New Financial Architecture

1
New Financial Architecture

• Proposals for Reform

2
Liquidity Crises

• A solvent borrower with
• Illiquid assets
• Short-term liabilities
• Two equilibria
• Bank run
• No bank run
• Diamond and Dybvig (1983)
• A bank run is a coordination failure Not just a
  lump-sum redistribution of financial claims

3
How do you deal with liquidity crises?

• Bagehot (1873) In a crisis, the lender of last
  resort should lend freely, at a penalty rate, on
  good collateral.
• There are three points here
• The lender of last resort must be willing and
  able to lend freely.
• It should lend at a penalty rate this is to
  mitigate moral hazard problems.
• It should lend on good collateral. Meltzer
  (1988) This is collateral that is good if there
  were no panic. This is to distinguish solvent but
  illiquid institutions from insolvent
  institutions.
• A good discussion of this Fischer (1999)

4
In a global financial system, liquidity crises
can become financial crises

• Consider banks in a country with a fixed exchange
  rate. Suppose that they are fundamentally
  solvent
• Short-term foreign-currency debt
• High-quality long-term domestic currency loans
• If there is no panic, the foreign debt is rolled
  over and serviced in full.
• If there is a panic, the banks need foreign
  exchange
• If the amount of foreign exchange that they need
  exceeds the central banks reserves there will be
  a currency crisis.
• The central bank is forced to devalue the banks
  assets and liabilities are now mismatched it is
  unsound.
• Foreign lenders write off their loans. The crisis
  may spread.

5
Example Mexico

• After the December 1994 devaluation of the peso
  Mexico had
• About 29 billion of dollar-denominated debts due
  in 1995
• Reserves of about 6 billion.
• Each holder of dollar-denominated debt realised
  that if other holders of the dollar debt refused
  to roll over their debts, then Mexico would
  default despite its long-run solvency.
• Mexico was pushed to the brink of default

6
Two things that would improve matters

• Most countries should abandon the use of fixed,
  but adjustable, exchange rate systems.
• Bank regulation should discourage excessive
  currency mismatches. The IMF should publish data
  on currency mismatches and make reduction a
  condition for loans. Goldstein (2005).
  Governments, instead, have deliberately courted
  mismatches Mexican issuance of Tesobonos
  Thailand gave tax breaks for offshore foreign
  borrowing Russia attempted to attract foreign
  capital to the domestic bond market.

7
UK Proposal

• Standing Committee for Global Financial
  Regulation
• establish and implement international standards
  for financial supervision and regulation
• Henry Kaufman suggests a similar International
  Regulator and Rating Agency

8
Is there a potential lender of last resort for
global financial markets?

• In a domestic liquidity crisis, the central bank
  is typically the lender of last resort.
• The main problem in managing global liquidity
  crises is the lack of an obvious global lender of
  last resort.
• Fischer (1999) The lender of last resort plays
  two roles
• It provides the funding.
• It manages the crisis.
• Potentially, these functions could be provided by
  two different institutions.

9
Could the IMF act as global lender of last resort?

• This is suggested by Fischer (1999)
• The 1997 Supplemental Reserve Facility allows the
  Fund to make short-term loans in large amounts at
  penalty rates to countries in crisis.
• Lender role The IMF has access to resources, but
  are they large enough?
• Manager role Countries with crises avoid
  approaching the IMF because they do not want to
  carry out IMF-mandated reforms.
• The IMF can ask for collateral, but generally
  does not. Is it able and willing to distinguish
  between solvent but illiquid countries and
  insolvent countries?

10
United States proposal

• A contingency finance mechanism within the IMF
• Countries with good policy fundamentals would
  have access to short-term borrowing at high
  interests rates

11
Can the Private Sector Act as Lender of Last
Resort

• JP Morgan led consortiums of private US banks
  that acted as lender of last resort to domestic
  banks before the creation of the Federal Reserve.
• Collective action problems probably make this
  infeasible.

12
A Global Central Bank

• If the global central bank were to act as lender
  of last resort, it would have to have access to
  funds equal to the liquidity gap the difference
  between short-term foreign currency liabilities
  and liquid foreign currency assets.
• If it acted as lender of last resort it would
  probably have to have a regulatory role this may
  not be politically possible.

13
Bailouts vs. Bail-ins

• Suppose there is a pure liquidity crisis.
• If the lender of last resort could guarantee
  sufficient loans, there would be no reason for a
  crisis.
• Alternatively, if it could force a comprehensive
  standstill on the part of creditors (a full
  bail-in), it could also stop the crisis. No
  creditor would want to withdraw its funds if all
  other creditors were unable to do so.
• If it is known that the crisis is a pure
  liquidity crisis, borrowers and creditors are
  equally happy with either solution. In
  equilibrium, the outcomes are the same.

14
But, bail-ins can be difficult

• If there is some chance that the crisis is a
  solvency crisis, rather than a liquidity crisis,
  creditors prefer bailouts to bail-ins.
• If the bail-in is negotiated ex post, almost
  every creditor would like to get out rather than
  to agree to defer payment. It is difficult to get
  all creditors to be part of the stand still and
  those who are not are apt to flee.
• If creditors think that a stand still is in the
  offing, they may flee.

15
Canadian proposal

• Part of the proposal is that the IMF should have
  the power to invoke an Emergency Standstill
  Clause affecting all cross-border financial
  contracts.

16
Replace the Lender of Last Resort with a
Mechanism that Automatically Bails Everyone In

• UDROP (Buiter and Sibert (1999))
• Universal Debt Rollover Option with a Penalty
• All foreign-currency loans must have a rollover
  option attached to them.

17
The Scheme Must be Universal

• All foreign currency obligations (loans) must
  have the option attached.
• This includes private and sovereign, long-term
  and short-term, marketable and non-marketable,
  negotiable and non-negotiable it includes
  overdrafts, credit lines and contingent claims.
• All borrowers, both public and private, must be
  given the option.

18
Rollover Option

• Each borrower, at his sole discretion, has the
  right to extend the loan for a specified period
  (say, three to six months).
• The option is only available if all debt has been
  serviced in full up until the rollover is
  requested.
• The rollover option can only be requested once
• Allowing multiple rollovers at ever higher
  penalties allow the borrower to engage in Ponzi
  financing without the lender being able to invoke
  the formal sactions of default and bankruptcy
• Liquidity crises tend to be short lived three to
  six months ought to be enough to stave them off.

19
The option carries a penalty rate

• For the scheme to work, the interest rate charged
  must be high enough that market participants
  would not choose to exercise the rollover option
  under orderly market conditions.
• It might be a large surcharge over the spread
  over LIBOR that the borrower would normally pay.
• Who should determine the penalty? Not necessarily
  the market. Individual lenders do not take into
  account the social benefit of lowering the
  probability of a liquidity crisis. It may be
  necessary to mandate a maximum rate.

20
Could UDROP Make Things Worse if the Lender
Hedges?

• When a financial institution grants a rollover
  option, it will cover its contingent exposure by
  shorting some of the borrowers assets the
  amount will depend on the perceived probability
  that the rollover is invoked.
• If the option is invoked, the lender will want to
  hedge more fully, but given that the borrower is
  unlikely to be obtaining any other private funds
  it is unlikely that this implies a reduction in
  funds to the borrower.
• Thus, UDROP will lower inflows in normal times
  and raise them in crises.
• See Ortiz (2002) for a discussion of contingent
  credit and lender hedging.

21
Variants of UDROP

• Instead of allowing individual borrowers to
  exercise the option at their discretion, allow
  the option to be exercised only when markets are
  disorderly.
• Allow some specified institution (the IMF,
  national central bank or regulatory authority)
  or mechanical rule to specify when markets are
  disorderly.
• The benefit is that it may reduce the moral
  hazard problem of insolvent, rather than merely
  illiquid, borrowers invoking the option.
• The cost is that the institution given the
  authority to say when markets are disorderly may
  be subject to moral hazard problems, politically
  motivated or slow to act. It might increase the
  likelihood of corruption. Simple rules may be
  inadequate the conditions for complicated ones
  may be difficult to verify.

22
Should the Option be Strippable?

• It might be efficient to allow the option to be
  stripped from the debt and traded.
• Market participants could create a reinsurance
  market to spread the risk of UDROP being
  exercised.
• However, borrowers should not be allowed to sell
  their option.
• If the option is exercised, the current lender
  must roll over the debt this ensures funds are
  always available.

23
Could UDROP be Voluntary?

• As borrowers do not take into account the affect
  of their actions on lowering the likelihood of a
  liquidity crisis, voluntary insurance schemes
  similar to UDROP are unlikely to be successful.
• One such scheme is the Contingent Credit Line
  scheme. Borrowers pay a fee to foreign banks to
  have the right to draw upon a foreign-currency
  credit line. This has been tried by borrowers in
  Indonesia, Mexico and Argentina. Participation
  was limited and neither borrowers nor lenders
  enjoyed the experience.