Financial Liberalisation and the South Korean Financial Crisis: Some Qualitative Evidence

This paper provides a novel analysis of the South Korean financial crisis drawing on the findings of a unique survey of IMF/World Bank officials and South Korean economists. 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, including Korea, were mainly to be found outside East Asia, including the IMF, the World Bank, western media and analysts. 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 lending to companies outside Korea. It also created additional disincentives for managing risk by intensifying competition and eroding bank franchise values. Finally, weaknesses in prudential regulation allowed bank portfolios to become much riskier, importantly in terms of maturity mis-matches 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.