Resolution of Non-Performing Assets - Experiences of Korea ...



Resolution of Non-performing Assets: Experiences of KoreaDongsoo KangKorea Development InstituteAugust, 2018Executive SummaryThe 1997 financial crisis is a watershed event in corporate and financial restructuring in Korea. Unprepared financial liberalization originated in various risk build-ups throughout the financial system, whereas corporate profitability gradually declined as the long high-powered growth era ended. Financial regulation and supervision were not adequate from the international standpoint so that risk management practices of financial institutions were poor. The contagion from Southeast Asian countries made Korea exposed of corporate credit risks and maturity and currency mismatches, among others, entailing her to undergo firstly currency, then banking and finally economic crises. In the face of such a full-blown crisis, at first, Korea made all-out efforts to resolve the shortage of foreign currency liquidity and to prevent bank-runs in financial institutions. After taking such emergent measures to stabilize liquidity, the government tried to ensure appropriate institutional arrangements in place. In the task of crisis resolution team, it was important to strike a balance between the political and technical works, including the delegation of authority and responsibility to technical experts. The highest decision making authority was the Ministry of Economy and Finance (MOFE), but most practical tasks were assumed by the Financial Supervisory Commission (FSC). Throughout the whole restructuring processes, two major implementing agencies, the Korea Deposit Insurance Corporation (KDIC) and the Korea Asset Management Corporation (KAMCO), played major roles as public fund managers of Deposit Insurance Fund (DIF) and Non-Performing asset Management Fund (NPAF), respectively.The Public Funds, or DIF and NPAF, were mobilized (1) to purchase NPLs from financial institutions, (2) to make a deposit insurance pay-out against the insured deposits of failing financial institutions, (3) to participate in capitalizing financial institutions whose balance sheets were weak, (4) to make contributions to acquiring the assets from closed banks, etc. It is worthwhile to note that the government needs to ensure that the Public Funds are sufficient enough to be credible to market participants, while maintaining flexibility in additional funding likelihood. The initial assessment on the size of Public Funds tends to be short due to misunderstanding or even downward bias regarding seriousness of crisis situations, but hidden but unknown distresses are highly likely to emerge into surface. Korea took and, in fact, could not help taking a market-friendly approach in resolving distressed assets. KAMCO purchased NPLs from financial institutions at close to fair market price, which meant heavy discount from nominal values. Therefore, KAMCO could make profits if it was able to add value through such actions as restructuring or pooling bad loans. This approach removed the binding constraints on selling prices for KAMCO, allowing more flexibility in its approach. Actually, KAMCO performed quite successfully, making profits of KRW 2.4 trillion afterwards.KAMCO hired various NPA resolution methods: direct sales, court auctions, securitization, establishing joint venture special purpose vehicles (JV-SPC), etc. Among others, It is interesting to look into the scheme of JV-SPC: KAMCO and an investor formed a Joint Venture Special Purpose Vehicle (JV-SPV) to store NPLs for future resolution through disposal and restructuring. KAMCO could move NPLs to the balance sheet of SPV, based on which bonds and equities were then issued. KAMCO and JV Investor equally subscribed to the SPV-issued securities. KAMCO paid 100% in NPLs and received 50% in cash and 50% in securities issued by the SPV. The investor paid 50% in cash and receives 50% in the same securities. KAMCO and the investor also formed a JV-Asset Manager to professionally manage the warehoused NPLs. Even though KAMCO had 50% ownership of the Joint Venture SPV, the SPV was legally independent of KAMCO, hence KAMCO could recognize legal and accounting sales on their balance sheet. The benefits of selling to a joint venture SPV as opposed to an outright sale is that KAMCO could realize upside potentials of future NPL values, through capital gains in the SPV equity owned by KAMCO. However, only half of the cash value was at the initial sale to the SPV. Drastic restructuring with an injection of the Public Funds and speedy NPL resolution laid a ground for regaining health and efficiency of the financial system. Relative to other neighbor countries which underwent financial crisis at the similar time, Korea made a good performance. Then, why has Korea been relatively successful? First, democratic leadership is crucial, given that the political economy around reform matters in the time of crisis due to social pressures stemming from conflicts of interests. At the beginning of the crisis and for a while thereafter, Korea had effective leadership: only 20 days after the outbreak of the crisis, the new president was elected for a five-year term, allowing his administration to make and implement a long-term plan for reforms. Second, Koreans acted cooperatively to yield material outputs. One of the salient examples of cooperation is the Gold Collection Movement in late 1997 and early 1998. It was enough to demonstrate Koreans’ ability and commitment to coalesce under crisis, which is in line with a long tradition found in Korean history. Third, Preemptive institutional building significantly shortened a period of time for devising plans and also curtailed inevitable debates and conflicts over restructuring. For example, the consolidated Financial Supervisory Commission (FSC), prepared well in advance, started at the same time as financial restructuring, while the Non-performing Asset Management Fund (NPAF) was founded before the crisis and KDIC was established a year ahead. All of these mechanisms played crucial roles in the reform. Lastly, but not least, timely international assistance prevented the financial crisis from amplifying up to the level of default for the country. Domestic efforts alone could not have mediated to mold a whole-lot new financial architecture. It is worth noting that one of the key success factors in KAMCO was absence of any reservation price as for NPLs, in other words, KAMCO accepted any price determined by market demand and supply, no matter how miserable and disappointing it was. As such, bold and decisive decisions by the government are essential in the success of a seller type of public AMC. In general, the first observable price just after the crisis tends to be too low to accept as a right market price. Korean experiences show that the belief and consistency in market transactions, even if they are not favorable to policy makers, would turn out a successful story at the end. In addition to rapid and efficient disposal of NPLs, KAMCO contributed to creating an NPL market and helped build up necessary capacities to resolve distressed assets afterwards. In the absence of relevant infrastructure at the beginning of the 1997 crisis, KAMCO functioned itself as a market where NPLs were traded and played a role of market maker. In the process of selling the NPLs to not only international and domestic investors, KAMCO enlisted various services from law, accounting, real estate, and management consulting firms. These services enabled KAMCO to accumulate a great deal of experience and expertise. Also, KAMCO hired many domestic investment banks to engage in NPL transactions. These experiences and expertise have been transferred to private sector, becoming an indispensable building-blocks for efficient market-based NPL resolution system. As a result, Korea utilized these experiences to develop NPL markets and infrastructure. From an institutional aspect, insolvency laws, credit collection laws, laws and regulations on securitization, etc. have been upgraded and/or newly made into law. This system provides a platform to dispose of NPLs even in the normal times. In fact, the crisis was an opportunity to upgrade and deepen Korea’s financial infrastructure.1. IntroductionThe 1997 financial crisis is a watershed event in corporate and financial restructuring in Korea. During the high-powered growth era prior to the crisis, the government had been at the center of both resource allocations and distress asset resolution. With their informational advantages over the private sector, government authorities had engaged themselves in the operational details of corporate businesses for the purpose of expediting economic development in a short period of time. Such a strategy had been very successful, resulting in over 7 percent real annual growth, without any serious catastrophes, for nearly 40 years until the late 1990s. The 1997 crisis terminated this prosperous era, exposing various systemic problems in the economy. With the high ratio of debt to equity, Korean corporations were supposed to and did produce commensurately high profitability. However, the corporate sector had become less and less profitable since the early 1990s. The return on capital, on average, had been lower than its opportunity cost for almost ten years prior to the crisis. In the meantime, Korean financial institutions were not able to properly control and absorb borrowers’ risks. More problematic was lack of understanding about the seriousness of both corporate and financial distresses inside the policy making entities, especially within the financial policy and supervisory authorities. Under these circumstances, it became a key issue to restructure both troubled financial institutions and corporations and to institute a whole lot of different structure than the past. Market principles thus became more important than government discretion. The relevant stakeholders started to move into the limelight, while the government remained behind the scenes.The main objective of this report is to introduce Korea’s experiences in the resolution of non-performing assets (NPAs) after the 1997 financial crisis. Starting with the descriptions over the situation of financial risk build-up in the pre-crisis era, we discuss the evolution of and policy measures to the event, putting emphasis on architecting financial restructuring scheme. Prudential impact on financial institutions was also highly considered in the process of non-performing loans (NPLs) because corporate delinquency was intimately related to financial soundness of banks. Next, we review various methods of disposing of NPAs vis-à-vis various types of corporate distresses. In the absence of properly functioning NPL markets, the distressed asset resolution agent, or Korea Asset Management Corporation (KAMCO), hired pro-market principles and technologies in close contact with investors, including from abroad. Finally, we conclude by evaluating NPA resolution policies regarding, mention lessons learnt from the Korean episodes and make suggestions for emerging countries which confront challenges from massive amounts of delinquent financial debts.2. Risk Build-up in the 1990sThroughout the 1990s financial markets had been greatly liberalized due to economic development and the prevailing mood of internationalization. The accession to the OECD in 1996 was a symbolic momentum where Korea widely opened up financial markets. The interest rate differentials between domestic and international funding, without due attention to foreign exchange rate risks, expedited large borrowings in dollar denomination. Even though Korea suffered from massive outflows of foreign reserves ex post, however, inexperience internationalization made her hard to discern macroeconomic imbalances like excessive credit explosions pumped by loosened liquidity constraints but not by real economic health.In addition to such a credit expansion, however, the distribution of the credits should have been taken into careful account. During the period of financial liberalization, direct financial instruments such as long-term bonds and short-term commercial papers (CP) had flourished. Also, the size of financial transactions intermediated by non-bank financial institutions (NBFIs) had grown tremendously. What made things worse, the maturity of corporate debts had become shorter until the currency crisis broke out. The sharp rise in commercial paper issuance implied that not only the corporate balance sheet but also the maturity structure of corporate debts had deteriorated substantially before the crisis. To put it briefly, the conventional banking sector shrank and was partially replaced by direct capital markets and NBFIs. Such a change in credit supply need not necessarily be understood as pessimistic. Instead, it might reflect on the deepening of financial markets and diversification of financial instruments. The relevant question would then be whether this change was accompanied by proper risk management of both credit suppliers, especially NBFIs, and demanders, or corporations. The answer to this question, unfortunately, was quite negative, thereby leading to the crisis. The emergence of the NBFIs, with increasing ownership by the chaebols (large business conglomerates in Korea), implied that, faced with tight controls over commercial bank credits, the NBFIs served as an alternative financing source for the chaebols along with direct financing vehicles such as commercial papers and bonds. Therefore, credit risks of the entire financial system became more heavily dependent upon the liquidity and solvency of the corporate sector. Stated briefly, Korean financial institutions were not able to properly control and absorb borrowers’ risks in 1996 and 1997. The fact that they had borrowed overseas with a short maturity in tandem with financial market opening deepened maturity and currency mismatches. In the end the Korean currency became heavily depreciated after the contagious crisis occurred in Southeast Asian countries in the fall of 1997. 3. Overview of Financial and Corporate RestructuringIn the face of such a full-blown crisis as encompassing all flavors of exchange rate, banking and then economic crises Korea made all-out efforts to resolve the shortage of foreign currency liquidity and to prevent bank-runs in financial institutions. The process began by securing US$ 35 billion in loans from such international organizations as the IMF, ADB, and World Bank, in order to restore settlement capacities for foreign transactions. This was followed by the conversion of US$ 23 billion in short-term external debts into mid- and long-term debts. In order to stabilize domestic liquidity problems, the Korean government issued extensive guarantees on bank liabilities. In November 1997, it fully guaranteed all bank deposits up to a period of three years. In effect, the government guaranteed virtually all subordinated liabilities in financial intermediaries, including life insurance companies. These measures, among others, constituted first-aid treatments for the financial crisis. After taking such emergent measures to stabilize liquidity, the government needed to ensure that appropriate institutional arrangements were in place. It was important to strike a balance between the political and technical works of crisis resolution, including the delegation of authority and responsibility to technical experts. This balance can be achieved by forming a special crisis management team with adequate skills, experiences, capacities and funding. Figure 1. Organizational Flowchart of the Financial and Corporate Restructuring in KoreaFigure 1 depicts the organizational flowchart of the financial and corporate restructuring process in Korea. Since restructuring involved both the financial and corporate sectors, the two sectors could not be separated from each other because certain steps were ordered in sequence in the restructuring processes. The highest decision making authority was the Ministry of Economy and Finance (MOFE), but most practical tasks were assumed by the Financial Supervisory Commission (FSC), a single consolidated financial regulator established in April 1998. After the legislation of the Public Funds Management Special Act in December 2000, the Public Fund Oversight Committee (PFOC) which was co-chaired by the Minister of Finance and Economy became in charge of overall restructuring. Throughout the whole restructuring processes, two major implementing agencies played a large role in operation. They were the Korea Deposit Insurance Corporation (KDIC) and the Korea Asset Management Corporation (KAMCO) as public fund managers of Deposit Insurance Fund (DIF) and Non-Performing asset Management Fund (NPAF), respectively. Even though the primary mission is to protect depositors, KDIC worked as a pay-box and restructurer in the course of financial restructuring by way of such measures as liquidating insolvent financial institutions with funds, participating in recapitalizing inadequate financial institutions, etc. The funds used in this process, namely the Deposit Insurance Fund (DIF), were mobilized through the bonds issued with government-guarantee. The main job of KAMCO in financial restructuring was to purchase non-performing loans (NPLs) from both insolvent and solvent financial institutions. The funds utilized in this process are called the Non-Performing Asset Management Fund (NPAF). Table 1: International Comparison of Crisis Management TeamsCorporate RestructuringNPL ResolutionAiling Fl’s ResolutionKoreaCRCC CRASCKAMCOKDICThailand Corporate Debt Restructuring Advisory Committee (CDRAC) Thai Asset Management Corporation (TAMC) Financial Sector Restructuring Authority (FRA) Asset Management Corporation (AMC) Thai Asset Management Corporation (TAMC)Financial Institutions Development Fund (FIDF)IndonesiaJakarta Initiative Task Force (JITF)Indonesian Bank Restructuring Agency (IBRA)Indonesian Bank Restructuring Agency (IBRA)Malaysia Corporate DebtRestructuring Committee(CDRC)DanahartaDanamodalThis kind of restructuring framework is not unique to Korea. Table 1 compares the crisis management team in four crisis-hit Asian countries. The overall structure of financial restructuring in all four countries was quite similar. Public asset management corporations (AMCs) like the KAMCO were established to resolve NPAs, while the deposit insurance corporations like the KDIC, or the funds appropriated by the central banks dealt with ailing financial institutions. Private organizations like the Corporate Restructuring Coordination Committee (CRCC), closely monitored by the financial regulators and/or central banks, mediated the process of corporate restructuring.4. Public Funds and Resolution of NPAs When the government tried to salvage financial system and to protect depositors, the central bank (Bank of Korea) and deposit protection entity (KDIC) did not have sufficient resources to absorb the ensuing costs. Therefore, the government had to arrange a financial package, called the Public Funds. The Public Funds were required (1) to purchase NPLs from financial institutions, (2) to make a deposit insurance pay-out against the insured deposits of failing financial institutions, (3) to participate in capitalizing financial institutions whose balance sheets were weak, (4) to make contributions to acquiring the assets from closed banks, etc. The government needed to ensure that the Public Funds were sufficient enough to be credible to market participants, while maintaining flexibility in additional funding likelihood. The early task of handling NPAs was to assess the size of distress faced by individual financial institutions and the entire financial system. Table 2 shows the initial estimate of non-performing loans in the financial sector as of the end of March 1998. Under the internationally accepted prudential standards in which loans more than three months overdue were classified as non-performing, KRW 118 trillion, or US$ 98.3 billion, of loans were found delinquent. With this estimate, the government built up the first-round Public Funds totaling KRW 64 trillion, of which KRW 43.5 trillion was issued as the DIF bonds and KRW 20.5 trillion as the NPAF bonds.In retrospect, the accounting and regulatory information existing at that time was quite misleading for two reasons. First, the government did not recognize the nature and depth of the financial crisis: the occurrence of new NPAs grew faster than the resolution of existing ones at the beginning of the crisis. This is related to the bankruptcies of many firms to teeter on the edge of viability. Thus, the initial assessment was heavily biased downward. Second, the default of the Daewoo group, whose total liabilities amounted to US$ 58.3 billion, was an unanticipated event. Most knew that the Daewoo was too highly leveraged to survive. Nevertheless, very few were suspicious of its solvency due to the “Too-Big-To-Fail” myth. In August 1999, however, 12 Daewoo subsidiaries entered into the Corporate Workout Program after the declaration of a moratorium. This event entailed the government authorities to make additional financial arrangements. The second-round Public Funds, totaling KRW 40 trillion, were therefore mobilized in 2000.Table 3 summarizes the source and usage of the Public Funds as of the end of December 2002. Out of the total amount of KRW 159 trillion, a majority of the Public Funds were spent on commercial banks, but significant amounts were also used for non-bank institutions such as investment trust companies, merchant banks, and insurance companies. In terms of usage, equity participation in viable financial institutions, totaling KRW 60.2 trillion or 37.9%, took up the largest portion, followed by NPL Purchases of KRW 39.1 trillion, or 24.6%.Table 2. Volume of Non-performing Loans(As of Mar. 30, 1998)(unit: KRW trillion)SectionSubstandard LoansCautionary LoansTotalCommercial Banks 40.046.086.0Non-banks 28.04.032.0Total 68.050.0118.0Source: Financial Supervisory Commission Table 3. Assistance and Funding Source of the Public Funds(As of the end of December 2002)(unit: KRW 1 trillion)SectionEquity ParticipationContributionInsurancePayoutAsset PurchaseNPL PurchaseTotalby AssistanceBanks33.913.6-14.024.686.1Securities7.7-0.01-8.516.2Insurance15.92.8-0.31.820.8MBC2.70.117.2-1.621.6MSFC-0.17.30.60.28.2Credit Unions--3.7--3.7Overseas----2.42.4Total60.216.628.214.939.1159.0by SourceBond Issuance42.215.220.04.220.5102.1Recovered3.91.36.14.417.032.7Gov’t assets14.10.12.16.31.624.2Source: Public Fund Oversight Committee The resolution of ailing financial institutions by way of closure or merger and acquisition (M&A), as well as the disposition of NPAs away from the balance sheet of financial institutions, are understood as hardware financial restructuring.The first financial industry that became subject to restructuring was the merchant banks, which were highly exposed to exchange rate risks under the currency crisis. Out of thirty merchant banks at the beginning of 1997, only three ones survived. The banking sector, most importantly, became enlarged by reshuffling through purchase and assumption (P&A). As for those financial institutions relatively small in asset size, like mutual savings and finance companies and credit unions, closure and M&A were more popular methods of resolution. As a result of the heavy hardware restructuring, more than 630 ailing financial institutions had been closed down. In general, a substantial amount of non-performing loans is a direct cause of financial crises. NPLs of KRW 118 trillion as noted in Figure 2, amounting to almost 15% of annual GDP, could not be managed by the equities of financial institutions. The resolution of NPLs required special expertise, but Korean banks did not have the relevant experiences and skills, let alone the incentives to undertake such rigorous tasks. Furthermore, the quality of the NPLs tended to deteriorate unless they were carefully and promptly managed. These constituted the reasons for introducing the public Asset Management Corporation (AMC), specializing in NPL disposition.Coincidentally, almost at the same time of the currency crisis, the NPAF was established, with its management entrusted to KAMCO. KAMCO then purchased NPLs from all financial institutions close to fair market price, in other words, with heavy discount from the book values. Since the relevant market price did not exist due to rare transactions of NPLs prior to and during the crisis, the actual transactions between financial institutions and KAMCO could not help being led by the government. FSC decided to qualify the NPLs for transactions and mediate the price based on factors such as loan recovery rate, default rate, auction discount rate, etc. Table 4. KAMCO’s Acquisition and Resolution of NPLs(As of June 30, 2002)(unit: KRW trillion)ClassificationPurchasedResolvedFace ValuePurchase PriceFace ValueRecovery ValueOrdinary Loans29.89.224.010.4Corporate Loans under In-court Restructuring41.117.033.515.4Corporate Loans under private Restructuring34.513.24.22.6Total105.439.461.728.4Source: Korea Asset Management Corporation (KAMCO)Table 4 shows that KAMCO acquired NPLs of KRW 105.4 trillion, or US$ 87.8 billion, in face value at the purchasing price of KRW 39.4 trillion, or US$ 32.8 billion, during four and half years of operation. Out of the acquired assets, KAMCO disposed of the assets nominally worth KRW 61.7 trillion, or US$ 51.4 billion, at the selling price of KRW 28.4 trillion, or US$ 23.7 billion. Table 5 shows the details of NPL resolution by the respective methods utilized. It is important to note that various methods and techniques have been employed, depending on the characteristics of the NPLs. The adoption of market prices vis-à-vis NPLs has an important policy implication on KAMCO’s disposition of the acquired assets. Since KAMCO purchased NPLs at close-to-market-prices, it could make profits if it was able to add value through such actions as restructuring or pooling bad loans. Otherwise, it would incur losses, no matter what efforts devoted, for all NPLs could not be restored performing. This approach removed the binding constraints on selling prices for KAMCO, allowing more flexibility in its approach. Actually, KAMCO performed quite successfully, making profits of KRW 2.4 trillion. Table 5. KAMCO’s NPL Resolution by Methods(As of June 30, 2002)(unit: KRW trillion)ClassificationAccumulated ResolutionFace ValuePurchase PriceRecovery ValueProfitsInternational Bidding6.11.31.60.29ABS Issuance 8.04.24.1-0.08Sale to AMC2.60.70.90.26Sale to CRC1.80.40.70.31Individual Loan Sales2.00.50.60.14Court auction, Public Sales8.22.53.10.57Collection10.63.65.01.41Others1)2.21.51.90.32Sub Total41.514.717.93.23Recourse & Cancellation18.19.79.7-Total59.524.427.63.23Note: 1) CRV resolution, recovery by restructuring plan, etc.Source: Korea Asset Management Corporation (KAMCO)5. NPA Resolution MethodsThe following methods have been taken to resolve NPLs in practice.5-1. Outright Sale to Third PartyOutright sale is the action of selling directly to a third party, with an aim at recovering loans at the highest price possible. These sales are either made individually or in bulk. Individual Sale: The individual sales methods are classified into court auction and corporate loan sales. Court auction is used for selling secured loans. Auctions are held after a creditor’s request to the court to hold an auction according to foreclosure laws, and the court pays the sale proceeds to the creditor. Loans are recovered by selling the collateral properties without title acquisition by the creditor. The corporate loan sales method, a method utilized by KAMCO to sell loans separately, can be classified into M&A and Individual Corporate Loan Sales (ICLS). KAMCO’s Corporate Disposition Department was engaged in individual corporate loan sales for borrower companies which had both high brand value and liquidity problems, or companies which had a high possibility for recovery. Bulk Sale: The Bulk sales are a method that involves pooling assets such as NPLs and real estate collateral and selling them to a third party for quick cash. By adapting this sales method, the seller can resolve a massive amount of NPLs through auctions or negotiations. In addition, the seller is able to enhance its balance sheet, while the buyer achieves better management of assets through the economy of size. As most buyers are likely to purchase NPLs at discount, they are in a stronger position for debt negotiation than the originating banks. One of the advantages of bulk sale is that the seller is able to sell off the assets of poor quality by pooling them with relatively healthy ones. 5-2. Sale to a Joint Venture Special Purpose Vehicle (JV-SPV)KAMCO and an investor formed a Joint Venture Special Purpose Vehicle (JV-SPV) to store NPLs for future resolution through disposal and restructuring. In this process, KAMCO moved NPLs to the balance sheet of SPV, based on which bonds and equities were then issued. KAMCO and JV Investor equally subscribed to the SPV-issued securities. KAMCO paid 100% in NPLs and received 50% in cash and 50% in securities issued by the SPV. The investor paid 50% in cash and receives 50% in the same securities. KAMCO and the investor also formed a JV-Asset Manager to professionally manage the warehoused NPLs. Even though KAMCO had 50% ownership of the Joint Venture SPV, the SPV was legally independent of KAMCO, hence KAMCO could recognize legal and accounting sales on their balance sheet. The benefits of selling to a joint venture SPV as opposed to an outright sale is that KAMCO could realize upside potentials of future NPL values, through capital gains in the SPV equity owned by KAMCO. However, only half of the cash value was at the initial sale to the SPV. Figure 2. Joint Venture SPV950595259715005-3. Asset Backed SecuritizationTo more fully realize the benefits of the SPV as a warehouse for NPLs, KAMCO established its own SPV for the resolution of NPLs in the future through disposal or restructuring. In this process, KAMCO transferred NPLs to a SPV at a fair price determined by an independent accounting firm. The SPV issued bonds and equity up to the value of the NPLs acquired. KAMCO subscribed to the SPV-issued equity only, and a 3rd party investor subscribed to the SPV-issued bonds. KAMCO paid 100% in NPLs and received approximately 90% cash and the balance in equity securities, while the investor paid in 90% in cash only. The purpose of issuing 10% in equity is to provide a buffer over the collateral amount to the investor, in case the value of the NPLs did not recover. KAMCO’s Disposed Asset Management Department managed the warehoused NPLs, as the SPV did not have any capacity to do so. Even though KAMCO had partial ownership in the SPV, the SPV was legally regarded as independent of KAMCO, hence KAMCO could recognize the sale as legal and account it on their balance sheet.The benefits of selling to a KAMCO sponsored SPV is that KAMCO was entitled to the whole upside potential of NPLs value in the future. The gain could be realized as a capital gain on the SPV equity owned by KAMCO. Additionally, 90% of the cash value was raised at the initial sale to SPV. 5-4. Debt to Equity SwapFrom the viewpoint of lenders: For financial institutions, debt to equity conversion has the following advantages; 1) resolution of NPLs, 2) meeting the BIS ratio requirements, and 3) normalizing corporate operations and reinforcing the supervisory function of corporations. However, there are the following disadvantages; 1) losing rights (security rights) as a creditor, 2) possibility of leading to corporate insolvency in case of liquidation, and 3) danger to be used as a cover-up for insolvent loans. From the viewpoint of borrowers: The advantage of a debt-equity swap is a lower debt-to-equity ratio as it is not converted into bonds. The disadvantages are a potential to lose management power due to lower shareholdings. 6. Performance Evaluation and Lessons LearntDrastic restructuring with an injection of the Public Funds laid a ground for regaining health and efficiency of the financial system. In the course of financial restructuring, around 630 non-viable financial institutions closed operations (See Table 5), while the Korean government dispose of NPLs of ailing institutions worth approximately KRW 157 trillion with the Public Funds. The speedy settlement of bad loans reduced NPLs in the banking sector to KRW 61 trillion by the end of June 2002, the equivalent of approximately 2.4 percent of total lending (See Table 5 and Table 6). Table 5. Number of Financial Institutions(unit: %)Market Share1)Number of Institutions19971998199920002001Banks543325232220Merchant Banking Corporations9301410103Securities Companies43631324346Insurance Companies124540403433Investment Trust Companies113125232730Mutual Savings & Finance Cos.4231211186147122Credit Unions21,6661,7401,4441,3171,268Leasing Companies42525211516Total1002,0972,1111,7791,6151,538Note: 1) Share of total assets as of the end of 1997.Source: Financial Supervisory CommissionTable 6. Non-performing Loans of Financial Institutions in Korea (As of June 2002)(unit: KRW trillion, %)SectionBanks Nonbanks DepositoryInsuranceSecurities & ITC Total Loans (A) 603.2113.347.88.5Substandard Loans (B) 14.211.82.23.9Uncovered Substandard Loans (C)7.33.70.91.2Substandard Loan Ratio (B/A) 2.410.44.645.9Uncovered Substandard Loan Ratio (C/A)1.23.61.920.7Why has Korea been relatively successful in financial restructuring in comparison with other Southeast Asian countries experiencing crises at the similar time? As in many reform movements, democratic leadership is crucial, given that the political economy of reform revolves around social pressure stemming from conflicts of interests. At the beginning of the crisis and for a while thereafter, Korea had effective leadership that not only fully committed to reforms but was also able to manage the social fallout. Only 20 days after the outbreak of the crisis, the new president was elected for a five-year term, allowing his administration to make and implement a long-term plan for reforms. Under strong political leadership, Koreans acted cooperatively to yield material outputs. One of the salient examples of cooperation is the Gold Collection Movement in late 1997 and early 1998. Though only US$ 2.2 billion worth of gold was collected under the campaign, it was enough to demonstrate Koreans’ ability and commitment to coalesce under crisis, which is in line with a long tradition found in Korean history.Preemptive institutional building significantly shortened a period of time for devising plans and also curtailed inevitable debates and conflicts over restructuring. For example, the consolidated Financial Supervisory Commission (FSC), prepared well in advance, started at the same time as financial restructuring, while the Non-performing Asset Management Fund (NPAF) was founded before the crisis and KDIC was established a year ahead. All of these mechanisms played crucial roles in the reform. Lastly, but not least, timely international assistance prevented the financial crisis from amplifying up to the level of default for the country. Domestic efforts alone could not have mediated to mold a whole-lot new financial architecture.Recall that one of the key success factors in KAMCO was absence of any reservation price, in other words, KAMCO accepted any price determined by market demand and supply, no matter how miserable and disappointing it was. As such, bold and decisive decisions by the government are essential in the success of a seller type of AMC. In general, the first observable price just after the crisis tends to be too low to accept as a right market price. Korean experiences show that the belief and consistency in market transactions, even if they are not favorable to policy makers, would turn out a successful story at the end. In addition to rapid and efficient disposal of NPLs, KAMCO contributed to creating an NPL market and helped build up necessary capacities to resolve distressed assets afterwards. In the absence of relevant infrastructure at the beginning of the 1997 crisis, KAMCO functioned itself as a market where NPLs were traded and played a role of market maker. In the process of selling the NPLs to not only international and domestic investors, KAMCO enlisted various services from law, accounting, real estate, and management consulting firms. These services enabled KAMCO to accumulate a great deal of experience and expertise. Also, KAMCO hired many domestic investment banks to engage in NPL transactions. These experiences and expertise have been transferred to private sector, becoming an indispensable building-blocks for efficient market-based NPL resolution system.As a result, Korea utilized these experiences to develop NPL markets and infrastructure. From an institutional aspect, insolvency laws, credit collection laws, laws and regulations on securitization, etc. have been upgraded and/or newly made into law. This system provides a platform to dispose of NPLs even in the normal times. In fact, the crisis was an opportunity to upgrade and deepen Korea’s financial infrastructure.ReferencesHahm, Jun-Ho (2002), “Reconstruction and Reform of the Korean Financial System”, mimeo, Yonsei University.Jeong, Jae-Ryong and Eun-Ju Hong (2003), Distressed Assets Resolution: A New Frontier of Financial Industry, Samsung Economic Research Institute.Kang, Dongsoo (2004), “Key Success Factors in the Revitalization of Distressed Firms,” Journal of Restructuring Finance, Vol. 1, No. 2.Klingebiel, Daniela (2000), "The Use of Asset Management Companies in the Resolution of Banking Crises: Cross Country Experiences", Policy Research Paper 2284, World Bank.Lee, Hun-Jai (1988), “FSC and its Future Role,” presented on April 25th, 1998, at a seminar sponsored by Financial Times.Lee, Sung-Kyu (2000), Explanations on the Corporate Workouts for Restructuring Specialists, Corporate Restructuring Coordination Committee.Scott, David (2002), “A Practical Guide to Managing Systemic Financial Crisis: A Review of Approaches Taken in Indonesia, the Republic of Korea, and Thailand.” World bank Working Paper Series No. 2843. ................
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