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KDI FOCUS
Effects of Revolving Doors in the Financial Sector: Evidence from Korea

January 15, 2019

PDF
KDI FOCUS
Effects of Revolving Doors in the Financial Sector: Evidence from Korea

January 15, 2019

PDF
    Ⅰ. Introduction

    Ⅱ. Two Contrasting Views on the Revolving Door

    Ⅲ. Changes in Risk Management Performance

    Ⅳ. Changes in the Probability of Regulatory Action

    Ⅴ. Interpretation of the Analysis Results

    Ⅵ. Comparison of the Results to Those in the US

    Ⅶ. Conclusion
KDI Report VOD
Retired financial regulators often find their way to executive positions in the private sector.

To explain the economic impact of such a practice, also known as “revolving door,” there are two hypothesis.

The first looks at the practice from a positive perspective, explaining that by hiring ex-regulators as executives, financial firms can utilize their expertise and experience to improve financial soundness.

The other takes a more negative stance, speculating that financial firms can use the ex-regulators’ connections to unjustly avoid being penalized by the financial authorities.

So, does this really happen?

To answer this question, KDI empirically analyzed the economic impact of ex-financial regulators joining private firms.

Firstly, an examination was conducted into whether ex-regulators actually contribute to the performance and improvement of the firms’ financial risk management.

Based on data of ex-regulators hired by financial firms from 2011 to 2017, The analysis revealed that there were no discernable changes within the first three months of appointment,

and while those from the Bank of Korea contributed somewhat, the remaining ex-regulators did little to improve the hiring firms’ financial risk management.

Next, an analysis was conducted to see whether the probability of a firm being penalized by the financial authorities changed after the appointment of an ex-regulator.

It was found that for firms whose executives had previously served in the FSS, the probability of regulatory action dropped by roughly 16% in the first 3 months.

This is much higher than when firms tried to curb the probability by reducing their non-performing assets.

Nevertheless, the analysis also revealed that this advantage disappears during the following three months.

Then, does the probability of regulatory action decrease because ex-regulators reduce non-financial risks such as personal information leaks?

An examination into whether there were, in fact, changes in the management of operational risks while the probability of regulatory action diminished found no such changes.

That is, the probability of regulatory action decreased despite the lack of improvements in the financial soundness of firms after the appointment of an ex-regulator.

In the US, where there are also many such cases, there were clear improvements in the firms’ financial performance while there was little change in the probability of regulatory action.

So, why is there a discrepancy between Korea and the US?

The answer lies in the fact that the US’ financial supervisory system has a decentralized structure while Korea’s is centralized and within which the majority of duties tied to financial supervision is undertaken by a single institution.

Indeed, if the authority was granted to numerous institutions, it would create the necessary checks and balances which, in turn, would make it difficult for financial institutions and private firms to collude.

Also, from the firms’ point of view, it would make it more difficult to form ties with a large number of regulators.

[Interview with the author]
(Keeyoung Rhee, Fellow at KDI)
If the current financial supervisory system itself incentivizes improper practices, a shift to a decentralized supervisory structure can be discussed. But, such a process is expected to entail substantial economic costs, so we also need to seek measures to reinforce the accountability of the supervisory authorities while maintaining the centralized system.
For example, the government can establish an information-sharing mechanism wherein all regulatory agencies have free access to the information on the risks of financial firms, which is mainly held by the FSS in the current system.

(Sunjoo Hwang, Fellow at KDI)
This study is meaningful in that it analyzes the economic impact of the revolving door practice, which has long been subject to criticism. However, there are limitations and while we were able to fully use the data avaliable, we still lacked information in certain areas. One example is the operational risk indicator in relation to the financial supervisory regulations, which was used in this study. However, the indicator is limited in fully capturing the non-financial risks of financial firms. Therefore, following studies should collect further data to analyze the effects in more detail.
□ The revolving door practice, i.e. the recruitment of ex-regulators by regulated firms, has long been subject to criticism in Korea. Despite its importance, however, there are few studies on the economic impact of the revolving door. By applying a unique dataset of financial firms in Korea, it was found that the practice does not improve the financial soundness of the recruiting firms. Additionally, it was observed that firms, shortly after hiring former regulators, are less likely to receive regulatory penalties. This result appears to be associated with Korea’s financial supervisory system, wherein the majority of supervisory tasks are concentrated within a single agency.

- Despite the public’s criticism, there have been few empirical studies on the effects of the ‘revolving door’ practice.

- This study provides analysis of the economic impact of the revolving door for financial regulators in Korea.

- The ‘expertise hypothesis’ argues that former financial officials can contribute to improving the risk management of recruiterfirms due to the officials’expertise.

- The ‘collusion hypothesis’ claims that financial firms recruit former officials to seek unduly gains, such as evading regulatory enforcement.

- The empirical analysis found no indications of improvement in financial risk management performance after the appointment of former financial officials.

- The probability of receiving regulatory action after hiring ex-FSS regulators as executives decreases 16.4% and it is statistically significant, while the probability does not change significantly after hiring ex-regulators from other institutions.

- It is possible that executives who were formly in the FSS can help manage the nonfinancial risks. But, the empirical analysis found no indications of such a contribution when the probability of regulatory action decreased.

- In the US, financial companies with former financial officials as executives exhibited noticeable improvements in their financial soundness while no meaningful changes were found in the probability of regulatory action.

- Unlike the US’ decentralized task structure run by multiple authorities, Korea’s financial supervisory tasks are concentrated in a single institution.

- According to relevant studies, such a centralized structure could incur more incentives for collusive ties between the pertinent government authority and financial firms.
 
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