Best Practices in Preventing
and Monitoring Systemic Risk
July 9, 2009
The Bank of Korea
Ilhwan Kim
Contents
Ⅰ Introduction
Ⅱ
Business activities of non-bank financial institutions,
and the policy authorities' measures in response.
Ⅲ Some pointers and best practice
Ⅰ. Introduction
 Among the causes of the recent global financial crisis, we may
single out the lax regulation of hedge funds and large unregulated
non-bank financial institutions (hereafter 'NFIs').
 In Korea, only a few hedge funds have a domestic market presence
and their way of doing business has had little influence on the
financial market.
 Things have not yet reached such a pitch as to give cause for concern.
 Recently, the「Capital Market and Investment Services Act」came
into effect.
 It provided a platform for the introduction of hedge funds.
Ⅰ. Introduction

It put in place a legal foundation for setting ceilings on derivatives
investment and borrowing of money.

We had experience of system risk arising owing to the relatively
more relaxed regulatory regime applied to large NFIs.
☞
Examine the systemic risk generated by the reckless way in which
merchant banking corporations (hereafter 'MBCs') and credit card
companies (hereafter 'CCCs') operated in Korea.
☞
Look at the measures adopted by the policy authorities in
response.
☞
Draw on it in order to consider best practices in preventing and
monitoring systemic risk arising from large NFIs rather than hedge
funds.
Ⅱ. Business activities of non-bank financial institutions,
and the policy authorities' measures in response.
1. Merchant Banking Corporations
 MBCs, as the highly-leveraged non-banking financial
institutions in Korea before the 1997 currency crisis, had
carried out businesses similar to those of banks.
 MBCs' business : Discounting commercial paper, Medium and
long-term lending, Leasing, Securities brokerage, International
financing, and Factoring.
 MBCs are believed to have triggered the currency crisis, due
to the following factors;
 Severe maturity mismatches
1. Merchant Banking Corporations
 MBCs Borrowed short-term capital at high interest rates in the
international financial markets, and used the funds to extend long-term
credit or invest in illiquid bonds in emerging markets.
This resulted in severe maturity mismatches between their foreign
currency liabilities and assets.
 In these circumstances, MBCs had troubles in short-term foreign
currency borrowing and roll-overs due to the worsening international
financial market conditions.
 Following defaults on EME bonds in which they had invested, they
faced foreign currency liquidity shortages.
1. Merchant Banking Corporations

Expansion of their domestic business scopes into more risky
areas.

Despite lacking credit rating and analysis abilities, MBCs had
extended non-secured loans to corporations with low credit ratings,
by discounting CP.

☞
As a result, MBC asset soundness was much aggravated due to
the defaults of such corporations from 1997.
As MBCs started to withdraw their loans from faltering firms in
response, a vicious spiral of accelerating firm bankruptcies and
increasing MBC weakness occurred.
1. Merchant Banking Corporations
 The loosening of regulations also triggered the currency crisis in
some sense, causing MBCs' deterioration.
① Financial supervisory and regulatory frame not systemically
established
 Although the policy authorities had the right to regulate the MBCs, it had
no infrastructure for supervision such as supervisory experts and
organizations.
 Their function in systemic and comprehensive coordination of MBCs
supervision turned out to be weak.
1. Merchant Banking Corporations
② Negligent MBC business activity regulation
 For the purpose of easing regulation of financial institutions, the new
market entry of MBCs was allowed without any setting of required
principles.
 To attract foreign capital, establishment of new MBCs and conversion of all
the existing investment finance companies into MBCs were allowed.
 The rapid increase in number of MBCs caused excessive competition and
lowering of business quality.
 The government ignored the MBCs' herd behavior, such as crowded
establishment of overseas branches.
☞This led to reckless foreign currency borrowing, increased funding
costs and unsound asset management.
1. Merchant Banking Corporations
③ Insufficient regulation
 The capital adequacy regulatory system was underdeveloped.
 Before the currency crisis, the government regulated MBCs by means of a
naive financial gearing ratio standard.
☞MBCs conducted careless asset management without considering
the related risks.
 The regulations on MBC credit concentration were loosened.
 The permitted ceiling on MBC credit to conglomerates was three times that
for commercial banks.
 Loans and leases made to 'dispersed ownership companies' were excluded
from ceiling calculation.
1. Merchant Banking Corporations
 Although MBCs' loans, mostly unsecured, should have been more strictly
regulated than those of banks, they were relatively loosely regulated.
☞ As a result, the troubles at MBCs worsened rapidly.
 There were imbalances between the regulations on MBCs' short-term
and their long-term foreign currency borrowings.
 In cases of medium and long-term (over 1-year maturity) foreign currency
borrowing, MBCs were required to declare the transactions to the
government.
 For transaction amounts more than 10 million US dollars, they had to notify
the government beforehand.
 Short-term (less than 1-year maturity) borrowings were not only unrestricted
but also excluded from the application of ceiling on total short-term
borrowings.
☞MBCs enormously expanded their short-term borrowings which
were more risky.
1. Merchant Banking Corporations
 Overseas securities investment was unregulated.
 The ceiling on investment in local securities had been regulated.
 However, investment in overseas securities, had been excluded from
application of the ceiling.
 Without making any provision for risk, MBCs had continued to borrow shortterm foreign currency and invest it in emerging-market bonds.
☞There were characterized by high risk and low liquidity.
 The policy authorities worked to overcome the financial turmoil
through restructuring, such as forcing the market exits or M&As of
bad MBCs.
 Only two MBCs are currently in business in Korea and their scope of
business reduced.
 They are regulated in accordance with the same criteria as banks.
2. Credit card companies
 After the 1997 currency crisis, the number of CCCs increased
substantially.
 The reasons were
 the growth of retail financing thanks to the rapid domestic economic
recovery and continuing low interest rate level, and
 the belief that credit card market would achieve higher returns.
 In particular, certain measures by the policy authorities', including a
tax deduction, elimination of both the administrative ceiling on
monthly cash advances and the leverage limit on credit card issuers,
and application of relatively light capital adequacy ratio, contributed
to a boom.
2. Credit card companies
 From 1999 to 2002, the number of credit cards in use tripled, while the
volume of total credit card transactions expanded sevenfold.
 During the same period, the total assets of CCCs also rose more than
fivefold.
 These institutional support and financial deregulation resulted in the
generation of a credit card bubble.
 Fierce competition for market share between CCCs, caused by the
easing of market entry regulations, led to a relaxation of lending
standards and risk management.
 The limited infrastructure for reporting and sharing of credit information
led to insufficient evaluation and investigation of the credit conditions of
card applicants.
2. Credit card companies
 Credit cards were excessively issued even to households with low
credit and they were given credit limits beyond their repayment
capacities.
 CCCs ignored the importance of risk management. On the contrary,
they concentrated their efforts on high-risk, high-return areas of
businesses including card loans and cash advances.
 Herd behavior appeared in the credit market, as some CCCs focused
on expansionary strategies and others followed the same strategy to
avoid losing their market share.
2. Credit card companies
 The credit card bubble burst in 2003, so the financial conditions of
CCCs deteriorated dramatically.
 The volume of delinquent card loans rose sharply due to the lowered
debt-servicing capacity of households.
 CCCs became more cautious in issuing new credit cards and making
card loans, and carried out follow-up measures including calling in of
loans to lower-rated borrowers, prohibition of balance transfers, and
reductions of loan ceilings.
☞ Household and credit company soundness deteriorated further with
the soaring volume of delinquent loans and appearance of a credit
crunch.
2. Credit card companies
 To prevent the deterioration at CCCs from spreading to systemic
risk, the policy authorities took the measures.
 They upgraded credit card asset classification standards, strengthened
loan loss provisioning requirements and began to apply Prompt
Corrective Action measures.
 They raised the minimum capital adequacy ratio for card issuers, from 7
percent to 8 percent.
 They also banned aggressive street marketing practices and
established a cap on cash advances of less than 50 percent of total
CCC assets.
 However, these measures did not calm market participants' unrest
as expected, but led to a worsening credit crunch among CCCs.
2. Credit card companies
 The policy authorities changed their tactics to more active
intervention.
 They provided a large volume of liquidity to support troubled CCCs and
thus enhance financial market stability.
 They pressured CCCs to undertake self-rescue efforts and to take some
measures to improve their balance sheet conditions, including injections
of capital by their majority shareholders.
 They allowed CCCs to roll over their delinquent credit card loans by
exercising de facto regulatory forbearance on ancillary business ratio
regulations.
2. Credit card companies
 They made the conditions necessary for exercising Prompt Corrective
Action more realistic and helped CCCs repay or dispose of their
delinquent loans.
 To ease the liquidity crunch of CCCs and the money market distress,
they also extended maturities of credit card receivables indefinitely.
☞ The financial market returned to stability, on the back of
expectations that the short-term liquidity problems of CCCs would
be resolved.
Ⅲ. Some pointers and best practice
 The irresponsible business models and ways of running operations
of large unregulated NFIs may lead to systemic risk .
 It can bring about heavy social costs in that the resulting financial
market unrest can give rise to financial crisis or financial panic.
 In the light of our experience related to systemic risk arising from
large unregulated NFIs’ deterioration in Korea, the following best
practices can be considered.
Ⅲ. Some pointers and best practice
① Construction and operation of internal control systems based on risk
management
 It is very important to bring about recognition of risk management.
To this end, NFIs’ routine construction of risk management systems
should be encouraged and a regime put in place to confirm compliance
at regular intervals.
 What is more, a risk management department should be set up as an
independent organization, and reporting systems put in place that
constantly report back to top managers.
 In addition, stress tests analysis should be undertaken to guard against
overly optimistic expectations as to the future management
environment.
Ⅲ. Some pointers and best practice
② Strengthening of prudential supervision and regulation of NFIs’
soundness

A risk-based supervisory framework should also be introduced and
brought into operation for the NFIs like that for the bank.

NFIs that have been in a comparatively relaxed prudential supervisory
and regulatory regime, should in future be subject to the same level of
supervision as banks.
③ Heightening the transparency of NFIs’ management information

The scope for disclosure of NFIs' management information should be
expanded, and accounting standards revised on a systematic basis.
Ⅲ. Some pointers and best practice
 The information should be promptly made available to market
participants.
 Moreover, the financial supervisory authorities should disclose within a
certain range the findings concerning NFIs’ evaluated in the course of
on-site examination.
④ Imposing liability on the majority shareholder of NFIs
 In order to avoid moral hazard on the part of market participants, the
majority shareholders should bear the liability for failed NFIs.
 A system should be established whereby majority shareholders of NFIs
make up a considerable part of management losses.
Ⅲ. Some pointers and best practice
⑤ The policy authorities' direct intervention in order to safeguard the
financial system stability by acting as an orchestrator.
 If NFIs failed, the policy authorities should swiftly divide them into those
that are systemically important and those that are not.
 In order to prevent contagion effects, support for a turnaround can be
given to those paths of systemically important through the supply of
liquidity whereas the remaining institutions should exit the market.
Thank you.