1、Best Practices in Preventing and Monitoring Systemic Risk,The Bank of Korea Ilhwan Kim,July 9, 2009,Contents,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, o
2、nly 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, theCapital Market and Investment Services Actcame into effect. It provided a platfor
3、m for the introduction of hedge funds.,. 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 ri
4、sk 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 systemi
5、c risk arising from large NFIs rather than hedge funds.,. Introduction,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 l
6、ending, Leasing, Securities brokerage, International financing, and Factoring. MBCs are believed to have triggered the currency crisis, due to the following factors;Severe maturity mismatches,. Business activities of non-bank financial institutions, and the policy authorities measures in response.,1
7、. 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 li
8、abilities 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. Mercha
9、nt 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 t
10、he 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 cris
11、is in some sense, causing MBCs deterioration. Financial supervisory and regulatory frame not systemically establishedAlthough 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
12、and comprehensive coordination of MBCs supervision turned out to be weak.,1. Merchant Banking Corporations,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
13、 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 crowd
14、ed establishment of overseas branches.This led to reckless foreign currency borrowing, increased funding costs and unsound asset management.,1. Merchant Banking Corporations,Insufficient regulationThe capital adequacy regulatory system was underdeveloped.Before the currency crisis, the government re
15、gulated 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.Lo
16、ans 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
17、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 amo
18、unts 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 whic
19、h 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, M
20、BCs had continued to borrow short-term 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
21、 MBCs are currently in business in Korea and their scope of business reduced. They are regulated in accordance with the same criteria as banks.,1. Merchant Banking Corporations,After the 1997 currency crisis, the number of CCCs increased substantially.The reasons were the growth of retail financing
22、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 c
23、ash 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.
24、 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 relaxa
25、tion 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
26、 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 m
27、arket, 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 sharp
28、ly 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.Househ
29、old 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
30、 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
31、 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
32、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
33、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 delinque
34、nt 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.,2. Credit card
35、companies,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 rel
36、ated to systemic risk arising from large unregulated NFIs deterioration in Korea, the following best practices can be considered.,. Some pointers and best practice,Construction and operation of internal control systems based on risk managementIt is very important to bring about recognition of risk m
37、anagement.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 co
38、nstantly 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.,. Some pointers and best practice,Strengthening of prudential supervision and regulation of NFIs soundnessA risk-based
39、 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.Heightening the transpare
40、ncy of NFIs management informationThe scope for disclosure of NFIs management information should be expanded, and accounting standards revised on a systematic basis.,. Some pointers and best practice,The information should be promptly made available to market participants.Moreover, the financial sup
41、ervisory authorities should disclose within a certain range the findings concerning NFIs evaluated in the course of on-site examination.Imposing liability on the majority shareholder of NFIsIn order to avoid moral hazard on the part of market participants, the majority shareholders should bear the l
42、iability for failed NFIs.A system should be established whereby majority shareholders of NFIs make up a considerable part of management losses.,. Some pointers and best practice,The policy authorities direct intervention in order to safeguard the financial system stability by acting as an orchestrat
43、or.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.,. Some pointers and best practice,Thank you.,
