On January 23, 2020, the European Banking Authority (EBA) acknowledged in an Opinion¹ (the Opinion) the European Commission’s (EC) decision to consider the supervisory and regulatory framework applicable to credit institutions in South Korea as equivalent to the rules applied in the European Union (EU). This means that certain categories of exposures to entities located in those two countries can benefit from the same treatment as applied to EU Member States’ exposures under the Capital Requirements Regulation (CRR) in terms of capital requirements.

The Opinion acknowledging the EC’s decision comes at the end of a process that started when the EBA provided technical advice and assessed non-EU countries’ equivalence with the EU’s prudential supervision and regulatory requirements. Following said assessment, the EBA provided its Opinion to the EC in November 2018 that the supervisory and regulatory framework applied to credit institutions in domestic laws and regulations in Serbia and South Korea could be regarded as equivalent to those in the EU. The EC approved this and published a related Decision on Equivalence². The current EBA Opinion comes after the publication of the Decision of Equivalence. EC Decisions of Equivalence, while capable of being withdrawn or further amended mark a major move forward in firms on both sides being able to access each other’s markets.

There are two annexes to the Opinion, one for each country. This Client Alert analyzes the South Korean Annex and the resulting opportunities as well as the next steps to be taken for EU and South Korean firms. This Client Alert should be read in conjunction with our separate coverage on the Serbian Annex. The EU’s recognition of equivalence of the South Korean regulatory regime is of course a welcome given the EU-South Korea Free Trade Agreement³ was ratified in December 2015 and the EU is South Korea’s biggest foreign direct investor and that the EU is South Korea’s third largest export market. For banks this provides ample opportunity to assist companies from household names to SMEs on both sides to trade and build closer linkages. 

EBA’s Annex’s findings relating to the Republic of South Korea

The South Korean Annex⁴ starts by providing a general overview of the banking sector in South Korea. The Financial Supervisory Service (FSS) is South Korea’s integrated financial supervisory authority, created in 1999. It is entrusted with the banks’ prudential supervision, capital market supervision, consumer protection, and other oversight and enforcement activities as delegated by the Financial Services Commission (FSC). The FSC on the other hand sets the government’s financial market policies, proposes changes to the financial legislation to the National Assembly, makes rules, grant regulatory licenses and decides on major enforcement actions. 

South Korea’s legal framework governing the banking business consists of the Banking Act (BA)⁵, the Enforcement Decree of the Banking Act (EDBA)⁶, the Regulations on Supervision of the Banking Business (RSBB) as well as the Detailed Regulations on Supervision of the Banking Business (DRSBB). The Annex then presents an overview of South Korea’s financial system as well the structure and performance of the South Korean banking sector as well as the implementation of the Basel III standards. Related to the latter, it is currently planned to introduce the new Basel III Large Exposure framework in line with the Basel III timeline, i.e. from January 2019. The final rule on Basel III’s risk-based capital was issued in November 2013 to implement the Basel III framework. 

The main part of the Annex consists of a detailed assessment of the Republic of South Korea of particular topics and sections, which despite set out with wrong numbering do get the relevant points across. 

Topic I – Supervisory Framework – Equivalent

The supervisory review process is aligned with the Supervisory Review and Evaluation Process (SREP)⁷ procedures governing supervision in the EU. FSS can impose a number of supervisory measures on banks, including a Pillar 2 capital add-on, which is levied by scaling-up the risk-weighted assets (RWAs).

Section 1 – General questions – Equivalent

All banks in Korea are subject to prudential regulation; however, the applicable rules to banks and non-bank financial institutions are different. Since December 2013, the minimum capital standards and phase-in arrangements have been the same as put forth by the Basel Committee on Banking Supervision.

Section 2 – Competencies of supervisory authorities – Equivalent

Clear provisions are in place for the supervisory rights and powers of the FSS, which is an independent organisation. The FSS Governor is appointed by the President of Korea at the request of the FSC Chairman. The FSC has the power to issue and revoke banking licenses. The criteria, consisting of positive and negative conditions, that a person needs to fulfil to hold executive positions (“Fit & Proper” test) are established in the Banking Act and reflected in the Act on Corporate Governance of Financial Institutions.

Section 3 – Prudential Supervision – Largely Equivalent

FSS exercises supervision both at the consolidated level and at the level of the individual institution. Both the FSC and the FSS are legally empowered to impose a set of administrative measures and penalties towards banks. The FSC grants and withdraws operating licenses and may also impose administrative fines on violations of legal limits.

Section 4 – Supervisory Review Process – Equivalent

Banks must submit to FSS an Internal Capital Adequacy Assessment Process (ICAAP) report yearly, including risk management structure, risk identification, risk limits, the result of stress tests, and a capital contingency plan. The FSS examiners perform full-scope and targeted examinations of financial institutions. The FSS also assesses banks according to the CAMEL-R approach (Capital adequacy, Asset Quality, Management, Earnings, Liquidity, Risk Management). The FSS can also impose a number of supervisory measures on banks, including a Pillar 2 capital add-on.

Section 5 – Professional Secrecy and International Cooperation – Equivalent 

The obligation of confidentiality for the FSS employees covers all the information that they come to know during their service.

Topic II – Own Funds – Partially Equivalent

South Korea’s and EU framework for own funds are similar in many aspects, however, the dividend stoppers are included in the South Korean legislation. Dividends stoppers are not allowed in the CRR.

Section 6 – Own Funds – Partially Equivalent 

The own funds requirements are structured as follows: (i) 4.5% CET1 (ii) 6% T1 and (iii) 8% Total Capital. There are differences however - according to the criteria for classification of common shares as CET1 (Appendix 3 of the Banking Act), distributions of CET1 instruments are “paid only after all legal and contractual obligations have been met and payments on more senior capital instruments have been made.” In addition, the cancellation of distributions/payments [of Additional Tier 1 capital] must not impose restrictions on the bank except in relation to distributions to common stockholders”. These provisions pertaining to distributions privilege AT1 holders compared to CET1 holders.

Section 7 – General requirements – Equivalent

The own fund requirements cover credit, market and operational risk and the provisions on reporting and disclosure are similar to those envisaged by the CRR.

Topic III – Credit Risk Requirements – Largely Equivalent 

Korea’s regulation includes provisions on Credit risk Standardized Approach (SA) and Internal ratings-based (IRB) Approach as well as on Credit risk mitigation techniques.

Section 8 – Capital requirements for credit risk – Equivalent 

The Korean regulation includes largely the same exposure classes as in the CRR. Most of the risk weights are also identical to the ones envisaged in the CRR, with some exceptions, where the treatment is notably more conservative. The framework for calculating own funds requirements for credit risk using the IRB Approach are overall equivalent to the framework included in the CRR. The definition of default only refers to exposures that are 90-day past due, and to those that are “unlikely to pay”.

Section 9 – Credit Risk Mitigation – Equivalent

The Korean regulation stipulates the same principles, rules and general conditions for the recognition of Credit Risk Mitigation (CRM) techniques for credit protection (funded and unfunded), which correspond to a large extent to the ones implemented in the EU under the CRR framework. There are no differences between the instruments eligible for funded credit protection in the Korean legislation and in the CRR. Similar to the CRR, guarantees and credit derivatives are made on the basis of an appropriate agreement.

Section 10 – Securitization – Equivalent

The Korea’s law on securitization is overall equivalent to the CRR. Simple, Transparent and Standardized (STS) rules have been implemented but banks do not get the benefits of it.

Section 11 – Exposure to transferred credit risk – Largely Equivalent

Minimum requirements for recognition of significant credit risk transfer in both traditional and synthetic securitization have been implemented and these provisions are aligned with the CRR. SRT is granted on the basis of a transaction-by-transaction assessment.

Topic IV – Market Risk – Equivalent

Korea’s capital adequacy regulation takes into account both the counterparty credit risk and all risks under market risk. They have provisions in place also for settlement risk, CVA risk and commodities risk. Market risks and CCR regulations are both equivalent to the CRR.

Section 12 – Counterparty Credit Risk – Equivalent

In general, Korea’s rules for the treatment of counterparty credit risk are found to be identical to the respective rules of the CRR. All three methods eligible to calculate own funds requirements are aligned with the CRR with regard to the calculation methodologies and accompanying operational requirements.

Section 13 – Own funds requirement for market risk, settlement risk and CVA risk – Equivalent

South Korea also has a trading book concept in place, similar to the CRR trading book concept both with regard to the instruments assigned to it and the requirements for its management, also the principles of prudent valuation. Korea's market risk provisions are based on a building block approach taking account of position risk for trading book activities, foreign exchange risk and commodities risk for all business activities and the country’s regulation allows both for the application of the SA and internal models approach (IMA) with the calculations of capital requirements being identical to the CRR. South Korea has also implemented the provisions on Stressed-VaR and Incremental Risk Charge (IRC) that are mandatory for banks using IMA. The calculations for the settlement risk include the same transactions as under the CRR. Unsettled repos are excluded. South Korea’s capital adequacy regulation imposes own funds requirement for CVA risk and both methods, Standardized and Advanced, have been introduced in the framework.

Topic V – Operational Risk – Equivalent

The South Korean regulations are driven by the similar principles and follow the similar direction of qualitative and quantitative supervision.

Section 14 – Operational Risk – Equivalent

Operational risk is defined in the Korean legislation as risk of loss that is likely to be incurred as a result of inappropriate or erroneous internal processes, human resources and systems, or an external event, which shall include legal risk, but exclude strategic and reputational risk. Legal risk includes, but is not limited to, fines, penalties, punitive damages resulting from supervisory actions, and exposures relative to private settlement. The FSS has practical experience with the supervision of all three approaches (BIA, TSA and AMA), and has established a comprehensive unified supervisory practice with the emphasis on basic principles for the implementation of all elements of the supervisory process.

Topic VI – Liquidity –Equivalent

The Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) are both established requirements in the jurisdiction.

Section 15 – Liquidity – Equivalent

Banks are required to maintain a LCR, where at present the ratio is phased in at 90% in contrast with the EU where it is currently at 100%. Korea also imposes a further liquidity ratio in their jurisdiction which measures loans to deposits. 

Topic VII – Capital buffers and macroprudential tools – Largely Equivalent

All the capital buffers applied in the EU regime are currently implemented and mandatory in South Korea, except for the systemic risk buffer.

Section 16 – Capital Buffers – Largely Equivalent

Three capital buffers are currently in place in South Korea: (i) the capital conservation buffer, (ii) the countercyclical capital buffer (CCyB) and (iii) the D-SIB/G-SIB buffers. No systemic risk buffer is envisaged in South Korea. The capital buffer framework is not currently applied to "internet banks", which have been given an exemption until end-2019. Internet banks account for 0.2% of total assets. The FSS Korea imposes Pillar 2 requirements as a scale-up of RWAs, which in turn feeds directly into the Pillar 1 requirement, which sits below the combined buffer. <

Section 17 – Macroprudential Tools – Equivalent

The authorities responsible for financial stability policy in South Korea include the Bank of Korea (BoK), the Ministry of Strategy and finance (MOSF), the FSC and the FSS as well as the Korea Deposit Insurance Corporation (KDIC). Cooperation among authorities is achieved through two comprehensive bodies - Macroeconomic Finance Meeting (MEFM) and the Emergency Operation Office (EOO), a joint office between the FSC and the FSS, headed by the Vice Chairman of the FSC.

Topic VIII – Other regulatory requirements – Largely Equivalent

The framework for large exposures is similar to the one implemented in the EU, with the main differences related to the definition of eligible capital and the inclusion of trading book exposure, although their relevance in the Korean banking system is relatively limited. The implementation of the new Basel framework in 2019 will address these differences. The definition, the limit and the calculation of the leverage ratio is fully aligned with the provisions set out in the EU regulation, and the only difference is a more conservative one, as the requirement is not only a reporting one, but is a binding one, since 2015.

Section 18 – Large Exposures – Largely Equivalent

The Large Exposure as provided in the Korean legislation is an exposure exceeding 10% of the bank's eligible capital, which is defined as the sum of T1 and T2 capital. This is less conservative than in the EU. Currently, the large exposure regime applies on an individual basis. Starting from 2019, it will be applied also on a consolidated level. Large exposures are constantly monitored through monthly reporting and administrative and accounting procedures to identify and report them. In 2019, the FSS Korea will align its Large Exposure framework to the final Basel Standard.

Section 19 – Leverage – Equivalent

The leverage ratio (called Tangible Common Equity Ratio in the Korean legislation) is defined as the ratio of Tier 1 capital to the bank's exposure measure and is expressed as a percentage. The requirement of disclosure has been established since 2015. Since 2018 there is a binding requirement of leverage ratio. The rules for netting of exposures are the same as in the CRR. The leverage ratio must be disclosed every quarter in the bank's publications.

Section 20 – Disclosure – Equivalent

What does this mean for South Korean firms accessing the EU?

While the above has assessed what this might mean for EU firms facing South Korea, the Decision on Equivalence also means greater business opportunities for South Korean firms facing the EU. Some of the key attributes that ought to be considered in relation to this development are:

• The Decision on Equivalence comes at favorable time for South Korean credit institutions, as they are - more than before - turning abroad for growth due to the slowing Korean domestic market.
• Through the Decision on Equivalence, South Korean credit institutions can more easily access the European market and hence can tremendously benefit from the same preferential treatment applied to EU Member States' exposures in terms of capital requirements.
• The Decision on Equivalence supports the follow-the-customer approach in Europe that South Korea’s credit institutions apply concurrently with the global expansion of Korea’s biggest companies such as LG, Samsung and Hyundai.

If you would like to discuss strategic options or any of the items mentioned above, in particular how to plan ahead for any operational impact from meeting compliance requirements and/or documentation or how these priorities may affect your business or your clients more generally, please contact our Eurozone Hub and further key contacts. 

Dentons can advise in Korean language South Korean credit institutions that are already active or interested in Europe. Mrs. Soo-Youn Kim, based in Milano, heads the Korea Desk Europe at Dentons. She fluently speaks Korean, Italian and English. Dr. Raphael Won-Pil Suh, based in Munich, heads the Korea Desk Germany at Dentons. He fluently speaks Korean, German and English. Both have vast experience in advising Korean clients in Europe. We can also advise South Korean credit institutions directly in Korea through our new office in Seoul – Dentons Lee. Please get in touch with us and we connect you with the right person.

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7. Please see our Eurozone Hub dedicated coverage on the topic here.↩