KFB’s Overall Performance KFB’s Overall Performance

Assets have been declining over time from 46,115 to Assets have been declining over time from 46,115 to 33,498 (Ex. 1)33,498 (Ex. 1)

A large part of the decline in assets is due to the decline A large part of the decline in assets is due to the decline in loans from 20,208 (‘96) to 15,025 (‘98), as well as in loans from 20,208 (‘96) to 15,025 (‘98), as well as Customers Liabilities on Guarantees [4,475 (‘96) to Customers Liabilities on Guarantees [4,475 (‘96) to 1,466 (‘98)]1,466 (‘98)]

Not surprisingly, Deposits are down from 26,910 (‘96) to Not surprisingly, Deposits are down from 26,910 (‘96) to 22,478 (‘98)22,478 (‘98)

Retained Earnings have declined precipitously from Retained Earnings have declined precipitously from 446,446 (‘96) to (1,914,597) (‘98) 446,446 (‘96) to (1,914,597) (‘98)

KFB’s Overall PerformanceKFB’s Overall PerformanceLarge decline in stock market price (see Figure 1); Large decline in stock market price (see Figure 1); significant decline that cannot be explained by decline in significant decline that cannot be explained by decline in Korean market (or the Korean Finance index) during the Korean market (or the Korean Finance index) during the same period (see Figure 1 and 2)same period (see Figure 1 and 2)

Consolidated net loss increase from (39,511) in ‘96 to Consolidated net loss increase from (39,511) in ‘96 to (2,731,029) in ‘98 (Ex. 2)(2,731,029) in ‘98 (Ex. 2)

Interest expense went up from 2,718,878 in ‘96 to Interest expense went up from 2,718,878 in ‘96 to 3,158,489 in ‘983,158,489 in ‘98

Other operating expenses shot up as well from 726,742 Other operating expenses shot up as well from 726,742 in ‘96 to 2,932,784 in ‘98in ‘96 to 2,932,784 in ‘98

Large decline in interest and dividends on securities for Large decline in interest and dividends on securities for sale from 1,207,088 in ‘96 to 356,054 in ‘98sale from 1,207,088 in ‘96 to 356,054 in ‘98

KFB’s Credit Risk (A)KFB’s Credit Risk (A)

KFB’s main exposure to business loansKFB’s main exposure to business loans

In ‘98 KFB has a slightly more diversified loan portfolio In ‘98 KFB has a slightly more diversified loan portfolio (% of total loans in the top 5 industries down to 37.4% (% of total loans in the top 5 industries down to 37.4% from 44.3% in 96) (Ex. 4)from 44.3% in 96) (Ex. 4)

In ‘98 KFB has a smaller percent of loans denominated In ‘98 KFB has a smaller percent of loans denominated in foreign currency than in ’97 (32.4% vs. 41.2%); FX in foreign currency than in ’97 (32.4% vs. 41.2%); FX loans could provide some diversification from Korean loans could provide some diversification from Korean market, but at the same time, potential FX risk market, but at the same time, potential FX risk

KFB’s Credit Risk (B) KFB’s Credit Risk (B)

However, top industries of KFB’s loan portfolio highly However, top industries of KFB’s loan portfolio highly correlated (e.g., correlation between chemicals and correlated (e.g., correlation between chemicals and textile (construction) 0.95 (0.92); wholesale and textile (construction) 0.95 (0.92); wholesale and construction: 0.97) (Ex. 5) (see also Figure 3)construction: 0.97) (Ex. 5) (see also Figure 3)

Bad loans and non-performing loans as a percent of Bad loans and non-performing loans as a percent of credits have increased significantly from 1.2% (6.7%) in credits have increased significantly from 1.2% (6.7%) in 96 to 8.7% (20.4%) in 1998 (Ex. 6)96 to 8.7% (20.4%) in 1998 (Ex. 6)

BIS capital ratio significantly higher than competitors BIS capital ratio significantly higher than competitors (e.g., in ‘98 (1.27%) versus 7.92% for Hanvit Bank and (e.g., in ‘98 (1.27%) versus 7.92% for Hanvit Bank and 7.9% for Hana Bank)-NPL have shot up to 20.4%, way 7.9% for Hana Bank)-NPL have shot up to 20.4%, way out of line with competitors [5.5% for Cho-Hung Bank out of line with competitors [5.5% for Cho-Hung Bank and 0.7% for Summit Bankcorp (US)] (Ex. 8) and 0.7% for Summit Bankcorp (US)] (Ex. 8)

Relative Performance of Korean Relative Performance of Korean Industry Specific Stock IndicesIndustry Specific Stock Indices

KFB Credit Risk (C)KFB Credit Risk (C)

Hanbo SteelHanbo Steel: large exposure to a chaebol; loaning large : large exposure to a chaebol; loaning large amounts to a chaebol risky; “Connections with industrial amounts to a chaebol risky; “Connections with industrial groups increased the likelihood of distress for East Asian groups increased the likelihood of distress for East Asian financial institutions during the East Asian crisis financial institutions during the East Asian crisis (Claessens, Bongini, and Ferri, JFSR 2001)(Claessens, Bongini, and Ferri, JFSR 2001)

Country rating decline during the Asian crisis by Country rating decline during the Asian crisis by international agencies affected all Korean firms international agencies affected all Korean firms regardless of their individual performances (country-risk)regardless of their individual performances (country-risk)

KFB’s Market RiskKFB’s Market Risk

KFB has reduced the % of corporate exposure to Korean KFB has reduced the % of corporate exposure to Korean market to 36.4% from 45.2% in ’96 (Ex. 9)market to 36.4% from 45.2% in ’96 (Ex. 9)

However, their equity investments still high (and volatile) However, their equity investments still high (and volatile) from 1268.4 in ’96 to 868.9 in ’97 to 1366.2 in ’98.from 1268.4 in ’96 to 868.9 in ’97 to 1366.2 in ’98.

As investment in foreign currency goes down over time, As investment in foreign currency goes down over time, (from 802.9 to 683) there is slightly more vulnerability to (from 802.9 to 683) there is slightly more vulnerability to Korean equity/bond marketsKorean equity/bond markets

Of course, compared to US banks (with no equity Of course, compared to US banks (with no equity investment) KFB has higher risk.investment) KFB has higher risk.

KFB’s Interest Rate Risk (A)KFB’s Interest Rate Risk (A)

In ’97, 4rth stage of interest rate liberalization by Korean In ’97, 4rth stage of interest rate liberalization by Korean government (Fig 4); significant negative impact on the bank: interest government (Fig 4); significant negative impact on the bank: interest rates on deposit adjusting upwards instantaneously, whereas rates on deposit adjusting upwards instantaneously, whereas interest rates on loans take a while to adjustinterest rates on loans take a while to adjust

As a result of increasingly intensified competition among banks, As a result of increasingly intensified competition among banks, interest on deposits increased causing downward pressure on interest on deposits increased causing downward pressure on average spreadsaverage spreads

KFB significant mismatch between loans and deposits (58.3% vs. KFB significant mismatch between loans and deposits (58.3% vs. 73.1%)- a lot different than Hana Bank (60.9% vs. 61.7%). Hana 73.1%)- a lot different than Hana Bank (60.9% vs. 61.7%). Hana Bank the best performer in the group (Ex. 8)Bank the best performer in the group (Ex. 8)

The one year accumulated gap between assets and liabilities in The one year accumulated gap between assets and liabilities in local currency was negative (1,971.6) bKW (Ex. 10)– and higher local currency was negative (1,971.6) bKW (Ex. 10)– and higher than in 1997 (1,707.7); significant risk in the event of rising interest than in 1997 (1,707.7); significant risk in the event of rising interest ratesrates

KFB’s Interest Rate Risk (B)KFB’s Interest Rate Risk (B)

Mismatch in Interest rate earned from Foreign loans Mismatch in Interest rate earned from Foreign loans (6.7%) and interest paid in deposits (9.4%) in 1998. (6.7%) and interest paid in deposits (9.4%) in 1998. Significant exposure to FX/Interest rate risk (Ex. 11)Significant exposure to FX/Interest rate risk (Ex. 11)

KFB’s Exchange Rate Risk (A)KFB’s Exchange Rate Risk (A)

Foreign loans in ’98 a lot smaller than ’97; foreign companies did not Foreign loans in ’98 a lot smaller than ’97; foreign companies did not want much business with Korean banks during crisis (Ex. 11)want much business with Korean banks during crisis (Ex. 11)

The percent of interest payout in foreign deposit dramatically hurt The percent of interest payout in foreign deposit dramatically hurt profitability of KFB [up to 9.4% from 5.2% in ’96]; as a result also profitability of KFB [up to 9.4% from 5.2% in ’96]; as a result also spreads have gone down dramatically from 2.2% in ’96 to 0.2% in spreads have gone down dramatically from 2.2% in ’96 to 0.2% in ’98 (Ex. 11).’98 (Ex. 11).

Foreign loans are down to 5,529.3 [from 6,773.1 in ’97] but foreign Foreign loans are down to 5,529.3 [from 6,773.1 in ’97] but foreign deposits are up from 2,626.8 to 7,200 (Ex. 11); mismatch in foreign deposits are up from 2,626.8 to 7,200 (Ex. 11); mismatch in foreign assets and liabilities (when the Korean won depreciates you want assets and liabilities (when the Korean won depreciates you want fewer deposits, more loans, as you now need more won to pay fewer deposits, more loans, as you now need more won to pay interest on deposits).interest on deposits).

KFB’s Exchange Rate Risk (B)KFB’s Exchange Rate Risk (B)

Relative to competitors (Hanvit Bank and Cho-Hung Relative to competitors (Hanvit Bank and Cho-Hung Bank), KFB has similar percentages of foreign currency Bank), KFB has similar percentages of foreign currency denominated assets to total assets (around 40%), but denominated assets to total assets (around 40%), but relative to Hana Bank, all of these banks have a lot relative to Hana Bank, all of these banks have a lot higher foreign currency exposure. Hana Bank has the higher foreign currency exposure. Hana Bank has the lowest percentage of foreign currency assets (13.6% in lowest percentage of foreign currency assets (13.6% in ’98)-and also has the highest average rate and spread ’98)-and also has the highest average rate and spread out of the group [2.8% spread in ’98, compared to 2.2% out of the group [2.8% spread in ’98, compared to 2.2% for Cho-Hung, 1.7% for Hanvit Bank and 0.2% for KFB] for Cho-Hung, 1.7% for Hanvit Bank and 0.2% for KFB] (See Ex. 8)(See Ex. 8)

KFB’s Liquidity RiskKFB’s Liquidity Risk

Significant shortage of assets in short maturities. The Significant shortage of assets in short maturities. The gap is even larger (and more serious for the Bank’s gap is even larger (and more serious for the Bank’s operations) in the short-term currency accounts (1,914) operations) in the short-term currency accounts (1,914) billion Kwon (Ex. 13)billion Kwon (Ex. 13)

KFB’s Operational RiskKFB’s Operational Risk

Transparency of loan issuance; past mishandling of loan Transparency of loan issuance; past mishandling of loan process (see Hanbo) have put the bank into jeopardy. process (see Hanbo) have put the bank into jeopardy. Does this belong in the past? Does this belong in the past?

Which Risks Should Be Which Risks Should Be Managed at KFB and Why? Managed at KFB and Why?

Credit risk-major problemCredit risk-major problem

Interest rate risk-significantInterest rate risk-significant

FX risk-another major devaluation in the future could be FX risk-another major devaluation in the future could be devastatingdevastating

Liquidity riskLiquidity risk

Market riskMarket risk

Operational risk-market would not tolerate another Operational risk-market would not tolerate another scandal-but under KFB’s controlscandal-but under KFB’s control

Credit risk measurement-KMVCredit risk measurement-KMV

2

)ln(t

t

D

V

z v

v

V: Asset ValueV: Asset Value

σ: annual volatility of asset valueσ: annual volatility of asset value

D: total obligationD: total obligation

t: time horizont: time horizon

2

)ln(t

t

eDV

z v

v

rtt

t

Credit Risk Measurement-KMVCredit Risk Measurement-KMV

1998 1997 1996

Asset Value 33,498,085 41,791,199 46,115,280

Liabilities 33,337,452 41,605,899 44,202,455

Annual -22.1% -9.8%

σ equity KFB 174% 77% 36%

σ asset 5% 8.72% 3.83% 1.78%

D= 33,337,452 41,605,899 44,202,455

V= 33,498,085 41,791,199 46,115,280

We 0.48% 0.44% 4.15%

z= (years) 1 0.011565751 0.096946117 2.365071555

EDF 49.54% 46.14% 0.90%

Credit Risk Measurement-KMVCredit Risk Measurement-KMV

σ equity Korea Fin 71.79% 59.83% 25.15%

σ asset Korea Fin 3.59% 2.99% 1.26%

σ equity US Fin 25.46% 18.49% 13.98%

σ asset US Fin 1.27% 0.92% 0.70%

EDF (korea fin) 43.96% 43.51% 0.04%

EDF (US fin) 35.05% 31.37% 0.00%

How Should Risks Be Managed?How Should Risks Be Managed?

Put new, efficient, transparent credit risk policies into place-ensure Put new, efficient, transparent credit risk policies into place-ensure the diversification of the loan portfolio [for example loans to the diversification of the loan portfolio [for example loans to industries with low correlations such as insurance and transport industries with low correlations such as insurance and transport equipment or machinery; medical and wholesale/financial]-(Ex. 5)equipment or machinery; medical and wholesale/financial]-(Ex. 5)

To improve the one-year negative gap, KFB should make efforts to To improve the one-year negative gap, KFB should make efforts to increase short-term loans and expand its investment portfolios-use increase short-term loans and expand its investment portfolios-use sophisticated profit/loss simulations to forecast impact of interest sophisticated profit/loss simulations to forecast impact of interest rate movements on bank spreadsrate movements on bank spreads

Try to sell high-risk assets and engage government participation to Try to sell high-risk assets and engage government participation to improve liquidity problem-also set liquidity targets for each maturity improve liquidity problem-also set liquidity targets for each maturity levellevel

Cut investment in high-risk securities – use VAR to evaluate and Cut investment in high-risk securities – use VAR to evaluate and monitor market riskmonitor market risk

What Should KFB do?What Should KFB do?KFB should articulate a comprehensive Risk Management Strategy-KFB should articulate a comprehensive Risk Management Strategy-Make it a Key Priority of CEO/Establish Position of Chief Risk Make it a Key Priority of CEO/Establish Position of Chief Risk Officer and give him/her decision making powerOfficer and give him/her decision making power

Strengthen controls; employ all risk management tools at its Strengthen controls; employ all risk management tools at its disposal; establish risk limits and obey them for each risk categorydisposal; establish risk limits and obey them for each risk category

Allocate total risks among different departments (e.g. Funds and Allocate total risks among different departments (e.g. Funds and Securities, Int’l Banking, etc.)Securities, Int’l Banking, etc.)

Most critical for KFB to update the credit policies (built databases to Most critical for KFB to update the credit policies (built databases to better assess and quantify credit risk (KMV)), increase transparency better assess and quantify credit risk (KMV)), increase transparency in the loan issuance process (establish an independent Loan in the loan issuance process (establish an independent Loan Committee) and convince regulators and the markets that new, Committee) and convince regulators and the markets that new, efficient and transparent processes are in place. This process will efficient and transparent processes are in place. This process will also help improve asset quality problem (improve BIS ratio)also help improve asset quality problem (improve BIS ratio)

Monitor risks on a frequent basis; decide the frequency based on Monitor risks on a frequent basis; decide the frequency based on nature of risks (e.g., FX/market on a daily basis)-cut high risk equity nature of risks (e.g., FX/market on a daily basis)-cut high risk equity investmentinvestment

What Should KFB do?What Should KFB do?

Examine what Korean competitors do with respect to risk Examine what Korean competitors do with respect to risk management-also comparable banks in the US/Japanmanagement-also comparable banks in the US/Japan

Role of Korean Government Role of Korean Government and International Regulators?and International Regulators?

Oversee the step-by-step implementation of risk Oversee the step-by-step implementation of risk management policiesmanagement policies

Strong measures against non-transparencyStrong measures against non-transparency

Remove the “implicit” guarantees-”too-Big to Fail”Remove the “implicit” guarantees-”too-Big to Fail”