Financial Sector Program and Institutional Strengthening of the Financial Sector Project to the Republic of Korea (Loans 1601/1602-KOR)

Evaluation Document | 31 December 2005

This report evaluates the performance of the Financial Sector Program and Institutional Strengthening of the Financial Sector Project which supported a broad range of policy reforms in the financial sector in the Republic of Korea.

The Financial Sector Program Loan (FSPL) was rated highly successful, bordering on successful. The Government demonstrated a strong commitment to the Program-it designed many of the key reforms; enacted some reforms before they were required for tranche release and, in some cases, went beyond what was required.

The FSPL reforms were appropriate and targeted toward addressing weaknesses in the financial sector that, at the time, were (correctly) thought to underlie the crises. All but one of the FSPL conditions was met. The direction of subsequent policy initiatives has been broadly consistent with those supported by the FSPL. The continued involvement of the Government in the financial and corporate sectors, however, has slowed down the pace of market development and raised mild concern about its commitment to allow the financial sector to eventually function mostly on the basis of market forces.

The contribution of FSPL to institutional development was substantial. Although the associated TA loan did require restructuring, it is rated successful as it became relevant and effective subsequent to the change in scope and was better owned by the institutions involved.

Summary of Findings

  • The FSPL design had several positive features that enabled it to achieve many of its envisaged impacts. Further, while the broad framework for the Program's design originated from the Government, ADB was the first of the three multilateral financial institutions involved in the crisis response to develop a detailed policy matrix with the Government in support of its Program that covered the entire financial sector, including the capital market. Thus, ADB made an incremental contribution to restructuring the financial sector in the aftermath of the crisis.
  • In hindsight, several weaknesses in the design were also apparent: the lack of transparency, coordination, and development of a unified policy matrix among the multilateral financial institutions; and, as ADB did not have a continuing program, the momentum of medium and long-term reforms undertaken and sustained was not tracked.
  • Emergency loans provided during the Asian financial crisis did not crowd out ordinary capital resource lending to other clients in the period following the crisis. However, ADB should have charged a premium on the emergency loan like the International Monetary Fund and the World Bank because the large volume affected ADB's financial ratios. Also, Korea had already graduated from ADB's lending program and was capable of paying a premium. Such loans, in principle should be more costly to the borrower to prevent moral hazard. At the time of FSPL approval in 1997, ADB concluded that to maintain its financial ratios, it would need its fifth capital increase in 2002 instead of 2003. However, by end-1999, ADB reviewed the OCR loan charges and decided to increase the cost of its OCR funds to all borrowers to maintain its financial soundness and address concerns of increased risk to its loan portfolio. Thus although there is no evidence of crowding out, it can be argued that the increase in quick disbursing loans to countries affected by the crisis resulted in a surcharge on all OCR borrowers.

Lessons Identified

  • Speed, client ownership, and the ability to leverage windows of opportunity to introduce contentious reforms are essential when responding to crisis situations.
  • Financial sector reforms are often crucially dependent on reforms in the real sector economy such as in the corporate sector during the Korean crisis.
  • Temporary credit support may be needed to prevent viable enterprises from failing during financial market instability. However, these must eventually be eliminated, once the markets have stabilized, to prevent moral hazard.
  • The adequacy of social safety nets must be considered when responding to large-scale external economic shocks.
  • At the time of the Asian financial crisis, ADB did not have an appropriate lending instrument for crisis support and had to resort to traditional program lending with accompanying conditionalities. In 2003, ADB established a special program loan modality to use in crisis situations that enables provision of large-scale loans as part of international rescue effort without conditionalities.
  • During crisis situations, effective coordination among multilateral financial institutions and sharing of information in a transparent manner are needed to ensure that external aid and programs are consistent and comprehensive and do not overlap work or work at cross purposes. Responsibilities should be allocated on the basis of core competencies.
  • In crisis situations, it may not be possible to address all weaknesses in a financial sector. Once a crisis has passed, attention should be given to further institutional strengthening to prevent future market failures. This suggests that periodic surveillance is needed to track developments, provide early interdiction when problems emerge, and facilitate learning across clients. ADB established the Office of Regional Economic Integration in 1999 to collect such information.

Contents 

  • Table of Contents
  • Executive Summary
  • Background
  • Planning and Implementation Performance
  • Achievement of Program Purpose
  • Achievement of Other Development Impacts
  • Overall Assessment
  • Issues, Lessons, and Follow-up Actions
  • Appendixes