Financial governance and policy learning in Korea: analysing the post-crisis experience

Abstract

The purpose of this project is to explore the response of the Korean authorities to the fallout from the financial crisis that began in the fall of 1997. The project is situated in the domestic and international political economy and examines how the Korean government adjusted to practices in global finance and commerce. What is being examined at a practical level is to what extent has there been policy learning about financial policy governance within the Korean state since the 1997 financial collapse. The article concludes that there has not been enough political, social and institutional development in financial governance to accompany the purely economic advances.

Keywords:

• Policy learning
• liberalization
• Korea
• financial crisis

Introduction

The purpose of this project is to explore the response of the Korean authorities to the fallout from the financial crisis that began in the fall of 1997. The analysis is informed by my earlier work (Harris 2003) which focused on the weakness of governance institutions and was set against the Korean accession process to membership in the Organization for Economic Cooperation and Development (OECD). The present project, situated in the domestic and international political economy, examines how the Korean government adjusts to practices in global finance and commerce. What is being examined at a practical level is to what extent has there been policy learning about financial policy governance within the Korean state.

In the period prior to the 1997 debacle Korea was a financial crisis waiting to happen. This was the unfortunate state of affairs because of inadequate financial regulatory oversight, state interference in credit allocation decisions, and an absence of responsible and accountable corporate governance. This confluence of events (a sort of democratic deficit), plus the premature opening of the short-term capital account gave rise to and exacerbated the severity of the crisis. Furthermore, there was a great deal of external pressure emanating from the US Treasury (acting the behest of the American financial services industry) and to a lesser extent, from other OECD members, for Korea to relax the protectionist regulatory environment surrounding its financial sector in order to conform with the OECD Codes of Liberalization.

Unfortunately, Korea, at the time an unconsolidated democracy, had not adequately pursued the values of democratic capitalism that were so necessary for enduring success in the world of global commerce and finance. Core beliefs in both the public policy and private sectors had not

adjusted to this new transnational environment. Highlighting the absence of so-called ‘global standards’ of governance in Korea is a critique of Korea's willingness to participate in first world activities with both a third world governance infrastructure (institutions) and core beliefs. ¹ This was a catastrophic recipe.

The main burden of the crisis fell on the ordinary workers (Harris 2002). The chaebols as organizations are by and large still in tact, though smaller in number, and institutionally remain very powerful. A good part of the banking system was taken over by the state, and their balance sheets cleaned up at taxpayers' expense. The banks were subsequently privatized, with sales to both domestic and offshore entities. ² However, the role of foreigners in Korean commerce has not been accepted in a passive manner by Korean civic society (Kwok 2006, Yonhap News 2006).

The conventional wisdom among financial commentators and economic analysts is that South Korea has recovered from the immediate effects of the 1997 crisis (The Economist 2002). ³ Such conclusions arose from the analysis of the country's legislated legal and intended institutional reforms, its national economic accounts, anecdotal evidence about improvements in corporate governance, and the perception that banks had cleaned up their imprudent credit practices. Indeed, there appears two phases in the recovery period: 1997–2002 when many institutional reforms were introduced but had not fully taken root; and since then when the new institutional framework and bureaucratic professionalism accompanied by the commitment to global standards became more conspicuous – although pressing prudential oversight difficulties persist.

On balance, this ‘net’ positive assessment emerges despite the reckless increases in the issuance of credit cards to consumers, the rapid expansion of mortgage credit which fuelled a bubble in the residential real estate market beginning in the 2001–2002 period, and the more recent debt-load problems of small and medium-sized enterprises (SMEs). The balance sheets of ordinary citizens in the post-crisis period began mirroring those of the chaebols in the period leading up to the 1997 crisis. These developments suggested imprudence on the part of both lenders and borrowers and a lack of sufficient and timely oversight by the prudential regulator (Lee 2002). The inflation of values in the real estate market reflected weaknesses in macroeconomic management as well as a power struggle between the Ministry of Finance and Economy (MOFE) and the central bank – the Bank of Korea (BoK) – over the proper balance of market-based monetary policy instruments and intrusive quantitative controls. The SME problem is rooted in the continued intrusive activities of the state.

One would not dispute that the real economy has recovered from the effects of the crisis. In the past few years (since 2004), however, the economic cycle has been dampened, consumers, the chaebols, and some SMEs have put their balance sheets on a more sustainable path. The incremental steps towards a more market-oriented economy (OECD 2005, pp. 20–23) are manifested in the adoption of inflation control targets by the central bank (Bank of Korea 2006b). ⁴ Most recently, corporate governance in the financial and industrial sectors has made headway. The bureaucracy has worked hard, and seemingly successfully, to implement global standards for effective prudential oversight in finance (particularly in the commercial bank sector). Industrial–financial links, which were a source of abuse, have been limited compared to the pre-crisis period. Moreover, transparency surrounding prudential oversight has improved dramatically – as measured by the public reporting by the key institutions involved in this essential public policy area. However, the main issue for Korea is whether there has been sufficient policy learning among the official bureaucracy and elected officials and whether good financial and corporate governance can be sustained.

The remainder of the paper proceeds as follows: the next section will provide a stylized review of the institutional weaknesses and the domestic and international political imperatives which contributed to the crises; Section 3 will examine some theoretical precepts surrounding the policy learning literature; Section 4 looks at the initial state response to the crisis and the intended ‘ideal-type’ institutional changes; Sections 5 and 6 provide an assessment of the changes in Korea since the crisis; and the final section contains some conclusions.

An institutional analysis of the financial crisis in Korea

The main contributing factor to the emergence of the financial crisis in South Korea in the fall of 1997 was the weak institutional underpinnings of the Korean developmental state. For much of its development in the post-Korean war period, under both authoritarian and emerging democratic regimes, the state was deeply involved in economic and commercial decisions that in Western countries are located in the private sector. Most importantly was the state's intrusiveness in commercial banks' credit allocation decisions. The imperatives of rapid economic growth and the power relationship between the chaebols and the political elites resulted in imprudent credit decisions by the banks – acting at the behest of the state. Governance, at least as understood in Western democracies, was virtually non-existent in the chaebols and the banks; and the Basle capital adequacy requirements for banks did not play a role in the prudential supervision of banks. ⁵ The special character of finance in facilitating national development and economic growth and the systemic consequences of the failure both of finance itself and the regulator to carry out their functions in a prudent fashion were not comprehended in pre-crisis Korea. These weaknesses were elements of the core policy beliefs embedded in state institutions. Essentially, the state was the underwriter of private risk.

In the 1980s and early 1990s, at the urging of both the USA (whose financial services industry wanted access to the Korean market) and the International Monetary Fund (acting at the behest of the US Treasury), ⁶ there were a number of aborted attempts to reform the financial sector. Its liberalization and reform began in earnest in the 1990s, when the Korean authorities thought that some political benefits could be gleaned from joining the OECD (Harris 2003, p. 144). Unfortunately for Korean society, the sequencing of this reform effort was improper (Harris and Pigott 1997). Rather than first ensuring that the prudential oversight apparatus for finance was robust and then liberalizing domestic and international financial relations, there was little, if any, institutional strengthening. Despite the opportunities to glean lessons from crises in other Western and emerging market countries the institutionally embedded core beliefs in the Korean state could neither properly identify the existence of imprudent private actions nor transfer the consequences of inadequate financial oversight into its belief system.

Indeed, during this initial period of reform, when the Korean economy was slowing in the face of global economic weakness, the state continued to encourage the banks to lend to the chaebols. Even as inventories piled up, production continued. Part of the problem for the state was that there was an inadequate social safety net. ⁷ So, if production adjusted to lower demand, the people that would be thrown out of work would find themselves without any financial support (Harris 2002, p. 10). The chaebols, on the other hand, thought they were ‘too big to fail’. However, as production continued, the chaebols and the smaller enterprises were unable to service their debts. The debt–equity ratio of the 30 largest chaebols reached some 520% in 1997 (Chung and Wang 2001). And, the debts were more than simply domestic credits. Because the short-term capital account had been liberalized, many banks had borrowed offshore at more favourable rates than were available in their domestic market. Not only were these short-term liabilities unhedged in the foreign exchange market, ⁸ they were in turn lent at maturities of longer term than the underlying liability. This violated a basic prudent banking principle – matching terms to maturity of assets and liabilities or hedging the risk.

Once the OECD member countries became involved in Korea's accession process the pressure to embark on financial reform became more generalized. Korea tried to resist the pressure to open its markets – bond, money, and equity – to foreign participants but the offshore pressure was too great and the perceived positive political rewards for membership miscomprehended by state elites.

A number of senior officials in the MOFE were replaced because it took Korea a long time just to achieve observer status on many OECD committees. ⁹ Moreover, following completion of the accession process many of those officials who were advocates of the work of the Organization found themselves ostracized by the major economic ministries and agencies when they returned to Seoul from their postings as representatives to the OECD in Paris. ¹⁰

So what originally was seen as a triumph by political and bureaucratic elites – the OECD accession and accompanying financial sector liberalization – was a monumental policy blunder. The policy discourse in Korea in the period leading up to accession covered a wide spectrum. The politicians saw membership in the OECD giving the country legitimacy in the global economic community, as well as lower financial market borrowing rates accompanied by wider distribution capacity of debt among institutional investors, and a lever to both encourage and accelerate the pace of structural reform. ¹¹

On the other hand the intellectual community in the research institutes and academia were generally opposed to the premature accession to the OECD. They were aware of the fundamental weaknesses in the Korean institutional and governance structures and in the core belief system. They were critical of the unchallenged power of the chaebols and their controlling families whose financial exposure did not mirror their structural power. ¹² Moreover, the governance structure, focused as it was at the centre of the state, was unable to cope with both complexity of manoeuvrings in a globalized world and the necessary decision mechanisms required to deal with the openness associated with the OECD Codes.

While the contagion effects of the Asian crisis pushed the Korean economy over the edge, the fashioning of the crisis was solely that of the Koreans. It would be misleading, however, not to record that the OECD Secretariat as well as government officials from the member countries participating in the Korean accession process were aware of the structural and governance weaknesses and thus carry part of the burden of culpability for the events leading up to the late 1997 Korean collapse. ¹³ But the objective function for the OECD Secretariat was to get Korea into the Organization – that was the nature of the reward system for the international bureaucrats and that was the wish of the US Treasury. The opportunity to ‘school’ the Koreans had escaped the multilateral institutions and thus the Koreans were satisfied that their core beliefs had not been undermined. Ex post however, the OECD Secretariat implicitly admitted the error of its advice to the OECD Council (OECD 1998). The International Monetary Fund (IMF) had also encouraged the Koreans to open their financial system. But the advice was not accompanied by the required symmetry of reforming both the oversight regime and private governance. ¹⁴

The weakness in the institutional structure of Korea was mostly related to the democratic deficit. In the post-war period Korea had experienced only one ‘democratically’ elected government – that of Kim Young Sam – and the crisis occurred at the end of his term of office. The official bureaucracy, for much of its existence, was loyal to the ‘party’ in power and not to the endurance of a system of good governance. ¹⁵ The values often associated with commercial and financial dealings in a democratic polity – such as openness and transparency and responsibility to shareholders – were absent. This was not necessarily a conscious effort of the Korean state and the private sector actors to be surreptitious, but was a structural phenomenon imbedded in the elites of society and circumscribed by their belief system.

In the Korean developmental state ‘markets’ did not provide signals about value, risk, supply, and demand – at least as they are known in advanced democratic societies. All risk in Korean society was socialized. The state's objective was production and job and wealth creation through export-led policies. Domestic producers were protected by import restrictions. In this environment political elites thought that there was no need for market signals to ‘regulate’ commercial and financial decision-making. ¹⁶ Consequently, there was no need for governance institutions to deal with market failure because the government covered all risk.

This situation was probably adequate for a society rooted in mercantilism. However, when Korea joined the community of market-based democracies it was at a clear disadvantage because the institutional infrastructure was not designed to deal with the complexities of globalization. State structures and commercial and financial practices as well as the institutions of the market were unable to respond to these stimuli because they had been socialized to respond to bureaucratic hierarchies. Korea was an accident waiting to happen – and it did. The social costs have been enormous as measured by labour force attachment and inequality. ¹⁷

Policy learning and policy change: some theory

There were many actors involved in the evolution of the financial landscape of South Korea over the past two decades. These actors represented sovereign nations, led by the hegemon; worked for the multilateral organizations, particularly the IMF and the OECD; wielded domestic power such as the chaebols and the controlling families; were imbedded within the state such as the bureaucrats in the MOFE and the central bank and more recently the Financial Supervisory Service; and of course there were the financial services actors acting at the behest of the politicians and bureaucrats.

These actors were not cut off from the real world of finance and the phenomenon of globalization. There had been numerous financial regulatory failures globally in the period prior to the 1997 crisis (Goodhart et al. 1998, pp. 16–33). Because the Koreans participated in the workings of the key international institutions they were aware of the causes and consequences of financial crises. Indeed, there were lessons to be learned by Korean policy makers from their own crisis.

A reasonable question to ask is: ‘during the post-crisis recovery period have the lessons of Korea's financial policy history resonated adequately within the policy community?’ Or to put it more bluntly, ‘has policy learning and policy change deflected the errors of the period leading up to the 1997 crisis?’

The public policy literature dealing with policy reversals (Hood 1994) and policy change and learning (Jenkins-Smith and Sabatier 1993) provides some guidance in this regard. For Jenkins-Smith and Sabatier, policy learning involves ‘enduring alterations of thought or behavioral intentions that result from experience and which are concerned with the attainment or revision of the precepts of the belief system of individuals or of collectivities …’ (1993, p. 42). Their model, the Advocacy Coalition Framework (ACF), ‘requires a time perspective of a decade or more’ (Jenkins-Smith and Sabatier 1993, p. 16) – appropriate to the Korean case. ¹⁸

In the case of Hood's explanation of policy reversals, they are rooted in four spheres (1994, p. 4): the force of new ideas that succeed in upsetting the status quo; the pressure of interests that succeed in achieving changes that suit their purposes; the changes in social habit that make old policies obsolete in the face of new conditions; and the pressure from inside as policies and institutions destroy themselves rather than being destroyed from outside.

Peter Hall sees learning as a ‘deliberate attempt to adjust the goals to techniques of policy in light of the consequences of past policy and new information so as to better attain the ultimate objects of governance’ (????, p. 278). In the case of Heclo (1974), learning results in a changed behaviour as a consequence of some perceived stimulus – the perception is rooted in the results of past policies.

To these definitions we can add policy learning and change associated uniquely with finance. It is partly based on the international transmission of ideas and experiences of member countries of the key multilateral institutions. In the case of the developed democracies this means that policy learning and change is associated with the practices identified in the Bank for International Settlements (BIS), the OECD, the G-20, and IMF. In the meeting fora of these organizations, individual countries explain their financial sector policies and experiences on a regular basis. When crises occur, the countries directly involved are typically invited to spell out the ex post reasons for the occurrence and the policies that are in place to address the problem and the safeguards to ensure the same problem does not arise again. Participants in the meetings are not well placed to avoid the lessons associated with imprudent (and prudent) financial sector policy – even if the learning is only by osmosis. Richard Rose (1991) refers to such events as ‘lessondrawing’ because they occur in the world of practical policy-making. These lessons of course can be ignored – and frequently they are. This partly explains the recurrence of financial crises and regulatory mistakes in both the advanced and emerging market countries.

Also relevant in this review of the Korean experience are the lessons to be gleaned from Michael Moran's examination of the liberalization of financial markets in the UK in the early 1970s (1984). In brief, the changes (known as Competition and Credit Control) were implemented by the UK Treasury and the Bank of England to permit a more competitive and market-oriented process of credit allocation in the British economy. Prior to the changes, the credit distribution process across the economy was rooted in the moral suasion of the central bank. That moral suasion was successful for so long in the UK can be attributed to the strong perceptions of the Bank's legitimacy by members of the banking community and to the associated robust structural/institutional linkages between the Bank and the private bankers.

What is of interest in Moran's analysis is not so much the character of the changes which were introduced to the London financial market, but the identification of the underlying forces (the linkages between the key public and private sector decision makers) that gave rise to the changes. The forces upon which Moran draws are rooted in complexity – intellectual, social and administrative, philosophy of governance, and esoteric and exoteric politics.

During the years prior to the introduction of Competition and Credit Control, in the absence of complexity, state institutions (in this case the UK Treasury and the Bank of England) were able to engage in esoteric politics – informal and private interaction with the financial sector (the so-called ‘wink-and-nod method’ of governance) to achieve financial policy-related objectives. However, in the face of complexity, a more formal (open and partisan) framework was required to keep the players in line with the wishes of the public policy makers. This latter phenomenon was characterized as exoteric politics. The practice of esoteric politics within the UK financial system was possible ‘because of the unusual social cohesion of the banking elite, and because the Bank of England exploited that cohesion to protect the system from exoteric influences’ (Moran 1984, pp. 27–28). This was not unlike the practices in Korea where the state used ‘direction’ to influence the actions and practices of the banks.

This distinction between esoteric and exoteric politics as applied to a financial system characterized by advancing complexity is an alternative and helpful way to understand events in Korea. That is to say, the pressures of domestic competition, globalization, trade in services, self-interest seeking behaviour by special interests are explanatory factors that can be cloaked in Moran's notion of complexity. More particularly, as globalization became an increasingly important factor impinging on the fortunes of the financial system during the 1980s and early 1990s, a political dynamic was put in place which ultimately gave rise to crisis and change in the structure of finance. The special relationship between the industry and the state appeared to be altered from a situation of state direction to one of more formal rules where there was less room for discretionary decision-making by regulators and politicians. There was a movement along the esoteric–exoteric continuum during the period when the impulses of globalization and pressures on financial services trade were being transmitted.

Coming back to the ACF, there are two additional precepts that must be considered in analysing policy reform in Korea. They are: first, the need to account for the interaction of actors from the different institutions involved in the substantive policy reform area (the policy community or subsystem) and they were noted above; and second, to interpret policy reform as a change in belief systems (or of values and causal assumptions) that will give rise to policy reform or change (Jenkins-Smith and Sabatier 1993, p. 16).

The argument here is that the environment surrounding Korean finance had changed. This itself was an impetus for change in the Korean industry – but was resisted for a time. However, it will be seen that economic change was an element in causing the change (Derthick and Quirk 1985, Quirk 1988). The lengthy process required to achieve it was in large part related to the fact that there was really no champion for change in Korea until the crisis materialized. Thus, while the ideas regarding reform of Korean finance had been well enunciated in the late 1980s and early 1990s, the self-interest seeking behaviour of the industry and the weakness of the MOFE bureaucracy and of the dominant regulator prevented change from occurring quickly. Lewis explained this phenomenon well:

People create political structure. They also receive it from the past. The received value mix that is political structure exists in persons and institutions. The received value mix of contemporary persons and institutions consists of the laws, customs, beliefs, and desires that have animated, regulated and directed agencies of the state and their constituent and clientele networks in the past. (Lewis 1988, p. 120)

In the case of the ACF, change can also be seen from the perspective of those who have the power to make change and is influenced by: their belief systems, their sense of history, their self-interest, or indeed of what is right from a social welfare perspective. These important factors influenced the financial policy environment and its reform in Korea. What was missing, however, in the Korean context was a policy entrepreneur:

a person who creates or profoundly elaborates a public organization so as to alter greatly the existing pattern of allocation of scarce resources. Such persons arise and succeed in organizational and political milieus which contain contradictory mixes of values from the past. Public entrepreneurs characteristically exploit such contradictions. (Lewis 1980, p. 9)

Kim Dae-jung (KDJ) came closest to such an individual, but his honeymoon with the Korean electorate, the chaebols, and labour was short-lived. In the event, in Korea, the optimum time for the ideas of reform in finance occurred on the occasion of the crisis, buttressed by the coercive conditionality of the IMF's restructuring programme. It came on the heels of a change in the party governing the country.

The Korean state's initial response to the banking crisis

KDJ was elected President of Korea just as the 1997 crisis was rearing its head. The values of the social democratic state that informed Kim's political ideology were exercised in the aftermath of the crisis. As a way of dealing with the political, social, and economic fallout of the crisis he attempted to fashion a tripartite (corporatist) social compromise among the key communal actors in Korea. However, both the mission and deliberations of the Tripartite Commission failed to resonate with the key actors. The cleavage between the peak representatives of labour was too wide for a compromise while the chaebols did not want to see their influence on public policy diluted.

The failure of the social compromise was manifest in a number of negative developments in Korea's financial and industrial sectors. Perhaps most importantly was the failure of businesses both industrial and financial to act responsibly – towards both their shareholders and society more generally. This was evidenced by continued corrupt business practices by the leaders of the chaebols; a flaunting of prudent lending and borrowing practices by the financial services industry and ordinary Koreans; and a failure of the state to monitor, regulate, and arrest imprudent financial activities by both lenders and borrowers. There was also little recognition that policy is more than simply supplying laws and regulations. It also needs proper implementation and evaluation. Policy is a pattern of action – patterns and actions which in the case of prudent business dealings had not yet converged to a global standard.

The momentum behind the reform process was stunning during the initial two years of KDJ's administration. Changes in core beliefs appeared to gather momentum as the chaebols accepted the precepts of Western industrial adjustment while organized workers reluctantly acquiesced to a flexible labour market regime. The government was able to extract some structural reforms from the corporate sector – mainly focused on shuffling assets between the chaebols and cajoling them to improve corporate governance. Chaebol restructuring occurred as a consequence of political arm-twisting and not as a result of enhanced bankruptcy laws to facilitate exit.

Kim's government proceeded rapidly to shut down or take over the insolvent banks and facilitate consolidation of the commercial banking sector including investment and takeovers by foreign entities. State ownership amounted to almost one-third of the banking system (Ro 2001) in the immediate aftermath of the crisis but was reduced by the sale of First Korea Bank and Seoul Bank ¹⁹ and the merger of Kookmin Bank with the Housing and Commercial Bank. ²⁰ And, Lehman Brothers of the USA invested close to US$1 billion into Woori Financial (Ward 2002a).

Non-performing loans of the insolvent institutions and of the otherwise precarious ones were moved to the Korean Asset Management Corporation. However, as the economic indicators began to show signs of a recovery in the real economy (between 2000 and 2002), the reform momentum began to wane. There were few mergers after 2003 – despite the measurable state exposure in two national and three local banks.

Additionally, there re-emerged some of the ‘old’ core beliefs in the form of imprudent credit card lending to households and the credit delinquency and/or bankruptcy of many ordinary Koreans who had abused these new financing facilities. The positive policy learning that was evident at the outset of the KDJ administration seemed to wane. However, this second episode of irresponsible action by policy makers and civic society generally served as a wake-up call for the Korean authorities to deal expeditiously with the misadventures of dealing with the systemic risk problems. More recently, however, the SMEs have fallen on hard times as debt service loads reached unsustainable levels.

The globalization struggle: governance and policy learning

The government expended almost one-third of GDP to bail out the banks. Prudential oversight has been strengthened in law although in practice many concerns still linger. The excesses in the credit card industry evident between 2001 and 2002 and the present SME debt load are the most important manifestations of the continuing fragility of governance and oversight present in both the private and public sectors. It is not yet clear that the market-signalling linkage between industry and finance is sufficiently robust for a significant level of discipline to be imposed by markets on industrial management. Thus, new core beliefs have not yet become satisfactorily imbedded in Korea's social structures.

Prudential supervision

Prior to the crisis, financial oversight in Korea was fragmented in a system of regulation by industry rather than by function. The BoK regulated the banks, and the MOFE had oversight responsibility for the non-banks (including insurance companies, finance companies, securities dealers, and merchant banks). ²¹ An overarching view of the systemic risks was unavailable to the authorities with this institutional structure. This was a situation not unlike the rationale for the introduction of the Financial Services Authority in the UK. Even though it was clear that national regulatory authorities had to adjust their functionality to that of the market, the objective of national supervision was not shared by all the functional principals in Korea when the need for change was so unambiguous. ²²

To the credit of KDJ's administration, and with the assistance of the multilateral institutions, the institutional weaknesses of the regulatory structure belatedly were recognized. All of the prudential regulatory function was reorganized under the umbrella of the Financial Supervisory Commission (FSC) – a policy-making institution – while the work of prudential oversight was located in the Financial Supervisory Service (FSS) – the implementation agency (FSS 2005, p. 3). A glaring omission from the single regulator model is oversight of the credit card companies. These latter entities are still subject to fragmented regulation by the FSS, FSC, and the MOFE. Indeed, this fragmentation was probably a contributing factor to the emergence of the credit card fiasco in the first place. More worrisome, is that the government has not made any moves to bring them under the umbrella of the consolidated supervisory system.

The Chairman of the FSC formulated the objectives of financial restructuring this way: we want ‘to develop a sound and transparent financial system based on international best standards, and to promote the financial industry as a core knowledge-based industry of Korea in the 21st century’ (Lee 2001, p. 6). In practical terms these objectives had a number of aims: first, financial institutions would be encouraged to expand the scope of their businesses, to enhance both risk assessment and management capacity generally, and to improve financial management and lending practices. Second, banking consolidation would be encouraged and it was expected that this consolidation phenomenon would spill over into other components of the financial services industry. Third, the regulator intended to re-regulate the financial services industry not only by strengthening capital adequacy rules, but also limiting regulations that interfere with competition in financial markets. It was also hoped that early warning systems, ²³ the introduction of both Prompt Corrective Action (PCA), and the development of efficient exit procedures (FSS 2005, p. 47), would serve to minimize systemic externalities from institutions that get themselves into trouble (Lee 2001, pp. 7–8).

The new regulator developed and ‘implemented’ a Continuous Risk Assessment System ‘to ensure that the credit risks posed by corporate borrowers are continuously monitored and timely measures are taken when necessary’ (Lee 2001, pp. 9–10). In principle, this was an important measure because for Korean society it would have implications that went beyond just prudential financial supervision. As Zysman pointed out some 20 odd years ago ‘particular arrangements of national financial systems limits both the marketplace options of firms and the administrative choices of government’ (1983, p. 16). In theory at least, finance would have to meet a prudential test rather than a political efficacy test. The developmental model would have to be reconsidered and thus the nature of state intervention in the economy would have to be adjusted. Certainly the traditional support of the ‘zombie’ ²⁴ firms would not fit the new ‘worldview’ that informed the KDJ administration and the FSC.

The FSC Chairman's underlying vision was broadly consistent with the rationale for bank regulation enunciated by Charles Goodhart et al. (1998) that: banks have a pivotal position in the financial system, particularly in clearing and the payments systems; bank runs pose systemic dangers; and adverse selection and moral hazard risks must be monitored carefully by banks' management.

The resolve to ensure that the financial system is safe and sound requires the regulator to be effective in understanding the nature, business scope, complexity, and risk profile of each financial institution in the system. This understanding would include the internal oversight that comes from the Board of Directors and its various committees, including the risk and audit committees – which should be populated by a majority of outside (non-executive) directors.

Normatively, the Board of Directors should be responsible for providing stewardship and oversight of management in these key areas (Office of the Superintendent of Financial Institutions 2002): reviewing and approving organizations' structure and controls; ensuring that management is qualified and competent; reviewing and approving business objectives, strategies, and plans; reviewing and approving policies for major activities; providing for an independent assessment of, and reporting on the effectiveness of organizational and procedural controls; monitoring performance against business objectives, strategies, and plans; reviewing and approving sound corporate governance policies; and obtaining reasonable assurance on a regular basis that the institution is in control.

The implementation of these principles was problematic at the outset because beliefs at the FSS were informed by past practices. Core beliefs had changed at the policy development stage, but not at the implementation stage. Moreover, this contradiction was understood at the MOFE, ²⁵ but was not initially corrected. This obviously raised a question about the commitment of the administration of KDJ to enhanced prudential oversight.

Early in the regulatory reform process a threatening weakness was that those who implemented the new regulations (the FSS) were essentially the same people that had been responsible for oversight prior to the crisis and represented the thinking surrounding the old core values. They were guilty of misreading the information that gave rise to the adverse selection and moral hazard problems. Jin-Wook Choi (2002) argues that regulatory forbearance was a significant problem for the regulatory authorities. For Choi, forbearance essentially arose from the incompetence of the regulators and the close ties between the elites of finance and the state. ²⁶ All this further enhanced the rationale for a strengthening of the capacity and independence of the regulator from the political imperatives of politicians (Das et al. 2002).

However, the need to reformulate the state's vision of how finance should be regulated stemmed from the belated recognition of the special place finance has in the economic and social life of a nation. A dysfunctional financial system upsets not only commerce but also social relations. Good governance of the financial system, involving both public and private sector actors became an imperative in Korea's economic and social life. Thus, in principle, the restructuring of finance and of the state's related institutions, coupled with policy learning, would ameliorate how the Korean economy could respond in the future to financial turbulence.

In order to realize the ‘ideal-type’ of prudential oversight there was a requirement for transparency in markets and governance. The wide dissemination of information about productive activity should result in better functioning markets and less risk of a systemic calamity. Accompanying the new regulations for enhanced transparency in transactions was accountability and responsibility in the governance of financial institutions and industrial firms. This meant that the directors of enterprises, executive and non-executive, should act in the interests of shareholders and customers of the firms and not solely in the interests of the owner-families or major shareholders of these enterprises – a practice that had been endemic. Restrictions on the voting rights of institutional investors would have to be removed. Truly independent directors from outside the firm should be required to be at arm's length from the firm or institutions' major shareholders. Only in this way could it be expected that confidence in markets and institutions would be enhanced. Indeed, the main improvement should be in the degree of confidence the ‘market’ develops and this would be evident in the cost of capital to the Korean economy. Black et al. (2005) confirm this in their analysis of the Korean post-crisis governance environment. The realization of greater transparency also required the adoption of generally accepted accounting principles (GAAP).

The Chair of the FSC also recognized that managerial transparency and global corporate governance structures were necessary in order for Korean industry to gain the confidence of the international community. It was also acknowledged that a rationalized bankruptcy law would facilitate the necessary corporate restructuring (Lee 2001, p. 10). It was also expected that permitting class action suits, the introduction of outside directors, and enhancing reporting standards would all serve to reduce the probability of deceptive and fraudulent corporate reporting (Lee 2001, p. 11), and enhance credit risk analysis.

The intrusiveness of the state in private markets also had to be diluted. Ideally, the state should not be a participant in credit granting decisions, for example. These are matters for institutional governance. However, this ‘ideal’ was compromised when the state was a major shareholder in a number of commercial banks while presently it provides an extraordinary level of support to SMEs.

The forbearance that Choi outlined may reoccur if the regulator finds itself in a conflict between prudential rule-making and competition in the financial industry because the FSC is responsible not only for a safe and sound financial system, but also for ensuring that competition in the system is sustained. In principle these functions are mutually exclusive and the risks of bias towards competition may result in regulatory ‘errors’. It would have been preferable if the competition issue had been placed in the portfolio of the competition authorities as is the case with the UK's regulatory regime.

Corporate governance and restructuring

The chaebol restructuring that has taken place is consistent with the values and practices in Anglo-Saxon countries and not with the quasi-corporatist values that had characterized Korea's business–labour relations. There seemed to be a contradiction between the industrial restructuring and the relations between the state and society. The industrial restructuring has tried to approximate the precepts of the neo-liberal paradigm, while the state society relations have been moulded into the welfare capitalism model – neither with complete success.

At the outset of the crisis in 1997 there were about 30 large chaebol groups; this has dwindled to about 18 recently. However, the most worrisome issue at this stage of the reform process is the weak SMEs. At the end of 2004 the Korean government had some 76 support programmes for the SMEs amounting to some 5 trillion won or 6% of GDP (OECD 2005, p. 170). In addition, the government had 47 trillion won in bank loan guarantees with a default rate of about 2.5% (OECD 2005, p. 171). Such subsidy programmes are a hindrance to restructuring, competitiveness, and innovation, and create the phenomenon of the ‘lazy manufacturer’.

Nonetheless, action by the government, particularly the roadmap for market reform prepared by the Korean Fair Trade Commission (KFTC), has provided a significant boost to the legitimacy of the state's efforts to change the underlying values of commerce in the country (KFTC 2003). The stated objective of the roadmap is ‘to improve the internal and external monitoring systems of companies and business conglomerates, and to enhance transparency, fairness and competition in market transactions’ (KFTC 2003, p. 2). The regulatory instrument is used to achieve these objectives. The regulations are aimed at:

• Strengthening Transparency and Accountability in Business through the introduction of class action suits, enhanced audits and accounting systems, electronic voting systems for minority shareholders at corporate annual meetings, and firewalls between industry and finance in the form of threshold ownership limits.

• Improving Governance Structure of the Chaebol through enhanced disclosure, limiting ownership in affiliates, and providing incentives for holding company structures.

• Enhancing Market Competition by amending regulations related to entry and abuse of market power by limiting the ability of firms and professions to form cartels (Yi Insill 1999).

The issue of moral hazard and adverse selection still lingers in the background. Moral hazard played a role in events leading up to the crisis. Much of the restructuring in the Korean economy occurred at the behest of the state. A good deal of what KDJ had hoped did not materialize until well into the term of his successor Roh Moo-hyun (RMH) (Ward 2003). As noted earlier, while Korea is on a path to a more sustainable market system, the state is still intrusive. An important element of risk in the private sector is still socialized and this poses not only credit risk to the economy but an obstacle to further restructuring.

Whither policy learning and change: return to normalcy?

Some 10 years into the post-crisis period in Korea the glass can appear half-empty or half-full. On the one hand, the momentum for policy learning and change evident in the early years of KDJ's administration has been faltering during the regime of RMH. A number of the state-owned banks and some associated with the chaebols have found themselves confronted with a solvency problem of their own making. In addition, there have been a number of corporate governance failures – perhaps the most notable being the fabricated financial statements at Daewoo in 1999 and the SK Global accounting debacle in 2003. There has been a corruption and bribery scandal at Hyundai (Kirk 2006, Park 2006) involving the Chairman and his son and implicating executives at the Korea Development Bank. More recently, the Chairman of the Samsung Group, Lee Kun-hee was indicted for tax evasion and breech of trust (Hardin 2008). While such difficulties are not unique to Korea, their occurrence in a period of hyper-sensitivity about reforming old values reinforces the judgment that South Korea is at best making only hesitant progress towards becoming an advanced and transparent economy (Ward 2003).

On the other hand, in the glass half-full camp, one can point to the progress that Korea has made reforming its governance institutions. This comprises not only the creation of an independent financial regulatory apparatus but also the reform of the laws and regulations dealing with corporate governance, bankruptcy, accounting, and the appointment of outside directors, for example. ²⁷ The presence of foreign firms on the financial landscape is also a positive development for Korea's future economic and financial stability. ²⁸

These developments are reviewed below.

State institutions and policy

In order to make some judgments about Korea's progress in strengthening its governance institutions it is necessary to evaluate the foregoing ‘ideal-types’ against observed developments. In this regard, the benchmarks that have been reviewed are partly culture bound. They are the practices and values that are imbedded in the conduct of commerce and finance in Western democracies. The restructuring of Korea's chaebols reflects Anglo-Saxon values and increasingly those in Continental Europe – particularly in Germany and France. These practices do not reflect the way Korean society has been socialized – and the consequences of the market-based policies have yet to reach equilibrium. This also explains why reform in Japan was thwarted for so long.

So how does one determine if South Korea has recovered from the 1997 financial crisis? Those actors making decisions in financial markets that determine the direction of capital flows suggest that Korea has indeed recovered from the 1997 debacle. Traditional indicators such as real GDP growth suggest recovery. The financial supervisors are visible and perceived to be carrying out their responsibilities until the significance of the problems at the credit card companies became evident. ²⁹ The credit card fiasco and the SME debt load have once again called attention to the vulnerability of the financial system.

An important area of concern is related to the perceived independence of the central bank from the machinery of government. This surfaced in 2002 in the face of unsustainable increases in consumer debt. An official of the MOFE suggested that because ‘Household loans have increased so much … an interest rate hike may cause a surge in consumer bankruptcies’ (Koh and Kim 2002, p. 1). This debt was partly associated with a rapid increase in the issuance of consumer credit cards – a new phenomenon in the post-crisis Korean environment – and the appearance of a property bubble in areas around Seoul and Busan.

The independence question arose because the state was attempting to deal with the rapid credit expansion using administrative measures and moral suasion ³⁰ rather than with market-based measures. For example, short of using administrative measures such as hiking banks' reserve ratios, and imposing credit limits and ceilings, the only tool a central bank possesses to slow credit expansion is higher interest rates. However, the MOFE feared that a rise in interest rates would slow growth in the economy and risk bursting the property market bubble. This would undermine the banks' balance sheets which were still fragile and in which the state still had a significant interest (Pyo 2002). Instead the government and the regulators implemented limits on credit and loan to value ratios to curb the credit expansion. And, the regulator raised the capital adequacy risk ratings on consumer lending (Lee 2002). In October 2003, the Minister was considering administrative measures to dampen housing demand. Measures such as higher property taxes and further tightening of lending rules had been proposed (Koh 2003a). Not only was the function of the central bank marginalized in this process, but perhaps more importantly the adequacy and competence of both the management and the governance of banks were called into question. In addition, the state was undermining its own efforts to move to a market-signalling regime rather than one dependent on bureaucratic hierarchies.

In March 2005, with the property bubble continuing, the government introduced quantitative controls to deal with this price instability. The key elements of this programme were an excess profits tax on redevelopment projects to curb speculation, restricting home loans to owner-occupied dwellings, and state supply of 300,000 dwelling units annually in the Seoul metropolitan area. The supervisory authorities established a debt service ratio of 40% for borrowers and a loan to value ratio of 60% (Bank of Korea 2006a). So here again we observe the state doing the credit risk analysis for financial institutions – suggesting that the risk and credit allocation functions in the market were still unable to respond appropriately to market signals.

One must conclude, therefore, that central bank independence is still in question. The absence of market signals in the pre-crisis environment was an important element contributing to the crisis in the first place. Power in macroeconomic policy-making still seems to be focused in the MOFE. As a consequence politics is playing an important role in the conduct of monetary policy. These are the old core values.

It is still too early to suggest that reform in the conduct of macroeconomic policy will not advance further. However, it is not unfair to conclude that at the present time the Korean macroeconomic authorities are still walking the fine line between market and state. The state presently holds the upper hand and the market signals – particularly those related to unsustainable consumer credit creation, to the elements of an asset bubble, and to SME debt financing – have not resulted in an appropriate market response. This is reminiscent of developments in Japan over the past decade. Policy memory and policy learning are important attributes of policy institutions and presently it is not obvious that the Korean macroeconomic policy institutions have acquired all that there is to be gleaned from history. Indeed, the lesson from these old core beliefs may be that South Koreans can rebound from adversity while at the same time continuing to practice imprudent governance.

After the government became the owner of a significant number of banks and stabilized the huge number of non-performing loans the banks were required: to adopt the Basle capital adequacy standards, to reform corporate governance requirements including the establishment of risk, credit, and audit committees of the boards, to ensure the election of independent directors from outside the banks, and to strengthen the rights of minority shareholders. Also, accounting standards were reinforced. ³¹ While on the surface these policies seem appropriate, in practice the independent directors appointed to the boards of companies are not always at arm's length, thus partly serving to undermine the intent of the new governance rules. ³² However, the empowerment of minority shareholders allows some resort to the courts to remedy the more blatantly adverse decisions of directors. ³³

While the regulators are able to verify capital adequacy measurement it is not clear that they yet have the capacity to ensure that the board committees can carry out their responsibilities prudently or that they fully understand all of the financial engineering confronting them. ³⁴ As well, many of the senior regulators in the Financial Supervisory Service are the same people who were in the central bank when it was responsible for prudential oversight – and that record is not good. ³⁵ ‘The most serious institutional problem at the FSS is the quality of the people working there. And, the problems are on both the operations and analytical sides.’ ³⁶ McKinsey & Company, in a Report dealing with Seoul's desire to serve as a financial hub in East Asia, suggested that the city ranked second from the bottom in terms of its qualifications to be granted central status in the region largely because its infrastructure lagged far behind international standards (Koh 2003b).

The MOFE is now urging the FSS to change. Some new blood at the senior level has been recruited, but the workers are unionized and this has slowed the modernization process. The regulatory mindset has not changed sufficiently towards ‘best practices’. ³⁷ The early oversight changes that occurred were ‘dictated’ and what has been achieved more recently reflects the increased presence of Anglo-Saxon bankers and their Anglo-Saxon practices. It is unlikely that this refashioning of the landscape would have been otherwise realized. So the quality of the supervision is the critical item right now for the safety and soundness of the financial system. ³⁸

The management of the banks still relies on some direction from the MOFE. Bank Presidents frequently seek ‘guidance’ from the MOFE. ³⁹ Moreover, they are often uncertain about their own decision-making capabilities. This suggests that bank management as well as board governance must be strengthened further.

Commercial banking system

Because Korea was a bank/credit-based financial system, the financial market was underdeveloped. Unfortunately, the Korean system did not develop the robustness that characterizes the German-based credit system. ⁴⁰ In that system the linkages between industry and finance were designed to ensure that bank lending was prudent, even though members of industry were represented on the boards of the banks. Indeed, the ownership by the banks of major stakes in industry served to enhance corporate governance structures. The power of path dependency is observable in both regimes.

The credit-based system in Korea was not designed to ensure prudence in bank lending nor effective investments on the part of industry, but to serve the interests of the state and of the key family-based shareholders in the chaebols. It now may be the case that Korea missed an important opportunity in the restructuring of the banks and the chaebols, to build on the existing credit-based system, and the system of social relations, by overlaying a robust public oversight and private governance regime including providing institutional investors a stronger role in ensuring a market for good corporate governance. Instead, the Anglo-Saxon model has been superimposed on a society rooted both in Confucian and corporatist values.

In the early post-crisis period the state restricted the access to debt by the chaebols and forced them into the market. The banks in shedding corporate debt found themselves searching for alternative assets to match their liabilities and turned to consumer credit, the residential property market, and SMEs. Such credit extension activities were new to the Korean system. As a consequence, consumer credit ballooned, a property price bubble appeared, and SMEs are burdened by an enormous debt load. This is a worrisome development because mistakes and/or imprudent actions are being repeated by private sector actors – both borrowers and lenders. So while Korea moves to a market-based system, it appears that the connection between financial market signals and real economic activity are not sufficiently robust to keep decision-making by bureaucratic hierarchies at bay.

In the case of the commercial banks, there is a lingering distrust over their classification of non-performing loans (see Table 1). ‘Figures disclosed by banks and regulators failed to reflect the potential bad loans the sector is laden with’ according to a banking analyst in Seoul (Kim 2004). Credit card companies have reported that their over due loan ratios stood at 8–13% but analysts suggest that ‘their real delinquency rates may come to 20 percent or more’. While it is difficult to confirm the veracity of these assertions, the implied pattern of action mirrors events in the period leading up to the 1997 crisis. And, this pattern adds to the accumulated evidence that the old core beliefs continue to influence actions.

Table 1. Korean banks' risky loan ratios – September 2004.^a

Bank	Reported by analysts (%)	Reported by banks (%)
Kookmin	10.0	4.8
Chohung	9.0	4.9
KEB	5.3	2.7
Hana	5.1	2.9
Woori	5.1	2.5
Shinhan	4.1	2.5
Korea First	3.5	1.5
Koram	3.1	2.0
^a Source: Korea Times and Korea FSS.

Official statistics, however, portray a rather different picture. The banks' non-performing loan ratio has been declining since the peak reached in 1999. And the improvement most recently has been in all lending sectors – corporations, households, and credit cards. And, bank profitability has also improved. The BIS capital adequacy ratio annually reaches new highs (Kim et al. 2006). If the veracity of these numbers is better than those estimated by ‘analysts’ and alluded to above, the commercial banks seem better placed than ever to deal with an economic shock – even if some of their lending practices are questionable.

The ratings agency, Moody's in Korea, is on balance, reasonably positive about the banking system. All of the rated banks are of investment grade (i.e. suitable for institutional investors) in the ‘medium to upper medium range’. The Korean government itself is an A3 rated investment (upper medium). There are no Triple A rated institutions and two are on the watch-list for a rating change – Kookmin for a downgrade (from A3) and the Korea Exchange Bank for an upgrade (from Baa2). ⁴¹

Nonetheless, as recently as early 2004 the Korean state was still

… prone to bailing out troubled private sector entities … [and] … recently the state-owned Korea Development Bank took over the operations of LG Card Company after helping engineer a 5 trillion won (US$4.5 billion) bailout package from banking creditors. Government officials had argued that a collapse of the nation's largest issuer, which was facing a steep liquidity crunch, would have cost the domestic financial sector 26.7 trillion won. (Nam 2004)

The Korean state, despite its stated objective continued to rely on the old core beliefs rather than ensuring improved financial oversight, corporate governance, and risk assessment.

The process of privatizing the state-owned banks has exposed the financial services industry to the practices in the industrial democracies. This means that both offshore expertise and offshore ownership are influencing banks' internal governance activities including borrowing and lending activities and this may account for the improvements observed in the banks' profitability.

However, foreign ownership and participation is probably close to reaching the politically tolerable threshold by Korean civic society. For example,

On the brink of bankruptcy, LG Card … in November dismissed the U.S.-controlled Korea First Bank as its main banker and chose the state-owned Woori Bank instead. Woori had helped South Korea's biggest credit-card company secure a 2 trillion won (US$1.7 billion) emergency loan … They had to get the foreigner out of there to clinch the bailout …

Most recently, the sale of LG Card to Shinhan Financial Group took place amid ‘Many bankers think[ing] the authorities are reluctant to allow LG Card to be sold to an offshore investor amid continued controversy over foreign ownership in the country's financial sector’ (Song 2006, p. 12).

Regulators may be concerned that foreign-owned lenders will be less likely to follow government orders, according to Eugen Loeffler, chief executive of Hana Allianz, a venture between Hana Bank and Allianz of Germany. ‘I understand why the government isn't comfortable to see foreign market shares rise because that means it would be difficult to control banks’ (Sangim Han 2004, p. B4). In February 2004, South Korea's new Minister of Finance, Lee Hun-jai warned the foreign-owned banks that they had to be more cooperative in the future, than they had been in the past, when dealing with issues of ‘market stability’ (referring to the bailout of the failed credit card industry) in the country (Ward and Song 2004b).

In September 2002, the Hanwha Group (at the time one of the top 30 chaebols) purchased a controlling interest in Korea Life, from the government (Chang and Kim 2002). Business Week warned that:

The regulators should pause before approving this sale, though … A Samsung Group unit, Samsung Life Insurance Co., controls 40% of the market. If Korea Life, with an 18% market share, ends up in the arms of Hanwha, well over half of the market will be controlled by two big chaebol. Analysts worry that they could be used as in-house banks for their parents, just as in the bad old days.

The proposed sale of Korea Life is not the only sign of backsliding … In April, the government began letting nonbank financial arms of the chaebol vote their shares held in affiliate companies. ‘This lets chaebol families use clients’ money to further their own interests, often directly against the clients' interests', says Kim Sang Jo, a Hansung University economist who heads a shareholder activist group. (Moon Ihlwan 2002)

And, a Hankyoreh editorial suggested that:

There were many problems with Hanwha's takeover of Korea Life. For starters, it went against the larger principle of economic reform in the area of separating industrial capital from financial capital. Furthermore, Hanwha did not have the right qualifications, and there were claims it was engaging in illegal means to convince elected officials and high-ranking bureaucrats during the process. Indeed, at the time, Hanwha was caught falsifying its account books so as to lower its debt to equity ratio. Now it is being accused of having brought in a foreign life insurance company to act the part of supporting actor so that it would qualify as a company that either was into life insurance or part of a life insurance consortium. (The Hankyoreh 2005)

This transaction has still not been finalized. On 1 June 2006 the Korea Deposit Insurance Corp. (KDIC) announced its plans to ‘ask an international court for arbitration regarding the issue of whether Hanwha Group's 2002 acquisition contract of Korea Life Insurance (KLI) is binding or not’ (The Seoul Times 2006). As late as February 2008, the KDIC Chairman Park Dae-dong was publicly opposed to the consummation of this transaction (Yoon 2008).

It would be unfortunate indeed if the connection between banks and industrial conglomerates became pervasively self-serving as was the case between the non-bank financial institutions and the chaebols in the decade prior to the crisis. ⁴² It is worth noting that in the case of the last noted transaction, the government obtained a commitment from the Hanwha Group that no connected lending would take place between the life company and the larger group – for a period of three years. ⁴³ Even though the KDIC seems to be on top of the situation resistance to greater foreign participation in the financial sector could translate into additional financial takeovers by industrial companies as the chaebols would be the only indigenous institutions with pockets deep enough to fund such takeovers.

Credit cards and the household sector

In the absence of operational market-based signals it is rather surprising that the prudential regulator had not been more active in dampening down the exuberant bank lending. By the fall of 2002, consumers' credit liabilities had resulted in an unusually large number of personal bankruptcies for Korean society. This was during a period when unemployment was relatively low and economic output was pushing the capacity limits of the economy.

Many banks were beginning to establish ‘work-out units’ in their branch networks to help individual customers restructure their liabilities. ⁴⁴ Given the short period since the breakout of the financial crisis one can reasonably question whether Korean authorities had the capacity or political will to bring the situation under control. Certainly, the opportunity for policy learning was overtaken by old core beliefs.

The sharp increase in credit delinquents can largely be attributed to an economic policy encouraging the use of credit cards to boost the stagnant … economy during the years 2000 and 2001. Credit card companies simply issues cards to anyone interested without any inquiry into the possible credit risks. (Kim et al. 2006, p. 599)

Perhaps even more shocking is that 40% of delinquent borrowers did not provide current addresses or phone numbers (IMF 2004, p. 15).

In February 2004 the defaults at Samsung Card – 56% owned by Samsung Electronics – were being funded by the parent industrial company. This was a continuation of the old core beliefs that ‘the chaebol use healthy subsidiaries as cash cows to bail out failing affiliates, often against the interests of minority shareholders’ (Ward and Song 2004a, p. 18). ‘Anyone investing in South Korea has to accept the risks associated with the chaebol. You may be investing in a world-class electronics company but you need to be aware of the weaker affiliates it may be connected to’ (Ward and Song 2004a, p. 18). A similar situation has arisen in conjunction with the default at LG Card – a subsidiary of the LG Group. The LG Group agreed to buy LG Card's commercial paper (about 150 billion won) as part of its commitment to inject 800 billion won (about US$1 billion) (Song 2004, p. 9) in order to rescue the card company.

The government and the financial institutions developed a number of work-out mechanisms for resolving the household debt problem – including debt rescheduling, debt forgiveness, interest free repayment and personal bankruptcy. However, the number of people who are delinquent was some 3.7 million at the end of 2004 (almost 10% of the adult population) (IMF 2004, p. 15) but by early 2006 the delinquency rate for credit cards had dropped to about 4% from about 8% at the end of 2004 and the peak of close to 16% in 2003.

Nonetheless, despite these positive developments it is the case the financial position of the household sector remains rather precarious. The capital gearing ratio (ratio of financial debts to financial assets) stood at about 50% at the end of 2005 which is higher than in 2003 (at the peak of the credit card crisis) and was higher than in the USA, UK, and Japan (Bank of Korea 2005, p. 28). The household sector is not well placed to deal with another economic shock.

This turn of events suggests that the regulatory and policy-making bureaucracies have yet to fully comprehend the prerequisites of a safe and sound financial system. A corporate debt problem may have been replaced with a consumer debt problem. While it is still too early for observers to dismiss the financial sector reforms as a failure, the policy learning within the official bureaucracy has been inadequate. Old core values or beliefs still permeate the official decision-making circles.

SMEs and chaebols

The situation surrounding SMEs is also problematic as noted earlier. Indeed, the SMEs may be the next systemic crisis that the Korean authorities will have to address. Profitability of SMEs has been weak (negative or slightly positive) since 1997 and the income gap between large and small companies is as wide as ever. During 2005 almost 90% of corporate earnings were concentrated in the top 5% of companies. The losses at the bottom 5% of firms widened (Bank of Korea 2005, p. 31). Perhaps more worrisome is the fact that credit risk of both large and small firms rose in 2005 after having improved persistently from 2000 to 2004 (Bank of Korea 2005, p. 32).

The vulnerable situation of the SMEs can be attributed to a number of factors including poor governance, moral hazard (associated with state intrusion in the financial affairs of these firms), and of course to cyclical factors. One-third of the SMEs are unable to cover their debt service charges. On the other hand the largest firms, the chaebols, have clearly recovered from the excesses of the pre- and immediate post-crisis periods. Nonetheless there is still some way to go to improve corporate governance, ensure both sustainability and a reduction in systemic risk.

This is corroborated by the work of Bernard Black et al. They constructed an index of Korean corporate governance (KCGI) comprising shareholder rights, board structure, board procedure, disclosure, and ownership. While the main purpose of this work was to determine the impact of corporate governance on firm value, their empirical work shows that that KCGI, on a scale of 0–100, has a mean value of about 32 and a maximum value of about 87 (Black et al. 2005, p. 52) although the average score increased from 24 in 1998 to 41 in 2003 (OECD 2005, p. 172). Again while progress is being made, there is still more to be achieved. This mediocre performance, in general, is responsible for the ‘Korea Discount’ observed in global equity markets (OECD 2005, p. 172).

The attempted rearrangement of the power structure in the industrial sector was designed to make the Korean economy more nimble and flexible. The Anglo-Saxon values related to corporate ‘core strengths’ were introduced into the Korean corporate culture by many of the Western-based consultancy and advisory firms. This phenomenon did result in some reshuffling of the deck among the chaebols, and a reduction in the excess production capacity in the economy, ⁴⁵ but public and private actors in Korea and elsewhere continue to suggest that the chaebols still wield a great deal of power and in many cases have hindered the restructuring of the economy. Certainly, the chaebols have interfered with the government's attempt to strengthen the tripartism tendencies in Korean society and have particularly scuttled both attempts to improve pension benefits for workers and to give workers some role in governance of firms.

In order to help itself out of the crisis, the Korean government put in place a number of measures to strengthen corporate governance and financial regulation. In the case of the chaebols, in addition to focusing on core strengths, these measures included a limitation on debt–equity ratios to 200%, a prohibition on cross-loan guarantees among components of the chaebol groups, and the elimination of the notorious opaqueness in financial reporting by having companies adopt more rigorous accounting standards. The government also prohibited financial–industrial links which in the lead-up to the crisis resulted in non-arm's length transactions and connected lending.

Increasingly, ‘the chaebols are getting the message from the market that there is a requirement to come clean if the market is to take a financial position in your company’. ⁴⁶ Nonetheless the uncertainties surrounding the bailout of Hynix Semiconductor were reminiscent of the ‘ancien regime’. The concern in the market about Hynix was whether the company had received illegal subsidies from the state-controlled Korea Exchange Bank (Ward 2002b, p. 17). ⁴⁷

These patterns of action by the chaebol suggest again that old core beliefs continue to prevail in Korean commerce and finance. Corporate governance has not changed significantly since the crisis. It will be recalled that connected lending was supposed to cease in light of the intended reforms of the KDJ administration. However, expedience, pragmatism, and forbearance are values that still capture the captains of Korean industry. Moreover, corruption at the company level continues – even in the administration of RMH. One of RMH's advisers was implicated in the SK Group's scandal (Financial Times 2003) suggesting that the questionable ties between business and politics – which marked the period leading up to the crisis – have really not fully abated. More generally, Transparency International, in its country study of 2006 notes of South Korea that ‘… at present Korea still ranks low in terms of integrity and anti-corruption activities, failing to do justice to its relative international economic standing and trailing well behind the other OECD countries’ (Transparency International 2006, p. 8).

In October 2002 the MOFE announced that the progress the chaebols had made in restructuring their debt loads and in enhancing corporate governance should be ‘rewarded’. Its proposals included the lifting of the investment ceiling preventing chaebols from directing more than 25% of their net assets into subsidiaries or other companies; and, allowing chaebols to hold 10% of the voting shares of a bank. The Minister, Jin Nyum, tried to explain this ‘reward’ by relating it to the competitive threat coming from China (Ward 2001, p. 9). Whatever the explanation, allowing ties between industry and finance, before the new governance environment is firmly embedded in the psyche of industry and bank actors is dangerous indeed. As the Minister himself noted, ‘We have changed the system itself a lot but we have to change the mindset, the way of doing business’ (quoted in Martin 2001, p. 17).

Conclusion: where are we?

Has Korea recovered from the 1997 financial crisis? The short answer is ‘it depends’ – it depends on where you sit. Certainly Korea has experienced a good deal of economic growth in the period since the immediate effects of the crisis dissipated. However, it appears that still there has not been enough political, social, and institutional development to accompany the purely economic advances. The central issue here is that Korea does not seem to have the full consciousness associated with a requirement for a robust institutional, social, and political infrastructure.

On the political front there has been some progress. The election of Kim Dae-jung and Roh Moo-hyun were important achievements and indicate that democracy is consolidating in Korea. The bureaucracy is becoming more conscious about power and is coming to grips with the idea that loyalty to the ruling government rather than to the ruling party is important. And, the values of accountability and responsibility within the public service are maturing. This will result in the elimination of bureaucratic authoritarianism which had been endemic in Korean governance.

The government still has an important structural influence in the financial sector. Earlier in the recovery process it was thought the entry of foreigners into the financial system would help the socialization process to world class practices. However, foreign entry in the financial services industry does not make for good politics. Unfortunately, this has set the stage for stronger participation of the chaebols – directly or indirectly – because they are the only domestic enterprises with pockets deep enough to facilitate further bank consolidation if that becomes necessary. This would indeed be a regrettable outcome. Moreover, financial institutions still engage in window dressing, stock price manipulation, and tamper with the principle of transparency. However, the banks are certainly more stable and prudently managed than was the case prior to the crisis.

Notes

1. For an alternative view see Keun Lee et al. (2005) where the argument is made that Korea, as a Confucian familial society, should not adopt Anglo-Saxon global standards to ensure success in the post-crisis world.

2. The sale of Korea First Bank to the US-based Newbridge Capital – an investment management company with little commitment to the banking industry – was subject to such criticism.

3. The Economist (6 July 2002, pp. 65–67) and confidential interviews.

4. Bank of Korea (2006b, pp. v and 37). The central bank introduced inflation targeting in 1998. The core CPI target for the 2004–2006 period was 2.5–3.5% and except for a period in mid-2004 the observed inflation rate was in the mid to lower half of the target range. In the second half of 2005 and early 2006 the core measure was below the lower target band.

5. Based on confidential interviews.

6. Confidential interviews in October 2000 suggested that ‘everyone’ knew that the IMF was being pushed along by the US authorities.

7. Presently business does not bear the brunt of slowdowns in domestic and external demand through inventory accumulation and production and hence stock adjust accordingly. See OECD (2005) and Jug Hyung Min (2005, p. 8).

8. Based on confidential interviews.

9. This was in sharp contrast to the OECD accession experiences of key Central and Eastern European countries.

10. Based on confidential interviews.

11. Because of the inertia in economic reform prior to 1996, the view among elites in Seoul was that OECD accession would facilitate reform without incurring the political wrath of citizens. Based on confidential interviews.

12. Based on confidential interviews.

13. Delegates to the OECD Committees invariably relayed messages to their capitals depicting the character of the discourse that took place.

14. Harris (2003). Subsequently confirmed numerous times in confidential interviews.

15. Based on confidential interviews.

16. A common refrain often heard from Korean policy makers in the period leading up to the crisis was that ‘Korea does work like other economies’. Based on confidential interviews. Economists in the international organizations brushed aside such assertions in ignorance.

17. Korea Labor Institute and The Korea Times (various issues).

18. Much of the post-crisis scholarship focuses on the 1997–2002 period.

19. It was the government's initial intent to sell Seoul Bank to foreigners. However, the earlier deal between Newbridge and Korea First was not as successful as had been anticipated and Seoul Bank was ultimately sold to Hana Bank.

20. Just prior to the December 2002 Presidential election in Korea Shinhan Finance (Korea's largest financial group) and Cerbus (a private US equity fund) were bidding for Chohung Bank. See Andrew Ward (2002c, p. 17).

21. It was the weaknesses in such a fractured system that gave rise to the single regulator in the UK – the Financial Services Authority.

22. Based on confidential interviews.

23. The government established the Center for International Finance which monitors global financial markets on a 24/7 basis.

24. A term coined by Marcus Noland (2002, p. 122).

25. Based on confidential interviews.

26. The South Korean authorities were not unique in pursuing regulatory forbearance, but among the OECD countries the rationale for the forbearance was probably unique.

27. Based on confidential interviews with a number of institutions that provided advice regarding ‘reform’ to the South Korean authorities.

28. Based on confidential interviews.

29. Based on confidential interviews in Seoul, Hong Kong, London, and Switzerland.

30. Based on confidential interviews.

31. Based on confidential interviews with independent directors.

32. Based on confidential interviews.

33. Based on confidential interviews.

34. Based on confidential interviews.

35. Based on confidential interviews.

36. Based on confidential interviews.

37. Based on confidential interviews.

38. Based on confidential interviews.

39. Based on confidential interviews.

40. See John Zysman (1983) for the original discourse on market and credit-based systems.

41. Moody's Korea.Com, Fundamental Ratings at http://www.moodyskorea.com/english/ratings/fundamental.asp

42. Confidential interviews revealed that Metropolitan Life was interested in Korea Life, but abruptly dropped out of the bidding. That left only Hanwha with any interest. The view within the government was that if the sale had been delayed Korea Life would have lost a great deal of its value.

43. The JoongAng Ilbo noted in its editorial on 26 September 2002 that there may have been some improper activities associated with the Hanwha–Korea Life transaction. See JoongAng Ilbo, 26 September 2002, p. 7.

44. Based on confidential interviews.

45. Virtually all of the reduction in excess capacity was achieved through layoffs of workers in the chaebols and the financial system.

46. Based on confidential interviews.

47. These allegations were alluded to in confidential interviews.