Unsurprisingly, there are grave concerns about the countryÆs new investment banks taking significant principal investments or engaging in the type of large-scale proprietary trading which had been cash cows for the top five US investment banks during the four years up to the summer of 2007. In a world where access to both short-term liquidity and long-term capital is tough, there is also anxiety about whether Korean banks will find sufficient funding sources. Indeed, this is already a struggle for them.
The government wants to transform Korea into a Northeast Asian financial hub, by attracting the worldÆs leading asset management companies to establish their regional headquarters in Seoul, expand the domestic presence of foreign financial institutions while also elevating at least one domestic firm to be a regional champion. Having fostered a more vibrant asset management business and set up a sovereign wealth fund, the Korea Investment Corporation (KIC), the government is pushing ahead with building an edifice on this foundation. The intention is that Korea should be a specialised financial hub by 2012, before moving to the third stage which should see Seoul evolve into one of AsiaÆs top three financial centres and attract foreign commercial and investment banks to set up their regional head offices.
The authorities envisaged the formation of financial investment companies, incorporating departments active in securities trading and intermediation, asset management, merchant banking, trust business and futures trading. Originally, they expected rapid growth in the exchange trading of derivative products other than the already actively traded equity warrants and options û fuelled by investment banks moving their focus away from financial advisory services (and underwriting) towards principal investment and proprietary trading û in line with the five US paragons: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley.
Samsung Securities identifies several examples of principal investments (PI) made by brokerages last year, including Samsung itself, which set up a PI team in its investment banking division to take stakes in pre-IPO firms and arbitrage M&A opportunities. Daewoo, which is part of Korea Development Bank (KDB), has bought stakes in Indonesian coal mines and Chinese building projects; Goodmorning Shinhan has invested in bio-diesel schemes in Laos, real estate funds in Kazakhstan and domestic and foreign IPOs; Korea Investment Holdings invested W1 trillion ($863 million) in Shinhan Financial GroupÆs LG Card takeover; and Hyundai has spent more than W500 billion for holdings in Hyundai Wise Asset Management, housing complexes in Kazakhstan and overseas securities.
FISCMA (also still popularly called the Capital Market Consolidation Act) was passed by the National Assembly in June 2007, and will be enforced from February next year. The model for the new regime is based on the US, UK and Australia. There will be a shift from institutional to functional regulation with a classification of operations into six business areas (dealing, intermediation, asset management, discretionary or non-discretionary investment advisory services, and asset custodian management), so jettisoning the current chaotic system where different types of institutions operate under different frameworks even if they offer similar products and services.
Instead of a Securities & Exchange Act covering securities firms or a Futures Trading Act controlling the activities of futures firms, for instance, there will be just one article on ôdealingö within FISCMA.
Market participants have been expected to improve their systems and adjust their equity capital within the grace period. Already, securities firms participating in any of the six business areas have either had to get a new license, or go through a registration process. Meanwhile, banks and insurers have had to report details of their financial investment services to the authorities. Any breach of conflicts of interest between investment trust companies (ITCs) and the new financial investment companies û for instance, stuffing the former with unwanted securities û will be punished by criminal and administrative penalties.
Falling barriers
Meral Karasulu, who was resident representative of the International Monetary Fund (IMF) Korea, before the multilateral lending agency left Seoul at the beginning of September, points out that the Act ôwill remove restrictions that separate securities, futures, asset management, trust services, and other financial services businesses, and introduce a negative list for new financial products providing opportunities for innovationö.
There will be an all-inclusive, ôanything goesö approach towards new product development, unless otherwise proscribed û although local bankers reckon the Financial Supervisory Service (the overall regulator of KoreaÆs financial institutions) is likely to show its disapproval of more risky and exotic instruments through its usual paternalistic practice of moral suasion. And there will be distinctions made between securities, exchange-traded derivatives and OTC derivative products. Brokers will be allowed to transact futures and investment trust business. The idea is that investor protection will be enhanced, with firms taking full responsibility for sales to their customers through a variety of fiduciary, contingency and product disclosure obligations.
Brokerages will be allowed to participate in retail payment and settlement services û once the preserve only of banks û which will give them access to new customers and cut funding costs. A lot of hope too has been pinned on the development of diverse and innovative product portfolios to boost the derivatives market. Policymakers expected that large brokerages would transform into investment banks, while small- and medium-sized firms, unless they agreed to sell up or merge, were expected to become niche players- in specialised asset management or as on-line service providers. Bank-affiliated brokerages, such as those sitting within financial holding groups (FHGs), would have a clear incentive to strengthen their asset management businesses, taking advantage of their parent banksÆ retail customer base. They might also build up their corporate banking businesses, tapping into their parentsÆ capital and corporate customer relationships.
Deregulation has been on the agenda since 1993 when the government allowed banks to buy insurers and brokerages as subsidiaries. The first major piece of reform took place in the immediate aftermath of the financial crisis when there was a government-driven consolidation of bad banks in 1998-1999. Voluntary consolidations, acquisitions and transitions into financial holding companies followed over the next decade. So far though, the process had been driven mainly by banks. The next phase is different. From next year, consolidation should be led by the non-bank financial sector, as mergers and acquisitions take place among brokers, insurers and asset management firms.
Industry consolidation
According to Karasula, ôthe act is expected to lead to consolidation of the securities industry and the emergence of domestic investment banks. Increased competition should generate efficiency gains, improve the allocation of capital, and raise the role of the financial sector in generating long-term growthö.
Few doubt that merger and acquisition activity within the crowded brokerage sector is inevitable as a wider range of businesses will require greater capital requirements. And it has already started. Kookmin Bank bought Hannuri Investment & Securities last November and plans another takeover; state-owned Industrial Bank of Korea has been allocated W1 trillion for a purchase; CJ I&S has been hiring to beef up its investment banking department and plans an initial public offering next year; Woori I&S intends to merge with a large domestic or foreign broker and reach W5 trillion in net assets; and both Seoul Securities and NH I&S have also been considering M&A as a way to expand.
And, of course, KDB made a bold û or reckless û dash for investment banking glory by trying to take a stake in Lehman Brothers in early September, which ended in ignominy for the state-owned bankÆs chief executive and former Lehman country head, Min Euoo-sung.
Samsung Securities believes that in the future, wealth management services rather than brokerage revenue earned from commissions - which are under increasing pressure - will be the key determinant of broker competitiveness.
In the new world, brokers will need to expand their customer base and diversify their revenues, as business models concentrate on the strengths of bank- or group-affiliated, specialised or foreign brokers. Bank-linked brokers, such as Daewoo and Woori I&S, should benefit from bigger distribution channels sourced from a wide customer base; those which are part of large conglomerates (chaebols), such as Samsung Securities, will have synergy advantages from access to corporate pension schemes for instance; specialised brokers, such as Mirae Asset Management and KIH, are likely to stick with what they know best; while foreign brokers, such as Goldman Sachs and J.P. Morgan, could boast superior brand power and product know-how û that is until recent events tarnished the former and cast considerable doubt on the latter.
Samsung Securities highlights synergy effects above all else, and thus concludes that securities brokers with various financial and manufacturing affiliates should have the advantage in the new landscape. In other words, firms rather similar to Samsung Securities.
The development of KoreaÆs capital markets is predicated on the view that as the countryÆs GDP per capita increases, demand for financial assets should also rise. Following the examples of the US and Japan, demand for financial assets start to rise rapidly when GDP per capita exceeds $15,000.
And it is macro factors, such as pension plan changes and a re-allocation of household assets, that are expected to be the most important growth engines for the securities industry. Regulatory changes in themselves wonÆt be enough to galvanise it û capital market growth in the US, UK and Australia was driven far more by pension fund reform. Also stacked against Korea is the relatively small size of its economy û less than 20% of JapanÆs and about 6% of the US - the low status of the won, and language issues.
The ruling Grand National Party is keen to maintain the FISCMA in its current form, but might concede greater reporting requirements for banksÆ capital adequacy ratios, derivatives exposure and other risk measurements. What is clear is that banks will not be allowed the 30% leverage that US ômonolineö banks were, now notoriously, permitted to take.
The IMFÆs Karasula warns, that ô[FISCMA] will place a premium on enhancing financial oversight and may increase wholesale funding dependence of banks, raising vulnerabilities and necessitating a change in their business modelsö.
One Seoul-based foreign bank chief reckons that, first and foremost, banks will need to find a low-cost funding source; they will be compelled to introduce much more robust risk management models; and that their leverage will be capped at 15%-20%. But, he points out, the financial sector is constantly evolving and will take an increasingly prominent role in KoreaÆs economy.
Banks are unlikely, however, to have the global, regional or even domestic impact the countryÆs planners originally intended. Instead, Korea might be forced to continue its reliance on manufacturing and technology that has been its growth engine for the past half-century. And that may not be such a bad thing.
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