Ⅰ. Introduction

1. Since the 1980s, while financial activities have become more complex and diverse at home and abroad under financial liberalization and globalization, uncertainty in financial markets has rapidly increased. Financial institutions became widely exposed to risks such as credit risk on which they had already begun to focus concern, including interest rate risk, foreign exchange risk, market risk and country risk. At the same time, as the volume of financial derivative transactions has sharply increased mainly due to the development of information technology, they have assumed even further risk.

2. As we have seen through the example of the Barings case, the stability of the financial industry as a whole has deteriorated due to derivative transactions and their contagion effect. To cope with this instability, financial institutions have taken care to develop various advanced financial commodities, to establish the consolidated risk management system on the basis of market risk, and to employ elaborate risk management techniques, including Value at Risk (VAR).

3. As advanced financial supervisory authorities such as the Office of the Comptroller of the Currency in the United States and the Financial Services Authority in the United Kingdom have changed their supervisory policies into "risk-focused supervision", many authorities in other countries are following suit. International organizations such as the Bank for International Settlements (BIS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) are trying to establish and employ international standards related to risk management to secure the soundness of financial institutions. Perhaps the best example is the Core Principles for Effective Banking Supervision of the BIS.

4. The need for stronger financial supervision is clear. Although Korean financial institutions have been able to continue to pursue high growth volume-oriented business, the growth of the Korean economic system as a whole has dropped off dramatically. Financial institutions have further faced a more competitive environment due to financial liberalization, aggravating their management soundness. Although they have made efforts to establish the Asset Liability Management (ALM) system and to expand electronic data processing facilities, their overall risk management is in its infant stages. In addition, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) have strongly recommended to Korean supervisory authority to improve its supervision level according to the Core Principles for Effective Banking Supervision of the BIS.

5. The Financial Supervisory Commission launched several task forces including the Team for Improving Supervisory Regulations from April 1, 1998 and has done its best to improve Korean financial supervision levels to meet international standards. It also has set up new paradigms to meet the goals of financial supervision such as the maintenance of a sound credit system, the establishment of fair financial transaction practices and consumer protection. This has involved the conversion of supervision from direct regulatory methods to indirect regulatory methods, from the positive system to that of negative system, from the application of abstract and subjective principles to that of transparent and objective principles, from organizational supervision to functional supervision and from the regulatory posture to the service offering one. On the basis of these principles, the FSC has continued its efforts to raise its level of supervision to that of international best practices and the level recommended by international financial supervisory organizations.

6. Accordingly, the Commission has taken a number of decisive steps. The Commission adopted the Prompt Corrective Action system, improved the management evaluation(rating) system in the manner of advanced countries and implemented a comprehensive risk-based policy including market risk. It has fostered the mark-to-market accounting system to enhance transparency while encouraging the adoption of improved accounting principles. In line with this, the FSC reformed the public disclosure of financial institutions and the sanction system to establish the accountable management system. It introduced off-site surveillance and supplemented the examination regulations and data base systems for more effective supervision and examination. It also drastically relieved or abolished various restrictions on financial businesses to create an environment for innovation and initiative in the management activities of financial institutions.

7. As you may be well aware, the Financial Supervisory Commission has done the necessary work to enhance the soundness of financial institutions and financial supervisory levels. Four existing supervisory agencies(Banking Supervisory Authority, Securities Supervisory Board, Insurance Supervisory Board, Non-banking Supervisory Authority) will be fully consolidated into Financial Supervisory Service(FSS) in January 1999. FSC/FSS will continue to focus more attention in the future as it has in the past to make strengthening financial supervision first priority by making the most of the technical assistant loans from the IBRD in process and by acquiring advanced supervision and examination techniques and skills that have been developed in foreign supervisory organizations.
　
Ⅱ. Strengthening of Prudential Regulation

1. The Adoption of Prompt Corrective Action (PCA)

8. A PCA is generally defined as the step by step imposition of obligatory corrective measures by supervisory authorities on unsound financial institutions that fall below a certain of level of capital adequacy. Its merits are to decrease the possibility of bankruptcy of financial institutions by strengthening market discipline, to decrease the social cost for clearing unsound financial institutions and to make conditions of fair competition between large and small financial institutions.

9. Since a legal basis for the enforcement of PCA was established by the 「Act Concerning the Structural Improvement of the Financial Industry」in 1997, the Financial Supervisory Commission has continuously made specific regulations concerning banks, securities companies, insurance companies and merchant banking corporations. The criteria for deciding whether financial institutions are sound through the use of capital adequacy standards has been simplified. These standards are the BIS capital adequacy ratio for banks and merchant banking corporations, the operational net capital ratio to the securities companies, and payment capacity insufficiency ratio to the insurance companies.

10. A three-step corrective measure, composed of management improvement recommendations, management improvement measures and management improvement orders, will be imposed on the unsound financial institutions according to the degree of their unsoundness. Management improvement recommendations include the improvement of man-power and organization management, the increase or decrease of capital, restriction of profit dividends, special provisioning, and warning against the institution and senior management. Management improvement measures include the merger or closure of establishments, restriction of additional establishments, sale of risky assets and subsidiaries, change of senior management, and partial suspension of operations. To the seriously unsound financial institutions, the Financial Supervisory Commission can order a management improvement that includes merger of shares, the firing or suspension of senior management activity, appointment of an acting manager, transference of operations, and merger or purchase and assumption (P&A), among other measures.

2. Improvement of the Management Appraisal System (Rating System)

on Financial Institutions

11. The management appraisal system makes possible graduated supervision measures based upon the result of appraisal. And it can enhance management efficiency by assessing the performance of financial institutions and providing corresponding incentives or penalties. The system of appraisal by supervisory authority for supervisory purposes is different from the credit rating institutions whose objective is to provide information to their customers as investors.

12. In the past each supervisory authority including the BSA has carried out management appraisal on its financial institutions with individual appraisal methods and appraisal goals, but the maintenance of these methods after the creation of the Financial Supervisory Service (FSS) may hamper the efficiency and consistency of the work. Therefore, the FSS is planning a revised management appraisal that is focused on risk assessment with a view to providing a service to the financial institutions as their supervisory authority.

13. Namely, the revised management appraisal is applied to all financial institutions that are supervised by the FSS, and the appraisal, which will take into account the reports from the financial institutions themselves, will be undertaken during normal on-site examinations. In the final stage, the results will be combined into the composite management appraisal. This will be composed of quantitative indicators and qualitative indicators under each appraisal section. It will aim to evaluate the indicators by a non-comparative one rather than a comparative method, and by a static method rather than a flow method, in order to enhance the objective trustworthiness of the appraisal result.

14. In particular, it will be strengthened by the inclusion of market risk appraisal because these days financial institutions are affected strongly by changes in interest and exchange rates and market prices. In the case of banks, the current CAMEL method will be changed to CAMELS, which includes sensitivity to market risk.

3. The Enforcement and Establishment of a Working Plan of Financial

Supervisory Policies Focused on Risk Management

15. In the past, financial supervision used only quantified standards based on balance sheet items such as capital regulation for the maintenance of solvency and liquidity regulation for temporary liquidity. However, since the exchange rate system became a floating exchange rate system and the liberalization and internationalization of financial industries intensified from the 1980s, the financial institutions became greatly susceptible to many risks such as interest and exchange rate and price fluctuation. In reality, prominent examples of small or large financial mishaps due to a failure of risk management could be seen around us: the failure of one dealer in derivative transactions led to the bankruptcy of the Barings Group with a long tradition. And an irregularity in the transaction of bonds at Daiwa Bank ended up with a large loss and the suspension of American operations was imposed on the bank.

To cope with this situation, the supervisory authorities in advanced countries such as the OCC of the USA or the FSA of the UK are carrying out a risk focused supervision policy. In addition, internationally, the supervision of risk has emerged as one of the greatest concerns. For example, international financial and supervisory institutes such as the BIS, IOSCO, IAIS have made guidelines on risk control to be carried out by each member country.
　
17. Therefore, in line with these international trends, the FSC has already made and carried out "A Working Plan on the Financial Supervision Policy Focused on Risk Control" in order to monitor consistently and control completely all risks arising in operations. Its main contents are as follows: First, the FSC is preparing a guideline on risk control including a basic direction, the role of management, organization and procedures for risk control. Second, the FSC is directing individual financial institutions to establish a unique internal control system corresponding to the condition of an institution.

18. Besides, the examiners are preparing and supplementing a risk check list in order to monitor the universal validity of the risk control system and its smooth working. In case of the management appraisal of financial institutions, they have increased the weight of the risk section and developed some indicators for the measurement of risk during off-site supervisions. As described above, the FSC is strengthening supervision on risk control in various ways.

19. Particularly, the FSC is helping financial institutions implement their own internal models in order to measure and control market risk using a standard method or VAR provided by the BIS for strengthening supervision on market risk such as exchange rate, interest rate, and price fluctuations. However, concerning the sequence of enforcement, the FSC is directing first of all large financial institutions and then others to implement the system with a grace period of up to one year in consideration of their computer systems and management circumstances.

4. The Strengthening of Supervision on Foreign Liquidity Management

20. The FSC has strengthened supervision on foreign liquidity and exposure because all risks have increased in carrying out foreign exchange operations based on multi-national transactions in the current environment of openness of financial markets and deregulation. Namely, the FSC now supervises simultaneously the flow of foreign assets as well as their stock and has strengthened control on the quality of foreign assets as well as their magnitude, including off-balance items.

Particularly, the FSC changed the frequency of monitoring from quarterly to monthly and enlarged the scope of monitoring to overseas subsidiaries and off-shore accounts. The FSC has permitted financial institutions to secure short-term foreign assets amounting to over 70% of foreign liabilities with a maturity of less than three months and to fund over 50% of long-term foreign assets with a maturity of more than one year in the form of long-term foreign liabilities. In addition, from January 1999, the FSC is planning to encourage the introduction of control systems on the gap between funding and investment considering residual maturity. To put it concretely, the gap between foreign assets and liabilities will be measured for 0-7 days, 8 days-one month, 1-3 months, 3-6 months, 6 months-one year and over one year. The ratio of the asset-liability gap over total foreign assets should be over 0% for up to 7 days, and over -10% for up to one month, and over -20% for up to three months
　
5. Update of Prudential Regulations

22. Loan classification procedures have been strengthened to classify all loans 90 days(previously 180 days) overdue as substandard and to increase loan loss provisioning rate for precautionary assets from 1% to 2%. Commercial papers, guaranteed bills and privately placed bonds in trust accounts, which are virtually equivalent to credit extentions, have been included in the asset category subject to loan loss provisions and, the requirement of 100% of loan loss provisions for trust accounts with guarantees of pricipals has been added to those with guarantees of interests. The criteria for the calculation of BIS capital adequacy ratios have been revised to deduct the provisions of those classified as substandard or lower from Tier 2 Capital. In addition, the definitions of loan classifications will be further revised in 1999 so as to reflect borrowers' repayment capacity as well as past performance. Loan loss provisions will also be required for payment guarantees of commercial banks.

Ⅲ. Enhancing Accounting Transparency

23. As the most important measure to enhance the accounting transparency of the financial institutions, the mark-to-market accounting has been introduced. Mark-to-market accounting is an accounting method that values the assets at fair current value at the valuation date, amends the book value and recognizes the gains or losses from the difference.

24. Until now, the financial institutions in Korea have not adopted the mark-to-market accounting for securities through it is in common use internationally and even in use by domestic corporations. As a result, transparency has been insufficient and distrust of financial statements has arisen, and following the IMF and the IBRD's request, its introduction is seen as pressing

25. Hereupon, the Financial Supervisory Commission (FSC) decided to introduce mark-to-market accounting overall in the accounting of the financial institutions. But, to decrease any negative impact on the financial market, it is introducing and implementing it step-by-step considering the types of financial institutions. Banks, securities companies, investment trust companies, lending specialized companies and credit unions have implemented it from the closing date of the first half of 1998 fiscal year, and mutual savings & finance companies, and insurance companies will implement it from the closing date of 1998 fiscal year and from 1999 fiscal year, respectively.

In addition, the accounting standards for public disclosure and the accounting standards for supervision, which had been integrated until now, will be separated and administered separately. In other words, the accounting standards for public disclosure will be established and implemented independently by the Securities & Futures Commission (SFC) following the establishment of procedures for corporate accounting standards. And the accounting standards for supervision will be established and implemented separately by the types of financial institution. Also, for the sake of users, titles of accounts, which have been in Korean so far, will be written in Korean and in English.　

Ⅳ. Establishing the Accountability Management System

1. Advancement of the Public Disclosure System of Management Performance

27. The public disclosure system of management performance is a supervision measure that aims to foster sound management of the individual financial institutions and the stability of the financial system as a whole through market discipline by offering accurate and timely information about the management and financial status of individual financial institutions to depositors, stock holders, creditors and other financial users.

28. Though individual supervisory bodies have administered the public disclosure system on the management of financial institutions, disclosure contents have been limited to the status of financial statements and have not been up to the minimum level of public disclosure requested by the International Accounting standards (IAS). Therefore, the Financial Supervisory Commission has improved it to the level of advanced countries for establishing the accountable management system and heightening the efficiency and effectiveness of public disclosure system as a supplementary supervision measure.

29. Concretely, the FSC has increased the regular disclosure items to the scope requested by the IAS, to include for example risk management, off-balance sheet transaction including derivatives, asset classification and so on, and special disclosure items such as those related to financial mishaps, the losing a lawsuit of large sum and others.

30. Also, the FSC has increased the frequency of regular disclosure from once a year to twice a year (quarterly disclosure will be recommended after the introduction of quarterly closing accounts from September 1999) and has implemented sanctions on insincere and untruthful disclosure with the introduction of electronic public disclosure via computer. Although, the public disclosure system has been carried out so far at the banks, security companies and insurance companies, it will be adopted all kinds of financial institutions including mutual savings & finance companies, financial companies specializing in loan business, credit unions and branches of foreign banks.

2. Improving the System of Sanctions on the Management of Financial Institutions

31. Though many financial institutions have been insolvent, they have been unable to impose accountability on the majority stockholders or the de facto directors that have exerted a direct or indirect influence in the managing financial institutions. Moreover, as there is a lack of effective sanction systems on the irregularities of financial institutions and their executives, the necessity of an accountable auditing system by the auditing institutions has become clear.

32. Therefore, the FSC has established and executed an efficient sanction system on the de facto director by investigating the responsibility for an insolvency of the majority stockholder when ruling on an ailing financial institution and imposing civil and criminal liabilities on them. Also, the FSC can impose a money sanction, such as a fine, on the executives and employees having responsibilities for insolvency and can impose the equivalent sanction on the external auditor and examiners of supervisory authorities for neglect of duties.

Ⅴ. Effective Supervision and Examination of Financial Institutions

1. Active off-site surveillance

33. According to the off-site surveillance system, the financial supervisory authority can take appropriate actions after analyzing the soundness and management status of financial institutions through regularly submitted documents, finding out their weaknesses, and making a diagnosis of the problems of each financial institution through special examination.
　
34. Each of the financial supervisory authorities has implemented this off-site surveillance system to the financial institutions under its own authority. For example, the Banking Supervisory Authority has conducted this system since October 1996 after reorganizing the old system and establishing a special team for this work in each examination department. But, this system was not completely effective because of differences in the details and implementing procedures among supervisory authorities, and because supervisors failed to develop indicators to estimate the problem banks early. An early warning system was not established which could be used to monitor the soundness of financial institutions with an EDPS program.

35. So, the Financial Supervisory Commission established a new plan to activate this system to make it one of the main supervisory instruments of consolidated Financial Supervisory Service. This has meant activation of the system. For example, data processing will be done by the information system management department or examination coordination department. Off-site surveillance will be monitored by the examination departments and disciplinary actions will be taken by the bank analysis department, examination departments or examination coordination department. Special task forces, which are dealing with off-site surveillance only and separated from examination teams, will be established in each examination department and in-house analysts for the management analysis of financial institutions will be dispatched to carry out this work.

36. The FSC is developing an electronic checking system of institutions for use from the beginning of 1999 to identify the symptoms of problem using indicators to estimate the soundness and risks of financial institutions. It is now supplementing the EDP system for searching and analyzing current data. In addition, it is also considering new developed reporting systems and methods which include reports with the standardized EDP data. It will employ the DART system when the electronic system for public disclosure is set up.

2. Improvement of the Guide Book on the Examination Regulations and Examination Data Base (DB) system

37. Till now, each supervisory authority drew up a guide book on the examination regulations and to use as a guideline in field examinations. It also established and utilized a data base (DB) system for effective supervision and examination.

38. But, the guide book on the examination regulations omitted several key areas. For example, they did not contain full explanations of financial business and related regulations. They instructed supervisors to concentrate on the wrongdoing of financial business in the past. So, this book has been improved to be utilized as an essential working tool instead of a simple working reference.

39. The utilization rate of the examination DB system has been miserable because of insufficient content and inconvenient programs that examiners can not make prompt use of. So, the FSC requested each authority to improve the management information systems of financial institutions to meet the examination goals.

40. It will continue the effort to improve the guide book on the examination regulations and the examination DB system in the future through making the most of technical assistant loans from the IBRD which can be used from around the end of 1998.

Ⅵ. Deregulation

41. The FSC has strengthened prudential regulations of financial institutions since its establishment in April 1998. At the same time, it has drastically relieved or abolished various restrictions on financial businesses that have hampered the autonomous management and competition of financial institutions.

The main contents for the improvement of foreign investment conditions are as follows: ① to lift an investment limit concerning all domestic securities transactions of foreigners ② to permit the over-the counter transaction for listed bond ③ to simplify the investment procedures. In addition, the FSC has liberalized issuance of overseas and domestic bonds by relaxing the issue conditions of bonds and abolishing the control of issue conditions of overseas securities and the issuing amount of specialized securities. And the FSC deregulated the control of credit on banks and expanded the autonomy of asset investment and operational activities by lessening administrative expense and the burden of works.

Since the second-half of 1998 the FSC has selected financial deregulation as the priority in carrying out overall governmental deregulation. Accordingly it is considering obstacles to domestic investment and regulations relating to internal management foremost and will make a yearly schedule for reviewing them. And the FSC will improve the management of regulations necessary to supervision policy by registering them in the computer and will refrain from making new regulations or strengthening existing regulations.

* Please refer to the attached file for details.