Many lenders believed that the 50 or 100 percent rate of interest on
loans to Russia prior to its crisis was close to a free ride because
the United States and the IMF would not let Russia default. We now
know these judgments were wrong in the case of Russia. International
lending has declined as lenders have lost money and become much more
cautious. Nevertheless, bailouts elsewhere, and their adverse
consequences for investor behavior, continue.

Pluses and Minuses of a Floating Exchange Rate

One way to reduce the risk of financial collapse is to let exchange
rates float. With fluctuating exchange rates, lenders would either
take the risk of a change in the exchange rates or hedge that risk in
the marketplace. Losses from exchange risk would occur gradually and
openly instead of in the large, one-time adjustments that have
devastated developing countries. The United States, Canada, the
European Union, Japan, Switzerland and many others have adopted this
approach.

Freely floating exchange rates are an entirely feasible and, some
would say, desirable policy. But with floating exchange rates, prices
of imported and exported goods and services change frequently, both
up and down. Many producers, importers and exporters do not want to
be exposed to frequent price changes, so governments often intervene
in exchange markets to smooth these changes. Further, countries
seeking to end inflationary monetary policies often fix their
exchange rate for a time to signal a change in regime. This is a
risky strategy unless the country can convince the market that the
new exchange rate will remain fixed. These intermediate policies,
neither floating nor credibly fixed, often increase country risk and
end in collapse. Economists oppose exchange rate intervention, citing
the long-term benefits for financial stability of a credible policy,
but unfortunately these exhortations have little impact.

What Is To Be Done

1) Rules for Stable Banking

The nation-specific political constraints that govern economic policy
will continue to give rise to two types of countries: those with
relatively sound, well-managed financial systems and those without
them. Rather than continuing to participate in financial bailouts,
the new IMF we envision should maintain incentives that avoid banking
crises in the first place, and thus the accompanying severe losses to
borrowing countries and their citizens. The role of the restructured
international lender that might replace the current IMF would be to
serve as lender of last resort to countries with sound financial systems,
while providing incentives for strengthening financial systems elsewhere.

We propose that a restructured IMF limit membership to countries that
meet certain standards of conduct in their banking systems. The
decision to adopt these standards would be left to each country, but
doing so would be a condition for joining the system.

The standards we have in mind would be simple and easily verifiable.
First, all domestic commercial banks would have to issue part of
their liabilities in credibly uninsured debt. The owners of the debt
would bear the risk of bank default, so they would have to be
non-government entities--preferably foreign banks and institutional
investors. Their function would be to monitor the banks' decisions
and share the risk of failure with owners of bank equity. Hence, they
would have incentives to demand prudent policies.

Current bank equity capital requirements are based on an
international agreement to maintain enough equity to protect
taxpayers (who insure bank deposits) from the consequences of bank
loan losses. In theory, the equity buffer forces owners to bear the
bulk of losses and discourages banks from taking unwarranted risks at
taxpayers' expense. But in practice, bank equity capital requirements
are an inadequate deterrent. Equity capital is not measured
accurately by bank supervisors because it is difficult to foresee
defaults, and supervisors lack economic or political incentives to
identify problems early. Failing to recognize losses and then
subtract them from the owners' capital means that capital is
overstated. Owners of banks that enjoy government deposit insurance
have much to gain and little to lose by increasing bank risk once
capital is impaired. Gains on the risky loans, or gambles in foreign
exchange markets, accrue to them; losses are borne by the government.

Existing bank equity requirements would be strengthened substantially
by requiring banks to finance a minimum proportion of their assets
with uninsured debt. To protect their positions and minimize the risk
to themselves, uninsured debt holders would discourage bank
risk-taking in the wake of losses. Thus market discipline from
uninsured debt would prevent banks from abusing government protection
of deposits more effectively than current equity capital standards.

Second, depositors would continue to be insured, as in fact they are
in almost all countries. Deposit insurance raises some problems, but
its absence raises the much larger problem of bank runs and
destruction of the payments system. Further, explicit deposit
insurance has several advantages, including the opportunity to charge
for the service and strengthen prudential regulation.

A third requirement for IMF membership would be that countries open
their financial markets to competition from abroad. Branches of
foreign banks domiciled in the country would provide competition,
improve standards of performance and train local personnel. In the
event of a problem or crisis, these foreign branches would be
protected by their home offices, so they would contribute to
stability and enhance safety. Further, their domestic loans would be
a small part of a diversified portfolio of loans to many countries.
Such diversification is an effective means of reducing risk.

The three elements of this plan for reforming banking systems are not
novel; some variant of each of them is now accepted practice in
several countries. Chile and Argentina have in place requirements for
uninsured debt finance. A broad consensus, including the Bankers
Roundtable, some Federal Reserve officials, and some members of
Congress, advocates a similar requirement for the United States. Many
Latin American countries have already opened their markets to foreign
banks. Approximately half of Argentine deposits are now held by such
banks, and foreign banks operate successfully in Mexico, Brazil and
elsewhere. Moreover, the World Trade Organization's financial
protocol requires free trade in financial services to be achieved
over the next decade. The implementation of our proposals would
strengthen countries' incentives to open their financial markets
sooner.

Many other rules could be added in the interest of promoting bank
solvency. Our aim is to have few, transparent and verifiable
conditions for membership in a new IMF. We rely on incentives and
competition to lead bankers toward more prudent behavior. Market
discipline provides that incentive and encourages banks and their
debt holders to improve transparency, adopt effective bankruptcy
codes and develop rules for contract enforcement.

Governments can accelerate the process of improvement by adopting
accounting standards that increase transparency and provide uniform
measures of profit and loss. But accounting rules and legal
restrictions are of little benefit if no one has an incentive to use
or enforce them. Market competition is a lever that raises standards
because prudent lenders are more secure and better able to service
their customers without interruption.

Historically, when banks have faced market discipline, they have been
far more resilient in the face of shocks. Banks have responded to
losses by reducing asset risk or raising capital. By increasing their
cash holdings and cutting dividends to stockholders, they have tried
to reassure depositors that bank losses would not result in depositor
losses. When discipline is absent, however, banks have opposite
incentives. Initial losses are followed by increases in bank
risk-taking. Failing U.S. savings and loans in the 1980s, for
example, increased risk-taking. Banks gambled to achieve high profits
but instead took large losses. Losses on risky investments were
shifted to taxpayers via the deposit insurance system. In Japan,
Korea, Thailand, Indonesia, Mexico and elsewhere, risks were
increased both in order to continue supplying credit to borrowers
favored by bankers or the government and to increase profits. In all
cases, failures were borne by the taxpayers, as they were in the
United States.

The taxation of ordinary citizens to pay for bank bailouts can wipe
out the savings of a generation. Losses in excess of 20 percent of
GDP are not uncommon in Asia today nor were they in Latin America
earlier. Japanese bank failures will cost taxpayers 20 to 30 percent
of GDP. Our proposal seeks to eliminate or reduce the size of bank
bailouts. Banking reform is one crucial step. Reform of international
lending is the other.

2) Rules for International Institutions

More than a century ago, a British economic journalist, Walter
Bagehot, set out the classical principles for a central bank acting
as lender of last resort: lend freely in a crisis at a penalty rate
against collateral. Adapted to international lending, Bagehot's rule
is the proper rule for a restructured, more effective IMF.

Adopting Bagehot's rule would require three major changes in IMF
practices. First, until this year the IMF lent at below-market rates
of interest, in effect subsidizing borrowers and encouraging delayed
repayment. We propose that lending be done at a penalty rate; that
is, a rate above the pre-crisis market rate on the borrower's
collateral. A penalty rate encourages the borrower to negotiate with
private creditors to seek (lower) market rates. The IMF would lend
only when there is a liquidity crisis--that is, when private lenders
are unwilling to lend. That is precisely the responsibility that a
lender of last resort should fulfill. If the system functions well,
the new IMF would lend infrequently.

Essay Types: Essay