An International Lender of Last Resort and the International Financial Markets

This paper draws heavily on "Lender(s) of Last Resort: National and International" dated January 28, 1998.

Increasingly the IMF is being called an international lender of last resort. What does it mean to be a lender of last resort (LOLR)? What supporting structures are required to effectively play that role? Central banks in national financial systems can (and some do) intervene to support some participants in the financial system in times of crisis. What can we learn from national LOLR experience for the occasions under which a LOLR might take action, the instruments the LOLR might use, and what supporting structures might be necessary for a LOLR to be effective in balancing the risks of financial crisis against the risks of moral hazard. If indeed the IMF is being called upon to act as an international LOLR, does it have (or can it be given) the instruments and supporting structures which appear to be necessary in the national context? If not, what are the consequences of the IMF playing with only half a deck, and is there another way out?

The bottom line is that the IMF is the only supra-national institution that can coordinate action when sovereign nations are involved, and when fast moving global financial crises demand large and immediate injections of credit. The foundation for growth in an increasingly global world is through international financial intermediation—a collapse of the international financial system cannot be risked.

However, the IMF operates without key supporting institutions and mechanisms that are integral to the environment of the national LOLR and which mitigate moral hazard. The IMF has neither a constant supervisory presence nor a fiscal redistributive authority. Consequently, IMF intervention in the current international financial environment magnifies moral hazard.

The recommendations contained in the recent communique from G-7 Finance Ministers, to improve transparency and disclosure and to strengthen national financial systems, clearly are necessary—but they are not enough. The proposed "international supervisor of the national supervisors" could help to some degree. But supervisors, to be effective, must be ever-present and have enforcement powers; authorities not given over lightly to supra-national entities. So, even as we bolster the IMF's credit line for when needed, we must seek ways to limit the occasions we resort to it.

We must focus on market-oriented solutions. The private financial market has the technical ability to create financial instruments that mitigate moral hazard and diversify risk to participants who can best bear it. The issue is how to induce the private sector to do its job.

Why have a lender of last resort? The role of the banking system, transparency, and the spillover of financial distress in the national context.

• The financial system plays a key role in monetary policy: Certain financial intermediaries, usually banks, play a key role in the conduct of monetary policy, and therefore are important for the transmission of monetary policy to economic activity in an economy.
• In addition, the financial system assesses and transforms economic exposures. In addition, financial intermediaries play an important role in transforming savings in an economy into investment. Some financial intermediaries, often banks, offer maturity transformation as a key service: they transform short-term deposits into longer-term lending. As part of this job, banks assess and manage risks of exposure to macroeconomic events (such as changes in interest rates or exchange rates) as well as microeconomic events (borrower specific effects).
• Financial balance sheets lack transparency, so financial systems are prone to contagion. A key feature of financial institutions is that their balance sheets are not fully transparent to the depositor, and truly cannot be made fully transparent, since financial intermediaries as a matter of course have access to privileged information. This lack of transparency combined with the on-demand characteristics of the funding base makes financial intermediaries prone to contagion.
• A national LOLR exists because distress at a single financial institution could spillover to other financial institutions, thus impairing the conduct of the whole system. Although financial institutions should accurately price and manage their own risks, no financial institution prices into its services the possibility that it will have to absorb the consequences of a spillover from another institution. Nor should it, since doing so would lead to an inappropriately high price and thus small amount of intermediation. Because the social value of the financial system as a whole exceeds the value created by individual firms, there is a rationale for centralized scrutiny and possibly intervention.

What instruments can a national LOLR use to prevent contagion or to intervene?

• Deposit insurance: Deposit insurance schemes is one approach to preventing contagion. Such schemes assure depositors that they will not lose the value of their savings even if the bank becomes unsound and is closed. Although depositors may not know which banks are sound and which are not, contagion is less likely.
• Equity cushion: Central banks can require an adequate equity cushion as one source of institutional strength. If risks are appropriately measured and provisioned, a greater equity cushion allows a financial institution to weather its own failings and some degree of generalized economic distress. Moreover, if more of their own capital is at risk, financiers may do a better job at assessing and managing exposures of their institutions.
• Liquidity support: Another approach to preventing contagion is for the central bank to stand ready to intervene and provide liquidity to a foundering institution. Depositors need not withdraw funds from the afflicted or other sound institutions, since such intervention can prevent the contagion from one institution to another.
• Arm twisting: Some financial systems have a limited number of actors. In this case, the public good nature of the financial system can be maintained, even in the face of a crisis, by the Central bank communicating with each of the market participants and requesting that they maintain their operations. Underneath is an actual or implied threat or assurance of Central bank reaction or support.
• Honest broker: Some financial disturbances start with a crisis of confidence, which may not have a real foundation, but which would have real consequences if not contained. In this case, a Central Bank can use its unique vantage point of the markets and individual financial actors to quell a financial disturbance by using its good name to assist in the unwinding of inter-related obligations. If there is no real foundation for the crisis, the Central Bank does not use its balance sheet in any way; simply by providing information it acts to restore confidence.

What are the consequences of these preventions or interventions?

• Moral hazard: The most important consequence of efforts to prevent contagion is that the financial institutions that receive actual or implied support may do a worse job of assessing economic exposure and therefore undertake riskier business strategies. Similarly, investors in financial institutions may not make a sufficient effort to distinguish among, or may ignore signals about, financial institutions since they believe they will be bailed out and not lose their funds.
• Incidence of loss or implied gain: If contagion is not prevented or even if it is, but certain institutions are closed, the incidence of the loss (and implied gain) across various segments of the population may be a relevant issue. This has more than a political dimension, since individuals in the market-place differ in their consumption and savings profile. For a national financial system and national LOLR, the incidence of loss and gain is likely to be mostly among domestic residents. As the share of foreign depositors increases or the importance of foreign financial intermediaries increases, the incidence of impact of national LOLR support can become much more complex, and international.

What supporting structures are necessary for a LOLR to intervene and to balance moral hazard with the social value of the financial system?

• Supervision and regulation: Because financial institutions might respond to actual or implied Central Bank support by following riskier business strategies, supervision and regulation of their activities is usually required. Central Banks have noted that the effectiveness of specific regulations on "exposures" has been undermined as financial innovation proceeds and as technical expertise of financial intermediaries increases. Consequently, regulation has increasingly focussed on risk management techniques, as opposed to "reducing" risk through numerical targets on exposures.
• Market discipline: Some countries encourage greater transparency of financial intermediaries using market discipline, such as rating agencies, to provide depositors with the information necessary to make informed choices about the risk and return profiles of alternative repositories for their funds. The market information should encourage depositors or investors to "beware"; those who take risks to earn higher returns might not be able to get their savings on demand or at its full value.
• Liquidity and taxing authority: In certain cases, a national LOLR may intervene by providing liquidity to either specific institutions or the marketplace more generally. In order to do so, it must be able to create liquidity. Or, a LOLR (or related authority) may choose to restructure financial institutions. Doing so may require funds, which the Central Bank may not wish to create. Taxing undertaken by the fiscal authority is one approach to such restructuring.

The purpose of setting out the role, instruments, and supporting structures for the national LOLR is to put into sharp relief what attributes the IMF brings, or does not bring, to international financial crises.

Does the international financial system need a LOLR? Is the IMF it?

• Intermediaries in the international financial system assess and transform economic exposures. But international actors need not imply that an international LOLR is needed. While there is no parallel in the international context to the conduct of national monetary policy, the international relationships and capital flows within and among national financial and corporate entities are increasingly important for global growth. These financial intermediaries transform savings in one economy into investment in another, which (at least in theory) yields higher returns than could be obtained within national boundaries. However, each of these international firms has a national LOLR; what is the value-added of an international LOLR?
• Cross-border financial intermediation can involve multiple currencies; in times of crisis, does the national LOLR have access to the currency to match the obligations of its distressed institutions? In the international context, not only do financial intermediaries offer maturity transformation, but transformation of currency exposures are key. As international trade in goods and services continues to grow faster than world output, the demand for these financial services increases. A national LOLR may wish to support a particular institution to contain a crisis, but not have access to the currencies of the open obligations. "Swap" networks among Central Banks can serve this purpose, but the amounts are limited. Whereas the IMF has access to many currencies through its callable capital, some currencies have rather little value in an international crisis. If an international LOLR were created, who would decide how much of a war-chest and of which currencies to have on hand?
• Transparency of balance sheets is worse, but would an international LOLR have better information than any of the national LOLRs? Financial institutions participating in the intermediation of savings internationally are perhaps the least transparent of all financial institutions. Some of these institutions operate on the fringes of the national LOLR's supervisory and regulatory environment. The IMF does not have access to these institutions, and is difficult to imagine how a supra-national international LOLR would obtain more detailed data than do national LOLRs. Can't national Central Banks work together (such as though the lead regulator concept broached by some Central Banks) to assure that an appropriate level of financial services is being provided and is appropriately supervised?
• International financial systems are prone to contagion; is an international LOLR needed to avoid coordination failures among national LOLRs? There is clear evidence that failures in one national market can affect other national markets through contagion of financial institutions as well as through capital markets. Nevertheless, a coordinated response of national LOLRs could obviate the need for an international LOLR. But, is an international LOLR, a single (independent?) institution, needed because national authorities may be unable to agree on an appropriate response within a time frame necessary to prevent disastrous contagion? Coordination failures among national institutions are a distinct possibility, due in part to the differences in behavior and mandate of national LOLRs. Moreover, in some cases, if a domestic crisis becomes an international one, it may indicate the failure of the national LOLR. In both cases, the IMF may be called upon, but it is not the independent supra-national authority that may be needed.

What instruments could an international LOLR use to prevent contagion or to intervene?

• Some of the mechanisms or instruments of the national LOLR are not available to an international LOLR, or have already been addressed by the Bank for International Settlements (BIS). National mechanisms, such as deposit insurance are not available to the IMF, although they in principle could be given to an international LOLR. For example, George Soros has suggested an international insurance agency that would guarantee international loans for a fee. However, the extent to which such schemes reduce or magnify financial distress is not clear, so extending them internationally may be the wrong direction, particularly in the absence of supervision. G-10 central banks, working through the BIS, are implementing in their own markets the Basle Accord on Capital Adequacy, which sets guidelines for both provisioning and equity capital that these central bankers see as minimum equity exposure. What additional role would an international LOLR play?
• Without a supra-national money, an international LOLR would be unable to offer true liquidity support. The IMF does have SDRs, although it cannot issue them at will. It can issue debt, although has never done so. It could activate its lines of credit (such as the GAB), but would have to get permission. Within its current set of constraints, the IMF has used its role as coordinator and as honest broker, perhaps with inside information on the actual situation of countries, to channel credit to governments.
• There is no international fiscal authority to finance the costs of intervention nor to ameliorate imbalances in the incidence of costs and benefits of intervention. If liquidity is not provided, financial institutions can be restructured through fiscal spending. IMF lending in support of financial sector adjustment programs allows governments to shift their national burden through time, but the burden is retained within a country. In order to share the overall burden of restructuring with international players, a complementary international fiscal authority would be needed. Arguably when some private sector financial intermediaries agree to rollover and reschedule debt it does alter the incidence of loss. Moreover, when the IMF has helped coordinate international debt reschedulings, it has performed some of the same functions as a fiscal authority, but without the ability to tax. To do more and in a less ad hoc way an international fiscal authority would be needed.

Do supporting structures exist to help an international LOLR balance the costs of moral hazard against the public good nature of the international financial system?

• The Basle Core Principles represents an effort to "internationalize" supervision and regulation. However, it falls to the national LOLRs to enforce the rules. There is no supra-national authority that can supervise individual financial institutions and close them when appropriate. Any such authority, or even a lead regulator, would have to operate within the national LOLR and regulatory presence and structure.
• Financial crises are a "repeated game"; LOLRs only have credibility if they can enforce the rules day after day, not just in times of crisis. The national LOLR has privileged information to know which institutions are at greatest risk. It, or related authorities, can supervise these most closely, and take prompt corrective action to improve or close an afflicted institution. The national LOLR and its associated supervisors are always present. IMF credit and conditionality are provided in crisis times and to governments, not intermediaries; no country subjects itself to conditionality without credit, and all countries step down from IMF conditionality as soon as possible. For these reasons, any international supervisory agency would lack credibility and force.
• The IMF data standards initiative and greater activity by international rating agencies represent efforts to increase market discipline. But, no supra-national authority can demand compliance and transparency without the ability to deliver liquidity when needed; that is the quid-pro-quo of supervision. As to the IMF's international data standards initiative, the accuracy of these data is questionable, its availability is spotty, and there is insufficient detail. International rating agencies face even greater hurdles, since they have even less to offer in return for access to information. Moreover, recent financial crises around the world have, more often then not, been associated with fraud or insider relations. Data provided freely may yield a less accurate picture than data collected by a supervisor.

What are the consequences of intervention by the IMF?

• The IMF is playing international LOLR, but without key supporting structures that help counter-balance moral hazard. Moreover, the incidence of gains and losses of international financial crises spread beyond national boundaries in important ways. Consequently, the situation that the IMF is responding to and the environment in which it operates magnify the moral hazard problems that are present with the national LOLR. The IMF, through its coordination of international credits, comes close to the model of the LOLR providing liquidity in financial crisis-though to countries not institutions. Through its conditionality it comes close to being the supervisor as well-although only for bad times, not all the time. Because of the fast-moving nature of these crises, the need for immediate and large injections of credit, and because sovereign nations are involved, the IMF is the only institution that can offer coordinated action, but it cannot effectively enforce its conditionality, in particular with regards to supervisory issues and restructuring of distressed financial systems. Adding to moral hazard is the fact that the incidence of loss or gain is spread internationally, and there is no quasi-fiscal authority that can redistribute it to, perhaps, the investors and institutions who "should" bear the losses. These problems existed in the context of the Mexican bailout and no changes were made to alter the equation; consequently, it should come as no surprise that few investors thought that the international financial institutions would stand aside for long as the Asian countries tilted one after another into financial collapse.

What is to be done? A greater role for the private sector.

• International lending of last resort will occur. The issue is how to compliment the IMF's role as coordinator of credit with greater discipline over moral hazard. It is unrealistic to suppose either that there will be no international lending or last resort or to suppose that the supra-national authorities that are need as a counter-weight to moral hazard will be created. Countries and their companies will be supported in times of financial distress because of the possible international systemic consequences.
• Creating financial instruments that better match risk and return will offer transparency and provide market discipline that will reduce moral hazard. A market mechanism needs to be developed that better prices risk and return so that institutions and investors that make risky choices are rewarded for risk, but do not get bailed out. One approach is to encourage the "financial engineers" to create financial instruments that differentiate better among sovereign and corporate obligations, and differentiate according to the terms of repayment. Examples are credit insurance and roll-over insurance. Such explicit tiering of debt was considered following the Mexican bailout; some complex instruments have been used by Japanese financial institutions to raise capital; and now "credit insurance" options have been created that allow pension funds to hold Asian bonds that have sunk to "junk" status. In brief, these obligations differentiate across how the debt would be treated in the case of financial distress and this tiering would be priced into the instrument. Other types of enhancements include debt that is explicitly subordinated, or transferable into equity of the corporation. There has been some experience with a type of tiering for sovereign obligations by the World Bank's Multilateral Investment Guaranty Agency (MIGA). The Brady Bonds are another example of tiering. The secondary market in Asian corporate debt and in Latin American sovereign debt before that, are examples of ex poste market response.
• A key issue is how to encourage the development of such instruments; look to the market. The more difficult, drawn-out, and ad hoc are the ex-poste financial-disaster workout process and procedures, the greater are the incentives for the market to create ex-ante tiered instruments. In this regard, the Korean "back-room" negotiations with the creditors solves their problems, but does not give the market the rationale to create new insurance instruments. On the other hand, Indonesia's hands-off moratorium might get us there. In any case, whether any such market-oriented strategy reduces dependence on international lending of last resort will not be known until the next financial debacle.