KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

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

□ 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.

Summary

Research Monograph KOR Bail-in, Implementability and Policy Implications

This paper examines the implementability of bail-in―a special bank resolution regime that reorganizes failed banks at the expense of creditors not taxpayers. In the first part of the paper, I consider the statutory bail-in case. I find theoretically the existence of multiple equilibria. If investors believe that the government will choose bailout (bail-in) in case of bank failure, the government indeed chooses bailout (bail-in). I also find that the depositor preference could be a commitment device by which the government can persuade the investors that it will choose bail-in. In the second part of the paper, I consider the contingent convertible bond (or CoCo bond), which is designed as a contractual bail-in tool. I find theoretically the same existence of multiple equilibria. Also, I show that if the government requires CoCo bond issuing banks to use rule-based triggers instead of discretionary triggers, the government can credibly persuade investors that it is tough. As a result, the equilibrium interest rates of CoCo bonds with discretionary triggers are lower than that with rule-based triggers. I confirm this theoretic prediction by conducting an empirical study. Using a CoCo bond issuance dataset from Moody’s and Bloomberg, I find that the interest rate gap is on average 2.5~3%p. The theoretic and empirical analyses imply that CoCo bonds with a discretionary trigger does not work effectively as a contractual bail-in tool.

Summary

Policy Study KOR Evaluation and Policy Implications of Personal Loan Modification Programs in Korea

This study attempts to derive policy implications in response to the acute increase in applicants for the reconstructive personal bankruptcy (Chapter 13 style). Thus, this study analyzes the determinants of debtors’ choice among various debt relief programs. This study also compares the characteristics of two programs, the reconstructive personal bankruptcy by the Court and the private debt modification program by the CCRS (Credit Counseling and Recovery Service). Main findings and implications of this study can be summarized as follows.

Firstly, analyzing the regionally aggregated data, we found out that the increase in the amount of household debt and the portion of high interest loans induced the recent increase in the number of applicants for the reconstructive personal bankruptcy. Moreover, we investigated the sample of debtors in Seoul who used the reconstructive personal bankruptcy and the private debt modification by the CCRS. We found out that the debt structure of an average debtor became more vulnerable in the period between 2012 and 2013, with the increases in the amount of total debt, in the portion of high interest loans, and in the number of creditors. Accordingly, we emphasize the necessity to enlarge the preemptive credit counseling for the over-indebted so that they could switch their consumption habits and debt structure.

Secondly, with the analysis of regionally aggregated data, we also found out that past rulings and attitude of the Court affect the choice of debtors. The nationwide declination in the number of applicants for liquidating personal bankruptcy (Chapter 7 style) can be explained by the strict procedure of the Court in Chapter 7 since 2007. And the regional variety in the ratio of applicants between Chapter 13 and the debt management by CCRS can be explained by the Courts’ acceptance rate of Chapter 13. Thus, abusive use of the reconstructive personal bankruptcy could be restrained if the Court reinforces its screening process.

Lastly, this study shows that the average reimbursement rates are similar between the reconstructive personal bankruptcy and the personal debt management by CCRS, and thus low-cost private debt management program could be more beneficial to debtors in some cases. Therefore, debtors should bear in mind that their legal agents might try to induce them to the Court for legal fee incentive. On the other hand, this study also demonstrates that the probability of failure with debt management by CCRS becomes larger for debtors in the category of a high debt-to-income ratio, the self-employed and older people. Thus, when the CCRS considers the probability of failure is high for some applicants, the CCRS should refer them to the Court and this will help increase the efficiency of debt modification procedure.

In addition, this study also introduces an existing discussion about the improvement plan of the debtor recovery system and suggests some proposals.

Summary

Policy Study KOR Risks in International Capital Flows: Foreign Investors’ Behavior in Korean Stock and Bond Markets

This paper studied the pattern of international capital flows in Korean financial markets to analyze their risks. In particular, this paper focused on foreign investors’ behavior responding key investment factors in Korean stock and bond markets, in which capital flows have become more volatile recently. It was found that foreign investors tended to retrieve their investment when global risk aversion (VIX) was high or when global liquidity (the U.S. short- term interest rate for stock markets and global money supply for bond markets) was reduced. The response to VIX was statistically significant in stock markets, but the significance level in bond markets was relatively low. This result reflects that foreign investors consider Korean bonds to be safer than Korean stocks are. This paper, in addition, founded that the significance levels are different across global liquidity indices, which implies that each index reflects different aspects of investment factors and hence investors respond accordingly. For domestic economic fundamentals, rather, foreign investors tended to retrieve their investment when the coincident indicator of business cycle improved. It is interpreted as domestic economic fundamentals are more important investment factors to domestic investors than to foreign investors. That is, in adjusting portfolios foreign investors put more weights on global factors whereas domestic investors on domestic factors.

Next, this paper explored the association between capital market openness and the pattern of international capital flows. In Korean stock and bond markets, foreign investors’ response to global risk aversion (VIX) is not significantly associated with capital market openness; that to global liquidity (the U.S. short-term interest rate for stock markets and global money supply for bond markets), however, was greater as capital markets were more integrated. It suggests that as capital markets are integrated, foreign investors’ response to some global factors might increase.

This paper also showed that foreign investors’ behavior in Korean stock and bond markets might be different by their nationality. In particular, it was found that it is difficult to identify the risks by looking just at relative volumes or relative volatilities across investors’ nationality. This paper, therefore, suggested that it is insufficient to analyze only total international capital inflows and it is necessary to understand the specific properties of international capital flows with disaggregated data.

Summary

Research Monograph KOR Financial Regulations on International Capital Flows and Exchange Rates

It has been widely known that global market openness and globalization have contributed significantly to the economic development of emerging markets, but now negative impacts have started to loom as a rapid cross-border capital flow after the global financial crisis has caused financial systems of emerging markets to become weaker. Accordingly, direct and indirect policy responses to international capital flows have been a key challenge for monetary and financial authorities of emerging markets.

Preceding studies understood that globalization has greatly helped emerging economies get easy access to required capitals for their economic growth and better quality of life, and that it is foreign financial institutions and global financial markets which played a critical role in this process of propelling capital flows. However, in the wake of the East Asian financial crisis in 1997 and the global financial crisis in 2008, emerging markets have revealed vulnerability in their financial systems, while it was found that the global financial system and international financial institutions also hold problems, thus resulting in requests for a new financial regulatory system on international capital flows.

This issue is also very important for Korea, with a high degree of openness, in the aspect of financial stability. With the onset of the global financial crisis in 2008, local banks experienced a halt in foreign capital inflow and the won depreciated sharply. Recognizing the risks involving cross-border capital flows, the Korean government responded with policies for macroeconomic prudence such as developing new regulations on international financial transactions. This study, based on empirical analysis of international financial transactions and case studies of emerging market economies, intends to suggest financial regulatory measures on the international capital flows and foreign exchange market in Korea, while particularly focusing on macroeconomic prudential policy, capital control and foreign exchange reserve; the chapter for macroeconomic prudential policy examines the need of macroeconomic prudential regulations and current status of its adoption in emerging market economies, followed by reviews on the impacts the same regulations had on Korea; the chapter on capital control includes feasible suggestions that could be more adoptable in reality than guidelines provided by IMF; and the chapter on foreign exchange reserve discusses theoretical models considering welfare effects and empirical effects of exchange rates of reserve assets.

Summary

Policy Study KOR Global Transmission of Financial Instability

This study aims to understand the transmission of financial turmoils across countries by analyzing the co-movement of stock markets. In addition, it attempts to figure out how the Korean stock market is exposed to the global markets by assessing potential determinants of the co-movement between Korean and the U.S. stock markets. Based on these results, policy implications are discussed to mitigate the international transmission of financial turmoils.

The DCC-GARCH model is employed and estimated to analyze the international co-movement of stock markets. It is found that the synchronization of volatility and returns of stock markets across countries have been strengthened while volatilities have converged to a similar level for major countries after the global financial crisis. In addition, common shocks seem to have contributed most to the strengthened synchronization of stock markets if shocks to stock returns were broken down into common and idiosynchratic components. Furthermore, the enhanced co-movement between stock markets during the global financial crisis can be explained by the worsening conditions of the short-term credit markets and the increased uncertainty of the global financial markets. These results imply that international cooperation may be sought to mitigate the international spillover of financial turmoils. Also, each country’s efforts could be sought to mitigate the negative impacts of the global financial turmoils as sovereign risks and foreign investors’ trading volumes may contribute to the propagation of financial turmoils.

Summary

Policy Study KOR Risk Assessment of Korean Households’ Indebtedness: Evidence from CB Data

We analyze and assess the risk of Korean households' indebtedness based on credit bureau(CB) data. In particular, obligers' credit risk is stress-tested while the size and characteristics of vulnerable obligers are identified in this micro-level analysis.

The present study shows that the share of the overly-indebted has increased while households' risk-adjustment processes at the micro-level have weakened since the global financial crisis in 2008. This result implies that credit risks of the indebted households have increased so that the household sector has become less resilient to external shocks during the period. In particular, the overly-indebted, the obligers from multiple nonbank financial institutions and the self-employed borrowers seem vulnerable so that their overall picture and characteristics are analyzed and documented in this study. In addition, there are a relatively large number of vulnerable obligers belonging to the brackets of low income and low credit worthiness so that social issues such as rising delinquencies may arise if the overall economic conditions suddenly deteriorated due to unexpected shocks for example. Nevertheless, it is not very likely for financial stability to be heavily damaged because the amount of personal loans held by the risky obligers are relatively small compared with the total amount of household debt.

There is a rising concern that personal loans may be exposed to higher risks as the GDP growth rates slow down while the global economy remains uncertain. The assessment of the impact of stress scenarios corresponding to the 2008 global financial crisis on the delinquencies shows that the nonbank borrowers, the self-employed and the indebted from multiple nonbank financial institutions could be financially distressed if the overall economic conditions were suddenly worsened. In addition, the credit risks of personal loans could be heightened due to supply side factors or financial market conditions if macroeconomic conditions suddenly change even without increases in the debt-servicing burden of households.

The results of the present research may contribute to understanding the risk structure of household indebtedness and designing policy directions for financial as well as social stability.

Summary

Policy Study KOR Structural Issues in the Korean FX Market during the 2008 Global Financial Crisis:Empirical Investigation of FX Risk Management by Nonfinancial Public Firms

Many countries were hit hard by the global financial crisis of 2008. Korea was no exception. With global liquidity quickly drying up, Korean banks failed to roll-over their dollar debt, the value of Korean won nose-dived against the U.S. dollar, and the size of foreign exchange reserve plummeted in the process of intervention.

At first glance, the reason behind this acute foreign exchange liquidity crisis is not very different from the one we experienced during the Asian crisis, back in the late 1990s. Korean Banks had huge dollar debt, mostly in short-term. At second look, however, there are fundamental differences. Back then, the crisis was triggered, in large part, by local problems. This time, the crisis originated outside of Korea, triggered by problems in other countries. The nature of excessive short-term dollar borrowing is also quite different. Back then, it was to support Korean corporations. This time, it was to square the long dollar position Korean banks entered when it purchased dollar forwards from the Korean ship manufacturers and Korean overseas portfolio investors that were hedging against the possibility of Korean won appreciating. In other words, FX risk management using FX derivatives was at the heart of the crisis.

Against this backdrop, in this research, I ask two important questions. First, why were forward buyers virtually absent during the pre-crisis period? More specifically, I ask why firms importing raw materials were not hedging against FX risk using forward buy contracts. If they did, sufficiently enough to offset the forward sell contracts, Korean banks would not have borrowed so heavily to square their positions, and Korea could have escaped from the crisis. Secondly, I ask if the ship builders that were entering forward sell contracts over-hedged their risk exposure. If they did, that could be one factor that exacerbated the crisis.

Regarding the first question, my empirical work gives two interesting results. First, firms importing raw materials are often also exporters, where a large part of their foreign exchange losses from higher import prices are offset by their increased export revenues. In other words, their transaction or translation losses are netted out by their economic gains, thus making it unnecessary to enter forward buy contracts. Second, in the case of oil refineries that import crude oil, I find that their domestic gas prices are negatively correlated with the value of Korean won against the U.S. dollar. This provides extra cushion to absorb losses from higher import prices, again making it unnecessary to use derivatives to hedge.

Regarding the second question, I investigate the three major ship builders and find some evidence of over-hedging. When the underlying exposures are estimated conservatively, one firm had a hedge ratio of 120 percent. Also, there is a firm where the fraction of speculative forward sell contracts takes up 5-10 percent of the total. These findings support the recent government move to lower the hedge ratio limit from 125 percent to 100.

This research also explores and identifies the future risks in the Korean foreign exchange market. Foreign fixed income investment, which is growing rapidly in recent years, is usually hedged in the off-share market, known as the NDF market. Korean banks also participate in this market and take short dollar positions. If Korean ship builders and overseas portfolio investors reemerge as major forward sellers, Korean banks will have more room to take short dollar positions against foreign fixed income investors. Although banks’ FX position will be squared and free from FX risk, a build-up of long position against residents and a build-up of short position against non-residents can be a source of systemic risk. This is because, in the event of sharp depreciation of Korean won, residents who are in short position must make dollar payments to nonresidents in long position. There would be a sudden capital outflow in the financial derivatives account. The problem is that it would not stop there. Sudden capital outflow can further depreciate the currency, which can then trigger another round of capital outflows. In an extreme case, this spiral effect can cause another FX liquidity crisis.

This prediction is not without any empirical basis. If one carefully investigates the 2008 balance of payments account, Korea experienced a huge capital outflow in its financial derivatives account. Thanks to the minimal presence of foreign fixed income investment back in 2008, most of the outflows were offset by inflows in the same account. But, things can be very different next time when the size of foreign fixed income investment is much larger. Therefore, this research calls for the government to closely monitor banks’ FX derivatives transactions and review the possibility of setting a limit on the aggregate amount of net short positions again nonresidents.

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