Money & corruption

click

Korea's savings bank fiasco is a replica of US S&L crisis

By Kim Jae-kyoung

The financial scandal associated with troubled savings banks here has been showing a totally different face, as former top financial regulators and policymakers turned out to be deeply involved in the fiasco.

Simply put, it is not just an accident stemming from reckless mismanagement of savings banks, formerly community-based mutual savings and finance companies. It is rather the outcome of a toxic mixture of loose regulation and widespread corruption among politicians, regulators and bank executives.

Local policymakers are now putting their heads together to come up with a breakthrough for the ongoing scandal. Experts say that they need to study the United States’ savings and loan (S&L) crisis of the 1980s and 1990s as the two cases, although there is a 20-year time gap, are alarmingly similar in many aspects.

First of all, in both cases, the root causes were the government’s measures to raise caps on state-insured deposits and subsequent competition to offer higher interest rates for funds.

In the early 1980s, the U.S. government under President Ronald Reagan adopted rules that enabled S&Ls to make high-risk loans, eliminate deposit caps, and hold less capital. S&Ls used their new freedom to pay higher rates to depositors and invested those new deposits in commercial real estate projects and junk bonds.

The key trigger was the March enactment of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which raised the bar on federally insured deposits from $40,000 to $100,000.

Loose regulation & moral hazard

This is comparable to the Korean government’s action to raise the cap on state-insured deposits from 20 million won ($18,500) to 50 million won ($46,200) in 2001. The issue of deposit insurance is critical to this kind of scandal.

“In an uninsured environment, depositors would have been wary of putting their money in secondary institutions, regardless of how high interest rates are, for fear of losing their savings,” an official at the Financial Supervisory Service (FSS) said on condition of anonymity.

“But due to state guarantees, even ailing lenders could attract funds by offering higher rates. The increase in the insured amount helped both S&Ls and Korea’s savings banks to attract more money,” he added.

Also the situation where lenders rushed to raise interest rates is very similar. In the U.S., the government eliminated deposit caps in 1980, a move that was seen as the first step to liberalizing the financial market.

Since then, S&Ls went into cutthroat competition to hike rates for funds while fixing rates on long-term mortgage, the main revenue source, at a low level, turning their net interest margin negative. Domestic savings banks also ruined their balance sheets as a result of the rat race of providing higher interest rates.

In order to offset the negative interest margin, both S&L and Korea’s savings banks invested in high-risk, high-return assets. S&Ls put their money into commercial properties and junk bonds, while savings banks lent most of their deposits to builders and project financiers.

Such investments look alright when the economy is in good shape. However, the prolonged slump of the real estate markets exposed hidden problems, with the once solid assets turning insolvent. In particular, with real estate prices plunging in the late 1980s, the losses snowballed, driving many S&Ls into bankruptcy.

This is akin to how Korea’s savings bank fiasco is unfolding, given that it was the outcome of a deadly cocktail of savings banks’ reckless lending to builders mixed with an bearish real estate market.

Following the global financial crisis, savings banks’ loans associated with project financing (PF), which accounted for more than half of their total lending, turned into losses en masse, triggering the ongoing financial scandal. The property market has stayed in the doldrums since the latter half of 2008.

The two cases also have some similarities on the regulation side. In both cases, financial regulators’ belated action and loose supervision made the situation worse, encouraging these lenders to use new funds to gamble their way into profit.

In the U.S., the government opted for the “forbearance policy,” believing that it could save some of ailing S&Ls. However, the policy ended up triggering a moral hazard among S&Ls and depositors.

This is the same of how the Korea’s case went from “bad” to “worse.” In Korea, top regulators just sat back and waited for the property market to rebound. Even when there were clear signs of PF lending turning sour in 2008, former FSC Chairmen Jun Kwang-woo and Chin Dong-soo, and former Financial Supervisory Service Governor Kim Jong-chang introduced only stop-gap measures and delayed fixing the root cause of the problem.

The root cause goes back to 2000 when a credit union was renamed as a savings bank. The name change gave the wrong impression to the public, making them believe that secondary lenders were as safe as commercial lenders, although they were more loosely regulated.

Policymakers and regulators underestimated the significance of the word “bank.” The change encouraged many working-class people to rush to savings banks for higher interest rates. With soaring deposits, the smaller lenders were looking for higher yields and invested large portions in risky activities, such as PF lending.

Lessons from the crisis

Given that Korea’s savings bank scandal is similar to the U.S. case in terms of how it happened and unfolded, it is worth taking lessons from it and learning how the U.S. government fixed the mess.

There are a few implications from the U.S. case that Korean policymakers should pay attention to. First, financial figures can be misleading since they involve risk-adjusted profitability in the banking industry. Second, poorly-controlled lenders can conceal problems by recycling bad loans and thus escalating market risks. Third, accelerated growth in new lines of business, such as PF lending, requires tighter risk management and control.

The short-term solution for the current savings banks’ trouble is to help the industry undergo a soft-landing by vitalizing the property market. However, taking some of the lessons into consideration, the fundamental solution is to strengthen regulations and restructure the industry.

Mauro F. Guillen, a director of Lauder Institute at the Wharton School, said that in order to ensure more transparent and tighter controls, the Bank of Korea (BOK) needs to be given the right to investigate local lenders in an independent manner.

“The only way to avoid these types of problems is to have two things; good regulations that prevent risks from building up without choking credit creation, and strong supervision by an independent agency and/or the central bank,” Guillen said.