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Macroeconomics and Financial Economics

KDI Policy Forum

Improving Capital Regulations on Financial Institutions to Reflect Group-wide Risks

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  • Author Rhee. Keeyoung
  • Date 2017/08/25
  • Series No. KDI Policy Forum No. 266 (2017-02), eng.
  • Language English
SUMMARY □ The group-wide risks associated with business group affiliation must be reflected in capital regulations that assess the soundness of financial institutions.

- When financial institutions hold shares with the intent to maintain control over a business group, the insolvency of one affiliate could rapidly spread throughout the entire group due to difficulties in disposing of the respective shares.

- If such risks are not reflected in capital regulations, the capital adequacy of financial institutions [in groups] against losses may be assessed inaccurately.

□ It was found that the current capital regulations on insurance and securities companies do not reflect the group-wide risks posed by affiliates?? investments in shares.

- The risks may be underestimated for capital regulations on insurance companies as the companies?? investments in non-consolidated affiliates are regarded as general stock investments.

- As for capital regulations on securities companies, capital adequacy may be incorrectly assessed due to the deduction of the whole investment in affiliates from their capital.
KDI VOD Report
Group-wide risks refer to the risks generated
from the various financial relationships
formed between the affiliates of a business group,
which can be formed of both financial and non-financial institutions.

For example, if an affiliate,
in whom the financial institution has invested,
becomes insolvent, this could rapidly spread
across the entire group to the respective financial institution
due to difficulties in withdrawing said investment.

- The most crucial policy aim of the financial supervisory authorities
is to accurately assess and manage the risks to financial institutions
within a conglomerate.

- Thus, group-wide risks must be reflected in capital regulations,
which are key to the policy.

- Moreover, when risks are generated in large corporations,
they will most likely be massive in scale and
have a significant impact on financial stability.
Consequently, a regulatory system that could appropriately deal with group-wide risks is needed.

Capital regulations set a minimum capital requirement
that acts as a buffer when financial institutions face unexpected losses.

Therefore, this obligates the companies to manage an amount of capital
that exceeds the minimum.

However, a distortion in the assessment of capital may occur
if the risks associated with financial institutions'''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''' investment in
and relationships with their affiliates are not adequately reflected.

Accordingly, this study examines the current status of Korea''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''s supervisory system
for group-wide risks in regards to capital regulations
and recommends directions for improvement.

In Korea��s case, the capital regulations for banks and holding companies
are based on a set of international standards proposed by the Joint Forum
and are implemented throughout the entire group.

But for the majority of groups with affiliates in insurance and securities,
the group-wide risks are not sufficiently reflected,
despite their focus on finance.

Take insurance for example,
if the insurance company is the largest controller of the group,
the capital adequacy is assessed in two ways.
The first method is to consolidate the group into a single regulated entity
and then adjust the minimum capital requirement.

And the second method is to deduct the insurance company��s total share
in affiliates from its capital.

Meanwhile, if the insurance company has shares in an affiliate
but is not the largest controlling entity,
adjustments are not implemented and therefore,
there may be an overestimation of its capital.

In fact, if the capital adequacy ratio is adjusted by applying the international standard,
which deducts the amount invested by the insurance company
in affiliates from its capital, the ratio falls significantly.

This suggests that the capital adequacy of insurance companies could be overestimated
as the current regulations only partially reflect the group-wide risks.

In the case of securities companies, capital adjustments are made by deducting
the total investment from their capital, regardless of the control structure.

But, even if a securities company is the largest controller,
the group is not evaluated as a single entity,
therefore the evaluation of equity capital may become distorted.

Such an evaluation method unnecessarily obligates securities companies
to hold a possibly excessive amount of capital.

On the other hand, as the parent company, securities companies
are not responsible for maintaining the total capital at an adequate level
even if their subsidiaries�� capital falls short of the minimum requirement.

- A revision of the sectorial capital regulations
must be implemented to properly reflect the group-wide risks
associated with financial institutions'''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''' holdings of shares in affiliates.

- If such risks are adequately reflected, they may also be utilized to improve
related regulations on the separation of industrial and financial capital.

- For example, if the regulation prohibiting financial institutions from holding assets
in non-financial institutions is supplemented with capital regulations,
financial institutions would be obligated to maintain an amount of capital
that is in proportion to the level of group-wide risk,
resolving the issue of misappropriation to some extent.
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