Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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Author(s)
EDUARDO FERNÁNDEZ-ARIAS1

This paper concentrates on taking stock of recent international initiatives to strengthen the financial system and the role that the IMF has played, and will play, in them, especially in the context of surveillance. The initiatives covered are of two types: (1) those to assess the risk and vulnerability of financial sectors; and (2) those to develop standards and codes to foster sound financial systems. The paper does not attempt to analytically review the content of the initiatives, but rather “overviews” them, except in a few passing references in the closing section on remaining challenges.

If the authors’ objective was to summarize the recent actions taken by the IMF and the international community concerning financial system stability, then they have largely succeeded. Except for some omissions outside the realm of regulation, supervision, and surveillance, such as IMF’s own Contingent Credit Line program, the authors’ account appears comprehensive. Within this narrow descriptive objective there is not much for me to comment on, other than adding details.

Therefore, I will focus my remarks on the many issues involving international cooperation for financial system stability that are not addressed in the paper. In fact, the title led me to expect a much more ambitious scope for this paper. Readers like myself concerned with international financial turmoil over the past few years would be interested in a discussion of whether the initiatives undertaken are an effective solution to the problem and whether there are effective international cooperation initiatives that are not being explored. Correspondingly, I will tackle, in turn, each of these issues, i.e., whether the initiatives undertaken are a solution to the problem and whether there are international cooperation initiatives worth exploring that are currently outside the “radar screen.” (These remarks draw from recent papers I wrote with Ricardo Hausmann for the International Forum on Latin American Perspectives, a seminar co-organized by the IDB and the OECD Development center, to which the reader is referred for further elaboration.)2

Are Current Initiatives a Solution to the Problem?

It cannot be debated that, by and large, risk assessments and the development of standards and codes will contribute to less risky and vulnerable financial systems.3 But that is not enough to be satisfied. Will the implementation of these initiatives prevent recent international financial turmoil from reoccurring—that is, is this medicine effective to cure the disease? How costly will these initiatives be in terms of less financing and less international financial integration—that is, how severe are the side effects? And, since we are talking about international cooperation, how will the standards be enforced if countries do not like them—that is, can the patient refuse the doctor’s treatment? Each of these areas is of concern.

Is the Medicine Effective?

The effectiveness of the medicine is quite doubtful. Recent experience in Latin America is a case in point. By and large, Latin America has moved in advance of most of the new standards on bank regulation and supervision, especially after the Mexican Tequila crisis. In fact, most Latin American countries have capital adequacy requirements that are above Basel standards, and supervisory systems have been thoroughly reformed. The prudence of liquidity regulation and policy in countries like Argentina would set a world record. This explains the resilience of the banking systems in the region during the recent financial turmoil and recession in 1998-99; in countries like Argentina, this experience was completely opposite the experience during the Tequila fallout in 1995. However, while this has made banks stronger, it has not led to more stable flows of international capital or spared countries from recession and crisis. Hence, while the new medicine remains quite uncontroversial in the region, it is unclear whether it does much to limit international financial turmoil.

In my view, the medicine will have only a modest effect because it is predicated on a wrong diagnosis of the disease. New financial standards on information, prudential regulation, and supervision are an adequate response to recent crises and turmoil only if moral hazard and lack of information are at the root of the problem. Under this interpretation—which in my view is the gist of the IMF’s current diagnosis—the main problem to tackle is the set of distortions preventing the display of market discipline. Correspondingly, the initiatives undertaken, plus the elimination of IMF rescue packages as an additional source of moral hazard in private financing (as it has been announced), would solve the root problem. The result would be the elimination of excessive capital flows and the drastic reduction of the risk of crisis. However, are moral hazard and misinformation the problem and, correspondingly, market discipline without official intervention the solution?

There is no evidence that moral hazard and lack of transparency are the main culprits in recent financial problems. Prudent financial policy in Latin America and proven fiscal discipline in recent years do not square well with the moral hazard hypothesis. A number of other pieces of evidence also point to its relative unimportance. First, the composition of capital inflows in emerging countries, relative to industrial countries, is not skewed in favor of types more likely to be covered by domestic guarantees, such as borrowing by banks and short-term flows, but rather the opposite. The new players in the 1990s, stockholders and bondholders, were also the ones who suffered the largest losses. Second, the historical record shows very large capital flows and frequent crises without any IMF-induced moral hazard. Third, even if moral hazard is relevant for the explanation of the East Asian crises, the fact that these countries have the most successful sustained growth record in known history under the same regime now being discredited should make us pause.

An alternative interpretation is that crises in the new world financial order are, to a large extent, characterized by self-fulfilling panic runs at the domestic level, leading to some combination of payments, currency, and banking crises, and by foreign investors subject to liquidity constraints leading to international financial contagion. This interpretation would account for the difficulty in reconciling economic fundamentals with financial crises and contagion. Most financial difficulties were not the necessary consequence of weak fundamentals. Rather, they resulted from inherently fragile domestic financial systems due to unavoidable aggregate currency mismatches generated by foreign currency-denominated capital inflows, and from highly leveraged, specialized foreign investors. Ultimately, at the root of this unstable financial system, there is sovereign risk, which severely limits the enforcement of cross-border contracts and financial integration.

How Severe Are the Side Effects?

Even if moral hazard and misinformation are not the main factors to be addressed, it is clear that sufficiently tight standards and regulations could reduce the risk of financial crisis. In the extreme, financial autarky, and more generally, the choking of financial activity, would eliminate financial crises. Evidently, this caricature is not applicable to the initiatives being implemented. But it should also be equally evident—and sometimes it is not—that an assessment of these initiatives needs to go beyond their effect on the risk of crisis and to look at their side effects on financial activity and development. Some of the initiatives, such as those on transparency and accounting, appear uncontroversial, if feasible. But some others, such as those on regulation, entail a higher cost of capital and, beyond a point, may be losing propositions. And the elimination of international rescue packages would shut off the only channel of liquidity support available in times of crisis. If, as advanced, liquidity crises and contagion are prevalent in today’s emerging markets, this side effect may easily outweigh the reduction in moral hazard and make the policy change counterproductive (and increase risk).

Given the degree of instability of financial markets and the limited access to financial markets that, for reasons beyond their control, emerging markets have to endure, it makes sense that, as a second-best proposition, their prudential regulations, e.g., solvency and liquidity standards, be more stringent than in OECD countries. And they are. Banking regulations in Latin America are typically more stringent in both capital requirements and, especially, liquidity. Countries keep inordinate amounts of international reserves, in the order of one-third of the M2 monetary aggregate, and in many cases have taxed short-term inflows. In fact, even in the midst of financial contagion, Latin America has complied with the “Guidotti rule” of matching short-term debt with reserves.

But it is important to recognize that all of these precautionary policies are costly in terms of the cost of capital and the degree of international financial integration. If these costs are not explicitly recognized, regulation standards are bound to be excessive. And perhaps even more important, the justification of these regulation standards is based on second-best arguments that take as given the underlying limitations of emerging markets in coping with financial stress. The implication is that, if feasible, the most direct course of action to strengthen financial systems is not to beef up regulation but to relax some of these underlying factors.

Patients’ Rights

For those convinced of the adequacy of the new initiatives, it may be tempting to use the institutional power of multilaterals to enforce compliance—for example, through conditionally. There are, however, two objections to this viewpoint. First, the convinced may be wrong. Given our degree of ignorance about the roads to successful development, of which the demotion of the Asian tigers to pet cats is one more proof, we should be reluctant to push any global standards in countries that do not voluntarily embrace them. And second, costs and benefits may be felt differently in Washington and in the field. Strict enforcement of standards eliminates potential Washington headaches at no visible cost. At the same time, some of the domestic financial standards involve potential international spillovers (e.g., a “contagious financial infection”) and nonvoluntary enforcement may be justified on the basis of this externality. The paper missed an excellent opportunity to discuss this key issue.

International Cooperation Beyond Current Initiatives

There are a number of additional avenues to explore that, on the basis of the alternative diagnoses offered above, are arguably more fruitful than the ones already walked. I group them in two clusters: (1) the financial institutional framework, and (2) official financial support and private sector involvement.

Financial Institutional Framework

Current initiatives include a good number of useful reforms in financial institutions of emerging markets but are much less concerned with reforms in financial regulation in developed countries. In my view, this imbalance is not justified, since many of the failures leading to recent financial turmoil had their origin outside emerging markets. Therefore, the first remark to be made is that international cooperation needs to focus on how to fix financial systems in developed countries, at least as they relate to emerging markets.

Current initiatives are aimed at reducing the risk of crisis by increasing the regulatory price of risk or limiting the leverage of international investors. These initiatives reduce risk by implicitly taxing capital inflows. I would suggest addressing more specific failures in ways other than increasing the cost of capital for emerging markets. For example, regulation could ameliorate the sell-off of emerging market paper and allow or encourage more lending at times of generalized financial contagion, breaking the vicious circle of lack of liquidity that gives rise to these unnecessary collapses in financing. One obvious way is to introduce regulatory forbearance for emerging market lending contingent on international financial contagion. Another way would be to allow institutional investors to have some marginal exposure to non-investment-grade paper, whose level may also be contingent. Such allowance would have an immaterial impact on investors’ portfolio risk but would help enormously in developing a liquid secondary market for emerging market paper.

Finally, it is clear that exchange rate arrangements are key for the vulnerability of financial systems. Within the moral hazard hypothesis, the argument has been made that pegged rates amount to an implicit guarantee that generates moral hazard, if the peg is seen as unsustainable—the implication being that currencies should float. The opposite argument has also been made that anything other than hard pegs induce financial uncertainty, shallowness, and vulnerability to currency depreciation—the implication being that, ideally, currencies should be given up for strong foreign currencies. While recommendations are debatable, it is clear that monetary arrangements and the scope for international cooperation in this regard are central to the problem, yet they remain outside the radar screen of international architecture reform.

Official Financial Support and Private Sector Involvement

The main idea concerning official financial support is the need for the function of lender of last resort at the international level. It is well known that that type of institution is the ideal solution for liquidity crises, i.e., those in which solvency is maintained if access to liquidity is adequate. To the extent that panic crisis and financial contagion are prevalent features of the new financial landscape, international cooperation along these lines, be it in the head of the IMF or regional funds, suggests itself. The main risk is that liquidity is provided in a case of insolvency, which would be costly ex post and would generate moral hazard ex ante. Since collateral is difficult to provide internationally, this risk needs to be mitigated by eligibility conditions based on solvency and prudent financial policy.

The Contingent Credit Line approved by the IMF is a substitute for a full-fledged lender of last resort. However, it has not attracted much interest so far. It is important to explore the reasons why it has not worked. I suggest the following two. First, it does not offer a firm commitment of support because there is a final determination of eligibility and amounts. Uncertain liquidity support is not an effective deterrent of crisis. Eligibility and ample access needs to be unambiguously established based on preconditions, which, as a bonus, would provide incentives for good behavior. Second, no country wants to be the first to ask for membership for fear of giving a signal of weakness. A mechanism needs to be designed by which a set of countries is declared automatically eligible. Furthermore, it is important that the private sector be given a cofinancing role; Argentina and Mexico have proved that the private sector may be willing to offer this insurance for a fee when arranged in normal times. Private cofinancing would allow larger volumes to achieve required levels for the program to be effective and would ensure that the financial terms of official support are not subsidized.

The above is a constructive case of private sector involvement arranged in normal times. It is well known that crises are very destructive once they are unleashed, so it pays to concentrate on this kind of prevention mechanism. Nevertheless, if and when a crisis strikes, especially if it is a solvency crisis, it is critical to have a plan B, in which the private sector also needs to be involved to ensure an efficient workout. The key factor here is to coordinate private participation in a comprehensive fashion, avoiding free riding, in a financial package in which the official sector takes the leading role in ensuring adequate country reforms and financing.

The main idea to explore in this regard is that of an international bankruptcy court, which would produce legally binding rulings on stays of payments or other workout formulas when it finds the default to be “excusable,” i.e., not opportunistic. True, sovereigns can unilaterally declare a stay of payments (moratorium), but its lack of legal standing makes this route uncertain and inefficient. This mechanism has a number of advantages relative to other proposals aimed at making private contracts more flexible. First, it is comprehensive across creditors, eliminating free riding and distortions, and solves the collective action problem of no country being willing to be the first to introduce changes. Second, it removes the incentive for governments to exploit flexibility opportunistically and, therefore, does not aggravate the sovereign risk distortion at the root of financial instability.

An international bankruptcy court provides the ideal framework for international cooperation between the official and the private sector (and the country). In its absence, the official sector is forced to choose between supporting the country and effectively bailing out the private sector, thus causing financial inefficiency and moral hazard, and forcing private sector participation in a largely arbitrary fashion as a precondition for official support to the country. In this second case, which to a large extent was unfortunately experimented in Ecuador and I fear may become a new doctrine, the official sector relinquishes its leading coordinating role and unnecessarily increases the perceived risk of the private sector, thus causing worse future access to external financing to emerging markets.

The views in this note are personal and do not necessarily reflect those of the the Inter-American Development Bank (IDB) or its Board of Directors.

The papers are “What’s Wrong with International Financial Markets” and “Getting it Right: What to Reform in International Financial Markets,” available at http://www.iadb.org/res. These papers are included in the IDB-OECD seminar volume on Global Finance from a Latin American Viewpoint.

It is true that in theory more transparency may increase volatility and more information may be counterproductive when there is asymmetric information, but until someone is able to show that in practice these second-best results are more than a curiosity, they will remain irrelevant.

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