Lenders of Last Resort
in a Globalized World
Keynote Speech by Maurice Obstfeld

The recent financial crisis teaches important lessons regarding the lenderof-last resort (LLR) function. Large swap lines extended in 2007–08 fromthe Federal Reserve to other central banks show that the classic conceptof a national LLR fails to address key vulnerabilities in a globalized
financial system with multiple currencies. What system of emergency
international financial support will best help to minimize the likelihoodof future economic instability? Acting alongside national central banks,
the International Monetary Fund (IMF) has a key role to play in theconstellation of LLRs. As the income-level and institutional divergence
between emerging and mature economies shrinks over time, the IMF
may even evolve into a global LLR that channels central bank liquidity
where it is needed. The IMF’s effectiveness would be greatly enhanced
by several complementary reforms in international financial governance,
though some of these appear politically problematic at the present time.
Keywords: Lender of last resort; Financial crisis; Central banking; International monetary system; International Monetary FundJEL Classification: E58, F33, F36

University of California, Berkeley (E-mail: obstfeld@econ.berkeley.edu)
This paper was prepared for the 2009 International Conference, “Financial System and Monetary
Policy Implementation,” held by the Institute for Monetary and Economic Studies, Bank of Japanin Tokyo on May 27–28, 2009. I thank Matteo Maggiori for excellent research assistance and theColeman Fung Risk Management Research Center and Class of 1958 Chair at the University ofCalifornia, Berkeley for financial support.
MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION

35

The main danger in international banking today is from a credit shock thatwould wipe out most or all of the capital of major international banks. Even
if LLR [lender of last resort] arrangements were effective and banks not fatally
damaged by such a shock had continued access to credit, the disruption caused
by major bank insolvencies would require remedies that go far beyond thefunctions of the LLR.1

I. Introduction
The time was the early 1980s and the prospective shock was a concerted default by
indebted developing countries, a shock that could have wiped out the capital of majormoney center banks. In the event, official suasion bolstered by easier money averted
the coordination failure of a wholesale run on developing economies. The developingworld suffered a lost near-decade of growth, of course, but the effects on industrialworld prosperity were contained. While this near-death experience (like those that
followed in the 1990s) prompted debate over possible reforms—and even some concrete actions—the pace of global financial development has continued to outstrip thecapacities of regulators and regulatory structures. The stage was set for the current
worldwide meltdown, a series of shocks unprecedented in scope and macroeconomic
impact since the banking turbulence of the early 1930s.
What does the 2007–09 crisis teach us about the role of lenders of last resort(LLRs) in a financially globalized world made up of politically sovereign nations? The
economic and financial landscape has evolved dramatically since the less-developedcountry (LDC) debt crisis that began in 1982. Notwithstanding the current difficult
environment, much of that evolution is desirable and is in any case likely to be irreversible. The new global landscape has now led to a degree of interdependence between poorer and richer economies that offers benefits but also entails a higher degreeof systemic risk than in the past. Our challenge going forward stems from the realitythat political globalization lags far behind economic globalization, and is likely to doso for the foreseeable future. Given that constraint, what system of emergency international financial support will best help to minimize the likelihood of global slumps
and price instability? I will argue below that, acting alongside national central banks,
the International Monetary Fund (IMF) has a key role to play in the constellation of
LLRs. Its effectiveness would be greatly enhanced by several complementary reforms
in international financial governance. Unfortunately, some of these appear politicallyproblematic at the present time.

II. Changes since the 1980s
For more than two decades, economies in both the developing and industrial worlds
have become more open and interdependent. The poorer countries as a group haveassumed increased importance in the world economy, and countries everywhere have
1. Guttentag and Herring (1983).

36 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009

Lenders of Last Resort in a Globalized World

Figure 1 Country-Group Percentage Shares in World GDP

Note: GDP is measured at purchasing power parity.
Source: International Monetary Fund, World Economic Outlook database, April 2009.

shown a tendency to liberalize their financial systems. Particularly in the less industrialized areas of the world, financial development has accompanied the growth inliving standards. My thesis is that the interdependence between rich and poor countries has grown and, while remaining asymmetrical in several respects, has becomemuch less so in some. The new global economy offers less scope for “decoupling,”
more for systemic shocks, and any discussion of the global financial architecture must
recognize this fact.
A first and obvious indicator of the less-industrialized world’s importance is its
share of global GDP. Figure 1 shows the shares of rich and poorer countries in worldGDP, where GDPs are valued at purchasing power parity exchange rates (to give a better sense of relative weights in tradable GDP). From 1980 through 1999, the advancedcountry share held steady in the range of 62 to 64 percent. By 2008 the rich and poor
shares, at 55 and 45 percent, respectively, were much closer to equality.2 Another quantitative indicator of weight in the world economy is trade. Over the 2000s, the export
and import volumes of emerging and developing countries have grown significantly
faster than those of the advanced economies. Data from the IMF’s World Economic
Outlook database (April 2009) show that the advanced-country share in world trade
dropped from 79 percent in 1999 to 67 percent in 2008 (with “trade” defined as thevalue of imports plus exports).
The importance of the less-developed world in the financial markets of the moremature economies has proceeded even more rapidly than the growth of trade. Figure 2
shows the ratio of emerging and developing country net asset acquisitions in advanced
2. Since 1999, the advanced-country share in world GDP at current market prices has dropped from 81 percent
to 69 percent.

37

Figure 2 Emerging and Developing-Country Asset Purchases in Advanced Countries,
as a Percentage of Advanced-Country GDP

Source: International Monetary Fund, World Economic Outlook, table B18, April 2009.

countries to advanced-country GDP. The asset flows are divided into net reserve andnonreserve transactions, the latter comprising private transactions as well as the activities of sovereign wealth funds. In 2007 the weight of such purchases in advancedcountry GDP neared 6 percent, before falling back below 4 percent as a result of the
global deleveraging of 2008. Still, one can expect the potential impact of the global
south on the advanced financial markets to continue its growth over time once thecurrent financial turbulence subsides. It is estimated that the sum total of emerging
and developing reserve plus nonreserve government foreign assets is currently around
15 percent of rich-country GDP (Alberola and Serena [2008]). Of course, even in
the early 1980s, the particular exposures of large industrial-country banks made themvulnerable to a systemic LDC debt shock.
Complementing and in part causing recent financial trends has been a secular process of financial market deregulation in mature and emerging markets alike. Indexesof financial market restriction are reported in Figures 3 and 4, which cover, respectively, the emerging and mature economies. The indexes are taken from Kaminsky and
Schmukler (2008) and give a coarse indication of the trends in repressive regulations
concerning the capital account, the domestic financial system, and stock markets. The
second of these measures is concerned primarily with banks and the presence of interest
rate restrictions and direct government allocation of credit. In particular, it does not capture the growth of important and lightly regulated shadow banking systems in advanced
economies such as those of the United States and the United Kingdom. Nonetheless,the indexes convey an accurate impression that especially since the late 1980s, bothinternal and external financial barriers have fallen quite sharply and widely. Not only

38 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009

Lenders of Last Resort in a Globalized World

Figure 3 Index of Financial Restriction: Emerging Markets

Source: Kaminsky and Schmukler (2008).

Figure 4 Index of Financial Restriction: Mature Economies

Source: Kaminsky and Schmukler (2008).

are national financial systems more interconnected today than at any time since thegold standard; in addition, national financial systems themselves have become far more
extensive and complex than ever before.3
For my purposes, the critical implication of greater complexity and interconnectedness is that it can raise the scope for global systemic shocks. An analysis of how LLRs
operate in an international context must take this possibility into account.

3. For further documentation of the growing importance and financial integration of emerging countries, see
Committee on the Global Financial System (2009).

39

III. The LLR Function
At least in a closed economy, the theoretical case for an LLR is well accepted. The
case is based on the inherent potential instability of fractional reserve banking, or moregenerally, of any scheme of financial intermediation in which short-term liabilities
fund longer-term or possibly illiquid assets. Generally the central bank is viewed as
the most plausible LLR, though this need not be the case and indeed, there can be
more than one official emergency lender. There is much less agreement about how andwhen the central bank should exercise its LLR role in practice—as the recent crisis has
amply illustrated.
In a global context, the balance-sheet mismatches justifying the LLR function arebroader and more complex, because currency mismatch becomes a key factor. Yet thescope for a single central bank to intervene effectively in the presence of currency
mismatch is obviously far more limited than in the case of pure term mismatch. There
are at least two further problems. The internationalization of firms’ financial operations has blurred the lines of responsibility for national LLRs (Guttentag and Herring[1983]). And even more importantly, central bank actions have effects on foreign financial markets, not least through potential effects on exchange rates, and in a situation of
global distress such actions, if widely pursued by individual authorities, may further
destabilize world markets. Once again, the recent crisis offers vivid illustrations ofthese mechanisms, as I describe shortly.
A major rationale for LLR intervention is the likelihood that a given institution’s
failure could bring into question the creditworthiness of other market participants,
leading to a generalized cascade of otherwise avoidable defaults. In an unrealisticallyidealized case, a single bank, say, loses retail deposits and short-term funding due
to a pure panic on the part of creditors. By providing cash, the LLR can prevent a
costly coordination failure—costly because of possible external effects as well as theunnecessary bank closure itself—at essentially no expense to taxpayers. According toreceived views, however, an insolvent institution should not receive LLR assistance,
as it would be unable to repay its creditors in full even by selling off all its assets inliquid resale markets. Resolution of the problem might or might not be brokered by thecentral bank. Normally, however, any taxpayer monies pledged in the deal—including
any guarantees extended to contain market contagion—would ultimately be backed by
the fiscal authorities’ taxation capacity.
The seemingly neat distinction between merely illiquid and truly insolvent institutions, while meaningful in some simple theoretical models, is of limited applicability
in practice. Liquidity problems rarely if ever hit an isolated intermediary unless there isgood reason for lenders to attach at least some probability to insolvency.
In addition, generalized financial distress blurs the distinction further, as the myriad
negative externalities that arise in broader crises can easily transform illiquidity into
insolvency. In a generalized crisis, informational asymmetries become more acute (whois exposed to which counterparties?) and capital positions may plummet as institutions
simultaneously attempt to reduce leverage through asset sales into illiquid markets. As
Fischer (1999, p. 88) observes:

40 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009

Lenders of Last Resort in a Globalized WorldThe line between solvency and liquidity is not determinate during a crisis. If acrisis is well managed, the number of bankruptcies may remain small; if it isbadly managed, it may end in general illiquidity and insolvency. A skilled lenderof last resort, able to assure the markets that credit can and will be made available
to institutions that would be solvent in normal times, can help stem a panic andreduce the extent of the crisis.
Almost by definition, aggregate or systemic shocks—for example, the collapsing
price of a widely held asset such as housing—can result in widespread and justified
fears of insolvency. It may become quite difficult to tell which institutions would be
solvent in normal times, and if the crisis fans out to affect the broader economy, thescope of insolvency will rise further. Because of the very real threat of insolvency ina generalized crisis and the high likelihood that at least some institutions are revealed
to be insolvent even in the absence of panic, the central bank’s LLR support alone,while critically important and usually the first line of defense, must be deployed in concert with the government’s powers of sovereign borrowing and conventional taxation.
Guttentag and Herring (1983) make this point in the quotation with which I started.
While these difficulties afflict policymakers even in closed economies, the challenge they face in open economies is greater still, as I suggested above. It is interesting
to reflect, therefore, that the classical 19th century writers on the central bank’s LLR
role, especially Henry Thornton, acknowledged the linkages among domestic financial
conditions, international capital flows, and the exchange rate. Thornton’s paradigm was
the open economy—but the focus was the single open economy rather than the financial
stability of a global economic system. Despite earlier episodes of international financial
contagion, the most dramatic illustrations to date of the repercussions of a global panic
come from the onset of the Great Depression. Kindleberger (1986, chapter 9) famously
decried the failure of the United States and United Kingdom to act consistently as
LLRs in those critical years, and documents that even at the time several economists
and policymakers (including Hawtrey and Keynes) were keenly aware of the need for a
global emergency lender.
That awareness led to the establishment of the IMF in 1946. In the immediate
postwar world of repressed domestic finance and largely closed international capital
markets, however, IMF lending was not intended to prevent financial contagion throughthe world economy. Instead, the goal was to support exchange rate stability without
recourse to the overly contractionary macroeconomic policies that had deepened theGreat Depression. In the earliest versions of the Bretton Woods system, national LLRs
were adequate to the task of preserving the stability of domestic finance, which had
minimal exposure to foreign finance (and was itself relatively limited in scope). With
the increasing flexibility of exchange rates after 1973 and the related liberalization ofdomestic and global finance, the IMF’s role has evolved considerably and a strong casefor global last-resort lending has emerged.

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IV. LLRs in the Current Crisis
The balance sheet of the Federal Reserve System has seen an unprecedented expansion since the collapse of broker/dealer Lehman Brothers in September 2008. The
U.S. monetary base doubled from about US$850 billion at the end of August 2008
to about US$1.7 trillion by the end of January 2009. Other central banks have likewise
expanded their balance sheets, although not as dramatically. These support operations,
often targeted on specific institutions or asset classes, have been complemented by fiscal
support measures such as government loans, government guarantees, capital injections,and proposed fiscal subsidies for purchases of impaired assets from banks and otherfinancial institutions.
From the international perspective, a key development is the extension of central
bank credits to foreign central banks—most notably the Fed’s expansion of reciprocal swap lines with industrial-country and emerging-market central banks. In October
2008, the Fed removed limits on the sizes of U.S. dollar credits to the European Central Bank (ECB), Bank of Japan, Bank of England, and Swiss National Bank (SNB).
This remarkable provision allowed the non-U.S. central banks to supply financial markets with potentially unlimited quantities of dollars (albeit on a temporary basis). The
resulting flexibility for foreign central banks to act as LLRs of dollars was a major
departure from past practice.4 There have also been initiatives in nondollar currencies
such as the November 2008 ECB and SNB agreements to supply their currencies to the
National Bank of Poland.5
In general, the process of global deleveraging has led to a collapse of gross crossborder asset purchases (which in many cases became net sales), as illustrated for the
U.S. financial account in Figure 5. This development has had particularly harsh consequences for some emerging markets. As the crisis has accelerated, countries havedrawn dollar liquidity from a limited range of sources. Emerging markets as a group
accumulated substantial foreign exchange reserves over the 2000s, as noted above(recall Figure 2), and several have deployed some of these hard-currency assets tofinance financial outflows while moderating exchange depreciation.6 The IMF, having
downsized itself as a result of the low global demand for crisis lending during much of
the 2000s, has more recently been doing a brisk business lending to an expanding listof countries ranging from Iceland to Pakistan.
These actions underscore the emergence in August 2007 of a global shortage of
hard currency—in most cases, dollar—liquidity. This shortage is connected with several
episodes of dollar appreciation during the recent months of financial turbulence and, ingeneral, probably has buoyed the dollar in foreign exchange markets above the declining trend that I believe is warranted by the nonfinancial macroeconomic fundamentalsof the world economy.

4. The Fed adopted swap arrangements involving foreign central banks and the Bank for International Settlements
in 1962. These have remained in place, in some form, ever since. The U.S. Treasury has also operated swap
facilities with foreign governments.
5. See Fender and Gyntelberg (2008).
6. See Obstfeld, Shambaugh, and Taylor (2009).

42 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009

Lenders of Last Resort in a Globalized World

Figure 5 U.S. External Financial Flows through 2009/I

Source: U.S. Department of Commerce, Bureau of Economic Analysis, seasonallyadjusted quarterly data.

While comprehensive data are elusive, a significant factor behind the shortage appears to reside in the strong desire of European banks over the 2003–07 period to invest
in dollar assets. From a level around US$4 trillion in 2003, European banks’ dollar
assets had more than doubled by the first quarter of 2007.7 U.S. banks held far fewer
assets denominated in European currencies, and so were less vulnerable to a seizure
in foreign currency liquidity than were European banks to corresponding problems
obtaining dollar liquidity. To hedge their long positions in dollars, European banks
drew short-term dollar funding from the interbank market and also borrowed nondollar
currencies, swapping these funds into dollars on a short-term basis. U.S. money market
funds also entered the business of lending short-term dollars to European banks.8
Much of the surge in European banks’ acquisitions of dollar assets was motivatedby the attractiveness of the AAA-rated tranches of securitized assets such as subprime
mortgage pools. As is now well understood, the high credit ratings of these structured
products had their basis in low expected loss, but ignored the significant systematic
risk the products carried due to the likelihood that they would default in and only instates of the world where financial markets were deteriorating globally. For that reason,
assets such as the AAA tranches of collateralized debt obligations offered relatively
high returns; but even so, they may have been overpriced relative to the predictionsof standard credit-risk models.9 Why? Part of the reason is that these assets carried an
7. See Baba, McCauley, and Ramaswamy (2009, p. 66).
8. See McGuire and von Peter (2009).
9. Coval, Jurek, and Stafford (2007) evaluate market prices of structured products and argue that investors placed
excessive weight on the ratings agencies’ assessments of their safety.

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important collateral benefit. By adding them to their balance sheets, banks were able toreduce the required regulatory capital ratio under the Basel II standards. In other words,
European banks’ desire for highly rated, dollar-denominated structured products was
driven not only by the search for yield—not adjusted for risk, of course—but also by
regulatory arbitrage allowing greater leverage (Acharya and Schnabl [2009]). Why did
investors not pay more attention to the risks? One answer is the short-termism often
induced by financial-sector compensation practices. A second is that it is precisely in“systemic” states of the world that the authorities are expected to intervene in force—as
they indeed have—to support markets and large financial institutions.10
As noted above, European banks funded purchases of U.S. assets through various
forms of short-term dollar borrowing, making them highly vulnerable to any reduced
availability of dollar liquidity. These factors helped fuel the pre-2008 surge in U.S.
gross external asset flows illustrated in Figure 5. Dollar funding risk became a painful
reality in August 2007, and the problems deepened after September 2008. Not only didinterbank markets freeze; in addition, foreign exchange swap markets became illiquid,
while U.S. money market funds faced a run in the fall of 2008 and retracted theirforeign dollar lending.11 A further exacerbating factor was central bank withdrawals
during 2007–08 of dollar reserves that had been placed in commercial banks.12 At
the same time that banks faced funding illiquidity, they faced market illiquidity due
to the difficulty of disposing of now-toxic assets. As McGuire and von Peter (2009,
p. 58) put it:
The frequency of rollovers required to support European banks’ US dollar investments in non-banks thus became difficult to maintain as suppliers of funds
withdrew from the market. The effective holding period of assets lengthened justas the maturity of funding shortened. This endogenous rise in maturity mismatch,difficult to hedge ex ante, generated the US dollar shortage.
Over the course of the crisis, the ECB has been in a position to easily provide
euro liquidity, but not dollar liquidity, to its resident financial institutions. European
institutions facing dollar funding difficulties, and with no recourse to the Fed’s LLR
facilities through U.S. affiliates, had to sell euros for dollars on the foreign exchange
market, the result of these aggregate sales being upward pressure on the dollar anda relatively weaker euro. To address this problem—one which the ECB apparently
denied for some months13 —the central bank swap arrangements for dollars were set
up starting in December 2007. Under these facilities, the ECB (for example) received
10. This factor tends to induce financial-sector concentration by giving an implicit subsidy to scale (Solow [1982,
p. 242]); in turn, concentration increases risk taking by systemically significant players and makes crises
more likely.
11. On spillovers to the foreign exchange markets see Baba, Packer, and Nagano (2008), Baba and Packer (2008),
and Genberg et al. (2009). These authors document how a rise in counterparty risk among European banks
led to deviations from covered interest parity. McAndrews (2009) argues that Fed swap lines with other central banks helped narrow spreads between Libor and the federal funds rate, while Baba and Packer (2008)
argue that the swap lines helped to lower the volatility of deviations from covered interest parity. Taylor andWilliams (2009) doubt the effectiveness of Fed interventions. On the plight of the money market funds, seeBaba, McCauley, and Ramaswamy (2009).
12. See McGuire and von Peter (2009, p. 57).
13. See Giles and Tett (2008).

44 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009

Lenders of Last Resort in a Globalized Worlddollars that it allocated to financial institutions, rebating interest earnings to the Fed.
The Fed received a corresponding credit of euros that it agreed not to inject into markets
and which offered no interest. Swaps were to be unwound at the initial exchange rate.
In effect, therefore, the dollars were used to augment global dollar liquidity, whereas
the swapped euros were immobilized.
In the current crisis, the Fed has played the role of a global LLR for dollars, just as
it has played its more traditional role as LLR in its domestic markets. It has done so inpart by subcontracting its LLR function (along with its monopoly on money creation)
to a selected set of foreign central banks. It seems highly unlikely, for practical as wellas political reasons, that this ad hoc scheme will be extended into any sort of largescale permanent arrangement. For example, it is not desirable over the longer term for
the Fed effectively to stand as an LLR for institutions over which it has no supervisory
powers. Nor is it desirable for the Fed to allow institutions over which it could exert asalutary influence to evade its guidance by going to alternative official sources of dollar
liquidity. An example of the type of problem that can arise is the allegation by Acharya
and Backus (2009, p. 320) that by borrowing from the ECB rather than from the Fed
between March and September 2008, Lehman Brothers was able to resist the Fed’s
advice to raise more capital.
Most likely, more limited swap facilities than those currently in place will be maintained into the future—as in the past—with the option (at the currency issuer’s discretion) for greater flexibility in times of crisis. To the extent that nondollar currencies
such as the euro and (eventually) the renminbi are potentially in short supply during
financial breakdowns, there is a case for crisis-elastic sources of those currencies aswell. Even the central banks and Treasuries of industrial countries may choose to accumulate larger stocks of liquid foreign currency reserves, easily available for lending
during episodes of turbulence.

V. The World as a Single Financial System
The correct perspective nowadays is that the world economy comprises a single,
interdependent financial system, one in which the emerging markets and the industrial countries are converging to comparable weights. While greater balance andinterconnectedness may present enhanced opportunities for sharing risks, those samedevelopments may well also raise the likelihood of systemic shocks, as the past two
years have amply demonstrated.
Observers of emerging-market crises have long noted the “bank run” nature ofsudden reversals in capital flows. Creditor panic can lead to sudden stops in capital
inflows as well as refusal to roll over maturing short-term foreign debts. This possibility motivates the famous Guidotti-Greenspan prescription for international reserveadequacy, a liquidity buffer sufficient to handle maturing foreign debts over a year.
But as the literature on “twin crises” shows, external financial instability is seldom
decoupled from internal financial instability. Runs on the domestic banking system andinto foreign exchange can deplete official reserves as the authorities intervene to limit
excessive depreciation; reserve depletion, in turn, can make a panic by external creditors45

more likely. Conversely, reserve depletion can raise fears of devaluation, leading to arun out of domestic banks.
These same bank-run dynamics have erupted in the industrial countries, playing
a key role in the crises surrounding Long-Term Capital Management, Bear Stearns,
and Lehman Brothers.14 Run dynamics become possible for nonbanks as well in thepresence of maturity or currency mismatch, and can operate at the national level as well.
In today’s world economy, however, runs on large complex financial institutions andon emerging countries alike are likely to have substantial repercussion effects abroad
through financial and ultimately trade linkages. This interdependence calls for a macroprudential systems approach to promoting global stability, as suggested in the domestic
spheres by numerous authors, including Crockett (2000), Goodhart (2006), Morris andShin (2008), Brunnermeier et al. (2009), and Turner (2009).
This approach argues that measures such as minimum capital-asset ratios designed
to protect the solvency of an individual institution may destabilize the system as a wholein situations of generalized panic. In the worst case, propagation mechanisms such as
fire-sale dynamics can transform more localized disturbances into generalized panics,
in which standard hedging mechanisms such as credit default swaps or forward foreignexchange contracts break down because of counterparty failure.15
Naturally enough, these insights apply to the global system. Consider, for example,
the prescription that countries enhance their liquidity by holding ample foreign currency
reserves. If emerging markets as a group withdraw reserves placed with European banks
and these ultimately find their way into U.S. Treasury securities, however, an emerging
market crisis may be propagated to European financial markets and beyond. Placementsof reserves as well as withdrawals can affect financial stability, for example, by depressing risk premiums on various debt instruments and appreciating the reserve currency.
Pure portfolio shifts by large reserve holders can likewise cause liquidity reallocations
or asset-price movements with systemic implications. To think that the international
system will necessarily be more stable simply because all countries hold more foreign
currency reserves is to subscribe to a fallacy of composition.
International reserves provide inside but not outside liquidity (in the sense describedby Holmström and Tirole [2008]), whereas resources provided by an LLR constitutetrue outside liquidity. Large reserve holdings may stabilize the individual country, but
possibly do so at some cost in terms of global stability. Reserve drawings by one country
may negatively affect another, so at least in one respect, use of owned reserves is inferior
to the availability of an LLR. The theme that the international reserve regime is subject
to strategic complementarities and coordination problems is an old one—as shown by
analyses of the gold standard’s role in the interwar period and the Triffin confidence
problem under the Bretton Woods system. It now underpins concerns about portfolio
decisions by large U.S. dollar reserve holders such as China.
If one accepts the necessity for international LLRs, I think it is hard to escape theconclusion that LLR powers are most efficiently vested in a centralized agency that bothsupervises financial markets on a consolidated basis and can internalize other external
14. See Morris and Shin (2008), Gorton (2009), and many others.
15. Some of these mechanisms also are familiar from emerging-market crises. See, for example, Calvo (2005).

46 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009

Lenders of Last Resort in a Globalized Worldeffects that arise from the national exercise of the LLR function.16 Furthermore, the LLR
would need to be backed up by a global fiscal authority that can provide real resources
for financial restructuring in cases where liquidity problems presage insolvency.17
This first-best solution, however, is simply not in the cards in a world of sovereign
nations managing separate national currencies. Witness the difficulty even the eurozone has had in centralizing supervision and organizing centralized fiscal backup for
its LLR, the ECB. Given the political constraints, it is more realistic to think about
how the present international LLR structure might be enhanced.
Central to the existing structure is the IMF, which plays a unique and increasingly
important role. As Roubini and Setser (2004, p. 338) put it:
The most important tool [for crisis response] remains the IMF’s capacity toprovide emerging economies with partial insurance against the risk of liquidity
runs. Without the IMF, countries would have to hold more reserves, borrow muchless, and impose more restrictions on domestic and external investors’ ability tomove capital freely across borders—and likely still experience crises. The IMF’s
institutionalized multilateral lending capacity avoids the need to organize an ad
hoc coalition of the financially willing each time a crisis occurs.
The IMF lends to governments rather than directly to financial institutions, but
this pathway for liquidity injection is analogous to the Fed’s dollar loans to foreign
central banks.
When a member country draws dollars from the IMF, the Fed creates those dollars,
which therefore constitute an injection of new dollar liquidity into the world financial
system. While the IMF cannot itself create outside liquidity ad libitum, funds that it
borrows under the General or New Arrangements to Borrow could represent outside
liquidity if financed by central bank money creation.18 Indeed, it is conceivable that
IMF arrangements could evolve into central bank credit lines similar in effect to thoseextended by the Fed to the ECB and other central banks. (In the past, the Bank forInternational Settlements has had access to central bank credit facilities.) In February
2009, the government of Japan agreed to lend up to US$100 billion to the IMF, andfurther such bilateral agreements are likely.
The IMF’s structure will enable it to extend liquidity in multiple currencies as theworld evolves away from dollar dominance toward a more multipolar system of several key currencies, including the dollar. Eventually, IMF assistance to richer countries
might become more common than it has been in the past three decades—especiallyas countries now considered emerging converge to higher income levels. Indeed, theIMF could evolve into a truly global LLR, with access to individual central bankcredit lines, thus institutionalizing the ad hoc methods that have been deployed in thecurrent crisis.
16. Calvo (2009) advocates a global LLR and recommends that “the topic of financial regulation should be
discussed together with the issue of a global lender of last resort.”
17. For an analysis of coordination failure in the sphere of bank recapitalization, see Goodhart and Schoenmaker(2009). The scope for coordination failure in international supervision is only too well appreciated by now.
18. The potential for Special Drawing Rights (SDRs) as currently designed to contribute true outside liquidity isextremely limited.

47

The IMF’s current inability freely to create outside liquidity does limit its power
as an LLR. Moreover, because the IMF does not lend on the basis of collateral, its
interventions depart even further from Bagehot’s classical outline of the LLR function.
Nonetheless, many countries will not be able to rely on the discretion of industrializedcountry central banks for liquidity support, and in such cases the IMF is uniquely
positioned to intervene. Fischer (1999) makes a convincing case that even the IMF’s
limited powers give it some scope to act as a global LLR.
Enhanced resources augment the IMF’s effectiveness as a crisis lender. In addition,
the IMF has been retooling its lending procedures to make them more flexible andautomatic. Its general past practice of subjecting loans to sometimes unpredictable conditionality both slows the lending process and makes borrowers reluctant to approach
the IMF—sometimes until they have no other choices. There have thus been attempts
to streamline the process through some sort of pre-qualification criteria. Unfortunately,
past initiatives along these lines have not succeeded.
The most recent attempt is the new Flexible Credit Line (FCL), under which countries judged by the IMF to have strong fundamentals and policies can pre-qualify forloans. In April 2009, the IMF’s Executive Board approved a one-year US$47 billion
credit line for Mexico, intended by the Mexican government as a purely precautionary
measure. Colombia and Poland also have signed up. These are hopeful developments,
but true success will require emulation by more large emerging markets. Simultaneous enhancements to the IMF’s stand-by arrangements likewise seek to ease access toliquidity support for countries that may not qualify for the FCL.
Fischer (1999) emphasizes that the IMF functions not just as a crisis lender, but also
as a crisis manager—just as many central banks do. Effective crisis management canpartially substitute for official liquidity provision.
Even a much bigger and more nimble IMF faces at least three major obstacles in
effectively complementing the existing constellation of national LLRs:
Perceived political legitimacy. The IMF is governed by its Executive Board, whose
members represent national governments. If IMF lending decisions are viewed aspolitically or ideologically motivated, however, countries will prefer to self-insure
rather than approaching the IMF. Many Asian countries accumulated large holdingsof international reserves after the late 1990s precisely to avoid having to borrow fromthe IMF. If the IMF is to be perceived as politically neutral in the exercise of its LLR
function, a minimal requirement is a revision in Executive Board voting shares in favorof emerging-market members (as now seems likely to occur). A truly independent (yetaccountable) IMF would be far better, but may be politically unattainable. A greater
reliance on clearly formulated rules rather than discretion in lending would further
promote a perception of political neutrality, while simultaneously moderating moral
hazard (to be discussed further below). The IMF’s exceptional access framework, put
in place in 2003, was an early step in this direction.
Mechanisms to deal with insolvency. Fund resources are meant to address illiquidity rather than insolvency, although the line between the two conditions is very difficult to define, as we have seen. The problem is even more complex in the sovereign
arena, where willingness rather than ability to pay is the issue and the constraints are

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Lenders of Last Resort in a Globalized World

political as much as economic. Fund lending therefore needs to be supplemented byfurther progress in regularizing workout procedures that will sometimes mark down
emerging-market debts at the expense of creditors. Such arrangements can be viewed
as analogous, in the sovereign context, to resolution procedures for troubled financial
institutions in the domestic context. Resolution requires an influx of real resourcesthat ultimately must come from creditors or creditor-country taxpayers—and usuallyfrom both. Limited time prevents more discussion of these topics here, although
Rogoff and Zettelmeyer (2002) and Roubini and Setser (2004) survey much of thecopious literature.
Moral hazard. A bigger and more flexible IMF, coupled with the unprecedented
monetary and fiscal interventions carried out by national financial authorities sinceAugust 2007, has made the prospect of moral hazard more problematic than ever inthe past.19 This worrisome development greatly raises the marginal value of effective
financial-sector supervision and regulation.
Again, a thorough discussion of the need for and feasibility of a new global regulatory regime would take me far beyond my time allocation. It seems doubtful tome that the IMF, with a governing body made up of political representatives, offers
the best home for a centralized regulatory agency. No matter how the enhancement of
global regulation is accomplished, though, the IMF should certainly have access to thefullest possible information on the vulnerabilities of its members’ national financial
systems and on the linkages among them. That information might allow the IMF’s
staff to predict more accurately the financial consequences of potentially unsustainableasset-price misalignments or flow imbalances in the world economy.
The IMF must confront moral hazard not only on the part of national regulatory
agencies, but also on the part of other national decision makers. Adherence to lending
rules as well as the use of rigorous pre-qualification criteria for certain credit facilities
can help in principle. But the issue of credibility remains, and certain problems haveno easy solutions. Will the IMF be willing to disqualify previously qualified countries,
possibly provoking a crisis, if their policies or political climates change? Can somecountries be too big to fail? Regulation can counteract concentration in the financial
sector; it is harder to do anything about national size or interdependence levels. International regulatory cooperation is of some help in this regard—for example, throughrules that effectively limit national exposures—but it is no panacea.20

VI. Conclusion
In the new world economy, LLRs capable of supplying outside liquidity globally are
more necessary than ever before. Within that group of lenders the IMF has a key roleto play, although modifications in both the IMF’s structure and in the global financial
19. Bagehot’s demand for collateral that would be good under normal conditions can be viewed as one mechanism
to limit moral hazard—one that is absent in the case of the IMF. The absence of collateralized IMF lending
raises the further issue of fiscal support in case of IMF losses.
20. Recent essays on the IMF’s role are collected in Truman (2006). Among the contributions most relevant to my
discussion are chapter 14 (by William Cline), chapter 15 (by Gregor Irwin and Chris Salmon), and chapter 21(by Michael Mussa).

49architecture are necessary if the IMF’s potential is to be realized. Given the growinginterdependence of all countries, richer and poorer, many of these same reforms would
be high on the financial stability agenda even if the IMF had never been created.
While LLRs play critical roles as a first line of defense in the face of global shocks,
their longer-term powers are limited and at that point, fiscal authorities must step in.
Moreover, the expansion in LLR resources seen in the current crisis raises the expectation that LLR intervention, backed by potentially large-scale fiscal support, will
be deployed in the future. The resulting moral hazard is one of the most dangerous
consequences of the policies followed since August 2007. The resulting need for global
financial regulation cannot be fully addressed by individual countries working at thenational level; it will require a greater degree of international coordination than in thepast, and perhaps even a greater sacrifice of national sovereignty. Failure, however, willplant the seeds of the next global crisis.

50 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2009

Lenders of Last Resort in a Globalized World
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