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AFDC Workshop on Developing Asian Bond Markets: Facilitating the pricing mechanism for Asian bonds May 29- June2, Shanghai. Risk Management and Sharing Case of South Korea. Korea Fixed Income Research Institute Chung Ang University. Gyutaeg, Oh. Contents.

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AFDC Workshop on Developing Asian Bond Markets:Facilitating the pricing mechanism for Asian bondsMay 29- June2, Shanghai

Risk Management and Sharing Case of South Korea

Korea Fixed Income Research Institute

Chung Ang University

Gyutaeg, Oh


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Contents

Risk Management: Early Warning System in Bond Markets

I

Risk Management : Early Warning Systems for Individual Credit Risks

II

Risk Management : SME Credit Risks

III

Risk Sharing: SME Securitization

IV

Implications to Asian Bond Market Initiative (ABMI)

V


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Risk Management: The Cases of Korea

I

: Early Warning Systems in Bond Markets


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Development of Corporate Bond Market

Maturity Concentration Crisis (2000)

Daewoo Crisis (1999.8)

SKG & Credit Card Crisis (2003.3)

Currency Crisis (1997.11)

Credit shock

Credit shock

Credit shock

Credit shock

  • Market Impact

  • Credit card Debt roll-

    over problems

  • Realizing the need for

    systemic risk

    monitoring system

  • Realizing the

    importance of credit

    Bureau

  • Plunge of ABS markets

  • Market Impact

  • Massive corp.Bond

    Issuance to refinance

    bank debts (from banks

    to ITCs)

  • ABS (Asset backed

    securities) development

    to handle NPLs

Market Impact

MTM accounting

for ITCs

Establish bond pricing agency

Improve post-

trade transparency

  • Market Impact

  • Issuance of P-CBOs to

    refinance corp. bond

    debt

  • Rapid pick-up of ABS

    markets


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Necessities of Early Warning Systems in Bond Markets

Problems both inside and outside bond markets prevented the proper function

of price discovery and pricing, finally leading up to the financial crisis.

Information on interest rates, issuing or trade volume is not enough to warn the potential risks of bond markets.

Creating various “bond market indices” and reporting them periodically will enable market participants to systematically expect the directions, credit risks, and concentration risks of the bond market.

I. Concentration Index

II. Credit Spread Index

III. Market Sentiment Index


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I. Concentration Index of Bond Markets

  • Outstanding Issue by bond

  • types (including the entire bonds)

  • Outstanding Issue and trade

    volume by industries (confined to

    credit-risky bond)

Prevention of risks caused by excessive concentration in specific sectors or industries

Concentration Index(Herfindahl-Hirschman index)

Market Concentration on Bonds

Concentration in overall markets

decreases a little, but differently

-Decrease in Corp. Bond/Agent Bond &

Increase in Government Bond/MSB

(See Figure )

GB LB SB MSB FB CB


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Manufacture

Finance

Other industries

Concentration Index by Industries

  • The increasing trend of concentration since 2001

  • Financial sector’s share has been increasing sharply

  • Corporate bonds on manufacture has been decreasing


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Advantages of using Concentration Index

By analyzing the concentration index of bond markets and its historical trend, it is possible to know in what sort of bond markets money is concentrated or in what industries bonds are focused.

Useful data to perceive bond market features or possible direction

Data by bond types and of industrial potion can be a referential material, when investing bonds

Used as benchmark indicator when deciding the portion of Investment by industries

Useful materials for managing industrial risks

Possibility to prevent possible risk caused by excessive concentration of money in specific bond types or industries.


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Telecommunication

Construction

Manufacture of Automobiles and Trailers

Graph

Table

Trend of

Yield

by Industries

Trend of

Spread

by Industries

Period

Standard

Trends

of Yields

and

Spreads

of Each

Industry

……

Trend of

Inter-

Industry

Spread

Chemical Ind.

II. Credit Spread Index

Objective

To provide trustworthy indexes for bond market participants by measuring credit

  • risks in the market, by grading credit and industries, based upon credit spread

    • Spread by credit levels can predict credit risk recognized in the market.

    • Credit spread by industries shows the changes of credit risks in each industry.

Trend of Spread Index by industries


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KIS

KSDA

(Korea Securities Dealers Association)

  • Calculation of spread

  • index by group/grade

  • and industries

  • Use of graph and tables

Rate of returns by group/grade

Homepage Notice

KBP

NICE

Market participants

Monthly Summary

Report

Rate of Returns

by Industries

Calculation of Credit Spread Index

  • Calculation Procedure

< Bond Pricing Agencies >

  • Calculation Method

  • Selection of Issues by index purposes: non-guarantee, senior, public offered or normal bonds

    (confined to only over BBB credit rate bonds)

  • Sector division by risks: by bond groups / credit rates / industries

  • Establishment of the event-rule: Rule-making in Corporation Restructuring Inducement Law and when

    restoring exceptional corporations


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III. BMSI ( Bond Market Sentiment Index )

BMSI Objective

  • To provide bond market warning signals

  • To uplift the security of financial system by letting the overall market atmosphere recognized

  • To enquiry of over research institutes, funds, banks, and asset management companies about the

    market sentiment.

Benefits of BMSI

  • Role as an indicator, when capital management institutions establish operational strategy

  • Utilization as an referential indicator of financial market decision-makings


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Example : Bond Market Sentiment Index

Bond market sentiment survey ( Example )

What do you think interest rates will be in one month?

1) increase 2) current level 3) decrease

BMSI = (Good-Bad) / (Good+Bad) ] x 100 + 100

Good = Number of respondents who expect that bond markets will be getting stronger (decrease of interest rate)

Bad = Number of respondents who expect bond markets will be getting weaker (increase of interest rate)

BMSI Interpretation

0: Cap

“ BMSI 30 indicates that market psychology is tightened. ”

“ If BMSI is higher than 100, it is expected that interest rate will overall decrease, showing the expectation of market participants.”

100:Base

“ BMSI 170 Indicates that market psychology is overheated.”

200: Floor

BMSI Level


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Example : Bond Market Sentiment Index

BMSI Graphs


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II

Risk Management: The Cases of Korea

: Early Warning Systems for Individual Credit Risks


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GoodZone

NeutralZone

Early Warning Systems for Individual Credit Risk

  • Background of Individual Credit Risk Index

  • After serious credit risk of the year 2003 in Korea, the need to develop a new index to show how the credibility of individual people changes has increased, with credit default rates being soared

  • Individual Credit Risk Index in Korea

  • Simple average of CB Risk Score over the entire population to calculate various indexes from

    Credit Panel Data


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Reporting the Credit Risk Index quarterly

STEP 4

Averaging the summation and Indexing

(Setting Index at the standard point of time, June 2004, as 1000.0)

STEP 3

Summation of Individual Credit Points

STEP 2

Calculating Individual Credit Points

STEP 1

  • Object: 33,679,786 people aged from 20 to 89, dealings on credit

Computation and Operation of Individual Credit Risk Index


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Financial CB Consortium

General member Companies

  • Banks

  • Credit Card Co.

  • Capital Co.

  • Insurance Co.

  • Federation of

  • savings banks

  • Federation of

  • community credit

  • corporatives

  • Credit union

  • Department stores

Finance & non-finance

credit rating corporations

NICE Credit Bureau

Credit Information

Database

= Gathering & Enquiry Info.

Korea Federation

of Banks

Financial organizations

Public organization

(ie. National Tax Service)

KCFA CB Consortium

Consumer finance

  • CB Service

  • Credit report

  • Credit grade

  • Early warning

  • Prevention of

  • deception

Communication

CB Consortium

Information

communication

Service Providing

Exchange of Info.

Information

Gathering

I. Credit Bureau Data Channel


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II. CB Risk Score

  • Credit Risk Score aims to provide credit score (average) and grade (10 levels), measuring credit risks within the given period over the entire population relating to credit activities

Goal

Credit risk estimation of the overall population

Object

Population relating credit activities

CB Risk

Score

Content

Forecast of non-performance of debts within 6 months ( over 90 days in arrears)

Activities

Utilized in screening loans and cards issuance, and estimating credit degree of the overall customers monthly and quarterly

Features

Regarded as the typical model with improved accuracy reflecting the recent CB information (esp. arrears information) in contrast to the existing risk score

Service type

Online search & deployment search


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  • Credit Panel Data by credit grades on a quarterly basis

Grade

Total

III. Consumer Credit Panel Data

  • Credit Panel Data –Credit panel data over the public

  • The entire individual on whom NCB has credit information; about 33

  • million people

  • CB Risk Score on each individual and aggregated grade on monthly

  • basis

  • Information has been accumulated since Jun. 2003

  • The expectation that various information monitoring will gather more

  • contents.

0bject individuals

Aggregated Information


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Grade

0

1

2

3

4

5

6

7

8

9

10

Compared companies

The Overall Public Delinquent Rate

  • The entire individual on whom NCB has credit information; about 33 million people

  • CB Risk Score on each individual and aggregated grade on monthly basis

  • Information has been accumulated since Jun. 2003

  • The expectation that various information monitoring will gather more contents.

0bject individuals

Aggregated Information


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IV. Credit Index illustrated by Credit Panel Data

  • Simple average of CB Risk Score over the entire population

  • Possibility of calculating various indexes by analysis purposes from Credit Panel Data

  • (ex. Trend of customers below the7 grade )

Credit Panel Data

Average

  • Credit Panel Data-Trend of Credit Index


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Credit Bureau Business in Korea

History of Credit Bureau in Korea

1987

2002

2003

2004

2005

CB Score Service

CB Early Warning System

Beginning of Credit Information Service

Establishment of CB Consortium

CB reporting service

Revolution of CB Market

Simple service of reporting negative credit information on credit risk

Diversified Service providing positive credit informatione.g.) credit evaluation


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Korea’s Credit Bureau Market


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6 Month Forecast

K-S = 67.1%

6 Month Forecast

K-S = 66.3%

1) Short-term and Long-term Credit Forecast

  • NICE CB Score uses the estimation items which can precisely predict short-term and long-term insolvency rates, to keep the forecasting capability

bad

Good

Possibility of being registered as delinquent customers within 6 months

bad

Possibility of being registered as delinquent customers within 12 months

*. Analysis sample: 2.5 million customers

estimated in 1st quarter, 2004

Good


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The overall public’s delinquent rate

The companies’ delinquent rate by grades

The entire public

The companies

2) Bench Mark Index illustrated by Credit Panel Data

  • Comparison of default rate of the overall public by CB grades with default rate over the companies’ portfolio

    by grades

  • Possibility to appreciate the soundness of companies’ portfolio relative to the entire population


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Risk Management : The Cases of Korea

III

SME Credit Risks


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SMEs in the Korean Economy

Importance

Difficulties

Number of Companies

  • Insufficient collateral

  • High transaction cost

  • Low credit risk assessment ability of financial institutions

    : Limited access to formal financing

SME 99% LE 1%

Number of Employees

SME 86% LE 14%

Exports

SME 43% LE 57%


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Head Office

Services

Shareholders

Capital

  • 8 Types of credit information services to domestic and overseas clients

  • KCGF(47.8%),

  • KOTEC

  • KDB

  • IBK

  • KFB

  • SBC

  • 5 Divisions, 2 Departments, 19 Teams/ Seoul

  • 8 Branches nationwide

  • $ 72 million

SME Credit Database in Korea

  • Established Korea Enterprise Data in Feb. 2005 as a spin-off company of KCGF’s credit

  • information services

  • Credit bureau specializes in credit information of SMEs


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Biz Information Report

FAPs(Financial Filtering)

Industry Rating

Financial RatioFactors

Non-financialQuantitative

Factors

Non-financial

Qualitative

Factors

Window Dressing

Check

Evaluated automatically

Judged by Analyst

Yes

No

Financial Rating

Quantitative Rating

Qualitative Rating

Combined Rating before

Filtering & Adjustment

NR(Not Rated)

Filtering

Adjustment

Credit Rating

Corporate Credit Rating System (CCRS) by KED


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CCRS - Estimated and Actual Default Ratio


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Risk Sharing:

Case Study of SME Securitization

IV

2


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Credit Risks involved in P-CBO program at SBC

  • The main problems are that SMEs in Korea have high default risk

  • Cumulative Default Rate

(by Korea Ratings, Periods : 1998~2004, unit : %)


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23 SMEs

Corporate bonds (72billion won)

Small Business Corporation

Asset sales

SPC

Credit Enhancement

by Korea Housing Bank

(10billion)

Senior bonds

(2yr 8.5billion, 3yr 36billion)

Junior bonds

(27.5 billion)

Repurchased by Small Business Corporation

Investor

SME Securitization Program by SBC: CBO Program in 1999

Primary in the sense the program helps SMEs issue bonds


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The Role of SBC (Public Sector): Agent for Change

  • Market Failure (Credit Quality Gap) Problems

  • SMEs have high default risk (WAR B+) but need alternative funding source

  • - Investors want good quality bonds

  • - Securitization helps reallocate risk

  • - Problems: How to sell junior bond?

  • Catch 22 Problem

  • No one knows what structure is appropriate

  • No one knows the risk-return profile of the structure

  • No one invests in mezzanine bonds

  • SBC securitization program illustrates dynamic evolutionary paths

  • - assumes junior bonds

  • - finds appropriate structures

  • - create mezzanine bond markets

  • - create junior bond markets


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P-CBO Programs for SMEs by SBC

  • Target WAR: BB - B+

  • Total Amount:1,834.7 billion KRW

  • # of firms: 598

  • Average funding per firm: 3 billion KRW

  • Special attention to

    2nd: together with KCGF

    8th : ABMI related Pan-Asian Bond


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P-CBO Programs: Underlying Assets

  • Currency: local/G3

  • Maturity

  • : 3 years for local

  • 5year for G3

  • Why 3 years benchmark corporate bonds has 3 year tenor extending to 5 years is not economically viable

  • Structure: three stages introduction: SB(2nd with KCGF) variation: Loan backed by receivables mature :BW


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Example of BW Structure: COROvoltin (5th)

Mezzanine bonds sold to domestic investors

Warrants sold overseas


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Rationale for BW structure (Example: COROVoltin, 5th)

  • venture companies listed on KOSDAQ or

  • IT companies which are expected to be listed soon

Participating

Companies

  • minimize interest rates (at the expense of issuing warrants)

  • raise funds in USD ( in anticipation of won appreciation)

Companies’

Needs

Warrant Investors’ Needs

  • participate in the growth potentials of the companies

  • offset the default loss with gain from exercising warrants


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Warrant Holders

  • SPC: buffer which offsets the default loss with either gain from exercising warrants or cash reserve from warrant sale

  • Market: speculators

    (various methods including public auctions)

  • Issuer:

    Corporate Control

    interest alignment

  • Participant: Sweetener to mezzanine tranche

  • Senior :Sweetener

    (*: linked to residuals after junior is paid off)

  • Warrants are detachable

  • Warrant Coverage:100%


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Mezzanine Investors and Risk Sharing Structure

  • Senior: market

  • Junior: SBC

  • Mezzanine

    Participating Institutions (underwriters,custodian banks), as they understand the risk better

    Issuer: Moral Hazard

    Market : Mezzanine Fund


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Credit Enhancement Structure

  • 11th BW-Mezzanine

  • 7th BW-receivable backed

  • Pool

  • WAR (B+)

  • 38 firms

43%

Senior

85%

(AAA)

  • Pool

  • WAR (B+)

  • 48 firms

46.49%

Senior

70.01%

(AAA)

  • External Credit

    Enhancement

    :Bank C/L

25%

16.53%

  • External:

    Bank C/L

11.99%

  • Mezzanine

  • Internal

    ;warrants 2%,

    receivables:15%

Mezzanine

11.99%

17%

  • Warrants

7%

Junior

18%

18%

  • Junior/SBC

Junior

15%

  • Junior/SBC

15%

  • Total 94.4 billion KRW

  • Total 84.7 billion KRW


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Variation: Piraruku Fund(10th)

SBC

US$25 million A1 Senior Floating Rate Notes due2007 (semi-annual coupon and bullet redemption)

Note Trustee

Investors

Seller(Hannuri)

US$25 million A2 Senior Floating Rate Notes due2008 (semi-annual coupon and bullet redemption)

Investors

US$71 million A3Senior Floating Rate Notes due2009 (semi-annual coupon and bullet redemption)

Investors

Piraruku Fund Limited

(SPV Issuer)

E1 Note- par value of 10% of Reference Bonds reducing to nil on Reference BW Event of Default- [contractual option to exchange into 25% of Reference Warrants any time after 2007]

BW Issuer

Hannuri

BW Issuer

E2 Note

Portfolio Manager(offshore)

BW Issuer

E3 Note

BW Issuer

E69 Note

Portfolio ManagerAdvisor (Hannuri)

BW Issuer

E70 Note

Junior Note (C & X Notes)

SBC

Hannuri


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Foreign Exchange Risk

Management Program

run by SBC

Forward Contract

Principal &

Interest (\)

Principal &

Interest ($)

BW Issue

SMEs

SPC

Investors

Bank

Principal &

Interest ($)

Proceeds (\)

Proceeds ($)

Variation: Structure of Piraruku Fund(10th)

  • Issuing companies can use Exchange Rate Risk Management Program to enter into

  • custom-tailored forward contracts with banks at smaller costs


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SBC’s Foreign Exchange Risk Management Program

  • Background of Exchange Rate management Program

- Since the end of 1997, currency has fluctuated greatly

- SMEs, 42.2% of whose annual revenue comes from exports, suffered high exchange

rate risks

- SMEs incurred high transaction costs (due to small scale or poor credit) when they tried to

hedge their foreign exchange risk

  • SBC initiates an exchange-rate risk-management program for SMEs in 2004

  • - SBC selects SMEs to form pools

  • - SBC selects sponsoring banks

  • - SBC sets transaction costs associated with hedging activities

  • loss sharing rule for default on forward contract:collateral money, 40% of fee

  • revenues to SBC, SBC


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Exchange Risk Management Program - Continued

  • Reduce transaction fee

  • SMEs pay 0.5 – 0.75% in advance, and SBC matches the same amount


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Future of P-CBO Program at SBC

  • P-CBO program will remain operative in the future

  • The maturity of bonds (issued by SMEs in the P-CBO programs) will be extended

  • from 3 years to 5 years

  • Mezzanine tranche is sold to the investors (since 8th transaction)

  • Junior tranche can be sold to other investors

  • CBO program can evolve to a platform program like “PROMISE” in Germany


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V

Implications to the Asian Bond Market

Initiative (ABMI)

2


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Pan Asia Bond: Yen-denominated P-CBO

  • Transaction date: December 13, 2004

  • The issuance of Japanese yen-denominated P-CBO between Korea and Japan is an important tangible outcome for the endorsement of the Asian bond market and also provides new sources for SMEs of other countries in this region.

  • The purpose of the issuance of yen-denominated P-CBO is to create momentum for the development of the Asian bond market and enhance economic cooperation between Korea and Japan

  • The securitization of a portfolio of yen-denominated corporate bonds (Portfolio Securities) of 46 Korean small and medium enterprises (Portfolio Obligors)

  • Further credit-enhanced by the Industrial Bank of Korea (IBK) and JBIC.

  • The P-CBO interest rate is 20 to 30 basis points lower than that for Korean won-denominated P-CBO, even after taking the cost of hedging for foreign exchange risks into account.

  • Singapore instituted SME securitization program in 2005


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Country I

SME

Loans/

Bonds

Senior

SPC

in

Country A

Senior

Junior

Junior

Country II

SME

Loan/

Bonds

Senior

Credit guarantee

Junior

Regional Guarantee Mechanism

Country III

SME

Loan/

Bonds

Senior

Junior

Korean Proposal for ABMI: Structure of the Scheme

Issued in Local Currency

Issued in Country A’s currency


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European Benchmark:EIF and SME securitization


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Thank You !


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