Korea has been a very attractive market for foreign banks because of their excellent earnings records in the past and the bright. outlook of the Korean financial market. It has been reported that net earnings of foreign banks operating in Korea in the past years have been consistently increased (The Bank of Korea, 1991).
The results of this paper should be of special interest to the banking industry of the U.S. because the U.S. banks have dominated both in number and in their share. As shown in Table 1 (omitted), about 37 percent of the foreign banks currently operating in Korea are American banks.
A HISTORY OF FOREIGN BANKS IN KOREA
In 1962, the Korean government launched the first of its ambitious Five Year Economic Development Plans. As an under-developed country in the early 1960s, Korea was not able to obtain internally the required resources for implementing the plan. To finance the plan, business and government used commercial loans from financial institutions in industrialized countries, especially those from the U.S..
However, there was some concern that the domestic banking system was not strong enough to compete with foreign banks. The domestic banking system in operation at this time was established in 1950 with the Bank of Korea Act and the General Banking Act, and was not ready to compete with well-developed foreign banks. Korea, however, decided to admit foreign banks because it believed that, in the long-run, the presence of foreign banks would be beneficial to the economic development of the country. Government officials also believed that for Korean banks to do business in other countries, it was necessary to allow foreign banks to operate in Korea. The Chase Manhattan Bank opened a branch in July, 1967 as the first foreign bank in Korea. During 1967, four other banks opened branches: Citibank, Bank of America, The Bank of Tokyo, and Mitsubishi Bank. It comes as no surprise that these pioneers were American and Japanese banks, because trade with the U.S. and Japan accounted for over 60 percent of the import/export market at that time.
Until 1976 only 11 foreign banks were operating in Korea. During 1977 and 1978, 19 more foreign banks were added. It is due to a more aggressive government policy aimed at greater participation in the international financial market, coupled with a rapid expansion of the Korean economy.' Since then, the number increased steadily, and reached 68 branches and 19 offices on June 1992. Twenty five branches and 3 offices of American banks are currently operating, followed by Japan with 14 branches and 9 offices (see Table 1). More than half of the branches and offices of the foreign banks are from the U.S; and Japan.
REGULATIONS ON FOREIGN BANKS
Foreign banks in Korea have had a mixed history of restriction and preferential treatment. In the 1960s and early 1970s, many privileges were granted to foreign banks to entice them to open branches in Korea, which was at that time a risky and developing country. Some profits were guaranteed by the government. Yet, many restrictions were imposed on their operations because the government was concerned that they might take over the domestic financial market.
In the 1980s, many changes took place in the Korean economy as well as in its banking systems. Many regulations on existing foreign banks were changed.
As the Korean government was liberalizing its banking systems, it took some protective measures that went against the foreign banks. In 1982, a mandated reduction became effective that lowered from 15% to 10% the percentage of loans to local borrowers that foreign banks could hold as security in the form of compensating balances. Now the banks had to pay interest on what had formerly been interest-free balances. Furthermore, new limits have been placed on foreign bank participation in Korean foreign exchange markets, domestic bond markets, and commissions earned on letters of credit. These restrictions were a result of the belief of Korean banking authorities that foreign banks were earning much higher profits than they actually reported.
In continuing of the banking system reform, there were several complaints from foreign banks, and especially from the U.S., about Korea's overprotected financial markets. In response to foreign pressure, the Korean government adopted a conciliatory stance in 1984, believing that the sophisticated Korean economy had outgrown its primitive financial system. First, foreign banks were admitted into the National Banking Association of Korea and were allowed to take part in clearing house operations. They were permitted to make more loans by broadening the definition of the foreign banks' capital base. Foreign banks were also be given access to the trust business, and permitted to use the government's discount window for export financing as well as general trade financing. The discount window is one of the most important and inexpensive sources of local funds.
A summary of the current regulations regarding privileges and restrictions to foreign banks in Korea, is shown in the Appendix.
CURRENT OPERATIONS OF FOREIGN BANKS
To evaluate the operating results of foreign banks in Korea, first, a statement of sources and uses of operating funds was prepared based on the Accounts of Foreign Banks In Korea of various Monthly Bulletins from the Bank of Korea; second, a return on total assets of foreign banks was computed; third, the relationship between net income and major components of assets was analyzed using regression analysis.
Sources And Uses of Operating Funds
Information regarding how foreign banks obtain and use funds was extracted from the statement of sources and uses of operating funds. As shown in Table 2 (omitted), 'foreign banks heavily rely upon borrowing from their headquarters while domestic banks obtain operating funds mainly from deposits received from their clients. As of 1991, the funds of $6,186 million were provided to foreign banks operation in Korea by their headquarters. This amount constitutes 43.0% of the total operating funds of all foreign banks. Even though the percentage has been decreasing gradually it is still a significant portion of their operating funds. It is also shown that deposits received from the public increased significantly during the past nine years. In 1983, the total amount was $392 million, which soared to $771 million in 1987 and $1,108 million in 1991.
Table 2 also demonstrates major usage of operating funds by foreign banks. Up to 1986, operating funds were primarily used for foreign currency loans. Since 1987, however, Korean currency loans have exceeded foreign currency loans. Korean currency loans have been increased consistently since 1983. They constituted 31.9% in 1983, 36.1% in 1987, and 39.0% in 1991 of their total loans, the largest uses of the operating funds. This, coupled with the fact that Korean currency deposits have been increasing rapidly, has enabled foreign banks to successfully penetrate the tight Korean financial market. Also, it is noted that marketable security has continued to maintain a relatively high portion of uses of funds, although recently this trend has been declining.
RETURN ON TOTAL ASSET ANALYSIS
For comparison, returns on total assets of foreign and domestic banks in Korea are shown in the Table 3 (omitted) (The Bank of Korea, 1992).(2) Return on assets in each period was computed in terms of net income divided by total assets. During the past eight years, the return on assets of banks in Korea increased gradually, from 0.52% in 1983 to 1.43% in 1990 for domestic banks and from 1.69% to 4.86% for foreign banks. This was caused by booming Korean economy during the period. Foreign banks consistently outperformed the domestic banks every year during the 1983-1990 period. In most years, the return for foreign banks is as much as four times larger than that of the domestic banks.
Regression Analysis of Net Income on Major Assets
The income statement is a common source of information used in analyzing the profitability of the firm. However, the income statement for foreign banks operating in Korea is not publicly available(3). Annual net income of these banks can be estimated from their published balance sheets. However, income from each of four major components of assets (i.e. Korean currency loans, foreign currency loans, customer's liabilities on acceptance and guarantees, and marketable securities) which accounted for approximately 90 percent of the total assets, is not available. Intuitively, surrogates of these earnings--the contribution of each component to net income--may be calculated by regressing the annual net income on the four assets components. Analysis of the regression results could reveal relationships between net income and each component of these assets.
Data from balance sheets of foreign banks in Korea were collected for the 1980-1990 period.(4) If the bank's operating period was less than one year, that period was not included in the analysis. Balance sheets of banks, of which fiscal years were ended from September 31 and March 31, were included in the analysis. Therefore, following number of banks from 1980 through 1990, were included in the regression equation: 32 in 1980; 35 in 1981; 38 in 1982; 44 in 1983; 44 in 1984; 52 in 1985; 50 in 1986; 51 in 1987; 58 in 1988; 59 in 1989; 67 in 1990.
Before regression analysis was performed, correlation analysis between net income and total assets was conducted. The result showed that there were high correlations between the two. From 1980 through 1990, correlation range was from .72 to .98. Therefore, it is anticipated that regression analysis identifies the relationship between net income and major components of the assets.
Two different regression equations were used in this study. The first equation was used when Korean currency loans could be classified separately from foreign currency loans; otherwise, the second equation was used.
1. Y = alpha + Beta sub 1 X sub 1 + Beta sub 2 X sub 2 + Beta sub 3 X sub 3 + Beta sub 4 X sub 4 + epsilon
Where Y: Net Income
X sub 1 : Marketable Securities
X sub 2 : Customers Liabilities on Acceptance & Guarantees
X sub 3 : Korean Currency Loans
X sub 4 : Foreign Currency Loans
2. Y = alpha + Beta sub 1 X sub 1 + Beta sub 2 X sub 2 + Beta sub 3 X sub 3 + epsilon
If X sub 4 is not shown in Table 4 (omitted), it means that:
X sub 3 : Korean and Foreign Currency Loans
The cross-sectional regression statistics are summarized in Table 4. The sign of each coefficient of every explanatory variable is positive for every year in the study period; this finding is consistent with the theoretical (positive) relationship between net income and assets. Among the four variables, coefficient of marketable securities is consistently the largest in every year. This result reflects the booming Korean security market during the study period. The regression coefficient of the Korean currency loans is higher than that of the foreign currency loans in most cases. Real profitability of Korean currency loans is higher because a 10 percent to 20 percent compensating balance is usually required for such loans.
Also reported (in parenthesis) in Table 4 are t-statistics of coefficients of the four variables for the 1980-1990 period. The t-statistics of Korean currency loans in the study are significant at the 0.05 level except 1987 and 1988 years. Those of customer's liabilities on acceptance and guarantees of every year are significant at 0. 10 level. Only one of the t-statistics of marketable securities variable (i.e. in 1982) is insignificant at the 0. 1 level.
The above findings indicate that the marketable securities is the largest contributor to net income of foreign banks in Korea and that Korean currency loans are a more important contributor to profit than are foreign currency loans.(5)
This study reviewed the banking environment and examined the operating results of foreign banks in Korea during the 1980-1990 period.
The empirical evidence shows that (1) in recent years, more operating funds of foreign banks have been used for Korean currency loans; (2) comparing return on total assets, foreign banks significantly outperformed domestic banks; (3) marketable securities are the largest contributor to the profits of foreign banks; (4) Korean currency loans are the second largest contributor and the contribution of Korean currency loans is greater than that of foreign currency loans;
Foreign banks may argue that their performance is overstated because of the relatively poor performance of the domestic banks. This argument has some validity. Korean commercial banks were handicapped by government interference for a long period of time. Government controls weakened the ability of financial institutions to adjust to the changing economic and financial environment. The commercial banks failed to develop sophisticated credit assessment techniques, since lending decisions were based on government policy. Consequently, operations of local banks are relatively less efficient than those of foreign banks.
On the other hand, domestic banks may argue that the preferential treatments given to foreign banks outweighed the restrictions on their operations. It is true that the swap facility and the use of compensating balances have been clearly advantageous to the foreign banks. However, as the figures in Table 2 suggest, the biggest restraint on the foreign banks is their lack of access to local currency. They had to concentrate on foreign currency lending and foreign currency operations.
For future study, an issue to be examined is how much of the profits in the foreign banks were created by each preferential treatment. An empirical study could be conducted if more detailed information on these profits were made available. The results of such a study would be useful for policy makers who regulate the foreign banks' operations.
The Korean banking system is still relatively underdeveloped, and lags far behind the nation's industrial and commercial achievements. In an effort to switch from an export-led, high-growth economy to more balanced development, in the next few years we are likely to see changes in Korea's financial industry. It will involve a major restructuring of the banking industry, capital, and stock markets. For example, policy loans will be eventually phased out and capital and stock markets have been opened to foreigners in 1992.
During these fluctuating circumstances, the future role of foreign banks in Korea is even more uncertain. During the past two decades, foreign banks in Korea have played an essential role in the infusion of urgently needed capital into the economy. Welcomed as a conduit for foreign capital and privileged in some respects, preferential treatment was given. However, the foreign banks were also highly regulated and barred from many activities open to local banks (Clifford, 1990). Korea's growing economy can be bad news for Seoul's community of foreign bankers. If Korea eventually reaches its target of financial self-sufficiency, the foreign banks may lose their present favored status.
Frequent worker-management disputes are another concern to foreign banks in Korea. The disputes have raised wages and benefits by close to 100% in the past five years and have caused occasional interruptions in operations. Until October 1993, labor unions have been organized at 51 foreign banks in Korea. Since 1986, three foreign banks left Korea due to labor disputes while Westpac will close its Korean operation in 1993 (Glain, 1993).
One positive aspect is that the banking industry in Korea can still be attractive with the new nonintervention policies of the current government and the shift to a more market-oriented economic interaction. Foreign banks are better prepared to operate in such a competitive environment than the domestic banks in Korea.
1. Korean Finance Ministry, Foreign Exchange Management System and Improvement of International Payments, December, 1976.
2. Domestic banks include the five major commercial banks whose headquarters are located in Seoul.
3. Article 92 of Securities and Exchange Act and Article 15 of Enforcement Decree require that publicly held firms in Korea release financial statements including balance sheet and income statement. But, Article 35 of the General Banking Act requires that a banking industry publish only a general balance sheet. Foreign banks are not publicly held Korean firms; therefore, they publish only a balance sheet as required by the General Banking Act.
4. Upon request, the data can be provided.
5. Whenever there are linear dependencies among the independent variables, the problem of multicollinearity is said to exist. The condition index (CI) and the variance inflation factor (VIF) were used to check the multicollinearity problem. The largest CI was 6.385 and the largest VIF was 4.751. The test suggests that inferences from the regressions do not appear to have been seriously affected by the multicollinearity problem (see Gujarati(1988)).
The Bank of Korea, Monthly Bulletin of Statistics, various issues.
The Banking Inspection Board of Korea (BIBK), Comprehensive Bibliography of Banking Organization, February 1989, 39-41.
The Banking Inspection Board of Korea (BIBK), Banking Management Statistics, 1993, 42-45 and 205-207.
Bureau of Statistics of Economic Planning Board of Korea (BSEPBK), Monthly Statistics of Korea, various issues.
Clifford, Mark (1990), "South Korean Banks Report Strong Profit Gains with a Little Help," Far Eastern Economic Review, Feb. 15, 62.
Clifford, Mark (1990), "Foreign Banks Face Forex Clamptown: Seoul's Scapegoats," Far Eastern Economic Review, July 26, 44.
Dee, Phillips S. (1986), Financial Markets and Economic Development: The Economics and Politics of Korean Financial Reform, Tubingen, Federal Republic of Germany, J.C.B.
Euh, Yun-Dae and James C. Baker (1990), The Korean Banking System and Foreign Influence, Routledge (London and New York) p. 46.
Euromoney (1992), "Korea's Big Bang," May, 2.
Glain, Steve (1993), "Dispute at Citibank's Korean Branch on Employment Fund Nears Conclusion," The Wall Street Journal, Oct.
Gujarati, Damodar (1988), Basic Econometrics, 2nd Edition, McGraw-Hill, Inc.
Korea Trade Promotion Corporation (KOTRA), Korea Trade & Business, July 1990, 41.
Korean Ministry of Finance, Foreign Exchange Management System and Improvement of International Payments, December 1976.
Kuznets, Paul W. (1985), "Government and Economic Strategy in Contemporary South Korea," Pacific Affairs, 58, Spring, 44-67.
Privileges and Restrictions to Foreign Banks in Korea Privileges
1. Guaranteed margin on SWAP: This is the foreign banks' most important source of local currency. Each foreign bank branch deposits foreign currency with the central bank and it receives local currency under a closed-out swap which eliminates all exchange risk. The transaction is structured in such a way that it guarantees the foreign bank a certain profit (currently 0.3 percent) when it re-lends the local currency at the maximum rate allowed by the government. Not subject to the variable exchange rate, foreign banks are allowed 0.3 percent net profit. Hence, SWAP rate = interest rate on Korean currency - interest on foreign currency - guaranteed margin (0.3%).
2. Transmission of net profits to the home office: Foreign banks are allowed to transmit net profit earned through regular business (after subtracting appropriations required by law) to their headquarters.
3. Exemption of currency control action: Foreign banks are exempt from currency control actions by the Korean government. For example, they are not required to buy or sell government bonds when the government attempts to adjust the currency level.
4. Favorable credit limit: The credit limits imposed by the government on Korean banks are 50 percent of the company's total capital for loans and 100 percent of the total capital for payment guarantees. Foreign banks can exceed these credit limits.
5. Favorable minimum percentage of loans: The required minimum percentage of loans to small and medium-sized businesses for foreign banks is only 25%, while, for domestic banks, the percentage is 35% for major national banks and 80% for local banks.
1. Limit on SWAP: The swap limit for each foreign bank is tied to the amount of its capital, which dictates how much local currency lending it can do.
2. Limit on expansion: Foreign banks currently operating in Korea are not allowed to open any new offices without the permission of the government. Each new office must be approved by the Korean government as a new, separate business unit.
3. Limit on the ownership of fixed assets: Foreign banks can accept buildings or land as collateral, but possession of these assets must be approved by the government.
4. Restriction on capital: To increase their capital, foreign banks must obtain approval from the Korean government. In determining the size of a foreign bank, the capital of the branch in Korea, not that of the head office, is regarded as the capital of the bank.
Source: Loan Operation Regulations of Banking Organization (Paragraph 8 of Section 2), Treatment Rules of Foreign Exchange Control (Paragraph 1 of Section 8 of Article 2), Supervisory Regulations of Banking Organizations (Paragraph 1 of Section 3 of Article 2), and Foreign Exchange Control Rules (Paragraph 4 of Sections 37-41 of Article 2).…