Effects of IFRS on Korean banks, and future prospects

Korean firms’ business activities, such as risk management and foreign investment, have been affected by the obligation since 2011 to adopt International Financial Reporting Standards (IFRS). Korean banks may need to reshape their credit-rating models and enhance their loan-collection systems to prepare for further changes in loan-loss accounting. In addition, the financial authorities must provide adequate guidelines to minimise discretionary accounting and organise regulatory acts in order to prevent false disclosure. 

Korea’s accounting standards, and the quality of financial information, have improved since the adoption of IFRS in 2011, but comparability between financial statements has declined.

• IFRS was first adopted for listed companies in EU member countries in 2005. Since then, it has expanded rapidly across the globe, leading Korea to also adopt the standards for its listed corporate bodies and most financial companies.
• IFRS regards consolidated financial statements as the main financial statements, and greatly expands disclosure requirements. Therefore, transparency in accounting standards and the quality of overall financial information have been upgraded. However, it is commonly recognised that the comparability of financial statements has declined because unlike the previous Korean GAAP (K-GAAP) standards, IFRS follows ‘principle-based standards’.

The introduction of IFRS benefited Korean banks by reducing the requirement to make an allowance for bad debts, but it has become more difficult for Korean banks to dispose of non-performing loans (NPL) through securitisation. And the adoption of IFRS has increased the exposure of Korean banks’ profits to the fluctuation of foreign exchange rates.

• Under IFRS, bad debts remain on the books even if the bank sells the debt to a third party through securitisation – where the bank is connected to the liquidised asset through subordinated debt or payment guarantee [1].
• Direct investment in a foreign subsidiary is classified as a non-monetary asset where there is no profit and loss with the fluctuation of the exchange rate. On the other hand, the investment source is financed with monetary liabilities, which are subject to foreign exchange risk if there is no hedging [2].
• Impairment of marketable securities directly affects net profit under IFRS, thus requiring enforcement of risk management on those securities.

In order to effectively utilise financial information for loan evaluation, Korean banks need to reshape their credit-rating models and re-educate loan officers.

• Annual IFRS financial statements are being disclosed for the first time in the first half of 2012. So, use of financial information based on the previous K-GAAP standard will no longer be comparable.
• Also, a wide range of footnotes needs to be effectively utilised in the process of credit-rating evaluation.

Korean banks will have to enhance their loan-information infrastructure in order to prudently adapt to further changes in the accounting standard for loan losses.

• Unlike the previous incurred-loss model, the expected-loss model of ‘IFRS 9 Financial Instruments’, which may be adopted in 2015, distributes credit loss provisions until maturity. So, a database of loan loss information needs to be developed in order to reflect long-term loss as a whole. 

Empirical studies [3] of 90 EU banks showed that the cost of equity capital rose after the mandatory adoption of IFRS in 2005. But, countries with efficient legal enforcement [4], such as Belgium, Denmark, Germany and the United Kingdom did not see an increase in their capital costs.

• This indicates that prevention of false reports through legal enforcement rather than increased disclosure requirements is more effective in alleviating information asymmetry.

In an effort to embed IFRS in the banking sector, the authorities should provide more transparent disclosure guidelines, and enhance enforcement to prevent false disclosure.

• Since the intent of IFRS is to allow a certain degree of discretion to individual firms, it would be better to provide examples of bad adoption, rather than to specify rules on how to handle each footnote.

1. For this reason, during 2010-11, domestic banks did not use the method of securitisation when disposing of insolvent obligations. This led to an energising of the NPL market in Korea.
2. Monetary assets include cash, loans, deposits, corporate bonds, etc, while non-monetary assets include stock investments, inventories, etc. If foreign assets or debts fall into monetary items, then they are evaluated using the exchange rate at the end of the fiscal year, but if they fall into non-monetary items, they are evaluated mostly using historical prices. In particular, as Korean banks expand their investments in Southeast Asia, their cross-currency exchange risk is increasing.
3. Hwang, L., J. H. Suh and S. Yim (2011) ‘The Impact of Mandatory IFRS Adoption on the Cost of Equity Capital: An Empirical Analysis of European Banks’, KIF Working Paper, December.
4. For more information, see La Porta, R., F. López-de-Silanes, A. Shleifer, R. Vishny (1998) ‘Law and Finance’, Journal of Political Economy 106, 1113-1155.