# 1. **Introduction**

It has long been acknowledged that extensive relationships between financial institutions and corporations can add to financial risks. It is also known that politics and regulatory capture can play an important role in dealing with financial distress. The East Asia financial crisis meant a large number of distressed and closed intermediaries clustered within a short span of time in an environment with many links between government, supervisors, politicians, corporations and financial institutions. This makes the East Asia financial crisis a good event to investigate the role of these connections in causing and resolving financial institutions' distress. Furthermore, the general causes of the East Asian financial crisis have been the subject of intense debate, with proponents of a sudden shift of views of (foreign) investors as the main cause on one side and proponents of weak fundamentals as the major cause on the other side. To date, little empirical evidence exists as to the role of individual financial institutions' weaknesses in contributing to the crisis: were institutions hit by an exogenous shock and became distressed or were there many weak institutions before the crisis which then led to the systemic financial distress? And, if the latter, did the resolution processes resolve these distressed financial institutions in a transparent way or did they add to the overall uncertainty and loss of confidence?

To explore these questions, we investigate the occurrence of distress and closure decisions for a sample of 186 banks and 97 nonbank financial institutions from five crisis-affected East Asian countries: Indonesia, Korea, Malaysia, the Philippines and Thailand. Coverage of the national financial sector in terms of total assets is high for all five countries. In terms of banking system assets, the sample covers between 80% and 100%; and in terms of number of banks between 36% and 100%. In terms of assets of nonbank financial institutions, the coverage of our sample is between 47% and 90%. Almost 42% of these institutions experienced distress after July 1997, i.e., were either closed, merged, recapitalized or had their operations temporarily suspended. By July 1999, 13% of all institutions in existence in July 1997 had been closed. This illustrates the systemic proportions of the East Asian financial crisis.

We document various financial data (balance sheet and income data for end- 1996) for distressed, non-distressed and closed financial institutions and analyze their ownership structures to explore whether these characteristics help explain distress and closure. Using the end-1996 financial data, we find that traditional, CAMEL-type variables-loan loss reserves to capital, loan growth, net interest income to total income, return on assets, and loans to borrowings-predict subsequent distress and closure well. Ownership data also help predict financial distress and closure. Foreign portfolio ownership decreases the probability of financial distress and none of the foreigncontrolled institutions was closed, while privately owned institutions were more likely distressed. "Connections"-with industrial groups or influential families-increases the probability of distress, suggesting that supervisors had granted selective prior forbearance from prudential regulations. Connections also make closure more, not less likely, suggesting that the closure processes themselves were transparent. Larger-sized intermediaries were more likely to become distressed, but less likely to be closed, suggesting a "TBTF" policy. The significant forbearance of already weak financial 2