Korea’s biggest banks rely too much on foreign currency funding markets. They have done so in the past, and they continue to do so now. The Financial Services Commission, the main regulator, has stress-tested this reliance — long a feature of Korea’s financial system — and has asked local banks to reduce their dependence on short-term foreign currency funding.
That is a step in the right direction, but Korean officials should get tougher still. It is time to push Korean banks to fund more at home, and develop the domestic debt market in the process.
The FSC tested the vulnerability of local banks to shock in the foreign currency markets in a month-long review that ended in late August. The regulator assumed that banks would roll over their loans to corporations, and asked how well they could withstand a seizure of the short-term funding market offshore. The results of the tests were not — and will not be — announced, but rumours quickly spread that several banks failed the test.
That came as little surprise. Korean banks are frequent borrowers in the international bond market, but that it is not the half of it. They rely on loans from US and European banks for more than 50% of their foreign currency borrowing, according to Nomura analysts. That is a source of liquidity that is already under a lot of strain, and could get more strained over the next few years.
Korean regulators — and bankers — have been in this situation before. The government was forced to launch a wave of bail-out packages at the end of 2008, including agreeing to guarantee $100bn of foreign currency debt issues. Could the government be forced once again to launch a foreign currency guarantee scheme? Things may not get so bad, but now is not the time for optimism. It is the time for preparation.
The regulator should act before it is forced to bail out the country’s banks once again. The first step should be to push the development of Korea’s financial market, giving local banks a good alternative to turning offshore.
Some of these banks have significant foreign currency needs — often for refinancing previous borrowing — so the domestic Korean won market is no panacea. But Korea’s banks are exposed to the swap market in the foreign currency space too, when they decide to raise dollars to swap back into their domestic currency. It makes sense to try to develop the domestic market now, before things get even worse in the foreign currency funding markets.
The regulator should also encourage Korean banks to find as many offshore sources of funding as possible, directing them to Asia’s other local currency markets as a way to tap a pool of investors who are likely to be present in the order books of international bonds. Many Korean borrowers are already adept at this, but more could learn from their example.
There are plenty of other options at the FSC's disposal. It could chose to cap foreign currency borrowing, it could offer its own won-dollar swap line and it could incentivise foreign funds to set up in Korea, all of which would help reduce local banks’ reliance on offshore funding. But while the regulator has many options, now is the time to pick one.
Korean banks are well-known and — usually — well-respected parts of the global financial system. But now is the time to get a little less global and a lot more local.