The Korean Financial Crisis: A Banking Perspective

Is the Korean miracle over? Can we say the same about the East Asian miracle? Did those miracles ever exist? Krugman (1994) argues that East Asia’s economies did not experience significant productivity growth despite their rapid growth. The implicit prediction was that sooner or later the bubble would burst. The current crisis facing the East Asian economies seems to bear out the dire prediction. Even economists who do not share Krugman’s perception of the East Asian miracle agree that structural change is needed if the region’s economies are to regain their dynamism. The main purpose of this paper is to explore Korea’s economic and financial difficulties in some detail so as to gain a deeper understanding of the dynamics of the East Asian crisis.

Bernanke and Blinder (1988) show the importance of credit channels in a modern monetary economy. Vegh and Edwards (1997) expand upon this line of research to explain shock propagation. By applying the same methodology to financial crises, we can better explain the Korean crisis in terms of a credit crunch. This is the basic approach of this paper, and we try to open the “black box” in the manner of Bernanke and Gertler (1995).

The research strategy of this paper is as follows. By developing a model of financial institutions, we show their vulnerability to shocks. We also show that different prudential measures differ in their effectiveness in reducing such vulnerability. Based on a simple model, we discuss the shock propagation mechanism in a macroeconomic framework. Section 2 provides a simple description of the Korean economy both before and after the foreign exchange crisis.

Section 3 develops a simple model to explain the behavior of financial institutions in Korea. Section 4 presents the results of a simulation analysis performed to test the propositions stated in Section 3. Section 5 addresses the implications of these propositions for Korea’s financial crisis. Section 6 discusses the economy after the shock. The paper concludes with section 7.

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