Banks, financial liberalisation and financial crises in emerging markets

Abstract

The East Asian crisis has drawn into sharp relief the connections between weaknesses in the domestic banking sector, financial liberalisation and currency crises. This paper has shown how a simple analytical model provides a useful and realistic framework within which to discuss these connections. The model is particularly relevant in the context of East Asian economies where the domestic banking sector has been very important, both as an outlet for domestic savers and as a source of finance for firms. We have suggested that a key characteristic of the East Asian economies was that economic liberalisation did as much to increase the demand for bank credit as it did to increase the supply, and that domestic banks acted as a friction preventing 'complete' international financial integration despite open capital accounts. Relatively high domestic rates did not therefore fall as interest rate parity theory suggests, and capital inflows were perpetuated. It was only when global interest rates rose and/or perceived risks increased that capital reversal occurred. Expansionary domestic monetary policy aimed at avoiding the effects of rising interest rates then perpetuated the capital outflows. The analysis also carries with it some messages for policy. How do the policy lessons tally with what is happening? While improving prudential supervision and standards is clearly relevant, it is only part of the story. A graduated and sequenced internationalisation of the domestic banking system is also a relevant part of financial sector reform aimed at raising efficiency. Moreover, there are policy pitfalls to be avoided. Amongst the most important of these is 'premature' capital account liberalisation. Emerging economies need to retain the option of using capital restraints in order to manage capital inflows, at least until other reforms to the domestic financial sector have been completed.