Korea Capital Market Institute

The financial sector is having heated discussions as regulatory reform emerges as one of Korea’s top national agendas. There is still a long way to go before the discussed ideas materialize as reform. The most difficult task of all is persuading the numerous economic entities with conflicting interests to reach a consensus. Hence, in order for regulatory reform to achieve substantial results, it is necessary to set the fundamental direction first. If consensus is reached about the overall direction, it will be easier to coordinate conflicting interests and maintain momentum. More importantly, it will help the reform be more effective, consistent, and persistent. This article diagnoses the trends in developed nations’ financial reform, and draws out the fundamental direction in which Korea should head. Based on that, I present concrete actions Korea should carry out.

The 2008 global financial crisis triggered considerable changes in financial regulations because it exposed new risks of which regulators were unaware. Indeed, some risk factors unveiled during the crisis were completely unconventional, and this made the case for regulatory reform all the more convincing.

Although new regulations were added and many were modified and strengthened, quite a few regulations remain unchanged. This is an indication that some rules were effective even during the crisis, reflecting the innate constancy of the financial industry. To better grasp the holistic picture of post-crisis financial regulation, it is useful to examine the immutable regulation, together with new and modified ones.

Global trends

In the post-crisis era, many developed countries, e.g., the US, the UK, and the EU nations, changed many regulations by adding new rules and modifying existing ones. The overall post-crisis regulatory reform can be broken down to two elements: one regarding universal banking, and the other about systemic risk. The former restricts banks from operating in-house securities business, and bank-affiliated securities firms from engaging in the high-risk securities business. The latter strengthens prudential regulation on banks, toughens regulation on systemically important financial institutions (SIFIs), and establishes new rules on large private equity funds and OTC derivatives. To sum up, post-crisis regulatory reform attempts to contain moral hazard involved in universal banking and rein in systemic risk.

On the other hand, there are two types of regulation that survived the global financial crisis: one is the regulation of synergy created from universal banking, and the other is the regulation over capital market firms. Overseas financial markets generally allow affiliates to share information and their executives to hold more than one position concurrently within a business group; this remains the same after the crisis for the sake of synergy creation among affiliates. It is worth noting that this came when the separation between banking and securities business grew wider. Also unchanged is the regulation on capital market firms. While new regulations are in place to regulate SIFIs, e.g., large investment banks and private equity funds, other capital market firms are barely subject to the regulatory reform.

The aforementioned global regulatory reform reveals the following three trends. First, while trying to contain the risk from banks operating their in-house securities business, the reform leaves room for synergy creation among affiliates. This reflects the policy intention to rein in systemic risk and moral hazard of the universal banking model. But it also acknowledges that banking and securities affiliates should share information and allow for their executives to hold concurrent jobs in order to create synergy. Limiting those two activities would de facto eliminate the benefits of operating banking and securities businesses within one firm.

Second, the regulation to control systemic risk is more stringent. Excessive credit was the primary cause of the recent global financial crisis, and therefore, it is necessary to preemptively contain credit bubbles. This is the rationale behind the strengthening of bank’s prudential regulation, which is related to traditional systemic risk. Another point to note is the recognition during the financial crisis that the capital markets are not completely free from systemic risk. As a result, the coverage of systemic risk regulation was extended to large financial firms and OTC derivatives trading, both of which once sat outside the regulatory boundary.

The pursuit of dynamic and innovative capital markets has never ceased. As mentioned above, the overall regulatory framework for capital market firms, except for certain large ones, remains mostly unchanged perhaps due to the judgment that the capital markets’ innate dynamics and innovation should be protected unless they directly give rise to systemic risk.

Recommended direction for Korea’s regulatory reform

The desirable regulatory direction for Korea is to converge the domestic regulations into the aforementioned three trends. The convergence should take into account the innate, universal properties of the financial industry. The areas with the greatest regulatory disparities between Korea and other countries require dramatic change. At the same time, Korea-specific factors should be considered in setting its regulatory direction. Simply put, Korea should consider the aforementioned three global regulatory trends in addition to Korea-specific conditions in determining its future direction for reform as described below.

1. Contain risk, but allow for synergy creation
When it comes to the first global regulatory trend, Korea should toughen its regulation on banks’ in-house operation of the securities business. The US has strictly separated banks from the capital market-related business for a long time. Since the global financial crisis, the UK and the EU are also shifting toward ring-fencing their capital market-related functions from commercial and savings banks. On the other hand, Korea places weak regulations on banks’ in-house operations of stock investments, OTC derivatives, and PEF investments. Since banks are SIFIs, it is not desirable for them to engage in the capital market-related business within their organization. This can lead to moral hazard because banks benefit from various safety nets, e.g., deposit insurance and the lender of last resort. In this regard, it is necessary to ban banks from engaging in their in-house capital market-related operation.
One may recommend restricting bank-affiliated securities firms from engaging in high-risk trading (e.g., prop trading, and investments in hedge funds and PEFs) like in the US. But such a rigid restriction could be excessive for Korea where high-risk trading is still inactive. Regulating the business of bank-affiliated securities firms should be a mid- to long-term goal that should be put off until the high-risk securities business takes hold in Korea.
Another issue is to leave room for synergy creation among affiliates within a business group. Unlike other countries, Korea places significant limitations in executives holding multiple positions in the same hierarchy within one business group (“horizontal” positions). Those limitations, however, seriously hinder synergy creation among affiliates, thus eliminating the basis on which financial holding companies stand. Those limitations should be relaxed considerably.

2. More stringent systemic risk regulation
The first priority related to the systemic risk regulation is identifying and containing systemic risk in the capital markets. The recent financial crisis confirmed the possibility of systemic risk through the capital markets. But this is unlikely for Korea given the capital markets’ current size and interconnectedness. Nevertheless, it is still necessary to identify any factors that may give rise to systemic risk in the mid to long term, and then closely review ways to contain the risk.
The next challenge is supplementing the regulations regarding OTC derivatives trading, which vary across countries. More specifically, Korea’s regulation is imperfect in governing trade repositories and electronic trading platforms. Also, Korea’s current registration system through which financial firms must pass to handle OTC derivatives should be extended to other major market participants. Furthermore, for risk readiness, the current
intraday margin placed for central counterparty clearing of OTC derivatives should be extended to exchange-traded derivatives.

3. Sustain the dynamics and innovation in the capital markets
Developed nations barely changed their regulation on capital market firms. Their intent is to facilitate the dynamics and innovation in the capital markets by having relaxed regulation as long as those firms do not directly cause systemic risk. Korea should follow that stance: It is necessary to ease regulation on capital market firms because Korea’s regulation is largely different from that of other nations.

(3-1) Securities industry
Korea’s regulatory reform for the securities industry has three challenges. First, the license system for the financial investment business should be simplified, and the entry barriers should be lowered. Currently, business units are excessively subdivided, which in practice acts as an entry barrier and hindrance to business extension. Those subdivided units need to be integrated and simplified as in other countries. Moreover, the requirements to enter the industry are excessive compared to those in other nations. This deters both the entry and exit from the industry, ultimately contracting the vitality of the capital markets. Hence, the entry requirements should be lowered.
Second, the OTC market regulation should be loosened. In other countries, securities firms play an important role in trading and dealing both exchange-traded and OTC securities. Korean securities firms, in contrast, are limited in their business related to OTC securities. This narrows the paths of investment exits and makes it difficult to meet the wealth management demand. Furthermore, the lack of activity in the OTC market negatively impacts the primary market.
Third, securities firms should be allowed to engage in more diverse business scopes. Unlike other markets, the Korean market has substantial restrictions in the foreign currency and foreign exchange business. Those rules make it difficult for securities firms to satisfy Korean investors’ overseas investment demand, but also hinder domestic players’ business globalization strategy. It would be wise to relax those restrictions and to switch the relevant regulation to a negative system.

(3-2) Asset management industry
With regard to asset management, first, a dual regulatory regime should be introduced. In other markets, publicly and privately placed funds are treated differently because regulating both these funds, which are completely different in nature as far as investor protection, requires a different regulatory purpose, regime, and level. But Korea’s fund regulation whose primary focus is on public offerings also covers most privately placed funds and their managers. That type of regulatory regime is not suitable for the nature of privately placed funds. Korea would benefit from a dual regulatory regime, one for public offerings and the other for private placements. Privately placed funds should be subject to the regulation much looser than publicly placed ones.
Second, the level of entry and prudential regulation should be relaxed sufficiently. Like the securities industry, Korea’s asset management industry faces entry requirements much higher than those of other nations. It seems obvious that they should be lowered to facilitate dynamic innovation in the capital markets. The integration and consequent simplification of the subdivided license system will substantially lower the entry barriers. Also notable is Korea’s prudential regulation over the asset management industry. It exists only in Korea and conflicts with the innate nature of the asset management business. Therefore, it is advisable to shift away from the current regulation toward a system that regulates operational risk.
Third, the regulatory regime needs to improve its consistency. Currently, each type of privately placed funds is regulated differently as stipulated in the Financial Investment Services and Capital Markets Act (FSCMA). This arrangement may create regulatory arbitrage and undermine the discretion of privately placed funds. Integrating the rules for privately placed funds, hedge funds, and PEFs into a single regulatory regime will not only eliminate regulatory arbitrage, but also provide asset managers room to maneuver when choosing the best strategy. In addition, all funds should be regulated by a single act to enhance consistency in investor protection.

Conclusion
Financial regulatory reform has entered the limelight as one of Korea’s national agenda. The financial sector has been debating this issue, with all the industries in the sector proposing detailed reform ideas based on their hands-on experience. It is impossible to overemphasize how important those ideas are in making the reform more viable. But without setting the fundamental direction in which the reform should head, those individual, microscopic proposals will have substantial limits. Dealing effectively with individual proposals when they collide will be extremely difficult without a holistic, macroscopic direction. Regulatory reform without that kind of clear direction will easily lose its momentum, effectiveness, and persistence.
Given that regulatory reform requires the extreme difficulty of persuading countless economic entities that have conflicting interests, setting the overall direction in advance is too important to ignore. Going forward, Korea should simultaneously develop microscopic ideas and set a macroscopic direction in order to secure momentum for reform.