Korean Financial Crisis in the Late 1990s Lesson for Current Euro Area Research Paper

Korean Financial Crisis in the Late 1990s: Lesson for Current Euro Area

The objective of this study is to examine what is unique or different about the Korean financial crisis as compared to other Asian financial crises and to determine the primary causes of the financial crisis in Korea. This work will further examine the government response to the crisis and what it is that can be learned from the Korean financial crisis and applied in Korea to the Euro Area.

The major components of the Korean financial system in the 1960s and 1970s are stated in reports to have been nationalized with "lending targeted toward favored sectors and firms including the exports and heavy industries. (Jeon and Miller, 2005) Regional banks came on in 1967 and could only operate in their own provinces, which provided encouragement for development that was regionally-based. In the early 1980s, plans were made for deregulation of the financial system and to place Korean commercial banks in the private sector. (Jeon and Miller, 2005, paraphrased) The power of commercial banks was expanded by deregulation in the 1980s allowing them to offer credit cards, issue negotiable certificates of deposit, and provide automated teller machines. At the same time, there was an easing of foreign exchange controls and restrictions on foreign ownership of Korean assets. (Jeon and Miller, 2005) However, the Korean government still had a hold that was strong in that they controlled interest rates on some loans and deposits and their informal credit policy still favored some sectors. During the middle part of the 1980s, it is held that the Korean commercial banking system underwent a crisis due to a high level of bad loans but it is stated that no banks failed during that crisis since charge-off rates for bad loans "were allocated slowly to maintain individual bank viability." (Jeon and Miller, 2005)

Introduction

The inflation rate nearly doubled in 1998 as compared to 1997 in Korea and simultaneously the unemployment rate more than doubled and this followed interest rates in Korea rising from 12.5 in 1996 to 21.3 in 1997 with the exchange rate in 1996 at 845 doubling to 1695 in 1997 in Korea. The Gross Domestic Product (GDP) rate in Korea dipped sharply in 1998 as shown in the following graph labeled Figure 1 in this study.

According to Jeon (2012), the value of Korean currency fell by more than one-half when there was an exodus of foreign capital in 1997 and the GDP contracted approximately six percent in 1998. This was preceded by a sharp contraction in corporate investment and consumer spending and a surge in corporate bankruptcies, which increased the unemployment rate. (Jeon, 2012, paraphrased)

I. Korean Financial Crisis

According to the work of Jeon and Miller (2005) entitled "Performance of Domestic and Foreign Banks: The Case of Korea and the Asian Financial Crisis" the economy of the world has witnessed quite a few financial crisis over the past ten years. Following a lengthy process of deregulation and privatization, "the Asian financial crisis hit the Korean economy." (Jeon and Miller, 2005) The Korean banking system is reported to have "evolved from an industry with large state ownership and significant government direction of credit flows to a more deregulated and privatized industry." (Jeon and Miller, 2005) The industry's viability as well as its structure and stability were tested severely by the Asian financial crisis following what was a "significant transition." (Jeon and Miller, 2005) This resulted in the government recapitalizing the banks, which were previously believed to be "too-big-to-fail." (Jeon and Miller, 2005) These banks were Korea First and Seoul banks receiving government financial support and in overseeing the closing and takeovers of smaller banks that were insolvent. (Jeon and Miller, 2005, paraphrased) It is stated that in the circumstances "the performance of the Korean banking system in the wake of the Asian financial crisis appears remarkable, probably helped by that government intervention." (Jeon and Miller, 2005)

II. Foreign Bank Lending Examined

It has been suggested by analysts that "foreign bank lending played a unique role in the Asian financial crisis vis-a-vis other similar events. Domestic banks supplied major quantities of credit to domestic firms and relied more heavily on foreign bank lending. When the crisis hit, the supply of foreign lending evaporated quickly, creating a liquidity crisis for domestic banks." (Jeon and Miller, 2005) It is related that there are some who "indict the initial International Monetary Fund (IMF) rescue programs as worsening the liquidity crisis by requiring tighter credit." (Jeon and Miller, 2005) The Korean financial crisis is differentiated in the work of Noland (2000) from other financial crisis in southeast Asia on the basis that the "Korean investment boom occurred in the manufacturing sector, especially the chaebols, rather than in real estate. Since short-term capital controls were liberalized while the long-term controls were not, investment growth was funded largely by short-run capital inflows." (Jeon and Miller, 2005) Basically the result of the financial crisis was that there were some primary corporate borrowers that defaulted on their loans to the banks resulting in reinforcement of the negative shock, which was "compounded by the loss of foreign lending to domestic banks." (Jeon and Miller, 2005) This resulted in intervention by the central bank providing assistance in locating merging partners and some of them foreign for the takeover of operations of the banks that had failed. (Jeon and Miller, 2005, paraphrased)

III. Performance of Korean Banks

While the performance of Korean banks "deteriorated dramatically in 1998. Most banks recovered somewhat in 1999." (Jeon and Miller, 2005) The results from studies are stated to show that there was a global advantage rather than a home field advantage with explanations including:

(1) foreign banks were not subject to the credit allocation directives from the Korean government to selected, favored industries; and (2) foreign banks, reliant on their mother bank in their own country achieved better efficiency and better asset and liability management; and (3) foreign banks rely more heavily on fee-for-service income rather than loan revenue. (Jeon and Miller, 2005)

IV. Examination of Foreign Banks in Domestic Financial Markets

The Asian financial crisis highlights the importance of markets that are strong and financially stable for maintaining economic development. (Jeon and Miller, 2005, paraphrased) It is argued by some analysts that foreign bank participation in domestic financial markets serve to strengthen the domestic economy while others hold that the financial service industry "possesses public good characteristics and that the unfettered private interests (markets) especially interest with foreign connections, should not control credit allocation decisions." (Jeon and Miller, 2005) The implication is that foreign banks should not operate in the domestic economy according to Jeon and Miller (2005). Stated as a more conservative view holds that state ownership and state mandated credit allocation "needs to send credit to those sectors most crucial for economic development." (Jeon and Miller, 2005)

Korea is reported to have "transverse this spectrum of views from a system with large elements of state ownership and state-directed credit flows to a more open and competitive financial market with a significant presence of foreign banks including a large privatization of state-owned banks." (Jeon and Miller, 2005) Foreign bank entry has been examined in the work of many authors and stated is that foreign banks serve to "facilitate capital inflows to finance domestic activities, which stimulates the domestic economy if such funding, adds to, rather than substitutes for, domestic funding." (Jeon and Miller, 2005) It is reported that a path for capital flight is provided by the capital flow channel when finances are strained and the increase in competition in banking serves to improve bank performance and financial services cost on the average lower. However, the foreign banks with a competitive advantage results in them being able to pick the best of the available domestic funding options and they also bring experiential regulatory and supervisory experience with them. Domestic regulators are not familiar with this type of experience in the banks and this results in complex situations that make the regulatory and supervisory process more difficult.

The difference between the performance of foreign banks and developed and developing countries is noted in the work of Clasessens et al. (2002) since higher profitability is usually achieved by foreign banks and in developed countries foreign banks generally achieve lower profitability. The explanations of the differences in the performance of foreign banks in developed and developing countries includes:

(1) low net-interest margins in developed countries may reflect participation in whole-sale rather than retail markets; and (2) the technical advantage that foreign banks possess may not cover informational disadvantages in developed countries. (Jeon and Miller, 2005)

These two explanations are stated by Jeon and Miller to "reverse themselves in developing countries. Foreign banks may enter retail markets more fully and/or they may possess higher levels of technical efficiency that overcomes any.....