Interest rate and exchange rate exposures of Korean financial institutions: implications for the propagation of financial crisis

Abstract

This paper empirically investigates the interest rate and exchange rate exposures of financial institutions in pre-crisis Korea. Using the sensitivity of stock returns as a measure of exposure, we found that Korean commercial banks and merchant banking corporations have indeed been significantly exposed to both risk factors in the pre-crisis period. The evidence strongly suggests that, coupled with sharp depreciation of Korean won and subsequent high interest rate policies, the negative exposure of financial institutions may have played a critical role in the propagation of initial currency crisis into a full-fledged financial crisis. The Korean case highlights again the importance of upgrading financial supervision and risk management infrastructure as a precondition of successful financial liberalization.