- The Washington Times - Thursday, March 30, 2000

Earlier this month, the International Financial Institution Advisory Commission released a report that calls for a significant rewriting of the International Monetary Fund's mission. The commission advised the Fund to restrict its country lending to short-term loans needed to maintain market liquidity during financial emergencies. If implemented, these changes would greatly reduce the scale of IMF lending.

Under the commission's proposed mission, future Fund loans should only be made in cases where the borrowing member country has met certain necessary preconditions. These preconditions include allowing greater domestic market access to foreign financial institutions, timely disclosure of financial data, adequate bank capitalization, responsible budget policies, and avoidance of pegged exchange rate systems.

The recommendation to limit country lending is driven by concern over the moral hazard problem associated with previous IMF bailouts. Proponents of the moral-hazard argument claim that private international lenders operate under the assumption that if a country's economy sours, the IMF will step in with funds to limit their losses. Although incomplete, this insurance results in a greater willingness to take on risk. The report concludes that IMF bailouts of Mexico (1994-1995), East Asia (1997), and Russia (1998-1999) may have provided lenders with just such an incentive.

While the majority of commission members believe that moral hazard from IMF bailouts is a potentially important problem, others do not. In his New York Times column on March 8, economist Paul Krugman argues "There is not a shred of evidence" concerning excessive risk-taking on recent loans to emerging economies. Mr. Krugman is right to a point. So far, economists have not provided systematic evidence supporting the claim that IMF lending encouraged excessive lending in Asia.

We should not conclude the moral hazard problem does not exist. We can look elsewhere for evidence. There is evidence of moral hazard problems with respect to bank deposit insurance and, in the United States, guarantee funds for life insurance companies.

Many countries have deposit insurance programs that protect bank depositors from loss in the event of a bank failure. While this policy reduces the chance of a bank run, it also reduces the incentive for depositors to monitor bank management. With less monitoring, managers of banks may take on greater risk, leading to more bank failures. This was a major factor in the savings-and-loan crisis in the United States during the 1980s.

In the 1980s, following the failure of Continential Illinois Bank, U.S. bank regulators instituted a "too-big-to-fail" policy that provided complete insurance against failure for the largest U.S. banks. Regulators feared the systemwide impact of a large bank failure. As a consequence, there is evidence that large banks increased the riskiness of their portfolios by expanding commercial real estate and business lending. The U.S. has since distanced itself from this policy by establishing risk-based capital requirements and other regulatory reforms.

A recent IMF study finds international evidence to support this premise. IMF researchers find deposit insurance increases banking instability, raising the chance of a banking crisis. In countries with broad deposit coverage, or where the deposit insurance insurance programs are run by the public sector, the situation is worse.

Another relevant moral hazard example comes from the life insurance industry. In the U.S., states have created funds that protect life insurance policyholders in the event that a company fails. In all these programs, the surviving companies pay a share of the failed companies' liabilities. The idea is to give life insurance companies an incentive to monitor one another's investments. But in some states, companies can write off all or part of their payment against their state taxes, leaving much of the tab with the taxpayer. Under this system, neither policyholders nor life insurance companies have much of an incentive to monitor.

Consistent with our expectations about moral hazard, researchers have found that life insurance companies in states with guarantee programs take on greater risk. Portfolio risk is even higher in states where taxpayers underwrite the program.

While economists have yet to provide systematic evidence of a moral hazard problem associated with IMF lending, the evidence from other financial markets indicates the concerns of the commission should be taken seriously.

The recommendations of the commission will reduce moral hazard problems that accompany IMF lending. Furthermore, the majority position of the commission does not call for the elimination of the IMF, but maintains the Fund's role as a "quasi" lender of last resort. Commissioners want countries to clean up their act before receiving loans. If the mission is adopted, countries will have an incentive to institute reforms that will make future financial crises less severe.

Robert Krol is a professor of economics at California State University, Northridge.

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