[Editorial] Investment banks

The Financial Supervisory Commission has renewed its attempt to create homegrown investment banks. On Wednesday the commission unveiled a draft bill that would allow brokerages with equity capital exceeding 3 trillion won to become investment banks.

The commission plans to submit the legislation to the National Assembly in October for passage within this year. If approved as planned, the bill will go into effect in June next year. But it remains to be seen whether the commission’s bill will win lawmakers’ endorsement.

There has been a broad consensus on the need for Korea to foster competent investment banks. Investment banks are necessary to help companies, especially small and medium-sized enterprises and venture firms, to tap capital markets more easily.

According to the FSC, Korean SMEs raise a mere 16 percent of the funds they need from capital markets, while relying on commercial banks and the government for 81 percent of their funding needs. The main reason for this low utilization of capital markets is the absence of high-caliber investment banks.

Fostering homegrown investment banks will help make capital markets more vibrant, which in turn will enhance the utilization of financial resources. In particular, investment banks will contribute to the growth of new technology sectors by channeling risk capital to innovative companies with funding problems.

Another important role that investment banks can play is to help domestic corporations win large-scale development projects in foreign countries by providing them with low-cost project financing.

For these and other reasons, the FSC has long sought to foster investment banks. Its efforts crystallized in the Financial Investment Services and Capital Markets Act, which was enacted in 2007 but went into effect in February 2009. The law eliminated or reduced the barriers between different financial services to create a “big bang” in capital markets.

Yet the law arrived at the wrong time. By the time it took effect, a global financial tsunami swept through Korea. As a result, the expected wave of mergers and acquisitions among brokerages never transpired.

In fact, such an M&A wave is something still hard to expect now. One main reason is that many brokerages are affiliated with either chaebol groups or financial holding companies. These groups consider it a matter of shame to sell any of their subsidiaries.

The revsion bill takes this reality into consideration. It proposes to allow brokerages to engage in diverse investment banking services if they raise their equity capital above 3 trillion won. Currently, no domestic security firm meets this requirement. But the bar is not high for the top five brokerages whose equity capital averaged 2.7 trillion won as of end-March.

Three trillion won cannot be seen as a large equity capital base for a full-scale investment bank. It is only one-thirtieth of that of Goldman Sachs. The FSC set the threshold low in light of little likelihood of mergers among major brokerages. But the FSC needs to encourage mergers because size matters in investment banking.

If the top five brokerages ― Daewoo, Samsung, Hyundai, Woori and Korea ― decide to transform themselves into investment banks, as is expected, the domestic brokerage market will undergo a segmentation process. The big five will likely emerge as dominant players as they can monopolize investment banking services.

The top players will also be able to enjoy the economies of scale in other services, including stock brokering, fund sales, asset management services and derivatives trading. This would force smaller brokerage firms to choose specialization as their survival strategy.

As a result, diversity would increase in the ecosystem of the Korean financial industry. Currently domestic security firms, large or small, are indistinguishable as they all engage in the same business ― stock brokering. Most of their income comes from brokerage commission.

Thus, fostering investment banks will catalyze the advancement of the domestic capital market and financial industry. But large investment banks can also pose systemic risks to the national economy as many services they provide involve risk-taking. It is therefore incumbent on the financial regulator to come up with measures that can prevent investment banks from pursuing excessive risk-taking.