economic, geographic region, market/asset classes). - The large exposure regime captures exposures to a single name or connected parties but does not sufficiently cover other forms of concentration risk. - Regulations should explicitly require a delegation framework for approval of large exposures. ### Credit quality, provisioning, and asset management companies - Provisioning and reclassification: - Prudential regulations covering loan loss provisioning have been strengthened since the last FSAP and in the transition to IFRS; a "reserve for Credit Loss" was introduced to prevent a decrease of banks’ loss absorbent capacity. - A notable weakness: criteria for exposures to return to performing status. Regulations allow banks considerable discretion when reclassifying exposures as performing "without the borrower having proved repayment capacity under revised terms." - Lack of conservatism in reclassification could negatively impact underlying credit quality; FSS has increased oversight but more supervisory attention is required, especially "at this point in the cycle." - Government-sponsored AMCs: - Since the financial crisis, government sponsored asset management companies (AMCs) have been introduced to acquire delinquent loans in several sectors. - AMCs have continued to operate as open-ended vehicles with a perception of permanency, which might introduce the risk of moral hazard into bank underwriting practices. ### Non-bank financial institutions (NBFIs) - Capital framework and consistency: - Regulatory/supervisory framework consistent with banks should be applied to larger NBFIs to strengthen resilience. - Current capital framework for NBFIs: a net capital ratio of equity over total assets subtracting deductions and loan loss provisions. - For deposit-taking NBFIs of size equivalent to banks, capital framework should be strengthened and calculated using the Basel Accord. - Definition of default inconsistency: - The definition of default differs across sectors: for commercial banks default is 90 days; for non-banks it is 180 days, creating potential for regulatory arbitrage. ### Assessment context, methodology, and procedural notes - Assessment context: - The assessment was completed as part of an FSAP update undertaken by the IMF and the World Bank during 2013 and reflects the framework "in place as of the date of the completion of the assessment." - It is not intended as an analysis of the state of the banking sector or crisis management framework, which are covered elsewhere in the FSAP. - Methodology and scope: - Korea agreed to be assessed against the Revised Core Principles (BCP) Methodology issued by the BCBS in September 2012. - Korea chose to be assessed and rated against both Essential and Additional Criteria. - Assessments use essential criteria (EC) and additional criteria (AC); the assessment is qualitative with a four-part grading system: compliant; largely compliant; materially noncompliant; and noncompliant. - The assessment must adopt a proportionate approach considering complexity, interconnectedness, size, risk profile and cross-border operations of banks; comparisons across countries or with the 2003 assessment are not appropriate because the methodology has been revised. - Key changes introduced by the 2012 Revised Core Principles (Box 1): - Number of principles increased "from 25 to 29." - Number of essential criteria expanded "from 196 to 231." - Introduction of "35 new essential criteria" and "16 additional criteria" for jurisdictions choosing AC assessment. - Emphasizes: (i) greater supervisory intensity and resources for systemically important banks; (ii) system-wide macro perspective alongside microprudential supervision; (iii) focus on crisis preparation, recovery and resolution; and (iv) fostering market discipline via corporate governance, disclosure and transparency. - Assessment process and team: - The assessment team reviewed laws, rules, and materials and held extensive meetings with FSC-FSS officials, auditing firms, and banking sector participants. - The assessment was made by Christopher Wilson, Monetary and Capital Markets Department, IMF, and Valeria Salomao Garcia, the World Bank. - Authorities provided a self-assessment, responses to questionnaires, and access to supervisory documents, files, staff and systems. - Comparative and temporal notes: - The assessment is not comparable to the 2003 assessment because the BCP methodology was revised in 2006 and again in 2012 and, as prescribed by the methodology, assessments should not be compared across countries. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14310.pdf* ### 8. An assessment of compliance with the BCPs is not, and is not intended to be, an exact ### _cr14310 - 8. An assessment of compliance with the BCPs is not, and is not intended to be, an exact ### Assessment methodology and compliance categories - The assessment relies on judgments by the assessment team but follows a common, agreed methodology to provide an internationally consistent measure of banking supervision relative to the CPs. - Five observation categories used: - compliant - largely compliant - materially noncompliant - noncompliant - non-applicable - Definitions preserved from the source: - "compliant": all EC and ACs are met without any significant deficiencies, including instances where the principle has been achieved by other means. - "largely compliant": only minor shortcomings, do not raise serious concerns about ability to achieve objective; clear intent to achieve full compliance within a prescribed period (example: regulatory framework agreed but not fully implemented). - "materially noncompliant": severe shortcomings despite formal rules; evidence that supervision has clearly not been effective, practical implementation is weak, or shortcomings raise doubts about ability to achieve compliance. - "noncompliant": not substantially implemented, several ECs not complied with, or supervision is manifestly ineffective. - "non-applicable": criteria do not relate to the country’s circumstances. ### Institutional setting and market structure — key findings - Regulatory architecture: - Integrated supervisory approach through the Financial Services Commission (FSC) and the Financial Supervisory Service (FSS). - FSC: in charge of financial policies and supervision of financial industries. - FSS: regulates financial markets and institutions under direction and supervision of the FSC. - Market composition and concentration: - Non-bank deposit taking institutions supervised by FSC-FSS (mutual savings banks, credit unions, credit cooperatives) account for 20 percent of total deposits (credit cooperatives 14 percent). - Community cooperatives and Korea Post office account for 8 percent of total deposits; supervised by Ministry of Public Administration and Security and Ministry of Knowledge and Economy, respectively. - Commercial banking sector maintains buffers above minimum prudential capital adequacy requirements: BIS capital ratio 14.3 percent and Tier 1 capital ratio 11.1 percent as of end-2012. - Non-performing loans are low; banks retain solid profit generation capacity. - Twelve financial holding companies (FHCs) constitute about 50 percent of financial sector assets (up from about 39 percent at end 2010); FHCs have 87 percent of consolidated assets in banking (accounting for about 70 percent of the banking sector assets). - Of 18 commercial and specialized banks, 14 operate under bank holding companies; those bank holding companies have a total of 275 subsidiaries. - Foreign participation and overseas presence: - Foreign financial institutions constitute roughly 11 percent of financial sector assets. - In banking: 41 foreign-owned banks from 16 countries (two subsidiaries, remaining branch presence) make up about 14 percent of the banking sector. - Insurance: 12 insurance companies’ subsidiaries from five countries make up 10 percent of the domestic insurance sector. - Securities: about six percent of assets held by 20 foreign companies from eight countries. - Korean banks operate 100 entities in 28 countries; 64 securities companies operate in 13 countries; 22 collective investment companies operate in 9 countries. - Domestic bank structure and assets: - 18 domestic banks: 7 commercial banks, 6 regional banks, 5 specialized banks. - Specialized banks are owned by government; Standard Chartered bank and Citibank are held by foreigners. - Total assets of domestic banks: W 1,827.9 trillion at end-2012, amounting to 143.7 of GDP. - 41 foreign banks operate 56 branches with total assets approximately W 204.1 trillion at end-2012. - Funding conditions: - Funding conditions improved since 2008; large external short-term debt and dependence on wholesale funding have been reduced. ### Preconditions for effective supervision — macroeconomic context and policy response - Growth and inflation: - Economic growth declined from 3½ percent in 2011 to 2 percent in 2012 due to a sharp decline in exports and weakened domestic demand. - Growth projected to rebound to 2.8 percent in 2013 and 3.9 percent in 2014. - Inflation: 1.4 percent at end 2012 (compared to 4.2 percent at end 2011); expected to pick up to 2½ percent in 2013. - Policy responses: - June 2012: Government announced two modest fiscal support packages within the 2012 budget. - Bank of Korea (BOK) cut policy rate by 25 bps in July 2012 and another 25 bps in October 2012. - 2013 budget reduces overall fiscal deficit (excluding social security funds) to 0.3 percent of GDP. - Short-term risks include re-intensification of the euro area crisis and lingering concerns over U.S. fiscal policy. - Capital flows and exchange rate considerations: - Capital flows highly volatile; Q3 2012 portfolio flows strengthened and currency appreciated. - Staff position: won is still undervalued; exchange rate should be allowed to appreciate further with fine-tuning of macroeconomic policy mix. - Authorities view existing macroprudential measures as geared primarily towards limiting short-term external bank borrowings; considering capital flow management measures including a possible FX transaction tax. ### Financial stability mandates, resolution framework, and tools - Allocation of mandates among five authorities: FSC, FSS, BoK, Korea Deposit Insurance Corporation (KDIC), Ministry of Strategy and Finance (MoF). - FSC-FSS, KDIC, and BoK have explicit mandates for financial stability under relevant laws and enforcement decrees. - FSC and FSS responsibilities include: “to promote the advancement of the financial industry and the stability of financial markets, establish sound credit order and fair financial transaction practices, and protect depositors, investors, and other financial consumers.” - KDIC responsibility: “to contribute to the protection of depositors and the maintenance of the stability of the financial system.” - BoK responsibility: “pay attention to financial stability in carrying out its monetary and credit policies.” - MoF develops and coordinates economic and fiscal policies and serves on decision-making bodies of financial regulators. - Special resolution regime: - Act on Structural Improvement of the Financial Industry (ASIFI) identifies FSC and KDIC as resolution authorities; FSC acts as lead resolution authority. - BoK not a resolution authority but can provide financial assistance via participation in funding the KDIC or public funds. - Special resolution regime under ASIFI and Deposit Protection Act (DPA) extends to banks (except specialized banks), Industrial BoK, investment traders, brokers, collective investment business entities, investment advisory business entities, discretionary investment business entities, insurance companies, mutual savings banks, trust business entities, merchant banks, and financial holding companies. - Resolution tools and procedures: - Resolution options: merger and acquisition, purchase and assumption, bridge bank, funding by government and other authorities (including KDIC), and liquidation. - FSC can appoint an administrator (management supervisor) and direct necessary resolution processes if an insolvent bank fails to comply with prompt corrective actions. - DPA mandates the least cost test in KDIC’s choice of resolution method; KDIC established Korea Resolution and Collection as a separate entity for resolution proceedings. ### Summary compliance with Basel Core Principles — selected highlights and grades - Overall presentation: Core Principle grades and comments provided; key CP grades include: - CP 1 (Responsibilities, objectives and powers): LC - Responsibilities and powers clearly defined, but potential conflicts between developmental objectives, consumer protection, and safety and soundness; FSC-FSS cannot increase prudential requirements for individual banks/groups based on risk or systemic importance. - CP 2 (Independence, accountability, resourcing and legal protection): MNC - Legal status of FSC as a Ministerial agency has mixed implications for independence; direct subordination to the Prime Minister can threaten independence. - Checks and balances exist (internal audit, BAI, Assembly investigations) but Commissioners include MoF and Korea Chamber of Commerce and Industry representatives—posing conflict of interest challenges. - Legal protection for supervisors needs enhancement; current setting can jeopardize staff willingness to act and effectiveness. - CP 3 (Cooperation and collaboration): C - CP 4 (Permissible activities): C - CP 5 (Licensing criteria): LC - FSC has power to set licensing criteria and reject applicants; no new bank licenses in 20 years. - Shortcomings: licensing criteria do not explicitly encompass detection/prevention of criminal activities or oversight of proposed outsourced functions; suitability assessment of large shareholders (ultimate beneficial owners) and Board members has shortcomings. - CP 6 (Transfer of significant ownership): LC - FSC can review, reject and impose prudential conditions; in practice some transfers do not require approval. - Banking Act definition of large shareholder is too narrow (does not contemplate shareholdings below 4 percent resulting in “de facto” control). - CP 7 (Major acquisitions): LC - Major acquisitions of non-financial companies are restricted; reliance on reporting for monitoring acquisitions and overseas establishments may create risks to safety and soundness. - CP 8 (Supervisory approach): LC - Heavy reliance on off-site monitoring and biannual full-scope on-site examinations; multiple autonomous teams limit holistic risk understanding and accountability. - Over-reliance on full-scope examinations every two years limits forward-looking supervisory capability; limited role for judgment in qualitative assessments. - CP 9 (Supervisory techniques and tools): LC - Broad range of techniques and robust off-site framework supported by comprehensive data and systems. - Recommendations include intensifying engagement with banks’ senior management during on-site exams, focusing partial exams on core issues, enhancing internal information sharing, and requiring immediate bank reporting of material adverse developments. - CP 10 (Supervisory reporting): LC - Powers to require solo and consolidated information; integrated financial information analysis system collects monthly and quarterly data. - Shortcomings: lack of systematic procedures to ensure data reliability and quality control; lack of process to assess suitability of external experts and requirements for external experts to report material shortcomings promptly; limitations in access to information from non-financial companies within a group. - CP 11 (Corrective and sanctioning powers): LC - Range of powers available, but the process for providing recommendations based on on-site exams remains lengthy, weakening effectiveness. - No provisions allowing FSC to impose more stringent prudential limits for individuals, to bar individuals from the sector, or to replace/restrict powers of Board members or controlling owners. *Source: IMF staff assessment as presented in the provided content unit.* ### 12. Consolidated ### 12. Consolidated ### Consolidated supervision - The FSC-FSS has put significant effort over the last few years towards implementing consolidated supervision. - The issuance of the FHC Act, as well as the implementation of the RFI for FHCs, has been key steps in that direction. - Several of Republic of Korea’s large banks are conglomerates with a wide variety of entities within the banking group and banks part of wider non-bank groups. - Given such background, the framework in place does not fully allow for an in depth understanding and forward looking analysis needed. - Group-wide supervision is based on monitoring of consolidated financials and on assessments regarding its internal controls for managing the various businesses. - Group monitoring is conducted through a dedicated team focuses mostly on the banking side, particularly through stand-alone supervision, given its relevance within the activities of the FHCs. - The overall monitoring is based on consolidated financials and assessment of the FHC regarding its internal controls for managing the various businesses. ### Home-host relationships (CP 13) - Grade: LC - The FSC-FSS has put in place procedures to share information and cooperate for supervisory purposes although mechanisms for effective handling of crisis situations from a cross-border perspective, as well as group resolution plans are yet to be established. - The FSC-FSS set up a task force that has been working on standards and rule changes for D-SIB and is looking to complete the task in the near future. ### Corporate governance (CP 14) - Grade: LC - Regulations are generally sound, although lack specificity in some aspects to fully satisfy the criteria, with scope for supervisory practices to be strengthened with specific minimum requirements for corporate governance. - Greater intensity of supervision and inspection of corporate governance could be applied across the entire deposit taking sector which includes non-banks where the regulations and oversight by boards are generally less developed. ### Risk management process (CP 15) - Grade: LC - Minimum requirements within the regulations not sufficiently broad to extend across the entire banking group. - Risk management and compliance obligations should be given greater attention by supervisors through more frequent onsite reviews. ### Capital adequacy (CP 16) - Grade: MNC - Basel II has not been fully implemented to include FHCs which are internationally active and calculate regulatory capital according to Basel I. - Pillar 2 of BII has not been fully implemented across the population of domestic banks (including - internationally active banks). - While an annual validation of internal models is performed by banks, there is no requirement in the regulations for the results of the validation to be assessed by the FSS prior to the updating of estimates used in the calculation of risk-weighted assets to determine the capital adequacy ratio. - Notification requirements to the FSS regarding the ongoing discriminatory ability of models should be strengthened to ensure that models used as inputs into the risk-weight calculation are robust and meet minimum expectations as set out at accreditation. ### Credit risk (CP 17) - Grade: (not explicitly stated in header; discussed in CP 18 section) - Credit risk is the most relevant risk in the banking system in South Korea. - Current macroeconomic conditions are challenging in this part of the credit cycle with an upward trend in unemployment and past due loans, albeit off a low base and potentially vulnerable credits could exist in performing credit portfolios. - The FSS are aware of the vulnerabilities that current developments on credit risk entail for the financial system, and monitors data carefully on a quarterly basis. - Owing to the importance of effective credit risk management, the team believes greater attention to this area is warranted. ### Problem assets, provisions, and reserves (CP 18) - Grade: MNC - Main factors driving the rating: - More frequent onsite credit risk examinations for the larger systemic banks to accurately assess credit underwriting standards and identify adjustments in risk-taking behavior; and - Greater verification of sound operation of collateral management systems. - The team recommends that the FSS increase its attention to on-site inspections of credit risk. More frequent onsite inspections will improve the ability to assess underwriting standards and forward looking indicators such as: exceptions and overrides to policy; changes in the application of credit risk policies; application of covenants for commercial lending and covenant monitoring by risk management – each of which might not be easily visible from offsite monitoring. - Special attention onsite should be given to independent valuation of collateral management systems. - Credit underwriting standards could be strengthened across the industry. - Particular weaknesses in the unsecured segment which has led to increasing levels of total debt, and with limited capacity to repay. - Stricter attention to capacity to repay at time of writing loan and monitoring exceptions to policy. - Particular weaknesses in the non-bank sector in credit underwriting that impact competitive tensions for market share with the banking sector. - The FSS does not meet EC9 as the regulations allow banks considerable discretion when reclassifying exposures as performing. - The regulations permit the reclassification of loans to performing without the borrower having proved repayment capacity under revised terms. - While the FSS has increased its oversight of banks’ application of internal politics for reclassification of assets, a greater amount of supervisory attention is required to ensure banks’ apply appropriate risk management around this process. - Attention to this aspect of provisioning should be enhanced, especially in the current credit cycle. - Supervisory oversight of collateral valuation practices for defaulted loans needs greater attention. - While the FSS implemented thresholds in December 2011 for exposures to be individual assessed and managed, greater supervisory attention is needed to ensure banks are applying the thresholds appropriately. - In practice, internal bank officers are predominantly responsible for valuing collateral. - FSS processes to assess the application of policies and the robustness of risk management of collateral valuation was not uniform across the major banks leading to potential inconsistencies and weaknesses. - Prudent collateral valuation processes are necessary to help ensure adequacy of provisions. - For the mortgage portfolios of banks (particularly inner-city apartments), collateral is re-valued on a regular basis against a market index (where available). - Regulations stipulate at least quarterly re-valuation of collateral, and industry practice is generally monthly. - In a reducing asset price environment, more frequent valuations are prudent, however, in a rising asset price environment this practice will lower the average portfolio LTV and raise collateral coverage against provisions through no change in debt reduction or increase in provisions respectively. - Contributing to the rating is a lack of consistency in the definition of default between the commercial banking sector and non-banks. - The definition of default differs across deposit taking institutions (mainly the domestic banks and non-banks). For domestic banks it is 90 days past due whereas for non-banks it is 180 days. ### Concentration risk and large exposure limits (CP 19) - Grade: MNC - This CP has been considerably expanded from the previous methodology, and the focus has shifted from “large exposures” to “risk concentration”, which includes not only name risk but by industry, economic sector, geographic region, and by market (for instance, when banks are exposed to particular asset classes, products, collateral, or currencies). - South Korea, as most countries, has not yet established guidance covering the whole spectrum of concentration risk management and monitoring. - The CP goes beyond large exposures and into management of concentration risk which requires more of a portfolio approach. - LE is by its nature focused on single name exposure requirements (or connected parties). Whereas concentration risk can be built up within a portfolio to the same asset class even where there are no LEs. - The ICAAP captures references to concentration risk which is about management of the risk, not about how to manage when it comes onto the book ex ante. - Risk management standards are not sufficiently detailed (i.e. Board reporting, management information systems, etc). - Regulations not clear about definition of connected counterparties or the instances where this might be considered. - No requirement in the Regulations for a LE to be approved by Senior Management or the BoD. ### Transactions with related parties (CP 20) - Grade: LC - Related party regulations for transactions with related parties permit exclusions under certain thresholds (30 percent for companies and 50 percent for non-profit organizations). - As a result, the definition might not be comprehensive to capture a sufficiently broad number of related party transactions. - The current definition of related party transactions is heavily geared towards credit exposures which is reflected in the reporting obligations of banks and the offsite analysis performed by supervisors. - Related party transactions such as lease contracts, derivatives, write offs etc are not included in the definition of credit extension and not captured by supervisory oversight. - Equally, scope to further develop specific guidance for banks on enhanced governance required for related party exposures i.e. Board reporting and approval. - Given a full scope onsite review is only performed every two years whereby related party transactions are assessed in detail, offsite surveillance processes need to be strengthened to identify risks. ### Country and transfer risks (CP 21) - Grade: LC - The regulations are general in nature without an explicit requirement for transfer risk which inhibits the effectiveness of oversight of this risk by supervisors. - Supervisory processes are not well developed to fully identify and assess this risk across the larger more complex banking groups. - For example, intra-group transactions not specified in the regulations. - The reporting by banks does not sufficiently aggregate across different asset classes, exposures and types of risk to provide an accurate and timely presentation of country and transfer risk. ### Market risk (CP 22) - Grade: LC - Regulations for market risk permit banks to exclude Trading Book (TB) exposures from the calculating of market risk regulatory capital under two conditions: - (i) where the ratio of the TB to total assets on the consolidated balance sheet is less than 5 percent maximum per day; and - (ii) A bank where the TB is less than W 100 billion maximum per day. - De-minimis exclusions from market risk are not unknown, however, the current thresholds are considered excessive. - Given the exclusions allowed in the regulations, supervisory processes should be strengthened to monitor and assess traded market risk where exemptions are applied. ### Interest rate risk in the banking book (CP 23) - Grade: C - The regulations require quarterly measurement and in the case of large change in risk, more frequent. - In practice, banks calculate and measure IRR on a monthly basis. ### Liquidity risk (CP 24) - Grade: LC - The regulations do not require banks to comply with the liquidity ratios on a continuous basis, only at end of month. - The method of calculation does not necessarily reflect the potential volatility in the preceding month or expected/forward looking volatility in deposit outflows. - The method of calculating the one month won liquidity mismatch does not encourage banks to term out issuance of wholesale funding in an effort to reduce potential roll over risk in a crisis. - To maximize management efficiency of assets to meet the one month maturity mismatch, banks are encouraged to invest in assets that mature within 30 days (which is actually the case in Korea where much of the wholesale money is short term). - The requirements for liquidity stress tests are not prescriptive. - As a result, the basis for stress tests will differ across institutions through bank discretion of inputs and parameters and the identification of outliers and peer comparison is not easily performed. - For example, banks with similar liquidity profiles might be applying vastly different run off assumptions obfuscating inherent risk profile. ### Operational risk (CP 25) - Grade: LC - Regulations in relation to disaster recovery and business continuity do not set expectations for frequency of testing and recovery and the reporting of test results to the FSS, especially in the instance where results are adverse. - There is a lack of specificity in the regulations of minimum requirements for data security and outsourcing. - Supervisory assessment for embedment of operational risk management systems as part of the onsite examination needs improvement in respect of assessing the extent of risk and the adequacy of operational risk capital. - Inputs into offsite analysis of operational risk could be improved with more granular detail, mainly nature of internal loss data. - Peer group benchmarking of loss data would enrich the benefits of this analysis. - The analysis of operational risk loss data could be enhanced. - Out-sourcing requirements are not well developed. - DR BCP minimum expectations are not well developed. ### Internal control and audit (CP 26) - Grade: C - The regulations pertaining to internal control and audit are generally comprehensive. - There is a strong focus on internal controls within the Regulations which is reflected in the extent of offsite analysis and data submitted by the bank to the FSS. - The onsite examination also has a strong focus on the effectiveness of Internal Audit. ### Financial reporting and external audit (CP 27) - Grade: LC - The regulations do not permit the FSS the power to establish the scope of external audits and in practice the scope of onsite and offsite supervision does not incorporate results from external audit. - If the supervisor considers a specific risk type of line of business to be higher risk, there is no provision within the regulations to commission the External Auditor to look at this issue as part of the external audit. - The Act of External Audit for Stock Companies does not apply to all depository institutions leaving the minimum standards for non-banks materiality short of banks. - The FSS does not have the power to reject and rescind the appointment of an external auditor, who is deemed to have inadequate expertise or independence, or is not subject to or does not adhere to established professional standards. - Removal of external auditors is left to the audit profession. There have been no incidence where the FSS or FSC has taken action in this regard to dismiss an auditor. ### Disclosure and transparency (CP 28) - Grade: LC - The regulations are not sufficiently comprehensive to require public disclosure of accounts on a solo basis and does not specify the circumstances where this would be appropriate. - The regulations do not refer to principles of transparency and comparability, relevance and reliability. - Regulations that govern Pillar 3 disclosure are not well developed and industry practice exhibits a number of inconsistencies with insufficient detail specifically in relation to banks that have been accredited to use the internal models. - There is room for the publicly available financial data to be used in the supervisory process. - The FSS reviews the public data but the supervisory framework is not complete or comprehensive as to how to use this data and integrate into the SREP and CAMEL-R approach by performing analysis and comparison against prudential data. *Source: _cr14310 - 12. Consolidated* ### 29. Abuse of financial ### 29. Abuse of financial services ### High-level supervisory observations - The supervisory approach does not use a risk-based methodology for supervising banks (although the FIU is exploring a methodology) whereby higher risk firms would receive greater intensity and frequency of oversight. - Scope to expand oversight across the entire population of deposit taking institutions. Attention has been focused on the domestic banks of which practices for AML are improving. FIU will transition its focus to strengthening practices in securities and insurance sectors and finally smaller non-banks where risk profile is comparatively higher but asset size is lower. ### Detailed Assessment — Supervisory powers, responsibilities, and functions (Principle 1) - Banking supervision is conducted through the Financial Services Commission (FSC), which delegates some supervisory functions to the Financial Supervisory Service (FSS), fully subordinated to the FSC. - The FSC is an integrated supervisory authority encompassing banking, insurance and securities supervision. - Overall objectives of the FSC and the FSS are defined through the Act on the Establishment of the Financial Services Commission (Establishment Act) with the purpose to contribute to the growth of the national economy of the Republic of Korea (Article 1). - Article 1 of the Establishment Act lists purposes: - To promote the advancement of the financial industry; - To promote the stability of the financial markets; - Establish sound credit activity and fair financial transaction practices; and - To protect depositors, investors and other financial consumers. - Article 2 requires the FSC and the FSS to endeavor to keep fairness, ensure transparency and refrain from disturbing the autonomy of financial institutions in performing their affairs. - Article 17 of the Establishment Act lists administrative affairs within FSC jurisdiction, including: - Finance-related policies and systems including proposing amendments to acts and presidential decrees; - Supervision and enforcement against financial institutions; - Licensing and other authorizations, including mergers, transfers and acquisitions; - Issuing regulations; - Bilateral and multilateral negotiations and international cooperation in relation to banking supervision; and - Other affairs specified by other acts and subordinate statutes as the jurisdictional affairs. - The FSS was established to perform inspection and supervision over financial institutions under instruction and supervision of the FSC (Article 24). Article 37 of the Establishment Act lays out FSS business affairs including: - Inspection of the business affairs and the financial status of banks; - Sanctions resulting from examinations; - Assistance to the FSC and the institutions affiliated with the FSC (SFC and KOFIU); and - Other business affairs. - The stability of the financial system is shared among five organizations: the FSC and the FSS, the Ministry of Strategy and Finance (MoF), the Bank of Korea (BoK), and the Korea Deposit Insurance Corporation (KDIC). ### EC2 — Primary objective and potential conflicts - Establishment Act objectives include promotion of financial industry advancement and refraining from disturbing financial institutions’ autonomy. - It is not clear in practice that the primary objective of banking supervision is to promote safety and soundness of banks and the banking system. - Some FSC/FSS objectives (notably to promote advancement of the financial industry and to refrain from disturbing the autonomy of financial institutions) might conflict with supervisory objectives focused on safety and soundness. - Consumer protection and FX controls are not clearly separated from banking supervision activities and may divert resources from core banking supervision. - Within the FSS, consumer protection affairs are the responsibility of the Financial Consumer Protection Bureau; the FX Supervision Department is in charge of FX supervision. Examinations related to these topics are conducted by examination departments, diverting resources to non-core supervisory activities. ### EC3 — Powers to set and increase prudential requirements - Article 34 of the Banking Act requires banks to insure safety and soundness through solid capital and appropriate liquidity; to observe prudential standards determined by the FSC relative to capital, assets, liquidity and other necessary matters; and allows the FSC to request banks to take necessary measures including ordering capital increases, restrictions on dividends, etc. - Article 50 of the Financial Holding Companies (FHC) Act requires FHCs to maintain equity capital in good faith, manage liabilities, cash flow, secure safety and soundness through proper management of subsidiaries, comply with prudential standards prescribed by the FSC; the FHC Act empowers the FSC to order corrective measures and require submission of action plans, capital increases, restrictions on distribution of profits, and disposal of stocks of any subsidiary. - The legal framework does not explicitly grant the FSC or the FSS power to increase prudential requirements for individual banks and banking groups based on their risk profile and systemic importance. ### EC4 — Updating laws, public consultation - Legal and regulatory framework updated frequently; Banking Act last updated in September 2011. - Presidential Decrees used for enforcement rules; last update as of February 2012. - Changes to banking regulations are proposed by the FSC and approved by FSC Commissioners; detailed regulations drafted by the FSS and approved by the Governor. - Administrative Procedures Act governs processes for passing Acts and issuing Decrees and Regulations; pre-announcements required with limited exceptions; administrative agencies may hold public hearings. Consultations are regularly held according to market participants. - The Regulatory Reform Committee reviews Acts and Presidential Decrees; regulations and detailed regulations are subject to review depending on potential economic/citizen impact (impact over W 10 million and/or over one million citizens). ### EC5 — Access to banks, groups, and foreign banks - Article 40 of the Establishment Act enables the FSS Governor to require institutions subject to inspection to submit necessary information and to require board members, executives or staff to present oral statements. FSS reports on on-site access to board members, executives and staff as necessary. - Article 38 lists institutions subject to inspection (banks, insurance and security firms, mutual savings banks, credit unions, specialized credit financial business companies and others). - No explicit powers to have full access to non-licensed non-financial subsidiaries of banks or FHCs. - Article 43–2 of the Banking Act requires monthly business reports from banks to the Governor of the FSS and grants general power to request data deemed necessary to perform supervision and inspection. - Article 51 of the FHC Act grants the Governor power to require FHCs to report on business or assets, furnish data and require officials to be present. ### EC6 — Corrective action, sanctions, revocation, resolution cooperation - Banking Act grants FSC powers to take or require corrective action, impose sanctions, and revoke a bank’s license. - Article 34(4) grants FSC power to request measures to ensure compliance with prudential standards (including capital increases, dividend restrictions). - Article 53(1) grants FSC power to issue a corrective order or order partial suspension of business for not more than six months (measures taken upon recommendation of Governor of FSS). - Article 53(2) grants power to order suspension of all business within a fixed period of at least six months or revoke authorization for banking business on specified grounds (e.g., license obtained under false means; violation of conditions; failure to execute corrective order; interests of depositors/investors likely greatly undermined). - Article 54 grants powers to sanction senior management and employees (suspension of functions, recommend dismissal, and request Governor of FSS to take disciplinary measures such as dismissal, suspension, deduction of salary and reprimand). - Articles 66–69 set out penal provisions for particular legal breaches. - No legal provisions for cooperation and collaboration with relevant authorities to achieve an orderly resolution of a bank, including triggering resolution, where appropriate. However, decisions related to bank resolution are taken by FSC commissioners, which include representatives from relevant domestic authorities and are decided by majority vote. - FSC commissioners composition: a Chairman, a Vice Chairman, the Vice Minister of the MoF, the Deputy Governor of the BoK, the President of the KDIC, the Governor of the FSS, two members recommended by the Chairman of the FSC, and one recommended by the Chairman of the Korea Chamber of Commerce and Industry. ### EC7 — Powers to review parent and affiliate activities - FSC–FSS have power to license and supervise FHCs. Powers do not extend beyond the FHC to controlling interests and affiliates except for limited cases (including possibility of illegal transactions—Article 48–2 of the Banking Act and Article 51–2). ### Assessment of Principle 1 — Largely compliant (LC) - Responsibilities, objectives and powers related to banking supervision are clearly defined in the Republic of Korea. - Conflicting objectives and responsibilities (promotion of financial industry, consumer protection, and refraining from disturbing autonomy of financial institutions) may conflict with safety and soundness duties and risk diverting supervisory focus and resources. - Legal framework provides necessary powers to authorize establishment of banks, conduct ongoing supervision, address compliance, and undertake corrective actions. Limitations include: - No explicit legal power to increase prudential requirements for individual banks and banking groups based on risk profile and systemic importance. - Legal limitations for access to affiliates and non-financial entities of banking groups (noted as reflected under CP12). - Observed structural change: In May 2013 two departments not directly related to banking supervision (the corporate credit department and the micro credit support department) were put directly under the FSS Senior Deputy Governor for banking and non-banking supervision. ### Recommendations (authorities should consider) - Clarify the primary importance and priority of safety and soundness duties. - Clearly segregate safety and soundness duties from other responsibilities assigned to the supervisory body. - Amend the legal framework to enable supervisors to increase prudential requirements for individual banks and banking groups based on their risk profile and systemic importance. *Source: IMF assessment, “29. Abuse of financial services” (content unit _cr14310).* ### Chapter II of the Establishment Act sets forth rules for the operation of the FSC ### Chapter II of the Establishment Act sets forth rules for the operation of the FSC ### Operation rules and emergency measures - Chapter II of the Establishment Act sets forth rules for convening meetings, preparation of written resolutions (which are mandatory), consideration of opinions (may consider opinions from Deputy Governors and other relevant experts), and emergency measures. - Emergency measures: - Can be taken by the Chairperson in case of any internal or external trouble, a natural disaster or a grave financial or economic crisis. - Are required to be reported to the Commissioners afterwards, who can confirm, amend or suspend them. - The FSC is supported by a secretariat. ### Governance and executive officers - Executive officers of the FSS: the governor, senior deputy governor, deputy governors, and the auditor. - The governor sets forth the duties for the executive officers (Articles of Incorporation, articles 7–11; Organization and Management Bylaws, article 33). - The FSC is staffed by public officials whose conduct is governed by the State Public Officials Act and the Public Service Ethics Act (Article 2–2). ### Conflicts of interest and ethical rules (EC5) - Rules and prohibitions: - Appointed Commissioners cannot join any political party or participate in political campaigns (Article 7 of the Establishment Act). - The Chairperson, the Vice Chairperson and the two financial experts Commissioners cannot engage in for-profit business, be an executive or employee of a supervised institution, be a member of the National Assembly or the local council, or hold any office which entitles remuneration while holding such positions. - Article 35 of the Establishment Act requires information received by FSS senior management and staff not to be disclosed or used for any purpose other than their duties. - Rules of Employment (Article 8) require confidentiality of information. - The Governor, Deputy Governors, the Auditor, and staff are not allowed to engage in affairs for profit other than their duties, or hold any office without approval from the appointing authority (Article 34). - Article 35 expressly forbids influencing financial institutions, their executives and employees to receive money, valuables or other benefits, or to obtain a loan from the financial institution. - Sanctions and criminal provisions: - Any person who divulges confidential information acquired in the course of performing duties, or uses such information for any purpose other than duties, is subject to imprisonment up to three years and a fine up to W 20 million (Article 68 of the Establishment Act). - Non-public official Commissioners and FSS executives and employees are deemed public officials for penal provisions relating to bribes (Article 69). - Violations of duties by public officials are subject to removal, dismissal, demotion, suspension from office, reduction of salary and reprimand (Article 78 of the State Public Officials Act). - Interfering with examinations and engagement in political activities can result in imprisonment for up to a year and a fine of up to W 5 million. - Institutional enforcement: - All employees of the FSS are subject to its Code of Conduct; Article 5 obliges avoidance of any possible conflict of interest. - The Ethical Committee may take punitive actions, in accordance with Personnel Management rules. - Assessment observation: - Overall, staff seemed diligent, dedicated and very thorough and professional in conducting tasks assigned to them. ### Resources, funding, staffing and training (EC6, EC7) - Funding and budgeting: - FSC’s budget allocation and deliberation processes are equivalent to other government organizations and are reviewed and approved by the MoF and the National Assembly (Article 54 of the Constitution). - The FSS is funded by fees charged to regulated financial institutions and securities issuers (Article 47 of the Establishment Act). Fees are levied according to clear standards and fixed rates, calculated taking into account costs of supervision and asset size. - The FSS budget is approved by the FSC (Article 45 of the Establishment Act). - The Establishment Act allows the FSS to borrow funds upon approval of the FSC (Article 48). Article 47 lists the Government and the BoK as additional funding sources. - The FSS is required to set its budget in accordance with “The Guidelines for the budget compilation on Public Institutions and Quasi-Government Organizations” of the MoF. - Major budget expenditures (currently): - Salaries; - Staff training; - Consultation fees for external experts; - Technology expenditure; and - Budget for travel, on-site examination, and other field work. - Human resources and compensation: - The FSC follows the salary scale of government’s civil servants; authorities stated FSS salary scale is comparable to that of the BOK. - Staff are government officials selected through a national exam; reported successful in attracting and retaining quality staff. - Authorities reported no practical budget constraints limiting supervisory actions. - Staff rotation, cooling-off, and training: - Regular and ad-hoc staff rotation and reassignments are used to allocate supervisory resources. - Managerial-level employees who leave the FSS are required to have a 2 year cooling off period from the date of termination before accepting employment in a private company that had contact or relationship with the FSS within the previous five years. Exceptions may be granted by the Government Officials Ethics Committee. - The FSS conducts wide-ranging training programs, runs an examination academy, operates a training credit acquisition system requiring employees to periodically take training and acquire minimum credits, and tests entry-level associates prior to promotion. ### Resource allocation, supervisory prioritization and operational independence (EC8) - Determination of supervisory programs and allocation: - Supervisory programs and allocation of resources within banking supervision are largely determined by assets’ size. - Risk profile and systemic importance of banks and banking groups are not explicitly taken into account in resource allocation. - Organizational and staffing concerns: - Current structure and allocation criteria do not appear to adequately prioritize or segregate safety and soundness concerns relative to other mandates (e.g., deputy governors in charge of banking supervision also handle consumer protection). - Number of staff directly allocated to banking supervision does not seem proportionate to the scope or relevance of activities; staff in key areas seemed extremely overloaded. - Authorities state organizational structure and human resources are flexibly adjusted and reviewed annually; supervisors assigned based on departmental surveys and reviews. ### Legal protection, litigation and indemnity (EC9) - Legal protections in practice: - Rules of the Board of Audit and Inspection: actions taken and omissions by bank supervisors while discharging duties in good faith are exempt from sanctions, provided conditions of public interest, transparency and validity are met. - When civil or criminal lawsuits are brought, the FSS Litigation Support Committee can provide an internally employed counselor, financial support to retain outside counsel, or cover defense costs (Regulation on Support for Employees facing lawsuits). - Financial support is deemed to be adequate to cover 70 percent of expenses. - Litigation statistics: - Currently a total of 87 cases of litigations and appeals involve the FSC, the SFC, and the FSS; of those, 4 relate to banking. - Over the last five years, 258 appeals and litigations were filed against the FSC, the SFC, and the FSS; the large majority referred to non-banking cases. - Favorable rulings accounted for 93.1percent (202 out of 217 cases closed); - 14 cases were ruled unfavorably and one case was determined to have no relevance by the Prosecutor’s Office. - During the past five years there has been no case in which the FSC or the SFC or the FSS has been required to compensate a third party for damages. ### Assessment of institutional independence and recommendations (Principle 2 — assessment: MNC) - Comments on independence: - Legal status of the FSC as a ministerial agency can grant additional means to exercise independence compared to structures within the MoF; direct subordination to the Prime Minister can also potentially threaten independence. - Checks and balances exist (FSC and FSS internal audit, BAI, Assembly investigations). - Commissioners include representatives from the MoF and the Korea Chamber of Commerce and Industry, posing challenges for conflicts of interest. - Legal protection for supervisors needs enhancements; current setting can potentially jeopardize staff willingness to act and effectiveness of supervision. - Authorities should consider: - Reviewing the current composition/functioning of the Commission to shield the Commission against conflicts of interest; - Revising the legal protection framework to ensure supervisors cannot be sued directly by market participants in cases of actions or omissions made in good faith; - Revising the current structure, staffing and distribution of activities within the FSS to allocate the appropriate volume of resources to safety and soundness and risk profile of activities. ### Cooperation and collaboration with domestic and foreign authorities (Principle 3 — assessment: C) - Domestic cooperation (EC1): - A MoU on information sharing and joint examination was signed in September 2009 among the MoF, the FSC, the FSS and the KDIC; updated in 2012 to include ad-hoc reports in addition to regular reports. - Detailed information on examinations or internal reports produced by the FSS is not shared under the MoU. - Committees fostering cooperation: - Macroeconomic and Financial Committee (deputy-heads of FSC, FSS, MoF, BOK, KDIC) for trends and risks; - Economic and Financial Council (heads of financial authorities) to coordinate and decide on macroprudential policies; - Financial Condition Check Meeting (FSC and FSS monthly) to review financial agenda. - BOK and KDIC can request FSS examinations or joint examinations for monetary policy and consumer protection purposes (Articles 62 and 66, Establishment Act). - Foreign cooperation (EC2–EC4): - MoUs signed with banking supervisors of 14 countries including the U.S., China, Japan, France, and Germany for supervisory information exchange. - FSS participates in supervisory colleges (home and host supervisors) and invites foreign supervisors to its supervisory colleges. - Information sharing under MoUs limits use to supervisory purposes and requires prior consent before passing to a third party. - Article 35 of the Establishment Act obliges confidentiality of information obtained by FSS senior management and staff. ### Resolution support (EC5) - The FSC is the resolution authority in the Republic of Korea. - Powers under the Structural Improvement of the Financial Industry Act: - Authorized to impose corrective measures including mergers and P&A (Article 10). - May entrust authority to the Governor of the FSS for timely corrective measures (Article 10). - Empowered to appoint special administrators to manage a bank or recommend dismissal of executives (Article 14). - A Macroeconomic Financial Committee was recently established (MoF, BoK, FSC, KDIC); in practice the Committee does not have decision power. ### Permissible activities of banks (Principle 4 — assessment: C) - Definitions and scope (EC1–EC2): - Article 2 of the Banking Act defines banking business as lending funds raised from many unspecified persons by taking deposits or through issuance of securities and other bonds; a bank is a legal person other than the BoK that regularly and systematically manage banking business. - Article 27: a bank may be engaged in all services in banking business within the scope of the Banking Act and other related Acts. - Banks may operate banking business, services incidental to banking business, and services concurrent to banking business. - Incidental and concurrent services: - Article 27–2 allows banks to operate services incidental to banking services, requiring filing at the FSC within seven days prior to starting such services; FSC may restrict or correct services that undermine soundness or depositor protection. - Article 28 allows “concurrent business” (financial business prescribed by Presidential Decree, finance-related business, other financial business with low risk); some require authorization or a seven-day prior filing. - Use of the word “bank” (EC3): - Article 14 states no entities other than the BoK and banks shall use the word “bank” or equivalent expressions; identified improper uses are made public via the FSS website. - Deposit taking (EC4): - Non-bank deposit taking financial institutions include mutual savings banks, credit unions and credit cooperatives, which are supervised by FSC-FSS and account for 20 percent of total deposits (credit cooperatives 14percent). - Community cooperatives and Korea Post office account for 8 percent of total deposits and are supervised by other ministries. - Act on “Regulation of conducting fund raising business without permission” (enacted 2010) penalizes unauthorized deposit-taking activities: up to five years imprisonment and fine not exceeding fifty million Won; advertising unauthorized business can result in up to two years imprisonment and a fine of up to 20 million Won (Article 6). - Public listing of licensed banks (EC5): - The FSS publishes on its website an updated list of licensed banks including branches of foreign banks. ### Licensing criteria and powers (Principle 5) - Licensing authority and powers (EC1–EC2): - Article 8(1) of the Banking Act: authorization from the FSC required to engage in banking business. - The Banking Act grants the FSC power to revoke a license (Article 53(2)) for false/illegal means, violation of conditions, failure to execute corrective orders, among others. - FSS conducts review and submits recommendation to FSC; decision made by Commissioners’ meeting. - Criteria for licensing are prescribed by the Banking Act, the EDBA and the RSBB; RSBB Appendix 2–2 details application content and minimum requirements. - The FSC can impose conditions on licenses (Article 8(4)). - Authorities reported no applications for commercial or specialized banking licenses over the past 20 years; no license revocations in the last five years. - Suitability of owners, governance and transparency (EC4–EC5–EC7): - Licensing requirements cover shareholding limits; fit and proper criteria for promoters and executives (Article 8 of the Banking Law; Article 18 of the Banking Act; Article 13 of the EDBA). - No explicit legal reference ensuring proposed legal, managerial, operational and ownership structures will not hinder solo and consolidated supervision, but Appendix 2–2 of the RSBB covers business feasibility, human resources, physical facilities, IT systems, risk management, etc. - For foreign financial companies, requirement to obtain home supervisor approval where necessary; parent must have solid financial and management status and be subject to consolidated supervision by home supervisor. - Fit and proper criteria include absence of criminal activities or adverse regulatory judgments and requisite experience and knowledge. - There are no requirements for Board members collectively to possess sound knowledge of the bank’s material activities and associated risks, nor explicit procedures for assessing potential conflicts of interest among board members. - It is not clear that assessment procedures would always encompass ultimate beneficial owners for banks not under an FHC. - Initial capital (EC6): - Minimum capital stipulated: KRW 100 billion for a nationwide commercial bank and KRW25 billion for a regional commercial bank (Banking Act, Article 8(2)). - Review of strategic and operational plans (EC8): - Necessary requirements for licensing broadly consistent with ongoing supervision (shareholding limits, fit and proper, prudential standards, internal control systems, human resources, physical facilities). - The FSC-FSS has not licensed a bank in 20 years; therefore limited practical recent licensing experience. *Source: _cr14310 - Chapter II of the Establishment Act sets forth rules for the operation of the FSC* ### Appendix 2 of the RBB—Standards for Approval for Banking Business—details the criteria ### Appendix 2 of the RBB—Standards for Approval for Banking Business—details the criteria ### Scope of licensing standards - Criteria encompass appropriate internal control systems, corporate governance and risk management. - For branches of foreign banks, reviews include adequacy of proposed strategic and operating plans as well as the IT risk management, internal controls and human resources (Appendix 2–5 of the RSBB). - Files reviewed by the assessors confirmed such practices. ### Gaps identified - There is no explicit mention to checks for the internal controls relative to the detection and prevention of criminal activities or the oversight of proposed outsourced functions. ### EC9 — Licensing authority review of financial information - The licensing authority reviews pro forma financial statements and projections of the proposed bank. - This includes an assessment of the adequacy of the financial strength to support the proposed strategic plan. - Reviews also include financial information on the principal shareholders of the bank. *Source: Appendix 2 of the RBB—Standards for Approval for Banking Business (CR14310).* ### Appendix 22 of the RBB—Examination Standards for Approval of Banking Business details ### Appendix 5 of the Regulations set out the areas to be assessed as part of the CAMELR onsite ### Appendix 5 — Areas assessed in the CAMELR onsite risk assessment (corporate governance and risk management) ### Management category — scope and approach to corporate governance assessment - Management category assesses corporate governance for head office banks and subsidiary banks, specifically: - Adequacy of management structure and establishment and enforcement of management policy; - Actual status of promotion of management efficiency and management improvement; - Subsidiaries management status and operating results; - Risk management system and operation status; - Internal control system and status; and - Enforcement status of laws and regulations, policies and matters pointed out as a result of examination. - Onsite supervisory process consists mainly of verifying documentation such as Board resolutions, Board agendas and meeting minutes, and adequacy of management structure. - Meetings with Permanent and independent (Outside) Directors might be conducted in exceptional circumstances but are not typically part of the onsite examination. The assessment did not appear to extend to subsidiary boards. - Banks are not universally required by regulation to develop and disclose corporate governance policies despite self-assessment assertions; larger banks’ annual reports typically summarize corporate governance arrangements, while smaller non-listed banks are not required to disclose such details. - Corporate governance assessment is primarily through the full-scope onsite CAMELR examination performed every two years; within that two year period assessment is not conducted systematically for domestic banks and the depth and frequency of partial examinations on governance is variable (example: 2011). - Separate examination item lists and processes apply for foreign bank branches, commercial banks, state-owned banks, and specialized banks (Korea Asset Management Corporation and Korea Housing Finance Corporation onsite manuals do not include management or corporate governance reviews; the only examination of these Specialized banks was in 2008). EXIM Bank assessment outcomes are reported to the Ministry of Strategy and Finance which has ultimate supervisory authority for EXIM Bank. ### Essential Criteria (EC) — corporate governance (EC3–EC9) — legal basis and supervisory findings - EC3 — Nomination and Board composition: - Banking Act (Article 18–22) provides election procedures and extensive selection criteria; prohibits unfit directors. - Regulations require that more than half of the Board should comprise independent non-executive directors (“outside directors”). - Article 23–2 requires an Audit Committee (AC) composed of at least 2/3 outside directors and at least one accounting or financial specialist. - January 2010: FSS issued a guidance note regarding good practices for compensation; major banks and FHCs have established remuneration committees. - EC4 — Duty of care and duty of loyalty: - Commercial Act Articles 382 and 382–3, and Article 681 Civil Act require Board members to exercise “duty of care” and “duty of loyalty.” - EC5 — Board oversight of strategy, risk appetite and policies: - Article 23(1) of the Banking Act prescribes Board decisions on management objectives, amendments of Articles of incorporation, budget and settlement of accounts (including remuneration), major organizational changes, and internal control standards under Article 23–3. - Article 31 of the RSBB sets Board responsibilities on risk management and risk tolerances including “Establishment of basic policy on risk management consistent with the management strategy; determination of risk levels which the bank can bear.” - FSS verifies plans, risk tolerances, risk management strategies and policies, and conflicts of interest/internal control policies in assessments. - Regulations are not specific on a requirement for regular Board review and approval of all material policies and procedures at a defined minimum frequency; expectation exists but is not stipulated. - EC6 — Fit and proper standards, succession: - Article 23–2 and Article 23–4 require banks to formulate and disclose internal corporate governance policies covering qualification criteria and appointment procedures for Board members and senior management and development of succession plans. Supervisors assess Board’s policies and succession arrangements. - EC7 — Compensation oversight: - FSS developed ‘Model Compensation Guidelines for Banking Institutions’ circulated in January 2010; not translated into law or regulations. - Files show banks transitioning toward compliance with FSS guidelines; supervisory focus and activities (e.g., meetings with Board Compensation Committees, identification of material risk takers, confirmation of risk-adjusted compensation) are not well developed. - EC8 — Board understanding of operational structure and risks: - Main supervisory activity to assess Board understanding is review of documentation and Board minutes. Full-scope examinations meet CEO/Chair; meetings with full Board are not typical and would only occur in exceptional incidences. - EC9 — Supervisor power to require Board composition changes: - Article 54(1) and (2) of the Banking Act gives FSS power to (i) suspend the executive; (ii) recommend that the general meeting of stockholders dismiss the executive; or (iii) request that the bank take appropriate action and dismiss the executive. - The Act does not give FSS direct unilateral power to dismiss or make changes in the Board of Directors. - Supervisor may recommend dismissal/replacement of Board members if they violate laws/regulations or engage in activities threatening bank soundness. - No evidence provided that FSS-FSC had dismissed or removed a Board member or senior manager after not complying with the examination manual. ### Additional Criteria and reporting (AC1) - Banks must report transactions with related parties such as Board members and senior management and Board members’ other engagements outside the bank. Material information that may negatively affect fitness and propriety must be reported to bank supervisors. - Supervisors may require submission of certain information on fitness and propriety (Article 47, Banking Act; Articles 15 and 99, Detailed Regulations). ### Assessment of Principle 14 — summary of shortcomings (rating drivers) - Two key drivers of rating: - Gaps in regulations for corporate governance; and - Need for broader supervisory practices to effectively test corporate governance. - Specific regulatory gaps and supervisory shortcomings identified: - FSS lacks authority to remove directors and has not exercised this power; - Sound compensation principles have not been transposed into regulations (currently guidance for banks); - No regulations requiring policies and procedures to be reviewed and approved by the Board of Directors on a minimum frequency; - No requirement in the regulations for regulated subsidiary boards to be composed of independent directors; - No reference in the regulations for a conflict of interest policy. - FSS oversight and inputs into risk ratings could be further developed, particularly for FHCs. There is no separate FHC examination manual; FSS does not assess corporate governance of Specialized banks. ### Principle 15 — Risk management process (overview) - Principle 15 requires a comprehensive risk management process to identify, measure, evaluate, monitor, report and control or mitigate all material risks and to assess capital and liquidity adequacy relative to risk profile and market/macro conditions; includes contingency arrangements and recovery plans where warranted; process commensurate with risk profile and systemic importance. ### EC1–EC6 — legal framework and supervisory implementation for risk management - EC1 — Board-approved risk strategies and risk appetite: - Article 31: Board must determine key risk management processes; levels of risks to be tolerated; acceptable losses; internal risk processes commensurate with bank business and management strategies. - Article 30: banks must establish systems for timely recognition, assessment, monitoring and control of various risks and for evaluating appropriateness of inside capital; set risk-bearing and transaction limits by department, transaction or person. - FSS assesses soundness of Board and senior management decision processes via CAMEL-R onsite; offsite monitoring is frequent but mainly quantitative; thorough review of risk management is typically only during full-scope examinations. - EC2 — comprehensive bank-wide policies and processes: - Article 30 paragraph 3 requires comprehensive risk management policies covering credit risk, operational risk, market risk, interest rate risk in the banking book, liquidity risk, and other risks including strategy and reputation. - ICAAP requirements establish minimum expectations for banks to consider risk profile and capital adequacy, including obligation to evaluate against external environment regularly. - ICAAP implementation is at an early stage for domestic banks; FHCs are yet to prepare and submit an ICAAP for a full assessment cycle. Guidance for FHCs circulated in 2012; 2013 will be the first year receiving ICAAPs for the FHCs. - EC3 — documentation, review, communication of strategies, policies and limits: - Article 30 (RSBB) references risk limits. FSS ensures via CAMEL-R that strategies, policies, processes and limits are executed and documented. Banks submit details on compliance with risk limits regularly; breaches trigger supervisory response. - Regulations do not prescribe Board review and approval frequency for policies and limits in line with risk appetite. - Banks using internal models for Pillar 1 capital are required to perform regular stress testing and report results to the Board; ICAAP regulations enforce the Board’s role. - EC4 — Board and senior management information and understanding: - Article 31 establishes Board oversight and requirement for independent risk management unit; regulations are less clear on specific Board reporting and management information requirements. - Full onsite examination occurs at a two year frequency as a minimum; review of Board papers is core element, but processes to confirm ongoing Board engagement and understanding of changing risk profile are not well developed. Offsite assessment of Board reporting quality is not part of normal procedures. - EC5 — internal capital and liquidity adequacy processes: - FSS uses CAMEL-R and RADARS to assess internal controls and capital/liquidity adequacy relative to risk appetite and profile. - Banks must carry out stress tests to assess liquidity risk exposure and adequacy of quantitative and qualitative liquidity buffers. - Regulations require liquidity risk management systems consistent with characteristics, size and complexity of operations; roles and responsibilities must be defined and systems periodically revised (Regulations for ICAAP, Annex 3). - FSS receives capital projections at start of calendar year and performs quarterly offsite analysis of capital adequacy trends. - ICAAP review is in early implementation and requires further embedding and development of guidance for supervisors (see CP 16). - EC6 — use of models: - Regulations for IRB, AMA and market risk require Board oversight for model approval and scrutiny of assumptions. - FSS performs periodic assessments of model outputs, benchmarking, and validation reports; when new models are implemented FSS approval includes assessment of model governance. Boards receive regular model performance and validation reports and set thresholds for model performance. ### EC7–EC14 — information systems, new products, resources, standards, contingency and stress testing - EC7 — information systems and reporting: - Banks must operate information systems supported by dedicated risk management units that measure, assess, and report risks across types, products, and counterparties. Reporting to Board and senior management is a key feature. - EC8 — new products and major initiatives: - FSS assesses roles and responsibilities of Board and senior management against risk management systems using RADARS; key supervisory interests include Board receipt and deliberation of material risk reports, efforts to improve reliability of risk measurements, understanding of methods/tools to manage risk, and appropriateness of risk committee composition/activities. - No regulatory requirement to notify FSS of a new acquisition of financial or non-financial business. FSS does not review bank strategic plans on an annual cycle; strategy is not a feature of CAMELR or RADAR. No specific regulatory obligation for new product approval process. - EC9 — risk management resources and independence: - Article 31 requires a dedicated risk management unit segregated from risk-taking activities to support Board and senior management; duties include monitoring adherence to risk parameters, managing risk information system, and providing timely risk information. - Article 31 does not mention requirement for the risk management function to be subject to regular review by internal audit as required in this EC. - EC10 — CRO and oversight for larger banks: - All banks must maintain a dedicated risk management unit irrespective of size or complexity (Article 31). - Proposals to amend governance provisions have been put to the National Assembly; FSS working on CRO guidelines expected to be completed and take effect during the first half of 2013. - Regulations do not currently stipulate a CRO function; in practice domestic banks maintain a CRO function. Removal of a CRO is not stipulated as requiring FSS engagement. - EC11 — supervisory standards for main risk types: - Supervisory regulations provide detailed standards for measuring credit risk, market risk, operational risk for capital calculations; contain specific rules on liquidity risk and interest rate risk calculations. Supervisory manuals provide guidance for off-site and on-site evaluation of risk management. - EC12 — contingency arrangements and recovery plans: - Contingency plans are required under regulations covering liquidity, capital, and IT. Banks must include contingency plans based on stress tests in capital decisions, but not for other material risks. - Korea is not required to introduce resolution plans for G-SIFIs because no domestic bank has been designated a G-SIFI. - Under existing laws, supervisors can demand submission of resolution plans only from troubled banks. When regulation on D-SIFI is confirmed, establishment of recovery plans for D-SIFI will be reviewed. - EC13 — stress testing: - FSS published ‘Model Guidelines for Stress Testing’. Banks should conduct stress testing of risk mitigation and control systems and, where necessary, adequacy of internal capital; banks evaluate their vulnerability under various scenarios. - EC14 — risk-adjusted pricing, performance measurement and new product approval: - RADARS & CAMELR are used to assess banks’ incorporation of risk into interest rate/service fees, allowance for loan losses, capital allocation, and performance measurement. - FSS monitors whether: (i) risk considerations are taken into account in new products, interest rate decisions, capital allocation, and allowance for loan losses; (ii) effective reporting systems provide timely information to senior management; and (iii) banks operate effective risk-adjusted performance measurement (RAPM) systems. - Market risk management validates new product pricing models and periodically estimates underlying parameters (correlations, volatilities). New product procedures should define interaction mechanisms among functions to ensure risk management, accounting and price adequacy. ### Additional Criteria (AC1) — other material risks - Supervisor requires banks to have appropriate policies and processes for assessing other material risks such as reputational and strategic risks. *Source: _cr14310 - Appendix 5 of the Regulations set out the areas to be assessed as part of the CAMELR onsite* ### Annex 3 of the Detailed Regulations provides that banks must maintain appropriate internal ### _cr14310 - Annex 3 of the Detailed Regulations provides that banks must maintain appropriate internal ### ICAAP, governance, and assessment of Principle 15 - Annex 3 of the Detailed Regulations provides that banks must maintain appropriate internal capital adequacy assessment process (ICAAP) as set by the FSS. - When assessing bank ICAAP, all bank risks—pillar 2 risks in addition to pillar 1 risks—must be taken into consideration. - Main factors driving this assessment include: - Regulations do not adequately reflect the need for an independent risk management function that reports to a head of risk management such as a CRO and the linkages with a Board Risk Committee which is chaired by an outside (independent director) and supported by other non-executive directors. Industry better practice reflect three lines of defense model where the assurance function is a hard line throughout an organization; - No independent external verification of compliance with the Regulations; - Oversight by supervisors of group-wide risks could be enhanced by transposing the FHC risk management guideline into regulation. Scope for supervision practices to be developed further; - While the ICAAP process for assessing adequacy of capital given the group risk profile is mature and embedded in banks, the same level of rigor for liquidity is less well developed. Mainly, the process for ensuring sufficient liquidity across the group and identifying liquidity risks on a forward looking basis. Liquidity ST, liquidity limits across group, maximum liquidity risk exposure not well developed; and - Regulations and supervision practices do not appear fully developed to effectively link stress testing outcomes and risk management and Board involvement in re-setting risk limits and risk appetite. ### Principle 16 — Capital adequacy (overview) - The supervisor sets prudent and appropriate capital adequacy requirements for banks that reflect the risks undertaken by, and presented by, a bank in the context of the markets and macroeconomic conditions in which it operates. - The supervisor defines the components of capital, bearing in mind their ability to absorb losses. - At least for internationally active banks, capital requirements are not less than the applicable Basel standards. ### Essential Criteria 1 (EC1) — laws, regulations, and minimums - Laws, regulations, or the supervisor require banks to calculate and consistently observe prescribed capital requirements, including thresholds by reference to which a bank might be subject to supervisory action. Laws, regulations or the supervisor define the qualifying components of capital, ensuring that emphasis is given to those elements of capital permanently available to absorb losses on a going concern basis. - Description and findings regarding EC1: - The Banking Act (Article 34(2)) and the Enforcement Decree (Article 1–2) provides for banks’ capital adequacy. The Banking Act stipulates that banks will maintain soundness in their management of matters concerning proprietary capital. Under the Act, the FSC will enforce the minimum capital requirements of 8 percent risk-weighted assets and implement corrective action as per the framework described in CP11. - The Enforcement Decree defines the components of the capital base for domestic banks. Core capital is the sum of amounts of capital, capital surplus and earned surplus, which incurs from the issuance of common stocks and equity securities that have been issued. The definition clearly refers to the ability for the capital instruments to absorb losses. - Supplementary capital is defined as subordinated to core capital and available for losses incurred where a bank is liquidated. - The minimum legal capital requirement is W 100 billion for a nation-wide commercial bank and 25 billion won for a regional bank. - The FSS maintains consolidated and risk-adjusted capital standards as recommended by the BCBS (referred to the BIS ratio in the regulations and Article 26(2)). - Korea adopted the first Basle Accord at the end of 1995 and the market risk amendment was implemented January 1, 2002. - For the 18 domestic banks, the FSS uses the BII framework to calculate regulatory capital which was introduced in 2008. For the non-bank sector the FSS applies BI. The FSS also applies BI to bank Financial Holding Companies (hereafter FHCs). - For the commercial banks, the FSS adopted the Basel II.5 amendments for market risk in 2010 (with implementation in 2012). - For the commercial banks the minimum capital requirement is 8 percent risk-weighted assets (RWAs). - Tier 2 capital can be no more than 100 percent core equity capital which equates to a minimum of 4 percent, and there is no minimum common equity T1 requirement. - The average CIS ratio for the domestic banks as at December 2012 was *Source: _cr14310 - Annex 3 of the Detailed Regulations provides that banks must maintain appropriate internal* ### 14.30 percent. ### _cr14310 - 14.30 percent. ### Capital requirements and baseline rules - Foreign Bank Branches must have core operational funds of at least three billion won at the time of establishment. - Branches must keep a minimum 8 percent of capital ratio against risk weighted assets and a 10 percent reserve rule also applies. - How often banks need to calculate capital is uncertain within the regulations (no stipulation); in practice banks report capital quarterly as part of their prudential reporting obligations. - At least for internationally active banks, the definition of capital, the risk coverage, the method of calculation and thresholds for the prescribed requirements are not lower than those established in the applicable Basel standards. ### Composition of regulatory capital (EC2) - Tier 1 Capital consists of: - (i) capital (except cumulative preferred stocks and redeemable preferred stocks); - (ii) capital surplus (excluding revaluation reserve); - (iii) earned surplus (excluding cumulative amount of unrealized gain or loss of financial debt due to changes in credit risk of banks); - (iv) exchange difference from accumulated other comprehensive income; - (v) unissued stock dividends from capital adjustment account; and - (vi) hybrid bonds. - Tier 2 is composed of: - (i) amount equivalent to 70 percent of the amount for which dividend distribution is restricted due to the resolution of the board of directors, general meeting of stockholders; - (ii) revaluation reserve under the asset revaluation approach; - (iii) an amount equivalent to 45 percent of gains on valuation of securities available for sale and gain on valuation of investment securities by the equity method and an amount equivalent to 70 percent of gain on revaluation of tangible assets, out of sum of total cumulative other income; - (iv) loan loss provisions accumulated for the assets classified as ‘normal’ and precautionary as a result of asset classification; - (v) fund raised by debt capital instruments such as perpetual bond and cumulative preferred stocks; - (vi) redeemable preferred stocks with maturity of 5 years or more; and - (vii) issuance amount of term subordinated bond with maturity of 5 years or more and term subordinated loan with maturity of 5 years or more. - Deductions consist of: - (i) equivalent amount of goodwill, deferred income tax assets, discount on stock issuance, evaluation loss; (from AOCI) of securities available for sale, negative changes in equity accounted for by equity method and treasury stocks (deducted from T1 capital); - (ii) fund raised by stock cross held with other banks in order to enhance equity capital ratio, debt capital instruments or term subordinated bond with maturity of 5 years or more (deducted from T1 capital); - (iii) subordinated claim against financial institutions determined by the Governor; and - (iv) asset or capital item not appropriated for loss of bank, determined by the Governor. - The method of deducting from capital for banks subject to the Basel II framework appears consistent with Basel II (100 percent from T1 capital for items such as goodwill). For FHCs subject to Basel I, the FSS has instructed banks to deduct from T2 until exhausted and then from T1. - Guarantees under 10 percent of capital do not need to be deducted from the capital base. - The amortization schedule for T2 instruments with maturity of less than five years is 20 percent per year. ### Limits, ceilings and other quantitative rules - Capital is composed of the sum of Tier 1 and Supplementary Capital. Supplementary Capital is limited to 100 percent of Tier 1 capital. - Supplementary capital and T3 capital appropriated for market risk cannot exceed 250 percent of the core capital appropriated for market risk. - Composition of T2 and T3 cannot be more than 250 percent of equity capital (Appendix 3–2, paragraph 6.B. (2)). - Inclusion of hybrid securities in T1 capital is limited to a maximum of 30 percent (or 15 percent if subject to a condition of raising interest rate) of equity capital (after subtracting deductions). Hybrid securities exceeding the ceiling may be included in T2. - Maximum allowance for credit losses included in supplementary capital is 1.25 percent for standardized banks and for an IRB bank maximum is 0.6 percent of RWAs if eligible credit losses exceed expected loss (EP>EL). ### Issuance, redemption and supervisory notification - Banks are required to notify the FSS prior to redeeming term subordinated debt and will consult with the FSS prior to issuing capital instruments that will be included in the definition of regulatory capital. ### Assessment, monitoring and CAMELR treatment - To assess capital adequacy as part of the CAMELR methodology, the FSS uses a ratings schedule consisting of 15 grades from +1 to +5 (i.e., -1, 1 +1) with established benchmarks. Example: to assign a +1 CAMELR rating for capital total capital will need to exceed 12 percent RWAs. - The Regulations do not require the submission of a detailed capital management plan to the FSS; the FSS will request capital plans if offsite analysis raises concerns. - Banks report quarterly their capital ratios as part of Business Reports with earnings information. - Analysis of banks’ capital management plans was not a systematic process evaluating capital projections with all underlying drivers and assumptions (expected credit growth, RWAs, profitability, provision levels, dividend payments by subsidiaries etc.). - Offsite analysis includes detailed information regarding a bank’s capital adequacy compared across peer group and through trend analysis. Responsibility for offsite analysis is distributed among subject matter experts (IRRBB, country and transfer risk, credit concentration, stress testing results). The process for incorporating results into a single view of capital sufficiency is not as well developed. - The Detailed Regulations (Article 17(2)) state banks shall calculate the capital to risk-weighted assets ratio based on the numerical value as of the provisional settlement date or final settlement date. There is no requirement to calculate capital adequacy more frequently or continuously. ### Exceptions and consolidation rules - One unique exception: The capital base for National Fisheries is a fund contributed from the central association and can be withdrawn, so it does not meet the perpetuity characteristic of capital per Basel guidelines. - The FSS applies BII to commercial banks, but has not extended BII to FHCs which have commercial bank subsidiaries. At the FHC level, BI is applied to the FHCs. The authorities plan to apply BII and BIII to FHC’s by 1 December 2013. - The FSS does not have the power to require the FHC to distribute capital throughout the banking group or FHC. ### Pillar 2, supervisory capital powers and buffers (EC3, EC4, EC6) - Pillar 2 of Basel II has not been fully implemented and all banks operate with a minimum capital ratio of 8 percent RWAs. - Typically the FSS will encourage banks to establish capital buffers usually through a written letter, although the FSS does not have the power to set minimum capital ratios above the Basel 8 percent RWAs. All banks’ minimum capital ratio is 8 percent notwithstanding their risk profile. - The FSS has attempted to encourage banks to operate with prudent capital buffers. - The regulatory level of capital is not higher than the minimum Basel requirement, but banks’ capital adequacy is verified with reference to both regulatory capital and internal capital. - A legal reserve requirement: banks must credit at least 10 percent of net profit to a legal reserve until it accumulates to a level equal to the total paid-in capital. The FSS recommends banks with an equity to assets ratio less than 5.5 percent to reserve 10 percent of net profit. - No formal framework currently exists to identify D-SIBs and capital requirements do not reflect systemic characteristics of banking groups; FSS plans to implement the D-SIB framework as promulgated by the BCBS commencing 2016. - The FSS has the power to require banks to perform stress testing; banks submit stress test results semi annually to a centralized BCBS team in the Bank & Non-Banking Supervision Division. Stress testing guidelines and a checklist are circulated. However, stress test outcomes are not linked to the FSS applying higher capital requirements because all banks maintain a standard 8 percent capital to RWAs. ### Internal models, accreditation and validation (EC5) - The framework offers both Standardized and Advanced model approaches for credit, market and operational risk. - Authorization counts: 7 banks authorized to use internal models for market risk, 11 banks authorized to use IRB, 5 authorized to use AMA. - Regulations stipulate minimum expectations and qualifying criteria for accreditation (e.g., IRB applicants must submit current status, implementation plan, internal audit report, self assessment, other material; a two year parallel run will be performed and submitted to the FSS). - Processes within the FSS to verify ongoing compliance with minimum criteria are not well established. Approval responsibilities are split: AMA approvals rest within the BCBS team; changes to internal models are the responsibility of the Bank Examination Team; credit and market risk decision-making is centralized within the BCBS team. - The FSS can revoke accreditation if banks fail to meet minimum criteria. No examples were found where the FSS imposed additional conditions tied to process/model complexity and bank risk profile. - Validation is required to be performed by an independent unit within the bank and is submitted to the FSS three months after the end of financial year. The refresh of new estimates, model parameters and risk factors are not subject to FSS approval prior to being used by the bank in calculating regulatory capital. ### Assessment summary for Principle 16 (key drivers) - BII calculation of regulatory capital is applied to commercial banks, while BI is applied to FHCs; the BCP methodology requires consistent application to banks and their holding companies, which has not been implemented. - The FSS does not set individual minimum capital requirements and does not impose higher capital requirements on individual banks commensurate with their risk profiles. Pillar 2 of BII has not been implemented. ICAAP assessment process is at an early stage and not integrated with the supervisory framework; ICAAPs have not been received for FHCs. - Regulations do not formally require a bank to seek prior approval before executing a capital reduction. - Annual validation of internal models is performed by banks, but there is no regulatory requirement for validation results to be assessed by the FSS prior to including new estimates in regulatory calculations. ### Transition to credit risk supervision (Principle 17) and EC1 findings - Banks are required to have appropriate tools to identify, measure, monitor, and control credit risk and manage capital adequacy (Article 30, Regulations). - The FSS assesses the adequacy of banks’ internal assessments of risks and capital and reflects these assessments in supervision. - Onsite CAMELR examinations assess credit underwriting practices and test quality of risk management. Onsite examinations sample loans to determine compliance with LTV and DTI requirements prescribed by the FSS. - In addition to LTV and DTI limits, domestic banks need to comply with a loan to deposit ratio of 100 percent. *Source: _cr14310 - 14.30 percent.* ### Appendix 3–5). By receiving detailed portfolio metrics on a quarterly basis, the FSS is able to ### _cr14310 - Appendix 3–5). By receiving detailed portfolio metrics on a quarterly basis, the FSS is able to ### Credit risk governance and management (EC2–EC8) - Legal and supervisory framework - Article 30: minimum expectations for a bank risk management system for timely recognition, assessment, monitoring and control of risks and for evaluating and managing these risks against capital. - Article 31: Board of Directors responsible for (i) establishing a basic policy on risk management consistent with management strategy; (ii) determination of risk levels; (iii) approval of risk limits and thresholds; and (iv) establishment and revision of regulations on risk management. - Detailed Regulations for IRB accredited banks prescribe: validation of credit management system; maintenance of management data; integrity of rating procedure; documentation and design of the credit assessment system, use of the model and stress testing. Board approval of these policies is not explicitly stipulated. - Supervisory practices - Onsite examinations review Board Minutes and Board Risk Committee minutes and use detailed credit information to select loans for file review. - Risk budgeting, observance of credit limits, tertiary oversight, overrides and exceptions are assessed. - Risk reports (typically monthly) circulated through senior management are reviewed for changes in underwriting standards relative to Board limits. - File sampling for full scope onsite examinations: approximately 20–30 percent of total loans (by asset size) and include a review of 80–90 borrowers; FSS examiners are onsite for approximately 20 days. - FSS verifies information management systems provide portfolio metrics of asset soundness and forward looking metrics of vintage analysis. - Specific expectations for bank policies and processes (EC3) - (a) Well documented and effectively implemented strategy and sound policies and processes for assuming credit risk, without undue reliance on external credit assessments; - (b) Well defined criteria and policies and processes for approving new exposures (including prudent underwriting standards) as well as for renewing and refinancing existing exposures, and identifying the appropriate approval authority for the size and complexity of the exposures; - (c) Effective credit administration policies and processes, including continued analysis of a borrower’s ability and willingness to repay; monitoring of documentation, legal covenants, contractual requirements, collateral and other forms of credit risk mitigation; and an appropriate asset grading or classification system; - (d) Effective information systems for accurate and timely identification, aggregation and reporting of credit risk exposures to the bank’s Board and senior management on an ongoing basis; - (e) Prudent and appropriate credit limits, consistent with the bank’s risk appetite, risk profile and capital strength, which are understood by, and regularly communicated to, relevant staff; - (f) Exception tracking and reporting processes that ensure prompt action at the appropriate level of the bank’s senior management or Board where necessary; - (g) Effective controls (including quality, reliability and relevancy of data and validation procedures) around use of models to identify and measure credit risk and set limits. - Monitoring of total indebtedness and FX risk (EC4) - Detailed Regulations (Article 48 (2)) require internal management systems to continuously monitor changes in borrower risk status. - Banks expected to have lending limits by borrower class and systems to aggregate borrowers’ total indebtedness including FX, derivatives and contingent loans. - Conflicts of interest and arm’s length lending (EC5) - Banking Act paragraph 34-2(8) ensures credit decisions free from conflicts of interest in relation to shareholders; Regulations are not prescriptive for related-party procedures (director loans, related party loans). - Board or senior management decision thresholds (EC6) - Article 35–2 of the Banking Act: where a bank intends to extend its large stockholders credit of not less than 0.1 percent of equity capital or W 5 billion, it shall undergo resolution by the board of directors, in advance; resolution requires affirmative vote of all incumbent members of the board of directors. - Article 35 sets single borrower limits but does not explicitly require Board approval for large exposures below LE threshold; no mandated delegations register in the Regulations. - Access to portfolio and bank officer information (EC7) - Article 48 of the Banking Act grants supervisors authority to request information and to question and interview bank officers. - Prior to full scope CAMELR onsite, FSS receives broad, detailed data across banking book and investment portfolios (borrower name, type of loan, length, amount, collateral value, name of external appraisal, LTV, DTI, etc.). Access to data is unfettered. - Stress testing credit exposures (EC8) - IRB accredited banks: obligation to conduct regular stress tests conservatively, considering a mild recession scenario, to assess impacts on required equity capital under IRB approach (Detailed Regulations, paragraphs 166 and 167, Annex 3). - Non-IRB banks: requirement to perform regular stress tests is not prescriptive; stress testing is required as part of the ICAAP. - FSS issued a guideline on Stress Testing recommending banks conduct stress testing to assess capital adequacy taking into account incidents or changes in future economic conditions that can adversely affect credit risks. ### Assessment and recommendations — Principle 17 (Credit risk) - Main factors driving the rating: - Greater focus on independent valuations; and - More frequent onsite credit risk examinations for the larger systemic banks to accurately assess credit underwriting standards and identify adjustments in risk-taking behavior. - Observations and recommendations: - Credit risk is the most relevant risk in the banking system; current macroeconomic conditions show an upward trend in unemployment and past due loans. - The FSS monitors data carefully on a quarterly basis and is aware of vulnerabilities; greater attention to credit risk is warranted. - Recommendation: FSS should increase attention to on-site inspections of credit risk. More frequent onsite inspections will improve assessment of underwriting standards and forward looking indicators such as exceptions and overrides to policy; changes in application of credit risk policies; application of covenants for commercial lending and covenant monitoring by risk management. - Special attention recommended for independent valuations for collateral, particularly conservatism for construction and project finance. - Emphasize focus on borrowers’ ability to repay under stressed circumstances and scrutiny of loan restructurings that might mask weaknesses. ### Problem assets, provisions and reserves (Principle 18 — EC1–EC12) - Asset classification framework (EC1) - Article 27: loans categorized into five categories: normal, precautionary, substandard, doubtful and presumed loss based on borrower’s debt servicing ability and credit history. - Regulations authorize FSS to require write-off of bad assets and oversee adequacy of asset classification, provisioning and write-off. - Regulations lack a comprehensive set of provisions for identification and management of problem loans; continuous credit risk monitoring and collateral valuation expectations need further development. - Regulations require internal control system independently operated by a credit review function and a suitable early write-off policy for assets classified as “doubtful” and “presumed loss.” - Assets subject to classification for provisioning include: (i) claims such as loans, advance for payments on guarantees etc; (ii) payment guarantee, the principal liability of which is fixed; (iii) securities; (iv) lease assets; (v) suspense received or amount receivable; (vi) interest receivable; and (vii) other assets recognized by a bank to be in need of forward looking criteria (Article 28). - Loan-loss provisioning schedule (Article 29) - 0.85/100 for normal loans (0.9/100 for construction loans; wholesale and retail trade; hotels and restaurants and rental businesses); - 7/100 precautionary; - 20/100 substandard; - 50/100 doubtful; and - 100/100 presumed loss. - Residential mortgage loans: normal increased to 1/100 and doubtful to 55/100. - Credit cards provisioning schedule: Normal (1.1/100); Precautionary (40/100); Substandard (60/100); Doubtful (75/100); Presumed loss 100/100. Cash advances and revolving credit have an even more conservative schedule. - Government-guaranteed or government-extended assets: 0 percent for Normal. - Transition to IFRS / reserve for Credit Loss - Reserve for Credit Loss introduced to prevent decrease in banks’ loss absorbent capacity under KIFRS; reserve calculated by deducting accounting reserves from regulatory reserves; regulatory reserves determined based on the larger of minimum regulatory ratios or expected loss under IRB approach. - Default definition and harmonization - Domestic banks (and FHCs) default defined as 90 days past due; non-banks default defined as 180 days past due. FSS plans to harmonize non-bank definition by 2017. (Article 172 of Detailed Regulations provides comprehensive default definition for banks). - Supervisory assessment of grading, provisioning and collateral valuation (EC2, EC8) - Banks must establish internal rules on asset classification, provisioning, credit rating model consistent with banking laws; supervisors determine adequacy through CAMEL-R ratings, onsite examinations and offsite surveillance. - Full scope onsite examinations include large cross-section loan file reviews; sample size related to risk exposure, data reliability and internal controls. - FSS assesses market indices used for valuations; banks use Kumin Bank housing price survey for housing; commercial property valuations use a mix of indices and independent appraisal. - Specific focus on collateral management systems was historically limited; integrity of systems to assign and identify previously pledged collateral could not be confirmed. - Off-balance sheet exposures and provisioning (EC3) - Regulations apply credit loss schedule to unused commitments (Article 28, paragraph 6). Off-balance sheet exposures, including guarantees, must be classified under same standards and provisioning applied using credit conversion factors (CCF). - Securitized assets treated as commitments/guarantees with 50 percent CCF. Project financing related exposures with ABCP apply 100 percent CCF (guidance issued 8 March 2010 as Administrative Guidance Note). - Timely provisioning and supervisory action (EC4, EC7) - FSC can amend Regulations to adjust standards on asset classification and supervisory provisioning when market or economic conditions deteriorate; process is not protracted. - FSS has power to require banks to revise asset classification, provisioning and write-offs (Regulations Articles 28 and 29). - Example: Mutual Savings bank sector problems in 2010—FSS instructed MSBs to reclassify loans and performed its own collateral valuations for large assets. - Early identification, testing for circumvention and documentation (EC5, EC6) - Article 48: banks required to have on-going monitoring, credit rating system, early warning system, audits of lending policies and administration, and resolution processes. - Testing for mis-classification (rescheduling, refinancing, reclassification) mainly through full scope examination every two years. - Articles 18 require quarterly submission of Business Reports on asset classification and provisioning with comprehensive metrics (repayment capacity, collateral value). - Reclassification criteria and concerns (EC9) - Banks may classify loan as non-performing when reasonable grounds exist that principal and interest will not be collected as contracted, based on borrower’s future debt servicing ability. - Regulations permit considerable flexibility for returning restructured exposures to performing; Appendix 13 allows restructuring back to performing without borrower proving repayment capacity under revised terms. - FSS issued an Administrative Note in 2009 to clarify expectations; nevertheless, discretion remains and regulatory guidance does not impose strict minimums for returning loans to performing. - Board reporting (EC10) - Banks required to report to Board on a range of activities (Article 23–2); Article 34 requires soundness in assets; Articles 29–31 establish Board’s role in risk management. No prescriptive guidance on minimum reporting to Board regarding loan loss provisions, asset classification or reserves. - Individual assessment thresholds (EC11) - Banks required to conduct valuation, classification and provisioning on an individual item basis for significant exposures with thresholds differing from 500 million won to 5 billion won depending on bank size. - FSS guidance (December 2011) grouped banks into four groups for individual assessment thresholds: - Group 1: Hana, KB, Woori Shinhan, KEB; - Group 2: Citi Bank, Standard Chartered, KB; - Group 3: National Fisheries, Industrial Bank, Industrial Credit Cooperative, Import Export, KDB; - Group 4: All others banks. - Independent valuation of collateral for individually assessed impaired exposures is critical; risk exists where valuations are not independent. - System-wide trends and concentrations (EC12) - FSS analyzes banks’ delinquency rate on a monthly basis and non-performing loans on a quarterly basis. - For syndicated medium to large borrowers, banks participate in work-out arrangements; residual risks after sale of problem asset must be included in BIS capital ratios. - Assessment and concerns — Principle 18 - Overall assessment: MNC. - FSS does not meet EC9 due to regulations allowing discretion when reclassifying exposures as performing without borrower proving repayment capacity. - Need for greater supervisory attention to ensure banks apply appropriate risk management around reclassification and collateral valuation. - In practice, internal bank officers predominantly value collateral; FSS processes to assess application of policies and robustness of collateral valuation were not uniform across major banks. - Regulations stipulate at least quarterly re-valuation of collateral; industry practice generally monthly. More frequent valuations are prudent in falling asset price environments; in rising price environments frequent revaluation can lower average portfolio LTV and raise collateral coverage without change in debt reduction or provisions. - Contributing to rating: inconsistent definition of default between domestic banks (90 days) and non-banks (180 days). ### Concentration risk and large exposures (Principle 19 — EC1) - Legal framework and bank requirements (EC1) - Regulation of Banking (Article 76) and Article 78 paragraph 5: banks required to prevent loan concentration by industry and customer groups. - ICAAP (paragraph 260 of Detailed Regulations) requires banks to identify credit concentration risks. - Banks required to establish internal guidelines for management and control of large credit extensions including: - An automated management information system to monitor the LE at all times; and - A system to detect LEs to control and prevent LE being extended. - Large exposure definitions and limits - Large exposure defined as 10 per cent of the relevant bank’s equity capital (Banking Act, Article 35(4)). - Monitoring: banks assess LEs based on balance at end of every month and submit report to FSS every quarter. - Single name limits (Article 35(1)–(4)): - Single name (individual or connected individuals) credit exposures must not exceed 20 percent of bank capital (individual); - Credit exposures to a single enterprise (enterprise group) must not exceed 25 percent of bank’s capital. - Aggregate limit: all large exposures to five times the bank’s equity capital (Banking Act, Article 35,(4)). - Treatment of connected counterparties - Connected counterparties defined under Fair Trade Act guidance; criteria for corporate connection include meeting/exceeding 30 percent threshold of voting stock, ability to appoint a Board member or provide a guarantee. - Exceptions and supervisory practice - Exceptions to LE requirements where necessary for national economy or to promote effectiveness in securing claims, or where exceedance arises due to changes in equity capital or borrower composition; exemptions prescribed by Presidential Decree. - FSS may offer a bank one year to comply where LE limits are exceeded due to capital changes. - Recent example: 2008 agreement to increase LE limits for a bank with exposure to a counterparty with high FX volatility. - Gaps and supervisory approach - Management and monitoring of other concentration sources is not standardized/systematic; supervised case-by-case via on- and off-site supervision. - Concentration other than name concentration is not considered in the quantitative measure; credit concentration risk does not appear to include on- and off-balance sheet items comprehensively. *Source: _cr14310 - Appendix 3–5). By receiving detailed portfolio metrics on a quarterly basis, the FSS is able to (PDF chapter/section)* ### Appendix 2 of the Regulations sets out the credit items that will be included in the ### _cr14310 - Appendix 2 of the Regulations sets out the credit items that will be included in the ### Large exposures and concentration risk (EC2–EC7, AC1) - Findings: - Appendix 2 of the Regulations defines credit extensions and denotes exclusions that reduce visibility of certain exposures to the FSS, undermining the integrity of the LE regime and potentially allowing hidden concentration risks to build up. - Banks must implement computerized systems and a self screening system to monitor and prevent large exposures (Article 76, paragraph 2, Detailed Regulations). - Banks are required to measure LEs at month’s end (not continuously); regulations do not require timely monitoring of concentration risk across name, industry, economic sector, geographic region, market, product, collateral, or currency. - Analysis of concentration other than name risk is conducted by on- and off-site supervision on a case-by-case basis. - Banks must calculate LEs to a single counterparty or group of connected counterparties on a monthly basis and report quarterly to the FSS. - Specific reporting obligations on concentration risk and LE limits are not explicitly defined in the Regulations; banks submit a quarterly Business Report containing borrower name, exposure value, ratio of the LE to capital, and usage of the limit. - Full scope onsite examination is performed every two years and includes quantitative and qualitative analysis of concentration risk. - The Banking Act (Article 35(1)) defines single borrower and links connected counterparties to “enterprise group” under Article 2 of the Monopoly Regulation and Fair Trade Act; regulations do not permit FSS discretion in interpreting connected counterparties. - The measure of credit exposure for LEs should reflect maximum possible loss and not use Basel risk-weighting for this purpose (footnote 49). - Key statistics and limits: - A large exposure is defined as exposures of "Ten per cent or more of a bank’s capital" (AC1(a)). - The FSS has adopted LE limits of "20 percent for single name" and "25 percent for an enterprise group" (AC1(b) and Description). - Sum of large credit exposures exceeding "10 percent of bank’s capital" must not exceed "five times the bank’s capital"; if exceeded, banks must comply within "one year". - Policy observations / recommendations: - Governance and reporting obligations for LEs should be developed further to ensure oversight and a full risk assessment using the LE definition (>10 percent). - LEs should be reported and approved by at least senior management and preferably the Board; FSS should be more active in assessing LEs prior to settlement. - Exceptions to LE limits and exclusions in definitions could allow circumvention and should be narrowed; treatment of connected counterparties is defined under the Fair Trade Act and is not sufficiently bank-specific. - Banks’ LE policies and processes should explicitly include a broader range of concentration sources beyond name risk. ### Transactions with related parties (Principle 20, EC1–EC7) - Findings: - Related party is defined in the Banking Act (Article 2.(1) 8) and scoped in Article 1–4(1) of the Enforcement Decree; included items: relative; non-profit organization where the principal has a majority; company where the principal has more than "30 percent issued voting stock"; person employed by the principal; company in which the principal owns "not less than 30 percent"; company that belongs to the group; person that exercises voting rights against voting stocks. - Explicit exclusions in Article 1–4(2) Enforcement Decree: (i) private equity fund acquiring stocks to raise company value; (ii) bank funds to Public-Private Partnerships for infrastructure; (iii) bank acquiring stocks via conversion for corporate restructuring under Corporate Restructuring Promotion Act and Debtor Rehabilitation and Bankruptcy Act. - Threshold exemptions: "30 percent" for companies and "50 percent" for non-profit organizations; exposures below thresholds are not treated as related party. - Regulations focus on credit exposures (Appendix 2) and do not explicitly include construction contracts, lease arrangements, derivatives, write-offs, etc. - Banks must report related party exposures monthly; credits reported include Large Exposures and credits in excess of "0.1 percent of paid in capital or $5 billion won (lesser of the two)". - Offsite monitoring is performed by a specialized unit in the Corporate Credit Department; reports are segmented into shareholders/executives/employees, subsidiaries, and other related parties. - In practice, breaches identified have been negligible. - Key legal / governance specifics: - Article 35–2(8) Banking Act prohibits gratuitous transfer of assets or extension of credit to large stockholders under substantially favorable conditions. - No specific regulatory provision requires Board prior approval for related-party transactions or write-offs exceeding specified amounts; Commercial Act provisions on Board responsibility (Article 393) and exclusion of conflicted Board members (Article 368(4)) apply but are not broad enough for write-offs. - For credit exposures exceeding the lower of "0.1 percent of bank’s capital or W 5 billion", Board approval must be by unanimous decision. - Policy observations / recommendations: - The related party definition and application thresholds (30 percent, 50 percent) may not capture a comprehensive set of related parties and should be tightened. - Scope of related party transactions should be expanded to include non-credit dealings (lease, derivatives, service contracts, write-offs). - Regulations could be enhanced to require Board approval/oversight and explicit governance requirements (Board reporting, staff declarations of interest). - No power in regulations for supervisors to deduct related party exposures from capital when problematic. ### Country and transfer risks (Principle 21, EC1–EC6) - Findings: - Regulations require banks dealing with FX affairs to establish internal management standards covering country risk, large credit risk, foreign currency liquidity risk, market risk (Article 67(1), Regulation on Supervision). - FSS manages transfer risk as a subset of country risk; Regulations reference country risk through FX transactions which may not capture the full Principle 21 scope. - Article 72 of the Regulations requires monthly/quarterly disclosures: (1) assets and liabilities in foreign currency and liquidity ratio by remaining maturity "as of the end of each month"; (2) maturity of borrowings in foreign currency "as of the end of each month"; (3) financing and operation of funds in foreign currency "as of the end of each month"; (4) riskless assets held in foreign currency "as of the end of each quarter"; (5) other matters determined by the Governor. - Offsite reporting (quarterly Business Reports) includes amount of credit extended, payment securities by country and for large borrowers; FXSD performs offsite analysis. - Responsibility split: FXSD responsible for country and transfer risk monitoring; Bank Supervision Department assesses loan loss provisioning and FX reserves. Coordination responsibilities not well defined. - No regulatory basis for mandatory consolidation of data, but in practice data are submitted on a consolidated basis. - Supervision practices are skewed towards transfer risk and quantitative offsite monitoring; qualitative assessment and integration with quantitative analysis are insufficient and mostly done during full scope onsite exam every two years. - No comprehensive group-wide (FHC) framework across regulated and unregulated entities. - Key statistics: - Banks' country exposure for domestic banks is "less than 3 percent of total capital" and at least half of that is allocated into developed countries. - Example exposures: banks’ exposure to PIGS countries was "$3 billion" at end 2010, "$2 billion" in 2011, and "$2.5 billion" at end 2012. - Policy observations / recommendations: - Regulations should be strengthened to require consolidated data submission and better coordination between FXSD and Bank Supervision Teams. - Banks should be explicitly required to include country and transfer risks in stress testing; supervisory frameworks should integrate qualitative assessments more systematically. - Group-wide analysis across FHCs (regulated and unregulated entities) should be established. ### Market risk (Principle 22, EC1–EC6) - Findings: - Banks must manage trading book (TB) separately; TB positions valued daily and market risk equity capital calculated daily (Detailed Regulations, Appendix 3–2). - Detailed instruments permitted in TB are exhaustively listed (Appendix 3–2, paragraph 2.G), including financial instruments held for short term trading; held with intent to earn risk-free return; underwriting/broking/market-making; derivatives classified as trading items pursuant to KIFRS; hedging of TB risks; other similar instruments. - De minimis exclusion: TB exposures may be excluded from market risk capital calculation if (i) ratio of TB to total assets on consolidated balance sheet is "less than 5 percent maximum per day"; and (ii) TB is "less than w 100 billion maximum per day". This threshold is considered excessive. - As of assessment, 17 of 18 commercial banks are subject to market risk capital calculation; one commercial bank and one Specialized Bank are exempt. TB assets average less than "5 percent" of total assets, though one domestic bank has ratio as high as "11 percent". - TB composition (end of June 2012): "52.7 percent" OTC derivatives trading, "42.9 percent" securities trading. - FSS guidelines (Market Risk Management Guideline final revision Nov 2009) recommended valuation/validation practices; guidance not yet codified in rules. - "T3" capital instruments permitted against market risk exposures per Detailed Regulations; when BIII is implemented these will be excluded. - Seven of 18 commercial banks accredited to use internal models for market risk; remainder use Standard approach. - Policy observations / recommendations: - De minimis TB exclusions should include an additional limitation linked to bank size to remain risk-based; current thresholds considered excessive. - Valuation and model governance guidance should be codified into Regulations rather than only guidelines. - For internal model users, Board governance is explicitly required (Appendix 3–2, paragraph 22). ### Interest rate risk in the banking book (IRRBB) (Principle 23, EC1–EC4, AC1–AC2) - Findings: - Article 30 establishes expectations for risk management frameworks including IRRBB; Appendix 9 of Detailed Regulations contains detailed IRR requirements. - IRR measured on non-trading positions on a consolidated basis; IRR components: interest rate change risk, yield curve risk, basis risk, option risk (Appendix 9–1, paragraph 2.A). - Measurement methods: interest rate Earnings at Risk (EaR) and interest rate Value at Risk (VaR); measured at least monthly in normal times and reported quarterly (regulations specify "at least quarterly" in paragraph 24.B). - Board reporting frequency in practice is monthly (not stipulated). - As of end December 2012, combined EaR for domestic banks was "1.6 trillion Won" or "1 percent of capital". - Measurement uses a "200bp parallel shift" in the yield curve. - Banks must file a report to the FSS if total IRR VaR exceeds "20 per cent of equity capital" explaining causes and corrective steps (Para 27 of Annex 9-1). - VaR threshold for total IRR is "20 per cent of equity capital"; banks required to reduce risk via hedging, position adjustments, or additional equity. - Banks file quarterly IRR data including interest rate gap, interest EaR, and interest VaR. - Assessment: - Principle 23 assessed as "C". - Regulations require quarterly measurement; in practice banks measure monthly. The FSS conducts full scope examination every two years to verify governance, controls, measurement integrity. - Policy observations / recommendations: - Board approval and regular review of IRR strategy/policies required by Detailed Regulations; clarification of ALCO and Treasurer roles could be standardized (no regulatory requirement for ALCO or Treasurer). ### Liquidity risk (Principle 24, EC1) - Findings: - Two domestic Won liquidity requirements (Article 26(1) of the Regulations): - Ratio of current assets in won currency to current liabilities in Won "1:1 or more". - Ratio of loans in won to deposits received in won (excluding certificates of deposits) "1:1 or more". - Won liquidity ratio based on end-of-month numerical value; loan-to-deposit ratio based on monthly average balance. - Foreign-currency liquidity requirements (Article 64): - Minimum "85 percent" for A/L with maturity of less than "3 month". - For A/L with maturity of less than "7 days", maturity mismatch ratio for L in excess of A must be "less than 3 percent". - For A/L with maturity of less than a month, maturity mismatch ratio for L in excess of A must be "less than 10 percent". - FX liquidity ratios calculated using FSS liquidation weights (Appendix 7), examples: - FX currency and deposits, FX call loans FX bills: "100 percent"; - Loans between banks, demand funds for o/s, syndicated loans and FX equivalents: "90 percent"; - Working capital and loans in FX: "80"; - Government bonds A-AAA: "100"; - Government bonds BBB- A: "90"; - Government Bonds below BBB: "60"; - Corporate Bonds A-AAA: "90"; - Corporate bonds BBB—A: "85"; - Corporate Bonds below BBB: "50"; - Securities publicly traded: "55"; - Securities not publicly traded: "35"; - Futures: "85"; - Others: "100". - Banks dealing in FX must confirm daily they meet limits on overbought/oversold FX amounts; a violation must be reported to the Governor of the FSS "three business days after the date of the breach". - Detailed Regulations (Appendix 9–2) require liquidity management strategy, management targets, policies, internal control systems, and contingency funding mechanisms. - Not stipulated that liquidity ratios must be calculated and complied with on a solo and consolidated basis. - Policy observations / recommendations: - Liquidity regime separates Won and FX liquidity with conservative FX calibration; clarification on solo vs consolidated measurement and supervisory action thresholds would strengthen the framework. *Source: Assessment and detailed findings as contained in the provided text from the Republic of Korea supervisory powers, responsibilities, and functions section.* ### Appendix 3–4 of the DRSBB sets out in more detail the liquidity requirements: ### Appendix 3–4: Liquidity requirements and supervisory findings (Republic of Korea) ### Liquidity requirements (Appendix 3–4 / Detailed Regulations) - Scope of calculation: - All assets and liabilities on the balance sheet and those with remaining maturity of one month or less related to transactions in off-balance sheet derivatives shall be subject to the calculation. Unclear whether all derivatives are included. - Won-denominated A/L liquidity ratio includes all on-balance sheet A/L and off-balance sheet derivatives with maturity of less than one month. Some EC2 items (e.g., contingent liabilities) are omitted; see Detailed Regulations Appendix 3–4 for an exhaustive list. - Foreign currency-denominated A/L used to compute liquidity and maturity mismatch ratios include: - (i) on-balance sheet foreign currency-denominated A/L; - (ii) forward contracts outstanding from currency swap arrangements; - (iii) forward contracts outstanding, including NDFs; - (iv) currency futures; and - (v) 20 percent of any outstanding off-balance sheet acceptances and guarantee, foreign currency-denominated acceptances and guarantees, and acceptances involving foreign counterparties. - High quality liquid assets (HQLA): - Requirement for banks to hold sufficient assets of good quality (HQLA) with no limits on disposal which can be liquidated in a crisis (Appendix 9–2 Detailed Regulations, paragraph 6). - No specific definition or quantitative minimum of HQLA; regulations provide characteristics: - Liquidation is possible without excessive loss; - Immediate availability without restrictions on disposal; - Transparency in the risk structure and characteristics; - Easiness of the valuation; - Meeting the requirements for qualified security possible to offer to the central bank; and - Existence of trading markets. - Composition of current assets to meet the Won liquidity ratio: - Approximately 60 percent consist of loans with duration less than 30 days. - Remaining 40 percent comprises 20 percent securities, 10 percent FX loans and 10 percent other. - Securities must meet a test of being investment grade (Appendix 3–4, paragraph 1.5.(b)). - Exclusions: - A number of exclusions apply (e.g., any securities regardless of maturity used for collateral will be excluded). - LCR implementation and monitoring: - Korea intends to adopt the first phase in the LCR commencing in 2015. - FSS monitors LCR data quarterly. - FSS indicated banks’ average LCR was approximately 130 percent. - Measurement timing and weighting: - Won liquidity ratio measured on numerical value as of the end of month (Article 17 of the Detailed Regulations). Regulations stipulate end-of-month compliance though in practice banks expected to comply intra-month. - FX ratio calculation weights are based on prescribed liquidity weighting set by the FSS; weightings closely reflect BoK haircuts, but BoK has discretion to set haircuts. ### Supervisory expectations for liquidity risk management (EC2–EC8) — description and findings - EC2 / General requirement: - Banks must operate with an effective liquidity risk framework; Detailed Regulations (Appendix 2, Chapter II, paragraphs 4–13). - Framework must incorporate maximum risk permitted, early distress warnings, stress tests, contingency funding plans, diversification and avoidance of maturity concentration. - Stress testing (EC3, EC7): - Banks required to conduct stress tests and assess impact on liquidity; results, scenarios and assumptions and remedial measures reported to BoD (Appendix 9–2, Chapter 3, paragraph 12.H). - FSS does not prescribe frequency, severity or survival horizon; scenario design must consider idiosyncratic and whole-of-market crisis. - FSS provides example assumptions (shortage in money market; secession of retail deposits; decline in wholesale funding; incidental cash flow from off-balance sheet items). - No requirement to submit stress-test results to FSS; in practice banks submit results at least annually. - Variation in banks’ assumptions impedes comparability and detection of outliers; requires intensive supervisor analysis of inputs. - Governance, information and board oversight (EC4): - BoD or Board risk committee must establish liquidity framework and set risk tolerance, limits and internal rules. - Management must report liquidity conditions to the board; frequency not stipulated (in practice at least annually). - Board review frequency of liquidity management is not prescribed and does not meet criterion of at least annually. - Information systems required to generate meaningful information to management and board (Articles 30 and 31, Regulation on of Banking Supervision; Article 29, Annex 9-2). - Funding strategy and HQLA (EC5): - Banks must maintain HQLA (characteristics set out) but no prescribed quantitative minimum (no LCR-like minimum defined in regulations). - Banks required to set concentration limits and funding sources across short-, medium- and long-term funding plans (paragraph 7, Detailed Regulations). - Banks with heavy wholesale funding reliance expected to consider adequacy of HQLA and diversification strategies; multi-currency banks expected to diversify funding by currency. - Banks required to formulate contingency funding plans incorporating stress test results (Detailed Regulations, paragraph 14). - Contingency funding plans (EC6): - Contingency funding plans must consider range of scenarios; feasibility evaluated and renewed at least once a year by the bank’s board (Annex 9–2, Detailed Regulations). - Plans must specify step-by-step actions, stress management team composition, funding amounts, and consider secondary effects (e.g., reputation). - Funding actions include central bank credit, repurchase agreements (RP), asset disposition, securing more deposits, restriction on acquisition of non-current assets, and communication with supervisors, central bank, rating agencies and media. - Foreign currency liquidity (EC8): - Banks with significant foreign currency business must conduct separate analysis and monitor liquidity needs per currency; set permissible currency mismatch boundaries; secure diversified funding for each currency (Annex 9, Regulation on Supervision of Banking Business). ### Assessment of Principle 24 — Key supervisory comments (LC) - Primary drivers of the rating: - Regulations require compliance with liquidity ratios only at end of month; method does not reflect intra-month potential volatility or forward-looking deposit outflow volatility. - Regulations not clear that all off-balance sheet assets and liabilities are included in mismatch liquidity ratios (e.g., contingent assets like credit lines in Won and FX; contingent liabilities like overdrafts and revolving facilities). - One-month Won liquidity mismatch calculation does not encourage terming out wholesale funding—incentivizes investment in assets maturing within 30 days. - Other factors: - Liquidity stress test requirements are general, not prescriptive; inputs and parameters not prescribed leading to wide variation across banks and hampering comparability and supervisor benchmarking. - Offsite supervisory data include quantitative liquidity data quarterly (and frequently) but not qualitative risk management information. ### Operational risk (Principle 25) — essential findings and gaps - Regulatory framework: - Banks required to establish operational risk management systems; Detailed Regulations paragraphs 248(A), 250 and 260 set out requirements including control structures, ILD, ELD, BEICFs and scenario analysis for AMA banks. - Five banks accredited to use AMA approaches; modeling approaches vary across banks; three rely primarily on scenarios, two use mix of scenarios and ELD. - AMA banks access external loss data via local data consortia (KOREC). - Supervisory practices and shortcomings: - BCBS team within FSS sets operational risk policy and approves AMA models; Bank Examination Department assesses changes. - Offsite supervision of operational risk is performed by Bank Examination Teams; qualitative analysis is limited and mainly occurs via full-scope onsite CAMELR every two years. - Disaster recovery / business continuity: - No regulatory requirement to develop comprehensive disaster recovery plan; FSS issued 2006 guideline (not legally enforceable). - No requirement to notify FSS of failure to adhere to plan or to update plan on minimum frequency. - Information systems and data: - Requirements to collect internal loss data exist but reporting maturity is basic and not mapped to Basel loss categories. - Regulations permit exclusion of credit-related operational risk losses from statistical models even when due to fraud—this may reduce operational risk loss history. - Model validation and monitoring: - Validation of internal models is not required to be independent; typically performed by staff associated with model development creating potential conflicts of interest. - Outsourcing: - Regulations for outsourcing not fully confirmed; ancillary electronic banking regulations set general standards; FSS has not clearly mapped outsourced providers to identify common vulnerabilities. ### Internal control and audit (Principle 26) — summary of structure and practices - Legal provisions and governance: - Internal control and audit requirements addressed in Article 23–3 of the Banking Act and Article 17–2 of the Enforcement Decree. - Audit Committee (AC) requirements: at least two-thirds outside directors; at least one member must be an accounting or financial specialist. - Internal Audit (IA) scope detailed in Annex 8-2 of Detailed Regulations (lists multiple IA responsibilities). - Supervisory approach: - FSS oversees IA through offsite data submission (IA reports, IA annual plan, tracking against audit plan) and full-scope onsite CAMELR every two years. - Onsite examination reviews financial reports, reports of financial irregularities, IA reports, audit committee papers, IA policies, and Board structure; interviews and sample testing performed. - Examination team typically meets IA and compliance staff and Chair of AC via Deputy Governor; team does not meet AC directly. - Findings and areas for strengthening: - Regulations set minimum experience and powers for Compliance Officer (Head of IA) including at least ten years’ experience and power to request materials (Article 17–4 Enforcement Decree). - FSS assessment focuses on bank operations; for bank FHCs, insufficient detail from IA on non-bank subsidiaries limits detection of intra-group issues. - Outsourcing supervisory activities inconsistently applied across banks and FHCs. - Assessment: Principle 26 rated C; regulations generally comprehensive though some areas (FHCs, cross-entity IA coverage) warrant attention. ### Financial reporting and external audit (Principle 27) — requirements and supervisory gaps - Accounting standards and reporting: - Article 32 requires banks to prepare financial statements according to IFRS (K-IFRS adopted); exceptions: KEXIM and Suhyup Bank use Korea GAAP (KEXIM plans IFRS from fiscal year 2013; Suhyup from 2014). - Article 43–2 requires banks to report performance details to FSS signed by a representative; Act does not require preparation/approval by an independent officer (e.g., CFO) — identified as a material weakness. - External audit framework: - AEASC thresholds require external audit for stock companies meeting criteria (total assets equal to or greater than KRW 10 billion; other thresholds include 7 billion and employee counts). - Larger systemic banks meet AEASC thresholds; some specialized or state-owned banks may be exceptions. - External audits follow ISA (2005) currently; Clarified ISA (2012) to apply from financial year 2014. - FSS can request external auditors’ workpapers (Article 48 Banking Act) but does not have power to set scope of external audits or to reject/rescind auditor appointments. - Disciplinary action and auditor removal primarily the domain of KICPA; no clear supervisory power for FSS/FSC to reject/rescind appointments (EC6 weakness). - Rotation and oversight: - Partner rotation rules: same partner must not perform audit for six or more consecutive business years (four or more for stock-listed companies); listed-company-specific partner rotation rules stricter. - FSS inspects large audit firms by thresholds; delegation to KICPA for other firms. - Disclosure and audit limitations: - AEASC does not require external auditor work to confirm regulatory capital calculations or RWA compliance; external audit opinion covers KIFRS reasonableness but not banking Act compliance. - Assessment: Principle 27 rated LC; drivers include limited FSS power over external audit scope and appointments, and gaps for non-AEASC-covered deposit-taking institutions. ### Disclosure and transparency (Principle 28) — public disclosures and supervisory use - Disclosure requirements: - Article 32 and Uniform Disclosure Standards require IFRS financial statements and Pillar 3-type disclosures; Pillar 3 disclosures required to be posted on Korea Federation of Banks website. - Article 41 requires financial statements published within three months of financial year end and two months for quarterly reporting; quarterly business reports submitted to FSS are not required to be audited or produced by an independent officer. - No regulatory requirement for solo (standalone) disclosures for significant banks within groups; Pillar 3 rules not sufficiently comprehensive on solo disclosures. - Content and gaps: - Uniform Disclosure Standards cover organizational structure, subsidiaries (consolidated and non-consolidated), capital, shareholders, profit, liquidity, capital adequacy, etc. - Compensation disclosure for key executives identified as weak / not required. - Pillar 3 disclosures are not well integrated into supervisory processes; FSS does not consistently reconcile public Pillar 3 data to prudential reporting. - Supervisory enforcement: - Non-compliance can attract disciplinary actions and fines (Articles 43–3 and 53 Banking Act; Article 8 Regulation on Examination and Sanctions). - FSS on-site examinations emphasize internal controls and reliability of systems rather than heavy reliance on assessing compliance with disclosure standards. - Assessment: Principle 28 rated LC; main issues include solo disclosure absence for FHCs, compensation oversight, and weak integration of Pillar 3 into supervision. ### Abuse of financial services / AML-CFT (Principle 29) — division of responsibilities and supervisory findings - Legal and institutional setup: - Korea’s AML legal framework: Financial Transaction Reports Act (FTRA) and Proceeds of Crime Act (POCA). - Korea Financial Intelligence Unit (KoFIU) (part of FSC) is AML/CFT authority; KoFIU may delegate onsite examination responsibility to FSS. In practice, KoFIU handles offsite supervision and FSS conducts onsite examinations; FIU developed the examination manual used by FSS. - Banks report STRs and CTRs to KoFIU quarterly; FSS receives reports of financial irregularities and shares information with KoFIU and law enforcement. - Supervisory practices and weaknesses: - KoFIU lacks a well-developed risk-based methodology to identify higher-risk banks; selection for onsite examinations determined by FSS supervisory cycle and policy direction from KoFIU. - Banks required to appoint executive compliance officer for AML/CFT (Article 5 FTRA). - Korea is FATF and APG member; last mutual evaluation in November 2008 (adopted 2009); next full assessment tentatively scheduled for 2016. Progress made since 2009 on some deficiencies; sanctions regime concerns remain (primary targets are employees/officials and sanctions mostly non-pecuniary). - Reporting threshold for suspicious transactions remains 10m Won; Bill proposed to repeal threshold. In practice 8–10 percent of STRs are below the 10m Won threshold. - Customer due diligence and correspondent banking: - Banks required to implement CDD, monitoring, record retention and enhanced due diligence for high-risk accounts and PEPs; retention period at least five years. - Correspondent banking guidance requires collecting information on respondent bank’s business, supervision, reputation and AML regime (Articles 58 & 59 of Regulation on Anti-Money Laundering). - Enforcement powers: - KoFIU has authority to take actions against breaches (Articles 11, 14, 17 FTRA); FSS conducts examinations; sanction authority lies with FIU based on FSS recommendation (change effective March 2012). *Source: Appendix 3–4 and related sections of the Detailed Regulations and supervisory findings in the IMF assessment document.* ### 2013. When it comes to light disciplinary action FSS can act—sanctions against executives ### 2013. When it comes to light disciplinary action FSS can act—sanctions against executives ### Supervisory powers, responsibilities, and functions (EC9–EC13) - EC9 — Supervisor determines banks have: - (a) Requirements for internal audit and/or external experts to independently evaluate the relevant risk management policies, processes and controls. The supervisor has access to their reports; - (b) Established policies and processes to designate compliance officers at the banks’ management level, and appoint a relevant dedicated officer to whom potential abuses of the banks’ financial services (including suspicious transactions) are reported; - (c) Adequate screening policies and processes to ensure high ethical and professional standards when hiring staff; or when entering into an agency or outsourcing relationship; and - (d) Ongoing training programs for their staff, including on CDD and methods to monitor and detect criminal and suspicious activities. - EC9 — Description and findings: - KoFIU and bank supervisors jointly conduct on-site examinations to assess AML compliance. - Examination checklist includes: - The overall effectiveness of the control system, the composition and the suitability of the internal controls; - Operational procedures and management; - Recordkeeping and retention of reports; - Appointment procedure for the reporting persons, their independence and professional expertise, the effectiveness of the internal control system; - Information system for identifying suspicious activities, reporting of suspicious activities; - CDD and operational procedures for large cash transactions; and - Staff training and soundness of internal audit procedures. - Regulatory references: Article 11, Financial Transaction Reports Act; Article 15, Regulation on Anti-Money Laundering and Prohibition of Financing for Offences of Public Intimidation. - EC10 — Supervisor determines banks have and follow clear policies/processes for staff reporting and adequate management information systems to provide Boards, management and dedicated officers with timely and appropriate information. - EC10 — Description and findings: - Board, senior management, and reporting persons must have clear roles and responsibilities for the bank’s AML management system. - The person responsible for reporting AML matters must regularly evaluate the bank’s overall AML system and report findings to management. - During on-site examination, bank supervisors periodically assess soundness and effectiveness of the bank’s AML system and scrutinize transactions warranting further inquiry. - Regulatory reference: Article 81, Regulation on Anti-Money Laundering and Prohibition of Financing for Offences of Public Intimidation. - EC11 — Laws provide protection from liability for staff who report suspicious activity in good faith. - EC11 — Description and findings: - Financial institutions and their employees (and anyone related to them) are not held liable for reporting suspicious transactions to supervisory and enforcement authority unless they make false report either deliberately or due to gross negligence. - Reference: Article 4, Financial Transaction Reports Act. - EC12 — Supervisor cooperates with domestic and foreign financial sector supervisory authorities and shares information related to suspected or actual criminal activities for supervisory purposes. - EC12 — Description and findings: - KoFIU and bank supervisors cooperate and support each other for AML supervision and enforcement. - KoFIU actively engages in information exchange with foreign AML authorities. - References: Articles 7, 8, and 11, Financial Transaction Reports Act. - EC13 — Supervisor has in-house resources with specialist expertise for addressing criminal activities and regularly provides information on ML/TF risks to banks. - EC13 — Description and findings: - KoFIU employees are highly trained specialists for AML enforcement and regularly disseminate AML and anti-terror financing information updates to financial institutions. ### Assessment of Principle 29 LC - Comments: - Factors driving the rating: Not a fully risk-based methodology for supervising banks (although the FIU is exploring a methodology); - Scope to expand oversight across the entire population of deposit taking institutions. At present attention has been focused on the domestic banks of which practices for AML are improving. FIU will transition its focus to strengthening practices in securities and insurance sectors and finally smaller non-banks where risk profile is comparatively higher but asset size is lower. ### Recommended actions to improve compliance with the Basel Core Principles (selected by reference principle) - 1. Responsibilities, objectives and powers - Clearly segregate its safety and soundness duties from other assigned objectives; and - Amend the legal framework in order to enable the supervisors to increase the prudential requirements for individual banks and banking groups based on their risk profile and systemic importance. - 2. Independence, accountability, resourcing and legal protection for supervisors - Review the current composition/functioning of the Commission in order to shield the Commission against conflicts of interest; - Revise the legal protection framework in order to ensure that supervisors cannot be sued directly by market participants in cases of actions or omissions made in good faith; and - Review the current structure, staffing and distribution of activities within the FSS in order to allocate the appropriate volume of resources to safety and soundness and risk profile of activities. - 5. Licensing criteria - Amend the banking and respective enforcement decree and regulation to ensure that suitability of shareholders encompass the ultimate beneficial owners; - Amend the legal/regulatory framework to expressly require a no-objection from the home supervisor in case of establishment of subsidiaries of foreign banks in the Republic of Korea; - Amend the RSBB to explicitly include assessments regarding the detection and prevention of criminal activities and oversight of outsourced functions; - Authorities intend to revise relevant regulations to enhance transparency of ownership structure of foreign bank branches with information on the group structure, including its affiliates and related parties, when they seek regulatory approval for a branch operation; - Authorities intend to revise the licensing criteria to evaluate internal controls relative to identification and prevention of criminal activities, oversight of proposed outsourced functions, and to expressly include requirement for a no-objection from the home supervisor. - 6. Transfer of significant ownership - Require approval for transfers of ownership that can result in changes in effective control; and - Amend the Banking Act in order to expand the definition of large shareholder. - 7. Major acquisitions - Amend the legal framework in order to require approval for major acquisitions or for the establishment of cross-border subsidiaries. - Authorities reported FSC-FSS will take regulatory measures to assess whether host country provides information flows necessary for satisfactory consolidated supervision and whether host country can exercise effective supervision on a consolidated basis. - 8. Supervisory approach - Establish a point of contact in charge of a particular banking/banking group, consolidate off and on site surveillance and any other information pertaining to a particular bank, including macroeconomic analyses; - Conduct partial examinations (or mix of off and on site) on particular risks; - Develop capacity/procedures for more in-depth and judgmental qualitative assessments; and - Review overall assessment process and check lists to incorporate more in-depth judgment qualitative procedures. - 9. Supervisory techniques and tools - Review annual planning process to focus partial examinations on core supervisory issues and risks; - Review policies for information sharing within the FSS for comprehensive and easier access to information by examination teams; - Intensify engagement with senior management during on-site examinations beyond partnership meetings; - Develop standard rules for hiring third parties, ensure quality control, and develop robust procedures to avoid conflicts of interest; - Review distribution of activities within the FSS to better allocate resources into core supervisory functions. - 10. Supervisory reporting - Amend legal framework to access all relevant data and information from non-financial entities within a bank or banking group; - Require external auditors (as mandated by banks) to review the quality of regular reports submitted to the FSS; and - Enhance rules and guidance for hiring third parties to perform supervisory work. - 11. Corrective and sanctioning powers of supervisors - Further enhance process of providing recommendations and sanctions to increase effectiveness; and - Amend legal/regulatory framework to be able to impose more stringent prudential limits and requirements to individual banks, bar individuals from the banking sector and to replace and restrict the powers of Board members or controlling owners. - Authorities plan to improve post-examination process by giving a separate notice on management status evaluation results and matters requiring special attention and improvement. - FSC-FSS has set up a task force working on standards and rule changes for D-SIB with intent to complete task with more stringent prudential limits and requirements. - 12. Consolidated supervision - Develop framework to systematically assess risks of non-financial business within the group; - Enhance qualitative assessment regarding overall groups’ strategy and risk appetite; - Seek and incorporate systematically information from other departments regarding non-bank financial entities supervised by the FSS; - Expand scope of fit and proper test to encompass related parties of all large shareholders; and - Eliminate possibility of exceeding related parties lending limit based on Board approval. - 13. Home-host relationships - Expedite process for establishing criteria for determining D-SIFIs and develop mechanisms for cross-border crisis cooperation and group resolution plans. - 14. Corporate governance - Strengthen regulations to require BoD to review and approve policies and procedures on a minimum frequency; - Introduce regulations requiring subsidiaries within a group regulated by the FSS to have BoD majority of outside (independent) directors; and - Develop further supervision practices to fully implement compensation principles as prescribed by the FSB. - 15. Risk management process - Strengthen regulations and supervisory processes of risk management, particularly for FHCs. - 16. Capital adequacy - Fully implement ICAAP assessments across all deposit taking institutions; - Implement Pillar 2 of BII for all banks where an individual capital ratio is applied to banks based on an assessment of their individual risk profile; and - Amend Regulations for banks to obtain prior approval from FSS for capital reductions. - 17. Credit risk - Increase frequency of onsite credit risk reviews; and - Issue guidance requiring that credit transactions be made on market terms and that large and/or high risk operations be approved by the Board. - 18. Problem assets, provisions, and reserves - Require that collateral be valued at net realizable value which includes appropriate haircuts which take account of realization costs; - Require that a valuation of collateral be performed at the time an asset is categorized as defaulted-non-performing, preferably by an independent third party. - 19. Concentration risk and large exposure limits - Issue guidance/regulation covering the whole spectrum of concentration risk management and monitoring required by the revised CP; - Review current exceptions to large exposures regime that may undermine prudential considerations; - Review limits as to apply consistently on both solo and consolidated; - Develop reporting requirements for LE and concentration risk information; and - Develop notification requirements by banks to the FSS in relation to LE above 10 percent. - 20. Transactions with related parties - Amend regulation to require that related party transactions should be approved by the board; - Amend regulation to require that related party transactions do not occur on more favorable terms than those to non-related party clients; and - Consider strengthening capacity of FSS to impose broader definitions of related party, based on influence of decision or economic dependence, on a case by case basis. - 21. Country and transfer risks - Issue guidance on country and transfer risk that can be understood and applied by all banks, emphasizing that overall deterioration of credit risk in a country can lead to many private contracts not being observed even when not linked to specific restrictions imposed by governments. - 22. Market risk - Amend thresholds for exemptions from the Regulations to calculate market risk equity capital for trading book exposures; and - Amend the Regulations to include valuation expectations contained within FSS guidance notes. - 23. Interest Rate Risk - (Recommendation listed but no specific actions in provided extract.) - 24. Liquidity - Amend regulations to require continuous compliance with liquidity ratios; - Develop greater specificity for liquidity stress testing (severity, input assumptions, parameters etc) to enable consistency across industry; and - Amend Regulations to contain a more explicit definition of high quality liquid assets. - 25. Operational risk - Amend regulations to provide more guidance, in particular to BIA banks, on how to identify, assess, evaluate, monitor, report and control or mitigate operational risk; - Amend regulations to clarify that the operational risk management policy needs approval by the board, that all banks must have adequate channels of information of operational risk data and events to boards or the supervisor; - Enhance regulations on IT and outsourcing, as planned. - 26. Internal control and audit - Strengthen oversight of IA as part of the partial examination; and - Ensure the examination team meets with the full AC; currently an FSS Deputy Governor who is not part of the examination team meets with the Chair. Allows a more informed assessment by the examination team as input into banks’ risk assessment captured in the CAMELR rating. - 27. Financial reporting and external audit - Expand scope of the FSS within the regulations to review working papers of the external auditor and place greater emphasis on the results of the external audit when planning onsite examinations; - Review the Banking Act and associated Regulations for an external auditor to be appointed to all deposit taking institutions; and - Increase the threshold for the appointment of an external auditor to a deposit taking institution in relation to expertise and experience. - 28. Disclosure and transparency - Strengthen the Pillar 3 disclosure regime whereby Pillar 3 reporting is made available on a banks’ websites or annual report. Where material banking subsidiaries within a FHC exist, amend regulations to require disclosure of accounts on a solo basis; - Greater use of Pillar 3 disclosures in offsite surveillance; and - Strengthen regulations in regards to compensation principles specifically in relation to risk adjusted returns in line with FSB principles. - 29. AML/CFT - Implement a risk-based methodology for supervising banks which discriminates risk profile and allocates recommendations for frequency and intensity of supervision. Extend the risk-based approach to supervision across deposit taking institutions. ### Authorities’ response to the assessment - FSC/FSS thanked the IMF, the World Bank, and the FSAP mission team for the assessment work. - FSC/FSS intends to utilize the assessment outcome to further improve and strengthen Korea’s banking regulation and supervision. - FSC/FSS has already started on some recommendations and plans to work on remaining recommendations under an appropriate timetable. - FSC/FSS reiterates that the mission team’s report is not appropriate for comparison with either previous assessments or other countries’ assessments. *Source: _cr14310 - 2013. When it comes to light disciplinary action FSS can act—sanctions against executives* ### 24. From the outset, the FSC/FSS welcomed the BCP assessment as an opportunity to take ### _cr14310 - 24. From the outset, the FSC/FSS welcomed the BCP assessment as an opportunity to take ### Overall response to the BCP assessment - FSC/FSS welcomed the BCP assessment as an opportunity to take a fresh look at the effectiveness of Korea’s banking regulation and supervision regimes and identify areas in need of improvement. - FSC/FSS agreed to BCP assessment on the basis of both the Essential Criteria (EC) and the Additional Criteria (AC) under the revised core principles (CPs). - FSC/FSS disagrees with many CP ratings in the final assessment report, arguing the ratings do not adequately reflect the overall strength or effectiveness of Korea’s banking regulation and supervision. ### Use of supervisory guidance (general) - Bank supervisors issue supervisory guidance (e.g., guidelines on integrated risk management, stress test, and performance-based pay) that banks promptly incorporate into internal policy and carry out for full compliance. - FSC/FSS contends the mission team appears to discount supervisory guidance because it differs from written rules and regulations. ### Independence, accountability, resourcing and legal protection for supervisors (CP2) - Recommendation noted: reconsider representation of the Ministry of Strategy and Finance and the Korea Chamber of Commerce and Industry among FSC commissioners due to potential conflicts of interest. - FSC/FSS response: Article 11 of the Act on the Establishment of the Financial Services Commission provides for recusal (voluntarily or involuntarily) of FSC commissioners from proceedings, deliberations, and resolutions that may pose a conflict of interest. - Recommendation noted: give regulators and supervisors immunity from litigation for actions taken in performance of duties. - FSC/FSS response: - Korea’s constitution does not provide for selective immunity for FSC/FSS. - FSC/FSS regulators and supervisors are liable for damage under the State Compensation Act only in the event of a violation of law resulting from an intentional wrongdoing or negligence. - In practice, regulators and supervisors effectively have virtual immunity from litigation for good-faith actions taken in the course of official duties. ### Licensing criteria (CP5) - Recommendation: include consent of the home supervisor, internal controls related to detection and prevention of criminal activities, and oversight of proposed outsourced functions in banking license criteria. - FSC/FSS response: existing laws and regulations already enable supervisors to closely examine and assess these items when reviewing banking license applications. ### Transfer of significant ownership (CP6) - Assessment suggestion: require approval for transfer of significant ownership if shareholder has less than 10 percent; classify shareholder with less than 4 percent as large shareholder if exercising “de facto” control. - FSC/FSS response: closely monitors shareholder status and ownership structure via shareholder reports and onsite examinations; monitors “de facto” control on an ongoing basis. ### Major acquisitions (CP7) - Suggestion: prior approval for major subsidiary acquisition and provisions to prevent undue risk from new acquisition or investment. - FSC/FSS response: banks must obtain approval when seeking to hold more than 20 percent of a company or take over a subsidiary the bank effectively controls; supervisors continuously monitor whether new acquisitions/investments hinder safety and soundness. ### Supervisory approach (CP8) - Mission observation: multiple points of responsibility among FSS teams may limit the ability to grasp overall risk profile of banks and groups. - FSC/FSS response: Off-Site Surveillance Team at the Bank Examination Department coordinates information and functions as central repository and point of contact for individual banks and financial holding companies. - Mission recommendation: expand risk-based partial examinations and qualitative assessments. - FSC/FSS response: - Qualitative assessment occurs in biennial full-scope examinations and on an ad hoc basis via partial examinations as vulnerabilities are identified. - CAMEL-R assessment contains considerable qualitative criteria, especially for Management and Risk components. - FSC/FSS will strengthen qualitative assessment with more in-depth risk analysis and partial examinations. - Correction of factual inaccuracy: EC1 claim that CAMEL-R linked PCA has not yet been triggered for banks is factually incorrect; PCAs were issued to four banks upon CAMELS assessments conducted between April and November 1998. ### Supervisory techniques and tools (CP9) - Current practice: ad hoc partial examinations when off-site surveillance identifies weaknesses and vulnerabilities. - FSC/FSS action: plans to bolster partial examinations to more effectively address banks’ risk vulnerabilities. ### Supervisory reporting (CP10) - Under the Financial Holding Company Act, non-financial subsidiaries of a financial holding company file quarterly reports on financial conditions and business activities. - FSC/FSS authority: compel submission of data or compliance with interview requests regarding business affairs or properties. - Use of external experts: guidelines exist to assess quality and prevent conflicts of interest. - Current participation: external experts used in 1.8 percent or 15 of the 811 examinations conducted as of the end of November 2013. - FSC/FSS expects to establish more formal rules on use of external experts as demand grows. ### Corrective and sanctioning powers of supervisors (CP11) - Changes to examination procedures in January (year not specified in source): - FSC/FSS now sends examination findings to the bank within five months for a full-scope examination and within four months for a partial examination. - Findings unrelated to sanctions—such as CAMEL-R ratings—can be notified separately before the final exam report is issued. - FSC/FSS will continue improving post-examination notification and supervision. ### Consolidated supervision (CP12) - Risk management assessment criteria for financial holding companies include ten qualitative components (e.g., group-wide risk strategy and profiles, management understanding of group-wide risk, adequacy of risk management framework, consultation with subsidiaries before setting group strategies). - FSC/FSS plans to continue improving qualitative components as needed. - Centralized information management system: - Departments share and access business reports via the FSS Integrated Financial Analysis System. - Material change information accessed from the FSS Information Management System. ### Corporate governance (CP14) - Recommendation: integrate the Model Guidelines on Sound Compensation Principles into supervisory regulations. - FSC/FSS response: proposed Act on Governance of Financial Institutions, encompassing most sound compensation principles, was submitted to the National Assembly on June 18 and is being deliberated. - Assessment reference to absence of regulation on conflict of interest: - FSC/FSS notes the Banking Act explicitly contains provisions to prevent conflict of interest between bank boards and other stakeholders and between a bank and its customers. ### Risk management process (CP15) - Banks required by law to incorporate results of risk assessment and stress testing into capital planning per the Model Guidelines on Stress Testing. - FSC/FSS regularly assesses banks’ compliance with stress testing and plans to formally adopt the guidelines into regulation. - Recommendation: independent external verification of compliance with regulations. - FSC/FSS response: banks are required to conduct internal audit of risk management; adequacy assessed under CAMEL-R. - Recommendation: mandatory reporting lines from bank’s risk management unit to the CRO and composition of the risk committee. - FSC/FSS response: proposed Act on Governance of Financial Institutions provides expressly for risk committee and its composition. ### Capital adequacy (CP16) - FSC/FSS disagrees with the assessment of Principle 16 and states: - First: FSC/FSS has complied with Basel standards, including capital standards, definition of capital compositions, and regulatory ratios; domestic banks maintained more than sufficient capital throughout the global financial crisis; common equity tier 1 capital of Korean banks is expected to rise under Basel III. - Second: with regard to Pillar II, FSC/FSS has carried out well-tailored capital supervision; rigorous off-site surveillance of the 18 domestic banks enables immediate follow-up supervision action; stress tests during the financial crisis were tailored to each bank and banks with capital ratio below 10 percent under stress were directed to raise capital. - Third: FSC/FSS disagrees with finding that supervisors did not verify in advance changes to estimates and parameters used in internal ratings-based models because such changes were in practice subject to advance approval from supervisors. - FSC/FSS will take follow-up actions to establish clearer rules to minimize misunderstanding. - FSC/FSS view: materially non-compliant finding is based on an inaccurate assessment and appears driven by minor deficiencies in explicitness of regulations on ICCAP. ### Problem assets, provisions, and reserve (CP18) - Since introduction of IFRS in 2011, domestic banks set aside loan loss provisions as provided under IFRS. - FSC/FSS directs banks to perform credit assessment of individual borrowers at risk when calculating provisions; where IFRS provisioning falls below estimated loss, difference must be made up as additional provisions. - At the end of September of this year: domestic banks’ loan loss provisions were KRW10.4 trillion more than the IFRS-based provisions of KRW21.2 trillion. - Supervisors use the SBL ratio (loans classified as substandard or below) as a measure of soundness; SBL ratio incorporates borrowers’ debt-servicing ability and is more conservative than NPL ratio. - At the end of September: domestic banks’ SBL ratio was 1.79 percent and the NPL ratio 1.23 percent. - Loans under debtor-creditor workout: - Must be classified as an SBL at the time of workout and can be reclassified to a higher category only after the borrower meets rescheduled payment obligations for a considerable period and demonstrates capacity to fully service the loan under forward-looking criteria. - Reclassification of an NPL into performing loan may be made only after the borrower’s debt-servicing capacity has significantly improved. - Rule changes in progress to provide specific regulations on NPL reclassification. - Fair value of collateral for SBL: regulations provide specific and prudent rules on estimating recovery amount net of incidental expenses; standard practice uses conservative collateral valuation based on market price, appraisal value, liquidity, and bids/offers in court auctions. - Discrepancy noted between banks and nonbanks on default criteria (e.g., 90 days past due for banks and 180 days past due for nonbanks). - FSC/FSS notes both banks and nonbanks must adhere to same classification and provisioning standards on a consolidated basis and supervision rules are being fine-tuned to encourage convergence. - Default for mutual savings banks will be changed to 120 days beginning July 2014; for credit cooperatives and unions, changed to 120 days in July 2013 and will become 90 days in July 2014. ### Concentration risk and large exposure limits (CP19) - FSC/FSS disagrees with overall thrust of CP 19 assessment. - Domestic banks’ heavy domestic concentration leads supervisors to ensure effective management of concentration risk from specific borrowers, industries, and other categories. - Although rules may lack highly detailed provisions, risks are effectively managed in practice: - Large credit extensions scrutinized and decided through deliberations by bank loan review committee and risk committee with board member participation. - Supervisors periodically inspect banks' management of concentration risk via on-site examinations and monthly or quarterly reports, and examine adequacy of internal controls. - Observation on “same borrower” term: mission team notes use of Fair Trade Act definition; FSC/FSS regards as insignificant formality—prudential standards apply to borrower and related persons sharing risk. ### Transactions with related parties (CP20) - FSC/FSS asserts strong and effective supervision of related-party transactions. - FSC/FSS notes Basel Committee has not yet firmly dealt with this matter; expects to follow up with additional measures when Basel guidance is finalized. ### Market risk (CP22) - Under existing regulation, 17 of the 18 domestic banks are subject to strict capital charges for market risks. - FSC/FSS disagrees with assessment that current exclusions are excessive, noting deviation from assessments for countries with similar capital charges. - Korea’s regulations provide for mark-to-market valuation of trading positions; domestic banks adhere to regulations and supervisors will continue improving valuation and capital regimes for traded market risks. ### Liquidity risk (CP24) - Korea’s liquidity regulations provide for won liquidity ratio (≧ 100 percent) and foreign currency liquidity ratio (≧ 85 percent). - In July 2012, FSC/FSS set loan-to-deposit ratio requirement to reduce wholesale and market funding and preempt liquidity risk. - FSC/FSS plans to introduce the LCR regime beginning in 2015 as set by the Basel Committee. - Since Basel Committee proposed new liquidity rules near end of 2010, supervisors have been working on implementation with quarterly review of domestic banks’ LCR calculation and preparatory measures. - FSC/FSS considers it premature for the assessment team to point to shortcomings on detailed LCR provisions before completion of new LCR regime. - For liquidity stress tests: supervisors encourage banks to design stress scenarios with individually tailored risk variables and assess effectiveness. - FSC/FSS welcomes mission proposal to further improve utilization of liquidity stress tests with more specific regulations. ### Operational risk (CP25) - Regulatory issues on board authorization for operational risk management, reporting of operational incidents, verification of internal models’ suitability, and disaster recovery are incorporated into regulation. - IT-related issues are specifically integrated into regulation. - Plan: review details in the Model Guidelines on Integrated Risk Management for new regulation. ### Financial reporting and external audit (CP27) - Mission assertion: supervisors’ onsite and offsite supervision does not incorporate results from external audit. - FSC/FSS response: - Under Article 48 of the Banking Act, supervisors may direct external auditors to provide external audit information. - Examination Manual and RM Manual state bank examiners may cooperate or consult with external auditors at any time and obtain audit results during the examination. - External audit coverage: - Act on External Audit of Stock Companies subjects listed companies, companies to be listed, and companies with assets in excess of certain thresholds to independent external audit, extending to most deposit-taking institutions. - Deposit-taking institutions not subject under that Act are subject to external audit under sector-specific regulations. ### Disclosure and transparency (CP28) - Domestic banks comply with regulatory disclosure requirements; disclosure items encompass most covered under Pillar 3. - FSC/FSS does not use Pillar 3 as a separate disclosure regime; disclosures are made through the Korea Federation of Banks’ Uniform Disclosure Standards for Financial Businesses. - FSC/FSS states it is erroneous to assume Pillar 3 is not in effect in Korea. - Compensation arrangements: - Model compensation guidelines issued in January 2010 as supervisory guidance. - FSC/FSS collects implementation data and incorporates compliance performance in supervisory ratings. - In November 2013, bank supervisors conducted an extensive review of compensation arrangements and issued supervisory guidance on areas needing improvement. *Source: Excerpt from FSC/FSS response and related discussion in the Republic of Korea BCP assessment document.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14310.pdf_