ABSTRACT
The recent Asian financial crisis has raised the concern for financial fragility, which precipitated the onset and spread of the crisis. The financial fragility of the economies affected by the crisis can be attributed to four major sources: currency mismatch and maturity mismatch in funding domestic investment, asset price inflation, and poor credit allocation (Lane 1999). In a typical case, an economy experiences rapid credit expansion associated with rapid growth, financial liberalization, and foreign capital inflow. Poor credit allocation eventually creates financial distress, triggering an outflow of shortterm capital. Due to the maturity mismatch in lending by domestic financial institutions—borrowing short and lending long—the reversal in short-term capital flow leads to insolvency among these institutions, triggering further capital outflow. The currency mismatch—borrowing in foreign currency to finance projects that generate incomes in domestic currency—makes the financial institutions vulnerable to domestic currency devaluation, which causes a loss of confidence in the domestic currency and further capital outflow. The inflated asset prices also contribute to the vulnerability of the financial system. A deflation of asset prices resulting from a domestic credit crunch severely impairs the credit quality of domestic borrowers and the asset quality of the financial institutions. These four factors combined cause a vicious cycle of credit deterioration and capital outflow—a feature of the latest Asian financial crisis. Central to the financial fragility is also the process of information flows essential for credit decision making. A financial system is fragile when information flows and hence the functioning of the system are vulnerable to the interference of shocks to the financial system (Mishkin 1999).
