by Edward M. Graham, Peterson Institute for International Economics
Reform of the financial and corporate sectors is a central element in Korea’s effort to recover from its economic crisis. This summary of a forthcoming study by Institute senior fellow Edward M. Graham suggests how such reform might be accomplished. Dr. Graham is author or coauthor of Global Competition Policy (1997) and Competition Policies for a Global Economy (1997) with J. David Richardson, Global Corporations and National Governments (1996), and Foreign Direct Investment in the United States with Paul Krugman (3rd edition 1995).
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Efforts to restructure the South Korean economy via financial sector reform and privately engineered “big deals” among the chaebol, the large conglomerate firms that dominate the South Korean economy, have not yet delivered the desired result of restoring the economy to health. South Korea should consider more radical approaches. One successful model that might be followed is that of the Resolution Trust Corporation (RTC). This was a state-owned enterprise created to resolve the crisis in the United States created in the late 1980s by the failure of significant numbers of savings and loan associations (S&Ls). S&Ls were a type of bank created to take long-term savings deposits from households and relend these mostly as residential mortgages. These banks, during the 1980s, were deregulated so as to allow them to hold more diverse assets and to remove interest rate ceilings that had been imposed during earlier times. As a result, many of them restructured their asset portfolios away from low return (but low risk) mortgages to higher return (but higher risk) assets such as so-called “junk bonds.”
Implicit in this asset switching was an element of moral hazard. This arose because most of the liabilities of the S&Ls—i.e., the savings deposits of households—were insured by the US federal government through the Federal Savings and Loan Insurance Corporation (FSLIC), a subsidiary of the Federal Deposit Insurance Corporation (FDIC). Thus, in the event that the high-risk assets were to drop so much in value that the S&Ls became financially insolvent, the liabilities were guaranteed by the US government.
During the late 1980s, this is exactly what happened: Numerous S&Ls became insolvent, and their liabilities became those of the US government. Among other things, this event called into question the wisdom of the extent of deregulation of these banks. One lesson, in retrospect, was that the banking sector cannot be fully deregulated. Banks must be subject both to fiduciary regulation to limit the riskiness of their investments and to effective supervision. Better bank regulation and supervision are, of course, key issues that South Korea now faces.
But by the late 1980s, the damage from this deregulation had been done. Thus, the immediate issue was how to resolve the crisis resulting from insolvent S&Ls. To achieve this resolution, the RTC was created on August 9, 1989, as a public company that would, upon completion of its task, go out of business. And, indeed, the RTC was closed at the end of 1995, one year ahead of schedule, with its task largely and successfully completed.
During the years of its existence, the RTC acted as receiver of the assets of failed S&Ls, most of which were sold or liquidated. The depositors of liquidated institutions received, in most cases, full value of their deposits under their FSLIC coverage. The assets of the institutions in turn were auctioned. Because the S&Ls were insolvent, by definition the values of their assets were less than that of their liabilities, and hence the RTC operated at a loss. The goal was to minimize this loss while disrupting as little as possible the normal functioning of financial markets.
By most accounts, this goal was met. The RTC resolved a total of 747 failed financial institutions. The book value of the assets of these institutions was $458 billion, and the RTC was able to sell 98 percent of these assets, for which it received $397 billion. (The figures include recoveries both from sale of certain failed institutions and liquidation of others.) Thus, a gross capital loss of about $61 billion was recorded. In addition, the RTC incurred administrative expenses. But it also realized revenues not associated with sales of assets. The bottom line was that the total costs of the RTC to the US taxpayer were $81.9 billion, or slightly more than 1 percent of 1995 GDP.1
It should be noted that much of the operating expense of the RTC resulted from the use of private contractors to manage and liquidate assets of failed S&Ls. The comptroller general of the United States reported in June 1996 that the RTC's controls over contractors, especially in the first several years of RTC operations, were lax and that recovery of assets sold might have been adversely affected by this laxity. One lesson is that, while use of contractors is desirable, adequate supervision and control of these contractors must be maintained.
If South Korea were to adopt the RTC model, there should be a number of changes with respect to what was done in the United States. For example, if a South Korean RTC were to operate under strictly the same rules as in the United States, then because of the magnitude of the nonperforming loan problem in South Korean banks, virtually all banks in South Korea would have to be sold or liquidated—but this clearly is not an option. Thus, the South Korean RTC would seek to allow a certain number of banks to survive. But the South Korean RTC should also seek to ensure that surviving banks were to change thoroughly their lending practices. To do so, the South Korean RTC would almost surely have to assume managerial control of these banks and, as explained below, to take some of the bad loans off their books.
In this regard, it is worth noting that, in the United States, the RTC also actually took control of failed financial institutions. And, even in the market-oriented United States, under a market-oriented Republican administration, there were few complaints about “undue government interference in the market” when this happened. Rather, it was recognized that a major crisis existed and that strong government action was needed. But, as already noted, the RTC existed only as a temporary institution to solve a crisis. The idea from the beginning was for the government, through the RTC, to act decisively as manager of failed financial institutions but, once the crisis was resolved, to withdraw from this role.
Likewise, in South Korea, one would expect the time during which the South Korean RTC actually controlled the banks would be limited. During this time, the South Korean RTC would, however, completely overhaul the ways in which banks did business. Key to the success of this effort would be massive training efforts to educate bank managers in techniques of credit analysis, risk management, and other aspects of financial management. Thus, the South Korean RTC might, among other things, serve as a management training institution (or as a sponsoring agent to send bank managers to management development courses in educational institutions such as graduate business schools). Beyond this, it would supervise effective implementation of the new techniques that were being taught.
To fulfill this role, the South Korean RTC, as did its US counterpart, would have to hire a competent, full-time staff. One issue would be what to do with this staff once the South Korean RTC ceased operations. An answer would be that this staff would largely consist of highly trained and experienced young financial managers who, after fulfilling their term of office at the South Korean RTC, would have received “on-the-job” training needed to staff the reformed banks of South Korea.
Beyond this, there are some other ways in which the South Korean approach should be quite different from the US one. One possibility would be for the South Korean government to issue bonds and to exchange these, at face value, for the nonperforming loans of bankrupt South Korean banks whose operations were taken over by the South Korean RTC. The stock of government bonds as a percent of total outstanding debt instruments in South Korea is quite low relative to other advanced nations, and creation of these bonds as tradable instruments would be in South Korea's interests under any circumstances as a means to developing a deeper bond market. Such a market is a necessary component of a well-functioning capital market. A deep bond market is also an essential element for the proper functioning of an independent central bank's open market operations to control the rate of expansion of the domestic money supply. This is of importance to South Korea because one of its recent reforms has been to create an independent central bank by removing the Bank of Korea from the control of the Finance and Economics Ministry.
Such a swap of bonds for nonperforming loans would be a particularly effective way by which to recapitalize the banks. But it would present the following dilemma: Because nonperforming assets would be replaced by performing assets, there would be a windfall gain to shareholders of the banks at public expense. The reasonable resolution of this dilemma would be for nonperforming assets to be written down to market value prior to the swap and, then, for the South Korean government to be granted equity in the banks of value equal to the markdown. The holder of record of the equity would logically be the South Korean RTC. But, because South Korea seeks that banks be private and not state-owned institutions, the South Korean government should then reprivatize its holdings in the banks by selling these to the public.
The swaps would also leave the South Korean government as the holder of a large amount of bad debt. The next logical step would be a mandatory equity for debt exchange at rates to be determined via independent valuation of the underlying securities. The equity in the chaebol and other South Korean firms that would now be held by the South Korean government then likewise should be sold to the public via the South Korean RTC. The result would be recapitalization of business firms via debt to equity swaps, with the new equity held by the South Korean public.
Thus, the South Korean RTC would serve as a means to privatize public holdings of debt and equity that resulted from recapitalization of the banking system. In doing so, the South Korean RTC would doubtlessly achieve another desirable goal, a broadening of the ownership of South Korea's large financial and industrial enterprises. Indeed, one question that is posed by the process of privatization is, exactly who will buy the assets that are privatized? Because South Korea has a very high rate of household savings, the answer could very well be that the ultimate buyers would be ordinary South Koreans. But, to achieve this, it would be desirable that there be created intermediate institutions such as professionally managed mutual and pension funds. And, thus, one final task of a South Korean RTC might be to help foster the creation of these institutions that now largely are lacking in South Korea but that are important components of a deep financial market.
One implication of this would be that the losses stemming from nonperforming loans would ultimately be borne to as great an extent as possible by the holders of existing equity in indebted enterprises. The losses would be manifested in dilution of this equity as the result of public sale of new equity created by the equity for debt swaps. The operations of the South Korean RTC thus would not have the effect of forcing the taxpaying public to absorb the losses properly accruing to owners of businesses that used debt to make bad investment decisions.2 Rather, the operations of the South Korean RTC would force an equitable outcome of bad debt resolution.
All of this suggests a set of very daunting tasks for a South Korean RTC. But South Korea does not lack for well-educated, talented persons who would be quite capable of carrying out these tasks. The issue is one of organizing these persons in a way to enable the crisis to be solved. A South Korean RTC could solve many of South Korea's problems, including providing a vehicle by which the human resources of South Korea could be put to work to rebuild the economy.
1. However, it should be noted that the costs of the RTC were not the only costs associated with the resolution of the S&L crisis. In addition, the costs of deposit insurance (not handled by RTC) were $64.7 billion directly and $7.5 billion indirectly. Partially offsetting these, $22 billion were reinsured in the private sector, so that taxpayer costs of this insurance were $50.2 billion. In total, the costs to the US economy of the S&L crisis were $160.1 billion, of which $132.1 billion was borne by US taxpayers and $28.0 billion was borne by the private sector. These figures include both the costs of the RTC and the FDIC. The $160.1 billion was about 2.2 percent of 1995 GDP, but the costs were spread out over the life of the RTC of slightly more than five years.
2. Or, at least this would be true if the residual value of equity (the current value of equity minus the nominal value of bad debt) were positive. If this value were negative, the South Korean RTC would be forced to absorb the difference between the payment of the bad debt and the revenue achieved via sale of the firm.
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