The Role of Financial Markets in a Crisis
2010/03/05 2 Comments
Financial markets play an important role as financial intermediaries in the economy. Surplus funds are channeled through financial markets from those who saved their excess money to those who need money.
Why is this channeling of funds from savers to spenders so important to the economy? The answer is that the people who save are not the same people who have profitable investment opportunities. Financial markets intermediate both sides and help funds get to those who need the money.
Recently, financial markets are severely hit by the financial crisis. Adverse selection and moral hazard are often blamed for the cause of financial crisis. They prevent financial markets from channeling funds to people with productive investment opportunities, leading to a sharp contraction in economic activity.
It has been frequently said that no matter how much money the government puts into the financial markets, it does not flow into the real economy quickly enough. This is mainly due to the increase in counter-party risks and economic uncertainty, particularly prevalent during the global financial turmoil and the downward trend of growth. In response, the government is pursuing restructuring of insolvent businesses, such as the construction and shipbuilding companies, in order to eliminate economic uncertainty. In addition, it will continue to provide liquidity to recoverable companies selectively through policy banks and government guarantee programs.
The Bond Market Stabilization Fund was created to help resolving credit crunch in the bond market. The amount of fund is almost 10 trillion won raised by all financial institutions. And the Bank of Korea has a plan to support up to 5 trillion won which is 50% of all amounts. The institutions of funding are consists of 91 financial corporations such as 17 domestic banks (8 trillion won), 36 insurance company (1.5 trillion won), and 36 stock company (0.5 trillion won).
Then let us consider the market evaluations about this bond market stabilization fund.
First of all, the firms’ liquidity problems are solved after the founding of the bond market stabilization fund. By acting as a safety valve, this makes investors buy bonds again who were reluctant to buy bonds even with good grades. The three-year bond yield with AA-grade was 7.98% when the bond market stabilization fund was created on December 17, 2008. It fell to 5.069% on May 15, 2009, recording about 292bp decrease in six months. And that with BBB- grade witnessed about 72bp decrease from 12.07% to 11.35%.
But bond purchasing time was delayed by the problem involved in raising funds and the scope of maintaining was narrow because this was raised by private party. Many market participants insisted that the bond market stabilization fund should continue to provide the insurance for potential risk although economical environment has improved.
The second fund I will introduce is “the Bank Recapitalization Fund.” The Fund aims to strengthen banks’ financial soundness and ability to absorb losses in the face of a prolonged economic slump and major restructuring, leading to a credit expansion in the real sector, including SMEs. A total of 20 trillion won will be raised by the BOK (about 10 trillion won in loans), institutional and individual investors (about 8 trillion won in investment) and KDB (about 2 trillion won in investment). With this fund, some securities such as a new kind of capital securities and subordinated bonds will be taken over. In particular, subordinated bonds will be sold to institutional investors as the type of asset-backed securities.
Basically, the fund will be used to support the real economy and restructuring. But for effective supporting, the specific objective will be admitted. Commercial Banks, Corporation Banks, National Agricultural Cooperative Federation, and National Federation of Fisheries Cooperatives apply for this, and then authorities fix the limit and support funds for asking. Fixing the limits is to prevent the concentration of the funds. And the authorities differentiate their funding amount depending on applicants’ performance such as progress in restructuring and financing foreign currency.
The Bank Recapitalization Fund was executed about 3.95 trillion won and this execution rate is below 20% as planned. At the end of March, last year, commercial banks such as Woori bank, Hana bank, Shinhan bank, and KB bank and local banks such as Kyongnam bank and national cooperative of agriculture and fisheries and so on, were supported. Originally, the Financial Services Commission has a plan to provide 12 trillion won at the first and to grant some applications at the second. But they cancelled the plan. Because there were no applicants at the second and monetary authorities judged that the financial market had taken a favorable turn as the business activities are picking up.
So far, we have reviewed some policies to cure the damaged financial system. Korean financial markets are not free from the effects of global financial crisis, or subprime mortgage crisis. The Korean securities market was hit hard by the financial crisis. The Korean government has implemented some policies such as raising funds. These two funds, Bond Market Stabilization Fund and Bank Recapitalization Fund, played important role in getting the markets right on the track.