At the inauguration ceremony on the 21st, Bank of Korea (BOK) Governor Shin Hyun-song said it has become difficult to fully identify and respond to risks in the financial system with only the existing framework, and noted that it is necessary to expand the scope of analysis to include off-balance-sheet transactions by financial institutions and nontraditional financial products.
Inside and outside the BOK, the remark is being interpreted as Shin signaling an intention to accurately identify hidden assets and liabilities that cannot be seen from the official books of financial institutions. The view is that the materials and indicators currently reviewed by the Central Bank and others for prudential oversight do not fully reflect risks, making it hard to anticipate and respond to crises.
The off-balance-sheet transactions Shin referred to are financial transactions not recorded on the balance sheet. A prime example is derivatives such as futures and options. Derivatives can generate large returns with a small investment. But if the investment fails, losses can swell to multiples of the principal. Whether there is revenue or loss is determined in the future, making it hard to reflect accurately in current books. Looking only at the books makes it impossible to pinpoint the exact risk.
Many interpret the nontraditional financial products Shin mentioned as referring to nonbank financial intermediation (NBFI). Private credit, which has recently drawn controversy, is one type of nonbank financial intermediation. Hedge funds and private funds, which are not regulated as strictly as banks, formed funds and lent to corporations with low credit ratings, but problems arose when redemption requests came in all at once.
Nontraditional financial products are largely created overseas, including in the United States. Shin, who spent most of his career abroad, is seen as having analyzed countless cases in which financial institutions that looked sound on the books collapsed at once due to unseen risks.
In a 2010 paper, Shin cited Allied Irish Banks (AIB), which was nationalized during the global financial crisis, as a representative case. Shin noted that AIB's capital adequacy ratio, which indicated its soundness, was highest at 11.1% in 2006, right before the global financial crisis. He added, The fundamental vulnerabilities of the loan book were exposed by the recession, and the capital adequacy ratio did not issue timely warnings.
A Bank of Korea official said, Foreign-exchange swap transactions, which play an important role in FX funding, are also not included on the balance sheet and are attached as notes, adding, It seems the focus is on identifying information on financial institutions' off-balance-sheet transactions to close the data gap.