THE FINANCIAL CRISES IN MEXICO AND KOREAResolution Strategies, What Worked and What DidntBy Sri Ram AiyerThe Latin American Corporate Governance Round Table, Mexico City, 8-10 April 2002

Background Mexican crisis Dec 1994; IMF assisted with macro economic reforms while World Bank and IDB assisted with Financial Sector Restructuring from early 1995Government led strategy to prevent systemic collapse of commercial banks (re privatized in 1991/92, sold to Mexican Grupos)Banks pursued reckless expansion of loan book from 1991to 94, growing by over 8 times real GDP growth rate. Understated deteriorating portfolio quality, and increasingly underprovisioned for NPLs in order to pay out dividends to shareholders Also, poor management of banks (e.g., insider lending), inadequate supervision and economic slowdown of 1994See handout for details

Governance ReformsGovernance ReformsFocus was on transparency and disclosureUpgrading of accounting and disclosure standards to USGAAP for all banks, and by regulator, and revision of prudential regulations aimed at market monitoring, and at shareholders and managementIncrease in quality of core capital- aimed at shareholders, to reduce moral hazard, but delayedStrengthened supervision- aimed at management and boardsAttempted to revise unlimited deposit protection by FOBAPROA- reduce moral hazard, and improve market monitoringIncrease competition- introduce foreign banking skills

Corporate debt was excessive in the crisis countries but Korea was an outlierDebt to common equity ratios of nonfinancial corporations, 1988 - 96

London, Dec. 21, 1999

Figure 1Low profitability and high leverage led to increased vulnerability of corporates

Table 1

Chaebols ownership of NBFIs is high in Korea(as of September 1999)

Source) Korea Institute of Finance

London, Dec. 21, 1999

Non-life Insurance

Securities

Credit Card

Life-Insurance

ITCs

Avg. Mkt. Share

( Mar-1999)

Avg.

Mkt. Share (Mar-1997)

Top five chaebols

(Percentage Share)

47.3

54.6

52.2

40.3

30.2

34.7

22.5

Korea-Governance AgendaKorea is a case of CG principles in actual operationNegotiated reforms in January 1998, first laws enacted in February 98 as part of first SAL, and then in December 98 for second SAL. Code of Best Practice issued and further laws enacted by September 1999while OECD principles were in discussion.Focus on shareholders, Boards of Directors, audit systems, stakeholder monitoring of management, and market monitoring; (see Oct 27, 2000 Press Release)Audit Committees WB believed US system was right; now obligatory for all Korean financial institutions, which should also have over half of total as outside directors, and minority rights further reinforced

Some IssuesBoards of Directors Finding qualified and independent ones was a problem as this was a new type of jobTraining them in the principles being adopted, their duties and limits, etc., needed quick capacity building of trainersFear of legal liabilities firms had hitherto been black boxes, while Feb 98 laws gave minority shareholders significant rightsMinority shareholders began suing large chaebol from March 98, with good effectStakeholders public interest groups taking active role as does pressForeign Institutional Investors- seen as reliable outside monitors of firmspractices, and their value appreciated more than other firms from late 1998 already. More firms sought such investment

Bankruptcy ProcessesWorked less well in Korea, mainly because of aversion to exit by large firms, and unwillingness of banks to recognize losses. SMEs were liquidated in thousands in 98, and this sector recovered fastest. WB suggested specialized bankruptcy courts but GOK preferred to use Seoul district courtThis said, collapse and break up of Daewoo in summer 99 showed that too big to fail myth had been crashed. Since then Hyundai group broke up, Hyundai ITC is being sold off as is Hynix, and other affiliates of chaebols. (Nothing like this was seen in Mexico)In March 2001 GOK revisited need for speeding up corporate restructuring, and by law enacted in September 2001 banks are obliged to reassess quarterly the financial situation of weak firms with view to pushing exit through courts if necessary.

Is it Working in Korea?Early days, but laws and regulations are in placeCorporate culture is the issue, but change is being seen, in banks and large firmsKorea was an industrialized society with a high level of literacy, so need for changes was understood- school kids know about BIS capital adequacy ratio! (Mexico is a more two speed economy, one modern and another more peri urban/rural and less literate)

Broader PointsGiven integration of financial markets and their innovations, improving and optimizing prudential regulations of Fis likely to improve their own and their borrowers i.e., corporationsgovernance practices. Positive externalities argue for BIS, OECD, IMF, WB etc to continue to review and update principles for such regulations for benefit of allConvergence of securities laws through uniform rules and standards would achieve same results, but these markets are harder to monitor being more dispersed and heterogeneous.Korea is a civil law society like Mexico, but using the crisis, was able to enact new laws in a number of areas, unlike Mexico.