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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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Risk Management and Sharing Case of South Korea


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    1. 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

    2. 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

    3. Risk Management: The Cases of Korea I : Early Warning Systems in Bond Markets

    4. 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

    5. 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

    6. 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

    7. 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

    8. 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.

    9. 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

    10. 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

    11. 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

    12. 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

    13. Example : Bond Market Sentiment Index BMSI Graphs

    14. II Risk Management: The Cases of Korea : Early Warning Systems for Individual Credit Risks

    15. 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

    16. 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

    17. 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

    18. 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

    19. 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

    20. 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

    21. 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

    22. 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

    23. Korea’s Credit Bureau Market

    24. 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

    25. 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

    26. Risk Management : The Cases of Korea III SME Credit Risks

    27. 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%

    28. 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

    29. 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

    30. CCRS - Estimated and Actual Default Ratio

    31. Risk Sharing: Case Study of SME Securitization IV 2

    32. 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 : %)

    33. 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

    34. 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

    35. 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

    36. 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

    37. Example of BW Structure: COROvoltin (5th) Mezzanine bonds sold to domestic investors Warrants sold overseas

    38. 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

    39. 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%

    40. 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

    41. 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

    42. 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

    43. 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

    44. 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

    45. Exchange Risk Management Program - Continued • Reduce transaction fee • SMEs pay 0.5 – 0.75% in advance, and SBC matches the same amount

    46. 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

    47. V Implications to the Asian Bond Market Initiative (ABMI) 2

    48. 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

    49. 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