M odern b anking however, Korea had the legal framework to deal with the chaebol

M ODERN B ANKING However, Korea had the
legal framework to deal with the chaebol
problems. Creditors have been able to use the
courts to put the chaebol into receivership.
Though the Daewoo crisis did not come to the
fore until mid-1999, its creditors negotiated
rate reductions, grace periods and debt–equity
conversions to stabilise its debt of $80 billion,
then proceed with the break-up and sale of its
assets. Other chaebol have been stabilised, after
debt restructuring agreements with bankers.
The state also intervened, requiring gearing ratios to
be reduced to at least 200%, and prohibiting
cross-guarantees of chaebol members’ debt.
21 The situation is quite different in Indonesia
and Thailand, where corporate restructuring
has been hampered by the absence of clear legal
guidelines on issues such as foreclosure, the
definition of insolvency and the legal rights of
creditors. ž Exchange rate regimes: these
countries had all adopted some type of US dollar peg.
22 In the absence of any serious inflation, real
effective exchange rates were stable, with only
a slight rise in 1995–96. Trade weighted exchange
rates were also stable. Once the Thai baht came
under pressure, and floated in July 1997, it
depreciated rapidly. The other countries responded
by widening their fluctuation bands (depending on
the system of pegging), but the runs continued,
forcing them, with the exception of Malaysia,23 to
float their respective currencies. The Indonesia
rupiah was floated in August; the Korean won in December.
All of these governments had used their central banks
to defend the currency, exhausting much of their foreign
exchange reserves24 and pushing up domestic interest rates.
The financial sector ž All of the Asian economies were
bank dominated, with underdeveloped money markets.
Between 1990 and 1997, bank credit grew by 18% per
annum for Thailand and Indonesia, 12% for Korea.
By way of contrast, credit growth averaged 4% per
annum for the G-10, and was just 0.5% for the USA.
By 1997, bank credit as a percentage of GDP for Thailand,
Korea and Indonesia was, respectively,
105%, 64% and 57% – amounts that were close to,
or in the case of Thailand above, those for developed
countries. The rapid increase in the supply of credit,
in the absence of the growth of profitable investment
opportunities, caused interest margins to narrow
(to the point that they were roughly equal to operating
costs), even though riskier business loans were being made,
largely in construction and property. Property was also
used as collateral – soaring property prices fooled the
banks into thinking the risk they faced from property-backed
loans was minimal. 21 This account comes from Scott (2002),
pp. 61, 63. 22 Hong Kong was the only economy in the
region with a currency board. Ferri et al. (2001), using
data on SME borrowers (1997–98), show that during a
systemic banking crisis, relationship banking with the banks
that survive has a positive value because it reduced
liquidity problems for SMEs, and therefore made bankruptcy
less likely. 23 Prime Minister Mahathir of Malaysia blamed
speculators for the run on the ringgit and refused to float
the currency, though the band was widened. 24 For example,
foreign exchange reserves in Thailand amounted to about
$25 billion pre-crisis, but by the time the baht was floated,
the central bank had issued about $23 billion worth of forward
foreign exchange contracts. [ 419 ] F INANCIAL C RISES Table
8.3 Bank Performance Indicators Thailand Indonesia Korea
Malaysia Weighted Capital Assets Ratio 1997 9.3 4.6 9.1 10.3 1999 12.4 −18.2 9.8 12.5 ROA 1997 −0.1 −0.1 9.1 10.3 1999 −2.5 −17.4 9.8 12.5 Spread∗ 1997 3.8 1.5 3.6 2.3 1999 4.8 7.7 2.2 4.5 ∗ Spread: short-term lending rate – short-term deposit rate. Source: BIS (2001), table III.5. ž The build-up of bad credit would not have been possible had foreign lenders been unwilling to lend to these countries. In a First World awash with liquidity,25 there were a number of reasons why Japanese and western banks found these markets attractive. Until the onset of the currency crises, the economic performance of these tiger economies had been impressive. Through the 1990s, real economic growth rates were high, inflation appeared to be under control, they had high savings and investment rates, and good fiscal discipline: government budgets were balanced. As Table 8.3 shows, the weighted capital assets ratios were, with the exception of Indonesia, respectable. Borrowers (usually local banks) were prepared to agree a loan denominated in a foreign currency (dollars, yen), thus freeing up the lender from the need to hedge against currency risk. Shortterm lending was particularly attractive, allowing western banks to avoid the standard mismatch arising from borrowing short (deposits) and lending long to firms. Finally, many foreign lenders were under the impression these banks would be supported by the government/central bank in the unlikely event of any problems (see below). ž Increasing reliance on short-term borrowing as a form of external finance: international bank and bond finance for the five Asian countries between 1990–94 was $14 billion, rising to $75 billion between 1995 and the third quarter of 1996. By 1995, the main source of the loans was European banks, and nearly 60% of it was interbank. By the beginning of 1997, foreign credit made up 40% of total loans in Asia.26 Of these loans, 60% were denominated in dollars, the rest in yen. Two-thirds of the debt had a maturity of less than a year.27 ž The almost unlimited availability of bank credit led to over-investment in industry and excess capacity. There was a close link between local bank lending and the construction and real estate sectors, especially property development. In Thailand, by the end of 1996, 30–40% of the capital inflow consisted of bank loans to the property sector, mainly 25 In the west, there was an easing of monetary policy from 1993. However, after the relatively harsh recession between 1990 and 1991, companies were reluctant to borrow or invest until 1997, when the economic boom increased borrowing once again. Japanese banks were keen to gain market share overseas. 26 Foreign investors were also attracted to the Asian stock markets – about 33% of domestic equities were held by foreigners at the end of 1996. 27 Source of these figures: Bank for International Settlements (1998, table VII.2). [ 420 ] M ODERN B ANKING developers. The figure for Indonesia was 25–30%. The problem was compounded by the use of collateral, mainly property. The loan to collateral ratios stood between 80 and 100%, creating a collateral value effect, that would further destabilise banking sectors once property (and equity) prices began to decline. The role of collateral and collateral values in models of shocks and money transmission has been emphasised by Bernanke and Gertler in various papers.28 ž Some government policies could inadvertently contribute to the problem. For example, the Thai government introduced the Bangkok International Banking Facility (BIBF) in 1993, to promote Bangkok as a regional banking sector and encourage the entry of international banks. The BIBF was also used by domestic banks to diversify into international banking intermediation by obtaining offshore funds for domestic or international lending. Unfortunately, they gave Thai banks29 a new way of borrowing from abroad, using BIBF proceeds to invest heavily in property and related sectors. ž Asian banks borrowed in yen and dollars from Japan and the west, and on-lent to local firms in the domestic currency. There was little use of forward cover against the currency risk arising from these liabilities because of the relative success of the peg, up to 1997. For example, the Thai baht had not been devalued since 1984, with only slight fluctuations around the exchange rate (BT25.5:$1). Rising interest rates and a collapsing currency proved lethal. Firms could not repay their debt, and banks found it increasingly difficult to repay the principal and interest on the dollar debt. Non-performing loans as a percentage of total loans soared, especially in Thailand and Indonesia. As Table 8.7 shows, by 1998, the percentage of non-performing loans was just under 40%. ž A tradition of forbearance towards troubled banks, and the widespread impression that governments would support the banking sector – through either implicit or explicit guarantees. For example, in Indonesia, the costly and protracted closing of Bank Summa in 1992 resulted in a policy of no bank closures in the years prior to the crisis.30 Similar attitudes prevailed in all these countries. An added problem was that even if the authorities had wanted to close insolvent banks, an inadequate legal framework in most of these countries made it very difficult to force firms into insolvency. ž Regulation of the financial sector was nominal, for several reasons. First, named as opposed to analytical lending, i.e. it was the individual’s connections with the bank that mattered. There was little in the way of assessment of the feasibility of proposed projects, nor was the risk profile of the borrower evaluated. Together with a lack of staff training and expertise, it meant no modern methods of risk assessment were used by the banks. In Korea political interference meant some financial institutions were subject to unfair audits and penalties.31 ž In Thailand, the same group of top officials moved back and forth between business, the banking sector and government. Offices were run to enhance an official’s future standing, 28 See for example, Bernanke and Gertler (1995). 29 In December 1996, 45 financial firms were licensed to handle BIBFs, or, effectively, engage in offshore activities. 15 were Thai banks and 30 were foreign banks or bank branches. The Thai banks used their BIBFs to borrow from abroad and lend locally. 30 Batunaggar (2002), p. 5. 31 Casserley and Gibb (1999), p. 325. [ 421 ] F INANCIAL C RISES and for regulators, this meant avoiding any controversial action which would upset senior bankers and/or politicians. Many of the banks had family connections: a family would succeed in a certain area of business and then expand into banking by buying up its shares. For example, in the early 1900s, the Tejapaibul family began a liquor and pawnshop business in Thailand, and by the 1950s the business was so large that ownership of a bank would ensure a ready source of capital. They established the Bangkok Metropolitan Bank in 1950, and bought controlling stakes in other banks in the 1970s and 1980s. After problems in the 1990s, the central bank appointed the managing director and other staff, while a family member remained as President. In 1996, US regulators ordered it to cease its US operations. In early 1998, with 40% of total loans designated non-performing, the family was forced to accept recapitalisation by the state and loss of management control, with the family losing close to $100 million.32 It is currently owned by the Financial Institutions Development Fund. Part of the Bank of Thailand, the FIDF was set up in the 1980s as a legal entity to provide financial support to both illiquid and insolvent banks. It normally takes over a bank by buying all its shares at a huge discount. ž The ratio of non-performing loans to total loans illustrates the growing problem of bad debt. Table 8.4 reports the BIS estimates. Even in 1996, they were on the high side if the benchmark for healthy banks is assumed to vary between 1% and 4%. In 1997, Thailand’s NPL/TL rose to 22.5%. In 1998, Korea’s and Malaysia’s percentage of NPLs are high by international standards, but dwarfed by the estimates for Thailand and Indonesia. These ratios are understatements because of lax provisioning practices. In most industrialised economies a loan is declared non-performing after 3 months. In these Asian economies, it is between 6 and 12 months. Bankers also practised evergreening: 33 a new loan is granted to ensure payments can be made or the old loan can be serviced. ž Weak financial institutions/sectors, supported by the state. By the time of the onset of the crisis (and in Indonesia’s case, long before), it was apparent that these countries’ financial sectors were part of the problem. In Thailand there was tight control over the issue of bank licences, but finance companies were allowed to expand unchecked. By 1997, the country had 15 domestic banks and 91 finance companies – their market share in lending grew from just over 10% in 1986 to a quarter of the market by 1997. In response to pressure from the World Trade Organisation, Thailand allowed limited foreign bank Table 8.4 BIS Estimates of Non-performing Loans as a Percentage of Total Loans Thailand Indonesia Korea Malaysia Philippines 1996 7.7 8.8 4.1 3.9 na 1997 22.5 7.1 na 3.2 na 1999 38.6 37.0 6.2 9 na Source: Goldstein (1998); BIS (2001). 32 Source: Casserley and Gibb (1999). 33 See Chapter 6 and Goldstein (1998), p. 12. [ 422 ] M ODERN B ANKING entry, with 21 foreign banks in 1997. However, their activities were severely constrained because each one was only allowed a few branches. ž In the Korean financial sector, activities were strictly segmented by function. Specialised banks provided credit to certain sectors, for example, the Housing and Commercial Bank, development banks (e.g. the Korea Long Term Credit Bank and the Export Import Bank), and nation-wide/regional banks. By 1997, there were eight national banks, serving the chaebol and the retail sector. Ten regional and local banks offered services to regional (or local) business and retail clients. Government influence was all pervasive. Not only did they own shares in some banks, but all executive appointments were political. There was directed lending – the government would pressure a bank to grant specific amounts of credit to firms. Political connections, not creditworthiness, was the determining factor in many bank loan decisions. ž There were also investment institutions, which held about 20% of total assets in 1997. They were made up of merchant banks, securities firms and trusts. Merchant banks had no access to retail markets, raising their funding costs. Using funds raised by commercial paper issues, overnight deposits and US dollar loans, they invested in relatively risky assets, including risky domestic loans and Indonesian and Thai corporate bonds. Once these economies collapsed, these banks faced mounting losses. Depositors panicked, especially those who held US dollar accounts. Loan rollovers were also terminated, which forced these banks to buy US dollars. The central bank tried to defend the won but by late 1997, had used up all of their foreign exchange reserves. An application for IMF standby credit was agreed by early December. It amounted to $21 billion over 3 years, with just under $6 billion for immediate disbursement. A few days later, the won was floated – in 6 weeks it lost 50% of its value against the US dollar. Indonesia’s banking sector aggravated the crisis in that country. It was unique among the countries in allowing foreign bank participation. Foreign banks could own up to 85% of joint ventures. Major banking reforms came into effect in 1988, and between 1988 and 1996, the number of licensed banks grew from 20 to 240. Branch networks grew and new services were offered by banks. This stretched the supervisory services, and banks began to engage in questionable practices. There was intense competition among banks. This contributed to the rapid expansion of credit, much of it named or ‘‘connected’’, 25–30% of it going to the property sector, especially developers. In 1991, prudential regulation was tightened by Bank Indonesia. Banks had to meet capital ratios, and were rated. Mergers were encouraged, but did not take place, and banks used their political connections to escape the tough new measures. From 1990, Indonesia’s private corporate (non-bank) sector borrowed heavily from overseas, with most of the debt denominated in dollars.34 By 1997, it had grown to $78 billion, exceeding the amount of sovereign external debt by close to $20 billion. Lack of confidence in the banking and corporate sectors caused the currency crisis to deepen, even after the rupiah was floated. 34 The government had stopped banks from taking on much external debt.