Instilling Instilling Responsible Responsible Responsible Lending

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					Vol. 20, No. 12 (26 March 2011)

                                                 Instilling Responsible Lending
                                                             Practices in Korea*

                                                                                                                Hyoungsik Noh


      Following the global financial crisis triggered by the US subprime mortgage meltdown, the US, EU,
    and UK have been drawing up legislation to instill responsible lending practices. In Korea, best practices
    for mortgage loans emphasize responsible practices during the loan review, but these also need to be
    assured over the course of the loan. Korea should move towards systematic lending rules for the entire
    financial sector and establish responsible lending practices in order to prevent excessive debt, ensure
    the soundness of lenders, and protect loan consumers.

    * Opinions expressed are those of the author and do not necessarily reflect the official positions of the Korea Institute of Finance.
  The US subprime mortgage loans that served as the primary cause of
the financial crisis were loans that were not extended based on ability
to pay. One of the remedies to prevent future crises is contained in the
Dodd-Frank Act passed in 2010, which tightens financial consumer
protections and moves towards restricting such unfair and reckless
lending practices. In Europe as well, where rules for responsible
lending practices had already been in place, regulations are being
enacted both to strengthen responsible lending and responsible
borrowing.     Korea went through a credit card crisis in 2003 that
produced many debt delinquents, and more recently sees growing
concerns about a soft landing for household debt. A mechanism for
reigning in excessive household debt by establishing responsible
lending practices at financial companies is thus urgently called for. This
paper shall examine the need for responsible lending practices and
outline future tasks by comparing the case of Korea with that of
other countries.

  The Nature of Loans & the Need for Responsible Lending

  Loans are a financial product that serves a lump sum of money
                                                                                         Loans extended
needed at the present point in time in return for a series of future cash                without consideration
                                                                                         of current and future
flows. If the borrower does not have sufficient future cash flows to                     ability to pay can
service the amount lent by the financial company, this complicates                       make the financial
                                                                                         consumer branded
repayment, and the loan contract may end up being non-fulfilled. In the                  with the label of a
                                                                                         debt delinquent.
latter case, the financial consumer is branded with the label of a debt
delinquent and has restrictions placed on future financial activities. Financial
companies should therefore exercise caution from the outset of the loan
approval process so that consumers do not lose access to financial opportunities.

                                                                                    Vol. 20, No. 12    1
                           This should be done by suggesting proper loan terms (maturity period,

                         repayment method) for the borrower through perceiving the borrower's needs
                         and evaluating their capacity to service debt based on future income streams,
Responsible lending      rather than just basing it on whether the borrower wants a loan. Even if the
is credit products
extended by l oan        lending institution accurately explains the characteristics of the loan product
institutions that meet
the needs and            (interest rate, commissions, etc.), borrowers may have bounded rationality that
payment capacity of      overestimates their future ability to pay, so this must be followed with
financial consumers.
                         consultation and advisory. Assessing the need for and ability to repay a loan

                         are core elements of responsible lending. In this sense, the EU1) defines

                         responsible lending as credit products extended by loan institutions that meet

                         the needs and payment capacity of financial consumers.

                           Unlike other financial products, loan products may incur losses not on the

                         consumer but on the financial company over the course of the loan period. For

                         loans with lump sum principal payment, even if the borrower pays interest as

                         normal, it is still possible for the principal to not be repaid normally upon

                         maturity. Thus, the lending institution must exercise caution throughout the loan

                         contract in terms of assessing how the loan contract will hold up amid changes
                         in borrowers' ability to pay or changes in interest rates.

                           Overseas Efforts to Instill Responsible Lending Practices

                           The US Truth in Lending Act, originally Title I of the Consumer Credit

                         Protection Act, stipulates that interest rates and other loan terms must be

                         disclosed to enable the financial consumer to compare and choose. In the

                         1) European Commission, Public Consultation on Responsible Lending and Borrowing in the EU,
                         June 2009.

 2    Weekly Financial Review
Dodd-Frank Act passed in July 2010, the Truth in Lending Act was amended
                                                                                                  The Dodd-Frank Act
under Title XIV entitled the Mortgage Reform and Anti-Predatory Lending Act,                      in the US stresses
                                                                                                  assessing debtors'
which strengthens federal-level regulations for preventing predatory lending
                                                                                                  ability to pay and
and mandates that mortgage loan institutions reasonably assess consumers'                         limits irresponsible
                                                                                                  lending practices.
ability to pay based on specific information. Further, the Office of Housing

Counseling for borrowers was established within the Department of Housing

and Urban Development.

  In the UK, among the business standards for approved financial firms, Article

11 of the Mortgages and Home Finance: Conduct of Business Sourcebook

(MCOB) stipulates that the debtor's ability to pay must be taken into account

before a loan is extended. Unlike the US, the UK has had responsible lending
practices in place for a long time, but it tried to strengthen this further through

the Financial Services Authority's (FSA) July 2010 Mortgage Market Review2),

which is slated to be put into law in the first quarter of 2011. Yet contrary to
expectations, responsible lending practices have not been well followed, with

45% of new mortgages in the UK from April 2005 to March 2010 extended

without proper income checks. Also, the strengthening of responsible lending

practices in the UK is in the context of efforts by the EU toward both

responsible lending and responsible borrowing.

  The EU viewed the housing bubble amid the financial crisis that hit countries

such as the Baltics, Romania, Spain, the UK and Ireland as being rooted in the

same reasons as the US, namely irresponsible mortgage lending. Based on this,
the EU issued a 2009 report entitled Responsible Lending and Responsible

Borrowing, followed by a related working paper in July 2010, as part of their

2) Financial Services Authority, Mortgage Market Review: Responsible Lending, Consultation
Paper 10/16, July 2010.

                                                                                             Vol. 20, No. 12   3
                        efforts to institute responsible lending. The EU intends to issue rules on
                        pre-loan selling practices, such as offering guidelines on the inherent risks in
                        loan products, pre-contract disclosure, and marketing and advertising prior to the
                        loan, as well as the appropriateness of the timing of the loan, rules on evaluating
                        ability to pay and advisory standards.

                           Korea's Efforts to Promote Responsible Lending

Korea's attempts to       Korea's attempts at instilling responsible lending are seen in the best
instill responsible
lending are seen in     practices on mortgage lending implemented from 2007. The Measure for
the best practices on   Consumer Protection in Home Mortgage Lending, implemented in April of that
mort gage l endi ng
implemented from        year, had the purpose of raising borrowers' awareness of mortgage product
                        characteristics, and particularly interest rate risk. It tightened disclosure

                        requirements regarding interest rate risk and facilitated product comparison,
                        more specifically ① tightening requirements on notification of interest rate

                        terms and risks, ② tightening requirements on notification of principal and

                        applied interest rates for floating rate loans, ③ building a system for gauging

                        the additional expected interest burden from a rise in rates, ④ providing a home

                        mortgage handbook and checklist, ⑤ and building a comparison chart for home

                        mortgage loan products. In addition, under the Measure for Advancing the

                        Credit Review System for Mortgage Lending implemented in March of that

                        year, credit reviews for mortgage loans were switched from being based on

                        collateral to being based on ability to pay. The Basic Principles for the

                        Assessment of Repayment Capacity states the importance of evaluating the

                        ability to pay upon extending mortgage loans, and standards for using an

                        evaluation index and proof of income. According to the basic principles, financial

  4    Weekly Financial Review
companies must first assess repayment capacity when extending a loan, even
                                                                                            The Act on Registration
if the collateral is sufficient. Moreover, if there are floating rate terms or terms        of Credit Business,
                                                                                            etc. and Protection of
for the deferral of principal repayment, this should include assessing the
                                                                                            Finance Users can be
potential for an increase in the repayment burden. Financial companies may                  c al l ed one ef f or t
                                                                                            toward responsible
voluntarily select evaluative indicators, such as the total debt service ratio or           l endi ng i n t hat i t
                                                                                            stipulates that each
debt-to-income ratio, as well as putting in place application criteria, and are
                                                                                            credit service provider
able to reflect risk characteristics such as the nature of the borrower, the                disclose credit terms
                                                                                            and enter into
collateral and the loan. The responsibility for income notification and proof is            contracts based on
                                                                                            objectively gauging
in principle placed on the borrower, while the financial company must confirm
                                                                                            the counterparty's
the validity of the income disclosure either by using objective materials or its            ability to pay.

own standards for determining suitability.
  Korea's attempts at instilling responsible lending can also be seen in the Act

on Registration of Credit Business, etc. and Protection of Finance Users, which

stipulates laws regarding the duty of disclosure about credit terms and of
evaluating ability to pay. In Article 6 of the Act, the credit service provider

must explain the amount, interest rate, and repayment period and method to the

counterparty, while Article 7 stipulates that credit contracts must be reached
within the objective ability of the counterparty to pay through gauging the

income, wealth, and liability situation.

  Tasks for Instilling Responsible Lending in Korea                                         Responsible lending
                                                                                            calls for a means of
                                                                                            information exchange
  Financial authorities need to present responsible lending principles across the           between the lending
                                                                                            institution and the
various sectors that extend loans in order to institute responsible lending                 borrower, consideration
                                                                                            of the l endi ng
practices. The basis for sanctioning must be made clear, rules should be put
                                                                                            institution's incentive
into law to enhance the effectiveness of the regulations. This can be done                  structure, and upon
                                                                                            legislation, quantitative
either by revising various sector-level legal provisions or by incorporating                impact assessments.

                                                                                       Vol. 20, No. 12       5
                     related financial consumer protection legislative efforts.

                       Responsible borrowing should also be emphasized alongside responsible
                     lending. We may call faithful disclosure of income and wealth conditions by the

                     borrower as the foundation of appropriate lending. The Dodd-Frank Act

                     established new provisions that, while stressing the responsibilities of the

                     lending institution, reduce such responsibilities if there is deception on the part

                     of the borrower. In the aforementioned public consultation papers offered by

                     the UK and EU, although the standards are not as strong as for responsible

                     lending, they clearly emphasize the importance of responsible borrowing.

                       The lending institution must make every effort to convey accurately in easy

                     to understand language information about the loan product, while financial
                     authorities should consider policies to consolidate and manage loan product

                     information disclosure through standardizing methods to enable the comparing

                     of various loan products across industry sectors.
                       The lending institution should also conduct an objective and reasonable

                     assessment of payment ability using a credit bureau's credit rating and proof

                     of income, etc. Further, the qualitative information acquired on meeting the
                     borrower should be bolstered. One of the lessons of the financial crisis was that

                     over-reliance on mass statistical data may serve as a macroprudential threat

                     from loan procyclicality. Therefore, financial authorities should take a
                     conservative approach to the regulation of advertising or telemarketing of loans,

                     and must encourage face-to-face consultations.

                       Even if loans extended based on loose assessments of ability to pay increase

                     financial company risk, if this risk is dodged through securitizing loan assets,

                     then the incentives for responsible lending may not function properly. Thus, in

                     terms of appropriately maintaining incentives for responsible lending, policies
                     should encourage covered bonds over MBS.

6   Weekly Financial Review
  Instilling responsible lending may be used as a means of preventing

over-indebtedness by extending loans only within borrowers' ability to pay.
However, the legislating of responsible lending may affect the availability to

loans, so more thorough preparation is needed, including quantitative

impact assessments.

                                                                                 Vol. 20, No. 12   7
                                                   Focus & Brief
                                                     April 4~April 8
                         ■ Policy Issue in Focus: Issues to Consider Regarding the Introduction
                           of Bail-In Bonds for SIFIs

                         ■ News Briefs:
                            -March Consumer Prices Jump Most in 29 Months
                            -Chinese Investors Flocking to Korean Securities Market
                            -Won/Dollar Rate Trends Downward
                            -FSC Strengthens Stance on Excess Bank Competition

                         ■ Market Indicators: April 4~April 8

                       ☐ Policy Issue In Focus:
                              Issues to Consider Regarding the Introduction of Bail-In Bonds for SIFIs
                              (Byung-Duck Kim, Senior Research Fellow)

                       ■ Overview: International regulatory bodies such as the BCBS
                          and FSB have been discussing how to introduce bail-in bonds,
                          which were one of the measures agreed upon at the G20 Seoul
                          Summit for tightening regulations on systemically important
                          financial institutions (SIFIs). Bail-in bonds refer to bonds that
                          are      automatically        converted    into       common     stock-or,
                          alternatively, where all or a portion of the bond are written
                          down-when a 'trigger' of pre-specified conditions is met.
                          Regulators would mandate the issuance of such bonds for
                          financial companies classified as SIFIs with the idea that
                          investors     would    bear    a   share   of   the    losses   when   such
                          companies ran into trouble.

                          Such bonds are classified into 'contractual bail-ins', in which
                          the conversion/write down ratio is stipulated in a private
                          contract between counterparties, and 'statutory bail-ins', in

8   Weekly Financial Review
  which supervisory organizations are vested with the legal
  authority to determine the ratio and timing of the conversion.

■ Current Situation: Initially, it will make the most sense to
  start with simpler contractual bail-ins, with a statutory bail-in
  scheme      postponed           until    further       assessment         of        market
  conditions.     This       is     because        country-level         variation        in
  bankruptcy schemes would make it challenging to introduce
  statutory bail-ins in an equitable manner. The authority for
  implementing bail-ins on global SIFIs may also create conflicts
  of   interest       between       home     and       host    country      supervisory
  organizations, so if statutory bail-ins are to be adopted, these
  implementation-related matters will need to be ironed out.

  Implementation will also need to establish the scope of the
  bonds targeted for bail-ins. In principle it is desirable to set
  this scope as broadly as possible, since a bail-in scheme
  would increase the incentive for SIFIs to raise funding through
  bonds not targeted in the scheme. However, including certain
  classes of bonds could bring various side effects.

  Bail-in    triggers       should        pose    no     particular    problems          for
  long-term           unsecured      bonds,        but     bring      challenges         for
  short-term bonds and for other financial products. Bail-ins for
  insured deposits would overlap with deposit insurance schemes,
  while uninsured deposits may result in regulatory arbitrage
  over country-level differences in deposit insurance ceilings.
  For derivatives, positions vary frequently, so it would be
  difficult to set a trigger. At the same time, if derivatives are
  excluded from bail-ins, this would give incentive to financial
  companies       to     raise     funding       through      derivatives        to    avoid
  regulation. For RPs, there could arise a legal conflict with
  bondholders' rights, so these should be excluded. Finally,
  bail-ins      for     short-term         bonds       could    aggravate         liquidity

                                                                                               Vol. 20, No. 12   9
                           problems for financial companies if it makes money market
                           funding more difficult when there is a fall in their credit
                           rating. On the flip side, there are concerns that excluding
                           short-term debt would give incentive for financial companies
                           to condense their funding structure.

                        ■ Outlook: Once the targets of a bail-in scheme are decided
                           upon, the loss ceiling and regulatory approach will need to be
                           considered. For example, since a bail-in scheme would aim to
                           eliminate the tacit funding cost advantage that SIFIs enjoy
                           from the too-big-to-fail problem, measures would have to be
                           considered to ensure that a level competitive playing field is
                           maintained among all financial companies. In Korea specifically,
                           if the trigger conditions for a bail-in bond are activated and
                           the bond is converted to stock, this may push shareholders
                           over their ownership ceilings stipulated under the Banking
                           Act, so this potential regulatory conflict would have to
                           be addressed.

                        ☐ Policy & Industry News Briefs: April 4~8

                        ■ March Consumer Prices Jump Most in 29 Months
                           Consumer   prices   rose   4.7%    year-on-year     during   March,
                           eclipsing the 4% level for the third month in a row. This was
                           driven by soaring input prices for industrial goods, and also by
                           food   prices   pushed     up     by   unseasonal   weather    and
                           foot-and-mouth disease. Core consumer prices-excluding oil
                           and food prices- rose 3.3%, the highest in 21 months, as
                           inflationary pressure was strong. This upward pressure is
                           anticipated to be maintained, with oil prices expected to stay
                           high and uncertain supply-demand conditions for both raw
                           materials and components.

10   Weekly Financial Review
■ Chinese Investors Flocking to Korean Securities Market
  Financial Supervisory Service (FSS) figures indicate that China
  has been a net buyer of Korean stocks for the past three
  months, and a net bond investor for 21 straight months.
  Although Chinese investors still held just 3.83 trillion won in
  stock, or 0.67% of the market, as of the end of March, this is
  a 24.7% increase over the end of 2010. Bond holdings surged
  to 7.63 trillion won, making China the fourth largest foreign
  investor in Korean debt; it will become the largest by the end
  of this year if the current trend continues. This may have a
  negative impact on the debt market by offsetting the Bank of
  Korea's   interest   rate   policies,    but   in    the   equity    market,
  increased investment from China should have a positive impact
  by making up for the steady outflow of European capital.

■ Won/Dollar Rate Trends Downward
  The recent fall in the won/dollar rate below the psychological
  1,100 barrier has drawn attention over the potential impact on
  Korea's economy. The recent fall has been driven by steady
  inflows of foreign capital and by expectations that policy
  authorities will tolerate a falling rate in order to stabilize
  prices.   A   stronger   currency       does   raise   concerns      for   an
  export-dependent         economy        such    as     Korea,       but    the
  overall impact -such as on price stability- remains difficult
  to conjecture.

■ FSC Strengthens Stance on Excess Bank Competition
  The FSS announced that examining whether there is excess
  competition will be its top priority in its overall monitoring of
  the 'Big 4' banks (Kookmin, Woori, Shinhan and Hana). This
  follows concerns over loose risk management due to fierce
  competition to win household and SME loan business, as well
  as signs of unhealthy competition to attract retirement pension

                                                                                   Vol. 20, No. 12   11
                                  funds. According to the Bank of Korea, the second quarter
                                  lending attitude diffusion index rose 6p over the previous
                                  quarter to 21, its highest level since early 2002, and banks are
                                  expected to increase lending further during the second quarter.

                         ☐ Market Indicators: April 4~April 8

                                                          2010 Avg.   March Avg.    April 4    April 5    April 6    April 7     April 8
                                   Call Rate (1d)             1.97        2.92        2.98       2.99       3.03       3.04          -
                                   CD Rate (3m)               2.63        3.35        3.39       3.39       3.39       3.39       3.39
                                   Industrial Bonds
                                                              3.38        3.74        3.72       3.72       3.72       3.70       3.73
                       Interest    (1yr)
                        Rates      Corporate Bonds
                        (%)        (3yr,                      5.81        4.28        4.47       4.48       4.49       4.48       4.55
                                   KTBs (3yr)                 4.04        3.74        3.68       3.69       3.70       3.68       3.76
                                   Nat'l. Housing Bonds
                                                              5.10        4.57        4.26       4.26       4.28       4.26       4.32
                                   (January 1, 1980 =     1,764.99    2,002.67     2,115.87   2,130.43   2,126.71   2,122.14   2,127.97
                       KOSPI       100)
                       (100        Trading Value           56,077      68,154       80,784     67,016     88,879     74,120     86,958
                                   Investment Balance     136,858     151,771      164,340    161,345    159,775    165,518          -
                                   Foreigner Net
                                                              859         526        1,820      2,179      5,180      6,487     10,503
                                   Won/Dollar             1,276.18    1,121.04     1,086.60   1,090.20   1,086.80   1,088.50   1,083.00
                        Rates      Won/Yen                1,363.83    1,372.59     1,289.43   1,277.78   1,274.99   1,281.19   1,274.72

                                   Won/Euro               1,773.65    1,570.97     1,540.36   1,554.30   1,554.12   1,556.23   1,548.37

                                                                                 Edited and Translated by Thomas Steinberger

12   Weekly Financial Review

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