Blueprints for a New
Global Financial Architecture
Charles W. Calomiris
[7 October, 1998 / Part 1 of 2]
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]
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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.
Part
2