Reserve Requirements On Sovereign Debt Would Reduce The Threat Of Future Global Financial Crises

Fed Chairman Alan Greenspan has proposed the imposition of reserve requirements on foreign bank loans as a means of imposing discipline on a global financial market that has been shaken by a series of major crises since the early 1990s. Writing in the latest issue of the Economic Journal, Professors Joshua Aizenman and Stephen Turnovsky show that since it is very difficult to commit to a policy of ''no bailouts'', the introduction of reserve requirements would improve welfare in both lending and borrowing economies. Borrowing would decline – and so would the risk of default, reducing the necessity for continuing bailouts.

Aizenman and Turnovsky note that attempts to stabilise the global system have led to massive bailouts, the sizes of which seem to increase exponentially. This experience suggests that the present system cannot survive indefinitely, as the willingness of taxpayers in the OECD countries to engage in continuing bailouts is approaching its limits. Growing recognition of this has resulted in a spirited debate among economists and policy-makers as to how to resolve the problem. The researchers evaluate one particularly innovative idea, analysing the general macroeconomic effects of reserve requirements in a world in which both borrowers and lenders experience risks. Of particular concern is how the effects of bailouts interact with the reserve requirements and how a system of optimal reserve requirements should be designed. Important objectives of the analysis are to identify the welfare consequences of imposing a country-specific reserve requirement and to investigate in whose interest these regulations would work.

The results highlight the importance of reserve requirements in determining the welfare effects of a more generous bailout. Specifically, they show that a more generous bailout, financed by the high-income block (the lending country), encourages borrowing and increases the probability of default, thereby raising the expected yield to lenders.

In the absence of reserve requirements, the associated higher bailout costs have a positive welfare effect on the borrowing country, but at the expense of the lending country. The impact on overall world welfare depends on whether the net benefits of the higher lending rate exceed the higher monitoring costs, ultimately paid by the borrowers.

The research also shows that the introduction of a reserve requirement in either country reduces the risk of default and raises the welfare of both the high-income block and the emerging market economies. In these circumstances, the lender''s optimal reserve requirement increases with the expected bailout. Such a policy induces the lender to internalise the expected cost of the bailout to the taxpayer.

Thus, a more generous bailout that is accompanied by an optimal adjustment in the lender's reserve requirements exactly neutralises its effects on welfare, leaving welfare in both countries unchanged. The effect of a more generous bailout on the borrower''s optimal reserve requirement is ambiguous, as are the welfare effects.

The overall conclusion is that the introduction of reserve requirements by either borrowers or lenders will indeed impose the kind of discipline on the international financial market envisioned by Chairman Greenspan. Borrowing will decline – and so will default risk, reducing the necessity for continuing bailouts. The introduction of reserve requirements will improve welfare in both the lending and borrowing economies.

But the design of the optimal reserve requirement in a decentralised world is a delicate matter and both the optimal lender's reserve requirement and the optimal borrower''s requirement have both attractive and unattractive features. The ultimate assessment of the desirability of the reserve requirement scheme rests on the assessment of the credibility of ''no bailout'' policy. As the record of the 1990s suggests, we are far away from resolving these ''time inconsistency'' difficulties, suggesting that the reserve requirement should be seriously considered as a valuable policy option.

''Reserve Requirements on Sovereign Debt in the Presence of Moral Hazard – on Debtors or Creditors?'' by Joshua Aizenman and Stephen Turnovsky is published in the January 2002 issue of the Economic Journal. Aizenman is at the University of California, Santa Cruz; Turnovsky is at the University of Washington.