KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Research Monograph KOR Digital Payment Innovation and Financial Consumer Protection

○ Even with weak legislative support, the digital economy is gaining momentum, propelled by the recent progress in contactless financial services and digital finance’s growing convergence with other sectors.
- As the primary legal framework for digital finance, the Electronic Financial Transactions Act (EFTA) had an amendment proposal in November 2020, but the bill is still pending at the National Assembly.
- Despite its vital importance in the Korean economy as a legal foundation for financial innovation, the EFTA has remained largely intact since its enactment in 2006 and has not been sufficient institutional support for critical technological changes like the rise of fintech and big tech.

○ Key point of the amendment is opening up payment services to non-banking financial institutions, such as tech firms (big tech) and credit card firms.
- Payment services are an essential amenity in our everyday life, encompassing payment for goods and services, cash deposit and withdrawal, salary transfer, domestic and foreign remittance, and utility bill payment.
- The amendment bill introduces a license of Comprehensive Payment Service Provider (CPSP), which is allowed to provide all payment services by directly offering a checking account like banks.
- Once the bill passes, some big tech firms as well as conventional nonbank financial institutions like credit card issuers are expected to get the license of CPSP.

○ The significance of payment services lies in that this sector is the basis for nonbank entities to expand into other areas, such as banking, insurance, and financial investment in the mid-to-long term.
- Because every economic activity involves the act of paying, CPSPs can accumulate vast user data.
- Also, these operators can bring in a massive amount of funds that customers deposit for payment transfers. Such funds can be used to launch new customized investment products or expand their business to other financial markets.

○ In the longer term, opening up digital payment services may thrust the financial industry to the next level by stimulating competition from within.
- A single app or metaverse platform is all it takes for users to carry out the whole array of financial services and e-commerce, not to mention payment transfers. Also foreseeable are crumbling barriers between different subsectors within the broad financial sector and spurring competition across the entire industry.

○ Some are rather pessimistic about the open-up because they perceive it as flinging open the door of banking; however, this study does not regard it as harming financial stability.
- The required regulatory level should be on par with banking regulations when deeming CPSPs as banks, but as nonbank payment service providers the degree of restrictiveness and protection would decrease.
- This study views the core function of banks as financial intermediation, which transfers customer deposits into illiquid loans. Since payment service operators cannot provide loans, it is reasonable to regard them as nonbank payment institutions (refer to Chapter 4).

○ On the other hand, financial consumer protection remains crucial agenda.
- Since most payment service users place their funds in demand deposit accounts, protecting these funds and guaranteeing service users’ rights are critical.
- The amendment bill contains some protective measures, but in the UK, where a similar scheme has been in operation, several payment service providers went bankrupt without returning customer funds.

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

Policy Study KOR Does Fiscal Instability Cause Financial Instability?

This study analyzes the impact of fiscal instability on the soundness of financial institutions. The IMF's long-term fiscal outlook (2021) forecasts Korea's public finances to weaken over the medium to long term. Deteriorating fiscal stability may undermine the soundness of the financial sector by way of the financing channels of government bonds and guarantees. Through an empirical analysis, this study finds that the higher the risk of sovereign default, as measured by credit default swap (CDS) premiums on government bonds, the higher the risk of bank default, as measured by bank bonds CDS premiums. Moreover, this study looks at other countries sharing similar fiscal and financial features as Korea―without reserve currencies, greater banking sector size relative to national revenue, and huge private sector credit that is rapidly expanding― and finds that for such countries, bank default risk is further amplified when sovereign default risk increases.

The analysis results may have two policy implications. Firstly, it is necessary to build up fiscal soundness, and this is an indispensable policy agenda item for the Korean economy to pursue over the longer term. Secondly, the banking sector needs to become less reliant on public finances and more self-sufficient. In case of a bank failure in contingencies, it is desirable to adopt a bail-in system that requires creditors to share the losses to rescue the defaulted financial institutions rather than bail-out, which provides relief at the expense of government revenue.

Summary

Policy Study KOR Introduction of Internet-Only Banks: Effects and Policy Tasks

This study examines the results of competition promotion in the banking industry due to the introduction of internet-only banks through empirical analysis. It discusses the direction that internet-only banks should pursue to improve consumer welfare in the future through overseas case studies.

The empirical analysis can be divided into two parts. First, this study examines whether the introduction of internet-only banks improved the inclusiveness of the credit loan market in the banking sector. To this end, we determine whether borrowers who were previously unable to receive credit loans from the banking sector increase the probability of successful lending to the banking sector after internet-only banks are introduced. Next, we examine whether the introduction of internet-only banks increased competition in the banking sector’s credit loan market and decreased the interest rate corresponding to the price of loan products.

The above two analyzes find that the introduction of the internet-only bank significantly improved the tolerance of the banking sector loan market, and at the same time, contributed to the drop in interest rates in the banking sector loan market. However, these benefits also tend to be biased towards borrowers with high credit ratings.

The analysis results provide two policy implications.

First, as the purpose of the introduction, internet-only banks need to expand the information combination system to use unstructured information to enhance credit evaluation capabilities. With the recent passage of the Data 3 Act, the legal and institutional framework for using unstructured information in credit evaluation has been laid and as such, the effectiveness of this new system should be bolstered. Next, it is essential that incentives are introduced to induce internet-only banks to focus on the credit loan market rather than the already saturated mortgage market.

Summary

Policy Study KOR Analysis of Market Discipline at the Capital Market: The Case of Korea

This paper analyzes how the size of firms, unrelated to inherent credit risks, influences firms’ access to capital markets. Specifically, we theoretically and empirically whether credit rating agencies (CRAs) unduly give favors to large-sized companies and conglomerates than small and mid-sized companies when CRAs evaluate default risks of these companies on their debts. In a simple theory model in a Bayesian persuasion framework, we find that CRAs have an incentive to generously underestimate default risks on the large-sized firms when these firms raise capital from bond markets more often than small and mid-sized firms, and thus become a very important client to CRAs. However, the bond buyers rationally infer the default risks on these large-sized companies with high credit rating, and thus charges a higher risk premium than they would to small and mid-sized companies conditional on the same financial conditions. Using a financial dataset in Korea, we document that the interest rates of bonds issued by mid-sized companies are in fact lower on average than those issued by large-sized companies. We further find that mid-sized companies are less likely to receive a high credit rating than the large-sized companies. These findings suggest that CRAs unfairly treat companies willing to issue bonds based on their sizes, thereby possibly distorting credit market structures.

Summary

KDI Policy Forum Impact of a Policy Rate Cut on Bank Profitability and Financial Stability

■ Concerns prevail that a policy rate cut could weaken bank profitability and trigger financial instability.

■ However, banks can sustain relatively high net interest margins with little fluctuation despite a rate cut owing to their dominant position in the deposit market and ability to adjust loan maturity.

- By virtue of their market dominance, banks set their deposit rates below the base rate by a fixed percentage, and as such, the former falls within a narrower range than the latter.

- Because deposit rates are little exposed to base rate fluctuations, banks are able to increase their share of long-term loans which are unaffected by short-term rate changes. This means that lending rates also fall by a smaller margin.

- An empirical analysis found that a 1%p change in the call rate, which moves in line with the base rate, adjusts the deposit and lending rates by 0.53%p and 0.58%p, respectively, indicating that the fluctuation (0.05%p) in the net interest margin is statistically insignificant.

■ Therefore, the possibility of financial instability due to a deterioration in bank profitability on a rate cut by the central bank should not be deemed as a constraint.

Summary

Research Monograph KOR Interest Rate Risk, Bank Profitability, Financial Stability and Financial Consumer Welfare

This study largely consists of two parts. The first part analyzes the relationship between market rates and bank profitability while the second examines the relationships between deposit and market interest rates, and that between deposit and loan size. Each part encompasses a micro-theoretic analysis that focuses on imperfect competition in the deposit market, and an empirical analysis that uses Korea’s aggregate-level and bank-level variables.

The theoretical analysis found that as deposit banks gain market power through imperfect competition in the deposit market, the sensitivity of deposit interest rates to market rates becomes very low. That is, when the market rate falls, the loan rate also falls to a similar level but the deposit interest rate does not, which reduces banks’ net interest margin, and leads to a deterioration in profitability. However, when it is additionally considered that banks can endogenously adjust the maturity of their assets and liabilities, a fall in the market rate would not have a meaningful effect on their loan-deposit margin because the deposit interest rate and loan rate have a low sensitivity to the market rate. The fact that the deposit rate has little sensitivity to the market rate means that banks are secure in terms of financing, and as such, they are not very exposed to interest rate risks; even when they handle highly profitable loans (fixed-rate or long-term loans) instead of variable rate or short-term loans. Accordingly, loan rates become less sensitive to market rates.

This theoretical prediction is supported by the empirical analysis in subsequent sections. By analyzing aggregate-level data, a very small negative relationship was found between the market rate and banks’ net interest margin. In addition, a panel cointegration analysis using bank-level data revealed that a 1%p drop in the market rate caused an approximate 0.05%p decrease in banks’ net interest margin. In other words, the profitability of banks is somewhat insensitive to the changes in market interest rates. Recently in Europe and Japan, some have argued that low interest rates could erode banks' profitability, and become a risk to the financial sector. Such an argument, however, could be dispelled by the implications from this study that indicate that the risk would not be as dire as expected.

Additionally, if the market power of deposit banks is strong enough, a fall in the market rate due to a policy rate cut will raise the demand for deposits. When faced with a choice between deposit or non-deposit investment products (financial products, real assets, etc.), deposit and market rates are important considerations for investors. This is because the rate of return on deposits is equivalent to the interest rate of the deposits while the (risk-adjusted) rate of return on non-deposit investment products is closely linked to the market interest rate. However, due to its unique characteristic as a means of payment (settlement), the interest rate of deposits is, in general, lower than the market interest rate. Thus, the difference between the market and deposit rates is negatively associated with the value of the deposits compared to that of non-deposit investment products. And, as the difference decreases, the demand for deposits increases. This study theoretically proves that when the market power of deposit banks is sufficiently high, the resultant decrease in the deposit interest rate is relatively small, even if the market rate decreases. This means that the difference between market and deposit rates narrows, leading to an increase in the demand for deposits.

The second part is again supported by empirical analysis. An analysis of aggregate-level data shows that a decrease in the market rate is closely correlated with an increase in the deposit demand. In addition, a panel cointegration analysis using bank-level data reveals that a 1%p drop in the market rate causes a 5.45% increase in deposits. It is also found that when the deposit, as a source of loans, increases by 1%, the loan increases by 0.73%. These results can be understood to mean that if the monetary authority cuts the policy rate to induce a 1%p decrease in the market rate, deposits will grow, leading to a 3.7% increase in loans. This suggests the existence of a new channel of monetary policy--the deposits channel.

Summary

Policy Study KOR A Study on the Delegation Management of Investments in Alternative Assets for NPS Funds

This study analyzes whether the current performance evaluation and compensation systems for alternative investment businesses in NPS funds are optimally designed to resolve incentive problems. The majority of alternative investment tasks are delegated to private equity funds (PEF), which have expertise in management and asset valuation of alternative investment assets. However, this expertise also gives rise to an inefficient transmission of information on the value of invested assets privately known to PEFs. Specifically, PEFs may have a distorted incentive to overestimate the value of invested assets to convince the NPS fund not to withdraw their funding until the investment has fully matured. On the contrary, PEFs also bear the cost of false reporting: they may be penalized by the regulatory authorities for any violations of good faith duties.

Combining moral hazard with strategic communication with lying costs, we find that PEFs’ incentive to misreport the valuation results is closely related to bonus pays that are contingent on the high return of invested assets. Specifically, the incentive to misreport is low if and only if the bonus pay is either very low or very high. We also find that the incentive to misreport grows stronger if the NPS fund rewards its employees based on the mid-term valuation of invested assets, suggesting that the mid-term performance evaluation with the NPS funds should be reconsidered. Lastly, we find that the optimal compensation system to resolve the incentive misalignment problems should contain a sufficiently large base upfront pay.

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