Since the Mexico crisis in 1994, a consensus has grown that IMF rescue packages are a major source of moral hazard. The moral hazard arises because financial assistance to countries hit by financial crises results in private-sector investors exercising less caution, in the belief that the Fund will always ensure they are repaid. This resulting excessive risk-taking not only weakens market discipline but also increases the likelihood of future crises. The failure of the Fund to resolve this problem provides ammunition for those who insist that the IMF is part of the problem rather than part of the solution. In addition, because the Fund is almost always paid back, these loans are effectively transfers from the taxpayers in the crisis countries to international investors; a situation that seems unacceptable on both equity and efficiency grounds.

The answer to these problems would seem to lie in ensuring private-sector participation in any future crisis: investors must bear at least some of the costs of crises if they are not to disregard the risks of lending altogether. Hence ensuring that investors are 'bailed-in', rather than 'bailed-out', is central to any strategy that seeks to limit moral hazard. Furthermore, the increase in the size of capital flows in emerging markets means that the Fund often does not have the resources to stabilize a country in financial crisis without the participation of the private sector. While there is agreement in principle that more private-sector participation is needed, how this is to be achieved in practice still remains contentious.

In a special issue of the ICMB/CEPR series of Geneva Reports on the World Economy, Barry Eichengreen considers two approaches to the private-sector bail-in problem: payment standstills and collective action clauses (CACs). He argues that the problem of private-sector participation is too deeply embedded in the structure of the markets to be solved by simply proposing changes in IMF lending practices. Any lasting solution will require changing the broader set of institutional arrangements governing international financial transactions.

Eichengreen evaluates both existing and proposed approaches to combating moral hazard from this perspective. Perhaps the most controversial reforms are those suggested by the Meltzer Commission, which proposed that the Fund should lend more freely to countries encountering liquidity crises, but that it should avoid lending to countries experiencing crises that stemmed from flawed fundamentals. This distinction is difficult to draw: the Meltzer Commission suggested it could be achieved by having the Fund lend for short periods, at penalty rates and only to countries with strong banking systems, strong fiscal policies and a willingness to treat obligations to the Fund as senior to other liabilities. If banking systems and budgets are sound, the Commission's argument runs, there can be a presumption that the problem is one of liquidity rather than fundamentals and the Fund will subsequently receive requests for assistance only from illiquid countries, while those with inadequate long-term fundamentals will opt to adjust.

Eichengreen takes issue with this argument, noting that in practice the assumption that high interest rates on IMF loans will filter out those borrowers with serious structural problems is problematic. It assumes that officials have the same discount rates as society, despite the limited life expectancy of governments; an expectancy that is likely to be especially limited in the face of a crisis. If the burden of making the distinction is placed on the Fund, it is still highly questionable whether they will be able to identify the true cases. For example, even now, observers continue to disagree about the extent to which the Korean crisis (1997) was the result of liquidity or deeper structural problems. Pinpointing the cause of the crisis when it occurs without the benefit of three years of hindsight would be substantially more complicated. More fundamentally, this solution plays down the domestic consequences and systemic repercussions of having the IMF stand aside. Even if it makes economic sense, inaction is unlikely to be politically palatable so long as society's poorest bear the costs.

Eichengreen reaches the same conclusion regarding the Fund's current ad hoc approach to involving the private sector – i.e. making the extension of multilateral assistance conditional upon a prior commitment by the private sector to roll over maturing claims, provide new money, or restructure existing debts. To date, there have been four experiments with this approach: Pakistan, Ecuador, Romania and Ukraine – see Eichengreen and Ruehl, DP2427, for a more detailed analysis. In each case, the debt has been bonds and the debtors have been sovereigns. Each of these experiments has failed to varying degrees, again reflecting the lack of credibility in IMF commitments to stand aside under present institutional arrangements.

The problem with the ad hoc approach, notes Eichengreen, is that default and restructuring are so difficult under the present arrangements that it is simply not credible for the Fund to threaten to stand aside if the markets refuse to participate, especially if the country in question is 'systemically significant'. Changes in the framework for negotiations are required if the Fund's threat to withhold assistance is to be credible; such changes in contracts or institutions are therefore a prerequisite for making bail-ins work. The form that these changes should take depends on the diagnosis of the nature and causes of the crisis. Eichengreen distinguishes two circumstances under which crises arise – when there are fundamental problems with a country's economic policies and performance (i.e. first generation crises) and when investors panic (i.e. second generation crises) – and proposes two solutions tailored to address each type of crisis.

Investor Panic and Payment Standstills

Theoretical models of investor panic are driven by the assumption of asymmetric information. Not only is information incomplete, but assessments of that information vary across investors. In such situations, individual investors may base their inferences on the actions of other, potentially better-informed investors. This can lead them to scramble out of a market when they see others doing likewise. Asymmetric information can thus encourage herding, which amplifies market volatility. An extreme form of the phenomenon is investor panic; dispelling a panic requires a cooling-off period for investors to collect their wits, for the authorities to signal their commitment to sound and stable policies, and for calm to return to the markets.

Eichengreen argues that a payment standstill can create this breathing space. It would give creditors time to reflect and agree on mutually beneficial actions, allow the authorities to communicate their commitment to policies that maintain consumer confidence, and ensure the country's finances were not undermined by the attempts of hedge funds and others to seize assets. Disruption to the financial system and the recession induced by the crisis would be moderated and, insofar as economic activity was stabilized, payments to the creditors could be greater than if investors engaged in a disruptive race to grab assets. The appeal of this idea stems from the analogy with national bankruptcy codes, which in many cases include standstill provisions designed to prevent creditors from engaging in such a race. With the commercialization and securitization of international lending this analogy acquires additional force.

The problem is that countries are reluctant to declare a standstill unilaterally, as this tends to have large costs in terms of reputation and subsequently in the price and availability of external finance. This creates the argument for the IMF (or a related body) to sanction or endorse the policy. Formally, the IMF's Articles of Agreement could be amended to give the Fund the power to impose the standstill, and creditor countries could pass legislation designed to give the amendment force in their courts. Less formally, the IMF's Executive Directors could simply declare that they were prepared to voice their approval of a crisis country's decision to impose capital controls and to lend into sovereign arrears under appropriate conditions (which is not very different from the status quo). The first, more formal, approach is less tractable and realistic politically, but the second would not shelter the country from disruptive legal action by its creditors.

Critics of this policy contend that by making it harder for investors to withdraw their money, a payment standstill could similarly render them more reluctant to commit their funds in the first place. In particular, they argue that the IMF does not have powers akin to a bankruptcy judge, who can replace the managers of a company in receivership, reorganize its financial affairs and impose terms on uncooperative creditors. Yet there are arguments pointing in the other direction: an officially sanctioned standstill may avert unnecessary crises by halting investor panics, which in turn could reduce borrowing costs. Which effect dominates is an empirical question.

Empirical analysis of the standstill proposal is difficult as no such policy is in place. Hence Eichengreen uses the features of domestic legislation for national bankruptcy and insolvency laws in emerging markets, which include provisions for payment standstills, to infer the likely effect of an IMF-sanctioned measure. Using data on over 2,000 international bonds (sovereign and corporate) from 24 emerging-market countries, his results suggest that countries with domestic standstill provisions are in fact able to borrow for less. Of course, an international standstill would differ from its domestic counterpart in that the IMF would not have the power to replace a government in the same way that a court can replace the management of a corporation. This raises the danger that an international standstill on sovereign obligations would increase moral hazard. While this danger cannot be dismissed, the results presented in the Report do not suggest that the favourable impact of the standstill in fact hinges on the possession of these powers.

Flawed Policies and Collective Action Clauses

Investor panic is not the only reason crises occur. Far more important in the mainstream view are problems with economic policy and performance that prevent a country from continuing to service its debts. If fundamental problems are the main cause of crises, then the idea of a standstill designed to create temporary breathing space is less appealing. If the debtor government is not committed to the policy adjustments needed to rectify the crisis, then an IMF-sanctioned standstill that puts off the inevitable restructuring will only worsen the underlying problem. The appropriate policy in this case is one that is designed to facilitate a restructuring of the debts and put the debtor back on a solid footing.

In practice, this has proved extremely difficult. Most emerging-market bonds are bearer bonds: their owners are not registered with the debtor or the underwriter. Furthermore, American-style instruments typically require the unanimous consent of the bondholders for any restructuring. The answer to this problem, claims Eichengreen, is the inclusion of collective action clauses (CACs) in the bond contracts. CACs refer to sharing clauses, which require individual creditors to share with other bondholders any amount recovered from the debtors; majority-voting clauses, which enable decisions on debt restructuring to be taken by a (qualified) majority of creditors; and collective-representation clauses, which make provisions for a bondholders’ meeting and specify who speaks for the bondholders.

Majority-voting and sharing clauses would discourage maverick creditors (including 'vulture funds') from resorting to lawsuits and erecting other obstacles to a settlement beneficial to the debtor and the majority of creditors. Clauses that specify who represents the bondholders and make provision for a bondholders' assembly would allow orderly solutions to be reached. The introduction of such clauses would change the pay-offs in the game between creditors, debtors and the IMF. As with the standstill approach, the dilemma for reformers lies in whether these clauses will raise borrowing costs. Critics argue that CACs would weaken the bonding role of debt, which would disrupt credit-market access and raise borrowing costs – essentially replacing one kind of moral hazard for another. Yet the provision for orderly restructuring would also make emerging-market debt more attractive by minimizing the number of disputes and unproductive negotiations. Hence the impact on borrowing costs cuts both ways, and the question of which effect dominates is, again, an empirical one.

The Report documents research by Eichengreen and Mody, who compare the borrowing costs of equivalent bonds issued under UK and US law – bonds issued under UK law typically include CAC-style provisions, whereas those governed by US law do not. The results indicate that the type of governing law has a negligible impact on borrowing costs. Yet this small impact disguises different effects of borrowers with different credit ratings: CACs lower borrowing costs for the most creditworthy issuers and raise these costs for the least creditworthy. Eichengreen and Mody conjecture that for the less creditworthy borrowers the advantages of CACs are offset by the moral hazard and additional default premium that they induce. These different effects suggest that CACs should become more attractive as emerging markets improve their creditworthiness.

Of course, no emerging-market borrower will unilaterally include CACs in their bond contracts as their inclusion can be viewed as a sign they will be used. But if the inclusion of CACs were unanimous, brought about by the requirement of the regulatory authorities, then there would be no such stigma. According to Eichengreen, the inclusion of CACs as one of the factors needed to qualify for the IMF's Contingent Credit Line is a step in the right direction, but more needs to be done – only about a third of emerging market debt issued in the last ten years was subject to UK law. In addition, including CACs in all future bond contracts does not address the problems created by the existing stock of bonds, some of which have as long as 20 years to maturity. To address this difficulty, Eichengreen recommends a voluntary exchange of old for new bonds, subsidized, where necessary, by the international financial institutions.

The evidence presented in the Report does not support the presumption that CACs and internationally sanctioned standstills would raise borrowing costs. Which of these initiatives is given higher priority therefore depends on the dominant cause of crises. Echoing the majority view, Eichengreen states that most crises are caused by fundamental problems. Indeed, in modern models of speculative attacks, the possibility of multiple equilibria arises only when fundamentals deteriorate sufficiently to place the country in a zone of vulnerability. Even the Korean crisis, the favourite case of proponents of the investor-panic view, can be interpreted as being caused by fundamentals. Furthermore, there are many political and practical problems involved with implementing an internationally sanctioned payment standstill. These judgements indicate that collective action clauses should be the priority for those seeking to strengthen the international financial architecture.