KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

KDI FOCUS Protecting Customer Funds for Emerging Financial Products

Emerging financial products driven by innovation, such as virtual assets and simplified payment services, introduce both new conveniences and in-transaction risks to customer funds. Despite regulations on segregating customer funds already in place, full compliance by businesses with these rules is unlikely, especially with insolvency on their horizon. This paper proposes a new protection framework that bolsters the safety of new financial products and reduces funding pressures for the compensation scheme.

- New financial products emerging through innovation offer novel benefits but may also expose customers to risks in managing their funds.

- A protection system for emerging financial products can lay a strong foundation, serving as a key safety net to support reliable financial innovation.

- Customer funds for new financial products include prepaid balances, virtual asset deposits,

- P2P lending deposits, and funeral service prepayments.

- The current volume of customer funds associated with new financial products is substantial, at about 18 trillion won, and is expected to grow further, driven by advancements in digital finance and population aging.

- There have been numerous cases where businesses misappropriated customer funds for new financial products and later went bankrupt.

- Although fund segregation regulations for customer funds are in place, firms on the verge of bankruptcy are highly likely to violate them, and several other limitations persist.

- While fund segregation regulations serve a preventive function, the best of such precautions cannot eliminate all incidents, necessitating a post-incident protection system.

- In the direct protection scheme, firms pay insurance premiums in advance, and KDIC protects customers in the event of business insolvency.

- However, the direct scheme applies uniform insurance rates regardless of fund segregation in contrast to the fundamental insurance principle of premiums proportional to risk.

- In the indirect framework, firms do not pay insurance premiums, and KDIC safeguards only the funds segregated in banks in the event of bank failure.

- The indirect approach only protects segregated funds, leaving customers unprotected from violations of segregation rules, resulting in reduced protection effectiveness.

- The proposed hybrid scheme indirectly protects customer funds segregated in banks while directly safeguarding all other customer funds.

- This hybrid protection system ensures high effectiveness by safeguarding all customer funds and keeps

- insurance premium burdens low for firms and customers, as firms are incentivized to deposit most customer funds in banks.

- The hybrid protection system addresses risk transfer, in which a bank’s failure can trigger a firm’s insolvency.

- Early detection of firms facing liquidity risks is enabled by the hybrid proposal.

- KDIC’s burden under the hybrid option is not expected to be substantial.

- While the indirect protection system is easy to implement, the hybrid option requires substantial changes to the existing framework, making immediate implementation challenging.

- Recently, major developed countries have expanded the coverage of deposit insurance institutions beyond traditional deposits to include a wide range of financial and quasifinancial services, aiming to responsibly foster financial innovation.

- This study builds on such global trends to propose protection measures for customer funds in new financial products.

- The proposed protection system, with its inclusive nature, can serve as a comprehensive framework to protect and foster future innovation by capturing new financial products within its regulatory scope.

Summary

Research Monograph KOR Financial Innovation and Reform in the Era of Digital Transformation

Since the financial sector restructuring after the 1997 crisis and the international financial reform after the 2008 global financial crisis completed with a well stabilized system, the main policy attention has shifted towards financial innovation. In general, financial innovation refers to a series of deregulation or redesigning to enhance the convenience of financial services, strengthening the competitiveness of the financial industry. In contrast, financial innovation in the era of digital transformation is characterized by more specific and practical attempts to drive profound changes in financial services than the general financial innovation. With the convergence of ICT and finance, transaction costs are drastically reduced, and the processes constituting financial services are subdivided into detailed tasks which are combined and synthesized to new services, Such a new type of services are sometimes not subject to or even contradicting to the existing financial regulatory system.

The so called unbundling and rebundling of financial services in the process of financial innovation have brought about a large legal gray zone in financial activities, That is, newly attempted activities are not clearly judged as lawful because of its absence of the stipulated financial codes so as to be often unduly checked. Also, financial innovation where platform and data-based technology companies enter the financial markets makes the boundaries of the financial industry blurred (Big Blur) and shifts customer contact points with non-financial firms, weakening an intermediary function of traditional financial ones. Ultimately, innovation to converge ICT and finance requires changes in the financial markets, industry, and system itself so that financial authorities confronts with a situation in which they must decide switching to a new system. In this sense financial innovation in the era of digital transformation is not just deregulation in the existing sphere, but means a reform and redesign of regulations at the micro and macro level.

When digital finance becomes commonplace, the financial regulatory system will also face serious challenges. For example, virtual assets are not underpinned with a clear legal foundation but are traded like securities and geared with leverage, mimicking conventional banking and brokerage in the name of innovation. The ICT companies, which are ambiguous to be classified as financial firms under the current system, function as service providers in the financial markets, or even pursue a decentralized finance platform where financial service intermediary firms do not necessarily exist. Thus, it is not so early that policymakers set the agenda for financial innovation which is fulfilling and harmonizing with policy objectives such as consumer welfare and protection, financial industry competitiveness as well as systemic stability.

This study examines the development of financial innovations related to recent digital transformation and resulting emergence of new tasks and services, and proposes the direction of financial policies focusing on regulatory and supervisory challenges and reforms. It proposes detailed policy suggestions on how to regulate electronic payment industry and security token markets. It then deals with regulatory and supervisory issues on systemic stability and consumer protection in the prevalence of digital platform. It also argues the divergence of production and sales of financial services in the digital transformation and consequently long-time controversial debates over banking and commerce separation. Finally, it discusses a legal framework and financial policy approaches consistent with regulatory paradigm shift in the digital transformation.

Summary

Research Monograph KOR A Study on Insurance Resolution

This study theoretically and empirically analyzes key issues to be considered in improving the resolution system for insolvent insurance companies and offers policy implications. The coming adoption of the new International Financial Reporting Standard (IFRS) 17 as well as enforcement of the new capital regulation named Korean-Insurance Capital Stand (K-ICS) will likely expose the latent risk factors in domestic insurance firms and harm their financial soundness. Although a sudden, large rise in bankruptcy filings is improbable, there should be a sound institutional framework that could effectively handle the insolvency resolution in case of a default or bankruptcy of insurance firms considering the importance of the insurance industry in the financial system.

The existing approach for insolvency resolution heavily relies on government support. When an insurance company collapsed in the past, Korea usually responded with the "total portfolio transfer" (or run-off) method. In other words, a reinsurer assumed and accepted the insolvent insurer's contracts without modifications, and in the process, the government provided support like financial bailouts for the losses incurred to the reinsurer. The drawback of this government-dependent process is that it may lead to moral hazards among insurance policyholders and carriers and a fiscal burden to the government. That way, insurance consumers are not sufficiently motivated to care for the financial soundness of their insurers, and thus, the insurers have little incentive to improve their financial health. As a result, the government's fiscal burden increases as the probability and severity of insolvency grow.

The empirical analysis in this study also shows that insurance companies worldwide are highly reliant on their government. Per the analysis, should their countries' sovereign credit rating drop, so will the financial soundness of these insurers due to the accompanying reduction in the government's tacit protection for the insurance carriers. The insurance industry exhibits greater dependence on government in countries like Korea in particular, whose fiscal soundness is projected to deteriorate henceforth, or that do not issue a reserve currency, or whose insurance industry is large relative to the size of the national economy or public finance. The lesson learned is that Korea needs to improve its insolvency resolution system with stronger vigor.

Therefore, this study suggests the adoption of a new insolvency resolution regime in which policyholders are obliged to share some losses in case an insurance company collapses. As insurers' financial condition will become an important factor for consumers to consider before signing an insurance policy, the new regime can induce insurers to race for better financial health.

However, the loss-sharing regime may trigger a phenomenon called "insurance run," in which policyholders terminate their insurance contracts en masse. When a considerable number of policyholders end their contracts and exit the contractual relations altogether, it may negatively affect the business normalization of the insolvent carrier or the financial fitness of the firm acquiring the bankrupt company. The situation may exacerbate when the exit is more prevalent among relatively low-risk policyholders.

This study recommends the following policy responses in an overview of the theoretical and empirical analysis findings. First, caution should be taken not to seriously damage the continuity of original insurance contracts due to the loss-sharing requirement. In essence, insurance contracts are long-term contracts. Insurance premiums are paid at present to prepare for future insurable accidents. Especially for disease risk later in life, people purchase an insurance policy from a young age. The theoretical analysis revealed that it is desirable to set insurance premiums relative to expected risks, higher for younger and lower for older persons, for maximum social well-being. Thus, this premium structure should not be extensively altered under the loss-sharing regime. In this context, loss-sharing measures geared towards contract termination with less-profitable older policyholders in case an insurance firm goes out of business deserve reconsideration. That is to say, rather than terminating original insurance contracts with insolvent insurers, it would be advisable to keep them with minor modifications such as increasing premiums or reducing indemnity payment amounts in order to retain the contract continuity and share the losses.

Second, the loss-sharing ratio should be set at an appropriate level. The theoretical analysis shows that a higher ratio leads to contrary results: insurance firms can bring in more premium income (or pay less insurance money) from consumers retaining original contracts, but some policyholders bring them to an end. Such a trade-off should be taken into account when setting a proper ratio.

Third, a maximum of 10% requirement for loss sharing seems not to cause serious alarm for an insurance run. According to the survey analysis, it is highly probable that many insurance consumers regard the 10% requirement as lower than anticipated. Accordingly, only a few have expressed the intent to terminate their insurance contracts if so required.

Summary

Policy Study KOR Impact of Lowering the Legal Maximum Interest Rate and Policy Implications

This report estimates the effect of a cut in the legal maximum interest rate on loan application rate, loan approval rate, default probability, a ratio of borrowers whose interest rate is lowered, changes in consumer surplus, and changes in financial institution profits.

To this end, I conduct the structural model estimation to establish a demand model for financial consumers' loan application and repayment and a profit maximization model for financial institutions. After that, based on the estimation results, I present the results of a counter-factual analysis for each scenario of lowering the legal maximum interest rate and each scenario of raising the funding rate.

In all scenarios where the maximum interest rate is cut by 2%p from the 24% level to the 10% level, the reduction in consumer surplus of borrowers excluded from the market exceeds the increase in consumer surplus of borrowers whose interest rates decrease. Accordingly, further lowering of the legal maximum interest rate from the 24% level causes an average decrease in consumer surplus. On the other hand, the financial institution's profit also decreases in all scenarios. In addition, even when the funding interest rate increases at the fixed legal maximum interest rate level, consumer surplus decreases as the number of borrowers excluded from the market increases.

This means that the current policy support is essential to minimize the side effects of lowering the legal maximum interest rate. Also, the fact that an additional number of borrowers is excluded from the market when the funding rate of financial institutions rises implies the need to introduce a legal maximum interest rate system linked to the market interest rate.

Summary

KDI Policy Forum KOR Examining the Liquidity Risk in the Household Sector and the Policy Implications

■ In the wake of an unprecedented health crisis, households who lack liquid assets that could tackle their growing deficit (=income-expenditure) will endure severe financial difficulties.

■ The share of households facing liquidity risk will increase as incomes fall by bigger margins and exposure to the shock intensifies.

■ The liquidity risk resulting from COVID-19 will be even more pronounced among the economically vulnerable; specifically, those in the bottom quintile in terms of income and net assets, and temporary and daily wage workers.

■ Households at liquidity risk are particularly concentrated in the low income quintile. As such, a short-term income support program offering even a small amount of aid (e.g. 1 million won) could greatly help to reduce their liquidity risk.

■ In terms of support for at-liquidity-risk households, a selective approach which focuses the income support on the economically vulnerable and provides credit support in the form of collateral loans to asset-owning households will be more effective in easing the liquidity risk and the government’s fiscal burden.

Summary

Research Monograph KOR Analysis of Behavioral Patterns of Government-funded Microfinance Users

Using data on personal credit information from the Korea Credit Bureau (KCB), this study examines the long- and short-term impact of Korea’s two representative political microcredit products: the Sunshine (Haetsal) Loan and New Hope Seed (Saehuimang Holssi, NHS) Loan. This study also analyzes the impact of the guarantee ratio level of the Sunshine-Loan on borrowers’ repayment capacity.

Around 2010, the interest rate for unsecured loans to borrowers with low credit scores (7 and below) was as high as 40%, and many were using predatory lending schemes that charge extremely high interest rates. To resolve the situation, the financial authorities put into operation political microcredit products for low-income, low-credit borrowers that charge lower interest than the market rate. But while there have been much criticism and speculation over the actual effects of these programs, they have not undergone any impact evaluations to examine whether those products should be sustained. In particular, the Sunshine-Loan suffers from a considerably high subrogation rate; making performance evaluations even more necessary.

In this context, Chapter 3 analyzes the long-term behavioral patterns of the borrowers of political microcredit products, including their average interest rates, cash advances, credit scores, credit card payments, and whether they filed for debt modification. It also summarizes how Korea’s credit loan market has changed after the launch of political microcredit products.

In Chapter 4 and 5, to discern the causal effects of the provision of political microcredit, this study constructed a control group of non-users who have similar traits to policy loan users through the propensity score matching (PSM) technique, and then analyzed the economic effects and performance of policy loans using the difference-in-difference (DID) method. Specifically, Chapter 4 examines the various aspects of the borrowers of the Sunshine Loan and NHS Loan in 2012 and 2014, such as DTI, credit card expenditure, credit score, average interest rate, etc. Chapter 5 looks into the changes in the use of high-interest rate unsecured loans provided by private money lenders and savings banks among political microcredit borrowers in 2016.

Chapter 6 analyzes the effects of the change in the credit guarantee ratio on the probability of filing for subrogation or debt modification among the borrowers of the Sunshine Loan with a logistics regression analysis.

The chapter can be summarized as follows. Borrowers of the Sunshine Loan and NHS Loan show a larger increase in credit card expenditure than non-borrowers, meaning that the provision of microcredit can reduce borrowing constraints and encourage consumption. However, six months later, borrowers exhibit lower credit scores than non-borrowers as well as an increase in their DTI ratio. Moreover, the likelihood of borrowers filing for debt modification decreases only for a short period. These results suggest that another policy is needed for the borrowers of the Sunshine Loan and NHS Loan to support long-term credit management.

According to the analysis in Chapter 5, the probability of taking out unsecured loans from private money lenders and savings banks was significantly low during the early period of loan issuance. But this increased dramatically, and even exceeded that of non-borrowers after six months among Sunshine- Loan borrowers and after two years among NHS-Loan borrowers. This reaffirms the necessity of a support policy for long-term credit management so that borrowers do not have to take out other loans that charge high interest rates.

The analysis results in Chapter 6 show that when the Sunshine Loan’s credit guarantee ratio is low, the probability of subrogation and debt modification decreases. It is found that borrowers who are given a credit guarantee ratio of 85% are 30%p less likely to choose subrogation and 17%p less likely to file for debt modification, compared to those given a ratio of 95%. This means that a high credit guarantee ratio could actually weaken financial institutions’ efforts such as ex-ante screening and ex-post monitoring.

Based on the analysis results of this study, three policy implications can be drawn upon. First, government-funded political microcredit need to be combined with credit management education and credit counseling to help borrowers to manage their credit scores on their own and in the long-term. Second, instead of simply taking out lump sums that are close to the borrowing limit at once, borrowers need to be encouraged to borrow multiple times, and only the amount they can repay at each time, which could help maintain the positive effects of public microcredit in the long-term. Additionally, this method is expected to slash the commission for loan agents and to help borrowers repay their debts on time. Third, the credit guarantee ratio for the Sunshine Loan, which is currently at 95%, needs to be lowered to below 85% so that financial institutions are able to conduct ex-ante screening and ex-post monitoring in a comprehensive and timely manner.

Summary

Policy Study KOR Study on the Distribution of Income and Wealth and Household Debt

This study analyzes the relation between the rise in household debt and household characteristics such as income and assets using microdata on households. Based on the findings, implications are presented for the management of Korean households’ financial soundness and of the relevance of household debt to economic inequality.

The growth in household debt since the early 2000s is significantly associated with income and assets. On the one hand, in terms of income, bottom-income households have increased their debt relative to income by a big margin, possibly posing a threat to financial soundness. In addition, the rise in household debt is positively correlated with income growth, suggesting that the recent slowdown in debt growth is linked not only to the policies of tightening housing finance regulations, but also to the reduced income growth stemming from the macroeconomic slowdown. On the other hand, in terms of assets, households with larger assets exhibit a higher increase in their debt-to-income ratio compared to other households. The increase in household debt is positively correlated with the growth in real estate assets, which can be understood to mean that the increase in real estate assets is closely tied to the increase in household debt during the period in question. However, if the growth in real estate assets had been driven by temporary factors, it would be possible for the risk of debt default to increase as the real estate market would adjust.

The relevance between income growth and debt growth and between the growth in real estate assets and debt growth is stronger among households in the lower income quintile. This may be due in part to the increase in lifetime income, but considering the restrictions on their access to the financial market, the increase in income and real estate assets seems to have acted to mitigate those borrowing constraints. Meanwhile, in terms of real estate asset quintile, households in the middle and upper groups were found to take on more debt when their real estate assets grow, meaning that the interaction between asset growth and debt growth appears much stronger in the middle and upper groups.

According to the relative income hypothesis, it is expected that the larger the income inequality, the higher the increase in debt, particularly among low-income households. This study analyzes microdata on households to examine whether the increase in household debt is actually related to the economic inequality during the period since the early 2000s. When the data is compared by region, the analysis reveals no significant relevance between income inequality and the debt growth of low-income households in the same region. Also, there is no meaningful relevance between the inequality in household asset and debt growth in bottom-asset households. On the other hand, when the comparison is based on age group (nationwide), the analysis finds that low-income households of the same age group react to the income inequality within the group and respond by taking on more loans.

The recent slowdown in debt growth seems to be associated with the slowing growth in GDP as well as with the tighter mortgage regulations. But, as long as the real estate market is thriving, more debt may follow. Furthermore, the income gap within similar age groups may also likely drive up the debt in low-income households within the age groups. Accordingly, to induce a soft landing for household debt, the government should seek policy measures to stabilize the real estate market and to reduce the consumption gap stemming from income inequality in addition to tightening borrowing regulations.

Summary

Policy Study KOR A Study on the Prospects of Vitalizing the Mid-range Interest Rate Loan Market

This study examines whether the mid-interest lending market can be autonomously activated without government intervention in terms of market failure due to information asymmetry. In this study, information asymmetry refers to a situation in which a financial consumer has more accurate information about the probability of defaulting his or her debt than the financial institution that sells the financial products. Empirical results show that the degree of information asymmetry between the group of loan holders and financial institutions has not been serious enough to disable financial transactions. This means that, at least for the holders of “Saitdol” loans (government guarantee loans) that were issued during the analysis period of July 2016-end-2017, private financial institutions had enough private information to handle their cases if they were accompanied by interest rate adjustments based on average default rates.

The result provide three policy implications. Firstly, a shift is needed in the policy stance, in which loans are guaranteed for fear of market failure due to information asymmetry, to encourage financial institutions to supply private mid-range interest rate products. Secondly, guarantee loans should be made available only for a limited time since the information asymmetry between potential consumer groups who still do not have access to mid-rate credit loans and financial institutions may be excessive compared to those that are currently borrowing. In this case, it would be advisable to lower the guarantee rate to enable financial institutions to become more proactive in ratings. Lastly, considering that one of the policy objectives of “Saitdol” loans is to accumulate the experience in lending medium credit loans and to develop and improve a credit rating model for said loans, we should also consider the policy incentives for financial institutions to expand the target of the “Saitdol” loans. In this regard, the policy stance to ease the recent requirements for “Saitdol” loans seems to be the right direction.

Summary

Research Monograph KOR Impact of Easing Housing Finance Regulations on Borrowing Behavior

As the primary drivers of Korea’s swelling household debt and continued signs of an overheating in the housing market, many have pointed to the government’s use of the LTV and DTI ratios to ease housing finance regulations in August 2014, especially within the capital region. Indeed, although there was much interest in and debates over the impact of the easing at the time, there was little understanding of the actual effects. Accordingly, this study examines the impact of the easing of housing finance regulations on households’ decision-making, particularly in terms of borrowing behavior, home purchases and credit risk. To that end, this study uses household survey data and individual-level Credit Bureau (CB) data, and applies the difference -in-difference identification method which uses households in the capital region―who were subject to more expansive regulatory easing―as the experimental group. Subsequently, the impact of the eased regulations on the borrowing behavior of both households and individuals, demand for home purchases and debtors’ debt structure and credit risk was then analyzed.

Drawing on the Survey of Household Finances and Living Conditions, Chapter 2 examines how the regulatory easing affected households’ borrowing behavior and home purchasing decisions. In particular, the changes in borrowing behavior were connected to the changes in the number of homes owned in order to discern not only the impact on borrowing behavior but also the direct and indirect impact on the demand for home purchases. According to the results, the effects of regulatory easing were mainly centered around households with pre-existing mortgages. And in terms of the effect on housing demand, there was a considerable indirect effect of increased additional home purchases without loans as well as the direct effect of increased home purchases via mortgages. An additional analysis was also conducted on the differing impact of the eased regulations according to household characteristics such as age, net asset, income, multi-home ownership and LTV level.

Chapter 3 explores the effects of the LTV and DTI ratio-based regulatory easing on the demand for mortgages at the individual level using the CB’s credit data on individuals. Above all, efforts were made to understand the changes in borrowing behaviour as a result of regulatory easing in relation to the demand for home purchases and housing market conditions by including information on borrowers’ residence and on the housing market conditions of the region, even at the administrative division-level (dong). The results show that the probability of taking on another mortgage was more pronounced among those with pre-existing mortgages for both the purposes of buying homes and being used for living expenses. In addition, the impact of the regulatory easing varied depending on the regional housing market conditions of borrowers as well as on individual characteristics such as income; whether the individual was self-employed and; credit ratings.

Chapter 4 analyzes the relation between the eased regulations in the capital region (August 2014) and borrowers’ credit risk, and examines which credit group was more affected by the changes in credit risk. It was found that borrowers in the capital region were less likely to make late payments than their non-capital region counterparts, and that the impact was more obvious among low-income/low-credit debtors. This is because the regulatory easing was more focused on low-rate mortgages which could help lower the credit risk of borrowers who could afford to take on another mortgage. The analysis confirms that the reduction in credit risk resulting from regulatory easing was driven by the changes in borrowers’ debt structure which comes with the decrease in the proportion of high-cost loans and repayment burden.

Overall, this study examines the impact of the eased regulations on households’ borrowing, demand for home purchases and credit risk using micro-data analysis. It also provides significant implications for not only the comprehensive understanding of the impact of the easing but also for the effects of different household and individual characteristics, relevance to the housing market and specific implementation methods. By comprehensively taking into account the heterogeneous characteristics of borrowers and housing market conditions, this study attempts to contribute to the understanding of the ripple effects of regulatory policies and to enhancing the effectiveness of future policy designs.

Summary

Research Monograph KOR A Study on Systemic Risks in Insurance Sectors and Resolution Schemes of Insolvent Insurance Firms

This paper provides analysis on insurance runs, which are defined as simultaneous requests to cancel insurance contracts by a large number of policyholders, as a potential source of systemic risk in insurance sectors. Contrary to runs on banks, the heterogeneity of risk management ability among policyholders enables insurance runs to have a direct impact on insurers’ solvency. We show that policyholders with high risk sensitivity are more likely to cancel their insurance contracts, which has a negative effect on the solvency of the insurer hit by a run. However, insurance runs may also induce the remaining policyholders to manage their own risks more prudently, which has a positive effect on the insurer’s solvency. We present numerical examples on whether or not the overall impact of the insurance runs exacerbates such solvency.

We further study how a resolution policy should be designed to maximize the social welfare, which is the sum of the consumer surplus and net worth of the insurer acquiring insurance contracts from the other insurer going bankrupt. An increase in the insurance premium may improve the net worth of the insurance contracts, but it may also accelerate the exit of policyholders managing their own risks more prudently. We numerically analyze how the optimal insurance premium varies with the coverage plans; the systematic risks and; the severity of the risks exposed to consumers without insurance.

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