Financial and corporate sector weaknesses played a major role in the Asian crisis in 1997. These weaknesses increased the exposure of financial institutions to a variety of external threats, including declines in asset values, market contagion, speculative attacks, exchange rate devaluations, and a reversal of capital flows.¹ In turn, problems in financial institutions and corporations worsened capital flight and disrupted credit allocation, thereby deepening the crisis.

As a consequence, policy responses to the crisis emphasized structural reforms in the financial and corporate sectors in addition to the implementation of appropriate macroeconomic policies. These structural measures were also necessary for macroeconomic policies to achieve the intended stabilization. Structural measures included dealing with nonviable financial institutions, establishing frameworks for recapitalizing and strengthening viable institutions, restructuring the corporate sector, and improving prudential regulations and supervision and market discipline.²

This paper reviews the policy responses to the financial sector crisis in five Asian countries, focusing in particular on Indonesia, Korea, and Thailand. It complements Lane and others (1999) and draws lessons for the future, largely based on experience in these countries. Given that the restructuring is still ongoing, the study is necessarily selective in the issues it addresses and provisional in some of the answers it provides. Because of a combination of domestic and foreign factors, the crisis was particularly severe in Indonesia, Korea, and Thailand--in this paper referred to as the crisis countries--all of which obtained the IMF's financial support. Other countries in the region also experienced some of the effects of the financial turmoil. Although they did not suffer a full-blown crisis, some of those countries also adopted measures to deal with that turmoil and to strengthen their financial systems. Among these other countries, Malaysia and the Philippines are useful to compare with the three crisis countries, and therefore are also discussed in this paper when appropriate.

The structure of the paper is as follows. Section II briefly reviews vulnerabilities in the financial sector in the run-up to the financial crisis. Section III discusses measures taken during the initial stages of the crisis to stabilize the system. Section IV discusses issues involved in setting monetary and credit policies and the issue of a "credit crunch." Section V reviews issues related to the respective governments' strategies to restructure the financial sector. Section VI reviews institutional reforms undertaken to diminish the likelihood of future financial crises. Section VII discusses issues relating to IMF advice and IMF-supported programs. Conclusions and lessons are presented in Section VIII. Appendices I–V present case studies from Indonesia, Korea, Malaysia, the Philippines, and Thailand. The studies discuss in detail the financial sector problems and the steps taken to address them. They set the stage for the comparisons and lessons that are drawn in the main body of the paper.

The following paragraphs offer a brief analysis of the crisis and summarize the paper's main findings.

Origins of the Crisis

Financial and corporate sector weaknesses combined with macroeconomic vulnerabilities to spark the crisis (see Box 1 for a chronology of events). Formal and informal currency pegs, which discouraged lenders and borrowers from hedging, also contributed to the outbreak. Capital inflows had helped fuel rapid credit expansion, which lowered the quality of credit and led to asset price inflation. The inflated asset prices encouraged further capital inflows and lending, often by weakly supervised nonbank financial institutions. Highly leveraged corporate sectors, especially in Korea and Thailand, and large unhedged short-term debt made the crisis countries vulnerable to changes in market sentiment in general and exchange and interest rate changes in particular. Malaysia and the Philippines were less vulnerable.

Box 1. A Chronology of the Asian Crisis, March 1977–July 1999 1997 March 3 Thailand First official announcement of problems in two unnamed finance companies, and a recapitalization program. March–June Thailand Sixty-six finance companies secretly receive substantial liquidity support from the Bank of Thailand. Significant capital outflows. April Malaysia Bank Negara Malaysia imposes limits on bank lending to the property sector and for the purchase of stocks. June 29 Thailand Operations of 16 finance companies suspended and a guarantee of depositors' and creditors' funds in remaining finance companies announced. July 2 Thailand Baht is floated and depreciates by 15–20 percent. Early July Indonesia Pressure on the rupiah develops. July 8–14 Malaysia Bank Negara Malaysia intervenes aggressively to defend the ringgit: efforts to support the ringgit are abandoned; ringgit is allowed to float. July 11 Indonesia Widening of the rupiah's band. July 11 Philippines Peso is allowed more flexibility. July 13 Korea Several Korean banks are placed on negative credit outlook by rating agencies. July 24 All "Currency meltdown"--severe pressure on rupiah, baht, ringgit, and peso. August 5 Thailand Measures adopted to strengthen financial sector. Operations of 42 finance companies suspended. August 14 Indonesia Authorities abolish band for rupiah, which plunges immediately. August 20 Thailand Three-year Stand-By Arrangement with IMF approved. August 25 Korea Government guarantees banks' external liabilities; withdrawal of credit lines continues. October 14 Thailand Financial sector restructuring strategy announced; Financial Sector Restructuring Agency and asset management company established; blanket guarantee strengthened; new powers to intervene in banks. October 24 Thailand Emergency decrees to facilitate financial sector restructuring. October 31 Indonesia Bank resolution package announced; 16 commercial banks closed; limited deposit insurance for depositors in other banks; other bank closures to follow. November 5 Indonesia Three-year Stand-By Arrangement with IMF approved. November 19 Korea Exchange rate band widened. Won falls sharply. Mid-November Thailand Change in government. Significant strengthening of economic reform program. November Korea Korea Asset Management Corporation's (KAMCO) nonperforming asset fund is established. December 4 Korea IMF approves three-year Stand-By Arrangement but rollover of short-term debt continues to decline. December 8 Thailand Fifty-six suspended finance companies are permanently closed. Mid-December Indonesia Deposit runs on banks, accounting for half of banking system assets. December 18 Korea New government is elected; commitment to program is strengthened. December 24 Korea Foreign private bank creditors agree to maintain exposure temporarily. December 29 Korea Legislation passed strengthening independence for Bank of Korea and creating Financial Supervision Commission. December 31 Thailand Bank of Thailand intervention in a commercial bank; shareholders' stakes eliminated. December Korea Fourteen merchant banks are suspended and two large commercial banks taken over by the government. 1998 January 1 Malaysia Measures announced to strengthen prudential regulations. January 15 Indonesia Second IMF-supported program announced. Indonesian Bank Restructuring Agency (IBRA) established and blanket guarantee announced. January 20 Malaysia Bank Negara Malaysia announces blanket guarantee for all depositors. January 23 Thailand Bank of Thailand intervenes in two commercial banks; shareholders eliminated. January 26 Indonesia Indonesian Bank Restructuring Agency (IBRA) established and blanket guarantee announced. January 28 Korea Agreement with external private creditors on rescheduling of short-term debt. January Korea Ten of 14 suspended merchant banks closed; 20 remaining merchant banks are required to submit rehabilitation plans. February 15 Korea New president and government take office. February Indonesia President Suharto reelected. Doubts about future of financial sector program grow stronger amid political uncertainty. Rupiah depreciates further and currency board is debated. March 11 Thailand One commercial bank purchased by foreign strategic investor. March 25 Malaysia Program to consolidate finance companies and to recapitalize commercial banks is announced. March 31 Thailand New loan classification and loss provisioning rules introduced. March Philippines Three-year Stand-By Arrangement agreed with IMF. April 4 Indonesia IBRA closes seven banks and takes over seven others. End of April Korea Four of 20 merchant banks' rehabilitation plans rejected; banks are closed. May 18 Thailand Bank of Thailand intervention in seven finance companies; shareholders eliminated. Mid-May Indonesia Widespread riots. Rupiah depreciates, deposit runs intensify, and Bank Indonesia must provide liquidity. May 21 Indonesia President Suharto steps down. May 29 Indonesia A major private bank taken over by IBRA. June 5 Indonesia International lenders and Indonesian companies agree on corporate debt rescheduling. June 29 Korea For the first time, government closes commercial banks (five small ones). Two merchant banks are closed and two merged with commercial banks. June 30 Korea New loan classification and loss provisioning rules introduced. June Malaysia Danaharta, an asset management company, is established. Mid-July Indonesia Authorities allow market-determined interest rates on Bank Indonesia bills. August 14 Thailand Comprehensive financial sector restructuring plan announced, including facilities for public support of bank recapitalization. Intervention in two banks and five finance companies; shareholders' stakes eliminated. August 30 Thailand Majority ownership in one medium-sized commercial bank by foreign strategic investor. August Malaysia Danamodal (bank restructuring and recapitalization agency) is established. September 23 Indonesia Indonesia's bilateral external debt to official creditors refinanced. September 30 Indonesia Bank Mandiri created through merger of four largest state-owned banks. Plans announced for joint government-private sector recapitalization of private banks. September Malaysia Capital controls introduced, exchange rate pegged, disclosure requirements relaxed, and measures to stimulate bank lending adopted. October 6 Indonesia Amended Banking Law passed, which included strengthening of IBRA. 1999 February 15 Malaysia Capital controls replaced with declining exit levies. March 13 Indonesia Government closes 38 banks and IBRA takes over seven others. Eligibility of nine banks for joint recapitalization with government announced. April 21 Indonesia Closure of one joint-venture bank. April Indonesia Government announces a plan to recapitalize the three other state banks (all insolvent). June 30 Indonesia Eight private banks recapitalized jointly through public and private funds. July 5 Indonesia Government announces plan for resolution of IBRA banks. July 31 Indonesia Legal merger of component banks of Bank Mandiri. July Thailand One small private bank intervened and put up for sale; one major bank announces establishment of an asset management company.

 
Weaknesses in bank and corporate governance and lack of market discipline allowed excessive risk taking, as prudential regulations were weak or poorly enforced. Close relationships between governments, financial institutions, and borrowers worsened the problems, particularly in Indonesia and Korea. More generally, weak accounting standards, especially for loan valuation, and disclosure practices helped hide the growing weaknesses from policymakers, supervisors, market participants, and international financial institutions--while those indicators of trouble that were available seem to have been largely ignored. In addition, inadequacies in assessing country risk on the part of the lenders contributed to the crisis.

The crisis was triggered by the floating of the Thai baht in July 1997. Changing expectations led to the depreciation of most other currencies in the region, bank runs and rapid withdrawals of foreign private capital, and dramatic economic downturns. When the crisis broke, Indonesia, Korea, and Thailand requested IMF assistance, both to obtain financial support and to restore confidence.

Coping with the Crisis

The initial priorities in dealing with the crisis were to stabilize the financial system and to restore confidence in economic management. Forceful measures were needed to stop bank runs, protect the payment system, limit central bank liquidity support, minimize disruptions to credit flows, maintain monetary control, and stem capital outflows. In the crisis countries, emergency measures, such as the introduction of blanket guarantees and bank closings, were accompanied by comprehensive bank restructuring programs and supported by macroeconomic stabilization policies.

Closings of the most insolvent or nonviable financial institutions were used initially to stem rapidly accumulating losses and central bank liquidity support. However, the experience of Indonesia showed that in a systemic crisis bank closings can lead to runs on other banks, if not accompanied by proper information, strong overall economic management, and a blanket guarantee.

Blanket guarantees for depositors and creditors were used in the crisis countries and in Malaysia to restore confidence and to protect banks' funding. Despite the enormous contingent costs and moral hazard problems involved, governments considered guarantees preferable to collapses of their banking systems. The guarantees were effective in stabilizing banks' domestic funding--although in some cases it took some time to gain credibility--but were less effective in stabilizing banks' foreign funding (Korea responded with voluntary debt rescheduling and Malaysia adopted capital controls). In Indonesia, a blanket guarantee was introduced only after an attempt to use a limited guarantee had backfired.

Liquidity support by central banks was reduced after the closure of the weakest financial institutions and the introduction of the blanket guarantees. Monetary control was maintained through sterilization measures--offsetting sales or purchases of securities by the central bank--in all countries, except initially in Indonesia. Monetary policy in all countries focused on the exchange rate, short-term interest rates, and the level of international reserves, rather than on traditional monetary aggregates, which had become unstable.

Credit growth slowed as demand contracted and supply plummeted, with bankers becoming more selective in their lending behavior. A heightened perception of credit risk, funding constraints, and a weakening capital position further constrained credit. In such circumstances, direct or indirect measures to stimulate new credit are unlikely to be sufficient to restore normal lending: that will take a return of profitability and solvency in the banking and corporate sectors.

Bank Restructuring

Comprehensive bank restructuring strategies in the crisis countries and in Malaysia sought to restore financial sector soundness as soon as possible, and at least cost to the government, while providing an appropriate incentive structure for the restructuring. (See Box 2 for a list of critical steps in resolving a systemic banking crisis.) The strategies included setting up appropriate institutional frameworks, removing nonviable institutions from the system, strengthening viable institutions, dealing with value-impaired assets, improving prudential regulations and banking supervision, and promoting transparency in financial market operations.

Box 2. Ten Critical Points in Managing and Resolving a Systemic Bank Crisis The sequence presented below describes the different phases one encounters when dealing with a major systemic financial sector crisis. This sequence is based on the assumption that a country's financial sector has public good aspects and, hence, that solving such a crisis warrants substantial public sector involvement. The different steps, from origin through recognition and resolution, and preventive measures are discussed in this paper. Although specific actions may differ among countries based on the depth of the crisis, the composition of the financial sector before the crisis, local circumstances and preferences, and the contents and sequence of the basic building blocks and strategies are similar across countries. Steps 1–4. The acute crisis phase: measures to stop the panic and stabilize the system. 1. The crisis usually begins because, in one form or another, there is excessive leverage in the economy. In the early stages there may also be a degree of denial on the part of the banks and the government. 2. Bank runs by creditors and depositors start and intensify. The central bank responds by providing liquidity support to the affected banks. 3. When central bank liquidity is unable to stop the runs, the government announces a blanket guarantee for depositors and creditors. Such a measure is intended to reduce uncertainty and to allow time for the government to begin an orderly restructuring process. 4. All along, the central bank tries to sterilize its liquidity support to avoid a loss of monetary control. Steps 5–8. The stabilization phase: measures to restructure the system. 5. The authorities design the tools needed for a comprehensive restructuring, including the required legal, financial, and institutional framework. 6. Losses in individual institutions are recognized. The authorities shift the focus from liquidity support to solvency support. 7. The authorities design a financial sector restructuring strategy, based on a vision for the postcrisis structure of the sector. 8. Viable banks are recapitalized, bad assets are dealt with, and prudential supervision and regulations are tightened. Steps 9–10. The recovery phase: measures to normalize the system. 9. Nationalized banks are reprivatized, corporate debt is restructured, and bad assets are sold. 10. The blanket guarantee is revoked, which, if properly handled, is a nonevent because the banking system has been recapitalized and is healthy again.

 
Key principles for bank restructuring strategies in the crisis countries have been the application of uniform criteria to identify viable and nonviable institutions, removal of existing owners from insolvent institutions, and encouragement of new private capital contributions, including from the foreign sector. Public support has sought to complement private sector contributions; liberalization of foreign ownership rules encouraged foreign participation.

Strategies must be adapted to fit countries' circumstances. Systemic bank restructuring is a complex medium-term process that requires careful tailoring. Accordingly, while the broad components of the restructuring strategies were similar, implementation details differed across countries according to the precise nature of the problems, legal and institutional constraints, and each government's preferences.

Valuation of bank assets is crucial for determining bank viability but is very difficult in a crisis environment, as markets are thin and values shift with changing circumstances. Tighter rules for loan classification, loss provisioning, and interest suspension were introduced to guide the valuation process. Different valuation procedures, including by banks themselves, external or international auditors, or supervisors, were used to provide the authorities with the best available data. Regardless of data quality, decisions had to be made as much as possible on the basis of uniform and fully transparent criteria.

Strengthening viable institutions involved asset valuation, loss recognition, and recapitalization. When banks breached minimum capital adequacy requirements, recapitalization and rehabilitation became mandatory, often under binding memoranda of understanding with the supervisory authorities. In the crisis countries loan-loss provisioning rules or capital adequacy requirements were implemented gradually--but transparently--to give banks time to restructure and mobilize new capital and to avoid aggravating credit supply problems. Public sector equity support was also provided to viable banks, subject to stringent conditions.

The authorities intervened in institutions that failed to raise capital and faced insolvency through such techniques as government recapitalization/nationalization, mergers, sales, use of bridge banks and asset management companies, purchase and assumption operations, and liquidation. Shareholders typically absorbed losses until their capital was fully written off. In all the countries, the governments aim at reprivatizing the nationalized financial institutions as soon as possible; in this, Korea and Thailand have already made significant progress.

Management of impaired assets, including nonperforming loans, is one of the most complex parts of financial restructuring. Impaired assets can either be dealt with by the financial institutions themselves, by bank-specific or centralized asset management companies, or under liquidation procedures. Speed of disposal has to be considered. Assets have to be managed and disposed so as to preserve values and maximize recovery, while at the same time create the right incentives so as not to undermine borrower discipline throughout the system. The choice of asset management structure should depend on the nature of the asset and available management capabilities. Nonperforming loans with reasonable chances of recovery are generally better managed in banks.

A centralized asset management company typically involves government ownership, compared with decentralized asset management companies, which tend to be privately owned and bank specific. All asset management companies seek to provide better management structures for problem assets and to relieve banks' balance sheets. Asset sales by banks to asset management companies should not amount to back-door capitalization of banks (and bailout of shareholders) by receiving inflated prices, a matter complicated by the above-mentioned difficulty of valuing impaired assets. Because banks have to take a loss when they sell loans to an asset management company (public or private), capital scarcity may limit their capacity to do so. Indonesia, Korea, and Malaysia have opted for a centralized public asset management company, while Thailand established a public asset management company that only deals with residual assets of closed finance companies, and has encouraged the establishment of bank-specific asset management companies.

Cost of Restructuring

The gross costs of the bank restructurings are massive. Estimates put the public sector costs in the three crisis countries and Malaysia between 15 and 45 percent of GDP. The estimates may increase if further losses are uncovered, but they may also drop depending upon the proceeds from asset sales and privatization. The revenue generated by these sales will not be known for several years. There are, in addition, efficiency gains and wealth effects resulting from the restructuring. Initially, the costs were mainly carried by the central banks in the form of liquidity support to ailing banks. Only recently have governments started to refinance this liquidity by issuing domestic government bonds.

The fiscal implications of the crisis were estimated by imputing the carrying costs of the debt created to finance the restructuring. Full and transparent recording in the fiscal accounts of all costs incurred by the government, including capital costs, is important for fiscal analysis. The very large costs of the crisis may affect medium-term fiscal sustainability.

Other Issues

Government "ownership" of the reform programs and strong leadership are necessary to take charge of and implement the complex microeconomic processes that a systemic bank restructuring entail. In the crisis countries, political changes had a positive impact on the pace and resolve of the restructuring process. Only domestic constituencies can deal with the legal and institutional factors that are prerequisites for success, but that also can bring the process to a halt. Restructuring has to take into account human resource constraints and legal issues, given that it typically has major effects on private wealth.

Corporate sector problems represent the flip side of banks' nonperforming loans. Bank restructuring should be accompanied by corporate debt restructuring, which has been lagging and is now delaying the bank restructuring process. At the same time, financial sector restructuring should be given priority as the governance structure of banks and their prudential framework provide powerful levers to bring about the corporate restructuring reform.

Prudential regulation and supervision have been strengthened to foster better bank governance and stronger market discipline. In all the countries, domestic standards are being brought closer to international best practices, including areas such as foreign exchange exposure, liquidity management, connected lending, loan concentration, loan provisioning, data disclosure, and qualifications for owners and managers. Steps have been taken to strengthen the autonomy and authority of supervisors, upgrade their powers and skills, and improve on-site examination, off-site monitoring, and analysis techniques.

Role of the IMF

The IMF-supported programs in Indonesia, Korea, and Thailand centered on financial sector reform, not only because financial sector problems were a root cause of the crisis but also because reestablishing banking system soundness was crucial for restoring macroeconomic stability. Although the IMF was able to draw on both its past experience and its analytical work, the specific circumstances of each country added dimensions that required careful tailoring of the reform and resolution strategies for each country, often taking into account the authorities' sometimes strong preferences. The design of the reform strategies required access to bank-by-bank supervisory data, which was provided in the crisis countries.

Letters of Intent and Memoranda of Economic and Financial Policies laid out the strategies and sequencing. The IMF-supported programs required a delicate balance between the needs for short-term IMF conditionality and the medium-term nature of financial sector restructuring, which often involves steps and negotiations beyond the authorities' direct control.

Cooperation with the World Bank and other international organizations was close from, or soon after, the beginning, with somewhat different divisions of labor in each country. The IMF took the lead in assisting the authorities in designing the overall restructuring program of the three crisis countries, while the World Bank took charge of specific areas of program formulation and implementation. Most tasks have been done jointly to provide the authorities with the best possible advice and to use the resources of the two institutions as efficiently as possible.

Could the Crisis Have Been Prevented?

More transparency in macro- and microeconomic data and policies would have exposed vulnerabilities earlier and helped lessen the crisis. Better regulatory and supervisory frameworks would have helped, but supervisors would most likely not have been able to take necessary actions in the middle of the economic boom. No one foresaw the sudden massive erosion of loan values, once market sentiment changed and exchange rates collapsed.

Broad-based reforms are under way to strengthen the institutional, administrative, and legal frameworks in the crisis countries, based on evolving international best practices, codes, core principles, and standards. The crisis has shown the need to tailor prudential policies so that resilience is built up in times of economic booms to deal more easily with inevitable economic downturns.

International efforts have been undertaken to reduce the likelihood and intensity of future crises. Initiatives include work on the international financial architecture, the Financial Stability Forum, and financial sector stability assessments. The Basel Committee on Banking Supervision has formulated improvements to regulation and supervision of international lenders to address weaknesses that contributed to the Asian crisis.