Bank soundness regulation is needed to secure financial stability, but concerns have been raised that the final Basel 3 package’s risk-weight-based system could strengthen banks’ preference for low-risk assets and shrink productive finance. The financial industry and regulators stressed the need to refine the capital regulation framework so it can support productive finance while maintaining consistency with global rules.

At the Korea Institute of Finance seminar on “Financial institutions’ soundness regulation and productive finance” held on Tuesday, Kim Seok-gi (김석기), a senior research fellow at the institute, said in a presentation that if emphasis on the standardised approach under the final Basel 3 package becomes excessive, banks will have greater incentives to build portfolios around assets with lower risk weights. He said this could hinder productive finance.

Kim said soundness rules could constrain bank business and financial support in the short term, but play a positive role for financial system stability over the medium to long term. He explained that during the global financial crisis, loose regulation of investment banks, which failed to properly control risks, was cited as one of the main causes of the crisis.

Still, he said the final Basel 3 package effectively mandates a standardised approach that sets risk weights in detail, increasing the likelihood of side effects. Exposures classified as productive finance, such as corporate loans, generally carry higher risk weights and raise capital burdens, while mortgages face relatively lower risk weights, he said.

Kim stressed that South Korea’s rules need to respect Basel regulations to maintain global consistency while also being able to complement vulnerable factors in the final Basel 3 package. He added that it is important to build an institutional foundation in which the two values of bank soundness and efficient resource allocation can coexist.

Basel 3 output floor impact expands; double regulation review also needed

Yoon Yeo-jun (윤여준), a managing director at PwC Consulting, also said the current regulatory system could constrain the efficiency of capital management at financial holding companies. Yoon said productive finance needs to be understood from the perspective of an integrated capital allocation system that encompasses the real economy’s multi-layered capital demand, rather than the supply of capital to a single sector.

Yoon said the output floor rule in the final Basel 3 package is expected to have a material impact after 2027 on most bank holding companies that apply internal ratings-based (IRB) approaches. Although it is being applied in stages over five years in consideration of the burden on financial institutions, he said the influence of the standardised approach-based risk-weight system could expand across capital management over time.

He stressed the need to review loss-absorbing capacity and subsidiaries under bank holding companies, as well as to check frameworks for carrying out productive finance.

According to the presentation, the average loss-absorbing capacity ratio of the top five financial holding companies this year is 13.1 percent, above the regulatory requirement of 9.0 percent plus alpha. It said there may not be much room to deploy capital, as the estimated level actually needed is 12.5 to 13.5 percent when factoring in stress buffer capital and resolution planning (RRP) standards.

He also pointed to the possibility of “double regulation”, as subsidiaries under bank holding companies are subject to both sector-specific rules and the holding company’s consolidated BIS ratio rule, potentially leading to the same exposure being reflected twice. If capital is dispersed to meet subsidiary-level requirements, efficiency of integrated group-wide capital management could also be constrained, the presentation said.

Yoon stressed that expanding productive finance requires improving the consistency and growth orientation of the regulatory operating system, rather than simply loosening capital regulations.

He said the regulatory framework should be reviewed in a way that considers stability and growth at the same time, based on maintaining the overarching principles of Basel 3. He said data-based review, phased implementation and ex-post monitoring should be pursued together under the principle of prioritising financial stability.

Regulators seek links to productive finance through rationalising capital rules

Hwang Jun-ha (황준하), head of the Bank Risk Supervision Department at the Financial Supervisory Service, said the United States and Europe have influence in global markets on Basel standards, but if South Korean financial companies and banks are judged not to comply with the standards, it would have a very big impact on their credibility. He said banks are also worried about that.

He said regulators have continued to rationalise capital regulation since September last year and are seeing significant effects as they improve it. He said they are also continuing work to exclude losses related to operational risk, and are in the process of resolving conflicts with Basel standards.

He said that, on the premise of complying with Basel standards, it could also be good to focus on encouraging productive finance through measures such as approval of internal ratings-based approaches and embedding alternative credit assessment, rather than simply adjusting risk weights.

Bae Su-am (배수암), an official at the Financial Services Commission, said productive finance and soundness regulation may appear to be conflicting values, but are complementary values that ultimately must be achieved together. He said expanding finance without soundness support leads to bad loans, while excessively strengthening risk management can push banks toward safe assets and shrink their financial intermediation function.

He said the government is pursuing measures to rationalise capital regulation for productive finance, and is also reviewing the need for improvements because alternative credit assessment information is used in actual loan screening but is not sufficiently reflected in calculating risk-weighted assets (RWA) under internal ratings-based approaches.