Cash-strapped Korea Merchant Banking Corp (KMBC) has received an unexpected lifeline after the Korean government decided to acquire a higher-than-expected amount of Daewoo debt. The decision comes just days after the Korean government decided to bail out KMBC with new funds, making it the first and only merchant bank to receive such treatment from the government.

Analysts believe the two actions together should slow the wave of deposit runs taking place at KoreaÆs third largest merchant bank, giving the bank enough room to work through the liquidity crisis that had been threatening its solvency.

ôIt really has to do with sentiment, as Korea Merchant BankingÆs asset quality is not that bad," says Daniel Yoo, analyst at Morgan Stanley Dean Witter in Seoul. "Since the merchant banking industry has suffered two recent closures, investors have been worried about the health of its leading merchant bank. And that triggered the wave of deposit runs at Korea Merchant."

Last weekend, Korean authorities announced they would acquire W4 trillion ($3.6 billion) in short-term corporate debt held by the ailing affiliates of the Daewoo group. Under the new plan, KoreaÆs bad loan agency KAMCO will buy all the debts that investment trusts, insurance companies and banks advanced to Daewoo affiliates between June and July last year, at 90% of the face value of those debts.

The move, which represents a major turnaround by Korean regulators, is good for KMBC in many ways. First, KoreaÆs authorities are planning to honour the debts at a higher face value than usual. Its usual debt-buyout policy is 60% of the face value. KMBC lent W190 billion to Nara Merchant Banking Corporation, which had been providing emergency loans to the Daewoo group and its affiliates.

ItÆs also a personal victory for KMBC over KoreaÆs deposit insurance agency (KDIC).

KMBC had extended the loan to Nara with the belief that all emergency lenders to Daewoo would be fully recompensed by the government. When Nara collapsed earlier this year, KMBC found itself caught out. The government refused to honour its guarantee policy, arguing that both KMBC and Daehan investment trust had manipulated the system. The government said the actual loan providers were not Nara and Yeungnam Merchant Banking (the two merchant banks that failed this year) - but KMBC and Daehan. It said it had no reason to cover KMBCÆs loan to Nara.

KMBC and Daehan took the government to court. The case has been resolved in KMBCÆs favour. But itÆs not such a hot verdict for the thorny issue of moral hazard in the banking system. Analysts say thatÆs a reason why regulators are tightening up the loopholes in regulation.

The first merchant bank bailout

This weekend's announcement is not the first time that the government has stepped in to bail out KMBC recently. Just three days ago, it pledged an additional W282.8 billion in support. State-run Korea Deposit Insurance will buy W188 billion of the merchant banksÆs subordinated debts. The remainder will come from state-run Hanareum Banking Corp in the form of a repayment to Hana Bank.

The governmentÆs new move ensures Hana Bank, KMBC's largest shareholder, will fulfill its obligations. Hana Bank, KoreaÆs second most profitable bank, had been reluctant to support KMBC further after providing an W85 billion emergency loan last week. With Hana shareholders baulking, KoreaÆs regulators were forced to announce they would pour more capital into KMBC, and help to solve the other Daewoo-related loan difficulties that KMBC faced. It worked. On Monday morning Hana sent an eight-member support team to KMBC to assess the merchant bank's operations, with a view to reducing the unit's risk profile.

Hana became the largest shareholder of KMBC six months ago, as part of Korean banks' bailout plans for the Daewoo group. At that time, Hana spent W17 billion to acquire a 22% KMBC share held by Daewoo units to help ease its cashflow problems. Analysts say Hana had no choice but to take a proactive role since emergency loans now outweigh its initial investment in KMBC by five times.

KMBC expects to post its first loss in its 25-year history for the fiscal year ending March 2000, as it has set aside W200 billion in loan loss reserves. KMBC had W3.1 trillion of debt as of September 1999, compared with assets of W2.13 trillion, according to reports.

A necessary bailout?

Local analysts, such as Morgan StanleyÆs Yoo, believe the KMBC bailout is good for the industry, and that the government is right to intervene.

KMBC is one of the few surviving lenders in KoreaÆs merchant bank industry. The merchant banks typically provide many short-term loans to KoreaÆs corporates and trade actively in KoreaÆs bond market. Without the government's aid, the future of KoreaÆs bond market would have been jeopardized and KoreaÆs corporates would have faced cashflow difficulties.

Korea has lost two-thirds of its merchant banks since the 1997 financial crisis, reducing the number to 10. Another two merchant banks fell by the wayside this year - Yeungnam Merchant Banking and Nara Merchant Banking - after encountering similar problems.

Keeping institutions such as KMBC afloat is seen as imperative for KoreaÆs bond market, which has been largely frozen following the near collapse of the investment trusts (ITCs), KoreaÆs biggest buyers of equities and bonds. Merchant banks offer much-needed liquidity to KoreaÆs bond market. ôThe question is whether the news will stop the deposit runs," says Morgan StanleyÆs Yoo. "My guess is with the governmentÆs support, the deposit runs will slow down.ö

Yoo anticipates problems for merchant banks will come to an end by 1 July. ThatÆs when Korea requires all its financial services companies - merchant banks, commercial banks, ITCs and brokerages - to disclose the condition of their portfolios; and all bonds must be marked to the market. Investors are waiting for to see what kind of bad loan numbers will emerge.

But donÆt expect the government and HanaÆs help to resolve all the merchant bankÆs problems, analysts say. Sure, the deposit runs will end and its liquidity crisis should ease. But regulatory moves removing blanket protection of deposits from 1 July will continue to erode weaker banks' funding base. KMBC's long-term solution may be found in a broader merger, they say.