Financial Stability Report. April 2011

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2 Financial Stability Report April 11

3 Financial Stability Report (April 11) Publisher Editor Kim, Choongsoo Governor, the Bank of Korea Kang, Tae Soo Director General, Financial System Stability Department Printed by Jeil Printech Co.,Ltd. Financial Stability Report is published twice a year and also posted on the web-site of the Bank of Korea ( Please contact Financial Stability Analysis Team, Financial System Stability Department, the Bank of Korea for any inquiries (Tel : , Fax : , finstabla@bok.or.kr).

4 Financial stability refers to a condition in which the financial system works smoothly with all key components duly playing their roles: financial companies carrying out their financial intermediary function, and market participants maintaining a high level of confidence in their financial market, and the financial infrastructure being well developed. Financial stability is regarded as one of the policy goals that must be achieved, together with price stability and economic growth, for the purpose of sustainable economic development. Awareness of the importance of financial stability has risen since the global financial crisis, and countries around the world have consequently strengthened their conduct of macro-prudential policies intended to maintain financial system stability. As a part of its conduct of macro-prudential policies, the Bank of Korea has published the Financial Stability Report twice each year since 3, aiming to identify and analyze systemic risks and suggest measures for mitigating these risks based upon this analysis. In particular, the Bank of Korea has made efforts to enhance the level of quality and confidence in this Report, and as part of these efforts the Monetary Policy Committee has reviewed every volume to be published since. It is hoped that this Report will help financial market participants, regulators and policymakers to recognize the risk factors inherent in the financial system at an early stage and deal with them appropriately.

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6 Contents I. Overview 1 II. Financial system stability Financial markets International financial markets Domestic financial markets. Foreign exchange soundness 7 3. Financial institutions Banking sector Non-banking sector 5. Payment and settlement systems 9 III. Potential financial system risk factors Increasing global inflationary pressures and uncertainties in global economy 73. Lingering uncertainties in international financial markets 3. Possibility of abrupt changes in capital flows 5. Structural vulnerabilities of household debt Polarization of business performances and increasing insolvency risk in some fragile sectors 1 IV. Overall assessment and policy directions Overall assessment 15. Policy directions for financial stability 19 < Appendix > Major changes in domestic financial system 113

7 Boxes <Box II - 1> Effects of the loan-to-deposit ratio requirement on bank management 3 <Box II - > Impact of the Basel III capital and liquidity requirements on Korean banks 3 <Box II - 3> Financial system stress tests, of a sudden rise in international raw material prices and a shrinking of the world economy 5 <Box II - > Review of thrift institutions household loan risks <Box II - 5> Review of mutual savings bank vulnerability <Box III - 1> Effect of global liquidity expansion on emerging market country inflation and asset prices 77 <Box III - > The credit cycle and asset prices 97

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9 Overview. Overview [Financial system stability] 1.~ ~11.3 Debt servicing capacity of business sector Financial stability map 1) Financial markets Debt servicing capacity of household sector Soundness of banks Domestic & global economies Note: 1) The closer to the center, the more stable a sector is. Source: Bank of Korea 1 5 Foreign exchange soundness The financial system has remained relatively stable, thanks to the buoyancy of the real economy despite the rapidly changing economic environment at home and abroad. Amid the generally stable movements of financial market price variables, the soundness of foreign exchange and of financial companies maintains favorable conditions. (bp) CDS premiums MENA region 1) Overly-indebted European Countries ) Japan Notes: 1) Average of Saudi Arabia, Egypt and Tunisia ) Average of Greece, Ireland, Portugal and Spain Source: Bloomberg (bp) Risk factors exist externally, however, such as the increasing global inflationary pressures and the possibility of international financial market unease. There are latent risk factors domestically as well, including the expanded volatility in foreigners securities investment fund flows, the continued structural vulnerability of household debt, and the increasing risk of firms in vulnerable sectors becoming insolvent with the polarization of - 1 -

10 Financial Stability Report April 11 business performances. 1 Global investment sentiment and credit risk indicators CBOE VIX (LHS) TED spread (RHS) EMBI+ spread (RHS) (bp) 1, The international financial markets are maintaining stable conditions in general, owing to the recovery of the world economy and abundant global liquidity, although the credit risks of some countries have increased. Amid an easing of risk aversion among global Source: Bloomberg investors and credit risk remaining at a low level, the supply of credit by financial institutions also continues to recover. There is a possibility of rising in international financial market unrest going forward, however, depending upon the future developments of the fiscal problems of overly-indebted European countries, the political unrest in the Middle East and North Africa (hereafter MENA), the changes in monetary policy stances in major countries and the aftereffects of the Great East Japan Earthquake. The long-term interest rates of major countries have shown an upward trend since October 1, owing to factors such as economic recovery and inflationary - -

11 Overview Major country interest rates, stock prices, and US dollar value 5 US interest rate 1) (LHS) World stock price index ) (RHS) 3 German interest rate 1) (LHS) US dollar index 3) (RHS) rise in dollar value expectations. Stock prices have maintained an upward trend, in line with the global economic recovery and continued monetary easing, but showed increased volatility entering 11, influenced by the political Notes: 1) Based on 1-year bonds ) Based on MSCI index (Jan. 9=1) 3) Against the yen, euro, pound, Canadian dollar, Swiss franc and Swedish krona (Mar. 1973=1) decline in dollar value unrest in the MENA region and the Great East Japan Earthquake. The US dollar showed a temporary strengthening in around November 1, with the resurfacing of sovereign debt concerns in Europe, but given such factors as the abundant dollar liquidity following the second round of quantitative easing (QE), has remained weak against other major country currencies. Interest rate, stock price and exchange rate volatilities 1).. Interest rate (3-yr Treasury bond yield) Stock price (KOSPI) Exchange rate (KRW/USD).. The domestic financial market shows a pattern of overall stability, despite the growing uncertainties at home and abroad, owing to the solid economic fundamentals Note: 1) Calculated by EWMA (Exponentially Weighted Moving Average) Source: Bank of Korea Secondary market yields on Treasury bonds (three-year) sustained a downward trend, owing to increases in foreigners bond investment and a reduction in Treasury bond issuance, to hit a historic low level in December of 1. They have since then - 3 -

12 Financial Stability Report April 11 Treasury bond yield and long/short-term interest rate spread (bp) 3 Treasury bond (3-yr) yield (LHS) Treasury bond (3-yr) - CD (91-day) (RHS) shown a rising trend, influenced by the hikes in the Base Rate, the upward pressures on prices, and a contraction in bond purchases by foreigners. In this process, interest rate volatility showed a temporary spike. The spread between long- and short-term interest Source: Bank of Korea -3 rates has continued its trend of narrowing, as short-term rates have risen much more to a greater extent than long-term rates, influenced by the Base Rate hikes. Corporate bond credit spreads 1) (bp) 1, Corporate bond (3-yr, BBB-) spread Corporate bond (3-yr, AA-) spread (bp) 1, Credit differentiation in the bond market continues, as the credit risk of prime corporate bonds has stabilized at the low 5 5 levels but the credit spreads of low-rated bonds remain high due to the poor Note: 1) Over Treasury bond (3-yr) yield Sources: Bank of Korea, Korea Financial Investment Association performances of marginal companies. Share prices continue on an upward trend. Stock price (KOSPI) and won/dollar exchange rate (19.1. = 1) (won),5 KOSPI (LHS) won / dollar exchange rate (RHS),3, 1, 1,5 While falling temporarily at the beginning of 11, influenced by the burdens stemming from their steep rise in a short period, they have shown a rapid recovery again since 1, Source: Bank of Korea 1,3 mid-march. Foreigners stock investment funds reversed to a net outflow at the beginning of 11, but since March are again - -

13 Overview showing net inflows. Domestic equity-type funds have shown a slowdown in their trend of outflow since February of 11. The Korean won/us dollar exchange rate has maintained a downward movement by and large, under the influence of the global dollar weakness, the net inflows of foreigners securities investment funds, and the current account surplus. Its volatility remains at a high level compared to those of other major Asian currencies, but is narrowing as a result of the efforts made to improve foreign exchange soundness. (1 million dollars) 3,,5 Foreign exchange reserves, and ratio to short-term external debt Foreign exchange reserves (LHS) Short-term external debt / foreign exchange reserves (RHS) 9 Foreign exchange soundness continues to appear favorable in general, with the external debt redemption capacity raised and the external debt structure improved., 3 The external debt redemption capacity has risen, owing mainly to the large increase in 1,5.1/ 9.1/ 1.1/ / Source: Bank of Korea foreign exchange reserves. The predominance of supply in foreign exchange supply and demand conditions persists as well, owing to the current account surplus

14 Financial Stability Report April 11 Roll-over ratio 1) and spread on domestic banks short-term foreign borrowings (bp) 3 Spread (LHS) Roll-over ratio (RHS) 15 Domestic banks foreign currency funding conditions also appear favorable, with the premiums on their foreign currency borrowings for instance maintaining low 1 levels Note: 1) Total amount of newly extended loans for period / Total amount of loans maturing during period Source: Bank of Korea Soundness of the banking sector has generally risen, with funding smooth, credit risk eased and profitability and capital adequacy improved. (year-on-year, %) 1 1 Commercial bank funding gap 1) and rates of deposit and loan increase Funding gap (RHS) Rate of deposit increase (LHS) 15 Rate of loan increase (LHS) Note: 1) Balance of won-denominated loans - balance of wondenominated deposits Source: Financial institutions' business reports Funding has been smooth owing to strong inflows of new deposits. With regard to fund operation, on the other hand, the situation is one in which an expansion of corporate lending is not easy, given the abundance of excess funds held by large corporations and the aversion to SME credit risk. The competition among banks to extend household loans is therefore becoming fierce. Credit risk in certain industries including construction and real estate remains at a high level, but has shown a gradual decrease recently, with the volumes of new delinquencies and of precautionary loans - -

15 Overview Commercial bank delinquency rates 1) lessening. In the case of the household. 1.5 Corporate loans Household loans. 1.5 sector, credit risk is still at a low level but shows signs of rising with the delinquency ratio becoming somewhat higher recently amid the continuing trend of increase in.5.5 household debt Note: 1) Based on 3-month moving averages (delinquencies one day or longer) Source: Financial institutions' business reports Profitability has improved greatly, owing largely to the widening of the net interest margin. With the easing of burdens from loan loss expenses, profitability is projected to continue its improvement in the future as well. Commercial bank BIS capital and Tier 1 capital ratios 1 Tier 1 capital ratio Common equity capital ratio 1 BIS capital adequacy ratio Capital adequacy appears favorable, with the BIS and Tier 1 capital ratios rising. In the case of domestic banks, the common equity capital Source: Financial institutions business reports ratio seems to be high, and even with the tightening of capital regulatory standards with the introduction of Basel III in the future, their burdens are not expected to be large. For non-bank financial institutions, funding has been smooth and their profitability improved as well. However, their asset soundness has worsened somewhat

16 Financial Stability Report April 11 Funding has been generally smooth, but on the asset management side they have increased their investment in securities including Treasury bonds more than their lending, due to credit risk aversion. Profitability has improved, with interest income increasing and securities-related income growing. Mutual savings banks posted expanding losses in 1, however, due to increasing loan loss expenses and to losses in the process of sales of bad PF loans. Some insolvent mutual savings banks have had their businesses suspended and are being taken over by large commercial banks Corporate credit soundness 1) of non-bank financial companies ) Change in precautionary loans (LHS) Loan delinquency rate (RHS) Substandard-and-below loan ratio (RHS) Notes: 1) Delinquency rate based on delinquencies of one month or longer (for mutual savings banks, delinquencies less than one month included) ) Based on mutual savings banks, mutual credit companies and insurance companies Sources: Financial institutions' business reports, Mutual Credit Federations Credit risk has increased, centering around the corporate sector and influenced by corporate restructuring and the slump in real estate market. Especially for mutual savings banks, the ratio of precautionary real estate PF loans remains high, and unless the real estate market picks up it therefore seems difficult for credit risk to decline much in the short term. - -

17 Overview The payment and settlement system Value (LHS) Volume and value of payments processed through BOK-Wire+ 1) Volume (RHS) Note: 1) Daily average basis Source: Bank of Korea (thousand transactions) operated stably in 1, notwithstanding the steady increase in settlement volume, thanks to the appropriate management of settlement risk. In particular, in the securities and foreign exchange settlement systems, risks due to differences in settlement time declined as the proportion of settlements made through delivery versus payment (DVP) and payment versus payment (PVP) systems rose greatly. [Latent financial system risk factors] Looking ahead, financial system stability seems likely to be greatly influenced by external factors, such as the increase in global inflationary pressures and the possibility of international financial market Major country price inflation rates 1) unease. US Euro area UK Emerging market countries Amid an increasing supply of global liquidity, inflation in major countries is rising due largely to the growth in aggregate demand stemming from the global economic Note: 1) Compared to same months of previous years Source: IMF - recovery and to the rises in price of international raw materials. The global - 9 -

18 Financial Stability Report April 11 inflationary pressures owe to a considerable extent to structural factors also, including the increased grocery demand in emerging market countries and the wage hikes in China, and are not expected to be easy to resolve in the short-term. Major country policy rates The inflationary situations facing advanced Recent level 1) Pre-Lehman collapse level Post-Lehman collapse lowest level and emerging market countries differ, and differences therefore exist between them in their stances on the policy side as well. For advanced countries, responding actively to counter inflation is difficult due to factors such US Japan UK Euro India Korea China Indo Brazil area nesia Note: 1) As of April, 11 Source: Bloomberg as the uncertainties about their economic recoveries. For emerging economies, on the other hand, the influence of supply shocks on their prices is great due to their structural dependence on raw materials. Upward price pressures stemming from expanding aggregate demand are high as well, and policy responses are thus urgently needed. Should global inflationary pressures rise further in the future, there is a possibility of growing downside risks to the global economy as the stance on monetary - 1 -

19 Overview tightening is strengthened, centering around emerging market countries. There is a risk of international financial market instability increasing, owing to a deepening of the fiscal problems of overlyindebted European countries and the aftereffects of the Great East Japan Earthquake. (%, %p) 1 Portugal 1 Overly-indebted European country government bond spreads 1), and German Treasury bond yield Ireland Greece Spain German Treasury bond yield (%, %p) Note: 1) Over German Treasury bond (1-year) yield Source: Bloomberg 1 The fiscal problems of overly-indebted European countries such as Ireland and Portugal have emerged again since October 1. The credit risk of overly-indebted countries is rising steeply, causing borrowing cost increases and funding difficulties for eurozone banks. The fiscal problems of these countries appear difficult to resolve within a short period of time, and likely to act as factors destabilizing the international financial market in the future. Since showing temporary turmoil following the Great East Japan Earthquake in March 11, the global financial markets have gradually regained stability. They could

20 Financial Stability Report April Major country government debt and fiscal deficits 1) Government debt-to-gdp ratio (LHS) Fiscal deficit-to-gdp ratio (RHS) 15 Japan Greece Italy Ireland US France Portugal UK Germany Note: 1) End-1 basis Source: IMF destabilize again, however, depending upon future developments related to the disaster. If, in the process of recovery from the damage, large-scale government expenditure is made, there is a possibility of growing concerns about Japan s fiscal imbalance. Moreover, if the problems of radiation leakage and power shortages become prolonged economic activities in Japan will contract greatly, interrupting the global supply chain and thus likely having a negative effect on global economic growth. Net emerging market fund inflows and foreigners net domestic securities investment 1) (billion dollars) Net fund inflows to emerging market countries - (stock-type+bond-type, LHS) Foreigners net domestic securities investment -3 (stocks+bonds, RHS) Note: 1) For bonds, including redemptions at maturity, etc. Sources: EPFR (Emerging Portfolio Fund Research), Financial Supervisory Service Given the continued existence of destabilizing factors in the international financial market, there is a possibility of sudden changes in global capital flows, and foreigners securities investment funds in the domestic market may therefore become more volatile. With the heightened linkages among financial market price variables such as interest rates, stock prices and exchange rates, foreign investors market influence has also grown, and there are thus worries about declining - 1 -

21 Overview financial system stability in the event of largescale foreign capital outflows. 3 5 Bank and non-bank financial institution 1) household loans Changes in bank household loans (LHS) Changes in non-bank financial institution household loans (LHS) Proportion of non-bank financial institution household loans ) (RHS) Amid a continuing trend of increase in household debt, structural vulnerabilities remain, such as the overborrowing propensities of low-income households and 15 borrowers with high-priced homes as collateral. The household debt problem is Notes: 1) Refers here to mutual savings banks, agricultural fisheries forestry cooperatives, credit unions and community credit cooperatives ) Balance of non-bank financial institution household loans / (balance of bank + non-bank financial institution household loans) Source: Bank of Korea accordingly acting as a factor burdening financial system stability. Non-bank financial institution housing loans, Loan-to-income ratios and proportions of overly-indebted borrowers 1), by collateral value Loan / income (LHS) 3 Proportion of overly-indebted borrowers (RHS) which are used primarily by the low income and low credit brackets, are increasing greatly. The debt repayment capacity of these households appears low, as their loan-toincome ratio is high. In line with this, should the income improvement of low income households slow, non-bank financial institutions household loans could deteriorate more rapidly than those of banks and below 3~ ~9 Over 9 (million won) Note: 1) Borrowers with loan-to-income ratio exceeding % Sources: Seoul metropolitan area home mortgage loan data of four major commercial banks (as of end-1) 1 For households borrowing with high-priced homes as collateral, a tendency of excessive borrowing relative to income in expectations

22 Financial Stability Report April 11 of a rise in housing prices has been observed. Given the possibility of a fall in prices of high-priced large homes in line with demographic changes in the future, concerns might be raised about these households repayments of their debts. Moreover, the majority of home mortgage loans are those on which interest alone is paid, without principal, and this structural characteristic is acting as a factor hampering household debt deleveraging. 1 Listed firm operating income-to-sales ratio Operating income-to-sales ratio (LHS) Exports (RHS) (1 million dollars) 5,, 3,, 1, Firms financial soundness has been enhanced, through the improved profitability following the continuing upturn of the domestic economy and the buoyancy of exports Sources: KIS-Value, Korea International Trade Association Economic conditions at home and abroad, however, including oil prices, exchange rates, and interest rates, are developing in directions unfavorable to firms business operations and concerns about a decline in profitability therefore exist. In this process, there is a possibility that the number of - 1 -

23 Overview Expected default frequency (EDF) 1) in construction sector Construction sector All sectors excluding construction marginal companies will increase, centering around the shipbuilding, construction, and real estate sectors with vulnerable financial structures. Particularly, in the case of the construction sector, its Expected Default 5 5 Frequency (EDF) remains at high levels Note: 1) Expected default frequency (EDF) calculated based on listed firm financial and stock price information, and displayed as a percentage (end-month basis) Source: Bank of Korea Accordingly, should the real estate slump be prolonged there are concerns about financial system stability declining as the number of bankrupt enterprises mounts. [Policy directions for financial stability] Going forward, in order to more firmly maintain financial system stability, the risk factors latent in the system should be thoroughly examined and policy efforts to resolve them should be strengthened. First, to prepare against an increase in world economic uncertainties due to the growth in global inflationary pressures and the international financial market instability, the degree of monetary policy accommodativeness must be adjusted at an appropriate speed

24 Financial Stability Report April 11 and extent, with an emphasis on ensuring that the basis for price stability is firmly anchored, while sustaining sound economic growth. As financial system stability can decline due to the continued existence of destabilizing factors domestically and abroad, the conduct of macroprudential policies must be strengthened. For this purpose, there is a need to improve the institutional arrangements such as the mechanisms for cooperation among the policy authorities and the related policy tools. A strengthening of policy efforts that can suppress the excessive in- and outflows of foreigners investment funds is necessary. In this regard, the utmost efforts must be made to draw up a detailed plan ensuring that the Macro-prudential Stability Levy system scheduled for enforcement from the second half of this year can be operated smoothly. The foreign exchange market structure must also be improved to alleviate the volatility in financial market price variables arising due to - 1 -

25 Overview in- and outflows of foreigners securities investment funds. To control the excessive increase in household debt, it is necessary that the expectations of a rise in housing prices are suppressed using diverse policy measures. Especially in the case of DTI regulations, in view of their effectiveness shown in reducing household loan size and improving its soundness, their continued and consistent implementation is called for. For gradual downward adjustment of household debt, there is a need for diverse plans to ensure that loan principal is steadily repaid. At the same time, the system of financial support for households in the lower-income brackets must be made more reliable, to prevent occurrence of households insolvencies due to sharp surges in interest payment burdens at times when interest rates rise. As there is a possibility of the number of marginal firms increasing through deterioration in the business environment, policy measures to address this problem

26 Financial Stability Report April 11 must be sought. In this context, for companies losing competitiveness and surviving only through borrowing, the related systems must be continually supplemented to ensure that they can be smoothly forced from the market or liquidated in accordance with market principles. Additionally, the risk of serial bankruptcies in the construction sector is rising due to financial institutions reduced supply of funds to real estate PF businesses. Monitoring related to this must therefore be strengthened, and a plan that can alleviate this risk should be arranged

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28 Financial system stability. Financial system stability 1. Financial markets <Figure II- 1> Global liquidity and world economic growth (Q = 1) (Q = 1) 7 US monetary base + foreign holdings of US Treasury bills (RHS) G M 1) (LHS) G nominal 1) GDP (LHS) / Note: 1) Sum of US, Euro area, Japan and UK Source: Bloomberg <Figure II- > 1 Global investment sentiment and credit risk indicators Source: Bloomberg <Figure II- 3> Corporate bond issuance and spread (billion dollars, billion euros) CBOE VIX (LHS) TED spread (RHS) EMBI+ spread (RHS) US corporate bond issuance (LHS) Euro area corporate bond issuance (LHS) US corporate bond spread 1) (RHS) (bp) 1, (bp).1/ 9.1/ 1.1/ 11.1/ Note: 1) Difference in yields between 1-year corporate bonds (BBB-) and Treasury bonds Sources: FRB, ECB, Bloomberg International financial markets The international financial markets have remained generally stable owing to the recovery of the world economy and the abundant global liquidity, although credit risk in some countries has risen. Several potentially destabilizing factors remain, however, depending upon how circumstances unfold related to such factors as the fiscal problems of overly-indebted countries in Europe, the worsening of political conditions in the MENA (Middle East and North Africa) region, and the aftereffects of the Great East Japan Earthquake. (Reduced credit risk) The risk-averse sentiment of global investors has been shrinking gradually, with the help of the world economic recovery. The VIX Index 1) spiked temporarily in 11, due to the political unrest in the MENA region, the resurfacing of sovereign debt concerns in Europe and the Great East Japan Earthquake, but has for the most part been continuing on a downward, stabilizing trend. In the funding market, as well, the TED Spread ) has 1) The CBOE VIX represents the inherent variability of the S&P5 index options traded on the Chicago Board Options Exchange (CBOE), reflecting the market-predicted volatility for the following 3-day period. The lower the index, the higher investor confidence. ) The TED Spread is the difference in interest rates of three-month US Treasury bills (T-Bills) and three-month Eurodollar contracts reflected by the LIBOR rate. It is used as an indicator of credit risk in the short-term interbank funding market

29 Financial Stability Report April 11 <Figure II- > Changes 1) in lending by financial institutions (billion dollars) (billion euros) US (LHS) - - Euro area (RHS) - - remained low and the credit spread of emerging market bonds (EMBI+ 3) ) has recovered to its level prior to the global financial crisis, as credit risk continues to ease. Private sector credit extension by global financial institutions has also rebounded. Since September 1, US bank lending has turned upward, and eurozone lending has also continued to increase gradually, centering on household loans Note: 1) Compared to same months of previous years Sources: FRB, ECB <Figure II- 5> Sovereign CDS premiums - However, Japan and the overly-indebted countries in Europe and the MENA region have shown increases in sovereign credit risk. (bp) Japan Emerging market countries 1) MENA region ) Overly-indebted European countries 3) (bp) Notes: 1) Average of premiums for Brazil, Russia, China, Korea, Hong Kong, Thailand, Malaysia and Indonesia ) Average of premiums for Saudi Arabia, Egypt and Tunisia 3) Average of premiums for Greece, Ireland, Portugal and Spain Source: Bloomberg <Figure II- > 9 3 Major country long-term treasury bond yields 1) US Japan Germany Average of PIIGS ) (Rises in long-term interest rates and stock prices of major countries continuing US dollar weakening) The long-term treasury bond yields (1-year) of major countries have continued to rise since October 1. Long-term interest rates of major advanced countries like the US and Germany fell until the third quarter of 1, but then turned to an upward trend from October owing to economic recovery and to expectations of inflation. The rates of increase in yields on treasury bonds of overly-indebted countries in Europe accelerated steeply due to the worsening of fiscal problems in the nd half of 1, and as of end-march 11 high rates of over % were seen. Stock prices have been on the rise due to the recovery of the world economy and the continued monetary easing, but in 11 have fluctuated repeatedly. US stock prices, which showed a steady increase in 1, Notes: 1) Based on 1-year bonds ) Average of Portugal, Ireland, Italy, Greece and Spain Source: Bloomberg 3) The EMBI+ Spread represents the average spread on an emerging market bond over a 1-year US Treasury bond, and signifies the level of risk of investing in emerging market bonds. - -

30 Financial system stability <Figure II- 7> (end-9 = 1) 1 1 Major country stock price indexes 1) US Japan Europe (end-9 = 1) 1 Emerging market countries Note: 1) Based on Dow Jones for US, Nikkei for Japan, Euro Stoxx for Euro area, and MSCI Emerging Market Index for emerging market countries Source: Bloomberg 1 fell slightly for a while in 11 as a result of the heightened political unrest in the MENA region, and the earthquake and tsunami disaster in Japan. However, they have since then resumed their rising trend. Stock prices in Japan and the euro area have shown gradual increases, but have become very volatile in 11 with the worsening of fiscal problems in overly-indebted countries. Stock prices in emerging market countries, which showed relatively high rates of increase in the nd half of 1, have slowed their pace as countries have implemented tightening policies in 11 in response to inflation. <Figure II- > Major country currency values against US dollar (end-9 = 1) (end-9 = 1) Euro Source: Bloomberg Japanese yen Chinese yuan Currency appreciation Currency depreciation Major country currencies have been strong against the US dollar since the nd half of 1 also, due to the abundant supply of US dollar liquidity. Japanese Yen appreciation, which continued throughout 1, accelerated immediately after the Great East Japan Earthquake in March 11, due to expectations that Japan would sell foreign assets to raise disaster recovery funds, and the yen / US dollar rate at one time fell to Thereafter, the yen agaiust US dollar rate rose with the international coordination in the G7 to stabilize the yen s value, and as of April stood at 5.. The Chinese yuan has also remained strong against the dollar since the People s Bank of China s announced policy of exchange rate flexibility (June 19, 1). The euro dropped against the US dollar from October 1, following the reemergence of European fiscal problems, but has reversed course in 11 amid expectations of interest rate hikes in response to inflationary pressures, and the euro is now gradually appreciating

31 Financial Stability Report April 11 <Figure II- 9> Interest rate Stock price Exchange rate Interest rate, stock price and exchange rate volatilities 1) Interest rate (3-yr Treasury bond yield) Stock price (KOSPI) Exchange rate (KRW / USD) Deviation of volatility ) <Figure II- 1> 1%p and over ~.5%p.5~1%p %p and below Notes: 1) Calculated based on EWMA (Exponentially Weighted Moving Average) ) Based on quarter-on-quarter changes Source: Bank of Korea Treasury bond yield, Bank of Korea Base Rate, and consumer price inflation 1. Domestic financial markets The domestic financial markets have shown a pattern of relative stability since the second half of 1 thanks to the solid economic fundamentals, despite growing uncertainties at home and abroad. Interest rate volatility expanded in the fourth quarter of 1 due to the slowdown in foreign investor purchases of domestic bonds, but rates are regaining stability in 11. Exchange rate volatility is also maintaining a stable downward trend. Credit differentiation regarding non-prime corporate bonds continues, however, while stock prices have become slightly more volatile in line with the aftereffects of the earthquake in Japan and the resurfacing of sovereign debt concerns in Europe. Treasury bond (3-yr) yield Base Rate Consumer price inflation (Reductions in foreigner purchases of domestic bonds, and continued credit differentiation) Sources: Bank of Korea, Statistics Korea <Figure II- 11> Foreign investment in Korean bonds 1 3 Net purchases (RHS) Outstanding values (LHS) Source: Financial Supervisory Service The three-year Treasury bond yield fell, owing to increased bond investment by foreigners and a reduction in Treasury bond issuance, to hit a historic low level of.9% on December 7, 1. The yield has since then reverted to a rising trend, influenced by the hikes in the Base Rate, the upward pressures on consumer prices, and a contraction in foreigners domestic bond purchases. It has continued to fluctuate since February 11, and stood at 3.7% on April. Foreign investors kept up their net purchases of Korean bonds through November 1, focusing on mediumand long-term bonds. ) Their purchases have, however, ) During January to November 1, foreigners expanded their investment massively (1.1 trillion won), centering on long-term (three-year and longer) Treasury bonds. Their investment in short-term - -

32 Financial system stability <Figure II- 1> (bp) Long- and short-term interest rate spreads Treasury bond (3-yr) - CD (91-day) Treasury bond (3-yr) - Call (overnight) (bp) lessened somewhat since December 1, when they showed a net selling position, as global investment funds have moved into the equity markets and fears of inflation have grown. Foreigner bond holdings, which had reached a historic peak (of.1 trillion won) at end-november 1, have consequently fallen and stood at 75.3 trillion won as of end-march Source: Bank of Korea <Figure II- 13> (bp) 1, 5 <Figure II- 1> 15 Financial conditions 1) of listed firms ), by credit rating (% 1, %) <BBB rated and higher> Corporate bond credit spreads 1) Corporate bond (3-yr, BBB-) spread Corporate bond (3-yr, AA-) spread Note: 1) Spreads over Treasury bond (3-yr) yield Sources: Bank of Korea, Korea Financial Investment Association <BBB- rated and below> (bp) 1, The spreads between long- and short-term interest rates have generally continued their trend of narrowing since the second half of 1. This owes to the fact that short-term rates have risen much more than long-term rates, influenced by the Base Rate hikes. In the corporate bond market, the phenomenon of credit differentiation regarding non-prime (rated BBBand below) corporate bonds continues. The spreads on prime corporate bond yields over the Treasury (3-yr) bond yield have stabilized at the low levels recorded prior to the global financial crisis. The credit spreads of non-prime corporate bonds remain high, however, due to the slump in the construction 5) business, the worsening of marginal companies financial structures, and other related factors. The financial soundness indicators of companies rated BBB- and below actually worsened in 1, unlike those of companies rated BBB and higher Operating Debt Borrowing income-to- ratio ratio sales ratio (% 1) Operating Debt Borrowing income-to- ratio ratio sales ratio (% 1) Notes: 1) Operating income-to-sales ratio = Operating income/sales, Debt ratio (%, industry avg.) = Total liabilities/stockholder equity, Borrowing ratio (%, industry avg.) = Borrowings/Stockholder equity ) Based on exchange-listed firms with bond credit ratings as of end-march 11 Sources: Fnguide, KIS-Value (mainly less than one-year) bonds such as Monetary Stabilization Bonds (MSBs) increased by only a small proportion (.3 trillion won). 5) In 1, the average debt ratio of construction firms, which account for % (based on sales revenue) of all companies with credit ratings of BBB- and below, was three times as high as that of other firms

33 Financial Stability Report April 11 <Figure II- 15> (Jan. =1) Major country stock indices Korea US Japan China (Jan. =1) Sources: Bank of Korea, KOSCOM <Figure II- 1> Foreigner net stock purchases 1), changes in equity-type funds ), and total wrap account balance Foreigner net stock purchase values (LHS) Changes in equity-type funds (LHS) Total wrap account balance (RHS) Notes: 1) Sum of KOSPI and KOSDAQ ) Domestic type Sources: KOSCOM, Korea Financial Investment Association <Figure II- 17> Net flows of equity-type funds 1), by KOSPI range Total - trillion won 3 trillion won, and over 1,~, 1,~1, 1, and below Net outflows Net inflows Pre-Lehman collapse (Jun. ~ Aug. ) Post-Lehman collapse (Sep. ~ Mar. 11) Note: 1) Domestic type Sources: KOSCOM, Korea Financial Investment Association (Increased volatility after steep rise in stock prices) Domestic stock prices (KOSPI) have shown a steeper upward trend compared to the equity indices of other major countries, owing to the solid and robust growth of the Korean economy and to net purchases of local stocks by foreign investors. Entering 11 the KOSPI fell, impacted by burdens stemming from its steep rise in a short period of time, but from mid-march it reverted to an upswing again and stood at,1 on April, 11. Stock price volatility has increased slightly, showing a sensitive response to developments related to domestic and international risk factors such as the aftereffects of the earthquake in Japan and the resurfacing of sovereign debt concerns in Europe. Foreign investors continued their net purchases in the Korean stock market in 1, owing to the expectations of improved business performances by domestic companies. Their equity investment funds then showed a temporary net outflow early in 11, as global investment fund portfolios reduced their emerging market weightings, but have been recording net inflows again since March 11. Domestic equity-type funds showed a trend of net outflow during 1, as some investors withdrew their funds following their recoveries of principal losses. Since February 11, however, this outflow trend has slowed. The significantly large amount of equity-type funds invested heavily prior to the financial crisis appears to have already been redeemed, in line with the rebound in stock prices since the financial crisis, implying that the risk of increased stock market volatility caused by equity-type fund redemption will subside as the pressure for redemption seems likely to ease somewhat. - -

34 Financial system stability <Figure II- 1> Exchange Market Pressure Index (EMPI) 1) Avg S.D. - Avg S.D Meanwhile, the total volume of contracted assets in wrap accounts ) has ballooned to 1.9 trillion won as of end-february 11. Wrap accounts, unlike investment funds and other investment products, tend to focus on certain stocks and may therefore cause increased stock market volatility. 7) (Downward movement of won / dollar exchange rate) Note: 1) If the EMPI rises or falls by more than a certain multiple of the standard deviation (1.5 times, as generally used in academia) in comparison to the mean value of observations made within the given time horizon, then the FX market will become more unstable. Source: Bank of Korea <Figure II- 19> KRW/USD and KRW/JPY exchange rates, and US dollar index 1) (won/dollar, won / 1 yen) 1, 1,5 1, -1 (Mar =1) 1 KRW / USD (LHS) KRW / JPY (LHS) US dollar index (RHS) 1 While Korea s foreign exchange market appeared unstable for a while, due to the surfacing of fiscal problems in Europe and geopolitical risks on the Korean Peninsula, it has maintained a stable downward trend by and large since the second half of 1. The Exchange Market Pressure Index (EMPI) ), which shows the degree of instability and disequilibrium in the foreign exchange market, has moved within a stable range thanks to the decreased volatility of the won exchange rate and the gradual increase in the nation s foreign reserves Note: 1) Showing the average value of the USD against currencies of six major countries Sources: Bank of Korea, Bloomberg ) These products are customized asset management services whereby securities firms manage the assets entrusted them by their customers in consideration of their customers investment tendencies. Unlike the usual investment funds, which diversify their portfolios and track the market index returns, wrap accounts have fewer restrictions on investment and management. Investments in wrap accounts hence tend to be concentrated on several stocks having high expected returns. 7) If other investors engage in tracking the investment patterns of wrap accounts (in so-called, herd behavior ), stock market volatility may intensify. ) This indicator measures the degree of disequilibrium in the foreign exchange market resulting from changes in foreign exchange reserves and exchange rates. This report used the IMF (World Economic Outlook, Oct. 7) method of analysis as its benchmark. The EMPI is defined as the sum of two components: one obtained by the currency appreciation (depreciation) rates and the other by the amounts of increase (decrease) in foreign reserves, with both weighted by the inverses of their standard deviations. However, the changes in foreign reserves are divided by the monetary base, to adjust for the trend-related factors arising from the expansion in size of the economy: (er: exchange rate; fr: foreign reserves; mo: monetary base; t: time) - 5 -

35 Financial Stability Report April 11 <Figure II- > Comparison with exchange rate volatilities 1) of major Asian countries ) Korea - Major Asian country average (RHS) Korea (LHS) Major Asian country average (LHS) Japan (LHS) / Notes: 1) Daily closing price - Previous day s closing price / Previous day s closing price 1 ) Japan, Singapore, Malaysia, Thailand and Indonesia Sources: Bank of Korea, Bloomberg <Figure II- 1> (%p) The Korean won / US dollar exchange rate has maintained a downward movement, under the influence of the global dollar weakness, the net inflows of foreigners securities investment funds, and the current account surplus. On April, 11 the won / dollar rate stood at 1,3 won, an 11.% decline compared to the end of June 1. The exchange rate of the won against the 1 yen is fluctuating within a narrow range at around the same level as in H1 1. Meanwhile, the daily volatility of the exchange rate in Korea is still relatively high 9) compared to those of other major countries in Asia. The gap is narrowing, however, as a result of the efforts made to enhance foreign exchange soundness. (%, %p) Arbitrage incentive 1) (%, %p) Arbitrage incentive FX swap rate Domestic / overseas interest rate differential The FX swap rate 1) in the foreign exchange market continues to rise, reflecting the favorable foreigncurrency funding conditions. As a result, the arbitrage trading incentive, obtained by subtracting the FX swap rate from the domestic / overseas interest rate differential, is fluctuating repeatedly at relatively low levels Note: 1) Domestic / overseas interest rate differential - FX swap rate, one-year contract basis Sources: Bank of Korea, Bloomberg - 9) The daily volatility of the exchange rate of Korea in 1, when geopolitical risk was at a heightened stage, was.% (higher than the G average of.7%). During the peak period of the global financial crisis (Sep. ~Mar. 9), the daily volatility was the third highest among the 5 major countries considered. 1) When the foreign-currency funding conditions of domestic financial institutions become more favorable, there is less demand for foreign currency funds raised through spot exchange purchases / forward exchange sales. As a result, the spot exchange rate falls and the forward exchange rate increases, leading to a rise in the FX swap rate [(forward exchange rate - spot exchange rate) / spot exchange rate]. - -

36 Financial system stability. Foreign exchange soundness (Foreign exchange soundness continues to improve) <Figure II- > Foreign exchange reserves and net external assets (1 million dollars) (1 million dollars) 3, Foreign exchange reserves (LHS) 9 Net external assets (RHS) Foreign exchange soundness continues to show a generally favorable picture, with the external debt repayment capability rising and the external debt structure improving.,5, 1,5.1/ 9.1/ 1.1/ / Source: Bank of Korea Foreign exchange reserves totaled a record high of US$9. billion as of end-march 11, thanks to the continued current account surplus. The net external asset position also expanded with the increase in foreign exchange reserves, the largest component of external assets. As of end-december 1, Korea s net external assets reached US$.3 billion. <Figure II- 3> Ratios of short-term external debt to total external debt and foreign exchange reserves Total external debt (LHS) (1 million dollars) Short-term external debt (LHS), Short-term external debt / Total external debt (RHS) Short-term external debt / Foreign exchange 9 3,5 reserves (RHS) 3,,5 7 The short-term external debt repayment capacity has been enhanced thanks to the massive increase in the nation s foreign exchange reserve holdings. As of end- December 1, the ratio of short-term external debt to foreign exchange reserves had fallen to %, from 55% one year earlier. In addition, as a result of the implementation of the Measures to Improve Foreign Exchange Soundness 11), the external debt structure was, 1,5 1,.1/ 9.1/ 1.1/ / Source: Bank of Korea ) The government, the Bank of Korea and the supervisory authorities implemented measures to improve foreign exchange soundness twice during 1. The main contents and implementation dates are as follow: Main contents Month effective Domestic bank medium- to Regulation strengthened long-term foreign currency % 9% Jan. 1 financing ratios 1) 9% 1% Aug. 1 Limits on use of foreign currency loans Foreign currency loans permitted for overseas use only July 1 Domestic banks : 5% of equity capital Limits on forward FX positions Local branches of foreign banks: 5% Oct. 1 of equity capital New requirement of foreign currency liquidity risk management standards (emergency funding plans, etc.) Domestic banks Jan. 1 Local branches of foreign banks Nov. 1 Note: 1) (Medium- to long-term borrowings / Medium- to long-term loans) 1-7 -

37 Financial Stability Report April 11 <Figure II- > (1 million dollars) 1, 9 7 Short-term external debt of local foreign bank branches External debt of local foreign bank branches (LHS) Short-term external debt of local foreign bank branches / Total external debt of local foreign bank branches (RHS) Short-term external debt of local foreign bank branches / Total short-term external debt (RHS).1/ 9.1/ 1.1/ / Source: Bank of Korea improved, with the share of short-term in overall external debt shrinking from 3% at the end of 9 to 37% as of end-1. Influenced by the introduction of forward FX position limits 1), the local branches of foreign banks in Korea have reduced their short-term external debt since June 1. Their shares of short-term external debt as percentages of their total external and total Korean short-term debt were 7% and 3% respectively at end- 1, declines of six and five percentage points compared to end-9. <Figure II- 5> (bp) 3 Roll-over ratio 1) and spread on domestic bank short-term foreign borrowings Spread (LHS) Roll-over ratio (RHS) 15 1 In regard to foreign exchange supply and demand conditions, supply has exceeded demand thanks to the current account surplus and the continued net inflow of securities investment funds from overseas. 13) This trend is expected to continue throughout 11, fueled by the current account surplus. Foreign currency supply and demand instability could increase, however, due to sudden capital flight if uncertainties surrounding the global economy lead to credit crunch in the international financial markets Note: 1) Total amount of newly extended loans during period / Total amount of loans maturing during period Source: Bank of Korea 1) Their total forward FX position (off-balance sheet basis) fell greatly after the June 13, 1 announcement of the limits (1% of capital as of end-may, 1 1% as of end-december, 1). 13) Korean balance of payments (1 million dollars) 9 1 Current account 3 3 Goods Services Capital and Direct investment financial Portfolio investment account Other investment Source: Bank of Korea - -

38 Financial system stability (Favorable foreign currency funding conditions for domestic banks) <Figure II- > Domestic bank foreign currency maturity gap ratios 1) and Proportion of short-term borrowing ) month or less maturity gap ratio (LHS) -month or less maturity gap ratio (LHS) 1-year or less maturity gap ratio (LHS) Proportion of short-term borrowing (RHS) Notes: 1) (Foreign currency assets - Foreign currency liabilities) / Foreign currency assets 1 ) Short-term foreign currency liabilities / Total foreign currency liabilities balance 1 Source: Financial Institutions business reports, Bank of Korea <Figure II- 7> (bp) 1, CDS premiums of foreign currency-denominated government bonds and bank debentures (bp) Foreign currency-denominated 1, government bonds CDS premium charged to banks managing proportionately high amounts of foreign currency assets 1) CDS premium charged to banks managing proportionately low amounts of foreign currency assets 1) Note: 1) The banks with the two highest and the two lowest amounts of foreign currency assets, among the largest four banks in terms of asset size Sources: Bloomberg, Markit 5 3 Thanks to the abundant global liquidity and Korea s sound economic fundamentals, domestic banks foreign currency funding conditions appear favorable, despite the worsening of fiscal problems in Europe. The roll-over ratio for short-term foreign currency borrowings has remained stable at around 1%, and risk premiums on short-term borrowings have also been fluctuating at around their pre-global financial crisis levels. The structure of the sources and uses of foreign currency of domestic banks has also improved. Their share of short-term in overall foreign currency borrowings had fallen to.3% as of end-1 (from.% at the previous year-end). And with this reduction in short-term borrowing the maturity gap ratios between banks assets and liabilities with durations of less than one year have increased, since turning positive (assets exceeding liabilities) at end- December 9. These favorable foreign exchange soundness conditions have been reflected in the credit default swap premiums. The CDS premiums on foreign currency-denominated bank debentures have fluctuated at a low level of around 13 bp, and that on foreign currency-denominated government bonds is also relatively low at approximately 1 bp

39 Financial Stability Report April Financial institutions <Figure II- > 1 9 Changes in commercial bank funding sources Deposits CDs Bank bonds + RPs + cover bills Banking sector Fund raising and usage 3 3 (Favorable liquidity conditions due to deposit inflows) Source: Financial institutions business reports <Figure II- 9> Commercial bank proportions of deposits and wholesale funding Source: Financial institutions business reports <Figure II- 3> Proportion of deposits (LHS) Commercial bank funding gap 1) and rates of deposit and loan increase ) Funding gap (RHS) Rate of deposit increase (LHS) 15 Rate of loan increase (LHS) 1 1 Proportion of wholesale funding (RHS) Commercial bank fund raising has remained smooth, with the continued inflow of large amounts of deposits. In terms of fund usage, however, banks core assets, i.e. their loan extensions, have remained sluggish. With regard to the raising of funds, the rate of deposit increase has expanded (from 1.1% in 9 to 17.5% in 1), in line with the higher preference for safe assets and banks policies for inducing conversion by customers of maturing CDs to time deposits. Wholesale funding 1) has meanwhile fallen sharply, as banks have refrained from issuing CDs and bank bonds in preparation for introduction of the mandatory loanto-deposit ratio. 15) Consequently, the share of wholesale funding in banks funding sources as a whole has fallen sharply, to 13.7% in January 11 from 3.9% at the end of 9. In terms of fund operation, despite the expansion of home mortgage lending since the second half of 1 the rate of lending increase remains low, at around 3%, Notes: 1) Balance of won-denominated loans - balance of wondenominated deposits ) Compared to same months of previous years Source: Financial institutions business reports 3-3 1) Includes CDs, RPs, cover bills and bank bonds 15) A mandatory loan-to-deposit ratio (won-denominated loans / won-denominated deposits) of 1% or below (average balance basis) is expected to be introduced starting from 1. For details, refer to Box II-1 Effects of the loan-to-deposit ratio requirement on bank management

40 Financial system stability <Figure II- 31> Commercial bank share of securities in total assets due to the sluggishness in SME lending growth stemming from credit risk concerns and the cessation of government financial support for SMEs. 1) The share of securities in total bank assets has on the other hand risen, since banks have invested mainly in securities as a means of managing their surplus funds, due to the increase in deposits and sluggishness of loan growth Source: Financial institutions business reports <Figure II- 3> Commercial bank loan-to-deposit ratios 1 Max-Min range 1) Inter-quartile range ) Median Liquidity-related indicators remain favorable, in reflection of these changes in banks fund raising and usage behavior. The loan-to-deposit ratio has since the second half of 1 remained below 1%, the mandatory ratio, for most banks. Banks liquidity ratio 17), meanwhile, indicative of their short-term liquidity conditions, greatly exceeds the 1% guidance ratio set by the supervisory authorities, and stood at 17% as of January Notes: 1) 1st~th quartile range when divided into quartiles ) nd~3rd quartile range when divided into quartiles Source: Financial institutions business reports <Figure II- 33> Results of quantitative impact studies on LCR and NSFR Basel III mandatory ratio 3.7 Major banks worldwide 1) Domestic banks ) Meanwhile, some new international liquidity regulations, for example of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), are planned for introduction. 1) According to a quantitative impact study by the Basel Committee on Banking Supervision (BCBS), domestic banks currently do not satisfy international liquidity requirements. In the short term, it is thus possible that these measures will have negative impacts on bank profitability, due to their expanded investment in highly liquid assets and the onset of competition to attract retail deposits to enhance their liquidity ratios. We may 7 LCR 7.3 NSFR Notes: 1) 91 banks in 3 countries worldwide ) Woori, Shinhan, Hana, Kookmin Banks, IBK Source: Basel Committee on Banking Supervision (BCBS) 7 1) The extension of debt maturities and expansion of credit guarantees, implemented since the global financial crisis, ended in June 1. 17) Liquidity ratio = (assets with remaining maturity of one month or less / liabilities with remaining maturity of one month or less) 1 1) The LCR regulation will take effect from 15 after the 11 to 1 observation period, and the NSFR from 1 after the 1 to 17 observation period. For details, refer to Box II- Impact of the Basel III capital and liquidity requirements on domestic banks

41 Financial Stability Report April 11 expect positive effects in the long term, however in that the ability to respond to sudden massive fund outflows will be improved, and that fund raising stability will be enhanced due to the resulting increase in long-term deposits. (Continued difficulties in fund operation) <Figure II- 3> Large corporation bond issuance and short-term liquid assets 1) Corporate bond issuance (LHS) Short-term liquid assets (RHS) Note: 1) Balance of cash, cash equivalents, and short-term financial instruments, as of the end of each year Sources: Financial Supervisory Service, KIS-Value, Bank of Korea <Figure II- 35> 1 Decomposition of SME loan interest rates Unexpected loss ratio Expected loss ratio Savings deposit rates 1 Loan-to-deposit interest rate differential (taking into account credit losses) SME loan interest rate Banks are experiencing difficulties extending more loans, their primary source of profit, even despite the swelling of deposits since the global financial crisis. As large corporations have abundant surplus funds, and are able to raise capital smoothly from the direct financial markets, banks continue to see little loan demand from them. With respect to SMEs, it is hard for banks to proactively increase lending because of continued worries about credit risk along with the ending of the government s expanded credit guarantees and other financial support measures. Decomposition of the SME loan interest rate 19) into funding costs and credit loss ratios ) shows that the credit loss ratio remains high, implying a low incentive for loan extension to SMEs. -.1/ 7.1/.1/ 9.1/ 1.1/ Source: Bank of Korea - 19) SME loan rate = funding costs (savings deposit interest rate) + expected and unexpected loan loss ratio + margin rate ) The credit loss ratio is the sum of the expected and unexpected loss ratios. The expected loss refers to the loss that can arise due to the possibility of default by an individual borrower. - expected loss = exposure default rate loss given default Meanwhile, unexpected loss refers to losses incurred through defaults arising due to unforeseen factors, and in such cases the bank must absorb the losses through its capital. Therefore, the unexpected loss ratio may be viewed as the cost of holding the capital necessary to absorb unexpected losses. - unexpected loss = exposure capital requirement - 3 -