[NH Financial 2.0] ① Repeated Financial Scandals... "Because of Governance"

FSS Diagnoses Governance Through May Regular Inspection
NongHyup Bank and Agricultural Cooperatives Financial Incidents
Long Time Taken to Detect and Low Recovery Rate

"Due to Unique Governance Between NongHyup Central and Financial Holding"
Issues with Overestimation of Agricultural Support Project Expenses Also Present

The Financial Supervisory Service (FSS) will conduct a regular inspection of NongHyup Financial Group and NH NongHyup Bank in mid-May. Since this inspection occurs every two years, the FSS describes it as a routine regular inspection. However, it also mentioned that it will conduct a comprehensive diagnosis of internal controls and governance weaknesses, referring to recent financial incidents at NH NongHyup Bank. There is a perspective that the series of financial incidents are due to the unique governance structure of NongHyup Financial.

[Image source=Yonhap News]

On the 24th, the FSS explained the background for initiating the regular inspection of NongHyup Financial Group and NH NongHyup Bank through a press release. The first reason is that the inspection cycle for NongHyup Financial and the bank has come due this year, as regular inspections are conducted every two years. It also added that “internal control weaknesses were exposed during the inspection related to recent financial incidents at NH NongHyup Bank,” and the inspection aims to address these issues.

On the 5th of last month, NH NongHyup Bank disclosed that a financial incident involving breach of trust occurred, amounting to 10,947,330,000 KRW. An employee in charge of loans at one branch of NH NongHyup Bank inflated the value of collateral and provided loans exceeding the actual value over approximately 4 years and 8 months, from March 25, 2019, to November 10 of last year, which was revealed during an internal audit. Subsequently, the employee received bribes from a real estate broker and, in collusion with them, engaged in forgery and use of private documents (such as creating false contracts) and inflated collateral values to process large-scale improper loans, as revealed by the FSS inspection. Another NH NongHyup Bank employee was found to have unilaterally canceled a fund worth 200 million KRW without the consent of a naturalized foreigner unfamiliar with domestic financial operations and embezzled the funds. This employee had previously been caught during an internal audit for causing another financial incident, but due to inadequate management, additional incidents occurred, according to the FSS.

Average 3 years 3 months until detection... Recovery rate below 60%, only 10% of embezzling employees dismissed

Financial incidents have occurred at NH NongHyup Bank and regional NongHyup agricultural and livestock cooperatives, but it takes a long time to detect them, and the recovery rate is low. According to data submitted by Hong Moon-pyo, a member of the People Power Party, from NongHyup Central Association, from 2017 to August last year, embezzlement incidents totaling 59.4 billion KRW (264 cases) occurred, including 56.3 billion KRW at regional NongHyup agricultural and livestock cooperatives and 3.1 billion KRW at NH NongHyup Bank. Analyzing the top 10 embezzlement cases by amount, it took an average of 3 years and 3 months to detect them. The recovery rate was only 59%, leaving 24.4 billion KRW unrecovered. Internal disciplinary actions are also considered weak. Cases where embezzling employees were dismissed accounted for less than 10% of all disciplinary actions, while 51% ended with 'reprimand' or 'improvement requests.'

NongHyup Central Association decides personnel exchanges in financial group... Weak internal controls

The FSS pointed to the unique governance structure of NongHyup Financial as the reason for the series of financial incidents. NongHyup Central Association holds 100% of the shares in NongHyup Financial Group, and personnel exchanges are possible between NongHyup Central Association, NongHyup Economic Holdings, and NongHyup Financial Group, which weakens the internal control system. The FSS stated in the press release, “Employees from NongHyup Central Association (at NH NongHyup Bank) serve as heads of city/county branches and oversee internal controls of the bank branches under their jurisdiction, which could weaken the internal control system.” An FSS official explained, "The city/county branch heads are NH NongHyup Bank employees, but they oversee not only the bank branches under their jurisdiction but also some NongHyup economic businesses. It’s a somewhat unusual structure." According to the bylaws of NongHyup Central Association, the Personnel Exchange Review Committee, chaired by the executive director of the Central Association, determines personnel exchanges among NongHyup Central Association, NongHyup Economic Holdings, and NongHyup Financial Group business divisions. It surveys personnel exchange demands and sets basic policies. In other words, NongHyup Central Association comprehensively decides personnel exchange matters.

Accordingly, employees responsible for economic businesses at the Central Association, who lack financial expertise, can gain short-term experience at NH NongHyup Bank or NongHyup Life Insurance, subsidiaries of NongHyup Financial. While this can be an opportunity to develop financial expertise, it is often pointed out that many only work for 1 to 2 years in a formal capacity. A senior FSS official said regarding personnel exchanges between the Central Association and NongHyup Financial, “Even if a complete ban on personnel exchanges is not necessary, it is important to properly establish principles for personnel exchanges.”

Excessive allocation of agricultural support project funds... Capital adequacy below standard

One controversial issue arising from this governance structure is the ‘excessive allocation’ of agricultural support project funds. Agricultural support project funds are contributions collected by NongHyup Central Association under the pretext of supporting farmers. From 2012 to last year, NongHyup Central Association received a total of 8.6153 trillion KRW from NongHyup Financial Group, comprising 3.8566 trillion KRW in dividends and 4.7587 trillion KRW in agricultural support project funds (land funds). During the same period, this accounted for 48.3% of NongHyup Financial Group’s cumulative net income (17.8349 trillion KRW). In 2020, although net income decreased compared to the previous year, dividends increased. Due to excessive expenditures, capital adequacy also falls short of regulatory standards. At the end of last year, NongHyup Financial’s Common Equity Tier 1 (CET1) ratio was 12.88%, below the recommended 13% by regulators.

Nevertheless, NongHyup Financial does not have practical authority over the calculation of land funds and dividends. The rate for land funds is decided at the NongHyup Central Association’s general meeting and then notified to NongHyup Financial. Although dividends are decided by the board of directors of NongHyup Financial Group, approval from the sole shareholder, NongHyup Central Association, is required at the shareholders’ meeting.

Use inconsistent with the intended purpose is also problematic. According to Hong’s office, from 2014 to 2022, 46% of the 4.3224 trillion KRW in land funds was used for personnel expenses, administrative costs, and other project management expenses. Under the Agricultural Cooperative Act, land funds are to be used for educational projects and distribution support projects, and project management expenses should be minimized, but nearly half of the funds were spent on project management.

Regulators also plan to review the method of calculating land funds. A senior official in the financial sector said, “Other bank holding companies receive similar funds under similar names, but the problem with land funds lies in the calculation method.”

Editor's NoteNongHyup, established for the development of farmers in the Republic of Korea, has undergone separation of credit and economic businesses (separation of credit and economic operations) for 12 years. The separated credit business transformed into NongHyup Financial Group and is growing with the goal of becoming a global financial group. However, the unique governance structure, in which NongHyup Central Association holds 100% of the shares, is increasingly being criticized for causing various problems such as financial incidents, agricultural support project funds, personnel systems, and weakening competitiveness of mutual finance in NongHyup agricultural and livestock cooperatives. This article reviews recent controversies surrounding NongHyup Financial Group and mutual finance businesses and explores the direction NongHyup Financial should take. If the separation of credit and economic businesses was version 1.0 of NongHyup Financial’s development, it is now time to create a version 2.0 blueprint and improve systems and institutions for NongHyup Financial to take a further leap forward.