Prudential regulation

Prudential regulation (건전성규제) is referred to the banking regulation and supervision conducted by the financial regulators:
 * Financial Services Commission (FSC, 금융위원회)
 * Financial Supervisory Service (FSS, 금융감독원)

Since the late 1980 when the Basel Committee on Banking Supervision (BCBS) under the Bank for International Settlements (BIS, 국제결제은행) proposed the so-called "BIS Rule", financial regulators over the world are committed to implement the prudential regulations, suggested by the BIS Committee, as far as possible in their financial environment.

Key words
prudential regulation, BIS Rule, capital adequacy, financial supervision and regulation

Capital Adequacy
The capital adequacy of financial institutions is of great importance to maintenance of their managerial soundness for two reasons.

First, as capital serves as a buffer to offset unexpected losses, financial institutions having large-scale capital are more likely to be able to avoid liquidation and survive.

Second, shareholders in financial institutions having large amounts of capital face the risk of great loss should the institutions become insolvent, and these institutions therefore tend to avoid riskier forms of asset management, which decreases the possibility of their poor management.

In relation to the capital adequacy of banks, FSC imposes the capital adequacy ratio regulation set by the Bank for International Settlements (BIS) under the Basel II Accord. Under the FSC regulation, prompt corrective actions are specified, including recommendations, demands and orders for management improvement at banks whose BIS capital adequacy ratios fall short of 8 percent, 6 percent and 2 percent, respectively.

FSC may also approve a variety of risk measurement methods for banks, examine every risk faced by banks, and require high-risk banks to maintain at least 8 percent capital adequacy when necessary.

Introduced with drafting of the Basel I Accord in 1988, the capital adequacy ratio regulation requires ― unlike simple forms of regulation of capital adequacy (using the ratio of capital to total assets) ― that banks maintain ratios of capital to risk-weighted assets at 8 percent or above. For this purpose, banks’ assets are categorized based on criteria including the credit ratings of the counter parties to their transactions, and the maturities and existence of collateral and guarantees of their claims. This regulation aims at improving banks’ asset soundness by applying higher weights to riskier assets and encouraging banks to hold prime assets. Korea introduced this system in 1992, and imposed minimum ratio requirements of 7.25 percent and 8 percent in 1993 and 1995, respectively. As the Basel Committee on Banking Supervision later stipulated the maintaining of a certain level of capital against market risks, in addition to traditional credit risks, Korea introduced a new capital adequacy ratio that reflected market risks in December 2000.

However, because the Basel I Accord failed to fully reflect the changing degree of risk that bank assets face due to financial liberalization and financial innovation, transactions that evaded regulations were not adequately controlled. The Basel Committee on Banking Supervision therefore announced the Basel II Accord in June 2004, and Korea has been enforcing it since 2008.

Adding operational risk to the existing risks faced by banks, Basel II strengthens regulation in three areas: minimum capital requirements (Pillar 1), supervisory review (Pillar 2), and market discipline (Pillar 3). Under Pillar 2, regulators must examine and assess banks’ adequacy in calculating their minimum capital ratios, and when necessary take appropriate measures. Pillar 3 market discipline, also primarily covers strengthened public announcement of the risk levels and capital adequacy of banks. In sum, on the assumption that minimum capital requirements are not sufficient to secure banks’ managerial soundness, the Basel II Accord reinforces and complements the ability of regulators and market participants to monitor and evaluate banks.

Prudential Regulation in Korea
FSC and FSS have devised various prudential management guidelines aimed at maintaining credit order and protecting depositors by ensuring sound bank management, and require the banks adhere to these guidelines.

In particular, FSS ensures sound bank management by directing banks whose major prudential management ratios are likely to decline, or which have vulnerable aspects in their management, to submit plans or letters of commitment to improve, or to sign management improvement agreements (in the forms of memorandums of understanding).

Major prudential management guidelines include the BIS capital ratio, ratio of liquid assets denominated in won to liquid liabilities denominated in won, ratio of loans denominated in won to deposits denominated in won, ratio of liquid assets in foreign currency to liquid liabilities in foreign currency, ratio of maturity mismatch between assets and liabilities in foreign currency, ratio of medium- to long-term borrowings (liabilities) to medium- to long-term loans (assets), and the obligation of holding a certain amount of safe assets in foreign currency).

Prudential Management Guidelines for Banks
Source: The Bank of Korea, Financial Institutions in Korea, p.255, July 2012.

Asset Soundness Classification
FSC requires financial institutions to classify their assets in accordance with asset soundness criteria and deposit certain percentages or higher of their non-performing loans as allowance for doubtful accounts. FSS reviews the adequacy of financial institutions’ asset soundness classifications and allowances for doubtful accounts deposited, and demands correction for those judged to be inadequate.

The asset soundness classification system aims to evaluate the degrees of credit risk for the assets of financial institutions, thereby preempting investment in non-performing loans and prompting early normalization of non-performing assets, with the ultimate goal of sound asset management. Financial institutions are required to classify assets into one of five categories ― normal, precautionary, substandard, doubtful and estimated loss ― in consideration of debtors’ capabilities to repay their debts and the contents of their financial transactions.

Debtors’ capabilities to repay debt should be evaluated using Forward Looking Criteria (FLC, 자산건전성분류), which sufficiently reflect debtors’ loan principal, past interest repayment performance, and future debt repayment capabilities. The FLC method was first applied to banks in December 1999, and its application has been expanded step-by-step; most financial institutions currently employ it for their asset soundness classification criteria.

The ultimate goal of asset soundness classification lies in depositing adequate amounts of allowances for doubtful accounts in accordance with the collectability of loans, and a financial institution should therefore establish a certain percentage of each asset as allowance for doubtful accounts, as required by each category. Here, the percentage of allowance for doubtful accounts varies slightly among the different financial business types.

Troubled assets that belong to the categories of doubtful assets or estimated loss by asset soundness classification should be accounted for early on as bad debt expenses, in order to induce asset deleveraging and prevent overstatement of assets. Here, recognizing bad debt expenses means subtracting loans judged to be uncollectible from asset book values and recognizing them as losses; this occurs when financial institutions apply for recognition of loans as bad debt to the FSS, and the FSS then approves them as bad debt, or when the FSS demands such recognition. Application for approval of loans as bad debt may be made by specialized banks, securities companies, insurance companies, merchant banks, mutual savings banks, credit-specialized financial companies and commercial banks, but the governor of the FSS may demand recognition of loans as bad debt only to commercial banks.