A Theoretical Model of Financial Crisis Jorge A. Chan-Lau and Zhaohui Chen* Abstract The paper develops a new model of private debt financing with an inefficient financial system at its core, where inefficiency is characterized by costly loan monitoring. The model suggests a mechanism that gener- ates the following series of events: a period of low capital inflow despite high rates of economic growth (capital inflow inertia), as observed in the take-off era in the Asian tiger economies; followed by a sudden acceleration of capital inflow (as seen in the 1990s); and then by a crisis, which is defined as a large reduc- tion in the amount of loans intermediated by the financial system (i.e., a large capital outflow or credit crunch). Under certain conditions, financial crisis can occur even when economic fundamentals and market sentiment change only slightly. Unlike most credit rationing models, the results presented here do not hinge on the assumption of asymmetric information. The model also provides guidance about the appropriate policy responses to an imminent crisis. 1. Introduction The scope and severity of the largely unexpected financial crisis in Asia in 1997 have prompted numerous postmortem commentaries and heated policy debates. In comparison, new work in theoretical modeling of the relevant aspects of the crisis has been lagging behind media discussions. This paper attempts to provide a simple theoretical model to help analyze some key aspects of the crisis. These aspects include: (1) the capital inflow inertia, as evidenced by the long lag of capital inflows after a decade of rapid economic growth in the Asian economies; (2) the surge in capital inflows immediately prior to the crisis; (3) the speed and magnitude of the reversal of capital flows during the crisis and the subsequent credit crunch; (4) the large share of bank lending in capital inflows; (5) the inefficiency of the banking system, notwithstanding the impressive banking infrastructure, because of government directed lending, inadequate supervision, the lack of open competition, and the lack of transparency in the corporate sector, among other things. Review of International Economics, 10(1), 53–63, 2002 © Blackwell Publishers 2002, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA *Chan-Lau: International Monetary Fund, 700 19th St NW, Washington, DC 20431, USA; and Institute of Contemporary Finance, Shanghai Jiao Tong University, China.Tel: (202) 623-4271; E-mail: jchanlau@imf.org. Chen: Institute of Contemporary Finance, Shanghai Jiao Tong University, and Center for the New Economy, Zhongshan University Business School, C/O PO Box 710725, Herndon,VA 20171, USA.Tel: (703) 868-8822; E-mail: harveychen@sjtu.edu. This paper was completed while the second author was an economist at the International Monetary Fund.We thank our discussant,Theo Eicher, and Eduardo Borensztein, Peter Clark, Hamid Faruqee, Peter Isard, Kenneth Kletzer, Jae-woo Lee, Marcus Miller, Caroline van Rijckeghem, Shang- jin Wei, and seminar participants at the Seattle conference on the Asian crisis, Banco de la Republica (Colombia), the CEPR/ESRC/GEI World Capital Markets and Financial Crises Conference at the Univer- sity of Warwick, Harvard Institute for International Development, Hong Kong University of Science and Technology, the IMF, the 1999 Meetings of the International Economic Association, the 1998 Latin Ameri- can Meeting of the Econometric Society, the NCER at Tsinghua University, and the State Development Research Center of the Chinese State Council for comments. The views and opinions expressed here are those of the authors and do not necessarily reflect those of the International Monetary Fund, the Institute of Contemporary Finance, or the Center for the New Economy.