Mr. Chairman, it's an honor to speak to you today. I will present a summary of a more detailed presentation, and I request that it also be entered into the record.
I would like to describe for you a concrete proposal for reforming the "global financial architecture" (and the IMF in particular) which considers current problems and solutions to those problems.
First, I review a comprehensive list of problems. The point of that discussion is not to determine the relative importance of each one, but rather to see how hard it would be to address all of them together.
Economics normally provides rather dismal news – emphasizing necessary tradeoffs among objectives. In the case of redesigning financial architecture, however, such is not the case. It is not difficult to construct a set of mechanisms that resolve at the same time problems of illiquidity (by providing a responsive international lender of last resort facility alongside a domestic deposit insurance system) while avoiding the governance and incentive problems attendant to counterproductive bailouts of risk takers by ensuring credible market discipline of financial institutions.
The hurdles that must be overcome in designing an appropriate financial architecture, then, are not those posed by economics, but rather by politics. The challenge is to get those with vested interests in the current allocation of political power – including bankers, developing country oligarchs, and the U.S. Treasury – to relinquish some of the power they currently wield in order to make the global financial system more efficient, competitive, and democratic.
The details of the plan are summarized in Table 1. I emphasize that the success of each component of the proposal depends on all the other components.
Without a reliable means of bringing credible market discipline to bear on banks, to provide strong incentives for prudent risk management, government deposit insurance and IMF lending will spur excessive risk taking, with its attendant costs. But in the presence of credible market discipline, deposit insurance and IMF lending (if structured properly) can strengthen the financial system by helping to avoid liquidity crises, which result either from problems of asymmetric information or self-fulfilling expectations.
In implementing such rules, the devil is in the details, hence my emphasis on "blueprints" (specific concrete proposals) rather than simply organizing principles. Slight differences in details can make the difference between a reform agenda that achieves both liquidity and proper incentives toward risk taking, and one that achieves neither.
This proposal is offered at an opportune time. Contrary to some statements by IMF officials and by officials of the U.S. Treasury, the IMF is facing a long-term funding squeeze, but not an immediate budget crisis, as the GAO testimony presented before this committee on July 23 showed.
IMF funds are still substantial, certainly more than enough to deal with any liquidity crises that are likely to arise in the next few months. So there is no need to rush passage of Congressional appropriations for the IMF. On the contrary, the longer term need to increase the IMF's resources offers member country governments (including the U.S. Congress) a unique window of opportunity to consider meaningful reform of the way the IMF operates.
Last week, the Shadow Financial Regulatory Committee – a bipartisan, independent group of experts on financial regulation of which I am a member – issued a statement on the IMF unanimously calling on Congress not to release new funds for the IMF until it had achieved substantive reforms that will prevent the abuse of IMF assistance, clarify IMF objectives, and make the IMF a more accountable institution. My statement today offers details on how to achieve those objectives.
Let me turn now to a brief discussion of the challenges facing the global financial system, and my proposals for addressing those challenges.
Over the last 20 years, 90 banking crises have occurred equal or greater in magnitude (in terms of banking system losses) to the U.S. banking experience during the Great Depression. In at least 10 cases, banking system losses will exceed 20% of GDP – a staggering and unprecedented set of losses, which are occurring during a time of relatively stable and rapid global growth!
Banking system collapse due to excessive risk taking by banks has been a common feature of all the recent financial collapses. Bank losses precede and cause exchange rate collapses.
Banking systems worldwide have become the key source of financial instability. Economists have pointed to several core problems that feed that instability.
First and foremost are incentive problems that encourage risk taking, particularly in response to adverse macroeconomic shocks. Before banks were protected by government safety nets, economic downturns produced contractions of bank credit supply and cuts in bank dividends, as banks scrambled to reassure depositors that bank loan losses would not result in losses for depositors.
Safety net protection has removed that important disciplinary check on bank behavior. Safety net protection (ultimately, taxpayer protection of banks and their claimants) relaxes market discipline on bank risk taking and subsidizes higher risk in banks. This effect is especially pronounced after banks experience initial losses to the value of their assets. In the wake of such losses, safety net protection encourages banks to consciously increase their asset risk. Those increases in risk often take the form of increased default risk and exchange rate risk after banks have already seen severe depletion of their capital.
Bailouts of developing economies' banks and international bank lenders, orchestrated by domestic governments in cooperation with the IMF and the U.S. Treasury, must stop. Not only do they produce inefficient risk taking, fiscal disasters for domestic governments, and enormous distortionary taxes for their taxpayers; by supporting crony capitalism – both within developed and developing economies – they also undermine the core competitive and democratic processes on which successful financial systems depend.
The IMF didn't invent bank bailouts and IMF involvement in bailouts is mainly indirect, but nonetheless, it is quite destructive. The IMF provides only a small wealth transfer to its borrowers in the form of its loan subsidy, and so does not directly pay for much of the cost of the bailout. But the IMF pressures borrowers to bail out foreign bank lenders, and lends support and legitimacy to domestic bailouts too by requiring government taxation to finance the repayment of IMF loans.
The destruction wrought by these bailouts have led many – including George Schultz and Anna Schwartz – to call for abolition of the IMF.
Others, however, argue that liquidity assistance by the IMF could be useful if properly designed. Indeed, IMF liquidity assistance has sometimes been helpful. The most obvious case may be the March 1995 IMF loan to Argentina. Here the IMF lent to a government that had pursued significant, tangible fiscal and bank regulatory reforms, and did so with the express goal of financing a defense of the Argentine currency board (not financing a bailout of banks or other government expenditures).
To summarize the discussion in the paper of liquidity problems, the two most important problems are (1) banking panics that result from temporary confusion on the part of bank debt holders about the incidence within the banking sector of losses attendant to an observable shock, and (2) self-fulfilling collapses of currencies that result from government illiquidity.
To solve the first problem, I propose a set of banking regulations that together would remove the threat of banking panics – including (1) capital standards founded on market discipline, achieved through a requirement that banks maintain a minimal proportion of uninsured, junior (or subordinated) debt; (2) credible deposit insurance for other bank debt claims; (3) a 20% "cash" (or equivalents) reserve requirement; (4) a 20% "global securities" requirement; (5) free entry by domestic and foreign competitors into banking; and (6) limitations on other government assistance to banks.
In the paper, I discuss in detail how to design effective, credible market discipline. Here, my plan is largely based on the Chicago Fed's 1989 subordinated debt proposal, although there are some differences.
It is important to emphasize that a broad consensus has emerged on the need to add some form of subordinated debt requirement to the Basle capital standards. Advocates of some form of such a requirement now include: The Bankers' Roundtable, the U.S. Treasury, several Federal Reserve Banks, one Fed Governor, some members of Congress, and the Shadow Financial Regulatory Committee. Recently the Federal Reserve Board assembled a task force which is now exploring the question of how best to design and implement a subordinated debt requirement.
The combination of domestic deposit insurance and market discipline (which prevents the abuse of deposit insurance) can resolve the threat of banking panics that result either from confusion about the incidence of shocks, or self-fulfilling concerns about the insufficiency of bank reserves.
The IMF's role would be mainly to address the other liquidity problem – liquidity crises that face member governments as the result of unwarranted speculative pressure on exchange rates. This was the original intent of the IMF's founders, and it remains a legitimate objective of IMF policy.
Recent studies that emphasize the value of IMF liquidity protection argue that the current form of IMF assistance is inadequate – it is too little, too late, and with too many conditions and delays to be effective in short-circuiting self-fulfilling runs on currencies or government debt.
But how does one provide effective liquidity protection without encouraging counterproductive bailouts of banks and/or governments?
My plan is to replace the current IMF and ESF with a new IMF, which would offer a discount window lending facility. That facility would only be available to IMF members – and membership would require adherence to the aforementioned banking regulations, as well as some additional rules regarding government debt management, and (if a fixed exchange rate is maintained), a 25% minimum reserve requirement for the central bank and a requirement that banks offer accounts denominated in both domestic and foreign currency.
By restricting access to the IMF window to members in good standing who conform to a few, simple, and easily verified rules, the IMF avoids free-riding on liquidity protection, and the hazard of unwittingly financing bank bailouts in the guise of liquidity protection.
The rules governing the discount window follow Walter Bagehot's classic principles for ensuring liquidity, while avoiding free riding: lend freely on good collateral at a penalty rate.
The specifics of membership rules, limits on collateral, and penalty lending rates (described in Table 1 of the paper) encourage member countries' central banks (like their banks) to diversify their securities portfolios and maintain adequate liquid reserves.
If a member is in good standing, loans are made available on good collateral using one week old prices to value collateral. The loan interest rate is set at two percent above the value-weighted yield to maturity on the collateral offered. That provides a fast and effective means to short-circuit a self-fulfilling "bad equilibrium."
Why no additional conditions for loans? For liquidity assistance to be effective, it must be delivered quickly and supplied elastically.
Why no more rules for members? There are lots of basic rules countries should meet to build effective domestic financial systems. These include accounting standards, procedures for registering collateral interests, court enforcement of creditors' and stockholders' rights, a transparent and efficient bankruptcy code, and many more. But these rules are more controversial (for example, I would argue the Swedish bankruptcy code is far superior to the American), and are hard to specify in a simple way. I have not tried to construct a list of all desirable rules, but rather, a set of minimal rules that are IMPORTANT, SIMPLE, and VERIFIABLE.
Furthermore, additional rules (accounting, bankruptcy, and commercial laws) will arise endogenously if there is credible market discipline within the financial system, which the subordinated debt requirement and other rules will ensure. Market discipline provides a strong constituency of banks and their debtholders who will seek ways to improve transparency, contract enforceability, and sensible workout procedures.
How will the IMF actually operate the window? IMF lenders would contribute (that is, lend) bonds to the IMF, which (along with borrowers' collateral) would be used to access the discount window of the hard currency central banks (who would lend cash to the IMF collateralized 100% by the government securities of that central bank's government). The hard currency central banks, thus, would lend risklessly. They would also be free to sterilize the effects of IMF borrowings on the aggregate supply of hard currency.
To avoid the potential for costly bailouts, other redundant mechanisms would be abolished – especially the Exchange Stabilization Fund, and emergency assistance to banks via the World Bank and IDB.
Having argued that this plan would achieve proper incentives in private banking and in government finance, and would also protect against liquidity crises, I now turn to the more difficult question: whether it is politically feasible.
Clearly, however, vested interests will oppose this approach, precisely because it might work, and thereby deprive them of a valuable (though socially costly) subsidy. It may be possible, and worthwhile, to "buy off" those vested interests (particularly within the banking system) by offering a one-time injection of public funds to recapitalize banks, and thereby make the pill of market discipline easier to swallow.
It is also worth considering how domestic governments interested in implementing true reform might be helped by the World Bank and other development banks to achieve membership in the newly constituted IMF. Too often the World Bank has crowded out private lending and removed incentives for countries to adopt credible market discipline. World Bank loans to China are the clearest example of this problem. But in some cases (notably in Argentina recently) the World Bank has provided subsidies to make privatization and market discipline more achievable. More of World Bank assistance should be directed toward that end.
A central principle of my proposal is to clearly separate the functions of the IMF and the World Bank. The IMF would focus on liquidity protection for member countries that have achieved sound financial liberalization. The efficacy of that protection would be much enhanced by focusing on achieving that narrowly defined economic objective.
The World Bank would facilitate liberalization (and hence help to expand the IMF's membership list). Encouraging bona fide liberalization is a long-term process. The form and pace of assistance required is different from that of emergency liquidity assistance, and it is very counterproductive to confuse the two missions, and the two kinds of assistance.
Possibly, the greatest obstacle to my proposal will be the likely opposition of the U.S. Treasury to repealing the ESF and focusing the IMF on providing bona fide liquidity assistance. The Treasury has used the Exchange Stabilization Fund and the IMF as slush funds to provide foreign aid (without the inconvenience of seeking Congressional approval) in the guise of "liquidity" assistance. Getting the U.S. Treasury to forswear such activities is a formidable challenge – one that may require veto proof support in Congress.
If all these challenges to reforming the IMF could be overcome, and something like this proposal were enacted, would the IMF abide by the new rules? Obviously, the goal of my plan has been to design rules that are transparent to outsiders, which would make it harder for the IMF to "forebear" in enforcing those rules. The more we all talk about ways to further limit such forbearance, the better.
In summary, I think it is economically feasible to restructure the way the IMF does business to promote a more efficient and democratic financial system – one that ensures market discipline while avoiding market chaos.
If the G7 chose such a path, other countries would follow – the rewards to participating in an open, market-oriented, and stable global financial system would be irresistible. The transition process could be facilitated if the funds currently channeled through the World Bank and other development banks could be redirected toward helping countries to qualify for membership in the newly constituted IMF.
The approach to reform I am advocating has many supporters. Yesterday's Wall Street Journal featured op-ed pieces by Martin Feldstein and by the British Chancellor of the Exchequer, Gordon Brown.
Mr. Feldstein wrote:
"The IMF can help prevent future crises by creating a collateralized credit facility that lends foreign exchange to governments that are illiquid but internationally solvent…A rapid payout facility can reduce the risk of speculative attacks and induce countries to maintain open capital markets and free treade…An international credit facility can only work if it provides credit rapidly, at an above-market interest rate that discourages unnecessary use and in exchange for good collateral…"
Mr. Brown wrote:
"Our task is not to weaken support for the IMF and World Bank, but to strengthen them by building the operational rules by which we monitor and discipline ourselves…The way to do this is to agree to abide by well-understood and internationally endorsed codes of conduct: for fiscal policy, monetary and financial policy, corporate standards and social policy…"
Sebastian Edwards, in today's Financial Times writes:
"The long history of currency crises in Latin America has shown that, more often than not, the problem is lack of bank supervision, and not excessive capital mobility. This was also the case in South Korea….By focusing on capital controls, the multilateral institutions have been barking up the wrong tree. There is a real danger that by doing this they will not focus sufficiently on what is truly important: achieving transparency, strengthening bank regulation, avoiding corruption, furthering the reforms and, in many cases, pursuing major corporate restructuring."
These voices and many others are calling for a new approach to managing the IMF and World Bank, one that emphasizes adherence to economic principles that ensure market discipline, liquidity, and competition, and that avoids allowing the IMF and World Bank to be the instruments for the political power plays of vested interests.
