Empowering KDIC's Risk Management Function

―――――――――――――――――――――――

Byung Duck Kim*‧Jae Youn Lee**

A broad spectrum of deposit insurance models from the most powerful "risk minimizer model" to the least powerful "pay- box model" exist around world. Korea's deposit insurance system started as a pay- box model, but a more empowered risk management function deems necessary for the proper management of ex- ante risk factors in insurance funds. Even after the legislative changes made in December 2000, which empowered many aspects of KDIC, there are still many risk management functions needed to be improved for KIDC to be a proper insurance fund manager. 

This paper analyzes the gap between the risk management functions of FDIC and CDIC to the risk management status of KDIC and proposes an ideal risk management framework for KDIC. The ideal risk management framework is composed of eight functional elements: membership standards, risk assessment, examination, monitoring of emerging issues, differential insurance premiums, links to fund management, corrective actions, and inter- agency relationships. The implementation of the new and revised functions of risk management should be prioritized by urgency since some of them will require corresponding legislative changes. 

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This study is not a reflection of the Korea Institute of Finance's official viewpoint.

* Research fellow at the Korea Institute of Finance

** Research fellow at the Korea Institute of Finance

Ⅰ. Introduction

The Korea Deposit Insurance Corporation (KDIC) was established in 1996 to protect bank deposits. After the 1997 Korean financial crisis, its role was extended to protect the deposits of all depository financial institutions. In 1998, the management of deposit insurance funds in securities companies, insurance companies, mutual savings & finance companies, merchant banking corporations and credit unions became a part of KDIC's functions. 

KDIC has played an important role in the massive financial restructuring process, providing 88.4 trillion won (as of Aug. 2001) in financial assistance for the recapitalization or resolution of failed or failing financial institutions. KDIC has been much more successful than originally expected.

KDIC's initial role was narrowly defined to ex- post risk management, maintaining the stability of the financial system. At that time, KDIC operated as a "pay- box"; its main role was to pay the claims to depositors of failed banks. After 

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the financial crisis, however, KDIC was asked to strengthen its ex- ante risk management function in order to keep funds sound. Because of restructuring, KDIC faced insolvency problems as a result of the funds' low recovery rate. 

This article will focus on the necessity of strengthening KDIC's role, especially its ex- ante risk management function, in order to keep deposit insurance funds sound. The Deposit Insurance Corporation(DIC) manages the risk in insurance funds, including fund recovery, in the broad sense or only the risk in insured Financial Institutions(FIs) in the narrow sense. This article will deal with the latter case. Section 2 describes the necessity of risk management at KDIC. Section 3 introduces the best practices of risk management at DICs in the United States and Canada. Section 4 highlights the current state of risk management at KDIC, and sections 5 presents the future framework of risk management at KDIC.

Ⅱ. Necessity of Risk Management

1. Objectives of the Deposit Insurance System

The objectives of the Deposit Insurance System(DIS) are to improve the stability of the financial system and to strengthen the competitiveness of Depository Financial Institutions(DFIs). Deposits at DFIs should be withdrawn immediately at the depositor's request and in the order of withdrawal request. A weakness of DFIs is aggravated when depositors try to withdraw their money at the same time. As a result, DIS plays an important role in detering bank runs and maintaining financial stability by protecting depositors at DFIs.

DIS also enables small DFIs to compete with large DFIs by protecting depositors at small DFIs. Depositors that believe larger is better, in this case safer, will always make their deposit at larger DFIs. With the presence of DIS, however, smaller DFIs would have an edge. Thereby, DIS increases competition in the industry.

Furthermore, DIS enhances the stability of the system by establishing a 

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framework for the effective resolution of failed MFIs. Without a protection system for small depositors, the financial supervisory authority can not resolve failed MFIs considering resolution effects on small depositors and the financial system. 

2. The Role of the Deposit Insurance Corporation

DIS's role is generally defined either broadly or narrowly. When it is narrowly defined as a pay- box model, DICs confine themselves to the functions of paying the claims of depositors at failed DFIs and managing insurance funds collected from insured DFIs. Under the󰡐pay box󰡑model, DIC is organized with a small staff, while the financial supervision authority is responsible for the risk management of insured DFIs. This type of DIS has been adapted by Northern European countries, such as Sweden, Finland, etc.

In contrast, when DIS is broadly defined as a risk minimizer, DIC not only performs a pay- box function, but also is a risk minimizer, preventing insurance accidents at DFIs. Under this system, DIC might complement the financial supervisory authority's risk management function. In United states, the Federal Deposit Insurance Corporation(FDIC) is the most powerful DIC as well as a supervisory authority.

3. Necessity of Risk Management

Risk minimizing types of DIS have the DIC complement the risk management function of the financial supervisory authority because there may be a conflict of interest between them. The main objective of the financial supervisory authority is to maintain the stability of the financial system by increasing the soundness of DFIs. Therefore, the financial supervisory authority has to be nonpartisan, reflecting the various interests of taxpayers, creditors, depositors as well as that of DFIs. In some cases, the financial supervisory authority might prefer delaying to provide 

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financial aid to failed DFIs as an instant resolution for if the DFI fails, the supervisory authority may be liable for unsuccessful supervision. Delaying the resolution of troubled DFIs, however, may increase the loss of insurance funds in the short- term and the loss of  depositors and taxpayers in the long- term if the DFI failed to recover though it received a large amount of funds. 

On the other hand, the financial supervisory authority and the DIC have different interests, because DIC's primary responsibility is to minimize the risk in insurance funds. In order to minimize the loss of insurance funds, DIC has the incentive to instantly resolve the failing institution when the bankruptcy cost is less than the cost of recovery from ongoing business 

There may also be a conflict of interest between the DIC and the Central Bank. As a lender of last resort, the Central Bank may be willing to provide liquidity to a failing bank for stability in the financial system. Liquidity assistance may delay the resolution of the failing institution, therefore increasing the loss of insurance funds when the failing DFI finally becomes bankrupt. 

As a complementary risk manager of DFIs, DIC could effectively resolve failing DFIs, thereby maintaining the financial stability, if the DIC cooperated with the financial supervisory authority.

Ⅲ. Best Practices 

1. FDIC's Risk Management(USA)

1) The Role of FDIC

The FDIC in the United States is a financial supervisory authority as well as a DIC. The Banking Act of 1933 established the FDIC, and its main role is to manage deposit insurance funds and to supervise banks so that they operate with adequate risk. The nation chartered banks and member state chartered banks are 

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compulsory members of the FDIC. Non- member state chartered banks, savings banks and S&L are voluntary members of DIS (see Table 1).

The FDIC examines and supervises, non- member state- chartered banks and protects deposit at them. The FDIC also helps supervise nation chartered banks, the state chartered banks, S&L and savings banks which are members of the DIC(see table 1). 

By using supervision and checks and balances, the supervisory system in America prevents corruption and moral hazard of supervisory authorities. The U.S 

<Table 1>           Financial Supervisory System in the US

Source : Lee, Jae Youn(1999)

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established the FFIEC (Federal Financial Institutions Examination Council) to ensure that federal supervisory organizations use consistency for the supervision of depository institutions and to minimize duplicate examinations of DFIs. The FFIEC is a formal interagency that can mandate uniform principles, standards, and report forms for the federal examination of depository institutions.

2) FDIC's Risk Management

FDIC's risk management system examines and takes corrective actions to solve insured DFIs' problems. The FDIC provides not only off- site monitoring but also on- site examinations in order to maintain the stability and soundness of insured DFIs. In addition, the FDIC implements informal and formal enforcement actions in order to solve problems based on the severity of the situation at troubled DFIs.

A. Off- site Monitoring

The necessity of the on- site examination is evaluated after examining the results of the off- site monitoring. Off- site monitoring is implemented based on the insured DFIs' financial reports. 

Computer technology has enabled the FDIC to analyse call reports for off- site monitoring, which reduces the administrative burden incurred by financial institutions subject to on- site examinations.

The FDIC uses computer analysis programs such as Statistical CAMELS Off- site Rating(SCOR), Growth Monitoring System(GMS), Real Estate Strength Test(REST) etc. The SCOR model, which is used as a substitute for CAEL, uses a statistical method rather than ratios to identify the probability of downgrade for the next periodic inspection. GMS is used to identify banks that will grow rapidly, but has a 

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high probability of becoming non- viable next quarter by using a similar statistical method as SCOR. REST is a modified version of the SCOR model and is used to identify the risk of mortgage loans. The FDIC has developed the technology to improve the effectiveness and accuracy of the off- site monitoring system by using the developments in computer technology. 

Off- site monitoring, is an efficient complement to the on- site examination. First, it detects early problems at DFIs. Second, it identifies any weaknesses or places of excessive risk at troubled DFIs. Third, it enables  the on- site examination to be completed more thoroughly by stressing the weaker and stronger parts, thereby distinguishing areas that heed to strengthened. The on- site examination needs cooperation from corporations and the sharing of information from everyone concerned: corporation, federal financial authorities, state governments, and etc.

B. The On- site Examination

The on- site examination plays the most important role in risk management at the FDIC. The FDIC evaluates insured DFI's overall financial state, managerial condition and compliance with regulatory requirements. It must conduct on- site examinations on both state and nation chartered banks at least once a year. The interval between examinations may be extended to 18 months if the insured bank received a high grade rating by the FDIC at the most recent examination. 

The FDIC focuses on asset quality, especially loan assets, and financial analysis during the on- site examination. The FDIC uses the CAMELS evaluation system to assign a composite rating based on the evaluation and rating of six essential components of an institution's financial conditions and operations. These component factors address the adequacy of capital, the quality of assets, the capability of 

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management, the quality and level of earnings, the adequacy of liquidity, and the sensitivity to market risks. 

The FDIC's Risk Focused Examination Program reviews in depth significant deficiencies or weaknesses in the functional area. The examination procedure is separated into three distinct tiers: the core analysis, the expanded analysis, and the impact analysis. The core analysis includes all the procedures that must be considered for the entire examination. If significant deficiencies or weaknesses are noted in the review after the core analysis, the examiner will be required to complete the expanded analysis. If the risks are material or the activity is inadequately managed, the examiner heeds to perform the impact analysis to assess the financial impact the risks and inadequately managed activities will have on the bank and to assess whether any enforcement action is necessary.

C. FDIC's Corrective Actions 

The FDIC takes corrective actions on problem DFIs, typically identified in the examination, to maintain the stability and soundness of the financial system. The FDIC can enforce formal or informal corrective actions depending on the severity of the problems (see Table 2).

Generally, informal corrective actions are enforced to correct less severe problems that do not present an immediate threat to an insured depository institution's viability and is usually applied to troubled DFIs with a CAMEL rating of 3. Informal corrective actions include commitments made by an insured depository institution's board of directors to correct identified problems and a board resolution or memorandum of understanding(MOU), which are not usually disclosed to the public. 

Comparably, formal corrective actions are taken in the form of a notice or order issued by the FDIC specifying the required corrective measures. The corrective 

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measures are legally enforceable and disclosed to the public. Formal corrective actions, which are legal decrees and are legally enforceable in the judicial courts, are usually implemented when the deterioration of a bank is very serious and it receives a CAMELS rating of 4 or 5. 

Formal corrective actions include the termination of deposit insurance, cease- and- desist orders, civil money penalty, suspension or removal of bank officers or directors, capital directive and prompt corrective action (PCA) directive. Among these measures, the termination of deposit insurance is the most powerful action that the FDIC can take for risk management. 

Besides informal and formal actions, the FDIC has the right of membership approval and imposes risk based premiums to manage the risk at insured DFIs. The FDIC examines the membership of FIs subject to the Deposit Insurance System according to their Deposit Insurance Membership Rule. The FDIC charges risk- based premium to the relative risk posed by DFIs to maintain the statutorily mandated reserve ratio and to enhance the soundness of DFIs.

<Table 2>             Types of the Corrective Actions

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2. Canada Deposit Insurance Corporation's Risk Management

1) Canada's Deposit Protection System 

Established in 1967 under the CDIC Act as a Federal Crown Corporation, Canada Deposit Insurance Corporation(CDIC) became a more powerful entity with authority over membership termination, resolution and recovery, and special investigation rights, transforming into a risk- minimization　 model with the revision of the CDIC act in 1987. The main statutes of CDIC are specified on the CDIC Act as follows: providing insurance against the loss of deposits at member institutions, promoting sound business and financial practice standards for member institutions, promoting and otherwise contributing to the stability of the financial system in Canada, and pursuing the above objects for the benefit of depositors and in such a manner as to minimize CDIC's  exposure to loss. 

Having a relatively small number of insured financial institutions, CDIC has a well coordinate operating procedure with the Office of the Superintendent of Financial Institutions(OSFI). CDIC is also different from the FDIC model in that it has no regular on- site supervisory authority. 

2) CDIC's Risk Management Process 

CDIC's risk management process is composed of the following five sub- processes: input gathering, risk assessment, validation, reporting, and corrective action.

Risk assessment is evaluated after conferring from several sources: 1) CDIC information, such as CDIC's Standards of Sound Business and Financial Practices and quantitative and qualitative data used in determining the differential deposit premium; 2) supervisory information meeting between CDIC and the regulator, discussing the results of regulatory examinations; 3) the integrated database at the Bank of Canada, which shares among CDIC, OSFI, and Bank of Canada; 4) market information, such as information from credit rating agencies, industry analysts and 

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other experts, and any other relevant information available from the market; and 5) any economic or policy related emerging issues, such as macroeconomic or financial market conditions and any legislative changes for the financial market.

The second sub- process, risk assessment, is not very complicated in the sense that it involves lots of judgement calls rather than relying on the statistical model. Usually the SWOT(Strength, Weakness, Opportunities, Threats) analysis and a binary comparison of a relatively small number of member institutions are useful. With the completion of risk assessment, CDIC can have a full distribution of all member institutions according to risk.

Depending on their purpose, there are four types of risk assessment reports. First, the "Member Institution Assessment" is the full list of financial institutions, including their ratings and risk assessment. Second, the "Assessment Status Report" is an explanation of the assessment status for CDIC's internal purposes. Third, the "Special Risk Report" is given to both OSFI and the CDIC board, so they can consider which corrective action to implement. Fourth, the "Membership Profile" is the summary of aggregate risk at member institutions, which is reported to the board. 

In the fifth sub- process, corrective action, the board of directors at CDIC determines the appropriate level of corrective measures necessary for the financial institutions on the special risk report (watch list). The corrective action can comes in one of three forms: 1) change based on the standards of sound business and financial practices; 2) a special examination or taking more significant corrective measures on a financial institution not fulfilling the order of change; and 3) terminating the membership of institutions thought to be non- viable.

3) CDIC's Differential Insurance Premium 

The differential premium is determined based on three criteria: capital adequacy(20%), other quantitative factors(40%), and qualitative factors(40%). Based on the above criteria, the premium rate is categorized into four different levels, ranging from 1/24 to 1/3 of 1%.

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CDIC has decided to adopt a simple differential premium model for the following reason. The risk assessment process at CDIC may look like a black box because it involves mostly judgement calls by the examiner and an evaluating staff and a binary comparison among member institutions. Realizing that a black box type of model may not provide the same incentives as a simpler model, their differential premium is not directly related to the results of the risk assessment.

Ⅳ. Deposit Insurance System in Korea and an Overview of KDIC

1. Deposit Insurance System in Korea 

The KDIC (Korea Deposit Insurance Corporation) was established in order to maintain the stability of the financial system by protecting depositors based on the Depositor Protection Act (DPA) of 1995. Since 1997, KDIC began to provide insurance services. Prior to 1996, there was no explicit deposit insurance system for banks while there had been several deposit insurance systems, as a type of insurance fund, for the several non- bank financial industries. After the 1997 financial crisis, the KDIC began to provide deposit insurance services to the depositors of six financial industries, including banks. The DIS in Korea has a compulsory membership system under which all DFIs of the insured industries must be members. 

Although Korea lacked a bank deposit system before 1996, the government implicitly protected depositors in the event of a bank failure or insolvency. The government's implicit role resulted in protecting stock holders and managers who were responsible for that failure as well as depositors. As a results, taxpayers bore the burden for insolvent operations. In addition, the government lent a hand to non- bank financial Institutions which had severe financial accidents or problems. Because the government could no longer protect depositors implicitly  with the 

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development of financial liberalization and the rising competitiveness between FIs, an explicit deposit insurance system was requested. 

Therefore, the DIS in Korea was introduced to formally protect the depositors of insured DFIs and to foment public confidence in the financial system because some FIs might be insolvent as a result of severe competition and financial liberalization. DIS was expected to enhance the competitiveness between the financial industries because DIS could accelerate financial liberalization by lowering the barriers for entrance and exit in the financial industries without worring about depositors.

As a result, the DIS in Korea was established as a pay- box model; its main role is to pay depositor claims at failed banks not managing the risk of insured FIs. The type of DIS in Korea was determined based on the public policy objective at the time the system was established. When the DIS was introduced in Korea, the possibility of bank failure was thought to be very low and conflict between KDIC and the Financial Supervisory Services(FSS) might occur if DKIC was given the power to examine insured FIs.

2. KDIC's Risk Management

Initially, KDIC did not possess the rights to ex- ante risk management and problem resolution. KDIC was allowed to manage risk only at failing FIs with money injected from the KDIC. KDIC was also not allowed access to the regular and comprehensive inflow of data from the insured financial institutions, but was allowed access to data necessary to calculate the insurance premium and the payment and resolution of any failed DFIs. In addition, KDIC and FSS may conduct a joint examination of the business and financial status of an insured FI considered to be hovering hear insolvency by the Policy Committee of KDIC. 

With the amendments to the Depositor Protection Act and the enactment of the 

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Special Public Fund Management Act in December 2000, KDIC's risk management function was strengthened to some extent. The legislative changes confirmed the belief that financial restructuring with public funds had not been managed properly.

The amendment to the Depositor Protection Act allowed KDIC to collect data, granted some freedoms to take corrective actions, and strengthened its ability to inspect. As a result, when the KDIC identifies DFIs that are likely to fail or those that have already failed, it may request from the insured DFI materials related to their business operations and financial status and can regularly access data necessary for analysing the status of the the DFI. Additionally, KDIC can investigate an insured DFI thought to be threatened with insolvency by the Policy Committee based on premonition. For corrective actions, KDIC was allowed to possess a limited right to ask the supervisory authority to take appropriate corrective actions for problem DFIs that are near insolvency. 

KDIC has the power to force DFIs receiving public funds to fulfill their MOUs. KDIC monitors to see if DFIs receiving public funds fulfills their MOUs and reports to the Public Fund Management Committee. Now, KDIC has the power to take corrective actions when a DFI owned by the KDIC fails to execute its MOU, especially against the laws or KDIC warnings, and unlawfully obstructs KDIC from completing its duty.

3. The Current Problem with Risk Management

Although KDIC's risk management function was strengthened by amendments to the Depositor Protection Act and the enactment of the Special Public Fund Management Act at the end of 2000, KDIC's risk management function was limited to a narrowly confined range. For effective risk management, however, KDIC should have a more powerful risk management function. In comparison to the CDIC or the FDIC, KDIC's risk management function is comparatively weak (see Table 3).

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By the amendments to DPA, KDIC has an off- site monitoring function but it has not developed an appropriate risk assesment system yet. Risk assesment through off- site monitoring is based on data collected from insured DFIs and the financial market, and risk assessment executes an early- warning function when it identifies problems or weaknesses with insured DFIs. Usually, off- site monitoring is accomplished with a quantitative risk measurement model or a qualitative risk assesment model according to the number of insured DFIs. The former generally applies to the risk assessment of a large number of insured DFIs, and the latter for a small number of insured DFIs. KDIC has developed and used risk assesment models for banks since 1999 and for mutual savings & finance companies since 2000; the latter needing much improvement.

The current insurance premium rate system does not reflect the level of risk taken by member DFIs. Therefore, the flat insurance rate system might cause moral hazard since a failing DFI prefers taking excessive risk for high profit. To solve this problem, KDIC needs to introduce the risk- based deposit insurance premium system, which might induce member DFIs to practice sound management because the insurance premium will be varied based on the risk taking level. Many countries, including the US and Canada, are adapting the risk- based premium system to prevent insured DFIs from taking excessive risk and moral hazard.

Another problem with KDIC's risk management is related to membership control. Membership should be controlled in order to prevent problem DFIs from entering the financial market and to operate funds in a manner which enhances the soundness of the Deposit Insurance Fund(DIF). For this purpose, KDIC should tighten the requirements for membership and eligibility; but, this policy could lead to controversy. The right to approve memberships might be misunderstood to mean the right to approve and cancel licenses, which is currently part of the duties performed  by the FSC. 

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Finally, an important factor for KDIC's risk management is the right to take corrective action. Currently, KDIC can ask the FSS to enforce corrective action on a problem bank that is near insolvency. KDIC alone can not force FSS. Thus, KDIC needs more power to resolve this conflict. 

Ⅴ. Future Framework for KDIC's Risk Management Function

The future framework for KDIC's risk management needs to hit the key operating elements of the risk management function, and these elements will need to be supported by processes, systems, procedures, people, and data in an effective and efficient operating environment. 

1. Membership Standards

The current, compulsory membership system is expected to remain in the future. The objective of compulsory membership is to prevent the adverse selection of financial institutions and maintain the soundness of insurance funds by protecting small depositors who do not have enough information or sophistication to make investment decisions.  Many countries, such as the US, Canada, Japan, and UK, have adopted a variety of different compulsory memberships, whereas examples of countries with voluntary membership are Germany and Switzerland. 

Even under the compulsory membership scheme, KDIC needs to control the right to accept Financial Institutions into the deposit insurance system and the right to terminate Financial Institutions from membership. The right to approve can prohibit problematic institutions ― of course in cooperation with Financial Supervisory Services(FSS); thereby strengthening the population of deposit taking institutions. The right to terminate membership can also prevent further loss from 

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the insurance fund by terminating the protection of new depositors at problem institutions and to prevent problem institutions from taking risks that are beyond their control. The rationale for empowering KDIC with the right to approve and terminate memberships is that KDIC's statutory objective might be slightly different from other regulatory agencies, such as FSS, possibly causing a conflict of interest or regulatory forbearances. 

Considering KDIC's inter- agency relationship, KDIC has several options it can take to receive the right to approve and terminate memberships in cooperation with FSS and MOFE.  One of the options is to ask FSS to incorporate KDIC's criteria in chartering FSS's criteria. 

2. Risk Assessment

Risk assessment effectively measures and identifies troubled deposit- taking institutions without concerning depositors and creating further stress on financial institutions, individually or collectively. KDIC's risk assessment should focus on evaluating the financial condition and potential risks of member institutions in order to minimize loss to the deposit insurance fund.

The main method of risk assessment by KDIC will be an off- site review of the information obtained directly from member institutions and under information sharing arrangements with other regulatory authorities, such as FSS and/or BOK, in order to avoid placing a burden on member institutions. For financial industries with large numbers of deposit taking institutions, such as Mutual Savings and Finance Companies(MSFC) and credit unions, risk assessment will be performed primarily through the use of risk assessing models. For industries with a small number of member institutions, such as banks and merchant banks, risk assessment will be performed by using risk assessing models and qualitative risk assessment by KDIC staff.

The off- site review requires information sharing between the KDIC, the 

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supervisory authorities, and the government. Information management is crucial for a thorough assessment of member institutions.

3. On- site Examination

On- site examinations may be necessary to assess a member financial institution's　overall financial condition, management practices and policies, and compliance with applicable laws and regulations. Another objective of the on- site examination is to verify the accuracy of the data given and information submitted by member institutions.

Considering the fact that conducting a periodic on- site examination requires a large number of examiners and might overlap with FSS and burden member institutions in terms of examinations, KDIC is considering the option of conducting a special examination with a specific purpose. The results of the regular, periodic on- site examinations by FSS can be shared by KDIC via inter- agency arrangements. 

4. Monitoring Emerging Issues 

KDIC needs to keep abreast of the developments and emerging issues affecting the financial services industry in order to maintain the keen capacity to assess and propose policy initiatives. The roles of monitoring emerging issues are to assess changes that are required for the deposit insurance scheme, to address new and emerging risks, and to enhance and manage payouts and liquidations as efficiently as possible. To efficiently monitor emerging issues, KDIC needs to maintain an honest dialogue and strong working relationship with the government, research institutes, member financial institutions, and other interested parties, to increase its own research capacity. Feedback from examiners and the industry on emerging risks and trends are identified and also communicated by other related parties of KDIC. 

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5. Differential Premium System

The rationale for a differential premium is that the insurance premium needs to be determined based on the insured institution's size of risk in order to avoid adverse selection. As a consequence, member financial institutions may think twice before taking a high risk / high return strategy, which may cause a loss of funds, and supervision by regulatory authorities. 

The differential premium system, however, may have some of the following potential problems: 1) if depositors knew the differential premium rates, depositors may move their money to banks with a low premium rate; 2) weak financial institutions may have more financial burden because of the high insurance premium; and 3) it may not be possible to exactly determine insurance premium rates based on the level of risk taken by member financial institutions. In addition, under the current situation with the huge loss in insurance fund, KDIC needs to collect up to the maximum level that each member financial institution can pay in insurance premium to recover from the loss in insurance funds as soon as possible.

Methods for assessing the differential premium can be classified into two different categories: one that fully reflects the results of the deposit insurance corporation's risk assessment and the other that is based on the several risk- related indices. They both have their cons and pros, but the latter scheme is presumed to be more appropriate in the Korean context. That is, the differential premium system should be relatively simple enough to effectively classify members into different risk groups. 

6. Links to Fund Management 

The fund management function is closely linked to risk management from the asset and liability management (ALM) perspective. The link between fund management and risk management work in following ways. The fund management department can estimate cash flow from the risk distribution of financial institutions identified by the risk management department. The risk management unit can 

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identify the risk distribution of insured financial institutions by each category. Once insured financial institution's risk distributions are identified, the expected insurance liability and cash outflow (due to insurance payment) can be estimated. The fund management department can assess the required cash inflow from the insurance premium (from the ALM perspective) and determine the actual premium rates, given the differential premium scheme from the risk management department.

The flow of information between the fund management department and the risk management department can be summarized in the following figure.

<Figure 1> Workflow among Risk Management Framework Components

7. Risk Control Measure

The risk control measure is the ex- ante risk controlling activities used to manage the potential loss of insurance funds based on the risk assessment of financial institutions. The multiple levels of risk control measures administrated by deposit 

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insurance corporations in other countries are: scheme of differential premium, reason and moral suasion, penalty premium, order or recommendation of business practice change (in cooperation with FSS), examination to determine underlying problems, order of investigation and audit, request to FSS for indirect enforcement, direct enforcement action, and membership termination (in cooperation with FSS or without). 

Currently, KDIC is very limited to the types of risk control actions allowed: examination to determine underlying problems and indirect enforcement requests to FSS. In principle, deposit insurance corporations should have access to enforcement actions, either directly or indirectly in order to manage in an ex- ante manner risks to the insurance fund. To properly conduct its risk management function, measures for more risk control will be indispensable for KDIC in the future. 

For the implementation of risk control measures, two options may be considered. The first option calls for DIC to exert enforcement action directly where the enforcement level has been decided in cooperation with regulators. The second option allows DIC to decide the enforcement level and the actual enforcement is exerted by a regulator (FSS) under DIC's request. If the regulator does not respond to DIC's enforcement request within a certain time frame and without explaining the reasons for negligence, DIC has access to implement the direct enforcement action. The actual implementation procedure should be decided in coordination with the related regulator. The second option seems to be a more plausible and effective way of implementing the enforcement action. If DIC directly exerts enforcement actions upon financial institutions, the role of the main regulator may be disputed. By delegating the enforcement action to the regulator, but having the right to measure and to initiate the enforcement decision, DIC can effectively control risks.

8. Inter- agency Arrangements

To facilitate the defined roles of each agency, promote the checks and balances between related agencies, and to supply an appropriate amount of guidance for each 

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agency to make decisions, operating arrangements for communication and information sharing among agencies are very important.  Inter- agency arrangements may flow more smoothly if the following guidelines are followed. Basic rights should be clear and specified for each role in the related acts, and implementation of the arrangements should be specified as subsidiary rules. Informal arrangements should be minimized to prevent any misunderstandings or power bargaining.

For coordination, multiple communication channels for each level of personnel between DIC and other related parties are desirable.  The right of risk management related components which require coordination properly function, such as risk control measures, examinations, and membership standards, and the information sharing scheme should also be specified in advance. 

Ⅵ. Concluding Remarks

The proposed risk management framework is envisioned for when KDIC is fully functioning as a deposit insurance corporation.  Currently, KDIC is managing not only deposit insurance funds but also public funds for financial sector restructuring. In KDIC's accounting books, there is no clear distinction between deposit insurance funds and public funds, and amalgamated fund suffers from a huge deficit. The proposed risk management framework will be applicable when insurance funds are separated from public funds and other environmental factors are met so that KDIC is functioning as a deposit insurer, not as a manager of public funds.

The new and revised functions of risk management should be prioritized depending upon urgency. The functions of risk assessment and monitoring emerging issues can be internally enhanced without legislative change. With changes in corresponding legislature, the inter- agency relationship can be enhanced. Link to fund management will be meaningful only after insurance funds are separated from public funds. For the rest of the proposed risk management functions, prioritization based on urgency is in order for the differential insurance premium, corrective actions, and membership standards.

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Reference

Choi, Jangbong and Park, Kyungseo, "Introducing Deposit Insurance to Banks in Korea", KIF, 1996 

Garcia, Cillian, "Deposit Insurance : Survey of Actual and Best Practices", IMF Working Paper, 1999

Garcia, Cillian, "Deposit Insurance and Crisis Management", IMF Working Paper, 2000

KDIC, "Implementation of Differential Deposit Insurance Premium", 1999

Lee Jaeyoun, "Study on Punishment of Management Fraud of Financial Institutions in US", KIF, 1999

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Macroeconomic Developments

Current Status and Prospects

1. Economic Growth

1) Review

The real GDP growth rate in the third quarter dropped to 0.6 percent. A 6.0 percent decrease in investments and a 3.7 percent contraction in net export are the major causes of the slump. Much of decrease in investments came from setback in facility investments in the IT and exports sectors as a result of a slowdown in the world economy. Construction investments are estimated to grow 0.6 percent as orders from the public sector flow in. The private consumption growth rate is also expected to decelerate to 1.9 percent from 2.9 percent in the previous quarter as precautionary savings increase as a safeguard against the growing uncertainty in the economy.

<Table 1>          Trend and Forecast of Economic Growth¹⁾

(unit: %)

Notes: 1) Year- on- year percentage changes.

2) Figures after the third quarter of 2001 are KIF forecasts. 

Source: The Bank of Korea, National Accounts, various issues.

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<Figure 1>      Contributions to the Growth Rate by Sector

<Table 2>        Contributions to the Growth Rate by Factors

(unit: %p)

Notes: 1) Year- on- year percentage changes.

2) Figures after the third quarter of 2001 are KIF forecasts. 

Source: The Bank of Korea, National Accounts, various issues.

- 2 -

According to the third quarter business survey index (BSI) provided by the Bank of Korea, the manufacturing sector BSI went down to 76 from 85 in the previous quarter. The business condition BSI for the domestic and exports sectors were also below 100. A number below 100 means that people are pessimistic over the coming period. The BSIs for the execution of facilities investment, the operation ratio, and profitability all slided down a few points, reflecting entrepreneurs' lack of confidence in an economic recovery.

Robust consumption but sluggish production and investments are the trends seen in the industrial activities indices. Reversing the trend in the second quarter, industrial production index lost 5.2 percent and producer's shipment recorded a 5.8 percent decrease on average during July and August compared to the same period a year ago. Producer's inventory of finished goods during July and August increased by 15.2 percent year- on- year because of a surge in semiconductor inventory. The operating ratio in the manufacturing sector continued its downward trend after peaking at 79.9 in the third quarter of 2000 and recorded 72.2 percent on average during July and August, slightly lower than 74.5 percent in the second quarter of

<Figure 2>             GDP and GDI Growth Rates

- 3 -

2001. The inventory to shipment ratio rose to 87.4 percent during July and August, up 1.8 percentage points from the previous quarter. Sluggish shipments due to retarding exports was a prime factor.

As for consumption activity, wholesale and retail sales slowed to a 3.2 percent growth on average between July and August, from a 4.4 percent growth in the second quarter. Construction materials, home electronic appliances, and furniture experienced strong figures in sales, while office equipment and agricultural products suffered most. Domestic shipments increased 8.7 percent during July and August, helped by sturdy sales in durable consumption goods, including cellular phones and water purifiers. The consumer evaluation index, which has continued to deteriorate since December 2000 except for a brief upswing in June 2001, recorded 85.6 in August 2001. 

Facility investment estimates decreased by 14.7 percent during July and August. Investments in computers and special industrial machinery were hit hard. Domestic machinery orders decreased by 10.4 percent during July and August, as the increase

<Figure 3>           Business Survey Index (BSI) Trend

Note: Figures after the fourth quarter of 2001 are KIF forecasts. 

Source: The Bank of Korea

- 4 -

in public orders was offset by a drop in private orders. The facility investment adjustment pressure index which is based on production and capacity measures is still negative at - 10.5 percent in the third quarter, indicating that a facility investment turnaround is hardly expected in the third quarter. Meanwhile, domestic construction orders went up by 8.0 percent during July and August because local governments increased their work order for improvements in the water and sewage service systems.

On the customs- cleared basis, exports almost came to a standstill with a 0.7 percent increase in the third quarter. This was due to a slowdown in the major export markets and falling export prices. The unit price of exports fell by 19.5 percent from a year ago in the third quarter. Because exports will be weak, the domestic economy will require less raw materials, and the world prices of major items, including crude oil, will plunge, imports are estimated to be cut short by 3.7 percent in the third quarter. The unit price of imports declined 9.7% year- on- year in the third quarter. For crude oil, its price fell 11.3 percent in the third quarter.

<Figure 4>         Industrial Production and Consumption

Source: National Statistical Office, Industrial Activity Review, various issues.

- 5 -

<Figure 5>          Growth Rate of Producer's Shipment

Source: National Statistical Office, Industrial Activity Review, various issues.

<Figure 6>  Equipment Investment and Domestic Construction Order Estimates

Source: National Statistical Office, Monthly Statistics of Industrial Production, various issues.

- 6 -

<Figure 7>   Growth Rate of the Manufacturing and Service Sectors

Source: The Bank of Korea

<Table 3>               Industrial Activities Indices 

(unit: yoy, %)

Note: 1) End of period. 

Source: National Statistical Office, Industrial Activity Review, various issues.

- 7 -

2) Forecast

Cyclical component of the coincident composit index has continued to fall since it peaked at 102.1 in August 2000 and is currently at 96.2, indicating that the economy is still in recession. On the other hand, the leading composite index turned around in August with a 0.3 percent increase from 0.4 percent dip in July. It has also improved on a month- on- month basis for four consecutive months since May 2001. What will happen in September and October will be critical in predicting the future course of the economy.

It is very hard, however, to forecast the trend at this point in time because the whole world is under the increased uncertainty since the September 11th tragedy in the United States. Consumption, investment, and exports will inevitably be affected a great deal by the way the consequences of the terrorist attacks unravel in the coming months. Although there was much talk about the recovery of the U.S. economy based on various macroeconomic indicators, the tragic event pushed the time of recovery further into the next year. If the United States passes the trough by the end of the first half of next year, at earliest, exports will not be the thrusting force that will pull the Korean economy out of recession in the fourth quarter. As other Asian countries, Korea depends heavily on the strength of US market for her exports.

Expansionary fiscal and monetary policies, including a target interest rate cut and monetary easing in the United States and other major leading economies, may bolster a flagging world economy. Monetary policy, however, will have a limited short- term effect due to policy lag. Therefore, it is very unlikely that the world economy will escape a downward trend within a period of one or two quarters. Under this bleak external environment, the fate of the Korean economy is dependent on movements in domestic consumption and investments. Considering the sensitivity of consumption and investments on expectations for the future, which is highly uncertain at this point, a rapid recovery in the near future is very hard to imagine. Consumption is expected to go up 2.3 percent, investment 4.4 percent, exports 2.3 percent and imports 3.0 percent, making the real GDP grow 3.5 percent year- on- year 

- 8 -

in the fourth quarter. The real GDP growth rate will then be 2.7 percent for the whole year.

<Figure 8> Changes in the Leading CI and Cyclical Component of the Coincident CI

Source: National Statistical Office, Industrial Activity Review, various issues. 

<Figure 9>      Consumer Expectation and Evaluation Indices

Source: National Statistical Office.

- 9 -

According to the National Statistical Office's survey on consumer expectations (a survey of 2,000 families residing in urban areas), the consumer expectation index remained almost flat at 98.2 in August from 98.4 in July. It had peaked at 100.3 in June 2001, after rising continuously from 82.2 in December 2000. The index falls below 100 when there are more families that planned to reduce consumption spending in the next six months than those who planned to increase spending. Thus, the August figure indicates that there will be no big upward movement in consumption in the fourth quarter. The third quarter survey by the Bank of Korea (a survey of 2,379 families in 16 cities) tells a similar story. Survey indices for spending plans, domestic economic situation, and employment situation all deteriorated. A ray of hope can be seen in the recent trend in durable consumption goods shipments. Consumption of durable goods is generally considered as a leading indicator of future consumption trends. According to the National Statistical Office's industrial activities report, sales of durable goods, including cars and cellular phones, are steadily increasing, heralding robust consumption in the fourth quarter. But the 

<Figure 10>              CSI Components Trends

Note: The peak of the business cycle in August 2000 is a KIF forecast.

Source: The Bank of Korea.

- 10 -

impact of the September 11th tragedy is not reflected in these numbers. If consumers and entrepreneurs feel unsecured and uncertain for the future, their economic activities will shrink, which will in turn lead to cut spending and investment. And if the capital market is shocked into a bearish market, the negative wealth effect will also hurt consumption. In sum, the possibility of any considerable improvements in consumption in the fourth quarter is quite remote at this moment. Although sales in department stores went up in the period after  September 11, it is not a sign showing a change in trend, but a reflection of seasonal impact because of the Chusuk holiday.

Since August, facility investments have continued to decline and the pressure index for facility investment adjustment is also falling deep into the negative territory, indicating that the economy is still suffering from overcapacity. The index for domestic machinery orders remains at a low level, so corporate capital spending is expected to remain inactive in the coming months. Nonetheless, the growth rate will improve due to a low- base a year ago. As for investments in construction, it 

<Figure 11>    Facility Investment Trend

Note: Pressure on facility investments is the difference of the growth rate of manufacturing industrial production and manufacturing production capacity. 

- 11 -

may contribute to the GDP growth in the fourth quarter despite the seasonal setback since aggressive fiscal expenditure programs will start to take effect. As for inventory investment, its growth rate will continue to decelerate because it will need to take more time to get out of the adjustment phase and enter the recovery phase of the inventory cycle.

<Figure 12>                  Inventory Cycle

Source: National Statistical Office, Industrial Activity Review, various issues. 

2. Price and Wages

1) Review

During the third quarter, the consumer price index (CPI) grew by 4.3 percent year- on- year and by 0.4 percent quarter- on- quarter. Although the inflation rate is down 1.0 percentage point, compared to the 5.4 percent rise in the second quarter last year, it is still high relative to that of 2000. Service fees and prices of 

- 12 -

manufactured goods, which had grown by 5.9 percent and 4.2 percent respectively in the first half, rose 4.8 percent and 2.9 percent respectively in the third quarter. On the other hand, agricultural, livestock and fishery product prices increased 6.0 percent, which is much higher than 3.0 percent in the first half. In July, CPI rose by 0.2 percent month- on- month as public service prices declined 0.6 percent swamped by a 1.4 percent rise in agricultural, livestock and fishery product prices and a 0.3 percent increase in housing rent. On a year- on- year basis, CPI was up 5.0 percent led by public service fees (9.6%) and agricultural, livestock and fishery product prices (6.6%). In August, CPI increased 0.5 percent month- on- month despite a decline in prices of manufactured goods due to the fall in oil prices. Agricultural products, including vegetables, fruits and livestock, was the main mover with a 8.9 percent rise in prices. In September, CPI remained stable as the soaring agricultural, livestock and fishery product prices dampened to a mere 2.5 percent increase, and prices of manufactured goods and services were kept steady. The living expenses index increased by 4.4 percent in the third quarter, down from a 5.6 percent increase in the first half.

<Figure 13>         Consumer and Producer Price Indices

Sources: National Statistical Office and the Bank of Korea.

- 13 -

The producer price index (PPI) increased by 2.0 percent year- on- year but fell by 0.2 percent quarter- on- quarter in the third quarter. After going up by 0.1 percent month- on- month in July, PPI fell by 0.4 percent in August, the largest decline since June 1999. Weak demand due to a staggering economy and a strong won pushed prices down. In September, PPI rose by 1.2 percent year- on- year and declined by 0.2 percent month- on- month. Increased shipments of agricultural, livestock and fishery products led to a drop in their prices and industrial product prices went down by 0.2 percent due to a fierce competition for dwindling demand.

Export prices declined by 0.5 percent year- on- year in the third quarter. Export prices have continued to fall for the past four months, since May 2001, and then went up by 0.4 percent month- on- month in September. In July, the falling prices of semiconductors, and agricultural, forestry and fishery products were the main factors. In August, export prices kept declining with the appreciation of the won and a slowdown in demand abroad. In September, export prices turned around and went upward due to the depreciation of the won and the rising prices of manufactured 

<Figure 14>              Growth Rate of Wages

Note: Three- month moving average.

Source: National Statistical Office. 

- 14 -

goods as well as agricultural, forestry and fishery products. Import prices declined by 1.0 percent year- on- year in the third quarter. From July to September, movements in the won/dollar exchange rate and the weak prices of oil and other raw materials were the main factors affecting import prices.

The nominal average monthly wage in companies with ten or more employees was raised by 5.6 percent year- on- year in July. Year to July increase was 6.5 percent compared with the same period last year. By industry, the financial industry was at the top of the heap with a 14.9 percent increase. The utility industry was next with a 13.0 percent increase, followed by the public health and welfare industry with a 1.4 percent. On the other hand, wages in the construction and mining sectors declined by 4.6 percent and 0.3 percent respectively. In the manufacturing sector, wages grew by 5.0 percent, which was a little below average. The unemployment rate third quarter recorded 3.3 percent, down 0.3 percent from the previous quarter. The number of people unemployed was down to 732,000, which was a 9.5 percent decrease from the second quarter. Students returning to school after summer vacation and people who gave up searching for jobs seemed to make the difference. 

2) Forecast

The inflation rate in terms of the consumer price index is expected to go down to 3.9 percent year- on- year in the fourth quarter, leading to a 4.4 percent on year average in 2001. Thanks to the stable won/dollar exchange rate and the falling prices of raw materials, including oil, the producer price index (PPI) in the fourth quarter will fall to 2.0 percent, continuing its downward trend since August. The year average is expected to record 2.5 percent. The core inflation rate, however, which excludes food and energy costs and serves as the central bank's inflation benchmark, could top the 4.0 percent ceiling in 2001, restricting the flexibility of the Bank of Korea's monetary policies in the coming months.

Historical risk factors, such as wage pressures, volatility in the prices of 

- 15 -

agricultural products, and rising public service fees, will not be much of a concern in the future course of inflation. Although the demand for labor in the service industry has been strong amid the economic recession, corporate and financial sector restructuring and competition will cap the wage increase at 6.0 percent. Recently, the weather conditions in Korea have become quite favorable and a󰡒year of plenty󰡓is expected for various crops. Some of the public service fees have been raised already. But the Ministry Finance and Economy stated that the government would restrain increases in public service charges during the remainder of this year. The upside risk for crude oil prices seems rather low since the possibility of reducing oil production in the coming months is remote. Inflation pressure from the demand side will be very weak due to the slowdown in the economy.

<Table 4>       Trends and Forecasts for Prices and Wages¹⁾

(unit: %)

Notes: 1) Percentage changes from the previous year.

2) Figures after the fourth quarter of 2001 are forecasts.

Sources: National Statistical Office, Consumer Price Index, various issues.

The Bank of Korea, Monthly Bulletin, various issues.

Ministry of Labor, Report on Monthly Labor Survey, various issues.

- 16 -

3. Current Account and Foreign Exchange Rate

1) Review

The third quarter current account surplus shrinked to $1.06 billion from $3.68 billion in the second quarter. This is because the goods account surplus contracted as exports went down and the service account deficits erased out a large portion of the goods account surplus. In July, the current account surplus recorded $0.44 billion and dipped into a $0.19 billion deficit in August, which was the first monthly deficit since April 2000. In September, however, the current account turned around to a $0.82 billion surplus as people abstained from traveling abroad in the aftermath of the terrorist attack on September 11th and the goods account as well as other service accounts, including royalty payment, improved. 

In the third quarter of this year, the goods account recorded a $3.10 billion surplus, which is much less than the $5.41 billion surplus recorded in the same period last year. 

The increase in travelling abroad during the summer vacation season and rising royalty payments made the service account stumble into a $1.61 billion deficit. Despite the increased return on foreign assets, the income account also recorded a $0.09 billion deficit due to large interest payments to foreign creditors. 

<Table 5>                 Current Account Trends

(unit: $100 Mil.)

Note: 1) Estimates.

Source: The Bank of Korea, Balance of Payment, various issues.

- 17 -

The capital account turned around to record a surplus of $1.25 billion in the third quarter, reversing the outflow of capital since the fourth quarter last year. In July, the inflow of money from sale of Korea Telecom's Depository Receipts (DR) and other medium-  to long- term debt securities by domestic companies to foreign investors was $0.83 billion more than the amount withdrawn from Korea's portfolio investment and payment of the IMF loan combined. In August, the collection of loans from abroad and borrowing from the international market by commercial banks with the return of foreign portfolio investments helped to maintain a capital inflow totaling $1.39 billion. But in September, the capital account turned into a $0.97 billion deficit. The largest portion of the deficit was caused by the redemption of trade credit and the flight of foreign portfolio investment funds in fear of tumult in the capital market.

Exports on a customs- cleared basis amounted to $35.86 billion in the third quarter, down by 19.2 percent year- on- year. Monthly exports had started to decline sharply in the fourth quarter last year and showed a negative growth rate since March 2001, culminating to a 21.1 percent drop from a year earlier to $11.5 billion in July. In August, the slowdown decelerated slightly, recording a 20.1 percent drop year- on- year to $11.9 billion. The gain of $0.4 billion in July exports, however, is rather significant in that the August figure is usually below that of July because in Korea summer vacations peak in August. In September, exports went down again, but it was a less severe decline recording 16.6 percent year- on- year to $12.6 billion. The slowdown is in part due to an increase in the exports of cars and ‘old- economy’ commodities produced by small-  and medium- sized companies, such as home appliances, consumer goods, plastic goods and clothes. 

There are many factors behind the continuous decline in exports. One is the downturn of the IT cycle. The $10.2 billion decrease in exports from a year earlier, during the period from January to August, is largely (84.5%) due to the collapse of IT exports. With an export base weighted heavily towards electronic products, Korea is particularly vulnerable to fluctuations in the worldwide demand for IT products. The drop in exports receipts accelerated in part by the sliding unit price of exports 

- 18 -

<Figure 15>   Exports, Imports, and Balance of Goods Account

Source: The Bank of Korea, Balance of Payments, various issues.

<Figure 16>   Foreign Investment and Balance of Capital Account

Source: The Bank of Korea, Balance of Payments, various issues.

- 19 -

items. Although the total volume increased 5.9 percent during the same period, the unit price dropped 13.2 percent, much more severe than the - 3.8～1.0 percent decrease in other competing countries. Another factor is that importing countries have󰡒beefed󰡓up their regulations. Korea has 121 trade disputes, 86 of them already under regulation and 35 issues under investigation as of the end of August. These numbers are rather high compared to 97 in 1999, and 109 in 2000. Trade disputes are quite damaging since they concern major exports items such as steel (34 cases), petrochemicals (30), textile (21) and electronics (14). With plummeting oil prices and uncertainties in the domestic economy, imports (c.i.f) in the third quarter shrank by 18.2 percent from year ago to $34.2 billion. The total quantity of imports went down by 5.4 percent and price by 9.8 percent. Capital goods import took most of the blunt, contracting 37.2 percent as domestic facilities investments remained subdued. Imports of raw material followed the same suit, dropping 8.9 percent. On the other hand, imports of consumption goods dropped only 2.8 percent. By month, imports in July recorded $11.08 billion, down 18.9 percent year- on- year. 

<Figure 17>           Trends in Semi- conductor Prices

Source: Bloomberg.

- 20 -

It was the largest monthly drop ever in 2001. In August, imports totaled $11.4 billion, a 15.5 percent drop. In September, imports amounted to $11.7 billion as consumption goods imports increased by about 10 percent, although imports of capital goods and raw material continued to shrink. By origins of imports, Japan's share of total imports declined to 18.6 percent from 19.8 percent in 2000 as imports from Japan dropped by 15.7 percent mainly due to a decrease in capital goods imports, including machinery and electronic products. Imports from the US declined by 29.9 percent, but imports from China rose by 6.7 percent.

<Table 6>         Exports and Imports by Item and Area

(unit: $100 mil.)

Source: Ministry of Commerce, Industry and Energy, Report of Exports and Imports, various issues.

- 21 -

Until the terrorist attacks the mid- September, the won/dollar and the yen/dollar exchange rates moved in a synchronized manner with a daily correlation of 0.842 this year. Early June, the Korean won depreciated against the dollar, easing to a level of 1,300 won per dollar due to the weake yen. After showing some sign of strengthening due to the large inflow of foreign direct investment from the end of June through early July, the won weakened and reached above the 1,310 won per dollar level over concerns in the emerging markets following the outbreak of a financial crisis in Argentina. After the commotion waned and the dollar weakened against other major currencies, the won resumed appreciating, reaching 1,280 won per dollar in August. The exchange rate turned upward again in September as the yen became weaker against the dollar, worries grew over the current account deficit in August, and disturbances in the domestic financial market due to Hynix Semiconductor's liquidity problem. In sharp contrast with the yen, which maintained its strength after the terrorist attack, the won/dollar rate climbed to the 1,300 level again due to the delay in economic recovery and the net sale of foreign investors in the stock market.

<Figure 18>   Unit Price of Exports and Imports and Terms of Trade

- 22 -

2) Forecast

The mid- September tragedy in the United States has cast a dark cloud over the outlook for Korea's external environment in the coming months. Even if current account remains surplus over the short- term, the size of the monthly surplus is unlikely to be large, achieving $0.6～$0.7 billion a month, and $1.9 billion for the quarter.

Major factors which will affect future exports include international trade flow, the U.S. economy's performance, and the market development of major trade items such as semiconductors and automobiles. The September terrorist attacks may hinder the trade of goods and services worldwide as cross border transactions have become more costly. As a result, it could strap capital flows, multinational corporate activity, and rapidly expanding trade. But shocks always subside and cooperation between world powers may counterbalance the backlash against the private sector's attempts

<Table 7>            Forecasts for the Current Account

(unit: US$100 Mil.)

Notes: 1) Estimates.

2) Figures in parentheses represent percent changes from the previous year.

3) Period average

Source: The Bank of Korea, Balance of Payments, various issues.

- 23 -

at globalization, at least for the moment. A recession in market for personal computers and other IT products will subdue semi- conductor prices for a substantial period into next year. Also, the recent pace of letters of credit (L/C) arrivals predicts that exports will continue to slow down until the end of this year, although the L/C is a rather weak indicator for predicting the performance of exports three or four months into the future since it accounts for only 30 to 40 percent of the nation's total trade settlement methods. We expect the exports of goods and services to decrease by 8.5 percent to $41.4 billion in the fourth quarter, reaching $155.7 billion (- 9.6 percent) in 2001.

Imports of goods and services are expected to slide 5.3 percent in the fourth quarter, partly reflecting the decrease in exports and investment activities. Since Korea imports about 900 million barrels of crude oil a year, oil price movements can make big difference in the total amount of imports. Oil prices in the world market have fallen by a third since September 11 and are expected to go down further amid cacophonous discussion among oil exporters on coordinated production cuts. The meeting of oil majors on December 10 will be a critical event concerning the future course of global oil prices.

<Figure 19>            Crude Oil Price Trend (Dubai)

- 24 -

The most important factors that will determine the won/dollar exchange rate in the coming months are the current account position, inflationary pressure, and the yen/dollar exchange rate. Recent developments in both the current and capital accounts are positive for the won's long- term outlook. The current account is also expected to record a $9.9 billion surplus while the capital account will be in a balanced position by the end of this year. With inflationary pressure and domestic interest rates under control, a healthy foreign reserves position will underpin the currency's stability. The stability of the won, however, will remain vulnerable to the movements of the yen. Whether the Japanese yen will remain stable or depreciate will be critical to the won/dollar exchange rate since the weakening yen will force Korean exporters to keep the US dollar prices of their goods low in order to maintain competitiveness. Although the events in September increased the uncertainties in the financial environment, the current trend in foreign direct investments and portfolio investments flowing into Korea is not likely to be affected very much. On balance, the won should stay under pressure for much of the remainder of this year fluctuating around a 1,280～1,320 won/dollar band, although there could be a sporadic bearish trend. 

<Figure 20>  Exchange Market Pressure and Won/dollar Exchange Rate

- 25 -

Money and Interest Rates

Money

1) Review

During the third quarter of 2001, the Korean economy slowed down more rapidly than anticipated due to a worsening world economy. The domestic economy as well as the world economy has been under great uncertainty after the terrorist attacks on the United States in September. Exports have continued to decline steeply and both industrial production and equipment investment have contracted significantly. The inflationary pressures that had been generated by supply side factors have gradually subsided. The growth rate of consumer prices eased to a level below 4 percent on a year- on- year basis in September. In the financial markets, both market interest rates and bank lending and deposit rates declined considerably following the consecutive call rate cuts by the Bank of Korea (BOK) in July and August. Despite the uncertainties surrounding the restructuring of several

<Figure 21>          Inflation Target and CPI Inflation

- 26 -

debt- ridden large  corporations, the corporate sector's fund- raising conditions have somewhat improved with ample liquidity in the market and decreasing interest rates in July and August. Entering September, however, concerns over worsening profitability and cash- flow into the corporate sector have been growing due to the prolonged economic slowdown, and the corporate sector's funding was contracted. 

Under such economic conditions, the BOK prescribed a low interest rate policy in the third quarter to ward off an economic slowdown. Since inflationary pressures have been moderated to some extent entering the second half, the BOK lowered its target for the overnight call rate in July and August by 25 basis points each month, from 5.0 percent to 4.5 percent. At the beginning of September, the BOK decided to maintain its benchmark overnight call rate at its current level for keeping a close eye on the effects of the monetary and fiscal measures. After the terrorist attack on the United States, however, the BOK announced an unexpected 50 basis point call rate cut at its special meeting on September 19, which lowered the call rate from 4.5 percent to 4.0 percent, in order to minimize the negative effects of the worsening external environment.

<Table 8>           Trends in Monetary Growth Rates¹⁾

(unit: %)

Notes:1)Year- on- year growth rate of the average balance. 

2) Preliminary values. 

3) Reserve Money = bank notes + reserves of deposit money banks. 

4) M1 = currency + demand deposits. 

5) M2 = M1 + savings deposits + foreign currency deposits. 

6) MCT = M2 + CDs + money- in- trusts. 

7)M3 = M2 + deposits in non- bank financial institutions + debentures issued + commercial bills sold + CDs + RPs. 

Source: The Bank of Korea, Money and Banking Statistics (various issues), Trends of Financial Market in September.

- 27 -

<Figure 22>     Discrepancies Between Monetary Growth Rates

<Table 9>              Money Multipliers and Velocities¹⁾

(unit: Times)

Note:1)Money Multipliers are the ratios of each monetary aggregate to the volume of the reserve money. The velocities of money represent the ratios of seasonally adjusted nominal GDP of each seasonally adjusted monetary aggregate. 

Source: The Bank of Korea, Money and Banking Statistics (various issues), Trends of Financial Market in September. 

- 28 -

The growth rates of major monetary aggregates, except M3, slowed down during the third quarter due to a shift in capital flow from the banking to the non- banking sectors. As a result, the discrepancies between the M2 and M3 growth rates have narrowed further from 10.2 percent in March to 5.1 percent in June. The M3 growth rate accelerated upwardly, recording 9.8 percent in July, due to the rise in deposits at investment trust management companies (ITMCs) in response to the lowering of deposit interest rates at bank deposits. On the other hand, the M2 

<Table 10>             Stock Investments by Foreigners

Notes: 1) Units are 100 million dollar.

2) Units are 100 million won.

Source: The Korea Stock Exchange, Monthly Bulletin, various issues. 

http://www.kosdaq.or.kr

<Table 11>           Monetary Stabilization Bonds Issued

(unit: bil. won)

Note:1)Preliminary values.

Source: The Bank of Korea, Monthly Bulletin, various issues. 

- 29 -

<Table 12>          Trends in Major Financial Indicators

(unit: %, number)

Notes:1)Dishonored value based (Dishonored- bill ratio adjustment for electronic settlements).

2)Based on nation- wide commercial banks and month- end figures.

Source: The Bank of Korea, Ratio of Dishonored- bill in June, Trends of Daily Financial Market, Trends of Financial Market in September.

<Table 13>    Recent Deposit Changes at Financial Institutions¹⁾

(unit: billion won)

Note:1)End of period. Changes from the previous period.

Source: The Bank of Korea, Money and Banking Statistics (various issues), Trends of Daily Financial Market, Trends of Financial Market in September.

- 30 -

growth rate recorded 12.7 percent in the third quarter, down from 15.4 percent in the second quarter. The slowdown in the M2 growth rate was attributable to the relatively higher level of M2 during the same period last year and the portfolio

shift of bank deposits to short- term marketable deposits, which are not included in M2, in addition to the capital flow from the banking to the non- banking sector. 

At the beginning of the third quarter, the call rate cut by the BOK initiated a sharp decrease in market interest rates and reductions in the interest rates of bank deposits. Since the expected yields of bond- type funds were higher amid declining 

market interest rates, deposits at ITMCs posted a 13.3 trillion won growth in July. In terms of increase by month, it was the largest single- month growth since January 1999. Deposit- taking by deposit money banks reached 2.8 trillion won in July, a decrease from the preceding month. Since the end of August, the increase in capital flow to ITMCs slowed down with an attenuated anticipation for a further drop in market interest rates and uncertainties over the fate of Hynix Semiconductor Inc. After the terrorist attack on the United States, fund flow into the banking sector rebounded as the appetite for safe assets returned.

At the beginning of the third quarter, corporate direct financing increased due to the decrease in market interest rates. The net issuance of corporate bonds reached 2.9 trillion won in July and 0.6 trillion won in August. Entering September, however, net issuance contracted to the net redemption of 0.9 trillion won. Widespread and heightened concern over corporate credit risk in response to an aggravated profitability in a prolonged economic slowdown is the reason for this contraction. Bank lending to small and medium sized firms maintained a solid increase, amounted to 6.7 trillion won during the third quarter. Meanwhile, bank lending to large firms showed a decrease because of the quell in demand for loans following an economic slowdown and the continuous issuance of corporate bonds on the demand side. On the supply side, the enhanced credit screening to companies with low credit ratings contracted bank loans to large firms. Meanwhile, the issuance of stocks by corporations was inactive due to the bearish stock market.

- 31 -

<Table 14>                 Trends in Bank Loans¹⁾

(unit: billion won)

Notes: 1) End of period. Changes from the previous period.

2)Excluding CP discounts.

Source: The Bank of Korea, Trends of Financial Market in September.

<Table 15>            Trends in Firms' Direct Financing¹⁾

(unit: 100 million won)

Notes:1)End of period. Changes from the previous period. 

2) On the basis of CP discounting of securities companies and merchant banks.

3)Figures in parentheses include Primary CBO and Korea Development Bank's Prompt Bond Underwriting. 

Sources: The Bank of Korea, Trends of Financial Market in September. 

Financial Supervisory Service, Monthly Financial Statistics Bulletin, various issues. 

- 32 -

<Figure 23>     Outstanding Deposit Bank Loans by Type and 

Ratio of Households to Total Loans

2) Forecast

In the fourth quarter, negative impacts of the international environment, especially the U.S. retaliation against the terrorist attacks, will further aggravate exports and make private consumption and investment more contracted in Korea. The business survey index, conducted by the BOK before the terrorist attacks, had dropped sharply below 100, implying that the economy will suffer from a further slowdown in the fourth quarter. Even the recent survey of consumer sentiments indicates that private consumption, which had been relatively steady in the first half this year, would be contracting in the second half. 

To counter the unfavorable external environment and to boost the domestic economy, an easing macroeconomic policy will be implemented. A more expansionary fiscal policy will be in place through a second supplementary budget. In line with this, the BOK is expected to further cut the call rate during the fourth quarter as the economy will be on the verge of sliding into a recession.

- 33 -

In the fourth quarter, capital flows to deposit accounts at banks are expected to slow down due to lowered deposit interest rates, stagnated demand for bank 

loans by corporations and continued capital inflow to the non- banking sector, including ITMCs, and short- term marketable deposits at banks. As a result, the M2 growth rate is forecasted to stay around 12.5 percent, while the M3 growth rate is expected to increase to 10.0 percent.

Recently, the BOK's decision to increase its issuance of monetary stabilization bonds has been controversial because it is said to have dampened the effects of the lowered interest rates and the increase in liquidity provisions. This argument is based on the fact that the M2 growth rate has continued to decrease. The slowdown in the M2 growth rate, however, is mainly due to the shift of funds from banking deposits to the non- banking sectors. Considering the fact that the M3 growth rate continues its increasing trend, it is not appropriate to conclude that the BOK tightly carried out its monetary policy.

<Table 16>         Monetary Growth Rate and Forecasts¹⁾

(unit: %)

Notes:1)Year- on- year growth rate of the average balance.

2)CPI is a realized value, M2 and GDP Growth Rate are preliminary values, and M3 is a forecast.

3)KIF Forecast.

Source: The Bank of Korea, Monthly Bulletin (various issues), Money and Banking Statistics, Trends of Financial Market in September.

- 34 -

Interest Rates

1) Review

Although the government and several private research institutions had projected a mild economic recovery for the third quarter, the macro economy underwent a significant recession in this period. From May to August, the industrial production growth rate recorded 2.3%, - 2.7%, - 5.7%, - 4.7%, and the rate of increase in total export (F.O.B.) went down to - 8.7%, - 14.3%, - 20.5% and - 21.0%, which was the poorest in the last 34 years. From this discouraging shrink in production and export, the main message delivered was that the depth and duration of the current contraction might be deeper and longer than expected. 

On the other hand, some price stability became visible in June. Obviously, the key factor in the stabilization was the severe economic slowdown. 

The "Fundamental Inflation Rate", which is closely watched by the Bank of Korea for the purpose of controlling inflation, started to decrease since June. More

<Figure 24>               Long- term Interest Rates

- 35 -

than half of the high inflation rate observed in the first several months of this year could be attributed to supply- side factors: increases in public utility charges, food and vegetable price increases owing to drought, heavy snowfall etc. As these supply- side factors subsided, the demand- side inflation, or the "fundamental" inflation rate, started to decline faster than the CPI inflation rate itself.

While the record- breaking sluggish macroeconomic performance aroused a strong demand for further interest rate cuts, the Monetary Policy Committee has kept the call rate frozen for 5 months until the end of June. The Committee hesitated to lower the call rate because the inflation rate was much higher than the upper bound of the target range, which was set to be 3±1%. However, the new stabilizing trend in the CPI and the "fundamental" inflation rates, which was set in motion since June, encouraged the Committee to entertain a cut in the call rate.

On July 5, the Monetary Policy Committee announced a new target call rate, 4.75%, which was 25bp lower from previous 5.0%. Then the committee slashed another 25bp on August 9. Long and short- term interest rates on government bonds decreased in a synchronized manner with the call rate. The decline in government 

<Figure 25>    CPI Growth Rates and Underlying Inflation Rates

- 36 -

bond yields was supported by the government's commitment that it will not adopt a fiscal expansion as a policy tool for boosting the economy. As government bond yields declined, corporate bonds attracted market attention inducing corporate bond yields to decline almost parallel with government bond yields.

<Figure 26>               Short- term Interest Rates

<Table 17>     Quarterly Movements of Major Interest Rates¹⁾

(unit: %)

Notes:1)Period averages 

Sources: The Bank of Korea, Korea Investors Service, INC., KIS- LINE.

- 37 -

As bond yields were falling, commercial banks immediately lowered deposit interest rates. The after- tax real interest rates on bank deposits turned out to be negative, a large amount of funds shifted from the banking sector to the bond market. Deposits at investment trust management companies(ITMCs) increased by 13.3 trillion won compared with previous month. It was opposite to what happened in April, when the deposits decreased by 12.3 trillion won in a month. ITMCs interpreted the reversed inflow of the fund to be a new long- term trend, not a short- term nor an abnormal accident. They bought bonds rather aggressively, and the corporate bond issuance amounted to be 4.5 trillion won in July, which is 43% more than that in June. 

These developments did not start a benevolent circle in the financial flow, however, due to some existent uncertainties in the financial market. Most of the corporate bonds issued in the third quarter were rated higher than or equal to BBB, while corporates with rates lower than BBB could issue only a negligible amount of bonds. 

<Table 18> Non- guaranteed Corporate Bond Issuance by Credit Ratings¹⁾

(unit: 100 million won, %)

Notes:1)Credit rating is based on the time when corporate bonds were issued. Excludes ABS. 

2) Figures in parentheses are percentage weights. 

Source:Financial Supervisory Service, The Statistics of Direct Financing in from January to August.

- 38 -

As soon as the NPL problem of Hynix Semiconductor company went public, the flow of funds into the non- banking financial sector, including ITMCs, was curbed abruptly. Instead, deposits at the banking sector increased. But the increase was concentrated mostly on short- term deposits. In this process, interest rates on bonds could have jumped up due to the negative market evaluation regarding the policy prescription for the Hynix problem. But the interest rates continued to decline overwhelmed by the sluggish economy.

During this period it was alleged that firms were inactive because of neither high interest rates nor low accessibility to funds. Rather, firms were delaying their investment schedule because they had no confidence in an economic recovery in the foreseeable future. Negative symptoms from the cuts began to stand out. The most precarious one was the recent movements in housing prices. It is a bad sign for the monetary authority to watch housing prices soar sharply while the stock market and macro economy are stalled. 

<Figure 27>             CPI and Core Inflation Rates

- 39 -

A study on the core inflation rate, the definition of which being the inflation rate driven by aggregate nominal demand and inflation expectation, estimates the core inflation rate to have been record low since mid- 1998. The result suggests arguably that interest rate cuts might not trigger a run- away inflation in near future. However, another study points out that the deposit- only and the monthly rental price indices of urban housing are the key factors underlying the core inflation rate in the sense that those indices seem to lead and forecast the movement of the core inflation rate. Therefore, the fact that the rate of increase in those indices have recovered from its negative trough, resuming its normalcy since July, implies that in the future it will become more difficult to keep demand- side inflation under control.

By the end of August, a widely accepted consensus was that the U.S. economic recovery seemed to be delayed significantly and domestic recovery also be delayed along with the U.S. economy. A natural interpretation was that the BOK might cut the call rate again in September. 

On September 6, the Monetary Policy Committee announced its position of "watchful waiting". That decision was a little bit surprise to the financial market participants. In retrospect, the Monetary Policy Committee's position of "watchful waiting" was understandable, especially when we considered the developments in the urban housing prices, and its implication for future demand- side inflation rate. While explaining its new position, the committee emphasized that it needed more time to examine the overall effects of the interest rate cuts in July and August. Furthermore, it needed to see how much of the other policy measures, such as the supplementary budget, income tax cut, etc., are going to be effective for propping the economy. 

<Table 19>           Average of Core Inflation Rates

(unit: number of month, %)

- 40 -

The Monetary Policy Committee's cautious stance was seriously influenced by the outbreak of the terrorist attack on the World Trade Center in New York City. Immediately after the disaster of "September 11", domestic stock prices plummeted. 

<Figure 28>     Growth Rate of Urban Housing Rental Price Index 

<Figure 29>                    Yield Curves

- 41 -

As it has been widely discussed, U.S. consumers' confidence will be severely discouraged, thereby the U.S. economic recovery, the main locomotive of global economy, could be delayed at least for several quarters. The terrorist attack and its aftermath were bad news for the global and domestic economic outlook. The Monetary Policy Committee called an emergency conference meeting on September 18 and voted for a 50bp cut in the call rate. 

Proportionately to the negative market sentiment caused by the terrorist attack, the demand for safe assets increased, and the government bonds yields declined. Led by the government bond yields, the yields on corporate bonds fell in a remarkable speed. 

2) Forecast

If a run- away inflation becomes visible, the low interest rate policy stance would not be sustainable anymore. However, the slope of the yield curves in the third quarter shows that financial market participants had kept abandoning inflation expectations even before the terrorist attack. If oil prices do not increase sharply, the probability of run- away inflation seems low.

By August, the composite leading indicator had recorded positive numbers for four consecutive months. But it seems highly probable that the terrorist attack in September might have delayed the much awaited global and domestic economic recovery. Notwithstanding unfavorable potential long- run side- effects from the negative real interest rates, the Monetary Policy Committee has cut the call rate by 100bp in total, for three times in the third quarter. Obviously, the main purpose of those actions was to help the economy to recover. Therefore, interest rates will go down further in the next quarter, forced by a delayed economic recovery and helped by the monetary authority's active intervention in the market to bolster the economy.

- 42 -

<Table 20>                Interest Rate Forecasts¹⁾

(unit: %)

Notes:1)Interest rates are period averages and others are percentage change from the previous year. 

2) CPI and interest rates are reported figures, and other figures are preliminary. 

3) Forecasts

- 43 -

Financial Market Developments

Banking

Deposit Market

1) Review

The total volume of bank deposits held by depository banks at the end of the third quarter in 2001 is estimated to have reached 504 trillion won, up 6.3% compared to last quarter. Despite the continuous decrease in the bank deposit interest rate, the total volume of bank deposits maintained a robust growth in the third quarter because of deteriorating external economic factors, such as a slowing economy in the advanced countries. As a result, the growth rate of exports has declined and prospects for recovery in the semi- conductor industry is bleak, boosting again a flight- to- quality psychology that was mitigated in the second quarter by consecutive interest rate cuts by the Bank of Korea(BOK). In addition, the delay in resolving problematic domestic factors, such as the restructuring of troubled companies like Daewoo Motor, Hynix Semiconductor, Hyundai Investment & Trust Company(HITC), etc., elevated uncertainties surrounding the restoration of the economy, leading consumers' confidence to decline. All these factors formed expectations in the market -  the worsening consumption and investment would eventually result in a situation where money will be refrained from flowing into the real sector. Investors remained too elusive, waiting to watch for signs of economic recovery. As a result, money that did not find itself in investment opportunities appears to be  wandering around in bank deposits, particularly short- term ones. 

At the end of the third quarter of 2001, the volume of deposits in won is estimated to have reached 434 trillion won, a 5.6% rise. The growth rate for demand deposits is still robust, recording 8.3% in the third quarter though it is a slower growth compared to the second quarter due to declining bank deposit interest 

- 44 -

rates. Time and savings deposits have shown successive growth, owing largely to the increase in short- term deposits whose maturities are less than six months. The situation with time and savings deposits indicate that investors' time horizon has shortened recently.

The volume of foreign currency deposit is estimated to have risen by 24.2%, totaling 21.3 trillion won in the third quarter this year. Fear of negative interest rate margins in some industries, which was caused by the prevailing low interest rate in the market, appears to have increased the demand for foreign- currency for overseas investments. In particular, after Beijing was selected to be the host city for the 2008 olympic games, investments in China increased, preoccupying the market.

<Table 1>                    Bank Deposits¹⁾

(unit: billion won, %)

Notes:1)Ending balance. The figures in parentheses represent the quarterly growth rate.

2) Estimates.

3) Forecasts.

4) Excludes BOK trust funds.

Source: The Bank of Korea, Money & Banking Statistics (various issues) and Daily Trend of the Financial Market. 

- 45 -

The volume of marketable financial products is estimated to have increased by 6.3%, totaling 47 trillion won. The continuous increase in marketable financial products is the result of the following. First, funds in time and savings deposits with expired maturities tended to flow into short- term investment products since the economy has continuously slowed down and prospects of a brighter future for the economy has not yet been envisaged. Second, declining interest rates made short- term funding more attractive to banks because banks could respond to changes in interest rates more timely with short- term funds. That is, funding through short- term financial products became more desirable to banks with falling interest rates. 

<Table 2>               Time and Savings Deposits¹⁾

(unit: billion won, %)

Notes: 1) Ending balance. The figures in the parentheses represent the quarterly growth rate.

2) Estimates.

3) Includes household preferential installment savings deposits.

4) Includes mutual installment savings, housing installment savings, workers' 

long-  term savings, and workers' property formation deposits. 

Source: The Bank of Korea, Money & Banking Statistics (various issues) and Daily Trend of the Financial Market. 

- 46 -

Though time and savings deposits recorded a handsome growth by 20 trillion won, which constitutes two third of total increase in deposits in the third quarter, the growth was mainly led by short- term products whose maturities are less than six months. Funds deposited in long- term products with maturities longer than one year continuously moved into products with short- term maturities. The high growth of short- term time and savings deposits and marketable funds that are not satisfied with low interest rates are increasingly on standby to seek higher yields. As an effort to reverse this trend, banks began to sell long- term products with small penalties imposed on pre- maturity withdrawal.

The average interest rate for deposits is estimated to have consecutively fallen in the third quarter. This phenomenon was caused by the Bank of Korea's low interest rate policy. Because of financial market conditions, yields of one- year financial bonds were lower than the interest rate of one- year deposits, helping to depress the deposit interest rate. 

<Table 3>        Interest Rates of Selected Bank Deposits¹⁾

(unit: %)

Notes: 1) End- of- quarter basis.

2) Estimates.

Source: The Bank of Korea, Money & Banking Statistics (various issues) and Daily Trend of the Financial Markets. 

- 47 -

2) Forecast

The total volume of deposits held by banks in the fourth quarter is expected to increase by 29 trillion won, reaching 533.2 trillion won, and raising the growth rate to 5.7%. Among bank deposits, deposits in won are expected to rise approximately 5.0% whereas marketable financial products are expected to show a higher growth rate, 7.8%. Why deposits held by depository banks will maintain high growth rate is explained as follows. First, the economy is not expected to escape the slump until the end of this year, and corporate bond markets do not have the capacity to absorb and attract investors' funds. Therefore, a substantial amount of funds that cannot find an investment opportunity will stay in short- term bank deposits. Second, a slowdown in the economy will stimulate corporations' cash holdings prepared for unforeseen situations. Third, after the Bank of Korea's interest rate cuts the real estate market indicated signs of growth. If the real estate market burgeons with momentum, the movement is not expected to easily crushed for another interest cut is expected. Therefore, funds awaiting investment opportunities in the real estate market may take a portion of the funds held in short- term deposit. 

Deposits in won are expected to successively rise by 5.0%, reaching 456.2 trillion won. Recently, the solutions to the problems of financially distressed companies such as Hynix Semiconductor, Daewoo Motor and HITC have found a new direction. However, after the terrorist' attack on the US, uncertainties in the world economy have increased and hurt investors' confidence. As a result, a substantial amount of matured deposit may flow into short- term products.

At the same time, demand deposits are expected to show a higher growth rate than time and savings deposits. Demand deposits are expected to grow by 15.2%, totaling 40.6 trillion won, due to the trend towards shortening investors' time horizons. The volume of time and savings deposits is also expected to continue its moderate growth rate in the fourth quarter; The growth rate is forecasted to be 3.8% and total volume will reach 415.5 trillion won. Around 15 trillion won of 

- 48 -

non- taxable investment products, including 5 trillion won in the banking sector, will mature in the fourth quarter. A substantial amount of these matured funds may flow into short- term financial products, waiting for other profitable opportunities.

Shortening investors' time horizons may also increase the balance of marketable financial products in the fourth quarter. The total volume of marketable financial products is expected to rise by 7.8%, reaching 51 trillion won. Banks need to finance loans by the market interest rate- sensitive short- term financial products when they increase loans with market interest rates. 

The volume of foreign- currency deposits will continuously show a fast growth and is expected to record a growth rate of 15.1%, reaching 25.3 trillion won in the fourth quarter. There are several reasons for the slowdown in the rate of growth of foreign- currency deposits compared with the last period. First, after the terrorist attack on the US, the increasing volatility of the US dollar makes US dollar denominated assets less attractive for risk- averse investors. Second, the US Federal Reserve's low interest rate policies may be causing the decline in the US dollar's value. Third, banks have a low demand for foreign currencies due to the lack of lucrative foreign investment opportunities. Therefore, they are cutting the interest rates of foreign currency deposits. However, the instability in the current global political situation may raise the demand for safety currencies, and thus the increase in the  balance of foreign currency holdings will be steadily increasing.

The average interest rate on deposits is expected to continuously fall in the fourth quarter. After the terrorist' attack, the US Federal Reserve substantially cut its interest rate and most developed countries joined the interest rate cut. Bank of Korea has also followed this movement and another cut in the inter- bank overnight rate is expected if the economy slows further. Also, commercial banks' drive for profit may act as an additional contributor to the declining interest rates. They are attempting to preserve operating profits by maintaining a sufficient interest rate margin, which is mainly accomplished by holding down deposit interest rates.

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Loan Market

1) Review

By the end of the third quarter in 2001, the total volume of bank credits provided by depository banks is estimated to have reached 372.4 trillion won, a 1.0% increase compared to the ending balance second quarter. The growth rate remains at a lower level because banks are still reluctant to give loans to corporations even after the corporations reached their non- performing loan target level. Several factors contribute to this recent trend in stagnating loan growth. First, a slowdown in the economy contributes to the falling industrial output. A decline in the investments of manufacturing plants and equipment is contracting the demand for loans. Nonetheless, BOK's successive interest rate cuts have begun to partly restore the corporate bond market, helping financially heathy companies rely more on direct financing than on bank loans. Second, the market for mortgage loans are almost saturated and banks are facing a situation where tighter criteria for small and medium sized companies' eligibility of bank credit are required. Third, because the financial problems of Hynix Semiconductor and Daewoo Motor have not been settled, high potential for more provisioning of bad loans has discouraged banks from expanding corporate loans.

Loans in won are estimated to have risen by 1.7% in the third quarter, totaling 333.3 trillion won, a 5.6 trillion won increase compared to the balance at the end of the second quarter. Due to the bi- polarization of the direct financial market, banks could not help but reduce the amount of loans to big corporations while increasing the loans to medium and small sized companies and individuals. 

At the third quarter of 2001, the ending balance of loans financed by bank- owned funds is estimated to have risen 1.6%, reaching 311.8 trillion won. The volume of bills discounted is estimated to have fallen by 11.9%, while that of overdrafts and general loans increased by 0.6% and 6.0% respectively. Demands for bills discounted appeared to have continuously declined with the development and 

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utilization of their substitute products by banks. For example, the electronic loan services secured by account receivable will be provided through the Korea Financial Telecommunications & Clearance Institute's network. As an indicator of corporations' financial urgency, unused balances of overdraft credit limits imply deteriorating economic conditions. However, the handsome 6% growth in general loans is attributed to banks' efforts at expanding their retail banking business. 

Loans in foreign currencies also showed a consecutive decline in the third quarter, down to 11 trillion won, a 1.0% decrease relative to the balance at the end of second quarter. The slowdown in growth of both the domestic and overseas economies has reduced the import of raw materials and capital goods. Consequently, the demand for foreign currencies has also declined in association with the decrease in imports. The possibility of the dollar being devaluated, moreover, made the expansion of foreign currency- denominated assets for banks less appealing.

<Table 4>                     Bank Loans¹⁾

(unit: billion won, %)

Notes: 1) Ending balance. The figures in parentheses represent the quarterly growth rate.

2) Estimates.

3) Forecasts. 

Source: The Bank of Korea, Money & Banking Statistics, various issues.

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The average interest rates on loans are estimated to have exhibited a slight fall in the third quarter. Together with the BOK's low interest rate policy and the falling yields on high- grade corporate bonds, the continuous decline in the demands for loans and fierce competition in the comsumer banking sector were major forces in lowering the interest rates on loans. 

<Table 5>               Loans with Banking Funds¹⁾

(unit: billion won, %)

Notes:1) Ending balance. The figures in the parentheses represent the quarterly growth rate.

2) Estimates.

Source: The Bank of Korea, Monthly Bulletin, various issues.

<Table 6>         Interest Rates on Selected Bank Loans¹⁾

(unit: % per annum)

Note: 1) End- of- quarter basis. 

Source: The Bank of Korea, Money & Banking Statistics, Monthly Bulletin and Trend of Interest Rates Offered by Banks and Non- Bank Financial Institutions.

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2) Forecast

The total volume of credit supplied by  deposit taking banks in the fourth quarter is expected to show a slower growth rate: 0.7%, reaching 375.9 trillion won. Several factors lead to the conclusion that credit growth rates will continue to fall in the fourth quarter. First, before closing the books at the end of the year, companies are usually expected to reduce the balances of their borrowing. Second, the world economy remains gloomy and is not expected to revive the demand for capital.  Third, low market interest rates have enabled financially healthy companies to cheaply raise funds in the bond market. Such companies are repaying loans serviced with high interest rates by using the funds financed in the cheaper bond market. As for low- grade companies which have a relatively high demand for capital but are virtually unable to access the corporate bond market, banks are enforcing strict credit evaluation criteria on them so that their demand for capital have failed to increase the supply of bank loans. Fourth, although the size of non- performing bank loans is declining, the potential for additional bad loans resulting from Hynix Semiconductor, Daewoo Motor and the default of additional companies is still high and is discouraging banks from supplying corporate loans. 

Loans in won are expected to rise by 1.6% in the fourth quarter, totaling 338.7 trillion won, and loans from bank owned funds are expected to record a low growth rate, 1.5%. Falling capital investments, strengthened requirements for the eligibility of bank loans, and corporations' expediency in repaying bank loans appear to be the forces blamed for such a low growth rate. If the US and the world economy is revitalized earlier than expected, however, demands on loans may increase with the rise of capital investments. Loans by government funds, unlike those by banking funds, are expected to steadily grow by 3.3% with the government's effort to reverse the falling business cycle.

The ending balance of the foreign currency- denominated loans is, in the third quarter, expected to amount to 11 trillion won, a 0.1% fall relative to the end of third quarter. Although during periods when the dollar is weak, enlarging 

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dollar- denominated liabilities benefits companies, they may reduce foreign currency liabilities to balance the position of foreign currencies before closing the books. From the loan providers' viewpoint, it is unprofitable to increase dollar- denominated assets when the US dollar's value is expected to weaken. Therefore, banks may ask borrowers to redeem their loans at maturity.

The average interest rates on loans are expected to fall. A major factor leading to the forecast is that deposits are increasing even faster than loans. This means that banks have a large supply of unused resources. In addition, banks are increasing loans linked with market interest rates while market interest rates are falling. If the BOK cuts its target interest rate, banks will react in response to the cut in loan interest rates.

Bank Trust Market

1) Review

The total volume of deposits in nationwide banks' trust accounts  increased by 0.3%, totaling 63.7 trillion won at the end of the third quarter. Despite the low interest rate, the unstable economy appears to obstruct the inflow of funds into the bank trust account. The following factors contributed to the slow growth this period. First, the growth rate of the Household Trust and the Non- specific Trust, which are a large part of the total bank trust balance, has shown a continuous decrease, while the Specific Trust lost half of its growth rate. Second, banks' roles, as sales agencies of investment and trust companies in pursuit of increasing the income from fees, adversely affected the sale of banks' own trusts.

The Additional Trust, a substantial portion of which had matured without being renewed in June, again had a positive growth while the outstanding balance of Unit Trust has continued to decrease. The growth of the New Old Age Pension has helped the Old Age Pension maintain a ceaseless growth though the growth rate of the Old Age Pension has been abating for a while.

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The total volume deposited into the Real Estate Trust Account dramatically fell by 16.7%, recording 292 billion won. Even though the real estate sector was beginning to burgeon, the steep drop in the Real Estate Trust can be mainly attributed to the beginning of the REITs' operation. Increasing direct investments on real estate by investors instead of relying on financial institutions appears to be another contributing factors.

The total volume of the Separate Taxation Trust, whose sale was allowed in February, highly grew by 13.4%, reaching 1.2 trillion won, while the tax exempt High Yield/High Risk Trust amounted to 56 billion won. The High Yield/High Risk Trust must include junk bonds above 30% in its portfolio, but gives tax exemption benefit to investors up to 30 million won. 

The yields for the Household Trust, Corporate Trust, and Installment Trust are estimated to fall this quarter compared to that of last quarter. Low yields appear to be the result of falling yields on Treasury bonds and public debentures owing to the low interest rate. The composition of th  trusts' portfolio, as shown in Table 7, reveals that the proportion of loans among the trust account's assets decreased whereas that of securities increased by approximately 2.4%.

<Table 7>                   Portfolio Summary¹⁾

(unit: billion won, %)

Notes: 1) Ending balance. The figures in parentheses represent weight.

2) Estimates. 

3) Excludes securities in investment trusts. 

Source: The Bank of Korea, Monthly Bulletin, various issues.

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<Table 8>                    Trust Accounts¹⁾

(unit: billion won, %) 

Notes:1) Ending balance. The figures in parentheses represent the quarterly growth rate. 

2) Forecasts.

3) Includes general unrestricted money trust, restricted installment trust, etc. 

4) From April 12, 1999 to April 12, 2000. 

5) From March 13, 2000 to March 13, 2001. 

Source: Individual Bank Data.