"Korean Stock Exchange 1998"

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QUESTIONS

1. What are the merits and demerits of a stock versus a bank system of financing?

The question can be answered by discussing the differences between a financial system based on relationships versus one based on arms-length transactions.

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A relationship based financial system is characterized by a close relationship between a bank and a company and has the comparative advantage of allowing a long-term investment perspective. Because of the close relationship, the bank can be relatively assured that it will be chosen to provide all of a companys current and future financing needs. Therefore, more emphasis is placed on all the business the relationship will produce rather than the merits of a particular project at a particular time. It allows banks to internalize joint surplus which means they can afford short-term losses by offering lower rates when a company may be financially weak and then make up for it in the long-run by offering above market rates when the companys ability to repay has increased.

This type of financial system occurs when there is a concentrated need and also allows the government greater influence on targeting industries for economic development. It is also occurs when the companies needing financing have fixed capital that they can use for collateral. Finally, it allows companies to overcome underdeveloped product, labor and financial markets.

The main drawbacks of this type of system is the misallocation of resources and lack of price signals. There is a shift of focus from profitability to growth and expansion. This may be done for political reasons to save or create jobs, but it prevents the creative destruction necessary for a economy to develop. For example, take two companies, one that is profitable and one that is losing money. In a developed capital market, the money loser would be shut down. However, in a relationship based economy, resources may be diverted from the profitable company to subsidize the money loser to save jobs and prevent social instability. This type of system favors empire building and overleverage, allowing a company to continue borrowing without regard to appropriate amount of debt that can be supported by its projected cash flows.

A relationship based system, or crony capitalism is also characterized by implicit government guarantees and lax banking supervision. Combined with a lack of transparency and an illiquid market for the assets pledged as collateral, this system is especially vulnerable to both internal and external shocks.

On the other hand, an arms-length system avoids the problems of moral hazard, adverse selection and transaction costs. It does a much better job of channeling resources to the most profitable projects and providing a return commensurate with the risk of the project. It does a much better job of bearing and managing economic risk by allowing investors to distinguish between healthy companies and those in financial distress. The economy becomes more resilient to shocks by localizing problem companies. A prime example is how the Enron collapse did not have a significant ripple effect through the US economy.

Rather than saying that one system is always better than the other, it is important to which system is better for a country at a particular stage of economic development. A country with little access to capital and a weak contractual infrastructure would be better served by a relationship-based system. This characteristics not only describe many Asian countries during the past 0 to 0 years, but also the US during the boom or railroad construction.

. To prevent another bad loan problem in the future, what changes should be made in South Korean banks?

There are two main steps that the Korean government is undertaking to prevent another future banking crisis. First they are strengthening the regulation and supervision of banks, and, second they are restructuring the chaebols. The first step includes measuring and addressing the current problem in order to start with a clean slate. This includes accurately identifying the extent of problem loans, creating necessary regulatory standards, and dealing with banks that do not meet minimum requirements. The second step is to essentially repeat the process for corporations. The Korean government created new guidelines to "improve transparency and governance" and also passed legislation to expedite the process by allowing "tax benefits for restructuring, simplified…the mergers and acquisitions process, and permitted corporate spin-offs and carve-outs."

Another important aspect of the restructuring program was the attraction of foreign capital. Foreign capital was an important, and often only, source of capital to purchase assets that the chaebols were divesting. Perhaps even more importantly, foreign investors would bring "world class management and governance practices to Korea."

To prevent a bad loan problem in the future the government needs to "improve transparency and accountability in their financial system" and to "fix its financial plumbing specifically its accounting…legal and bankruptcy codes." Essentially, the country, while in the short term, it is probably better to rely on its current relationship based banking system to prevent capital from leaving the country, the long term solution is to develop the basis for an arms-length financial system. In the meantime, temporary government guarantees and restriction on capital flows can improve the probability of success of the transition.

. Is it a good idea for South Korea to rely more on the stock market as a source of corporate finance? Is it a good idea from the perspective of the Chaebols?

As South Koreas economy develops, it is more likely to benefit from relying on the stock market as a source of corporate finance. This will allow for the most efficient allocation of resources and highest return to investors. It also will lower the likelihood of future financial shocks by allowing the separation of good investments from bad ones. This gives foreign investors more confidence to make longer term investments and also prevents the broad problems in the system to grow and risk breaking the entire system. As conglomerates trade at a discount relative to potential sum of their parts, investors will likely demand them to break-up so they can focus on their core businesses and also to end cross-subsidization.

Chaebol management will likely not immediately welcome the change because it will be more difficult for them to raise money and place their actions under more scrutiny. Ultimately, though, it will allow them to shift their focus from asset intensive industries to more investments in intangibles asset and research and development that will provide more opportunities for future growth.

4. What are the impediments to develop a vibrant stock market?

In order to develop a vibrant stock market, South Korea should focus on developing its institutional versus physical infrastructure. Most importantly, this includes developing a strong system of contracts and laws, corporate governance and intermediaries.

Whereas a relationship based system may rely on oral or even implied agreements, a vibrant stock market requires contracts that both parties believe will be upheld and laws that provide recourse if one side breaks their part of the bargain. Strong corporate governance is important to protect shareholders rights which is necessary to assure foreign investors entering the market and to also encourage domestic citizens to invest rather than deposit all their money in the bank. Financial intermediaries, such as mutual funds, investment banks and venture capital firms all play important roles in providing information to the market and ensuring that the system remains efficient. The ability of a minority shareholder to sue management or for a firm to mount a hostile takeover or a poorly run company are both necessary ingredients for a properly functioning market. All of these factors contribute to increasing the liquidity of the market and its ability to correctly price risk and allocate resources.

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