The IMF and the Lender-of-Last-Resort Function An External View

• Author: Curzio Giannini
• Position: Deputy Head of International Relations at the Bank of Italy

Recent financial crises have led to renewed interest in having an international lender of last resort. Would this make sense and, if so, would it be appropriate for the IMF to play such a role?

The string of foreign exchange crises of the last few years has brought the lender-of-last-resort function once again to the fore. This time, what is at issue is whether and how this function can be adapted to the international environment. Making the relevant decisions is no easy task, however, because of all the functions a central bank may carry out, serving as the lender of last resort is by far the most difficult to pin down. For one thing, the desirability and appropriate contours of the function cannot be identified independently of the monetary policy framework. Suppose bank deposits were not defined in nominal terms, much like mutual fund shares, or that monetary policy could be run in a purely discretionary manner without raising credibility problems. Would a lender of last resort still be needed? Many would doubt it, to say the least. But there is more. Intervention by a lender of last resort amounts to a suspension of market discipline, since it means lending in situations where other lenders are not. Hence, the very existence of a lender of last resort raises a potential moral hazard problem, which can be kept within acceptable limits only by relying on the broader legal and institutional setup-on regulation in the broadest sense of the word. In short, what the Tao Teh Ching says of the wheel could equally well be said of the lender-of-last-resort function: for all its complexity, what makes it work lies outside of it. Therefore, if we are to understand how a lender of last resort can address financial instability at the national level, as well as whether the notion of an international lender of last resort makes any sense, we must first look beyond the function's boundaries.

Evolution of concept

When Walter Bagehot, the nineteenth-century economist whose Lombard Street is still the classic in this field, was writing, the monetary framework was pretty rigid. It was based on the gold standard and on severe restrictions on the supply of currency, while the world's main financial center, the City of London, was run by a handful of financial institutions in a clublike fashion. This helps explain the Bagehot doctrine: when things turn bad, first expel the rotten apple from the club (that is, let it go broke), then come to the rescue of the club as a whole by lending freely to all who can supply good collateral and can afford to pay a penalty rate.

The present situation at the national level is very different from the one Bagehot had before his eyes. For instance, in the industrial world, rigid monetary frameworks have been replaced with "illuminated discretion," namely, stability-oriented monetary policy devised and implemented by an independent central bank. Moreover, in most financial systems, clublike behavior is but a vague memory, having long since been swept away by financial liberalization and heightened competition.

As a consequence, the function of a lender of last resort has also undergone momentous changes. The market-support operations to which Bagehot referred have become extremely rare. In countries where they are still carried out, such as the United States, they take the form of open market operations, which by their very nature cannot embody a penalty rate. By contrast, lender-of-last-resort operations directed at individual institutions-often even at those verging on insolvency-have become much more common. Under these circumstances, constructive ambiguity has become the main check on moral hazard. Since ambiguity means discretion, however, this way of containing moral hazard is subject, like all other forms of discretionary policymaking, to the risk of inconsistency over time. Its...