3rd UPDATE: South Korea To Step Up Monitoring Of Foreign Banks

SEOUL (Dow Jones)--South Korea said it would step up monitoring of foreign banks operating in the country after finding cases of improper outsourcing of key trading operations, marking the latest step in the nation's efforts to contain potentially destabilizing capital flows and adding another measure focusing on the role foreign banks play in triggering volatility in local financial markets.

Financial Supervisory Service Deputy Gov. Kim Yung-dae told reporters at a briefing Tuesday that some foreign bank branches in Korea were handing over day-to-day trading operations involving money held in local accounts to a bigger foreign branch or regional headquarters in places like Hong Kong and Singapore. Such outsourcing is illegal in Korea.

"Such practices stem from the foreign banks' desire to manage their entire Asian portfolio," Kim said. "In cases of big investment banks, trading on a regional level can have a great impact on the domestic financial markets as such management can lead to sharp changes to the portfolios of the banks' local branches."

Kim said HSBC Holdings PLC (HBC) and Credit Agricole S.A. (CRARY) have already been sanctioned for improper outsourcing of operations involving derivatives.

A person familiar with the situation told Dow Jones Newswires later Tuesday that the Royal Bank of Scotland Group PLC (RBS) may also be sanctioned for engaging in similar activity, with the FSS likely to decide on the matter in June or July.

Credit Agricole declined to comment, while HSBC and RBS had no immediate comment.

Local authorities have introduced several measures since last June to safeguard the economy from potential shocks triggered by so-called hot money. Asia has seen a surge of foreign capital into its markets amid expectations for economic growth and higher interest rates as the region's central banks combat inflation--and Korea has been no exception to the trend.

South Korea fears that capital inflows could exit just as swiftly, like they did during the 1997-1998 Asian financial crisis and the 2008 economic crisis. So the local government last June implemented a cap on the amount of foreign-exchange forwards positions that banks operating in the country can carry, as such contracts can be used to speculate on future market moves involving the South Korean won.

Foreign banks have been under scrutiny because their Korean branches tend to take on short-term foreign currency loans to do business like corporate financing and trading of derivatives and securities--activity which can lead to sharp swings in financial markets, particularly the won. They are also often the intermediaries for foreign investors looking to move money in and out of the country.

While not directly related to the current issues, the emphasis for greater regulatory supervision of foreign banks has been heightened following a Nov. 11 incident when Deutsche Securities Korea, the local unit of Deutsche Bank AG (DB), triggered a massive drop in the local stock market in the last 10 minutes of trade by selling KRW2.44 trillion worth of stocks.

Local authorities subsequently ruled the Deutsche unit deliberately manipulated the market that day, dumping the shares on the stock market to profit on "speculative derivative positions" through the options and futures markets, and suspended the brokerage's proprietary securities and exchange-listed derivative trading operations for six months.

"Foreign banking branches (in Korea) are considered to have a great effect in increasing the volatility of capital flows in and out of the market," the FSS said in a separate statement, explaining the need for greater monitoring of their business operations.

A government official told Dow Jones Newswires Tuesday that Bank of Korea and the FSS are jointly probing the Korean operations of Mizuho Financial Group Inc. (MFG) unit Mizuho Corporate Bank and Mitsubishi UFJ Financial Group Inc. (MTU) unit Bank of Tokyo-Mitsubishi UFJ as part of their investigation on foreign banks' role in the issuance of kimchi bonds--foreign-currency denominated debt issued in Korea.

Mizuho and Bank of Tokyo-Mitsubishi UFJ declined to comment.

Local authorities are seeking to regulate the growing use of kimchi bonds to circumvent local restrictions on foreign-currency borrowings. The authorities suspect foreign banks are arranging such kimchi bond deals, advising local companies that the instrument could lower funding costs.

Under Korean law, banks can only provide loans in foreign currencies if borrowers need the funds for overseas use. However, the authorities suspect that the local companies selling kimchi bonds are going into the swap market to change the proceeds into won, with foreign banks acting as counterparties.

The FSS plans to inspect 15 of 37 foreign banks operating in Korea annually to monitor their fund management from this year, citing the need to proactively manage potential market risks. The authority also said it will conduct inspections on foreign banks whenever there are concerns about improper fund management or whether they are complying with capital flow regulations, such as in their foreign-exchange forward positions.

"We will expand our joint inspections with the Bank of Korea on foreign-exchange transactions when necessary," the FSS said.

-By Se Young Lee, Dow Jones Newswires; +82 2 3700 1904; vincent.lee@dowjones.com

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