APARC-KCMI Joint Workshop

The Korean Investment Banking Industry - The importance of strong investment banks for the Korean economy -

April 20, 2012

Bo Sung Shin (Korea Capital Market Institute)

Banks vs. capital markets • Banks – Provide financing for borrowers who have stable cash flows or enough collateral • New entrants find it hard to secure money for growth • Dominance of incumbents becomes permanent when the role of banks is excessive

• Capital markets – Willing to finance even firms with unstable cash flows or insufficient collateral • Newcomers can easily enter the markets and compete with incumbents with the help of capital markets • The existence of well-developed capital markets can vitalize the economy

-1-

Capital markets and economic vitality • Capital markets facilitate the growth of new entrants – The ratio of newcomers to incumbents among the current 10 largest firms is higher in market-based economies than in bank-based ones – Time for new entrants to become Top 10 firms is double in bank-based economies The Composition of 10 largest firms in different financial structures Market-Based

New entrants 63%

Incumbents 37%

Korea

Bank-Based

New entrants

Incumbents

New entrants

50%

50%

40%

Incumbents 60%

Newcomers: current Top 10 firms which did not belong in the Top 10 or did not exist 30 years ago Incumbents: Firms that have been in the Top 10 for the last 30 years • New comers: current Top 10 firms which did not belong in the Top 10 or did not exist 30 years ago • Incumbents: firms that have been in the Top 10 for the last 30 years • Excludes financial firms, service firms, and public utilities Source: Shin (2009) -2-

Capital markets and economic concentration • Capital markets reduce the concentration of economic power by promoting the growth of new entrants – Economic concentration is more remarkable in bank-based economies, especially Korea

Financial structure and economic concentration* (Multiple) 20 16

13.7

12 8

5.7 4.1

4 0

Market

Bank

korea

• Economic concentration= the average market capitalization of 1~10th ranked firms divided by that of 11~30th ranked firms • Excludes financial firms, service firms, and public utilities Source: Shin (2009)

-3-

Capital markets and investment banks • Investment banks are key intermediaries in capital markets – Competitive investment banks are necessary for capital markets development – Nowadays, financial capital becomes more important than before • Issuers and investors have both increased in size • Overseas networks • Market making, deal ensuring • Infrastructure for asset management services

-4-

Too many small players • No market leader and many small players – Perfect competition unlike commercial banking or insurance industry – In the US and Japan, the investment banking industry is more concentrated than other sectors Market concentration of financial sectors Commercial banks

Life insurance

HHI

3,000

3,000

Investment banks HHI

HHI 3,000

2,178 2,000

2,168

2,000

1,599 1,163

1,000

1,115 544

1,000

462

-

-

Korea

Japan

1,757

2,000

USA

1,000

542

-

Korea

Japan

USA

Korea

Japan

USA

-5-

Brokerage-like service only • Most revenue comes from simple brokerage activities • Even underwriting business is done through brokerage style • Commoditization of services and products – Fierce price competition among players Commission of underwriting business (%) IPO

SEO

Corporate bonds

7.0

3.0

3.0 1.8

USA

Korea

USA

Korea

0.5

0.1

USA

Korea

-6-

Difficult to expand capital market base • Very few new issuers and investors entering the capital markets – Competition only for a few established issuersà unable to expand market supply – Weakness of S&T, asset mgt à unable to expand market demand – Average value-added per capita of Korea’s five largest IBs is only 26% of their US counterparts Corporate bond issuance according to issuer size (2011) SME 0.6%

Durability of issuer-IB relationship (%) 70.0

25.8

Large Companies 99.4% USA

Korea

Source: Krigman et al (2001), Shin (2005)

-7-

Weak overseas networks • Weak overseas networks make it difficult for Korean IBs to connect emerging markets’ financial products to Korean investors – Aggravates problems caused by Korea’s low economic growth and population aging

• Korea’s IBs are ruled out in “Korean paper” markets (securities in foreign currency issued by Korean firms) League table in Korean paper markets (2011) rank

Lead Manager

1

BoA Merrill Lynch

2

HSBC

3

RBS

4

Daiwa

5

BNP Paribas

-8-

Revision of Capital Market Act (2011) • Some new businesses can be run only by large IBs – Introduces new businesses to expand the market base: prime brokerage service, internalization, etc. – Incentivizes the emergence of sizable investment banks

• Allows alternative trading systems (ATS) – Enhances market efficiency through competition among exchanges – Strengthens Korean IBs’ institutional investor-related businesses

-9-

Fostering IB activities amid global reregulation? • IBs in the US and EU – Extremely high leverage • US IBs: 3,000~4,000%, European universal banks: 6,000~7,000%

– Too much focus on the principal business • Likely to end up with conflicts of interest as well as excessive risk

– Should return to more agent-like business by reregulation

• Korea’s IBs – Average leverage is only 467% as of 2011 – Even the agent business is under-developed

Agent Korea’s IBs

Principal

Agent + Principal • Ensuring Deals • Market Making

Global IBs

Risk ↓

Risk ↑

Conflicts of Interest ↓

Conflicts of Interest ↑

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The end