Sweden is highly open to the rest of the world, dependent on extensive cross-border transactions
in goods, services, and financial assets and liabilities. Exports are now around half the size of GDP. Cross-border financial assets and liabilities are each 2½ times GDP. The banking system is more than 4 times GDP. Even more than in past decades, Swedish financial institutions and markets are pervasively linked to the rest of the global financial system.

Sweden has been buffeted by financial instability twice in the last twenty years. The dominant sources of the instability in the early-1990s crisis were domestic. In the recent global crisis, however, the underlying causes were predominantly external in origin, stemming from financial shocks emanating from financial markets and institutions outside Sweden.

Financial openness is essential to Sweden’s healthy economic growth. But openness comes with risks as well as benefits. Our report attempts to assess these risks and benefits. We analyze the policy responses of the Swedish authorities to the recent crisis and examine how policies might be adjusted to improve stability in the future. We advocate a continuing review of the desirability of adjustments in policies that would reduce Sweden’s external vulnerability.

When the financial crisis erupted in the fall of 2008 following the collapse of Lehman Brothers, the Swedish authorities responded with alacrity. In addition to adjustments in traditional monetary policy, they took a broad range of other collective-support activities including emergency lending, emergency market support, modification in government guarantees, and facilitating the orderly recapitalization or resolution of institutions coping with possible insolvency.

The immediate problem in the crisis was that assets previously regarded as safe suddenly became suspect. In its initial response, the Riksbank provided substantial liquidity to the banking system both in foreign currency and Swedish kronor at longer than typical maturities and, at different times, at fixed and variable rates. In making these longer-term loans, the Riksbank was doing something akin to the socalled quantitative easing pursued by the Federal Reserve and the Bank of England. To ensure that enough liquidity could be supplied, in addition the Riksbank relaxed collateral requirements and extended the list of eligible counterparties.

Also at the outset of the crisis, the Swedish National Debt Office held extra auctions of Treasury bills. The proceeds were lent out accepting covered mortgage bonds as collateral to help stabilize financial markets. A few days later, the Riksbank sold “certificates” which had interest rates and maturities similar to those of Treasury bills and which were just as safe and as liquid. Issuing Riksbank certificates was another way to enhance liquidity.

A further significant crisis measure was the National Debt Office’s guarantee program. Only newly issued debt was guaranteed. The peak use of the program came to some SEK 325 billion, about 10 percent of GDP, with some two thirds related to borrowing in U.S. dollars and euros. Two notable aspects of the guarantee program were its selective importance for a few institutions and the importance of foreign currency funding.

Still other emergency measures were appropriately adopted in the crisis. These included modifications in the deposit-insurance program, ancillary actions to support liquidity such as the extension of collateral arrangements, and attention to potential or actual insolvencies of a few individual financial institutions.

The complex effects of the various policy measures taken by the Swedish authorities during the financial crisis are difficult to disentangle. Sweden experienced significant declines in output and stock prices. Yet spreads on financial instruments were stabilized, albeit at above pre-crisis levels. Credit to households was relatively stable, and credit to companies rebounded fairly quickly. Importantly, the financial system survived the crisis essentially intact.

Our report here and there raises questions about the details of particular policy measures. And our analysis takes into account some larger questions. Did the authorities move fast enough? Were their actions too timid, or did they intervene too aggressively? Could more have been done in preparing contingency arrangements for managing crisis conditions? When reading our evaluative observations, it should be remembered how much more difficult it is to make decisions in a crisis than when looking backwards with the advantage of hindsight. Crisis actions have to be decided in the heat of the moment with very uncertain foresight.

All things considered, we judge that the Swedish crisis actions were commendably prompt and typically appropriate. The experience in the past crisis, moreover, augurs well for the management of potential future crises.

Our report discusses several aspects of the Riksbank’s conduct of traditional monetary policy during the crisis. The main monetary-policy instrument, the Riksbank’s repo rate, was forcefully reduced, cut from 4.25 percent to 0.25 percent in a nine-month period during 2008-2009. The rate reductions were slower than cuts by the Federal Reserve and slightly slower than those by the Bank of England. It is an open question whether the Riksbank repo rate should perhaps have been lowered more rapidly and whether reductions in the repo rate should have ceased when the rate had fallen to 0.25 percent.

Difficult decisions were necessary when the repo rate had reached the neighborhood of the zero lower bound. As we look in the rear-view mirror at the crisis period, we find the arguments for keeping the repo rate from falling below 0.25 percent not fully convincing. The hypothesis that a literally-zero policy rate would create significant problems has not yet been tested in any country. Nor does the recent experience with low rates appear to strengthen the arguments against a zero or even mildly negative rate. We believe that it would be worthwhile, in Sweden and elsewhere, to devote more resources to studying the issues associated with a zero lower bound for the repo rate, including whether innovative options might mitigate the hesitancy of central banks to cut policy rates all the way to zero.

The common belief is that the Riksbank, unlike the central-bank authorities in the United States and the United Kingdom, did not engage in large-scale asset purchases as part of their crisis response. Yet the Riksbank did make large amounts of fixed-rate longer-maturity kronor loans to the banks, against collateral, in July, September, and October 2009. Most commentators agree that the main purpose of those loans was to enhance the expansionary stance of policy. The collateral arrangements, the credit risk, and the term risk to the Riksbank of the loans were not very different from the credit and term risks that would have been associated with direct purchases of comparable-maturity securities from the banks. The ultimate effects on interest rates paid by households and nonfinancial corporations of the two options, direct lending against collateral versus explicit asset purchases, might not have been all that different either. Similarities between the two options, broadly speaking, were probably even more important than the differences. To put the point more provocatively, we contend that the Riksbank put its toes in the water with a policy having many effects similar to the quantitative easing pursued by the Federal Reserve and the Bank of England.

Our report emphasizes the forward-guidance aspects of the Riksbank’s crisis-period monetary policy. We ask, for example, whether the forward guidance for prospective repo rates might have projected somewhat lower paths and whether greater prominence might have been given to the uncertainty associated with the repo-rate paths and the paths for the inflation and output target variables. We take it as given that the levels of forward-guidance paths and what is said about the degree of uncertainty associated with them are both fundamental aspects of the communication problem. And our predisposition is that – during crisis times of severe financial stress – the uncertainty aspects of forward guidance should be emphasized perhaps even more than forecast levels. In our view, most central banks – including the Riksbank – insufficiently focused on the uncertainty aspects of forward guidance during the crisis period and did not give enough attention to how to incorporate their judgments about forwardlooking uncertainty into their communications with the public. In particular, we are inclined to believe that the Riksbank’s forward guidance in 2008-2009 said too little about the possible consequences of the severe uncertainty for the target variables of monetary policy. And, free from the time constraints facing the Riksbank staff, we believe that it would have been helpful to amend the procedures for presenting the uncertainty bands in the Riksbank’s fan charts.

The recent period 2010-2011, as the severe strains of the crisis were somewhat dissipating, has been characterized by a vigorous debate within the Riksbank about the most appropriate stance for projected repo-rate paths and more broadly about how best to manage forward guidance during exit from the crisis period. The differences of view within the Riksbank have resulted in a persistent division of the Executive Board into majority and minority views. These differences are a first-order issue. Modestly different projected levels for the repo-rate forward-guidance path are associated with likely significant differences in possible outcomes for the economy.

The division in Board members’ views can be explained in large part by differences of judgment about the appropriate analytical approach for making decisions, not least about uncertainty. It is a subtle and unresolved issue whether the analytical treatment of uncertainty in the preparation of forwardguidance paths should help to determine the choice among the paths. The issue is subtle because the existence of uncertainty, great or small, does not by itself constitute persuasive grounds for relying on one or another analytical approach. All approaches, no matter to what extent they are based on explicit models, should try to incorporate sensitivity to uncertainty. Existing models are unable to capture adequately the uncertainty dimensions of financial strains, whether severe or moderate. Hence all model-based analysis must be cautiously amended by judgmental adjustments. The difficult tasks for policymakers are to determine how best to combine model-based and judgmental analysis and how best to explain the process and its associated uncertainties to the public. The ongoing debate within the Riksbank is a prime example of how very difficult these tasks can be.

Analysts and policymakers alike have been forced by the global financial crisis into a much sharper awareness of the deficiencies of existing models used to guide monetary policy. Models of the transmission of monetary policy through the financial system to the real economy have been shown to be more inadequate than was realized before the crisis. One can now discern, fortunately, an intensification of research efforts to improve the modeling of financial behavior, including at the Riksbank. Eventually, modeling of macroprudential instruments and their effects will need to be integrated into the larger, general-equilibrium analytical frameworks underpinning all types of macroeconomic and prudential policy actions.

The turbulence of the last few years has altered the debate about how to conduct financial policies in at least four important ways. First, central banks, market participants, and analysts in general are taking much more seriously the view that traditional monetary policy should give higher priority to financial stability. Second, they are according new urgency to making improvements in prudential policies. Third, they are recognizing that traditional monetary policy and prudential policies have important implications for one another so that they probably should be coordinated if they are to be used to best advantage. Fourth, given these new preoccupations, government authorities and outside observers are focusing anew on the institutional allocation of the responsibilities for the various financial policies – within national governments and among international institutions. The latter sections of the report touch on all these issues.

Before the global financial crisis, most analysts expressed doubts whether the central bank’s policy rate should respond to a financial-stability variable in addition to responding to the usual output and inflation variables. After the crisis, however, the debate has shifted ground. The debate now is broader, more about how to inhibit systemic financial strains and how to support financial stability more generally. Opposition to the general idea of “leaning against the wind,” interpreted loosely as putting greater emphasis on financial stability, has softened somewhat. And even though crisis tensions have partially dissipated, the still vivid memories of the meltdown turmoil have encouraged more sympathy for attempts to reduce the probability of future crises.

Policymakers charged with traditional monetary policy will understandably look to prudential instruments for a major part of the task of ex ante crisis prevention. That proclivity, however, cannot rationalize a complete neglect of the issues of financial stability when making monetary-policy decisions. We share the increasingly widespread agreement that it is unwise to rely solely on prudential instruments for reducing the risks of financial instability.

Prudential policies encompass both micro and macroprudential policies that aim at reducing the risk of financial instability. Although consultations at the BIS play a key role in developing international guidelines under the Basel III accord, domestic authorities implement the policies. In addition to more general increases in capital requirements for banks, the ongoing international discussions are proposing measures to make these requirements countercyclical. Such countercyclical capital requirements (CCRs) can potentially be used to deal with “bubbles” and to moderate credit fluctuations for stabilization purposes. The BIS and others have analyzed how CCRs can be implemented in practice — and in particular which conditioning variables can be used to determine when to build up and when to draw down buffers. Some progress has been made, but more is needed to implement this type of requirement in a systematic way.

Sweden now has in use a loan-to-value ratio cap as a prudential tool. Its effects are being debated; further study is both warranted and promised. Liquidity ratios designed to reduce maturity mismatches currency by currency are another prudential tool potentially important for Sweden (given Swedish banks’ extensive operations in foreign currencies). Many of the proposed prudential instruments are promising for use, in Sweden and elsewhere. But it is still too early to generalize confidently about how effective they will be in reducing vulnerabilities.

Buffers to deal with financial shocks can be built at the national as well as individual bank level. During the crisis in the fall of 2008, the Swedish authorities set up the Financial Stability Fund, which can extend support to troubled financial institutions, with a target size of 2.5 percent of GDP by 2025. In response to the external vulnerabilities in the financial system, the authorities also decided to increase foreign currency reserves in order to be able to support the financial system with liquidity not only in Swedish kronor but also in foreign currency. The size and funding of these buffers have been somewhat contentious.

In Sweden, as elsewhere, the authorities are addressing the issue of the degree to which “the financial system should pay for itself.” Our report considers two situations in which this issue arises. One involves the Riksbank’s foreign-currency reserves. If the Riksbank is to provide liquidity in foreign currencies to financial institutions on short notice without relying on central-bank swap facilities, it has to hold foreign-currency reserves. Funds are obtained through long-term borrowing and used to purchase short-term liquid assets. The cost of holding foreign-currency reserves is the difference between the long-term borrowing rate and the lower return on short-term assets. We believe that financial institutions that want access to emergency foreign-currency borrowing from the Riksbank should pay an “insurance fee” that covers this cost. Such a fee may reduce the amount of foreigncurrency business done by the financial institutions; as things stand now, that business is essentially being subsidized by the Swedish tax payer.

The other situation involves the financing of the Financial Stability Fund. The government started the fund off in 2008 with a contribution equal to .5% of GDP. Over time, as has been argued by the Swedish National Audit Office, private financial institutions themselves should replace the government’s initial contribution by paying that amount into the fund (taking accumulated interest into account). In addition, financial institutions are required to pay fees to build up the Fund until it reaches the announced target of 2.5% of GDP. As recommended by the EU, those fees should be lodged in an account that is invested in a geographically diversified portfolio of liquid assets. Investing in that way actually increases government assets whereas using the funds to buy Swedish government debt does not (because government assets and liabilities are increased by the same amount).

The potential for instability in financial activity cannot be attributed to cross-border finance per se. The causes are deeply rooted in the information asymmetries, the expectational and informational cascades, and the adverse-selection and moral-hazard problems that pervade all aspects of financial behavior, domestic as well as cross-border. Yet the cross-border features unquestionably magnify the potential for instability. How to allocate resolution responsibilities and associated costs among Swedish authorities and foreign authorities for complicated cross-border cases is very much an open question, now under active international consideration.

For Sweden, a small open economy with extensive financial links to the rest of the world, the development of macroprudential tools aimed at external vulnerability of the financial system seems to us a logical priority. Many practical aspects of such efforts remain to be worked out. If macroprudential financial policies have a promising future at all in Sweden, the prospects ought to be bright for those aimed at external-sector vulnerability. In any case, that is where the challenge may be greatest, and perhaps the payoff greatest, for successful measures and procedures.

Traditional monetary policy, to repeat, is relatively better suited for achieving stability of inflation and resource utilization. Macroprudential policies are relatively better suited for achieving financial stability. Yet all the target variables are affected by both types of policies. Thus even though a specialization in the two types of policies might seem appropriate, it would be inefficient – perhaps risky – if the two were conducted independently. Hence the logical question: to what degree, and how, should interactions between the two be managed? Should monetary policy and macroprudential policies be coordinated, even integrated? These issues are now high on the agenda in Sweden (as in most other countries).

Existing theory points in the direction of coordinated decisions. In general, decentralized noncooperative decisionmaking produces outcomes for a society that are inferior to the best attainable outcomes that could result from centralized decisions or the equivalent situation of full cooperation and information sharing among the decentralized decisionmakers. The broad principle is that coordination of decisions has a potential payoff.

Decentralized policymakers should, other things being equal, take account of the effects of the instruments they control on the entire set of target variables (relevant to all policymakers). If, despite the general principle, decentralized decisions without cooperation and information sharing are to be pursued, then it is incumbent on the advocates of that approach to identify benefits from decentralization – such as increased accountability, or improved specialization of function, or the avoidance of an undue concentration of power in a single authority – which offset the potential efficiency losses stemming from the lack of coordination.

Much of Swedish political thinking and political history, we have learned, has struggled with striking an appropriate balance between centralized and decentralized decisions. For Swedish financial policies, a significant degree of decentralization exists. Four separate authorities have important responsibilities. Microprudential policies are the province of Finansinspektionen. The Riksbank is responsible for monetary policies. The allocation of responsibility for macroprudential policies has yet to be clearly determined.

The Riksbank and Finansinspektionen engage in extensive information sharing and coordination at all levels. Integrating the two institutions could increase efficiency by removing the need for many of these activities. All three of the functions – macroprudential, microprudential, and monetary policy – would be under the same roof. Such a change, however, appears unlikely. Whatever the efficiency benefits of a merger of the Riksbank and Finansinspektionen might be, most of those with whom we talked in our interviews were either in favor of, or resigned to, a continuation of something like the current division of responsibilities between the two agencies. Most also did not envisage a major change in the responsibilities of SNDO and the Ministry of Finance. Several interviewees expressed reluctance to have the Riksbank gain more power relative to the other three agencies.

The difficult problem for Sweden, therefore, is how to catalyze coordination among the different authorities’ decisions regarding monetary policy and financial stability while still preserving the perceived advantages of decentralization. The approach under most active consideration entails the creation of a new umbrella institution, a “Financial Stability Council” (FSC). The FSC would have overall responsibilities for financial stability and crisis management. Detailed decisionmaking authority, however, would remain decentralized among the same four agencies who now share the various responsibilities. The FSC would be charged with engendering the desired amount of information sharing, analysis, and coordination of decisions. The presumption seems to be that the FSC would primarily act as a vehicle for joint consultation and peer pressure.

Problematic challenges lie ahead in working out precise responsibilities and detailed procedures for the FSC. Difficulties will arise, for example, when macroprudential-policy and monetary-policy considerations call for different actions. When the Riksbank participates in a shared-responsibility approach to macroprudential policymaking, will it be possible for Sweden to retain all the gains that have been attributed to political independence for monetary-policy decisions? The task of the FSC may be made more difficult by institutional features of the four Swedish financial-policy agencies that appear unlikely to change. It would be unfortunate if beneficial coordination were to be undermined by an understandable albeit regrettable tendency of decentralized institutions to insist on agency prerogatives predating the establishment of the FSC. We conjecture that the inter-agency problems can be resolved successfully provided that all parties are fully committed to the new institution.

Two procedural guidelines, as proposed by some advocates, would make it more likely that FSC joint recommendations to an individual agency would receive serious consideration. The first feature would be, following a FSC recommendation to an agency, a “comply-or-explain” obligation. The agency’s response might be subsequently published. The second feature would be a commitment to publish the minutes of FSC meetings, perhaps with some lag. We believe both procedural guidelines would be supportive steps encouraging constructive cooperation.

Our analysis in this report focuses on coordination issues within Sweden. But we are mindful of the broader European and world context in which Swedish decisions are made. Intra-European and international considerations are powerful constraints on Swedish policymakers. The complications arise for all prudential policies, microprudential and macroprudential. And they arise powerfully for traditional monetary policy. Swedish policy must take into account, and try to contribute to, the evolution of European Union financial policies.

Perhaps the greatest uncertainty facing Swedish policymakers – about financial policies but also about every aspect of Sweden’s economic policies – stems from doubts about the future of the Eurozone within the European Union. In late 2011 as this report was written, no one could clearly foresee whether a 17-member Eurozone struggling with sovereign debt issues would stay intact. Key aspects of the mandate of the European Central Bank were being debated. Although the issues were less explicitly discussed, it was also quite unclear how the European Union in the future would handle within its single-market framework the tensions between Eurozone countries and non-Eurozone countries. Those tensions are likely to become increasingly important for Sweden, as all the non-Eurozone countries — especially the United Kingdom and Denmark as well as Sweden – try to work out arrangements for themselves that are satisfactory and politically feasible.

The Eurozone member nations will be under continuing pressure to move faster toward measures of “fiscal union” (unless the Eurozone itself fractures). The European Central Bank will probably be pushed to play a stronger role as a lender of last resort for the Eurozone. Amid such pressures, it is unclear whether the issues of financial policies will evolve as a Eurozone responsibility rather than as a European Union responsibility. Perhaps even more in the next than in the last decade, the future of Europe – and Sweden within Europe – will continue to dominate financial, economic, and political discourse.

      

 

 

During coming months, member governments will again re-negotiate quota shares and voting-rights shares – “governance shares” – for the International Monetary Fund. This essay emphasizes principles and guidelines that, ideally, should influence the negotiations.

By emphasizing basic principles and introducing ideas not currently entertained, the analysis here is out of tune with the ongoing negotiations. Nonetheless, some participants and observers may find it helpful to stand back, pondering an overview of the issues. Moreover, governments will eventually find themselves pushed to allocate governance shares in the IMF with guidelines that are more defensible and that can be better sustained for the longer run. The analysis here should be, at the least, a cautionary check on the propensity to make short-run choices that exacerbate future problems.

The essay begins with relevant principles and then explains the need for a “quota formula,” an objective assessment of countries’ relative status in the world polity, economy, and financial system. No one formula can be judged as unambiguously preferable. But a powerful case exists for developing a satisfactory formula as an objective starting point for negotiations. An objective formula is a presumptive norm superior to alternative procedures ignoring an objective assessment of the relative status of members. The final outcome of negotiations should be an artful blend of formula calculations and constructive political bargaining.

The preferred structure for a quota formula incorporates variables expressed as the fractional shares of an IMF member in a global total. Ratio-share variables should be included as well as level-share variables. Ratio-share variables can better identify features of members’ economies and polities that are qualitatively distinct rather than dominantly determined by economic size.

The most comprehensive gauges of countries’ relative economic status are based on gross domestic product or income – measured at market prices and exchange rates, measured at purchasing-power parities, or measured as a blend of both. GDP-based variables are the single most important class of variables for a quota formula. Other gauges, however, can be judged relevant. In principle, financial-activity variables should be incorporated (although lack of sufficient data for all IMF members will probably prevent that from happening in the near future). Shares in world population merit inclusion (notwithstanding the failure of official discussions to seriously discuss that possibility). Two ratio-share variables that deserve consideration are the ratio of gross cross-border current-account transactions to market-price GDP (an analytically more appropriate measure of current-account openness than the faulty “openness” variable currently in use) and a scaled gauge of the variability of cross-border transactions (the ratio of standard-deviation calculations of variability scaled by market-price GDP). Alternative conceptual perspectives can of course lead to different choices about the variables to be included in a quota formula.

Against the background of principles and general guidelines, the essay examines the current quota formula that was agreed at the time of the package of governance reforms concluded in April 2008. The communique of the September 2009 G-20 meeting in Pittsburgh indicated that “we [G-20 leaders] are committed to a shift in quota shares to dynamic emerging market and developing countries of at least five percent from over-represented to underrepresented countries using the current IMF quota formula as the basis to work from (italics added). We are also committed to protecting the voting share of the poorest in the IMF.” Unfortunately, there is no straightforward way – however the words are interpreted – to use the current formula as a basis for meeting that commitment. The current formula justifies a large calculated increase in quota share for China, substantial increases for countries such as Mexico, Brazil, Turkey, and moderate increases for some dozen other emerging-market countries. But it calculates declines in quota shares for countries such as India, Russia, Pakistan, and Peru. For the aggregate of all countries other than China, India, Brazil, Mexico, and Russia that are classified as not-advanced and not-higher-income, the formula mandates a share reduction of 3.09 % points. The G-7 countries taken together are calculated as over-represented by the meager amount of only 0.31 percentage points. For the 71 countries eligible as of late 2009 to borrow from the IMF’s Poverty Reduction and Growth Trust Facility (PRGF), the formula calculates a decline in aggregate share of 1.74 percentage points.

The current formula imposes an arbitrary mathematical device of a “compression factor.” If this compression factor is removed from the calculations, the results from using the current formula are still more problematic. For example, the G-7 countries are calculated to be underrepresented by 2.35 percentage points! For the 71 PRGF countries, the current formula without the compression factor points to an even larger decline in aggregate share of 2.16 percentage points.

The conclusion seems inescapable that the current formula is an inadequate basis from which to work if the intent really is to significantly increase the aggregate quota share of dynamic emerging-market and developing countries by at least 5 percentage points. And the current formula points in the wrong direction if the goal is to prevent a diminution in the quota shares of the IMF’s poorest members. Semantic euphemisms aside, negotiators will have to abandon the current formula and find some better way to construct and explain their decisions.

One possibility would entail de facto jettisoning of all formulas and negotiating a bargaining outcome that could command consensus from the largest, most influential IMF members. Yet that course would undermine, now and for the future, development of a presumptive norm for objective assessment of countries’ relative status.

To encourage thinking about possible revisions in the quota formula, the essay describes an illustrative revised formula and reports results from its use. That illustration raises the combined weight associated with GDP variables; reduces the weights on gross cross-border transactions, on unscaled variability, and on international reserves; adds a new variable for shares in world population; and introduces ratio-share variables for current-account openness and scaled variability. The illustrative formula is not so much a recommendation as a catalyst for further thinking about how to improve the ability of the quota formula to achieve systemic IMF goals.

The illustrative formula generates very different conclusions from those obtained with the current formula. For example, the G-7 countries are over-represented by the large amount of 4.72 % points. China is calculated with a much larger quota share; the calculated shares of India, Brazil, and Mexico are significantly larger. The 78 poorer IMF members eligible to borrow from the IMF’s PRGF are under-represented by 5.02 % points (instead of over-represented by 2.25 % points).

The illustrative formula is an improvement in several respects. But other aspects are problematic. For many IMF members, the calculated increments in shares would be controversial. No doubt many official participants in the negotiations will perceive the illustration as going too far in shifting quota shares away from developed and toward emerging market and developing members.

The adjustments in quota shares to be decided in the upcoming negotiations – and, in turn, the changes in voting shares derived from them — are just part of the large subject of reforms for IMF governance. The size and composition of the IMF Executive Board, and hence the organization of members into constituencies, are at least as important. Other key issues include the size of prospective quota increases and SDR allocations, and implementation of the Council provided for as a possibility in the Articles of Agreement.

This essay has a restricted focus and does not try to cover the other dimensions of governance reform. Yet those dimensions are closely interdependent with what has been analyzed here. An improved formula and procedures for allocating quota shares is a necessary condition – necessary, but not sufficient – for satisfactory resolution of the whole range of governance issues.

The world community in the upcoming negotiations in 2010 should frankly acknowledge the inadequacy of the existing quota formula and try to reach agreement on an improved approach for the determination of governance shares.

      

 

 

Failing to cooperate could weaken confidence further and worsen the crisis. The disaster of the 1933 London World Economic Conference, occurring at a similar time of worldwide economic distress, is a reminder of the damaging effects that can occur if leaders fail to act cooperatively.

The needed cooperation is of two sorts. With fires already raging, the existing fire brigades must fight the short-run acute problems. But because the existing firehouses, their equipment, and fire regulatory safety codes are inadequate, efforts to rebuild are required to assure that fires can be better fought over the medium and long runs. One’s first thought may be to concentrate solely on the acute problems, postponing rebuilding agreements for later. Agreements on how to fight the acute fires of today, however, will not be reached without credible commitments to rebuild the firehouses and regulatory codes for tomorrow. As G-20 leaders plan their April 2nd meeting, they should focus on agreed actions to address the immediate emergency but also on specific commitments to enhance intergovernmental cooperation over the longer run.

If far-sighted, the G-20 leaders will strengthen the powers and stature of international institutions as conduits for their cooperation. For now, the most critical needs are at the IMF, the Financial Stability Forum, and groups charged with responsibilities for supervision and regulation of financial institutions (such as the Basel Committee on Bank Supervision). Such strengthening is very much in the interests of all countries — large and small, rich and poor. Yet few governments are strongly committed. The United States has not acted as though an effective IMF is essential for supporting its goals and prosperity. The Europeans have been preoccupied with maintaining their disproportionately large share in IMF voting rights and Executive Board seats rather than promoting a stronger, more effective institution. Emerging-market nations such as China, India, Brazil, and Mexico likewise do not perceive the IMF as an institution serving their fundamental interests. Yet those national views are all shortsighted. They underemphasize, if not ignore completely, the fact that appropriate strengthening of the international institutions can advance the collective interests of all nations.

International institutions have not always functioned effectively. They have not been given sufficient authority to conduct multilateral surveillance, and have been timid in exercising the limited powers they do have. Their analytical capacities are not strong enough. For today’s world, their governance has major flaws. Despite their weaknesses, however, they can and do play a positive role. In the current crisis, the world community has no better choice than to rely on the institutions and strengthen them as quickly as possible.

A collective bargain among all nations is required to support near-term actions and to reform the institutions for the longer run. It is true that some needed reforms are a zero-sum game. For example, the share in voting rights of many developed countries, particularly in Europe, must fall so that the share of underrepresented countries such as China, India, and Brazil can rise. But many other aspects of needed reforms are a positive-sum game. Most notably, major developed countries and large emerging-market countries could join together to negotiate a strengthening of the IMF, the Financial Stability Forum, and other institutions that would prove mutually beneficial to all countries in the world.

The remainder of this note identifies specific short-term commitments that could be an initial installment of that collective bargain. Judged from the perspective of the London summit meeting, each component is a short-term “deliverable” for the summit communique on April 2nd.

The G-20 leaders should agree on (1) a cooperative package of macroeconomic policies, highlighting especially fiscal stimulus programs. The package should contain a fiscal stimulus program for each country that has policy space to implement fiscal expansion. The programs should contain specifics for each country. Equally important, the IMF should be charged with monitoring the implementation of the specific programs and prominently identifying countries that are not adequately pulling their weight. The leaders should pledge that they want the IMF monitoring to have “teeth.” A credible commitment to support IMF monitoring is a promising step that leaders can take to bolster confidence that cooperative policies will mitigate short-run contractions in output and employment. The commitment would also be a downpayment on strengthening the IMF’s multilateral surveillance of countries’ macroeconomic and exchange-rate policies over the longer run.

The leaders should negotiate (2) a counterpart agreement for monitoring the commitments of countries to avoid beggar-thy-neighbor policies. The WTO and perhaps also the IMF should be given an explicit mandate to report regularly on the entire range of countries’ policies affecting cross-border transactions. Countries that sail too close to the wind with policies that have protectionist effects, either for goods-and-services trade or for financial transactions, should be named and shamed. G-20 leaders must credibly indicate that they support this monitoring and will not undermine the international reports even if their own countries are criticized.

G-20 leaders should (3) urgently plan to provide additional resources for IMF lending and to ask for revisions in its terms and conditions. Substantially larger resources are needed in the short-run emergency, and for the medium term as well. Access and conditionality provisions for IMF lending facilities will require changes. The needs are especially acute for low-income countries and for some emerging-market countries experiencing a severe shortfall in net capital inflows.

Far and away the preferred method for increasing the IMF’s resources is to expand aggregate quotas. An expansion of the New Arrangements to Borrow (NAB) is also warranted. But those desirable changes cannot be adopted quickly because they must be preceded by time-consuming negotiations and be accompanied by a major reform in the governance of the IMF (point 4 below).

For the immediate future, therefore, the G-20 leaders have only two practical choices. One is to ask for approval under existing IMF procedures for (3a) a large one-time immediate SDR allocation. The size should be at least the equivalent of $200 billion. As an interim step, a large SDR allocation could be implemented promptly without any change in the IMF articles. (It would require an 85% majority of total IMF votes.) An SDR allocation is an imperfect, blunt instrument for an immediate expansion in world liquidity. The largest fraction of an allocation, some two-thirds, would go to countries for whom the direct benefits would be small or non-existent. Nevertheless, the effects for the world as a whole would be unambiguously positive. Because the world financial and economic system faces a severe emergency, the effects of an SDR allocation could help substantively and as a way of boosting short-run confidence.

The other short-run choice for increasing IMF lending resources is (3b) augmented bilateral borrowing from particular IMF members. The recent special borrowing of $100 billion from Japan is an initial example that the IMF Managing Director hopes to supplement with analogous borrowings from other high-reserve countries. This approach can help provide immediate resources. But ad hoc borrowings from individual countries are at most an interim step. A major difficulty is that several of the other candidate countries for bilateral borrowings, China being the most prominent, may justifiably prove reluctant to lend in the absence of upward adjustments in their voice and representation in the IMF so as better to reflect their weights in the world economy.

Because of the inevitably close links between additional IMF resources and governance reforms for the IMF, G-20 leaders should pledge to (4) re-open international negotiations about the financial resources available to the IMF and about the entire range of IMF governance reforms. A commitment to negotiate comprehensive reforms is primarily a matter of rebuilding the IMF firehouse rather than fighting this year’s fires. But that commitment is essential to encourage the necessary cooperation for this year’s firefighting (in particular, the active participation of China and other large emerging-market nations). Although a package of reforms was agreed by the IMF membership in April 2008 after three years of negotiations, those reforms were timid and inadequate. Further government and legislative consideration of that package should be deferred. Instead, G-20 leaders should commit the IMF and their Finance Ministers, Deputies and staffs to renewed negotiations over the coming year. The leaders should set an explicit timetable and ask for definite progress by the fall 2009 annual meetings of the IMF and World Bank.

The bold package to be negotiated should provide a major increase in the size of aggregate quotas (at least a doubling); review and expand the arrangements for borrowing under the NAB; refine the terms for member borrowing from the IMF’s Short-term Liquidity Facility; revise the terms for members’ access to other IMF facilities; incorporate an improved formula to serve as a basis for determining quota and voting-rights shares; revise the composition of the Executive Board and of member constituencies, reducing the number of Executive Directors to no more than 20; eliminate the provision that prohibits split voting within constituencies; reduce from 85% to 80% the required special-majority vote for many key decisions; retain the tripling of basic votes agreed in the April 2008 package; enhance the mandate for IMF multilateral surveillance and macroeconomic oversight of the world economy, including exchange rates; and strengthen the analytical capacities of the IMF staff for conducting such surveillance.

As a credible downpayment on the comprehensive IMF reform to be negotiated in the coming year and as a step to bolster short-run confidence, G-20 leaders should announce (5) an agreement that leadership selection at the IMF and World Bank will henceforth be solely based on merit, with candidates considered from any nationality. Leadership selection should require a double-majority voting approval (analogous to that required for approval of amendments to the IMF and World Bank Articles of Agreement.) This agreement would make obsolete the longstanding but now inappropriate convention that European governments designate a European to be Managing Director of the IMF and the U.S. government designates an American to be President of the World Bank. (A joint United States and European Union statement reiterating the agreement could be timed with the G-20 communique.)

Finally, the April 2nd communiqué should reiterate commitment to (6) reforms of the international institutions with responsibilities for catalyzing cooperation about prudential oversight (supervision and regulation) of financial institutions. Insufficient time exists prior to the April 2nd meeting to negotiate sound, specific measures in this area. Most such measures in any case pertain to the longer-run task of rebuilding the firehouse and designing better fire safety codes. An immediate step can be taken to broaden the country participation in the Financial Stability Forum and restructure how the seats are arranged around the table. Expansion should likewise occur in the countries participating in the Basle Committee on Banking Supervision, the International Accounting Standards Board, the International Organization of Securities Commissions, and the International Association of Insurance Supervisors. The primary responsibility for improved financial standards and prudential oversight, it is true, necessarily resides within individual nations. But the G-20 leaders should build on their November 2008 agreement by credibly committing their countries to intensified cooperation to develop agreed world minimum standards and to provide monitoring and enforcement of those standards.

      

 

 

Governments and central banks should act jointly to improve world standards for the prudential oversight of financial activity. And they should cooperate to monitor and enforce those standards.[1]

Two major underlying issues must be addressed before significant progress can be made toward those goals: Which international forums and institutions should be the locus of the cooperative efforts? How should important countries that heretofore have not been included in the existing cooperative efforts be brought into the process?

As of the autumn of 2008, a variety of international institutions and intergovernmental committees already address issues of prudential financial oversight. The most active have been committees or groups under the auspices of or associated with the Bank for International Settlements (BIS), especially the Basel Committee on Banking Supervision (BCBS). Supervision and regulation of securities and insurance have been discussed primarily in, respectively, the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). Cross-border accounting issues are the domain of the International Accounting Standards Board (IASB). The International Monetary Fund (IMF) and the World Bank have limited monitoring responsibilities in these areas. An umbrella organization created in 1999, the Financial Stability Forum (FSF), provides some oversight and coordination among the institutions and committees.

In recent years the combined international efforts fell well short of the cooperation that would have helped to mitigate today’s crisis. Nevertheless, the primary failures in prudential oversight were substantive rather than institutional.

Looking forward, some policymakers seem to yearn for a completely new institution. For example, some sweeping ideas in the air prior to the November 15th G-20 summit call for the creation of new “international colleges” to harmonize the supervision and regulation of the activities of the largest, internationally-active banks.

Some commentators pitch the ideas of a new “supranational regulator” or a complete re-design of the international architecture of financial regulation in a “Bretton Woods II” conference. These ideas, however, are vague and premature, if not naïve. Such staff expertise as now exists on prudential oversight of finance is lodged in national central banks and financial supervisory authorities, or to a small extent at the BIS, the IMF, and the World Bank. The staff and secretariat resources for a new supranational regulator or an international college of supervisors would in the shorter run have to be stolen from these institutions. How would a reshuffling of the existing inadequate expertise to a new institution lead quickly to better prudential oversight?

The allocation of responsibilities among the existing international institutions and committees is partly a haphazard result of historical events. It does not conform to an orderly blueprint. Even so, those who wish to create new institutions should be asked to explain why they believe the benefits would exceed the costs and why a tidier institutional structure would better foster cooperative prudential oversight of financial activity.

The relative roles of the BIS and the IMF are the most difficult institutional reform issue lurking beneath the surface. Some may argue that the IMF should be the center of gravity for cooperative prudential oversight for the longer run, and hence that it should gradually assume a dominant role in the global aspects of standard setting, data dissemination, and prudential monitoring. That view presumes that the BIS and committees such as the BCBS should play a declining and merely supporting role.

Sorting out the relative responsibilities of the IMF and the BIS involves much more than the functions of standards, data dissemination, and prudential supervision. Still more difficult is the issue of whether the IMF’s mandate should include primary responsibility for the surveillance of national monetary policies. Consensus exists that the IMF should appraise the monetary policy of an individual nation as an integral part of IMF surveillance during that nation’s Article IV consultations. But the central banks of the largest nations perceive the BIS rather than the IMF as the primary institutional conduit for cooperative consultations and surveillance of their monetary policies. When the major central banks have perceived a need for direct cooperation on issues of crisis management and lender-of-last-resort emergency lending, the BIS has also been their preferred venue.

The most delicate and fundamental issue at stake in defining relative responsibilities is the desirable degree of political independence for central banks. Because major central banks prize the BIS as their institution, they have not welcomed finance ministries inserting themselves into BIS activities. The IMF is often perceived as more beholden to finance ministries in national governments than to national central banks. Academic and public support for the political independence of central banks has waxed strong in recent decades.

Some single international organization may eventually come to be perceived as the principal locus for collective financial governance on a global scale—as a global central bank for national central banks. Today, one cannot perceive whether the IMF or the BIS is the more likely embryo for such an institution. It is equally unclear whether the IMF, if perceived as the embryonic world central financial institution, will have to be given greater political independence from national governments. An alternative line of speculation about the longer-run future is that the IMF and the BIS will both survive as powerful global financial institutions.

For the shorter run, the pragmatic choice may be to ask the Financial Stability Forum to serve as the main locus for coordinating decisions of the IMF, the BIS and associated committees, and the finance ministries, central banks, and supervisory agencies of national governments. At some point, however, the world community will have to formulate a clearer vision for the BIS and a refined mandate for the IMF in the areas of monetary policies and crisis management as well as financial standards, data dissemination, and prudential oversight. If both the IMF and the BIS plus its associated committees are to survive and prosper for the longer run, difficult decisions will have to be made — de facto if not transparently — about how to divide or share functional responsibilities between the two sets of institutions.

The issue of “Which Countries?” is closely related to “Which Institutions?” Some important countries and virtually all smaller countries have not so far been included in international decisionmaking about the prudential oversight of financial activity. In particular, China, India, Brazil, Mexico, and Korea have not had seats at the table when world standards and codes have been discussed.[2] Yet increasingly such countries are deeply engaged in the world financial system. Without greater voice in cooperative decisions, the excluded countries are unlikely to support the decisions.

China, India, Brazil and other emerging market economies do not attend meetings of the BCBS and other BIS-associated committees. Nor are they represented at meetings of the Financial Stability Forum. Indeed, the FSF was created after the Asian financial crises of 1997-1998 with the intent of including only the supervisory authorities and central banks of the main industrial countries.[3]

The summit on November 15th is formally a meeting of the G-20 and will thus include China, India, Brazil, Mexico, and Korea. Their participation on November 15th is an encouraging development. But when the discussion focuses on prudential financial oversight and when consideration is given to further activities of the FSF and the BCBS, will Europe, North America, and Japan propose that the big emerging-market countries be given a seat at those tables? It would be highly awkward to assert that countries such as China and Brazil should adhere to reformed world standards for prudential supervision and should cooperatively participate in reformed mechanisms for the management of financial crises without giving them a voice in the design of those standards and mechanisms.

Alternatively, do the major industrial countries wish to have expanded prudential oversight occur primarily through the IMF rather than through the FSF and BIS-associated groups? For that alternative, too, an awkward mismatch exists. China, India, Brazil, Mexico, and Korea have disproportionately small quotas and voting shares in the IMF while European countries have disproportionately large quotas and votes. The world community in the last three years went through a protracted negotiation to better adjust IMF quotas and votes to relative positions in the world economy. But the adjustments agreed in April 2008 were very modest and fell far short in addressing the challenges facing the IMF in its evolution toward a global institution with more balanced and inclusive representation and voting power. The April 2008 agreement failed completely in reducing the excessive number of seats held by European members in the IMF’s Executive Board (in fact, the issue was kept out of the negotiations altogether). The revised formula agreed in the negotiation for calculating the presumptive quota and voting shares of members, taken on its own, generated changes in shares that moved away from, rather than toward, a better alignment of voting power with economic realities. The agreement negotiated in April achieved its very modest improvements in raising the quotas and shares of countries such as China, India, Brazil, Mexico, and Korea only because the underlying formula was overridden with one-time, ad hoc gimmicks that masked the unpalatable consequences of the formula.[4]

Given the world financial crisis and the impetus in some quarters to “reform the international financial architecture,” a strong case exists for re-opening the negotiations about the governance of the IMF (and the World Bank). The United States Congress has not yet acted to pass the adjustments incorporated in the April 2008 IMF agreement (they had not even been submitted to Congress as of the summer of 2008). Given that President-elect Obama seems likely to adopt a more multilateralist approach that will strongly support international institutions, it would be better for the Congress not to act on them and instead encourage the Obama administration to re-start the negotiations, leading the way to a more solid and sustainable reform agreement.

Achieving a better agreement about the governance of the IMF and the World Bank – including a substantial increase in the quotas and voting shares of the emerging-market and developing countries – is, for a variety of reasons, an important task for the world community. That step forward is surely necessary if the IMF is to be given enhanced responsibility for catalyzing international cooperation about prudential financial oversight.

      

 

 

The prudential supervision and regulation of financial activity, never appearing on radar screens in normal times, is suddenly near the top of worry lists. Many observers deem them a priority problem badly needing to be “fixed.” And because financial activity is now global and the financial crisis is worldwide, many jump to the conclusion that prudential oversight has been inadequate not only within individual countries but also in its cooperative international dimensions.

The beginning of wisdom about prudential financial oversight is to eschew extreme perspectives and to recognize that extremist remedies are unlikely to be a net improvement.

It is true that inadequate supervision and regulation of financial activity significantly contributed to the evolution of today’s crisis. Banks and nonbank financial institutions were allowed to become badly “overleveraged.” Financial institutions moved assets off their balance sheets to avoid having to hold adequate capital reserves. There was insufficient transparency, disclosure, and supervisory monitoring for complex financial instruments such as collateralized debt obligations and derivatives such as credit default swaps. Credit default swaps, essentially insurance contracts, were not subject to regulation acknowledging their insurance as well as derivative character. Hedge funds were not required to disclose sufficient information and were lightly regulated. Internal techniques for evaluating the risks taken on by financial institutions were faulty and were not adequately second-guessed by prudential supervisors. Credit-rating agencies failed to give cogent appraisals of the instruments they rated. Sadly, the preceding is merely a partial list.

Yet it is also true that today’s crisis had multiple causes. Inadequate prudential oversight was not the only, not even the primary, difficulty. Imprudent behavior of both lenders and borrowers in projecting housing values and in the origination of mortgages were critically important. First-best supervision and regulation could have mitigated that imprudence, but not forestalled it altogether. As investors became skittish and confidence declined sharply, the crisis became increasingly unanchored from its original triggers. Herd behavior led to a freezing of all lending and borrowing, which in turn threatened even healthy, adequately capitalized financial institutions.

Just as inadequate prudential oversight, both in the United States and abroad, contributed to the emergence of the financial crisis and to the speed with which it worsened, cooperation among national supervisory authorities in recent decades can also be validly criticized. More progress could have been made to improve world standards for the prudential supervision and regulation of financial activity. More cooperation could have led to better monitoring and enforcement of world standards. Again, however, it is important to recognize that failures of international cooperation were not a dominant cause of the worldwide crisis.

As with so many aspects of public policy, ideologically extreme views about financial activity attract disproportionate attention. One polar view emphasizes only the presumptive efficiency of financial markets. The opposite extreme perceives only market failures. But thoughtful analysts have always recognized the inevitable tensions between market efficiency and market failure. The decentralized decisionmaking embodied in market supplies and demands can accomplish allocative feats of great complexity. Yet markets can also malfunction; decentralized, noncooperative decisionmaking can sometimes produce outcomes decidedly inferior to those attainable when decentralized decisions are constrained by collectively agreed guidelines and collective monitoring.

An eclectic and agnostic stance about prudential financial oversight is essentially the same mainstream stance that makes sense in resolving the tensions between market efficiency and market failure. And eclecticism is the most judicious response to extreme views. If you find yourself being lectured about the damaging effects of unfettered free markets and the need for a sweeping re-regulation of financial activity, your mind should flood with the mischief that can be caused by anachronistic and ineffective government regulations, the beneficial discipline of interbank and intercountry competition, the merits of lending decisions decentralized to where information about credit risk is least unreliable, and the potential for improved resource allocation and faster growth that can result from savings being channeled to investment projects yielding the highest return. Conversely, if you find yourself in the company of someone arguing that across-the-board financial deregulation will work supply-side miracles in the national and world economy, your mind should then overflow with thoughts of the bank executives who behave like sheep in choosing a portfolio dominated by securities backed by subprime mortgages, drug-smuggling proceeds laundered through banks in offshore financial centers, stock prices fluctuating in response to false rumors started by market participants in order to make exploitive trades, and competitive laxity between governments trying to attract financial institutions to their jurisdictions by reducing taxation and the stringency of supervision – not to mention the Asian financial crises of 1997-98, the failures of the Herstatt and Franklin National banks in 1974, the Credit-Anstalt in Vienna in 1931, and the South Sea Company in London in 1720.

In the United States and several other developed countries, government policies about supervision and regulation in the last decade tended to drift in the direction of de-regulation, away from a judicious middle ground. As new financial instruments were created, disclosure and transparency requirements were not imposed. Out-of-date regulations were not updated. Prudential supervision was not enhanced even though the need for it was increasing.

Inevitably, the current crisis will force the general stance of supervision and regulation sharply in the opposite direction. Getting back to a sensible middle ground is badly needed. But there is significant risk that, as with a pendulum, the middle ground will be overshot.

The risks of overshooting, of adopting ill-considered steps, are especially high in the area of international cooperation. To reduce the probability of future crises, governments and central banks over the medium run do need jointly to improve world standards for prudential oversight. And they do need to support enhanced cooperation to monitor and enforce those standards. But some of the sweeping ideas in the air prior to the November G-20 summit – such as creation of a new “supranational regulator” to harmonize the supervision and regulation of the activities of the largest, internationally-active banks; or a complete re-design of the international architecture of financial regulation in a “Bretton Woods II” conference – are as yet vague and, at best, highly premature.

Proposals for incremental progress should, at the very least, be closely informed by the merits and deficiencies of the cooperative actions that have already been taken in recent years through groups such as the Financial Stability Forum, the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO), the International Association of Insurance Supervisors (IAIS), and the International Accounting Standards Board (IASB).

A cooperative approach at the world level for refining financial standards and prudential oversight should be based on the following general principles:

1) Responsibility for improved standards and prudential oversight should begin and end at home within the individual nation. Cooperative design of standards and collective international monitoring should shape a world environment that encourages individual national governments to take appropriate actions. “Supranational” institutions will have limited political authority for the foreseeable future. Strengthened standards and oversight within nations cannot be imposed from outside.

2) Standards and oversight at the world level should take the form of core principles rather than detailed codes or fully specified regulations. It would be premature to try to obtain worldwide intergovernmental agreement on detailed codes and regulations. National governments may be able to accept core principles and guidelines, but typically they will prefer — often with justification — to adapt the core to the particular indigenous characteristics of their own situations. Even if detailed regulations were somehow politically negotiable, it could still be undesirable to aim for such detail. Although standards and regulations can err by being too loose and fuzzy, they can also err by being excessively detailed.

3) The preferred approach at the world level is an encouragement of agreed minimum standards combined with the presumption of “mutual recognition.” This approach differs from the negotiation of “harmonized standards.” Explicit harmonization across nations would require substantial departures from national governments making decentralized decisions; harmonization would also require a major overhaul of international financial organizations. Mutual recognition (as understood, for example, within the European Union) does entail intergovernmental cooperation: it requires exchanges of information and consultations among governments that will constrain the formation of national regulations and policies. In contrast with harmonization, however, mutual recognition presumes a continuation of decentralized decisions by national governments.

4) No financial institution, anywhere in the world, should escape adequate supervision by one or more national prudential authorities. Since first articulated in 1975, and revised in 1983, a similar principle has been widely accepted — for banks — as the “Basel Concordat.”

5) World standards and oversight should, when possible, rely on market incentives rather than direct restrictions. Within individual nations, prudential oversight that relies on market incentives will usually, if feasible, be preferable. The same principle applies to standards and prudential oversight designed to cover cross-border financial transactions and the world financial system as a whole. Detailed direct restrictions require large staff resources. Detailed restrictions are difficult to update to changed conditions, and if not updated can easily become anachronistic. Detailed restrictions, though designed to offset market failures, can founder because of government failure.

6) Standards and oversight designed at the world level should highlight disclosure and transparency. A close link exists between the degree of disclosure and the ability of supervisors to rely on market-based, incentive-based regulations. Without ample disclosure of institutions’ accounts and behavior and without the information being readily available globally as well as domestically, an emphasis on incentive-based oversight instead of direct explicit regulations cannot be successful. Ample disclosure of accurate and timely information helps to reward safe and well-managed institutions while exerting market pressures on institutions that are excessively risky and poorly managed.

7) Monitoring and enforcement of world standards and oversight are at least as important as sound design. Even if well designed and fully agreed, standards and guidelines are of limited worth without adequate monitoring and enforcement. Private institutions have strong incentives to innovate to circumvent existing regulations. Such innovations require supervisors to adjust their monitoring and enforcement (sometimes even the design). Monitoring and enforcement is especially difficult when reliance must be placed on direct restrictions rather than on standards and regulations based on market incentives. The greatest risks come from the latent potential for regulatory capture and regulatory forbearance.

8) The primary mechanisms for monitoring and enforcement of a nation’s standards and oversight should be implemented internally within the nation (self assessment), but evaluation from outside the nation (external assessment) should be used as a supplement. Because responsibility for prudential oversight for a national financial system must be shouldered at home (principle 1), the bulk of monitoring and enforcement activity must also be implemented within the nation. Each nation, acting voluntarily, should strengthen its own indigenous procedures for self assessment. Self assessment alone, however, is unlikely to be sufficient. To ensure rigor, to foster consistent application of world standards across national jurisdictions, and above all to enhance credibility, national self assessments need to be complemented by external verification and probably even by external assessments. Initiatives in recent years, such as reports on the observance of standards and codes (ROSCs) and financial sector assessment programs (FSAPs) carried out under the auspices of the IMF, World Bank, and the BIS, are initial international efforts at external assessment. Evaluations by the Financial Action Task Force in the specialized area of financial crime and money laundering are another illustration of external assessments of nations’ compliance with world standards.

9) No governmental jurisdiction should be accorded the full benefits of participation in the world economic and financial system and its supporting international organizations if it persists in maintaining standards and prudential oversight that are weak relative to world minimum standards. In a world financial system with nearly 200 separate national jurisdictions, a few may be opportunistic free riders. The most problematic jurisdictions may intentionally have inadequate transparency, weak standards and supervision, loopholes that facilitate tax evasion, and little willingness to cooperate internationally. Such weak-standard jurisdictions, for example a subset of so-called offshore financial centers, may exploit their supervisory laxity to attract private customers and financial institutions trying to escape sensible tax regimes and high prudential standards elsewhere. The world community should try to discourage the adverse externalities originating from such free-rider behavior. If a jurisdiction makes little effort itself at self assessment, or even actively inhibits self assessment, in such instances the world community has no choice but to impose some form of external assessment. Widespread dissemination of such an assessment for a problematic jurisdiction — a “name and shame” policy – may influence the jurisdiction to change its behavior. If a name-and-shame policy proves insufficient, the world community will eventually have to agree on stronger measures.

The preceding principles are “soft” rather than “hard,” shaped by a strategy of pragmatic incrementalism. Agreement on more detailed principles and codes, not to mention monitoring and enforcement, will be difficult and slow. But these broad principles are a place to start. They could constitute a feasible foundation for a near-term strengthening of the surveillance of individual nations’ financial systems and the world financial system as a whole.

Meaningful progress on international cooperation for prudential oversight cannot be achieved without addressing two difficult underlying issues. Which international forums and institutions should be the locus of the cooperative efforts? How should important countries that heretofore have not been engaged in the existing cooperative efforts be brought into the process? These two issues are discussed in a companion essay.[1]

      

 

 

Because the crisis is worldwide, vigorous international cooperation is necessary to restore the normal operation of financial markets. Yet government officials and parliaments may not be able to act promptly (witness the difficulty in the United States of getting rescue legislation though the Congress). The burden of cooperative actions in the short run may therefore continue to fall on central banks. So far, central banks have consulted closely and acted aggressively to supply liquidity to the financial markets (backed up by increases in their swap lines with each other). That commendable and reassuring collaboration will have to be continued, even enhanced.

The turmoil in asset values could spread to exchange markets. Sudden, disorderly changes in exchange rates have not yet been observed on a significant scale. But central banks should have contingency plans for coping with such disorder if it were to occur. In normal times central banks are reluctant, correctly so, to engage in massive intervention in exchange markets. If contagion were to inflame the exchange markets and put severe pressure on individual currencies, however, central banks might be compelled to take aggressive action there too. Such cooperative intervention would entail central banks buying a currency judged to be under unwarranted attack, preventing its disruptive decline.

As the financial crisis has spread in Europe and Asia, the U.S. dollar has recently strengthened, not weakened, against the euro, the British pound, and the Japanese yen. Market transactions have been skittish but not disruptive. However, a further meltdown of American financial institutions and a surge of bearish expectations about American political and economic developments could conceivably turn market sentiment against the U.S. dollar, causing sudden selloffs of dollar-denominated assets by private foreigners. In the worst case, declines in confidence in the American economy could even intensify pessimistic judgments about the continued sustainability of the U.S. dollar’s use as a reserve currency. A sharply falling dollar, were it to happen, would sorely test central bank cooperation. Moreover, such cooperation might have to include not only those central banks who have already been supplying massive amounts of liquidity to financial markets but even the central banks of nations such as China, Russia, India, and Brazil that hold large amounts of dollar-denominated assets in their reserves. Judgments about exchange-market intervention – when might a currency be experiencing “unwarranted” attack? how to estimate an appropriate post-crisis valuation of the U.S. dollar against foreign currencies? – would be difficult and controversial. With luck, cooperating central banks will not need to make those judgments. But precautionary contingency planning is certainly in order.

Contingency consultations about coordinated reductions in policy-determined short-term interest rates should also be considered. Domestic goals and needs differ across the major countries. Given cross-border contagion and disruptive herd behavior, however, consultations among central banks leading to mutually-timed announcements of monetary-policy actions could help to restore confidence.

For the longer run, to reduce the probability of future crises, governments and central banks need jointly to improve world standards for prudential supervision and regulation of financial institutions. And greater cooperation will be needed to monitor and enforce those standards. Improvements will be slow. Yet genuine progress over the longer run is essential to achieve a healthier and more stable evolution of the world’s financial markets.

It is no more reasonable for nations to act independently in stemming financial crises and in prudentially supervising their financial institutions than it would be for one nation’s signalling codes at sea and in airspace to take no account of the signalling codes of other nations. International cooperation is an increasingly vital underpinning for nations’ economic activity and political governance.

      

 

 

The reform of IMF governance is a key requirement for strengthening this international financial institution at a time of great financial turmoil. The essential goal of the reforms is to enhance the IMF’s legitimacy and credibility, thereby strengthening its ability to facilitate prosperity and stability in the world economy and financial system. One factor weakening the legitimacy of the IMF has been that members’ quota and voting shares, which underpin IMF decisions, have become unbalanced over time, less adequately representing the current distribution of economic and financial power and needs in today’s world. The IMF’s member countries embarked two years ago on a major effort to rebalance quota and voting shares. The goal of those negotiations was to develop a new formula for calculating quotas and votes that would better reflect members’ relative positions in the world. A rebalancing based on the formula would among other things give a substantially greater vote and voice to rapidly growing emerging-market economies. Another goal of the negotiations was to protect the share of lower-income developing countries from declining.

The concern expressed in the experts’ letter is that the proposed package of reforms falls far short of the goals of the exercise. Problems and weakness are numerous (for background, see the summary analysis by Ralph Bryant). A major weakness is the proposed revised formula for calculating the presumptive quota and voting shares of members. Taken on its own, the formula generates changes in shares that move away from rather than toward a closer alignment of voting power with economic realities. The proposed package as a whole achieves its very modest improvements only because the formula is overridden with one-time, ad hoc adjustments that mask the unpalatable consequences of the formula and because the basic votes allocated to each member are tripled. The new formula, despite assurances to the contrary, is not a viable basis for making future adjustments in quotas and votes that will adequately reflect changes in relative positions in the world economy.

The proposed tripling of so-called basic votes (identical in number for each member country), which produces an increase from about 2 percent to 5-1/2 percent in the fraction of basic votes in total votes, is a beneficial move in the right direction since on balance it strengthens the representation of small countries, the majority of which are poor developing countries and many of them in Africa. Yet even that increase falls well short of restoring the share of basic votes in the first decade of the IMF, when they were as high as 13-15 percent of total votes.

The proposed changes in members’ quota and voting shares are very modest, moving only slightly toward achievement of the goals announced for the reform. By way of example, the combined voting share of China, India, Korea, Brazil, and Mexico will increase from 8.2 percent to only 10.7 percent of total votes. The combined share of the five European countries Italy, Netherlands, Belgium, Sweden and Switzerland will decline only modestly, from 10.4 percent to 9.5 percent. Yet the world shares of GDP at market prices of these two groups, which are respectively 11.9% for the five emerging-market countries and 8.1 percent for the five European countries. The disparity between GDPs measured at purchasing-power-parity prices is even greater: the emerging-market countries account for 20.7 of the world total while the European group has only 5.8 percent. And of course the disparities between the emerging-market group for variables such as international reserves and population are still more extreme. China, India, Korea, Brazil, and Mexico combined have 43.1 percent of the world’s population compared with only 1.6 percent for Italy, Netherlands, Belgium, Sweden and Switzerland. The increase in voting share for all “non-advanced” developing countries taken together is only some 2.2 to 2.7 percentage points (depending on the particular definition of advanced and non-advanced countries).

These changes in shares and votes are much too modest to have major influence on how the IMF operates or the sense of legitimacy which it generates around the world. That conclusion is all the more true because of the omission in the package of any changes in the composition and size of the IMF Executive Board. The representation of Europeans on the Executive Board is excessive — totally out of proportion to their role in the current, let alone future, world economies.

Indeed, the largest obstacle to more fundamental governance reform is the unwillingness of European members of the IMF to accept a significant reduction in their voting shares and in their dominance on the Executive Board. By locking in the current proposal, another 3-5 years at least will be lost before a more significant change will be contemplated. It’s a signal that the Europeans, in particular, have not yet come to realize that the world is changing dramatically around them; that if they want to have effective global institutions they will need to give up some of their traditional prerogatives of exceptional representation in these institutions; and that if they want to have a stronger influence in these institutions they need to speak with one rather than many different voices.

The fact that most other member countries (including the United States) appear willing to live with the European blockage may be read as a signal that they have waning confidence in the IMF as a vital global institution. The spread of such an inference would be bad news for the world economy and financial system.

Read the related letter >>

      

 

 

The Executive Board of the International Monetary Fund approved on March 28th a recommended set of reforms for IMF quotas and voting shares and asked the Governors of the 185 member nations to vote by the end of April 2008 to approve the resolution embodying the proposed reforms.

The Managing Director of the IMF, Dominique Strauss-Kahn, described the proposed reforms as “a very important step.” The package does contain modest improvements in existing governance procedures for the IMF. But the improvements fall very far short in addressing the challenges facing the IMF in its hoped-for evolution toward a global institution with more balanced and inclusive representation and voting power.

The most serious failing of the proposed reforms is the omission of any changes in the composition and size of the IMF’s Executive Board. Throughout the discussions leading up to the March 28th agreement, all questions about the size of the Executive Board and the disproportionate dominance of European “chairs” were taken off the table completely. Yet the composition and procedures of the Executive Board are the aspects of IMF governance most in need of reform.

The proposed revised formula for calculating the presumptive quota and voting shares of members is an especially weak component of the proposed package. Taken on its own, the formula generates changes in shares that move away from rather than toward a closer alignment of voting power with economic realities. The proposed package as a whole achieves its very modest improvements only because the formula is overridden with one-time, ad hoc adjustments that mask the unpalatable consequences of the formula and because the basic votes allocated to each member are tripled. The new formula, despite assurances to the contrary, is not a viable basis for making future adjustments in quotas and votes that will adequately reflect changes in relative positions in the world economy.

This note identifies the positive and the disappointing aspects of the recommended reform package and assesses the package in the light of further, more ambitious reforms that will be required in the future.

      

 

 

Effective international institutions typically cannot operate with one-nation-one-vote governance (as is used, for example, in the General Assembly of the United Nations). It is a strength of the IMF that its existing governance structure accords weighted votes to individual nations. A large nation has, other things equal, a larger stake and greater responsibilities in the IMF than a small nation. Hence the large nation has, appropriately, a larger vote share.

As the world economy and financial system evolve, however, the weighted votes must adapt to reflect changes in the relative importance of nations. At the September 2006 annual meetings of the IMF and World Bank, governments took a small “first-round” step in tackling this thorny question. Quotas, and hence voting shares, were adjusted upwards by small, ad hoc amounts for four countries (China, Korea, Mexico, and Turkey). Governments also promised, much more ambitiously, that—no later than the annual meetings in September 2008—they would agree on a simpler and more transparent formula for rebalancing the quotas and voting rights for all member nations. That formula was to be a foundation for a comprehensive “second round” of adjustments in quotas and vote shares.

Progress toward a satisfactory agreement has been meager. At the October 2007 annual meetings, negotiations about a rebalancing formula appeared close to stalling out.

      

 

 

A presumption that the President of the World Bank should always be an American is indefensible. Yes, when the World Bank and the International Monetary Fund (IMF) were created more than six decades ago, an informal convention was agreed between the Americans and Europeans that the United States would designate the President of the World Bank while the Europeans would designate the IMF’s Managing Director. Even long ago, that convention — a side agreement nowhere reflected in the charters of the two organizations — was a questionable political compromise among the major postwar powers. In today’s world, the old side agreement should be jettisoned and replaced with selection procedures that reflect two key principles: transparency of process, and competence of prospective leadership.

The IMF and World Bank in recent years have strongly advocated greater transparency for financial transactions and national governance. And they have made available much more information about their own operations. National governments should promote a comparable transparency for the selection procedures for the top posts in these organizations. After the decision process is completed, for example, the names of the candidates seriously considered should be announced and a public report should summarize key aspects of the Executive Board’s deliberations.

The selection procedures themselves should identify multiple candidates who are deemed by governments or outside observers to be highly qualified. Nominations should be made to the Executive Board of the organization (where after advice from member governments the ultimate decision is taken) without undue emphasis on candidates’ national origins. At the outset the Executive Board should indicate that an individual from any of the 185 member nations is eligible to be chosen, regardless of geographical origin. Because judgments about competence are inevitably controversial, the Board’s choice of the best qualified person among the multiple candidates will of course be difficult. If the dominant criterion is a candidate’s competence, however, member nations are more likely to converge on an ultimate choice by the Executive Board.

Rough guidelines emphasizing transparency and selection on merit regardless of nationality already exist. Following the contentious selection of Horst Köhler as the IMF’s Managing Director in 2000, working groups were established in both the IMF and the World Bank to review selection processes. The 2001 reports of the working groups were bland and were never officially endorsed. But they remain on the table and could now be approved and implemented.

Improved selection procedures for the leadership of the World Bank and the IMF could be a stimulus for progress on even more basic issues of reforming the governance of the institutions. Because of historical and political inertia, Western European nations and even the United States exert voting influence and control of Executive Board constituencies disproportionate to those of the rest of the world’s nations. For the two institutions to be perceived as legitimate, responding equitably to all the world’s people, adjustments in the relative sizes of countries’ quotas and voting powers to mitigate those imbalances are needed. Such adjustments, now under discussion in ongoing negotiations, are politically complex.

The governments of the United States and European Union countries, taking a far-sighted step to improve leadership selection procedures, could favorably transform the prospects for constructive reform of the IMF and World Bank. The United States should announce that it will no longer presume that the President of the World Bank should be an American and that the United States will support an open and transparent process to choose Wolfowitz’s successor independently of candidates’ national origin. Analogously, European Union governments should state that they will, when next a new person needs to be chosen as Managing Director of the IMF, encourage the nomination of multiple candidates and will support the best qualified candidate without regard to whether the person is European or non-European.