Financial Liberalisation and the South Korean Financial Crisis: An Analysis of Expert Opinion

Abstract

This paper provides a novel analysis of the South Korean financial crisis drawing on the findings of a unique survey of IMF/World Bank and South Korean experts. The survey reveals that over-optimism and inadequate recognition of financial risks inadvertently led to excessive risk-taking by Korean financial intermediaries. It also indicates that the sources of over-optimistic assessments of East Asian economies were mainly to be found outside East Asia and included the Bretton Woods Institutions themselves, Western media and analysts. In Korea, weaknesses in risk management were the result of (i) lack of expertise in relation to handling the risks associated with capital flows, and (ii) disincentives to manage risks emanating from a relatively successful history of government-provided safety nets for both industry and banking. Financial liberalisation widened risk-taking opportunities, by allowing Korean financial institutions to both borrow from and lend to institutions outside Korea. It also created additional disincentives for managing risk by intensifying competition and eroding bank franchise values. Weaknesses in prudential regulation allowed bank portfolios to become riskier, especially in terms of increased liquidity risk as a result of maturity mismatches between dollar-denominated assets and liabilities. The liquidity crisis, which followed the re-assessment of the South Korean economy by international lenders in late 1997, triggered a full-blown financial crisis because of the absence of an effective international lender of last resort.