The Role of Derivatives in the East Asian Financial Crisis
Derivatives played a key role in the East Asian financial crisis of 1997. Their use developed alongside the growth of capital flows to those developing economies in the 1990s. Derivatives facilitated the growth in private capital flows by unbundling the risks associated with investment vehicles such as bank loans, stocks, bonds and direct physical investment, and then reallocating the risks more efficiently. They also facilitated efforts by some entities in raising their risk-to-capital ratios, dodging regulatory safeguards, manipulating accounting rules and evading taxation. Foreign exchange forwards and swaps were used to hedge as well as speculate on the fixed exchange rate regimes, while total return swaps were used to capture the “carry business” of profiting from the interest rate differential between pegged currencies. Structured notes were used to circumvent accounting rules and prudential regulations in order to offer investors higher, though much riskier, returns. Viewed at the macroeconomic level, derivatives first made the economy more susceptible to financial crisis and then quickened and deepened the downturn once the crisis began. This analysis of the East Asian crisis offers several policy lessons. Financial regulations should contain reporting requirements, capital requirements should be updated to reflect the market risk of derivatives, regulations governing the holding of assets and liabilities should be updated to reflect that they often have attached derivatives, and regulatory incentives should be structured so that derivatives are used to facilitate capital flows and not be used to increase risk-to-capital ratios by out-maneuvering government regulations.
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