Korean Capital Injections: KDIC 1997

In January 1997, the Korean government passed the Act on the Structural Improvement of the Financial Industry (ASIFI)—legislation that permitted the government to invest in insolvent financial institutions (FSS 2000; ASIFI 1997). When the government responded to the Asian Financial Crisis in late 1997, its top priority was to resolve insolvent financial institutions (D. S. Kang 2010). However, government institutions such as Bank of Korea and KDIC lacked sufficient resources to cover all restructuring costs (D. S. Kang 2010). Korea’s sovereign credit rating declined within international markets, so Korean companies could not easily raise capital from other financial institutions, corporations, or foreign investors (D. S. Kang 2010). Given constraints on financing its restructuring efforts, the Korean government decided that public funds were necessary to resolve nonviable institutions (D. S. Kang 2010).

The Korean government uses the term “public funds”^FNOther sources of public funds included budgetary allocations and asset exchanges (Baliño and Ubide 1999). to describe “capital raised by the Korean Asset Management Corporation (KAMCO) and the Korea Deposit Insurance Corporation (KDIC) through the issuance of bonds with a government guarantee on the payment of principal and interest” (D. S. Kang 2010). KAMCO used public funds to purchase non-performing assets, while KDIC drew on public funds to pay out deposit insurance for failing financial institutions, acquire assets of closed banks,^FNThe KDIC compensated for losses associated with purchase and assumption (P&A) operations by purchasing the insolvent portion of the acquirers’ assets (KDIC 1999). KDIC asset purchases were also the product of counterparties that executed put-back options after acquiring a Korean financial institution (Kwon 2016). When the KDIC funded asset purchases by the Resolution and Finance Corporation (RFC), a KDIC subsidiary, the KDIC recorded the RFC’s expenses on its own financial statements—even though the RFC managed the and recapitalize financial institutions with weak balance sheets (D. S. Kang 2010). Capital injections, as part of the public funds injections, were subject to the same criteria as public funds injections; these criteria are described by the Special Act on the Management of Public Funds (SAMPF). Before injecting public funds, the KDIC required financial institutions to sign Memoranda of Understanding (MOUs) that outlined financial goals (Asian Banker 2000; FSC 2000). See Key Design Decisions Nos. 10 and 12 for further discussion of SAMPF in the KDIC’s capital injections.

The Korean government recapitalized financial institutions by purchasing common stock, preferred equity, subordinated debt, NPLs, assets, the payout of deposit-insurance policies, and directly injecting cash (Baliño and Ubide 1999). The largest of these measures was KAMCO’s mass purchases of non-performing loans (see Figure 9 in the Appendix). Non-KDIC government agencies financed these activities through KAMCO bond issuances, the government budget, and the exchange of government shares of subordinated debt, depending on the mode of recapitalization (Baliño and Ubide 1999). When banks’ turnaround plans involved foreign capital, the government recapitalized them by purchasing subordinated bonds (Kyu-Sung Lee 2011). To recapitalize state-owned banks, the Korean government directly provided state-owned property^FNBetween September 15 and November 10, 1998, the Korean government infused cash worth KRW 1.35 trillion into the Korea Development Bank, KRW 100 billion into the Export-Import Bank of Korea, and KRW 200 billion into the Industrial Bank of Korea (Kyu-Sung Lee 2011). The government also transferred its own shares of KT&G and POSCO worth KRW 1.5 trillion to the Industrial Bank of Korea (Kyu-Sung Lee 2011). On December 31, 1998, the government transferred shares—including shares of the Korea National Housing Corporation—worth KRW 3.4 trillion to the Korea Development Bank (Kyu-Sung Lee 2011). The Export-Import Bank also received KRW 450 billion worth of government-owned shares (Kyu-Sung Lee 2011). in addition to cash contributions (Kyu-Sung Lee 2011).

By 1997, the Korean government recognized the need for regulatory and supervisory reform due to changes in surrounding Asian financial systems: the lack of a clear boundary between bank/non-bank activities, financial market liberalization, deregulation, and globalization (FSS 2018). In January 1997, the Korean government assembled the Presidential Commission for Financial Reform (PCFR) to brainstorm new supervisory protocol and procedures (D. S. Kang 2010; FSS 2018). Comprised of 31 members from business, financial, and academic sectors, the PCFR published two sets of policy recommendations in 1997 to reform the Korean financial sector (D. S. Kang 2010). The PCFR’s main objectives were to strengthen the financial industry competitiveness,^FNThe PCFR believed that establishing Prompt Corrective Action and Early Resolution frameworks was a key part of financial sector competitiveness (D. S. Kang 2010). To achieve this, the PCFR recommended: (1) Prompt Corrective Action (PCA) for undercapitalized financial institutions, (2) mergers and acquisitions (M&A) for insolvent financial institutions, (3) improving the liquidation and bankruptcy procedures for failing financial institutions, and (4) improving measure to protect depositors and investors against the failure of financial institutions (D. S. Kang 2010). The PCA framework, later enacted in April 1998, was triggered by low capital adequacy ratios and explained the conditions that would require the KDIC to inject capital (D. S. Kang 2010). to foster financial market efficiency, and to stabilize the financial system (D. S. Kang 2010). On December 4, 1997 the Korean state committed to a Stand-by Arrangement^FNThe aims of the IMF program were: (1) to commercialize the financial system and to strengthen its supervision, (2) to restructure the corporate sector, and (3) to restructure and recapitalize the banking system by cleaning up the stock of bad loans and restoring capital bases (Baliño and Ubide 1999). with the International Monetary Fund (IMF) for Special Drawing Rights (SDR) 15.5 billion (Baliño and Ubide 1999). The IMF’s conditions and policy agenda had already been discussed in the PCFR^FNResearch from the Korean Development Institute document suggests that the IMF enacted the PCFR’s policy recommendations “without a major revision to the original draft,” an act that “enabled Korea to save time and resources in overcoming and rebounding from the crisis” (D. S. Kang 2010). (Baliño and Ubide 1999; D. S. Kang 2010).

The PCFR also recommended the consolidation of financial supervisory bodies (D. S. Kang 2010). On December 29, 1997, the Korean Assembly approved the Act on the Establishment of Financial Supervisory Organizations (AEFSO)^FNThe AEFSO was submitted to the National Assembly for ratification on August 23, 1997, but was not ratified until December 29, 1997 (D. S. Kang 2010). The “Act on the Establishment of Financial Supervisory Organizations” was renamed “Act on the Establishment of the Financial Services Commission” in 2008 (FSS 2018). to consolidate financial supervision into one entity (FSS 2018). Supervisory consolidation occurred in two stages to make necessary preparations and to not detract from crisis management (Lindgren et al. 1999). The resultant Korean financial supervisory system was two-tiered: while the Financial Supervisory Commission^FNIn 2008, the “Financial Supervisory Commission” assumed the policy functions of the Ministry of Finance and Economy’s Financial Policy Bureau and was renamed the “Financial Services Commission” (FSS 2018). (FSC) handled rule-making and enforcement, the Financial Supervisory Service (FSS) conducted safety/soundness examinations, educated and protected consumers, and administered the FSC’s rule-making and licensing activities (FSS 2018).

As Korea’s first integrated financial supervisory body, the FSC led financial reform and restructuring efforts—including capital injections—in the wake of the 1997 crisis (D. S. Kang 2010). The FSC was established on April 1, 1998 under the AEFSO (FSS 2018; D. S. Kang 2010). The FSC was the government agency charged with setting financial market policies, proposing legislative changes to the National Assembly, granting regulatory licenses,^FNIn April 1999, the FSC acquired the power to license and de-license financial institutions and to supervise specialized development banks (Lindgren et al. 1999). and enforcing the rules (FSS 2018).^FNHoused within the FSC, the Securities and Futures Commission (SFC) oversaw securities and futures markets, directed investigations of market misconduct and abuse, and established accounting and auditing standards (FSS 2018).

On January 1, 1999, the Office of Bank Supervision (OBS), Securities Supervisory Board (SSB), Insurance Supervisory Board (ISB), and Nonbank Supervisory Authority (NSA) were consolidated into a single supervisory entity: the Financial Supervisory Service (FSS)^FNLegally, the FSS was a quasi-government supervisory authority responsible for all the financial sector (FSS 2018). To examine and supervise institutions, FSS regularly coordinated activities and shared information with the Bank of Korea, the Korea Deposit Insurance Corporation, and the Financial Supervisory Commission (FSS 2018). (D. S. Kang 2010). The FSS examined and supervised financial institutions to ensure they operated safely and soundly, served consumers and investors, and followed financial rules and regulations (FSS 2018). The FSS also supervised capital markets and mediated disputes between financial institutions, investors, depositors, and creditors (FSS 2018; D. S. Kang 2010).

The government enacted the Depositor Protection Act (DPA) on December 29, 1995, and established the KDIC on June 1, 1996 (KDIC 1998). The KDIC’s purpose under Article 1 of the DPA is “to contribute to [the] protection of depositors, etc. and maintenance of the stability of the financial system by efficiently operating the deposit insurance system, etc. in order to cope with a situation in which a financial company is unable to pay back deposits, etc. due to its bankruptcy, etc.” (DPA 1995).

Between June 1, 1996, and January 1, 1997, the KDIC was a special juridical entity with no capital; thereafter, it launched bank protection operations—including capital injections—while nonbank financial institutions^FN“Nonbank financial institutions” included securities companies, insurance companies, merchant banks, mutual savings and finance companies, and credit unions (KDIC 1998). still had separate insurance agencies (KDIC 1998; DPA 1995). On April 1, 1998, all depositor protection functions were collected under one institution; the KDIC assumed the assets and liabilities of the Insurance Guarantee Fund, the Korea Non-Deposit Insurance Fund, and Credit Union’s Security Fund (KDIC 1998). Given its stated purpose, the KDIC was both legally obligated and enabled to recapitalize any insured financial institution—not just banks—on April 1, 1998 (Lindgren et al. 1999). Following 1998 changes to the Act on the Structural Improvement of the Financial Industry (ASIFI) and DPA, non-depository institutions such as insurance companies and credit unions were also required to hold insurance^FNThe KDIC also expanded the scope of insurable deposits to “maintain the stability of the financial system” (KDIC 1998). From 1998 to 2001, the KDIC insured the deposits of the government, certificates of deposit, money raised by selling bonds under repurchase agreements, and bank bonds, among other securities (KDIC 2001). with the KDIC on deposit-like liabilities (KDIC 1998; Kyu-Sung Lee 2011). The KDIC also offered blanket deposit coverage from December 1997 to July 1998,^FNIn July 1998, the KDIC decided to insure principal and designated interest up to KRW 20 million per individual depositor (KDIC 2001). Concerned about moral hazard, the KDIC only covered principal for deposit accounts with more than KRW 20 million (KDIC 2001). in response to financial market instability (KDIC 2001). After markets stabilized, the KDIC decided in October 2000 to raise the limit to KRW 50 million per depositor, beginning January 2001 (KDIC 2001).

Within the KDIC, the Policy Committee^FNThe “Policy Committee” was renamed the “Deposit Insurance Committee” following an amendment to the DPA on May 29, 2003 (DPA 1995). The shorthand for both is still “the Committee” in relevant documents and legislation. was the highest decision-making body (KDIC 1999). In 1999, its membership included 14 individuals: the Vice Minister of the Ministry of Finance and Economy (MOFE), the Assistant Director of the Budget Planning Office, the Vice Chairman of the Financial Supervisory Commission, the Vice President of the Bank of Korea, the President of the National Bankers Association, representatives of seven financial industries, and two appointees of the MOFE Minister (KDIC 1999). The responsibilities of the Policy Committee included funding support for financial resolution institutions and institutions looking to acquire, merge, absorb, or take over the operations of other failed institutions (KDIC 1999). The Policy Committee’s decisions regarding resolution were subject to approval of the KDIC Board of Directors (KDIC 1999).

As capital injections were part of massive restructuring efforts, it appears that they did not receive any dedicated announcement before they were conducted. The first English-language mention of recapitalization efforts took place on December 5, 1997: an International Monetary Fund press release states that troubled Korean financial institutions would be restructured or recapitalized if deemed viable (IMF 1997). Later public dialogue between the Korean government and IMF officials confirms that capital injections were a part of the government’s restructuring plans (Lee and Lim 1998; Chon and Lee 1998).

The Korean government usually announced the type, size, and recipient of capital injection on an ad hoc basis (MOFE 1999). Other forms of public disclosure included public fund management reports, reports from institutions themselves (as required by law), and press releases from various regulators. The MOFE Minister was required to write quarterly reports on the use of public funds to the Korean National Assembly, and the Public Fund Oversight Committee was required to publish an annual white paper on public fund management by the end of August (BOK 2001). All financial supervisors, including the KDIC, Bank of Korea (BOK), MOFE, FSC, and Financial Supervisory Service (FSS), publish reports at quarterly and/or annual intervals—each describes capital injections in varying levels of detail.

Each insured institution had to publicly report the contents of its relationship with the KDIC in accordance with public guidelines established on August 10, 1998 (KDIC 1999). To investigate compliance, the KDIC could examine passbooks and promotional materials, public availability of pamphlets and posters provided by the KDIC for public distribution, and public availability of pamphlets containing a list of insured financial products (KDIC 1999). Furthermore, the KDIC publicly disclosed the contents of MOUs to improve the transparency of public fund injections (D. S. Kang 2010).

In May 1998, the Korean government estimated that KRW 64 trillion would cover the costs of financial restructuring and secured approval from the National Assembly to raise bonds through the KDIC and Korean Asset Management Corporation (KAMCO) (Shin 2003). This KRW 64 trillion was later regarded as the first “phase” of financial restructuring (KDIC 2003). By late 1999, the financial sector still needed more funding, and in 2000,^FNSecond-round public fund operations were delayed due to “ill-coordinated policy dialogues and political agenda” (D. S. Kang 2010). The Korean government recognized the need to raise more public funds to head off any unforeseen complications with financial and corporate sector restructuring and convened in early 1999 to discuss if and how much additional public funds ought to be raised after the first round had been depleted (D. S. Kang 2010). However, an “unanticipated happening in the high level meeting masked further discussions on the necessity of public funds” (D. S. Kang 2010). After a national election for lawmakers in April 2000, the government formally declared the second round of fundraising in mid-2000 (D. S. Kang 2010). Some scholars suggest that the Korean government sought to avoid political backlash before the election, and that the National Assembly waited until financial markets became sufficiently turbulent before expressing the need to raise additional public funds (Lim and Hahm 2004). the National Assembly approved a second round^FNSecond round objectives were to: (1) recapitalize distressed banks to enhance BIS capital adequacy ratios, (2) uphold Seoul Guarantee Corporation’s capital base (so that it could guarantee Daewoo Group and non-Daewoo workout companies), and (3) offset shortfalls that caused more NPL sales (Kang 2010). of public fund mobilization worth KRW 40 trillion (Shin 2003). The amount of money used for restructuring does not equal the amount of bonds raised because recouped public funds were re-spent on financial restructuring, and the government relied on multiple funding sources (Shin 2003).

Article 24 of the DPA established the Deposit Insurance Fund (DIF) on April 1, 1998, the same day that the KDIC assumed the assets and liabilities of the Insurance Guarantee Fund, the Korea Non-Deposit Insurance Fund, and Credit Union’s Security Fund (DPA 1995; KDIC 1998). The DIF funded deposit payoffs and financial assistance—including capital injections—to distressed financial institutions (KDIC 1998). The DIF’s financial statements were separated into six different accounts: banks, securities companies,^FNBefore February 2009, the Korean government used “securities companies” and “financial investment companies” interchangeably (KDIC 2009). After the enactment of the Capital Market Consolidation Act in February 2009, “financial investment companies” included securities companies, investment dealers, and brokerage firms (KDIC 2009). insurance companies (life and non-life), merchant banks, mutual savings & finance companies, and credit unions (KDIC 1998).

Article 26-2 of the DPA permitted the KDIC to issue government-guaranteed^FNIn 1998, the National Assembly guaranteed payment of (DIF) bond principal, and KDIC borrowed from the central government to pay DIF bond interest payments (KDIC 1998). Specifically, KDIC borrowed from the government’s “Special Account for Financial Loans” in the form of three-year, zero-interest loans (KDIC 2002). KDIC borrowed a total of KRW 18.6 trillion from 1998 through 2002 to make DIF bond interest payments (KDIC 2003). Under the Public Fund Redemption Fund Act, KDIC was exempted from repaying previous fiscal borrowings (KDIC 2003). bonds for the purposes of financial restructuring;^FNOther sources of DIF funding included contributions (from insured financial institutions and the government), the gratuitous transfer of state property, borrowings, collected insurance premiums, recovery (from deposits purchased, or from funds provided for the resolution of failed financial institutions), and income from the operation of the DIF (KDIC 1998). the KDIC bond issuances funded KDIC capital injections (DPA 1995; D. S. Kang 2010). The KDIC’s subcommittees (for example: Banking Subcommittee, Insurance Subcommittee) discussed prospective bond issuances before submitting them to the Policy Committee, who submitted them to the National Assembly for approval (KDIC 1998; KDIC 1999; D. S. Kang 2010). The KDIC raised about KRW 87.2 trillion in bond issuances between 1998 and 2002 (KDIC 2018). The KDIC issued most bonds with maturities of at least five years because it expected repayment to take that long (KDIC 1999). A comprehensive list of bond terms, rates, and volume by sector can be found in Figures 5, 6, and 7 of the Appendix.

On January 1, 2003, and under the “Public Fund Redemption Plan,” the first Deposit Insurance Fund was renamed the “Deposit Insurance Fund Bond Redemption Fund” (DIFBRF) to alleviate public concerns about the loss and recovery of public funds (KDIC 2003). An amendment to the DPA separated the DIFBRF from the new Deposit Insurance Fund (“new DIF”)^FNThe new DIF ran normal deposit insurance operations, collected insurance premiums, and dealt with new insolvencies from 2003 onward (KDIC 2003). (DPA 1995; KDIC 2003). The DIFBRF was responsible for completing financial restructuring efforts related to the 1997–1998 crisis, including the relevant recovery efforts and repayment of public funds (KDIC 2003). The DIFBRF received the assets, debts, and other rights and duties^FNThe DIFBRF ought to be fully liquidated before December 31, 2027—afterward, the remaining assets, debts, and other rights and duties will be turned over to the Treasury or the new Deposit Insurance Fund (BOK 2003). of the original DIF registered before January 1, 2003 (BOK 2003). KDIC paid for the original DIF bonds with special assessments levied on insured deposits, contributions from the DIFBRF, money raised from DIFBRF bond issuances, and other borrowings (KDIC 2003). The original DIF bonds were all repaid by the end of 2008 (KDIC 2018).

The KDIC could assist an insured financial institution in three scenarios: (1) an institution applied for financial assistance to smooth a merger, or the KDIC deemed financial assistance necessary to facilitate a merger; (2) the KDIC determined that financial assistance was necessary for depositor security and the “stability of credit order,” or (3) the FSC requested^FNArticle 12 of the ASIFI permitted the Financial Services Commission to request the purchase of securities from an inviable financial institution (ASIFI 1997). Article 5-5 of the ASIFI Enforcement Decree clarified that “securities” referred to government bonds, subordinated bonds issued by the inviable institution, or any security recognized by the FSC to be equivalent to the other two types of securities (ASIFI ED 1997). the KDIC to provide financial assistance (DPA 1995).

The ASIFI authorized the KDIC and FSC to designate a financial institution as insolvent/failed^FNBefore 1998 amendments to the ASIFI, the definition of “insolvency” was limited to the suspension of deposit payments (Kwon 2016). if: (1) liabilities exceeded assets due to business operations, major financial scandal, or accrual of non-performing loans; (2) payments of claims (including deposits and money borrowed from other financial institutions) were suspended; (3) the institution was unable to pay claims without outside support or separate borrowings (excluding borrowings ordinary financial transactions) from the FSC or KDIC’s Policy Committee (Oh 2018; ASIFI 1997; DPA 1995). Any institution at risk of becoming insolvent/failed was regarded as “insolvency-threatened” or “failing” (KDIC 1998; DPA 1995).

With respect to insolvent/failed institutions, the KDIC could make deposit payoffs to depositors, arrange mergers, assign the transfer of contracts, or provide financial assistance in support of either of the previous processes (KDIC 1998; DPA 1995). “Financial assistance” referred to: extending loans or depositing funds, purchasing assets, guaranteeing or accepting obligations, and contributing capital (KDIC 1998; DPA 1995). The Policy Committee decided which type of financial assistance to use (KDIC 1998; DPA 1995) (KDIC 1998; DPA 1995). The KDIC could also arrange a merger or contract transfer by establishing new resolution financial institutions to take over the failed institutions (KDIC 1998; DPA 1995).

The KDIC could aid insolvency-threatened/failing institutions if the Policy Committee determined that supporting an individual institution was necessary to protect depositors and to maintain the stability of the financial system (KDIC 1998; DPA 1995). Methods of assistance for failing institutions included liquidity support, contributions, or equity participation (KDIC 1998; DPA 1995). The Ministry of Finance and Economy determined the list of securities that the KDIC Policy Committee could purchase from the failing financial institution (KDIC 1998; DPA 1995).

The Korean government focused on the most systemically important institutions at the onset of the crisis, so the first wave of public support in late 1997 and 1998 was aimed at insolvent commercial and merchant banks (Chopra et al. 2001). In 1998, public funds capitalized Seoul Bank and Korea First Bank, because if two prominent banks were liquidated, all remaining Korean banks likely would have endured bank runs with “severe systemic risk for the financial industry” (D. Kim 1999). Nonbank financial institutions were initially restructured under majority shareholders’ responsibility without government support because they were presumed free from systemic risk; exceptions were Korea Investment Trust Company and Daehan Investment Trust Company, which received public fund support in late 1999 (Shin 2003).

The Korean government diluted shareholder equity^FNWriting down capital was a frequent phenomenon during the restructuring process. For example: when four small banks were recapitalized at the end of 2000, all shareholder equity was written down (Chopra et al. 2001). Before the KDIC nationalized Seoul Bank and Korea First Bank in 1998, the FSC ordered them write down capital from KRW 820 billion to KRW 100 billion each, and the shareholders had to take losses (Chopra et al. 2001). In September 1998, the government demanded workforce reductions from Korea First Bank and Seoul Bank in exchange for capital injections (Kyu-Sung Lee 2011). to avoid moral hazard (Chopra et al. 2001). In August 1998, Korean authorities amended the ASIFI to further reduce the value of shareholder capital in the event of a write-down (Baliño and Ubide 1999; Kataoka 1999).

 In 1998, the government agreed to support banks that did not merge by matching their private capital raises (Claessens, Ghosh, and Scott 1998). Thereafter, the KDIC had the right to review and assess management performance, and to take appropriate corrective action.

Prompt Corrective Action is a regulatory framework in which financial supervisors can automatically issue orders to institutions that fail to meet management standards (S. M. Kim, J. Y. Kim, and Ryoo 2006). The Korean government relied on PCA to minimize regulatory forbearance and to ease the taxpayer burden from rescuing financial institutions (D. S. Kang 2010). To determine whether PCA ought to be used for banks, supervisors relied on measures of bank health, such as the Basel capital adequacy ratio and CAMELS ratings (FSS 2000). The FSC/FSS issued PCA recommendations, requirements, and orders; the severity of PCA reflected the institution’s financial status (D. S. Kang 2010). Though PCA alone did not permit the KDIC to directly inject capital, the FSC could order a capital injection at any stage of PCA—subject to the approval of the KDIC Policy Committee (ASIFI 1997; DPA 1995). The KDIC could also request the FSC to act against a distressed financial institution (KDIC 1998). A full list of PCA enforcement criteria and actions from the year 2000 can be found in Figures 1 and 2 of the Appendix.

In January 1997, the Korean government established the ASIFI (effective March 1997) and laid the legal foundation for what would later become PCA procedures in September 1998 (Kataoka 1999; ASIFI 1997). Following IMF recommendations, the Korean government announced in late 1997 that all banks failing to meet the Basel minimum capital adequacy ratio of 8% by the end of 1997 would be identified as “potentially nonviable” (FSS 2000; De Luna-Martinez 2000). After the Korean government established the FSC, the FSC subjected 12 banks to PCA for the first time on June 28, 1998, although PCA would not take effect until September (De Luna-Martinez 2000). The MOFE evaluated merchant banks at the same time as commercial banks (Kyu-Sung Lee 2011). The FSC (and later FSS) began to evaluate nonbank financial institution^FNThe March 1997 amendments to the ASIFI granted a supervisory grace period to securities companies and credit-specialized financial companies, which did not face PCA until 2000 and 2001, according to an external reviewer. (insurance companies, investment and securities companies, mutual savings and finance companies, credit unions, and credit-specialized financial companies) and to issue PCA orders in the second and third quarters of 1998, respectively (Kyu-Sung Lee 2011). Nonbank financial institutions followed similar PCA procedures, with different measures of capital adequacy. Amendments to the ASIFI in September 1998 included trust companies in the list of financial institutions eligible for government support, formally codified PCA procedures, and increased the number of institutions subject^FNIn addition to those institutions whose assets exceed liabilities or suspended deposit liabilities, “insolvent” or “failing” institutions also included those suspected to be insolvent (BOK 1999). Financial scandal or non-performing assets—in addition to insufficient capital adequacy ratios—could warrant PCA (BOK 1999). to PCA by financial supervisory authorities (BOK 1999; ASIFI 1997).

In addition to PCA, the FSC relied on informal supervisory actions to improve the relationship between financial institutions and supervisory authorities (D. S. Kang 2010). The FSC could require institutions to submit management improvement plans, letters of commitment, or Memoranda of Understanding (D. S. Kang 2010). Under the SAMPF, recipients of public funds were obliged to conclude MOUs with government agencies to prevent moral hazard (SAMPF 2000; SAMPF ED 2001). Fourteen financial institutions had to enter into MOUs with the KDIC after receiving capital injections, and the majority were signed in 2000 (KDIC 2018). The KDIC actively added and adjusted business performance targets from the date of origination through 2018 (KDIC 2018). The KDIC terminated 12 MOUs after institutions either merged with or were acquired by larger financial institutions (KDIC 2018).

Each MOU contained a main text, a business normalization plan, and document attachments^FNThe main text describes the institution’s responsibility to follow the business normalization plan on an agreed-upon schedule (KDIC n.d.2). The business normalization plan describes the institution’s plans to better its balance sheet and measures to strengthen other financial and non-financial indicators (KDIC n.d.2.). The attached documents include a pledge to implement the MOU and management/staff signatures (KDIC n.d.2.). (KDIC n.d.2.). These plans included details on a financial institution’s target capital adequacy ratio,^FNFollowing an agreement with the World Bank, minimum BIS targets for banks were 10% after signing MOUs (FSC 2011). The Korean government believed 10% was necessary for financial soundness in the business normalization process (FSC 2011). profit-to-assets ratio, bad-loan ratio, restructuring plans, and the written consent of the in-house labor union to restructuring (BOK 2001). The government standardized and publicly announced the contents of the MOUs (D. S. Kang 2010). The government evaluated MOU adherence on a quarterly basis, allowing financial supervisors to take punitive action against non-adherence (KDIC 2000). From MOUs, the KDIC maintained broad informational authority and could request the institution to provide documentation at regular intervals, to create Implementation Plans, and to notify the KDIC of any interruptions to the institution’s completion of responsibilities (US SEC 2000, Articles 3–6). The KDIC could also request information indirectly from the Financial Supervisory Commission or the Financial Supervisory Service (KDIC 1999). The KDIC could directly manage institutions when they failed to abide by the terms of the MOUs (US SEC 2000, Article 9).

To quickly recover public funds, the KDIC aimed to improve the value of the assets (including equity) by strengthening the financial status of the underlying institution (KDIC 1999). KDIC attempted to help the institution by fortifying their human resource management, supporting various restructuring efforts, and establishing and implementing new budgets (KDIC 1999). If the management did not comply, the KDIC could assume legal rights to take “appropriate legal actions to accomplish [the KDIC’s] objectives” (KDIC 1999). From related government agencies, the KDIC could request information about the assets of failed institutions, their managers, and their officers (KDIC 1999). In January 1998, the government amended the ASIFI to order capital write-downs for the existing shareholders responsible for the insolvency of banks that the government has recapitalized or decided to recapitalize (Kataoka 1999). The KDIC could demand damage payments from the management (“managerial entity”) of a failed institution (KDIC 1999). The KDIC monitored management’s adherence to normalization plans on a quarterly basis and requested the FSC to take necessary action if the institution failed to hit the MOU targets (KDIC 2000).

“Regulations Concerning the Accountable Management of Financial Institutions and the Guarantee of the Transparency of the Financial Administration” was established on November 13, 2000 (BOK 2001). Its purpose was to aid the financial supervisory institution in establishing financial policy and to execute its supervisory responsibilities through “objective and transparent procedures” (BOK 2001). This law forbade the financial supervisory institution from making unwarranted interventions in its management of financial institutions (BOK 2001). The financial supervisory institution was required to request support or cooperation (from financial institutions) through writing or at a formal meeting (BOK 2001). The government and KDIC were requested to dispose of their shareholdings in these financial institutions as quickly as possible (BOK 2001).

Other efforts to improve bank management included improvements to governance and ownership structures (Shin and Hahm 1998). While rights of minority shareholders were strengthened (Lim and Hahm 2004), controlling shareholders sometimes impeded the restructuring process (Lim and Hahm 2004).

The KDIC recovered the costs of capital injections by selling equity stakes, accumulating equity dividends, and collecting bankruptcy dividends^FNTo effectively recover public funds, including those used for recapitalization, the KDIC studied foreign schemes (KDIC 1999). From the United States, the KDIC obtained information on the US FDIC’s failed bank resolution and the US Resolution Trust Corporation’s (RTC) resolution of failed savings and loan associations (KDIC 1999). The KDIC also studied US and Japanese modes of debenture recovery through asset management/disposal contracts (KDIC 1999). To prevent moral hazard, the KDIC studied resolution procedures, relevant regulations, and legal actions taken by the U.S. and Japanese governments against financial crime. The KDIC attempted to create effective and preventive anti-failure measures by developing assumptions of damage claim rights (KDIC 1999). (KDIC 2001). However, the KDIC did not authorize equity dispositions on its own. The Special Act on the Management of Public Funds established a Public Fund Oversight Committee (PFOC)^FNThe use of public funds to manage and resolve financial institutions was politically contentious, and there were strong negative public reactions to “the injection of taxpayer money to rescue essentially private financial institutions” (M. Kang 2009). Korean authorities created PFOC in late 2000—after the majority of capital injections had already taken place (M. Kang 2009). Myung-Koo Kang (2009) suggests that the Korean government created PFOC in an attempt to divert public criticism (248). at the Ministry of Finance and Economy; PFOC oversaw public funds, including approving and arranging their provision and collection (BOK 2001). Within the PFOC, a Sales Screening Subcommittee decided when and how the KDIC and other government agencies ought to dispose of assets (including stock holdings and equity participation) (BOK 2001). If a recipient of public funds were to become insolvent or to dissolve, the court was required to designate the KDIC or a member of its staff as a receiver or liquidator for a minimum of five years (BOK 2001; KDIC 2000).

Following a change to the DPA, the KDIC could recover public funds more efficiently by performing liquidator and bankruptcy administrator roles itself beginning in 2000^FNKDIC was able to actively seek recovery efforts by convincing courts and bankruptcy estate trustees to adopt an auditor system under Bankruptcy Law (KDIC 2000). Under the SAMPF, the KDIC developed criteria for how to dispose of and manage the assets held by bankruptcy estates (KDIC 2000; SAMPF 2000). To analyze performance, KDIC also developed annual plans for recovery and trustee dividend distribution for each estate (KDIC 2000). (KDIC 1999; DPA 1995). With the goal of completing early bankruptcy proceedings, the KDIC also planned to file subrogation damage claim lawsuits and/or to participate in relevant lawsuits via the revised regulations (KDIC 1999).

A major objective of privatization was to recoup public funds injected for financial restructuring, so the Korean government began selling nationalized banks to foreign investors in late 1999 (S. M. Kim, J. Y. Kim, and Ryoo 2006). The Korean government encouraged foreign investment to increase the capital base of viable financial institutions^FNThe banking sector depended on the flow of foreign capital because the Korean government was only willing to support part of the recapitalization, domestic capital markets were insufficient, and there were legal restrictions on chaebol ownership of banks (Shin and Hahm 1998). (Shin and Hahm 1998). The Korean government raised the ceiling on foreign ownership from 7% to 50% between November and December 1997 and eliminated it by May 1998, six months after the onset of the crisis (M. Kang 2009). In 1998, the Korean government also eliminated a rule that required the boards of directors to approve a foreign institution’s purchase of at least one-third of a company’s outstanding shares (Y. K. Lee 2004).

On September 16, 1998, the government amended the Securities Investment Trust Act, and repealed caps on equity ownership by individual investment trusts (Kyu-Sung Lee 2011). The move permitted controlling shareholders of investment trusts to aid in restructuring efforts via recapitalization (Kyu-Sung Lee 2011).

In the past, the Korean government had prohibited financial institutions from setting up financial holding companies (FHC) for fear that they would stifle the financial sector and create systemic risk (Ro 2001). Commercial banks' refusal to participate in mergers led the government to adopt FHC-friendly legislation^FNThe Korean government hoped that staff resistance would be lower for takeovers by FHCs than takeovers by other banks because affiliated companies would be able to avoid employee downsizing, in contrast with the P&A approach of 1998, which incited employee resistance (Ro 2001, 97; Hahm and Kim 2006). (Ro 2001). In October 2000, the Korean National Assembly passed the Financial Holding Company Act, which permitted the creation of financial holding companies with government approval (Ro 2001; FHCA 2000). In December 2000, the FSC/FSS created the Regulation on Supervision of Financial Holding Companies to establish authorization criteria for institutions to either start financial holding companies^FNAs with mergers, the Korean government offered relatively healthier banks priority approval if they were willing to integrate voluntarily as holding companies (Ro 2001). or to join them as subsidiaries (S. M. Kim, J. Y. Kim, and Ryoo 2006).

On March 27, 2001, the KDIC established Woori Finance Holdings Company (FHC) as a wholly owned subsidiary through the stock transfers of four banks (Hanvit, Peace, Kwangju, and Kyungnam) and one merchant bank (Hanaro, later “Woori Merchant Bank”) (KDIC 2001). Each member received a capital injection to raise its capital adequacy ratio above 10% before it became a subsidiary of Woori FHC (Hahm and Kim 2006). The KDIC suggested that Woori’s establishment reflected the KDIC’s own effort to recover public funds quickly (KDIC 2001). Later government FHCs include Shinhan Financial Group (September 2001) and Dongwon Financial Group (May 2003); both groups incorporated nonbank financial institutions (S. M. Kim, J. Y. Kim, and Ryoo 2006; Hahm and Kim 2006). 

The Korean government’s 1998 interventions were characterized by rescue, recapitalization, and resolution. The following year ushered in new legal frameworks for prudential regulation and supervision, in-line with the conditions of the IMF’s large assistance package (Kyu-Sung Lee 2011). The prudential overhaul signaled Korea’s shift toward a market-based financial system (Kyu-Sung Lee 2011). To bring the Korean financial system up to international standards and practices, the Korean government needed to toughen the state’s lax financial supervision and bolster market oversight (Kyu-Sung Lee 2011).

Lawmakers modeled banking supervision after the Basel Core Principles for Effective Banking Supervision, which shifted the overall methods^FNFinancial supervision shifted from: direct to indirect regulation, positive-list to negative-list regulation, abstract and political supervisory standards to transparent and objective standards, institution-specific supervision to function-oriented supervision, unconsolidated to consolidated supervision (including parent, subsidiary, and overseas branches), and regulation-focused to service-oriented oversight (Kyu-Sung Lee 2011). of financial supervision in Korea (Kyu-Sung Lee 2011). The government improved the management evaluation of financial companies^FNManagement evaluation ratings for securities firms, insurance companies, and investment trusts were introduced in January 1999 (Kyu-Sung Lee 2011). by adopting CAMELS bank ratings in October 1996, and added sensitivity to risk in 1998 (Kyu-Sung Lee 2011).

On September 2, 1998, the Economic Policy Coordination Committee (EPCC) recommended that banks with BIS capital ratios lower than 8% raise them to at least 6% by March 1999, 8% by March 2000, and to 10% by December 2000 (Kyu-Sung Lee 2011). Along the same timeline, regional banks with no international clients faced targets of 4%, 6%, and 8% (Kyu-Sung Lee 2011). The target for domestic merchant banks was 8% by June 1999 (Kyu-Sung Lee 2011).

Beginning on July 1, 1998, supervisory authorities shortened the delinquency window for “precautionary” loans from three to six months to one to three months (Kyu-Sung Lee 2011). Loans delinquent for periods longer than three months were designated “substandard” (Kyu-Sung Lee 2011). Financial institutions also endured more stringent provision requirements for loan losses and write-offs in July 1998 (Kyu-Sung Lee 2011). The government also revamped loan management practices^FNPractices revamped included the definition of equity capital, loans subject to the lending rules, and lending ceilings (to a single person, to a single business group, loans in excess of a certain amount, and to a large shareholder) (Kyu-Sung Lee 2011). and implemented risk-based supervision at the end of 1998 (Kyu-Sung Lee 2011). Forward-Looking Criteria (FLC), loan criteria that more accurately reflected the future abilities of borrowers to service their debt, became effective December 31, 1999 (D. S. Kang 2010; Kyu-Sung Lee 2011).

The government also changed definitions of capital. Starting January 1999, loan-loss provisions for non-performing assets were deducted from tier-2 capital within the capital adequacy ratio (Shin and Hahm 1998). Prior to May 1999, “equity capital” was the sum of paid-in-capital, reserves, and other surpluses (FSS 2000). After May 1999, “equity capital” referred to the sum of tier-1 capital and tier-2 capital, in accordance with Basel capital standards (FSS 2000).

Supervisory authorities gradually introduced mark-to-market accounting^FNPrior to the introduction of the new system, financial companies disclosed financial data to satisfy regulatory requirements rather than to inform investors and shareholders (Kyu-Sung Lee 2011). Under the old accounting regime, companies could easily distort financial statements by misrepresenting income and expenses (Kyu-Sung Lee 2011). Shin and Hahm (1998) argues that banks overstated their true BIS capital adequacy ratios through two practices: the recognition of parts of loan-loss provisions as capital, and the partial recognition of stock revaluation losses (22–25). The authors contend that in the early to mid-1990s, Korean banks overstated their true BIS capital adequacy ratios by 1–2% (Shin and Hahm 1998). to financial companies between the beginning of 1998 and the end of 1999 (Kyu-Sung Lee 2011). Other additions to the supervisory framework include Prompt Corrective Action, regulations on foreign exchange, reporting and disclosure requirements, and off-site surveillance (Kyu-Sung Lee 2011).

Stronger asset classification criteria and higher scrutiny of NPLs aimed to make the Korean financial system more efficient and stable (Lim and Hahm 2004). The Korean government introduced forward-looking criteria so that financial institutions would "take decisive actions on distressed firms" and decrease regulatory forbearance^FN“Forbearance” refers to the “granting of exemptions or delaying intervention action in relation to banks as regards compliance with minimum regulatory requirements or intervention criteria” (IADI n.d.1.). (Lim and Hahm 2004). See Figure 8 in the Appendix for details on changes to asset classification. In light of corporate failures and investor losses,^FNDaewoo was one of the top five chaebols, and it failed in 1999 (Lim and Hahm 2004). The government used taxpayer money to allow Daewoo creditors to redeem their corporate bonds at a 5% loss, which was a shift away from "too-big-to-fail" (Lim and Hahm 2004). the Korean government's institutional reforms appeared credible (Lim and Hahm 2004).

The new loan classification and provisioning standards effectively classified most banks as undercapitalized (M. Kang 2009). Between 1998 and 1999, the new rules increased non-performing loans by about KRW 45 trillion (M. Kang 2009). After the Daewoo Group’s insolvency and failure in 1999, additional financial restructuring efforts appeared inevitable (KDIC 2003). In addition to the new rules, overall economic contractions and tightening fiscal and monetary policy created KRW 93 trillion of additional NPLs in the banking sector (KDIC 2003; M. Kang 2009). In response to the deteriorating economic conditions, the Korean government launched the second phase of restructuring in September 2000: raising KRW 40 trillion of public funds bonds and injecting them into the financial sector (KDIC 2003; M. Kang 2009).