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Finance
in Korea
Establishment of Financial Institutions
The introduction of a modern banking system in Korea dates
back to the beginning of imperial Japan's influence over the Korean nation. In
1878, the First National Bank, a Japanese bank, opened a branch office in Pusan,
the port city nearest to Japan. It engaged in modern banking practices,
including the issuance of bank notes. Other Japanese banks opened soon
thereafter, establishing a network of branches in Korea.
The Bank of Korea was founded in 1909 as the first central
bank in Korea. The legal right to issue bank notes was transferred from the
First National Bank, which until that time had been the only bank authorized to
issue notes under the Korean government's commission. In 1911, following Korea's
formal annexation by Japan in 1910, the Bank of Korea was renamed the Bank of
Choson, which replaced the currency with new Bank of Choson notes. Subsequently,
numerous commercial and specialized banks were established under the Japanese
colonial government. Among them, the Choson Industrial Bank, established in
1918, was especially notable, as it played a major role in medium and long-term
financing in close cooperation with other institutions established to support
the Japanese colonial government.
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In addition to the Bank of Choson and the Choson Industrial
Bank, pre-1945 Korean financial institutions, including two commercial banks,
were established: the Choson Commercial Bank (later renamed the Commercial Bank
of Korea) and the Chohung Bank, the Choson Savings Bank, and the Federation of
Financial Association. The Choson Savings Bank was a subsidiary of the Choson
Industrial Bank and channeled its funds largely into Japanese government bonds:
the Choson Industrial Bank was used mainly for long-term financing. The
Federation of Financial Associations specialized in loans to farmers and small
businesses.
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The Bank of Korea
The financial foundation of the Republic of Korea was laid out
amidst a wildly turbulent domestic and international background. Korean
independence from Japanese occupation and the subsequent separation of the North
from the South put the Korean economy in a state of chaos. The temporary U.S.
military government inherited the Bank of Choson, which created runaway
inflation through its issuing of currency. Various factors such as the shortage
of productive facilities due to the sudden Japanese withdrawal and the large
influx of immigrants from the North and abroad after liberation forced the Bank
of Choson to continuously increase its money supply.
Following the inauguration of the government of the Republic
of Korea in 1948, the National Assembly established the Bank of Korea under the
Bank of Korea Act. The Bank of Choson which was the acting central bank until
that time, relinquished all of its power to the newly established Bank of Korea.
It was subsequently given complete control over the money and credit supply. The
architects of the Bank of Korea stressed the stabilization of currency.
Therefore, the Bank of Korea was given the traditional money tools, such as
discount rate adjustment, reserve requirement ratio adjustment, and open market
operations. The central bank system was divided into three parts, the Monetary
Board as the legislative body, the Bank of Korea as the executive body, and the
Department (later Office) of Bank Supervision as the regulatory body. In
addition to the Bank of Korea Act, the Banking Act was also passed to reorganize
the commercial banking system.
In the aftermath of the Korean War, due to a chronic shortage
of funds, heavy dependence on the central bank for solvency, and underdeveloped
financial markets, the traditional tools of the central bank such as rediscount
rate adjustment, reserve requirement ratio adjustment, and open market
operations could not be implemented properly. Consequently, the government
relied on direct or selective control of money and credit to channel funds
toward productive sectors.
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Monetary and Credit Policy
The increasing influence of the government in the financial
sector was accelerated under the military regime of President Park Chung Hee
(1961-1979). The 1962 amendment to the Bank of Korea Act made the government a
supreme body of monetary policy-making, relegating the Monetary Board to a mere
"policy implementing" agency. The amendment also increased the power
of the Minister of Finance so as to, in effect, bring the Bank of Korea under
the Ministry of Finance.
Under President Park, the monetary authority's control
instruments were extremely limited. General control instruments were defective
and malfunctioning due to the underdevelopment of money and capital markets
while the use of selective and direct controls were very effective. The policy
loans and credit control lie at the core of government's financial policies,
which convinced private enterprises to undertake risky projects, while the
government implicitly provided insurance against possible loss. Such an
arrangement was in accordance with the government's stated goal of economic
development, for which financial development had to be sacrificed. Enterprises
became dependent on long-term, low interest funds and their capital structure
deteriorated. The banks neglected credit evaluation and monitoring of loans. As
a result, the share of nonperforming loans to the total assets of commercial
banks increased from 0.5% in 1962 to 3.43% in 1979. The government entrenchment
in the financial sector, led to glaring market-failing features, as the
government involvement became less justifiable in the 1980s.
After Park's assassination in 1979, the Chun Doo Hwan
administration slowly paved the way to economic liberalization and
internationalization. The Bank of Korea increasingly demanded more autonomy from
the government's tight grip, and between 1980 and 1989, the bank made a pressing
demand for the amendment of the Bank of Korea Act to ensure its independence. An
uncertain truce was made between the Ministry of Finance and the bank in 1989 to
the effect that the prevailing practices and interrelationships were to be
improved to enhance the central bank's autonomous operations.
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The Banking and Financial System
In 1948, the Korean government became the largest shareholder
of all the financial institutions as it assumed the shares previously held by
the Japanese. Commercial banking services were provided by five banking
institutions, including the Bank of Choson, the central bank at the time, which
handled some commercial activities. The Choson Commercial Bank, originally
established to supply long-term industrial funds, faced a severe shortage of
funds. Due to rapid inflation after 1945, however, other specialized banks,
trust companies, and mutual savings companies were allowed to survive within its
business boundaries with rapid inflation after 1945. Consequently, these banks
were allowed to handle commercial activities.
The fiscal stabilization plan implemented during the
reconstruction period in early 1957 aimed to stabilize prices through tight
monetary control. The rate of increase in bank loans was limited due to the rate
of increase in savings deposits. During this time, significant reorganization
took place in the financial sector as the Korea Reconstruction Bank (renamed
later as the Korea Develop-ment Bank) was established in 1954 after reorganizing
the Choson Commercial Bank. Its purpose was to supply long-term development
funds, and it made significant contribution in important projects. The
Agricultural Bank was established in May 1951 under the purview of the Banking
Act to aid the economic recovery in the agricultural sector.
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During the 1950s, an important development in the financial
sector occurred when the government attempted to privatize commercial banks for
the first time. The government sold its holdings of commercial banks to emerging
business groups, a process which soon revealed conflicts of interests among bank
owners, managers, and customers. This eventually brought about the ownership
reversal of commercial banks in 1961.
In 1959, the first regional bank, the Bank of Seoul was
established in Seoul and the Kyonggi-do province. Its operations were limited
only those areas. However, in September 1962, it was upgraded as a nation-wide
bank. A new local bank system was introduced. The Bank of Taegu, for example,
began its operation in 1967. Between 1967 and 1971, 10 local banks were
established, one for each province. The branch network of each local bank was
allowed only within his province, in which his head office was located. These
local banks were privately owned with no restrictions placed on major
shareholders' voting power.
During the 1960s and 1970s, the government created a package
of commercial banks by rearranging the existing ones and initiating new ones. In
most cases, they were established by individual ad hoc acts outside the
Banking Act. These included the Small and Medium Industry Bank (1961), the
Citizens National (Kookmin) Bank (1962), the National Agricultural Cooperatives
Federation (1962), the National Federation of Fisheries Cooperatives (1962), the
Korea Exchange Bank (1967), the Korea Housing Bank (1969), the Export-Import
Bank of Korea (1976), The Korea Development Finance Corporation (1967), and the
Korea Trust Bank (1968).
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Concentration of financial power in the hands of the
government began with the 1962 and 1969 amendments to the Banking Act. Examples
of Banking Act amendments were reinforced restriction on loans without
collateral, restrictions on asset management, office tenures of board members
and auditors, and new punitive provisions for bank officials. In addition, the
government took other banking operations through the official legislation or
other means of regulations, such as annual budgeting and the appointment of bank
officials. Faced with chronic excess demand for funds, commercial banks depended
heavily on the rediscount facility of the central bank and operated at the mercy
of its window guidance.
The government tutelage of the financial sector became
increasingly inefficient as the economy grew larger and more complex. As a part
of an effort to shift the market structure from government management to a
market-oriented system, the government privatized four banks in the early 1980s:
the Hanil Bank in 1981, the Korea First Bank and the Bank of Seoul and Trust
Company in 1982, and the Chohung Bank in 1983.
With the Commercial Bank of Korea already privatized in 1972,
privatization of all five leading commercial banks was completed. Among the
specialized banks, the Korea Exchange Bank was privatized in 1989. In addition,
the Banking Act was revised in 1982 to grant banks more autonomy in managerial
affairs.
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The gradual dismantling of the financial system that existed
for the purpose of industrial support of chaebols continued through the
1980s and 1990s. In 1994, the government allowed unfettered development of new
financial products. It also allowed banks partial entry into the securities
business by allowing them to become the leading managers of government bond
issues and sell them at their counters.
The 1994 revision of the Banking Act
attempted to improve the ownership structure of banks and created specialized
financial groups. At the same time, privatization of banks continues as the
Kookmin Bank was privatized and the Korea Development Bank Law and the Korea
Housing Bank Law were revised. However, these measures toward liberalizing the
financial sector proceeded in a marginal and passive manner, and they were all
too often modified or withheld. Moreover, the direction of the financial
liberalization was frequently altered or reversed as the political situation
changed.
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Non-bank Financial Institutions
Toward the end of 1960s, the government recognized that the
existing banking system was not able to meet the surging need for investment
funds for further economic development. Confronted with this problem, the
government tried to diversify the sources of investment funds by introducing
various non-bank financial institutions and by fostering the securities market.
The Korea Development Bank, the Export-Import Bank of Korea,
the National Investment Fund, the Land Bank of Korea, and the Korea Development
Finance Corporation (KDFC) consist of development institutions in the category
of non-bank financial institutions. These institutions supply long-term
industrial credit with the funds raised by borrowing from the government,
international institutions, and foreign banks, and by issuing debentures. They
differ from the regular commercial banks in that they are not permitted to
accept deposits from the general public except from special customers. As an
example, the KDFC, a private development financial institution later renamed the
Korea Long Term Credit Bank, was organized with the assistance from the World
Bank in 1967. One of the major objectives of the KDFC was to develop a long-term
credit capital market as alternatives to the prevailing dependence on bank
loans, foreign loans, and the curb market.
In 1972, three laws were enacted authorizing investment and
finance companies, specializing in receiving installment savings and small
loans, and credit unions, to engage in short-term dealings in papers issued by
business firms, mutual savings, finance companies. In 1974, merchant banking
corporations were introduced to induce foreign capital and supply long-term
funds. These types of institutions were intended to absorb unorganized curb
market into the regulated financial market.
Although the securities market existed in Korea since 1943, it
only began to grow in a meaningful manner since 1972 with the series of
supportive measures aimed to promote domestic investment. Late in the 1970s,
various institutional arrangements were established to ensure sound operations
of the market. These included the strengthening of the underwriting function of
investment trust companies and establishment of the Securities and Exchange
Commission as well as the Securities Supervisory Board. In 1992, the government
allowed direct purchases of Korean securities by foreign investors, whom, until
then, relied on indirect vehicles such as country funds, beneficiary
certificates, and overseas securities issued by domestic companies exclusively
for foreign investors.
These non-bank financial institutions grew rapidly thanks to
the relatively higher interest rates they are permitted to apply and to the fact
that they were given more independence than banking institutions. The share of
non-bank financial institutions in terms of deposits increased from 15.1% in
1971 to 29.0% in 1998.
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The Financial Crisis of 1997
With its usable foreign exchange reserves nearly exhausted in
November 1997, the Korean government requested emergency assistance from the
International Monetary Fund (IMF) to avoid a moratorium on its foreign debt. On
December 3, 1997, the government of Korea and the IMF signed a financial aid
package agreement totaling US$58.3 billion subject to the government's
willingness to fulfill certain broad conditions, including macroeconomic
stabilization and structural reform.
The situation continued to deteriorate throughout December as
the exchange rate plummeted to almost 2,000 Won/US$ while the benchmark
three-year corporate bond rates soared to almost 30% in the wake of large-scale
capital flight. However, foreign exchange reserves began to increase with the
emergence of a large current account surplus in December, funds from
international financial institutions and renewed capital inflows following the
agreement in January 1998 to extend the maturity on short-term foreign bank
debt. By March, Korea's macroeconomic indicators stabilized.
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Given Korea's strong macroeconomic trends until October 1997,
the crisis came as a surprise. However, throughout the 1990s, analysts both in
and out of Korea voiced warnings about systematic fault lines imbedded in the
Korean economy that are making it increasingly vulnerable to shocks. The
structural vulnerability that came from internal and external sources originated
from the systemic failure of risk allocating mechanisms that the government-led
financial sector did not previously need.
However, the changing environment has forced the Korean
financial sector to grow out of its reliance on government guidance. External
vulnerability is characterized by the over reliance of short-term oriented
external financing. While the size of external debt was not an unsustainable
level given Korea's economic growth potential, the rapid increases in short-term
debt and term-mismatches resulting from the absence of prudent supervision were
clearly signaling possible foreign exchange liquidity problems. Internal
vulnerability is characterized by highly leveraged corporate financial
structure. The corporate debt to GDP ratio has been rising substantially
throughout the 1990s. The excessive dependence on borrowings mainly to finance
risky investments had not been possible without imprudent and inefficient credit
allocations of the financial sector and distorted incentive mechanisms.
The so-called "East Asian miracle" obscured the
dichotomy between a strong real economy on the one hand, and an excessively
indebted corporate sector and a poorly supervised financial system, on the
other. These weaknesses stem from the fact that banks and corporations were
linked closely with the government in a web of implicit guarantees which had
come to be called "Korea Inc." This close mutual relationship created
a "too-big-to-fail" mentality, resulting in excessive risk-taking,
over-investment and insufficient attention to credit and exchange-rate risks.
These fault lines, which had existed for some time and had not prevented rapid
growth, nonetheless left Korea vulnerable to shocks in an increasingly global
financial market. As the financial meltdown spread through Asia beginning in the
mid-1997, these fault lines were transformed into an outright fracture in
Korea's fragile financial system.
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Post-crisis Financial Reform
The Korean Won's depreciation following the foreign exchange
crisis in December 1997 led to spiraling interest rates, liquidity shortfalls,
foreign exchange losses, erosion of equity capital, and an immediate
deterioration in bank loan portfolios. Thus, restructuring the financial sector
is one of the most pressing issues in solving the credit crunch in the financial
markets and improving the economic situation. The main purpose of financial
sector restructuring is to stabilize the financial system in the short term and
to enhance the soundness and efficiency of financial institutions in the longer
term.
On December 29, 1997, 13 financial reform bills were
legislated to provide the legal basis for financial reforms. According to the
revised Bank of Korea Act, the independence of the central bank has been
substantially reinforced. The Governor of the Bank of Korea (BOK), previously
appointed by the Minister of Finance and Economy, has been appointed by the
President after deliberation of the State Council. The Monetary Board, a supreme
policy-making body of the BOK, is now chaired by the Governor of the BOK instead
of the Minister of Finance and Economy. The objective of the central bank is to
maintain price stability, changed from the previous dual objectives of
maintaining the stability of currency value and strengthening the soundness of
the banking and credit system.
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As for the financial supervisory system, the Financial
Supervisory Commission (FSC) was established in April, 1998 under the Office of
the Prime Minister to function as a neutral and independent supervisory
policy-making body. To insure effective financial supervision on a consolidated
basis, the existing supervisory bodies will be merged into a new Financial
Supervisory Board (FSB) in the near future, and the FSC will then directly
superintend the FSB. The existing deposit insurance bodies were also merged into
a consolidated deposit insurance body to strengthen deposit protection.
To quickly restore normalcy in bank management, the FSC
reviewed rehabilitation plans of banks that did not meet the BIS capital
adequacy ratio. Subsequently, the FSC ordered some banks to close, and
encouraged some to merge with other banks. Even for those banks that met the BIS
capital adequacy ratio, the FSC drafted restructuring plans based on its
assessment of those bank's management results after the closing of their
semi-annual accounts.
Both the government and the banking sector are in favor of
restructuring the system. In an effort to take the lead in the banking sector,
the wave of interbank mergers have begun, beginning with the merger between the
Commercial Bank of Korea and the Hanil Bank in July 1998, to create a Ôsuper
bank' with a capitalization of over 100 trillion Won (US$77.69 billion).
The Korean government is seeking to attract more capital into
Korea's banking sector by modifying laws governing the shareholding structure of
the banking institutions. To attract more investment in the equity of financial
institutions, the limit on the overall and individual shareholders' equity
holdings in banks was fully liberalized. This change was made to encourage joint
ventures and M&As between foreign and domestic financial institutions. In
addition, the Banking Act has been amended to allow banks to elect foreigners to
serve on the board of directors.
The restructuring of non-bank financial institutions follow a
similar sequential pattern. The government plans to encourage
self-rehabilitation efforts by majority shareholders by strictly applying prompt
corrective action. Where an institution turns out to be financially inviable due
to liabilities that exceed its assets or excessive losses, it will be liquidated
or sold to a third party.
Normalization of the financial system, is the most important
task in Korea's economic rehabilitation program, and is being pursued through
swift and extensive reform measure. Carrying out the restructuring process of
the financial system requires a substantial amount of fiscal support. The
government's basic principle is that the cost of economic restructuring should
be minimized and met primarily by financial institutions themselves so as to
minimize the burden on taxpayers. Nonetheless, the government is providing
fiscal support for the purchase of nonperforming loans by the Korea Asset
Management Corporation, recapitalization of financial institutions, and deposit
protection. The government announced in August 1998 that it would increase its
fiscal expenditure for these purposes by an additional 50 trillion Won (US$4.2
billion), which is an example of the importance it is placing on the successful
outcome of this undertaking.
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