International Economic Trends - November 1998
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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.