Is Profit-Maximizing Finance a Toast Reserved for Them Alone?

Recently, banks have been celebrating record-high profits while also facing social criticism for engaging in what many call a “cash feast.” Why has this phenomenon occurred?

From the banks’ perspective, they use performance-based bonuses as an incentive for existing executives and employees to maximize profits. At the same time, given the outlook that the banking industry may face broader difficulties in the future, along with structural changes such as AI (artificial intelligence) replacing human labor, they have continued to streamline their organizations.

Using the record profits generated under an evaluation system focused primarily on profit creation for institutions and management, banks are paying extraordinary bonuses to current employees while actively using honorary retirement programs by offering attractive severance packages to those leaving the organization. Recently, the banking sector has paid existing employees bonuses of 300–400% and offered severance payments of 600 million to 1 billion won, which has increasingly been seen as creating a sense of relative deprivation among struggling businesses and ordinary citizens facing difficult economic conditions.

Broadly speaking, profits in the financial sector are divided into interest income and non-interest income. Interest income arises from the spread between deposit and lending rates, while non-interest income comes from investments and other such activities. Korean banks are known to rely more heavily on interest income than global banks. According to the financial sector, the four major financial holding companies—KB Kookmin, Woori, Shinhan, and Hana—recorded interest income of 39.6735 trillion won last year, a 20% jump from the previous year, and this appears to have been driven mainly by interest income.

Let us look at the structure through which lending rates—the key driver of interest income—are determined. In the case of corporate loans, the final rate is generally set by adding a certain margin to the funding rate after evaluating the company’s creditworthiness. The most important factor in determining interest rates is, of course, the funding rate. Interest rates are determined by supply and demand in the market; if the same margin is maintained, rates will rise during periods of increasing interest rates and fall during periods of declining rates. If margins also increase when interest rates rise, the increase becomes even greater, allowing banks to generate larger profits.

Public outrage is being stirred by the perception that the current “cash feast” in the banking sector is due to this expansion of margins. It is often said that the nature of financial institutions is to “take away your umbrella when it rains.” Now, more than ever, this seems to be the moment when warm finance is needed—finance that, contrary to past practices, offers a wider umbrella when it rains.

For debtor companies, rising interest rates increase the burden of interest payments, making it harder to generate profits. Their credit ratings then decline, causing rates to rise further in a vicious cycle. In personal lending as well, the interest burden can increase further because of the margin banks add, which can worsen borrowers’ credit conditions.

It is natural that interest rates have recently been rising. However, considering the impact of the increase on businesses and the public, even though financial institutions are private enterprises, now is the time—as the President has recognized in noting that they have the character of a public good—to operate a form of voluntary regulation under which they share the pain of rate hikes with businesses and individuals, economic actors in the market, by reducing margins to some extent rather than expanding them further in line with rising market rates.

How are companies with actual financing needs affected? First, they are influenced by market interest rates. Second, rates are determined according to the company’s own credit evaluation. Third, they are affected by the portion reflecting each financial company’s fixed margin rate.

In corporate lending, loan guidelines arise precisely in the area where financial institutions set a fixed margin rate. In other words, market interest rates are determined by domestic and external supply and demand, and a company’s credit evaluation can also be seen as stemming from the company’s own responsibility. However, rate increases caused by each financial institution’s margin rate deserve scrutiny. Of course, financial institutions are also businesses that must generate profits, but such loan guidelines ultimately have a major impact on sole proprietors and other individual businesses. For example, if companies receive credit ratings of A, B, and C, and the corresponding interest rate guidelines are set at 50bp, 100bp, and 200bp, then companies in grades A, B, and C must add the margin rate on top of the rate determined by their credit evaluation, resulting in a double burden.

In the past, when the market was demand-driven—when finance was supplied according to corporate demand—it would not be an exaggeration to say that there were almost no such lending guidelines. Financial institutions extended loans so long as they could secure a minimal margin, and companies could operate on that basis at more favorable rates or reinvest as well. By contrast, in a structure where funding in the market is not smooth and companies are mostly subject to the rates set by financial institutions, businesses will want even the slightest reduction in borrowing costs.

What does the rate-setting structure look like at frontline branches where loans are actually made? Only when loans are issued in compliance with the interest rate guidelines after each company’s credit evaluation do they become so-called performance results for which branch offices can be evaluated. If the interest rate guidelines are followed, financial institutions can secure a certain level of profit based on the expected loan amount.

Given the reality of Korea’s financial sector, where profits still depend heavily on lending, this may be necessary for the profitability of financial institutions. But how does it look from the perspective of ordinary citizens, including small business owners? In difficult economic times like these, it seems that not only the government but all businesses and citizens should coexist and prosper together.

Under interest rate guidelines, the rate structure is such that rates cannot fundamentally fall below the guideline. One small business owner offered a bitter smile and said, “These days, the economy is honestly worse than during the IMF foreign exchange crisis. Sales and profits are falling, but loan interest rates remain a burden. I haven’t even been delinquent once all this time. Financial institutions say they are posting record profits—so is there no way to share the pain together?”

Now that this has become a social issue, the banking sector has announced policies such as social contribution projects, support for vulnerable groups, and support for small and medium-sized enterprises as part of giving back to society. But stopgap policies whenever an issue arises make a fundamental solution difficult. A strategy of simply enduring for a little while and waiting for things to pass cannot be a real solution. Rather than artificial oversight by the government or supervisory authorities, financial institutions should take the lead and present voluntary measures as institutions that coexist with society.

As for the problematic interest rate component, to resolve it in practice, lending rates should operate with broader discretion and guaranteed autonomy. Of course, this could reduce the profits of financial institutions. However, each financial institution should simultaneously make continued efforts to find profits in other sectors or in sound alternative areas. Only then can they escape the stigma of conducting business in an effortless, risk-free manner.

Financial institutions should abolish the “financial loan guidelines,” an easy means of generating profits, and adopt an autonomous rate-setting structure. Through this, many businesses and citizens will be able to achieve the so-called “warm finance” of shared prosperity.

The profit structure of the financial sector also needs to be diversified. In other words, the share of interest income dependent simply on the spread between deposit and lending rates should gradually be reduced, and the profit structure should be transformed by finding diverse sources of non-interest income. Only then can Korea’s financial industry advance to the level of developed countries. Rather than increasing profits easily by raising interest margins, efforts are needed to discover various non-interest income sources while taking on the risks of investment. By changing the portfolio between interest income and non-interest income, it is possible to generate sustainable and stable profits, and through this, finance can play the role of warm finance in which businesses and citizens share in the benefits.

The financial sector’s voluntary social contribution should also be expanded. Without market participants such as businesses and individuals, financial institutions themselves would have no reason to exist. As private enterprises, it is admittedly very difficult for them to voluntarily place great weight on social contribution and pursue it actively. But considering that financial institutions also grow by coexisting with society’s economic actors, if they voluntarily give serious thought and make efforts toward “continuous social contribution,” not only for vulnerable groups, young people, and small business owners but also for ordinary citizens, rather than one-off initiatives, they can earn their standing as financial institutions that are truly with the people.

The “voluntary continuity” of financial institutions must also be guaranteed. Self-reappointment of the heads of the financial sector, including those of the four major financial holding companies, raises the concern that financial institutions, which have the character of a public good, could degenerate into purely private entities. They must not appear to be dispensing favors as though it were their own money. Otherwise, they could devolve into a so-called “long league for themselves alone” in which management control has been secured.

Given the impact financial institutions have on all citizens, this is not a time for them to raise a toast to maximum profits, but a time for them to exercise genuine autonomy and manage with society in mind. As a task for the future, since most large financial institutions are run in a quasi-public corporation style without a true owner, there must be an in-depth solution to governance that strengthens autonomy while also establishing a real owner-like role. This is because the failure of financial institutions ultimately has a major impact on all citizens.

Heonsuk Lee, Director of External Cooperation, Center for Free Enterprise (CFE)

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Original title: 최대수익 금융은 그들만의 축배인가

Author: Heon-seok Lee

Date: 2023-02-17

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&idx=25405