Korea sanctions banks for derivatives violations

A Korean regulator has handed down strict sanctions to branches of some large foreign banks that allegedly violated laws regarding outsourcing of derivatives trading operations. Reportedly, the charged banks include HSBC Holdings Plc and Credit Agricole SA.

Results of examinations of foreign bank branches in Korea and future directions

1. Recent findings from examinations of Korean branches of foreign banks

The FSS has handed down strict sanctions, as a result of examinations conducted in 2010 and 1Q 2011, to branches of some large foreign banks in Korea which were found to have disrupted market order and violated laws or regulations such as improper outsourcing of derivatives trading operations.

Article 42 of Capital Market and Financial Investment Business Act stipulates that a financial investment services provider should not outsource its business from the third party if such business outsourced is essential to the relevant provider to protect investors and help establish a sound trading order.

Dealers are not allowed to outsource the execution of trades and presentation of quotations for financial investment products. However, some foreign bank branches had improperly outsourced the business from their Hong Kong branches, etc. (please refer to the attachment).

Other violations include violation of the limit on credit extension to individual borrowers, violation of duties of confirmation of foreign exchange transactions and real name financial transactions, violation of confidentiality, unfair treatment of funds and derivatives, unauthorized brokerage of financial investment products, violation of internal control rules in relation to dealing, etc.

2. Future directions of examinations of foreign bank branches in Korea

The FSS is projected to oversee how the funds are managed at branches* of large global banks in Korea that can have big impacts on domestic financial markets and launch investigation into banks immediately upon the occurrence of possible improper acts.

*14 large investment banks with a large volume of foreign exchange and derivatives transactions (KRW100 trillion or more in derivatives outstanding)

This aims to prevent risk factors in markets in a pre-emptive way as foreign bank branches are considered to have a significant influence* on an increase in volatility of capital flows, which were considered as main reasons for two previous financial crises.

*This is because they raised short-term foreign currency borrowings and invested them in derivatives and treasury/public bonds.

Improperly outsourcing business, as found in the recent examinations, paralyzes the business authorization system, a key component of the Capital Market Act, and may disrupt domestic financial markets by off-shore markets such as Hong Kong.

Considering this, the regulator will focus on improper outsourcing of business in examining foreign bank branches and impose tough sanctions in the event any violations are found.

In addition, the FSS will examine irregular or abnormal transactions taking advantage of fund flows of foreign bank branches on an ongoing basis and check compliance with regulation of capital flows such as limits on FX forward positions, preventing them from disrupting domestic financial markets.

The FSS will increase the frequency of joint inspections with the Bank of Korea of foreign exchange transactions*, if necessary.

*Joint inspections of FX forward positions including NDF were conducted in October 2010 and April 2011.
To this end, the FSS created the Foreign Bank Branch Supervision office, a new department focusing on the examination of foreign bank branches and increased manpower in an organizational shakeup conducted in May.

*About 15 out of 37 foreign bank branches will receive inspections on an annual basis.

1. Seoul branch of Bank A (examined in Mar.’10)

Findings: Improperly outsourcing derivatives trading business from its Hong Kong branch

Violation: Found to have violated of Article 42 of Capital Market and Financial Investment Business Act by outsourcing from its Hong Kong branch dealer derivatives trading business (interest rate swap, currency swap, etc.)

*KRW74.7 trillion in 1,877 cases and U$18.28 billion in 72 cases from Sept.21, 2007 ~ Dec.31, 2009 (in nominal amount)

Sanctions: (Institution) Institutional warning, (3 executives and employees) pay cuts to caution

2. Seoul branch of Bank B (examined in Jun.’10)

Findings: Improperly outsourcing derivatives trading business from its Hong Kong branch

Violation: Found to have violated Article 42 of Capital Market and Financial Investment Business Act by improperly outsourcing derivatives trading business (non-generic interest rate swap, etc.) from its Hong Kong branch dealer.

*KRW6.164 trillion in 77 cases and U$12 million in 1 case from Feb.4, 2009 ~ May 24, 2010 (in nominal amount)

Sanctions: (Institution) Institutional warning, (4 executives and employees) pay cuts to cautionary warning

3. Seoul branch of Bank C (examined in Feb.’11)

Findings: Improperly outsourcing financial investment products trading business from its regional headquarters in Singapore.

Violation: Found to have violated of Article 42 of Capital Market and Financial Investment Business Act by improperly outsourcing financial investment products trading business (won-dollar currency options, FX spot, forward, NDF) from its Singapore headquarters.

*U$443 million in 142 cases from Apr.12, 2007 ~ Nov.12, 2009 (equivalent to KRW456.0 billion, in nominal amount)

Sanctions: Sanction procedures underway

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