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
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
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.
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
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
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
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
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
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
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
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.
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
7 IMF conditionality is not always
ineffectual. But banking reform is a protracted process, and
cannot be accomplished easily through IMF pressure (see Calomiris
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).
Elements of the Reform Plan
Membership Criteria for the IMF
- 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
- If fixed exchange rate, banks offer accounts in domestic and
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
- 25% of the 125% collateral must be in foreign government
- 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
- The IMF borrows from the discount windows of the Fed and other
- IMF borrowings from central banks are 100% collateralized by
government securities issued by the government of the lending
- Government securities that serve as collateral for IMF
borrowings from central banks are lent to the IMF by its member
Other Emergency Lending
- IMF, World Bank, IDB, and others would make no other emergency
- The Exchange Stabilization Fund would be abolishe
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to Part 1