Benedikt Zanker

On the Viability of an International Lender of Last Resort

Baden-Baden Nomos Verlagsgesellschaft, February 2007, 374 Pages ISBN 3-8329-2568-6 [AMP, Bd. 73]

Over the last decade the global financial system has been shaken by financial crises in emerging economies all over the world. The result of these crises has been turmoil in financial markets, a severe deceleration of economic growth and hardship in the economies involved. The International Monetary Fund was quickly identified as a main culprit and has been the subject of intense debate ever since. While a consensus has developed that the Fund is in need of wide-ranging reforms, an agreement on which reform path to follow is still lacking. An often recurring proposal is to restructure the IMF into an international lender of last resort along the lines developed by Walter Bagehot, then editor of the Economist, in the late 19th century. Although this proposal appears initially suggestive, it has been frequently dismissed out of hand as unrealistic by policy makers as well as academics. "On the viability of an international lender of last resort" analyses in detail whether this dismissal is founded or whether a rigourous reform along Bagehotian lines could indeed help to increase the stability of the global financial system.

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Table of Contents

Acknowledgements
p. 13

1. Introduction and Theory
p. 15

1.1 Introduction
p. 15

1.2 Theory
p. 20

1.2.1 Regime Theory
p. 21

1.2.2 Public Choice Theory
p. 25

1.2.2.1 Global Public Goods
p. 27

1.2.2.2 Moral Hazard Problems
p. 29

1.2.2.3 Principal-Agent Problems
p. 31

1.2.3 Financial Market Theory
p. 33

1.2.3.1 The Efficient Markets Hypothesis
p. 34

1.2.3.2 The Financial-Instability Hypothesis
p. 37

1.2.3.3 Rational Herding
p. 39

1.3 Structure of the Analysis
p. 42

2. Financial Crisis Theory
p. 47

2.1 Financial Crises in an International Context
p. 49

2.1.1 Four Types of Currency Crises
p. 50

2.1.2 The Problem of Contagion
p. 52

2.2 Three Generations of Financial Crisis Models
p. 53

2.2.1 First Generation Models
p. 54

2.2.2 Second Generation Models
p. 56

2.2.3 Third Generation Models
p. 58

2.2.3.1 Macroeconomic Feedback Models
p. 58

2.2.3.2 Bank-run and Liquidity Models
p. 59

2.2.3.3 Models of Expectations Formation and Herding Behaviour
p. 60

2.3 Evidence and Evaluation
p. 62

2.3.1 Empirical Evidence
p. 62

2.3.2 Evaluation
p. 63

2.3.3 Lessons and Implications
p. 66

3. Selected Proposals to Increase Global Financial Stability
p. 68

3.1 General Proposals to Increase Global Financial Stability
p. 68

3.1.1 Improved Transparency and Higher Regulatory Standards
p. 68

3.1.2 An International Credit Insurance
p. 71

3.1.3 The Tobin Tax
p. 72

3.1.4 A Global Central Bank
p. 74

3.1.5 A World Currency
p. 75

3.2 Proposals Addressing the Role of the IMF
p. 76

3.2.1 A Sovereign Debt Restructuring Mechanism
p. 77

3.2.2 The Calomiris Proposal
p. 78

3.2.3 The Report by the Independent Task Force
p. 80

3.2.4 The Meltzer Report
p. 84

3.2.5 The Köhler Approach: Procedural Changes
p. 86

3.3 Conclusion
p. 88

4. The Lender of Last Resort: The Concept in Theory
p. 90

4.1 The Importance of Foreign Currency
p. 90

4.1.1 Enhancing Access to Foreign Currency
p. 91

4.2 The Concept of a Lender of Last Resort
p. 92

4.2.1 Henry Thornton (1760–1815)
p. 93

4.2.1.1 Issues in Last Resort Lending
p. 94

4.2.1.2 Individual Institutions versus the Monetary System
p. 96

4.2.1.3 Contemporary Response
p. 97

4.2.2 Walter Bagehot (1826–1877)
p. 98

4.2.2.1 Lending Freely
p. 100

4.2.2.2 Penalty Rates
p. 101

4.2.2.3 The Collateral
p. 102

4.2.2.4 Financial Stability after 1866
p. 103

4.3 An International Lender of Last Resort
p. 104

4.3.1 Theoretical Considerations
p. 105

4.3.2 The Case for an International Lender of Last Resort
p. 107

4.3.3 Fundamental Differences between International and Domestic Settings
p. 109

4.3.4 The IMF as International Lender of Last Resort
p. 111

4.3.5 The Fund’s Record as Crisis Manger
p. 113

5. The Lender of Last Resort: The Concept in Practice
p. 117

5.1 The Panic of 1907
p. 117

5.1.1 The Setting
p. 118

5.1.2 The Run on Banks and Trust Companies
p. 120

5.1.3 Pressure on Money, Stock and Call Loan Markets
p. 121

5.1.4 Lessons of 1907
p. 123

5.2 The 1960s Sterling Crisis
p. 124

5.2.1 The Setting
p. 124

5.2.2 The Crisis
p. 125

5.2.3 Lessons of the Sterling Crisis
p. 128

5.3 Emerging Market Crises in the 1990s
p. 129

5.3.1 The Mexican Peso Crisis
p. 130

5.3.2 The Asian Financial Crisis
p. 131

5.3.2.1 Crisis in Thailand
p. 133

5.3.2.2 Crisis in South Korea
p. 134

5.3.2.3 Crisis in Indonesia
p. 136

5.3.3 The Asian Crisis’ Aftermath
p. 138

5.3.3.1 The Rouble Crisis
p. 138

5.3.3.2 Crisis in Brazil
p. 140

5.3.3.3 Crisis in Argentina
p. 142

5.3.4 Lessons from Emerging Market Crises
p. 143

6. The Principle of Lending Freely
p. 146

6.1 The Fund’s Resources
p. 147

6.1.1 Current Funding Needs of the IMF
p. 150

6.2 Funding Needs of an International Lender of Last Resort
p. 153

6.2.1 Lending-in-last-resort as Input in Monetary Policy
p. 155

6.2.2 Lending-in-last-resort as Input in Banking Policy
p. 157

6.2.3 Necessary Funding for an International Lender of Last Resort
p. 160

6.2.4 Estimating Short-term External Obligations in the Developing World
p. 161

6.2.5 Liquidity Gaps in the Past
p. 166

6.3 Conclusion and Implications
p. 170

7. The Collateral Question
p. 173

7.1 The Concept of Collateral
p. 174

7.2 Assets Acceptable as Collateral
p. 176

7.2.1 Financial Assets
p. 177

7.2.1.1 Argentina’s Contingent Repurchase Facility
p. 179

7.2.2 Collateralising Equity
p. 181

7.2.2.1 Privatisation in Latin America
p. 182

7.2.2.2 Privatisation in East Asia
p. 184

7.2.2.3 Privatisation in China
p. 186

7.2.2.4 Privatisation in Russia
p. 187

7.2.3 Securitisation of Future Flow Receivables
p. 188

7.2.3.1 Securitising Natural Resources
p. 189

7.2.3.1.1 The US-Mexican Framework Agreement
p. 190

7.2.3.2 Securitising Alternative Foreign Currency Receivables
p. 192

7.2.3.2.1 Telephone Receivables
p. 193

7.2.3.2.2 Workers’ Remittances
p. 194

7.2.3.2.3 Credit Card Receivables
p. 196

7.2.3.2.4 Taxing Export Earnings
p. 196

7.3 Problems Arising from the Imposition of Strict Collateral Requirements
p. 199

7.4 Implications for the Viability of an International Lender of Last Resort
p. 201

8. Pre-qualification
p. 203

8.1 Advantages of Pre-qualification
p. 203

8.2 Pre-qualification Criteria
p. 206

8.2.1 Transparency Criteria
p. 207

8.2.2 Criteria Ensuring Financial Sector Stability
p. 211

8.2.2.1 Capital Adequacy Requirements
p. 212

8.2.2.2 Minimum Reserve Requirements
p. 216

8.2.2.3 Internationalisation of the Financial Sector
p. 217

8.2.2.4 Deposit Insurance
p. 220

8.2.3 Criteria Indicating Sustainable Sovereign Indebtedness
p. 222

8.2.3.1 Solvency Ratios
p. 224

8.2.3.2 Liquidity Ratios
p. 226

8.3 Conclusion: Pre-qualification Is the Way Forward
p. 228

9. Moral Hazard
p. 230

9.1 IMF Induced Moral Hazard
p. 231

9.2 Empirical Evidence on Moral Hazard Issues
p. 233

9.2.1 Evidence on Creditor-side Moral Hazard
p. 234

9.2.2 Evidence on Debtor-side Moral Hazard
p. 241

9.3 Catalytic Finance
p. 244

9.3.1 Empirical Evidence on Catalytic Finance
p. 246

9.4 Instruments Mitigating Moral Hazard Problems
p. 249

10. Principal-Agent Problems
p. 253

10.1 The Actors’ Interests
p. 253

10.1.1 Interests of Borrowing Countries
p. 254

10.1.2 Interests of International Investors
p. 255

10.1.3 Creditor Country Interests
p. 255

10.1.3.1 Foreign Policy Objectives
p. 256

10.1.3.2 Financial Sector Interests
p. 257

10.1.3.3 Creditor Country Costs
p. 258

10.1.4 Evidence on IMF Lending Arrangements
p. 259

10.2 The Distribution of Voting Power at the IMF
p. 260

10.2.1 IMF Voting Weights
p. 261

10.2.2 Voting Power at the IMF
p. 264

10.2.2.1 Voting Power at the Board of Governors
p. 266

10.2.2.2 Voting Power at the Executive Board
p. 269

10.2.2.3 Constituencies at the Executive Board
p. 272

10.2.2.4 The Power of Industrialised and Developing Countries at the IMF
p. 273

10.3 The Case for Reforming IMF Governance Structures
p. 275

10.3.1 Governance Reform Proposals
p. 277

10.3.2 Political Difficulties
p. 279

10.3.3 Governance Reform and Pre-qualification
p. 281

11. Sovereign Debt Restructuring
p. 283

11.1 Debt Restructuring in the Past
p. 283

11.1.1 New Money Approach
p. 284

11.1.2 The Brady Plan
p. 286

11.2 The Changed Environment
p. 287

11.2.1 Successful Restructurings
p. 288

11.2.2 Problems due to Renegade Creditors
p. 290

11.2.3 Need for Reform
p. 293

11.3 Proposals to Facilitate Sovereign Debt Restructuring
p. 294

11.3.1 A Code of Good Conduct
p. 294

11.3.2 Collective Action Clauses
p. 297

11.3.3 A Sovereign Debt Restructuring Mechanism
p. 300

11.4 SDRM versus CAC and Code of Conduct
p. 303

11.4.1 Concerns on the Effectiveness of Collective Action Clauses
p. 304

11.4.2 Market-based Approach as the Way Forward
p. 309

12. A Proposal
p. 311

12.1 Underlying Principles
p. 311

12.1.1 Principles for Effective Liquidity Assistance
p. 312

12.1.2 Principles for Effective Monitoring and Supervisory Work
p. 313

12.2 Membership Rules for a Restructured IMF
p. 315

12.2.1 General Membership
p. 315

12.2.2 Access to Large-scale Liquidity Assistance
p. 317

12.2.2.1 Sovereign Stability Criteria
p. 319

12.2.2.2 Criteria Indicating Financial Sector Stability
p. 320

12.3 Lending Rules Governing IMF Facilities
p. 322

12.3.1 Lending Rules Governing PRGF and SBA Facilities
p. 322

12.3.2 Lending Rules Governing ELA Facilities
p. 323

12.3.2.1 Ensuring Liquidity Assistance in Sufficient Amounts
p. 323

12.3.2.2 Ensuring Liquidity Assistance Is Employed Effectively
p. 325

12.3.2.3 Reigning In on Debtor-side Moral Hazard
p. 326

12.4 Funding Issues and Transition Period
p. 327

12.4.1 Funding Issues
p. 328

12.4.2 Transition Period
p. 328

13. Epilogue: Chances of Implementation
p. 331

13.1 Opposition to Reform
p. 332

13.1.1 Opposition by Developed Countries and the G-7
p. 332

13.1.2 The Lacking Clout of Developing Economies
p. 336

13.2 The Potential for Gradual Reform
p. 337

13.2.1 Regional Monetary Cooperation
p. 338

13.2.2 Changes Inside the IMF
p. 341

Appendix
p. 345

Abbreviations
p. 345

Bibliography
p. 347

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