by Catherine L. Mann, Peterson Institute for International Economics
One of the central issues arising from the Asian/global financial crisis is the relative role of the International Monetary Fund and the private markets in preventing further financial crises. Dr. Catherine L. Mann, senior fellow, draws on her experience in Washington policymaking at the Federal Reserve Board, the President's Council of Economic Advisors, and the World Bank and on her executive teaching at Vanderbilt University Owen School of Management and University of Chicago Graduate School of Business.
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Should the IMF be the international lender of last resort? It played the leading role in the financial dramas in Mexico, Asia, Russia, and Brazil. Both Stanley Fischer and George Soros want to place the IMF-cum-international lender of last resort at the center of the new financial architecture (Wall Street Journal and Financial Times, 4 January 1999). Indeed, the IMF is the only institution that can coordinate large and immediate injections of credit when fast-moving global financial panics overwhelm sovereign nations and threaten to undermine international finance, global trade, and world growth.
However, there is a missing actor. There is no supranational supervisor, and there will not be one. No sovereign nation will give over to a supranational entity the right to monitor and close its individual financial institutions. Yet, this supporting actor is critical to the effectiveness of the lender of last resort. So, even as we bolster the IMF's credit line for when needed, even extending funds at penalty rates to borrowers, we must severely limit the occasions when we resort to such financing.
This implies a more important role for the private financial community, as the actor not sufficiently or willingly involved. Private financial insurance instruments complement proposals to strengthen the IMF. They can differentiate borrowers and lenders, help mitigate moral hazard, and diversify risk to participants who can best bear it.
The International Financial System Needs a Creditor of Last Resort, Which the IMF Can Be
In the national context, the lender of last resort exists because distress at a single financial institution could spill over to sound financial institutions, thus impairing the conduct of the whole system. Although financial institutions should accurately price and manage their own risks, no financial institution prices into its services the costs of contagion. Nor should it, since doing so would lead to an inappropriately high price and thus to too small an amount of financial intermediation. Because the economic benefit of the financial system as a whole exceeds that created by individual firms, there is a rationale for very occasional intervention by a lender of last resort to prevent contagious spillovers.
In today's global environment, national economic well-being increasingly relies on global production, distribution, consumption, and the web of international financial transactions that binds them all together. Contagion from one national market to other national markets and the international financial system obviously happens, with great detriment to countries and to the system. A coordinated response of national lenders of last resort might obviate the need for an international lender of last resort. However, a single supranational credit institution is needed because national authorities may be unable to agree on an appropriate response within a time frame necessary to prevent disastrous contagion. Coordination failure among national institutions is a distinct possibility, due in part to the differences in their behavior and mandate. Moreover, if a domestic crisis becomes an international one, it may indicate that the national authority has failed.
But it Also Needs an International Supervisor, Which the IMF is Not and Should
Even as the backstop of possible intervention benefits everyone, it also alters the burden of public and private costs of a financial crisis. Governments, institutions, and investors may undertake excessively risky strategies when the possibility exists that the taxpayer will bear the negative consequences of those actions. These costs of moral hazard exist as the flip-side of ensuring maximum benefits from the financial system. Moral hazard cannot be eliminated, but we should try to mitigate it.
In the national context, the critical complements to the lender of last resort are regulation, supervision, and closure of financial institutions. On-going supervision of institutions is the quid pro quo for very occasional financial support from the central bank or taxpayer. Both the national lender of last resort and its associated supervisors are ever-present, are privileged to know which institutions are at greatest risk, and most important, can take prompt corrective action to improve or close an afflicted institution.
Is there an international analog? The Basle Core Principles draw out best-practice from national financial regulations, but the Bank for International Settlements is not the international supervisor! The IMF Article IV consultation process does address the soundness of financial institutions and the supervisory process. But, IMF credit and conditionality are provided only in crisis times and to governments rather than to private financial institutions, and all countries step down from IMF conditionality as soon as possible. And the threat of penalty rates is insufficient to prevent misguided behavior. In sum, there is no international supervisor that has the same knowledge, presence, and clout as does the national supervisor in its own domain. No sovereign nation will invite constant oversight of its financial institutions by a supranational entity, nor give to that entity the right to close some of them.
What to Do? Fund the IMF, But Demand More From the Private Sector.
It is unrealistic to suppose that there will be no international lending of last resort; some countries and some of their banks or companies will be supported in times of financial distress because of the possible international systemic consequences. The IMF cannot print its “money” (the SDR) at will like a national lender of last resort, so the IMF must be reinforced as coordinator of international credits and must have sufficient funding to be credible.
However, at the same time, we must limit moral hazard by reducing the frequency of occasions when IMF credit is directed at stabilizing the global financial system instead of its principal role, which is to ameliorate individual macroeconomic imbalances. The fundamental way to avoid systemic financial distress is to make sure that borrowers and lenders accurately price and manage risks in their own portfolios.
What makes financial markets work well? The recipe has these ingredients: Market participants with different tastes for risk, armed with full information, and offered “complete” markets of financial instruments. What has been missing in recent years? Arguably, all three! First, market participants have appeared more herd-like than heterogeneous. The very narrow risk spreads on emerging market debt in early 1997 and the huge risk spreads following the collapse of the Russian effort point to lack of differentiation among borrowers as well a swing in collective sentiment completely out of line with changes in the underlying economic prospects of many of the countries caught in the financial maelstrom. Second, differentiation has been made more difficult by incomplete or wrong information revealed only very slowly by certain market participants. Finally, the market for financial instruments is incomplete, lacking in particular financial insurance against the rare events of credit downgrade or restructuring (e.g., delay in payment or rollover) of, in particular, short-term obligations.
Could financial insurance instruments, such as credit risk insurance or restructuring insurance, help to stabilize the international financial system? First, these instruments differentiate the market participants. Not all borrowers would offer insurance, and not all lenders would buy it. But for those that did, when the financial crisis hits, the insured lenders would not abandon the insured borrowers, at least not for the duration of the policy. For example, if they had bought financial insurance, pension funds that unloaded low-rated bonds would not have had to sell into a declining market. Banks that provision when payments are delayed might have followed a different strategy. Firms that had to write off intracompany receivables could have reported revenues.
Insurance could significantly alter the herd mentality in the market by diversifying the exposure of market participants and by moving risk from those who fear it to those who manage it. Slowing down the race to the exits could dramatically alter the self-fulfilling nature of some financial crises. Moreover, with at least some lenders buying insurance, intervention by the lender of last resort would be less frequent and moral hazard reduced.
Second, financial insurance splits the pricing of financial products into pieces that can then be priced separately. A financial relationship needs to consider two situations: the borrower-lender relationship during normal times and the relationship when the borrower is distressed. The interest rate on a loan or bond only prices the relationship during normal times. There is no interest rate high enough to pay off the principal of the loan or bond if a borrower defaults. In contrast, financial insurance prices in only the cost of default.
Get the Private Incentives Right to Reduce Intervention by Public Institutions
Who might develop these financial products? Private financial institutions have the technical ability to create financial instruments that will price default risk and diversify it to participants who can bear it. They performed a similar function in developing foreign exchange insurance after the breakdown of Bretton Woods. Now, ongoing structural change in the financial sector is bringing together these creditors and insurers. And, the insurance industry has its own diversification medium—the well developed re-insurance market. The IMF might yet have a new, limited role as the ultimate backstop to this market, just as a federal government often is the ultimate backstop for insurance for national disasters such as floods and earthquakes.
A key aspect of the demand for financial insurance is the presence or absence of international bailouts or orderly (e.g., IMF or public-sector coordinated) workout agreements. To the extent that creditors are made whole or partially whole through nonmarket mechanisms, the demand for insurance instruments will not develop. Why should any creditor pay for insurance if it gets an international bailout for “free” (as in tesobonos in Mexico in 1995) or if the costs of renegotiation of the terms of repayment are coordinated by an official third party (as in South Korea in early 1998)?
Can these instruments be created before the next financial crisis? An example from the 1980s offers hope. After the move to floating exchange rates, volatility in the foreign exchange market created the incentive for currency swaps and options so that investors could pay for insurance, in advance, against unexpected movements in exchange rates. In the current situation, the more difficult, drawn-out, ad hoc, and therefore costly are the financial disaster workouts, the greater are the incentives for investors to demand and institutions to offer instruments ex ante that will help to generate a market-oriented solution to the workout process. So rather than intervening more frequently, official institutions must stand aside.
Perhaps the Asian financial crisis has got us nearly to this point—perhaps Indonesia's hands-off moratorium and Russia's default will get us there faster. As to whether a market-oriented strategy reduces moral hazard and dependence on international lending of last resort, we will have to await the next financial debacle.