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Global Financial Crisis and Systemic Risks in the Korean Banking Sector
Region: Asia
Theme: Economics
Location: Korea, South
Published May 25, 2009
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Financial crises are more common than people usually expect. In fact, 139 financial crises from 1973 to 1997 have been identified by Eichengreen and Bordo, and they concluded that the frequency of the crises is increasing although these crises are not necessarily becoming more severe. Recently, Laeven and Valencia filed a data set covering 124 systemic banking crises from 1970 to 2007, and Reinhart and Rogoff also convincingly showed, based on a long-term historical database for the past eight centuries, that international debt and banking crises, currency crises, and defaults have been a very common, historical phenomena. Most countries have passed through various types of external debt crises as their financial sectors become more liberalized and integrated into the global financial markets.
Since World War II, however, the current global financial crisis has been unmatched in its scope and depth of negative impacts on the global economy. Advanced economies are going through the deepest recession since World War II, and the crisis is spilling over to emerging and developing countries. The International Monetary Fund (IMF) estimates that the global economy will shrink for the first time since World War II during the coming year. In particular, accelerated financial leleveraging has had immediate impacts on global demand, and it is posing serious challenges to the global economy, regardless of the soundness or “fundamentals” of each national economy. Currently, deleveraging is posing a serious challenge to the export-driven East Asian economies, and the Korean economy is no exception.
Various ominous economic indicators have created a sense of foreboding: if the crisis is not managed well, the current Korean economic situation could escalate into a much more serious crisis than the financial crisis Korea had to go through a decade ago during the Asian financial crisis. Since the last quarter of 2008, when the financial turmoil originating from the subprime mortgage problem in the United States came to be a full-blown global crisis after the bankruptcy of Lehman Brothers on 15 September, both exports from and imports to Korea have rapidly decreased, while macro financial instability has been increasing. The gross domestic product (GDP) growth rate of Korea—one the lowest growth rates among OECD countries—shrank to –5.6 percent from the preceding quarter.

The Korean financial markets are suffering from massive financial deleveraging by foreign investors as well. As a symptom of this financial leleveraging, the Korean currency has sharply depreciated—one of the highest depreciation rates among major currencies—and is fluctuating against the U.S. dollar. Among others, two factors currently pose a concern for the potential for a systemic banking crisis in Korea: (1) a remarkably increasing short-term foreign debt, especially from 2006 onward; and (2) the highly leveraged banking sector joined by household debt that rose to 158 percent of disposable household income by the end of 2008, which is above the U.S. level (142 percent) and close to that in the United Kingdom (185 percent). What, then, went wrong in the Korean case?
The above question may be unfair if the intention is to find a political scapegoat responsible for the current situation because the current global financial crisis originated not from Korea but from the epicenter of the global financial markets, the U.S. financial markets, owing to the credit and asset bubble accelerated through the securitization of various financial derivatives. We may also reasonably claim that the Korean economy, including other emerging markets, is suffering regardless of the soundness of its economic fundamentals. Furthermore, policy measures by the Korean government against the current economic downturns are constrained by the pace of restoring stability in the global financial markets and the upturn swing of the business cycle of the global economy. Questions on this issue are, however, reasonably raised in order to learn policy lessons to prevent or at least minimize the cost of systemic banking crises in the future.
In this paper, I argue that, despite the Korean government’s tremendous achievement in transforming the country’s depressed financial markets into more globalized and open ones, the financial deregulation measures pursued by the government for the past decade have increased the vulnerability of the Korean banking sector to external shocks. Specifically, the Korean government has aggressively attempted to deregulate foreign exchange, both inward and outward capital flows, while the Korean currency has not been fully internationalized; and the government has allowed the reckless practices of short-term foreign borrowing by domestic branches of foreign banks without establishing an appropriate monitoring system. The current situation demands a new regulatory framework that can prudentially supervise the financial system, not only for promoting efficient financial intermediation of cross-border capital flows and the soundness of individual financial institutions but also for managing the systemic risks of the entirefinancial system. This regulatory reform will certainly be a challenging task under the increasingly globalized financial intermediation, not only for the Korean government but also for other governments in the world. Moreover, the current financial crisis highlights that the highly leveraged, external borrowing model of economic growth cannot be sustained as before.
Discussion will proceed, first, by reviewing the sharp currency depreciation and the out flow of foreign investors’ portfolio investment from the Korean stock market especially. We will then explore the reasons for the increasing short-term foreign debt and household debt in the banking sector by reviewing the financial deregulation measures adopted by the Korean government in regard to foreign exchange and banking activities. Last, some lessons and policy implications will be discussed.

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