Information about Asia and the Pacific Asia y el Pacífico
Asian Financial crises

Chapter 15 Korea’s Financial Sector Reforms

International Monetary Fund
Published Date:
January 2001
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Information about Asia and the Pacific Asia y el Pacífico
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Korea has made great strides in its financial sector reforms, but many challenges remain. Most importantly these concern the deep links between corporate and financial sector reforms and the large fiscal resources required to resolve the current under capitalization of banks. This paper draws on work of other World Bank colleagues, in particular Ira Lieberman and Bill Mako. It also draws on information from the Korea government, in particular, Korean Government’s Economic Reform Progress Report. Helpful comments were received from Jose De Luna Martinez and participants in the conference, Asia: An Analysis of Financial Crisis, Chicago, October 8-10, 1998, jointly organized by the Federal Reserve Bank of Chicago and International Monetary Fund. The opinions expressed are the authors’ own, however, and do not necessarily reflect those of the World Bank. For comments, please contact Stijn Claessens, e-mail:, fax: (202) 522-2031.


1.1 Underlying problems

Difficulties in the corporate and financial sectors have been at the core of Korea’s financial crisis. The incentive framework for the financial sector did not lead to an efficient allocation of resources or promote the institutional development of financial institutions that adequately appraise risks. Poor credit culture and the lack of adequate risk analysis and management were two main weaknesses. Following a long period of government control, liberalization measures in the late-1980s and 1990s were mostly half-hearted and often not backed up by improvements in the supervisory and disclosure framework. Merchant banks, for example, were allowed to operate under more liberal capital adequacy requirements than commercial banks while they are inherently more risky. Prudential rules and their applications had fallen behind international best practices and differences existed between the treatment of various related financial instruments and institutions. Supervision of financial institutions was weak, scattered over various government agencies, and mostly focused on compliance with rules, rather that on assuring soundness and proper management. Especially in the area of dealing with troubled financial institutions there was a legal and institutional vacuum. Despite steps to increase openness, such as those negotiated with the Organization for Economic Cooperation and Development (OECD), Korea’s financial system remained protected from foreign competition, with a low share of foreign investment in capital markets and limited foreign ownership of financial institutions. Earlier reform plans, such as those suggested by a presidential financial reform commission in early 1997, failed to gain enough political support.

Adding to the financial sector problems were difficulties in the corporate sector and its competitiveness. Major corporations (chaebols) had undertaken ambitious expansion, and diversification drives in the last few years, including numerous overseas investment projects. The expansion drives were funded with very aggressive borrowings from Korean commercial and merchant banks, often short-term. Banks relied mainly on collateral in the allocation of credit and relatively little attention was paid to the earnings performance and cash flow generation, or the corporates’ ability to repay. The chaebols generally supplied guarantees to their affiliates and subsidiaries to secure loans. The Korean stock market is thinly capitalized, and chaebols have traditionally raised little in new equity. The government often supported this expansion and directed chaebols into specific lines of business.

The policy of aggressive, leveraged expansion worked well as long as the economy and exports expanded vigorously and returns on new investment exceeded the cost of capital. In recent years, however, all measures of financial performance among the thirty largest chaebol worsened—free cash flow, return on equity, profit margin, and debt coverage ratio—while their debt/equity ratios continued to rise. Rapid wage increases, a result of a highly unionized and strong labor force, often outstripped productivity growth. Declining demand and falling prices for Korean exports—particularly in semiconductors, chemicals, shipbuilding and steel markets—in part associated with a depressed Japanese economy and weakened yen, further weakened profitability in the last years.

The low internal profitability fuelled large borrowings in the last few years, from both domestic and foreign sources, and debt-equity ratios rose to over 30 percent by 1996. The very complex system of cross guarantees from affiliates within the group, as well as personal guarantees, allowed loss-making affiliates to continue to borrow from banks and drain financial resources from healthier affiliates. Serious problems began to surface starting early in 1997 and drew attention not only to the weakness of many conglomerates, but also to banks closely related to the business groups. On January 23, 1997, Hanbo Iron and Steel, Korea’s second largest steel maker, was unable to honor its promissory notes and was forced to file for bankruptcy. The collapse of Hanbo was followed in quick succession by a series of other business failures. Key financial ratios deteriorated further and by end 1997, the debt/equity ratio of the thirty largest chaebols reached an average of 500 percent (600 percent if the debt of their financial subsidiaries is included). This compares with an industrial country norm of below 200 percent, and is four times the Taiwanese ratio. Total corporate debt is currently estimated to be on the order of $500 billion (or more than 150 percent of GDP at current exchange rates), of which around ninety percent is domestic.

1.2 Spillovers and initial policy responses

Following the devaluation of the Thai Baht—which had heightened investor sensitivity—investor concerns about Korea grew in the face of mounting evidence of difficulties in the corporate and financial sectors especially the liquidity positions of merchant banks. In response, the government announced on August 25, 1997 that it was committed to providing financial support to commercial and merchant banks and that it would ensure repayment of foreign debt liabilities of Korean financial institutions. It also announced that all financial institutions would be required to submit restructuring plans to be implemented over a period of three to five years. The market, however, remained unsatisfied and the failure of the National Assembly to pass important bills to institute financial reforms further weakened investor confidence. On November 19, the government announced another set of policy measures to deal with the growing financial crisis.1 Once again, these measures did little to calm the markets, and when it was announced that the daily exchange band had been widened to plus/minus ten percent and that there would be no more intervention on the foreign exchange market, the Korean Won began a free-fall in late November/early-December, reaching a low of almost 2,000 won/dollar. In the end, the Korea crisis became a triple crisis—balance-of-payments, banking and corporate crisis.


2.1 Financial sector

Restoring confidence and expediting the resolution of troubled financial institutions was the most urgent priority in the first few months. While there was no significant loss of confidence among depositors, also as there was a general guarantee in place, financial distress was widespread. Significant improvements in the framework for the financial sector, many of which had been proposed earlier by the Presidential Reform Committee and which had been debated but not enacted in Parliament, were passed in late December.

2.2 Resolution of financial institutions

The government first had to deal with the troubled merchant banks, and it closed ten in the first weeks of January. Two major commercial banks (Korea First Bank and Seoul Bank) had run up substantial nonperforming loans (NPLs). The government imposed substantial losses on the owners of these banks, injected public resources to stabilize their capital position, and assumed ownership control. The government plans to privatize these two banks in the near future. The role of the Korean Asset Management Corporation (KAMCO) in restoring bank portfolios was initially large as it bought substantial amounts of NPLs from many banks in December and early January. Commercial banks which did not meet the eight percent BIS capital adequacy ratios as of end-1997 (12 out of 25) were asked to provide recapitalization and rehabilitation plans.

2.3 Supervision and legal reforms

A new supervisory structure was enacted late December, consolidating various supervisory functions—covering banks, nonbank financial institutions (NBFIs) and capital markets—in one body (Financial Supervisory Board, FSB and Financial Supervisory Committee, FSC) under the direct supervision of the prime minister. The Bank of Korea (BOK) Act was amended to provide for greater independence of BOK in setting monetary and credit policy. Barriers between financial service providers were lowered to increase competition within the financial sector and enhance stability. Prudential rules for merchant banks were tightened and harmonized with other financial institutions. Legal changes were made to consolidate and improve depositor protection schemes and to enhance the powers of the deposit insurance agency to undertake examinations of financial institutions, and intervene in and resolve troubled financial institutions.

2.4 Financial services and capital account liberalization

The government went beyond the WTO Financial Services Agreement of December 1997, and liberalization measures agreed earlier with the OECD, and opened up more to foreign entry in the financial sector. For capital account transactions, the IMF-program included, among others, full liberalization of foreign exchange transactions over time, no limits on foreign investment in local bonds and short-term money markets, and no limits on foreign banks and brokerage houses to establish subsidiaries. The government also made general changes in the liberalization of the foreign direct investment regime, and issued clarifying guidelines governing foreign investment in financial institutions, including through mergers and acquisitions.

2.5 Corporate sector

Given the very high levels of debt to banks (the top thirty chaebols account for over sixty percent of bank lending), the problems of the banking sector have been very closely linked to those of the corporate sector. With the onset of the economic crisis in late 1997 and the spike in interest rates in 1998, five major groups worth about $20 billion in assets quickly failed, unable to pay their debts. Moreover, it soon became apparent that eighteen of the largest thirty groups were at risk of bankruptcy, with combined liabilities of about $75 billion. Not surprisingly, a series of syndicated emergency loans were provided by major banks to a number of major groups at risk, totaling some 2.5 trillion won. The problems of the largest groups quickly spread to SMEs, which often operate as satellites of the major groups. Also a complex system of payments from the big to small firms via promissory notes, traditionally discounted at banks, adversely affected the liquidity of the latter, as the terms of the notes were extended from an average of 30–60 days to 90–180 days and discounting rates rose from 12–30 percent. Moreover, exporting SMEs found it difficult to finance imports of needed raw material and other inputs.

2.6 Corporate sector reforms

A number of acts passed late 1997 and on February 14, 1998 provided for many changes in the framework for corporate transactions. These included permitting takeovers of non-strategic companies by foreign investors without government approval and raising the foreign stock ownership ceiling; accelerated introduction of consolidated financial statements and requirements for audit committees; and strengthening minority shareholders’ rights. The Composition and Reorganization Acts were revised to induce a more expedited process for financial restructuring by fixed deadlines, promoting expertise of the courts by creating a separate administrative body, and strengthening the creditors’ role by allowing creditor committees. New cross guarantees were prohibited and all existing guarantees would need to be unwound by the year 2000.

2.7 Macroeconomic stabilization

Macroeconomic stabilization aimed—in the first instance—at restoring exchange rate stability, rebuilding international reserves and containing potential inflationary pressures resulting from the economic shocks. This initially involved a relatively sharp tightening of monetary policy (benchmark interest rates rose from twelve to thirty percent), as well as some fiscal tightening. The program restored exchange rate stability, with the currency strengthening from a low of near 2,000 won/$ to about 1,300–1,400 won, and over the past few months Korea has seen a significant improvement in its external reserves position. Output has fallen very sharply, however, and is expected to register negative growth of seven percent in 1997. And although greater stability in the foreign exchange market and the subsiding of inflationary pressures in recent months have led to an appreciable decline in nominal interest rates, real lending rates are still above those before the crisis, especially for SMEs.

As often in financial crises, macroeconomic developments and corporate and financial sector distress have reinforced each other. Given the very high leverage of Korean corporates, corporate financial positions, and consequently also the health of the portfolios of creditor financial institutions, have been particularly vulnerable to interest rate spikes.2 Compounding the effect of higher interest rates has been the depreciation of the won, albeit now stabilized, the plunge in domestic demand and the only slowly growing external demand (in value terms), which has further lowered firms’ profitability. Corporates’ financial difficulties, in turn, led to a cutback in demand for (and supply of) new lending. NPLs increased rapidly, and, including those classified as nonperforming on a precautionary basis, amounted to almost nine percent of all bank loans in March 1998, compared to less than one percent in 1995. Banks, in the face of rising NPLs and the need to restructure and recapitalize, have resorted to loan recalls and higher spreads.


Avoiding systemic risks, and restoring solvency of financial institutions, while keeping fiscal costs manageable, have been the main goals of the financial sector reform program. The government was also committed to conclude many aspects of the first phase of its bank-restructuring program by the end-of-September. As of end-of-September, a number of non-viable financial institutions—including sixteen merchant banks, two securities companies, and one investment trust company—have been closed, while the operations of other troubled financial institutions, including insurance companies, have been suspended. In total, ninety-four financial institutions had their operations suspended or were closed as of the end of September. Table 1 provides an overview of the financial sector restructuring progress to date.

Table 1.Financial Institutions Suspended or Closed(as of September)
Total No. of





Commercial Banks2655
Merchant Banks301616
Securities Companies34246
Insurance Companies5044
Investment Trust Companies8112
Mutual Savings and
Finance Companies23012122
Credit Unions1,6531212739
Leasing Companies25


Source: MOFE, Korea.


Source: MOFE, Korea.

3.1 Commercial banks restructuring

Korea has relatively concentrated banking, with the six largest banks accounting for more than fifty percent of the banking system. Korean banks are also large relative to GDP: assets of the six largest banks account each for about ten percent of GDP, compared to less than five percent for the largest bank in most other OECD-countries. Dealing with the large commercial banks has been a central part of the restructuring strategy. Of the twenty-six commercial banks in existence at the end of 1997—which includes sixteen national banks and ten regional banks—two as noted were taken over by the government and recapitalized in December. The government has initiated the privatization of these banks, with the objectives of attracting foreign capital and expertise into the system. Twelve commercial banks that failed to meet capital adequacy standards at end-1997 were asked to submit rehabilitation plans and subjected to asset quality diagnostic reviews. The FSC announced on June 28 that the rehabilitation plans of five of the twelve banks were deemed infeasible. These five banks had their business licenses suspended and have since been acquired by five stronger banks under purchase and assumption (P&A) transactions, with public support to ensure that the acquiring banks would not be weakened.

The remaining seven undercapitalized banks received conditional approval. These include four large banks that account for more than one third of total commercial bank assets (Cho Hung, Commercial, Hanil Bank, and Korea Exchange Bank). Banks were instructed to submit revised implementation plans containing proposed management changes, cost reductions, capital increases, and measures taken to limit the accumulation of nonperforming assets. Currently, six large banks, including both conditionally approved banks and other banks, are, on a voluntary basis, proceeding with mergers so as to increase their scale economies and efficiency. Of these, the agreed merger of Commercial Bank of Korea and Hanil Bank is the largest. Other conditionally approved banks not involved in merger deals are taking rehabilitation actions, such as disposing of NPLs, inducing new equity capital, and streamlining business operations. The nine healthy banks not involved in mergers, including the five receiving banks involved in P&As, are being reviewed for their financial soundness and management practices.

3.2 Nonbank financial institutions

The FSC is applying basically the same scheme with regard to the restructuring of NBFIs. Self-rehabilitation under the initiative of major shareholders is being encouraged, but is closely monitored by the FSC. If self-rehabilitation steps are deemed inadequate, the institutions will either be subject to corrective actions or face closure. Of the thirty merchant banks at the end of 1997, sixteen troubled merchant banks have had their licenses revoked and have been undergoing resolution procedures. The remaining fourteen merchant banks will be monitored for the implementation of rehabilitation plans and achievement of capital adequacy targets. Securities firms, insurance companies, leasing companies, and investment trust companies have had to submit rehabilitation plans, followed by review by the FSC and, if necessary, resolution through closure. The first round of restructuring was completed in September, and some NBFIs had their licenses revoked.

3.3 Supervision and regulations

The FSC, formally established in April 1998, is an integrated financial supervision body, and all financial institutions will be supervised by the FSC. The four existing supervisory agencies (Banking Supervisory Authority, Securities Supervision Board, Insurance Supervisory Board, and the Non-Bank Financial Institution Supervisory Authority) are expected to be fully integrated into the FSB by end-1998. With the consolidation of supervisory organizations, supervisory arrangements for commercial banks will be extended to all NBFIs. The FSC will also be granted powers to enforce supervisory actions against specialized and development banks, and prudential rules applied to commercial banks will be extended to other type of banks.

Since December 1997, the regulatory framework is being strengthened to conform more closely to international norms. Changes have been made in rules for mark-to-market accounting, disclosure of NPLs, asset classification criteria, and foreign exchange liquidity and exposure criteria. On July 1, a number of additional prudential regulations and reporting requirements were announced: loan classification and provisioning,3 accounting and disclosure of trust accounts, and short-term foreign borrowing and foreign exchange exposures. Limits on connected lending that apply to commercial banks will be extended to merchant banks, and full disclosure will be required of such lending. To reduce large exposures, single borrower and group exposure limits for commercial banks will be reduced over time, with a phased reduction of exposures in excess of these limits. Deposit insurance consolidated in KDIC and the present general protection will be narrowed.4

3.4 Fiscal support

Public support is being provided through purchases of NPLs by KAMCO and recapitalization and depositor protection by KDIC. During late 1997 to early 1998, public support consisted of the reinforcement of commercial banks’ capital through the subscription by the government of subordinated debt issued by these banks the assumption of impaired loans from some commercial banks by KAMCO; equity injections amounting to three trillion Won to recapitalize Korea First and Seoul Bank; and payments to the depositors of the fourteen merchant banks that were closed through KDIC. Support has since been provided to the five banks involved in the recent P&A transactions—through purchases by KAMCO of NPLs and a put-back option, and KDIC capital injections. For other banks that merge as part of their rehabilitation plan, the government is will bring these banks’ capital adequacy ratio up to at least ten percent (in the case of mergers between weak banks) and up to those of sound banks (in the case of mergers between sound and troubled banks). Government will support stand-alone banks (i.e., those that are not merging as part of their rehabilitation plans) by matching new equity contributions (under the condition of sufficient operational restructuring efforts).

At the end of September, the government has budgeted in total sixty-four trillion won or fourteen percent of GDP for financial sector restructuring, of which approximately thirty-eight trillion won has already been spent. The sixty-four trillion won is to cover equity injections, purchases of bad assets from commercial and merchant banks, purchase of subordinated debt from commercial banks, recapitalization of commercial banks and expenditures on depositor insurance for all commercial banks.5 Fiscal resources are being mobilized largely by issuing public bonds. These interest costs are estimated to be 3.6 trillion won for 1998 and eight to nine trillion won for 1999.

3.5 Strategy

The strategy for restructuring financial institutions is to provide government support in addition to private recapitalization efforts. The latter have been limited, however, with total domestic private equity raised by commercial banks in 1998 equal to $0.6 billion and foreign capital equal to $0.7 billion. NBFIs have attracted another $0.7 billion in foreign capital, but the total raised is still much less than total government resources committed, about $6 billion. Recapitalization with government resources has led to significant government ownership; the government now controls banks which assets are about a third of total bank assets, or, put differently, banks which assets’ size is equal to about fourty percent of GDP. This effective nationalization of a substantial part of the banking system raises the question of interim governance. The government will have to assume the responsibilities of ownership, including contracting with experienced senior managers to undertake restructuring, until sale to strategic investors with sufficient capital and expertise to manage banks. This privatization will be difficult, however, given the lack of domestic, qualified capital, and the reluctance, so far, of foreign investors to provide resources. Deteriorating global conditions have made this task even more difficult. A substantial period of time may thus elapse before re-privatization.

Nevertheless, the importance of foreign know-how to help strengthen Korea’s financial sector can not be understated. Korea, as many other Asian countries, had before this crisis limited the entry by foreign financial institutions. Empirical evidence for Asia—and other countries—suggested that this slowed the banks’ institutional development and led to more costly financial services provision. It was then recognized that, going forward, Asian countries could benefit from accelerating the opening up. These benefits are even larger today as there is not only a severe shortage of bank capital, but also an even greater need for the introduction of foreign expertise to help in the restructuring of the corporate sector and in enhancing the quality of the financial sector in general. Formally, most East Asian countries have opened up considerably. In practice, there are many barriers still to be overcome to make it attractive enough for foreign investors to come in.

The strategy for NBFIs centers on the rationalization of the industry in a market-based manner. In the context of NBFI resolutions, only explicitly government-guaranteed liabilities will be covered. In exceptional cases, and in the context of a comprehensive restructuring plan, support may be provided to NBFIs if failure of these institutions poses a systemic risk.


4.1 Status

The needed corporate restructuring involves both financial and operational restructuring. Overextended chaebols need to restructure their balance sheets, increase equity and the maturity profile of their debt. Reducing debt/equity ratios is also essential to reduce vulnerability to future financial shocks. The longer-term process of operational restructuring will need to include improved corporate governance, product line rationalization, increases in productivity, and a fundamental change in corporate strategies and culture, focusing on profitability and liquidity versus aggressive expansion at virtually any cost.

The approach to restructuring has differed for the top five chaebols versus the other chaebols, six through sixty-four. The top five (Hyundai, Samsung, LG, Daewoo, and SK) are generally considered to currently have a better cash flow position than the other chaebols. They have more access to external financing, particularly through capital markets, and have the ability to sell off some of their foreign assets acquired during their expansion. Some of this better liquidity position derives perhaps from their size—they may be considered too big to fail—and thus raises issues of its own. SMEs, as noted, have been more affected by credit crunch directly and indirectly through links with chaebols. Separate government programs are adopted for these firms.

4.2 Policy actions to date

The immediate focus of restructuring efforts has been on restructuring the “non-top five” chaebols. In principle, all methods of financial restructuring are contemplated. In practice, market conditions and deadlines of the reform program encourage initial emphasis on debt restructuring, including debt/equity conversions. Subsequent emphasis is likely to be on asset sales, foreign investment, and new equity infusions. Among the non-top five chaebol in distress, some owners appear willing to give up control, and restructuring efforts have been addressing the issue of cross guarantees. Size, cross-ownership and cross-guarantees are insulating the top five chaebol to a larger degree from change. The government is responding with Fair Trade Commission actions against improper intra-chaebol transactions, statutory reductions in cross guarantees, more careful standards for future lending, and pressures for banks to exit from non-viable chaebol affiliates. This process is expected to take time. In the mean time, the risk is that cross—guarantees both postpone the reckoning for non-viable affiliates and continue to compromise the financial health of the whole group.

Supportive macroeconomic policies, involving the gradual easing of monetary policy—with due regard to maintaining exchange rate stability—and more expansionary fiscal policy are being pursued. In addition, changes have been underway in accelerating the role of banks in corporate restructuring, the enabling environment, the framework for corporate restructuring, and the role of capital markets.

4.3 Commercial banks

The government has opted so far for bank-led voluntary corporate debt workouts for the non-top five chaebols. Hence the recapitalization and restructuring of banks is a central element in the strategy for corporate financial restructuring. Eight major creditor banks, identified as lead banks, are to take the responsibility for negotiating workouts. Each of the banks has formed a workout unit. Policy measures are being implemented to strengthen incentives to undertake debt restructuring.

4.3.1 Curtailing emergency or rescue loans to corporates

Emergency syndicated loans to troubled debtors, which had the effect of delaying restructuring, will be curtailed in the future. Fresh capital will be provided to financially distressed but viable companies only in the context of the workout process, and subject to guidelines. Only in exceptional cases, can corporations not in the process of a workout, but due to be restructured, be provided with new loans.

4.3.2 Tightening prudential limits

The government has adopted a schedule for over time tighter prudential limits on connected lending and large exposures by banks, which will place further pressures on banks to undertake corporate debt workouts. This is especially relevant for the larger chaebols where exposures are currently above the (future) lending limits.

4.3.3 Reducing cross guarantees

The FSC is encouraging banks to reduce cross-guarantees through the workout process, and is proposing market-based approaches to unwind these guarantees, such as exchanging the guarantees for equity or warrants.

4.4 The enabling environment

An integral element has been changes in the legal and regulatory environment to remove impediments to corporate restructuring, encourage the infusion of new equity into the system and facilitate debt/equity conversions. Regulations governing foreign ownership in listed stocks have been changed (it now allows 100 percent foreign ownership); the M&A regime has been liberalized (it now allows hostile takeovers by foreigners); tax incentives, e.g. on asset sales, have been introduced; the real estate market has been opened to foreigners; financial disclosure and reporting have been strengthened; and insolvency procedures have been improved. Changes have also been made to the labor law, which now allows layoffs and measures to improve labor market flexibility. These measures will not only complement financial restructuring, but are also needed to improve the efficiency of corporates over the medium term.

The stock of corporate debt is so large, that sustainable debt/equity ratios cannot be achieved over a reasonable time frame only through the flow of new equity, asset sales and retirement of debt. In addition, stock adjustments in the form of conversion of debt into equity will be necessary. In the first instance, the banking law has been changed to allow banks to hold up to fifteen percent of their equity in a corporation (and no more than 100 percent of their equity in total). Since banks can hold only so much equity, however, and may moreover be ill-prepared to manage equity, equity will need to be unloaded over time. So far, indications are that the supply of equity capital is insufficient to allow an off-loading of equity over a reasonable period of time.

4.5 Voluntary framework

The FSC has developed an out-of-court framework for corporate workouts. This framework, within which banks, NBFIs and corporates will undertake workouts, utilizes so-called London Rules, which basically call for extra-judicial resolution of problem debtors. A Corporate Restructuring Accord (CRA) has been signed by some 200 Korean banks and NBFIs, which commits them to follow agreed workout procedures. In the event that financial institutions cannot agree on a workout strategy among themselves or the lead bank and the debtor cannot reach agreement, an arbitration committee, the Corporate Restructuring Coordination Committee (CRCC), has been created to resolve differences. If a CRA signatory fails to comply with an approved workout agreement or the CRCC arbitration decision, the CRCC has the power to impose penalties. The FSC will monitor the workouts agreed under the CRA to ensure consistency with the guidelines issued for the workouts.

4.6 Capital markets

Capital markets development is another important component. Deeper capital markets will help shift corporate finances away from debt and associated risk thus far carried by the banking system. A new regulatory framework, providing greater independence to market institutions, is being put in place. The FSC will accord securities market agencies increased authority to regulate and supervise their members. Prudential rules for securities markets activities are also being strengthened, including standards for risk management, adoption of mark-to-market accounting, and use of credit rating. Improvements in financial disclosure and minority shareholder rights will further support securities market development by enhancing investor confidence.

To develop a more liquid and active bond market the government is developing a clear, comprehensive funding strategy, including financing of the financial sector restructuring costs. The strengthening of the institutional investor base, being supported through changes in the legal and regulatory framework, allow the establishment of mutual funds and other corporate restructuring vehicles.6 Improvements in the management of pension system reserves are also underway.

4.7 Role of KAMCO

A bridge bank has assumed distressed assets from merchant banks and KAMCO has bought NPLs from commercial banks (as of the end of September, 37 trillion won was purchased by KAMCO at a cost of 17.2 trillion). KAMCO will have to restructure these loans and has a number of tools at its disposal to restructure loans: asset-backed securities; loan portfolio sale; asset sale; and M&A or direct investment. Potentially, KAMCO can be an important actor in the corporate restructuring process.

4.8 Support for SMEs

The government has adopted a special program for SMEs caught in the wake of the financial crisis. As a first step, the government decided to rollover the debts of the SMEs by extending working capital maturities. It has also provide liquidity to finance working capital needs of SMEs, to discount promissory notes, and to provide trade finance for critical imports. The scope of corporate workout programs is being expanded to include SMEs. Creditor banks have evaluated the financial status of approximately 22,000 SMEs with outstanding loans of one billion won or more, and have classified about 13,000 of these as viable, and candidates for workout programs. A special task force unit within each bank is reviewing the feasibility of rehabilitation plans and will devise specific measures and schedules for workout programs.

4.9 Corporate governance improvements

Important changes in the corporate governance framework have been adopted. Transparency and accountability in corporate governance are being facilitated by: consolidated financial statements required from 1999; domestic accounting practices conforming to international standards; representation requirement for class action suits was drastically relaxed from one percent to 0.01 percent in May;7 restrictions on institutional investors’ voting rights were eliminated in June; and all listed companies are required to appoint outside directors from 1998.

4.10 Strategy

The current approach to corporate restructuring can best be described as bank-led, in a “market-based” environment, enhanced by an out-of-court process. The main function of creditor banks will be to drive the operational restructuring process, reduce the level of debt to appropriate levels, and, if necessary, provide new money for working capital purposes. The government does not plan to intervene directly in the restructuring process. All types of restructuring tools are in principle at the banks’ disposal.8 The presumption is that banks will to try to bring in genuine new equity from strategic investors to take over some of the (converted) loans. Some additional sticks and carrots to accelerate restructuring are in place. In particular, the recapitalization of banks will provide a carrot as it allows for debt rescheduling and debt relief. The recapitalization of the banking sector, together with the change in the banking law which now allows banks to hold more equity, means that banks can convert loans into equity as part of the restructuring package. The CRA is a stick as it sets processes and deadlines and allows the imposition of penalties. And the revamped bankruptcy code is a stick to encourage voluntary agreements while maintaining payment discipline.


The Korea government realizes the enormity of the task ahead. Several areas are of particular challenge: the size of the problem; the fiscal resources required; the tight links between bank and corporate restructuring; and the credit crunch.

5.1 Size of the problem

Measured by assets, commercial banks and the entire financial system represented 171 percent and 344 percent of GDP, respectively, at the end of 1997. According to official estimates, as of the end of June 1998, estimated total NPLs of all financial institutions, broadly defined to include loans classified as “precautionary”, was 136.0 trillion won, or 21.8 percent of total outstanding loans, up from 13.3 percent at the end of 1997 (Table 2). Due to the tightened loan classification standards effective July 1, 1998, and continued economic decline, a substantial portion of precautionary loans are likely migrate to the “substandard” category before the end of this year. Furthermore, the quality of some of the precautionary loans may deteriorate over the course of corporate restructuring process. In light of this, the government expects core NPLs, i.e., loans more than three months overdue, to peak at 100–120 trillion won by the end of this year, or about 25 percent of GDP. Including possible migration of precautionary loans will raise this number further.

Table 2.Nonperforming Loans(end of period)
Nonperforming Loans (unit: trillion won)
Dec. 1997March 1998June 1998Dec. 1998(e)

Or below (A)
Total Loan (B)647.4668.7624.8
Precautionary and
below/Total loans(%)13.3517.5421.77

Denotes estimated figures.

Source: MOFE, Korea.

Denotes estimated figures.

Source: MOFE, Korea.

Currently the private sector already estimates higher NPLs, thirty percent of GDP or more, with some estimates of fifty percent of GDP or more by the end of the year. Analysis of corporates’ financial positions also suggests higher figures. For a sample of large Korean firms, under current exchange and interest rates, total liabilities exceed assets for 40 percent of corporates, i.e., 40 percent of firms are technically insolvent.9 Extrapolating this sample, non-performing bank loans could be 24.8 percent of GDP, and non-performing assets (including all forms of credit) 64.2 percent of GDP. The latter is probably a more appropriate measure in case of Korea given the large trust-account activities and the many capital markets instruments which are guaranteed by banks, but which are not captured in the first figure.

5.2 Fiscal resources

The estimates of NPLs suggest that the final fiscal costs will likely be sizably higher than 75 trillion won. At least 125-150 trillion won may be a more realistic assessment, or approximately 30-35 percent of GDP. Assuming that the government would want to restore bank solvency quickly and finance the costs primarily by the issuance of government bonds, the stock of public debt would jump sharply. This raises the issue whether the stock of public debt would rise to too high levels, and, related, whether the annual financing costs would become unsustainable. Given Korea’s very low initial public debt levels—10.7 percent of GDP in 1997, financial restructuring costs of thirty-five percent of GDP would still result in levels of public debt that are lower than or comparable to other countries.10

Such higher public debt also appears sustainable. Taking the mid-range of current estimates—150 trillion won—and using a simple debt sustainability calculation, reasonable medium term growth and real interest rate projections suggest that this initial debt/GDP of fourty-six percent can be brought down to about twenty percent of GDP over a decade by running primary surpluses on the order of four percent—five percent of GDP. Although Korea has run relatively high primary surpluses in the past, it might not be necessary to run this level of primary surpluses as stabilizing debt/GDP might suffice. Primary surpluses on the order of only 1.4 percent of GDP would already stabilize Korea’s debt/GDP at fourty-six percent.11 Thus, there might not be a great urgency to run large primary surpluses. And, in any case, it needs to be assured that the way in which the primary surplus would be generated (by taxes, cut in expenditures, privatization proceeds, etc.) is the most efficient in restoring growth. Indeed, given the current macroeconomic downturn and need for higher social expenditures, it might be more appropriate to postpone running significant primary surpluses, and achieve the decline in debt/GDP on a more gradual path. In fact, the decline in debt/GDP could probably be phased over a even longer period: if debt/GDP were brought down to only thirty percent in the next ten years (requiring average primary surpluses of under four percent of GDP), Korea’s public debt ratio at the end of the period would still be comparable to that of other many countries.

5.3 Links between corporations and the financial system

Korea is following by-and-large a voluntary, bank-led corporate restructuring strategy (with supportive measures to encourage corporate restructuring). This approach has benefits. It signals clearly to the market that the financial sector problems are being addressed. Since the government has already guaranteed the liabilities of banks, it formalizes some of its responsibility and thus creates clarity. It mitigates, in appearance at least, any direct government involvement in corporate restructuring. And, provided it is accompanied by substantive changes in the corporate governance of and operations of banks, it can amount to an up-front investment that may lead to lower ultimate costs as the moral hazard of bailouts may be avoided.

Yet, a bank-led approach has risks given the large exposures of banks, especially for the top five chaebols, the tight historical links, the lack of credit culture, and especially the lack of debt restructuring skills and experiences. Several specific risks can be identified. For one, recapitalization of banks in advance of substantial progress on debt restructuring has risks: many countries have gone through recurrent recapitalizations because the overhang of bad debts was not adequately dealt with and eliminated. Concurrent reforms—covering the governance of banks, the prudential and supervisory framework, and the role of markets in disciplining banks—are also necessary. Banks will also need enhanced technical capacity and institutional capacity to deal with the restructuring of a large number of corporates and a large magnitude of corporate debt. Related banks will need to enhance their institutional capacity to manage and dispose of equity holdings (if banks end up with large amounts of equity holdings that they can not dispose off quickly, banks’ portfolios may become unstable and perverse incentives may result). Furthermore, it has been questioned whether banks would be strong enough vis-à-vis corporates. It has been argued, partly because of “too big to fail” reasons, as well as because of the social and political consequences associated with restructuring, that banks will not be able to hold their own vis-à-vis the chaebols. This may result in not deep enough corporate financial and operational restructuring plans and a larger ultimate fiscal cost. The risks are that restoration of corporations’ competitiveness, and thereby economic growth, will not be attained.

Most notably, it is not clear whether this approach will achieve fundamental changes in the way corporates are controlled. The shortage of equity in the system will mean that current shareholders can not be completely be diluted, as otherwise the government will own much of the corporate sector. It might also be necessary to retain the current owners as they have important managerial skills. Leaving the current shareholders too much in control of corporations, however, risks a repeat of vulnerable financial structures and inefficient investments. Going forward, alternatives may be necessary which achieve both good short-term and medium-term outcomes. Certainly, the government needs to continue to set the rules of the game, and let corporates, banks and third parties negotiate without direct interference. It is also essential that adequate safeguards are built in, market-based principles are accepted at the political and operational level, as much as possible the current institutional structure is used, private involvement is maximized, and no new mechanisms for financial support to corporates are created. Lastly, it should aim to achieve, over time, a better corporate financing and governance structure.

One proposal which has been put forward is to have corporates “apply” to a process in which they can have their debt restructured provided they undertake the necessary operational restructuring. Corporates can be encouraged to submit themselves to this process by instructing all banks to stop lending to corporates with debt-servicing problems or by greatly increasing the provisioning requirements for loans to such corporates. The corporate then needs to provide an operational and financial restructuring plan to a committee of creditor banks and other independent members. Various consultants and staff would support the committee. The plan should indicate the savings achieved through operational restructuring, sell-off of assets, the contribution in new equity, and the degree of financial restructuring and relief sought and through what modalities. If an acceptable plan can not be agreed, the corporate is due for the standard bankruptcy process.

In many ways, this is akin to the current process for corporate restructuring. The key additional feature of this approach would be to introduce to the workouts not just banks and corporations, but directly (new) private investors and a party representing government interests. The government could be represented by a privately managed fund (possibly with private-sector equity interest) and would negotiate as a potential equity investor in the restructured corporation. Financial relief provided by creditor banks would be mainly lengthening maturities and interest relief, and some (limited) debt–equity swaps. Creditor banks might also provide working capital, but only under strict conditions (for example, highly collateralized). The private investor and the government fund would take over some loans from creditor banks and swap these claims for equity. The bank could be compensated for losses these on loans, through cash, a claim on the fund or a government bond.

All this requires participation by of the private sector, by putting up capital and being heavily involved in management of the fund. One way would be to make the fund jointly owned (private and public) with private shareholders the ultimate claimholder. This would ensure those private shareholders in the fund, which have to make the final decision on the viability of financial restructuring, face the right incentives. Public resources would only be provided at the point when all parties—creditor banks, other creditors, new private investors, and the private shareholders in the fund—have reached agreement with the corporation.

This could lead to deeper capital markets. As an equity holder, perhaps the largest one, the fund(s) would have responsibility to ensure that enterprises are properly managed. But the government should not be a permanent corporate owner. It should dispose of its holdings—through sales to strategic or portfolio investors—as quickly as it can at realistic prices. This may be difficult, however, given the limited supply of (domestic and foreign) capital. Options include making an equity distribution to taxpayers, or transferring the shares to an institution to be held in trust for the public’s benefit. Or the public could be encouraged to buy shares on advantageous terms (for example, with a small down payment and the balance paid over an extended period). This would lead to deeper capital markets, with attendant benefits in terms of improved corporate governance, better risk diversification, and better price signals.

5.4 Credit crunch

Availability of credit has emerged as one of the main issues. As of the second quarter of 1998 the nominal growth of domestic credit to the private sector was only nine percent yoy—as compared to a growth of twenty-one percent yoy in the second quarter of 1997. As in other financial crises, the slowdown in credit is likely attributable to a mixture of supply and demand factors: banks’ lending capacity, in part affected by deteriorated capital adequacy positions and tighter prudential regulations, may play a role on the supply side, while the drop in aggregate demand (domestic and external), weakened balance sheets of corporations and increased risk (perceptions) may play a role on the demand side. Whether there is a credit crunch, i.e., whether there is excess demand for credit at prevailing lending rates, is unclear.

The minimum eight percent capital adequacy ratio, tightened provisioning and other prudential requirements, and more rigorous enforced standards could have affected the supply of loanable funds. Analysis based on reported data through May suggests that deposit money banks’ capacity to lend remains higher than the volume of domestic credit extended to the private sector. Analyzing deposit money banks’ lending capacity in aggregate suggests that banks have capacity to lend. This is not to say, of course, that individual banks may not be constrained in making loans. It is also likely that reported figures underestimate the true capacity of banks to lend. Many banks may realize that their real capital adequacy position is much weaker, and are therefore holding back lending to the private sector in an effort to restore (risk-weighted) capital positions. And, even if currently not the case, banks’ capacity to lend could become a constraining factor in the future.

Historically, domestic credit to the private sector has often tended to be supply-constrained. Currently, however, it appears that demand for credit, or lack thereof, has become the determining factor.12 The fact that many of the financing schemes for SMEs are currently still underutilized would appear to corroborate these findings. Of course, given the distribution of credit, there may be borrowers with unsatisfied credit demand—i.e., there may be particular borrowers or sectors that currently face a credit crunch. It has been reported, for example, that an increasing share of lending has gone to the largest chaebols, thus skewing the lending. Moreover, the tightening of credit and higher interest rates contributed to corporate sector distress early on, and may therefore have also contributed to lower credit demand. Since SMEs are heavily dependent on bank financing, any credit crunch that occurred in the early stages of the crisis would have disproportionately affected them.13

This importance of demand factors reflects in part that at current (or any) interest rates, many corporates are not creditworthy or cannot borrow. To a large extent, these high lending rates are reflecting a large risk premium (which in turn is related to the problems in the financial and corporate sector). This suggests that a (further) loosening of credit would not necessarily lead to larger extension of credit. Put differently, high lending rates are reflecting the financial/corporate sector problems and general uncertainty in the economy as opposed to tight monetary policy. In addition to progress in financial and corporate sector restructuring, macro-policies that help re-ignite the economy, and thus improve earnings prospects of corporates, might be the best course to bring down risk premiums and hence lending rates.

5.5 Other challenges

Asset problems are not just large in banks; many NBFIs, most notably insurance companies, have significant asset problems. In addition, management and corporate governance in these institutions needs to be improved. While the government has committed itself not to provide any resources for the restructuring of NBFIs,14 the risk is that some of the problems in the NBFIs will spill over into the banking system, in part as there are many cross-ownership, financial and other links.

The external financing situation has improved significantly. Foreign exchange reserves have been restored to levels almost equal to short-term debt outstanding. A large debt service hump, from claims rescheduled in early 1998 as well as previous claims, exists, however, for 1999. Extending the maturity of financing will thus remain an important issue.

Social consequences of reform have included a rapid rise in unemployment, now above eight percent, up sharply from below three percent pre-crisis. Opposition to restructuring from labor unions has become an important factor in affecting the speed of corporate restructuring. Observers have also drawn attention to the serious competitiveness problems in some sectors, notably cars and electronics. The depreciation of the won has alleviated some of this, but global import demand and a possible rise in protectionism in import demand may not allow rapid export responses. In any case, the operational restructuring process will likely be long and intense, and the risk of lost value is great if firms can not maintain sufficient investments in plant and equipment, and acquire the necessary inputs. Accelerated restructuring will be necessary to make firms creditworthy again.

There is little disagreement that in the medium, the role of capital markets in financing of corporations will need to increase. Which model of corporate governance will emerge, and what the role of capital markets will be in the oversight of corporations, is much more unclear. Lastly, the degree of independence and authority of supervisors and restructuring agencies and the speed of their institutional development will be important. Clearly, Korea has the capacity, with the help of technical assistance, to develop over time a good and independent supervisory system, but it will require adequate political support.


Korea has made great strides in its financial sector restructuring and reform. Nevertheless, the challenges are large and the process of corporate restructuring has just started in earnest. Large amounts of fiscal resources will be needed to deal with the extensive repair of banks’ and corporations’ balance sheets. The operational restructuring of corporations will require a long time, and adequate external resources will need to be available. To achieve long-lasting solutions, the process of restructuring will need to be more decentralized so as also to limit the political backlash and develop a larger support base for the reforms. This will require bringing in other agents and investors. Further foreign direct investment can be beneficial as part of this process.


This included increased funding for the Korean Asset Management Corporation (KAMCO) to enhance its capacity to deal with distressed assets; incentives to promote merger and acquisition among financial institutions and rules that mandated the restructuring and exit of nonviable institutions; increased funding for the new consolidated Deposit Insurance Corporation; further liberalization of capital account transactions; and enhanced disclosure standards and loan classification requirements.


The interest coverage (or the ratio of operating income before interest and taxes to net interest payments) of Korean corporations had already been declining progressively and was about 135 percent at end-1997—by comparison, interest coverage ratios range between 250–450 percent in other OECD countries. For every one-percentage-point increase in domestic interest rates, interest coverage in Korea falls by about 3–4 percentage points.


Until July, loans more than six months overdue were classified as nonperforming. This has been changed to more than three months overdue.


All deposits made until July 31 are fully protected until the year 2000. Under a revised deposit protection law, for deposits made after August 1, 1998, only the principal will be guaranteed until 2000 if the amount exceeds W20 million (both principal and interest will be guaranteed for smaller deposits).


Some specialized banks (KDB, KEXIM, IBK and KCGF) will also receive support.


Corporate restructuring vehicles (CRVs) are expected to play an important role in purchasing and/or managing converted equity. The CRVs, e.g. trusts or mutual funds, might operate by purchasing converted equity from banks, managing converted equity for a fee, or purchasing debt and converting it to equity. Such CRVs would be privately owned and managed. The government has reviewed the tax and regulatory regime to remove any barriers that may exist to the establishment and operation of such vehicles.


Recently, a court ruling was handed down in favor of minority shareholders in a suit against the management of the Korea First Bank. The executives were held responsible for lending money in defiance of the shareholders’ objections. This unprecedented ruling is expected to open the door for other suits.


While the government has improved the enabling environment for enterprise restructuring, there are still some issues related to the process of restructuring to be resolved, e.g., what is the seniority status of various claims, what are the exact tax and regulatory implications of debt restructuring, how long can banks keep equity on their books, how will this equity be valued, etc., which will have to be resolved, mainly as the restructuring process evolves on a case-by-case basis. There may also be a need for a separate approach for small debtors. These issues are not discussed here.


Stijn Claessens, Simeon Djankov and Giovanni Ferri, 1998, “Corporate Distress in East Asia: Assessing the Impact of Interest and Exchange Rates Shocks,” World Bank, mimeo, September. They also find that in the post-crisis scenario, forty-nine percent of Korean firms are illiquid, that is their interest payments exceed their earnings.


The average (central government debt/GDP ratios for high-income countries was around sixty percent, while that of OECD was fifty-four percent in 1995.


These calculations assume a medium-term, real growth rate of output of five percent of GDP and real interest rates of around eight percent. While real interest rates have traditionally been relatively high in Korea, so has the rate of growth-which averaged around 7.5 percent per annum during 1990–96. Therefore the calculations above may well overestimate the primary surpluses required.


Preliminary analysis through the first quarter of 1998. Swati Ghosh, 1998, “Korea: Credit Crunch or Lack of Demand?,” World Bank, mimeo, September.


See Ilker Domac and Giovanni Ferri, 1998 “The Real Impact of Financial Shocks: Evidence from Korea,” World Bank, mimeo, for evidence that the credit channel is particularly operative for SMEs.


In the context of NBFI resolutions, only explicitly government-guaranteed liabilities will be covered. In exceptional cases, and in the context of a comprehensive restructuring plan, support may be provided to NBFIs if failure of these institutions poses a systemic risk.

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