Failure to recognize bad debts 9. Having landed themselves with bad debts, banks failed to face up to the problem. In particular, systems for loan classification and provisioning have been inadequate. As a result, capital ratios have been overstated, and insolvent or near-insolvent banks have been allowed to continue in business and to build up further losses. Banks have been allowed to accrue income on non-performing loans, thus overstating revenue and capital. Lack of transparency  1  Paul Krugman, “What happened to Asia?”, January 1998  BIS Review 28/1998  ˝  -3-  10. All this has been made worse by a lack of transparency in regional banking systems. Failure to disclose the true scale of bad debt problems has weakened market discipline on bank management and reduced the need for them to face up to the problems. Public confidence in banking systems has been undermined because, with no credible information, depositors and investors assume the worse in even relatively sound banks and rush to take their money out. Moral hazard 11. The final ingredient has been the perception that many banks in the region are effectively government-guaranteed. This has created a problem of moral hazard whereby bank management can afford to indulge in reckless lending behaviour because they believe that government will bail them out if they fail. Similarly, depositors have less incentive to check the creditworthiness of the banks with which they place funds. Weakness in supervision 12. How did Asian banks get into this state of fragility?
Much of this borrowing was short-term, giving rise to a maturity as well as a foreign currency mismatch, either on the part of the banks or the companies to which they on lent. When the initial pressure on currencies emerged, domestic borrowers that had previously never had to think about hedging their foreign currency liabilities rushed to do so, turning a slide in the currency into an avalanche. Those who were too late were left with liabilities to the banks that were vastly inflated in terms of their domestic currency - and the banks were left with the resultant bad debts and a crippled ability to finance the routine needs of their customers. Captive banks 7. Why were banks not more discriminating in their credit choices and decisions? Part of the explanation is that in a number of economies banks were ordered or persuaded by the government to lend heavily to particular industries and companies. In other words, they were “captive banks”. This allowed the companies concerned to become over-leveraged (and thus vulnerable to economic downturn) and directed resources into unprofitable investments. The banks concerned had little incentive to develop proper lending skills. Concentration risks and connected lending 8. Moreover, banks in some economies were over-exposed to single borrowers, often those connected with the lending institution. Such lending is usually of poor quality, not having been made at arm’s length, and means that the shareholders have no real capital at stake in the bank (because it has effectively been lent back to them).