220 PA R T I I I Financial Institutions it was still restricting foreign capital inflows and to claim that it was opening up to foreign capital in a prudent manner In the aftermath of these changes, Korean banks opened 28 branches in foreign countries that gave them access to foreign funds Although Korean financial institutions now had access to foreign capital, the chaebols still had a problem They were not allowed to own commercial banks and so the chaebols might not get all of the bank loans that they needed What was the answer? The chaebols needed to get their hands on financial institutions that they could own, that were allowed to borrow abroad, and that were subject to very little regulation The financial institution could then engage in connected lending by borrowing foreign funds and then lending them to the chaebols who owned the institution An existing type of financial institution specific to South Korea perfectly met the chaebols requirements: the merchant bank Merchant banking corporations were wholesale financial institutions that engaged in underwriting securities, leasing, and shortterm lending to the corporate sector They obtained funds for these loans by issuing bonds and commercial paper and by borrowing from inter-bank and foreign markets At the time of the Korean crisis, merchant banks were allowed to borrow abroad and were virtually unregulated The chaebols saw their opportunity Government officials, often lured with bribery and kickbacks, allowed many finance companies (some already owned by the chaebols) that were not allowed to borrow abroad to be converted into merchant banks, which could In 1990 there were only six merchant banks and all of them were foreign affiliated By 1997, after the chaebols had exercised their political influence, there were thirty merchant banks, sixteen of which were owned by chaebols, two of which were foreign owned but in which chaebols were major shareholders, and twelve of which were independent of the chaebols, but Korean owned The chaebols were now able to exploit connected lending with a vengeance: the merchant banks channelled massive amounts of funds to their chaebol owners, where they flowed into unproductive investments in steel, automobile production, and chemicals When the loans went sour, the stage was set for a disastrous financial crisis Also, stock market declines and increases in uncertainty initiated and contributed to full-blown financial crises in Mexico, Thailand, South Korea, and Argentina (The stock market declines in Malaysia, Indonesia, and the Philippines, on the other hand, occurred simultaneously with the onset of these crises.) The Mexican economy was hit by political shocks in 1994 (specifically, the assassination of the ruling party s presidential candidate, Luis Colosio, and an uprising in the southern state of Chiapas) that created uncertainty, while the ongoing recession increased uncertainty in Argentina Right before their crises, Thailand and South Korea experienced major failures of financial and nonfinancial firms that increased general uncertainty in financial markets As we have seen, an increase in uncertainty and a decrease in net worth as a result of a stock market decline increase asymmetric information problems It becomes harder to screen out good from bad borrowers The decline in net worth decreases the value of firms collateral and increases their incentives to make risky investments because there is less equity to lose if the investments are unsuccessful The increase in uncertainty and stock market declines that occurred before the