Blueprints for a New
Global Financial Architecture

Charles W. Calomiris

[Part 2 of 2]

IMF Goals, Lending Policy, and Sources of Funds

Thus far, I have outlined the criteria for membership in the newly constituted IMF. IMF membership depends on satisfying four bank regulatory requirements (free banking, market-based capital standards, reserve and securities requirements, and deposit insurance), and three additional policy requirements (limits on short-term government debt, and two additional rules for fixed-exchange-rate economies: a minimal central bank reserve requirement, and the requirement that banks be permitted to offer accounts denominated in both domestic and foreign currency). Countries that do not satisfy these seven requirements would be ejected from the IMF; there would be no room for discretion in bending those rules.

Now I turn to the question of what function the IMF would serve, and how it would achieve its objectives. The goal of the IMF would be to mitigate problems of illiquidity that may arise when a country is pegging its exchange rate. Note that most of the problems listed in Section II are addressed by IMF membership requirements. Problems associated with bailouts, and banking panics resulting either from asymmetric information about bank loan portfolios or multiple equilibria, are addressed by the requirements that limit abuse of the safety net and by mandatory insurance of bank deposits. Problem 5 (government debt rollover risk) is addressed by limiting short-term sovereign debt issues, which also prevents governments from free riding on IMF insurance against liquidity risk.

The systemic risk that remains to be addressed is the possibility that central bank illiquidity could produce a speculative attack on the exchange rate peg caused either by multiple exchange rate equilibria or irrational speculators, rather than by fundamental fiscal and monetary policy weakness. Preventing such attacks was the clear intent of the IMF's founders who sought to provide a safeguard against unwarranted currency depreciation that might result from sudden pressures on the balance of payments.

To provide liquidity protection I propose that the IMF operate a discount window to lend to central banks. The proposed discount window lending policy is based on Bagehot's (1873) rule: lend freely during crises on bona fide collateral at a penalty rate. By penalty rate I mean a rate higher than the preexisting market clearing rate, but not as high as the rate would be if no protection were offered. Bona fide collateral is defined as any government debt instrument held by the central bank that is priced in the market, so long as at least 25% of the amount of the collateral offered is in the form of foreign government securities.

To be concrete, a government that is a member in good standing would be able to have its central bank borrow dollars from the IMF for a short period of time (say, 90 days) if it posts 125% of the borrowed amount in securities. Collateral securities would be valued using prices from one week prior to the request. The borrowing interest rate would be two percentage points above the value-weighted yield on that bundle of securities one week before the request. Thus, since the bulk of collateral will consist of the borrowing countries' sovereign debt, by setting the interest rate at a fixed amount above the lagged yield on the sovereign debt, IMF lending can successfully provide an elastic supply of liquidity, and can short-circuit a "bad equilibrium" in which self-fulfilling expectations produce a collapse in the value of government debt.

To ensure that bank regulatory protections remain in place, central banks would not be permitted to post as collateral securities they borrowed or purchased from their local commercial banks. IMF loans should not be rolled over for an additional 90 days without some form of special approval (say, a large supernumerary majority of IMF members voting in favor of extending the loan).

To avoid abuse of IMF protection, it may be desirable for the IMF to retain the option to turn down a request if it could provide evidence that the fundamentals driving the value of the collateral securities had deteriorated precipitously in the week before the request. For example, if yield spreads between bank accounts denominated in local and foreign currency had widened dramatically in response to political events that weakened fundamentals, then the IMF might reasonably refuse assistance. Russia's experience during August 1998 is an example of such a precipitous fundamental deterioration.

The 125% collateralization, along with the requirement that 25% of the collateral take the form of government securities issued by foreign governments, and û perhaps most importantly û the banking reforms that limit member government fiscal exposure to bank losses all serve to limit the default risk suffered by the IMF and encourage central banks to maintain foreign government securities holdings in addition to cash reserves, which bolsters the credibility of the exchange rate. The collateral requirements, the short duration of the loan, and the penalty interest rate together limit the size of the credit subsidy received by the borrowing central bank, which discourages frivolous use of the IMF discount window. Countries that default on IMF loans should be barred from borrowing for some time (say, 5 years), and should not be permitted to re-enter as members until they have repaid their debts in full (including accrued interest).

The new IMF discount window would provide significant protection against short-term liquidity problems. Governments would be able to convert large amounts of their bonds into cash on short notice, provided that they also maintained sufficiently large holdings of foreign government securities to meet the 25% collateral requirement. Assistance would be available on short notice, and no conditions (other than membership) would be attached to it.

Of course, this discount window would not protect a country against persistent balance of payments outflows, and it should not attempt to do so. Persistent outflows, which would lower central bank holdings of hard currency and hard-currency-denominated securities, would be a sure sign of fundamental weakness. IMF lending should not try to lend to prop up unsustainable currency pegs. It should lend freely, however, to ensure that sudden "self-fulfilling" speculation does not undermine an otherwise sustainable peg.

It is worth emphasizing that a Bagehotian lender of last resort cannot provide much protection against banking panics that are caused by asymmetric information about bank loan quality, since lending against securities collateral makes the value of deposits more, rather than less, susceptible to declines in the value of bank loans.9 That is why it is necessary to combine a Bagehotian lender of last resort (like the reformed IMF discount window envisioned here) with credible protection against asymmetric-information problems in the banking sector. Deposit insurance eliminates depositors' incentives to run banks when they become concerned about the value of loan portfolios. Credible market discipline (through a subordinated debt requirement and asset portfolio requirements) reduces the incidence of such asymmetric-information problems and provides strong incentives for banks to control loan risk, which eases the funding burden of providing deposit insurance protection, and fosters deposit insurance credibility. Thus the IMF's ability to provide liquidity protection against speculative attacks on exchange rates will only be effective if combined with those other regulatory requirements.

How would the IMF finance its lending to central banks? The IMF would borrow cash from the central banks that issue it (in the U.S., Germany, or Japan). IMF borrowings from central banks would be fully collateralized by the government securities of the hard-money country of issue. Those collateral securities would be contributed by all IMF members, and held by the IMF to be used as needed. For example, if the IMF were borrowing dollars from the Fed, it would post 100% collateral in the form of U.S. government securities. IMF members would share the financial burden of supplying that collateral, and therefore would share the risk of the borrowing country defaulting on its IMF loan. IMF lending would not imply an increase in the aggregate supply of hard currencies, since the Fed, the Bank of Japan and the European Central Bank would all be free to sterilize the effects of their loans to the IMF.

Transition Problems

Some of the world is very far from meeting the conditions specified above for IMF membership. How difficult would it be for countries to satisfy the seven membership requirements, and what transitional policies could facilitate that process?

The central bank reserve requirement, the limits on government debt maturity, and the requirement that banks be permitted to offer accounts in domestic and foreign currency would be relatively easy to satisfy. The main difficulty is transforming the banking systems of many countries (including those in some Western European countries, as well as the vast majority of those in developing economies) into competitive, market-oriented systems. The problem is not mainly an economic one; if governments opened their banking systems to foreign entry and imposed the regulations suggested above, efficient banking systems would develop quickly. The problem, however, is the politics of banking û the resistance of entrenched special interests to reforms that would erode the rents they currently enjoy. The challenge reformers face is to find a way to placate that political opposition.

The resistance to market discipline can be found even in relatively efficient banking systems (like that of the United States), where only recently some of the largest banks have begun to call for subordinated debt requirements to eliminate "too-big-to-fail" protection. Those banks consistently opposed such measures over the past decade, predictably preferring to maintain the implicit subsidy from the taxpayers. But now many of them (and, notably, The Bankers Roundtable, which represents the largest 150 U.S. banks) are calling for reform because they see credible market discipline, and a subordinated debt requirement in particular, as a means of permitting an expansion of bank powers (The Bankers' Roundtable 1998).

Deregulation is one way of buying support for market discipline, but in many developing economies (where banks already enjoy broad powers, and where bank owners would have great difficulty in meeting market-enforced capital standards), it may be necessary to buy support more overtly through a government-financed recapitalization of existing banks. That recapitalization would make it easier to swallow the pill of market discipline, and if a one-time subsidy would set the stage for credible regulatory reform (on the lines described above), it would be well worth the cost.

Such a recapitalization must be carefully designed, however, so that it is cost effective, and does not undermine market discipline in the future. One approach to providing government subsidization of bank recapitalization without undermining the effectiveness of market discipline is proposed in Calomiris (1998b, 1999). Assistance would take the form of subsidized government purchases of bank preferred stock for a short period (say, five years). Those purchases would occur on a matching basis with arms-length public offerings of new common stock. To qualify banks would have to agree to other provisions, including the suspension of dividend payments on common stock during the period in which the government holds preferred shares. The one-time recapitalization subsidy is designed automatically to target assistance toward the relatively strong, and to help make subordinated debt requirements feasible.

The World Bank, and other development banks, could help during the transition process in two ways: by providing financial assistance to encourage countries to implement credible market discipline (and thereby qualify for IMF membership), and by offering advice on how to structure complementary institutions and laws (including commercial laws, accounting codes, and bankruptcy laws). Too often World Bank loans have crowded out private lending and removed incentives for countries to adopt the fundamental reforms of property rights on which private lending depends. World Bank loans to China are the clearest example of such misdirected lending. But in some cases the World Bank successfully has targeted its assistance to encourage privatization of financial institutions and the creation of credible market discipline. Its loan subsidies to Argentina to help pay for the privatization of provincial banks are an example. The World Bank and other development banks could help ensure broad based membership in the new IMF by redirecting loan subsidies toward government programs that restructure banking systems to encourage adherence to market discipline.

Large Macroeconomic Shocks

No matter what the stated commitment to market discipline, time inconsistency problems will tempt governments to provide assistance to banks during severe macroeconomic downturns. Banking systems that respond properly to market discipline will necessarily magnify recessions by curtailing the supply of loanable funds when they experience losses on their loan portfolios. Governments will be tempted to relax market discipline to prevent the aggravation of cyclical downturns.

A better approach is to maintain market discipline through the subordinated debt requirement, but subsidize private bank recapitalization (using the preferred stock matching subsidy described above) to counteract especially severe economic downturns. I am not arguing that bank recapitalization is desirable economically; rather, I am arguing that if government intervention into the banking system is politically inevitable, it is better to intervene to help banks meet the standards of market discipline, rather than simply repealing those standards.

It is also crucial that other forms of bank bailouts be forsworn. In particular, central banks of IMF member countries should not be permitted to operate discount windows that implicitly bail out banks. In the presence of deposit insurance, a private interbank market for reserves, and IMF liquidity assistance there is no need for a domestic discount window to implement monetary policy (Goodfriend and King 1988, Bordo 1990). If central banks insist on operating a discount window, they should be required to restrict potential abuse by employing in their domestic discount window lending the same Bagehotian principles advocated here for the IMF window.

V. The Political Economy of Financial Reform

Politics poses challenges for any attempt to bring economic reason and market discipline to bear on the regulation of the global financial system. Politicians and regulators are jealous of their power, tend to prefer systems that rely on discretion rather than rules, and are more comfortable managing cryptic decision making processes (the proverbial smoke-filled rooms in which IMF policies are determined today) than engaging opponents openly in public fora.

Thus the reforms I advocate û the abolition of the Exchange Stabilization Fund and a sweeping reform of the IMF û will likely not be very welcome in Washington or in the treasury departments or finance ministries of many nations. That does not mean that reform is impossible, but it certainly will be an uphill battle.

Consider, for example, the problem this proposal poses for the U.S. Treasury Department. It has frequently used the Exchange Stabilization Fund (Schwartz 1997, 1998) and the IMF as means to provide foreign aid under the guise of liquidity assistance. These mechanisms have the advantage that they avoid the unpleasant and inconvenient requirement of seeking Congressional approval for such aid. The recent IMF assistance programs for Mexico in 1994-1995, and for Russia in 1998, were among the most unseemly recent examples of pushiness by the U.S. administration.

The political obstacles to rationalizing the current system are formidable. But the distortions in decision making created by those obstacles also are motivating a redoubling of effort in some quarters to reform the system. Simplifying the IMF's role and decision making process by setting simple, meaningful, and publicly observable membership criteria, and placing strict bounds on how and when the IMF provides assistance, would be a welcome means of reducing politically motivated distortions from the process of providing necessary liquidity assistance. These reforms would also remove the IMF from the uncomfortable position of dictating the details of macroeconomic and microeconomic policy to its member nations (see Feldstein 1998). Aside from IMF membership criteria, according to my proposal, no conditions would be attached to IMF liquidity assistance.

The prospect of a world where the power to allocate risk would be less abused, and where political puppeteers would find the strings of the financial system beyond their reach, fires the imagination and invites the effort to see such a project through. The recent failings of IMF-U.S. Treasury policies in Mexico, Asia, and Russia, and the chorus of criticism facing the IMF and the Treasury, provide a window of opportunity for reform. Congress is now poised û for the first time in U.S. history û to thoroughly evaluate the process of decision making within the IMF.

Yet, a deeper question remains unanswered. Assuming that something like this plan did succeed in being passed, and that it would perform as advertised, would the policies be politically credible? The key to credibility is the willingness to enforce market discipline in the banking system û which ensures that first-tranche losses from financial collapse are borne privately by subordinated debt holders. Will member governments do so, and will the IMF be willing to eject members that fail to impose those losses?

It is not possible to predict political processes very exactly. At the same time, the subordinated debt plan has been designed to maximize the probability of political survival. Subordinated debt is a very thin sliver of private loss (2% of risk-weighted assets), and would be held (preferably, outside of the country of issue) by large, diversified international financial institutions for whom that sliver of loss should not be devastating. The vast majority of claims on banks are protected from loss by deposit insurance. Subordinated debt also is specifically earmarked ex ante for loss, and governments that do not bail out subordinated debt holders can point to IMF membership requirements that prohibit bailing them out. Furthermore, allowing for stock recapitalization during the most severe macroeconomic crises removes one of the main threats that might otherwise relax market discipline.

That said, it must be admitted that no economic plan is foolproof, and that much will depend on how the IMF reacts to attempts by members to undermine market discipline. The more economists and policy makers worry about this issue in advance, the better.

Other details of the plan must also be addressed to make it more politically survivable. Non-bank banks (intermediaries that operate as banks, but do not call themselves banks) and similar evasions of the spirit of the membership requirements must be guarded against. Small banks, who will find it hard to access global subordinated debt markets, and who may possess the political power to block regulatory reform, must be compensated as well. The easiest way to proceed might be to allow small banks (defined, say, as banks with less than $1 billion in assets) to issue their subordinated debt in the form of interbank deposits held by large local banks.

A final political obstacle to reform might be called the "one world syndrome." I propose that the IMF charter prohibit loans to non-member countries. Because membership criteria will not be met by everyone, that implies that some countries will be excluded (by their own actions) from IMF protection. For some, it will be awkward to devise a global safety net and an international lender that excludes countries from membership and protection. But this is necessary for two reasons.

First, restricting access to the IMF helps taxpayers worldwide to limit their own governments' abuse of IMF lending in support of bailouts that transfer resources to influential oligarchs. Policy markers should recognize that without the core institutions of a successful market economy û clear and credible private property rights, competition, and adherence to market discipline to ensure appropriate incentives toward risk taking û quasi privatization of banks and liberalization of capital flows builds a house of cards that will inevitably topple. It is counterproductive for the IMF to assist such economies or to encourage them to enter global capital markets. Helping oligarchs to preserve their power and status at the expense of local taxpayers only makes it harder for economies to build the foundations of successful liberalization.

Second, IMF membership rules are necessary to prevent member countries from abusing the protection offered by other members. As in all successful private and public arrangements that provide liquidity protection, regulations are necessary to prevent free riding. For a mutually beneficial liquidity insurance system to work, membership criteria must be meaningful and membership must be valuable, otherwise the ability to free ride will undermine the willingness to reform domestic banking systems and other policies.

Of course, the U.S. government, and others, would still be able to provide foreign aid to non-member countries for strategic or humanitarian reasons. But that assistance would not flow through the IMF or the ESF.

VI. Conclusion

A global financial architecture can be defined as the set of institutions, contracts, and incentives that determine how financial risks are taken and how losses and gains from taking those risks are allocated. This paper offers an ecumenical proposal for reforming that architecture. As a working assumption, I have assumed that there is some truth in virtually every argument that is made about the problems facing the global financial system, and have argued that it is possible to design a global safety net that properly allocates risk, eliminates (or at least significantly reduces) problems of moral hazard, and still provides protection against illiquidity problems. I have argued that the imagined system would be simple to operate, and would be more credible politically (more "time consistent") than many alternatives. It would also permit the IMF to provide elastic liquidity assistance to help members defend their exchange rates from unwarranted attacks.

The proposed changes would also avoid IMF micro-management in the midst of crises, which has been criticized as an abuse of power (Feldstein 1998), an ineffectual means of financial system reform, and counterproductive to the provision of rapid liquidity assistance. Focusing the IMF's mission on true liquidity assistance would transform it from an agency that balances political interests to one that solves well defined economic problems, which would do much to rebuild the shattered reputation of the Fund.

Others, no doubt, will find ways to improve this proposal. By being concrete û drafting "blueprints" rather than just outlining broad principles û I do not mean to suggest that mine is the only imaginable way to proceed, but rather I hope to have stimulated specific discussions, and to have pointed to the need to combine economic logic with political pragmatism when designing the rules that govern the global financial system.

Offering a plan for reform does not constitute an unconditional argument for keeping the IMF. Schwartz (1998) is right, in my view, to argue that in its current form the IMF does more harm than good. Abolishing the IMF may be the right policy to pursue if it turns out that the path to reform, including credible IMF enforcement of meaningful membership criteria that limit safety net abuse, is blocked by those with vested interests in preserving the status quo.


1 For more details, see Calomiris (1998a) and Meltzer (1998a, 1998b).

2 For a discussion of the responses to loss by New York banks during the Great Depression, see Calomiris and Wilson (1998).

3 For details on the moral-hazard costs of safety nets over the past two decades, see Caprio and Klingabiel (1996a, 1996b), Lindgren, Garcia, and Saal (1996), Demirguc-Kunt and Detragiache (1997), Calomiris (1997, 1998a), Meltzer (1998a, 1998b), and Kane (1998) for summary analyses; De la Caudra and Valdes (1992) on the Chilean crisis of 1982-1983; De Krivoy (1995) on the Venezuelan crisis of 1991-1993; and Wilson, Saunders, and Caprio (1997) on the Mexican crisis of 1994-1995.

4 For details, see Calomiris (1998a) and Meltzer (1998a, 1998b).

5 Calomiris and Gorton (1991) review models of banking panics and provide empirical evidence on their causes. See Mishkin (1991) and Wicker (1998) for complementary evidence. Bordo (1985), Calomiris and Schweikart (1991), Calomiris (1993, 1994), and Calomiris and Mason (1997) provide similar perspectives on the Panic of 1857, the Penn Central Crisis of 1970, historical banking panics outside the United States, and the Chicago Banking Panic of June 1932.

6 For a review of the use of short-term debt finance by the United States historically, see Calomiris (1991).

7 IMF conditionality is not always ineffectual. But banking reform is a protracted process, and cannot be accomplished easily through IMF pressure (see Calomiris 1998a).

8 For historical evidence supporting this view, see Calomiris (1989, 1990, 1993).

9 For further discussion, see Calomiris (1994), Calomiris and Mason (1997), and Mason (1997).

Table 1

Elements of the Reform Plan

Membership Criteria for the IMF

Bank regulations:

  • Basle standards (but without restrictions on subordinated debt/tier 2 capital)
  • 2% subordinated debt requirement (with rules on maturities, holders, and yields)
  • 20% cash reserve requirement
  • 20% "global securities" requirement
  • Free entry by domestic and foreign investors into banking
  • Bank recapitalizations are permitted, but strict guidelines must be met (and must follow pre-established rules, as in preferred stock matching program)
  • Domestic lenders of last resort avoid bank bailouts by following Bagehotian principles

Other membership criteria:

  • Limits on short-term government securities issues
  • If fixed exchange rate, 25% minimum central bank reserve requirement
  • If fixed exchange rate, banks offer accounts in domestic and foreign currencies

IMF Lending Rules

  • Loans are provided only to members in good standing (those following above rules)
  • If a member defaults, it may not borrow for 5 years, and then only after arrears paid
  • Loans are for 90 days
  • Supernumerary majority of members required to roll over loans for another 90 days
  • Loans are collateralized by 125% of value of loan in government securities
  • 25% of the 125% collateral must be in foreign government securities
  • The interest rate on the loan is set at 2% above the value-weighted yield on the collateral observed one week prior to the loan request
  • The IMF reserves the right to refuse a loan to a member
  • No conditions are attached to IMF loans

IMF Funding

  • The IMF borrows from the discount windows of the Fed and other central banks
  • IMF borrowings from central banks are 100% collateralized by government securities issued by the government of the lending central bank
  • Government securities that serve as collateral for IMF borrowings from central banks are lent to the IMF by its member countries

Other Emergency Lending

  • IMF, World Bank, IDB, and others would make no other emergency lending available
  • The Exchange Stabilization Fund would be abolishe


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