International lender of last resort

International lender of last resort (ILLR) is a facility prepared to act when no other lender is capable or willing to lend in sufficient volume to provide or guarantee liquidity in order to avert a sovereign debt crisis or a systemic crisis.

The role and suggested functions of an ILLR in a crisis is like domestic lender of last resort but one at an international level that can bailout one or several countries. A number of different proposals and structures have been suggested and some have been implemented but with limited success. One such example is the International Monetary Fund's supplemental reserve facility (SRF). Some suggested ILLR's have been limited to supranational regions such as the Eurozone where agreements and funding are easier to achieve.

Antecedents, current arrangements, and related proposals

Calls for an ILLR arose following the Mexican crisis (1994–1995) and the Asian and Russian financial crises of the late 1990s. While no comprehensive mechanism has been implemented, in late 1997 the International Monetary Fund instituted the supplemental reserve facility (SRF), designed to make large short-term loans with policy conditions at penalty rates during crises. To date, only Korea, Russia and Brazil have made use of the SRF.

Other less than comprehensive mechanisms have been proposed but not adopted. The first is International or Sovereign Bankruptcy, which would impose a stay on payments by a country in crisis. The second involves the use of credit lines for sovereigns to draw upon in times of crisis. A flexible credit line (FCL) would be made available with few or no conditions to countries with very sound economic and financial policies, while a precautionary credit line (PCL) could be made available to countries that do not meet FCL criteria but nonetheless display essentially sound policies. In contrast to FCL provisions, countries drawing on the PCL would be subject to policy conditions. A third proposal, broader and less clearly defined, calls for a global stabilization mechanism whereby the IMF could temporarily use an expanded "tool kit," with instruments including the unilateral offer of FCLs for multiple qualifying countries as well as other special facilities and relaxations of the terms of existing facilities.

Rationales

A variety of rationales have been offered for the creation of an ILLR. Particularly prominent in recent years is offering countries an alternative to self-insurance through accumulation of foreign exchange reserves, which, in spite of a high cost of carry, has been widely practiced in emerging economies since the 1997 Asian financial crisis, the 1998 Russian financial crisis and the 1998 bailout of Long-Term Capital Management. An ILLR might also provide a cushion against shocks and volatility, as well as reduce the likelihood of financial panic within countries and financial contagion across countries.[1] Moreover, an ILLR might allow a country's Central Bank to shift their holdings from liquid but low-yielding foreign exchange reserve to less liquid but longer-term and higher-yield assets. Finally, having an ILLR with established rules and procedures in place before a crisis might make collective action problems less likely than in the case of an exclusively ex post response.[2]

Proposals and characteristics

The role and suggested functions of an ILLR in a crisis like domestic lender of last resort, as set forth by Walter Bagehot and subsequent authors, are the following: i) lending against any marketable collateral (finance) valued at its value in normal times; ii) lending in large amounts (on demand) at terms steeper than at market terms in normal times; and iii) establish the above principles ex-ante and applying them automatically. The functions of an ILLR could be undertaken by a new institution such as a global central bank, but current proposals have generally suggested the creation of a fund or facility within an existing institution, particularly the International Monetary Fund. A leading role has also occasionally been suggested for the Bank for International Settlements.[3] Less consensus exists on whether an ILLR should additionally assume the functions of a crisis manager by coordinating the responses of other relevant actors. Disagreement likewise exists regarding whether an ILLR should directly provide international liquidity to a country's financial institutions or should only provide liquidity to institutions serving as a country's financial safety nets.
Based on the traditional doctrine, four desirable aspects of a feasible ILLR can be set forth:[4]

There are, in addition, important distinctive characteristics of a feasible ILLR to bear in mind:[5]

It should be noted that any ILLR arrangement assumes a high level of trust and cooperation among international financial actors. Reserve asset countries, for example, would be expected to provide liquidity on demand to the ILLR. That liquidity would in turn be drawn from a network of Central Bank swaps and other reliable sources, including regional arrangements in a position to co-finance and committed to fulfilling their obligations. Trust and cooperation would also be implicit in the function of channeling liquidity to qualified countries.

Criticisms

The greatest single objection to ILLR is fear of moral hazard, as access to a liquidity facility may lead countries to opt for bolder policies with less liquidity self-protection (e.g. lower reserves) and, in the event of a liquidity crisis, to choose to incur debt from the ILLR to avoid default on private debts and preserve creditworthiness.[6] In addition, private risk-taking as well as public risk-taking might increase in a setting characterized by a combination of inadequate macro-prudential regulation and the elimination of systemic risk.

A variety of more specific objections have arisen as well:[7]

See also

Notes

  1. ↑ Fernández-Arias (2010).
  2. ↑ Sachs (1995).
  3. ↑ Fratianni and Pattison (2001).
  4. ↑ Fernández-Arias (2010) and Fernández-Arias and Levy Yeyati (2010).
  5. ↑ Fernández-Arias and Fernández-Arias and Levy Yeyati (2010).
  6. ↑ Calomiris (2003).
  7. ↑ See Eichengreen (1999) and Inter-American Development Bank (2010).

References

Further reading

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