Financial liberalization that increases welfare if bank crises do not occur may also enlarge the set of circumstances in which such crises are indeed possible. The analysis in section 3 above suggests that moves to deregulate the banking system -whether by lowering reserve requirements or fostering greater competition among banks- must be undertaken with care. comments
In the event of a crisis, large real costs may be incurred as a result of early liquidation of investments, and asset prices may consequently fall farther than they would have had this liquidity crunch been avoided. This observation is helpful in designing policies to respond to the crisis -for instance, in dealing with troubled banks. The proper policy prescription clearly depends on one’s assessment of the crisis. If the problem is primarily one of moral hazard and overlending (as Krugman 1998 has claimed for Asia) or of outright fraud (as Akerlof and Romer 1996 argued for the U.S. S&L crisis), then banks are insolvent and they should be either closed or forced to recapitalize. But if the problem is one of illiquidity made acute by panicked behavior by depositors and creditors (as we have argued), liquidity should be injected into banks, not withdrawn from them, in order to minimize costly asset liquidation.
Section VI suggests that distorting government policies such as deposit guarantees or investment subsidies are to be avoided not so much because they cause efficiency losses, but because they can increase banks’ illiquidity and hence worsen financial fragility. While “overinvestment” may be part of the Asian story, for instance, it is hardly plausible that it could account for the magnitude of the real contraction in activity. That can only be understood as the result of the accompanying financial collapse.
The combination of an illiquid financial system and fixed exchange rates can be lethal. If the central bank commits not to serve as a lender of last resort, then bank runs can occur; if it acts as a lender of last resort in domestic currency, bank runs are eliminated at the cost of causing currency runs. Hence, with fixed exchange rates and insufficient reserves (that is, illiquidity), a crisis is unavoidable if investor sentiment turns negative; the only choice authorities face is what kind of crisis to have.
In our view this represents a strong case in favor of flexible exchange rates. But there are caveats. One is that the combination of flexible rates plus a lender of last resort in local currency can protect banks against self-fulfilling pessimism on the part of domestic depositors (whose claims are in local currency), not against panic by external creditors who hold short-term i.o.u’s denominated in dollars.
If financial crises such as those in East Asia were at least partially caused by self fulfilling liquidity squeezes on banks, there is a role for an international lender of last resort that can help overcome a financial system’s international illiquidity. Funds from abroad to prevent unnecessary credit crunches and avoid costly liquidation of investment can increase welfare.
The usual (and valid) objection is moral hazard. But this need not be a rationale for policy paralysis. Fire insurance and bank deposit guarantees also risk inducing moral hazard, but the risk can be minimized by proper contract design and appropriate monitoring. No one advocates banning fire insurance simply because it leads some home-owners to be careless with their fireplaces. The same should be true of an international lender of last resort.