South Korea: A soft transition

Before the Basel Capital Accord in 1988, bank regulation in Korea did not factor in credit risks of the assets the banks kept on their books, and simply required a minimum level of paid-in capital.

As the Basel Committee on Banking Supervision introduced the first Basel Accord (Basel I) in 1988, Korea followed the global trend in adopting a minimum capital standard based on risk-weighted assets. In accordance with the 1996 amendment to the Basel Accord that addressed issues related to market risks in the banking sector, Korea also amended its financial regulatory system in 2000 (which became effective beginning in 2002) to evaluate market risk for supervising banks.

Financial regulators in Korea require all banks involved in international banking activities to maintain a minimum capital adequacy ratio (CAR) of 8% based on risk-weighted assets. Banks with a CAR below 8% are subject to prompt corrective actions by the Financial Services Commission (FSC) and the Financial Supervisory Service (FSS), Korea's prime financial regulators.

With the introduction of Basel II in 2004, Korea began to revamp its financial regulatory system to be fully compliant with the newly-adopted international standards for bank regulation. Thus the FSS began drafting the Guideline to Calculating the New CAR starting from late 2006; this was finalised and approved by the FSC in June 2007.

Originally the Guideline was to come into effect at the beginning of 2008. Based on the level of preparation of Korean banks, however, the regulatory authorities decided to postpone the implementation of the Advanced Approaches (one of the three risk-weighting methods allowed in Basel II), both for credit risk and operational risk measurement, to the beginning of 2009. This decision was also in line with the implementation schedule of other Basel Committee members such as the UK and Canada.

Korea became a member of the Basel Committee in 2009. Korea is also the founding member of the G20 which was established in 1999, and served as the chair of the Group for 2010. As a member of both the Basel Committee and the G20, Korea is committed to comply with its implementation schedule.

Based on this schedule, the FSC and the FSS have formed a task force for revising Korea's regulatory system, and will be able to finalise the redrafting of rules and regulations within 2012. The substance of Basel II is reflected in Article 34 of the Banking Act, Article 26 of the Regulation on Supervision of Banking Business, and Chart 3 of the Guidelines for Supervision of Banking Business. Therefore, introducing Basel III will essentially mean revising those laws, rules and regulations. Although the provisions granting the authority to regulate banks can be found in the Banking Act, revision of this Act will be minimal because the actual supervision of banks is based on the regulations and guidelines. Thus there should be very little legislative difficulty in implementing Basel III.

Based on the fact that Korean banks are relatively sound, compared with banks in some other countries, the impact of the implementation of the Basel III framework on Korean banks will likely be manageable. The three main enforcements of Basel III are CAR, leverage ratio and liquidity coverage ratio (LCR). Among the three, Korean banks already satisfy the proposed criteria under Basel III for CAR and leverage ratio, and thus implementation should not be much of a concern.

First, considering CAR, individual banks have met the standard for capital adequacy under Pillar I. The capital of most Korean banks consists of common equity, and the amount of capital measured against its assets is relatively large. Furthermore, unlike banks in the United Sates or Europe, their exposure to securitised products is not significant.

According to data released by the FSS, as of late September 2011, the average CAR for Korean banks under Basel II is 14.13%, much higher than the minimum requirement of 8% proposed by the Basel Committee. To provide some insight to these numbers, in mid-2011 the top 20 banks in the world had an average CAR of 14.69% (see The Banker, July 2011). Thus the capital adequacy level of Korean banks seems to be close to the global standard.

It should be noted, however, that these numbers were derived under the Basel II standard; there may be concern that these numbers will likely drop under the Basel III standard. According to the quantitative impact study issued by the Basel Committee on December 16 2010, however, while the average CAR of Korean banks does fall from 14.75% under the Basel II standard to 13.5% under that of Basel III, it is still sufficiently higher than the proposed minimum requirement.

In terms of Tier 1 capital only, the average CAR for Korean banks fell from 11.1% under the Basel II standard to 10.4% under the Basel III standard, but still remains high enough. Even the common equity ratio, which should be at least 7% (4.5% core tier 1 plus 2.5% capital conservation buffer) under the Basel III framework, is 10.3% for Korean banks. Korean banks in general will need very few adjustments, if any, to meet the requirements regarding the CAR even if Basel III were to be immediately implemented.

Although Korean banks are fairly well prepared from the viewpoint of Pillar I, there are some concerns regarding Pillar II. This pillar deals with the supervisory review process which allows regulators to evaluate a bank's internal capital assessment process and may also require banks with high risk to increase its equity holding above the bare minimum requirement (8%). Pillar II is equally applicable under the Basel III framework. In Korea, Pillar II is implemented through the FSS by assessing a bank's management condition, with its CAR being an important indicator. For example, if a bank wishes to receive the highest grade under this assessment, it must have a CAR of 10% or higher, regardless of whether requirements under Pillar I are met.

If the bank receives a grade below certain predetermined levels, then the bank must undertake corresponding corrective measures.

Recently the FSS has alluded to adopting a stricter standard for Pillar II. In particular, as banks quickly increase retail lending among their asset portfolio, the FSS intends to apply a higher risk-weight on high-risk retail loans. This will not affect a bank's CAR (Pillar I), but will increase the minimum requirement of capital under domestic rules (Pillar II). There remains some uncertainty going forward because the FSS has not finalised its regulatory approach under Pillar II, and thus Korean banks are increasing its cashable assets as a precautionary measure.

Financial holding companies must comply with the capital adequacy standard based on their consolidated financial statements that include not only their affiliated banks, but other affiliates as well. Thus even if the individual bank held by the holding company has sufficient capital, the same may not be true for the holding company itself. On July 20 2011, during a series of meetings with the executives of several financial holding companies, the FSS recommended that holding companies should raise more capital by increasing their cash reserve. The FSS specifically requested them to increase their Tier 1 capital ratio because there are concerns that they might fail to meet the higher standard set by Basel III.

The consolidated Tier 1 capital ratio for Korean financial holding companies as of September 2011 was 10.43%. Looking at the top four, KB had the highest Tier 1 Capital Ratio with 10.72% followed by Hana (9.67%), Shinhan (9.05%) and Woori (8.79%). Although the bare minimum requirement for Tier 1 capital is 6%, the actual minimum requirement is 8.5% when the capital conservation buffer of 2.5% is taken into account. Adding to that the counter-cyclical buffer that ranges between zero and 2.5% and the Sifi (systemically important financial institution) surcharge that is under review, Korean financial holding companies will have very little breathing space in meeting the capital adequacy standard under the Basel III framework.

Because the Korean bank supervisory system has been using tangible common equity ratio, which is similar to the leverage ratio under Basel III, in order to assess a bank's management condition, Korean banks will not need a radical change in the event of Basel III's implementation.

All of the large banks have maintained the highest grade under such assessment, and according to the Basel Committee's quantitative impact study, large Korean banks have an average tangible common equity ratio of 4.6% which is significantly higher than the minimum requirement of 3%.

On the other hand, Korean banks may have difficulty fulfilling the requirements regarding LCR under the Basel III framework. The quantitative impact study indicated that large Korean banks had an LCR of 76% and a net stable funding ratio of 93% – figures which fall below the minimum requirement. Fortunately, because it has been agreed that the LCR standard will be implemented by 2015, banks will have some time to prepare.

Regarding new supplemental capital, the one primarily under review is contingent convertibles (so-called CoCos). Under Basel II, banks heavily relied on subordinated debt in order to meet the CAR, but under the new Basel III standard, subordinated debt may be only partially admissible as adequate capital, and thus banks face a big hurdle in finding a substitute source to fund the newly-defined supplemental capital. As for CoCos, the Commercial Law and Enforcement Decrees of the Banking Act have already been amended in 2011, and guidelines regarding bank supervision that set the standard for adequate capital are scheduled for publication during the first half of 2012.

Second, even though the Basel Committee has already finalised the regulatory framework for global Sifis (G-Sifis), at this time there are no financial institutions in Korea that can be considered to be a G-Sifi. Local subsidiaries of foreign banks such as Citibank Korea may encounter some difficulty because their headquarters will be subject to G-Sifi regulation, on top of having to comply with local regulation. Issues also remain as to whether or not the headquarters may be permitted to hold CoCos raised by its Korean subsidiary as its own supplemental capital and, if so, how much it will be allowed to hold. These issues have not yet been clearly addressed.

Third, the Basel Committee has recently taken under review the consideration of capital surcharges on domestic Sifis (D-Sifis); this will be finalised during the G20 meeting in June 2012.

Each member country will have until June 2013 to complete its own domestic rule-making process. This is the same timeline that Korea plans to follow. Because the cost of capital directly relates to a bank's profit level, Korean banks are very interested in which banks will be designated as D-Sifis and how much additional capital they will be required to raise.

Fourth, because Korean banks are having difficulty in meeting the LCR requirement, financial regulators have been repeatedly issuing warnings. An issue related to this matter is that, under Basel III, only corporate bonds with a credit rating equal to or higher than AA- by a recognised external credit assessment institution will be eligible for the purpose of measuring liquidity. Because Korea has a grade A sovereign rating for overseas debt, many of the overseas bonds issued by local entities may not qualify as liquid assets under Basel III. As this approach may have a negative impact on Korean bond market, especially at the time of financial stress, the Basel Committee should consider relaxing the standard.

Finally, legal entity reorganisation (which has been a big problem in the United States and Europe) has not yet become an issue in Korea. This is because the significance of banks within a financial holding company is much greater than that of the other non-banking financial units, and thus financial group reorganisation in order to segregate the prop trading section is rather insignificant.

Biography
		Sang Hwan Lee Kim & Chang Sang Hwan Lee is a partner in Kim & Chang’s banking, securities regulations, investment management, and derivatives practice groups. He practises in a wide range of areas of finance-related law, with a focus on banking laws and regulations and M&A of financial institutions. He also has extensive experience advising clients in financial derivatives transactions and corporate finance matters. His representative works in recent years include advising on significant M&As of domestic banks and post-transaction integration of banks and representing financial institutions investigated by the Financial Supervisory Service. He has also acted as an outside adviser to the Ministry of Finance and Economy as a member of the ministry’s Financial Industry Deliberation Committee and as a member of the ministry’s Task Force for Improvement of Credit Information System. Sang Hwan Lee received his BA in law from Seoul National University and his LLM from Cornell Law School. He is admitted to practise in Korea and New York.

Biography
		Sang Hoon Lee Kim & Chang Sang Hoon Lee is a member of Kim & Chang’s banking, securities regulations, investment management, and automobile industry practice groups. He advises clients on areas ranging from development stage ventures to large public companies in regulatory, transactional and general corporate issues. As a member of the banking and securities group, he has a wide range of experience representing various financial institutions on matters regarding banking, securities laws and regulations and derivative transactions. He also has extensive experience in advising clients in the automobile industries. His practice areas include disputes relating to finance, accounting and corporate governance. Sang Hoon Lee received his LLB from Seoul National University and his LLM from Georgetown University Law Center in 2007. He was admitted to practise in Korea in 1998 and was certified as a US CPA in 2007.