Financial Crisis and Credit Crunch as a Result of Inefficient Financial Intermediation—with Reference to the Asian Financial Crisis

This paper develops a new model of international private debt financing. It shows the possibility of discontinuity in the amount of financial intermediation when the intermediary is inefficient. The model suggests a mechanism that can generate the following sequence of events: A period of relatively low capital flow despite a steady improvement in economic fundamentals (capital inflow inertia), followed by a fast buildup of capital inflow, and ended with a large capital outflow (crisis), as observed in the recent Asian financial crisis. In addition, there exists a minimum level of economic fundamental strength that can sustain large capital inflows. If the fundamental strength is not far above this minimum level, the economy will be vulnerable to shifts in market sentiment and to even a small deterioration of fundamentals. We use comparative statics to evaluate the pros and cons of various policy responses to the crisis.