Korean Financial Crisis of 1997–98: Causes, Reforms, and Lessons

Introduction

The objective of this study is to examine what is unique or different about the Korean financial crisis as compared to other Asian financial crises and to determine the primary causes of the financial crisis in Korea. This work further examines the government's response to the crisis and what can be learned from the Korean experience and applied to the Euro Area.

The major components of the Korean financial system in the 1960s and 1970s were reportedly nationalized, with "lending targeted toward favored sectors and firms including the exports and heavy industries" (Jeon and Miller, 2005). Regional banks emerged in 1967 and could only operate within their own provinces, which encouraged regionally-based development. In the early 1980s, plans were made for deregulation of the financial system and to transfer Korean commercial banks to the private sector (Jeon and Miller, 2005). Deregulation in the 1980s expanded the powers of commercial banks, allowing them to offer credit cards, issue negotiable certificates of deposit, and provide automated teller machines. At the same time, foreign exchange controls and restrictions on foreign ownership of Korean assets were eased (Jeon and Miller, 2005). However, the Korean government still retained a strong hold: it controlled interest rates on some loans and deposits, and its informal credit policy continued to favor certain sectors. During the mid-1980s, the Korean commercial banking system underwent a crisis due to a high level of bad loans, yet no banks failed during that period since charge-off rates for bad loans "were allocated slowly to maintain individual bank viability" (Jeon and Miller, 2005).

The inflation rate nearly doubled in 1998 compared to 1997 in Korea, and simultaneously the unemployment rate more than doubled. This followed a rise in Korean interest rates from 12.5% in 1996 to 21.3% in 1997, with the exchange rate moving from 845 won per dollar in 1996 to 1,695 in 1997. Korea's Gross Domestic Product (GDP) dipped sharply in 1998.

According to Jeon (2012), the value of the Korean currency fell by more than one-half when there was an exodus of foreign capital in 1997, and GDP contracted approximately six percent in 1998. This was preceded by a sharp contraction in corporate investment and consumer spending and a surge in corporate bankruptcies, which drove the unemployment rate higher (Jeon, 2012).

The Korean Financial Crisis and Banking System

According to Jeon and Miller (2005), the world economy has witnessed numerous financial crises over the preceding decade. Following a lengthy process of deregulation and privatization, "the Asian financial crisis hit the Korean economy" (Jeon and Miller, 2005). The Korean banking system is reported to have "evolved from an industry with large state ownership and significant government direction of credit flows to a more deregulated and privatized industry" (Jeon and Miller, 2005). The industry's viability, structure, and stability were severely tested by the Asian financial crisis following this "significant transition" (Jeon and Miller, 2005). This resulted in the government recapitalizing banks previously believed to be "too-big-to-fail" (Jeon and Miller, 2005). These banks — Korea First Bank and Seoul Bank — received government financial support while the government oversaw the closing and takeover of smaller insolvent banks (Jeon and Miller, 2005). Under these circumstances, "the performance of the Korean banking system in the wake of the Asian financial crisis appears remarkable, probably helped by that government intervention" (Jeon and Miller, 2005).

While the performance of Korean banks "deteriorated dramatically in 1998, most banks recovered somewhat in 1999" (Jeon and Miller, 2005). Studies show that foreign banks enjoyed a global advantage rather than a home-field disadvantage. Explanations include: (1) foreign banks were not subject to the credit allocation directives from the Korean government to selected, favored industries; (2) foreign banks, relying on their parent institutions, achieved better efficiency and better asset and liability management; and (3) foreign banks relied more heavily on fee-for-service income rather than loan revenue (Jeon and Miller, 2005).