Relationship Banking after the Crisis in Korea

Even though commercial banks are in a good position to monitor borrowing firms, it has been widely recognized that they have largely neglected the monitoring of their corporate clients in most Asian economies. Relationship banking has been weak in spite of the heavy reliance of major corporations on bank loans in the absence of a well-functioning capital market. After the financial crisis, however, the situation seems to have changed to some extent with the reduction in bureaucratic or political interferences in bank management, and the decrease in the resulting moral hazard that is considered to have been responsible for the crisis. In this section, the results of a questionnaire survey conducted among the officers of large Korean commercial banks are presented. The questionnaires were designed to evaluate whether there has been any progress towards closer bank monitoring of client firms and the practices of relationship banking following the crisis. Also included are opinions on the governance of banks, which are now in the hands of the government, and the desired ownership and governance structure for these banks in the event of privatization.

5.1. Characteristics of Sample Banks and Questionnaire Respondents

The questionnaire study was conducted for the three major commercial banks in Korea. These three banks represent four of the six largest City Banks that existed before the crisis (two of them merged to become Hanvit Bank). All six banks fell into trouble after the crisis, and have undergone a drastic change in their ownership structure as the result of the injection of public funds for recapitalization, mainly by the Korea Deposit Insurance Corporation (KDIC). Of the five banks (following the merger), the study covers only the three largest: Hanvit Bank, Chohung Bank, and Korea Exchange Bank.²⁶ Unlike the other two, which are mostly owned by the government, Korea Exchange Bank had a large foreign shareholder – Commerzbank (see Table 4 [PDF 131kb | 1 page]). These three banks suffered from a substantial decrease in total assets after the crisis, and streamlined their organizations and personnel to significantly reduce the number of branches and employees. Thanks to these efforts, together with the public fund injection for the purchase of non-performing assets and recapitalization, the banks are now in a much better situation in terms of capital adequacy and operating profits (see Table 5 [PDF 180kb | 1 page]).

Given the nature of the questions, the questionnaires were distributed to bank officers in charge of loan evaluation, managing relationships with corporate clients, setting overall credit policy, and strategic planning. A total of 313 sets of answered questionnaires were collected in early April, 2002. Table 6 [PDF 92kb | 1 page] shows the characteristics of the respondents including their length of service in the financial sector, age, and position in the bank.

5.2. Results of the Questionnaire Survey

For most of the questions, the respondents were asked to express the extent to which they agreed or disagreed with a given statement. They were asked to choose from five items to indicate their opinions: {3 - strongly agree; 2 - agree; 1 - weakly agree; 0 - neither agree nor disagree (or no opinion); N – disagree}. For the purpose of calculating the average score of opinions for all the respondents, N was given a numerical value of –2 in order to maintain symmetry between "agree" and "disagree."

Intensity of bank monitoring

Korean banks are generally known to have neglected the monitoring of their corporate clients, and that this was responsible for the failure of several chaebols that triggered the Korean crisis in late 1997. As background for evaluating the bank-business relationship, it would be helpful to evaluate the major reasons for this negligence and whether the situation has improved after the crisis. Many of Korea’s large business firms are owned and controlled (and managed) by a family, exposing them to potentially serious agency problems between the controlling and outside (minority) shareholders. It is in these firms that proper corporate governance is most needed. The results of the questionnaire survey on bank monitoring are summarized in Box 2 [PDF 132kb | 2 pages].

1. Are banks making increased efforts to monitor borrower companies?

   The respondents generally believe that banks have increased their effort to monitor client firms. Among the three different types of monitoring by stage, the respondents indicate that banks have increased ex ante monitoring (screening loan application) more than interim monitoring (after loans are made) or ex post monitoring (corporate restructuring in the event of financial distress). Given that what distinguishes relationship banks from other banks is interim and ex ante monitoring, this results seem to indicate that relationship banking is not yet prevalent in Korea.

2. What is the most important factor behind these enhanced monitoring efforts by banks?

   Stronger monitoring is most strongly motivated by the higher risk of corporate default as well as increased concern about the future of banks themselves. These concerns seem to result from a new perception that the government no longer stands ready to rescue distressed business groups or banks. Strengthened prudential regulations and better information on corporate clients often newly acquired in the process of corporate restructuring following the crisis have also contributed to the enhanced monitoring. However, the strengthened bargaining power of banks vis-à-vis corporate clients and banks' corporate ownership resulting from a debt-equity swap (often arranged as part of corporate debt restructuring), turn out to be relatively less important. It seems that equity ownership by creditor banks, as a means of cementing the relationship between a bank and its client firms, is not generally recognized, or that banks have no intention to be stable shareholders of the firms.

3. What factors have strengthened banks' bargaining power vis-a-vis their large corporate clients after the crisis?

   Even though stronger bargaining power of banks is known to be far from an important factor behind better monitoring, it seems true that their bargaining power has actually been strengthened. More important contributing factors include reduced expectations of government bailouts of distressed firms (which might have been considered to be too big to fail before the crisis), better information about corporate clients, and reduced forbearance of bank managers. It is somewhat surprising that the weaker economic power of business groups or reduced interference by bureaucrats and politicians turn out to be relatively unimportant. In spite of the bankruptcy of some business groups, banks do not appear to have much stronger bargaining power over the surviving groups. Also, bureaucrats and politicians seem to continue to interfere in banking operations, something that may be inevitable given that the sample banks are now owned and controlled by the government.

4. What have been the most important factors constraining the closer monitoring of borrowing corporations?

   There seem to be no major constraint in the monitoring activities of banks. Constraints with some importance include unreliable corporate financial statements, weak incentives for bank officers to do close monitoring, the weak bargaining power of banks vis-a-vis borrowing firms, and the poor system of managing client information (due to the high turnover of loan officers, shortage of manpower, etc). Inadequate expertise for bank officers or weak incentives for top managers do not seem to pose a constraint for the monitoring activity of banks.

5. What are the most important reasons for the weak incentives for monitoring on the part of bank officers?

   Even though bank officers seem to have insufficient incentives to closely monitor their client firms, it is not clear what makes these incentives inadequate. Respondents weakly agree that rewards for good monitoring and penalties for the neglect of monitoring are not very strong. However, monitoring activities do not seem to be much discouraged by the securing of collateral or the dictation of loan decisions by supervisors without much regard to screening or monitoring. Furthermore, bank officers tend to disagree to the claim that monitoring doesn’t matter much since some clients are "too big to fail."

6. How important is the role of banks in overseeing corporate management in comparison to that of other stakeholders?

   Whom do corporate managers fear most, or whose interests are corporate managers most willing to accommodate? There is general consensus that corporate managers pay the keenest attention to the interests of the controlling owners in normal times. The second focus of attention is creditor banks, and the third the workers or labor unions. In large corporations, however, workers or labor unions are nearly as important as creditor banks. The least important is the interests of non-controlling shareholders. In times of financial times, however, the voice of creditor banks becomes stronger than that of the controlling owners, and more so for small and medium-sized firms.

Relationship banking

It is not clear to what extent Korean banks have maintained a close long-term relationship with their corporate clients. Even though a "principal transactions bank" has long been designated for each of the large chaebols, it was largely imposed as a regulatory superstructure rather than as an autonomous relationship. With the increased need for the monitoring of corporate clients and other changes in the business environment (for both banks and other corporations), it is of great interest to see whether "relationship banking" is emerging in Korea after the crisis. Presented in Box 3 [PDF 214kb | 3 pages] is a set of questions on relationship banking and the summary responses to these questions.

1. Is there any trend toward, or greater awareness of, a more stable long-term relationship between banks and their borrowing firms?

   There seems to be greater awareness of the importance of relationship banking among bank officers. Moreover, most of the respondents who report such awareness also tend to think that some progress has been made toward relationship banking.

2. What are the most important factors behind the progress toward relationship banking?

   Several factors have been instrumental in fostering relationship banking, though no single one seems to stand out. The more important factors include higher corporate risk perceived by both banks and their clients, more focused marketing strategies of banks with operational divisions specializing in a particular type of clients, and better information on corporate clients. Other contributing factors include debt-equity swaps (making the creditor bank a substantial shareholder of its client company), accumulated information and experience as the "principal transactions bank" of client firms, the strengthening of the bargaining power of banks, and less outside interference in lending decisions. The lower importance of bank bargaining power, outside interference, and debt-equity swaps seem to be consistent with the findings on monitoring presented before.

3. What are the most important motivations or expected benefits for having such a relationship for borrowing firms?

   The most important benefits of relationship banking for borrowing firms as seen by bank officers include advice from bankers on overall business and financial strategies, easy access to other financial markets, reduced costs in times of financial distress, and better credit availability. However, bank officers do not appear to be very convinced about the benefits, since their scores are generally low. Even less recognized benefits are risk sharing or the mitigation of liquidity constraints by relationship banks.

4. What are the most important motivations or expected benefits for having such a relationship for creditor banks?

   Bank officers seem to better appreciate the benefits of relationship banking for creditor banks. They tend to believe that relationship banking allows them to better monitor borrowing firms, secure a customer base for a lucrative banking business, and ensure timely management intervention and control in times of performance deterioration. However, the respondents seem less convinced of the potential extraction of "monopoly rents" by a relationship bank from the informational monopoly over its client firms.

5. What factors may make borrowing firms reluctant to develop such a relationship?

   The declining corporate dependence on bank loans among more creditworthy corporations stands out among the factors constraining the development of relationship banking. Other constraints include the high turnover of bank officers in charge of managing the relationship with particular corporate clients, the reluctance of firms to reveal sensitive corporate information to the bank, and inadequate expertise offered by banks to meet corporate demand for diverse financial services. Among the less important factors are the discouragement by banks of risky but promising investment projects, the possibility of being informationally captured by the bank, concern about banks' excessive monitoring and management intervention, and the higher perceived risk of banks' own distress.

6. What factors may make creditor banks reluctant to develop such relationships?

   Declining corporate dependence on bank loans is the most important deterrent to relationship banking on the part of banks as well. Other factors include keener competition in the financial markets, expected difficulties in making timely and rational decisions when client firms are in financial distress, and increased costs of maintaining relationship banking in times of economy-wide financial turbulence.

7. For which type of firms will relationship banking be most beneficial form the standpoint of banks and firms?

   From the standpoint of creditor banks, relationship banking is believed to be most beneficial with promising small and medium-sized firms, followed by that with large and creditworthy firms, large but less creditworthy firms, and less promising SMEs. From the standpoint of client firms, both large but less creditworthy firms and promising SMEs are viewed as benefiting the most from relationship banking, while large and creditworthy firms benefit the least.

8. What specific actions of a bank will help build strong relationship banking with its clients?

   Avoiding frequent changes in bank officers in charge of managing the relationship with particular clients is seen as the most important in fostering relationship banking. Close consultations with the bank on major corporate decisions and concentrating the use of banking services on one or a few banks are also viewed as instrumental. Actions that are viewed as somewhat less important include banks’ holdings of the equity shares of corporate clients and dispatching personnel to the corporate boards.

9. What effects can be expected from a bank’s holding of equity shares in its client firms?

   The respondents seem to believe that a bank’s holdings of both loans and equity shares in corporate clients will strengthen its monitoring incentives, reduce conflicts of interest between the bank and corporate shareholders, and prevent the premature liquidation of solvent firms. Potential negative effects such as the higher chance of undertaking unprofitable investments (due to eased liquidity constraints) and the exertion of stronger influence on the firms for banks' own interests seem to be less recognized by bank officers.

10. Will the relationship of "principal transactions bank" or "main creditor bank" evolve naturally into an autonomous relationship banking for the client firms?²⁷

    The expectation that this seemingly similar bank – business (group) relationship will evolve into more autonomous relationship banking seems to be rather weak. It may reflect the fact that the system, imposed by the financial supervisory authorities, has not been very successful in reducing information asymmetry and building reputation on the part of the banks. Given that the bank-business relationship has been imposed only on business groups and their subsidiaries, and that such firms tend to be less dependent on bank loans, the room for this system to evolve into autonomous relationship banking seems to be limited.

11. How does a creditor bank typically react when a medium-sized borrowing firm falls into financial distress (from which the firm, although considered solvent, may not get out in the short run), and asks for an additional loan?

    The intent of this question was to evaluate the extent to which the response of banks is consistent with relationship banking. The respondents most strongly support the bank action of providing loan that are conditional on necessary restructuring efforts. Though this response is consistent with what is expected from a relationship bank, the respondents do not seem to be very convinced of the action. Other responses with a slightly lower support level include providing credit while adjusting the terms to reflect the increased risk or sending a bank officer to the firm for better monitoring, and urging the firm to look for other financial sources. The bank may liquidate the firm if most of the existing loans to it can be recovered. This behavior, however, has little support among the respondents. Overall, some of the bank responses are consistent with those of relationship banking, while others are not, and are probably typical of a less-committed relationship bank.

Governance of banks

With the recapitalization of troubled banks by the government, many banks are now in the hands of the government. As the controlling shareholder of these banks, the government may intervene in their operations and may be negligent in supervising the bank management. While these banks will be privatized in the near future, questions remain about the desired ownership structure for the privatized banks in terms of efficiency as well as the avoidance of serious conflicts of interest. Box 4 [PDF 214kb | 3 pages] shows the perception of bank officers on these questions.

1. What are the most important factors behind the weak discipline in bank management?

   There seems to be a fairly strong belief that government ownership of banks and political or bureaucratic interference in banking operation will weaken the accountability of managers for bank performance. Somewhat less important factors include the virtual absence of hostile takeovers of banks and diffused ownership (of other banks). The moral hazard for banks due to deposit insurance or the expectation of government bailout of troubled banks turns out to have little to do with the weak discipline of bank management. Respondents do not seem to believe that the weak discipline is due to the neglect of duties by the financial supervisory authorities or banks' creditors, or by an oligopolistic banking market structure.

2. Will the government ownership of commercial banks seriously constrain the efficiency of banks? If so, why?

   The respondents believe that government banks are inefficient because outside interference in bank management constrains management initiatives, the appointment or dismissal of senior managers is not strictly based on their capability or performance, and incentives for monitoring bank management are weak. Relatively unimportant factors include the belief that the government will not allow banks to go bankrupt, and the absence of pressure from the stock market. It seems remarkable that bank officers do not suffer from complacency, which is likely to reflect the uncertain future for some of the banks that have only survived due to the recapitalization by the government.

3. Will large chaebols be allowed to own and control major commercial banks?

   The respondents did not seem to have a strong opinion on this issue. The negative view is slightly stronger than even the cautious permissive view that chaebols may gradually be allowed to own banks with institutional safeguards against possible side effects.²⁸ The opinion that chaebol ownership is better for a bank than having no controlling owners or remaining a government bank is weakly supported. A view with even weaker support is that chaebols may be allowed to own a bank with strengthened prudential regulation.

4. What are likely to be the most serious problems with banks owned and controlled by chaebols?

   The respondents show rather serious concerns about a wide range of potential problems that might arise with chaebol-controlled banks: these banks may abuse the market power of their group to promote their banking business; may discriminate against competitors of their group, and may have larger scope for abusing conflicts of interests (due to their diversified businesses). Other concerns associated with chaebol-controlled banks include bank instability, larger room for moral hazard, lower managerial efficiency, and excessive favor to chaebols.

5. What would be the most important advantages of chaebol-ownership of banks?

   The respondents are not very convinced of the benefits of chaebol-controlled banks. Even the most important benefit of such banks has a lower support level than the least important concern. Relatively important benefits include higher efficiency due to strong monitoring and supervision incentives by the controlling owners, better attention on share value maximization, and higher efficiency resulting from economies of business scope. The view that chaebol-controlled banks might be more stable, better serving their affiliated firms, and more reliable turns out to be not much supported.

6. What ownership and governance structure might be most desirable for the governmentowned banks that are to be privatized?

   The most preferred controlling owners turn out to be financial groups without nonfinancial businesses, which is understandable given such benefits as the small room for conflicts of interests, economies of scope, and strong monitoring incentives. The least preferred owners are foreign financial institutions and chaebols. The objection to foreign financial institutions might, to some extent, reflect concern about job security. Interestingly, the second most preferred choice is joint ownership and control by a chaebol and a foreign financial institution (though they are least preferred as sole controlling owners). The next preference is for widely-held ownership. However, among widely-held banks, those controlled by public institutional investors and, to a less extent, by private institutional investors are preferred to those without any controlling institutional investors.

Are there any differences between more and less experienced bank officers?

Bank officers form their perceptions on the monitoring of client firms, relationship banking and bank governance through their experience at work. As such, their perceptions are influenced by the norms and practices they have acquired throughout their careers in relevant fields. When they are exposed to new business environment and norms (such as those after the financial crisis) they may look at the changes in a more sensitive way (either positively or negatively), or may react to the new rules in defence of old ways of doing business. Table 7 [PDF 213kb | 2 pages] shows the questions for which more experienced officers (working in the financial sector for 20 years or more) or more highly positioned officers (deputy general managers or over) responded rather differently from others.

Bank monitoring of client firms. Higher-level and more experienced officers tend to more strongly believe that the lack of transparency in corporate financial statement and the poor system of managing client information (with the high turnover of loan officers and shortage of manpower) have been the factors constraining closer monitoring of client firms. They also believe that the bargaining power of banks vis-a-vis borrowing firms has been strengthened (though it is still weak) by reduced interference by bureaucrats or politicians, as well as by the less serious problem of forbearance by bank managers. They, however, react negatively to the claim that the dictation of loan decisions by supervisors has weakened monitoring incentives.

Relationship banking. Experienced or high-position bank officers believe more strongly than others that less interference by bureaucrats or politicians in lending decisions is an important factor in fostering relationship banking. Nevertheless, they are far less convinced about what can be expected from relationship banking (either benefits or concerns) including having banks hold equity shares of client firms. This perception may reflect the fact that they are accustomed to making loans under the direction of the government or supervisors, with little attention given to relationship management. They also tend to more strongly feel that declining corporate dependence on bank borrowing discourages relationship banking while concentrating a firm’s banking services on one or a few banks helps relationship banking.

Bank governance. More experienced or higher-positioned bank officers tend to put less blame on government ownership/intervention or diffused ownership for the weak discipline in bank management. They are generally less convinced of the inefficiency of government-owned banks due to bureaucratic/political interference in bank management, political appointment/dismissal of bank senior managers, and weak monitoring incentives. More experienced officers also look more favorably at the potential advantages of chaebolcontrolled banks, though they are more concerned about the potential problem that these banks might discriminate against business firms that compete with their subsidiaries and other affiliated companies.

Are there differences among banks?

It would be interesting to see whether the responses to some of the questions are significantly different among banks. The three sample banks have common characteristics: substantial public funds have been injected following the financial crisis through the Korea Asset Management Corporation, Korea Deposit Insurance Corporation, and other government banks resulting in a controlling share being held the government. As the major city banks, their business and customer bases are similar, with heavy exposure to large business firms. Nevertheless, there are some differences between them as well in the ways and degree of restructuring after the crisis. Hanvit Bank, which was created as a merger of two major city banks, underwent the most severe restructuring. During the three-year period until the end of 2000, its assets declined from 97 trillion won to 72 trillion won; branch offices were reduced from 991 to 625; and the number of employees dropped from 17,000 to less than 10,000. Korea Exchange Bank underwent almost the same degree of restructuring, with a German bank (Commerzbank) participating in management as a major shareholder. Chohung Bank, however, has been least affected among the city banks: during the three years until the end of 2000, there were almost no changes in the size of its total assets and number of branches, even though there was a substantial reduction in the size of its staff (see Tables 4 and 5).

Monitoring efforts and relationship banking after the financial crisis. The results of the self-assessments by bank officers of their monitoring and relationship banking practices are presented in Figure 1 [PDF 93kb | 1 page]. The figure shows that Hanvit Bank officers believe most strongly that their monitoring of client firms and relationship banking practices have been strengthened after the financial crisis. Chohung Bank scores the lowest among the three, which may be explained by the fact that the bank’s restructuring was relatively less painful. As the result, the urgency for changing old ways of doing business might have not been as great as in the other banks.

Perceptions on government ownership or intervention and its impact on bank efficiency. Officers from different banks may have somewhat different views about government ownership or intervention, depending on their bank-specific experience. Table 8 [PDF 93kb | 1 page] presents regression results on the responses to various questions related to government ownership and intervention in banking, explained by the length of service for the respondent and bank dummy variables. Consistent with the evidence presented above, more experienced bank officers tend to see the environmental changes (reduced bureaucratic/political interference, bank manager forbearance, and expectation of bailouts) as more significant. Chohung Bank officers seem less assured of better monitoring or stronger bargaining power resulting from reduced government involvement in corporate bailouts. The officers of Chohung Bank and KEB share (more strongly than Hanvit officers) the view that bank monitoring is constrained by the weak interest of CEOs whose evaluation are not strictly based on bank performance, and that government-owned banks are likely to be inefficient due to associated complacency.

Perceptions on chaebol ownership of banks. The government equity shares in the sample banks are scheduled to be divested in the future, and bank officers may have their own views on the desirability of chaebol ownership of banks. The responses regarding chaebolowned banks, together with their potential problems and advantages, show that Chohung Bank officers least object to the idea of such banks, followed by Hanvit Bank. The unfavorable perception of KEB officers toward chaebol ownership might partly be explained by the bank’s culture, originating from the late 1960s, when the bbank started as a specialized bank with the central bank as its major shareholder. The difference in perception between Hanvit and Chohung Bank officers is also understandable given that Havit is larger and has formed a financial group (Woori) comprising other smaller banks and non-bank financial institutions. Given the not-very-favorable public sentiment toward chaebols, it would be difficult to justify a chaebol taking over a large financial group (see Figure 2 [PDF 93kb | 1 page]).

Summary evaluation of the survey results

The responses to some of the questions seem to indicate that relationship banking is far from firmly established in Korea, which is hardly surprising. First, even though monitoring has been intensified since the financial crisis in late 1997, the major effort has been directed toward ex ante monitoring (screening of loan applications) rather than relationship-intensive interim or ex post monitoring. Second, bank officers’ understanding of the advantages of relationship banking for corporate clients is rather limited, though they understand them well from the bank’s point of view. Relationship banking is even less appreciated by more experienced officers. Finally, responses to a hypothetical situation of a client firm in financial distress are partly inconsistent with what can be expected from a relationship bank.

The most important factors motivating better monitoring and relationship banking turn out to be higher risk of corporate default and the banks' own survival, as well as the better information base they have built since the onset of the financial crisis. More structural factors, including changing bargaining power vis-à-vis client firms and banks' holding of equity shares in their corporate clients, do not appear to have played a major role. This may indicate that banks’ enhanced efforts for monitoring and relationship banking may be weakened if the financial situation in the corporate and banking sectors improves. However, current efforts in this area seem to be institutionally supported as part of prudential regulation and the organizational innovations of banks emphasizing relationship management, which might provide a more permanent base.

Finally, officers of the sample banks that are owned solely or largely by the government are well aware of the problems of this ownership and governance structure: political or bureaucratic intervention may distort the process of CEO appointment or dismissal and weaken managerial initiatives as well as discipline in bank management.²⁹

They also express concern about chaebol control of banks and the associated side-effects. It will be a great challenge to privatize these banks as soon as possible, while still putting into place a desirable structure of ownership and governance. Though these officers prefer to see their banks owned and controlled by a group specializing in finance, the financial groups currently existing in Korea do not seem to be strong enough to control these banks. It is interesting that these respondents prefer the option of joint ownership/control by chaebols and foreign financial institutions to widely-held ownership with control exercised by institutional investors. The option, which brings both capital and expertise, with each holding the other in check, may allow relatively early privatization without a great depressing effect on the stock market.

The views expressed in this paper are the views of the author/s and do not necessarily reflect the views or policies of the Asian Development Bank Institute nor the Asian Development Bank. Names of countries or economies mentioned are chosen by the author/s, in the exercise of his/her/their academic freedom, and the Institute is in no way responsible for such usage.

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