The Bank of Korea: "Possibility of Recurrence of Financial and Bond Market Instability... Need to Devise Market Stabilization Measures"

Concerns Raised Over Moral Hazard in Financial Institutions Amid Low Interest Rate Environment

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[Asia Economy Reporter Seo So-jeong] The Bank of Korea assessed that while the domestic commercial paper (CP) and credit bond market instability triggered by the Legoland incident is gradually calming down due to the government's market stabilization measures, risks such as high uncertainty in the international financial market, deterioration of real estate project financing (PF), and potential year-end liquidity tightening remain. Therefore, it is necessary to consider appropriate market stabilization measures if needed.

In the Monetary and Credit Policy Report published on the 8th, the Bank of Korea diagnosed the recent short-term finance and bond market instability by stating, "Although the instability has somewhat eased following the government's and the Bank of Korea's market stabilization announcements, a high level of credit caution continues, and market functions have not yet returned to normal levels."

It is expected that the money and bond markets will gradually recover their functions as the effects of the market stabilization measures become visible. However, since related risk factors remain, attention should be paid to the possibility of market instability recurring.

Recently, amid an expansion in bank bonds and public bonds issuance increasing the supply-demand burden in the credit securities market, credit caution in the CP market has intensified due to issues related to Gangwon-do PF-asset-backed commercial paper (ABCP), rapidly spreading instability across the short-term finance and bond markets.

Since the beginning of this year, overall market liquidity has decreased, increasing vulnerability to external shocks. Large-scale Korea Electric Power Corporation (KEPCO) bond issuance has further increased supply-demand burdens in the credit bond market, and investment demand for credit securities with low credit ratings and liquidity has contracted.

Additionally, the surge in interest rates and exchange rates has increased demand for highly liquid assets, leading to expanded issuance of bank bonds, further intensifying supply-demand pressures in the bank and public bond markets. At the end of September, credit caution sharply increased in a short period due to the Gangwon-do PF-ABCP issue, spreading PF-ABCP market instability to the overall CP and repurchase agreement (RP) markets. This impact caused major public and bank bond issuance yields to surge, and even AAA-rated top-tier bonds struggled to be absorbed smoothly in the market, deepening the contraction of the credit bond market.

By mid-October, market instability affected government bond investment sentiment, causing government bond yields to exhibit significantly higher volatility compared to major countries, spreading anxiety throughout the market.

The Bank of Korea evaluated that the domestic financial market has escaped the tightening phase in October thanks to market stabilization measures but noted that high credit caution still persists, especially in the CP market. Although credit bond yields have fallen considerably, the trend of rising CP yields and credit spreads continues due to sustained high credit caution.

While issuance volumes of public and bank bonds have been absorbed and issuance spreads have narrowed, corporate bond and specialized finance bond issuance remain sluggish, and refinancing difficulties for securities company CPs and PF-ABCP persist.

The Bank of Korea stated, "Going forward, the domestic CP and credit bond markets will gradually show the effects of market stabilization measures, but since risk factors remain, it is necessary to closely monitor market conditions." It also emphasized, "However, underlying the recent market instability is the excessive risk-taking behavior, such as leveraged investments in specific sectors like real estate, mainly by the non-bank sector under the prolonged low-interest-rate environment. Attention should also be paid to the moral hazard issues of these financial institutions."