Kookmin Bank CEO Kang Chung-won suddenly withdrew from his nomination as chairman of KB Financial Group (KBFG). He who was the sole candidate for the chairmanship won the approval from the board on December 3, 2009 and was awaiting the shareholders' votes slated for January 7, 2010. Kang insisted his decision had nothing to do with the government's pressure but most market participants have raised a doubt. The overall situation supports the suspicious view.

The turmoil started as the other candidates suddenly called off their application, complaining the election process was unfair. As such, Kang became the sole applicant and earned the unanimous endorsement from the board. But the financial authorities didn't like Kang and asked KBFG to delay the shareholders' approval to March or later. KBFG board rejected the request in fear of any management vacuum as chairman Hwang Young-key resigned over investment losses last September but it caused the regulators' outrage.

The controversy heated up as the Financial Supervisory Service launched a probe as what they call a "preparatory steps for general examinations." The inquiry was exceptionally long and broad, with inspectors three times more than usual mobilised to question the bank's officials during December 16 to 23. Some executives agreed to the transfer of confidential data to the auditors. Even Kang's driver was questioned. Some outside directors and their close aids were known to have gone through interrogations. Amid the intensified political pressure, Kang stepped back

The KBFG case reconfirms the widely-spread perception that financial companies, even private ones, could be in a serous trouble if they do not listen to the regulators. The spectre of "state-controlled finance" has revived. The government and financial watchdog has different view. They blame the outside directors' rise to the unchecked power. They raise a problem with the current practices that the outside directors have the mighty right to nominate a chairman and select their successors.

However, the failure to comply with the regulators' will cannot become a sin. The authorities should ask for a correction in accordance with appropriate procedures if they find any problems in selecting the head of a financial holding company. But they unfairly put heavy pressure on those subject to their supervision by revealing their intention.

KBFG is a private company and owned by shareholders. Therefore, the financial watchdog or any other authorities have no right to reverse the decision by its board to select a chairman through appropriate procedures stated by the related laws and prospectus. Under the Banking Law (Article 22) and the Financial Holding Company Law (Article 20), outside directors should comprise more than half of a board of a bank or a financial holding company and its committee to select outside board members. And each bank is free to set a rule about forming a committee to select its president. Against this backdrop, Kang's nomination appears to have violated any rules and regulations.

The regulators should have penalized the outside directors who were accountable for any wrongdoing. They didn't have to deny the very system of a chairman selection committee. Reinforcing regulations and supervisions is different from intervening into management matters. Forcing a nominee selected by proper rules and procedures to step down is itself an act of interference. The bank is privately owned only by appearance and actually run by the authorities. As such, the government cannot avoid the criticism that the state-controlled finance has revived.

Probe in retaliation

The conflict between the authorities and KBFG has entered a new stage. The fight started with the KBFG's board decision to disregard the authorities' will and nominate Kang as its chairman. Then it went into the second round as the authorities forced Kang to give up the post through unusually intense preliminary reviews. The third round would be the Financial Supervisory Services' comprehensive probe beginning Jan. 14. The watchdog was reported to dispatch about 35-40 of its top inspectors for the investigation.

The regulators defended their pressure by directly aiming at Kang and some outside directors. The intense audit consists of four areas: the purchase of Bank Center Credit (BCC) in Kazakhstan, losses over covered bond issuance, losses from investment in movies, and various suspicions regarding the CEO and outside directors.

KB acquired 30.5 percent stake in BCC for 800 billion won in 2008, short of management control, only to post paper losses of about 250 billion won due to a plunge in stock prices of the Kazakhstan bank. The nation's largest lender also issued $1 billion worth of covered bonds backed by cash flows from mortgages of public sector loans in May 2009 at a high premium, incurring huge losses. The FSS has raised questions over why the lender issued high-priced bonds although the economy was fast escaping from the fallout of the global financial crisis and the sovereign credit default swap (CDS) spread was narrowing on easing credit crunch.

The rest charges appear to be private. Kang is suspected of asking the bank's affiliates to invest 1.5 billion won in a move produced by one of his acquaintances in 2007, which failed to make an office box hit and incurred losses to the bank. He is also blamed for trying to take control of the board by granting lucrative research projects to some outside directors before or after their appointment. Those charges should be thoroughly investigated.

But a probe on investment losses should be made in a very careful and prudent manner as it could stir up a controversy of retaliation. It is absurd to hold someone accountable for his past investment decisions as nobody can avoid uncertainty for future investment. This is like making someone take responsibility for managerial judgement. If the purpose of the BCC investment is not to make profit but to explore overseas business opportunities, it's a different story. Similar interpretation is possible for the covered bond issuance. The decision may have been the best possible option at that time. We should not apply the present yardsticks to assess what happened in the past. And whether to accuse the top managers for any mistakes or misjudgement is not a job for financial watchdog but for shareholders.

The financial regulators have another reason to stick to a conservative position. They have already experienced a failure in supervising the financial industry. The watchdog forced Hwang Young-key to resign from KBFG chairman, belatedly raising issues in September 2009 over sizable derivatives-related investment losses at Woori Finance Holdings Co's banking unit in late 2007 and 2008 when he served chief executive officer of state-owned Woori unit. It's a huge mistake to reverse the ruling of 2008 by the Korea Deposit Insurance Corp and the Financial Supervisory Service that the investment decision had no procedural problems.

Launching an investigation to review a financial institution's management conditions or an executive's qualification belongs to the authorities' jurisdiction. But what's more important task for them is to keep financial institutions sound and improve the stability of the financial markets. The regulators should not abuse its power to penalize someone or push for its will. But there are many aspects in the KBFG case that can be seen as a retaliatory probe. We have to question whether it is appropriate to make an issue of what happened several years ago. Unless the financial supervisory system works in a transparent and consistent way, it could itself become a source of uncertainty.

Reform may backfire

The watchdog is known to have been working on ways to improve the outside director system at financial holding companies. They are set to significantly improve the present system for higher independence and transparency of outsider directors by limiting their terms and enhancing their qualifications. They are also considering a proposal to give shareholders' representatives a vote to select outside directors and candidates for chairman.

The outside director system was introduced as part of the efforts to improve the corporate governance structure when the nation weathered through the Asian financial crisis in the late 1990s. The basic framework of the system has no major problems. If there is any element that needs improvement, the companies in question are urged to change their prospectus accordingly. It's not a big job that the watchdog should take the initiative.

The proposal to give more say to shareholders in selecting chairman is more likely to backfire. Given the share ownership structure at a private financial holding company, those who can become a shareholder representative are mostly institutional investors, including the state-run National Pension Service. The chances for them to cast a vote against the authorities' will are pretty slim. The scheme may fail to have the shareholders' opinion more reflected in key management decisions but instead serve only as a channel for the watchdog to exert more influence on the procedures to select outside directors and chairman.

Should end the practice of intervention in the name of supervision

What's underlying behind the KBFG's turmoil is the authorities' deep-rooted distrust with private financial institutions. They simply believe that the finance industry is too important to leave it free. They could not allow any mismanagement that may lead to injecting public funds. In this sense, it's not tolerable for a chairman to have a mighty control of a financial institution, albeit privately owned.

Those perceptions are highly misleading as the main threat to the health of financial institutions is unclear cut between political and economic perspectives. It's apparent as seen in South Korea's foreign currency debacle in the late 1990s and the U.S. financial meltdown. In the U.S. case, it was politicians who encouraged the reckless sub-prime mortgage lending to individuals with low credit rating. The greedy Wall Street was not the main culprit. Since management control is not a political power, it should not be viewed as a chairman's ploy to build his own empire. Top managers are subject to strict assessment by shareholders and financial market players based on their performance.

The economic freedom data from the Heritage Foundation has a significant policy implication when compared with other major economies with a population more than 10 million and per capita annual income exceeding $30,000 on average between 2004 and 2008.

Comparison of economic freedom scores (Year: 2004¡­2008)

Sources: Heritage Foundation's annual reports on economic freedom and database from the World Bank

As the Table 1 shows, the average population of high-income economies is about 74 million, nearly 1.5 times bigger than South Korea. Their average per capita income amounts to $38,000, a double of Korea. As expected, Korea's Heritage economic freedom has a big gap with developed countries, especially in terms of financial industry freedom, anti-corruption index, and labour market flexibility.

The financial freedom is a yardstick to show the degree of the state ownership of a financial industry and the central bank's independence. The index cannot improve unless the government drops long-standing belief that even private financial institutions should be subject to the state control. It's hard to expect a breakthrough development in the financial industry as long as they have to wonder "the real intention of the regulators" all the time. Without an improvement in the sub-index of the economic freedom, Korea has no chance to enter the league of developed economies.

The KBFG turmoil can dent into international confidence on our financial system and financial institutions. Who would invest in Korean banks and companies if the authorities force a chief executive officer of a New York Stock Exchange-listed company to step down at their disposal and cancel the already announced plan for a planned shareholders' meeting? The government should end its long-held practice of intervening into a management issue by using its supervisory power. They should allow the market to do its own function. The watchdog needs to focus on implementing regulations in a stern and well-controlled manner. Abusing power could cause the market's wrath. A river running quietly is much more fearful.

By Cho Dong-keun / Emeritus Professor at Myungji University