I fear that I must not expect a very
favorable reception for this work. It speaks mainly of four
sets of persons , and I am much afraid that [none] will altogether
like what is said of them.
Walter Bagehot, Lombard Street |
Part One
I. Introduction
This paper considers current problems in what is often termed the "global
financial architecture" and proposes a set of solutions to those
problems. The solutions take the form of redesigning (in combination)
rules governing domestic bank safety net policies, lending by the
International Monetary Fund (IMF), international competition in
banking, global capital flows, and government debt management
policies.
Section II outlines the problems the proposal is meant to address.
Section III describes the principles that should guide reform. Section
IV discusses details of how to implement those principles, including
specific rules governing domestic bank safety nets, IMF membership and
IMF lending policy. These would replace not only the current IMF, but
other lending programs including the Exchange Stabilization Fund (ESF)
and ad hoc emergency lending by the World Bank the InterAmerican
Development Bank. Section V discusses the political economy of the new
set of rules and whether enforcement would be credible. Section VI
concludes.
Economics normally provides rather dismal news, emphasizing
tradeoffs among objectives and hard choices. In the case of
redesigning the global financial architecture, however, such is not
the case. It is not difficult to construct a set of mechanisms that
resolve problems of illiquidity (by providing a responsive lender of
last resort facility) while avoiding the governance and incentive
problems attendant to counterproductive bailouts of risk takers. The
claim that it is possible to deliver liquidity assistance without
bailouts presumes an economic definition of liquidity
assistance, a concept with clear and narrow meaning. Politicians and
bureaucrats, in contrast, often define "liquidity" crises
and "liquidity" assistance broadly and vaguely to disguise
transfers of wealth that have nothing to do with true liquidity
assistance.
In essence, my proposal would replace ex post negotiations over
conditions for IMF lending with ex ante rules for IMF membership and
restrictions on the manner in which the IMF lends to its members.
These rules and restrictions would automatically constrain the
circumstances under which assistance would be provided, and at the
same time make potential assistance much more rapid and effective.
Proposed membership criteria include rules that impose market
discipline on banking systems and limit government abuse of liquidity
protection.
A credible reform of bank capital regulation that ensures market
discipline makes it possible to construct an effective domestic bank
safety net in the form of a deposit insurance system, which addresses
liquidity problems attendant to banking panics. These domestic
safeguards ensure that IMF protection û if provided through an
appropriate lending mechanism û will not be abused. Requiring
that IMF members meet standards that ensure market discipline in their
banking systems and protection against domestic banking panics makes
it possible for the IMF to fulfill its proper role in global financial
markets û preventing unwarranted speculative attacks on member
countries' exchange rates. Private market discipline, therefore, is
the linchpin of effective domestic and international safety net
reform.
While I argue that providing liquidity protection without bailouts
is feasible economically, I recognize that the political economy of
the global safety net poses formidable obstacles to its
rationalization. It will be hard to design effective rules that will
not be fought by special interests, and hard to design mechanisms that
ensure that those rules will be reliably enforced. The approach I
advocate tries to come to grips with political challenges to reform
and enforcement.
II. The Weak Foundations of the Current Global Financial Structure
Financial crises are the defining moments of the problems that
confront policy makers. This section reviews and interprets the recent
history of crises, and the factors that are alleged to have produced
them. The list of problems includes (1) fundamental policy-design
flaws in banking systems and in international assistance programs that
subsidize risk and foment fundamental bank and government insolvency,
and (2) inherent problems of financial systems that aggravate those
shocks through four different channels (which are referred to
collectively as "liquidity" problems).
The last twenty years, and particularly the last five years, have
witnessed an unprecedented wave of financial collapses. The magnitude
of the losses incurred by banks during these collapses is staggering.
The negative net worth of failed banks in the U.S. for the years
1931-1933 was roughly 4% of GDP. Nearly a hundred crises with losses
of this or higher magnitude have occurred over the past two decades.
Twenty of those crises have resulted in losses in excess of 10% of
GDP, and ten have produced losses in excess of 20% of GDP.
Another novelty of the new crises has been the simultaneous collapse
of banks and fixed exchange rates. Exchange rate collapses
historically were sometimes associated with banking system collapses,
but historically the two occurred together much less often than today,
and the historical exchange rate collapses were less severe.
What is driving these crises? The literature has produced a number
of explanations, which are not mutually inconsistent. Since the
purpose of this paper is to devise solutions (not just for the sake of
devising them, but also in the hope of fostering change) I do not
pre-judge the weights that should be attached to the various views.
For a proposed set of reforms to the global financial architecture to
attract supporters, it must encompass a broad spectrum of views.
Problem 1: Counterproductive financial bailouts of insolvent
banks, their creditors, and debtors by governments, often assisted by
the IMF, have large social costs. Bailouts are harmful for
several reasons.1 First, they
entail large increases in taxation of average citizens to transfer
resources to wealthy risk-takers. Tax increases are always
distortionary, and serve to accentuate the unequal wealth
distribution. Second, by bailing out risk takers local governments and
the IMF subsidize, and hence encourage, risk taking. Moral-hazard
incentive problems magnify truly exogenous shocks that confront
banking systems. Excessive risk taking by banks results in banking
collapses and produces the fiscal insolvency of governments that bail
out banks, leading to exchange rate collapse. Banks willingly and
knowingly take on more risks û especially default risks and
exchange risks û than they would if they were not protected by
government safety nets.
Risk taking often follows a two-stage process. Initially,
macroeconomic shocks (e.g., a decline in the terms of trade) reduce
bank capital and raise the possibility of currency devaluation. That
changes both the incentives for banks to take risks and their
opportunities to do so subsequently. The incentives to take risk rise
both because bank capital is lower and because banks seek to protect
their loan customers (who sometimes also own the bank) from the
effects of the adverse macroeconomic shock. The opportunity for taking
on risk during a downturn is higher both because of increases in the
credit risk of borrowers and because of increased exchange rate risk.
Furthermore, a rising risk of depreciation lowers the relative cash
flow cost of borrowing dollar-denominated funds, which can make
borrowing in dollars attractive to distressed firms and banks. Banks
that borrow short-term dollar-denominated funds economize on the
current cash flow cost of those borrowings, but take on a large risk
of capital loss if the exchange rate peg collapses.
In the absence of safety net distortions that encourage risk taking,
macroeconomic shocks would encourage the opposite behavior û a
reduction in bank risk exposure to reassure bank debt holders.2
But overly generous protection of banks insulates them from market
discipline and makes them willing to increase their asset risk in the
wake of adverse shocks. Banks are willing to do so because potential
losses will be borne by taxpayers through government-sponsored
bailouts of the banking system.
The risks in these banking systems constitute an off-balance sheet
liability of their governments, since governments either explicitly or
implicitly guarantee to bail out banks that fail. Thus bank risk and
fiscal risk grow together and explain the simultaneity of banking and
exchange rate collapses. The differences between emerging market
financial crises of the last two decades and historical crises û
the larger size of current banking system losses, and the coincidence
of banking system and exchange rate collapses û are attributable
to the new link between private risk taking and public financing of
the losses produced by those risks.3
Banks are not the only entities protected by government safety nets.
Large, politically influential firms other than banks often receive
implicit protection from the government on their debts, which
encourages a similar tendency to bear exchange risk and to rely on
short-term dollar-denominated funds, particularly in the wake of
shocks that raise the risks of devaluation.
The moral hazard problem also can exacerbate the extent of
devaluation during exchange rate collapses. Domestic banks that bet
against devaluation prior to the exchange rate collapse (by borrowing
dollars or entering forward exchange contracts) can magnify the extent
of the collapse by adding selling pressure to the market once the
collapse begins. As banks experience initial losses on their open
exposures to exchange risk, they may be forced to sell their positions
suddenly, which magnifies short-term devaluation pressures. In Mexico,
this process of unraveling excessive bank (or non-bank) exposures to
exchange risk (in the form of dollar-denominated borrowings and
derivative positions) contributed to the severity of the exchange rate
collapse in 1995. Garber (1997) argues that the dumping of derivative
positions and the scramble for cash by Mexican banks in response to
large losses on those positions led banks not only to liquidate their
long peso positions, but also to dump their short-term government
securities (tesobonos) on the market, which put added pressure on the
peso in early 1995 and contributed to government problems in rolling
over maturing treasury debt.
In addition to the immediate economic costs associated with bailouts
(tax increases and moral hazard), there is also a longer term cost
from the way bailouts affect the political process domestically and
internationally. Domestically, bailouts encourage crony capitalism in
emerging market economies and thus help to stunt the growth of
democracy and reform. Bailouts also undermine democracy and economic
competition in industrialized countries. Bailouts (whether channeled
through the IMF or the ESF) are often a means for the U.S. Treasury to
provide subsidies to international lenders and foreign governments
without Congressional approval under the guise of liquidity
assistance.
IMF policies exacerbate all these problems.4
The IMF's role in bailouts is threefold. It provides a small wealth
transfer (via the interest subsidy on its loan). Second, and more
importantly, it pressures countries to bail out international lenders
who are often complicit in excessive risk taking. Third, the IMF helps
to ensure that domestic taxation (to finance the bailout) will occur,
by lending legitimacy to the bailout and by requiring increased
taxation as a condition of IMF assistance.
So far I have argued that moral hazard is the key villain in the
recent, unprecedented wave of financial system collapses. That is not
to say that all the costly consequences of financial crises
are an unavoidable consequence of moral-hazard-induced fundamental
bank insolvency and its fiscal consequences.
If the only costs of financial system collapse were the direct
costs of fundamental insolvency û that is, the amount of
wealth lost directly through the actions of protected banks and
borrowers û then the only threat to the global financial system
would be safety net protection itself. In that case, the simple
solution to redesigning the IMF arguably would be simply to abolish
it, as Schwartz (1998) suggests. The argument for reforming the IMF,
rather than abolishing it, revolves around the view that there are
important indirect costs attendant to "liquidity problems"
that magnify the direct costs to fundamental bank and government
solvency. The potential importance of these indirect costs, and the
potential for the IMF to mitigate them, underlies the argument for
preserving the IMF. Concerns about liquidity costs can be divided into
four additional problems, which are discussed separately below.
Problem 2: Asymmetric information about the incidence of
observable shocks within the financial system, especially when
combined with short-term debt finance can magnify the economic
consequences of fundamental shocks by leading to a liquidity crisis.
The historical evidence on banking panics in the U.S. and elsewhere
suggests that panics resulted from observable economic shocks with
unobservable consequences for individual financial intermediaries. The
vulnerability of financial intermediaries to crises reflects the fact
that the value of their assets are hard to observe (loans are not
marked to market) and their debt is very short term (often
demandable). Those characteristics are intrinsic to the value-creating
functions of banks, but they also make banks vulnerable to crises.
Small fundamental shocks to aggregate banking system solvency can
promote widespread disintermediation from banks, leading to a
contraction in credit, a decline in economic activity, price
deflation, and "fire sale" losses as banks and their loan
customers scramble to gain liquidity.
Asymmetric-information-induced runs on banks prompted by fundamental
shocks to bank asset values characterized the panics of 1873, 1884,
1890, 1893, 1896, and 1907. The weeks and months prior to these
banking panics witnessed uniquely adverse combinations of the
growth of business insolvencies and declines in equity prices.
Previous and subsequent financial panics, in and outside the United
States, have been similarly traced to observable fundamental shocks
with unobservable consequences for individual banks and bank
borrowers. 5
Because bank panics result from bank vulnerability to asset value
shocks, bank diversification can be extremely useful in forestalling
panics. The peculiar propensity for banking panics in the U.S.
reflected the fragmentation of U.S. banks by location, which made bank
loans less diversified than in other countries. That observation
suggests that an important ingredient in reducing banking risk in
today's global economy is to encourage banks to operate branches
throughout the world, and to hold an internationally diversifed bundle
of securities in their portfolios. Lack of bank diversification has
been shown to be a major contributor to bank instability in emerging
market economies in recent times, as Caprio and Wilson (1997), Wilson,
Saunders, and Caprio (1997), and Kane (1998) emphasize.
Problem 3: The expectations of speculators can exaggerate the
effects of adverse shocks, and can even precipitate self-fulfilling
financial collapses when weakened financial systems are also illiquid.
Current IMF assistance is inadequate to deal with this problem because
it offers too little assistance, and attaches too many conditions to
that assistance at the time of the loan request, which delays the
availability of funds.
There is a "Sachs version" of this alleged liquidity
problem, and a "Mahatir version." The Sachs version
(outlined in Sachs et al. 1996, Cole and Kehoe 1996) recognizes that
economic fundamentals still drive crises to some degree (which, for
example, explains why Singapore has not come under speculative attack
in the recent crisis). The Mahatir version, predictably, sees
speculative attacks as conspiracies that victimize the innocent.
My own view is that the evidence does not support placing much
weight on multiple-equilibria explanations of current financial
crises. The Mahatir version has been contradicted by recent empirical
studies of the behavior of hedge funds and other institutional
investors (see Brown et al. 1998, Choe et al. 1998). The Sachs version
is also very weak on empirical support. As a general theory of crises
it should apply not only to the current wave of disasters, but to
historical cases as well. But the evidence cited above on the history
of financial crises, contrary to Radelet and Sachs's (1998) claim,
does not support the view that historical crises are explicable as bad
equilibria within the context of the Diamond-Dybvig (1983), or the
Sachs, models of multiple equilibria. In other words, a model that
would explain the current wave of crises as bad equilibria must also
explain (as these models do not) why these purported bad equilibria
are new. The moral-hazard approach can do so (since safety net
protection and the quasi-privatization of risk are relatively new
phenomena); it is not clear whether the multiple-equilibria approach
can.
Furthermore, Sachs and others search for multiple equilibria
explanations mainly because they find little evidence of extreme
fundamental weakness in macroeconomic flow indicators (e.g.,
conventional measures of government deficits or current account
deficits). But, as argued above, they are simply looking in the wrong
place for evidence of fundamental weakness. Expectations of future
government expenditures often drive crises, not current expenditures.
Financial sector imbalances (expected government costs of a bank
bailout, or the bailout of an underfunded pension system) produce
fiscal imbalance through the off-balance sheet contingent liabilities
of the government, not through measured flows that show up in today's
current account balance or current taxes and expenditures. In a world
where banking sector collapses often produce fiscal costs in excess of
20 percent of GDP, and where government expenditures move smoothly
compared to changes in off-balance sheet liability exposures of
governments (since banking system losses can occur very quickly), a
focus on macroeconomic flows as measures of fundamentals leaves the
prince out of the play.
Despite these objections, there surely is something to Sachs's
argument if rephrased as the simple claim that a country with very low
international reserves is more vulnerable to speculative attacks on
its exchange rate or banking system than are others. Furthermore, as
Garber (1997) points out, it is very hard to reject
rational-expectations multiple-equilibria explanations
econometrically. For these reasons, for the purposes of developing my
proposed reforms I will assume that the Sachs and Mahatir views have
some validity, and that it would be desirable for a global safety net
to address the potential for self-fulfilling financial crises to
emerge from a combination of small fundamental weaknesses and low
liquidity (i.e., low bank and central bank reserves relative to
short-term obligations).
Problem 4: "Contagion" across countries in securities
and loan markets. Correlations in asset returns are much higher
across emerging market countries during crises than at other times,
and even government bond yields move together to an unusual degree
during financial crises. There are several explanations for this "contagion."
One is irrationality on the part of investors. A second is rational
portfolio rebalancing by international investors; if portfolio
investors (like banks) target a given default risk on the debt they
issue, then they will endogenously shrink asset risk
in one country in response to capital losses or exogenous increases in
asset risk in another country. A third explanation revolves around
linkages in international trade that can transmit economic decline,
which is then reflected in asset prices. A fourth explanation revolves
around multiple equilibria (either through changes in speculators
views about the probability of bad equilibria, or through reductions
in central bank liquidity following a global flight to quality). To
the extent that cross-country contagion reflects irrational
speculation or multiple equilibria, policies that would solve those
problems would also eliminate cross-border spillover effects.
Problem 5: Government debt management sometimes leans too much
on short-term debt. There are good reasons (incentive
compatibility) for governments to shorten their debt maturities during
times of fiscal uncertainty. Indeed, governments have been doing so
for centuries.6 But doing so might
promote self-fulfilling attacks on currencies (following the
multiple-equilibria reasoning of Cole and Kehoe 1996, and Sachs et al.
1996). Mexico's financial crisis is often held up as an example of
such a problem. While I have argued that these authors likely
overstate the empirical evidence in support of that view (particularly
in Mexico, where weak fundamentals in the banking system and in
central bank policy were clearly present by late 1994, and persist to
the present), there is a version of this view that is reasonable: A
short term structure of government debt probably aggravates liquidity
problems that have their origins in other fundamental shocks (fiscal
risks associated with banking system collapse), as in Mexico during
the tesobono selloff of 1995.
There is another reason to be concerned about the short term
structure of government debt. Governments suffer a moral-hazard
problem with respect to the maturity structure of their debts because
IMF protection removes the cost of taking illiquidity risk through the
shortening of government debt term structure. In an environment where
the IMF cannot credibly say no to bailing out governments who abuse
its protection, the IMF may be encouraging financial fragility by not
penalizing government debt structures that rely excessively on
short-term obligations.
From the perspective of these five challenges to financial system
stability, current IMF policies are woefully inadequate, and indeed,
are part of the problem. When a country suffers a banking
system-cum-exchange rate collapse, its government protects politically
influential domestic stakeholders by bailing out banks, their debtors,
and their creditors, all at the expense of taxpayers. IMF loans to
countries suffering financial collapse serve as bridge loans to permit
the rescheduling of debt. The conditions imposed by the IMF along with
its financial support help to ensure that tax increases to finance the
bailout will be forthcoming, making the IMF an accomplice to the
transfer of wealth from taxpayers to domestic oligarchs and global
lenders. Banking reforms, promoted by the IMF as a condition for
assistance, are inadequate and there is no credible mechanism for
ensuring that "mandated" reforms will be carried out.7
Furthermore, IMF assistance is provided only after an agreement is
reached, and funds are released in limited amounts over several
months. That way of providing assistance is not effective in solving
liquidity problems, which require large amounts of funds to be
available on very short notice. Thus current IMF assistance is a
non-starter, both from the standpoint of limiting moral hazard
problems and reducing the risks of liquidity crises.
We can do much better. Public policy cannot eliminate unavoidable
shocks to the financial system. But thoughtful policy can reduce the
five avoidable risks listed above, which magnify the costs of
exogenous shocks that buffet banking systems and government finances.
III. Principles on Which to Build A Global Financial System
In light of Section II's discussion, the central two-fold
objective of policy is to avoid moral-hazard problems that give rise
to imprudent banking practices while also protecting against the four
"liquidity" problems that can magnify fundamental shocks.
A careless approach to providing liquidity assistance results in
excessive and counterproductive assistance û a tendency to "throw
money" at fundamental problems, which aggravates problems of
imprudent banking and encourages unwise fiscal, monetary and debt
management policies.
Finding the right balance between liquidity assistance and market
discipline is the crux of the policy problem. A financial system
safety net will not achieve that balance by making it impossible for
banks to fail or for exchange rates to collapse. A system that would
eliminate the possibility of collapse would also encourage poor
management of private and public affairs. Banks should sometimes fail,
exchange rates should sometimes depreciate, and governments should
sometimes have trouble rolling over their debts.
While finding the appropriate balance requires care, I will argue
that constructing a balanced safety net does not pose an intractable
economic dilemma. It is not the case that policy makers confront an
inevitable dismal tradeoff between higher incentive costs from the
safety net and greater benefits from safety net protection against
liquidity crises. It is possible to capture the benefits of legitimate
"liquidity insurance" without suffering the costs of moral
hazard.
How can financial system safety nets provide systemic insurance
against illiquidity without engendering moral hazard? To achieve that
goal credible ex ante rules must be devised that properly allocate ex
post losses to private agents, local governments, and international
agencies. A global financial safety net, therefore, must define
more than the IMF's lending policy, it must define the "tranches
of risk" that are credibly assumed by parties other than the IMF,
as well as the risks the IMF assumes.
This goal is not new. In fact, it underlay Walter Bagehot's (1873)
classic policy prescriptions for domestic central banking: to lend
freely at a penalty rate on good collateral. Bagehot argued an elastic
and immediate supply of liquidity was essential to an effectively
structured lender of last resort, and that appropriate loss sharing
rules in the form of collateral requirements and penalty interest
rates would discourage abuse of the safety net.
Successful lenders of last resort historically have had in common an
ability to set credible rules for defining the sharing of risk that
minimize moral hazard while maximizing the ability of the system to
provide liquidity during crises. In the United States prior to the
Civil War, three states (Indiana, Ohio, and Iowa) successfully
operated mutual insurance systems for member banks, which revolved
around that principle (Calomiris 1989, 1990, 1993). These were
imitated by the New York Clearing House, and by other private clearing
houses (Cannon 1910, Gorton 1985). Member banks were constrained by
rules and credible monitoring arrangements that limited the riskiness
of their debts. Insolvent banks were ejected from coalitions that
provided liquidity protection for solvent banks. Enforceable rules
requiring the pooling of risks during crises to solve liquidity
problems ensured sufficient collective protection. These systems
provide examples worthy of imitation today. All successful historical
safety net systems revolved around credible arrangements for limiting
moral hazard by clearly defining how losses incurred by members would
be allocated.
Defining the allocation of risk for the global safety net requires
a segmentation of risk into three tranches: the private tranche
(exposures to loss incurred by private claimants of individual
financial institutions), the domestic government tranche (exposures to
loss assumed by local government bank safety nets, and hence, local
taxpayers), and the IMF tranche (exposures to loss assumed by the
IMF). The other key design feature of the global safety net is
determining how the IMF's financial positions are financed (how risks
taken by the IMF will be passed on to other parties).
The role of financial system regulations, which include IMF
membership criteria and the rules for IMF lending, is to clearly
define when and how the IMF lends, and how losses are allocated within
the financial system to maximize the effectiveness of protection
against illiquidity, while minimizing the moral-hazard costs of
protection. To be effective, those rules not only have to make
economic sense, but must be transparent and credible.
In other words, the rules governing the global safety net have to
qualify not only as economically sensible, but also as politically
robust.
IV. A New Institutional Structure for Credible Loss Sharing
Without a credible "first tranche" of private loss, moral
hazard will plague any attempt to provide liquidity, either from
domestic governments or the IMF. What is needed is a set of
transparently credible rules that impose a margin of private loss on
bank claimants, which limits the exposure of taxpayers to bailout
costs ex post, and in so doing, limits banks' willingness to undertake
risks ex ante. Putting those safeguards into place should be a
requirement of membership in the IMF. Members would then be eligible
for IMF liquidity protection û loans from the IMF that are
specifically designed to resolve liquidity problems, not to bail out
insolvent banks.
By setting these clear, credible criteria for IMF membership, and
devising rules for IMF lending that guard against liquidity problems
without providing bailouts (that is, without absorbing bank solvency
risks), the IMF and its loan programs would help to stabilize global
financial markets. What sorts of rules would work to accomplish these
objectives? The rules divide into three types: (1) domestic
regulations required as a condition for IMF membership, (2) rules
governing IMF lending to members, and (3) rules defining the way IMF
loans are financed.
Credible Bank Regulation: Subordinated Debt, Liquidity,
Insurance, and Free Entry
The bank regulatory requirements that should be mandatory for IMF
members include four components: (1) capital requirements (including,
in particular, a subordinated debt requirement as part of the capital
requirement), (2) "reserve" requirements (minimum ratios of
assets in cash and in "global securities"), (3) the explicit
insurance of bank deposits, and (4) "free banking"
(unlimited chartering of banks conforming to common regulatory
standards, and unlimited investment by foreigners in banks, conforming
to the same standards as domestic investors).
A key function of capital regulations is to provide a credible
first tranche of private loss by ensuring that uninsured bank
claimants (stockholders and subordinated debt holders) will lose
wealth when banks suffer adverse shocks to the values of their risky
assets. Minimum cash reserve ratio requirements serve a similar
function (effectively ensuring a margin of protection for insured
debt), and also enhance bank liquidity. A minimum amount of "global
securities" û domestic and foreign marketable instruments û
adds to the transparency of bank balance sheets and helps to diversify
bank risk. Thus restrictions on asset holdings and on the composition
of bank liabilities provide crucial buffers that ensure the
privatization of bank losses, and thus make it easier for local
governments and the IMF to provide liquidity protection cost
effectively. These regulatory requirements are a first line of defence
that reduces the risk of bank failure, the potential for costly bank
bailouts, and the liquidity risk that banks face.
Free entry into banking by foreign investors provides an important
source of capital (to meet regulatory capital requirements). It also
helps to diversify both the ownership base of banks and their asset
portfolios (since foreign banks naturally hold more globally diverse
portfolios), which makes banks more resilient in the face of adverse
domestic shocks. Finally, foreign banks provide important competitive
pressure that improves the quality of domestic bank management
(Demirguc-Kunt and Levine 1998, Kane 1998).
Because of the importance of credibility and transparency,
bank capital and portfolio regulations must be designed carefully.
Credibility and transparency require a reliance on market
discipline to enforce bank regulations (Keehn 1989, Wall 1989,
Flannery 1998, Berger et al. 1998). In capital standards, the devil is
in the details. A key flaw in the Basle capital requirements to date
has been their emphasis on government supervisory standards when
measuring capital. Book value equity is measured by supervisors who
often have little skill, and even less incentive, to report bank asset
losses accurately. Second, the Basle standards imply an arbitrary link
between their measure of asset risk and book value capital, while the
true asset risk of the bank can differ from the Basle measure of "risk-weighted
assets." The mandated 8% capital requirement is not sufficient if
banks assume very high asset risk, and the measurement of
risk-weighted assets under the Basle standards leaves much room for
bank manipulation of risk.
The Basle capital requirements can be substantially improved by
incorporating into the Basle framework a minimal (say, 2%)
subordinated debt requirement, as a means to ensure a credible
relationship between capital and asset risk via market discipline.
This approach was first proposed by the Chicago Federal Reserve Bank
(Keehn 1989) and the Atlanta Federal Reserve Bank (Wall 1989) in
response to the U.S. S&L and banking crises of the 1980s. The
approach outlined here is a modified version of the Chicago Fed plan.
As part of the existing 8% tier 1 and tier 2 Basle capital
requirement, banks would be required to issue at least 2% of
risk-weighted assets (as defined under the Basle standards) in the
form of a new class of subordinated debt. That debt would be
subordinated to (that is, junior to) other bank debts. Unlike equity
holders, subordinated debt holders do not benefit from "asset
substitution" (increasing asset risk in order to exploit the
implicit put option value of deposit insurance). Thus subordinated
debt holders would be a conservative force for restricting bank risk
taking, and protecting relatively senior bank deposits. Because
subordinated debt is easy to measure (unlike the book value of
equity), a minimal subordinated debt requirement avoids the problems
of relying on domestic bank supervisors to measure compliance with
equity standards. Furthermore, the yields on the debt are observable,
which provides a continuous and transparent market opinion about bank
risk.
To be successful, however, subordinated debt issues should be
restricted in several ways. To ensure that it serves its role as a
source of market discipline, subordinated debt must be held at arms
length, and therefore, cannot be held by any willing purchaser. I
recommend that the debt be non-tradable, and held only by a group of
approved and registered holders (which would differ for each issuer).
Each bank's group of qualified holders would be a subset of, say, 50
institutions pre-approved by both the domestic regulator and the IMF
as reputable foreign financial institutions with no other
financial transactions with the issuing bank. Placing subordinated
debt in the hands of well-diversified foreign institutions also helps
to ensure that subordinated debt holders will not be bailed out, which
is necessary for subordinated debt to serve as a source of market
discipline.
It is also essential that a subordinated debt requirement specify
how increased bank risk (visible in the yields of subordinated debt)
would be penalized by bank regulators. Perhaps the simplest procedure
is to set a maximum yield spread over comparable maturity treasury
instruments (say, 5%) and require that subordinated debt not be issued
at yields in excess of that maximum spread. Banks that fail to roll
over their debts at or below the mandated yield spreads eventually
would have to contract their risk-weighted assets to remain in
compliance with the 2% subordinated debt requirement.
The maturity of subordinated debt should reflect the right balance
between enhancing market discipline (by requiring that the debt be
rolled over sufficiently frequently) and limiting the amount of
rollover that can occur over short intervals (to avoid the risk of
sudden illiquidity). For example, requiring that subordinated debt be
issued in the form of 24 overlapping generations of two-year debt û
one-twenty-fourth of which mature each month û would be a
reasonable way to achieve discipline without leaving banks vulnerable
to liquidity crises. That arrangement would limit the rate of decline
of subordinated debt to roughly 4% per month. Given the required
minimum ratio of subordinated debt to risk-weighted assets, that would
also limit the maximum monthly decline of risk weighted assets
mandated by the requirement to 4%.
The subordinated debt requirement is designed to encourage prudent
behavior by banks ex ante (since, on the margin, they are always
subject to market discipline), and to encourage appropriate adjustment
of asset risk to adverse shocks ex post. Unlike many banks currently,
banks subject to a subordinated debt requirement would not purposely
increase risk in the wake of losses. Instead, banks would have strong
incentives to reduce asset risk and cut dividends (or find alternative
ways to raise capital) in the face of losses, much as banks did before
safety nets changed their incentives to react appropriately to shocks.
Because subordinated debt holders bear risks that come from both
on-balance sheet and off-balance sheet asset risks, they discourage
attempts by banks to avoid regulatory capital standards by placing
transactions off banks' balance sheets. Subordinated debt holders also
encourage banks to develop clear reporting procedures and effective
tools for risk management.
A banking system governed by a credibly uninsured subordinated debt
requirement is self-equilibrating. Banks may have difficulty rolling
over subordinated debt in response to severe shocks (given the
proposed yield spread limit on subordinated debt). The failure to roll
over subordinated debt mandates a contraction of risk weighted assets
(e.g., a contraction of loans). That contraction itself reduces asset
risk, eventually allowing the market spread on subordinated debt to
fall within the prescribed limits of the regulation.
Restrictions on bank asset composition are also desirable, both to
promote liquidity for the system as a whole, and to provide a
transparent safeguard against bank default risk in addition to
requiring subordinated debt. Argentina's high reserve requirements
were extremely useful in helping Argentine banks to weather the
tequila crisis in early 1995. Argentina has also shown creativity in
the way it allows banks to meet those reserve requirements. Banks are
encouraged to hold up to 50% of their reserves offshore in private
commercial banks, and may hold much of their reserves in the form of
standby arrangements with foreign commercial banks (for which the
Argentine banks pay a fee) rather than in the form of actual dollar
deposits. Like a subordinated debt requirement (also a feature of the
Argentine system) this arrangement rewards low-risk banks who are able
to pay low fees for their standbys.
I propose a similar requirement as part of the mandatory minimum
reserve requirement for banks û a 20% reserve requirement
relative to bank debt, with half to be held offshore (partly to
protect against government confiscation of bank resources). Banks can
satisfy the 10% offshore reserve requirement by maintaining standbys
in that amount with any AA rated international bank.
The "global securities" requirement would also be set at
20% of deposits. At least half of that securities portfolio must
consist of foreign hard-currency-denominated (meaning denominated in
dollars, yen, or euros) debt securities placed and priced in
international public markets, with yield spreads at the date of
purchase of less than 3% over the comparable maturity treasury
instrument (of either the U.S., German, or Japanese governments
denominated in their respective currencies). The other half of the
required securities portfolio could consist of any publicly traded
debts (including local government and private bonds), so long as their
yield spreads were less than 5% over comparable treasury securities at
the date of purchase. The securities portfolio requirement serves the
dual function of encouraging global diversification and providing an
additional liquidity buffer for banks.
The final regulatory requirement is deposit insurance. All bank debt
that is not included in subordinated debt should be explicitly insured
by the local government. Doing so would eliminate the possibility of
banking panics, either due to asymmetric-information problems (Section
II's "Problem 2"), or multiple equilibria (Section II's "Problem
3).
The argument for government deposit insurance is primarily a
political, rather than an economic, one. Arguably, private methods of
protecting against banking panics may be superior to government
deposit insurance. But since governments tend to be incapable of
credibly committing not to provide insurance ex post, it is not
possible to construct effective private systems.
Explicit government insurance is superior to implicit government
insurance. While there are some theoretical and empirical arguments in
favor of "constructive ambiguity" in deposit insurance that
might favor implicit over explicit insurance, those arguments are not
convincing. Implicit insurance does not provide as much protection
against runs. Also, making insurance explicit allows governments to
charge insurance premia for the protection, and helps government
actions to conform better to stated government policy (surely a
desirable principle in a world where reputation building has value).
In the presence of the other prudential regulations (the
subordinated debt requirement and the portfolio requirements), deposit
insurance should not be very costly. In a world where market
discipline constrains bank behavior, there are likely to be few bank
failures, and small losses from insuring banks.8
These four regulations û subordinated debt requirements,
minimum reserve and securities ratios, free banking, and deposit
insurance are a minimal standard, which should be required as
a condition for membership in the IMF. I would recommend that
countries go beyond that minimal standard when devising their bank
regulations, particularly in the areas of insider lending limitations,
barriers between commerce and banking, regulations of market risk
exposures, and more realistic definitions of risk weighted assets than
those found in the Basle standards. For example, risk weighted assets
should be defined in a way that is more sensitive to real risk than
are the Basle standards. In Argentina, risk weights on loans are
determined by the interest rate on the loan, and can be as much as
600% of the book value of the loan for very high interest loans.
While it is desirable to improve bank regulation by including
requirements in addition to the four minimal standards, some
regulatory standards should vary across countries. Furthermore, a
subordinated debt requirement, and the market discipline it brings,
arguably subsumes other regulatory standards, and makes additional
measures less important. If banks have to satisfy market discipline,
markets will informally "impose" safeguards against market
risks, insider lending, and other potential problems, since banks will
have to satisfy market perceptions about their overall risk profile.
By keeping the list of required regulations short and simple it will
be easier for the IMF to credibly enforce the rules it sets (see
Section V below). By vigorously enforcing these rules (e.g., ejecting
countries from the IMF if they fail to enforce minimal requirements or
if they bail out subordinated debt holders when banks experience
losses) the IMF will return reason and balance to international
banking, and prevent its own protection from being a source of
financial instability.
A reformed global banking system will also reduce the riskiness of
emerging market securities. Banking systems as a rule have been run
inefficiently in emerging market countries, and banks often pursue
opportunities more on the basis of insiders' interests than a proper
valuation of loans. For that reason there are many viable projects
that should be financed by banks rather than via securities issues
(that is, projects that require ongoing monitoring and discipline by
banks through concentrated local holdings of claims on borrowing
firms), but are pushed into securities markets for lack of a local
means of bank finance. In a properly functioning global banking
system, those projects would be financed by banks, and banks would be
more internationally diversified to permit them to deal with the risks
that arise from those risky projects.
The four core banking regulations would ensure a properly
functioning global banking system. Free entry, competition, and
credible market discipline would encourage proper diversification,
prudent management of risk, and an efficient allocation of bank
capital. It would also make it possible for the IMF to do the job it
was chartered to do û providing liquidity insurance û
without the destabilizing side effects of moral hazard.
Other IMF Membership Requirements
Thus far I have focused on the structure of banking systems, and on
proposed mandatory bank regulatory requirements for IMF membership.
That emphasis is appropriate given the important role banking system
losses and moral hazard have played in exchange rate collapses and
IMF-sponsored bailouts. But there is more to the global financial
architecture than the regulations governing banks.
In addition to the mandatory bank regulations, the IMF should
impose restrictions on government recapitalizations of banks (or
implicit subsidization of banks through a variety of other means), and
set minimal standards for government debt maturity structure, and for
a prudent fixed exchange rate policy. It is appropriate for the IMF to
set standards for debt management and exchange rate policy, as well as
banking practices, since the IMF will provide liquidity assistance to
buttress fixed exchange rates or to facilitate debt rollover.
The main purpose of restrictions on government assistance to banks
is to ensure that the market discipline brought by the subordinated
debt requirement is not undermined by government assistance through
channels other than deposit insurance. A detailed discussion of the
limits on recapitalization policy are described below under the
rubrics of "transition problems" and "large
macroeconomic shocks."
As in the case of mandatory banking regulations, the other rules
should be as few and as simple as possible, and should be designed to
make compliance with them easily observable to the IMF and to third
parties. Countries should face a ceiling on the proportion of
short-term sovereign debt they issue. For example, members could be
required to maintain ratios of short-term debt that were no more than
25% of the previous year's export earnings, and no more than 25% of
total sovereign debt.
Countries should not be required to maintain fixed exchange rates,
but if a country does peg its exchange rate, then it should be
required to meet two additional requirements. First, it should have to
maintain a minimum ratio of reserves to high-powered money. Economic
theory has little to say about the "right" reserve ratio for
a central bank to maintain, except that the right minimal proportion
of reserves depends on the confidence the market places in fiscal and
monetary policy. Countries operating currency boards maintain ratios
of nearly 100%, but there are many examples of countries that have
been able to maintain exchange rates for long periods of time with
much smaller reserve ratios (the United States prior to 1933, for
example). Rather than requiring everyone to hold 100% reserves, or
trying to set standards for reserves that depend on hard-to-observe
fiscal and monetary fundamentals, I propose requiring a low minimal
reserve ratio (25%), and encouraging countries to properly manage
their reserve policies by making it clear (by enacting the
aforementioned reforms) that the IMF will provide support only to
resolve bona fide liquidity problems.
Second, member countries with fixed exchange rates should be
required to permit banks to offer deposits denominated in both
domestic and foreign currency. Doing so (as Argentina did when it
adopted its currency board) helps to insulate banks from the risk of
devaluation; funds can flow out of the domestic currency without
flowing out of the banks. Bank deposit accounts in both currencies
also provide continuous market information about the risk of
devaluation. Domingo Cavallo, the Argentine finance minister, has
argued that observing interest rates in both currencies gives domestic
policy makers a valuable signal of market perceptions of government
policies that bear on the maintenance of the exchange rate (Cavallo
1999).
Observing interest rate differentials prior to a speculative attack
also gives the IMF valuable information which may be useful in judging
the causes behind a speculative attack. If the perceived risk of
devaluation (reflected in the interest rate differential) rises
gradually over a matter of months, while the government makes little
effort to diffuse market concerns through increases in reserves or
fiscal reforms, then it is hard to blame the speculative attack on
multiple equilibria or irrationality. In some cases, as discussed
below, the IMF might wish to withdraw its support for an exchange peg
that so obviously ignores market concerns over long-term fundamentals.
I do not include any membership requirements with respect to
capital controls or devaluation policy. It would be too difficult to
devise general rules to cover these areas; moreover, the appropriate
policies with respect to capital controls and the appropriate
circumstances for a devaluation should be left to governments to
decide for themselves.
Many economists have rightly argued that the proper alternative to
bailouts is a functioning bankruptcy code that can distribute loss
according to clearly specified rules. I agree with that point of view,
but do not attach it here as a condition for IMF membership for two
reasons. First, it would be hard to specify the terms of that
bankruptcy code in an uncontroversial way (the Swedish code is my
personal favorite). Second, it is probably not necessary to add
bankruptcy reform as an additional requirement of IMF membership. A
banking system that is responsive to market discipline will be a
powerful force for creating bankruptcy reform endogenously. The same
can be said for the endogenous reform of commercial law, collateral
registration procedures, and accounting standards.
I also omit any discussion of fiscal policy targets. It is too hard
to design useful, credible, uniform rules about fiscal policy û
for example, off-balance sheet exposures are often crucial to
long-term fiscal health and are very hard to measure.
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