The Resolutions of Non-Performing Assets:  Korean Experience


A text prepared for presentation at the Seminar
held by the World Bank in 1998.



It is a singular honor for me to be invited to this seminar on Road to Recovery to share with you some of my thoughts on Korea‘s current financial crisis with a focus on the problems involved in the resolution of non- performing assets and companies in financial distress. Before I begin, I would like to take this opportunity to express my sincere appreciation for the financial support and policy guidance provided to my government by the IMF and World Bank including the IFC during my days in government service throughout the 1970s. Without the World Bank‘s generous and valuable assistance, Korea’s rapid economic growth in that period might have not been possible. Unfortunately, Korea stumbled at the threshold of the developed countries, and I am here this morning to speak about this.


Structural Weakness in the Financial System

This audience perhaps is well aware that the Korea‘s financial system has been suffering from some structural weaknesses, which include  (1) lack of managerial independence from the government and close ties with business conglomerates or chaebols ; (2) lack of a responsible and  transparent managerial system accountable to shareholders and (3) lax supervisory functions of the government. Under the protection of the government, banks have been regarded by both banks themselves and the public as institutions which are too important to fail.  In the absence of competition and market discipline, banks have been loath  to learn from Western banks modern techniques of banking services and risk management with the result that they now find themselves saddled with an inordinate amount of bad debts.

Under the on-going policy reforms of Korean government guided by the IMF, these institutional defects and unhealthy practices are being remedied by the changed laws and regulations and by the creation of a new supervisory body. One of the most challenging issues at present is to how to pay for the consequences of the institutional legacies, that is to say, to clean up the huge burden of bad debts accumulated within the financial system, dispose of insolvent banks, recapitalize financially weaker banks, and make shareholders take their losses.

Increase in Non-performing Loans

Large amount of non-performing loans has long been one of the major issues confronting Korea‘s financial system prior to the onset of the financial crisis last November. Non-performing loans held by banks, adjusted to the U.S. standard, varied between 3% and 6% of total loans during the period from 1993 to 1996. But it jumped to 8.7% toward the end of  November in 1997 in which financial crisis started. By the end of 1998,  it will reach more than 100 trillion won, (about $74 billion) or 25% of GDP projected for 1997, according to a forecast by the Korea Development Institute (KDI). 

Factors contributing to the upsurge of bad debts

The problem here is that the non performing assets increased sharply  following the out-break of the financial crisis and the implementation of the resolution policies guided by the IMF.  It is difficult to say to what extent the increase in the bad debt was due to mismanagement of the companies and to what extent due to the impact of the changed government policies in response to the crisis which were beyond control of the companies in general. No doubt the reform policies worked to weed out inefficient marginal firms, but it is also true that many firms otherwise viable were victimized by the brunt of the resolution policies.

The reasons for the rash of defaults and bankruptcies following the IMF intervention may be explained as follows. In the first place, few companies can survive to pay interest on loans as high as 20-30% per annum even for a short period of time, particularly when the debt-equity ratio of firms are generally high in Korea.  

Secondly, since the exchange rate of won against dollar jumped from 840won at the end of 1996 to a peak of 1992 won on December 23, and then declined gradually to the current level of around 1400won (at the end of August 30, 1998), the value of principal and amortization cost of foreign debt in terms of won has increased by more than 70 % on the average during the period, driving all companies with foreign debts into financial crisis.  

In addition to the high interest rate and exchange risk, the credit squeeze was another important- even more important –cause of the rapid increase in business failures adding to non-performing loans of banks. This is related to the BIS capital adequacy ratio of 8%. All banks were instructed by the regulatory agency to submit restructuring plans to meet the BIS capital-adequacy requirement by the end of April this year. At that point, the Financial Supervisory Commission was to evaluate their plans and decide the modality of restructuring and was to impose corrective actions.

Second, apart from the regulatory requirement, banks realized that unless the capital ratio is improved, international credit rating will go down, making them more difficult to get foreign debts due rolled over, let alone obtaining fresh loans. Thus the capital ratio became a figure on which the future of a bank was to depend. Under this situation banks were obliged to recall risky loans as much as possible. Unfortunately, this was self- defeating because recalling of loans and contraction of new lending, combined with high interest rate and foreign exchange risk, resulted in more business failures only to increase non-performing asset on their part. In fact this vicious circle has made structural reform even more difficult.

Credit squeeze was caused not only by the capital ratio but also by dislocation of banking networks and disruption of banking operation caused by execution of various reform measures on ad hoc basis. At a different point of time during the past 9 months, 13 merchant banks, 5 commercial banks, and one investment trust company have been closed down by the decree of the regulatory agency. Other two commercial banks have been on sale to foreign banks but so far no deal has been completed.  The each of five viable banks, under the behest of the regulatory agency, is currently trying to take over the assets and liabilities of one of the five exiting banks considerable frictions including labor disputes. The remaining banks are also in great distress facing uncertain future as the regulatory agency made it known that final decision on those banks depended on the outcome of further evaluation. They are desperately seeking for foreign investors for recapitalization and joint ownership. Naturally, the banking system is on the verge of total paralysis, aggravating credit contraction. In addition to the credit crunch, sagging demand under the deep depression worsened business conditions, producing a chain of business failure. This gloomy picture can be understood as a transitional state of affairs and inevitable cost for a revolutionary structural reform for the better future. Yet question remains as to whether or not the actual path Korea has been taking was the single best alternative.

The Resolution of non-performing loans

For the purpose of facilitating resolution of non-performing assets, the Korea Asset Management Corporation (KAMC)--remodeled an existing institution for similar purpose—was set up as a public institution to buy up non performing assets of the banks by using the Resolution Trust Fund capitalized by the government and the banking community. The Fund has been authorized to issue public bonds for the amount of 12 trillion won (about $8,8 billion) this year for the purpose. An additional 10 trillion won will be needed to buy up a half of the non-performing assets which will reach 100 trillion won by the end of this year according to the KDI.

The KAMC has been instructed to buy up non performing assets for a half price of the book value of the asset with the condition that the difference between the purchasing price and selling price of the asset will be settled ex post. The KAMC pays the bank with a bond which will be redeemed by proceeds from the sale of the non-performing assets.

Some problems encountered in the course of resolution of non-performing assets include the following. First, non-performing assets is kept increasing as if without bound in the wake of the current chaos in the banking system. This increases fiscal burden on account of increasing bond issues and interest payment accruing to the government.

Second, the present government plan assumes that a half of the non-performing assets would be cleared by banks themselves. However, this is not realistic assumption, given the narrow market base and lack of fund available to the potential buyers.

Finally, more than often, non-performing assets involve not merely a piece of collateral but involve virtually a company as a whole. In this case resolution of the matter becomes extremely complex; In the case of open bidding the sale of the assets are relatively simple. But there are many cases in which dealing has to be made with a single buyer without competition. In this case valuation of assets or a company is called for, but it is a matter of negotiation rather than mechanical application of preset criteria even if it exists. This situation implies that some irregularities can be involved in the course of negotiation and that the outcome of the deal can become a matter of controversy when public organization such as KAMC is involved. In fact Korean experience with this sort of business was marred by some irregularities, political scandal, or political censure with the false allegation that lack of fairness or some irregularities was involved. I have heard that the resolution of non-performing assets has been retarded for the reason, among others, that officials in the KAMC are reluctant to get involved in such negotiations for the fear that they may become target of political censure or controversy in later days.

Some Reflection

On the basis of my observation on Korean experience, I venture to make one or two policy recommendation to Korean government, the IMF and the World Bank.  

First, the imposition of BIS capital adequacy requirement seems to need a second thought. I don‘t mean that the required capital ratio is too high; on the contrary even a higher ratio may be necessary for promoting sound banking management in developing countries. What I mean is that the realization of capital adequacy in Korea in a short period of time is practically impossible while the current side effects are too serious.  According to a KDI estimate, a about 35 trillion won (about $30 billion) is needed for the banks as a whole to meet the IBS capital requirement at the present time. Of this amount 7.2 trillion won will be taken by the government to support recapitalization of viable banks which are willing to take over assets and liabilities of the closed banks. The remaining 27.8 million has to come from Korean equity market and foreign investors. However, this amount is roughly equivalent to 40% of the total current value of stocks listed in Korea Stock Exchange. It is difficult to believe that the current stock market will be able to raise that much of equity capital, given the current situation in which bank credit is dried up and economic outlook is extremely uncertain.

The banks are seeking M&A with foreign banks or investors, but this cannot be done overnight. The only way open to the banks is to reduce their risk assets, which will, however, end up with increasing business failures and non-performing assets as has been seen earlier. If this vicious circle goes on the industrial base of Korean economy could be undermined.

I am forced to conclude that its improvement should be pursued in gradual steps over time. It may be noted here that even in the United States it took about 10 years for the banks to reach a average leverage ratio of a 8% level in the middle of 1990s from a little more than 6 % in the middle of 1980s, according to a statistics of the FRS - although the definition of the leverage ratio is a little different from the BIS ratio. 

Second, as I said earlier there are many companies failing not because of mismanagement but because of the adverse impact of the resolution policies- high interest, credit squeeze, labor strike of the parent company, sagging demand etc. Although it is difficult to distinguish them from other companies failing from their own faults, it is true that there are many companies worthy of rehabilitation for national interest.

This reminds us of the need for a safety net to protect viable companies from becoming innocent victims in the course of the resolution of the financial crisis. One significant safety net was provided by the World Bank in the form of Structural Adjustment Loan (SAL). On March 26, the Bank approved the first installment of $2 billion SAL for Korea, which will be used for payments of imported raw materials by small and mid-sized enterprises.

Coming back to problem of rehabilitation of the worthy companies, this task may be entrusted either to the KAMC or to a new organization. I was advocating for a new organization involving, if possible, international organization such as World Bank or its subsidiary IFC. Let’s call the new organization for the moment Business Rehabilitation Corporation-BRC. A gist of modus operandi of the proposed organization is something like the following.

Foreign participation and managerial control in the BRC is  indispensable for several reasons.

In addition to these advantages the BRC will have the following merits. In the first place it will speed up clearance of the non-performing assets and failing companies by a specialized organization. The recovery of ailing firms will take a long time with the BRC, but the bank can get out of the bad debts hangover and engage in normal business operation. The key point here is to hospitalize ailing companies to one place so that they can receive expertise treatment while the bank can clean up its house and go back to its normal business operation – a condition badly needed at present to ameliorate credit crunch.

It can avoid a question of moral hazard when debt-equity conversion or debt rescheduling is granted to a company since its ownership has been transferred to a pubic organization. In my opinion there seems to be no other way but debt –equity conversion or debt rescheduling to rehabilitate ailing companies.

Concluding Remark

I have made some observations on the problems involved in the resolution of non-performing assets and failing companies in Korea. I would like to make two policy recommendations from my personal perspective.

In the first place I would like to urge the IMF to give a second thought to the imposition of the BIS ratio. A more realistic target should be set for the banks that can be approached in steps over the years. The same applies to other reform target such as recognition of non-performing assets. The U.S. standard may be suited to American conditions but it is alien to Asian countries including Korea. It should also be approached in steps over time.

I am aware of the controversy over the big ban v.s. gradualism in structural reform. Definitely an overall reform at one shout is preferable to piecemeal approach. But “overall reform at one shut” means preparation of  a policy program comprehensive enough to cover all problem areas which is, however, well coordinated for interrelation between policies, time phasing of each policies, policy impact on the economy and the ensuing cost involved. It does not mean that the government tries to do many things at one time on ad hoc basis without heed to its impact on the economy.

Korean approach to the structural reform led by the IMF is quite comprehensive and is expected to produce many positive results in the years to come. Yet considering the serious setback in the economy it seems to leave something to be desired.

Secondly I would like to urge the World Bank to consider the idea of the BRC or the like in which the Bank play a leading role. I believe the World Bank can thereby make invaluable contribution to an effective and more efficient structural adjustment in the banking and corporate sector, and at the same time minimizing confusions and business failures in Korea. As we all know the fort of the World Bank has been structural adjustment in developing countries throughout its history. Korea now badly needs an active participation of the World Bank in structural reform with its rich experience in Mexico and elsewhere.