Global Financial Architecture - Article by Charles W. Calomiris
April 29, 2008 – 7:40 pmCharles Calomiris article on a New Global Financial Architecture from October 1998 is an interesting document, outlining the criticism of the International Financial Institutions (IFIs).
He starts with an interesting claim:
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.
Critique of the Global Financial Structure
The particularity of the financial crises in the late 1990s was the simultaneous collapse of banks and fixed exchange rates. Calomiris says that these were the reasons for these crises:
- Counterproductive financial bailouts of insolvent banks, their creditors, and debtors by governments, often assisted by the IMF, at large social costs because of the transfer of resources from average citizens to wealthy risk-takers through taxation and thus encouraging excessive risk-takings by banks and corporations relying on the financial safety net by governments.
- 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 or bank runs especially in emerging market economies, which can however be avoided if investors hold a diversified bundle of securities.
- 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, which can be avoided if countries have enough reserves.
- “Contagion” across countries in securities and loan markets increases the severity of the crisis.
- Because of IMF protection, the costs of liquidity risk from government depending on short-term debt are not internalized
He concludes:
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.
Instruments for a stable global financial system
According to Calomiris, regulation ought to avoid the moral-hazard problems and protect against the four “liquidity” problems that can magnify fundamental shocks. There is a need to find a balance between liquidity assistance and market discipline.
In order to find that balanced global financial safety net, three “tranches of risk” must be defined: private exposure, government exposure and international (IMF-type)-exposure to risk.
Bank regulation consisting of capital requirements, “reserve” requirements, deposit insurance and “free banking” (capital market liberalization for financial institutions that comply with regulatory standards. These regulatory requirements should be mandatory for IMF membership, Calomiris argues, 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 ensure a margin of protection for insured debt), and also enhance bank liquidity. Minimum amount of “global securities” helps to diversify bank risk.
For the government exposure to risk, he wants the IFM to set standards for debt management and exchange rate policy, central bank reserve requirements, and require governments to allow banks to offer accounts denominated in both domestic and foreign currency)
The IMF role would be to provide liquidity to central banks in cases of speculative attacks against an exchange rate peg. He proposes that the IMF operates a discount window when lending to central banks which are normally solvent, but at a penalty rate. The IMF would finance the lending by borrowing cash from the central-banks.
Calomiris acknowledges that sharing reaching a system is not easy, especially since it will be strongly objected by governments, central bankers, banks and regulators.
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