Could We Have Learned from the Asian Financial Crisis of 1997-98?

Galina Hale of Federal Reserve Bank of San Francisco writes a nice short paper on the topic.

She says though the 1997-98 and 2007 crisis are similar there are some major differences. Moreover, the regulatory changes brought after 1997-98 crisis were not really enough to contain the 2007 crisis because of the differences.

This Economic Letter takes a step back in time and looks at the lessons drawn in the literature written in the aftermath of the Asian financial crisis of 1997–98, the most serious predecessor in recent decades of the current crisis. The Letter examines why those lessons might not be applicable to developed economies. It focuses on policies that, following the Asian financial crises, were thought to prevent similar crises, or at least mitigate their economic effects and speed up recovery.

The Letter argues that, despite many similarities between the Asian financial crisis and the recent global financial crisis, there were also important differences. Those largely had to do with differences in the economies and financial systems of the emerging market countries of East Asia prior to 1997 and those of the United States and developed nations of Western Europe before 2007. Those differences explain why recommendations made to Asian countries following the 1997–98 crisis did not lead to major banking and financial regulatory reform in the developed world. 

She looks at the Asian crisis first. Much of the recipe is well-known by now:

  • Fixed exchange rates,
  • Currency mismatch: liabilities in dollars and assets in local currency; as currency depreciated, value of liabilities rose
  • Maturity mismatch: long-term assets and short-term liabilities. This is a classic banking problem. It worsened because of currency mismatch

What were the suggestions after EA crisis?

  • Bank regulators were encouraged to require greater transparency and supervise lending activity more strictly, paying particular attention to currency and maturity mismatches.
  • Some scholars urged that highly leveraged institutions be required to improve risk assessment and reduce leverage ratios.
  • Some argued for capital controls to lengthen the maturity and alter the composition of foreign capital inflows so that more investment came in as equity and less as debt.
  • An international lender of last resort was needed to resolve crises, economists said, questioning whether the IMF could fulfill this role given its limited funds. Economists also called for private-sector contingent credit lines to manage liquidity problems. Private-sector involvement in crisis resolution was held to be vital, given the enormous volume of international capital flows.

One can clearly see the similarity as we see near similar suggestions given in this crisis as well. However, the EA crisis did not shake up adv economies. There were differences as developed world financial system was seen as more mature. The lessons were for EA countries to make their fin systems like developed:

First and foremost, financial markets in the developed world were much more mature and regulation stricter than in Asian countries. Regulatory changes proposed for Asian economies were designed to make financial and banking regulation more like that in the developed world.  Specifically, the proposals were intended to align regulation with the core principles of banking supervision as practiced in the G-10 countries. For example, economists recommended that East Asian banks bring their capital ratios in line with the Basel Accord levels adopted in the developed world. In short, developed world financial markets were in much better shape in 2007 than financial markets in East Asia prior to the Asian crises.

A second set of differences stems from the fact that mature financial markets that had been through the Great Depression and the collapse of the Bretton Woods global monetary system were much more resilient to shocks, due to their depth and sophistication, and their supervisory and insurance systems. Developed world financial systems were thought to be able to function safely with less oversight and more leverage. However, as we have learned, reduced oversight and high leverage tend to reduce transparency.

Third, developed world financial systems had proved to be capable of rebounding from external one-time shocks. The Russia/Long-Term Capital Management crisis of the fall of 1998 and the September 11, 2001, terrorist attacks are two cases in point. These events precipitated large temporary declines in asset prices, especially in the United States. But they did not grow into widespread financial market freezes like the one that occurred in the fall of 2008 after the collapse of the investment bank Lehman Brothers.

In all, there was a lot of overconfidence in developed world wrt to their financial systems.  Amazing journey of ten years for developed world financial systems. How they have all collapsed is really like a thrilling ride.

It is like this movie inception where one actually is confused whether all these collapses of Citi, Lehman, BofA, AIG etc is reality or a dream? Even after nearly 3 years of their collapse, one wonders whether it is a dream… Alas, the top (Leonardo DiCaprio‘s totem) does not spin perpetually….

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