Lessons from the 1997 Asian Financial Crisis

gambling at casinos after losing everything. Therefore, the risky “gambling” behavior to revive the S&L organization’s operations is considered the most logical and profound explanation among the causes leading to the widespread S&L crisis in the mid-1980s.

Fourth, the reform of the financial system and the relaxation of supervision and regulation have allowed the S&L industry to gain more power, which has led to several problems. First, many S&L boards have not required experts to manage risky business activities when they are allowed to invest in new business areas. Second, the expansion of power has meant that S&L institutions have invested rapidly in new areas, especially real estate. Therefore, even if these institutions use experts, the available information sources to support investment decisions and help promote hot credit growth are not timely, which leads to overinvestment in risky and uninformed areas. Third, the new powers of S&Ls allowed them to expand into highly complex investment areas that required regulation to properly control these investments. But in practice, S&L policy makers at the Federal Savings and Loan Insurance Corporation (FSLIC) were not experts or had the information to help monitor these new investment areas. Fourth, many S&Ls made loans to their own officers, their own companies, and friends and family members at low interest rates and with little collateral. S&L executives concealed the poor quality of their loans by continuing to lend to the same borrowers, who then used the money to pay off old debts. Government investigations have found that this phenomenon exists in approximately 25% of the S&L institutions that have failed [81]. Thus, with the lack of experienced professionals at S&L institutions and at the FSLIC, weaknesses in the management system, and the moral hazard incentive created by the deposit insurance system, it is inevitable that S&L institutions have engaged in overly risky business practices, leading to large losses from poor-quality loans.

Fifth, even after the crisis has occurred, moral hazard has the opportunity to continue to develop. Its main cause comes from the intransigent attitude of regulatory agencies.

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When the S&L crisis hit, it was right for the regulators of S&Ls to shut down insolvent S&Ls, which was the responsibility of the Federal Home Loan Bank Board (FHLBB) and its insurer, the Federal Savings and Loan Insurance Corporation (FSLIC). Instead, the agencies used a delaying solution. Specifically, they did not close down insolvent S&Ls, but instead used unorthodox accounting principles to reduce the capital requirements for these S&Ls.

Failure to take the aftermath of the crisis seriously has rapidly increased moral hazard, as insolvent S&Ls that continue to operate with little to lose have taken on extremely risky investments and gambled with their assets. If the investments are lucky and they make money, they can avoid insolvency. Conversely, if the investments are truly risky and lose money, the S&Ls’ losses will increase and the deposit insurance agency will have to pay for those losses.

Sixth, political factors are also a factor that creates opportunities for moral hazard in the operations of S&Ls. The role of political power is analyzed under the relationship between the principal (depositors, taxpayers) and the agents (policy makers, managers or S&L management boards). Stemming from the conflict of interests between the principal and the agent, managers have relaxed capital requirements, loosened the control of risky assets, and pursued a policy of delaying the handling of violations. The motivation for this is that they are afraid of being blamed for not performing well the role of representatives of depositors or individuals who have to pay taxes to the government, and at the same time they want to protect their position by agreeing with the views and pressures of those who influence their profession. By relaxing capital requirements and being indecisive in handling violations, managers can cover up the problems.

problems that are arising at insolvent S&Ls and the hope that the situation will improve.

Seventh, the S&Ls' risky investments were also made possible by the laxity and incompetence of regulatory agencies. When S&Ls invested in complex and high-risk products, regulators needed to closely monitor the S&Ls' operations. To do so, regulators needed the financial resources to properly monitor their operations. However, Congress did not provide the funds because Congress itself was bribed by the S&Ls. As a result, depositors' representatives (regulators) did not have enough staff to perform their monitoring and had to reduce their visits to S&L headquarters to only when absolutely necessary. During the period from January 1984 to June 1986, hundreds of S&Ls were not inspected at all. S&Ls even bribed Congress to pass the 1987 Banking Fairness Act to withhold sufficient funding to bail out insolvent S&Ls and prevent them from being closed. At the same time, Congress also introduced provisions to force regulators to delay closing the institutions.

The above facts show that the structure of the political system has caused a mismatch of interests between depositors/taxpayers and managers/politicians; politicians have strong incentives to act in their own interests rather than in the interests of individuals in the economy. Because of the costs of election campaigns, American politicians have to mobilize enough financial resources and this has created conditions for bribery to take place to entice politicians to act against the interests of the majority of the public .

1.3.1.2. Experience from the 1997 Asian financial crisis

The Southeast Asian financial crisis was the third global currency crisis that occurred in 1990 and had a strong impact on the exchange rate and stock markets in the Southeast Asian region.

The consequence of the Asian crisis was that the currency and stock markets in most countries affected by this crisis fell sharply in value from 20% to 75% in the first half of 1997. Its impact was to make the economic growth rate of most emerging Asian economies that year only reach about 1%-2%. The economies that were strongly and directly affected by this crisis were Thailand, Indonesia, and South Korea. This crisis also spread to economies outside the region and according to the International Monetary Fund (IMF) estimates, this crisis reduced the global economic growth rate from 4.5% to 3.8% in 1998 [79].

Consider the interplay between moral hazard and the consequences of this crisis.

First, weak corporate and banking governance and the absence of a market discipline framework, coupled with weak and ineffective prudential supervision, have created opportunities for financial institutions to engage in high-risk activities. Close relationships between governments, financial institutions, and borrowers have worsened the situation, especially in Indonesia and Korea. Weak accounting standards, especially in credit appraisal, and lack of disclosure have helped policymakers, supervisors, market participants, and international financial institutions conceal growing weaknesses. The first shot that signaled the crisis began with the floating of the Thai Baht in July 1997. Expectations for the East Asian market were dampened, causing most other currencies in the region to depreciate, capital was withdrawn from banks and foreign investors' capital was withdrawn rapidly, and the economy quickly collapsed [95].

Second, moral hazard arises from government protection mechanisms. Normally, the government can provide depositors with deposit insurance, thereby eliminating the need for depositors to monitor the activities of banks. The task of monitoring now falls on the government. When the government sees signs of weakness in banks, the government will take measures to close the banks.

or merge with other banks. For banks that have fallen into a weak state but have not been seriously dealt with, they will be willing to bet on investing in high-risk activities because they have nothing to lose, and from there moral hazard will become more and more serious. So this is the basis for the potential existence of moral hazard.

In an analysis by Corsetti [78], he and his team showed that Asian governments actually provided an insurance scheme that increased moral hazard behavior. According to the team, political pressure to maintain high economic growth rates led to governments supporting private projects, some of which were government-controlled, directly financed or supported by direct credit policies, for a long time. Even without the promise of financial bailouts, production plans and strategies in the business sector did not take into account the cost factor and ignored the risk level of the projects. With policies in the financial and business sectors that were not transparent, and government intervention that favored weak businesses, markets operated under the illusion that investment returns would be “insured” against economic shocks [78].

Moral hazard has the potential to arise under government protection of banks and businesses, which has led to banks being lax in assessing and monitoring the investment activities of high-risk borrowers. At the same time, state-owned commercial banks have borrowed large amounts of foreign currency at low costs to invest in unprofitable projects but expected to be protected by the government. The implicit process of government protection explains why Asian economies have been slow to adopt effective procedures for handling failed banks, while still allowing banks with large losses to continue operating.

Third, the business practices of financial institutions and a weak information system led to the failure of the financial system. In Indonesia, Thailand and later Korea, commercial banks cut funding costs by borrowing foreign currency from foreign institutions for short terms, but invested in

The stock and real estate markets have been in a state of flux. Over-investment and over-concentration in these long-term assets with short-term capital sources have affected the liquidity of commercial banks. These reckless business practices are supported by weak supervision by management agencies. Regulations on debt classification and provisioning are too loose; state-owned commercial banks have not paid attention to the creditworthiness of borrowers; equity capital is often insufficient to cover the banks' risky business activities; and commercial banks always have an expectation that the government will provide financial support if the commercial banks' performance deteriorates. But above all these problems is a lack of transparent information in the banking and financial system [78]

Fourth, moral hazard emerged during the Asian financial crisis from the actions of government officials and international financial institutions, which created conditions for moral hazard to arise by inducing domestic debtors, foreign creditors, or both to act in ways that were counterproductive to economic stability and exacerbated the crisis.

In fact, the East Asian debtors did not incur any costs to hedge their foreign currency borrowings, mainly US dollars. This was also due to the fact that their currencies had held up even in the face of the sharp fluctuations in the Japanese yen-dollar exchange rate in previous years, and most Asian countries’ exports were adversely affected by these fluctuations. Most East Asian debtors had reason to believe that their governments held sufficient foreign exchange reserves to protect the fixed exchange rate regime from speculative activities. What they did not know, for example in the case of Thailand, was that the Bank of Thailand had intervened in the foreign exchange forward market several months earlier, and the forward sales had reduced the Thai government’s foreign exchange reserves, which would have helped to accurately assess the level of foreign exchange risk in US dollar borrowings. This, in turn, has given domestic financial institutions reason to believe that there is an implicit government guarantee mechanism in place.

government about the volatility in the price of the dollar. This is a clear sign of moral hazard.

A similar situation occurred in Indonesia, where banks had written off large amounts of foreign currency call options in the years leading up to the crisis, believing that the exchange rate would remain stable. Many large banks even had the illusion that their large scale of operations made them “too big to fail,” and many large private corporations that borrowed foreign currency also had the illusion that their influence was too great to fail. With this in mind, these large corporations did not borrow foreign currency from the domestic banking system but borrowed directly from foreign sources. The illusion of invincibility was reinforced when the Central Bank of Indonesia guaranteed excess liquidity to domestic banks and other financial institutions under the jurisdiction of some powerful agencies that were experiencing liquidity difficulties. Once the exchange rate faced contagion pressure from Thailand, these banks and large corporations tried to hedge their exchange rate risk by buying foreign currency immediately, which only accelerated the rapid decline in the value of the rupiah.

The crisis in South Korea once again demonstrated the overreliance on an exchange rate guarantee. Based on the long-standing fixed exchange rate regime between the Thai baht and the Malaysian ringgit and the US dollar, Korean financial institutions borrowed Japanese yen through their overseas subsidiaries to finance the fixed exchange rate between the dollar and the two currencies. When the fixed exchange rate collapsed, investors were saddled with a huge debt burden, adding to the burden on Korean financial institutions that were already struggling as the won depreciated against the yen.

Fifth, another aspect of moral hazard is also considered. That is the international level of moral hazard, arising from the behavior of foreign financial institutions. These foreign institutions have for a long time made short-term credits through the interbank market on a large scale to financial intermediaries in countries in the region without regard to

assessing the safety of such sources of capital [78]. This is because foreign financial institutions believe that such sources of credit will be guaranteed by the governments of countries in the region or by indirect bailouts from the IMF. Therefore, a large amount of short-term, unhedged foreign currency debt of commercial banks. Estimates of the ratio of short-term foreign debt to foreign exchange reserves - a ratio to measure financial safety - are greater than 100% in Korea, Indonesia and Thailand [78]

1.3.1.3. Experience from the 2007 Subprime Crisis

The subprime mortgage crisis was a real estate and financial crisis that began with a sharp increase in delinquencies in real estate lending and the repossession of these assets in the United States, causing serious consequences for banks and financial markets worldwide. The starting point of the crisis was the bursting of the US housing bubble, which peaked in prices around 2005–2006. After the housing bubble burst, the rate of delinquencies increased in subprime loans with adjustable-rate interest rates. The decline in prices also made the value of the house lower than the value of the credit, forcing banks to foreclose on the house to collect debts. The widespread foreclosures that began in late 2006 in the United States created a global economic crisis, as it weakened the financial capacity of consumers as well as of banking and financial institutions [92].

So how does moral hazard relate to this crisis?

Moral hazard is primarily manifested in the over-concentration of capital and the loosening of credit conditions by lending institutions in order to seize profitable opportunities. Low interest rates and large foreign currency inflows gave these lending institutions the opportunity to loosen credit conditions in the years before the crisis, which heated up the housing market and encouraged borrowing for consumption. Subprime lending was a major factor in the rise in home ownership in the United States and the rapid rise in home prices. Between 1997 and 2006, the average home price in the United States increased by 124% [78]. The credit easing and housing boom in the United States fueled a construction boom that eventually led to a surplus of

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