Wednesday, September 24, 2014
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Banking on the IMF

CHICAGO – The biggest financial nightmare looming over the world economy is the insolvency of a large international bank. Be it because of a sovereign default or because of large losses accumulated under complacent accounting rules, the insolvency of a large bank (particularly a European bank) is far from a remote possibility. Even if it were a remote possibility, the 2008 financial crisis has taught us that rare events occur.

What makes this possibility the financial nightmare of choice, worse than the collapse of Lehman Brothers in 2008, is the fear that many sovereign states have already shot all their bullets and would thus be powerless to intervene. Credit default swaps (CDS) of major southern European banks trade slightly lower than the CDS of their sovereign states, indicating that the market does not perceive the latter as able to support the former.

Unfortunately, almost two years after Lehman’s collapse, little has been done to address this risk. The United States Congress is about to finalize a bill that will grant resolution authority over major US financial institutions to a newly formed systemic council. The procedures to trigger this intervention, however, are complex and the funding is sufficiently opaque that the bill will not eliminate collateral damage from a large bank failure even for US institutions, let alone for international ones, whose unwinding would require coordination by several states, with varying degree of solvency.

To minimize the risk of an unruly collapse, it is necessary to approve an international resolution mechanism with authority over all major international financial institutions. The goal would not be to rescue banks and their creditors, but to minimize the disruption that an uncontrolled default might cause.

This institution should be an international version of the US Chapter 11 Bankruptcy Code. But, while the goal of Chapter 11 is to save the ongoing value of a firm, the goal of the international resolution mechanism should be to preserve the ongoing value of the counterparties of insolvent financial institutions.

The first problem to resolve in approving this mechanism is who should have this authority. The obvious answer is the International Monetary Fund.

Created after WWII to finance temporary imbalances of the members of a fixed-exchange rate system, the IMF has been in search of a cause since the demise of the dollar exchange-rate system in 1971. More importantly, through its numerous rescues of sovereign states, the IMF has acquired expertise in debt restructuring, while developing a reputation for toughness and impartiality, which would be very useful in these situations.

The IMF also has the unique advantage of being the only depositary of international reserves. In the absence of an international fiscal authority, the IMF is the organization that comes closest to being one.

When a large financial institution is insolvent, the IMF should take it over, guaranteeing its short-term obligations, but wiping out the shareholders and repaying the long-term creditors only after all the other creditors (including the IMF itself) are repaid. Some people would scream that this is tantamount to nationalization, but it is no more a nationalization that the US Chapter 11 bankruptcy process is.

Takeover by an international organization has three advantages over a domestic solution. First, it makes certain that the cost (if the losses exceed the combined value of equity and long-term debt) is shared by the international community and not only by the country where the institution is located, making the intervention credible even when the sovereign state is not.

Second, by removing decision-making power from the national government that hosts an insolvent institution, this solution minimizes the potential distortions created by the lobbying power of the incumbent bankers. Would you trust the Greek government to run a Greek bank in a non-corrupt way after a government takeover? The IMF would be better.

Finally, thanks to IMF involvement, even less advanced countries would be able to take advantage of the best international expertise to address the problem. If a major oil spill in Haiti were threatening the Gulf of Mexico, wouldn’t we want the best technology (and not just the technology available in Haiti) to try to contain it? Why should it be any different in financial markets?

The last problem to be resolved is the trigger. In the case of the US resolution authority, this has been a very controversial issue. The fear was that powerful banks would exploit national government help, asking for intervention too soon.

Two safeguards can avoid this problem in the international context. First, rigid rules that wipe out shareholders and penalize long-term creditors are a clear deterrent from bankers’ point of view. Second, because IMF intervention would reduce the influence of powerful domestic insiders, early intervention would be less attractive to them. The trigger should be the domestic government itself. Refusing international help in such instances would mean electoral suicide for any government that faces a major bank collapse.

There are few areas in which government intervention is known to create value: reducing the devastating effects of a bank run is one. Only a government that is sufficiently powerful, in terms of legal authority and solvency, can do so. Unfortunately, in the international arena these two conditions are almost never met. Empowering the IMF to take over failed international banks would fill this gap – and chase away our worst nightmare.

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