Banking on the IMF

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.

Luigi Zingales is Professor of Entrepreneurship and Finance at University of Chicago Graduate School of Business and co-author, with Raghuram G. Rajan, of Saving Capitalism from the Capitalists.

Copyright: Project Syndicate, 2010.www.project-syndicate.orgFor a podcast of this commentary in English, please use this link:

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