International Lender Of Last Resort Research Articles

Redesigning the international lender of last resort

ABSTRACT This paper is concerned with the issue of how to balance bailouts (or into arrears) with debt reductions (or sector involvement) in the resolution of sovereign debt crises. It provides a review of recent proposals for improving the sovereign debt restructuring process. In addition to defending a sovereign bankruptcy proposal we have put forward in recent work, this article proposes a major reorientation of the IMF's role in sovereign debt crises. I. INTRODUCTION Since the Mexican Debt Crisis of 1994-95, which gave rise to an International Monetary Fund (IMF) bailout of unprecedented size, there has been a raging debate on how the IMF should handle sovereign debt crises. Despite the successful resolution of the crisis and Mexico's quick repayment of all its emergency debt, the sheer size of the intervention has raised worries that bailouts could cause significant sovereign debt market distortions. These concerns, in turn, have led to a reconsideration of the prevailing wisdom that the IMF can and should act as the de facto international lender of last resort (ILOLR) by arranging bailouts in response to major sovereign debt crises. As is now widely recognized, the problem with a purely bailout-based policy is that it requires ever larger funds to be credible and successful. It also invites undesirable policies by debtor countries. The prospect of a bailout encourages sovereign debtors to borrow more than they should, and it tempts them to resort to highly risky fixed exchange rate policies as a quick fix towards macroeconomic discipline.1 Of course, the worst debtor misconduct can be controlled to some extent by imposing conditions on the debtor country before granting a rescue program, but more often than not, the IMF finds itself in a weak bargaining position at the onset of a debt crisis. How credible is the IMF threat to withhold a financial aid package when a potentially contagious debt crisis is about to erupt? And once the bailout has been granted, why should the debtor country abide by the conditions it agreed to? Because of the potentially enormous financial commitment a pure ILOLR policy requires, and because of the moral hazard it may induce in sovereign debt markets, it is now widely understood that bailouts need to be supplemented by at least a partial bailin of the private sector. According to this view, the IMF's involvement in a debt crisis should be conditioned on debt reduction or rescheduling by private sector lenders. Private creditors should be required, that is, to share at least some of the costs of resolving a crisis. Despite this emerging consensus on the importance of private sector involvement, however, there is still considerable disagreement on the appropriate balancing between bailout and bailin, and on the best process for crisis resolution and debt restructuring. The most ambitious overhaul of IMF policy contemplated so far involves the introduction of some form of bankruptcy institution for sovereigns and envisions a single forum where the extent of debt reduction and the size of new emergency lending would be decided simultaneously. There was considerable discussion and research of this strategy-which the IMF calls a Sovereign Debt Restructuring Mechanism (SDRM)-from late 2001, when the IMF first announced its support for a sovereign bankruptcy framework, up to the G-10 meetings in April 2003, when the IMF's proposal was shelved. Despite all the writing and debates, many open questions were still unresolved at the time of the G-10 meetings, including the role of the IMF in an SDRJVI regime. No doubt these questions would have received further attention if the SDRM proposal had gone forward. But in the aftermath of the SDRM debate, no clear new role has been marked out for the IMF and no clear rules have emerged to direct the IMF's balancing of bailins and bailouts in future debt crises. As a result, the IMF now finds itself at a crossroads. …

The US as ‘Sovereign International Last-Resort Lender’: The Fed's Currency Swap Programme during the Great Panic of 2007–09

Beginning in late-2007 and culminating in autumn 2008, the US Federal Reserve took extraordinary action to address global dollar scarcity through the provision of dollar swap lines with a total of 14 foreign central banks. At their peak, these emergency credit lines provided nearly $600 billion in financing to economies starved of dollars. This case represents an archetypal example of ‘sovereign international last-resort lending’. The article explores this case in order to engage the following two questions. First, what criteria qualify a state to play the role of international lender of last resort (ILOLR)? Second, under what conditions will a state with the capacity to act choose to do so? The article argues that the primary factor from which states derive the capacity to act as ILOLR is the international status of their national currency. Additionally, it contends that states with the capacity to act as ILOLR do so for defensive reasons. Examining the Fed's swap programme, three spillover effects are identified that threatened the US economy and motivated the US central bank to engage in defensive international last-resort lending during the crisis: financial system exposure, interest rate concerns, and a dramatic appreciation in the dollar's exchange rate.

Global Financial Safety Nets: Where Do We Go from Here?

AbstractFrom an emerging markets perspective, the global safety net remains full of holes despite recent stitches during the crisis. This paper proposes an effective and workable international lender‐of‐last‐resort (ILLR) for systemic liquidity crises based on (i) an automatic trigger to access the facility; (ii) unilateral country pre‐qualification to the facility during IMF Article IV consultations; and (iii) liquidity funded by the world's ‘issuers of last resort’. These principles support a reliable and broad‐based ILLR without the carrying costs associated with inefficient reserve hoarding; one that would actually work as an effective preventive facility with minimal room for moral hazard.

Global Financial Safety Nets: Where do We go from Here?

An analysis of the performance of the global financial safety net during the 2008-2009 crisis, and an evaluation of its new components, indicates that, from an emerging markets perspective, the net remains full of holes despite recent stitches. This paper therefore proposes an effective and workable international lender of last resort (ILLR) for systemic liquidity crises based on: i) an automatic trigger to access the facility; ii) unilateral country prequalification to the facility during Article IV consultations; and iii) liquidity funded by the world’s “issuers of last resort.” These principles would support a reliable and broad-based ILLR without the carrying costs associated with inefficient reserve hoarding, which would actually work as an effective preventive facility with minimal room for moral hazard.

The international lender of last resort and selective bail-out

In the event of a third generation crisis, international lending of last resort should be used if and only if the international lender of last resort (ILOLR) is informed on the subject of domestic financial and banking markets. Therefore, it will act at a macroeconomic level, as an usual ILOLR, but also at a microeconomic level, since there will be selective lending to commercial banks. There are two conditions of optimality of this intervention: first, the country should be eligible; and secondly, only solvent banks should be bailed out.

Coordination Failures and the Lender of Last Resort: Was Bagehot Right after All?

The classical doctrine of the Lender of Last Resort (LOLR), elaborated by Bagehot (1873), asserts that the central bank should lend to “illiquid but solvent” banks under certain conditions. Several authors have argued that this view is now obsolete: in modern interbank markets, a solvent bank cannot be illiquid. This paper provides a possible theoretical foundation for rescuing Bagehot's view. Our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. We built a model of banks' liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot find liquidity assistance in the market. We derive policy implications about banking regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort. Furthermore, we find that public (bailout) and private (bail-in) involvement are complementary in implementing the incentive efficient solution and that Bagehot's Lender of Last Resort facility must work together with institutions providing prompt corrective action and orderly failure resolution. Finally, we derive similar implications for an International Lender of Last Resort (ILOLR). (JEL: G21, G28)

Solvency Runs, Sunspot Runs, and International Bailouts

This paper introduces a model of international lender of last resort (ILLR) activity under asymmetric information. The ILLR is unable to distinguish between runs due to debtor insolvency and those which are the result of pure sunspots. Nevertheless, the ILLR can elicit the underlying state of nature from informed creditors by offering terms consistent with generating a separating equilibrium. Achieving the separating equilibrium requires that the ILLR lends to the debtor at sufficiently high rates. This adverse electing problem provides an alternative rationale for Bagehot's Principle of last-resort lending at high rates of interest to the moral hazard motivation commonly found in the literature.

A Simple Model of an International Lender of Last Resort

This paper develops a simple model of an international lender of last resort (ILOLR). The world economy consists of many open economies, each with its own banking system and its own central bank which uses its reserves to manage a pegged exchange rate. The fragility of the banking system and the limited ability of a domestic central bank to provide international liquidity together can cause currency and banking crises. An international interbank market can help an economy with the needed international liquidity, but this risk‐sharing also comes with potential costs of international financial contagion. Such contagious risk is much higher when there is an international interbank market than otherwise. An ILOLR can play a useful role in providing international liquidity and reducing international contagion.

A Simple Model of An International Lender of Last Resort

This paper develops a simple model of an international lender of last resort (ILOLR). The world economy consists of many open economies, each with a banking system and a central bank operating under a pegged exchange rate regime. The fragility of the banking system and the limited ability of a domestic central bank to provide international liquidity together can cause currency and banking crises. An international interbank market can help an economy with the needed international liquidity, but with potential costs of international financial contagion. An ILOLR can play a useful role in providing international liquidity and reducing international contagion.

On the Need for an International Lender of Last Resort

Is there a useful function for an international lender of last resort (ILLR)--defined as crisis lender and crisis manager? Yes for international capital flows are excessively volatile and contagious, and because an ILLR can help mitigate the effects of this instability. I examine the Bagehot rules, and their applicability in an international context, focusing on the problem of moral hazard. I argue that a critical condition for the successful operation of an ILLR, a role that is to an important extent played by the IMF, is to ensure private sector involvement in the resolution of emerging market financial crises.