South Korean regulators’ push for banks to make up for investors’ losses incurred from equity-linked securities tied to a Hong Kong index has left both Korean and foreign banks baffled.

Korea's major lenders accepted compensation guidelines suggested by financial watchdog the Financial Supervisory Service last month, agreeing to partly redress investors for the losses from the ELS products.

The payback scheme is expected to cost around 2 trillion won ($1.47 billion) in total for the lenders, as it covers some 40 percent of the 5 trillion won investment losses from the ELS products that face maturity in the first seven months of this year.

While Shinhan Bank and Hana Bank have already started to hand out compensation, KB Kookmin Bank, a top seller of ELS products among local banks, announced it would start the compensation process next Monday.

Yet there have been concerns that the compensation scheme could set a bad example for the finance industry overall, violating the principles of responsible investment, which mandates each investor should hold responsibility for one's own investment decision.

"The banks should bring the case to court. The FSS’ meddling is extreme,” an official from the local banking industry said.

It is not the first time the financial watchdog has taken the matter into its own hands, giving out compensation guidance directly when arbitrating a misselling fiasco.

A few years back, the regulator gave out guidance for banks to make up for some of the investment losses for the misselling crises related to derivatives-linked fund products (DLF) and knock-in knock-out currency derivatives (KIKO). It suggested specific compensation rates, similar to the ELS incident.

For foreign banks operating in Korea, in particular, the decision to adopt the payback plan has presented more challenges, according to industry sources.

“Making the head offices understand the compensation procedure was even more difficult for foreign banks,” an official from the local financial circle said.

The discrepancy in understanding comes as the FSS suggested the guidelines without involvement from the judicial branch.

Though it is typical for financial authorities to step in to mediate disputes, the absence of court involvement in the ELS dispute could be considered exceptional for Korea, experts said.

“The difference seems to be that the Korean regulator is setting these terms without bringing litigation in court or administrative proceedings first,” said Lauren Willis, a professor of law at Loyola Law School in Los Angeles.

“In the US system, a defendant firm would have to consent to the terms for resolving the case against them or the case would go to trial, only after the government proves a violation of the law would a court impose an order resolving the case.”

Willis further added it is not unusual for more compensation to be given to consumers believed to be more vulnerable, concerning how the FSS' guidelines suggest banks make up more of the losses for aged investors or those who lack investment experiences.

Responding to criticism that it is inappropriate for the FSS -- not the court -- to suggest the guidance, the regulator claimed it has the legal right to interfere through a statement issued in February.

“The FSS has the right to mediate a finance-related dispute between financial consumers and institutions, as stated by the Act on the Protection of Financial Consumers,” the statement read.

"(The compensation plan) was designed to yield results that are close to legal decisions without bringing the case to court," FSS Gov. Lee Bok-hyun said.

Some also viewed that the FSS’ proactive involvement could “efficiently” bring down the costs for related parties.

“If the investors or banks fail to accept the compensation plan, they would have to take the case to the dispute committee, and if they fail to negotiate again, they would have to head to the court eventually,” said Lee Hyo-seob, a senior research fellow at the Korea Capital Market Institute.

“This would be both tiresome and costly for both parties,” Lee said. "Then, coming to a compromise on a voluntary level would be considered rather efficient."