International Economic Trends - November 1998

							                                                                                                        November 1998


InternationalEconomicTrends



A New Architecture?                                              contracts often contain collateral and net worth require-
                                                                 ments, credit rationing and other restrictive covenants.
                                                                     The existence of intermediaries doesnÕt entirely
    At the annual meeting of the IMF and World Bank              solve problems of asymmetric information, however.
this fall, finance ministers from a 22-country working           To the extent that owners and depositors fail to moni-
group discussed proposals aimed toward the ultimate              tor the intermediary itself, incentives for undue risk-
objective of creating a Ònew architectureÓ for the               taking can simply move up the chainÑbanks have
world monetary system. Reports from three working                incentives to make risky bets with their depositorsÕ
groups were presented with suggestions for enhanc-               funds. This incentive also can be problematic when
ing transparency and accountability, establishing stan-          government support and guarantees are present in the
dards for strengthening national financial systems,              form of features such as deposit insurance and access
and improving the management of future economic                  to a lender-of-last-resort. These government programs
crises. Although fundamental reform of world financial           have an implicit value, and financial institutions might
arrangements still is a long way off, it is worthwhile to        find it beneficial to engage in risky leverage of that
consider some basic construction principles we can               value as well. Consequently, such government pro-
draw on from economic theory.                                    grams intended to limit systemic risk usually are
    Whatever their scale and scope, financial markets            accompanied by portfolio and net worth requirements
exist to channel funds from savers and lenders to the            for banks that parallel the restrictive covenants that
most profitable business opportunities. International            banks require of their borrowers.
financial markets relax the constraints that link invest-            In considering proposals for improving the man-
ment with domestic savings, and provide opportunities            agement of financial crises, the same considerations
for individual investors to globally diversify portfolios.       should be heeded. Although we have seen how capi-
By efficiently allocating capital, a smoothly functioning        tal outflows can have disruptive effects, proposals to
financial system can be an important element of eco-             restrict the flow of capital are likely to reduce the allo-
nomic growth and development.                                    cational efficiency of financial markets. On the other
    However, the smooth operation of financial markets           hand, arrangements intended to mitigate the disruptive
often is inhibited by problems associated with asymmet-          effects of capital flows taking the form of implicit
ric information. That is, borrowers generally have better        guarantees or ÒbailoutsÓ raise the potential for risky
information about the riskiness of their behavior than do        leverage of the value of those guarantees. That is,
their creditors. One particularly nefarious manifestation        moral hazard is just as much of a potential problem in
of this problem is known as moral hazard. If a borrower          the worldwide economy as it is on smaller scales.
is allowed unrestricted access to funding, there is an               Precautions need to be taken in any proposals for
incentive to engage in riskier behavior than would be            reform to take account of these risks. Nevertheless, it
desirable from the lenderÕs perspective.                         is in the interest of all to make sure that global financial
    To some extent, the very existence of banks and other        markets are able to operate as efficiently as possible.
financial intermediaries reflects efforts to overcome            As proposals for a new architecture are evaluated, it
problems of moral hazard. By specializing in origi-              will be important to keep these sound construction
nating and maintaining many loans, banks can exploit             principles in mind.
economies of scale in monitoring borrowers. To further
reduce the ability of borrowers to take undue risks, loan                                          ÑMichael R. Pakko


                Views expressed do not necessarily reflect official positions of the Federal Reserve System.