Necessary reform? The IMF and international financial architecture.

Cooper, Richard N.

The most salient issue of those concerned with the international financial architecture back in mid-2007 was "governance," in particular governance of the International Monetary Fund (IMF). This involved, among other things, the selection of future Managing Directors (by convention since 1946 always a European), representation on the Executive Board (which is responsible for the operating decisions of the IMF), and voting rights, which were based on out-dated formulae. The "legitimacy" of the IMF was said to be in doubt. This concern with governance was against a backdrop of excellent performance of the world economy since 2002, high and widespread growth, and low inflation but rising commodity prices, which helped exporters of primary products. The IMF had made no significant loans since 2003, many countries had repaid their outstanding debts to the IMF (down from US$107 billion in 2003 to US$15 billion in 2007), and with low interest income the IMF was anticipating difficulty in meeting its normal operating expenses.

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Much has changed since mid-2007. The likelihood of worldwide recession has moved governance reform to the back burner--or, in the views of some, made it more urgent. There is much talk of the need to reform the international financial system substantively and calls for a second Bretton Woods, recalling the international meeting in 1944 that agreed on the main features of the post-1945 international monetary system and that led to the creation of the IMF and its sister institution the World Bank.

However, a key unasked question lies behind these calls: if international financial governance had been plausibly different, would it have markedly attenuated the magnitude of international ramifications of the evolving financial and economic crisis? My tentative answer is negative, as international organizations such as the IMF are constrained by the limitations on international action. But that is not to say that the IMF does not warrant an expanded role.

A New Governance Proposal

There were signs of difficulty in the US subprime mortgage market beginning in 2007, when defaults had begun to rise and construction of new residences had declined from their peak in 2005. This even had a modest international impact, as two French mutual funds suspended trading because they could not properly value some of their securities backed by US mortgages. But all this seemed to be mainly a US problem, no doubt manageable.

However, by mid-2007, events were changing, often rapidly and dramatically: the seizing up of asset-backed commercial paper markets in August 2007, requiring large injections of liquidity both by the European Central Bank and by the Federal Reserve; the failure and government takeover of Northern Rock, a major British mortgage firm; the takeover of Bear Stearns, America's fifth largest investment bank, by JPMorgan Chase with strong financial assistance from the Federal Reserve; government financial support to two large US mortgage institutions, Fannie Mae and Freddie Mac; unusual support to AIG, the world's largest insurance company; the failure of Lehman Brothers, the fourth largest US investment bank; and by September 2008 a general flight to safety and aversion to risk among most financial institutions.

By the fall of 2008 the IMF was back in the lending business, with loans to Iceland, Hungary, Ukraine, and Pakistan, and more in the works. Governance issues had receded in deference to more operational concerns--not only for the IMF, but also for other parts of the international financial structure, such as the several committees of the Bank for International Settlements charged with improving financial regulation, the Financial Stability Forum, and of course for governments and central banks as the world seemed to be sliding into recession, or worse.

Edwin Truman and I put forward a proposal in February 2007 to reform the governance of the IMF, addressed to the issue of legitimacy. Briefly, our proposal called for revising the formulae by which IMF voting rights (and borrowing rights) are established, giving modestly greater weight to all small countries, substantially greater weight to many rapidly developing countries (so-called emerging markets), less weight to medium-sized European countries; reducing the number of Europeans (nine of 24, counting Russia) on the Executive Board; and increasing IMF quotas by about 50 percent both to accommodate the rising value of world trade and to avoid any reduction in quota that otherwise would have occurred with the re-weighting of voting rights. (The last quota increase was in 1998.)

The IMF addressed the issue of governance in a report of March 2008 to its Governors. The proposal would reduce the voting share of the 26 industrial countries by 2.6 percentage points, and Europe's share by 1.6 percentage points, compared with 14 percentage points and 11 percentage points, respectively, in the Cooper-Truman proposal. Thus the Fund remains dominated by Europeans, both in votes (31 percent) and in Board representation. Whether this modest agreed change (but not yet fully implemented, since amendment to the Articles requires parliamentary ratification) responds to calls for greater legitimacy remains to be seen.

One can nonetheless play a thought experiment: suppose the Cooper-Truman proposal had been adopted in 2002. Would the IMF responses in 2007-2008 have been markedly different from what they were? Would the IMF have significantly attenuated the international crisis? I believe an honest answer must be negative.

Part of the reason for this answer is that the key central banks, including most notably the US Federal Reserve, responded vigorously to the emerging financial crisis with a speed, magnitude, and unorthodoxy--providing general liquidity in abundance, supporting specific institutions whose failure would have threatened much wider damage, and extending swap lines to selected foreign central banks in excess of US$700 billion--that it would be difficult to imagine coming from the IMF as an international organization under any plausible set of governance arrangements.

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Exploring Alternative Regulatory Agencies

The IMF is not a regulatory agency, and is not staffed adequately to be a regulatory agency, although it occasionally gives advice to member states on desirable financial regulation. However, the Bank for International Settlements in Basel, Switzerland, plays host to several international committees that are concerned with financial performance and regulation: committees on banking supervision, on the global financial system, on payment and settlement systems, on markets, and on counterfeit deterrence. These committees regularly brought together relevant officials from national capitals to discuss common problems and to identify potential problems. The best known product is agreement on the so-called Basel II risk-based capital requirements for banks that are heavily engaged in international activities. For large banks, it placed reliance on sophisticated individual bank risk assessment models, models that apparently failed signally during the recent financial turmoil.

In addition to the BIS committees there is the Financial Stability Forum, created with 12 member countries in 1999 to assess risks and vulnerabilities affecting the international financial system and to encourage and coordinate action to address them. In April 2008 the FSF submitted a report to the G-7 finance ministers that called for action in five areas: strengthened oversight of capital, liquidity, and risk management; enhanced transparency and valuation; the role of credit ratings; strengthened official response to risks; and arrangements for dealing with stress in the financial system. It built on earlier work, but obviously action was too late to avoid the financial meltdown of September 2008.

The bottom line: there has been no shortage of fora for discussions among relevant national regulatory authorities about potential financial problems. But they evidently were deficient in imagination and/or unable to convey effectively their concerns to the national political authorities who alone could have taken effective action.

The key problem is this: in a period of economic euphoria, when everything seems to be going well, no one wants to take away the punch bowl, to use the colorful metaphor of former Federal Reserve chairman William McChesney Martin. As time goes on, personnel in financial institutions change, and each new generation of traders and financial managers believes it is intellectually and technically superior to its predecessors. Moreover, they maintain that they have nothing to learn from their experiences, particularly their unhappy experiences. Their world is different from that of their elders. In addition, the system of rewards in the private financial community has placed a premium on short-term performance and has neglected long-term risk.

Under these conditions, it is difficult to imagine structural changes at the international level that would either have prevented the financial crisis or substantially ameliorated it.

The IMF at a Glance

Voting Power of IMF Member States

Europe 31%
Remaning Countries 39%
Other Advanced Economies 13%
United States 17%

-Current membership: 185 countries, of which 30 are considered
"advanced economies"

-Total quotas: $352 billion, advanced economies contribute 63% of
quotas

-Outstanding loans: $ 19.4 billion

-Biggest contributors: United States, Japan, Germany, France, United
Kindom

International Monetary Fund, 2009

Note: Table made from pie chart.

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Expanding the IMF's Role

However, the crisis is not yet over, and as the world economy slides into recession the IMF can play an important role in mitigating the damage, particularly to countries heavily dependent on inflows of foreign capital that have now diminished or even dried up. The Short-term Liquidity Facility (SLF) of US$100 billion created by the IMF in October, with its relaxed lending conditions, is a partial response, but with limitations both in magnitude and in coverage. Moreover, the total resources of the IMF, at about US$250 billion, are hardly adequate to deal with a financial crisis of the current magnitude. Hungary alone, a country of 10 million people, will absorb US$15 billion.

One can imagine a much bolder version of the IMF, a true lender of last resort. Since the late 1960s the IMF has had the capacity to create international money, called SDRs (for Special Drawing Rights, but that term is not helpful in understanding them). Financial journalists dubbed them "paper gold," since they represented a functional substitute for monetary gold, exchangeable among official monetary authorities and other designated institutions such as the BIS and the World Bank for national currencies. SDRs were created to help satisfy the long-run liquidity needs of the world economy. (SDRs are now defined as a weighted average of four currencies: the US dollar, the euro, the British pound, and the Japanese yen, so has an exact value that changes from day to day with market exchange rates among these currencies). They were issued on only two occasions, in 1970-72 and 1979-81, in total amount of SDR 21.4 billion (roughly US$32 billion today). With the huge growth in international reserves, to over US$5 trillion, they now play a negligible role in provision of international liquidity, and then mainly for transactions with the IMF itself. But the SDR could become an important source of liquidity during periods of financial crisis, such as the present.

The IMF's Articles of Agreement could be amended to allow the IMF to create SDRs not only to satisfy long-term official demands for international liquidity, but also to respond quickly to periods of intense increase in demand for liquidity, with tight terms of reference such that when the period of crisis passed the liquidity would again be mopped up, i.e. repaid to the IMF. But during the crisis there need be no limits on the issuance.

Under current arrangements the SDR can only be held by monetary authorities of countries that are members of the IMF (such as their central banks) and other designated institutions. Thus to deal with a market crisis the SDRs would have to be converted into the national currencies relevant for dealing with the financial crisis, which the relevant central banks could do.

A more ambitious change would be to allow SDRs to be held by private financial institutions, or even by any private party. They would become a kind of global money, at least for large institutions, and could coexist with national monies, which people would continue to carry in their pockets.

A compromise proposal was made some years ago by Professor Peter Kenen of Princeton University, whereby a special clearinghouse would be established that was allowed to hold SDRs, and commercial banks would be able to deal with this clearing house in transactions denominated in SDRs but actually executed in national currencies. This enlargement of the potential use of the SDR would give the IMF the financial capacity to deal with crises large in magnitude. Of course it would have to develop the procedures to use the funds effectively when necessary, which would require giving appropriate authority to the Executive Board, which resides in IMF headquarters in Washington; or (with modern technology) convening as necessary their superiors, ministers of finance (including the US Treasury Secretary) around the world.

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While the IMF is not suited to be a regulatory agency, it could and should beef up execution of its periodic surveillance of the macroeconomic conditions of member countries to include greater focus on the soundness and potential risks attending the practices of their financial institutions, and in particular compliance with international best practice as determined in other fora. Coordination of regulatory policies would remain in the hands of the various Basel-based committees.

This proposed change would require amending the IMFs Articles of Agreement, and this would require parliamentary ratification around the world. It would thus be too late to rectify the situation in the current crisis. But it is not too early to think about how to prepare ourselves to deal effectively, at the global level, with the next major financial crisis.

RICHARD N. COOPER is the Maurits C. Boas Professor of International Economics at Harvard University. He has previously worked as the Chairman of the National Intelligence Council and as the Chairman of the Federal Reserve Bank of Boston.