An analysis from the Bank of Korea has emerged indicating that a cut in the base interest rate could lead to financial imbalance over time. The Bank of Korea advised that macroprudential regulations need to be consistently implemented to account for the negative impact of easing financial conditions on financial stability.

According to the 'Financial Stability Report' published by the Bank of Korea on the 24th, the Financial Vulnerability Index (FVI), which indicates long-term financial system vulnerabilities, increased from the third quarter of 2012 to the third quarter of 2017 after the bank lowered interest rates. Specifically, it was below 20 in the third quarter of 2012 but rose to 30 by the third quarter of 2017.

Interest Rate Reduction Financial Vulnerability Index, Household Loan Growth Rate Trend. /Courtesy of Bank of Korea

Interest rate cuts have been shown to expand financial imbalance through channels such as ▲ increased household loans ▲ intensified concentration of corporate loans in the real estate sector ▲ expanded external sector risks.

First, looking at the relationship between past interest rate levels and household loan growth rates, it has been shown that as interest rate levels decrease, loan growth rates increase. This is due to increased preference among economic agents for real estate and financial assets as relaxed financial conditions are established.

In the corporate loan institutional sector, the concentration of loans in areas such as the real estate industry, which are not highly productive, has increased. Examining loan concentration by industry, real estate increased from 1.7 in the third quarter of 2012 to 2.46 in the third quarter of 2017, and the hospitality and food industries rose from 1.60 to 1.90 over the same period. The influx of abundant liquidity into the real estate market influenced the increase in the volume of dwelling transactions.

Concerns are also rising about the expansion of external sector risks due to the increase in exchange rates. Generally, interest rate cuts lead to a decrease in the yield of won-denominated financial assets and an increase in market participants' proportion of foreign currency-denominated investment assets. In this process, exchange rate increases and foreign exchange market volatility can occur.

The Bank of Korea particularly emphasized that concerns about financial imbalance have grown with the current interest rate cut. This is because, before the rate cut in the second quarter, dwelling prices rose centered in the metropolitan area, and household debt surged. The potential for policy changes by the new U.S. government is also increasing external uncertainties.

The Bank of Korea advised that to prevent the expansion of such financial imbalances, macroprudential regulations should first be strengthened to curb household loan growth. According to the Bank of Korea's estimation, strengthening macroprudential regulations reduces the growth rate of household loans by approximately 1.0 percentage points (p) over four quarters. For increases in mortgage loans, the rate dropped by up to 2.4% p in four quarters, indicating that the effect of regulation strengthening was greater.

A diagnosis was also made that the impact of interest rate cuts on financial and foreign exchange markets should be closely monitored. It was noted that monitoring needs to be strengthened to identify early risks such as non-traditional financial products and, at the same time, there is a need for continuous cooperation between policy authorities to prevent potential risks to medium- and long-term financial stability.

The Bank of Korea emphasized the need to examine potential risks, stating, 'If the volatility of the won-dollar exchange rate expands due to factors such as the pace of monetary policy loosening by the Bank of Korea and the U.S. Federal Reserve (Fed), policy interest rate differences, the new U.S. government's strengthening of protectionism, and the global strong dollar, it can act as a negative factor in enhancing the loss absorption capacity of financial institutions and liquidity.'