I. Introduction
The performance of the Korean economy over the past six years has been nothing short of remarkable; it recovered from a near collapse brought about by the economic crisis that erupted in November 1997. In the last six years, the structure and software of the once-ailing economy was rendered more transparent and upgraded to global standards. Although many factors con-tributed to the unexpectedly rapid recovery, the most important factor was the sweeping reform undertaken in all sectors of the economy, especially in the fi nancial and corporate sectors.
The Korean government initiated drastic reforms after the financial crisis under the recognition that the crisis was caused by long-standing economic structural weaknesses rather than merely a temporary shortage in foreign exchange reserves resulting from a loss of credibility by international inves-tors. These fundamental fl aws made Republic of Korea vulnerable to the fi -nancial turbulence sweeping through Asia in 1997. They included excessive borrowing and reckless investment by the corporate sector, imprudent provi-sion of loans by fi nancial institutions funded by short-term borrowing in the international fi nancial markets, and lack of transparency in the accounting and management of fi nancial institutions and corporations.
The fi nancial crisis in Republic of Korea can be traced back to long-standing structural weaknesses in the fi nancial system and fi nancial institutions. For example, low profi tability and ineffi ciency had long characterized fi nancial institutions in Republic of Korea. The government-led development strategy over the previous thirty years had involved routine government intervention in the fi nancial sector, preventing market discipline from ever taking root.
Selective credit allocations and prolonged interest rate controls were primary tools of economic development in Republic of Korea. Furthermore, the strict segmentation of the fi nancial industry and high entry barriers limited the ini-tiative and innovation of banks, and extensive government involvement in their internal management undermined the autonomy and accountability of
market liberalization and market opening. The government lifted various re-strictions on asset and liability management of fi nancial institutions and en-couraged changes in the existing institutional framework in order to enhance the long-term soundness of the fi nancial sector. To be sure, liberalization can have numerous impacts on the market, some of which are unexpected and undesirable, and this was certainly true in Republic of Korea. Changes in the environment allowed an increase in short-term foreign currency debts held by domestic financial institutions. Banks started to dramatically increase new lending without appropriate credit-risk evaluation. Behind the excessive risk-taking was moral hazard due to the government’s implicit guarantee as lender of last resort and weak regulatory and supervisory systems. All these factors together plagued the banking industry and put the entire financial system at risk.
Ineffi ciency and ill-use1 of the fi nancial supervisory system in Republic of Korea had been the subject of criticism since the early 1980s. Implicit full deposit guarantee coupled with typical cases of regulatory forbearance, regulatory capture, and political capture also served to create moral hazard in the fi nancial institutions in Republic of Korea.
Exacerbating the situation, a series of corporate bankruptcies in 1997 sad-dled the nation with a heavy burden of non-performing loans (NPLs). The ratio of non-performing loans to total credit increased from 4.1% in 1996 to 6.0% in 1997. These unfavorable ratios coupled with the endemic problems of ineffi cient management, low profi tability, and lack of transparency made the fi nancial sector highly vulnerable to the fi nancial turbulence then occur-ring in Southeast Asia.
1. The regulatory and supervisory tools have been used frequently by the government to allocate resources for its purposes or even The regulatory and supervisory tools have been used frequently by the government to allocate resources for its purposes or even for corrupt and political reasons, rather than for the soundness of the fi nancial industry.
1990–93
Return on Assets (%) 0.56 0.42 0.32 0.26 -0.93 -3.25 Return on Equity (%) 6.40 6.09 4.19 3.80 -14.18 -52.53 Net Interest Margin (basis
points)
2.72 2.30 3.02 3.52 3.67 3.91
Non-performing Loans at
10.00 10.62 9.33 9.14 7.04 8.23 Source: “Annual Banking Statistics,” various issues, Financial Supervisory Service.
In recognition of such structural problems, there had been intermittent at-tempts2 before the crisis to make the outmoded financial system market-oriented. However, these government-initiated reform efforts often faced po-litical opposition, and the scope was too limited to eradicate the distortions deeply rooted in the fi nancial sector. Finally on December 29, 1997, just one month after the onset of the crisis, the National Assembly passed a package of 13 long-awaited fi nancial reform bills designed to facilitate fi nancial re-structuring, improve prudential regulation, and accelerate capital market lib-eralization. The package contained bills to correct the built-in ineffi ciency of the fi nancial market by enhancing the independence of the central bank, es-tablishing a neutral consolidated Financial Supervisory Commission (FSC), and liberalizing foreign ownership of Korean securities. The enhancing of the independent central bank to conduct monetary policy and the establish-ment of the FSC for neutral supervision implied a shift from a Ministry of
2. The most recent attempt was the proposal made by the Presidential Commission for Financial Reform (PCFR). Recognizing the urgency of fi nancial reform, the government established the 31-member PCFR in January 1997 to prepare a comprehensive set of reform measures to overhaul the financial system. Most of the Commission’s recommendations were included in 13 fi nancial reform bills only on December 29, 1997, after the IMF Letter of Intent required it, which was too late to prevent the financial crisis.
cation and provided the legal basis for fi nancial reforms.
Since the outbreak of the financial crisis in December 1997, a number of important steps have been taken to reform the banking sector in Republic of Korea. Most of the efforts were focused on cleaning up non-performing loans, recapitalization, and restructuring and consolidating the banks and other financial institutions, as well as legal and institutional reforms for strengthening prudential regulation and establishing an appropriate deposit insurance system. In particular, signifi cant measures have been introduced to improve the corporate governance of banks. A new board governance sys-tem was hastily assembled and launched in the Korean banking sector after the fi nancial crisis in response to pressing concerns over the viability of the major Korean banks. Under the supervision of the Financial Supervisory Commission, Korean banks have established a board governance system satisfying the global standard with outside-majority boards and a committee structure. The proportion of outside directors in the new boards has reached 60 to 80%. The Korean banking sector has adopted the functions of vari-ous committees including the governance committee, the management de-velopment and compensation committee, the audit committee, and the risk management committee, which are under the board of directors. It has also reformed the system of decision- making. The regulations concerning the roles, the authorities, and the obligations of the board have all been stipu-lated. Helped by all these reform efforts, Korean banks were able to improve their soundness and profi tability more quickly than expected.
Considering the current and future fi nancial environments, with accelerated fi nancial liberalization and globalization coupled with a wide application of new communications technologies to fi nancial products, threats to fi nancial stability are even greater and more diverse than they were during the pre-crisis period. It is not likely that any one set of measures can be expected to ensure against the recurrence of future problems. Financial intermediation is a continuously evolving activity, involving new risks, instruments, and challenges. Financial institutions and policymakers need to upgrade their processes continually to remain in control of these risks. To that end, it is imperative that new standards that are developed are suffi ciently robust to meet the new challenges in a dynamic way and to effectively handle unex-pected changes.
dividual fi nancial institution level, (2) effective market discipline based on transparency and accountability, and (3) an effi cient fi nancial safety net, in-cluding strong prudential regulation and supervision.
Sound corporate governance at the individual fi rm level is the fi rst bulwark against instability in the fi nancial system. It involves capable management with clear responsibilities and accountability, well-established business plans supported by effective internal control, and effective risk management.
The second line of defense is effective market discipline, which should be supported by sound accounting standards, substantial and timely information disclosure, and accountability based on a credible legal framework. This so-cial infrastructure is the basis for effective individual fi rm management and effective supervision. Even with effective institution-level management and substantial market discipline at work, neither can substitute for the crucial roles played by offi cial regulation and supervision since the fi nancial service industry is inherently unstable. Due to the possibility of a Nash equilibrium in the financial market, the soundness and safety of the financial system should be supported by the fi nancial safety net.
This paper explores major aspects of bank governance issues in Republic of Korea. According to the survey conducted in 2004, the board of direc-tors system in Republic of Korea is believed to be functioning much more effectively since the crisis under a well-established corporate governance system. More than 70% of board members are outside directors with diverse backgrounds, and they are actively participating in bank management. Also, various subcommittees have been established on the board to facilitate the decision-making process. At the same time, the top management of the com-mercial banks clearly recognizes the importance of corporate governance and the need to enhance the transparency of bank management in maintain-ing bank soundness. However, the boards of directors still need to be im-proved in many areas. Among other needed changes, the outside directors should be granted greater independence from the CEOs and major share-holders. The incentive structure should be improved to encourage outside directors to actively participate in the decision-making process for the best interests of the banks. Finally, more opportunities for training and education need to be provided for the outside directors.
and resolution of non-performing loans, and also the legal and institutional measures to enhance corporate governance of banks are reviewed. Section 3 explains the legal and institutional reform measures for developing fi nan-cial safety nets, including deposit protection and prudential regulation after the crisis. Section 4 briefl y introduces the corporate governance system in Korean banks and its distinguishing characteristics. Also we evaluate and analyze the performance of the new corporate governance system utilizing survey data. Section 5 analyzes the role of market discipline in Republic of Korea’s banking industry. Finally, the concluding section summarizes major tasks for the strengthening of banks’ corporate governance.