Private Inflows when Crises are Anticipated: A Case Study of Korea

Models of financial crises based on distortions in capital markets have strong implications for the behavior of investors leading up to crises. In this paper we evaluate the hypothesis that deregulation of financial markets in Korea provided the incentives and opportunities for a sequence of capital inflows and crisis. We show that deregulation was associated with a sharp declines in the franchise value of Korean banks. Banks responded by expanding their balance sheets and accumulating high risk, high return assets. The regulatory mechanism appears to have failed because of the failure to consolidate onshore and offshore activities of banks. Foreign banks that supplied deposits to Korean banks behaved as if they were insured in that they did not discriminate between weak and strong Korean banks. Finally, this expectation was validated at the time of crisis by government intervention that allowed foreign banks to liquidate their claims on Korean banks.