Short Essay on Financial Crises

Financial crises are common to both authoritarian and democratic societies, and both suffer from crony capitalism of different forms. Irrespective of location or cause of a crisis what is being done to deal with it remains the same as told by Washington Consensus.

Financial systems have four functions: Resource allocation, price recovery, risk management and corporate governance. The Asian Crisis, the Global Crisis and the recent European Sovereign Debt Crises were excellent examples of how these four functions were not performing well in the concerned Markets.

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The resource allocation for a long time had been “policy or state-directed”, which meant the protected banking system providing resources to ‘priority sectors’ such as exports, industrialisation and infrastructure. Korea followed the family-controlled conglomerate or chaebol.

They enjoyed negative real interest rates. These chaebols were extending loans to loss-making group members to keep the entire group afloat. “Gains were privatised and losses were socialised’, as the state either bailed out the banks out or bailed the conglomerates out. It was a strong but effective nexus between state, banks and conglomerates.

The banks lost the capacity to evaluate more as they provided more credit to large borrowers and ultimately banks lost the independent credit culture. The finance for growth policy gave way to preference to the interest of enterprises rather than savers.

Since the banks were the major source of funding they also became too big to fail. Interestingly, before the Asian Crisis except that of Philippines, and South Korea there was no deposit insurance. Since the banks knew that the state was behind them, they undertook risks that would not have been possible without such backing. Of late, globalisation has led to contagion factor, affecting other economies as well.