The State Guarantee of External Debt of Korean Banks

Having previously weathered the Asian Financial Crisis of 1997, the Republic of Korea was considered to have been relatively more prepared than its Western counterparts to manage the economic fallout from the Global Financial Crisis (Rhee 2008). However, the country was not completely immune to the deleterious effects of the subprime downturn in 2007; Korea in particular suffered major losses in the first half of 2008 as overseas investors collectively withdrew $886 million and net foreign direct investment turned negative for the first time since 1980 (Fackler 2008). This divestment would later contribute to a deterioration in Korea’s ability to repay its external debts. Consequently, despite efforts by the government to emphasize the economy’s relatively stable domestic position, Korean markets remained vulnerable to exogenous shocks (Harden 2008).

Confidence dropped precipitously over the summer of 2008 as the stock market plummeted 38% and the Korean won fell 30% against the dollar (Harden 2008). In response, both banks and major corporations, such as Hyundai and Samsung, began hoarding domestic currency (Harden 2008, Sang-Hun 2008). To worsen matters, the September 15 Lehman Brothers bankruptcy sent global credit markets into turmoil and fueled further anxieties over the strength of Korea’s export markets and foreign currency reserves (Fackler 2008). Domestic banks also began to bear the costs of the crisis more directly: Woori Bank, one of Korea’s largest lenders, found itself unable to borrow after the collapse. Overseas banks refused to roll over many existing loans and insisted that Woori pay in dollars as the debt came to maturity (Fackler 2008). Dollar loans from the government totaling $280 million kept the bank afloat.

This lending crisis spread quickly throughout the Korean financial system as it became increasingly clear that domestic banks would not be able to honor their maturing foreign currency loans. Following news of Lehman’s insolvency, between 4Q2008 and 1Q2009, the banking sector suffered from rapid deleveraging as $42.8 billion in assets were taken out of the country (Kim 2009). Such a large selloff, coupled with the depreciation of the won and rising borrowing costs, caused Moody’s to declare Korea to be “one of the few banking systems in Asia where domestic deposits are insufficient to fund loans” (Eggertson and Krugman 2016, Sang-Hun 2008). Additionally, S&P downgraded the Big Four Korean banks —Kookmin Bank, Woori Bank, Shinhan Bank, and Hana Bank—from “stable” to “negative”on October 1. Their ability to raise foreign capital thus continued to decline (Gup 2010).

Having relatively recently opened its markets to the international community, Korea did not have access to the same emergency sources of foreign currency reserves as did other countries (Fackler 2008). At the same time, it was more susceptible to market instability due to its transparency and openness to foreign capital (Fackler 2008). The Korean government attempted to calm markets by pointing to the soundness of the domestic real economy, particularly in terms of its low sovereign debt levels and steady economic growth of 4.5% over the previous five years (Rhee 2008). Still, it was decided on October 19, 2008, that the government should follow its international counterparts in instituting tangible stabilization measures. As part of the program, the government began to offer guarantees on inter-bank loans to mitigate the ongoing liquidity crisis, “calm markets and preemptively minimize the total cost of employing the intervention” at a later date (Rhee 2008).

The State Guarantee of External Debt of Korean Banks (henceforth, the “State Guarantee”) would be operational from its announcement date of October 20, 2008, through June 30, 2009. The Operational Guidelines for National Guarantees of Foreign Debt Obligations of Domestic Banks (henceforth, “The Guidelines”), served as the memorandum of understanding between the government and the bank applying to issue debt under the guarantee program (2008). The “Proposed measures” document, a press release issued on October 19, 2008, by the Korean Ministry of Strategy and Finance, outlined the projected terms of the State Guarantee (Ministry of Strategy and Finance 2009).    

Under the authority of Article 92 of the National Finance Act, the Enforcement Decree of the National Finance Act, and The Rules for the Management of State Guarantees, the Korean government introduced a foreign debt guarantee scheme as part of a comprehensive set of stabilization measures intended to alleviate market liquidity pressures and ensure that its domestic banks maintained a competitive advantage in overseas funding (Ministry of Strategy and Finance 2008). Together with the Bank of Korea, the government would provide the banking sector with an additional $30 billion in dollar liquidity from foreign exchange reserves. Among other measures, it also provided tax incentives for the long-term holding of funds, invested Korean Won 1 trillion (ca. $760.5 million^FNThe October 20, 2008, exchange rate was 1 U.S. dollar = 1,315 Korean Won.) in the Industrial Bank of Korea, and took concrete steps to strengthen regional and international ties. Recapitalization of financial institutions and the expansion of deposit guarantees were deemed unnecessary at the time (Ministry of Strategy and Finance 2008).

“We believe providing the government guarantee on banks’ foreign exchange dealings is the strongest step to save our foreign exchange reserves,” said Korean Finance Minister Kang Man-soo (Kim and Choonsik 2008).

Any debt denominated in foreign currency issued (including extensions of maturity) by a domestic Korean bank or its overseas branches during this period and owed to a “non-resident” institution (excluding foreign currency deposits and subordinated debt) would be eligible for a guarantee by the government for up to three years from the date of issuance or acquisition (The Guidelines). The government does not appear to have established minimum maturity requirements for eligible debt. On April 30, 2009, the guarantee was extended by the Ministry of Strategy and Finance to five years, although this allowance would prove to be unnecessary given the program’s limited utilization (Ministry of Strategy and Finance 2009a).

The Korean government needed to secure the approval of the National Assembly to fund the guarantee structure. In the interim, either the Korean Development Bank or Korea Eximbank would provide guarantees. The Ministry of Strategy and Finance would then, after having received authorization, assume responsibility for all guarantees, including those previously offered by KDB or Korea Eximbank (“Proposed measures”). New debt would be guaranteed by the government only if explicitly requested and applied for (The Guidelines). The standardized guarantee (participation) fee, regardless of an individual bank’s credit rating, equaled 1% per annum of the daily outstanding balance of guaranteed debt on the basis of a 360-day calendar year (Ministry of Strategy and Finance 2009a). However, the Ministry of Strategy and Finance retained the right to set different guarantee fee rates “depending on market conditions, the financial condition of the Obligor, performance of covenants by an Obligor…and other relevant factors” (Ministry of Strategy and Finance 2009a). On February 16, 2009, the Korean government lowered the guarantee fee to 0.7% per annum (Ministry of Strategy and Finance 2009a).

The government imposed a $100 billion cap on the total value of guarantees, as it was estimated that the external debt reaching maturity by the end of June 2009 would total $80 billion (Ministry of Strategy and Finance 2008). There were also individual guarantee limits imposed on each bank. These were determined by the Financial Services Commission, which gathered information from the Financial Supervisory Services on the amount of each domestic bank’s foreign debt maturing by June 30, 2009, and added an extra 25% cushion (Jin-Woo 2008).

The guarantee agreement would be triggered by an event in which the “Obligor fails to satisfy its payments on a date due as required under the Guaranteed Debt” (Ministry of Strategy and Finance 2009a). Coverage would include 100% of principal and interest, as well as default interest and related expenses, accrued “until the date of actual payment by the guarantor, up to the Guaranteed Amount” (Ministry of Strategy and Finance 2009a). The government would also pay out in the event that the guaranteed debt were accelerated “as a result of the Obligor’s failure to comply with the covenants under the Guaranteed Debt” (Ministry of Strategy and Finance 2009a).

The Korean government issued only two bond guarantees to one of its eligible domestic banks over the course of the program’s duration. On April 6, 2009, Hana Bank issued $1 billion worth of guaranteed bonds for a period of three years. Subsequently, it issued $280 million for a period of either two and a half or three years. Hana Bank was ultimately able to meet all payments to foreign creditors without triggering the guarantee (Korea Institute of Finance 2009). All obligations, as specified by The Guidelines, were repaid to the lenders by June 30, 2012, at which point the program was terminated (Korea Institute of Finance 2009).