Capital Market Reform and the Challenges Facing

the New Government in Korea

Yuta Seki
Managing Director, Research
Nomura Institute of Capital Markets Research

I. Korea's capital market reforms: the past 10 years

1. The new government's first moves

On 25 February 2013, Park Geun-hye took office as Korea's new president. Facing,
as she does, mounting criticism for the disparities that her predecessor's pro-chaebol,
pro-globalization growth model is seen as having led to and having pledged her
government to pursue "economic democratization," boost employment, and improve
social welfare, the new president is likely to have her work cut out devising policies
that will stimulate a stagnant economy hampered by a strong currency. Nor is it clear
what policies the new president will pursue on the financial front.
In this report we consider Korea's success in reforming its capital markets and the
challenges it still faces on this front.

2. Korea's Financial Hub Vision and the Financial Investment Services and
Capital Markets Act
Korea's capital market reforms gathered momentum when the IMF program it
adopted following the Asian Currency Crisis came to an end in 2001 (Figure 1).
However, it has to be said that the radical measures it adopted as part of the program
(namely, mandatory injections of public capital to help restructure the banks and
tackle their non-performing loans, a policy of encouraging foreign investment in the
country, and moves to restructure the chaebol) formed the basis for the capital market
reforms that followed.
Both President Park's predecessors, Roh Moo-hyun (2003–2008) and Lee Myung-
bak (2008–2013), advocated a policy of turning Korea into a financial hub. This
vision (of strengthening Korea's financial services industry so it could compete
globally) was probably intended not only to boost Korea's financial markets but also
the growth potential of the economy as a whole. In other words, the aim was not
simply to improve the ability of Korea's capital markets to supply Korean industry
with capital but to increase the added value of Korea's financial services industry, of
which its capital markets formed a part.

1 Nomura Journal of Capital Markets Summer 2013 Vol.5 No.1

 Figure 1: Korea's capital market reforms: main developments in recent years

Kim Dae-jung government's restructuring of the banks and

injections of public money
1997 IMF bailout (completed in 2001)
Near-collapse of Daewoo Group restructuring and reform of
the chaebol

Roh Moo-hyun government's Northeast Establishment of Korea Investment Corporation (KIC), complete
2003
Asian Financial Hub initiative deregulation of forex trading, etc.

Merger of Korea Stock Exchange (KSE), Korea Futures

2005 Establishment of Korea Exchange (KRX)
Exchange (KOFEX), and the KOSDAQ
Announcement of amendments to Section 3
(Companies) of Commercial Code
2007 (two separate sets of amendments passed Definition of "non-executive director," "supervisory board," etc.
in 2009)
Lee Myung-bak government's Financial Hub Seoul and Busan designated financial hubs on the basis of Act
2008
Vision on the Creation and Development of Financial Hub s

Establishment of Financial Services Ministry of Finance's Financial Policy Division integrated in

Commission Financial Supervisory Commission

Move from industry-based rules to function-based rules

2009 FSCMA comes into effect (covering the entire financial investment industry)
Financial investment instruments defined intensionally

Debate on reforming the IMF and on financial regulatory reforms

2010 Seoul G20 summit
aimed at dealing with the "too big to fail" problem

Securities companies meeting certain conditions redefined as

investment banks: to encourage industry to reorganize
Deregulation of Korea's asset management industry: to
2011 Reading of FSCMA amendment bill
increase asset managers' independence and innovativeness
Creation of central counterparty (CCP) for derivatives
Ban on alternative trading systems lifted

Amendments to Commercial Code (with Executive officer system, different classes of shares, triangular
effect from 2012) mergers, etc.

Source: Nomura Institute of Capital Markets Research, from a variety of sources

One of the most noteworthy developments in this connection and one of the
reforms carried out by the Roh Moo-hyun government was the establishment in 2005
of Korea Exchange (KRX)1 through the integration of the country's three exchanges—
the Korea Stock Exchange (KSE), the Korea Futures Exchange (KOFEX), and the
KOSDAQ—to create "the number one capital market in East Asia." Headquartered in
Busan, KRX's two stock exchange divisions are based in Seoul's Yoido district, while
the futures division is based in Busan. In order to raise Busan's profile as a financial
center, trading in KOSPI 200 futures and options, which used to take place on the
KSE, was transferred to KOFEX, while trading in KOSPI derivatives was boosted by
the integration of the three exchanges' trading systems2.
The most noteworthy of the country's later financial market reforms was the
Financial Investment Services and Capital Markets Act (FSCMA or "the Act"),

1
Taki, Toshio, "Kankoku Torihikijo no Tanjou" (The Birth of KRX), Capital Market Quarterly,
Spring 2005 (in Japanese).
2
Hayashi, Hiromi, "Kankoku Deribatibu Shijou no Hatten to Shihon Shijou Kaikaku," (The
Development of Korea's Derivative Market and Capital Market Reform), Gekkan Shihon
Shijou, February 2012 (in Japanese); Hayashi, Hiromi, "Kyuusoku na Hatten o Togeta
Kankoku no Deribatibu Shijou," (The Rapid Development of Korea's Derivative Market),
Capital Market Quarterly, Spring 2012 (in Japanese).

Capital Market Reform and the Challenges Facing the New Government in Korea 2
promulgated in 2007 and effective since 2009. The Act integrated and rewrote the
various laws governing capital markets (e.g., the Securities and Exchange Act and the
Futures Trading Act) as rules governing the markets' various functions (e.g., approval,
registration and prudential supervision of financial investment companies, conduct of
business, and collective investment schemes). Discussions about enacting such
legislation began in 2003 and were apparently influenced by the debate on Japan's
Financial Instruments and Exchange Law, which was enacted at about the same time.
However, the Act was more ambitious in that, for example, it defines the scope of
financial investment instruments intensionally (i.e., using their properties) instead of
extensionally (i.e., using exhaustive lists).
In February 2008, roughly a year before the Act came into effect, Lee Myung-bak
became president. At the same time, the old Financial Supervisory Commission's
responsibility for supervisory policy and the old Ministry of Finance's responsibility
for financial policy were amalgamated in a new Financial Services Commission
(FSC), while the (non-governmental) agency responsible for day-to-day oversight and
enforcement, the Financial Supervisory Service (established in 1999), was also
reorganized. In February 2009 the various organizations regulating the securities and
investment industries (namely, the Korea Securities Dealers Association, the Korea
Futures Association, and the Asset Management Association of Korea) were also
amalgamated to form the Korea Financial Investment Association (KOFIA).
What distinguishes Korea's capital market reforms in recent years is the leading
role played by the government and the influence of similar reforms in Japan. However,
the Korean reformers' aims were more global. Also, the aim of Korea's Financial Hub
Vision was more to foster the development of a cluster of financial functions that
would make it easier for Korean companies to raise capital than, as in the case of
Singapore and Hong Kong, create an international center where foreign companies
could raise, and foreign investors invest, capital. Although the Lee Myung-bak
government sought to support efforts to put Korean investment banks and Korean
corporate governance on a more global footing towards the end of its term in office
(e.g., by amending the Act and the Commercial Code), many of these aims have yet to
be achieved—partly as a result of the global economic and fiscal disruption triggered
by the collapse of Lehman Brothers, partly as a result of a global trend towards tighter
financial regulation, and partly as a result of domestic public opinion3.

II. Current state of and outlook for Korea's capital markets

1. Growing importance of direct finance

The most obvious result of Korea's capital market reforms is the growing
importance of direct finance. Traditionally, Korea's financial system has been
dominated by its banks. However, a breakdown of Korean companies' sources of
3
Hayashi, Hiromi, "The Revisions to Korea's Financial Investment Services and Capital
Markets Act and Korean Securities Companies' Efforts to Diversify Their Earnings,"
Nomura Journal of Capital Markets, Winter 2012, Vol.3, No.3.

3 Nomura Journal of Capital Markets Summer 2013 Vol.5 No.1

 finance in recent years shows that direct finance is now a comparatively regular source
of corporate finance, bolstering it particularly in the immediate aftermath of the
collapse of Lehman Brothers, when the banking system's ability to create credit
malfunctioned and Korean companies issued nearly KRW70 trillion in bonds (Figure
2).
Similarly, while Koreans traditionally hold most of their financial assets in the
form of cash and bank deposits, the proportion they hold in the form of marketable
securities is higher than in Japan. A closer look also reveals that, whereas in 2003 (i.e.,
soon after Korea completed the program imposed by the IMF during the Asian
Currency Crisis) Koreans held 53% of their financial assets in the form of cash and
bank deposits and 24% in the form of shares, investment trusts and other marketable
securities, at the end of September 2012 they held 46% in the form of cash and bank
deposits and 28% in the form of marketable securities. In other words, the proportion
held in the form of marketable securities has increased steadily, even if it has yet to
regain the level it reached before the collapse of Lehman Brothers (34% in 2007).
In absolute terms, however, Korean personal financial assets are still under
accumulation. As of end-September 2012, they stood at KRW2,450 trillion (roughly
¥210 trillion), a mere one-seventh the level of Japanese personal financial assets
(roughly ¥1,510 trillion as of end-September 2012). That said, Korean personal
financial assets have more than doubled during the past 10 years, showing solid
growth both before and since the collapse of Lehman Brothers.

2. Stock market
One of the most frequently mentioned results of Korea's capital market reforms is
the size of its exchange-traded derivative market—one of the largest in the world.

Figure 2: Breakdown of Korean industry's sources of finance

(Unit: KRWtrn)
2003 2004 2005 2006 2007 2008 2009 2010 2011
Total funds raised 89.2 67.8 109.1 184.2 184.3 230.4 152.3 117.1 145.1
Indirect finance 34.4 2.9 23.8 68.1 98.6 115.0 19.4 23.4 47.0
Deposit-taking banks 41.2 14.9 20.4 60.4 92.4 106.9 11.1 4.8 33.5
Non-bank financial institutions -6.8 -12.0 3.4 7.7 6.2 8.1 8.3 18.6 13.5
Direct finance 28.9 29.2 52.9 80.5 54.1 66.9 95.4 61.5 63.9
Equities 27.5 22.2 19.2 38.9 33.6 28.4 33.1 29.6 25.2
Commercial paper -2.6 -1.9 4.1 14.5 24.5 12.9 -8.5 2.7 8.0
Bonds -1.1 1.8 12.5 26.3 -4.8 24.6 69.6 28.4 30.0
Foreign loans 4.7 8.7 5.7 5.9 6.4 8.4 6.1 4.3 14.9
Other 21.2 26.9 26.7 29.6 25.2 40.0 31.4 27.9 19.3
(Unit: %)
(Share) 2003 2004 2005 2006 2007 2008 2009 2010 2011
Indirect finance 38.6% 4.3% 21.8% 37.0% 53.5% 49.9% 12.7% 20.0% 32.4%
Deposit-taking banks 46.2% 22.0% 18.7% 32.8% 50.1% 46.4% 7.3% 4.1% 23.1%
Non-bank financial institutions -7.6% -17.7% 3.1% 4.2% 3.4% 3.5% 5.4% 15.9% 9.3%
Direct finance 32.4% 43.1% 48.5% 43.7% 29.4% 29.0% 62.6% 52.5% 44.0%
Equities 30.9% 32.8% 17.6% 21.1% 18.2% 12.3% 21.7% 25.3% 17.4%
Commercial paper -2.9% -2.8% 3.8% 7.9% 13.3% 5.6% -5.6% 2.3% 5.5%
Bonds -1.2% 2.6% 11.5% 14.3% -2.6% 10.7% 45.7% 24.3% 20.7%
Foreign loans 5.3% 12.8% 5.2% 3.2% 3.5% 3.6% 4.0% 3.7% 10.3%
Other 23.8% 39.7% 24.5% 16.1% 13.7% 17.4% 20.6% 23.8% 13.3%

Source: Nomura Institute of Capital Markets Research, from Bank of Korea data

Capital Market Reform and the Challenges Facing the New Government in Korea 4
This has been attributed to (1) the integration of Korea's capital markets in Korea
Exchange, (2) the high level of participation by individual investors in the exchange-
traded derivative market, and (3) the ability to trade the market's two key products
(KOSPI 200 futures and options) during European and US trading hours as a result of
tie-ups with the CME Group (KOSPI 200 futures) and Eurex (KOSPI 200 options).
Recently, however, the turnover in exchange-traded derivatives has declined slightly
as a result of a number of factors, including alleged market abuse of high-frequency
trading in equity-linked derivatives (e.g., warrants) and regulatory reforms intended to
give individual investors greater protection (e.g., increases in the size of contracts).
What distinguishes the cash stock market, on the other hand, is the high proportion
of stocks owned by foreign and individual investors (Figure 4). The increase in the
proportion of shares owned by foreigners is largely the result of Korea's capital
market reforms and the unwinding of some of the cross-shareholdings held by group
companies and the owners of chaebol companies. Similarly, the increase in the
proportion of shares owned by individual investors has been attributed to
improvements in IT infrastructure (e.g., the increasing availability of broadband
connections), which encourage high levels of online trading. One problem, however,
has been the relatively small size of Korean institutional investors. Another is the need
to foster small-/mid-cap stocks and start-ups, and encourage IPOs as market
capitalization and trading volume are both dominated by large chaebol companies.
Another controversial issue, this time with regard to market infrastructure, is how
to encourage competition (e.g., by means of alternative trading systems (ATS)) in a
market monopolized by Korea Exchange. This is one of the main issues for the
FSCMA amendment bill, which has yet to be enacted.

Figure 3: Breakdown of Korean personal financial assets (KRWtrn, %)

Investment trust Other
Cash/ Insurance/ Equities/
beneficiary marketable Other Total
deposits pension reserves equity stakes
certificates securities

2003 (KRWtrn) 617.7 252.9 190.9 42.7 49.8 15.9 1170.0

(Share) 53% 22% 16% 4% 4% 1% 100%
2004 (KRWtrn) 624.1 281.6 204.3 64.1 57.8 13.9 1245.8
(Share) 50% 23% 16% 5% 5% 1% 100%
2005 (KRWtrn) 672.3 306.8 286.8 81.4 51.3 15.4 1413.9
(Share) 48% 22% 20% 6% 4% 1% 100%
2006 (KRWtrn) 717.3 345.8 290.8 110.0 57.4 13.0 1534.2
(Share) 47% 23% 19% 7% 4% 1% 100%
2007 (KRWtrn) 732.8 391.8 368.6 167.6 51.7 11.5 1724.0
(Share) 43% 23% 21% 10% 3% 1% 100%
2008 (KRWtrn) 790.9 424.2 273.9 122.9 69.5 15.8 1697.2
(Share) 47% 25% 16% 7% 4% 1% 100%
2009 (KRWtrn) 883.6 476.6 367.4 130.6 89.5 15.4 1963.1
(Share) 45% 24% 19% 7% 5% 1% 100%
2010 (KRWtrn) 986.8 534.7 438.7 98.9 113.6 15.2 2187.9
(Share) 45% 24% 20% 5% 5% 1% 100%
2011 (KRWtrn) 1069.4 590.1 418.5 84.6 124.0 16.7 2303.4
(Share) 46% 26% 18% 4% 5% 1% 100%
2012Q3 (KRWtrn) 1115.3 653.5 437.4 86.7 139.6 17.4 2449.9
(Share) 46% 27% 18% 4% 6% 1% 100%

Source: Nomura Institute of Capital Markets Research, from Bank of Korea data

5 Nomura Journal of Capital Markets Summer 2013 Vol.5 No.1

 Figure 4: Ownership of Korean stocks
(%)
45

40
Individuals
35

30 Foreigners

25
Government &
government agencies
20
Institutional investors
15

10 Other corporate investors

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Nomura Institute of Capital Markets Research, from Korea Exchange data

3. Bond market
Until the Asian Currency Crisis, the growth of Korea's bond market was driven by
corporate bonds as the government pursued a balanced budget policy. Reflecting this,
the benchmark was three-year corporate bonds.
Following the Asian Currency Crisis, however, a number of measures were
adopted to encourage the development of a market in government and public bonds
(e.g., greater transparency of the issue process and the adoption of a primary dealer
system). Since then, Korea's government bond market has seen solid growth. There
has also been active issuance of corporate bonds (e.g., by banks and credit card
issuers), and there is now also a nascent market in asset-backed securities (Figure 5).
Various reforms have been undertaken to increase activity in the secondary bond
market and make the market more efficient. In addition, efforts have been made to
attract investors. A key role in this has been played by KOFIA, Korea's equivalent of
the Japan Securities Dealers Association. Since April 2010, KOFIA has operated
FreeBond, a dedicated system that enables OTC bond market participants to discover
quotes for trading or brokerage and negotiate with counterparties, while, since
February 2010, it has operated BondMall, a website (www.bondmall.or.kr) intended to
give individual and small investors easier access to information on corporate bond
prices. KOFIA also develops and releases bond price index data that can be used, for
example, by asset management companies to originate their own index-linked bond
ETFs4.

4
See Korea Financial Investment Association, "2012 Capital Market in Korea."

Capital Market Reform and the Challenges Facing the New Government in Korea 6
 Figure 5: Korean bond issuance

(KRWtrn)
600

500

400
Other public bonds
Currency stabilization securities

300 National housing bonds

Government bonds
Corporate bonds
200

100

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Note: "Corporate bonds" includes asset-backed securities. "Currency stabilization

securities" are bonds issued by the Bank of Korea to enable it to control the
money supply and conduct open market operations.
Source: Nomura Institute of Capital Markets Research, from Bank of Korea data

4. Investment trust market

As a result of a series of regulatory reforms, including the Indirect Investment Asset
Management Business Act (promulgated in 2003 and subsequently amended several
times) and FSCMA (promulgated in 2007), Korean investment trusts have (1)
undergone a transformation from specialist companies engaged in both asset
management and sales to securities companies, with securities companies and banks
both able to sell investment trusts under the same regulatory system, and (2) their
assets have become diversified and are no longer restricted to marketable securities.
As of end-2012, Korean investment trusts had a total net asset value (NAV) of
roughly KRW317 trillion. As a result of the regulatory reforms, their NAV saw solid
growth until the mid-2000s, accounting for a growing proportion of personal financial
assets. However, as a result of a number of factors, including the collapse of Lehman
Brothers, it has remained at roughly the same level (KRW300 trillion or roughly ¥25
trillion) for the past few years (Figure 6). As far as investment trust sales channels are
concerned, banks accounted for a growing share until the collapse of Lehman
Brothers. Since then, however, their sales have failed to grow, while securities
companies have become an increasingly important sales channel once again,
accounting for roughly 60% of new sales5.

5
See Footnote 4.

7 Nomura Journal of Capital Markets Summer 2013 Vol.5 No.1

Figure 6: Korean investment trust market: assets under management (year-end)
(KRWtrn)
400

350

300

250 Other

Money market
200
Hybrid
150
Bonds

100 Equities

50

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 (year-end)

Note: "Other" includes derivative funds, real estate funds, funds of funds, and
special asset funds.
Source: Nomura Institute of Capital Markets Research, from KOFIA data

Much has recently been made of the need for more sophisticated and efficient asset
management as well as greater investor protection. As a result, since 2011, the
government and KOFIA have sought to wind up small investment trusts with a net
asset value of less than KRW5.0 billion (roughly ¥350 million), a goal they have
largely achieved6.

III. "Japanization" of Korean economy and capital market

reform

1. Korea's chaebol a growing presence once again

One of the most eagerly awaited tasks facing the new government of President
Park is the reform of the chaebol. The total assets of Korea's 10 largest chaebol
continued to grow while President Lee Myung-bak was in office, topping KRW900
trillion by mid-2012 (Figure 7). Although the direct ownership of group companies by
their owners has declined, the proportion of chaebol shares owned by insiders has, if
anything, increased recently as a result of cross-shareholdings by affiliates (Figure 8).

6
Nomura, Akiko, "Kankoku no Shoukibo Toushi Shintaku Seiri no Ugoki," Capital Market
Quarterly, Spring 2012 (in Japanese).

Capital Market Reform and the Challenges Facing the New Government in Korea 8
 Figure 7: Assets and number of group companies of 10 leading chaebol
1000 700
Assets (KRWtrn): lhs
900
Group companies: rhs 600
800

700 500

600
400
500
300
400

300 200
200
100
100

0 0
2005 2006 2007 2008 2009 2010 2011 2012
Source: Nomura Institute of Capital Markets Research, from Korea Fair
Trade Commission data

Figure 8: Internal ownership of 10 leading chaebol

(%)
60

50

40

Affiliates
30

Owner family
20 members

10

0
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Source: Nomura Institute of Capital Markets Research, from Korea Fair

Trade Commission data

While there has been growing public criticism that the growth of the chaebol has
widened social disparities and sapped the economy's strength, there is also a
realization that the chaebol have fueled economic growth and that some globally
competitive chaebol have drawn foreign investors to the Korean stock market. There
is therefore a risk that putting too much political and regulatory pressure on the
chaebol could paralyze Korea's financial markets or make them less competitive7 .
Much has also been said about the need for better corporate governance by the

7
“Peeling back the power of Korea’s chaebols”, Asiamoney, March 2013.

9 Nomura Journal of Capital Markets Summer 2013 Vol.5 No.1

chaebol. However, it has also been pointed out that large chaebol companies have
often been more willing to adopt some corporate governance reforms (e.g., the
appointment of non-executive directors and the creation of supervisory boards) than
have SMEs8.
It will therefore be interesting to see how President Park's government approaches
the somewhat paradoxical problem of how to make the chaebol more transparent and
how it sets about reforming the market so as to revitalize the country's SMEs.

2. An aging society with low interest rates and low economic growth
Recently there has been a lot of talk in Korea that the strength of the currency and
the decline in interest rates could bring about structural economic reforms. In
particular, there have been repeated reports in the media since the autumn of 2012,
when the Korean economy slowed markedly, that the Korean economy has
succumbed to the "Japanese disease" (i.e., the problems created by a strong currency
compounded by prolonged low growth and low interest rates, falling property prices,
and mounting bad debts). In addition, concern in the country's financial services
industry also appears to be mounting (Figure 9).
Although the economic situation in Korea, where, for all the talk of a "strong
currency," the won is trading, against both the dollar and the yen, well below the level
at which it stood before the collapse of Lehman Brothers and, for all the talk of "low
interest rates," inflation stands at 1.3–1.4%, the Bank of Korea's policy interest rate at

Figure 9: Korea's real GDP growth rate (q-q, %)

-1

-2

-3

-4

-5

2008 2009 2010 2011 2012

Source: Nomura Institute of Capital Markets Research, from Bank of Korea data

8
Kwon Sehoon, “Issues on the Independent Directors in the Korean SMEs”, Capital Market
Perspective 2011 Vo3, No.3 (Korea Capital Market Institute).

Capital Market Reform and the Challenges Facing the New Government in Korea 10
2.75%, and long-term interest rates at 3%, strikes us as very different from deflation
in Japan, there is no denying that Korean industry is dominated by the chaebol and
that there is a lot of concern about issues such as household debt (in the form of
housing loans) and societal aging. In particular, the ratio of the over-65s to the
population as whole is similar to that in Japan, albeit with a 25-year lag, topping 10%
in 2005–2010 and set to rise sharply to 20% by 2025 and 30% by 2040 (Figure 10).
While it remains to be seen how President Park's government, which has not
adopted market-oriented policies, approaches these problems, it may well be that it
finds itself having to carry out more sweeping market reforms as well as being
challenged over the success of the reforms it has already carried out. Similarly,
Korean securities and asset management companies are likely to face calls to overhaul
their existing business model and to give better advice to both issuers and investors in
order to survive. It will therefore be interesting to see what happens.

Figure 10: Over-65s as percentage of total population: Japan, Korea and China
(actual and expected)

40%

35%

30%

25%

20%

Korea
15%
Japan
China
10%

5%

0%

Source: Nomura Institute of Capital Markets Research, from United Nations,

World Population Prospects, (2010 Revision (incl. estimates))

11 Nomura Journal of Capital Markets Summer 2013 Vol.5 No.1