[BOJ Financial Stability Report] BOJ's Warning: "Financial System More Vulnerable Than Pre-COVID"

Financial Vulnerability Index 58.9... Up 17P from Pre-COVID (41.9)

[Asia Economy Reporter Kim Eun-byeol] Since the COVID-19 pandemic, continued monetary easing has led to a clear rise in risk appetite, and with a sharp increase in debt, financial imbalances have accumulated, expanding potential vulnerabilities within the financial system.

According to the "2021 First Half Financial Stability Report" released by the Bank of Korea on the 22nd, the Financial Vulnerability Index (FVI), which comprehensively evaluates financial system vulnerabilities and resilience, recorded a provisional figure of 58.9 in the first quarter of this year, higher than 41.9 in the fourth quarter of 2019 before the COVID-19 outbreak. The FVI measures the financial system's vulnerability to domestic and external shocks by comprehensively considering the degree of financial imbalance and the resilience of financial institutions. A higher index value indicates a greater potential negative impact on finance and the economy when shocks occur. It is composed of 39 detailed indicators across 11 sectors within three evaluation elements: asset prices, credit accumulation, and financial institution resilience.

The Bank of Korea explained, "Although short-term financial instability following the recent COVID-19 crisis has been resolved, potential vulnerabilities within the financial system have rather expanded from a medium- to long-term perspective," adding, "Financial imbalances have accumulated due to strengthened risk appetite driven by continued accommodative financial conditions and asset price increases linked to private credit expansion."

In particular, the profit-seeking tendency in the stock and real estate markets has intensified, raising the overall asset price index to levels close to past crisis periods. The overall asset price index stood at 91.7, approaching levels seen during the Asian Financial Crisis (Q2 1997, 93.1) and the Global Financial Crisis (Q3 2007, 100.0).

Since the COVID-19 outbreak, real estate and stock prices have surged sharply. The Bank of Korea noted that the rise in real estate prices, coupled with increased borrowing to finance investments, has exacerbated financial imbalances, estimating that some assets, including real estate, are significantly overvalued relative to fundamental economic conditions. It specifically pointed out that speculative demand has surged and prices have risen sharply in crypto assets despite their uncertain economic value, indicating a spread of risk-seeking behavior in asset markets.

If financial imbalances deepen, asset price adjustments and rapid deleveraging triggered by domestic and external shocks could negatively impact the real economy. The Bank of Korea assessed that under the current level of financial imbalance, there is an inherent risk that GDP growth could fall below -0.75% (annualized) in extreme cases (with a 10% probability).

Risk factors that could affect the stability of the financial system going forward include ▲uncertainties related to COVID-19 ▲investment sentiment deterioration and increased asset price volatility due to the reduction of major countries' monetary easing policies amid global inflation concerns ▲normalization of various financial support measures implemented after COVID-19 ▲and differentiated recovery patterns across sectors and industries amid overall economic recovery.

The Bank of Korea advised that efforts to reduce vulnerabilities within the financial system through asset market stabilization and private credit management are crucial to mitigating the negative impacts of domestic and external shocks. As of the end of the first quarter, the ratio of private credit to nominal GDP reached 216.3%, increasing by 15.9 percentage points compared to the same period last year, reflecting a significant rise in loans. Household debt stood at 1,765 trillion won at the end of the first quarter, up 9.5% year-on-year, maintaining a high growth rate.

It also recommended closely monitoring price trends and capital inflows in asset markets such as real estate, stocks, and crypto assets, and strengthening joint response efforts with relevant policy authorities when necessary. Furthermore, it emphasized the need to gradually adjust financial support measures according to economic conditions. Selective support for heavily affected sectors should be provided to alleviate private credit accumulation caused by broad liquidity support measures.

The Bank of Korea also stressed the importance of continuing efforts to build loan loss provisions and expand capital in financial institutions in preparation for a potential increase in non-performing loans due to changes in financial and economic conditions. It added, "Although it is still difficult to accurately gauge the ripple effects, it is necessary to identify factors that could threaten financial system stability and prepare countermeasures." Factors that could threaten financial system stability include climate change, crypto assets, and the expansion of big tech companies' business areas.

This content was produced with the assistance of AI translation services.