Min-Kyu Song. Vol. 21, No. 25 (23 Jun 2012) SUMMARY

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1 Vol. 21, No. 25 (23 Jun 2012) Investment Advisory Business in Korea* Min-Kyu Song SUMMARY Since investment advisory business provides specialized advice and its actual software to asset management, its development is necessary to the growth of the asset management industry. Investment advisory service 1 improves efficiency on providing information to investors, 2 contributes specialization and diversification of the asset management industry through developing innovative managing skills, 3 complements to the manpower of securities firms and asset managers and 4 may improve the selling channel of financial instruments with independent and unbiased consultation. Since the foundation of Financial Investment Services and Capital Markets Act (FSCMA) in 2009, investment advisory business has developed in quantity basis, but its managing skills are still behind and since its diversification and speciality are below average, thus it is thought to be that there are still many problems remaining in forming a competition structure. Especially problems of insufficient information disclosure of investment adviser, tepid attitude from the supervising authorities and lowered reliability due to pseudo investment advisers need to be resolved ASAP. In order to achieve sound growth of investment advisory business, the following needs to be promoted: 1 vitalizing small-and-medium-sized hedge fund by alleviating conditions on the capital conditions, 2 reinforcing qualitative conditions and improving effectiveness on regulations so as to gain credibility in the market, 3 allowing performance compensation according to the characteristics of investment advising, 4 differentiating from the financial advisory business, and, 5 protecting pseudo advisory business from being misconceived as officially proved investment advisory business. * Opinions expressed are those of the author and do not necessarily reflect the official positions of the Korea Institute of Finance.

2 Investment advisory business is a service that provides specialized advice about asset management. Since investors manage their assets according to the Since investment advising is a service that provides specialized advice about asset management, its development is necessary to the growth of the asset management industry. advice and the investment advisory business provides actual software for asset management, the development of the investment advisory business is a necessary condition for the growth of the asset management industry. In Korea, the asset management industry has developed very rapidly on a quantity basis. The asset under the management of mutual funds was KRW108 trillion in 2004, which almost doubled up to KRW201 trillion by May 25, In addition, the amount of private equity fund increased by 43% (KRW79 trillion -> 113 trillion) during the same period. As Korean-style hedge funds were adopted in 2012, the size of asset under management overcame KRW570 billion as of April 13. However there is still room for improvement on a quality basis. In the case of mutual funds, the managing mechanism has not yet been diversified by managing skills and is only divided in its size, which creates chaos for small-sized funds. For hedge funds and private equity funds, due to lack of managing skills, the level is thought to be much behind compared to developed countries. As the fact that most of the asset management vehicles have been adopted in Korea, the growth of the asset management industry may depend on the development of the investment advisory business. Under such circumstances, this paper looks into the definition of the investment advisory business, current state and problems as well as its outlook in Korea. Definition of Investment Advisory Business in Korea Generally, the investment advisory business in Korea includes both investment advising services and discretionary account services. Under 2 Weekly Financial Review

3 the FSCMA, investment advising services are consultations on the investment decision about financial instruments or their value, and discretionary account services are defined as when investors entrust their total or part of their financial instruments and the entrusted person shall manage those assets according to the preferences of those investors. By the FSCMA, investors have the final decision rights about their investment when using investment advising services, but in discretionary account services, investors entrust everything including discretionary authority. However, Investment advisory business includes both investment advising and discretionary account services and which is differentiated from collective investment business in a sense that it provides advice on individual demand. since both investment advising and discretionary account services affect crucial decisions on asset management, both services are generally called as investment advisory business. Although, in a sense that investment advisory business provides investment consultation on individual demand, it is differentiated from collective investment business. In Korea, securities firms, asset management companies and independent investment advisory companies take a role in the investment advisory business. Since the investment advisory business is directly related to securities transaction, brokerage and collective investment, securities firms and asset management companies play a role in investment advising together Investment adviser is possible to start up a business with small capital and labor, so it is considered as financial venture business. as well as their original services. On the other hand, independent investment advisory companies only play a role in investment advising or discretionary account services. Furthermore, since independent investment advisory companies may start up a business with small capital and labor, they are considered as venture businesses in the capital market. When discussing the development of the investment advisory business, usually the focus is on independent investment advisory companies due to their characteristics as venture businesses. Vol. 21 No. 25 3

4 Functions of Investment Advising Functions of investment advising may be summarized in four basic categories. Investment advisers improve efficiency on providing information by giving advice so that investors can easily understand related data which includes public disclosures. First, investment advising directly helps investors to choose financial instruments. As the financial industry consistently develops and investors have a wide range of financial instruments to choose, it is getting more difficult for them to make a decision. Even though specific information on each financial instrument is officially disclosed to the public, it needs additional analysis for investors to choose the right instruments. However, most of investors are not specialized in finance and therefore are not proficient in analyzing or evaluating information regarding the instruments. Investment advisers improve efficiency by giving professional advice so that investors may easily understand any related data, which includes publicly disclosed materials. Second, investment advising contributes to the specialization and diversification of the asset management industry with its innovative managing skills. The core nature of investment advising is providing asset management service to institutional or private investors. Thus, it may develop specialized managing skills in grouping, transaction mechanism, benchmark, etc. It also can Investment advising contributes to specialization and diversification of the asset management industry with its innovative managing skills and is complementary to securities firms and asset managers in labor and managing mechanisms. be managed variously in small to large-sized management. With these characteristics, the investment advisory business can be adapted to changes in market conditions and can use a variety of managing skills. Also, it complements the asset management service, which is not fulfilled by private equity funds or mutual funds. Especially, revised FSCMA in September 2011 allowed Korean-style hedge funds to be adopted in the country and therefore investment advisers are allowed to manage hedge funds. This may cause investment advisers to develop innovative managing mechanisms. Third, investment advisers contribute to enhance competitiveness in the 4 Weekly Financial Review

5 capital market by complementing securities firms and asset managers in labor and managing skills. Pecuniary entry barriers for investment advisers are comparatively low, therefore specialized managing skills that have been used in securities firms or asset managers can assist investment advisers to start up their businesses. Also, the specialized labor force originating from investment advisers may transfer to securities firms or asset management companies. The Investment advisory business may contribute to the selling channel of financial instruments with independent and unbiased consultation. circulation of the labor force leads to the circulation of asset managing skills. Of course, if only specific asset managing skills are needed, then the exchange of management skills may occur without the circulation of labor force. In developed countries, we may observe that large-sized securities firms or asset managers establish an investment advisory company as a subsidiary and the exchange of labor and managing skills are actively taking place. Fourth, investment advising may contribute to the improvement in the selling channel of financial instruments. If the object of investment advising is already existing financial instruments, the role of investment adviser is very similar to selling advice. Here, investment advisers take fees on advising or entrusting. It is important to note that investment advisers are differentiated from the general selling counter in that they don t receive selling fees from financial instrument producers directly. As a result, investment advisers have an advantage in that they can provide services from an independent and unbiased position without having prejudice on specific financial instruments. Thus if the investment advisory business plays a proper role, it may relieve the side effects of the one-company-selling system which includes monopolies on the selling side, lack of dependence in selling consultation, etc. 1) 1) Here, the one-company-selling system refers to where it allows the selling right of a financial product to only one specific company. The system has an advantage in management and surveillance but has a chance to bring monopoly from the selling side and lack of dependence in selling consultation. Vol. 21 No. 25 5

6 Current State and Evaluation Since the implementation of the FSCMA in 2009, the investment advisory business has developed greatly on a quantity basis. At the end of 2008, the Investment advisory business has developed much in quantity basis, but its managing skills are still behind and since its diversification and specialization are below average, it still hasn t form a competition structure in development. number of investment advisory companies, which includes securities firms and asset management companies, was 279 and increased to 388( 39%) at the end of Also, the contract amount was KRW335 trillion( 44%) at the end of 2011 compared to KRW232 trillion at the end of If we exclude securities firms, asset managers and foreign companies, the number of domestically independent investment advisory companies also increased from 92 at the end of 2008 to 159( more than 70%) at the end of With this rapid growth, the contract amount increased from KRW12 trillion at the end of 2008 to KRW23 trillion at the end of Nevertheless, there are still some issues existing in the domestic investment advisory business. Innovative managing skills are still behind and diversification and specialization are too low to form a competition structure. Also, some risks are still inherent in the business. The majority of investment advisors are competing to take funds from large-sized institutional investors and aiming at short-term profit of stock management. As a result, lots of small-and-medium-sized investment advisers are experiencing a worsening of profits where they don t have their own specialized business area. Of the total 159 investment advisory companies at the end of 2011, the top 10 firms took more than 60% of total contracts and about 90 of them are in the state of impaired capital. Overall credibility of the investment advisory industry has decreased. It is difficult for investors to gather related information due to insufficient disclosure 6 Weekly Financial Review

7 of management or product information from investment advisers. Also, tepid attitudes from supervising authorities regarding cancelling low credited advisory companies further lowers the credibility of the industry. Even though the pseudo investment advisory business has completely different characteristics from the investment advisory companies, it negatively influences the investment advisory industry. the pseudo investment advisory business usually provides information on securities investment through internet or TV but doesn t provide advisory services on individual demand, which is core Insufficient information disclosure on management or products, tepid attitude from the supervising authorities, and problems on pseudo investment advisers all contribute to lowering reliability in the industry. nature of the investment advisory business. Since it is not regulated on soundness or services, it is very different from regular investment advisory business. Nonetheless, the names of those pseudo investment advisory businesses create confusion for investors, which may bring damages and unfair transactions in society. Tasks to be Done The purpose for the establishment of the FSCMA in 2007 was to lead drastic growth in the Korean capital market. Due to the after-effects of the 2008 global financial crisis and continuing European fiscal crisis, the governments of many countries are focusing on capturing stability instead of developing their financial industries. On the other hand, it may be a great chance to make a new leap forward in the capital market on the sound base. In addition, the adoption of the 2011 Korea-style hedge funds creates Entry barrier in capital condition of investment advisory business is not high but hedge fund side needs to vitalize small-andmedium-sized hedge funds. important issue of developing the investment advisory business in Korea. In order to achieve overall development of the investment advisory industry, the following conditions need to be promoted. First, fresh and specialized investment advisers should be able to enter into Vol. 21 No. 25 7

8 the market more easily. The overall entry barrier in capital condition of investment advisory businesses is not high, however, the barrier for hedge funds should be further lowered. Under the FSCMA, investment advisers and investment entrusted parties need to hold KRW250 million and 750 million, respectively. On the other hand, in order to manage hedge funds, they need to have KRW6 billion of capital and KRW500 billion of entrusting assets. Managing hedge funds is crucial for the creativity of the investment advisory business. Quality side of investment advisory business needs to be reinforced and it is necessary to improve effectiveness and surveillance so as to bring reliability in the market. Thus, it seems reasonable to lower the entry barrier of hedge fund-related areas and vitalize small-and-medium-sized hedge funds. Second, along with lowering pecuniary entry barrier, quality conditions need to be reinforced to bring credibility to the market. Most of the risks in investment advising are related to service behaviors. Thus it is necessary to reinforce the inside control system, infrastructure, managing roles, surveillance, etc. It is also necessary to intensify monitoring for unfair transactions and strictly apply exit standards so as to bring effectiveness of regulation and sound development to the investment advisory business. Third, it needs to allow performance compensation according to the characteristics of investment advising. The revised FSCMA of 2011 doesn t allow performance compensation regarding investor protectio n 2). But for hedge funds or private equity funds, performance compensation is to be allowed. Fourth, considering the proposed Laws on Customer Protection, investment advisory services should be differentiated from financial advisory business in economical role. Financial advisory businesses not only include financial investment instruments but also overall advisory 2) But if it does not violate investor protection or regulations, incentive was allowed under a presidential decree. 8 Weekly Financial Review

9 businesses (e.g. deposit, loan, insurance) are included. This is because the financial advisory businesses play a role in giving advice on financial customers whole debt and asset circumstances, which include asset distribution, managing debts, changes in asset, etc. Thus, investment advising needs to be more specific on how to manage those financial investment instruments after the financial advice. Lastly, it needs to stop the pseudo investment advisory business from It needs to allow incentive system and differentiate from financial advisory business. Also it is necessary to intensify regulations on pseudo investment advisory business. being understood as one of the regular investment advisory businesses. Instead of using the word pseudo investment advisory business, it may be right to use investment information providing business. Also, if it is connected to unfair acts under any circumstances, it should be strictly regulated and restricted. Vol. 21 No. 25 9

10 Focus & Brief Jul 2-6 Policy Issue in Brief: Promoting Bank Loans for Low Credit Holders News Briefs: - Interest Rates on Deposits and Loans Dropped in May - Measures to Encourage Foreign Currency Deposits - Regulations on Financial Investment Partially Amended Market Indicators: Jul 2-6 Policy Issue in Brief: Promoting Bank Loans for Low Credit Holders Jeong Ho Suh, Senior Research Fellow Summary: Despite the efforts of the banks to enhance microfinancing of the working class, criticism still remains that the banks have not done enough to supply the low credit holders. Banks may need to pursue loan underwriting more actively in terms of expanding the credit supply and discover new source of revenue. For this, banks may need to further segment the sub-grade credit rating to enlarge the discriminating power of the credit rating and set up special branches that focus on dealing with loans to low credit holders and whose performance evaluation system differentiates with others. The proportion of loans to low credit holders (normally KCB grade 7 or lower) made by banks has been stagnating for the last few years while criticism of banks not doing enough to supply those with low credits has been escalating. With the creation of such new microfinancing programs as the

11 New Hope Loan in November 2010 along with other microfinancing efforts, borrowing have increased for those with at least level 7 grade credit rating. However, the proportion of borrowing by those with less than level 7 grade credit rating continues to remain stagnant. (See Graph 1) Although this can be attributed to the domestic banks innate conservative risk appetite, it can also be interpreted as domestic banks' way of deterring additional criticism from the public about issuing high interest loans for the working class. Since the global financial crisis, not only has the banks conservative risk appetite been more strongly enforced (See Graph 2) but the banks have become more aware of frequent complaints rising from loan processing fees on small scale loans by borrowers which would lead to potentially tarnishing the reputation of the banks. <Graph 1> Banks' 3) Proportion of Credit Loans to Low Credit Holders ( Balance Criteria (grade 7 or lower) New Balance Criteria (grade 7) 2 '08.12 '09.12 '10.12 '11.12 '12.5 Source: KCB 3) Based on the following Banks: KB Kookmin, Shinhan, Woori, KEB, NongHyup, Kyongnam, and Kwang Ju. Balance is based on the balance at the end of each year; New balance is based on the new inflow of loans on the applicable month. Note that new loans include loans that have changed status due to credit level changes. Bad write-offs also influenced changes in proportion of low credit loans. Vol. 21 No

12 <Graph 2> New Credit Commitments KRW1 Billion Source: KCB Orange Report (2012.5) Also, since for performance evaluation of banks, asset quality index/indicator such as default rate are more concerned than risk-adjusted return, banks are passive in underwriting low credit loan despite its medium and long term profitability. Large banks motivation to directly handle low credit loans is even lower because its subsidiary or affiliated company retains functions to deal with high-interest loan products (capital, saving banks, credit card company, etc.) There may be a dispute on whether banks active participation in low credit loan markets is economically and socially desirable. However, at least at this time, banks participation is meaningful in terms of enlarging credit supply to stagnant low credit loan markets and pioneering new sources of revenues. Since banks financing cost is lower as compared to non-bank organizations, when banks low credit loans become active, financial cost will also be lowered for ordinary borrowers. Especially for the 15~35% rate of interset section among domestic credit loan market, fund supply is very stagnated. Thus, banks participation is needed to alleviate tipping effect. 4) 4) Chang-gyun Park, Current Status of Microfinancing and Policy 2012 Korean Finance Association-Korea Institute of Finance Joint Symposium (June 14) Presentation 12 Weekly Financial Review

13 However, when banks actively enter into the market, there is a chance that they could encroach upon the loan markets of non-bank financial institutions, which shows low business results and might heighten the vulnerability of the household debt problem. To achieve this, banks need to enhance their risk analysis capabilities such as further segmenting the sub-grade borrowers in the grade 7 whose weight has been growing. For levels lower than grade 6, as the grade falls, the default rate rapidly rises while the stability of default rate decreases, making decisions on loan pricing substantially difficult. Banks will need to enhance the risk analysis system on low-grade borrowers through subdivision of growing level 7 grade (e.g., 7-A grade, 7-B grade, 7-C grade, etc.), using of credit scores instead of credit ratings, joint analysis of KCB grade and bank s own credit grade. Also, banks need to adopt non-traditional approaches to complement traditional credit evaluation/assessment models to enhance the accuracy of credit risk evaluation on low credit borrowers. Credit information agencies that retain extensive credit information on low-credit borrowers, need to devise a more discriminative grading system on borrowers less than level grade 6 and think of ways to commercialize it. In addition, banks will need to consider establishment of a few branches specialized in low credit loans (tentatively named microfinancing center ) that intensively deal and manage with low credit loans. It will be difficult for existing general branches to actively pursue low credit loans. So it is necessary to establish branches that will handle low credit loans specifically by region, calling it tentatively " microfinancing center,'" using different business strategies and performance evaluation criteria. In addition, in light of social responsibilities, such centers will be able to provide consultation and credit counseling to low credit holders and introduce appropriate microfinancing institutions. Vol. 21 No

14 Policy & Industry News Briefs: Jul 2-6 Interest Rates on Deposits and Loans Dropped in May According to the BOK, the weighted average interest rates on new deposits and loans in May 2012 both fell to 3.64% and 5.66%, down 0.06%p and 0.05%p respectively from the previous month. The interest rate on household loans especially continued to fall in May from the month earlier to 5.51%, 0.03%p drop while, the interest rate on mortgage loan recorded the lowest rate since January 2011 to 4.85%, 0.09%p decline. The deposit banks' interest margin for new deposits and loans widened by 0.01%p between April and May 2012 to stand at 2.02%. Among non-bank deposit institutions, credit unions and mutual credits' lending rates were 7.12% and 6.22%, down 0.04%p and 0.01%p respectively. The loan rate of mutual savings banks fell to 15.20%, down 0.36%p from a month earlier. Measures to Encourage Foreign Currency Deposits The government released a three-phase plan to increase foreign currency deposits to stabilize the domestic financial market and foreign exchange market at times of crises. During the 2008 global financial crisis, funds from foreign borrowing and bond issuance showed a sudden outflow, while in comparison, foreign currency deposits in domestic institutions stayed more stable. For this reason, the government has proposed a long-term plan to encourage foreign currency deposits. In the first phase, the government will encourage the residents to increase their deposits in foreign currencies, and attract overseas Koreans' mid- to long-term foreign currency deposits to domestic banks. The second phase will include measures to transfer the residents' overseas foreign currency deposits to domestic institutions and extend maturities of foreign currency deposits. In the third and final phase, full-scale efforts will be made to attract local firms and individuals to increase time and savings deposits in foreign currencies and to ensure stability of foreign currency deposits on the comparable level to the won currency deposits. The government will provide incentives in each phase, improve related regulations including tax treatment, and monitor banks' performances to use them as auxiliary index for the 14 Weekly Financial Review

15 prudential regulation. Regulations on Financial Investment Partially Amended The FSC has passed a vote for a partial revision of the Regulations on Financial Investment Business to enhance loss absorbing capacity of REITs and to uproot fund companies' malpractice of selling products of their affiliate firm. Major revisions include raising the ratio of loan loss provisions to the level of savings banks' PF loan and banning fund sellers such as banks, securities firm and insurance companies from giving unfair advantage to their affiliated asset management companies. To reduce burden of REITs, 50% of the additionally required ratio for loan loss provisions will be applied six months after the revision becomes effective and the rest will be applied one year after the effective date. The FSC plans to start its monitoring on the observance of the ban within 1~2 months after the revised regulation comes into force. Market Indicators: Jul Avg. Jun Avg. Jul 2 Jul 3 Jul 4 Jul 5 Jul 6 Call Rate (1d) Interest Rates (%) KOSPI & Trade Value (KRW 100 mil.) CD Rate (100 mil. won) Industrial Finance Bond Corporate Bonds (3yr, unsecured AA-) Korean Treasurys (3yr) Nat'l. Housing Bonds (5yr) KOSPI (1 Jan 1980 = 100) Trading Value Investment Balance Foreigner Net Purchases Won/Dollar , , , , , , , ,308 40,717 36,085 48,767 45,851 36,545 42, , , , , , , , ,582 1, , , , , , , FX Rates Won/Yen Won/Euro 1, , , , , , , , , , , , , , Vol. 21 No