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

January 2007
Banks and Bank Systems 2(2)

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Technische Universität Darmstadt

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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Ukrainian Academy of Banking of the National Bank of Ukraine

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Banks and Bank Systems

International Research Journal

Volume 2, Issue 2, 2007

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Banks and Bank Systems / Volume 2, Issue 2, 2007

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

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

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

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 economy”1. 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

♦ 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

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

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

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

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

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

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

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

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

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

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

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

♦ 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

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

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

1. DVOŘÁK, P. Bankovnictví pro bankéře a klienty. 3. vyd. Prague: Linde, 2005. 681 s. ISBN

80-7201-515-X.

2. FABOZZI, F.J., The handbook of asset/liability management: state-of-the-art investment

strategies, risk controls, and regulatory requirements. Rev. ed. Boston: Irwin, c1996. vi, 506

s. ISBN 1557388008.

3. JÍLEK, J. Finanční rizika. 1. vyd. Prague: GRADA Publishing, 2000. 635 s. ISBN

80-7169-579-3.

4. PETRJÁNOŠOVÁ, B. Bankovní management. 1. vyd. Brno: Masaryk University, 2004. 132

s. ISBN 80-210-3481-5.

5. UYEMURA, D.G., Financial risk management in banking: the theory & application of asset

& liability management. New York: McGraw-Hill, c1993. xviii, 361 s. ISBN 1557383537.

6. Act No. 6/1993 Coll. of 17 December 1992, on the Czech National bank, as amended by later

Acts.

7. Act No. 21/1992 Coll. of 17 December 1991, on Banks, as amended by later Acts.

8. Decree of the Czech National Bank No. 522 of 15 September 2004, amending Decree of the

Czech National Bank No. 333/2002 Coll., stipulating the prudential rules of parent

undertakings on a consolidated basis.

9. Decree of the Czech National Bank No. 333 Coll. of 3 July 2002, stipulating the prudential

rules of parent undertakings on a consolidated basis.

10. Provision of the Czech National Bank No. 2 of 3 July 2002, on capital adequacy of banks and

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

93/6/EC).

13. http://www.bis.org (official websites of the Basel Committee on Banking Supervision).

14. http://www.cnb.cz (official websites of the Czech national bank).

15. http://www.czech-ba.cz (official websites of the Czech banking association).

16. http://www.europa.eu.int (portal of the European union).

Banks and Bank Systems / Volume 2, Issue 2, 2007

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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