FINANCIAL

SYSTEM
INTRODUCTION
The financial system is an integral
component of modern economies. In most
Asian countries, commercial banks constitute
the primary component of the financial system.
However, informal financial institutions also
play an important role. Furthermore, in the last
decade or so, other financial institutions,
including insurance companies and pension
funds, as well as stock and bond markets, have
gained greater importance.
BANKING AND THE FINANCIAL SYSTEM

The banking and financial systems in the

developing economies in Asia evolved from
systems that were in place during the colonial
period. In South Asia, Taiwan, Malaysia, Hong
Kong and Singapore, the British system was
adopted, while in East Asia, the Japanese model
was adopted in Korea. In cases such as Thailand
and China, which were not colonized to any
significant extent, the financial system were
borrowed from the industrial countries.
 By the early 1970s, the region as a whole could be
characterized by the widespread presence of financial
repression. It is a situation, first described fully by Shaw
(1973) and McKinnon(1973), where government taxes and
subsidies distort the domestic capital market (compared
with a free and competitive system where private banks are
supervised by a central bank) by imposing interest rate
restrictions and high reserve requirements. At the same
time there are compulsory credit allocations to some
sectors and the lack of credit to others. As a result, loans
extended by banks were not thoroughly analyzed in terms
of risk or proper viability. Competition among banks was
also limited, particularly as foreign banks were not allowed
to enter the market or where their presence was highly
regulated.
FINANCIAL REPRESSION
“Repressed” financial systems were characterized by
low or negative real interest rates and a low and
sometimes falling ratio of monetary assets to GDP/GNP.
In a repressed system, the government usually plays a
dominant role in controlling the banking system by
imposing these kinds of controls, using banks to serve as
the instruments for allocating credit to key selected
sectors. Often, specialized banks were created to address
the needs of particular sectors. Rural banks were often
created for this purpose in the early stages of
development and were complemented by banks focusing
on key industries later in the development process.
FINANCIAL REPRESSION
At the same time, credit to other potential borrowers
was lacking. As a result, informal or “kerb” markets
developed outside the formal financial system to
mobilize and direct credit to those sectors not effectively
serviced by the formal financial and banking system.
The overall impact of these developments was a
fragmented banking system where the organized banking
system serviced only a small part of the total capital
market while informal finance emerged to serve the
needs of other borrowers.
 FINANCIAL LIBERALIZATION
Designed to remove all the restrictions that
characterize financial repression. These include the
lowering of reserve requirements, freeing up interest
rates, and allowing them to respond to market forces.
Managed credit allocations to key sectors should be
reduced or eliminated, and loan officers should be
required to evaluate potential borrowers on the merits of
the project and not to give loans indiscriminately based
on other economic criteria. Competitive forces should be
allowed to operate in the banking system to improve
economic efficiency through the relaxation of entry
requirements, both domestically and for international
banks.
 THE FINANCIAL CRISIS OF 1997
The Asian financial crisis of 1997 refers to a macroeconomic
shock experienced by several Asian economies – including Thailand,
Philippines, Malaysia, South Korea and Indonesia. Typically countries
experienced rapid devaluation and capital outflows as investor
confidence turned from over-exuberance to contagious pessimism as
the structural imbalances in the economy became more apparent.

The crisis of ’97-99 followed several years of rapid economic

growth, capital inflows and build up of debt, which led to an
unbalanced economy. In the years preceding the crisis, government
borrowing rose, and firms overstretched themselves in a ‘dash for
growth.’ When market sentiment changed foreign investors sought to
reduce their stake in these Asian economies causing destabilishing
capital outflows, which caused rapid devaluation and further loss of
confidence.
LONG-TERM CAUSES OF THE ASIAN FINANCIAL CRISIS

 Foreign debt-to-GDP ratios rose from 100% to 167% in the

four large ASEAN economies in 1993-96. Foreign companies
were attracting capital inflows from the developed world.
Investors in the West were seeking better rates of return, and the
“Asian economic miracle’ seemed to offer better rates of return
than lower growth economies in the West.
 Current account deficits. Countries like Thailand, Indonesia,
South Korea had large current account deficits; this meant they
were importing more goods and services than they were
exporting – it was a reflection of very high rates of economic
growth and consumption. The current account deficits were
financed by hot money flows (on capital account). Hot money
flows were accumulated because of higher interest rates in the
East.
LONG-TERM CAUSES OF THE ASIAN FINANCIAL CRISIS

 Fixed or semi-fixed exchange rates. This made

currencies vulnerable to speculation. Also, interest
rates were used to maintain the value of a currency.
Causing relatively high-interest rates in S.E. Asia
which caused hot money flows.
 Financial deregulation encouraged more loans and
helped to create asset bubbles. But, the regulatory
framework and structure of banking and firms meant
loans were often made without sufficient scrutiny of
profitability and rates of return.
LONG-TERM CAUSES OF THE ASIAN FINANCIAL CRISIS

 Moral Hazard. With a strong political desire for rapid

economic growth, governments often gave implicit
guarantees to private sector projects. This was magnified by
the close relationships between large firms, banks and the
government. This closeness encouraged private firms to place
less emphasis on the costs of projects and an assumption
expansion plans would be supported by the government
 Over-exuberance. The booming economy and booming
property markets encouraged expansive borrowing by firms.
It also encouraged international investors to move the capital
to these fast-growing economies. There was an element of
irrational exuberance – the idea that Asian economies were
undergoing an economic miracle where high returns were
guaranteed.
INFORMAL FINANCE

Informal finance is defined as contracts or

agreements conducted without reference or
recourse to the legal system to exchange cash in
the present for promises of cash in the future.
INFORMAL FINANCIAL SECTOR