Minouche Shafik: Fixing the global financial safety net - lessons from
central banking
Speech by Ms Minouche Shafik, Deputy Governor for Markets and Banking of the Bank of
England, at the David Hume Institute, Edinburgh, 22 September 2015.
* * *
The views in this speech are my own, and not those of the Bank of England. I would like to thank James Benford,
Simon Whitaker, Ed Denbee and Glenn Hoggarth for their policy analysis and insights; and Chris Salmon, Andrew
Hauser, Ankita Mehta and Grellan McGrath for their comments.
1. Introduction
It gives me great pleasure to deliver my first internationally themed speech as a central banker
in Edinburgh on the 30th Anniversary of the David Hume Institute. Of course, Scots have
played a vital role in the Bank of England's history - including one William Paterson, whose
idea it was to set up the Bank of England to help put order on the government's finances in the
late 17th century. But Paterson is perhaps best known for the catastrophic Darien scheme -
an unsuccessful attempt to establish a Scottish trading colony in Panama. It has been argued
that the failure of the scheme crippled the country's economy - an early example of how
troubles abroad can rebound at home1.
Scotland also has a tradition of producing internationally renowned economists including, of
course, David Hume. Hume was a great advocate of free trade between nations. His "Of the
Balance of Trade", published 34 years before Smith's "The Wealth of Nations", was arguably
the first example of modern economic reasoning. In it he railed against the "numberless bars,
obstructions, and imposts, which all nations of Europe, and none more than England, have put
upon trade" which "deprive neighbouring nations of that free communication and exchange
which the Author of the world has intended, by giving them soils, climates, and geniuses, so
different from each other2." What an elegant way to talk about the gains from international
trade!
The benefits of free trade are now well established. Similarly, economic theory provides
compelling arguments for the potential advantages of integrated global capital markets based
on the efficient allocation of resources. But, in practice, cross-border capital flows can be fickle
and flighty, with destructive effects on the real economy. It is fair to say that the case for the
free movement of capital took something of a knock following the string of crises since the
early 1990s in Latin America, East Asia, Russia and most recently in Europe. As a result, a
variety of means to insure against sharp changes in capital flows have developed at domestic,
regional and international levels which are collectively referred to as the "global financial safety
net".3 The cross border impact of the global financial crisis has forced a fundamental rethink
about whether this global financial safety net is functioning as efficiently as it should, and
whether more needs to be done to contain the systemic spillovers from sovereign crises.
A key means by which the Bank of England pursues its mission of monetary and financial
stability is through the provision of liquidity insurance to the financial system - something it has
been doing in one form or another since David Hume's time. In some ways, this makes the
Bank of England the domestic safety net for the liquidity needs of solvent financial institutions.
As Hume himself put it: "private bankers are enabled to give...credit by the credit the receive
from the depositing of money in their shops; and the Bank of England in the same manner,
from the liberty it has to issue its notes in all payments4."
Today, given my current role overseeing the Bank of England's market functions, as well as
my previous experience at the IMF dealing with the crisis in the Eurozone and in the wake of
the Arab Spring, I would like to offer some thoughts on how lessons from reform to the domestic
financial safety net for banks could be applied to sovereigns, to the IMF as international lender
of last resort and to the global financial safety net more broadly. I will argue that we need a
stronger and more resilient global financial safety net to reduce the systemic implications of
sovereign crises and allow nations to cope with shocks in order to reap the economic rewards
of an integrated system of trade and finance. I will also argue that the effectiveness of that
safety net would be enhanced by implementing policies that strengthen surveillance and the
stress testing of countries balance sheets, and better mechanisms for resolving sovereign debt
crises when they occur. These are of course my personal thoughts rather than an official UK
position, but I offer them in the spirit of encouraging debate.
2. The domestic financial safety net
Before turning to the global safety net, let me first say a few words about how the financial
regulatory reform agenda in the UK has enabled the strengthening of the domestic safety net
- the provision of liquidity insurance to the financial system by the central bank.
Since the onset of the financial crisis, to keep the financial system open for business, central
banks have used their balance sheets as never before. At the Bank of England, for example,
new published liquidity facilities have been introduced that extend liquidity for longer durations
against expanded sets of collateral to new counterparties.5 As with any kind of insurance,
however, liquidity insurance creates incentives to take more of the insured risk. The extent of
this moral hazard and how best to tackle it was a key concern for the Bank of England when
making these changes - it is not the role of the central bank to lend to insolvent institutions.6
To that extent, the expansion of the provision of liquidity insurance was enabled by reform to
the regulatory framework for banks, including:
(i) Micro prudential supervision that raised the levels and quality of capital and liquidity
banks are required to hold;
(ii) Regular, transparent stress testing to ensure an ongoing assessment of solvency
under different scenarios;
(iii) A credible resolution regime for insolvent banks that reduces contagion to the wider
system and the need for taxpayer support.
It would be foolish to declare categorically that the Bank of England has eliminated stigma or
moral hazard. But we can say that these regulatory reforms have made it easier for the Bank
of England to provide liquidity insurance to solvent institutions. In turn, this has allowed us to
increase the availability and flexibility of our liquidity facilities and to give more clarity around
the circumstances under which that insurance would be provided. These changes should help
to reduce the stigma attached to the use of central bank liquidity facilities, and encourage
earlier take-up to limit contagion and protect financial stability during future crises.
3. Are sovereigns like banks?
Attention more recently has turned to sovereign rather than banking vulnerabilities and two
issues in particular have brought this into sharper focus. First, do fundamentally sound
emerging market economies have access to the right form of liquidity insurance to deal with
the challenges posed by lower growth, falling commodity prices and potential spillovers from
the possible exit of exceptional monetary policy in advanced economies? And second, how
can we manage the tension between the need to recognise when one sovereign's debt has
become unsustainable and the need to avoid contagion across countries in times of stress?
There are many ways in which sovereigns are like banks in terms of the liquidity risks they
face. Cross-border capital flows can "run"- just as deposits can "run" for banks. And the
majority of a sovereign's assets - claims on future taxpayers, are both hard to value and
inherently illiquid - so, like banks, they are susceptible to runs by international investors, which
even if not based on fundamentals, could threaten their solvency by raising borrowing costs.
Sovereigns are particularly exposed to run risk or a sudden "stop" if they have borrowed in
foreign currency - the so called "original sin" - as large depreciations raise the domestic
burden of repaying the debt, particularly if there is a shortage of foreign exchange reserves. In
the Euro-area, countries have become painfully aware of the risks of borrowing in a domestic
currency that individual sovereign states have no right to issue.
But of course, sovereigns are also very different from banks. By definition, their finances are
not regulated by any authority, and there is no legal framework for dealing with bankruptcy or
resolution, giving them more discretion to default. Instead, we have IMF surveillance (which is
weaker than bank supervision) and a complex and often messy process whereby markets and
the official sector deal with sovereign debt restructurings. While there are important differences
between sovereigns and banks, I think there are enough parallels to draw some insights.
4. Problems with the global financial safety net
Hume himself recognised that the nature of sovereign flows created an incentive to insure
against a sudden stop, lamenting: "There still prevails, even in nations well acquainted with
commerce...a fear, that all their gold and silver may be leaving them7."
There are different ways for countries to insure against the risk of sudden stops in capital flows:
(i) individually through the stockpiling of foreign exchange reserves, (ii) via collective
arrangements with other countries, for example regional reserve pooling or swap
arrangements or (iii) through the International Monetary Fund (IMF). This multi-layered global
safety net has some advantages but it seems to me that the current configuration is suboptimal:
it is fragile, costly and fragmented.
Fragile
The aggregate size of the global financial safety net had been in decline before of the financial
crisis, despite rapid reserve accumulation. There has been some recovery since then, as the
size of the IMF and Regional Financial Arrangements increased in response to the crisis and
central bank swap agreements were put in place. But the composition of the global financial
safety net is now more fragmented [Chart 1] and it is unclear whether it would be sufficient
during a systemic crisis. The IMF element is fragile, with borrowed resources accounting for
an unprecedented three-quarters, around $500 billion of which are temporary loans due to
start rolling off next year with no agreement in place to extend them [Chart 2].
Costly and inefficient
Self-insurance remains the most popular tool. Individual countries' reserves remain the largest
component of the global financial safety net - reserves have risen from $1.5 trillion in 1995 to
over $11 trillion now. To be sure, self-insurance is prudent to a point - indeed it is something
we have encouraged banks to do. But there are several problems with excessive reserve
accumulation:
(i) First, reserves are distributed very unevenly across and within some regions.
Emerging markets with adequate reserves (largely in Asia and the Middle East) are
over-insured by about $1.5 trillion in total. By contrast the Central and Eastern
European region and Latin America are underinsured by around $200 billion
[Chart 3]. This suggests the distribution of reserves does not correspond well to the
distribution of risks.
(ii) Second, even when they are in abundance, there are doubts about countries'
willingness to run down their reserves. In the last financial crisis, nine of the largest
emerging market economies refrained entirely from using reserves. There is some
evidence that markets judge countries according to their relative rather than absolute
level of reserves. So no one wants to blink first by running them down.
(iii) Third, issuing high yielding local currency debt to purchase reserves is costly to
emerging markets, resulting in an annual cost of around 0.5% of GDP8.
(iv) Finally, reserve accumulation causes distortions to domestic economies with
potential spillovers to the global system. It can crowd out domestic investment, the
flip side of current account surpluses and savings gluts. The investment of emerging
market savings in advanced countries' public debt has contributed to a worldwide
shift in preferences for risk-free assets, which may have been partly responsible for
the build-up in financial imbalances prior to the financial crisis.
Uneven coverage
Pooling reserves would seem to be one obvious solution to these costs and inefficiencies. And
indeed there have been moves in that direction at a regional level with the expansion of the
Chiang Mai Multilateralization Initiative and more recently the BRICs Contingent Reserve
Arrangement. But pooling at a regional level is ineffective against shocks that affect the entire
region and these regional mechanisms remain untested, with the exception of the European
Stability Mechanism. Regional arrangements are also complicated because of the difficulties
of imposing reform conditions on a neighbour (as the Eurozone learned with Greece).
Moreover, many emerging market economies do not have access to Regional Financial
Arrangements at all [Chart 4]. So while regional insurance is a welcome layer of the safety net,
it needs to operate in concert with a better global system including possible IMF facilitation of
lending.
5. The role of the IMF
If we are to continue to benefit from global financial integration then we need a system that
can effectively and efficiently provide liquidity insurance to fundamentally sound sovereigns in
order to contain spillovers to other parts of the globe. As with an independent central bank that
houses supervision and liquidity provision under one roof, there are advantages to combining
country surveillance and lending in one global institution, with an impartial and experienced
staff. And risks are most efficiently pooled at a global level. This is the raison d'etre for the IMF.
Unfortunately, signs of fragmentation of the global financial safety net are obviously in part a
reaction to the failure to implement the 2010 quota and governance reforms to bolster the
IMF's resources and the representation of emerging market economies. The priority must be
to implement those. But we also need to consider whether and how the temporary resources
collected by the IMF in the form of bilateral loans when it passed the hat around in 2012 could
be put on a more permanent footing. One possibility is to extend these bilateral loans further.
Another possibility is for the IMF to borrow directly from capital markets9 during a systemic
crisis which would create safe assets when demand for them is high, allowing funds to be
recycled to those parts of the world with temporary liquidity needs.
A more reliable and flexible resource base would allow the IMF to more credibly perform a
crisis prevention role of providing committed lines of credit to sound sovereigns through its
Flexible and Precautionary Liquidity lines. Take up of the IMF's liquidity lines has been
disappointing in large part because of stigma. As a country with a sound balance sheet, but
concerned about potential liquidity problems arising from spillovers from shocks in the rest of
the globe, what signal does requesting liquidity support from the IMF convey? Some members
of the IMF have resisted more widespread use of these liquidity facilities because of concerns
about moral hazard. Is there a way to address both the stigma and moral hazard issues?
6. Lessons from central bank liquidity insurance
These are precisely the issues the Bank of England has had to deal with in the context of
central bank liquidity insurance facilities. The Winters Review10 conducted into the Bank's
published liquidity facilities highlighted the risk of these facilities becoming stigmatised - usage
being taken as a signal of fundamental solvency problems. If that led banks to self-insure
against extreme "tail" liquidity risks, that would be inefficient for the financial system as a whole.
The Bank has reduced the stigma associated with its liquidity facilities by offering greater
predictability of access on more favourable terms. This improved access to liquidity has been
enabled by the fact that supervision is tougher on capital and liquidity requirements, banks
undergo regular stress testing, and credible resolution tools (including ring fencing to protect
depositors and bail-in to protect taxpayers) are being put in place. These reforms are recent
and not yet fully tested under the most difficult circumstances. But I do think there are some
lessons that can be learned from the overhaul of central bank liquidity facilities that could be
applied to the provision of liquidity insurance to sovereigns.
What would the equivalent enablers be for sovereigns?
(i) Better surveillance, particularly of the vulnerabilities to sudden stops;
(ii) Stress testing countries' balance sheets through better debt sustainability
assessments; and
(iii) Better mechanisms for reducing disorderly spillovers.
Surveillance
The Bank of England's Sterling Monetary Framework11 is available to banks and building
societies on a presumptive basis - banks with a genuine short-term liquidity can rely on it when
a shock hits. A key part of that access is the agreement of supervisors that firms meet micro
prudential standards. By contrast, there is no system of pre-qualification for the IMF's
precautionary liquidity facilities, at the margin discouraging sovereigns from relying on the IMF
as a form of insurance. One potential means of giving countries greater incentives to rely less
on self-insurance could be to offer pre-qualification on the basis of strong economic
fundamentals and policy track records as part of the Article IV process of surveillance, on a
confidential basis. Strengthening countries' resilience through advice on better financial sector
reforms or ways to reduce excessive debt would also help. Though, I should note that the
IMF's job of assessing sovereigns' fundamentals is made more difficult by the fact that they
have no formal supervisory role in relation to sovereigns.
Stress testing
The Bank of England carries out an annual stress test12 for major UK banks to assess their
ability to withstand shocks in a range of scenarios and takes pre-emptive measures to enhance
resilience if necessary. This not only reduces the likelihood that banks will require liquidity
support from the Bank of England, but also provides an ongoing assessment of their solvency.
This informs the difficult judgement of insolvency vs illiquidity in the event that a bank does
require access to the Bank of England's liquidity facilities.
There is scope for the IMF to strengthen its surveillance toolkit to include stress testing. The
2014 Triennial Surveillance Review13 highlighted the importance of national balance sheet
analysis in detecting risks and identifying spillover channels. The IMF could extend debt
sustainability assessments to cover external liquidity risks and analysis of how balance of
payments flows are likely to respond in crisis scenarios. This ex ante analysis would provide
greater assurance on the economic fundamentals of countries seeking liquidity support from
the IMF and enable countries to take pre-emptive measures to increase their resilience.
Reducing the risk of disorderly spillovers
A strengthened global financial safety net alone does not address the tension between the
need to recognise when one sovereign's debt has become unsustainable and the need to
avoid contagion across countries via a disorderly restructuring. To do that, we need to put in
place mechanisms analogous to those we have put in place for banks to ensure that they can
be resolved in an orderly fashion. This would have the added benefit of increasing the
credibility of the IMF's commitment not to lend to insolvent sovereigns, just as improved
resolution regimes for banks has strengthened the credibility of the Bank of England's
commitment not to lend to insolvent institutions. Usefully, the IMF has launched important work
on drawing lessons from recent experiences with sovereign debt restructurings14. Here I offer
three preliminary ideas which could reduce the systemic spillovers of sovereign debt crises:
(i) Managing the risk of sovereign crises
Sovereign balance sheets could be made safer by using state-contingent bonds to increase
risk-sharing with private sector creditors. For example, GDP-linked bonds advocated in a Bank
of England paper in 2013,15 are debt instruments that directly link principal and interest
payments to the level of a country's nominal GDP and so provide a form of 'recession
insurance'. Economies with higher GDP growth volatility or countries where monetary policy is
constrained in its ability to respond to growth shocks (such as those in a monetary union) are
likely to benefit most. Giving such bonds favourable treatment in debt sustainability
assessments could enhance their attractiveness. More work is needed to pin down how such
instruments could be implemented in practice. Work by the IMF on introducing flexibility for
sovereign debt in distress situations is also worth considering.
(ii) Facilitating agreements on a debt restructuring
The Bank has also been a strong supporter of the recent contractual innovations to ease
resolvability once default occurs: i) changes to "Collective Action Clauses" (CACs) in bond
contracts so that decisions can be taken by a majority of creditors across all bond issuances,
without the need for an issuance-by-issuance vote; and ii) reforms to the "pari passu" clause
to prevent a repeat of the Argentinian situation.
Indeed, the Bank has set an example here by including a new style CAC clause in a recent US
Dollar bond issue. The new style contracts have also seen good take-up among emerging
market issuers in their foreign-law bonds (the new clause was designed for foreign law bonds,
for which the collective action problem tends to be more acute). Since October 2014, 59% of
the nominal principal amount of total issuances has included these enhanced CACs for
countries such as Mexico, Armenia, Bulgaria, Croatia and Egypt.16 But as the September 2015
G20 communique17 highlighted, there is a need to further explore market-based ways to speed
up the incorporation of such clauses to the outstanding stock of debt.
(iii) Reducing large cross-border exposures
A commitment to bail-in rather than bail-out creditors of sovereigns can only be credible if
losses can be absorbed safely without significant spillovers across borders. Sovereign
exposures receive special and in some cases preferential treatment in prudential regulation,
with low or even zero capital requirements and exemptions from large exposure limits. It is
hardly surprising then that they make up an important part of banks' balance sheets. Claims
on foreign public sectors reported by BIS-reporting banks as a share of their total foreign claims
have risen from 17% in 2004 to 25% at end-2014.18 The Basel Committee has recently started
a review of the treatment of sovereign exposures in the Basel Standards. This is an important
part of the resolution agenda - reducing international spillovers from sovereign debt
restructurings will make it more feasible to implement them when needed.
Conclusion
Promoting cross border capital flows as a means of allowing resources to flow to where they
will be best used is a logical extension of the arguments David Hume first put forward in favour
of free trade more than 250 years ago. However, such flows leave nations exposed to a "capital
stop", in much the same way that banks can experience a run on their deposits.
The mix of self- and multi-lateral insurance arrangements that have arisen in response to
recent events and liquidity pressures appears suboptimal - resembling more of a patchwork
than a safety net. We need a better global financial safety net with the IMF at its heart and
three key additional elements that will make the safety net more effective.
• First, a more reliable and flexible source of funding for the IMF and greater clarity on
coordination with Regional Financial Arrangements.
• Second, a stronger mandate for IMF surveillance and stress testing to reduce the
likelihood that countries might need recourse to the safety net, and possible
prequalification to reduce stigma when liquidity is needed.
• Third, better mechanisms for dealing with debt restructuring and reducing the risk of
disorderly spillovers.
None of this will be easy. As Hume said "it must, however, be confessed that...all these
questions of trade and money are extremely complicated.19" But there are some important
lessons from the experience of central bank reforms since the crisis that, while complicated,
show us what might be possible.
Charts and Tables
Chart 1: Evolution of the global financial Chart 2: Composition of IMF resources
safety net as a percentage of external
liabilities
(1980-2014)
Per cent of global external Per cent of global external
liabilities liabilities
14 3.5
Regional Financing Arrangments
Swap Lines
12 3.0
IMF Temporary
10 2.5
IMF Permanent
8 Self Insurance: FX Reserves 2.0
(LHS)
6 1.5
4 1.0
2 0.5
0 0.0
1980 1984 1988 1992 1996 2000 2004 2008 2012
Sources: IMF, central bank websites, RFAs, Lane and Milessi- GAB - General Arrangements to Borrow
Feretti (2012) and Bank calculations. NAB - New Arrangements to Borrow
Source: IMF and Bank calculations.
Chart 3: Regional FX over- and under-
insurance (2014)(a)
$ billion
1000
900 Sum overinsurance
800
Sum underinsurance
700
600
500
400
300
200
100
0
and
East
Asia
North
Latin
America
Europe Africa Africa
Eastern
and
Central
Middle
Sub-saharan
Sources: IMF and Bank calculations.
Chart 4: Access to regional financial arrangements bigger than 0.5% of regional GDP
(2014)
Sources: National Sources, IMF and Bank calculations.
References
Brooke, M et al (2013) Sovereign default and state-contingent debt, Financial Stability Paper
No. 27.
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Pagan, W (1865) The Birthplace and parentage of William Paterson, founder of the Bank of
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