On the Need for an International Lender of Last Resort -- Stanley Fischer

IMF News, January 3, 1999

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On the Need for an International Lender of Last Resort -- Stanley Fischer

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Bibliographic details

• Published: January 3, 1999

Overview and context

• Speech prepared for delivery at the joint luncheon of the American Economic Association and the American Finance Association, New York, January 3, 1999.
• Motivating events: financial crises concentrated in emerging market countries over the preceding five years, including Mexico in 1994, East Asia in 1997 and 1998, and Russia in 1998, with notable contagion effects across regions.
• Central proposition: the international financial system needs an international lender of last resort; the IMF already plays important lender-of-last-resort functions and reforms can make that role more effective.

Domestic lender of last resort — role and operational rules

• Core functions and objectives:
  • Prevention and mitigation of financial crises defined as sudden actual or potential breakdowns of important parts of the credit system.
  • Restore confidence and steer the system toward a good (non-panic) equilibrium.
• Bagehot-derived operational rules (as summarized and developed by Meltzer):
  • Central bank is the lender of last resort in a monetary system such as that of the United States.
  • Lend on any collateral that is marketable in the ordinary course of business when there is no panic.
  • Make loans in large amounts, on demand, at a rate of interest above the market rate (penalty rate).
  • State these principles in advance and follow them in a crisis.
  • Insolvent institutions should be sold at market price or liquidated; losses borne by owners of equity, subordinated debentures, debt, uninsured depositors, and deposit insurance corporations.
• Six practical issues analyzed:
  • The central bank is historically not the only crisis lender or crisis manager (Treasury, clearing houses, private actors have filled roles).
  • Ability to create high-powered money helps crisis response but is not strictly essential if alternative funding is available.
  • Lending against collateral judged by normal-times value helps speed of action and reduces moral hazard.
  • The penalty rate is relative to normal-time market rates; in practice central banks have sometimes lent at non-penal rates.
  • Lending to the market versus to individual institutions: preferable to support market liquidity when possible, but failures of large institutions and externalities may require direct intervention.
  • Tension between specifying rules in advance and constructive ambiguity; central banks should specify general principles even if not full ex ante rules.

Moral hazard — sources and mitigation

• Definition and framing:
  • Moral hazard arises from insurance-like protection changing behavior; hidden actions and incomplete observability mean moral hazard cannot be fully eliminated.
• Principal mechanisms to limit moral hazard:
  • Official regulation and supervision (eligibility for discount window tied to restrictions and oversight).
  • Encouragement of private-sector monitoring and self-regulation (limits on deposit insurance coverage, rescue packages financed by private sector).
  • Imposition of costs on mistake-makers (penalty lending rates, losses borne by equity and subordinated creditors, management change, enforcement of bankruptcies).
• Tradeoffs and judgments:
  • Constructive ambiguity reduces moral hazard incentives but can increase frequency/severity of crises if private agents withdraw prematurely.
  • Specifying general principles (e.g., willingness to act in systemic crises) can reduce panic and encourage private behavior conducive to stability.
• Empirical assessment: domestic mechanisms have not controlled crises perfectly over the last two decades; moral hazard must be managed rather than fully eliminated.

International lender of last resort — necessity and IMF role

• Need and rationale:
  • International capital flows are volatile and contagious; an international lender of last resort can mitigate instability and contagion, especially for emerging market countries.
  • Capital mobility can be beneficial but only if frequency and scale of capital-account crises are reduced.
• IMF as lender of last resort:
  • IMF is not an international central bank but can act as crisis lender (on-lend pooled resources) and crisis manager (lead negotiator and coordinator).
  • IMF resource context and scale issues:
  • Following the eleventh general review of quotas, total quotas will reach approximately $275 billion.
  • If the Fund were today the same size relative to the output of its member states as in 1945, it would be more than three times larger than it will be when the present quota increase is completed.
  • If the 1945 quota formula were applied today, the Fund would be five times its present size.
  • If the Fund had been maintained relative to the volume of world trade, it would be more than nine times larger — that is, the size of the Fund would be over 2.5 trillion dollars.
  • The Fund can borrow under the New or General Arrangements to Borrow and member governments and other institutions can add financing in systemic cases.
  • Article XVIII permits an 85 percent majority allocation of SDRs "to meet the long-term global need ... to supplement existing reserve assets," though a general SDR allocation is not well suited to targeted support for specific groups of countries.

Reforming the international system — four central elements

• Exchange rate regimes:
  • Recent major external crises affected countries with more or less pegged exchange rates.
  • Probable shift toward more flexible exchange rate systems (including crawling pegs with wide bands); fewer nominal pegs expected but not universal float.
• Reserve holdings:
  • Countries with large reserves have fared better; likely increase in reserve holdings among emerging markets.
  • Reserve accumulation by many countries could impart a deflationary impact to the world economy.
  • Alternatives to reserve buildup include international SDR issues and precautionary lines of credit.
• Private sector involvement and bail-ins:
  • Precautionary private sector lines of credit (Argentina model) are constructive.
  • Contractual innovations: collective representation clauses, majority decision clauses, contract provisions to facilitate rescheduling in crises.
  • Formal stays on payments (international bankruptcy concepts) and IMF lending to countries in arrears if pursuing appropriate policies are discussed.
  • Caution: mandatory creditor-sharing clauses could be destabilizing by incentivizing creditor runs.
• International standards and transparency:
  • Development and adoption of standards: Basle Core Principles, Special Data Dissemination Standard (SDDS), fiscal and monetary transparency codes, international accounting standards, IOSCO standards, and international bankruptcy standards.
  • Adoption of standards should reduce frequency and intensity of crises; additional incentives may be needed (e.g., risk weights by creditor-country regulators reflecting observance of standards).

Improving the functioning of the international lender of last resort (IMF-specific reforms)

• New and proposed IMF facilities:
  • Supplemental Reserve Facility (SRF) introduced end-1997: short-term loans in large amounts at penalty rates; used for Korea, Russia, and Brazil subject to policy conditionality.
  • Executive Board considering a contingency or precautionary facility; features include lending terms similar to SRF and possible prequalification for assistance.
• Application of Bagehot lessons internationally:
  • SRF embodies penalty rate and concept of lending freely; "lending freely" internationally may mean readiness to lend early and sufficiently to countries affected by contagion.
  • Policy conditionality can be interpreted as part of the penalty from the borrower's policymaker perspective.
• Collateral and conditionality:
  • Articles permit the Fund to ask for collateral though it has done so only once; a contingency facility might rely more on collateral and less on conditionality, creating incentives to maintain internationally acceptable assets and reserves.
• Addressing international moral hazard:
  • Three domestic mitigation mechanisms map to international reforms:
  • Improved official regulation via international standards.
  • Enhanced transparency and monitoring to encourage private-sector monitoring and self-regulation.
  • New bail-in procedures to impose costs on private creditors and reduce investor moral hazard.
  • Different forms of international lending carry different moral hazard risks (e.g., interbank lines of credit pose more serious hazards than equity).
  • Supervisory authorities of creditor countries share responsibility to ensure their institutions participate in bail-ins and workouts.
• Eligibility and incentives to meet standards:
  • Proposal (Calomiris and Metzler inspired): limit lender-of-last-resort access to countries meeting stiff requirements (notably on banking systems), with loans on collateral and without policy conditionality.
  • Fischer suggests a tiered approach: only countries that adopt certain standards or make good faith efforts would qualify for contingency facilities; non-qualifiers could face tougher conditionality or higher charges.
  • Implementation horizon: expect at least five years for a prequalification-based system to begin operating; transition arrangements could reward good-faith progress (analogous to SDDS transition).

Key policy implications and projections

• The international system should aim to make capital markets operate at least as well as the better domestic capital markets by:
  • Strengthening national and international regulation and supervision.
  • Developing and enforcing international standards and transparency.
  • Designing workable private-sector bail-in and contractual mechanisms.
  • Enhancing IMF facilities (SRF, contingency/precautionary lending, borrowing arrangements) and ensuring timely country engagement.
• If reforms succeed, IMF lending need not increase; success should reduce the frequency of international crises and occasions for crisis lending.
• Implementation timeline expectation: development and adoption of standards and a prequalification system could take at least five years.

Stanley Fischer, January 3, 1999 — "On the Need for an International Lender of Last Resort" — International Monetary Fund

References

• Argentina and the IMF
• Brazil and the IMF
• United Kingdom and the IMF
• Republic of Korea and the IMF
• Mexico and the IMF
• Russian Federation and the IMF
• United States and the IMF
• Conditionality
• Special Data Dissemination Standard
• Gold in the IMF -- A Factsheet
• IMF Quotas -- A Factsheet
• IMF Policy Advice -- A Factsheet
• Speeches
• PRESS CENTER
• https://www.imf.org/en/home