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Financial Services Industry Overseas Expansion of Korean Financial Services Institutions Bosung Shin, Research Fellow* Evidence is emerging from all corners that the growth of the Korean financial market has reached a saturation point. For a breakthrough, Korean financial institutions must look overseas, but they have to decide which region to target. One of the main criteria to set the target should be countries where the economy is growing fast but whose financial markets are underdeveloped. Korean firms will find opportunities in areas where there is large demand for financial services to support economic growth, but where domestic financial institutions cannot supply the demand. Fortunately, the neighboring Asian countries meet these criteria. Korean financial institutions thus must aggressively develop foreign expansion strategies to enter into this region. I. Drivers of Overseas Expansion of Financial Services Institutions 1. Necessity for overseas expansion To begin, we look at the domestic market conditions, or push factors, that necessitate foreign expansion by Korean financial services institutions. A. Saturation of the domestic market The first factor that is driving Korean financial firms to overseas expansion is that the Korean financial market has reached its growth limits. This can be seen clearly * All opinions expressed in this paper represent the author’s personal views and thus should not be interpreted as the Korea Capital Market Institute’s official position. Tel: 02-3771-0651, E-mail: [email protected] 7 Capital Market PERSPECTIVE when looking at the growth rate of financial services customers. First, the number of deposit accounts of commercial banks has remained flat since the beginning of the 2000s. Also, the share of households investing in equity has stagnated. Furthermore, after an initial period of a rapid increase, the number of funds held by households has recently begun to decline (Figure 1). In addition, the insurance penetration rate of Korea is one of the highest in the world, implying that customer base expansion will be a challenging task (Figure 2). Figure 1. Number of clients/accounts in each financial sector Number of deposit accounts in depository banks The number of population holding stocks to the total population (Unit: 1 million accounts) (Unit: %) 200 25 Number of mutual fund accounts held by households (Unit: 1 million accounts) 10 The ratio to the economically active population The ratio to the total population 20 150 18.5 19.1 7.8 8 7.4 7.2 6.2 15 6 15.1 100 9.2 10 9.6 4 2.5 50 5 0 7.0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2004 2005 2006 Note: The ratio of stock investors to the total population Source: Bank of Korea, Korea Exchange, OECD Figure 2. Insurance penetration of Korea vs. the OECD average (Unit: %) 20 Korea 15 OECD 13.8 10.9 10 8.4 8.6 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Note: Insurance penetration: Insurance premium/GDP Source: Financial Supervisory Service (FSS), OECD 8 2010 Vol. 2, No. 4 2007 2008 Overseas Expansion of Korean Financial Services Institutions A common consequence of market saturation is increased competition which leads to the decline of profitability. Korea is not an exception to this rule, as the bottom lines of financial companies have seen systematic and sustained declines across all financial sectors (Figure 3). The net interest margin (NIM) for commercial banks, which stood at 3% in 2005, has declined every year and was 2% in 2009.The fact that their return on equity (ROE) ratios has been trending downwards across all financial industries is another indicator of intensifying competition.1) Figure 3. Profitability of Korea’s financial sectors Return on Equity Banks’ Net Interest Margin (Unit: %) (Unit: %) 30 5 bank securities insurance 20 4 3 2.8 2.6 2.4 2.3 2.0 2 10 1 0 0 FY2005 FY2006 FY2007 FY2008 FY2009 FY2005 FY2006 FY2007 FY2008 FY2009 Source: FSS For financial firms, there are two avenues to mitigate the circumstances of escalating competition and declining profitability. One is to look for solutions within the domestic market and the other is to develop opportunities abroad. For the former option, the easiest way to face competition and falling profits is to remove the source of competition. This can be done through mergers or acquisitions of competing firms, which will intensify market concentration. By using the increased market power, the acquiring firm will be able to improve margins. But the current market structure is not conducive to this approach. The combined market share of the top 5 commercial banks is well over 80% and the situation is not very different in the insurance industry. As excessive market concentration and its negative effects 1) The reason for the high ROE in the life insurance sector in FY2009 was the increase in investment returns from falling interest rates and the short term recovery of the stock markets. 9 Capital Market PERSPECTIVE are already a concern, trying to gain increased market share through mergers and acquisitions is not feasible.2) Ultimately, the only realistic solution is to find opportunities for growth beyond the domestic market. Schoenmaker and Van Lacke (2007) have shown empirically that the higher the domestic market concentration, the faster the rate of overseas expansion by commercial banks. Figure 4. Market concentration of Korea’s financial sectors (2009) CR5 HHI (Unit: %) 100 2,000 83.5 1,628 80 1,500 60.8 60 1,177 1,000 46.7 40 635 500 20 0 0 bank securities insurance bank securities insurance Source: FSS B. Economic slowdown and demographic changes Since 2000, Korea’s GDP growth has remained below 5%, indicating that the country has structurally entered the low growth phase of economic development (Figure 5). To make matters worse, Korea’s population growth is stagnant because its birth rate is one of the world’s lowest. This will result in a declining working age population and drag future economic growth (Figure 6). As the Korean economy enters the mature growth phase, the need for domestic financial companies to succeed overseas becomes even more critical. By enabling domestic investors to access high growth countries, the overseas entry of financial firms can help alleviate the problem of Korea’s low economic growth. 2) The level of market concentration is far less among securities firms. However, this is more a consequence of the small size of the domestic capital markets not providing sufficient incentives for economies of size. From this perspective, domestic securities firms need just as much to grow in size and expand abroad. 10 2010 Vol. 2, No. 4 Overseas Expansion of Korean Financial Services Institutions Figure 5. GDP growth (Unit: annual growth rate in %) 10 Korea OECD 8 6 4 2 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: World Bank DB Figure 6. Population growth and birth rate population growth birth rate per a thousand people (Unit: annual growth rate in %) (Unit: %) 1.0 15 0.8 13 0.6 11 0.4 0.2 9 Korea Korea OECD OECD 7 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 2008 In addition, Korea is the world’s fastest aging society (Figure 7), and fiscal pressures to support the increasing number of senior citizens are growing. The foreign expansion of financial firms can also help reduce the fiscal burden, albeit partially, because it provides better access to higher returns on investments. 11 Capital Market PERSPECTIVE Figure 7. Speed of aging: The growth rate of the population over 65 years old (Unit: %) 10 Korea OECD 8 6 4 2 0 2001 2002 2003 2004 2005 2006 2007 2008 Source: World Bank DB C. Level of internationalization of domestic financial institutions Despite the various motives for Korean financial firms to go abroad, the current state of internationalization of these institutions leaves a lot to be desired. Figure 8 shows that overseas assets of domestic banks accounted for a mere 4.2% in 2009. The situation is not much different for their net income, among which only 5.3% is generated from overseas. The fact that Korean banks lag behind in overseas expansion is even more evident when measured against global players. For instance, Deutsche Bank generated 71% of its net income from abroad as of FY2009 (Figure 9), compared to around 5% for all Korean banks. 12 2010 Vol. 2, No. 4 Overseas Expansion of Korean Financial Services Institutions Figure 8. The ratio of overseas assets (revenue) to total assets (revenue) in Korean banks (Unit: %) 10 Overseas assets/total assets Overseas revenue/total revenue 8 6 5.3 4 4.2 3.0 2 2.5 0 2005 2006 2007 2008 2009 Source: FSS Figure 9. The ratio of overseas revenue to total revenue in world-leading banks (2009) (Unit: %) 100 80 71.4 60 51.1 44.0 40 24.5 19.1 20 5.3 0 Deutsche Bank Citigroup Goldman Sachs JPMorgan Chase Morgan Stanley Korea’s banks Source: Annual reports 2. Criteria for choosing a destination for overseas expansion A saturated domestic market, high levels of accumulated domestic assets, low economic growth, and a rapidly aging population are all key drivers of foreign expansion and the reasons why domestic financial companies must improve their unimpressive level of overseas market participation. But the question is where to go, 13 Capital Market PERSPECTIVE meaning which region and countries offer the most attractive opportunities. To answer this question we must look at the key criteria, or pull factors, to determine candidate markets for overseas expansion. The first is market size. The bigger the market size, the larger the potential customer base, as well as the space to implement diverse business strategies. The importance of market size in an overseas market entry decision is a natural consideration (Claessens et al, 2000; Brealey and Kaplanis, 1996; Buch, 2000). Measures of market size include GDP, population, land area, urbanization, and natural resources. The second of the criteria is the economic growth rate. An early entry into a small but fast-growing market will increase opportunities to acquire a large market share when the market does become sizable (Focarelli and Pozzolo, 2005). Measures of growth rates of economies include the GDP growth rate, population growth rate, urbanization speed, and industrialization rate. Another important factor is geographic proximity. The greater the geographic proximity, the easier it is for resource allocation and control. There is empirical evidence that overseas expansion of a financial firm is concentrated in geographically close regions (Berger and DeYoung, 2006, Berger et al., 2001). Last, for overseas expansions of financial firms to be effective, the target country should have a gap between the development level of the real economy and the financial sector (Goldberg and Grosse, 1994; Grosse and Goldberg, 1991). This means that a desirable target country should have a fast-growing economy and a relatively underdeveloped financial sector. It is in such places where the supply of credit is insufficient to meet demand, and Korean financial firms will find opportunities to actively participate. Measures of disparity between the real economy and the financial sector include the ratio of commercial bank loans to GDP and the ratio of market capitalization to GDP. 14 2010 Vol. 2, No. 4 Overseas Expansion of Korean Financial Services Institutions II. Attractive Entry Region: Asia Here, we provide evidence that the major Asian countries are the most appropriate markets for Korean financial firms to enter. Asia has the most attractive conditions in terms of market size, growth rate, geographic proximity, and gap between the real and financial economy. 1. Market selection criteria With many rapidly growing countries, Asia is naturally one of the most appealing regions for entry by foreign firms. However, within Asia, economies such as Japan, Australia, and Hong Kong are already well developed and have more advanced financial markets than Korea. This implies that the financial needs of these countries are met sufficiently within the domestic market and that there is little room left for Korean firms in these nations. Thus, countries with advanced economies should be omitted from the list of overseas expansion candidates. Also, those countries that are too small in market size or politically unstable should be excluded as well. Based on the above criteria, we choose 15 target candidates including China, Thailand, Vietnam, Indonesia, India, Malaysia, 6 GCC countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, UAE), Uzbekistan, Kazakhstan, and Turkey. Then, we attempt to examine the 15 nations’ potential as destinations for overseas expansion. 2. Growth potential In 2008, the combined GDP of the 15 target countries was small compared to that of the world or the OECD, but their growth rates were significantly higher (Figure 10). Such fast growth rates imply large demand for financial services which is necessary to back up economic growth. This is one of the factors that work favorably for the entry of Korean financial firms in these markets. 15 Capital Market PERSPECTIVE Figure 10. GDP and GDP growth (2008) GDP GDP growth (Unit: $ billion) (Unit: annual growth rate in %) 50,000 10 40,232 40,000 8 30,333 30,000 6 20,000 5.3 4 10,000 2.0 2 1.1 4,743 0 Target World 0 OECD Target World OECD Source: World Bank DB In 2007, the ratio of gross fixed capital formation (GFCF) to GDP of the 15 target countries stood at 26.8%, which was around 5% higher than the global average of 21.7% and the OECD average of 22.5%. Especially, the growth rate of GFCF in the target countries was 13.9%, significantly higher than the world’s growth rate of 4.5% and 5.5% of the OECD. This reflects the fact that new investments in these countries are taking place at a rapid pace, which will lead to increased demand for financial services overall (Figure 11). Figure 11. GFCF and its growth GFCF/GDP GFCF growth (Unit: %) (Unit: annual growth rate in%) 50 15 40 12 30 13.9 9 26.8 21.7 22.5 20 6 5.2 4.5 10 0 3 Target World OECD 0 Target World OECD Note: GFCF to GDP excludes Oman. GFCF to GDP growth rate excludes Kuwait, Oman, Qatar, and Turkey. Source: World Bank DB 16 2010 Vol. 2, No. 4 Overseas Expansion of Korean Financial Services Institutions Asia’s attractiveness also dominates in terms of demographic factors. Population size is an important factor both as a key input of economic production and as the basis of market demand. In 2008, the population of the 15 target countries was 3 billion, representing 45% of the world population. Not only is population high in these countries, but the rate of population growth is very high, making it likely that attractive markets will come into shape (Figure 12). Figure 12. Total population and its growth (2008) Total population Population growth (Unit: billion persons) (Unit: annual growth rate in %) 10 3 8 2.3 6.7 2 6 4 1.2 3.0 1 2 0 0.8 1.2 Target World OECD 0 Target World OECD Source: World Bank DB Rapid urbanization raises the demand for social overhead capital, energy, and real estate, which in turn increases demand for financial services. In addition, the expansion of the middle class associated with urbanization increases demand for private financial services, such as mortgage financing. Figure 13 shows that the target countries’ urban population growth rate is 3 times that of the OECD, indicating that the demand base of financial services is expanding rapidly. 17 Capital Market PERSPECTIVE Figure 13. Urban population growth (2008) (Unit: annual growth rate in %) 5 4 3 3.0 2.0 2 1.0 1 0 Target World OECD Source: World Bank DB 3. Socioeconomic similarities Korea’s economy is closely knitted with the major Asian economies, and such interrelatedness can facilitate Korean firms’ entry into these countries. A measure of the relatedness between countries is how actively companies of one country are operating in the market of the other country. In this regard, Asia is quite attractive as the share of major Asian nations for overseas expansion by Korean firms increased from 43.3% in 2000 to 49.5% in 2008 (Figure 14). Thus, about half of foreign entry by Korean firms is taking place in Asia. The interrelation of Korea with major Asian economies can also be seen in trade volumes and foreign direct investments. In Figure 15, it can be seen that Asia’s share of Korea’s total trade volume continues to increase. As a result, in 2008, Asia represented 35.1% of Korea’s exports and 45.5% of its imports. The figures for foreign direct investment are even stronger. In 2008, over 90% of Korea’s foreign direct investments were within Asia. 18 2010 Vol. 2, No. 4 Overseas Expansion of Korean Financial Services Institutions Figure 14. Fifteen Asian countries’ share in the total number of overseas expansion by Korean firms (Unit: %) 50 49.5 48 46 44 43.3 42 40 2005 2006 Source: The Export-Import Bank of Korea DB Figure 15. Trade with and FDI to Asian countries Korea’s FDI Asian countries/ Korea’s total outbound FDI Trade with Asian countries (Unit: %) 10,000 Export 80 Import 8,000 60 40 41.0 41.1 31.7 34.1 2006 2007 100 The amount of FDI (LHS) The share of Asian countries (RHS) 80 6,000 60 4,000 40 2,000 20 45.4 35.1 20 0 (Unit: %) (Unit: $ million) 100 2008 0 2006 2007 2008 0 Source: The Export-Import Bank of Korea DB Finally, we look at proximity in terms of the number of Korean residents living abroad. Figure 16 shows the total number of Koreans abroad and the share of the target countries. As can be seen from the figure, the target countries account for close to half of the total Koreans living abroad. A large share of the Korean population in the target market encourages trade activities, thus making it easier for Korean firms to enter the region. This is another important factor for foreign expansion. 19 Capital Market PERSPECTIVE Figure 16. Korean residents in Asia/Total overseas Korean residents (Unit: 1 million persons) (Unit: %) 10 100 Number of overseas Korean residents (LHS) Asia’s share in overseas Korean residents (RHS) 8 80 6 60 4 40 2 20 0 0 2006 2007 2008 2009 2010 Source: Ministry of Foreign Affairs and Trade DB 4. The Gap between the real and financial economy The target countries in Asia are attractive for Korean financial firms from the perspective of growth potential and proximity. Next, we examine whether these countries are qualified for the last criterion for entry, the gap between the real and financial economy. Figure 17. Private sector loans to GDP (Unit: %) 120 112.6 100 80 60 57.8 59.3 40 20 0 Target World OECD Note: The figures are for 2008. Private sector loans to GDP include banks and all other financial institutions. Source: World Bank DB 20 2010 Vol. 2, No. 4 Overseas Expansion of Korean Financial Services Institutions First, in looking at the development of the banking sector relative to the economy, we see that the private sector loans to GDP for the target countries is only half that of the OECD level (Figure 17). This implies that the supply of credit is insufficient to support the growth of the real economy in these countries. The situation is similar when looking at the ratio of bank deposits to GDP. In Figure 18, this ratio is 57.7% for the target countries, substantially lower than the OECD average of 91.6%. This implies that the flow of credit is not sufficient to fully support economic growth due to a lack of financial asset accumulation. Figure 18. Bank deposit to GDP (Unit: %) 100 91.6 80 60 57.7 59.3 40 20 0 Target World OECD Note: The figures are for 2008, and China, Bahrain, Qatar, UAE, and Uzbekistan are excluded from the data. Source: World Bank DB The development of capital markets, the other pillar of the financial sector, in the target economies is also lagging. First, the number of listed companies in the target countries is only one third of that of the OECD average (Figure 19). The size of the capital markets is also relatively small. Especially, the bond market of the target countries is only half of the OECD average (Figure 20). 21 Capital Market PERSPECTIVE Figure 19. Number of listed companies (Unit: Number of companies) 60,000 48,904 50,000 40,000 30,000 27,487 20,000 9,542 10,000 0 Target World OECD Source: World Bank DB Figure 20. Capital market size Market capitalization (aggregate value of listed stock) to GDP Total bond outstanding to GDP (Unit: %) (Unit: %) 150 100 89.0 120 112.6 94.0 90 89.6 79.7 80 60 46.6 60 40 30 20 0 Target World OECD 0 Target World OECD Note: The figures are for 2008. Market capitalization to GDP includes Thailand, India, Indonesia, Malaysia, Saudi Arabia, Kazakhstan, and Turkey. Bond market to GDO includes China, Thailand, India, Indonesia, Malaysia, and Turkey. Source: World Bank DB 22 2010 Vol. 2, No. 4 Overseas Expansion of Korean Financial Services Institutions III. Conclusion and Implications Based on our examination, some Asian countries are appropriate destinations for overseas expansion by Korean financial services companies. Compared to the OECD averages, these countries combined have 5 times the economic growth rate and 3 times the population growth rate, along with faster rates of urbanization. These are some of the key factors that will ensure the development of the Asian region into a huge market in the future. On the other hand, the development of the financial sector of these countries is lagging compared to the real economy. The banking sector is underdeveloped, with bank assets to GDP at only half of the OECD average, and the capital markets are even further behind. This implies that there are ample opportunities for Korean firms to fill the gap in the financial sector. Moreover, Asia offers advantages for Korean firms in terms of cultural proximity, which is an important consideration when taking the first step into a foreign market. Conditions are ripe for overseas entry of Korean financial firms. For a while, the global expansion of financial institutions in developed countries will be slowed because of the recent financial crisis. Also, attractive acquisition targets are likely to surface as a depressed global economy leads to the emergence of distressed financial institutions in some Asian countries. Given these circumstances, Korean financial firms should not miss out the opportunities that will present themselves in the next few years. 23 Capital Market PERSPECTIVE <References> Berger, A., DeYoung, R., 2006, Technological process and the geographic expansion of the banking industry, Journal of Money, Credit and Banking 38. Berger, A., DeYoung, R., Genay, H., Udell, G., 2001, Globalization of financial institutions: evidence from cross-border banking performance, Brookings-Wharton papers on financial services 3. Focarelli, D., Pozzolo, A.F., 2005, Where do banks expand abroad, Journal of Business 78. Goldberg, L., Grosse, R., 1991, Foreign bank activity in the United States, Journal of Banking and Finance 15. Goldberg, L., Grosse, R., 1994, Location choice of foreign banks in the United States, Journal of Economics and Business 46. Schoenmaker D., Laecke, C.V., 2007, Determinants of international banking: evidence from the world’s largest banks. 24 2010 Vol. 2, No. 4