The purpose of this paper is to investigate factors underlying the buildup to the 'Financial crisis' in Malaysia. As earlier researchers pointed out, the direct cause of currency crisis is the exchange rate arrangement. After 1995, dollar-peg system raised the value of ringgit against Japanese yen, which deteriorated the country's competitiveness.
In 1990's, favorable interest rates, better fundamentals and expected high value of ringgit attracted large volume of funds from overseas. Most of them were short-term funds. Commercial banks have channeled the high proportion of loans and advances to the less productive sectors (broad property, consumption credit and for the purchase of shares). After the crisis in 1997, economic recession has turned much of these loans into non-performing ones.
Furthermore, on the debt side of commercial banks it is important that the maturity of deposits has been getting shorter and shorter. Stronger functioning of maturity transformation has made liquidity risks much higher.
Today, banking system in Malaysia faces two types of vulnerabilities: Non-performing loans and liquidity risks. Although many researchers and politicians discuss for withdrawing exchange controls accomplished in September 1998, it is obvious that deregulating these controls generate high potential costs for Malaysian economy.