Margin—The Journal of Applied Economic Research 7 : 1 (2013): 29–60 SAGE Publications Los Angeles/London/New Delhi/Singapore/Washington DC DOI: 10.1177/0973801012466102 The Effect of Reliance on International Funding on Banking Fragility: Evidence from East Asia Fazelina Sahul Hamid The East Asian crisis highlights the importance of liquidity for smooth functioning of the banking system. It also shows the vulnerabilities that arise as a result of high dependence on international liquidity. This article empirically analyses the inlux of liquidity before the crisis and illiquidity during the crisis in inding out whether banks in East Asia held ‘too little’ or ‘too much’ liquidity before and during a crisis and how their vulnerabilities to failure changed as a result of that. Instrumental Variable estimation is used to dis- sociate the effect of international illiquidity on banks’ liquidity risk during a crisis year. The study inds that the effect of liquidity on the probability of bank failure varies before and during a crisis. The indings also highlight the vulnerabilities of banks to failure as a result of international illiquidity and high reliance on external funding. These indings bring forward the case for stronger regulation of banks’ liquidity, which can be brought forward by better liquidity management. Keywords: Banking fragility, Liquidity, East Asia JEL Codes: G21, N20 1. IntroductIon Banks have traditionally played a much larger role in East Asian countries like Indonesia, Korea, Malaysia, Philippines and Thailand. This can be seen by the rapid increase in the ratio of domestic credit from banks to GDP from 7.23 per cent in 1995 to 14.83 per cent in 1997. 1 A scarcity of capital caused these countries to rely more on external funding in inancing their rapid economic development and a large percentage of capital inlows were channelled into these countries through the banks. This inluenced the type and amount of liquidity held by banks in East Asia. When a sudden and drastic outlow of Fazelina Sahul Hamid is a Lecturer at the economic section in the School of Distance Education, Universiti Sains Malaysia, Malaysia, email: fazelina@usm.my 1 For more details, check International Monetary Fund’s International Financial Statistics database. at Universiti Sains Malaysia on December 1, 2015 mar.sagepub.com Downloaded from