The poor state of Korean finance

Local investors are in danger of losing big money from equity-linked securities (ELS) due to the sharp fall in the benchmark Hang Seng China Enterprises index, or H-shares, on the Hong Kong bourse. The Hong Kong trading shares-backed securities were hugely popular with Korean investors, as they offered moderately high returns with less risk than other emerging markets. About 37 trillion won ($31 billion) worth were sold, of which about 4 trillion won is in danger of going down the drain as the principal-at-risk securities have already breached the predetermined barrier.

The H-shares that flirted with 15,000 levels in May last year retreated to below 7,500 last week. Most of the ELS connected to Hong Kong equities promised an annual coupon yield of more than 5 percent unless the underlying shares do not crash by half. The free fall in Hong Kong shares could translate into losses for thousands of investors.

Industrial products fall under strict quality control through various regulations and procedures. Few companies can survive if they in turn sell flawed and hazardous products. But consumers of financial products, especially in investment funds, are not guaranteed that kind of protection.

A few years back, Korean investors rushed to invest in government bonds of emerging markets, led by Brazilian notes. Financial institutions marketed them as high-return safe bets as the underlying economies were growing at a staggering pace. But local investors were burned after oil-producing emerging economies were hit hard by the plunge in oil and commodities prices and the capital exodus to a safer U.S. dollar.

High-yield investments are accompanied by the risk in principal loss. But it is not easy for a common investor to think clearly about the potential losses. Because of the complexity in structured derivatives products, investors would only understand what the marketers show and guide them. For instance, if the marketer first explains riskier products and then shows ELS, an average investor would believe ELS are safer with a generous yield. It is marketing with the so-called context effect, as the context can affect our judgment. Many consumers simply believe they are guaranteed the principal plus steady interest income if a product is recommended by a well-known financial institution. Although they know it would be their responsibility in the end, they have that much faith in the financial institution.

But Korean financial institutions are not worthy of that kind of trust. They still have a long way to go. They emphasize that in today’s aging society, long-term investment is more secure for the future than bank savings. The government seconds the notion, as it can no longer fund a rapidly aging society amid a low-interest environment. It has been lifting barriers to the capital market and liberalizing the financial sector to boost investment. But all the efforts would be rhetorical and in vain if the investments do not generate higher returns and security than bank savings. The best way to vitalize the financial market and investment would be real stories and examples where people actually make money.

This cannot be done without efforts by the industry. The industry must train and foster manpower capable of developing lucrative and reliable products. To develop a new car, you need human expertise in mechanical engineering, physics and industrial design. We also need education and training to groom experts to research and develop new financial products. Universities have been running financial science and MBA courses, but the number and quality remain lacking.

The industry and academy should join forces to invest and groom experts for asset management. The University of Reading in the United Kingdom, where I worked, has been running a mock exchange fitted with monitors that show real-time data from markets around the world starting from the late 1990s. The more trained experts we have, the less damage local investors will suffer from investing in exotic securities.

Second, we need a market environment that can freely utilize the latest analysis and financial techniques. High transaction rates prevent the use of sophisticated methods like high-frequency trading that raises yields through frequent trades. There may be concerns for high-frequency trading, but mechanisms could be set to minimize the side effects and abuses.

There also must be improvement in the distribution system of financial products. Currently, financial institutions market their products instead of the best products. Asset management companies design and run financial products while banks and securities companies sell them. Banks and securities companies usually recommend products of affiliated asset management companies. Among the funds banks sold over the last five years, 45 percent were products of the same group units. Although they are part of the service sector that should offer a variety of choices, they could be sticking to a menu that serves them more than their customers.

Customers must be able to compare and contrast funds of similar categories available by asset management companies through online and mobile platforms. Increased consumer choices can help spur competition for better products and service quality. Instead of just saying so, financial institutions must show that they really place customers first.

Translation by the Korea JoongAng Daily staff.

JoongAng Ilbo, Feb. 15, Page 29

The author is a professor at Korea University Business School.

by Lee Jang-hyuk