THE JOURNAL OF THE KOREAN ECONOMY, Vol. 7, No.

1 (Spring 2006), 77-118

Financial Supervision of Merchant Banking Corporations

as a Cause of Korea’s Currency Crisis *

Doo-Yull Choi ** ⋅ Yeonho Lee ***

This study investigates the ineffectiveness in the financial

regulations and supervision of Korea’s merchant banking corporations
(MBCs) prior to the 1997 currency crisis, whose behavior is thought to
trigger a vicious circle of credit contraction from Korea’s MBCs to
conglomerates. The study is based on the presumption that large parts
of MBCs’ business behavior are endogenously determined under the
given financial regulations and supervision system. The main point of
this study is that the financial regulations and supervisory system
surrounding MBCs were very much out-dated and ineffective. In
particular, MBCs were supervised based on an anachronistic paradigm
that foreign and domestic currency businesses undertaken by financial
institutions were distinctively separate from each other. This is a
good example showing the dangers when institutions and cognition do
not catch up with changing circumstances. Even under the new
supervisory system, bureaucratic sectionalism and no cooperation
among the supervisory agencies, which had resulted in the gray areas of
supervision of MBCs, are still often found in reality. In fact, the
supervisory agencies still rarely share the information on supervision
and hardly cooperate in examination. It cannot be overemphasized,
therefore, that these bad practices among supervisory agencies should
be corrected for the soundness of Korea’s financial system.

JEL Classification: F3, G2

Keywords: merchant banking corporation, financial regulation,
financial supervision, currency crisis

*
Received October 10, 2005. Accepted November 30, 2005. We are mostly grateful to
the anonymous referees for their helpful comments.
**
Author for correspondence, Dept. of Industrial Management, Korea University of
Technology and Education, 307 Gajeon-ri, Cheonan, Chungnam, 330-708, Korea, Tel:
81-41-560-1435, Fax: 81-41-560-1439, E-mail: dychoi@kut.ac.kr
***
Dept. of Economics, Chungbuk National University, 12 Gaeshin-dong, Cheongju,
Chungbuk, 361-763, Korea, Tel: 81-43-261-2215, Fax: 81-43-271-1713, E-mail:
leeyh@chungbuk.ac.kr
78 Doo-Yull Choi ⋅ Yeonho Lee

1. INTRODUCTION

A somewhat superficial view of the evolving processes of Korea’s 1997

currency crisis summarizes its development as follows. The series of
bankruptcies of large conglomerates since around the beginning of 1997 had
placed a number of domestic financial institutions near insolvency.
International creditors, worried about the near insolvency of Korea’s
financial institutions, reacted by squeezing their credit lines on Korea’s
financial institutions. Adding to squeezing of credit lines of international
financial market, the authorities’ imprudent exchange rate defense eventually
depleted the foreign currency reserves.
Therefore, Korea’s 1997 currency crisis may be characterized as being
evolved from financial crisis, combined with the policy failure on exchange
rates. In the evolving process of the financial crisis, the business behavior
of Korea’s merchant banking corporations (hereafter referred to as MBCs)
were singled out as one of the most fatal impetus fueling the outbreak of
Korea’s currency crisis. Specifically, the criticisms have been based mainly
on two grounds.
Firstly, MBCs have been criticized for triggering a chain reaction of
bankruptcies of Korea’s large conglomerates, “chaebols”. MBCs, which
typically lacked capabilities in credit ratings and analysis, had extended
non-secured credit to low credit-rated conglomerates under the traditional
myth that large conglomerates were too-big-to-fail. As large conglomerates
began to show signs of bankruptcy from early 1997, MBCs were pressed to
desperately attempt a withdrawal of their outstanding loans from faltering
conglomerates. MBCs’ indiscriminate demand for return of their loans
from corporations is said to have caused domino-like bankruptcies of large
conglomerates. The chain reaction of bankruptcies in effect led to the
deterioration of Korea’s financial institutions, which were driven to almost
complete insolvency. Such a vicious circle of credit contraction from
Korea’s MBCs to Korean conglomerates has been thought of as having
fueled the financial panic in the midst of Korea’s weakening financial sector.
 Financial Supervision of Merchant Banking Corporations 79

Secondly, MBCs have been criticized as having aggravated Korea’s

foreign liquidity crisis, in particular, by their reckless behavior in
international business markets. They usually borrowed short-term foreign
capital at attractively lower interest rates, and then invested in long-term
lease assets and/or illiquid junk bonds in a number of developing countries.
When MBCs were cut off from the short-term international financial markets
and the junk bonds of developing countries in which MBCs invested
defaulted, they immediately fell into a foreign currency liquidity crisis.
This is said to have accelerated Korea’s foreign currency liquidity crisis.
The two arguments above constitute the main arguments why Korea’s
MBCs were believed to have played a major pivotal role in the outbreak of
the 1997 currency crisis. Before placing the blame on MBCs for destroying
Korea’s financial system, however, it should be noted that MBCs were
commercial enterprises that seek to maximize profit, and whose behavior is
affected by the given exogenous environment: law, regulations, national
strategies, policies, societies, politics, cultures, etc. From this point of view,
special attention should be taken to the financial regulation and supervision
system that had a decisive impact on the business practices of financial
institutions.
It is also notable that besides Korea’s MBCs, financial crises have
occurred repeatedly on international scene and a similar kind of blame has
gone to the impetuous growth and sudden collapse of non-banking financial
institutions. The Japanese Jusen (housing loan companies) and Thailand’s
finance companies are examples.
Despite this, similar mistakes continue even today. What is more, the
financial regulation and supervision system that had played a critical role in
the collapse of non-banking financial institutions has yet to be properly
reviewed. There are hardly any systematic studies of the currency crisis
from the point of system’s approach (i.e. failure of institutions or regulations).
In the same manner, despite numerous denunciations of MBCs, very little
effort has been made to understand their behaviors within an institutional
setting which are primary factors behind their insolvency.
80 Doo-Yull Choi ⋅ Yeonho Lee

In contrast with the typical macroeconomic approach, 1) the role of MBCs

and the financial regulation and supervision system concerning them are
investigated here. A study of the financial regulation and supervision
system is essential if one is to properly appreciate the reasons for the reckless
business behavior of MBCs before the crisis.
An important aspect of this study is that even under the general severe
financial suppression, MBCs had been operating in a relatively more
liberalized commercial environment based on market principles. It is in this
sense that the business behavior of MBCs is more likely to be endogenously
determined under the given business environment, especially financial
regulations and supervision, than otherwise. This study will argue how
financial regulations and supervisory system surrounding MBCs were
out-of-date, containing many defects which made them improper instruments
in regulating the business activities of MBCs.
An overview of the growth of MBCs and their tasks is provided in section
2. Section 3 provides the main evidence for this study by taking a careful
look at the weak financial regulations and supervision that induced MBCs’
unsound business activities. Section 4 closes the study with a summary and
conclusion.

1)
Most of the existing literature adopt a macroeconomic approach in analyzing the causes of
the Korean currency crisis. As such they tend to miss the most important factor causing the
change in macroeconomic variables, namely, the financial regulation and supervision systems
governing financial institutions. For example, Lee and Lee (1998), Choi (1998), and Radlet
and Sachs (1998) argue that the Korea’s currency crisis was caused by exogenous shock.
Chung (1998), and Corsetti, Pesenti and Roubini (1998) emphasize structural problems in the
Korean economy, while Krugman (1988) stresses moral hazard of financial institutions as the
major factor. Lee and Eo (2000) look at big conglomerates, while Yu (2000) takes on the
impact of government regarding the crisis. Oh (1998) emphasizes the role of capital market
liberalization; Cho (1999) emphasizes the adverse effects of short-term financial markets.
Park and Choi (1999) emphasize the impact of real exchange rate appreciation; Park and Lee
(1998) point to the government and the civil sectors’ naive response to Southeast Asia’s
currency crises; Kim, Nam and Lee (2000) focus on over-consumption before the outbreak of
crisis in 1997.
 Financial Supervision of Merchant Banking Corporations 81

2. THE GROWTH OF MBCS AND THEIR BUSINESS SCOPE

In the early 1990s, initially 6 MBCs were operational in the market. In

1994 and 1996 respectively, 9 and 15 investment finance companies
(hereafter referred to as IFCs) were transformed into new MBCs. The
initial 6 and transformed 24, totaling 30, MBCs were in operation
immediately before the 1997 currency crisis.
Because most of the existing MBCs then were in fact IFCs, discussing the
role of MBCs in the process of Korea’s currency crisis requires reference to
the growth processes and functional scopes of IFCs before they were
transformed into MBCs. IFCs were established by the legislation of the
Short-Term Financial Business Law in August 1972. The Law aimed to
bring out the underground private financial sector into the open after the
so-called 8.3 Private Loan Freeze Emergency Order in 1972 and create
short-term banking institutions for business enterprises. 2)
On the other hand, Korean MBCs had appeared based on the legislation of
the Law of MBCs in December 1975. Between 1976 and 1979, the “initial
6 MBCs” were established. Contrary to the Short-Term Financial Business
Law, the Law of MBCs was originally legislated to establish long-term
financial institutions. To encourage long term financing to the industrial
sector, MBCs were originally modeled on the Merchant Banks of England.
To make appropriate adjustments to fit Korea’s actual financial
circumstances, the Ministry of Finance and Economy (hereafter referred to as
the MOFE) also added the function of investment banking and
medium/long-term equipment financing, as well as the typical functions of
Merchant Banks of England. Interestingly, the Law of MBCs allowed
MBCs to do almost all the financial businesses. MBCs had much broader
scope and functionality than IFCs. In detail, the major businesses of MBCs
consist of five categories; short-term financing, international financing,

2)
What is noteworthy is that IFCs were modeled on the finance companies of Thailand, which,
as already mentioned, had played a pivotal role in Thailand’s 1997 currency crisis. For more
details, see Man-Su Kang (2000. 8), pp. 440-448.
82 Doo-Yull Choi ⋅ Yeonho Lee

medium-term financing, long-term financing, and securities brokerage.

The most important difference between the business scope of IFCs and
MBCs is that the latter were allowed to participate in international financial
businesses. This included the introduction and brokerage of foreign capital,
overseas investment, as well as the introduction of foreign capital on their
own account for re-lending to domestic enterprises. At the beginning, as
with the IFCs, the main business of the MBCs was short-term financing, like
selling CPs. However, as time went by, largely to avoid competition with
IFCs in short-term finance, MBCs began to place more emphasis on
medium/long-term financing and leasing. However, this kind of ecological
balance between IFCs and MBCs in the non-banking sector was destroyed by
the massive conversion of IFCs into MBCs in the mid-1990s. IFCs had
customarily conducted their business by pursuing high-risk and high-return
investment activities. They did not break from this customary business
behavior even after they were transformed into MBCs. Consequently, the
effect was to turn MBCs into a high-risk and high return financial industry.
Before going on to further details of MBCs, it is necessary to look at the
process of the rapid growth of IFCs and MBCs. The aggregated market
share of IFCs and MBCs in Korea’s financial sector had rapidly increased up
until the 1997 currency crisis. 3) Table 1 shows the aggregated market share
of MBCs in terms of total assets. Total assets of MBCs had reached
155,910 billion won in 1996, which constituted almost 45.6% of commercial
banks’ total assets of 341,558 billion won. Such a staggering figure would
be abnormal given that the non-banking sector, which mainly engages in
short-term financial business, would constitute such a huge market share in
financial businesses.
We now move on to provide reasons why Korean MBCs had become so
dominant compared to commercial banks. Firstly, MBCs had been placed
under a more relaxed set of regulations and restrictions concerning interest
rates compared to commercial banks. Secondly, they had been allowed more

3)
All remaining IFCs were eventually converted into MBCs in 1996, by which time the market
share of MBCs includes that of IFCs.
 Financial Supervision of Merchant Banking Corporations 83

Table 1 Yearly Assets and Equities of MBCs

(unit: billion won)

Assets of Equities of
Assets of Equities of
End of year Commercial Commercial
MBCs1) MBCs
Banks Banks2)
1990 48,308 2,440 135,519 12,339
1991 54,720 2,035 161,516 13,781
1992 61,590 2,246 180,615 14,891
1993 75,261 2,544 194,988 16,223
1994 88,973 3,181 228,961 18,917
1995 123,878 3,657 288,687 21,380
1996 155,910 3,969 341,558 23,237
1997 166,771 3,884 483,498 22,290
Notes: 1) Includes new MBCs including existing IFCs that were transformed on July 1, 1996;
data before July 1996 are aggregated accounts of IFCs and MBCs.
2) Includes Nation-Wide Commercial Banks, Local Banks and Foreign Banks in
Korea.
Source: The Bank of Korea, “Money & Banking Statistics,” various issues.

autonomy in their management, thereby allowing them to manage their

businesses as a profit-making corporation on the basis of commercialism and
not as a public enterprise.
Before the conversion of IFCs into MBCs, the latter had enjoyed high
profitability. Their ROE (Return On Equity) was well over 10%, for
example. However, after the massive conversion of IFCs into MBCs, a
total of as many as 30 MBCs began to face competition amongst themselves,
thereby sharply eroding profitability. This excess competition in the
short-term financial business became a major reason behind their dwindling
profitability. Faced with this sharp drop in profitability, MBCs decided to
extend their business scale so as to remedy this deteriorating situation.
However, such decisions often were made without considering accompanied
risks. In particular, MBCs extended their credit to conglomerates with
unsound financial structure.
84 Doo-Yull Choi ⋅ Yeonho Lee

Table 2 Foreign Currency Liabilities of Financial Institutions

(unit: 100 million dollars)

1994 1995 1996 1997 1998 1999 2000

Foreign Currency
650.9 896.4 1,165.3 899.0 709.8 609.8 507.7
Liabilities of
(100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0)
Financial Institutions
360.8 496.9 630.9 330.2 278.6 256.0 213.3
Domestic Banks
(55.4) (55.4) (54.1) (36.7) (39.3) (42.0) (42.0)

Development 147.7 203.3 265.3 294.3 251.5 200.0 154.9

Institutions (22.7) (22.7) (22.8) (32.7) (35.4) (32.8) (30.5)

33.6 62.9 103.9 79.0 40.7 16.3 9.9

MBCs
(5.2) (7.0) (8.9) (8.8) (5.7) (2.7) (2.0)

Foreign Banks 108.8 133.3 165.2 195.6 139.0 137.5 129.5

in Korea (16.7) (14.9) (14.2) (21.8) (19.6) (22.6) (25.5)
Note: Figures inside the parentheses are %.
Source: Bank of Korea, “Annual Report of Foreign Exchange Statistics,” various issues.

They are also contrived to have raised their profitability by the so-called
“riding the yield curve” strategy; borrowing short-term foreign capital from
international financial institutions and investing them in long-term
investments in order to reap the yields between them. Their long-term
investments, however, mainly consisted of illiquid assets, which included
long-term leases in domestic financial businesses and junk bonds of
developing countries like Thailand, Indonesia, and Russia, amongst others.
Table 2 shows the foreign liabilities of Korea’s financial institutions.
Among the total of 116.53 billions dollars of foreign liabilities of financial
institutions at the end of 1996, MBCs constituted 10.39 billions dollars or
8.9% of the total. The total amount of the foreign liabilities of financial
institutions showed a 180% increase from 1994 to 1996. Even more
noticeable is that foreign liabilities of MBCs showed more remarkable
growth, jumping from 3.36 billion dollars (5.2% of the total) to 10.39 billion
dollars (8.9% of the total), which is an increase of about 310% over the same
period.
 Financial Supervision of Merchant Banking Corporations 85

Table 3 Bad Loans of 7 Bankrupt Chaebols

(unit: 100 million won)

Han Sam Jin Dae Hai New
Kia Total
-bo -mi -ro -nong -tai -coa
Commercial
46,274 8,108 13,897 6,986 44,403 13,104 9,373 122,679
Banks
(Collateralized) 24,182 4,448 8,871 2,952 19,545 900 6,733 67,631
MBCs 530 105 4,331 5,253 36,042 17,425 2,030 65,716
Source: Korean Federation of Commercial Banks, Maekyung Daily News, “Are MBCs nearly
Bankrupt?” November 6, 1997, p. 7.

With the advent of the Asian currency crisis, liquidating such illiquid
assets into liquid assets to redeem short-term loans that were not rolled over
became considerably difficult. As will be discussed later, the foreign
currency liquidity crunch of MBCs thereby began to fuel the problems at the
outset of the Korean currency crisis. In addition, the bad loans of MBCs
began to rapidly grow following a chain of bankruptcies of large
conglomerates from the beginning of 1997.
Table 3 shows the amount of bad loans of commercial banks and MBCs
linked to 7 bankrupt conglomerates at the end of 1997. The amount of bad
loans of MBCs stood at 6,571.6 billion won, which far surpasses their total
equities of 3,884 billion won. This unsecured credit risk exposure adversely
affected MBCs’ external credit worthiness, which isolated them from
international financial market.

3. FINANCIAL REGULATION AND

SUPERVISION OF MBCS

3.1. Financial Supervision and Examination System of MBCs

Various ways of classifying financial regulation and supervision are

possible. However, for the purposes of this study, we will classify financial
86 Doo-Yull Choi ⋅ Yeonho Lee

supervisory activities into three broad categories: entry regulation, ex-ante,

and ex-post supervision. Firstly, we refer to the authorization, permission,
and licensing by the supervisory body regarding financial institution as
“entry regulation”. Secondly, we consider the making and amending of
rules and regulations for prudential reasons as “ex-ante supervision”. Lastly,
we refer to financial supervision including the examination and punishment
functions as “ex-post supervision”. 4)
Before we look into the financial supervision system of MBCs, a glance
over the entire framework of Korea’s financial supervision system should be
useful. Table 4 shows the whole framework of supervisory jurisdiction on
Korea’s financial institutions up until the crisis. Among various
supervisory institutions, the Office of Bank Supervision (hereafter referred to
as OBS) and the MOFE were the two main supervisory bodies. 5) The
Office of Bank Supervision has legal authority of supervision over
commercial banks. It was established under the Bank of Korea (hereafter
referred to BOK) and was subject to the instructions and directives of the
Monetary Board of the BOK. The OBS exercised both ex-ante and ex-post
supervision over commercial banks.
Except for commercial banks, the MOFE took legal authority of
supervision over most of specialized banks and non-banking financial
Table 4 Supervisory Jurisdiction in Korea

4)
In Korea’s financial supervisory statues, there is no official terminology distinguishing
between ex-ante and ex-post supervision explicitly. However, it is clear that separately
treating these two concepts is important, especially when considering the fact that supervisory
bodies that are responsible for each might be different. Until the currency crisis, generally
ex-ante supervisory power and ex-post supervisory power were separated, as is seen in table 4.
5)
In Korea, there have been serious disputes among supervisory bodies, especially between the
OBS of the BOK and the MOFE, over the jurisdiction of supervision of financial institutions.
The supervisory jurisdiction has had an important meaning for the placement of ex-officials of
supervisory institutions. Traditionally supervisory power had been exploited as an important
revolving door for ex-bureaucrats of supervisory institutions to finding jobs in supervised
financial institutions. Leveraging on their supervisory power, the supervisory institutions had
controlled high-handed personnel administration over the supervised financial institutions,
where ex-official of supervisory institution could be placed as CEOs or auditors. Such
revolving doors of ex-bureaucrats of regulating institutions to take up important posts in
regulated institutions can also be found in Japan, which is called “Amakudari”.
 Financial Supervision of Merchant Banking Corporations 87

Financial Institutions Supervised by Examined by

Commercial Banks OBS1) OBS

Specialized Banks MOFE MOFE
Non-Bank Financial Institutions
(Development Institutions,
MOFE MOFE
Investment Institutions,
Savings Institutions)
MBCs MOFE MOFE
2)
Securities Institutions MOFE, SSB SSB
Life Insurance Institutions MOFE, ISB3) ISB
Notes: 1) OBS means the Office of Bank Supervision of the BOK.
2) SSB means the Securities Supervisory Board.
3) ISB means the Insurance Supervisory Board.

institutions, including MBCs. 6) In fact, the MOFE has had ultimate power
of financial supervision over MBCs. But compared with those of
commercial banks, financial regulation and supervision of MBCs turned out
to be much weaker.
Regarding ex-ante supervision on MBCs, the MOFE seemed to have
outdated financial rules and regulations and did not meet timely the needs to
amend supervisory standards and provisions. Not only did the ex-ante
supervision become outdated, the MOFE turned out to have been negligent
regarding ex-post supervision, e.g. surprise on-site examination, on-site-
confirmation of reports, field confirmation of constructing financial risk
management system, and so on. Such ineffective financial supervision
allowed MBCs to undertake risky business activities, which finally led to
their collapse with the outbreak of the currency crisis.
There were three main reasons why the MOFE’s financial supervision of

6)
MBCs may be considered similar to banks if we consider that MBCs and commercial banks
have few functional differences and are exposed to similar credit risks. Therefore, there is
little reason why MBCs should be supervised by different supervisory bodies from
commercial banks. Nonetheless, financial supervision of commercial banks has been
assigned to the OBS of the BOK, while the supervision of MBCs has been assigned to the
MOFE.
88 Doo-Yull Choi ⋅ Yeonho Lee

MBCs became ineffective. Firstly, the MOFE was primarily a

policy-making institution rather than an executive organization. It did not
have important executive organizational structures, nor did it develop
specialty for supervising financial institutions. As a result, the MOFE had
frequently relied upon partial delegation of ex-post supervision to the OBS,
SSB, Korea Credit Guarantee Fund and others. However, such ex-post
supervision by ways of partial delegation had some critical defects as will be
discussed later.
Secondly, even under the partial delegation of the supervision system,
coordination of supervision of the MOFE turned out to be extremely poor.
Although it was the prerogative of the MOFE to systematically and
comprehensively organize the supervisory activities of MBCs, in reality it
failed to do so. Moreover, under the supervision system by partial
delegation of ex-post supervision, many gray areas of supervision cropped up.
Most of these occurred when the scope of partial delegation was not clearly
defined or when the MOFE failed to properly coordinate financial
supervision among the entrusted supervisory agencies. As the business
areas of MBCs were highly diversified, the laws, which govern their
businesses, were also multifarious and complex.
Even within the MOFE, the power of supervision of MBCs was dispersed
into several departments. 7) Because MBC governing laws and supervisory
agencies were diversified, it was even more vital that the MOFE coordinate
the supervisory activities of entrusted agencies more comprehensively.
However, consolidated planning and coordination of financial supervision of
the MOFE had proved to have been extremely weak, plagued with many gray
areas over financial supervision.
For example, supervision over the foreign exchange businesses of MBCs
was commonly plagued by weak financial supervision. Regarding MBCs’
foreign exchange business, neither ex-ante nor ex-post financial supervision

7)
Such departments included the followings; Capital Market Department, Industrial Fund
Department, Securities Business Department, International Finance Department, Securities
Business Department, International Finance Department, etc.
 Financial Supervision of Merchant Banking Corporations 89

had been properly conducted especially from 1994 to 1996 when the
newly-converted MBCs had began to engage in international financial
business recklessly. On the side of ex-ante supervision of MBCs foreign
exchange business, rules and regulations to secure their soundness had not
been updated to meet the changing times. Necessary guidelines were not
established, for example, regarding the level of adequate foreign currency
liquidity; exclusion of lease loans from regulating medium/long-term foreign
currency ratio; exclusion of overseas securities investment from the limit on
securities investment; exclusion of foreign currency loan from the limit on
short-term loan, etc. On the side of ex-post supervision of foreign exchange
business, the performance of MBCs in the foreign exchange business from
1994 to 1996 went unexamined especially during the critical period in which
the newly-transformed MBCs engaged in the international financial sector
without due proper preparation. As the supervisory institutions had not
checked whether MBCs observed even the outdated rules and regulations,
MBCs ended up recklessly expanding their businesses.
The MOFE manages the “Foreign Currency Exchange Transactions
Regulation,” which regulates the soundness of foreign exchange banks
among which MBCs are included, and it is therefore responsible for ex-ante
supervision of MBCs’ foreign exchange business. The related law
prescribes that if necessary, the MOFE may entrust to the OBS parts of
ex-post supervision of foreign exchange businesses, including examination
and reporting. 8) However, regarding ex-post supervision of MBCs’ foreign
exchange business, the MOFE did not explicitly include the examination of
MBCs’ foreign exchange businesses when the MOFE requested examination
of MBCs to the OBS, even though it could have done so. In the process of
parliamentary inspection after the currency crisis on the causes of currency
crisis, the MOFE and the OBS blamed each other for irresponsibility over
MBCs’ foreign currency business. 9) Be as it may, neither the MOFE nor

8)
The Law of Managing Foreign Currency specifies that the MOFE has the ultimate power of
supervising foreign exchange businesses in foreign exchange banks and if necessary, it may
delegate part of supervision to other supervisory agencies.
9)
The MOFE defended itself arguing that it was not necessary to request the OBS explicitly to
90 Doo-Yull Choi ⋅ Yeonho Lee

the OBS performed appropriate financial supervision on MBCs’ foreign

exchange business. 10)
Thirdly, there is also an important institutional factor that hindered the
effective financial supervision of MBCs. There had been a long-standing
practice in Korea’s financial industry whereby ex-bureaucrats of supervisory
bodies took up senior positions in financial institutions under their
supervisory jurisdiction after their retirement. 11) Ex-bureaucrats who have
taken over posts in non-banking financial facilities including MBCs from the
MOFE made supervision of target financial institutions incapacitated. It is

examine MBCs’ foreign exchange businesses, saying that the Law of Managing Foreign
Currency could be interpreted to have comprehensively entrusted the power of examination of
foreign exchange businesses of foreign exchange banks to the OBS. On such grounds, the
MOFE argued that the OBS was responsible for neglecting the ex-post supervision on MBCs’
foreign exchange businesses. On the other hand, the OBS insisted that the MOFE should
have remained the responsible institution. The OBS defended itself saying that it was never
entrusted comprehensively the right to examine the foreign exchange businesses. As the
right to examine the MBCs was given in the form of special request of the MOFE, so far as
there was no explicit request of examination from the MOFE on the foreign exchange
business of MBCs, it had absolutely no right to examine the MBCs’ foreign exchange business
by itself. Before making any judgment on these two opposite assertions, we need to consider
the usual practices of delegating ex-post supervision of other business areas of MBCs.
Customarily, when the MOFE requested the OBS to examine financial institutions, the MOFE
specified target financial institutions and the scope of businesses to be examined. Therefore,
the examinations of the OBS were mainly restricted to ex-post supervision. Under such
circumstances that related laws and regulations ambiguously defined the delegation of
supervisory power, we can infer that the OBS may have believed that the MOFE’s delegation
was the result of coordination among the MOFE’s departments and did not include MBCs’
foreign exchange businesses in its examination.
10)
Even after the crisis, the conflict and sectionalism of supervisory agencies are not clearly
dissolved. After the crisis, Korea integrated diversified financial supervisory bodies into the
Financial Supervisory Commission (FSC) and the Financial Supervisory Service (FSS).
However, it is not yet distinctly resolved who takes the control of examination on the foreign
exchange businesses of financial institutions. There are still some conflicts between the FSS
and the BOK surrounding the examination on financial institutions' foreign exchange business.
The BOK, which is now given the right to co-examine with the FSS on financial institutions,
wants to perform the co-examination with the FSS on the foreign exchange businesses of all
the financial institutions. But the FSS insists to restrict the co-examination on the foreign
exchange business of financial institutions with the BOK only to the commercial banks, for
fear of transferring part of its supervisory right to the BOK. For more detail, read Munwha
daily news, “Disputes between the FSS and the BOK surrounding the supervisory right on
FOREX businesses of financial institutions,” 2005. 11. 7.
11)
Such practices are known as “Nakhasan” in Korea, which literally means “parachuting,” say,
from an airplane, and “Amakudary” in Japan, which means “coming down from heaven”.
 Financial Supervision of Merchant Banking Corporations 91

not easy to expect supervisory bodies to properly supervise financial

institutions where their former colleagues or bosses are working as CEOs.
They even acted as lobbyists by rendering rectifying measures incapacitated
and, even in some cases, making various financial regulations favorable to
their financial institutions. These customary practices impaired the
effectiveness of financial supervision by solidifying a close relationship
between the supervisory power and the supervised institution. 12)

3.2. Entry Regulation of MBCs

As mentioned before, a total of 30 MBCs were operating in the market

before the outbreak of crisis. In the middle of the 1990s, all IFCs tried
eagerly to acquire entry permission into the MBC business. For Korean
financial institutions, the foreign exchange business was regarded as a
golden-goose-like business. Around the middle of the 1990s, coupled with
Korea’s increased foreign exchange liberalization, financial institutions that
had been allowed to introduce foreign capital enjoyed economic rent that
resulted from differences in interest rates between international and domestic
markets. 13) While MBCs had been allowed to bring in foreign capital, IFCs
were not, because MBCs and not IFCs were classified as Foreign Exchange
Banks. This is one important reason why IFCs desperately wished to
become MBCs. As both of IFCs and MBCs could receive short-term

12)
What is interesting is that such practices have also been common in other Asian
non-banking financial institutions as well, especially in the case of the Japanese Jusen. The
Ministry of Finance in Japan had supervisory jurisdiction over the Jusen and had directly
supervised them. Almost all of Jusen executives were ex-bureaucrats from the Ministry of
Finance, and in lieu of this, Jusen obtained various kinds of regulatory favors in their business
from the Ministry of Finance. Such practices were important reasons why the supervision of
Jusen by the Ministry of Finance became so ineffective.
13)
In the then-international financial market, there had been abundant international liquidity
around the world. Several countries including the US and Germany maintained low interest
rates. Especially, Japan’s interest rates were particularly low thereby causing cheap Japanese
capital to flood into international financial markets. Many financial institutions engaged in
the so-called “Yen Carry Trade”; borrowing in Yen denominated funds and investing into
dollar denominated assets or in emerging markets’ junk bonds. Korea’s MBCs were known
to have actively engaged in this “Yen Carry Trade”.
92 Doo-Yull Choi ⋅ Yeonho Lee

financial business licenses, excessive competition in short-term financial

business had occurred among them, which in turn resulted in low rates of
return.
In this respect, it is important to verify whether entry regulations, i.e.
authorization of the conversion of IFCs into MBCs in 1994 and 1996, had
been appropriate from the point of financial supervision. The Kim
Young-Sam’s regime announced the principles governing the authorization
of the conversion of financial institutions in the Financial Reforming Parts of
the 5-Year New Economy Plan. The original principles emphasized the
following: firstly, IFCs should specialize in comparatively superior
businesses among the commonly operated ones in international finance,
short-term finance, corporate banking services, etc.; secondly, IFCs should
provide comprehensive one-stop financial services for local companies.
Instead of the original strict principles of new 5-Year Economy Plan,
however, very relaxed requirements were applied to the conversion of IFCs
into MBCs in 1994. The newly relaxed requirements for conversion are as
follows: (i) IFCs must have equity capital of more than 40 billion won; (ii)
IFCs must not have any records on tax avoidance and suspension of business
over the latest 3 years, and; (iii) IFCs must hold more than 30 billion won
after deducting doubtful capital from their equity capital. The 9 new MBCs,
which were licensed under such easier requirements, were also allowed
access into the foreign exchange business.
What thickens the story further is that the lowered standards for
conversion in 1994 were lowered again regarding conversion in 1996; the
requirement on the size of equity capital was alleviated subsequently. With
the requirement for equity capital alleviated, 8 IFCs in Seoul and 7 in local
areas were permitted to become MBCs as from July 1996. Thus, through
imprudently lowering the standards of licensing of MBCs, in merely three
years, the MOFE had effectively authorized a total of 24 new MBCs. 14)

14)
After the currency crisis, investigation by prosecutors was carried out regarding the process
by which IFCs were transformed into MBCs, based on the opposition parties’ assertion that
some IFCs had bribed government bureaucrats and politicians for permission to be
transformed into MBCs.
 Financial Supervision of Merchant Banking Corporations 93

From the point of financial supervision, the license of conducting foreign

exchange business of the newly converted MBCs should have been
suspended until their actual viability to engage in such businesses is properly
evaluated. However, without such a filtering mechanism, the MOFE de
facto authorized automatically the opening up of all kinds of businesses to
the newly-transformed MBCs in one or two years.
If we reflect on the licensing policy of the transformation of IFCs into
MBCs, we can see that the MOFE should have given business permission to
transformed MBCs only in specialized business areas, as was initially
scheduled in the original policy. In order to decide the business areas, the
MOFE could have mandated IFCs to submit comprehensive business plans
explaining scheduled job scopes, work to be specialized, method of operation,
prospect of results, ways of fund raising, recruiting plans of specialized
personnel, etc. Only after evaluating the feasibility of their plans
thoroughly should the MOFE have approved MBC business licenses only in
viable specialized business areas. In addition, the MOFE should have set up
a strict criteria for measuring the capability of performance in new areas in
the form of a licensing condition, and in accordance with their achievements,
should have decided whether to permit MBCs to continue their new business
areas.
Unfortunately, such supervision-oriented licensing policies and procedures
were completely absent. Especially, the newly-transformed MBCs in
provincial areas hardly had proper infrastructure and experience to conduct
international financial businesses. Most of them considered international
financial businesses simply as an extension of domestic short-term finance.
MBCs typically pursued profits mainly in two ways; firstly, by seeking
differences in long-term and short-term international interest rates; secondly,
by seeking differences in international and domestic interest rates.
However, in constructing their international financial portfolios, they pursued
profits neglecting the associated risks of their financial position.
What is interesting are the different ways in which businesses were carried
out between original and newly-transformed MBCs. During the currency
94 Doo-Yull Choi ⋅ Yeonho Lee

crisis, it was mostly the newly-transformed MBCs that experienced a severe

foreign currency liquidity crisis. In contrast, the pre-existing MBCs
maintained a relatively better foreign currency liquidity status. One of the
reasons for this difference lies in the different funding costs of foreign capital
between original and newly-transformed MBCs. Mostly, from their
establishment, the major shareholders of the original MBCs were
internationally well-known foreign investors. Thanks to the reputation of
their foreign major shareholders, the original MBCs borrowed from
international markets at more favorable conditions than the
newly-transformed MBCs. On the other hand, most of the major
shareholders of newly-transformed MBCs were local firms. Therefore, they
could not benefit from their ownership structure in raising funds. As such,
the newly-transformed MBCs had little choice but to borrow short-term
capital with higher interest rates. This added further commitment to their
risky portfolios. Moreover, the original MBCs were better able to roll over
their foreign debt given that they were of higher credit rating in lieu partly of
their foreign major shareholders. They even borrowed foreign capital from
their foreign major shareholders themselves. In contrast, the newly-
transformed MBCs did not enjoy similar kind of protection from their major
shareholders.
There is also another important issue regarding entry regulation of MBCs,
the licensing of overseas branches. In the middle of the 1990s, all MBCs
tried to establish overseas branches. The problem is that the MOFE
licensed too many overseas branches of MBCs in Southeast Asia. This
unbalanced licensing of overseas branches resulted in the scrambling of
Korean MBCs, creating as a result excess competition among them for
funding, which in turn increased funding costs. MBCs had created a total of
13 branches around the end of 1997, most of which were concentrated in
Southeast Asia (11 in Hong Kong, 1 in Singapore, etc.). 15) The reason why

15)
Unlike the licensing policy of overseas MBC branches of the MOFE, the OBS that was in
charge of the supervision of commercial banks had restricted the number of branches in the
same area to prevent excess competition among Korean banks. As a result of this balanced
entry regulation, commercial banks had overseas branches that were far more diversified, i.e.
 Financial Supervision of Merchant Banking Corporations 95

MBCs tried to locate overseas branches mainly in Hong Kong may be that
for MBCs, which had relatively low credit rating in international finance,
Hong Kong was a relatively easier market for funding foreign capital than,
say, the US or Europe.
As Korean MBCs’ overseas branches scrambled for Hong Kong’s limited
financial market, the interest rates of borrowing foreign capital that were
applied to Korean financial institutions stiffened with the excessive
competition among them.

3.3. Regulation and Supervision of MBCs’ Capital Adequacy

Another regulatory failure that had aggravated MBCs’ financial structure

was the poor ex-ante regulation system regarding their capital adequacy.
Up until the currency crisis, the MOFE had overlooked introducing
appropriate regulatory system like the BIS standards regarding capital
adequacy for MBCs.
In the case of commercial banks, the OBS had already introduced the BIS
regulatory standards in 1992. Consequently, Korea’s commercial banks had
been required to adopt the BIS capital adequacy ratio of above 8%. The
OBS also adopted an early rectification system, which was activated
according to the amount of risky assets of supervised banks. However, it
was not until April 1998 that the FSC and FSS introduced a BIS capital
adequacy ratio for MBCs. Compared to Korean commercial banks, the
introduction of a BIS regulatory system for MBCs was rather late.
Regarding the capital adequacy requirements, at least until the currency crisis,
the MOFE regulated MBCs by means of naive financial gearing ratios like
the capital ratio. 16) Regulations for capital adequacy based on naive

47 in the US, 27 in Japan, 50 in Europe, 34 in Hong Kong, 15 in Singapore, and 83 in other

countries.
16)
The financial gearing ratios are sort of simple capital ratios; MBCs were regulated not to
exceed credit expansion 20 times their equity capital and not to issue corporate bonds
exceeding 10 times their equity capital. However, even such naive gearing ratios had not
been strictly observed given the poor ex-post supervision.
96 Doo-Yull Choi ⋅ Yeonho Lee

financial gearing ratios could not give precise information on the level of risk
held by MBCs. As MBCs had extended their credit mostly by
un-collateralized discounts, sales of CPs, and payment guarantees, this
simple gearing ratio could not provide the precise information on how much
risky assets MBCs had been bearing compared to their equity capital.
Such a naive regulatory system on capital adequacy had left MBCs
expanding their risky assets imprudently and, furthermore, made it difficult
to refrain them from recklessly extending their credit. Consequently,
MBCs’ management continued recklessly and unabatedly their risk-taking
business activities. With such out-of-dated ex-ante regulatory measures, the
ex-post supervision could hardly be effective. International financial
institutions could not trust the financial status of Korean MBCs because it
was difficult to evaluate properly their capital adequacy by means of such
out-of-dated gearing ratios.
Despite the changing circumstances with MBCs rapidly expanding their
credit and offshore financing in international financial markets, the MOFE
had reacted too slowly in introducing a BIS capital adequacy requirement for
MBCs. It was only after the outbreak of the currency crisis that the
supervisory body introduced a risk-weighted BIS capital adequacy
requirement for MBCs.

3.4. Regulation and Supervision of Credit Concentration and

Connected Lending

Another piece of institutional failure that aggravated MBCs’ financial

structure was the weak regulation and supervision of MBCs’ credit
concentration and connected lending. In fact, MBCs had little ability to
evaluate the credit ratings of their borrowers even though most of their
credits were unsecured. Therefore, they had strong tendency to concentrate
their credit to large “chaebols,” under the naive belief that the chaebols were
“too-big-to-fail”.
In order to prevent MBCs from recklessly concentrating credit to chaebols,
 Financial Supervision of Merchant Banking Corporations 97

supervisory authority placed strict credit ceilings to refrain credit from

exceeding certain limits to large chaebols. However, the then supervisory
standards on MBCs’ credit ceiling to conglomerates were largely defective
and contained in them many loopholes. MBCs credit ceiling on a chaebol
were three times as high as that of commercial banks. Specifically, the
credit ceiling by MBCs on a single chaebol was restricted at 150% of their
equity capital, while that of commercial banks was set at a maximum limit of
45% of equity capital. In addition to this, even though a company belonged
to a chaebol, if it could be classified as a so-called “company with
decentralized ownership structure,” then the credit and lease loans to such
companies were excluded when calculating the total credit ceiling of the
chaebol. 17)
As most credit of MBCs were unsecured, they carried higher credit risk
than commercial banks, and so the MOFE should have enforced credit
ceilings on chaebols more strictly than, say, commercial banks. However,
this common notion of supervision was not observed then. The supervisory
standard permitting credit concentration of MBCs to reach 3 times that of
commercial banks was a seriously unbalance in financial regulation. This
unbalanced credit concentration increased MBCs portfolio risk, eventually
leading to their insolvencies when one of their main borrowers, particularly
the chaebols, faced bankruptcy during the currency crisis.
In addition, there was yet another piece of regulation on credit
concentration that also contributed to increasing MBCs’ portfolio risk. The
supervisory standard on credit limits of financial institution lending to large
shareholders was aimed at preventing a situation in which financial
institutions would become a private vault for large shareholders. Up until
the currency crisis, the supervisory standard on the credit limit of MBCs to
large shareholders, including all interrelated companies, was set within 100%
of their equity capital. However, mutual savings and finance companies,

17)
From the point of financial supervision, placing a credit limit aims at reducing the
concentration of credit to specific firms or chaebol. In this respect, there is usually no reason
to exclude credit and lease loans to “companies with decentralized ownership structure” in the
credit limit to a chaebol.
98 Doo-Yull Choi ⋅ Yeonho Lee

which are also non-banking financial institutions, were completely banned

from providing credit to their large shareholders. Considering the purpose
of such credit limits on large shareholders, we find that the supervisory
standard on credit limit to large shareholders of MBCs had been far too
loosely set up.
Combined with such loose supervisory standards on credit concentration,
weak ex-post supervision of MBCs ended up aggravating the concentration
of MBCs’ credit. Table 5 shows results of a special investigation in the
process of disclosing non-viable MBCs after the outbreak of crisis. Among
the violations of supervisory standards by disclosed MBCs, cases in which
the excess of the credit limit to the same borrowers recorded the largest
amount at 2,279.5 billion won out of 4,056.8 billion won.
Other typical violations on the regulations on credit concentration included
cases in which major shareholders used an assumed person’s name (this
being a violation of the “real name system in financial transactions”)
particularly when money was borrowed from MBCs, and in which major
shareholders of different MBCs swapped loans with each other. These
violations were not easily detectable without intensive on-site examinations
because they involved assumed names as well as behind contracts. Up until
the currency crisis, illegal acts by MBCs like using an assumed name when
borrowing had been quite common. This implies that ex-post supervision
was hardly effective and was unable to prevent such illegal violations
regarding supervisory standards. 18)
Table 5 Incidence of Violation of Regulations of Disclosed MBCs

(unit: 100 million won)

18)
After the outbreak of the currency crisis, as it became evident that ineffective regulation on
credit concentration of MBCs was a major factor in the collapse of MBCs, the supervisory
authority revised supervisory standards on credit concentration; the concept of a single
business group was redefined as inter-linked companies sharing common credit risk; the credit
limit to a single business group was changed from 150% to 25% of MBCs’ equity capital
based on the new concept of a single business group; credit limit applicable to majority
shareholders of MBCs was reduced from 100% to 50% of their equity capital: concept of
major shareholders was redefined as inter-related major shareholders sharing common credit
risk; and based on the new concept of inter-related major share holders, credit limit to the
major shareholders were reduced to up to 25% of MBCs’ equity capital etc.
 Financial Supervision of Merchant Banking Corporations 99

Types of Violation of Regulations

Illegal
Name of Excess of Inadequate Illegal
Management
MBCs the Limit selling of Manage-
of Foreign Others Total
on Same unsecured ment of
Exchange
Borrowers bills Credit
Business
Kyungnam 1,865 274 90 2,229
Kyongil 160 259 419
Koryo 269 806 141 42 1,258
Taegu 356 1,869 253 2,478
Daehan 9,813 1,681 285 29 1,626 13,434
Samsam 672 575 1,247
Samyang 7 150 279 35 471
Saehan 2,617 181 2,798
Shinsaegie 378 330 708
Shinhan 393 35 428
Ssangyong 99 246 149 9 503
Jaeil 1,969 190 2,159
Chungsol 359 241 600
Hangil 4,607 624 25 58 5,314
Hansol 408 2,032 139 383 2,962
Hanwha 569 708 1,277
Hangdo 119 2,041 123 2,283
Total (17) 22,795 13,617 1,570 823 1,763 40,568
Source: Korea Deposit Insurance Corporation, “The 3rd Investigation on the Causes of the
Insolvencies of the Disclosed Financial Institutions,” Report for the Press, 1999. 12.
It is reasonable to assume that violation of regulations by financial
institutions would occur when expected revenue from violation was greater
than expected cost of violation in the event that it be detected. The
expected cost of violation can be viewed as the product of the probability of
being detected and the degree of penalty inflicted if detected. On this basis,
the supervisory body could diminish incentives of financial institutions and
100 Doo-Yull Choi ⋅ Yeonho Lee

prevent them from committing illegal acts by intensifying punishment and

thereby increasing expected costs.
Another important channel of reckless credit expansion by MBCs was the
endorsing of payment guarantees to CPs beyond their limit. CPs are by
themselves unsecured accommodation (kite) bills. Unlike commercial bills
that are issued for the settlement of real transactions, CPs are basically
unsecured accommodation bills that are issued as short term financing for
enterprises. In related regulations, MBCs are restricted from taking
liabilities of more than twenty times their equity capital. Payment
guarantees by MBCs are included within the limit of approved liabilities.
However, prior to the currency crisis, MBCs recklessly issued payment
guarantees beyond their approved limit on liabilities in an expedient way by
selling CPs to investors. Ex-post supervision on MBCs was so ineffective
that it could not refrain MBCs from illegally granting payment guarantees
beyond the limits on their CP sales.
The payment guarantee on CPs beyond their limit had been conducted
mainly through so-called “side-guarantees,” which are behind the scene
contracts between MBCs and purchasers of CP (mainly institutional
investors), certifying that MBCs would pay the CPs instead in the event that
CPs were dishonored by the issuers.
Although supervisory authorities in fact prohibited such side-guarantees on
sales of CPs as unsound financial behavior, side-guarantees themselves are
perfectly legally valid contracts between the concerned parties. Therefore,
aside from the issue of punishment by supervisory bodies, when the issuers
dishonored side-guaranteed CPs, MBCs were left with the obligation to pay
investors. In addition, payment guarantees are not fixed liabilities, but
contingent liabilities. For this reason, they are not qualified to be listed as
balance sheet items, but are simply recorded in the notes of balance sheets.
Therefore, the amount of payment guarantee is not disclosed clearly, to say
nothing of side-guarantees.
Accordingly, until before the onset of the currency crisis, the amount of
side guarantees by MBCs increased remarkably. Although there is no
 Financial Supervision of Merchant Banking Corporations 101

precise statistic showing how large side-guarantees were, 19) we can gauge the
relative importance of side-guarantees regarding the collapse of MBCs
through table 5. According to the table, the severest (worth 2,279.5 billion
won) had been assumed by violations on limitation of credit to the same
person. The second (worth 1,361.7 billion won) was the inadequate selling
of unsecured bills, which comprised selling CPs with side-guarantees.
Conclusively, MBCs contained excessive contingent liabilities compared
with their equity capital by way of side-guarantees. In 1997, when the
chaebols that issued CPs became bankrupt and the CPs which MBCs
side-guaranteed were dishonored, MBCs collapsed under the burden of their
outstanding obligations that became inevitable.

3.5. Regulation and Supervision of Foreign Currency Assets Liquidity

The supervisory body’s regulatory failure concerning MBCs is most

evident with regards to the foreign currency liquidity regulation of MBCs.
As was mentioned earlier, IFCs, after their transformation into MBCs, were
permitted to conduct quite unreservedly international financial businesses.
They devoted themselves to the so called “riding the yield curve strategy”
and “Yen Carry Trade”: borrowing short-term funds, especially Japanese
funds from Hong Kong at low interest rates, and investing them in long-term
assets such as leases, equipment loans and developing countries’ junk bonds,
while neglecting the risks of maturity mismatching between foreign currency
assets and liabilities.
The maturity mismatch risk was finally realized in late-1997 when
international lenders refused to roll over short-term loans to MBCs. Early
in 1997, when some large conglomerates including Sammi and Hanbo began
to experience insolvency problems, international financial lenders became
concerned about the financial health of Korean financial institutions.
Consequently, they began to squeeze credit lines on Korean banks,

19)
Kang (1998) estimates the amount of side-guarantees at a huge 52 trillion won as of the end
of 1996, which is almost 27% of money supply (M2) at the time.
102 Doo-Yull Choi ⋅ Yeonho Lee

withdrawing loans in some cases. And, for the same reasons, they also
refused to roll over short-term loans to MBCs. Under such a situation,
MBCs’ long-term assets, especially in emerging market junk bonds,
long-term leases and long-term loans, became illiquid in the wake of Asian
currency crisis. With illiquid long-term foreign currency assets, MBCs
could not roll over their maturing short-term liabilities, causing MBCs to
immediately fall into a foreign currency liquidity crisis. With MBCs’
international financing clogged, they rushed into Korea’s weak domestic spot
foreign exchange market for funds to repay their maturing short-term foreign
currency borrowings. This accelerated the shortage of foreign exchange in
the already weakened domestic foreign exchange market, thereby leading to
skyrocketing won/dollar exchange rates. Referring to table 6, the amount of
MBCs’ due foreign currency denominated liabilities was 4.9 billion dollars in
November 1997, and 1.6 billion dollars in December 1997. The total
foreign currency liability of MBCs due was almost 6.5 billion dollars at the
end of the year.
To understand the unsound business behavior of MBCs, we need to
examine the financial regulation environment. The change in Korea’s
financial regulation environment started with the inauguration of the Kim
Young-Sam’s regime in February 1993. In November 1994, President
Kim declared the so called “Saegyehwa” (globalization) as his political
slogan. Kim’s regime, without second thoughts, aimed at joining the
OECD. He did not consider seriously whether Korea was able to fulfill
the requirements for joining the OECD. In the process of hastily
de-regulating capital inflows to satisfy the entry requirements in the OECD,
the regulators had produced something of a reverse discriminative financial
Table 6 Amount Due of MBCs’ Foreign Currency Denominated
Liabilities in November and December of 1997

(unit: million dollars)

Classification Nov. of 1997 Dec. of 1997 Scale of Overnight1)

Incumbent MBCs in Seoul 2,139 710 162

 Financial Supervision of Merchant Banking Corporations 103

Transformed MBCs in Seoul 839 435 273

Incumbent MBCs in Local area 1,729 412 932

Transformed MBCs in Local area 199 71 34

Total Amounts 4,906 1,628 1,401

Size of Korea’ FOREX market2) 22,800 21,500

Notes: 1) Includes daily averages from October 1, 1997 to November 5, 1997.
2) Monthly trade volume of Korea’s spot foreign exchange market.
Source: Maekyung Daily News, November 9, 1997, p. 7.

regulatory environment between short-term and long-term foreign currency

borrowings.
More specifically, very few measures had been imposed on financial
institutions’ short-term borrowings of foreign currencies, while lots of
regulations and bureaucratic red tape had remained on long-term borrowings
of foreign capital. According to the Foreign Currency Exchange
Transactions Regulations, financial institutions that induced short-term
foreign capital had no obligation to declare this transaction to the MOFE.
On the other hand, when financial institutions induced long-term capital
inducement, they were mandated to declare the transaction to the MOFE. In
addition, if the amount was greater than 10 million dollars, they had to notify
to the MOFE beforehand.
Moreover, what made financial institutions prefer short-term capital were
the quota restrictions in inducing foreign capital. Regarding short-term
foreign capital, there were no quota restrictions in inducing foreign capital,
while for long-term capital, strict quota restriction had been set up. Such
asymmetric regulation against long-term borrowings made financial
institutions including MBCs prefer short-term borrowings to long-term
borrowings. In fact, as a result of such unbalanced regulations, financial
institutions including MBCs were encouraged to replace long-term
borrowings by short-term borrowings. This contributed to distorting the
foreign currency exposure toward short-term borrowings.
104 Doo-Yull Choi ⋅ Yeonho Lee

Another piece of regulatory failure that led to the deterioration of foreign

exchange maturity mismatches of financial institutions was the relaxation of
the “Long-term Borrowing Ratio for Foreign Currency Loans.” Prior to the
President Kim Young-Sam’s regime, foreign exchange banks were required
to finance 70% or more of their foreign currency loans for longer than 3
years by foreign currency borrowings of maturity longer than 3 years.

Long-Term Borrowing Ratio for Foreign Currency Loans

Foreign Currency Borrowings (longer than 3 years)
= ≥ 70%
Foreign Currency Loans (longer than 3 years)

However, with the new regime under Kim Yong-Sam, as part of the “New
Economy Plan for 100 Days,” the minimum long-term borrowing ratio for
foreign currency loans was lowered to 50% from 70%. This relaxation of
regulations encouraged foreign exchange banks including MBCs to increase
overseas short-term borrowing that carried lower interest rates. This
deregulation was another important factor that aggravated MBCs’ maturity
mismatch of foreign currency assets and liabilities.
What is noteworthy is that the maturity mismatch of foreign currency
assets and liabilities was much more severe in MBCs than in commercial
banks. Table 7 shows the consolidated foreign currency assets and
liabilities of MBCs immediately before the currency crisis. Considering the
funding side of the foreign currency liabilities, 64.7% (9.33 billion dollars)
were short-term borrowings. However, regarding the operating side of
foreign currency assets, around 92.9% (13.52 billion dollars) were oper`ating
in the form of medium/long-term assets. Thus, the previous-“Long-term
Table 7 Foreign Currency Assets and Liabilities of MBCs (1997. 8. 10)

(unit: 100 million dollars)

Foreign Currency Assets Foreign Currency Liabilities

Long-term Assets 135.2 (92.9) Long-term Liabilities 50.8 (35.3)

 Financial Supervision of Merchant Banking Corporations 105

Loans 16.2 (11.1) Bank Loans 23.8

Leases 95.3 (65.5) Issuance of Securities 24.5

Securities 23.7 (16.3) Trust Money of BOK 2.5

Short-term Assets 10.4 (7.1) Short-term Liabilities 93.3 (64.7)

Ultra Short-term
Deposits 2.5 25.4
Liabilities
Other Short-term
67.9
Borrowings

Total 145.6 (100) Total 144.1 (100)

Note: Figures inside the parentheses are %.
Source: The Bank of Korea.

Borrowing Ratio for Foreign Currency Loans” covering MBCs stood at only
37.5%, far below the newly revised minimum required level at 50%.
Compared with MBCs, commercial banks turned out to have managed their
foreign currency liquidity much better. As is shown in table 8, the
long-term assets of banks was 47.1%, while their long-term liabilities was
29.2%, thereby bringing the “Long-term Borrowing Ratio for Foreign
Currency Loans” of commercial banks to 61.7%.
What caused MBCs to expose themselves to far riskier foreign currency
maturity mismatch than commercial banks? We find an answer to this
question by looking at the ex-ante and ex-post supervisory failures of MBCs.
First, the supervisory failure was ex-ante; most importantly, the amount of
foreign currency short-term borrowings had not been included when
calculating the upper limit of short-term borrowings of MBCs. Related
regulations had limited short-term borrowings of MBCs not to exceed three
Table 8 Foreign Currency Assets and Liabilities of Commercial Banks
(1997. 8. 10)

(unit: 100 million dollars)

Foreign Currency Assets Foreign Currency Liabilities

106 Doo-Yull Choi ⋅ Yeonho Lee

Long-term Assets 276.2 (47.1) Long-Term Liabilities 170.6 (29.2)

Loans 211.2 Bank Loans 8.3

Securities 34.0 Issuance of Securities 75.9

Trust Money of BOK 85.7

Short-term Assets 310.0 (52.9) Short-term Liabilities 413.0 (70.8)

Ultra Short-term
Foreign Currencies 210.0 44.7
Liabilities
Other Short-term
Deposits 56.8 98.2
Borrowings
Total 568.2 (100) Total 586.2 (100)
Note: Figures inside the parentheses are %.
Source: The Bank of Korea.

times their equity capital. However, in practice, when calculating the upper
limit of short-term borrowings of MBCs, the supervisory standards included
only domestic currency short-term borrowings, excluding the amount of
foreign currency short-term borrowings.
The second supervisory failure was ex-post; supervision on MBCs’ lease
accounts and its own accounts had been conducted separately without
considering systematically insider trading aspects between the two accounts.
To understand this, we need to go over some technicalities regarding MBCs’
business behavior. The related law on lease business activities required that
lease business activities be accounted separately from other activities in
managing funds and in analyzing performance. In accordance with such a
requirement, MBCs managed two respective accounts, namely, its “own
account” for merchant banking business, and a “lease account” for leases in
general. These two accounts were stipulated to have been independently
managed with a kind of firewall in between them. In fact, however, these
two accounts were managed as if integrated without any real separation
between them.
 Financial Supervision of Merchant Banking Corporations 107

Regarding merchant banking and the lease business, there were separate
responsible departments within the MOFE. Because of bureaucratic
sectionalism and a lack of cooperation among supervisory bodies, however,
authorities seldom cooperated in supervising “own accounts” and “lease
accounts” of MBCs. Until the currency crisis, MBCs’ own and lease
accounts had never been supervised in a consolidated way.
MBCs exploited the loopholes in this unconsolidated supervision system
to escape regulations on foreign currency liquidity. This regulation-
escaping business practice had been conducted in the following way.
MBCs borrowed short-term foreign capital through their own accounts, and
loaned these short-term borrowings to their lease accounts on a long-term
basis. Exploiting the loophole of unconsolidated supervision, MBCs could
easily disguise their own accounts’ virtually long-term foreign currency loans
to their lease accounts as short-term foreign currency loans. By doing so,
MBCs could raise the “Long-term Borrowing Ratio for Foreign Currency
Loans,” as the denominator of the index was reduced, and could escape the
regulation of the “Long-term Borrowing Ratio for Foreign Currency Loans”.
As a matter of fact, in the lease business also, there were indeed
regulations on foreign currency assets and liabilities maturity. Such
regulation required that leasing financial institutions had to use only
long-term funds. This regulation was also applicable to the lease business
of MBCs. However, MBCs could circumvent this regulation on the lease
business by simply using a similar way to avoid the regulation on MBCs’
own account. Most long-term loans of MBCs’ lease accounts were actually
supplied from short-term foreign currency borrowings of MBCs’ own
accounts. However, virtually short-term funds of lease accounts were
disguised as long-term funds in a similar way as was mentioned above.
3.6. Regulation and Supervision on the Limit of Investing
in Foreign Currency Securities

MBCs’ reckless investing in foreign currency denominated securities were

another component of their risky international business behavior. Up until
108 Doo-Yull Choi ⋅ Yeonho Lee

the currency crisis, MBCs had invested a significant portion of their foreign
currency assets in high yield junk bonds of emerging market countries such

Table 9 Funding and Operating Side of Foreign Capital of MBCs

(unit: million dollars)

Classification 1992 1993 1994 1995 1996 1997

Foreign Currency Assets 4,123 4,624 5,633 8,971 13,347 13,576

1. Overseas Assets 83 66 185 338 2,432 2,408

Foreign Currency Securities 16 31 131 274 2,152 1,811

2. Domestic Assets 4,037 4,557 5,436 8,604 10,881 11,159

Foreign Currency Loans 772 650 571 861 1,426 1,330

Leases 3,010 3,747 4,642 7,315 8,935 9,422

Foreign Currency Liabilities 4,123 4,624 5,633 8,971 13,347 13,576

1. Overseas Liabilities 1,774 1,450 1,820 3,872 5,942 4,179

Bank Loan Borrowing 730 727 491 435 327 398

Other Borrowing 573 283 608 1,910 3,132 1,578

Bond Issuances 437 419 674 1,470 2,388 1,970

2. Domestic Liabilities 2,345 3,172 3,805 5,095 7,349 6,240

Source: The Bank of Korea, “Annual Report of Foreign Exchange Statistics,” various issues.
as Russia, Indonesia, Thailand, amongst others. As was already mentioned,
their funding sources were mainly short-term foreign currency borrowings,
especially cheap Japanese funds from Hong Kong. However, when the
Asian currency crisis broke out, the high-yield junk bonds of emerging
markets became insolvent and illiquid, thereby accelerated the foreign
 Financial Supervision of Merchant Banking Corporations 109

currency liquidity crisis of MBCs.

Table 9 shows the trend of MBCs’ overseas securities investment.
According to the table, investments by MBCs in foreign currency securities
were negligible in 1993 and 1994, merely recording 31 million and 131
million dollars, respectively. However, this rapidly increased during 1995
(274 million dollars) and 1996 (2,152 million dollars). In 1996 alone,
MBCs’ overseas securities investment showed a tremendous jump of 780%
over the previous year.
Looking at table 10, among the total balance of 2,152 million dollars
investment in foreign currency securities in 1996, MBCs had invested 86%
(1,860 million dollars) in emerging market securities. At the time, MBCs’
total equity capital was only 4,716 million dollars, implying that MBCs
invested as much as 40% of their equity capital in illiquid emerging markets’
high yield junk bonds.
The main reasons that incited MBCs to increase rapidly their investment in
emerging market junk bonds is related to the process of financial
deregulation in 1996. From 1996, the amount of overseas securities
investment was excluded from the calculation of the ceilings in all securities
investments. With this deregulation, MBCs were encouraged to increase
investment in overseas junk bonds funded by short-term foreign currency
borrowings with hardly any limits.
Actually, the “Merchant Banking Corporations Act” defines the ceiling of
MBCs’ investment in securities as 100% of their equity capital. The aim of
this ceiling was to help to keep the MBCs financially sound and to refrain
them from taking too much risks from excessive investment in stocks and
bonds. Considering such an aim, overseas securities investment should
have been included in calculating the ceiling of MBCs’ securities investment.
Table 10 MBCs’ Investment in Securities

(unit: million dollars)

Classification 1992 1993 1994 1995 1996 1997

110 Doo-Yull Choi ⋅ Yeonho Lee

Equity Capital 3,089 3,149 4,218 5,004 4,716 2,895

Amount of Securities
4,575 5,097 7,404 8,104 10,254 8,828
Investment
Amount of Securities
1.48 1.62 1.76 1.62 2.17 3.05
Investment / Equity Capital
Balance of Investment in
Foreign Currency 16 31 131 274 2,152 1,811
Denominated Securities
Balance of Investment in
Securities in Domestic 4,559 5,066 7,273 7,830 8,102 7,017
Currency

Balance of Emerging Market

1,860 1,160
Securities Investment

Balance of Emerging Market

Securities Investment of 3,440 2,710
Commercial Banks
Note: Emerging Market includes Thailand, Indonesia, Malaysia, China, Mexico, Brazil,
Columbia, Rumania, Hungary, and Russia.
Source: The amounts of investment in emerging market are from Financial Supervisory
Service. Others are from The Bank of Korea, “Annual Report of Foreign Exchange
Statistics”.

However, previous supervisory standards did not support such a common

notion. Since 1996, the MOFE allowed the exclusion of overseas securities
investment when calculating the ceiling of total securities investment. This
exclusion allowed MBCs to increasingly invest in emerging markets’ junk
bonds without any supervisory ceiling. This deregulation measure was an
important ex-ante supervisory failure that had induced MBCs’ excessive
overseas investment in securities, rendering other parts of the supervision
system for restricting excessive investment in securities quite ineffective.
3.7. Other Prudential Regulations

3.7.1. Prudential Regulation on Won-Liquidity

Prior to the currency crisis, there was no prudential regulation on MBCs’
 Financial Supervision of Merchant Banking Corporations 111

won-liquidity. It was not until 1998 that the FSC/FSS set up supervisory
standards on MBCs’ won-liquidity, namely, that MBCs should maintain at
least a 30% won-liquidity ratio. Unlike MBCs, however, commercial banks
had long been regulated by the measure, which required them to maintain at
least a 30% won-liquidity ratio. This loophole in supervisory standards was
another regulatory environmental factor that helped increase MBCs’ portfolio
risk.

3.7.2. Risk Management

The supervisory body’s negligence in introducing proper ex-ante
regulation and supervision standards is also evident in the area of MBCs’ risk
management system. Until the onset of the currency crisis, there had in fact
been no ex-ante regulation and supervision on MBCs’ internal risk
management systems, in particular, regarding how MBCs should prepare
their internal control system to cope with different kinds of financial risk
such as credit risk, market risk, and operational risk.
Generally speaking, the supervisory body should have made guidelines for
financial institutions to set up their own internal risk management system so
that they could properly manage financial risks. However, until right before
the outbreak of the currency crisis, no ex-ante regulation and supervisory
standard for MBCs requiring them to set up their internal risk management
systems were in place. This lack of supervision regarding risk management
of MBCs had left the management of MBCs focusing only on profitability,
while neglecting proper assessment and control for accompanied risks.
Unlike MBCs, however, commercial banks, even before the crisis, had
been mandated to set up an internal control system for risk management.
They had been required to establish a comprehensive risk management
system that included asset liabilities management. Based on this,
commercial banks themselves tried to set up their own risk management
system. As a matter of fact, the direction and monitoring of MBCs by a
comprehensive risk management system is no less urgent than that of
commercial banks, if not anything else but for the reason that with their
112 Doo-Yull Choi ⋅ Yeonho Lee

mostly unsecured credit, MBCs contain higher credit risk portfolios than
commercial banks. However, ex-ante supervision and regulation of MBCs
had not kept up with developments like that of commercial banks.

3.7.3. Asset Classification and Provision

Another example of the lack of ex-ante prudential regulation was that
MBCs had not been supervised or regulated for their soundness regarding
their holding of assets. Normally, regulations of asset classification and
provisioning require that financial institutions classify their assets on a
regular basis into one of five categories; “Normal,” “Precautionary,”
“Substandard,” “Doubtful” and “Estimated Loss”. According to
categorization into the above asset classifications, financial institutions must
then accumulate and maintain adequate loss provisioning, including
allowances for payment guarantees.
However, prior to the currency crisis, no minimum guidelines on MBCs’
asset classification and provisioning were in place. This vacuum in the
regulation system left MBCs insensitive to reckless lending and endorsing
payment guarantees. In contrast, commercial banks had been controlled by
strict asset classification and provisioning standards even before the currency
crisis.
Only after the outbreak of crisis, the supervisory body introduced similar
asset classification and provisioning system for MBCs. This can be counted
as another example of negligence and irresponsibility regarding the
regulation of MBCs prior to the crisis. Trough the hardship periods of IMF
era, most of the unsound behavior of MBCs that had driven MBCs to
insolvency had been removed after the currency crisis. Under the new
supervisory system, the FSS are in charge of the supervisory business of
almost all financial institutions and the BOK and the KDIC (Korea Deposit
Insurance Corporation) possess limited on-site examination functions.
However, bureaucratic sectionalism and no cooperation among the
supervisory agencies, which had resulted in the gray areas of supervision of
MBCs, are still very often found in reality. In fact, the supervisory agencies
 Financial Supervision of Merchant Banking Corporations 113

still rarely share the information on supervision and hardly cooperate in

examination. These kind of bad practices among supervisory agencies
should be corrected for the soundness of Korea’s financial system.

4. CONCLUSION

This study analyzed the financial regulations and supervision systems of

Korean MBCs (Merchant Banking Corporations). This study is carried out
on the premise that the financial regulation and supervision of MBCs has not
been fully investigated so far. We emphasize that MBCs were financial
institutions that had been operating with relatively more autonomy among
domestic financial institutions. As relatively more liberalized for-profit
enterprises in a financially repressed economy, large parts of their business
behavior could be viewed as simply the outcome of endogenously generated
business behavior given the business environment. It is for this reason that
this study finds it important to focus on the regulations and supervision of
MBCs.
The main point of this study is that the financial regulation and
supervisory system surrounding MBCs right before the outbreak of the
currency crisis were very much out-dated and ineffective. In particular, the
regulations and supervision system were managed based on an outdated
paradigm that foreign and domestic currency businesses undertaken by
financial institutions were distinctively separate from each other. Such a
view was no longer valid in the modern era of increased capital flow
liberalization.
Since the beginning of the 1990s, the business environment surrounding
MBCs had changed in many respects, and most notably in terms of the
increased number of new entries into MBC businesses as well as increased
financial market and capital liberalization. These factors resulted in higher
competition among MBCs raising their business risk generally. Despite
rapid changes in the business environment, the financial regulations and
114 Doo-Yull Choi ⋅ Yeonho Lee

supervisory system hardly kept in pace, and thereby was generally ineffective
until the outbreak of the currency crisis. Such ineffectiveness in the
financial regulation and supervision of MBCs came to be a main
environmental factor behind their domino-like insolvencies during the period
around the crisis.
In this study, the factors analyzed were as follows. First, the MOFE,
which had the ultimate responsibility for financial regulation and supervision
of MBCs, were found not to have had appropriate organizational
infrastructure and specialty to conduct important financial regulation and
supervision functions. The ex-ante supervision system was hardly updated
in a timely manner, nor was the ex-post supervision system strictly conducted,
and both weaknesses rendered financial regulation and supervision on MBCs
ineffective.
Second, regarding the entry regulation of MBCs, the MOFE’s licensing or
transformation of unqualified IFCs into MBCs between 1994 and 1996 had
encouraged reckless and risk-taking business behavior among the
newly-transformed MBCs. The newly-transformed MBCs had expanded
their business size by competitively entering into the international financial
markets and establishing their branches overseas, especially in Hong Kong.
This ended up with ruinous results as accompanied risks had been largely
overlooked.
Third, the supervisory body’s negligence in introducing an appropriate
capital adequacy requirement system for MBCs did little to check the
expansion of MBCs’ risky assets. Before the crisis, the equity capital of
MBCs had been regulated by gearing ratios based upon simple financial
ratios like equity to total assets. Such naive gearing ratios were too coarse
an index to reflect properly the risk borne by MBCs.
Fourth, the loose ex-ante regulation especially regarding credit
concentration helped intensify MBCs’ concentration of credit. MBCs credit
ceiling on chaebols had been permitted to be three times higher than that of
commercial banks. Moreover, loans and leases to the so-called “dispersed
ownership companies” were excluded from the credit ceiling on chaebols.
 Financial Supervision of Merchant Banking Corporations 115

Fifth, behind the extreme maturity mismatch of foreign currency assets of

MBCs, there were various unbalanced ex-ante supervisory factors. Such
unbalanced ex-ante supervisory factors included the followings: unbalanced
regulation between short-term and long-term foreign currency borrowings,
the exclusion of foreign currency short-term borrowings when calculating the
ceilings set for total short-term borrowings, and the exclusion of foreign
currency lease loans when calculating MBCs’ foreign currency long-term
loans.
Sixth, in the extreme maturity mismatch of foreign currency assets and
liabilities of MBCs, various critical ex-post supervisory failures were also
identified; there had been no consolidated supervision on both lease and own
accounts of MBCs in any systematical manner. This loophole in the ex-post
supervisory system had left MBCs to circumvent the so called “Long-term
Borrowing Ratio for Foreign Currency Loans”.
Seventh, MBCs’ local and overseas investment in securities had been
regulated asymmetrically. Overseas investment in securities had been
excluded from the ceiling of MBCs’ total investment in securities, which was
another critical regulatory environmental factors that allowed MBCs’
excessive investment in emerging market junk bonds.
Eighth, supervisory standards of MBCs’ risk management systems were
hardly updated. Significant parts of the regulations in risk management
were outdated, and did not keep up with the changing times. It was not
until the outbreak of currency crisis that the authorities introduced prudential
regulations on MBCs’ won-liquidity, internal risk management systems, and
on asset classification and provision.
Summarizing the above points, up until the outbreak of the currency crisis,
we see that MBCs had been operating under a very fragile regulation system
that was outdated not least in terms of ex-ante and ex-post supervision.
Judging only from outward appearances, such historic regulatory failure
would seem to have occurred by misallocations of supervisory power to an
unqualified administrative organization, namely the MOFE, which was
hardly equipped with the proper infrastructure and specialty for financial
116 Doo-Yull Choi ⋅ Yeonho Lee

supervision. However, a closer look beneath these ostensibly unrelated

chains of regulatory failures shows a hugely mistaken, deep-rooted cognitive
paradigm, which divided local and foreign currency businesses of financial
institutions in a dichotomous way. Such an outdated paradigm was
responsible for the making of the above inappropriate regulations, including
the various exemptions and asymmetries in rules and restrictions.
This is a good example showing the dangers when institutions and
cognition do not catch up with changing circumstances. Regulators must
keep up with the changing environment. The currency crisis was a precious
and, indeed, an expensively obtained lesson that made the nation suffer
miserably. Without overcoming such an anachronistic paradigm that
regards domestic and foreign exchange businesses distinctively and
separately, all financial policies, including financial supervision, are doomed
to the same failure again as capital flow liberalization continues. It cannot
be overemphasized therefore that history will repeat itself unless such
outdated paradigm is completely replaced with a new one that acknowledges
financial institutions’ domestic and foreign exchange business as identical.

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