Opinion Leaders' Digest 99-26
Date : July 2, 1999
Author : Han-Eung Kim, Former Director of Finance Training Center

Delays in the Sell-off of Korea First Bank
and Seoul Bank and the Limitations of Banking Sector Restructuring

Up until now, a government-led reform drive, as opposed to a market-led reform drive, has been used in the process of overcoming the economic crisis. The reason why the government has played such a leading role is because the people believe that government-led reform measures would be more efficient, and would bring about the intended results faster. For these reasons, the government has decided to reform the banking sector first, and then implement corporate restructuring, including chaebol reform, through banking sector reform. In addition, various government agencies, including the Fair Trade Commission, the Office of National Tax Administration, and the prosecutory authorities, have been supporting the government's reform ideas both directly and indirectly.

In tandem with its reform measures, the government has ordered 5 commercial banks to exit from the market, and while injecting public funds into other commercial banks, including Korea First Bank and Seoul Bank. With the announcement of the government's decision to sell-off KFB and Seoul Bank to foreign buyers, domestic and foreign experts have come to acknowledge that the banking sector reform has been successfully completed. Some foreign experts praise the Korean government's decisions, saying that the Japanese should learn from the Korean-style financial sector reform. However, even after all the accolades, we are encountering various press releases which state that the much-talked-about sell-off deals are facing difficulties, making us wonder how to evaluate this situation.

Did banking sector reform bring about efficiency in the market?

Even if one accepts the idea that a government-led reform drive can produce better results, is it possible to evaluate the current banking sector reform as a successful one? The reform can be viewed as a positive, if one only takes into account the fact that the estimated net profit for the first half of 1999 will reach 2.4 trillion won for 15 major commercial banks. However, given the fact that the government had injected 28.4 trillion won of public funds as of the end of March 1999, the level of projected net profit for the first half of the year can be viewed as an unsatisfactory figure in evaluating current banking sector reform. In particular, it is hard to assess current banking sector reform as a success, when one sees that KFB and Seoul Bank, who received public funds worth more than 1 trillion won each in the beginning of last year, had a decrease in assets of 7 trillion won and 4 trillion won respectively in only a 5 to 6 month period.

With respect to efficiency, when one looks at this case referring to various studies done by experts in industrialized countries, the banking sector reform cannot be viewed as successful. Those study results show that financial sector liberalization decreased savings rates but improved investment efficiency greatly. The basic reason for improved investment efficiency initiated by the financial sector liberalization has its grounds in that each individual bank employee can select where to invest better than politicians and bureaucrats. Therefore, it is hard to expect banks to improve their investment efficiency based on commercial judgment when the government decides where to invest using methods like business swaps (the so called "big deals") and corporate restructuring. The banks are put in a difficult situation in terms of creating an efficient lending policy, since they have observed difficulties in business swaps in the electronic business some time ago, and business swaps in the automobile industry more recently.

In addition, despite the fact that the companies involved in business swaps are limited companies, politicians and a variety of civic groups argued that the principle shareholder of these limited companies should offset the losses resulting from corporate management by providing the principle shareholders' private wealth. This makes the issue a socio-political one, rather than an issue of economics and loans between banks and corporations. This kind of atmosphere will make it more difficult for banks, which are still under the control of the government to make efficient decisions.

The commercial banks' lending activities are further restricted by the government's low interest policy designed to support small and mid- size firms. Since interest rates for small and mid-size firms are low compared to their credit risks, it is very difficult to make loans to these firms unless they have exceptionally good credit. Therefore, the banks are put in a situation where they have to direct their funds into portfolio investments and loans to large business conglomerates. Generally speaking, when lending rates are low, the banks' profit margin decreases. Therefore, banks are more vulnerable to shocks caused by imprudent lending when lending rates are low as opposed to when lending rates are high. When stock prices are rising rapidly, putting too much into one's portfolio is not desirable for the banks.

Only market-oriented reform guarantees efficiency

When viewed from the standpoint of efficiency, banking sector reform should have been left to the market. More specifically, at the very least nonviable banks should have been selected and liquidated by the market. The government should have announced that it would not provide any support for banks, and would order them to exit from the market if the banks' BIS ratio fell below a certain level, thereby, forcing the banks themselves to look for ways to survive in the market. If the government had taken the initiative to order the banks to exit from the market on an ad hoc basis, whenever it found that banks did not meet the set BIS ratio or equity levels, we could have seen a revolutionary improvement in the banking sector. In addition, the side effects from the huge confusion associated with forced retirement of bank employees in a short span of time could have been avoided. Consequently, the amount of public funds required for supporting the banking sector would have been much smaller.

If the government had employed the methods described above, each bank could have experimented with the various methods that fit its own situation and the banks could have survived in a variety of forms. Some banks could have merged with other domestic or foreign banks, some banks could have introduced foreign capital, and some other banks could have made an alliance with other domestic and foreign banks to overcome the problem. Of course, there could have been banks that employed more creative ways to solve the problem. The point is that, the banks could have improved their own efficiency by taking a variety of reform measures themselves.

Did banking sector reform guarantee swiftness of reform?

Although the government-led reform drive tends to lag behind that of the market-led reform drive in terms of efficiency, the government-led reform drive tends to work better in terms of speed. Therefore, although a government-led reform drive is somewhat less efficient than a market-led reform drive, it can be argued that a government-led reform drive was an inevitable choice for Korea, which had to overcome an economic crisis in a short period of time. The Korean government's decision to order five commercial banks to exit the banking sector, and to sell-off KFB and Seoul Bank to foreign buyers after injecting public funds, were made so quickly that some people argued that even Japan has something to learn from this, as mentioned in the beginning of this paper.

But, what does the drastic reduction in overall asset size of those two banks during the 5-6 month period after the government's announcement of bank sell-offs mean? In particular, the total assets of KFB currently stand at about negative 1.5 trillion won, down drastically from 50 billion won at the end of last year. Both Newbridge and HSBC are reportedly reluctant about purchasing the two banks. If that is the case, is it possible to assess the government-led reform drive as a swift one? And can one say that the banks, which acquired other non-viable banks, are satisfied with the decision?

If the sale of KFB and Seoul Bank were done through pure market transactions among the shareholders of the banks, the problems associated with the sell-offs would have not been this complex. During the decision to sell-off these two banks to foreign companies, there was criticism that the government was selling off these banks at unreasonably low prices. However, this criticism could have been offset if the sales of these banks were completed quickly. The problem becomes more complex, though, when the government starts to actively intervene in the process. It is assumed that politicians, who are very sensitive to public criticism, find it difficult to ignore criticism over the sell-off deal for KFB, with the recent rise in stock prices. The problem is getting more difficult because of the government's recent decision to inject an additional 5.3 trillion won into the KFB and to allow minority shareholders to take more losses. Even if the sell-off deal for KFB is completed successfully, it represents an accomplishment that has been costly.

When the government leads reform, politics is bound to intervene, and as a result, the decision process gets complicated, creating more delays while not making a satisfactory decision for all concerned parties. Considering all these factors, it is easy to see that government-led reform is not the best way to garner efficient solutions for the problem.

One more thought

The international financial environment has been changing ever more rapidly. Only a year ago, when banks in industrialized countries tried to enter foreign markets, they simply acquired local banks. Recently, however, the most efficient way to enter the foreign markets is to create alliances with respective local banks. There is a possibility that Newbridge and HSBC are hesitant about the purchase for this reason.

The government-led reform drive casts a darker shadow on chaebol reform, now that the government seems to be speeding up the reform drive once again. When no concrete results from financial sector reform are produced from government-led corporate restructuring and inter-conglomerate business swaps, while interest rates are maintained at low levels, the banking sector's financial soundness can deteriorate once again. Furthermore, if KFB and Seoul Bank's sell-off deals are not completed as planned, and the Korean banking sector's international credit rating goes down, the Korean economy can face an even gloomier future.

Even Prime Minister Schroeder's German socialist government is making pro-corporate reform statements, despite opposition from his party. His intra-party opponents are against moving German corporations overseas. It is high time that we make a comprehensive review on the government's direction of reform, which is excessively pressing the corporations and banks, while it tries to overcome the economic crisis.

(The view expressed here is the author's personal view. It is not the official view of the CFE.)