DOES THE IMF CAUSE MORAL HAZARD?

The IMF was created to ensure stability of the international monetary system. A
crucial responsibility of the IMF is to extend loans to member countries that are
experiencing or may experience balance of payments problems. Over the years,
the IMF has customized the kind of loans it provides, based on the actual or
potential crisis it is responding to. These include Stand-By Arrangement, Extended
Fund Facility, Flexible Credit Line, and Rapid Credit Line. At the end of 2016,
around forty countries had received a loan from one of these categories. Though
IMF loans are a helpful tool in times of crises, they also raise the issue of moral
hazard. These loans may be perceived by countries as the assurance of safety nets
and lead to risky or unbalanced policies. What can prevent the IMF from becoming
an insurer? First, the IMF has put a conditionality agreement in place. This means
that it intervenes only if the country requesting a loan commits to adopting a
relevant recovery program. To create this program, the IMF focuses on the policies
on subsidies and public sector among other things. That may be causing economic
malfunction. The result is a tough negotiation, which has even led some Latin
American governments to protest against the IMF. Second, like World Bank loans,
IMF loans are never included in any rescheduling agreements as part of the
recovery plan. This means these loans must always be fully repaid. Thus, a country
cannot treat the IMF’s aid as a windfall gain. Finally, the call to the IMF is
stigmatizing in the eyes of the international community: a country asking for help
from the IMF signals that its situation is critical. This leads to a drop in confidence
in the country’s economy and discourages foreigners to continue to lend to and to
invest in it. These are some of the factors that preserve the IMF’s intended role.
Moral Hazard and the Problem of “Too Big to Fail”
The banking safeguards that can be identified include: i) deposit insurance, ii)
reserve requirements, iii) capital requirements and asset restrictions, iv) bank
examination, v) lender of last resort, and vi) government organized
restructuring and bailouts fall into two categories: facilities for emergency
financial support to banks or their customers and curbs on unwise risk taking by
banks. It is important to realize that these two types of safeguard are
complements, not substitutes. An expectation of LLR support or a government-
organized bailout package in case of problems may cause banks to extend
excessively risky loans and to provision inadequately for investment losses.
Deposit insurance will reassure depositors that they need not monitor the bank
management’s decisions; and without the threat of a bank run to discipline them,
bank managers will pursue riskier strategies on the margin, including maintaining
an inadequate capital cushion and holding insufficient cash.

The possibility that you will take less care to prevent an accident if you are
insured against it is called moral hazard. Domestic bank supervision and balance-
sheet restrictions are necessary to limit the moral hazard resulting from deposit
insurance and access to the lender of last resort, which otherwise would lead
banks to make excessively risky loans and inadequate provision for their possible
failure. The deposit insurer’s limit on the size of insured deposits is meant to limit
moral hazard by encouraging big depositors, and other bank creditors including
interbank lenders, to monitor the actions of bank managers. In principle, those
big depositors could take their business elsewhere if their bank appears to be
taking unwise risks.

The problem is that some banks have become so big in global markets and so
interconnected with other banks and shadow banks that their failure might set off
a chain reaction that throws the entire financial system into crisis.

In Sweden, for example, the government had to rescue three of the four largest
banks from insolvency either by providing large loans (in case of Forsta
Sparbanken) or by nationalization (in the cases of Nordbanken and Gota Bank).
Moreover, the Swedish government declared an unlimited guarantee for all forms
of debt of all Swedish banks, thereby effectively reducing the probability of
additional insolvencies. The policy of maintaining the peg of Swedish krona to the
ECU, however, turned out to be less successful. When international financial
investors anticipated a devaluation of the krona in late 1992, the resulting outflow
of capital and foreign reserves could not be stopped even by raising the overnight
interest rate to the extremely high level of 500% (expressed at an annual rate).

The fixed exchange rate was abandoned eventually, allowing the krona to freely
float against other currencies ever since. During the course of the year 1993,
financial markets calmed down and the Swedish government was able to sell off
most of its bank holdings thereafter. All in all, this decisive combination of
temporary nationalization, creation of “bad banks” for non-performing assets,
and unlimited guarantees for creditors (but not for shareholders) became a
general benchmark for countries in financial crises. At the same time in the United
Kingdom, the financial crisis primarily affected small banks that were not by
themselves systematically important. More specifically, the group of banks whose
solvency was threatened accounted for less than 1 percent of the stock of U.K.
lending to the non-financial private sector. Although 25 banks failed over the
course of four years (i.e., much more than in Sweden at the same time), their
combined assets amounted to just 0.2 percent of GDP.

Due to the high degree of interconnectedness of financial institutions, however,

the Bank of England (i.e. the central bank) became increasingly worried about the
possibility of contagion to larger, systemically important banks. Eventually, it
decided to intervene by arranging financial support to three small banks and by
providing close supervisory review to further 40 small banks. When a financial
institution is systemically important—that is, “too big to fail” or “too
interconnected to fail”—its managers and creditors expect that the government
will have no choice but to support it in case it gets into trouble. The resulting
moral hazard sets off a vicious circle: Because the institution is perceived to be
under the umbrella of government support, it can borrow cheaply and engage in
risky strategies that (while times are good) yield high returns. The resulting profits
allow the institution to become even bigger and more interconnected, leading to
more profits, more growth, and more moral hazard. The entire financial system
becomes less stable as a result.

For this reason, economists are increasingly in favour of curbs on the size of
financial firms, despite the possible sacrifice of scale efficiencies. Many
economists also favour forcing large complex banks and shadow banks to draw up
“living wills” allowing them to be closed and wound down, in case of insolvency,
with minimal disruption and minimal cost to taxpayers. The credible threat of
bank closure is necessary for limiting moral hazard—bank managers need to know
they can be put out of business if they misbehave— but devising concrete
procedures is not easy, especially in an international context.

As we shall see, the problem of moral hazard is central to understanding both the
2007–2009 global financial crisis and the measures proposed to avoid future
crises. Another important element in that crisis and its international transmission,
however, was the globalized nature of banking.

EXCERPTED FOR TEACHING PURPOSES