May 13, 2019

IMF published its staff report and selected issues report under the 2019 Article IV consultation with Korea. The IMF Directors encouraged the authorities to rely more on targeted macro-prudential policies to manage financial stability risks such as the still high household indebtedness and the possibility of house price corrections. They also welcomed ongoing efforts to strengthen the regulatory and oversight frameworks.

Staff report

The staff report highlights that the banking sector appears to be well-capitalized, with sizable liquidity buffers in place. Capital ratios of banks are well above the regulatory minimums (16.1% in the third quarter of 2018). Banking system liquidity is improving, with the loan-to-deposit ratio at 97.7% and expected to edge lower as loan growth moderates. Banks’ reliance on wholesale funding for their domestic activities appears relatively low and foreign assets continue to exceed liabilities, thus reducing the risk of currency mismatches. Bank asset quality is good, with a non-performing loan (NPL) ratio of 0.54%. However, with a return-on-assets (ROA) at about 0.6% in 2017, Korean banks’ profitability lag that of regional peers. The financial system in the country has performed well with the subsequent implementation of the Basel III framework and regular stress tests for the financial market. The BOK and the Financial Supervisory Services have implemented regular stress tests to monitor the loss-absorbing capacity of the financial system against potential risk factors given financial institutions’ interconnectedness.

Additionally, the average indicators of financial soundness for non-bank financial institutions are also strong, although NPL ratios at about 2% have tended to be higher than for banks. The staff believes that regulatory reforms are addressing financial stability risks and strengthening the resilience of the financial system. Latest measures adopted by the authorities include tightening of the loan-to-value (LTV) and debt-to income (DTI) ratios, which target credit demand. To tackle the interest rate risk from household debt at floating rates, the authorities have been incentivizing fixed rate loans and capped the stressed DTI at 80% for banks. Measures were also introduced to enhance the resilience of the financial system, particularly against risks from household debt. The risk-weighting of loans with LTVs above 60% was increased from 35% to 50% in June 2018. A household-based countercyclical capital buffer will be adopted in 2020.

The report notes that macro-prudential policies, rather than monetary policy, should be used to manage financial risks in Korea. The Bank of Korea (BOK) is in a difficult position to balance the two mandates (2% inflation and financial stability) using the interest rate and macro-prudential policies. Staff estimates suggest that targeted macro-prudential instruments rather than monetary policy have been effective in reducing financial risks in Korea. The macro-prudential policy stance should be kept tight to contain risks from high household debt and support financial sector resilience. The authorities should closely monitor and supervise potential leakages from the recent tightening in prudential policies. The forthcoming Financial Sector Assessment Program (FSAP) missions will evaluate the effectiveness of Korea’s financial system oversight framework and assess adequacy of current prudential policies in mitigating systemic risks. The authorities should also consider measures that directly address the systemic financial risks but are not designed to limit capital flows.

Selected issues report

The key topics discussed in the selected issues report include the evolution of macro-prudential policies in Korea, the efficacy in prudential policies in taming financial excess and building financial resilience, interaction between monetary policy and macro-prudential policies, and risks to financial conditions. The use of macro-prudential policies in Korea have evolved in two ways. First, the macro-prudential toolkit has been expanded. Second, macro-prudential instruments have been used more aggressively over the financial cycle. There has been a shift in the types of macro-prudential tools used in Korea to safeguard financial stability. A database of macro-prudential policies constructed by the IMF (in 2018) shows a move away from monetary macro-prudential tools to broader borrower-based prudential instruments. Since the Asian crisis Korea has used prudential policies more actively to address financial cycles more systematically. A macro-prudential policy index is constructed of prudential policies that principally target financial swings.

The change in the aggregate macro-prudential index has in general moved in phase with fluctuations in credit growth. Periods of higher credit growth have often been associated with tighter prudential policies and vice versa. Bank-based prudential tools, such as capital requirements or loan loss provisioning, are a central part of the macro-prudential toolkit in Korea. The empirical evidence suggests that a tightening in bank-based prudential policies reduces financial vulnerabilities and creates financial space for banks. Bank leverage and non-core funding decline by a similar magnitude. Bank-based prudential policies would tame the financial cycle by shifting the risk appetite of banks. External financial risks remain due to vulnerabilities such as rising corporate debt, house price mis-alignments, and sovereign-banking sector links in some EU countries while domestic financial risks arise from higher household and corporate leverage.

The report also examines current domestic and global macro and financial conditions and links them to a distribution of possible financial condition outcomes in Korea. An important advantage of this approach is that it allows an assessment on whether slower domestic growth/higher household leverage and/or a tightening in global financial conditions is net financial-critical and puts the financial stability at risk in Korea.

 

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Keywords: Asia Pacific, Korea, Banking, Macro-Prudential Policy, Article IV, FSAP, Systemic Risk, Bank of Korea, IMF

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