Korea Capital Market Institute

There were very few cartels in the financial industry since the introduction of cartel regulation to Korea in 1975. However, since 2000, based on the number of cartels filed by the Fair Trade Commission of Korea(hereinafter, the KFTC), a total of 12 cases were associated with financial industries: four in the banking industry, seven in the insurance industry, and just one in the capital market. Strikingly, nine cases have been filed since 2007.
It became a new trend in Korea that cartel regulations on the financial industry have been reinforced more than ever before. Despite this trend, the financial industry does not understand  new regulatory changes for two reasons. The first is the financial industry used to be regulated by the financial authorities. For this reason, they are not considering that cooperation between financial companies can be regulated by the KFTC rather than the financial authorities.
The second is they regarded joint actions as natural to help financial markets work orderly and efficiently. Due to negative externalities or information asymmetry, the financial industry could be easily over-competitive and therefore become inefficient.
Because of this, self-regulation among financial firms has been widely recognized as a way of limiting over-competition. hey not consider that the joint self-regulation can be judged as a illegal cartel and thus regulated by the KFTC.

The report is to examine how a joint activity in the financial industry could be judged as an illegal collusion. In particular, the report theoretically show that limiting competition is not illegal if the joint activity improves social welfare. analyzing a oligopolistic market with negative externalities, which can be extended to a general market with market failures, in this study provides reasonable criteria for judging collusion illegality rather than current cartel regulations.
Article 19 of the Fair Trade Act says that an illegal cartel is defined as an unfair collaborative act between more than two firms, entrepreneur shall agree with other entrepreneurs by contract, agreement, resolution, or any other means, to jointly engage in an act which unfairly restrict competition or allow any other entrepreneur to perform such unfair collaborative act. However, the meaning of “unfair” is not explicitly presented in the Act. Therefore, the criteria of collusion illegality may depend on how “unfair”.
The KFTC interprets the meaning of “unfair” in Article 19 of the Act as representing the characteristics of anti-competitive collusions. Therefore, it is also regarded per se illegal since they believe anti-competitiveness is illegal by itself. For this reason, the KFTC tends to focus anti-competitive agreements between suspected firms.

However, the KFTC's decision often reversed by the Court. Recently, the Court began to require collusion illegality to be prove as an independent requirement, let alone proving anti-competitiveness. That is, it can be judged that an anti- competitive cooperation is legal. For example, in the case of fixing insurance premiums in May 2011, the Supreme Court judged that fixing the premiums in the case is not illegal if the collective decision on the premiums has enhanced each company's financial health and ensured ‘balanced development of the national economy’.
The reason why the Court perceives collusion illegality as a separate and independent requirement is because it judges the rationale of regulating cartels based on whether the collusive actions spontaneously agreed by firms infringe ‘social welfare’ or ‘market efficiency’. It is in line with the rationale of limiting private property rights guaranteed in the Constitution. The Constitution allows limiting private property rights only when they are not suitable for the social welfare. Therefore, a cartel should be a collaborative act which infringes social welfare so much more than it restricts the freedom of competition. Also, if collaborative act restricts competition but improve social welfare, it is not illegal in origin and thus shouldn’t be as an illegal cartel.
The report also suggest reasonable and proper criteria for collusion illegality by evaluating the KFTC’s current criteria.

In particular, it considers the characteristics of the financial industry that tends to easily be overheated and over-competitive.
The KFTC established ‘Collaborative Act Guideline’ to judge whether an observed collective action agreed by more than two firms is illegal. Lee(2008) stated that the KFTC guideline describes the step-by-step procedures of deciding whether the collective action is illegal. In , it a collusive action is illegal if the action is agreed by more than two firms in a market and to limit competition in the market. It presumes that illegality is implied by anti-competitiveness itself.
The KFTC’s judgment on illegality begins with analyzing the characteristics of a suspected collaborative action. First of all, the KFTC analyzes if the action is obviously anti-competitive. For example, fixing price or quantity or segmenting a market is referred to an obviously anti-competitive collusion.
Next, if the action comes with the effect of, the final decision is made after comparing the effects between limiting competition and increasing efficiency. The effect of limiting competition is evaluated by whether the market share of firms within the collective action has increased before. In turn, the effect of increasing efficiency is analyzed based on whether to improve consumer surplus or promote market competition. Here, it is worthy to note that the KFTC determines the effect of increasing efficiency based on consumer surplus rather than social welfare. That is, the effect of increasing efficiency is not if the collective action decreases consumer surplus.

There are two shortcomings in the current KFTC guideline. The first is that the obviously anti-competitive collusion is determined as illegal whereas the action improves social welfare. The second is that the effect of increasing social welfare is not whenever the action results in decreases in consumer surplus.
The rationale for regulating cartels is that anti-competitive collusion may infringe market efficiency and eventually worsen social welfare. If so, it may not be rational to regulate a collusive action that improves market efficiency and increases social welfare.
The report examines whether the freedom of competition may result in market inefficiency or a market failure by using the oligopoly model with free entry of Mankiw and Whinston (1986). In equilibrium of this model, excessive entries occur because private entry cost is less than social entry cost, which leads to an inefficient equilibrium of overproduction with lower price than the socially optimal level. In such a situation, jointly limiting competition may improve market efficiency.
However, the KFTC determines the obviously anti-competitive collusion is illegal by itself and also the Court judges the anti-competitive collusion itself is illegal but exceptionally denies the illegality in cases of having special reasons. As shown in the model of Mankiw and Whinston(1986), the anti-competitive collusion would not be illegal in origin in the existence of market inefficiency. If so, it is necessary to the current KFTC guideline and establish a clear and reasonable criterion on illegality.

What is the extent that anti-competitive collusion is allowed in an inefficient market? To answer this question, the report analyzes a Cournot model with negative externalities. The negative externality is the case that social marginal cost in production is higher than private marginal cost in production. Due to negative externalities, the level of production is over-provisioned and thus the price is lower than the social optimal level. That is, the negative externalities result in much competition more than the social optimal level.
Such an over-competition is also a loss to firms. Thus, firms may agree to fix the level of production to the socially optimal level. In this case, firms’ profit increases but consumers’ surplus decreases, resulting in improving social welfare in sum. That is, fixing the level of production is the exercise of the right of private property which is suitable for social welfare.
But the KFTC guideline determines that fixing the level of production is illegal if the existence of an agreement between firms is since it is obviously limiting competition. Though the anti-competitive collusion improves market efficiency and thus increases social welfare, the effect of increasing efficiency would be ignored only because consumer surplus decreases with it.
Therefore, the current KFTC guideline should take into account the characteristics of an inefficient market with market failures. In particular, collusion illegality should be judged on whether to infringe market efficiency and social welfare rather than on the characteristics of a collective action.

The changes in the KFTC guideline do not affect the illegality criteria oligopolistic markets. It is because market power in an oligopoly is one of the factors causing market inefficiency. In this case, if there are no other factors causing market inefficiency, an anti-competitive collusion may aggravate market efficiency so that it can be determined as illegal.
On the other hand, if the anti-competitive collusion is excessively practiced even in an inefficient market, it should be regulated as illegal. That is, the action should be regulated as illegal cartel if it targets more market power than the socially optimal level or it is practiced to attain other purposes.
The findings of the report can be applied directly to the cartel regulation on the financial industry. It is because the financial industry tends to easily get competitive to a greater extent than the socially optimal level, as presented by the Financial Supervisory Commission Chairman before the KFTC staff in December 7, 2007.
Furthermore, market inefficiencies in the financial industry have been indeed prevented by public regulators. However, due to limited resources in public sectors and procedural limitations, self-regulation also played role remedying market inefficiencies.
The certificate of deposits(CD) rate case which the KFTC started to investigate July 2012 can be understood in the same context a collective action in an inefficient market. In recent years, marketable CDs are not well circulated in the money markets and even are not digested in the primary markets.

As a result, there has been controversy over whether the CD rate functions properly as a representative indicator of short-term interest rates. Meanwhile, if the CD rate is not disclosed properly and continuously, mortgage loans and derivatives markets could be in a negative way.
The report suggests that the current KFTC guideline should be developed in threeways taking into account the nature of the financial industry which is prone to excessive competition. First, illegality should be determined independently regardless of whether the collective action is obviously anti-competitive. Therefore, it is necessary to set up a procedure of a judgment on illegality depending on whether to infringe market efficiency rather than whether to cause anti-competitiveness. Nonetheless, it could be difficult to objectively measure the effect of market efficiency and thus it should be considered apply the new criterion to the in.
Second, it should be analyzed what factors cause inefficiency in a given market. In other words, the reasons of over- competition. It is because it could not be illegal if a collective action limits over-competition and results in improving social welfare.
Third, it should be evaluated whether the anti-competitive collusion improves social welfare rather than consumer surplus or market competition. If the action is purpose to improve market efficiency and also social welfare, it could not be determined as illegal.

However, if the action is anti-competitive more than the socially optimal level, it is necessary to be judged as illegal.
In summary, it is more reasonable that a collective action’s illegality should be judged based on the effect of the action on market efficiency and thus on social welfare, rather than on the anti-competitive nature of the action itself.