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Private Equity Investments in the Banking Industry - The Case of Lone Star and Korea Exchange Bank

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Abstract

This paper examines success factors for the value creation of a private equity fund investing in a bank - based on Lone Star's acquisition of Korea Exchange Bank in 2003. Despite the value de- struction mergers and acquisitions in the banking industry have shown, Lone Star turned the bank successfully around. Considering regulatory restrictions and limitations to lever a transaction, the private equity fund also capitalized on the recovery of financial markets after the financial crisis in Asia during the late nineties. With regard to these circumstances success factors of the performed value creation are evaluated by the case study approach.
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issued quarterly
2007 2
Ukrainian Academy of Banking of the National Bank of Ukraine
Publishing Company "Business Perspectives"
Banks and Bank Systems
International Research Journal
Volume 2, Issue 2, 2007
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CONTENTS
J.A. Consiglio
Financial Services Privatisation in the CEECs – An Overview 4
Ivana Valová
New Capital Rules According to Basel II 14
Matthias Menke, Dirk Schiereck
Private Equity Investments in the Banking Industry – The Case of Lone
Star and Korea Exchange Bank 22
Christophe J. Godlewski
An Empirical Investigation of Bank Risk-Taking in Emerging Markets
Within a Prospect Theory Framework. A Note 35
Mete Feridun
Financial Liberalization and Currency Crises: The Case Of Turkey 44
Alper Ozun, Atilla Cifter
Industrial Production as a Credit Driver in Banking Sector: An Empirical
Study With Wavelets 69
AUTHORS OF THE ISSUE 81
Banks and Bank Systems / Volume 2, Issue 2, 2007
© J.A. Consiglio, 2007.
4
FINANCIAL SERVICES PRIVATISATION IN THE
CEECs – AN OVERVIEW
J.A. Consiglio*
Abstract
Financial services privatization in the Central and Eastern European countries (CEECs) is an ac-
count of significant differences in strategy processes and implementation, and of strongly asym-
metric evolution paces of bank and economic restructuring. The inherited background disorganiza-
tion factor, different motivating factors, extent and pace of the process, and the lingering argumen-
tative positions on its real need, make this one of the most fascinating contemporary banking his-
tory themes.
Key words: privatisation, financial services, CEECs.
JEL classification: D53, E44.
Popular Western media presentation of the post-communist block of countries often suggests their
being homogenously placed in the economic transition ladder. The spread of characteristics of the
CEECs’ banking sectors shows quite sufficiently how differently they must be considered from
each other: for example in aspects like the pace of change, privatization infrastructures, legal and
social elements.
Just as much as the move from the economics of communism to the economics of democracy re-
quired a particularly sequenced methodology, similarly the shift from privatization to market struc-
turing, inclusive i.e. of the element of M&As in the financial services industry (FSI), could not be
expected to flourish before privatization too had evolved to status and levels of both mass accept-
ability and efficient methodology. By the end of the 1980s transition from communism to democ-
racy still had much to suggest a perception there of a big black box. The regimes were “familiar”
with both systems in terms of their respective economic implications, but the paths from one eco-
nomic system to the other very often were not as familiar to them.
Even if some exceptions must be made, a substantial part of the literature on this much-dealt-with
ground of privatization in the CEECs has predominantly been characterized by holistic approaches
that consider the process as a feature of economic transition that has generally common, and to-
tally undifferentiated, characteristics across the whole spectrum of these countries’ economies.
This paper will focus on some of the more particular characteristics of a specific sector’s, financial
institutions’ privatisation, in that region. It must be considered as part of a lengthier study that this
author has made which includes, inter alia, various country case studies, synthesisation of deduced
specific country characteristics of the process into a general model of the process in the whole re-
gion, and adoption of the analytical evolution model to the experience of a small Mediterranean
island’s analogous privatization experience.
Economists and policymakers in the CEECs possessed a lot of information on the transition from
democracy to communism, and on its economic parallel i.e. from capitalism to central planning
and collective property. But no instance or guide was available for the reverse process. But in this
context it is useful to note that Rossini (1998) draws attention to the fact that the process towards a
socialist economy had also partially been undertaken by several Western democracies who, in this
context, one could say were wrongly described as “market economies”1.
* University of Malta, Malta.
1 Rossini G. (1998). Review of The Economics of Post-Communist Transition by O. Blanchard – Economic Notes, Banca
Monte dei Paschi di Siena, No. 1/1998.
Banks and Bank Systems / Volume 2, Issue 2, 2007
5
Despite the Cold War, during the 1950s and 1960s there seemed to be an inclination towards a
form of convergence of some Western economies towards a system in which the original spirit of
capitalism could coexist with a strong presence of the state in the economy. One version of this
was touted as “the social market economy”. Such convergence attempts, it can be argued, came to
a gradual halt in the 1980s when in most Western European countries the state could control al-
most a half of the flow of wealth produced, with the other half being allocated through market in-
stitutions. A classical and influential example of such a situation was Italy with its IRI (Istituto
per la Ricostruzione Industriale).
By contrast, for several historical reasons such convergence did not proceed on the other side of
the Iron Curtain. One could argue that one of the main obstacles against moving towards a sys-
temic organization more akin to the capitalist one was not the large diffusion of state property and
state presence in all sectors of the economies there (including in the FSI), but rather the concomi-
tant centralization of all relevant, and less relevant, economic decisions.
The “disorganization” factor
Blanchard (1998), when exposing the characteristics of the economics of post-Communist transi-
tion, is prompt to emphasise the effect of the disappearance of central planning in former Commu-
nist countries1. There was a ‘disequilibrium’ factor which explains the poor performance of some
of those economies in both a total and sectorial sense. Differently said, the restructuring of East-
ern Europe was muddled by a lack of that coordination which in capitalist economies is provided
partly by markets and partly by the state, even when reacting to unexpected crises.
Markets in post-communist transition countries did not exist, not at least in the freely functional
and operative sense that the Western world knew. The state was neither ready to use macroeco-
nomic instruments, nor to undertake any industrial policy which had to operate without compul-
sory planning. And yet there were differences amongst some of those former Communist coun-
tries, the most noteworthy being that of the timing and speed with which some of them started
their economic revolution, regardless in some cases of heavy social distress that was involved.
Poland, for example, was able to adopt certain forms of market legislation and practices well ahead
of others. A good example here was that of antitrust law, which it adopted early on (indeed even
before certain Western European countries). Hungary too was fairly early off the mark with a va-
riety of legislative changes. Other countries were loath to decisively undertake the same route, and
it became ever clearer that different adjustment speeds, and a different politico-economic psycho-
sis, prevailed within this group of vastly different countries. Perhaps the best illustration of this
was that, in various ways, they were deeply, awkwardly, and differently dependent on the notion
of “nothing succeeds like what at least popularly appears to be a success”, a scenario that various
astute politicians of the old guard for long still continued to play with wisely for their own per-
sonal interests.
The study of privatization in the financial services sector in the economics of post-Communist
transition must therefore also concern itself with some of the reasons why these Eastern European
countries experienced different adjustment speeds in this sector, and why restructuring was so
awkward to implement. The response of output to transition policies was, in this sector as in oth-
ers, often U-shaped, with some countries still trapped in the bottom of the U. Expectations often
went wrong, and particularly disappointed were those who though that recovery was just a matter
of freeing latent animal spirits of economic agents.
When we touch upon the long-term nature of the whole process, issues relating to various factors,
including the historical FSI evolution models applicable, the restructuring context and methodolo-
gies applied, some very important human resources factors, and others, are all important and ex-
1 Blanchard O. (1998) – The Economics of Post-Communist Transition – (Clarendon Press, Oxford).
Banks and Bank Systems / Volume 2, Issue 2, 2007
6
plain why some CEECs stayed long in this position and why, for example, none of the CEECs has
– up to our times – so far evolved as a reputable, dynamic, competitive financial centre able to
hold its own with the London, New York, Paris, Frankfurt, and Tokyos of the Western world.
Gardner and Molyneux (1990, p. 143 et seq.) hold as the traditional explanation for the develop-
ment of financial centres in the nineteenth and early twentieth centuries “the way in which [these]
tended to dominate international trade financing and capital export, and the important role they
have played in the world economy1. For the CEECs this was certainly not the case. In their eco-
nomic environment the privatization process was nothing like what many in the West would imag-
ine it should be. If Russia is taken as only one brief example of this, at a period when official pol-
icy was professedly very much in favour of the process, the economy was showing a sharp decline
in output which was much larger than the decrease in employment. The simple explanation was
that in most cases redundant workers were retained on the books of firms, and adjustment took
place in the form of reduced wages rather than dramatic lay-offs. And the FSI was often no excep-
tion to this approach.
This sort of softer adjustment carried out in many firms has, as one possible explanation, the fact
that many were in fact cases of insider privatizations. Insider control, alongside state control, is
viewed by Bonin J.P. et al. (1998, p. 1 et seq.) as having been continued, and often entrenched,
from the fact that privatization, as practiced in many of the economies in transition (EITs), often
failed to insure independent governance2. But insider privatizations, one must admit, are not the
only explanation for reallocation and restructuring not to have produced immediate effects. What
we refer to as “disorganization” was often the more conspicuous culprit which, in cumulative
terms over national levels, also caused derailment risks of the totality of the economies.
Establishing markets where there are only centrally planned links is anathema to the processes of
restructuring and reallocation. In the absence of properly functioning markets, privatization in the
CEECs could not be undertaken according to the full methodologies and contexts known in West-
ern Europe. Blanchard (op cit) reaches the conclusion that insiders privatization was not only one
of the most common ways (excepting possibly in the Czech Republic) of pushing takeovers, but it
may also have been the most efficient, given the actual conditions of financial markets. It avoided
dramatic underpinning and made the adjustment more gradual, even if painful over a longer pe-
riod. This however is not a view generally shared by all Western economists, many of whom
would not agree with him on the assumed ground that inefficiency may undermine insiders priva-
tization.
Objectives
The raising of public efficiency was of course one of the stated objectives of privatization pro-
grammes in many countries, including in the CEECs group. But it is not the only one. Others in-
clude:
A concomitant improvement of the quality and range of services to citizens.
The redeployment of national resources in a more efficient manner.
Allowing governments to concentrate on what are – according to a particular political
stance – considered as being their sole or core activities in their economic role, and in
the process encouraging an independent “enterprise culture”, and
The turnaround or consolidation of public finances.
From a more restrictedly FSI viewpoint, privatizations are often viewed as the way forward for:
The introduction, enhancement, and development of local capital markets.
Encouraging competition and modernization in the sector.
1 Gardener E.P.M., Molyneux P. (1990). Financial Centres in Changes in Western European Banking – (Routledge, Lon-
don).
2 Bonin J.P. et al. (1998). Banking in Transition Economies – (Edward Elgar, Cheltenham).
Banks and Bank Systems / Volume 2, Issue 2, 2007
7
Attracting foreign and domestic private investment in infrastructure which enhances
technology through strategic partnerships.
Labour market restructuring, i.e. away from state-owned enterprises (SOEs).
Achieving all or several of these objectives is easily traceable as a leitmotiv of many prominent
CEEC politicians’ (sincerely, or otherwise, motivated!) speeches and writings during the first dec-
ade after 1989. But that analysis quickly brings up the timing factor as often raising the issue of
whether the process should in fact have been done when it was. Or, indeed, when it was not. The
fact however remains that with the breakup of the Soviet Union, and the start of market-oriented
reforms in many former socialist of Central and Eastern Europe, that was a period where the pros-
pect of privatizing inefficient state-owned companies started to figure not only, on the one hand in
academic writings, but also in the new popular mens, the new general mindset, which started to
create and form mass and popular perceptions.
As one of the headline events symbolizing change from central planning to capitalism, privatiza-
tion seemed to promise an end to the inefficiencies of the former, and in mass perception became
the key to freezing the resources and talents of people everywhere, but more so in the CEECs,
where the ideal of lifting living standards to those of the industrial countries of Western Europe
became a holy grail.
When did it start?
Havrylshyn and McGettigan (1999), who were prominent in the International Monetary Fund’s
(IMF) Europe II, and Policy Development & Review, departments, summed up some analysts’
views holding that when the CEECs embarked on the privatization route in the way of severally
apparently nationally embraced formal programmes, there existed no formally theoretical base to
guide the practical process of economic transition. For many analysts there only existed generic –
or even sometimes insistently specific – theories on capitalism and socialism.
This is perhaps a somewhat surprising position if one considers the fact that the IMF argues in its
own favour a claim for historical antecedent in this area – [its 1977 strict pressurizing of the Brit-
ish Labour government that it effects a sale of its then held shares in British Petroleum (BP)] –
prior, that is, to the introduction by the Thatcher government in the UK in 1979 of a formal
lengthy programme of divestitures. That was one year after Prime Minister Harold Wilson – who
had made much of his intention to modernize Britain with a much touted “white hot technological
revolution” – had resigned.
In the UK several Tory politicians have claimed credit for that country’s privatization process, but
later former Chancellor Sir Nigel Lawson held that the paucity of references to privatization in the
Conservative Party’s 1979 general election manifesto was in actual fact, according to him, a re-
flection of “Lady Thatcher’s lack of enthusiasm” for privatization1.
But Megginson, Nash, and Van Randeburgh (1994), and again Jones, Megginson, Nash and Netter
(1999)2, also argue that “the first large-scale, ideologically-motivated denationalization programme
1 “The Financial Times Guide to Privatisation” – Jan 8th, 1996. Vide also FT, Oct 15th, 1999 where Robert Peston signifi-
cantly reports thus, under “Thatcher’s flagship finally runs aground”:
“The death sentence has been posted. The 20-year campaign to privatize public services is over. No less a figure than the
Prime Minister (Tony Blair) read the last rites over the archetypical Thatcherite policy this week. “Today the issue is not
ruling back government, hammering trade unions, or more and more and more privatization of public services”, Tony
Blair wrote in a little-noticed article in Monday’s issue of London’s “Times” newspaper. “It is investment in public ser-
vices, allied to their reform and modernisation…………….”.
2 Megginson W.L., Nash R.C., & Van Randeburgh M. (1994). “The Financial and Operating Performance of Newly Priva-
tised Firms: International Empirical Analysis”, The Journal of Finance Vol. XLIX, No. 2, June.
Jones S.L., Megginson W.L., Nash R.C., & Netter J.M. (1999). “Share issue privatizations as financial means to political
and economic ends”, Journal of Financial Economics, No. 53, pp. 4-5 and 217-253. Other discussions of the purely histori-
cal aspects of the development of privatization are to be found in, inter alia, Jenkinson & Meyer (1988), Van Der Walle
(1989), Shirley & Nells (1991), Brada (1996), Bennell (1997), Yergin & Stanislaw (1998), and The World Bank (1995).
Banks and Bank Systems / Volume 2, Issue 2, 2007
8
of the post-war era was launched by the government of Konrad Adenaur (one of the so-called
“founding fathers” of the European Union) in the FDR. In 1961 (i.e. four years after the EU’s
birth) the German government sold a majority stake in Volkswagen1 in a public share offering
heavily weighted in favour of small investors. Four years later the German government launched
an even larger offering of shares in VEBA, the mining and heavy industry giant. Both offerings
were initially very favourably received, increasing the number of private shareholders in Germany
from around 500,000 to some 3 millions, but the appeal of share ownership did not survive the
first cyclical downturn in stock prices, and the government was actually forced to bail out many
small shareholders.
The Adenauer government’s 1960’s privatization programme had officially announced objectives
which read identical to those of the two decades’ later Thatcherite plans. When one then pursues
the historical iter of privatizations even in other European countries (Denmark, Italy, France, and
from the mid-1990s in the EU generally), in Asia (Malaysia, Singapore, Japan), and South Amer-
ica (Chile2), one sees that, regardless of ideological basis, the objectives are nearly always similar,
viz:
Raising revenue for the state
Promoting increase efficiency
Reducing government interference in the economy
Promoting wiser share ownership
Providing opportunity to introduce competition
Exposing SOEs to market conditions
Developing national capital markets.
After Germany and the UK, the next major Western European nation to pursue privatization as a
core element of its politico-economic policy was France. Jacques Chirac’s conservative govern-
ment which came to power in March 1986 was declaredly committed to selling off not only the
financial and industrial groups which had been nationalized during 1981 and 1982, but also the
large banks nationalized even further back by General Charles De Gaulle in 1945.
With the benefit of hindsight it can be said, for the period between 1965 and 1979, that the number
of non-European governments who implemented deeply well enough thought out scientific poli-
cies of privatization was fairly small. Later, after 1987, privatisation programmes spread rapidly
round the globe, and the 1989/1990 events in the former USSR and Eastern Europe thereafter
shifted the “movement” to that part of the world.
Shirley and Nells (1991) motivate the imperative for privatization in these countries as being that
“to create a market economy as quickly as possible, using all available methods, and almost re-
gardless of the social cost entailed”3. However, irrespective of when, and to where, an exact
chronological start of this widely discussed economic policy innovation is to be accredited, it can
be argued that from the decade between 1989 and 1999 – which was the first whole and continu-
ous period of the transition economies’ experience with privatization – some elements for the cob-
bling together of a workable “model” of transition or transformation which, it can be imaginatively
said, should be ‘grateful’ or ‘owe a lot to’ privatization, can be individualized.
1 There is a touch of irony in the fact that the German term “Volkswagen” actually means “People’s Car”.
2 Possibly the one which attracted most media interest was the case of Chile, where the Pinochet government, which gained
power after the ouster of Salvador Allende in 1973, attempted to privatize companies that the Allende regime had national-
ized during its short but eventful reign. However the process was poorly executed, and required very little equity invest-
ment from purchasers of assets being divested. Thus, many of these same firms were renationalized once Chile entered its
debt and payments crisis in the early 1980s. Chile’s second privatization programme, which was launched in the mid-
1980s, and relied more on public share offerings, than direct asset sales (where the government acted as both creditor and
seller) was much more successful. These Chilean vicissitudes are assessed in more detail in Yotopoulos (1989).
3 Shirley M. & Nells J. (1991). “Public Enterprise Experience” – World Bank, Washington DC, Publication No. 9800;
(1991) – “Public Enterprise Reform – The Lessons of Experience” – World Bank, Washington DC.
Banks and Bank Systems / Volume 2, Issue 2, 2007
9
In considering some of these elements it is easy to see that all are – at least theoretically – such as
can be hypothesized in a general manner for the financial services sector. Consider, inter alia,
The forcing through of moves from a sellers’ to a buyers’ market – through price lib-
eralisation this is also possible in the market for financial services.
The enforcing of a hard budget restraint – through privatization itself and the elimi-
nation of various government support mechanisms the FSI is, again, a possible con-
tributor1.
The reallocating of resources from old to new activities – closures and bankruptcies,
combined with the establishing of new enterprises, within the FSI is again theoreti-
cally relevant.
The restructuring within surviving firms – even in the FSI labour rationalization,
product line changes, and new investment, are relevant factors to be considered.
Extent and pace
Any hypothesized model of the evolution of the CEECs’ FSI privatization perhaps carries too
much to resist analogy with Schumpeterian creative destruction. And yet, again naturally a poste-
riori, it can now be said that this became the generally accepted road down which developing
countries chose to travel. Between 1988 and 1992 the pace of privatization in these countries de-
creased dramatically. From 6% of total world privatization sales income in 1988, the developing
countries’ share rose to 42% in 1992. In 1995 an ILO report stated that proceeds from the sale of
public enterprises in developing countries rose from just over US$2 bn in 1988 to almost US$ 20
bn in 19922. And indication of to what extent privatization proceeds became for these countries the
more important source element for their financing needs, when compared to their previous heavy
dependence on external financing, is suggested by the following World Bank figure covering just
the beginning of these countries’ experiences with privatization.
Fig. 1. Provatisation proceeds in developing countries ($bn)
By the first half of 1995 worldwide privatization was progressing at a much slower pace compared
to the same period in 1994. During that period total proceeds from the sale of SOEs stood at US$
18.4 bn, down from the peak reached in the comparable previous year period of almost US$ 37
1 There is of course a ‘flipside’ soft budget constraint position that can also be made, with concomitant issues.
2 “Privatisation surge in developing countries” – Financial Times, April 26th, 1995.
Banks and Bank Systems / Volume 2, Issue 2, 2007
10
bn. Privatisation International (1995) – published in the US – however maintained that a large
number of deals were already in the pipeline for the second half of 1995, or for early in 1996, and
so, “barring an adverse turn in markets, the value of privatization worldwide could still reach US$
45 bn or more for 1995”1.
World Bank calculations show that privatization raised US$ 270 bn worldwide in the period be-
tween 1988 and 1993. As the above figure suggests, developing countries received a large share
of those revenues. State sell-offs, in Latin America, in Asia, and in other developing countries
elsewhere raised a total of US$ 96 bn during the period in that group of countries, with more than
a third of it coming from foreign investors. That size of activity was large in itself, but both in its
factually completed component as well as in what was being programmed down the road, was in
fact to an extent that at one stage loomed dangerous in the eyes of the OECD.
In 1995 the OECD warned that the current privatisation programmes in its member countries were
so large that their implementation would have a powerful impact on the countries’ financial sys-
tems. It estimated that these programmes could result in equity offerings totaling US$ 200 bn dur-
ing the successive five years, creating the crucial issue of whether the financial markets would be
able to absorb this. The OECD’s report included warnings referring, inter alia, to “fatigue among
retail investors”, and to the possibility that “future privatizations would have either to reduce the
tranches specifically directed to retail investors or to enhance the attractiveness of the offering to
these investors”2.
The digression here towards OECD experience, and away from CEECs specifically, is explained
by the intention of underlining the substantial differences in both the economic and political envi-
ronments, and timings, within which privatizations occurred in these different scenarios of the
world. Whilst the developed world presented issues like
equity prices of offerings needing to remain strong to support investor appetite for
new issues,
downturns in equity markets leading to shifts away from equity and thus potentially
undermining privatization plans,
some large-scale privatizations having negative effects on share prices (e.g. in 1994),
and having to compete in a rising interest rates market,
meanwhile when some governments carried out privatization programmes in the
transition economies a key question constantly bothering investors and analysts was
“Is the country, or that sector in that country, ready?”
Even when the whole concept has long been accepted as an ideal or methodology along the road of
economic transition, the banking sector in Central Europe was factually not yet totally ready for
privatization, and forcing the issue was likely to hurt rather than help banking development.
A non-proven case?
For a long time many observers’ first look at the progress made by the CEECs towards transition
was summed up in the question about what is the extent of the private sector’s share of an econ-
omy. But whilst this was a legitimate way of measuring a country’s progress away from central
planning, it did not, on its own, necessarily follow that bank privatization was always essential or,
when effected if needed, that it was well timed. The simple, key, standard question would need to
be: what was privatization trying to achieve in that particular country, and how would it increase
banking efficiency? Answers from different CEECs are less simple, and specific case-studies3
1 “First-half slowdown in worldwide privatisations” – Financial Times, July 18th, 1995.
2 “Privatisation and Capital Markets in OECD Countries” in “Financial Market Trends (OECD), Feb 1995. See also
“OECD warns on scale of privatization programmes”, FT, March 6th 1995. Specific case studies of countries where such
scenarios effectively came very close to reality feature in the Ph.D. thesis of which this paper is a component.
3 The financial services privatization experiences of Hungary, the Czech Republic, the Slovak Republic, Romania, Esto-
nia, and Russia, are extensively analysed in my 2006 Ph.D. thesis on the subject, as referred to on Page 1.
Banks and Bank Systems / Volume 2, Issue 2, 2007
11
highlight issues like the extent to which Central Europe’s economic and industrial vicissitudes in
post-privatisation years showed much progress away from state planning, whether and at what
stage had the state really arrived in total readiness to give up control of the banking sector, and
again indeed whether arguably it should have at all.
Michael Kapoor, who in 1996 was making a strong case against “forced quasi-privatisation” dis-
tracting the CEEC banks from acting more commercially, assessing risks better, and generally
offering better service, maintained that at its simplest privatisation is a bottom-line question: the
commercial orientation of private companies means that they should operate more profitably than
state dinosaurs1. For corporates needing fundamental refocusing to survive, the argument is com-
pelling, and in many cases privatization was indeed an essential step to commercialization. But
the bottom-line argument was at times of limited relevance to Central European banks, some of
which – according to certain yardsticks – were actually amongst the most profitable in the world.
The excessive caution they were charged with stemmed as much as anything from a determination
to keep profits up. Indeed, problems did as often as not come from naïve commercialization (e.g.
chasing new business when distinctly unqualified to gauge risks) as from complacency.
Moreover, many would indeed argue that the banking system in any of these countries was run on
commercial, rather than political, lines. Along the way, whilst state influence certainly remained
there, direct control had long gone. Nor could privatization be seen as the guaranteed key to bank
restructuring, for there was actually no evidence that privatization per se would speed up the proc-
ess. At times, even the IMF seemed to be maintaining an arm’s length approach to the issues of
privatisation’s worth as an essential component of bank restructuring methodology within the
much wider sphere of appropriate macroeconomic policy in transition economies2. Indeed the
presence of competition seems to be a far more effective catalyst to development than mere trans-
fer of ownership. Most observers for example agreed that Hungary’s OTP Bank restructured more
effectively than the Czech Republic’s Sporitelna, even though the Czech savings bank was privat-
ized significantly earlier.
Up to early in 1996 the case for bank privatization in the CEECs was, at best, unproven, and at that
point in time, when the difficulties of selling what were effectively large institutions in some of
these economies were factored in, the conclusion was that it was better to concentrate on increas-
ing their efficiency – if necessary even under state ownership – than on privatizing them. The
situations in Hungary, the Czech Republic, and Slovakia are specific examples of that particular
conjuncture.
Most of the literature originating from non-CEEC sources suggests that the perception around the
beginning of 1996 was that Central European banks were not yet ready for privatization, and that
forcing the issue was likely to hurt rather than help banking development. The general popular
approach was that of looking at the progress made towards transition, and posing as a first quote
the private sector’s share of the economy. But whilst this was a legitimate way of measuring these
countries’ progress away from central planning, it did not necessarily follow that bank privatiza-
tion was essential. The simple question which had to be posed was: what was privatization trying
to achieve, and how would it increase banking efficiency? The answer was always less simple,
and highlighted the extent to which Central Europe’s economic and industrial future at that stage
still remained unplanned. The state was not yet ready to give up control of the banking sector, nor,
arguably, should it have done so.
1 Kapoor M. (1996). “Are banks ready?”, Business Central Europe, February, pp. 7-11.
2 It is significant, for example, that privatization is totally absent in all the papers published in the IMF’s 1997 publication
“Systemic Bank Restructuring and Macroeconomic Policy” – (Alexander W.E., Davis J.M., Ebrill L.P., Lindgren C.J.
(eds) – which was the joint product of the IMF’s Fiscal Affairs and Monetary & Exchange Affairs Departments arising
“from the need to advise countries on how to deal with banking system problems, and on how to consistently incorporate
the macroeconomic aspects of systemic bank restructuring into IMF policy advice and IMF-supported adjustment pro-
grammes”.
Banks and Bank Systems / Volume 2, Issue 2, 2007
12
At its simplest, privatization is a bottom-line question: its defenders will consistently hold that the
commercial orientation of private companies means that they should operate more profitably than
state-owned dinosaurs. For companies needing fundamental refocusing to survive, the argument is
compelling and in many cases is an essential step to commercialization. But the bottom-line argu-
ment was of limited relevance to Central European banks, which were arguably amongst the most
“profitable” in the world. The excessive caution they were rightly charged with stemmed as much
as anything from a determination to keep profits up. Indeed, problems did as often as not come
from naïve commercialism (e.g. chasing new business when unqualified to gauge risk) as from
complacency.
By early 1996 few would deny that the banking system in any of these countries was run on com-
mercial, rather than political, lines – while state influence was certainly there, direct control had
long been gone. Nor could privatization be seen as the key to bank restructuring, for there was no
evidence that privatization per se was speeding up the process. The presence of competition was a
far more effective catalyst to development than mere transfer of ownership. For example, Hun-
gary’s OTP Bank restructured more effectively than the Czech Republic’s Sporitelna, even though
the Czech savings bank had been privatized significantly earlier.
At that stage it therefore appeared that the case for bank privatization in the CEECs remained at
best unproven, and when difficulties of selling such large institutions were factored in the obvious
conclusion was that it would be better to concentrate on increasing their efficiency, if necessary
still under state ownership, than on privatizing them. The most obvious example of this debate
was Poland, where international creditor pressure was forcing the authorities to take drastic steps
to privatize the long-stagnant banking industry. But, because it was impossible to sell the banks on
what were effectively shallow domestic capital markets, privatization was likely to be a sham by
any meaningful criteria. If banks could be sold to private investors working through aggressively
managed funds, then the debate would have been different, because there would be an emphatic
distancing from the state, and corporate governance could be imposed by the market. But with
40% of Polish stock market capitalization already dominated by the banks, significant further is-
sues were impossible, meaning that the shares would, one way or other, be given away (unless the
banks were to be sold to foreigners, which was then politically unlikely), and market control, as
opposed to legal ownership, would still be lacking.
1996 – WHAT THE POLISH GOVERNMENT WANTED
The structure of Polish banking was too dispersed, and the Government in-
tended to rationalize the industry around existing regional and specialized
banks.
In early 1996 the structure was:
Five state-owned commercial banks
Three state-owned socialized banks
Agricultural and cooperative banks (BGZ SA Holding)
Private banks
Foreign banks.
Post-reform it wanted it to be:
Two or three banking groups with some foreign capital and re-
maining state minority share (formed around Handlowy Bank and
Pekao Bank)
PKO BO state-owned savings bank
BGZ SA (food economy bank) and cooperative banks
Two or three private banking groups formed out of the regional
banks, probably with a remaining state shareholding
Socialised banks (e.g. mortgage).
Source: Business Central Europe, Feb. 1996, p. 7.
Banks and Bank Systems / Volume 2, Issue 2, 2007
13
Ironically, this very lack of domestic capital appeared to be as the only thing which, in an inverse
sort of manner, motivated the banks themselves towards privatization. Up to around 1994 Po-
land’s largest bank, Bank Handlowy, showed absolutely no eagerness to privatize: ownership, to
it, was irrelevant. Two years down the road it became desperate to do so, not out of conversion to
Thatcherite idealism, but because it had become seriously scared by its inability to compete with
larger banks. It needed growth capital; there was none available in Poland; that meant going to
international markets; and that in turn required the transparency of a listed – and therefore private
– company. Looking prophetically ahead the then deputy director of the bank put it very wisely:
“If we don’t have access to international markets, then in ten years’ time we’ll be the 20th biggest
bank [in Poland], not the biggest”.
Conclusions
It is easy to see how the debate on financial services privatization in the CEECs can become en-
tangled in conflicting positions between issues related to systemic banking sector problems on the
one hand, and those associated with individual banks in the region on the other.
A well-functioning banking infrastructure should be considered as a public good everywhere. The
different CEECs’ perception of the various elements discussed here is one important explanation
of why the different governments there addressed banking sector problems with heterogeneous
(sometimes outrightly inconsistent and often questionable) levels of urgency. And this must be
seen alongside the fact that systemic banking problems often turn into full scale banking crises
with related negative effects for macroeconomic growth.
Those CEECs which did consider the banking sector positively (e.g. Estonia) did so because there
was realization of the fact that the size and impact of a systemic banking crisis on economic output
and growth are dependent on the stage of development of the financial sector, and of course its
linkages with the real sector. Actually however there are two views to be considered here.
On one hand is the argument that in a big country, say, the US, if a significant portion of such a
country’s banking system would collapse, the relative adverse consequences would be larger than
if a similar event occurred in a smaller country. Matousek (1997) on the other hand does not think
that this is quite so where big developed economies are concerned1. His view is that it is ‘in many
transition countries [that] bank credits still represent the only financial channel for the real sector,
and that, moreover, a small number of commercial banks tend to have dominant positions as key
lenders to the biggest companies”. Therefore a collapse of such key institutions in the CEECs
could be very harmful indeed for the real sector as well as for the emerging financial sector, some-
thing which, he holds, is not the case elsewhere.
This paper has not looked at the actual transformation and restructuring process of the banking
sector in Central and Eastern Europe, a process which can generally be said to have commenced
around 1989-1990, and which can justifiably be held as yet another consequence of known politi-
cal events. Systemic national bank system restructuring during the 1990s developed into a disci-
pline of its own, had a dynamic of its own, and comprised comprehensive programmes to rehabili-
tate significant parts of countries’ banking systems, with the ultimate objective being that of pro-
viding vital bank services on a sustainable basis. Close study of policy assessments and strategic
steps relevant to the different situations in each CEEC invariably reveals many issues that make
this possibly one of the most fascinating areas of study in contemporary banking history.
1 Matousek R. (1997). Comments to paper by Hans Bloomestein in “The New Banking Landscape in Central and Eastern
Europe” – (OECD, Paris).
Banks and Bank Systems / Volume 2, Issue 2, 2007
© Ivana Valová, 2007.
14
NEW CAPITAL RULES ACCORDING TO BASEL II
Ivana Valová*
Abstract
The Basel Committee on Banking Supervision (known as “the Basel Committee”) was established
by the central-bank Governors of the group of ten countries at the end of 1974. In 1988 the Basel
Committee on Banking Supervision decided to introduce a capital measurement system for a credit
risk commonly referred to as the Basel Capital Accord (known as “Basel I”). Amendment to the
Basel Capital Accord to incorporate market risks was issued by the Basel Committee on Banking
Supervision, in 1996. The final version of the New Basel Capital Accord (known as “Basel II”),
covered operational risk, was released in June 2004. The article, “New capital rules according to
Basel II”, is devoted to the problem risks by credit financial institutions. The paper dedicated to
the importance of risks, capital adequacy, risk measurement and risk management, and advantages
and disadvantages of the new capital rules are described. The Czech National Bank, a central bank
of the Czech Republic, defines the prudential framework for banking business and cooperates with
banks to implement the New Basel Capital Accord too. The paper talks about trends and actual
situation in accordance with the New Basel Capital Accord and some interesting things being re-
lated to the Czech Republic too.
Key words: Capital adequacy, Czech national bank, Basel Committee on Banking Supervision,
Basel Capital Accord, New Basel Capital Accord, risk management.
JEL classification: G18.
Introduction
A creditable and stable banking sector is one the basic preconditions for a functioning economy.
But such stability is not guaranteed by market mechanisms alone. The activities of banks are gov-
erned by a number of injunctive regulations. We have to be aware that banking sector is somewhat
different from other sectors. It is a specific area with specific banking products and services, with
specific risks and management. Because of these the banking sector has to be regulated and super-
vised.
Regulators want to ensure that banks and other financial institutions have sufficient capital to keep
them out of difficulty. Regulators try to protect depositors and also the wider economy. The reason
is that the failure of a big bank has extensive knock-on effects. The risk of knock-on effects that
have repercussions at the level of the entire financial sector is called systemic risk.
Objective and Methodology
The aim of the paper is to give brief information on a theory of the Basel Capital Accord, and
namely of the New Basel Capital Accord, issuing by the Basel Committee on Banking Supervi-
sion. The article points the moral that it is necessary and very important for each bank to measure,
manage and monitor the banking risks. The attention is given to capital adequacy and basic
changes in the risk management in accordance with Basel II and advantages and disadvantages
that the new rules bring to banks.
The basic method of submitted article is the deduction. It is gone from common pieces of knowl-
edge and theory to particulars.
* Masaryk University, Czech Republic.
Banks and Bank Systems / Volume 2, Issue 2, 2007
15
Results
Banking Regulations have several goals: improving the safety of the banking sector, levelling the
competitive playing field of banks through setting common benchmarks for all players, promoting
sound business and supervisory practices. Regulations have a decisive impact on risk management.
The regulatory framework sets up the constraints and guidelines that inspire risk management
process of banks. Regulations promote better definition of risks, and create incentives for develop-
ing better methodologies for measuring risks.
In 1988, the Basel Committee on Banking Supervision1 issued the Basel Capital Accord. This ac-
cord established minimum levels of capital in order to strengthen the soundness and stability of the
banking system as a whole and create a more “level playing field” in competitive terms among
internationally active banks.
Since 1988, the framework has been introduced in virtually all countries with internationally active
banks. In 1999, the Basel Committee decided to replace the Basel Capital Accord with a more
risk-sensitive agreement. The new framework is based on current risk management techniques.
Banking risks
Banking risk is uncertainties resulting in adverse variations of profitability or in losses. There are a
large number of risks in the banking sector. Most of them are well known. In connection with
Basel II, the credit risk, market risk and of recent years operational risk too are very often dis-
cussed.
The first of all risks in terms of importance is credit risk. Credit risk is the risk of loss due to a de-
terioration of the credit standing of a borrower. We may not forget the view of the risk differs for
the banking portfolio and the trading portfolio. Traditional measures of the credit quality of debts
are ratings. We know the internal rating and external ratings. Internal ratings use bank, and exter-
nal ratings are made by rating agencies Moody's, Standard & Poor's and so on. There are various
types of ratings. Rating is ordinal measures of credit risk, but it is not sufficient to value credit
risk. Because of that the portfolio models are used.
Market risk is the risk of adverse deviations of the mark-to-market value of the trading portfolio,
due to market movements, during the period required to liquidate the transaction. The period of
liquidation is critical to assess such adverse deviations. If it gets longer, so do the deviations from
the current market value.
The last risk, we will talk about is operational risk. The New Basel Capital Accord defines opera-
tional risk as “The risk of direct of indirect loss resulting from inadequate or failed internal proc-
esses, people and systems or from external events”. Operational risk covers people's risk (it means
human errors), processes risk (for example errors in the recording process of transactions), techni-
cal risk (model errors, the absence of adequate tools for measuring risks) and information technol-
ogy risk (system failure).
Capital adequacy
Capital adequacy exists for a long time and it is the main pillar of the regulations. The two most
important capital adequacy requirements are those specified by the Basel Committee on Banking.
The first implemented accord, known as Basel I, was focused on credit risk and set up the mini-
mum required capital as a fixed percentage of assets weighted according to their nature in 1988.
The range of regulations extended gradually later. A major step was the extension to market risk,
with the 1996 Amendment. Basel II enhances the old credit risk regulations.
1 The Basel Committee was established in 1974 by supervisors of the Group of Ten (G10) countries.
Banks and Bank Systems / Volume 2, Issue 2, 2007
16
Capital adequacy accordiny to Basel I was defined as a single number that was the ration of a
banks capital to its assets. There were two types of capital – tier 1 and tier 2. The requirement was
that tier 1 was at least 8% of assets. Each class of asset has a weight of between zero and 100%.
The weighted value is multiplied by the weight for that type of asset.
The Capital Accord is to be replaced by New Capital Accord. The new capital framework is based on
three pillars: minimum capital requirements, a supervisory review process, and effective use of mar-
ket discipline. With regard to minimum capital requirements, the Basel Committee set that a modi-
fied version of the actual Basel Capital Accord should remain the standardised approach. But there
are possibilities for some banks to use internal credit ratings and portfolio models. And so a capital
requirement of a bank can be in relation to its particular risk profile. It is also possible that the Ac-
cord's scope of application be extended, so that it fully captures the risks in a banking group.
Basic characteristics of BASEL II
Basel II is a regulatory capital adequacy framework, which will be implemented by all banks lo-
cated in the EU countries and by all internationally active banks in non-EU G10 countries. The
main objective of the framework is to improve security and soundness of the financial system. The
new package is the set of consultative documents that describes recommended rule for enhancing
credit risk measures, extending the scope of capital requirements to operational risk, providing
various enhancements to the existing accord and detailing the supervision on market discipline
pillars. The New Basel Accord provides a menu of options, extended coverage and more elaborate
measures, in addition to descriptions of work in progress, with yet unsettled issues to be stream-
lined in the final package. The New capital accord contains three basic pillars:
1. Pillar – Minimum capital requirements
The pillar contains minimum capital requirements for credit risk, market risk, and now also covers
operational risk. The pillar offers a wider range of risk measurement approaches for determining
capital requirements, including banks' own internal models.
Different options for credit risk are:
1. Standardised Approach (SA) – It is the simplest method. The risk weights are derived
from ratings set by external credit assessment institutions or export credit agencies.
2. One of two internal ratings-bases (IRB)
Foundation IRB Approach (FIRB) – By the method bank uses own esti-
mates of the probability of default of its client and banking supervisory au-
thorities determine the other characteristics.
Advanced IRB approach (AIRB) – All the components are determined by
banks.
Measurement methods for the market risk are unchanged, but there is change in the definition of
the trading book and assessment of the capital requirement in the case of a small trading book.
Banks can use one of three basic methods for measurement of operational risk:
1. Basic indicator approach (BIA) – Calculation of the capital charge as a fixed percent-
age of the bank's net income.
2. Standardised approach (STA) – Calculation of the capital charge separately for each
business line, as a fixed percentage.
3. Alternative standardised approach (ASA) – banking supervisory authority may allow
bank to use another alternative indicator for commercial or retail banking business
lines.
4. Advanced measurement approaches (AMA) – Banks are allowed to use their own
various internal methods and models. The methods and models have to be approved
by the supervisory authority.
Table 1 shows an overview of the methods for risk management in accordance with Basel II.
Banks and Bank Systems / Volume 2, Issue 2, 2007
17
Table 1
The methods for risk management within Pillar 1
Type of risk Methods
CREDIT RISK Standardized Approach Foundation Internal
Rating Based Approach
Advanced Internal Rating
Based Approach
MARKET RISK Standardized Approach Internal Models
Approach
OPERATIONAL RISK Basic Indicator Approach Standardized Approach Advanced Measurement
Approach
2. Pillar – Supervisory review process
The second pillar is intended primarily on the process of assessment of each financial institution's
capital adequacy by the banking supervision. Very important point is soundness and quality of the
bank's management and control mechanisms. It is necessary for bank to have internal processes in
place to assess so-called Capital Adequacy Assessment Process (known as CAAP). The absolute
minimum of capital adequacy is still 8% of the value of risk-weighted assets.
3. Pillar – Market discipline
The third pillar is focused on the issue of transparency and information disclosure. Each bank has
to disclose more detailed information about its activities (for example publication made about the
methods used to calculate capital adequacy or own approaches to measure and control risks). All
banks have to do the core disclosure requirements.
The Czech National Bank´s approach
Following part of the article is devoted to the Czech National Bank's approach and is worked out
namely in terms of information recovering from the Czech National Bank and websites.
In the Czech Republic banking regulation and supervision are regulated by the Czech National
Bank (known as “CNB”). The CNB defines the prudential framework for banking business1.
Banks have to adhere to that framework. Regulations contain the terms and conditions of entry
into the banking sector and setting prudential rules for specific areas of banking business. Czech
National Bank Banking Supervision checks whether banks are adhering to those rules2.
The Czech Banking Association is a voluntary association of legal persons, which do business in
banking and in nearly connected areas. One of the objects of its activity is to present and promote
the common interest of its members in the Government and the Czech National Bank. The core
part of the Czech Banking Association activities consists in an active involvement in the prepara-
tion of laws and lower legal provisions, securities, regulating banking supervision, capital market
and so on3.
The CNB and the Czech Banking Association cooperate with banks to implement the New Basel
Capital Accord.
New rules are also reflected in the re-casting of Directive 2000/12/EC4 and Directive 93/6/EEC5
(hereinafter referred to as the EC Directive). The Czech Republic – as European Union member
1 Under Act No. 21/1992 Coll. on Banks, the Czech national bank is authorised to issue regulations.
2 For more information see www.cnb.cz.
3 For more information see www.czech-ba.cz.
4 Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit
of the business of credit institutions (recast version of Directive 2000/12/EC).
5 Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of invest-
ment firms and credit institutions (recast version of Directive 93/6/EC).
Banks and Bank Systems / Volume 2, Issue 2, 2007
18
state – will have to implement. The CNB agrees with the proposed revisions to these Directives
and supports and regards, namely, follows the elements1:
Promoting safety and soundness in financial systems and enhancing competitive
equality and international comparability among credit institutions and investment
firms as a result of introducing the new rules.
Implementation of the new rules on the date proposed in the Directive (January 1,
2007, whereas some advanced approaches will not be applied until January 1, 2008).
Implementation on a solo and consolidated basis for all credit institutions, i.e. banks,
electronic money institutions and credit unions, and for investment firms in the
Czech Republic.
An individual, more risk-sensitive approach tailored to the institution's risk profile.
Flexibility as regards choice of method and the use of more sophisticated and accu-
rate risk management methods for determining capital requirements.
Timely preparation of the banking sector for implementation of the new rules, on
which the CNB and the financial sector will need to work together (see below).
Active co-operation at international level.
An internationally uniform interpretation of the new.
CNB Banking Supervision has to prepare for a fundamental change in banking sector regulation in
connection with Basel II. This will involve elaborating approaches that are as objective as possi-
ble, incorporating them into the Czech laws and regulations, and subsequently applying them in
practice. It will also be necessary to establish a uniform interpretation of the EC Directive rules
and requirements and to ensure sufficient transparency of procedures, especially where the super-
visor has the option of taking an individual approach to banks (such as in risk profile assessment).
At the same time, banks must have the opportunity to adapt to the new methods sufficiently in
advance. It is therefore vital for the CNB to work with the Czech Banking Association, with indi-
vidual banks and with the Czech Chamber of Auditors in both the preparatory phase and the im-
plementation phase. These objectives can only be achieved through active co-operation at interna-
tional level as well.
The Czech Republic was involved in the preparation and implementation of Basel II – via its
membership of the Core Principles Liaison Group (known as “CPLG”) and the CPLG Working
Group on Capital. The CNB is also involved in the work of the relevant EU committees and work-
ing groups. In late 2001, the CNB prepared a questionnaire surveying banks' preparedness for in-
troducing the new approaches for credit risk. The CNB has also addressed the issue of training and
has organised several seminars on Basel II with internal and external instructors).
Now that the final version of Basel II is known and the texts of the EC Directives are mostly final,
the Czech National Bank's most important tasks at present are as follows2:
to implement the EC Directives into the Czech legislation and regulations,
to enhance the awareness of both specialists and the general public (through presen-
tations, seminars and publications in the press),
to co-operate actively within the Joint Project of the CNB, the CBA and the CA CR,
to enhance the skills of the Joint Project participants and prepare for the implementa-
tion of the new rules,
to participate actively in the QIS5 quantitative impact study organised by the Basel
Committee on Banking Supervision in cooperation with the CEBS (the study focuses
on impact assessment and recalibration of Basel II and the EC Directive, as the case
may be),
1 For more information see www.cnb.cz.
2 For more information see www.cnb.cz.
Banks and Bank Systems / Volume 2, Issue 2, 2007
19
to develop cooperation with foreign supervisory authorities and, where possible, to
conclude agreements on cooperation in respect of supervision of individual bank
groups (especially with regard to "home/host issues" such as data validation and in
the area of national discretion).
The time schedule for the implementation of the new rules also places considerable demands on
supervisory authorities. Because the new regulations implementing the EC Directive have not been
issued yet, banks are not to be permitted to calculate tier capital requirements using the current and
future rules in parallel.
Discussion
In articles, new or other public origins we can read very often that the New Capital Accord take up
and amends the Basel Capital Accord. I take it that it could be relatively misleading formulization
for unfamiliar people.
The Basel Capital Accord made the first imaginary step towards banking supervisions harmoniza-
tion. For the first time we could hear of minimal capital adequacy for a credit risk and later for a
market risk too. There was only one method of risk measurement methodologies.
The New Basel Capital Accord is focused on providing more sensitive and accurate risk measure-
ment. It induces credit financial institutions to enhance their risk management abilities. Unlike
Basel II, it gives more comprehensive approach and the flexible options for measuring risks and
includes operational risk. For operational risk the first pillar offers a wider range of risk measure-
ment methodologies, including banks´ own internal models, qualifying criteria etc. I think it is
necessary to cover up operational risk. But it is very hard to find the way of measurement and con-
trol of the risk.
The New Basel Capital Accord accordingly includes three pillars. The first pillar contains mini-
mum capital requirements for a credit, market and operational risk. The second pillar covers su-
pervisory review process, and the third one contains market discipline. For the second and third
pillars we could not talk of taking up and amending the Basel Capital Accord.
Table 2 takes down important changes and basic differences between the Capital Accord and the
New Capital Accord.
Table 2
Basic differences between the Capital Accord and the New Capital Accord
Basel I Basel II
1. Banking Supervision Centred on capital adequacy Three pillars of Banking Supervision
2. Capital requirements For credit and markets risk For credit, markets and operational risk
3. Setting capital requirements One method only More than one method
4. Risk weights (and height of
capital requirements for a credit
risk)
Dependence on client type
and independence from
endured risk
Dependence on riskiness of client (it is
inferred from external rating by
standardised method, and from internal
rating by IRB methods)
5. Risk measurement
methodologies – banks´ own
internal models and qualifying
criteria
By market risk only
By market risk, credit and operational
risk too
6. Administrative costs Low costs High costs
7. Motivation to risk management
quality
Banks are not motivated
Banks are motivated to risk
management quality, they can reach
for lower capital requirements
Banks and Bank Systems / Volume 2, Issue 2, 2007
20
The table shows there are significant differences between Basel I and Basel II. The New Basel
Capital Accord is more emphasis on banks´ own internal methodologies, supervisory review and
market discipline. It is possible to tell advantages and disadvantages the New Basel Capital Ac-
cord.
The CNB and the Czech Banking Association have cooperated to implement Basel II. On May 21
2007, a new framework was published. The new framework comes into force on July 1 2007 and
implements the New Capital Accord taking into account the EC Directives. In principle the CNB
respects opinion of the Basel Committee on Banking Supervision, or more precisely European
Commission.
Banks in the Czech Republic knew of the new rules preparation. They had enough information on
the basic principles of Basel II and on-coming changes. Banking management has been trained by
the CNB. Banks prepared their systems in advance. Because of the facts I think the new frame-
work is not surprise to banks and will not be the cause of their difficulties. In this respect the new
framework shall have no radical impact on banks. But on all accounts I have taken the view the
Czech National Banking system will be more transparent and safer for depositors, stakeholders
and banks too.
Conclusion
Basel Capital Accord established a risk measurement framework with a minimum capital standard
of 8% and 5 risk classes. This framework proved competent. Because of further development of
financial markets, introduction of new financial products and emergence of sophisticated risk
management techniques, Basel I leaved off performing its purpose and it was necessary to find out
more sufficient framework.
Contribution of Basel II is more refined scale of risk classes, multiple options for calculation
minimum capital requirements and introduction of a capital charge for operational risk.
Table 3
Minimum capital ratio calculation
Total capital 8 %
Risk-weighted assets for credit, operational and market risk
Table 3 shows a basic minimum capital ratio calculation. An item “credit risk” is changed by Basel
II, “operational risk” item is new, and items “total capital” and “8%” stand similar.
The other difference between Basel II and Basel I is three pillars approach for establishment of
required capital:
Pillar 1 – minimum capital requirements (Calculation of risk weighed assets for credit risk, opera-
tional risk and market risk subject to strict minimum requirements);
Pillar 2 – supervisory review (A bank-wide, integrated risk governance model has to be intro-
duced, with a more a more comprehensive supervisory review to assess alignment of the bank's
capital with its risk profile);
Pillar 3 – Market discipline (More extensive disclosure requirements to provide more transparency
to stakeholders with respect to a bank's risk profile).
The objective of the capital requirements is to have in place a comprehensive and risk-sensitive
framework and to foster enhanced risk management amongst financial institutions. This will
Banks and Bank Systems / Volume 2, Issue 2, 2007
21
maximise the effectiveness of the capital rules in ensuring continuing financial stability, maintain-
ing confidence in financial institutions and protecting consumers.
The implementation of Basel II will accelerate convergence of supervisory practices. Basel II in-
tended to facilitate the establishment of effective systems of management, especially in the area of
credit and operational risk.
The CNB agrees with the proposed revisions to these Directives. The new rules should enhance
risk management by credit institutions and investment firms and improve their capital coverage. It
is possible to expect that the new framework will result in greater market transparency and bolster
overall stability in financial markets.
References
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other prudential rules on a solo basis.
11. Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating
to the taking up and pursuit of the business of credit institutions (recast version of Directive
2000/12/EC).
12. Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the
capital adequacy of investment firms and credit institutions (recast version of Directive
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16. http://www.europa.eu.int (portal of the European union).
Banks and Bank Systems / Volume 2, Issue 2, 2007
© Matthias Menke, Dirk Schiereck, 2007.
22
PRIVATE EQUITY INVESTMENTS
IN THE BANKING INDUSTRY – THE CASE OF LONE
STAR AND KOREA EXCHANGE BANK
Matthias Menke*, Dirk Schiereck**
Abstract
This paper examines success factors for the value creation of a private equity fund investing in a
bank – based on Lone Star’s acquisition of Korea Exchange Bank in 2003. Despite the value de-
struction mergers and acquisitions in the banking industry have shown, Lone Star turned the bank
successfully around. Considering regulatory restrictions and limitations to lever a transaction, the
private equity fund also capitalized on the recovery of financial markets after the financial crisis in
Asia during the late nineties.
With regard to these circumstances success factors of the performed value creation are evaluated
by the case study approach.
Key words: Private Equity, Bank, Acquisition, Value Creation, South Korea.
JEL Classification: G14, G21, G24, G34.
Introduction
Are private equity funds able to create shareholder value in the banking industry? Considering the
research on mergers and acquisitions (M&A) with regard to banking and private equity, the field
of (financial) industry-specific private equity investments remains largely unexplored. Existing
studies about M&A transactions in the banking industry have shown certain value destruction.
Negative value impacts for banks as acquirers question the value-creation potential for other inves-
tors, in particular private equity funds. Compared to transactions in other industries, the acquisition
of a financial institution has certain particularities. Besides regulatory restrictions and limitations
to lever a transaction due to capital adequacy, the generation of cost synergies is challenging. In
the case of an acquisition of a bank, public opinion plays also a role in the success of the transac-
tion – especially if the bank is listed on a stock exchange. Furthermore, given the narrow invest-
ment period of a fund, the financial sponsor will already need to have factored in measures to pre-
pare a successful exit to reach a required internal rate of return. Taking this background into con-
sideration, we analyze the value creation of a financial buyer through the acquisition of a bank.
The analysis is performed by the case study approach.
As an immediate reaction to the financial crisis in Asia during the late nineties, which also hit the
Republic of Korea (Korea), the Asian country received a support package of USD 57 billion from
the International Monetary Fund (IMF) in December 1997. The IMF provided these funds under
the condition that structural reforms would have to be initiated in the Korean economy1. As a result
of the initiated measures banking business in Korea became attractive for national and interna-
tional players2. Besides the geographic distinction of acquiring companies, strategic (e.g., Citi-
group and Standard Chartered) and financial players (e.g., Lone Star, Newbridge Capital, and The
Carlyle Group) entered the Korean market through the acquisitions of banks to participate in the
positive economic developments.
* European Business School, International University, Germany.
** European Business School, International University, Germany.
1 See Ahn, Choong Yong (2001), p. 1.
2 “[…] Korea has achieved an annual growth rate of 5.5 per cent during the past five years […].” OECD (2005), p. 11.
Banks and Bank Systems / Volume 2, Issue 2, 2007
23
Performing one of the largest M&A transactions in the Korean market in the aftermath of the 1997
crisis, Lone Star acquired a majority stake in Korea Exchange Bank (KEB) in 2003. The private
equity fund intended to sell its stake in 2006. Due to the ongoing allegations by Korean authorities
concerning irregularities and potential fraud in connection with Lone Star’s acquisition, the in-
tended sale of Lone Star’s KEB stake to Kookmin Bank had been cancelled by the private equity
fund. Despite these allegations, the following case study investigates the value creation by Lone
Star1. Also, key factors for a successful acquisition of a bank by a private equity fund – including
turnaround measures – are exemplarily discussed.
Besides the described developments in Korea and the resulting transactions in the financial indus-
try, there are similar transactions (e.g., in Japan and Germany) where financial investors acquired
banks, initiated and implemented turnaround measures, or already exited their investment2.
The rest of the paper is organized as follows. A brief overview of the theoretical background and
current research will be presented. Taking the regulatory status of the selected transaction into
consideration, banks as investment objects as well as economic and banking developments in Ko-
rea will be discussed. Key factors of the transaction and the following turnaround measures will be
elaborated upon to provide a basis for the empirical analysis. Therefore, the strategic rationale, the
execution of the transaction, and post-acquisition measures will be analyzed. The latter factors and
the results of the empirical analysis serve as a foundation for the concluding discussion of key fac-
tors for a successful acquisition.
Theoretical Background and Current Research
The private equity market represents a financial source for enterprises. This organized market can
be described as follows: “[…] professionally managed equity investments in [registered and] un-
registered securities of private and public companies. An equity investment is any form of security
that has an equity participation feature. […]”3. Within its investments, financial investors focus on
the acquisition of majority shareholdings which are in late financing rounds.
The research about private equity has been intensified in the last decade. Studies about tasks, func-
tions, fundraising, organization, value creation, and performance analysis, or publications concern-
ing financing stages and exits with geographical or industry-specific focus have been performed4.
Also statistics about the private equity investments in the financial industry will be shown sepa-
rately (e.g., European Venture Capital Association). Besides the performed research and statistics,
no further breakdown of sub-industries (such as banking industry) will be provided.
Worldwide, banks are subject to regulatory conditions which refer to the contribution of services
as well as to the associated refinancing of their business. Apart from national laws, international
1 On November 23, 2006, Lone Star announced the cancellation of the purchase and sales agreement between the private
equity fund and Kookmin. Shortly after that announcement, the Korean prosecutors revitalized its claim on December 7,
2006, and prepared a lawsuit against Lone Star. Due to the ongoing allegations, no final judgment can be made at this time.
Therefore, the selected procedure will be pursued without consideration of the described allegations. See Irvine, Steven
(2006), pp. 1-5, and Lone Star (2006), pp. 3-8.
2 Examples for transactions in Japan are engagements of Lone Star in Tokyo Star Bank and First Credit Corp., Cerberus’s
investment in Aozora Bank, and Ripplewood’s acquisition of Shinsei Bank. See Securities Data Corporation (SDC) Data-
base, Thomson Financial.
3 Fenn, George. W./Liang, Nellie/Prowse S. (1995), p. 2. This definition of private equity and the market needs to be ex-
tended, due to the fact that the targeted bank was listed at the Korean Stock Exchange.
4 Considering research with an industry-specific focus, studies explored different industries: high-technology, biotechnol-
ogy, software, services, telecommunication and networking, medical equipment, and computer hardware. Exemplarily, the
following studies can be named; Armstrong et al. (2005) analyze the relationship between “Venture-Backed Private Equity
Valuation and Financial Statement” and explore six of the listed industries. Wu (2001) examines a dataset within the high-
technology industry between 1986 and 1997, focusing on the “Choice between Public and Private Equity Offerings”.
Within his study about “The Value Relevance of Financial Statements in Private Equity Markets,” Hand (2004) analyzed
US biotechnology firms. Loos (2006) analyses the value creation of financial investors through their investments in Europe
and the United States based on a dataset of more than 3,000 leveraged buyout transaction from various industries.
Banks and Bank Systems / Volume 2, Issue 2, 2007
24
sets of rules have been extended in recent years (such as Basel II). For example, the specified 8%
minimum capital requirement of Basel II forces banks to determine the amount of regulatory capi-
tal for unexpected losses of their uncovered loans in more detail. In addition to the changing regu-
latory environment, banks face economic concerns and the need for restructuring in light of na-
tional or international developments. According to Beitel et al. (2003), technological change, in-
creasing demand of shareholder value by shareholders, currency alignments, as well as globaliza-
tion and increasing competition can be exemplarily named for these developments.
Following these remarks, it is essential for private equity funds, by investing in banks, that the new
regulations will be adopted, that the bank has sufficient regulatory capital, and a loan portfolio
with a high portion of a qualitative customer base; there should also be the opportunity to settle the
bad loan portfolio.
Post-crisis Economic and Regulatory Developments in Korea’s Financial Sector
The Korean government outlined the following strategic cornerstones to implement the requested
IMF restructuring of the financial sector1: 1) Provision of liquidity support, time-bound deposit
guarantees, and intervention in important nonviable institutions to quickly restore the stability of
the financial system; 2) Intervention in nonviable institutions, acquisition of non-performing loan
portfolios, and usage of government funds for recapitalization as restructuring measures to revital-
ize the financial system; 3) Adoption of international regulatory and supervisory best practices to
strengthen the existing legal framework; 4) Implementation of measures to reduce the dependency
of corporate distress and financial institutions exposed to the credits.
In order to build up trust and to ensure the operability of the financial systems, the government
guaranteed all deposits of financial institutions until end of 2000 and negotiated prolongations for
currency debts with foreign banks. In addition to that, foreign investors were also allowed to own
commercial bank shares. To adopt best international regulatory practices, the Korean supervision
consolidated the independent authority Financial Supervisory Commission (FSC) and the execu-
tive agency Financial Supervisory Service (FSS). Both are responsible for granting and revoking
banking licenses and are the regulatory authorities for banking and non-banking financial institu-
tions. Since 1998, foreigners have been able to serve as executives for Korean banks. As an addi-
tional measure to strengthen the corporate governance of banks, non-executive committees of out-
side directors have been introduced in banks. In 2000 the chaebol2 companies faced financial diffi-
culties again. Therefore, the regulatory authorities had to revitalize their restructuring activities3.
To accelerate changes and economic restructurings, the government asked foreign investors to
participate.
Due to Korea’s reform efforts – especially in the financial sector where “[…] the restoration of
healthy bank balance sheets has strengthened the transmission of monetary easing to the econ-
omy”4 – the positive economic development could already be seen in the following years. At the
beginning of 2003, the economic outlook for 2003 and 2004 was positive – projecting an output
growth of 5.5 to 6%. In addition to these growth expectations, Korea’s Central Bank retained its
medium term inflation target of 2.5 to 3.5 %. While inflation was in that expected range in 2002,
the policy interest rate could be increased by 0.25% from its record low of 4%. This was the eco-
nomic environment Lone Star was facing in early 2003 while considering the acquisition of a ma-
jority stake in KEB.
1 See Chopra Ajai et al. (2001), p. 36, and Dymski, Gary (2004), pp. 17-19.
2 “A chaebol is a Korean conglomerate where various firms are loosely linked through their shareholders. There is gener-
ally no holding structure, at least for the group as a whole.” Delhaise, Phillipe F. (1998), p. 46.
3 By the end of 2000, the Korean government had spent approximately USD 106,482.2 million to support the restructuring
of the financial sector. See Ahn, Choong Yong (2001), p. 30.
4 OECD (2003), p. 9.
Banks and Bank Systems / Volume 2, Issue 2, 2007
25
Selection of the Transaction
The acquisition of 51% of KEB by Lone Star in August 2003 corresponds to a value of USD
1,171.7 million and was one of the largest M&A transactions in the Korean market in the after-
math of the 1997 crisis. The investment in KEB, which had been publicly listed since 1994 and
was the fifth largest Korean bank representing 6.1% of Korea’s total bank assets, was also the big-
gest overseas investment in Korea’s financial industry. The public listing of KEB enables an
analysis based on publicly available data. In addition to the deal size, it is one of the landmark
transactions in the private equity industry focusing on the acquisition of banks.
Annual figures from 2003 to 2005 are available for the analysis of balance sheets as well as profit
and loss data. Also, the capital market data will be used for the analysis of the value creation.
In accordance with other case studies prepared in the field of banking M&A (e.g., Calomiris and
Karceski, 1998), the transaction partners and their motives will be described in an initial step. Fol-
lowing that description, the investigation and turnaround measures will be discussed in detail to
serve as a basis for the empirical analysis.
Description of Korea Exchange Bank
The following description of KEB covers the economic base, reorganization plans, and organiza-
tional issues as well as an overview about the shareholder structure. With total assets of USD
68,604.2 million by the end of 2002, KEB was the fifth largest Korean nationwide bank. At that
time, KEB had a common equity of USD 1,180.0 million and a market capitalization of USD
713.7 million.
The Asian financial crisis in the late nineties also hit the KEB; a number of bankruptcies of corpo-
rate clients resulted in an increase of loan loss provision and subsequently to the disposal of non-
performing assets. As an immediate action, a corporate restructuring program was initiated and led
to a reduction of the workforce and a subsidiary restructuring. The management additionally initi-
ated a “five actions plan”1 to prepare KEB for the future: 1) To improve the credit process by the
adoption of loan screening techniques – and therefore to reduce the bad debt amount – KEB set up
an internal “Bad Bank” division; 2) Measures for the enhancement of transparency and responsi-
bility were introduced. Therefore, the bank reorganized its Board of Directors, enabling non-
executive directors and working committee members to influence the new corporate governance
structure; 3) KEB switched from a function- to a customer-oriented organization through the im-
plementation of a business unit system; 4) The bank set up a new risk management system; 5) The
management initiated a project to reorganize the information and technology infrastructure.
From 1998 to 2000, several measures to recapitalize the bank had been implemented. As a foreign
bank and strategic investor, Commerzbank AG (Commerzbank) participated in these capital meas-
ures. The German bank injected capital USD 290.7 million (in 1998), USD 228.1 million (in
1999), and USD 166.0 million (in 2000) and therefore increased its shareholding to 32.55%.
KEB’s merger with its subsidiary, Korea International Merchant Bank, in January 1999 led to an
increase of KEB’s paid in capital of USD 1,280 million. Following the five-step plan initiated in
1998, KEB presented in 2000 an updated turnaround plan to the FSA and received the approval to
continue with its business operations independently. Optimizing the capital base, reducing non-
performing loans, and raising the profitability were the core elements of the restructuring plan ap-
proved by the FSA. By the end of 2002, KEB had the vision to become the “First Choice Bank for
Customers, Shareholders, and Employees”2. In light of the poor performance in 2002 – net income
decreased significantly in 2002 to USD 56.4 million from USD 241.5 million in 2001 – the man-
agement focused on the realignment of its business strategies and strengthening internal capabili-
ties of KEB. Therefore, services in retail banking, corporate banking, global banking, foreign ex-
1 See KEB (1999), pp. 3-5.
2 KEB (2003), p. 22.
Banks and Bank Systems / Volume 2, Issue 2, 2007
26
change, trade financing, and risk management, as well as products for its broad national and inter-
national private and corporate customer base, emerged from the selected organizational structure.
To operate the business, the Executive Committee and its subcommittees led 9 Business Units, 20
Banking Groups, 34 Divisions, and 4 Temporary Divisions (Marketing, Loan, Personnel, Risk
Management Steering, and Capital Markets).
On December 31, 2002, KEB’s shareholder structure was as follows: Commerzbank (32.55%),
Bank of Korea (10.67%), Export-Import Bank of Korea (32.50%), and other shareholders
(24.28%). Bank of Korea and Export-Import Bank were government-owned institutions. Com-
merzbank as well as the Korean government, were dependent on each other. Neither the govern-
ment nor Commerzbank had a controlling stake that could be divested or alternatively used with-
out the other’s permission or future decision support.
Due to the deteriorating capital position of KEB in early 2003 and the unwillingness of KEB’s
major shareholders to inject additional capital, they endorsed the active search for an external in-
vestor.
Description of Lone Star
Until May 2006 Lone Star had invested in almost 50 separate investments in Korea worth USD 5
billion. The private equity fund performed its first engagement in the Asian country in 1998.
Before the acquisition of KEB, Lone Star was an active player in the acquisition of non-
performing loan portfolios, real estate investments, and distressed banks (only in Japan) in the
Japanese and Korean markets. As a specialized private equity investor with entrepreneurial focus
that invests in distressed real estate, distressed debt, distressed companies and distressed banks,
Lone Star acquired bad debt portfolios and real estate in Korea (e.g., a loan portfolio of KEB
Credit Services Co. Ltd. [KEBCS] after an extensive due diligence).
Besides, Korea Lone Star is mainly active in the United States, Canada, Japan and Germany. Until
the end of 2005, Lone Star had raised USD 13.25 billion for its six funds since its founding and
realized annual returns between 9 and 28% for its first five funds1.
Strategic Rationale and Description for the Transaction
As briefly described above, KEB was facing financial challenges in 2003 and the majority of exist-
ing shareholders were not willing to invest additional money. At that time Lone Star had analyzed
KEB and its subsidiaries for months; it was their intention to turn the bank around, increase organ-
izational efficiency, and pursue the best available exit option following the economic recovery of
the bank and the Korean economy. In addition to financial engineering measures were opportuni-
ties to increase the efficiency of the existing and invested capital. The governance structure in
terms of the board and the shareholding structure, also provided potential for further optimization.
“Lone Star was the only realistic potential buyer at that time willing to provide the necessary capi-
tal injection of about USD 750 million.”2 On August 27, 2003, Lone Star Fund (LSF) IV signed a
Memorandum of Understanding with KEB regarding a Share Subscription Agreement to acquire
51%; a new issue of shares served as a capital injection to recapitalize KEB. Also, as part of the
transaction, Commerzbank and Export-Import Bank of Korea sold shares to Lone Star. The right
for Lone Star to acquire further shares from the two major shareholders until October 31, 2006,
was granted by a call option3. The Korean regulatory authorities approved the transaction as of
September 2003, but it was requested by the FSC and the FSS to pre-notify the regulatory authori-
1 See Effinger, Anthony/Yu, Hui-yong (2005), pp. 40-42.
2 Appendix B of Lone Star (2006).
3 On June 2, 2006 Lone Star Fund exercised its option to raise its interest to 64.63% from 50.53%. See SDC Database,
Thomson Financial.
Banks and Bank Systems / Volume 2, Issue 2, 2007
27
ties in advance of the execution of the options1. Additional key terms of the acquisition were the
agreement of a lock-up period for two years after closing, no put back-option of non-performing
loans, as well as the right for Lone Star to nominate seven of the ten members of the Board of Di-
rectors.
After the execution of the transaction, the shareholder structure was as follows: LSF-KEB Hold-
ings (51.00%), Commerzbank (14.75%), Bank of Korea (14.00%), Export-Import Bank of Korea
(6.18%), and other shareholders (14.07%). Due to the financial situation of KEB, Lone Star could
not expect any dividend payments at short notice, but had to focus on the immediate implementa-
tion of turnaround measures.
Post-acquisition Measures
Management and Corporate Governance
After the acquisition by Lone Star, a new management team, including a new Board of Directors,
was implemented within KEB. This team was experienced and operations-focused while defining
a core-competency-focused strategy.
Immediately after its implementation, the management team initiated corporate restructuring
measures. Within a month after the closing (October 30, 2003) of the Lone Star’s KEB acquisition,
the Board of Directors had decided to merge KEB with its subsidiary KEBCS. The latter offered a
wide range of credit card services. KEBCS was established by a spin-off. KEB’s credit card opera-
tion was separated in 1988. The encountered growth path after the public offering in 2001 slowed
down sharply in 2002 and early 2003. A shortfall of receivables and sales growth, in combination
with credit losses and high delinquency ratios, forced the management to initiate turnaround meas-
ures for KEB’s subsidiary2. The merger of KEBCS and KEB became effective on February 28,
2004, and diluted Lone Star’s shareholding to 50.53%. Besides the reduction of complexity and
alignment of the governance structure, reduced funding costs – through an improved rating for
KEBCS – could be exemplarily named as reasons behind the merger. By taking full control, addi-
tionally, the credit card exposure could be stabilized and controlled. The corporate restructuring of
KEB also took place in Europe and the United States.
Strategic and Operational Developments
The new management team adopted immediately global management standards and a new man-
agement philosophy to enhance the competitiveness of KEB. Changing the organizational struc-
ture as of December 2002, KEB reshuffled its organizational frontline structure in profit centers to
the divisions Global Corporate Banking, Retail Banking, and Credit Card. In line with this reshap-
ing was the strategic focus on small and medium enterprises, wealthy clients, as well as customers
with deposit accounts and no KEB credit cards in its Credit Card Division. To support these divi-
sions, three operational business groups were set up in May 2004 as cost centers: Credit Manage-
ment-, Service Delivery-, and Information Technology Group. Since then, Risk-, Financial-, Hu-
man Resources Management, and Corporate Communications serve as support functions for the
banking business divisions and operational groups. In addition, a new structure performance
measurement system was introduced.
In order to reduce bad assets, KEB improved its loan quality through credit control processes and
improved the customer classification in the Global Corporate Bank division by industry type. In
early 2004, KEB initiated measures to improve the cost efficiency. The organizational restructur-
ing of the headquarters was completed in June 2004. Caused by the peaked Information Technol-
ogy (IT) depreciation charges in 2003, a focus within the initial restructuring phase was on IT
spending. Also at that time, a staff realignment and branch remodeling program had been started.
In contrast to the stated initiatives, short-term effects could not be expected on the profit-and-loss
1 See FSS (2003), p. 4, and KEB (2006), p. 97.
2 See KEB (2006), p. 144, and KEBCS (2003), pp. 26-41.
Banks and Bank Systems / Volume 2, Issue 2, 2007
28
account. In opposition to that, a focus on trading and settlement operations, as well as reengineer-
ing banking operations and a reallocation of staff, led to early positive results.
Based on this initial success in the first full accounting year of Lone Star’s ownership, the man-
agement focus for 2005 was as follows1: 1) Build marketing excellence for targeted customer seg-
ments by trade-oriented corporate banking, affluent retail banking, and focus on fixed income and
international settlement as well as credit card business; 2) Enhancement of KEB image; 3) Re-
finement of credit reviews and deal-structuring capabilities; 4) Maximization of capital efficiency
and building up of the capital base; 5) Continuous focus on process and cost efficiency (by being
not the biggest but the best by implementing smarter, faster, and more efficient procedures); 6)
Expansion on global standard Human Resource improvement systems.
Balance Sheet Restructuring and Recapitalization
Due to dependencies on the Korean chaebol and the economic turmoil as a result of the Asian cri-
sis in the late nineties, KEB faced a large amount of corporate bad debt on its balance sheet. After
the initial recovery of the corporate sector starting in 2002, the private household sector lacked
liquidity and, therefore, the bad debts in this sector increased as well2. Already initiated measures
had been further enforced after Lone Star’s engagement. The continuation of prudent credit man-
agement (e.g., Hynix Semiconductor Inc.) and the sale of non-performing loan-portfolios as well
as new loans led to the lowest amount of loan loss reserves since the end of the Asian crisis.
By the end of 2003, KEB had also restructured its debt by swapping the maturity from short-term
to long-term, taking advantage of the low interest level in Korea at that time. Lone Star’s capital
injection of approximately USD 900 million covered the losses in 2003 and increased sharehold-
ers’ equity. The completion of the merger with KEBCS caused an increase “in debentures amount-
ing to” USD 1,932.1 million “converted from the merger”3. Also, USD 784.4 million of the bank’s
capital was used to complete the merger. The measures to restructure the balance sheet revoked an
improved Bank for International Settlement (BIS) capital adequacy ratio (BIS Ratio). The highest
net income in KEB’s history of USD 2,056.4 million was the primarily driver for the improvement
of the BIS ratio by the end of 2005 and also represented the best performance of a nationwide bank
in Korea (13.68%).
The rating agencies – Moody’s Investor Service (Moody’s), Standard and Poors (S&P), and Fitch
Ratings (Fitch) – acknowledged the refinancing efforts by KEB and lifted their ratings in
2005/2006 (Moody’s: Baa2/P-2; S&P: BBB/A-2; Fitch: BBB+/F2).
Through the execution of the described measures, KEB became a profitable bank. In order to ex-
amine the impact of Lone Star on the shareholder value creation, share-price developments, its
balance sheet figures, as well as a comparison with its competitors, an empirical analysis will be
performed.
Empirical Analysis
Description of the Research Method and Definitions
Initially, the short-term and long-term value creation will be analyzed in an event study. Within the
following benchmark analysis, it will also be explored if KEB shows a higher value creation than
other banks. Also, as part of the empirical analysis the long-term performance of fundamental data
will be analyzed.
Following the definition of the event, the event window will be defined. The temporal deferment is
necessary, in order to determine the expected net yield for an estimation period and for the event
window, which includes periods before and after the event.
1 KEB (2005), p. 29.
2 See Dymski, Gary (2004), p. 19.
3 KEB (2005a), p. 34.
Banks and Bank Systems / Volume 2, Issue 2, 2007
29
August 27, 2003, is defined as event day (t = 0). Based on t the event window will be expanded to
40 trading days before and 40 trading days after the event day (T = [-40,+40], while t ε T).
Through the selection of the trading days before and after t, alternative events distorting the results
should be avoided. A further detailed view takes place via the analysis of intervals within the
originally selected window from T.
To analyze the impact of the announcement that Lone Star acquires a KEB stake, daily stock re-
turns are used (Total Return Index – TRI). Within these returns, dividend payments are considered.
They are also adjusted by corporate actions.
Market-adjusted models assume a linear relationship between the return of any security and the
return of the market portfolio. As this is a commonly used model, the following formula will be
used to calculate the expected return on security i in period t (Rit
*)1.
Rit
* = αi + βiRmt + εit (1)
Thereby, αi and βi are estimated over the defined estimation period by an ordinary least squares
(OLS) regression of the respective stock versus the national banking index in Korea (Rm). The un-
derlying assumption for the calculation of formula (1) is a linear relationship between the return of
security i and the overall market Rm. Based on the expected return (Rit
*) and the return on security i
in period t (Rit), the abnormal return (ARit) is calculated as the difference between Rit and Rit
* and
therefore the value creation. The calculated daily abnormal returns will be summarized to quote
the cumulated return for the respective intervals.
Short-term Analysis
In the following short-term analysis, the described methodology is applied on the defined event
day. Table 1 provides an overview of the abnormal returns within the event window for KEB and
its national competitors Kookmin Bank and Shinhan Financial Group.
Table 1
Short-term abnormal returns of Korean banks
Abnormal return in % Abnormal return in %
Intervals
Korea Ex-
change
Bank
Kookmin
Bank
Shinhan
Financial
Group Intervals
Korea Ex-
change
Bank
Kookmin
Bank
Shinhan
Financial
Group
[-40;0]
[-35;0]
[-30;0]
[-25;0]
[-20;0]
[-15;0]
[-10;0]
[-5;0]
[-2;0]
[-1;0]
[0]
2.33
4.45
10.83
11.53
9.71
10.97
10.19
13.31
-1.66
1.68
3.63
-4.28
-5.44
-6.24
-5.68
-6.37
-4.63
-2.45
-1.73
-1.67
-1.86
-1.17
7.23
6.65
-0.28
-1.86
-5.54
-4.24
-7.92
-7.28
-3.00
-1.62
-0.56
[-40;+40]
[-35;+35]
[-30;+30]
[-25;+25]
[-20;+20]
[-15;+15]
[-10;+10]
[-5;+5]
[-2;+2]
[-1;+1]
13.00
17.68
23.62
16.67
28.99
15.42
24.42
23.27
14.31
15.36
-9.46
-10.16
-9.85
-7.58
-9.72
-5.42
-3.94
-0.44
-2.78
-3.93
11.99
7.11
5.45
5.53
2.16
5.49
2.16
-6.78
-3.64
-2.55
On the event day, KEB’s stock price increased by more than 3.6%. Also, in all other intervals
within the event window – except for two – KEB had the highest value creation. This result corre-
1 Peterson, P. (1989), pp. 39-55.
Banks and Bank Systems / Volume 2, Issue 2, 2007
30
sponds with M&A banking research, where a positive value impact on the acquisition target can be
recognized. In addition, the impact of Lone Star as an experienced investor with financial strength
also had a positive impact on the value creation. Due to KEB’s described situation, its value crea-
tion could be interpreted as a reaction to Lone Star’s investment and the expectation of a success-
ful turnaround.
Even though a positive impact of Lone Star’s engagement can be seen, the presented analysis pro-
vides only a short-term view, and the long-term value creation needs to be analyzed.
Long-term Analysis of Capital Market and Fundamental Data
The long-term value creation of KEB’s share-price development is analyzed on daily stock returns
in accordance with the short-term analysis. In addition to the presented procedure, extensions to
consider the extended time period had to be made: 1) Extension of the time frame to 39 months in
advance and 36 months after the months of the announcement of Lone Star’s KEB acquisition; 2)
Setup of a benchmark portfolio. Based on these extensions, the long-term abnormal returns are
calculated. Thereby value creation in the subsequent three years of t is calculated in the intervals
([0-12 months], [0-24 months], [0-36 months]). For the abnormal returns, which are also the dif-
ference between daily and expected returns, αi and βi were determined by an OLS regression. For
this regression 36 months, starting three months preceding August 2003, serve as an estimation
period. With these results, the expected return is calculated.
Cumulated daily abnormal returns are presented in Table 2. It is recognizable that KEB outper-
formed its local competitors within the first 36 months after the transaction.
Table 2
Long-term abnormal returns of Korean banks
Abnormal return in %
Intervals Korea Exchange Bank Kookmin Bank Shinhan Financial Group
[0-12 months]
[0-24 months]
[0-36 months]
34.82
51.00
23.71
-45.97
-74.11
-97.54
8.85
9.60
-2.58
Despite KEB’s success, the presented long-term event study approach does not cover all particu-
larities. Exemplarily deviations in the calculation of long-term abnormal return can be stated.
Therefore, the benchmark approach is used to apply an acknowledged research approach.
Out of Thomson Financials Datastream Banking Index Asia, five benchmark companies were se-
lected by comparables (market capitalization as measurement for the size and the expected return;
market-to-book ratio to evaluate the return by calculating the market value in relation to the book-
value as measurement for the expected growth). Adopting these criteria, Towa Bank, Fukui Bank,
Awa Bank, Metropolitan Bank and Trust Company, and RHB Capital were selected. Due date for
the selection criteria was the last year-end balance sheet date (December 31, 2002) before Lone
Star’s acquisition.
The return for KEB and the five selected banks was calculated for the same intervals like in the
long-term event study. By subtraction of the respective average of the five banks from KEB’s per-
formance, the abnormal return of KEB is determined. The results are presented in Table 3.
Banks and Bank Systems / Volume 2, Issue 2, 2007
31
Table 3
Long-term abnormal return calculated with benchmark approach
Intervals
Return
Korea Exchange Bank in % Average benchmark in %
Abnormal return
Korea Exchange Bank in %
[0-12 months]
[0-24 months]
[0-36 months]
26.40
103.18
118.16
-7.06
4.57
14.03
33.47
98.61
104.13
In all three intervals KEB outperformed the average benchmark in the respective periods. Due to
the adjustments of the cons of the previously discussed approaches, as well as the clear results of
the value creation initiated by Lone Star in KEB, the latter approach can be qualified as the best in
the context of this paper. To also evaluate the described qualitative measures and the calculated
value creation based on share-price developments, the fundamental data is analyzed.
Since Lone Star’s engagement, the implementation of financial and operating measures can be
acknowledged. Considering an increase of total assets in 2005 after its initial “balance sheet shake-
up” with significant reserves for loan losses in 2003 and a decline in 2004, the net loans grew
slightly in 2005; in comparison with the increase of net-loans in the years before Lone Star’s en-
gagement, this considerable generation of new credit business can be accounted to the new credit
and risk processes. KEB’s balance sheet restructuring as well as an optimized “interest manage-
ment” caused an increased net interest margin. As one important driver for KEB’s performance
improvement, the interest income also increased the retained earnings. This can be acknowledged
in Tables 4 and 5.
Table 4
Reserves for loan losses and net interest margin of Korean banks
Reserves for loan losses as % of
Total loans Net interest margin in %
Banks 2002 2003 2004 2005 2002 2003 2004 2005
Korea Exchange Bank
Kookmin Bank
Shinhan Financial Group
2.56
2.39
1.71
5.18
2.66
2.88
2.00
2.25
1.95
1.38
1.78
1.67
2.19
3.73
2.36
2.76
3.89
2.18
2.70
3.33
2.52
3.41
3.99
3.22
The growth of the latter earnings increased the return on average equity (RoAE) of KEB signifi-
cantly. The resulting BIS Ratio of 13.68% by the end of 2005 is the highest a Korean bank has
reached within the last years (see Table 5).
Table 5
Return on average equity and BIS Ratio of Korean banks
RoAE in % BIS Ratio in %
Banks 2002 2003 2004 2005 2002 2003 2004 2005
Korea Exchange Bank
Kookmin Bank
Shinhan Financial Group
3.00
13.33
17.83
-42.73
-7.99
6.11
20.41
6.25
14.11
44.84
20.78
18.17
9.31
10.41
10.92
9.32
9.81
10.49
9.47
11.14
11.94
13.68
12.84
12.27
This brief retrospective review of the financial performance also represents clear indications for
the success of the turnaround initiated by Lone Star, but focuses on past performance. Therefore,
Banks and Bank Systems / Volume 2, Issue 2, 2007
32
the latter approach can only be an indicative approach to support the calculated value creation by
the benchmark approach. A summary will be provided in the following to conclude the key drivers
for success.
Determination of Success Factors and Evaluation of the Presented Analysis
The presented case study approach provides an in-depth view of the measures and implications
initiated and performed by the financial investor. Even without the exit of the US fund, various
key factors for the successful turnaround can be named.
Lone Star’s profound knowledge of the Korean market, as well as its long-term experience in the
financial industry, served as a catalyst for the success of KEB’s turnaround. In addition, the fol-
lowing criteria can be identified as critical success factors for the performed value creation: 1)
Macroeconomic environment: The selection of a bank which was located and operating in a coun-
try with growth potential after an economic downturn was a key driver for Lone Star’s success.
Additionally the low interest rates in Korea and the regulatory reforms within the financial sector
enabled Lone Star to implement financing measures and to act in a stabilized economic environ-
ment; 2) Target selection, deal preparation, and execution: The extensive knowledge of the target
market served as an essential reason for the turnaround. Based on this and the negotiated key deal
terms – especially the acquisition of the majority shareholding and the ability to nominate key de-
cision makers – the private equity fund was able to initiate measures for enabling the turnaround;
3) Governance and corporate measures: The adoption of international management practices and
the execution of corporate measures, in addition to a stringent credit and risk management, were
essential to assign performance goals and to generate synergies of scope; 4) Financial reengineer-
ing program: Restructuring the balance sheet on the asset and liability side supported by the inter-
est level was a key in executing the new business strategy; 5) Business strategy: The clearly identi-
fied customer orientation was the basis for the extension of business with the existing customer
base and the acquisition of new clients. Additionally the focus on KEB’s core competencies, in
combination with achieved quality improvement, was an important factor for the success; 6) Hu-
man Resource measures: The reshuffling of the employee structure, in combination with and im-
plementation of an incentive system, was the basis for the cultural development. Even though each
of the listed factors has significant impact on KEB’s performance, the selected and implemented
mix of the measures is the essence of the success of Lone Star’s value creation.
The presented research results are based only on a single transaction. To verify these results, a
broader data sample should be analyzed. Even if there might be only a limited number of transac-
tions where a private equity fund invested in a regulated bank, the evidence of the results should
be supplied.
In addition, the conditions of the acquisition can be questioned. On the one hand, this transaction
was partially a government privatization and, therefore, represents an ownership change that rarely
happens in comparison to banking M&As and private equity investments in other industries. On
the other hand, therefore, the selection of competitors and selected benchmarks can be questioned.
Finally, a final judgment of the value creation performed by Lone Star cannot be ultimately made
due to the exit, which was not performed until the end of November 2006. Additionally, it needs to
be considered that Lone Star had negotiated favorable terms in its initial deal to restructure KEB
(e.g., board seats), but parts of the initiated and implemented measures required the approval and
know-how of the other majority shareholders as well and not only the selected Lone Star represen-
tatives.
Conclusion and Outlook
The objective of this case study was to analyze the value creation of a private equity fund in the
banking industry. The performed analysis clearly states the positive impact which Lone Star’s en-
gagement had for the performance of KEB. Being trapped in a regulated environment and, addi-
Banks and Bank Systems / Volume 2, Issue 2, 2007
33
tionally, continuously monitored by quasi-government shareholders, a significant portion of
KEB’s performance can be attributed to Lone Star. The selected approach provides a comprehen-
sive overview of the measures performed by Lone Star and the associated limitations the fund had
to deal with. Therefore, it fills the gap of the performed banking M&A and private-equity field
research. In order to extend the current research on banking and private equity, the presented case
study serves as a valuable addendum in named fields.
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Banks and Bank Systems / Volume 2, Issue 2, 2007
© Christophe J. Godlewski, 2007.
35
AN EMPIRICAL INVESTIGATION OF BANK
RISK-TAKING IN EMERGING MARKETS WITHIN
A PROSPECT THEORY FRAMEWORK. A NOTE1
Christophe J. Godlewski*
Abstract
The purpose of this note is to investigate the validity of some behavioral conjectures as alternative
explanations of bank risk-taking behavior. We especially focus on the different valuation of gains
and losses relative to a reference point and the changing attitude toward risk conditional on the
domain (gains vs. losses) features (Tversky and Kahneman, 1992). We follow a methodology
based on Fiegenbaum and Thomas (1988) and the Fishburn (1977) measure of risk, applied to a
sample of banks from emerging market economies. Results show that the Tversky and Kahneman
(1992) framework could provide an alternative explanation of risk-taking behavior in the banking
industry.
Key words: Cumulative Prospect Theory, bank risk taking, emerging market economies.
JEL Classification: C12, C31, D81, F39, G21.
1. Introduction
In order to investigate the deviations of agents from traditional finance models, relying on perfect
information and coherent beliefs, behavioral finance models based on cognitive psychology pro-
pose specific features of agents' behavior, relaxing the individual rationality hypothesis (Shleifer,
2000; Barberis and Thaler, 2002).
Another crucial feature of a model that aims at explaining trading behavior for example is the hy-
pothesis made on investors’ preferences and the way they evaluate risky choices. Prospect Theory
is one of such theories, due to Kahneman and Tversky (1979) and Tversky and Kahneman (1992).
It is the most successful one because of its capacity to capture and fit results obtained in laboratory
experiments. Its starting point is a critique of the expected utility theory as a descriptive model of
decision making under risk. Following experimental results, agents usually under-weight the prob-
able results compared to certain one (certainty effect), which implies risk aversion when gains are
certain and risk loving when losses are certain. Agents also exhibit a lack of coherence in their
preferences when the same choice is differently presented (isolation effect and framing).
The Prospect Theory's formulation provides several important features:
1) utility is defined on the gains and losses, and not on the final wealth value,
2) the evaluation function form, particularly its concavity in the gains domain – agents
are risk-averse on the gains and risk loving on the losses – with a kink at the origin
showing a greater sensibility to losses (loss aversion),
3) non-linear transformation of probabilities: small one are overestimated and agents are
more sensible to differences of probabilities at higher probability's levels.
The principals of judgment and perception are possible thanks to the use of the value function. The
value is treated as a function of two elements: the asset's value as a reference point and the ampli-
tude of changing from this starting point.
* Louis Pasteur University, LaRGE, Strasbourg, France.
1 I would like to thank Marie-Hélène Broihanne for valuable discussions and suggestions. I also thank the participants of
the AFFI International Conference 2005, Paris-La Défense, France, the Global Finance Conference 2005, Trinity College,
Dublin, Ireland and the Campus for Finance 2006 Conference, Koblenz, Germany. The usual disclaimer applies.
Banks and Bank Systems / Volume 2, Issue 2, 2007
36
Prospect Theory features can be applied to study investors behavior (like insufficient or naive di-
versification or excessive trading) (see Odean, 1998; Odean, 1999; Barber and Odean, 2000, Bar-
ber and Thaler, 2001). It has also applications in corporate finance. For instance, Wiseman and
Gomez-Mejia (1998) build a behavioral managerial risk taking agency model, through the linkage
of corporate governance mechanisms and prospect theory features (especially framing). Their
main contribution concerns an alternative risk formulation compared to the agency theory, based
on loss aversion and not risk aversion.
In a behavioral framework, preferences will be unstable due to the framing feature, contrary to the
agency theory that assumes constant preferences. The same choice can be presented in the poten-
tial gains or losses domain, altering traditional agency theory results. In this framework, changing
the performance benchmark for the manager affects its reference point (translating the gains and
losses domains), and therefore may adversely alter its risk taking behavior. In addition, the use of
compensation mix in order to establish proper incentives for the manager, aligned with the princi-
pal interests, may also adversely affect agent's risk taking behavior in such a framework.
The application of behavioral finance features to investigate risk-taking in the banking industry is
of central interest in this paper. As far as we know, this area has received scarce attention from the
behavioral finance perspective1, although risk-taking remains the core activity of banks. It has been
proven that excessive risk taking2 is the principal bank default factor (see for example Pantalone
and Platt, 1987; and O.C.C., 1988). The last 20 years have witnessed several bank failures
throughout the world, particularly in emerging market economies (EME) (Bell and Pain, 2000).
The interest for bank failures comes mainly from its costs: financial losses for the stakeholders
(shareholders, clients, and deposits insurance fund), loss of competitiveness, and a potential desta-
bilization of the financial system, through the contagion mechanisms, when several individual
failures lead to a banking crisis. The resolution of these failures is a waste of resources, particu-
larly scarce in EME (Honohan, 1997)3.
Several explanations of the excessive risk taking sources can be found in the literature4: inefficient
corporate governance mechanisms (Gorton and Rosen, 1995; Knopf and Teall, 1996; Simpson and
Gleason, 1999; Anderson and Fraser, 2000), inadequate bank capital regulation (see Jeitschko and
Jeung, 2005), intense market competition (Keeley, 1990; Cordella and Yeyati, 2002; Repullo,
2004; Boyd and Nicolo, 2005), and an adverse regulatory, institutional and legal environment
(Barth et al., 1999, 2000, 2001, 2002; La Porta et al., 1997, 1998, 2000).
Alternative explanations of excessive risk taking in banks seem neglected. As risk-taking decisions
are made upon human subjective judgment and especially perception of risk, it seems quite natural
to engage in the behavioral perspective to better investigate and understand this process. Effec-
tively, the final decisions concerning credit approvals and loan terms are based on many different
attributes, from which experience and the judgment of the credit staff continue to play a significant
role (Crouhy et al., 2001).
Bowman (1980, 1982) findings are of particular interest in this perspective because they provide
the basis of the so-called risk-return paradox. The prospect theory's feature stipulates that risk
attitude is determined by the outcome's relation to a reference point and not the outcome's level.
Therefore, some testable hypotheses are provided by Kahneman and Tversky (1979) framework:
when performance is below a given target level, decision makers should be risk seeking, and when
performance is above the target level, they should be risk-averse.
1 Shen and Chih (2005) empirically investigate earnings management in banks within a prospect theory framework.
2 This can be defined as a level of risk-taking that amplifies the bank’s probability of default above an acceptable level by
the different partners of the bank, especially the shareholders and the regulator.
3 For example, the banking crises in Indonesia (1997) and Thailand (1997-1998) cost about 50-55% and 42.3% of the GDP
(fiscal contribution) respectively in terms of restructurization.
4 See Godlewski (2006) for a survey.
Banks and Bank Systems / Volume 2, Issue 2, 2007
37
Fiegenbaum and Thomas (1988) tested these predictions using accounting data, defining bench-
mark returns as median returns, and dividing the firms of their sample in two groups – above and
below target. Their results strongly corroborated the presented prospect theory predictions.
Jegers (1991) replicates Fiegenbaum and Thomas (1988)'s methodology using Belgian accounting
data, testing some new return and risk variables, like ROA (return on assets) in addition to ROE (re-
turn on equity), which should take into account managerial performance view, and cash flow on eq-
uity, and a coefficient of variation, defined as the standard deviation of returns divided by the average
return, in addition to the variance of returns. Jegers (1991) calculates each firm's time average return,
ranks firms according to these values, and divides the firms into 2 equally sized groups: those with
above and respectively below target returns, the target being defined as the median return. Then, for
each group, Spearman rank correlations between return and risk and the negative association ratio are
calculated. The results corroborate those of Fiegenbaum and Thomas (1988).
Finally, Johnson (1994) also places his analysis of risk-taking in banks in a behavioral finance
framework, following Fiegenbaum and Thomas (1988), and using Fishburn (1977) measure of
risk, defined as dispersion about the mean outcome. Johnson (1994) tests several measures of re-
turn and risk for a sample of US commercial banks for the 1970-1989 period. He uses standard
measures of return like ROA and ROE, as well as primary capital ratio. Risk is measured as stan-
dard deviation of outcome. The study aims at examining historical data to determine whether there
is any evidence consistent with prospect theory, by measuring the relationship between outcome
variability and distance from target. Targets are defined as the median values of return variables.
Banks are classified in two separate groups according to this target, and correlation between dis-
tance to target and standard deviations are computed. The statistical tests are based on Kendall
τ
correlation coefficient. The obtained results also corroborate Fiegenbaum and Thomas (1988) con-
clusions.
Following this literature, we aim to empirically investigate risk taking in the banking industry in
emerging markets in a Cumulative Prospect Theory framework. We focus on the banking industry
in a specific framework – emerging market economies – where risk-taking behavior can become
adverse, generating excessive risks and therefore amplifying bank's default probability, thus affect-
ing negatively the whole economy. The specificities of these economies, mainly historical heritage
(political, economic, social, moral, …), restructuring process in progress, rapidly evolving eco-
nomic reality, inadequate regulatory, institutional and legal environment, may foster excessive risk
taking, affecting the perception of risk by the bankers. For example, an evolving economic envi-
ronment forces the banker to constantly adapt his appreciation of risk. An inadequate institutional
or legal environment may bias banker's risk perception. Therefore, an investigation of this risk
perception in a behavioral finance framework is important.
The rest of the note is organized as follows. Section 2 describes the methodology and the data used
in this study. Section 3 presents the results and their discussion. Finally, section 4 concludes and
proposes further research perspectives.
2. Methodology and data
In the present study, we follow Johnson (1994)'s methodology for the formalization of the tested
hypothesis in order to provide empirical evidence dealing with bank risk taking based on prospect
theory features.
We use a pooled sample of 894 commercial banks for the 1996-2001 period from two main areas
of emerging market economies – South-East Asia and South and Latin America (see Table 1). The
accounting data come from Bankscope.
Banks and Bank Systems / Volume 2, Issue 2, 2007
38
Table 1
Banks' in sample frequency by country
Country Banks Frequency
Argentina 151 16.89
Bolivia 23 2.57
Colombia 104 11.63
Ecuador 63 7.05
Indonesia 68 7.61
Korea (South) 33 3.69
Mexico 95 10.63
Malaysia 82 9.17
Peru 100 11.19
Thailand 54 6.04
Venezuela 121 13.54
894 100
Source: Bankscope.
We calculate several return and risk measures, following the existing literature, but also trying to
propose some alternative measures. The definition of the variables used in this study and their de-
scriptive statistics are provided in Table 2.
Table 2
Variables definition and descriptive statistics
Variable Calculation M. Med. S.D. Min. Max.
ROE Net Income/Equity -2,97 7,86 193,16 -4864,15 2057,90
ROA Net Income/Total Assets 0,26 0,73 5,84 -112,21 23,66
EQTA Equity/Total Assets 10,80 9,86 8,19 -120,92 53,45
SPREAD1 Interest Income/Total Loans 26,31 21,71 16,53 4,57 162,68
SPREAD2 Interest Income/Total Operating Income 11,62 8,50 10,07 1,53 111,01
NPLGL Non Performing Loans/Gross Loans 11,09 7,40 11,50 0,00 89,59
LLRNPL Loan Losses Reserves/Non Performing
Loans
98,81 70,24 104,45 3,18 846,15
LLRGL Loan Losses Reserves/Gross Loans 6,71 5,16 6,17 0,00 60,24
NLTA Net Loans/Total Assets 57,04 57,41 13,69 25,38 92,35
M.: mean, Med.: median, S.D.: standard deviation, Min.: minimum, Max.: maximum.
Concerning the return measures, we use “traditional ones”, like the ROE (reflecting rather the
shareholder point of view), the ROA (reflecting rather the management point of view) and the
EQTA (reflecting the shareholder, the management and the regulator points of view). We also use
SPREAD1 and SPREAD2 measures that focus more precisely on the bank's credit activity and
should give a more adequate perspective on return in commercial banks.
Concerning the risk measures, apart from the standard deviations of the return variables discussed
above, we also investigate the usefulness of standard deviations of the “loss measures” mainly
NPLGL (reflecting a potential loss for the bank), LLRNPL, LLRGL (both reflecting management's
Banks and Bank Systems / Volume 2, Issue 2, 2007
39
perception of risk and its coverage with reserves which alter the profitability of the bank) and
NLTA (which reflects both potential future returns but also potential problems in term of reserves
and/or losses).
We also investigate the framing issue, testing the correlations between risk and return measures in
different domains – gains versus losses. Therefore, we test the significance of the correlation coef-
ficient between measures of return and risk crossing the domains (gains and losses). The Kendall
τ
correlation coefficient measures the strength of the relationship between two variables, and like
Spearman's rank correlation, is carried out on the ranks of the data. It ranges from +1 to -1, with a
positive correlation indicating that the ranks of both variables increase together, whilst a negative
correlation indicates that the rank of one variable increases the other one decreases. Its main ad-
vantage is the possibility for direct interpretation of the statistic in terms of probabilities of observ-
ing concordant or discordant pairs.
Our tests rely on time average and their standard deviations measures, as well as median of these
variables. The medians of the employed measures represent the target levels – the reference points
for the bank. We work with 9 zones which are: Zone 1 – ROE, Zone 2 – ROA, Zone 3 – EQTA,
Zone 4 – SPREAD1, Zone 5 – SPREAD2, Zone 6 – NPLGL, Zone 7 – LLRNPL, Zone 8 –
LLRGL, Zone 9 – NLTA.
3. Results and discussion
The Fishburn's measures of risk are the distance of the variable from the target level. For each
zone, we split the sample in 2 areas: ABOVE and BELOW, corresponding respectively to banks
above and below the target level – the median of the variable corresponding to the zone. In Tables
3 and 4, we compute Kendall
τ
correlation coefficients between the standard deviation of the vari-
able and the distance to the target level corresponding to the zone and by area.
Table 3
Correlations results between standard deviation and distance to benchmark measures
(gain domains)
Area Zone 1 Zone 2 Zone 3 Zone 4 Zone 5
(ROE) (ROA) (EQTA) (SPREAD1) (SPREAD2)
ABOVE -0.0851** -0.0962*** -0.0418 -0.1706*** -0.1498**
BELOW 0.1675 0.1772* 0.0115 0.0464 -0.0357
Kendall
τ
correlation coefficients between the standard deviation and the distance to median are shown for
each zone, by area. ***, ** and *: statistically significant at 1%, 5% and 10% levels respectively.
Concerning the correlation results in the gain domains for the Zones 1-5, we observe significant
and negative Kendall
τ
coefficients for each zone (except Zone 3 corresponding to the EQTA
variable) in the ABOVE area. We can interpret these results in the following way: for banks lo-
cated above the target level in the gains domain, bankers exhibit a risk averse behavior, as the
standard deviation and the distance to median are negatively correlated. It may correspond to a
“defensive attitude”, as being above the target in terms of outcome implies preserving the privi-
leged position, and therefore exhibiting risk aversion. For banks located below the target level, the
relationship between these 2 measures is not significant.
Banks and Bank Systems / Volume 2, Issue 2, 2007
40
Table 4
Correlations results between standard deviation and distance to benchmark measures
(loss domains)
Area Zone 6 Zone 7 Zone 8 Zone 9
(NPLGL) (LLRNPL) (LLRGL) (NLTA)
ABOVE -0.1182* -0.0635* -0.0824 -0.0996***
BELOW 0.0045 -0.1734 -0.028 0.0513
Kendall
τ
correlation coefficients between the standard deviation and the distance to median are shown for
each zone, by area. *** and *: statistically significant at 1% and 10% levels respectively.
Concerning the correlation results in the loss domains for the Zones 6-9, we observe mixed evi-
dence. In the ABOVE area, except for the Zone 9, corresponding to the NLTA variable, other
Kendall coefficients are weakly significant and negative, the coefficient being not significant for
Zone 8 (LLRGL). For banks above the target levels in terms of potential losses (NPLGL) or their
coverage (LLRNPL), bankers exhibit a risk aversion behavior. Having, for example, a level of
NPLGL above the target level implies a more risk averse attitude, as these potential losses may
drive the bank into default. The Kendall correlation coefficients for the BELOW area are all not
significant.
In Tables 5 and 6 we propose to cross the domains (gains vs. losses) in order to investigate the fram-
ing issue which is one of the crucial feature of Prospect Theory. The same choice may be presented
in alternative ways (as a gain versus as a loss), affecting the editing phase of an agent, and therefore
affecting its preferences. We do this in the following manner: in Table 5 we compute Kendall corre-
lation coefficients between standard deviations of gain measures (ROE, ROA, SPREAD1,
SPREAD2) and distance to median losses measures (NPLGL, LLRNPL, LLRGL, NLTA, corre-
sponding to the Zones 6-9). In Table 6, we invert the measures, showing Kendall coefficients be-
tween standard deviations of loss measures and distance to median gains measures (Zones 1-5).
Table 5
Correlations results between standard deviation and distance to benchmark measures (cross gain
vs. loss domains)
Zone 6 Zone 7 Zone 8 Zone 9
(NPLGL) (LLRNPL) (LLRGL) (NLTA)
ABOVE BELOW ABOVE BELOW ABOVE BELOW ABOVE BELOW
SDROE 0.0859 0.0901*** -0.0294 -0.0758 0.0748 0.089** -0.0811** -0.0478
SDROA 0.0977 0.0919*** -0.0287 -0.0963 0.085 0.0958** -0.0835** -0.079
SDSPREAD1 0.0979 0.0955*** -0.0181 -0.0881 0.0843 0.1037*** -0.0779** -0.16
SDSPREAD2 0.0784 0.0788*** -0.0209 -0.1167 0.0573 0.0956** -0.075** -0.0257
Kendall
τ
correlation coefficients between the standard deviation and the distance to median are shown for
each zone, by area. ***, ** and *: statistically significant at 1%, 5% and 10% levels respectively.
Concerning the results shown in Table 5, we observe significant Kendall
τ
correlation coefficients
only for the BELOW areas for Zone 6 and Zone 8, and for the ABOVE area for Zone 9. The re-
sults for the BELOW areas seem to indicate that banks located below target levels in terms of po-
tential losses (NPLGL) and their (costly) coverage (LLRGL) exhibit risk loving behavior, as the
relationships between the distance to median and standard deviations of return measures is signifi-
cantly positive. Being under such target “leaves room” for aggressive risk taking within the bank.
Banks and Bank Systems / Volume 2, Issue 2, 2007
41
As to the ABOVE results, we observe significantly negative Kendall coefficients between the dis-
tance to target in terms of NLTA and the standard deviation of the return measures. This may be
interpreted as a feature of risk aversion on the side of the banker, as being above a target level of
loans volume compared to total assets restrain the risk taking attitude materialized in terms of
standard deviations of return variables. This volume of loans represents potential revenues but may
also transforms into NPL, enhancing the bank's risk of default, contrary to NPLGL or LLRGL
variables, which are proxies of ex post excessive risk taking, already materialized.
Table 6
Correlations results between standard deviation and distance to benchmark measures (cross loss
vs. gain domains)
Zone 1 Zone 2 Zone 3 Zone 4 Zone 5
(ROE) (ROA) (EQTA) (SPREAD1) (SPREAD2)
A. B. A. B. A. B. A. B. A. B.
SDNPLGL -0.0511 0.1455 -0.069** 0.0214 -0.1321** 0.0371 -0.2177*** 0.0101 -0.1931*** -0.0183
SDLLRNPL -0.05 0.1195 -0.067** -0.0013 -0.1118* 0.035 -0.2075*** 0.0007 -0.1823*** -0.0272
SDLLRGL -0.0545 0.1221 -0.0738** 0.0013 -0.1264** 0.0338 -0.2108*** 0.0103 -0.1877*** -0.0187
SDNLTA -0.0585* 0.1169 -0.0771** 0.0013 0.1165* 0.0359 -0.2135*** 0.0004 -0.1789*** -0.0145
Kendall
τ
correlation coefficients between the standard deviation and the distance to median are shown for
each zone, by area. ***, ** and *: statistically significant at 1%, 5% and 10% levels respectively. A.:
ABOVE, B.: BELOW.
Turning to the interpretation of the results in Table 6, we observe significant negative Kendall
τ
correlation coefficients only for the ABOVE areas for Zones 2-5. Concerning the Zone 2, corre-
sponding to the ROA, we can interpret these results as indicating risk averse behavior rather on the
management side, as the relationship between the distance to the ROA target and the standard de-
viation of losses measures is negative1. Concerning the Zone 3, corresponding to the EQTA vari-
able, we also observe significantly negative Kendall
τ
correlation coefficients between the dis-
tance to EQTA target and standard deviations of losses measures (except for the standard deviation
of NLTA). We can interpret this result in a similar manner as for the Zone 2, except that it may
reflec