Although securities firms have played a pivotal role in the development of capital markets, in-depth research on financial soundness regulations that have the greatest impact on their business activities has rarely been undertaken. Since its first introduction to Korea in 1997, the previous Net Capital Ratio rule had been in place for about 20 years. In 2016, the financial authorities decided to adopt the new Net Capital Ratio approach (new NCR) with a view to enhancing global competitiveness and expanding risk investment capabilities. However, a systematic analysis of how the introduction of the new NCR has affected Korea’s securities sector has not been sufficiently conducted. In this regard, this report intends to take a look at financial soundness regulations on the securities industry in major economies like the US, Europe, and Japan, countries with a long history of the capital requirements regulation, and to examine changes that the adoption of the new NCR has brought about to Korea’s securities sector. In addition, it would analyze regulatory divergence between Korea and other advanced countries, aiming for presenting directions for regulatory improvement in the prudential framework to which Korea’s securities firms are subject.
As shown in the analysis of regulations on the securities sector’s financial health in major economies, the US NCR has evolved based on the philosophy of company liquidations-related liquidity requirements with a top priority of protecting customers’ assets in case of an insolvency event. The US introduced the NCR in 1934 when the Securities Exchange Act came into effect, and established the current capital requirement formula after undergoing several revisions such as the 1975 introduction of the Uniform Net Capital Role. The current NCR approach can be classified into three types: the basic method, the alternative method, and the alternative net capital method. European countries including the UK use a Basel-style approach that has emphasized the importance of preventing bankruptcies of securities firms under the regulatory philosophy of the going concern-based prudential framework. The previous Basel-based regulation on the securities sector is similar to the capital requirements to which commercial banks are subject. Europe is expected to significantly improve regulations on the securities industry’s financial soundness from the second half of 2021. This means that in practical terms, European countries would shift towards the US NCR approach.
Amid the worsening financial health of securities firms in the mid-1990s, Korea introduced the previous NCR rule in April 1997 by benchmarking Japan’s capital requirements framework. The previous NCR rule laid the foundation for the regulatory framework for the securities sector’s financial health, which helped securities firms overcome the 1997 Asian financial crisis and the 2008 global financial crisis. Since the new NCR was implemented in 2016, Korea’s securities industry has seen a sharp increase in equity capital amount, expanded into overseas markets, and considerably increased profitability in IB businesses. Given this performance, the new NCR appears to have achieved its policy objectives. On the other hand, some brokerage firms have seen a surge in the issuance of derivative-linked securities and the debt guarantee value over the same period, which increased prudential risks in some segments. Furthermore, small securities firms have suffered reduced investment capabilities and worsening profitability. This highlights that the impact that the new NCR approach had on the securities industry varied by size of firms.
Additionally, this report undertook a comparative analysis of capital adequacy requirements for the securities sector in both Korea and major economies. The analysis reveals that in terms of calculating the capital adequacy ratio, the net operating capital, and gross risks, Korea’s regulatory regime is more stringent than those of other countries. Korea is not much different from its counterparts when it comes to the calculation of capital adequacy ratios. However, its regulatory scheme can be considered more rigorous given that Korea is applying a single capital adequacy ratio to brokerage firms regardless of their size. What is also notable is that it is hard to find any government around the world that has adopted a leverage ratio regulation as part of the prompt corrective action system. Against this backdrop, the introduction of the leverage ratio regulation to the securities sector appears to be a somewhat stringent regulatory measure.
The following suggestions should be taken into consideration to improve Korea’s regulatory framework with respect to the securities industry’s financial soundness. First, the financial authorities need to provide more flexibility to the application of capital adequacy ratios depending on the size and function of securities firms. For instance, it may be desirable to apply the Basel-style capital requirements to IB securities giants and to allow small- and medium-sized brokerage firms to choose between the net capital ratio and the Basel-based approach. Second, the net operating capital and gross risks should be calculated in proportion to economic risks. Third, it is necessary to keep to a minimum the use of capital requirements for achieving policy objectives. Lastly, in the long run, the leverage ratio system should be employed only to curb systemic risks. In this regard, the potential systemic risk of the securities sector needs to be assessed on a regular basis, and if the risk assessment shows that the risk level remains low, the regulatory threshold of leverage ratios should be reduced.