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Chapter 9 The Korean Banking Crisis: Picking up the Pieces

Author(s):
International Monetary Fund
Published Date:
January 2001
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As is well known, the industrial policy of the Korean government during the 1970s gave rise to the chaebol groups, i.e., large family controlled industrial conglomerates. These companies, unlike traditional Korean companies, focused on the production and export of products in heavy industries such as industrial machinery, electronics, chemicals, autos, and shipbuilding. During this time, Korean commercial banks were instructed to allow easy credit access (at favorable loans rates) to the firms in these industries. This policy required additional sources of funding that the existing commercial banks were unable to meet. Subsequently, the government established specialized banks to fill the gap. Toward the latter part of the 1970s, policy loans, i.e., loans which supported government programs and aimed primarily at the chaebol companies, accounted for nearly eighty percent of domestic credit extended during that period. During this same period, tightly regulated non-bank financial institutions were introduced into the economy in an effort to diversify financing sources and to attract funds into the organized market. The development strategy bolstered the expansion of existing firms into targeted sectors through preferential access to bank credit at below-market rates. These firms not only expanded rapidly into many areas of specialization but also into many which were not explicitly targeted by government policy. As a result, these firms grew into internationally recognized economic conglomerates and dominated the Korea economy. These firms also held equity investments in the commercial banks.

Although the economy was growing at a rapid pace under this strategy, some government policymakers recognized that privatization and deregulation of the banking sector was imperative. Market mechanisms provide banks with the incentive to exert self-discipline to effectively allocate financial resources, which is necessary to sustain economic growth. The government began to re-privatize the banking system near the end of the 1970s and undertook an additional series of financial reforms in the early 1980s. With revisions to the General Banking Act in 1982 and the launch of a new five-year economic plan in the early 1980s, direct government controls over banking practices were eased, and permissible banking activities were expanded. For example, permissible banking activities were expanded to include a wide variety of fee driven non-interest income activities including sales of commercial bills and government and public bonds under repurchase agreements. The government also had a stated goal of eliminating policy preference loans in the banking sector and further steps were taken to liberalize interest rates.1

Further reforms were announced when the General Banking Act was revised again in 1991 and 1994. These revisions gave commercial banks further autonomy in their business activities and management. For example, banks were allowed to act as leading underwriters for government and public bonds. In 1991, a four-stage plan for the full liberalization of interest rates was announced to effectively set the price mechanism of interest rates. Through interest rate deregulation, the competitiveness of domestic financial services industry could be strengthened to cope with continued global financial liberalization.

As is evident from the recent collapse of the Korean banking system, the liberalization initiatives were, in a large sense, proven ineffective. With a growing number of large corporate failures and mounting domestic debt, Korean banks are currently bearing the consequences of widespread corporate insolvency. As such, much of the country’s current economic crisis can in part be traced to the failure of the financial reforms to take effect and to the collusive links among the Korean government, the chaebol, and the privatized banking industry (the so-called crony capitalism).

Immediately following the collapse of the Korean economy, the country’s unemployment rate reached its highest level in thirty-one years and during the first half of 1998, the country’s GDP shrunk 5.3 percent—the largest drop in Korean history. This situation is not expected to improve dramatically in the near term. Against this backdrop, the short-term prospects for the Korean banking sector appear dire indeed. Most bank stocks are now trading well under $1 per share and twelve small merchant banks and five small commercial banks were closed by the Korean government following the imposition of the IMF rescue package. With nonperforming loans approaching as much as forty percent to fifty percent of GDP and expected to rise further before falling, future prospects for the Korean economy depend significantly on the ability of the government to recapitalize and restructure the banking and financial systems. The prospects also depend on the country’s ability to break the collusive links among government officials, the chaebol, and the banking industry.

The government officially began its major bank-restructuring program in early 1998 and has committed to complete a significant amount of the needed restructuring of the financial sector by the end of 1998. As of October, of the twenty-six commercial banks in existence at the end of 1997, two banks—Korea First Bank and Seoul Bank—have been nationalized and are being prepared for sale to foreign investors. Twelve banks that failed to meet the eight percent Bank for International Settlements (BIS) capital adequacy standard at the end of 1997 were asked to submit rehabilitation plans and were subjected to asset quality diagnostic reviews. The plans of five of these twelve banks were deemed infeasible and these banks had their licenses suspended and are in the process of being acquired by five banks deemed be stronger (with the addition of public support) under purchase and assumption transactions. The remaining undercapitalized banks received conditional approval to operate and most are currently in the process of seeking merger partners. The nine healthy banks not involved in mergers, including the five involved in purchase and assumption transactions, continue to operate under strict supervision to insure that they do not become distressed.

It should also be noted that several banks deemed to be most healthy have been identified as lead banks in corporate restructuring for the sixty-four large chaebol groups deemed to be in financial distress. These banks include: Commercial Bank of Korea, Cho Hung Bank, Hanil Bank, Korea Exchange Bank, and Bank of Seoul. These banks have created internal workout units which will address their chaebol bad loan problem. These bank workout units will be assisted by external financial advisors retained under the World Bank’s technical assistance loan.

Of the many interesting questions one might ask regarding the Korean banking system restructuring effort, one involves the question of the relative economic performance of the banks that have been designated as lead or acquiring banks in the restructuring (either by government fiat or voluntarily) during the period prior to the crisis. While such factors as the level of nonperforming loans and other accounting ratios were undoubtedly key in determining which banks were designated as lead banks, it is interesting to see whether these banks had the most effective management and were the more efficient producers of intermediation services during the period prior to the crisis. To this end, the results of a recent study (Hao et al., 1998) examining the efficiency of the private Korean banks between 1985 and 1995 are informative.

This study begins by estimating the level of efficiency of each bank in the sample. Rather than concentrating on traditional scale and scope analysis of productive efficiency, the study concentrates on management efficiency. Recent research in banking indicates that ineffectiveness in managing resources accounts for a significantly higher percentage of costs compared to scale and scope efficiencies. Furthermore, instead of comparing the operating performance of the sample banks with a set of superior-operated banks by using financial ratios, the study uses production theory and econometric procedures to extract information on managerial efficiency.

The stochastic frontier approach was used to calculate a measure of production efficiency for each bank in the sample. This approach uses a parametric technique to estimate the characteristics of “best-practice” banks. These best-practice banks represent institutions which produce their financial products and services at the lowest cost using the most efficient mix of productive inputs or factors of production. Individual bank efficiency indices were measured by computing the deviations of costs from the cost frontier estimated from the sample data. This inefficiency factor captures both allocative inefficiencies from failing to react optimally to relative prices of inputs, and technical inefficiencies resulting from employing excessive amount of the inputs to produce outputs. In this framework, systematic deviations of cost from the frontier or best-practice levels are associated with poor management. Random deviations are attributed to uncontrollable factors that affect total costs, such as weather, luck, labor strikes, or machine performance.

To calculate each bank’s efficiency index, we first fitted a stochastic frontier cost function to characterize the efficient frontier for the sample banks. Total costs included all labor costs, physical capital expenses, and allocated interest expenses. Three output quantities were included in the cost function: total loans and securities, demand deposits, and fee income. The prices of inputs used in the production of bank assets were the wage rate, interest for borrowed funds, and the price of physical capital. The cost function also included equity capital for each bank. It was used to adjust for increased costs of funds due to financial risk. Using this methodology, the most efficient bank in the sample had efficiency score of 1.0 and the least efficient bank had a score of 0.

The banks included in the sample along with their efficiency scores are presented in Table 1.

Table 1.
Bank NameAverage

Efficiency
Standard

Deviation
MinimumMaximum
Cho Hung Bank0.90809180.02057540.88230580.9494293
Kookin Bank0.84962470.09412740.67053320.9577079
Hanil Bank0.85162100.04599960.77265630.9092797
Korea First Bank0.82306040.08070170.67379050.9371849
Commercial Bank of Korea0.87074370.05102450.78510770.9523536
Bank of Seoul0.93424830.03643890.86758670.9716806
Shinhan Bank0.91911860.04471350.82540230.971082
Korea Exchange Bank0.75718750.13220260.57582390.9323697
KorAm Bank0.90636660.06479560.75611790.9614145
Daegu Bank0.91140720.04078670.8165410.9516561
Pusan Bank0.84460820.0490140.75875630.9282293
Kwangju Bank0.87293110.06742260.70889320.9589421
Chungbuk Bank0.76438860.11300810.52669240.9281676
Chung Chong Bank0.87636450.06312930.76263390.9589659
Kangwon Bank0.85232740.06802080.72408660.9351441
Kyungki Bank0.85510510.0704520.75892810.9637721
Kyongnam Bank0.85739980.07948250.71675670.9663202
Jeonbuk Bank0.87778080.06932470.73000030.9612096
Bank of Cheju0.93044480.03836380.84852340.9734144

The grand mean efficiency score for the sample was 0.866 with a standard deviation of 0.082. The highest efficiency index in the sample was 0.9734 while the lowest index was 0.5267. The mean efficiency index is well within the range estimated for other countries, including the U.S. Studies that have used stochastic econometric methodologies have found efficiency on the order of twenty to thirty percent in U.S. banking. The average bank in our sample would have increased its efficiency level about 13.4 percent had it been able to operate on the efficient frontier.

Regarding the disposition of the banks included in the original sample, as of September 1998, two of these banks—Korea First Bank (average efficiency score of 0.823) and Bank of Seoul (average efficiency score of 0.934)—were nationalized. The Commercial Bank of Korea (average efficiency score of 0.871) and the Hanil Bank (average efficiency score of 0.852) are merging on a voluntary basis. The Kookim Bank (average efficiency score of 0.85) acquired the Dae Dong Bank, a failed bank not included in our original sample. The Kookim Bank has subsequently become involved in a merger transaction with Korea Long-Term Credit Bank. Two banks—Chung Chong Bank (average efficiency score of 0.876) and Kyungki Bank (average efficiency score of 0.855)—have been closed and sold in purchase and assumption transactions with banks not in our sample. Two banks—Shinhan Bank (average efficiency score of 0.919) and KorAm Bank (average efficiency score of 0.906)—are acquiring failed banks in purchase and assumption transactions. KorAm is acquiring Kyungki Bank, one of the failed banks in our sample.

Regarding the question of the lead bank’s managerial capacity to restructure the acquired banks, it appears from this study that the lead banks identified by the Korean officials were on average more efficient than the banks being acquired or closed during the pre-crisis period. In addition, most of the lead banks typically were among the set of banks that exhibited improving efficiency scores after the 1991 deregulation. Thus, on the basis of these results, it appears that the management of these banks may be the most qualified to lead the restructured banking institutions.

It should be noted that the impact of chaebol bankruptcies on the Korean banking sector cannot be overstated. For example, the failure of Korea First Bank (average efficiency score below the sample average) can be traced directly to the failure of its key chaebol borrowers: Kia motors, Hanbo Iron and Steel, Sammi, New Core, Sinho, and Tongil. Similarly, the Bank of Seoul (average efficiency among the highest in the sample) was brought down by the failure of its main chaebol customers: DaeNong, ChungGu, HanshinGongYoung, and Jindo.

In conclusion, although the process of rationalization of the Korean banking sector seems reasonable from a bank performance perspective, one might question the decision of the Koreans to merge some of the best performing banks into one organization reducing the number of competitively viable institutions in the market. Given the importance of a competitive banking sector to the process of economic growth and development it could be argued that the most efficient banks should be merged only with less efficient ones, thereby preserving the maximum number of competitor banks in the system. Although some Korean analysts argue that Korea needs a few large globally competitive banks, to compete in international markets and to serve Korea’s large multinational corporations, this argument ignores the negative consequences which would follow from a more concentrated domestic banking industry (for example, the proposed merger between the Commercial Bank of Korea and the Hanil Bank would control almost fifty percent of the country’s banking assets). Clearly, the possible adverse consequences of such a high level of concentration deserves careful evaluation.

Note

Beginning in 1984, banks were permitted to vary their lending rates within a limited range depending on the creditworthiness of borrowers and to increase competition, openness, and efficiency, the government further lowered both entry barriers for bank and nonbank financial institutions and restrictions upon foreign bank branches. New commercial banks and investment and mutual savings companies were established as a result of the policy change. Discriminatory restrictions were also reduced to allow for equal treatment between foreign and domestic banks. Foreign banks were able to access the central bank rediscount window for financing and to engage in trust activities.

Reference

    J.HaoW. C.Hunter and W. K.YangDeregulation and Efficiency: The Case of Private Korean Banks,Federal Reserve Bank of Chicagoworking paperNovember1998.

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