Financial reform, institutional interdependency, and supervisory failure in postcrisis Korea.

Kim, Hong-Bum ; Lee, Chung H.

In the aftermath of the economic crisis of 1997-1998, South Korea undertook a number of reforms in financial supervision. Questions have been raised, however, as to whether Korea has in fact succeeded in creating a system of financial supervision capable of dealing with certain risks and responding to new challenges. This article examines Korea's recent experience in financial instability resulting from misconduct by credit card companies as a case in point and argues that the postcrisis reform in financial supervision was limited to changing formal institutions for financial supervision and that further reforms will have to be undertaken in other related institutions if Korea is to improve its financial supervision.

KEYWORDS: financial reform, institutional interdependency, formal and informal institutions, institutional reform, postcrisis reform, financial supervision, supervisory failures, Korean credit card companies

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In the aftermath of the economic crisis of 1997-1998, South Korea (henceforth Korea) undertook a number of reforms in financial supervision: it created the Financial Supervisory Commission (FSC) in April 1998 and the Financial Supervisory Service (FSS) in January 1999. The former was created to function as an integrated supervisory agency for all types of financial institutions and markets, while the latter was established to act as an executive arm of the former. FSC is a state agency, whereas FSS is a private corporation in the form of a special legal entity operating in the public domain. Although they are formally separate, the two agencies are supposed and expected to operate as a single supervisory authority.

Under this new system of integrated financial supervision, FSC/ FSS is the sole supervisory agency for banks and nonbanks, formerly the charges of the Bank of Korea (BOK) and the Ministry of Finance and Economy (MOFE), respectively. The monetary and credit policy functions, over which MOFE had considerable leverage, are now wholly vested in BOK, with its autonomy to pursue the goal of monetary stability much strengthened. The Korea Deposit Insurance Corporation (KDIC), which first began its deposit insurance operation for insured banks in January 1997, became an integrated deposit insurance agency in April 1998, taking in as its charge not only insured banks but also insured nonbank financial institutions (NBFIs). With these changes in place, MOFE, FSC/FSS, BOK, and KDIC are the four public agencies that are now responsible for keeping Korea's financial system efficient and stable.

All these changes clearly attest to the fact that Korea has established a number of public agencies that are supposed to function as independent, specialized institutions. Doubts have been raised, however, as to whether Korea, with these reforms, has in fact succeeded in creating a well-functioning system of financial supervision. (1) For instance, a World Bank report on Korea's financial sector reform, which seemingly commends Korea for having taken significant steps toward reforming its financial sector, notes that "despite notable progress in prudential supervision, concerns remain about the regulator's ability to supervise certain risks in an integrated, coherent manner and to respond to new challenges." (2) The recent costly financial instability relating to credit card companies and household debt in Korea is a case in point that renders support to the concerns raised by the World Bank and others about Korea's "success" in reforming its financial supervisory system.

In this article, we argue that the postcrisis reform in financial supervision in Korea was largely confined to changing formal institutions (3) for financial supervision and that reforms will be needed in other institutions relating to their proper functioning if Korea is to further improve its financial supervision. Although they were created or reorganized as independent agencies in the aftermath of the crisis, FSC/FSS and BOK have not in reality functioned as such due to constraints imposed on them by other, formal as well as informal, institutions in Korea. Lacking de facto independence, the supervisory agencies have failed to properly carry out their statutory responsibilities and prevent the abuses and misconduct by credit card companies that led to the recent financial instability. In fact, this is a point alluded to by the World Bank when it recommended that "the division of responsibilities between MOFE, FSC, and the FSS should be made more transparent ... [and that] ... steps should be taken to reassure markets that the independence of the regulator is important." (4)

The article is organized as follows. We first argue that institutional interdependency affects the outcome of an institutional reform, and we then present a few empirical cases that attest to this relationship. In the next section, we argue that the postcrisis financial reform in Korea has failed to change fundamentally the way financial supervision is carried out due to institutional interdependency. We then focus on the problems relating to credit card companies and point out how the various public agencies that were created or restructured by the reform have failed to properly supervise them. In the final section, we offer some concluding remarks.

Institutional Interdependency and Reform of Institutions

Why has Korea, in spite of its apparent success in reforming its financial system, failed to create regulatory agencies that are, according to the World Bank assessment, capable of handling certain risks and new challenges? The answer may lie, as suggested by the World Bank, in Korea's success in bringing about a rapid economic recovery from the financial crisis: that success made further reforms appear less urgent, or even unnecessary. (5) In this article, however, we offer another, perhaps much more fundamental, reason for the failure: institutional interdependency as an impediment to piecemeal institutional reform. In reforming the system of financial supervision, Korea has limited the scope of reform to institutions and organizations that are directly involved in financial supervision and has left more or less intact other institutions that, although not specific to financial supervision, affect the functionality of the reformed supervisory agencies. With those institutions remaining intact, the supervisory agencies have not been able to operate as effectively as their statutory mandates have called for. In other words, by limiting the scope of reform to institutions and organizations directly involved in financial supervision, Korea has failed to create the right institutional structure (6)--a set of interdependent institutions--in which the supervisory agencies are embedded and operate.

Institutions in a society do not function in isolation, because the interdependency among them makes the functionality of a particular institution depend on other institutions. (7) This institutional interdependency (8) thus makes it difficult to alter or design individual institutions in isolation. It also implies that an institutional reform, whether it is for establishing de novo a new institution or for changing some of the existing institutions, may fail to create an effectively functioning institution if either (1) the institutions that are complementary to it are absent (9) or (2) the new or reformed institution is not compatible with some of the existing institutions. (10) In the first case, the absence of complementary institutions would impede the functioning of the new or reformed institutions, while in the second case, the presence of incompatible institutions would limit their effectiveness.

Institutional interdependency thus implies that for an institutional reform to succeed in achieving its intended objectives, it will have to be followed, if not accompanied, by reforms that either create complementary institutions or abolish incompatible institutions, or both. Obviously, reforming all the interdependent institutions, along with the particular institution being created or reformed, in a "big bang" manner will not be an easy task, given that the number of such institutions may be large; and reforming all of them at once would be too costly, if not impossible. Further compounding the difficulty of such reforms is that at the time of reform, little may be known a priori about the institutions that are either complementary to or incompatible with the institution being newly created or reformed. Such information may become known only after the reform and even then only after the passage of some significant length of time.

The problem becomes more serious when institutional interdependency is between formal institutions that are newly created or transplanted from abroad, and the country's indigenous informal institutions, such as social norms and conventions, which are slow to change. This interdependency seriously limits the autonomy and thus the effectiveness of the new institutions, because they are to function in conjunction with the extant institutions that are embedded in a "culture in which their logics are symbolically grounded, or organizationally structured, technically and materially constrained, and politically defended." (11) Thus the country introducing new formal institutions from abroad may find them not functioning as well as they do in the country of their origin. (12) Such interdependency may not be obvious, being revealed only after new institutions have been installed, which makes institutional reform a path-dependent process with slow-to-change informal institutions constraining the choice of new institutions that can function effectively.

In this article, we focus on this form of institutional interdependency as revealed in Korea's postcrisis reform in financial supervision. Such interdependency is not, however, unique to Korea, as demonstrated in the following three empirical cases in which piecemeal formal institutional reform has failed to achieve its intended objectives due to either the absence of complementary informal institutions or the persistence of incompatible informal institutions. These cases, although not directly related to financial reform, demonstrate the unavoidable and unexpected consequences of carrying out institutional reform in a piecemeal fashion and thus support our argument that by limiting the postcrisis financial supervisory reform to changing only a part of formal institutions, Korea has failed to create a well-functioning system of financial supervision.

The first case is related by Douglass North, (13) who observes that the US Constitution has facilitated US economic development, whereas similar constitutions adopted in many Latin American countries after their independence in the nineteenth century have not done as well. He attributes this difference to the absence of appropriate complementary informal institutions in the Latin American countries: their norms and worldviews are less conducive to innovation and growth, and the effective enforcement mechanisms that are crucial for the development of a complex system of contracting and a world of specialization and division of labor have been lacking.

The second case, which involves the Icelandic government's attempt to improve farmers' livestock management in the late nineteenth century, provides an example of the persistence of incompatible informal institutions as an impediment to effective institutional reform. The government passed laws requiring the provision of fodder and the prudent management of livestock in order to stop soil erosion and sheep overgrazing and to help farmers cope better with vicissitudes in hay production resulting from severe changes in weather. However, the laws had little impact on the farmers' behavior because they were incompatible with Iceland's age-old "Good Samaritan norm," an informal social security system based on sharing. (14) That is, the Icelandic government's effort to limit the soil erosion failed because it contravened the country's deeply rooted social values. This case clearly demonstrates how informal institutions may influence the functionality of newly introduced formal institutions.

The reform experience of the transition economies of Eastern and Central Europe is yet another case in point. The persistence of incompatible informal institutions--those rooted in centrally planned socialist economies--has presented an obstacle to the establishment of market economies. According to A. Brzeski,

 It will be years, in some cases decades, before the Rechtsstaat can
 create an environment favorable to private activities, especially
 those involving capital formation. Statutes can be altered easily
 enough; Western law teams stand by, keen to provide legal expertise.
 But it will take time for the complementary psychological, social,
 and cultural changes to take root. Perhaps only demography--a
 generational succession--can bring about those changes. (15)

As this observation, based on the costly experience of transition in Eastern and Central Europe, suggests, a successful institutional reform cannot be achieved in a piecemeal fashion, because for it to succeed, it must be accompanied by reforms that create complementary institutions and abolish incompatible institutions. This is a lesson that Korea should have learned before it launched its institutional reform following the crisis of 1997-1998.

In the following sections, we examine the postcrisis reform in financial supervision in Korea as a case in which the persistence of incompatible--formal as well as informal--institutions has hampered the functionality of the reformed formal institutions. We argue that the reform was limited to changing the specific agencies and formal institutions that were directly involved in financial supervision, leaving very much intact other institutions that affect their functionality. These are, for example, the practice of rotating appointments of supervisory government officials, which has hampered FSC from developing a long-term policy horizon and top-notch supervisory expertise; lack of transparency and openness in government decisionmaking, which might have led to a purposeful cover-up of supervisory problems; and the highly hierarchical structure of government that places MOFE above other public agencies such as FSC/FSS and BOK, which has allowed MOFE to dominate them in policy matters and, specifically, to subordinate their supervisory task to achieving its short-term macroeconomic objectives. The price Korea has paid for the limited reform is the recent large-scale financial instability, which has its root cause in the inadequate supervision of credit card companies by the reformed supervisory agencies.

Has Institutional Reform Effected Any Change in the Modus Operandi of Financial Supervision in Korea?

As part of the postcrisis reform of the financial system, the Korean government undertook a major structural reform in its main economic ministry, MOFE. With the promulgation of the newly amended Government Organization Act early in 1998, MOFE was reorganized with some of its functions transferred to other public agencies. For instance, its nonbank supervisory function was transferred to FSC/FSS, while the monetary and credit policy functions were transferred to BOK. In addition, the budgetary functions were taken away from MOFE. This reorganization of MOFE was prompted by the realization that "policy decision-making had become overly concentrated, thereby undermining the checks and balances required for effective government" (16) and by the criticism that those weaknesses had greatly contributed to the outbreak of the 1997-1998 financial crisis in Korea. (17)

The reform of MOFE and reform in financial supervision led to the division among a number of public agencies of responsibilities and powers that had been concentrated in MOFE. MOFE was given the task of preparing and coordinating economic policies, drafting tax and customs legislation, and formulating policies for the financial system; FSC/FSS was charged with supervising financial institutions; BOK was responsible for maintaining monetary stability and keeping an oversight of the financial system; and KDIC was assigned to protect depositors. In other words, the defining characteristic of the new regulatory regime is the division of responsibilities among a number of public agencies, with each of them given its own policy mandate and responsibilities while sharing the common objective of securing financial stability. (18) The new regime, however, has not been successful in achieving this objective, as it failed both to bring about the interagency cooperation necessary for policy coordination and to maintain checks and balances among them.

In spite of the apparent division of responsibilities and powers among specialized and separate agencies, it was not long before the new regulatory regime turned into a hierarchical system headed by MOFE. (19) In effect, appearances to the contrary, the modus operandi of the new regulatory regime has remained the same as that of the old one in which all the powers and policy functions were concentrated in the hands of MOFE, with FSC/FSS and BOK subject to its direct influence. In short, the postcrisis reforms in financial supervision have had very little effect on the way that financial supervision was carried out in Korea. (20)

In this regard, it is worth quoting fully a passage from the World Bank report on Korea's financial sector reform: (21)

 Given the scope and power of the FSC, FSS, and SFC, their
 independence is a matter of great importance. Although embodied in
 the law, in practice their operational independence has been called
 into question. Concerns arise because of the role taken by MOFE in
 interpreting laws and supervisory regulations, giving the FSC, FSS,
 and SFC only limited freedom in implementing supervision. In
 addition, the rapid turnover of the FSC chairmanship (the chairman
 also is the governor of the FSS) and the policy whereby FSC staff
 sometimes move to and from MOFE have the potential to detract from
 the credibility of supervisory independence.

In other words, the institutional reform that was meant to create independent financial supervisory agencies in Korea has failed to do so, because it left intact other institutions and policies that affect the functionality of the reformed institutions. These obviously include MOFE's presumptive role in interpreting laws and regulations, frequent staff rotation between FSC and MOFE, and the rapid turnover of FSC chairmanship, which are symptomatic of the informal institutions that underlie the bureaucratic system of the Korean government in general and MOFE in particular. (22) The postcrisis reform has left these institutional arrangements intact, thus allowing MOFE to influence the operation of the supervisory agencies and thereby limit their operational independence.

In the following section, we discuss the recent supervisory failure relating to credit card companies as a case in point. This failure was a consequence of limiting the scope of reform to those formal institutions directly involved in financial supervision and not extending it to other institutions that, although not directly involved in financial supervision, affect the functionality of the supervisory agencies.

Supervisory Failures Relating to Credit Card Companies

In 2003, the financial markets in Korea suffered instability with serious prudential problems relating to credit card companies and huge household indebtedness. (23) In March of that year, the solvency of those companies began to be widely questioned, and soon the financial markets were shaken with instability. To prevent an impending crisis MOFE, FSC/FSS, and BOK intervened, taking the lead in arranging rescue plans and forcing credit card companies to abide by hastily drawn-up restructuring packages. (24) Soon afterwards the markets returned to a seemingly stable situation.

The basic underlying problem, however, persisted, threatening market stability. For instance, the LG Card, the biggest credit card company in Korea, became illiquid in November 2003; it subsequently became insolvent and had to be bailed out in January 2004. The seriousness of the problem can be seen in the fact that at the end of 2003, there were over 3.7 million credit defaulters (one-sixth of Korea's economically active population), (25) with total credit to households amounting to US$389.2 billion (26) (over three-fifths of Korea's GDP for 2003).

What brought about such huge credit default and household indebtedness? The following quote from FSS (27) points to a proximate cause for the problem: misconduct by credit card companies.

 Granting cards to minors without parental consent, renewal or
 re-issuance of cards after expiration without the consent of the
 member even though no transaction took place in the member account
 ... attempts to attract new members with offers of high-priced
 giveaways, ... setting credit limits well beyond the card members'
 income or ability to pay only after perfunctory or negligent
 verification process, and using the offer of high credit limit as a
 marketing tool to attract new members. (28)

It seems obvious that misconduct on the part of credit card companies such as these contributed to the huge credit default and household indebtedness, but it is also obvious that they could not have been committed if those companies had been properly supervised by the appropriate supervisory agencies. We must thus hold those agencies ultimately accountable for the misconduct of credit card companies and the consequent credit default and household indebtedness. (29) The following discussion, based on a detailed examination of the relevant documents and data published by MOFE, FSC/FSS, and BOK during the period 1999-2003, reports how these public agencies failed in their role as supervisory agencies. (30)

MOFE

MOFE began undertaking a series of deregulatory measures for credit card companies in 1997-1999. It included expanding the scope of financial activities permitted (e.g., cash advances and card loans), removing the corporate borrowing limit (twenty times the stockholders' equity), and also removing the ceiling ratio (60 percent) of account balances of noncore credit card businesses (i.e., cash advances and card loans) to those of both core (i.e., settlement of credit card payment) and noncore credit card businesses. (31) These were soon followed in 1999-2001 with another series of deregulatory measures, which aimed at popularizing a wide use of credit cards by the general public. It included removing the monthly credit limit (approximately US$609) on cash advances, offering tax breaks for credit card purchases, (32) awarding lottery money for the receipt of credit card payments, requiring corporate entertainment expenses to be paid with corporate credit cards, and offering further tax breaks for credit card purchases. (33)

These deregulatory measures were undertaken as part of government policies aimed at boosting domestic demand in the postcrisis economy. (34) These and other actions taken by MOFE to stimulate real estate investment in mid-1998 were probably warranted at that time, when the Korean economy was experiencing a credit crunch and a high rate of unemployment as a result of the crisis. MOFE, however, continued with the policy of promoting the use of credit cards well beyond the time when it was appropriate.

Early in 2001, there began to appear signs of excessive competition among credit card companies, as evidenced in widespread practices such as "indiscriminate granting of credit cards--often to unqualified or ineligible applicants" and "street solicitation" for membership. (35) Household debts (including credit card debts) were snowballing, and the number of credit defaulters was increasing at a rapid rate. MOFE nevertheless stuck to its credit card promotion policy through the first half of 2002, apparently because it was intent on boosting domestic demand and making a rapid recovery from the crisis of 1997-1998. This action by MOFE suggests that it was interested more in achieving a rapid economic recovery than in securing financial stability.

In February 2002, the Financial Policy Coordination Committee, (36) which consisted of the MOFE vice-minister, the FSC vice-chairman, and the BOK vice-governor, agreed to pursue a broad set of policy measures to limit the surge of household debt. As it turned out, however, the public agencies did not regard it as a top-priority issue; what concerned them the most then was economic recovery from the crisis. In fact, at a meeting subsequently held in March 2002, the committee expressed its reservations about taking excessive measures against household indebtedness, as it feared such measures would suppress consumption and thus delay economic recovery. It thus appears that the task of supervising credit card companies was subordinated to the goal of rapid economic recovery. A consequence of this policy stance was an increase in overdue credits, credit default, and household indebtedness.

In May 2002, the MOFE minister, the FSC chairman, and the Policy Committee chair of the Millennium Democratic Party (then the incumbent party) got together in the Ruling Party-Administration Consultation Meeting (37) and agreed to make an aggressive effort to combat the prudential problems relating to credit card companies and household debt. Finally, faced with the signs of the aggravating problems, MOFE decided to give up its policy of boosting domestic demand that it had maintained for four years, from mid-1998. In July 2002, MOFE undertook policy measures to deal with the problems, but its belated action only had the effect of putting a heavier regulatory burden on credit card companies instead of mitigating the severity of the problem. Then, in mid-March 2003, the discovery of accounting frauds by SK Global triggered a very serious, albeit temporary, instability in the financial markets already overburdened with overdue credits, credit default, and household indebtedness.

FSC/FSS

In February 2001, FSC/FSS first recognized signs of excessive competition among credit card companies and subsequently decided to carry out a comprehensive set of measures to deal with the prudential problems relating to credit cards. They wanted to reintroduce, for instance, the ceiling ratio of account balances of noncore credit card businesses to those of both core and noncore credit card businesses. FSC/FSS was, however, unable to put such measures into practice because of MOFE's opposition to revising the relevant laws and regulations.

As noted earlier, the ceiling ratio, which had been set at 60 percent, was removed in 1999 in the hope that such a measure would accelerate economic recovery from the financial crisis. In April 2001, FSC, being concerned with the rapid increase in noncore credit card businesses, such as cash advances and card loans, requested that MOFE provide a legal basis for FSC to reintroduce the ceiling ratio. (38) In May 2001, faced with MOFE's opposition, FSC attempted on its own to reimpose the ceiling ratio at 50 percent, (39) taking the position that the reimposition was a matter of FSC's regulatory discretion and was within their jurisdiction. (40) MOFE, however, took issue with FSC, insisting that the reimposition of the ceiling ratio required a revision in law and was not, therefore, a matter of regulatory discretion. MOFE was probably opposed to the reintroduction, fearing that such a measure would have a negative impact on domestic demand and slow the pace of economic recovery. Then, in May 2002, when the problems became more serious and urgently demanded a solution, MOFE finally agreed to revise the law. In June 2002, it finally reintroduced the ceiling ratio--a whole year later than FSC/FSS thought appropriate and necessary.

The inability of FSC/FSS to reintroduce the ceiling ratio clearly demonstrates the lack of their autonomy in carrying out the supervisory task that was alluded to in the World Bank report. (41) The cause for this lack of autonomy lies, we argue, in the hierarchical relationship that MOFE has maintained with other public agencies. By being at the apex of this hierarchy and by turning discretionary regulatory issues into legislative matters, MOFE has been able to dominate other agencies in policy matters, rendering them practically impotent to carry out their statutory responsibilities, especially when in conflict with MOFE's own policy objectives. (42) In fact, the International Monetary Fund (IMF) also noted in its report on Korea that "prudential regulators lack the unfettered fight to issue new regulations when they perceive a need to do so." (43) In this regard, it is notable that the Board of Audit and Inspection provides delineations of several specific incidents in which MOFE has dominated FSC/FSS in supervisory issues on prudential problems of credit card companies. (44)

Until May 2002, FSC/FSS was sending out mixed signals regarding the problem of household debt. In April 2002, they announced plans to strengthen prudential supervision of credit card companies, but later that month, the FSC chair stated in a public speech that prudential policy measures would be pursued carefully so that economic recovery would not be deterred. Such inconsistent messages from the supervisory authorities are likely to have stirred up confusion in the financial markets while damaging credibility in supervisory policy. When MOFE took the occasion of the Ruling Party-Administration Consultation Meeting in May 2002 to announce a change in its policy stance of boosting private consumption, FSC/FSS quickly became decisive in their view on the prudential problems and started taking strict supervisory actions. These actions by FSC/FSS demonstrate that they lacked autonomy and were simply following the policies set by MOFE.

BOK

BOK itself took note of marked increases in cash advances of credit card companies and in household debt as early as September 1999 but did not regard them as a major threat to financial stability. In the first half of 2002, however, BOK began to express in various public statements its concern about the ever increasing household debt, although, like MOFE, it appeared to be torn between two conflicting objectives: boosting domestic demand for economic recovery and maintaining financial stability. But, by announcing in February 2002 that private consumption needed to be boosted, BOK in effect sent out a message saying that it was not overly concerned with the size of household debt.

In May 2002, the BOK Monetary Policy Committee made a decision to move the target level of the call rate slightly upward by a quarter percentage point. The decision was made with the problems of household indebtedness and financial instability in mind. A few weeks later, MOFE made a complete and abrupt turnaround in its policy stance, giving up its long-standing policy of boosting domestic consumption. BOK itself then suddenly became expressly concerned with the prudential problems of credit card companies and household debt.

BOK is not a part of the government, unlike FSC, which is a government agency at a lower level of hierarchy headed by MOFE. But its passive inconsistent patterns of behavior toward prudential problems relating to credit card companies and household debt strongly suggest that in spite of the statutory independence it has gained with the postcrisis financial reform, BOK has been subject to influence from MOFE. A weakened legal basis of BOK involvement in matters of financial stability, which is a consequence of the 1997 revision of the Bank of Korea Act, may have contributed in part to such a situation. More likely, MOFE has been able to exert its influence on BOK by having a strong voice in appointing a majority of members of the BOK Monetary Policy Committee. (45)

Synopsis and Policy Implications

The Ruling Party--Administration Consultation Meeting held in May 2002 marked the watershed at which MOFE basically abandoned its policy of boosting domestic demand in an attempt to bring about a rapid economic recovery from the crisis. It now began to tackle the prudential problems relating to credit card companies that had been festering unattended for years. With this change in policy stance by MOFE, all other public agencies, including FSC/FSS and BOK, followed suit and became outspoken and decisive in their views and actions regarding the prudential problems. Their new public policy stance was in stark contrast to the inconsistent and ambiguous attitudes they had adopted before in public and was a clear manifestation of their closely following the decisions of MOFE in matters relating to the economy.

What FSC/FSS and BOK had done before was to follow the policy line chosen by MOFE, which was primarily concerned with achieving short-term macroeconomic policy objectives. But as soon as MOFE made a complete and abrupt turnaround in its policy stance in May 2002 and became concerned with financial stability, FSC/FSS and BOK likewise made its policy turnaround. Such behavior by FSC/FSS and BOK clearly demonstrates that in spite of their statutory independence, they have lacked true autonomy, which, as we argue, is due to the persistence of the institutions that are incompatible with their functioning as independent agencies. (46)

In short, the prudential problems relating to credit card companies and household debt were a failure of an institutional structure in which MOFE dominated other public agencies, making it difficult for them to carry out their statutory responsibilities when their doing so went against MOFE's achieving its own policy objectives. In such a system, the task of financial supervision and the interagency supervisory coordination necessary for solving the credit card and household debt problems were simply relegated to a back burner until the problems reached crisis proportion and became serious enough to dominate other policy issues.

What should Korea do to secure the de facto independence of the supervisory agencies from MOFE? It will have to stop the practice of rotating appointments of supervisory government officials so that these agencies can develop their own cadre of experienced and skilled technical experts and establish a long-term policy horizon. Clearly, it should also introduce greater transparency and openness in government decisionmaking, the lack of which may lead to a purposeful cover-up of inchoate supervisory problems and reinforce the tendency toward regulatory forbearance and political/industrial capture of supervisory officials. Finally, Korea should change the current highly hierarchical structure of government that places MOFE above FSC/FSS and BOK. As long as the current hierarchical relationship between MOFE and the other public agencies persists, there is the possibility that financial supervision will be subordinated to MOFE's short-term macroeconomic objectives. Severing that relationship is thus a sine qua non for creating supervisory agencies that are truly independent and capable of carrying out their statutory responsibilities. (47)

Conclusion

The recent financial instability involving credit card companies has cast doubts on whether the postcrisis reform in financial supervision has fundamentally changed the manner in which financial supervision is carried out in Korea. Tangentially, it also raises a question about whether Korea's postcrisis institutional reform has contributed to its rapid economic recovery. With regard to the first question, we have argued that in spite of the reform, the supervisory agencies such as FSC/FSS and BOK were unable to function as fully independent entities due to constraints imposed on their operation by other institutions. These will have to be changed as well if the reformed supervisory agencies are to operate with autonomy and fully carry out their responsibilities as mandated. With respect to the second question--the effect of the reform on Korea's economic recovery--our conjecture is that the rapid recovery was more the result of the government's expansionary macroeconomic policies than the consequence of the changes it has made in the country's economic institutions. Obviously, a final verdict on this question will have to wait for more comprehensive studies on the effect of the postcrisis reforms, including those in corporate governance and labor market institutions. As far as this study is concerned, we will have to conclude that the reform in financial supervision has had little to do with Korea's rapid economic recovery.

Our study of Korea's experience in reforming financial supervision points to the complexity relating to institutional reform in general; that is, reform of an institution, if it is to be successful, cannot simply end with that reform. The fact that there is interdependency among various institutions in a society implies that the reform will have to be followed, if not accompanied, by reforms in other institutions that affect directly or indirectly the functionality of the reformed institution. That is, reforming an institution requires reforming the entire institutional structure in which it is embedded. Some of the institutions in that institutional structure may be known prior to the reform, while others may be revealed only afterward. (48) And some of them may be the society's overarching institutions, such as culture and social norms, and changes in such institutions would have societywide implications. Obviously, reforming all interdependent institutions at once--a sort of "big bang" approach--will be difficult, if not impossible, since we may know little about what they are prior to the reform and how they may interact with the particular institution at issue. This is also the conclusion that J. Y. Lin and J. B. Nugent reach at the end of their extensive review of the literature on institutions and economic development: (49)

 Mere transplantations of successful institutions from DCs to LDCs
 [are], at best, unlikely to have the expected positive effects on
 performance, and, at worst, may have rather disastrous effects.
 Where to start and how to bring out the reforms in a country are
 questions that can be answered only with serious consideration of
 the country's existing institutional structure and human and
 physical endowments.

The need for such consideration suggests that there is no one-size-fits-all formula for institutional reform and that there is a limit to what science can teach us on how to carry out institutional reform. Successful institutional reform may thus require, as observed by Victor Nee, (50) a poet's insight into the human condition as much as science.

Notes

An earlier version of this article was presented at the 2005 KDI/KAEA Conference on Korea's Corporate Environment and Sustainable Development Strategy and at the Gyeongsang National University Institute of Social Sciences. We wish to thank Shigeyuki Abe, Charles Goodhart, Stephan Haggard, Joon-Ho Hahm, Sang Moon Hahm, Kyung Soo Kim, and two anonymous referees for their helpful comments and suggestions. Research for the study was partly funded by the Center for Korean Studies at the University of Hawaii and the Center for Research Initiative and Development at Doshisha University.

(1.) Jae-Jung Kwon, "Financial Reform in Korea: Unfinished Agenda," Seoul Journal of Economics 17, no. 3 (Fall 2004): 403-437.

(2.) World Bank, "Financial Sector Assessment Korea," Report No. 26176, June 2003, p. 2.

(3.) In this article, we follow Douglass North's definition of institutions--that is, any form of constraint that human beings devise to shape human interaction. See Douglass C. North, Institutions, Institutional Change and Economic Performance (Cambridge: Cambridge University Press, 1990), p. 4. Institutions may be formal or informal: examples of formal institutions are rules and statutes; examples of informal institutions are conventions and codes of conduct.

(4.) World Bank, "Financial Sector Assessment Korea," p. 2. Recently, Quintyn and Taylor elaborated on the proposition that "regulatory and supervisory independence is for financial stability what central bank independence is for monetary stability," developing the notion of regulatory and supervisory independence. See Marc Quintyn and Michael W. Taylor, "Regulatory and Supervisory Independence and Financial Stability," IMF Working Paper WP/02/46, March 2002, p. 10. This discussion was subsequently expanded to include accountability, transparency, and integrity in the so-called regulatory governance. See, for example, Udaihir S. Das and Marc Quintyn, "Crisis Prevention and Crisis Management: The Role of Regulatory Governance," IMF Working Paper WP/02/163, September 2002; Udaihir S. Das, Marc Quintyn, and Kina Chenard, "Does Regulatory Governance Matter for Financial Stability? An Empirical Analysis," IMF Working Paper WP/04/89, May 2004; Eva Hupkes, Marc Quintyn, and Michael W. Taylor, "The Accountability of Financial Sector Supervisors: Principles and Practice," IMF Working Paper WP/05/51, March 2005.

(5.) World Bank, "Financial Sector Assessment Korea."

(6.) Lin and Nugent define "institutional structure" as the totality of institutions--organizations, laws, customs, and ideology--in an economy and differentiate it from an "institutional arrangement," which is a "set of rules that govern behavior in a specific domain." See J. Y. Lin and J. B. Nugent, "Institutions and Economic Development," in J. Behrman and T. N. Srinivasan, eds, Handbook of Development Economics, vol. 3A (Amsterdam: Elsevier, 1995), p. 2307. In our article, we use the term in a less inclusive way to refer to a set of institutions that impact directly and indirectly the functioning of a specific institution (or institutional arrangement). In other words, an institutional structure encompasses all the institutions that are interdependent.

(7.) Bruno Amable, "Institutional Complementarity and Diversity of Social Systems of Innovation and Production," Universite de Lille II and CEPREMAP, September 1999; Masahiko Aoki, Toward a Comparative Institutional Analysis (Cambridge: MIT Press, 2001); Robert Boyer, "Coherence, Diversity and Evolution of Capitalisms: The Institutional Complementarity Hypothesis," CEPREMAP-CNRS-EHESS, Paris, 2005; Francis Fukuyama, State-Building: Governance and World Order in the 21st Century (Ithaca: Cotnell University Press, 2004); J. Y. Lin and J. B. Nugent, "Institutions and Economic Development," in J. Behrman and T. N. Srinivasan, eds, Handbook of Development Economics, vol. 3A (Amsterdam: Elsevier, 1995).

(8.) In this article, we choose to use the term institutional interdependency instead of institutional complementarity. Institutional complementarity is a subset of institutional interdependency, which includes both a situation where a particular institution does not function effectively because of the presence of incompatible institutions and a situation where it does not function effectively because of the absence of complementary institutions. We should also note that Aoki defines institution as a "self-sustaining system of shared beliefs about a salient way in which the game is repeatedly played." See Aoki, Toward a Comparative Institutional Analysis, p. 10. His definition is much narrower than and differs from the commonly used and more general definition of institutions as humanly devised constraints on behavior, such as constitution, statutes, laws, custom, conventions, and social norms.

(9.) There is complementarity between two institutions when the performance of one institution is greater when it is in conjunction with the other than when it is not. See Boyer, "Coherence, Diversity and Evolution of Capitalisms."

(10.) As defined by Boyer, institutional compatibility is present when two institutions can be jointly observed in existing economies and societies. See Boyer, "Coherence, Diversity and Evolution of Capitalisms." This may be so in the state of equilibrium, but in an economy undergoing reforms, we may jointly observe institutions that are not compatible with each other.

(11.) J. Rogers Hollingsworth and Robert Boyer, "Coordination of Economic Actors and Social Systems of Production," in J. R. Hollingsworth and R. Boyer, eds., Contemporary Capitalism: The Embeddedness of Institutions (New York: Cambridge University Press, 1997), p. 2.

(12.) Robert Boyer and J. Rogers Hollingsworth, "The Variety of Institutional Arrangements and Their Complementarity in Modern Economies," in Hollingsworth and Boyer, Contemporary Capitalism; Helmut Leipold, "Comments on Jan Winiecki, 'Shaping the Institutional Infrastructure,'" in H. Siebert, ed., The Transformation of Socialist Economies (Tubingen: J. C. B. Mohr, 1991); J. Y. Lin and J. B. Nugent, "Institutions and Economic Development," in Behrman and Srinivasan, Handbook of Development Economics; Andres Ruis and Nicolas van de Walle, "Political and Cultural Institutions and Economic Policy Reform," paper presented at the Global Development Network Workshop on Understanding Reform, Cairo, Egypt, January 16-17, 2003.

(13.) North, Institutions, Institutional Change and Economic Performance.

(14.) Thrainn Eggertsson, "Norms in Economics, with Special Reference to Economic Development," in M. Hechter and K-D. Opp, eds., Social Norms (New York: Russell Sage Foundation, 2001).

(15.) A. Brzeski, "Postcommunist Transformation: Between Accident and Design," in W. Campbell, ed., The Postcommunist Economic Transformation: Essays in Honor of Gregory Grossman (Boulder: Westview Press, 1994), p. 6.

(16.) Ministry of Finance and Economy, "About MOFE," 2002, available at english.mofe.go.kr.

(17.) Chung H. Lee, Keun Lee, and Kangkook Lee, "Chaebol, Financial Liberalization, and Economic Crisis: Transformation of Quasi-Internal Organization in Korea," Asian Economic Journal 16, no. 1 (2002): 17-35.

(18.) Kim Daesik, Kyung Soo Kim, Hong-Bum Kim, and Seok Won Lee, "Suggestions to Improve the Deposit Insurance System in Korea" (in Korean), unpublished paper of the research project that was commissioned by and submitted to the Korea Money and Finance Association, December 2002.

(19.) Ibid.

(20.) Hong-Bum Kim, Political Economy of Financial Supervision in Korea (in Korean) (Seoul: Jisik-Sanup, 2004); Hong-Bum Kim, "The Government Bureaucracy and Financial Supervision in Korea" (in Korean), Journal of Korean Economic Analysis 11, no. 3 (2005): 195-251.

(21.) World Bank, "Financial Sector Assessment Korea," pp. 6-7 (emphasis in the original). The Securities and Futures Commission (SFC), which appears in this quotation, is a subcommittee under FSC and has five members. The FSC vice-chairman presides over SFC, which is responsible for oversight of securities and futures markets. In this article, we make no distinction between FSC and SFC since the former includes the latter organizationally.

(22.) Among such informal institutions are "strict order-obedience" and "exclusive cohesion," which underlie the bureaucratic culture of government officials in general, and "deep-rooted elitism," which is instilled in MOFE officialdom in particular. These three characteristics have their roots in Confucianism, which is oriented toward preserving order and hierarchy across people and across social institutions. For a discussion on these characteristics, see HongBum Kim, "Financial Stability and the Public Agencies Concerned: The Case for Supervisory Cooperation and Checks and Balances" (in Korean), Quarterly Economic Analysis (of the Institute for Monetary and Economic Research of the Bank of Korea) 10, no. 2 (2004): 58-107; also published (in English) in Economic Papers (of the Bank of Korea) 7, no. 2 (2004): 20-60.

(23.) This section draws heavily from Hong-Bum Kim and Chung H. Lee, "Financial Reform and Supervisory Failure: A Critical Appraisal of Post-Crisis Reform in Korea," Working Paper 2004-02, Korea Development Institute, Seoul, December 2004.

(24.) Kim, "Financial Stability and the Public Agencies Concerned."

(25.) As regards individual consumers, a credit defaulter is by definition a person who has loans in arrears in excess of KRW 300,000 (US$261 at the exchange rate of US$1 = KRW 1,150) for over three consecutive months. For the definition, see Ministry of Finance and Economy, "Credit Defaulters: Current Situations and the Direction of Policy Responses" (in Korean), news release, March 10, 2004. Individual consumers who were on the list of credit defaulters totaled over 3.7 million at the end of 2003. The default by 2.4 million (64.4 percent of these credit defaulters) was related to credit card uses. Compared with the situation at the end of 2002, the year 2003 saw a dramatic increase both in the number of credit defaulters (1.1 million) and in the number of credit card-related credit defaulters (0.9 million). The ratio of the latter to the former also increased from 56.7 percent to 64.4 percent in 2003. Since Korea had about 22.9 million economically active people at the end of 2003, we can surmise that roughly one person out of six was a credit defaulter and one out of nine or ten a credit card-related credit defaulter. For relevant statistics, see Ministry of Finance and Economy, "Credit Defaulters," Bank of Korea, Monthly Bulletin (in Korean) 58, no. 8 (November 2004). The register system of credit defaulters was abolished on April 28, 2005, when the Act for the Use and Protection of Credit Information was revised. Now efforts are being made to build up the infrastructure for managing credit information, such as credit bureaus.

(26.) See Bank of Korea, Monthly Bulletin. An exchange rate of US$1 = KRW 1,150 is used for conversion throughout this article.

(27.) Financial Supervisory Service, "Policymakers to Push for New Policy Initiatives Aimed at Credit Card Businesses," Weekly Newsletter 3, no. 19 (June 1, 2002).

(28.) Most of these practices became widely used by early 2001 and rapidly popularized by street solicitors who were under contract with credit card companies. At the end of 2000, there were 31,000 credit card solicitors nationwide, and they contributed to 58 percent of the total of 18.3 million credit cards newly issued during 2000. For details, see Financial Supervisory Service, "New Measures to Prevent Excess Competition in Solicitation for Credit-Card Membership and to Strengthen Financial Supervision" (in Korean), news release, February 27, 2001.

(29.) Hong points out that the absence of a credit rating system and appropriate bankruptcy laws is accountable for the problems relating to credit card companies in Korea. The United States experienced a similar expansion in credit card uses after deregulation but did not suffer as severe consequences as Korea did, since it had a well-developed credit rating system and bankruptcy laws. See Jong Hak Hong, "A Comparative Study of Credit-Card Problems in Korea and the United States" (in Korean), mimeo, Department of Economics, Kyungwon University, 2004.

(30.) Hong-Bum Kim, Political Economy of Financial Supervision in Korea; Hong-Bum Kim, "Financial Stability and the Public Agencies Concerned."

(31.) Of the three deregulatory measures, the first two were based on the Credit-Specialized Financial Business Act initiated by MOFE and introduced in July 1997, four months before the financial crisis broke out in November 1997. The last measure was introduced by MOFE's revising the enforcement ordinances in April 1999. This revision provided MOFE with the regulatory basis for the ensuing revision in the enforcement rules in May 1999--that is, the removal of the monthly credit limit on cash advances. See Financial Supervisory Service, "Prudential Problems of Credit-Card Companies: Causes and Countermeasures" (in Korean), a report prepared by the Office of Credit-Specialized Financial Business Supervision and submitted to the Board of Audit and Inspection, December 2003.

(32.) In addition to acting as a booster of domestic demand, the tax break measures had a salutary effect of enhancing transparency in business transactions, thwarting tax evasions, and generating additional tax revenues. For this fact, see Board of Audit and Inspection, "Requisition of Measures on the Basis of the Audit Report on the Realities of Supervision of Financial Institutions" (in Korean), July 2004. According to an anonymous referee, this tax revenue aspect was a factor in MOFE's delay in heeding the potential problem of an increasing number of credit defaulters.

(33.) Of these five deregulatory measures, the first one was introduced by MOFE's revising the enforcement rules in May 1999. This single measure, among others, proved to have had explosive impacts on credit card holders' use of cash advances for years. Cash advances in 2002 amounted to about US$311 billion, approximately eleven times as large as that in 1998, which was about $28 billion. The second measure, a tax break offer, was introduced in August 1999, the third in January 2000, the fourth in October 2000, and the fifth in August 2001. For details, see Financial Supervisory Service, "Prudential Problems of Credit-Card Companies."

(34.) Although no documentary evidence, such as a public document from MOFE, is available in support of this proposition, indirect evidence is readily available. An example is an article written by Byong Won Bahk, in his capacity as director of the Economic Policy Bureau of MOFE, for the JoongAng Ilbo and posted on the official website of MOFE (www.mofe.go.kr). Byong Won Bahk, "The Policy of Boosting Domestic Demand Was an Unavoidable Option That Was Chosen to Stimulate the Economy" (in Korean), JoongAng Ilbo, November 11, 2002. As the title clearly reveals, his writing attempts to justify MOFE's policy stance of boosting domestic demand, which was strongly maintained in 2001 and up until the end of the first half of 2002. In light of Bahk's own admission, together with the fact that all those deregulatory measures that had been introduced in the aftermath of the 1997 economic crisis were kept unblemished all along during that period, it is reasonable to conclude that those deregulatory measures, including credit card promotion policy measures, were actively promoted as a means for boosting domestic demand during that period. In addition, a recent audit report from the Board of Audit and Inspection (BAI) makes the point very clearly by beginning its general comments as follows: "In response to the occurrence of the 1997 economic crisis, the government removed, in its pursuit of the credit card promotion policy, part of the existing limits and regulations that related to credit card companies and credit card uses. The policy was intended to revive the economy through boosting domestic demand and to secure the tax base through enhancing transparency in commercial transactions." See BAI, "The Audit Report on the Realities of Supervision of Financial Institutions" (in Korean), news release, July 16, 2004, p. 2. Finally, in his interview with Chosun Ilbo, Jeung-Hyun Yoon, current FSC chairman since August 2004, commented that "prudential problems of credit card companies originated in the process of boosting private consumption that had been undertaken during the previous [Kim Dae Jung] administration." See Chosun Ilbo, "Supervisory Powers of MOFE Will Be Transferred to FSC" (in Korean), an interview with Jeung-Hyun Yoon (Section B2), August 5, 2004.

(35.) Financial Supervisory Service, "Policymakers to Push for New Policy Initiatives Aimed at Credit Card Businesses."

(36.) The Financial Policy Coordination Committee, an ad hoc organization without any legal basis, usually meets eight times a year to discuss financial and/or macroeconomic policies. For years the committee has allegedly been known as the only channel of communication between the public agencies concerned. The Financial Policy Coordination Committee served not as a channel for interagency cooperation and coordination but as a means for justifying MOFE's policy dominance over FSC/FSS and BOK. For this critical point of view, see Kim, "Financial Stability and the Public Agencies Concerned."

(37.) The Ruling Party-Administration Consultation Meeting is held two or three times a year on an irregular basis. It is likely that at such meetings political influence, if not political pressure, is transmitted to supervisory agencies, thus compromising their operational independence.

(38.) Board of Audit and Inspection, "Requisition of Measures."

(39.) Financial Supervisory Service, "Plans to Enhance Competitiveness in Credit Card Industry," Weekly Newsletter 2, no. 15 (May 12, 2001).

(40.) The ceiling ratio was correctly regarded then as one of the most powerful direct measures with a great impact on profitability and business patterns of credit card companies.

(41.) World Bank, "Financial Sector Assessment Korea."

(42.) Financial Supervisory Service, Primer on Financial Supervision (in Korean), Department of Human Resources Development, December 1999.

(43.) International Monetary Fund, "Republic of Korea: Financial System Stability--Assessment," IMF Country Report No. 03/81, March 2003, p. 24.

(44.) The incidents that BAI reports include those in which MOFE has turned down or delayed a request made by FSC for revision of relevant legislation, and those in which the line of demarcation between laws and regulations has been drawn arbitrarily by MOFE with the result that the competent authorities that are responsible for applying the same rules (e.g., capital adequacy ratios) or the same procedures (e.g., licensing) may often differ--either MOFE or FSC in this matter--across sectors and types of financial institutions such as banking, securities, merchant banks, insurance companies, credit card companies, and savings banks. See Board of Audit and Inspection, "The Audit Report": Board of Audit and Inspection, "Requisition of Measures."

(45.) The BOK Monetary Policy Committee (MPC) consists of seven members: BOK governor and vice-governor and five members recommended by five institutions and appointed by the president of the Republic of Korea. The five institutions are BOK, MOFE, FSC, the Korea Chamber of Commerce and Industry, and the Korea Federation of Banks, each recommending one prospective member. With its ability to influence most of those institutions, MOFE has a strong voice in the selection of the members of MPC.

(46.) The belated turnaround in policy as well as the abrupt implementation of strict measures led, according to an anonymous referee, to a hard landing. Better policies would have softened the impact of the credit card problem but would not have stopped it, which was a consequence of poor financial supervision.

(47.) One anonymous referee recommended that, in addition, Korea should have laws governing markets that are free from direct political intervention, more "professionalism" in both commercial banks and regulatory agencies, and people at the top of the financial system who are well trained in quantitative and statistical analysis and not "gentlemen bankers."

(48.) Wolfgang Streeck, "Taking Uncertainty Seriously: Complementarity as a Moving Target," in The Transformation of the European Financial System: Where Do We Go? Where Should We Go? Proceedings of OeNB Workshops, Osterreichische Nationalbank, Vienna, June 20, 2003.

(49.) Lin and Nugent, "Institutions and Economic Development," p. 2307.

(50.) Victor Nee, "Norms and Networks in Economic and Organizational Performance," American Economic Review 88, no. 2 (1998): 85-89.

Hong-Bum Kim is a professor in the Economics Department of the College of Social Sciences at Gyeongsang National University, Chinju, South Korea. His research interests range from central banking and financial supervision to financial policies and financial structure of emerging market economies. In his recent (2006) book, Reform in Institutional Structure of Financial Supervision in Korea (in Korean), he discusses the urgency of institutional supervisory reform by highlighting why the task of financial supervision, if it continues to be left in the hands of government bureaucrats in Korea, is doomed to failure.

Chung H. Lee, professor in the Department of Economics and interim associate dean of the College of Social Sciences at the University of Hawaii at Manoa, has published extensively on East Asian economies. His recent publications include an edited book, Financial Liberalization and the Economic Crisis in Asia (2003), and articles in the Journal of the Korean Economy and the Journal of the Asia Pacific Economy.