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«Basel Committee on Banking Supervision Regulatory Consistency Assessment Programme (RCAP) Assessment of Basel III risk-based capital regulations – ...»

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Basel Committee

on Banking Supervision

Regulatory Consistency

Assessment Programme

(RCAP)

Assessment of Basel III

risk-based capital

regulations – Korea

September 2016

This publication is available on the BIS website (www.bis.org).

© Bank for International Settlements 2016. All rights reserved. Brief excerpts may be reproduced or

translated provided the source is stated.

ISBN 92-9197-673-7 (online)

Contents

Preface

Executive summary

Response from the Financial Supervisory Service of Korea

1 Assessment context and main findings

1.1 Context

1.2 Structure of the banking sector

1.3 Scope of the assessment

1.4 Main findings

2 Detailed assessment findings

2.1 Scope of application

2.2 Transitional arrangements

2.3 Pillar 1: Minimum capital requirements

2.3.2 Capital buffers (conservation and countercyclical)

2.3.3 Credit risk: Standardised Approach

2.3.4 Credit risk: Internal Ratings-Based Approach

2.3.5 Securitisation framework

2.3.6 Counterparty credit risk framework

2.3.7 Market risk: Standardised Measurement Method

2.3.8 Market risk: Internal Models Approach

–  –  –

2.3.10 Operational risk: Advanced Measurement Approaches

2.4 Pillar 2: Supervisory review process

2.5 Pillar 3: Market discipline

2.6 Observations and other findings specific to the implementation practices in Korea

2.6.1 Definition of capital

2.6.2 Credit risk: Standardised Approach

2.6.4 Counterparty credit risk framework

2.6.5 Operational risk – Partial Use

Annexes

Annex 1: RCAP Assessment Team and Review Team

–  –  –

Annex 4: Local regulations issued by Korean authorities for implementing Basel capital standards.. 34 Annex 5: Details of the RCAP assessment process

Annex 6: List of rectifications by Korean authorities

Annex 7: Assessment of bindingness of regulatory documents

Annex 8: Key financial indicators of Korean banking system

Annex 9: Materiality assessment

Annex 10: Areas where Korean rules are stricter than the Basel standards

Annex 11: List of approaches not allowed by Korean regulatory framework

Annex 12: List of issues for follow-up RCAP assessments

Annex 13: Areas for further guidance from the Basel Committee

Annex 14: Korea’s implementation of the Pillar 2 supervisory review process

–  –  –

The Basel Committee on Banking Supervision sets a high priority on the implementation of regulatory standards underpinning the Basel III framework. The prudential benefits from adopting Basel standards can only fully accrue if these are implemented appropriately and consistently by all member jurisdictions.

The Committee established the Regulatory Consistency Assessment Programme (RCAP) to monitor, assess and evaluate its members’ implementation of the Basel framework.

This report presents the findings of the RCAP Assessment Team on the domestic adoption of the Basel risk-based capital standards in Korea and its consistency with the minimum requirements of the Basel III framework. 1 The assessment focuses on the adoption of Basel standards applied to the Korean banks that are internationally or regionally active and of significance to Korea’s domestic financial stability.

In recent years, the Korean authorities 2 have undertaken several noteworthy initiatives designed to strengthen the prudential framework relating to bank capital. The Korean authorities issued the final rule on Basel III risk-based capital in November 2013 to implement the Basel III framework (taking effect in December 2013).

The RCAP Assessment Team was led by Mr Michael Schoch, Head of Banks Division and Member of the Executive Board of the Swiss Financial Market Supervisory Authority (FINMA). The Assessment Team comprised seven technical experts drawn from Belgium, China, India, Hong Kong SAR, Germany, Singapore and South Africa (Annex 1). The main counterparty for the assessment was the Financial Supervisory Service of Korea (FSS).

The assessment relied upon the data, information and materiality computations provided by the FSS. The assessment findings are based primarily on an understanding of the current processes in Korea as explained by Korean authorities and the expert view of the Assessment Team on the documents and data reviewed. The overall work was coordinated by the Basel Committee Secretariat with support from FINMA staff.

The assessment began in November 2015 and comprised: (i) completion of an RCAP questionnaire (a self-assessment) by the Korean authorities; (ii) an off- and on-site assessment phase (November 2015 to June 2016); and (iii) a post-assessment review phase (July to September 2016). The off- and on-site phases included: (i) the Team Leader’s on-site visit for preliminary discussions with the Korean authorities and representatives of Korean banks (which were used as the RCAP sample banks for the purpose of impact assessment); (ii) an off-site Assessment Team meeting; and (iii) an Assessment Team’s on-site visit for discussions with the Korean authorities and external audit firms. These exchanges provided the Assessment Team with a deeper understanding of the implementation of the Basel riskbased capital standards in Korea. The third phase consisted of a two-stage technical review of the assessment findings: first by a separate RCAP Review Team and feedback from the Basel Committee’s Supervision and Implementation Group; and secondly, by the RCAP Peer Review Board and the Basel See also the separate RCAP assessment report on Korea’s compliance with the Basel III Liquidity Coverage Ratio. Other Basel III standards, namely the Net Stable Funding Ratio, the leverage ratio, and the framework for systemically important banks will be assessed as those standards become effective as per the internationally agreed phase-in arrangements.





Korean authorities refers to the Financial Services Commission (FSC), Financial Supervisory Service (FSS) and the Bank of Korea

–  –  –

Regulatory Consistency Assessment Programme – Korea Committee. This two-step review process is a key instrument of the RCAP process to provide quality control and ensure integrity of the assessment findings.

The focus of the assessment was on the consistency and completeness of the domestic regulations in Korea with the Basel minimum requirements. Issues relating to adequacy of prudential outcomes, capital levels of individual banks, the adequacy of loan classification practices, or the FSS’s supervisory effectiveness were not in the scope of this RCAP assessment exercise.

Where domestic regulations and provisions were identified to be not in conformity with the Basel framework, these deviations were evaluated for their current and potential impact (or non-impact) on the reported capital ratios for a sample of banks that are internationally active or regionally active and of significance to Korea’s domestic financial stability. Some findings were evaluated on a qualitative basis.

The assessment outcome was based on the materiality of findings and the use of expert judgment.

The report has three sections and a set of annexes: (i) an executive summary with a statement from the FSS on the material findings; (ii) the context, scope and methodology and the main set of assessment findings; and (iii) details of the deviations and their materiality along with other assessmentrelated observations.

The RCAP Assessment Team acknowledges the professional cooperation received from the Korean authorities throughout the assessment process. In particular, the Assessment Team sincerely thanks the staff of the FSS for playing an instrumental role in coordinating the assessment exercise. The series of comprehensive briefings and clarifications provided by the Korean authorities enabled the RCAP assessors to arrive at their expert assessment. The Assessment Team is hopeful that the RCAP assessment exercise will contribute towards strengthening prudential effectiveness and full implementation of the recent reform measures in Korea.

4 Regulatory Consistency Assessment Programme – KoreaExecutive summary

The Korean risk-based capital regulations (Basel II) came into force in January 2008. The prudential framework applies to all banking institutions, including national and commercial banking institutions. The frameworks of Basel 2.5 and Basel III came into effect on February 2012 and December 2013, respectively.

The RCAP Assessment Team (Assessment Team) identified a number of deviations from the Basel framework, the majority of which the FSS has rectified. The FSS used the discipline of the RCAP exercise to undertake reform and upgrade their prudential capital framework – to the extent feasible and consistent with Korean national interests. In all, Korean’s capital framework benefited during the course of the RCAP assessment work from 38 rectifications.

Overall, as of the 30 June 2016 cut-off date for the RCAP assessment, the Assessment Team finds Korea’s prudential regulations to be largely compliant with the standards prescribed under the Basel framework. Overall, 12 of the 14 components assessed are compliant with the Basel framework, and one component (definition of capital) is largely compliant while one component (transitional arrangements) is materially non-compliant. In view of this, the prudential regulatory framework in Korea was evaluated to be largely compliant with the minimum standards prescribed under the Basel framework.

The Korean implementation of the detailed requirements of the definition of capital and transitional arrangements are in line with the Basel framework in many respects. Nevertheless, the Assessment Team noted a few but important material deviations that would lead to a higher capital base for the affected Korean banks.

The transitional arrangements component grade is driven mainly by one material finding. The Basel rules text requires that instruments issued after 1 January 2013 should be compliant with PONV requirements and would otherwise be fully derecognised. As the enforcement date of Korean domestic regulation on Basel III was in November 2013 (instead of 1 January 2013), due to delays in national implementation of Basel III, the issuances of capital instruments without PONV requirements between January 2013 and November 2013 were allowed to be recognised as part of transitional arrangement (until end-2022) instead of being fully derecognised immediately, as required by Basel standards. As of December 2018, the most affected bank had an outstanding issuance that formed 0.71% of its total RWAs, representing a 71 bp overstatement of its capital ratio, and the weighted average ratio of these issuances to the seven banks’ RWAs was 0.34% (implying a 34 bp overstatement of capital ratios on average). While the impact is expected to gradually decrease based on the applied transitional arrangements, the underlying issuances are expected to remain in the books of seven Korean banks until end-2022. Given this current impact, the transitional arrangements component was assigned a materially non-compliant grading, following the RCAP methodology.

Concerning the definition of capital component, the Assessment Team noted one key finding that contributed to a largely compliant grading. Basel standards require instruments to be perpetual, ie to have no explicit maturity date, in order for such instruments to be eligible for Additional Tier 1 (AT1) capital. Under Korean rules, instruments with an initial maturity date of a minimum maturity of 30 years and combined with an embedded rollover clause are viewed as perpetual and consequently are then considered eligible for AT1 capital. This was implemented consciously by the Korean authorities to accommodate the existing legal constraint introduced by the Korean Commercial Act that requires all debt instruments to have a maturity date.

Regulatory Consistency Assessment Programme – Korea As part of its rectification action, the FSS introduced a new article in the Enforcement Decree of the Banking Act (EDBA) 3, and deleted the reference to the 30-year maturity in the DRSBB. The FSS explained to the Assessment Team, that this new article in the EDBA (a governing law of the RSBB and the DRSBB), would allow Korean banks to issue contingent capital instruments without any reference to an explicit maturity date in the underlying debt term sheet. In contrast, such bonds are regarded as carrying an implicit maturity date aligned with the exercise of permanent write-down following the contingent trigger event (ie a bank’s liquidation or bankruptcy). The FSS confirmed the Assessment Team’s understanding that “implicit maturity” upon PONV confers no right to repayment and it is simply the term used to confirm that the instrument no longer exists as a result of the write-down/conversion. In this regard, the Assessment Team finds the rectification action proposed by the FSS to be satisfactory.

Notwithstanding, the remaining legacy issue as a result of the previous regulation cannot be fully ignored. The Assessment Team noted there is a considerable amount of outstanding previous issuance of ineligible AT1 instruments with a 30-year maturity date. As of December 2018, the impact remains material, affecting two Korean banks, with the most affected bank having an outstanding issuance of 0.62% of its total RWA (ie an overstatement of capital ratio by 62 bp) and a weighted average impact of 0.17% of the total RWAs (ie an overstatement of capital ratio by 17 bp) of the sample banks. In its assessment, the Assessment Team reflected that the FSS has prohibited banks from issuing such instruments following the RCAP on-site review in February 2016. The Assessment Team also anticipated that the impact would be reduced over time, as the FSS may ask banks to redeem the outstanding ineligible AT1 instruments on the call date. However, the Assessment Team had to be cognisant that the risk of such instruments being recognised as Tier I capital until 2025 cannot be fully ruled out.



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