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Korea’s DIF Should Invest Overseas
2019 Nov/19
Korea’s DIF Should Invest Overseas Nov. 19, 2019 PDF
Summary
The Deposit Insurance Fund (DIF) is a fund that accumulates premiums received from insured financial institutions at normal times and uses them to help the insured repay customers’ deposits when the insured lose their repayment ability at times of distress. Under the current regulatory framework, the DIF reserve can be managed via a limited range of vehicles such as government and public bonds, government-guaranteed bonds, monetary stabilization bonds, bank bonds, public fund investment pools, and bank deposits. At the end of June 2019, the reserve amounted to KRW 11.31 trillion, of which 58.3% is held in bank deposits, 40.6% in bonds, and 1.1% in public fund investment pools, with the 2.45% return on investment. For the DIF to immediately respond to any bank run in a deposit-taking institution, the management principle should admittedly prioritize stability and liquidity ahead of others. The DIF’s current asset portfolio composition seems to reflect that. However, further effort is needed to improve investment returns to the extent that it doesn’t hinder such a principle.

Also notable is the unique significance underlying in the DIF’s stability. In general, stability can be viewed as achievable by minimizing the potential loss of the principal, for example, by purchasing low-risk government bonds or bank deposits. However, in a situation that requires the DIF to step in, in other words, when a bank’s repayment ability is seriously undermined, there’s actually no chance at all for the principal of bank deposits to remain intact. Also worth considering is the high probability that distress at one bank could spread to the whole banking system. Under such circumstances, it’s impossible for the principal of the DIF’s bank deposits to remain intact. Hence, it’s advisable to replace a substantial part of DIF bank deposits with other assets whose principal is likely to be protected even when the whole banking system’s repayment ability is seriously undermined. US and German government bonds with high liquidity and low credit risk could be an alternative. This would be possible either by a reform on the Depositor Protection Act, or by the Financial Services Commission recognizing high-grade foreign government bonds as investment assets. Since 2008, Hong Kong has included US Treasury securities in investment assets, via which the deposit insurance fund has been managed.
1. DIF: Regulatory framework and management

Korea’s National Finance Act stipulates that a fund shall be established and operated according to the law if the nation needs to flexibly manage a specific fund for a specific purpose outside revenue and expenditure budgets. Based on the provision, the Depositor Protection Act established two funds, the Deposit Insurance Fund (DIF, hereinafter) and the Deposit Insurance Fund Bond Redemption Fund (RF, hereinafter), both of which are managed under the authority of Korea Deposit Insurance Corporation. The DIF is a fund that collects and accumulates insurance premiums from insured financial institutions (IFI, hereinafter)1) to help IFIs repay customers’ deposits when IFIs fail to do so due to distress, etc. When the DIF alone cannot play the role at worst cases, DIF bonds are issued. For example, when many financial institutions became financially distressed during the 1997 Asian financial crisis, the DIF reserve alone wasn’t enough to deal with the situation. At the time, large-scale DIF bonds were issued to weather the crisis. However, most of the debts raised for dealing with the distressed IFIs at that time were later found to be irrecoverable, which could be onerous to the national finance. To address such burden, special premiums were charged to IFIs, based on which a separate RF has been established and managed. The Depositor Protection Act allows surplus funds in the DIF and RF, in other words, reserves, to be managed via the purchase of the government and public bonds; the purchase of securities designated by the Deposit Insurance Committee;2) depositing the funds in IFIs designated by the Deposit Insurance Committee;3) and other methods designated by the Financial Services Commission.4) 

At the end of June 2019, the DIF and RF reserves amounted to KRW 11.3 trillion and KRW 879 billion, respectively. They are managed via deposits, bonds, and MMFs in the public fund investment pool. While the DIF holds 58.3% of the reserve in deposits in financial institutions and 40.6% in bonds, an overwhelming proportion of the RF reserve, 92.5%, is held as financial institution deposits. Such a stark contrast stems from both funds’ different objectives. Because the RF was established for the purpose of repaying debts of the DIF that had incurred before December 31, 2002, its fundamental management principle lies in securing abundant liquidity. On the other hand, the DIF can enjoy a more long-term horizon whose management focus is on higher returns because the DIF exists as a precaution in the preparation of the worst case where distressed IFIs fail to repay their customers’ deposits. The DIF’s slightly higher return at 2.45% than the RF’s 2.09% makes perfect sense given the two funds’ innate characteristics and consequent portfolio composition. 
 


 
2. DIF characteristics and overseas investment

Fundamentally, deposit-taking institutions have a structure vulnerable to a bank run because the fractional reserve system underlies their value creation mechanism. A turmoil in one bank always does more than disabling that bank only. It often spreads to other deposit-taking institutions that would eventually destroy public confidence in the whole financial system. The deposit insurance system serves to protect systemic stability as it proactively responds to a bank run and thus effectively rein in a potential systemic risk. Hence, the DIF assets should be managed under the principle prioritizing stability and liquidity so that it immediately deals with a crisis. Any effort to improve investment returns should be made to the extent that it doesn’t hinder the principle.

One thing worth mentioning is that stability in the DIF has a unique significance. In general, stability is interpreted as achievable by minimizing the possibility of any loss on the principal. Hence, any investor seeking for stability creates a portfolio of assets with low credit risk, for example, government and public bonds, bank deposits, etc. This appears to be the rationale behind the DIF’s asset portfolio that consists equally of deposits and high-grade bonds. However, also notable here is that the DIF’s stability cannot be achieved by purchasing assets with low credit risk. In a crisis situation that requires the DIF to step in, in other words, that a bank’s repayment ability is distressed seriously, there’s actually no chance at all to expect the principal deposited in the bank to remain unaffected. Moreover, distress at one bank is highly likely to go beyond the bank to spread into the whole banking sector, in which case the principal of DIF bank deposits cannot remain intact.   

Hence, the stability of bank deposits held by the DIF should be narrowly interpreted in a way that gives much leeway to the DIF adjusting its investment management strategies for higher stability that is fit for purpose. It’s required for the DIF to replace a substantial part of its bank deposits with other assets whose principal is likely to be protected even when the whole banking sector’s repayment ability is seriously undermined. An easily available investment strategy toward that direction is to invest a substantial part of the DIF reserve in overseas assets. Because overseas investments also should comply with the fundamental principle for stability and liquidity, the portfolio should focus on high-grade government bonds. 

Although investing in high-grade foreign government bonds doesn’t always guarantee the principal, for example, in the case of a transnational shock such as the 2008 global financial crisis, this could effectively minimize the potential loss of principal against a shock in the domestic financial market. 


3. Investing DIF overseas

Replacing a substantial part of the DIF reserve deposited in banks with less risky, highly liquid foreign government bonds issued by the US or Germany will certainly secure stability that fits the DIF’s purpose. Certainly, it’s necessary to keep a certain level of bank deposits in preparation for sufficient liquidity to repay maturing DIF bonds. But holding bank deposits above that level is undesirable in terms of stability.

The current law and regulations strictly limit the range of investment assets the DIF can hold. What’s necessary is a new regulatory environment that broadens the range into high-grade foreign government bonds, so that the investment strategies discussed so far can be actually implemented. More specifically, this could be done either by a reform on the Depositor Protection Act, or by the Financial Services Commission allowing for such investment. Since 2008, Hong Kong has included US Treasury securities in the investment assets via which the deposit insurance fund has been managed.

Investments in foreign government bonds, however, require no hedging against the foreign exchange risk. When any of the holdings matures, the DIF can repurchase the bond to keep the investment currency the same. When there’s a situation requiring the DIF to step in, it can then purchase the holdings in foreign government bonds to convert them into the Korean won and secure necessary liquidity. A financial market turmoil as serious as requiring the involvement of deposit insurance is usually expected to accompany a significant depreciation in the Korean won against foreign currencies. Hence, no hedging is a desirable direction from the DIF’s perspective.
 
1) Currently, designated insured financial institutions include banks, dealers, brokers, life insurers, non-life insurers, securities finance companies, merchant banks, and mutual banks. Among their financial products, deposit insurance protects only cash deposits taken from customers that are explicitly protected by the relevant laws. 
2) Securities designated by the Deposit Insurance Committee include bonds guaranteed by the government and municipalities; monetary stabilization bonds; special bonds whose losses are protected by the government and municipalities; MMF of the public fund investment pool; bank bonds, etc. rated AAA or higher by more than one credit rating agency; government and public bonds of the public fund investment pool, etc.
3) Such depositing is allowed in financial institutions designated by the Deposit Insurance Committee, including financial institutions authorized under the Banking Act, Korea Development Bank, Industrial Bank of Korea, Nonghyup Bank, National Federation of Fisheries Cooperatives, etc.
4) The FSC hasn’t designated any details on managing the reserves.