Market Oriented Solutions to Financial Crises
Statement presented at a conference sponsored by Heinrich Boll Foundation and Friends of the Earth
© Peterson Institute for International Economics
In thinking about the plethora of "solutions" to the recent (and not so recent) financial crises, we should distinguish between proposals that make individual borrowers and lenders more robust to crises or less exposed to crises vs. proposals that make the financial system more robust to crises or less prone to crises. Although many think that the financial system is merely the sum of its parts (so that proposals that focus on the individual will aggregate up to the system), in fact this is not completely true. The financial system is greater than the sum of its parts because of the important interlinkages between the financial intermediaries and instruments. That said, some of the proposals do overlap and would benefit both individual participants as well as the system as a whole.
A second issue is that we need to distinguish between proposals designed to ameliorate the current crises vs. proposals designed to improve the environment so as to avoid these crises from happening again. As it turns out, it may be necessary to deviate from the principles laid out for the latter in order to move ahead on the former.
Some background: On financial markets and underpinnings of crises
Before we address solutions, need to review some fundamentals of what a financial system does, what makes it work well, and why the global financial system matters: Institutions in the financial system transform savings into investment opportunities. The critical role is to price and manage risk. Financial intermediaries take on risks-it is what they are supposed to do.
Financial markets work best-(1) If the participants have full information to assess and price risk; (2) If there is heterogeneity among market participants in desires for risk and return; and (3) If there are a full set of financial instruments that span the spectrum of risks.
But, whereas 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 negative 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.
In today's global environment, national economic well-being increasingly relies on global production, distribution, consumption, and the web of international financial transactions that binds it all together. Contagion from a one national market to other national markets and the international financial system obviously happens and with great detriment to countries and to the system. 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 international financial intermediation-and the cost of a collapse of the international financial system cannot be risked.
Review the underpinnings of the recent crises and the peso and ERM crises
On the borrowers side: Some borrowers chose to liberalize short-term capital inflows first (Thailand's offshore banking units, Korean restrictions on FDI but not on short-term overseas borrowings by corporates). Moreover, some borrowers chose to limit information and instead offer incomplete or wrong information that was revealed only very slowly. Finally, some borrowers created "one-way bets" in their choice of fiscal and monetary policy (U.K., Korea).
On the lenders side: Market participants have been more herd-like than heterogeneous. The very narrow risk spreads on emerging market debt in early 1997 and the huge risk spreads following the collapse of the Russian rescue effort point to lack of differentiation among borrowers as well a swing in collective sentiment completely out of line with changes in the underlying economic prospects of many of the countries caught in the maelstrom.
In the financial market generally: The market for financial instruments is incomplete, lacking in particular financial insurance against the rare events of credit downgrade or restructuring (e.g. delay in payment or rollover) of, in particular, short-term obligations.
Review the proposals: for borrowers, for the financial system, and for lenders
How do G22 proposals alter the robustness or exposure to shocks of lenders and borrowers? Most of these proposals focus on the borrowers. G-7/G-22 proposals for transparency and disclosure, international banking standards, enhanced banking scrutiny and risk management etc. are all well and good since this information helps lenders price risk and borrowers assess risks. Moreover, the more stable are banks, the more likely the financial system can withstand shocks. For example, when ERM failed, financial systems of Italy and UK did not fail.
A proposal that has received relatively minor mention (both in the current set of proposals and the earlier G-10 Working Party Report (Reye Group)) should receive greater attention, despite the political sensitivities: Increased foreign participation in domestic financial markets will further the objective of achieving stable domestic banking systems.
- Financial intermediaries (FIs) with a stake in the country are less likely to leave in the case of a shock (Korea, for example).
- FIs with global presence have broader capital base, which means the domestic system is less exposed to shocks.
- FIs with global presence have built in regulatory scrutiny. Granted that there have been some spectacular failures (Barings, Daiwa). But, these failures remained well contained; are notable for their rarity.
- FIs with global presence help teach domestic FIs critical banking skills.
- FIs with global presence do not eliminate domestic FIs or reduce the ability of the domestic central bank to conduct monetary policy because the global entities must work with the unique information available to fully domestic firms.
Why are capital controls not the answer? It is obvious when external shocks hit the domestic system. But capital controls limit the learning process, which is key to getting the banking system on a sound footing and able to price and manage risks. In addition, capital controls protect inefficient banking systems, and those costs pervade the whole economy. Ultimately termites cause as much devastation as an earthquake.
What role is there for the IMF? Given the role of financial intermediation in growth, we want to avoid breakdown of the financial system. A single supra-national credit institution is needed because national authorities may be unable to agree on an appropriate response within a time frame necessary to prevent disastrous contagion. 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.
However, the IMF operates without key supporting mechanisms of a constant supervisory presence and a fiscal redistributive authority that are integral to the environment of the national LOLR and which mitigate moral hazard. Consequently, IMF intervention in the current international financial environment magnifies moral hazard. 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.
What about market-oriented solutions? The financial markets are large and play a powerful role in credit allocation-the objective of a market-oriented solution is to make the market work better. Financial insurance instruments could help mitigate moral hazard and stabilize the financial system. Financial insurance instruments help "complete" the set of financial instruments to manage risk.
How would financial insurance instruments, such as credit risk insurance or restructuring insurance, help mitigate moral hazard and stabilize the international financial system? These instruments differentiate the market participants. In addition, they are designed to split the distribution of outcomes into two pieces which can then be priced separately: the average outcome (the center of the distribution) and the rare outcome (the tail). Bond and loan instruments have only one price that must span the whole distribution.
Not all borrowers would offer insurance, not all lenders would buy it. But for those that did, when the financial crisis hits, the insured lenders will not abandon the insured borrowers, at least not for the duration of the policy. For the duration of the policy, the insured lender will be made whole through the pay-out of the insurance policy against the rare event. This could significantly alter the herd mentality in the market by diversifying the exposure of market participants and by moving risk from those who fear it to those who manage it. This change in the pace of race to the exits could dramatically alter the self-fulfilling nature of some financial crises. Moreover with at least some lenders buying insurance, intervention by the lender of last resort would be less frequent and moral hazard reduced.
Can these instruments be created ex-ante the next financial crisis? Before this crisis, volatility in the foreign exchange market created the incentive for currency swaps and options so that investors could pay for insurance, in advance, against unexpected movements in exchange rates. Similarly, the more difficult, drawn-out, ad hoc, and therefore costly are the financial-disaster workouts, the greater are the incentives for investors to demand and institutions to offer instruments ex-ante that will help generate a market-oriented solution to the workout process. Perhaps the Asian financial crisis has got us nearly to this point-perhaps Indonesia's hands-off moratorium and Russia's default will get us there faster.
As to whether a market-oriented strategy reduces moral hazard and dependence on international lending of last resort-we will have to await the next financial debacle.
Towards a Better Functioning International Financial Market: Getting from Here to There
How can we get through this crisis while setting up the correct set of incentives to avoid the next one? There are two phases: Phase one deals with the existing exposures, with a large dose of private sector input. Phase two is set out above.
Phase One is getting out from under now: The private sector should play a key role with IMF and BIS to restructure existing debt. Debt should not be written off for countries and companies that have the capacity to repay, which is all the countries, probably most of the corporates who borrowed directly, but perhaps not all of the financial intermediaries. For sovereign and corporate-cum-sovereign debt, the IMF along with the BIS-Joint Forum (public accounting firms and financial specialists meetings under the auspices of the BIS) should come up with a set of guidelines to reschedule the debt for longer maturities, transfer it into equity, or some combination such as debt with equity warrants. This is akin to Chapter 11 restructuring of debt of on-going institutions.
The IMF is needed because sovereign nations are involved, but private sector expertise is needed for the complex internal analysis of the firms and the types of financial workout instruments. The Joint Forum under the auspices of the BIS has been addressing issues of this type for several years, although more in the context of industrial country markets and without the duress of a crisis at hand. Nevertheless, this is an on-going operation and their human capital should be brought to bear on this situation.
Debt of insolvent financial intermediaries and assets (loans) of financial intermediaries to corporates that have no hope of surviving should be transferred to a workout institution and sold for market price. To maintain the balance sheet of on-going financial intermediaries, the junk assets should be replaced by bonds of the workout institution, probably government bonds or government guaranteed bonds. Financial specialists (junk bond artists) can take a hefty fee, if required, and the government should not intervene to set a floor price or otherwise interfere with this market on nationalist grounds.
The fiscal cost of the bonds used to replace the assets on the balance sheet of the financial institutions represents the current cost of previously incurred liabilities and therefore should not count against the fiscal targets of an IMF program.