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Tuesday, May 27, 2003
INSEAD, Fontainebleau, France
Hosted by the Research Group on Global Financial Governance, the Guido Carli Association, the G8 Research Group, the EnviReform Project, INSEAD, the Club of Athens-Global Governance Group, le Comité pour un Parlement Mondial, Futuribles and the Académie de la Paix
We develop a positive interpretation of the governance structures of international financial institutions (IFI), with particular emphasis on the International Monetary Fund (IMF). Residual control rights are vested with the critical shareholders of the IFIs, a small group of industrial nations that certainly includes the United States, Germany and Japan but can stretch to the G-7 finance ministers. This group controls vast financial resources and enjoys the highest regulatory and governance standards among IMF members. We underscore the weaknesses of IFI governance structures and propose that IFIs not be exonerated from the codes of behavior that apply to the private sector. The principal implication of club theoryinternational cooperation requires the leadership of large countries that incur a disproportionate share of the cost and benefits of cooperationis at odds with the requirements of legitimacy and full participation of all member countries on an equal and democratic basis. This is an important practical design hurdle for IFIs, and is consistent with post-Bretton Woods developments.
Concern with the governance structure of public corporations has grown dramatically following events of corporate malfeasance, market volatility, inadequate disclosure and conflicts of interest that are injurious to the public and undermine confidence in the marketplace. As a result, governments have examined corporate, banking and securities laws, the roles and duties of directors and audit committees, conflicts of interest, and the supervisory practices of regulatory bodies in overseeing markets and corporations. International analogues to these issues have generally received little attention. Yet, governance structures are as relevant to the efficiency and legitimacy of international financial institutions (IFIs) such as the International Monetary Fund (IMF), the World Bank and the Bank for International Settlements (BIS)as they are for private-sector corporations and national government agencies. To be sure, there are differences between IFIs and corporations. For example, in the absence of "shareholders" who can exit through the sale of shares, who are the stakeholders of the IFIs and how can their rights be defined? Do corporate governance principles apply also to IFIs? The thrust of this paper is that there is no compelling justification for governance principles to be less than universal.
Our interest in governance structure has less to do with distributional issues than with the over-all efficiency of the international financial system; reform proposals of the so-called international financial architecture cannot ignore governance issues. If they do, changes are bound to occur through the actions of IFI bureaucracies (compare with the roles of management), the influence of major governments (compare with the roles of major shareholders), and mission creep and drift (compare with corporate strategy).
The structure of the paper is as follows. We begin with a review of the essential tenets of governance as they apply to both the private sector and government agencies. We then develop a positive interpretation of the governance structures of IFIs. Next, we compare and contrast our interpretation against the literature. Next, we identify the basic weaknesses in the current governance structures of IFIs, using the IMF as a primary example. Finally, we offer some conclusions
With complete contracts the principal would have no need to create a governance structure to control his agents. A complete contract would specify all possible contingencies, all actions that the agent would take under each contingency and the procedures to resolve all possible disputes. The contract would protect the principal against malfeasance and shirking on the part of the agent, as well as against disputes and conflicts of interest between the agent and third parties. A governance structure would be redundant under these conditions. But the reality is that contracts between a principal and an agent are bound to be incomplete in listing all possible contingencies, planning all possible actions, and solving all possible disputes. This imperfection gives rise, in the language of Grossman and Hart (1986), to residual rights of control over the firms assets. Governance deals with the allocation of these residual rights of control. Shareholders cannot efficiently monitor the activity of management because of free riding, large shareholders much less so than small shareholders. Thus, shareholders elect a board of directors to monitor management activity. But also the board will inevitably monitor imperfectly, either because the interests of some of its members are aligned with those of management, or because of conflicts of interest between the interests of the board and those of the company or because monitoring by members who are outside the firm is inherently difficult, costly and inefficient relative to benefits.
Monitoring can be improved and the agency problem can be lessened with better governance. Improving governance structure was the theme of the landmark Cadbury Committee (1992, p.14), which was set up to deal with "the perceived low level of confidence in both financial reporting and in the ability of auditors to provide the safeguards which the users of company reports sought and expected". Cadbury was also a reaction to corporate failures and the perceived problem that boards of directors of U.K. companies were loaded with inside directors, excessive executive pay, and inadequate accountability of directors. The significant conclusions of the committees report were that the chairman of the board should be independent of management to reflect the interests of shareholders; independent (of management) directors should constitute audit and remuneration committees and report on the companys systems of internal control; and directors reappointment should not be automatic, while their compensation should be disclosed.
The Cadbury Committee focused on the functioning and behavior of boards of directors to strengthen governance procedures. Essential in this process is how directors adhere to their duties of properly representing the interests of shareholders. Since the director represents the interests of the shareholder in the firm, a governance structure needs to pay a great deal of attention to the identification and resolution of potential conflicts between the interests of the shareholder and the interests of the director. Disclosure is an essential, although partial, remedy to these conflicts. Should a conflict actually arise, a good governance structure must trigger procedures that ensure that the interests of the shareholder prevail over those of the director. In addition to the fiduciary duties, a director is expected to represent the interests of the shareholder with professional competence and prudent behavior.
The Sarbanes-Oxley Act of 2002, a U.S. Federal law, is a legal elaboration of these principles, although it may be judged by posterity as an over-reaction to the revelations of corporate malfeasance that came to light after the stock market boom of the 1990s. Just to exemplify some of its most prominent features, the Act prescribes that the board of directors must have five financially-literate members, two of whom qualified as Certified Public Accountants (CPA). The Chair may be held by one of the CPA members, provided that he or she has not been engaged as a practicing CPA for five years. The other three of the financially-literate members must not be and cannot have been CPAs. Board members cannot receive any remuneration other than retirement payments from public accounting firms. In fact, the board is responsible to ensure that the corporation complies with the provisions of the Act. One headline article of the Act bearing on management is that the chief executive office and the chief financial officer must attest to the fairness of the corporations financial statements. The board and top management are legally responsible, collectively and individually, for accounting abuses, defined primarily as departures from Generally Accepted Accounting Principles (GAAP). Since there is a latitude in the interpretation of GAAP, the Act creates uncertainty on the nature of these abuses; to avoid incurring penalties boards, management, and public accounting companies will opt for the most conservative interpretations.
Casual observation suggests that agency problems and effective monitoring of the agent (the bureaucrat) by the principal (the electorate or parliament) are more serious in the public sector than in the private sector. To begin with, corporations seek profit or shareholders wealth maximization. Government agencies, instead, have multiple objectives and have to resolve the difficult task of assigning weights to each of those objectives. Furthermore, objectives or their associated weights change because of the political process and the power of interest groups. While privately held corporations remain focused on the maximization of profits or shareholders wealth, the political process changes the rules of the game as political parties or groups, with different ideological agendas, alternate in power. In democracies, political control is contested at fixed dates or within fixed intervals. Elections are the equivalent of takeover bids in the private sector. Political takeovers can be interpreted in either of two ways. The first is that they give an opportunity to replace inefficient bureaucrats with more efficient ones (Breton and Wintrobe 1982, p. 97). The second is that elections serve the purpose of altering the ideological make-up of the civil service, either by replacing top management, as in the U.S. tradition, or by demanding that the civil service fully adhere to the policies of the new government, as in the U.K. tradition. According to the second interpretation, political takeovers are different from private takeovers. Private takeovers are motivated by profit, political takeovers by ideological agendas. This is the reason why government agencies suffer from time inconsistency and their commitment to a given policy is weak (Tirole 1994, p. 5).
Pecuniary incentives play a smaller role in government agencies than in the private sector. The multiplicity of objectives, the fuzziness of weights associated to them, and the lack of observable output and product prices make it difficult to remunerate the civil servant up to its marginal value product. This, in turn, gives rise to low powered incentives and the potential for capture by interest groups (Laffont and Tirole 1993). The principal, on the other hand, is the electorate or its representatives, one best characterized as being small, relatively uninformed and consequently at a big disadvantage in monitoring the agent. To offset these tendencies, government agencies tend to leave less discretion to their management and employees than their counterparts in the private sector. Transactions between private-sector parties and government agencies are regulated by detailed contracts aimed at minimizing discretion on the part of agencies management.
In sum, governance in the public sector is complicated by multiplicity of objectives, fuzzy weights, and time inconsistency. These complications affect the distribution between what is prescribed and what is left as part of residual rights.
An Interpretation of the Governance Structure of IFIs
International organizations exist, to a large extent, to provide international cooperation. Public goods and externalities often extend beyond national boundaries. In the absence of a world government, the provision of public goods and the capture of externalities fall on methods of international cooperation and international organizations. In this paper, the focus is on those international organizations that deal with money and financial products, the so-called IFIs. The most important IFIs are the IMF, the World Bank, and BIS. The IMF and the Bank are Bretton Woods institutions designed to provide, respectively, the public goods of an international monetary system and economic development. Since its inception, the IMF has transformed itself into a multi-product institution. The IMF of today provides a good housekeeping seal of approval to member countries through so-called surveillance and conditionality lending; is a coordinator of lenders in a debt crisis; disseminates member countries policies and essential macroeconomic and financial data and the establishment of various types of international financial standards; is a crisis manager through emergency lending to countries in distress; is a concessional lender to countries that are either poor or have no access to private credit markets; and gives advice and technical assistance (Bordo and James, 2000, p. 18). The BIS, created after World War I to handle German war reparations, functions as the banker of a small group of central banks, is a forum of policy coordination, and is a setter of international financial standards (Fratianni and Pattison 2001a).
The shareholders of IFIs are typically national governments with the exception of the BIS. The BIS in currently in the process of eliminating non-governmental shareholders. As with privately held corporations, IFI shareholders face a monitoring problem and delegate this activity to boards of directors and management. On the other hand, the characterization of small, uninformed and disenfranchised shareholders does not readily apply to IFIs. Take, for example the IMF. Decision making at the IMF is based on weighted voting and not on the principle of one member country one vote. At present, the United States has 17.11% of the total votes, Japan 6.14%, Germany 6 %, France and the United Kingdom 4.95%, Italy 3.26%, and Canada 2.94%. The G-7 countries, as a group, hold 45.35% of the votes in the Fund. Power is very asymmetrically distributed. Nothing of substance in the Fund can take place without the approval of the G-7 countries, or for that matter the United States. The United States has enough votes to block a quota increase. The World Bank, as described by the Meltzer Commission (1999, p. 56-7), "was to be the institutional meeting ground, where rich industrialized members would supply resources and AAA credit support to enable the Bank to gather money in the financial markets and redistribute the funds as loans to emerging members". It was heavily criticized by the Commission who noted (p. 55) that "even the World Banks self-audited evaluations reveal an astonishing 55-60% failure rate to achieve sustainable results." Such an outcome in a private sector financial institution would have led to financial collapse, severe regulatory sanctions, penalties for and replacement of directors and management. Yet, by implication, this is acceptable to IFIs.
The BIS has few shareholders and, in fact, its core constituency is formed by the central bank Governors of the Group of Ten (G-10 Governors): G-7 plus Belgium, the Netherlands, Sweden and the affiliated Switzerland (the 11th member of the Group). The BIS has shown an ability to adjust its corporate strategy to changing international financial circumstances. It began to concentrate on international supervisory cooperation after the failure of Herstatt Bank, and pioneered common international capital standards. While the BIS has also been subject to criticism, its smaller constituency and narrower focus, plus the fact that it is a financial institution that must make a profit in its own right, have made it arguably more efficient that other IFIs.
Whatever literature exists on IFI governance, it tends to focus on decision-making processes; for a review see Frey (1997, pp. 110-15). We would like to expand the horizon and provide a framework that attempts to respond to a wider range of questions, such as who sets the mission of the IFIs, who controls their agenda, who implements decisions, what is the likely size of agency costs, how independent are management and staff from shareholders, and how are potential conflicts of interests between directors and the IFIs clients resolved.
Our point of departure is that directors of IFIs play a different role from directors of a privately held company. IFIs directors are typically high-level civil servants who faithfully represent the interests of their governments. IFIs directors rarely set strategy as corporate directors do. In fact, IFIs directors are often excluded from the decision-making process, yet they retain an implementation role. This distinction is not new. It goes back to differences between the United Kingdom and the United States, and between Keynes and White, in the creation of the Bretton Woods institutions. Mikesell (1994, p. 52), at the time an U.S. Treasury economist who was heavily involved with the Bretton Woods meetings, recalls that:
"White had wanted control of the Fund to be in the hands of a board of directors whose members represented their governments and who would be continuously involved in decisions on exchange rates, drawings and other matters".
Keynes, on the other hand, wanted an international secretariat to manage and direct day-to-day operations. Mikesell goes on to say that:
"Whites position, and that of the U.S. administration generally, reflected a desire to have the Fund heavily influenced by the United States in order to promote the U.S. economic objectives of stable exchange rates, nondiscrimination in trade, and international financial equilibrium".
As a result, the Articles of Agreement of the IMF were never clear on the matter, a convenient resolution of the differences.
Residual control rights are vested with the critical shareholders of the IFIs. This is a small group of industrial nations, a group that certainly includes the United States, Germany and Japan but can stretch to the G-7 finance ministers and possibly, but less likely, to the entire G-10 finance ministers. This group controls vast economic and financial resources and enjoys the highest regulatory and governance standards. It is difficult to identify ex-ante the exact number of IFIs critical shareholders; it changes from one circumstance to another. For example, the U.S. government is a critical shareholder in an IMF quota increase because it has sufficient votes to block it. In many other cases, the G-7 is the core of critical shareholders. Note that beyond the G-5 the marginal economic and financial contribution as each new member is added diminishes rapidly, whereas the marginal costs of reaching agreement increase exponentially; more on this below.
Another feature of the system is that critical shareholders own equity shares across all of the many IFIs. This means that these shareholders can effectively coordinate their strategy by relying on a portfolio of international institutional and financial assets in addition to their national assets. The IFI portfolio hypothesis has several implications. In so far as governance is concerned, cross-ownership means that the vote of a director representing a given country in a given IFI is not independent of the vote of another director representing the same country in a different IFI. Thus, governance is exercised, not over a homogeneous "corporation" with defined objectives, but over a financial conglomerate of IFIs. The finance ministers of the critical shareholders set agendas for the IFIs more like a portfolio of investments than as a holding company; the IMF, for example, is just or one firm of the conglomerate. This also means that "institution shopping" occurs; it is common for governments to orchestrate which institution or institutions are asked to lead over a particular issue. As a further example of this point, European financial regulators have at least twenty different fora from which to choose to discuss any particular international issue. This includes, among others, all of the various European Union Committees, the International Organization of Securities Commissions, the Basel Committee on Banking Supervision and its related committees.
IFIs critical shareholders meet regularly during the year and delegate execution of policy to the national directors who often report to other parts of government such as central banks, bank regulatory agencies or ministries of foreign affairs. The critical shareholders exert leverage on the wide range of professional expertise of the directors of various IFIs to raise the efficiency of the policy execution in terms of their own interests.
The presence of critical shareholders in IFIs raises issues similar to those of controlling shareholders in privately held companies, namely the potential that benefits are not distributed symmetrically across shareholders. In privately held companies, the controlling shareholder may capture a disproportionate share of the profits by inducing management to deal preferentially with companies owned or controlled by the shareholder (Hart 1995, p. 683). The capture of excess profits is the return of monitoring by the controlling shareholder. Corporate and securities laws are designed in part to reduce the scope for abuse and to protect minority shareholders. In IFIs, a critical shareholder may obtain a disproportionate share of the benefits by persuading directors and management of IFIs to divert a disproportionate share of the institutions resources to governments that are friendly to the critical shareholder. In other words, the critical shareholder uses IFIs as an integral part of its foreign policy.
There are two fundamental differences between governance in the private sector and governance in IFIs. The first is that private sector governance, as we have already indicated, pays a great deal of attention to conflicts of interests. Incompatible duties are segregated, so that different organizations, or divisions within an organization perform separate tasks or report to different parts of management or the board. The nomination of a board director automatically triggers a potential conflict of interest between the company where the director may be employed and the company in question. In contrast, nothing of the sort applies to IFIs. The second is that in the private sector corporate strategy and direction are decided at board level, disclosed to shareholders and shared with management. Determining accountabilities for strategy are an integral part of board duties and management responsibilities. In contrast, nothing of the sort exists in IFIs; strategy for IFIs is often determined by the interests of one or more major shareholders.
In sum, critical decisions about the mission and policies of IFIs are in the hands of few, large shareholders. Each IFI is akin to a firm within a conglomerate. Critical shareholders can activate simultaneously several IFIs, as part of a large portfolio of international and national assets. But there are competing models of behavior. One sharp alternative to the critical shareholder model is that management and staff of IFIs may make important decisions without much of a say on the part of shareholders. In other words, they may be captured by various interests. Management and staff, under this alternative, would seek self-preservation and aggrandizement, and would cater to the interest of client governments, the borrowing countries.
Evidence from the Literature
In this section we review the literature that bears directly on governance issues. We start with studies that favor an interpretation along the lines of the critical shareholders model, then continue with those that favor a capture theory, and conclude with a synthesis of the two.
Solomon (1977, p. 5), in his analysis of the international monetary system from 1945 to 1976, remarks that "to call it a system is to impute more formality to it than it deserves." Yet he identifies in the G-10 Ministers and their Deputies an important group:
"the IMF Executive Board was expected to do the preparatory work and to receive the views in practice, the decisions of the Interim Committee" (p. 303).
The Interim Committee, constituted by 24 IMF governors, was formed in 1974 to replace the Committee of Twenty and was replaced by the International Monetary and Financial Committee in 1999. The members of the Interim Committee played the role expected of corporate directors, which is advising and recommending strategies to management for them to implement.
Williamson (1977, p. 60) goes a step further on the role of the G-10:
"The G-10 had filled the role of discussing such issues for the previous decade and it had been active as the natural body in which to negotiate the exchange rate realignment".
For Plumptre (1977, p. 281):
"[the Interim Committee] is to stand between the Board of Governors massive and cumbersome, with more than 125 members who deliver set speeches to audiences of thousands at annual meetings -and the twenty Executive Directors In short, the intention was to introduce a more effective political influence into the Funds decision-making".
In contrast, the Executive Board of the IMF is described as "reflecting the diverse views of 20 Executive Directors from Europe, Asia, Africa, and North and South America, [and] was inevitably bland in its recommendations, overt or implied" (Solomon 1977, p. 225). The irrelevance of the Executive Board is emphasized by Woods (2001, p. 87):
" real debates over policy and issues are conducted outside of the Board. Controversial cases and stand-off debates are rare. For example, a loan that did not meet with US approval would seldom be presented to a Board for discussion."
For Woods (pp. 87-88), this failure stems from the Directors acting as cheerleaders for the countries they serve.
Boughton (2001) has an extensive discussion of the relationship between the IMF and its critical shareholders. In chapter 5, he examines the review process under Article IV of the Articles of Agreement between the IMF and each of the G-5 countries (the United States, Germany, Japan, France and the United Kingdom). The opening sentence of the chapter sets the tone for what follows: "Nowhere is the difficulty of conducting surveillance more apparent than in the relationship between the IMF and the major industrial countries" (p. 135). The story can be simply summarized that the G-5 countries are too powerful to mind the advice of the IMF, and this is especially true of the United States. In chapter 7, Boughton tells the history of policy cooperation, starting with the creation of G-10 and the General Arrangements to Borrow in the early 1960s, then G-5 and its enlargement to G-7 in the mid-1970s, then the Plaza Accord of 1985, and finally Louvre of 1987. In retrospect, the critical shareholders of IFIs were acting quite cooperatively in 1980s, although there were signs that even the G-7 was too large a group and had its own super-cooperative core of G-3 countries (the United States, Germany and Japan). In all of this activity, the IMF played a subsidiary and technical role. Boughton candidly acknowledges that "the Fund participated only at the pleasure of the countries officials and had no real standing to guide the process" (p. 186). In sum, the G-7 countries stand out from the rest of the shareholders of the IMF, and behave as if they are in charge.
The Meltzer Commission (2000) laments the undue influence of the critical shareholders:
"[the] IMF should not be used as a slush fund to satisfy decisions of the G-7 finance ministers or other groups of powerful members" (p. 48).
The Commissions main recommendation of setting a rule whereby the IMF would lend only short term, at penalty rates, and conditional on ex-ante standards of financial soundness (p. 8) may be interpreted as a mechanism to rein in the disproportionate influence exercised on the IMF by its critical shareholders (Tarullo 2001, pp. 625-6).
Barro and Lee (2002) present econometric evidence that being close to critical shareholders enhances the probability and size of an IMF loan. Using panel data encompassing 130 countries over five-year intervals from 1975 to 1999, these authors estimate Tobit and probit models to explain the size of IMF program approval, and the frequency with which a member country benefited from an IMF program. The explanatory variables include country-specific economic factors (e.g., per capita GDP), time dummies to account for shifts in global shocks, the borrowing countrys clout with the IMF, and the borrowing countrys political-economic closeness to critical shareholders. The borrowing countrys clout with the IMF is measured by the relative size of its quota and by the relative size of nationals among IMF professional staff; closeness to critical shareholders by fraction of votes at the U.N. General Assembly that agrees with the positions taken by critical shareholders and by the ratio of the bilateral trade between borrowing country and critical shareholder to borrowing countrys GDP. There are four critical shareholders in the sample: the United States, France, Germany, and the United Kingdom. While the empirical findings differ from equation to equation, the overall pattern is that both clout and closeness to critical shareholders matter for participation in IMF programs.
The Barro and Lees results echo earlier ones found by Frey and Schneider (1986) with respect to World Bank loans. Frey and Schneider, using data from 1972 to 1981, find that a political-economic model of lending that links critical shareholders to connected borrowers (e.g., former colonies) is superior to alternative models of lending based on development need or officially declared World Bank criteria.
One of the sharpest criticisms leveled against the IMF, and consequently against its critical shareholders, is the high failure rate of conditional lending programs. An important reason for this can be blamed on the unwillingness or inability of borrowing countries to control government budget deficits, as well as to the misforecasts of the needed adjustments by the IMF staff (Boughton 2001, p. 617). Furthermore, these patterns repeat over time. For example, in 1990, the number of countries that had borrowed five or more times in the preceding 10 years and with outstanding credit of at least 100 percent of their quota had quadrupled with respect to 1980 (Boughton 2001, Figure 13.6, p. 619). Bird (2003, Table 4.2) provides further evidence of recidivism: over the 1980-96 period Argentina, Central African Republic, Democratic Republic of Congo, Costa Rica, Ivory Coast, Ecuador, El Salvador, Hungary, Jamaica, Kenya, Madagascar, Malawi, Mali, Mauritania, Morocco, Niger, Philippines, Senegal, Togo, Uganda, and Uruguay had tapped IMF resources at least seven times, an average of almost a program every two years. For the bulk of these countries IMF programs serve the undeclared purpose of economic aid. But what can one say about Argentina and Uruguay?
Mussa (2002) gives a straightforward assessment of the failure of the IMF with regard to Argentina, a country that " throughout the 1990s operated under the auspices of a Fund-supported program" (p. 3). The IMF made two egregious mistakes, the first to overlook Argentinas profligate fiscal policy in the first half of the 1990s and the second to provide the country with a huge financial package of $40 billion in 2001, despite the evidence that the crisis could not be averted (p. 4). Mussa blames both the critical shareholders and IMF staff for this state of affairs. In the eyes of the critical shareholders,
" Argentina was generally seen as a country deserving sympathy and support; and the Argentine authorities were certainly willing to draw on this sympathy and support" (p. 47).
This support has continued to these days. In January, 2003 the IMF approved an eight-month stand-by credit to Argentina for $ 2.98 billion, a decision pushed by the G-7 against strong opposition on the part of IMFs management (Financial Times, January 20, 2003). But Mussa also blames IMF management of acting "too much as a sympathetic social worker" (p. 69) and the staff for being soft in the analysis; more on this below.
Momanis (2002) PhD dissertation develops an informative case study of the influence of the United States on IMF decisions to grant loans to Egypt. By relying on internal IMF documents covering approximately ten years of IMF staff reports on IMF-Egyptian agreements, as well as on archival material from the U. S. Department of State, the case study concludes that the U.S. government was instrumental in pushing for lenient terms in the 1987 and 1991 agreements despite contrary opinions by IMF staff.
Further evidence on the critical shareholders hypothesis is offered by Blustein (2001), for whom the industrial countries, but in particular the United States and in particular the U.S. Treasury, believe strongly in unfettered capital movements. The IMF, according to Blustein, sings to the U.S. Treasury tune and promotes the same philosophy. Blustein identifies a High Command of the global financial system, consisting of officials at the U.S. Treasury, Fed and G7 countries, and their delegates at the IMF (p. 9). With a touch of irony, Blustein calls them " the guardians of global financial stability [who] were often scrambling, floundering, improvising, and striking messy compromises" (p. 14). The messy compromises are driven often by incentives to rescue the creditors of industrial countries. Like the Meltzer Commission, Blustein is concerned that the High Command encourages moral hazard behavior with large country bailouts.
A more balanced view of the role of critical shareholders is provided by Bird (2003, ch. 3) who acknowledges that powerful shareholders exert influence on IMF lending but cautions "not to get overexcited about their consequences for prediction. Since IMF agreements are present in only about 20 percent of the observations, in most large sample econometric studies a prediction of no agreement would be correct about 80 per cent of the time" (p. 60). For the purpose of this paper, however, the relevant issue is not whether the prediction of no agreement is 0.8 but rather what effect political considerations have on the 20 percent of the cases where agreements have been reached.
Vaubel (1991) was an early proponent that the rapid expansion of the IMFs loan programs was fueled by bureaucratic self-preservation, power, and prestige, an outcome that is consistent with the implications of the capture hypothesis. Meltzer (1999) is even more explicit on this theme:
"IMF officials are judged partly on their contacts with high officials of borrowing governments. Critical reports by an IMF task force reduce the welcome the IMF team can expect on its next visit Borrowing governments recognize this power, so they are able to restrain criticism and prevent or delay information from reaching the IMFs top management." (p. ).
Bordo and James (2000, p. 7) echo similar concerns and speak of "clientism" among Fund staff. These authors also emphasize how the IMF branched into development work that went beyond the original function (p. 20) and for which it was not well prepared. In the private sector, moving into a new business without shareholders or directors approval and without adequate disclosure to shareholders generally would be considered a serious governance failure.
Mussa (2002, p.70) finds a pro-borrower bias among the staff of area departments:
" by the nature of their responsibilities and because of their need and desire to maintain close cooperative relations with the authorities of member countries, this bias toward the member tends to be particularly strong in the Funds area departments."
This bias, in turn, is neither compensated for, nor controlled by other departments that work with the area departments, nor by management that "normally sides with the area departments in their efforts to be as cooperative with members as possible" (p. 70). The friction between area departments and the Research Department of the IMF is underscored in a report of a group of independent experts commissioned by the IMF to assess IMF surveillance (IMF 1999). For the experts, disagreements between the two departments:
" were at least in part responsible for the fact that that concerns about the health of Koreas financial system were not properly reflected in surveillance nor communicated to the Executive Board" (p. 32)
Note that in the private sector, both regulation and supervisory oversight seek the identification and management of conflicts of interest and mandate the separation of areas that may be conflicted.
Coexistence of the capture theory and the power of critical shareholders
The literature reviewed seems to agree that non-economic considerations enter into IMF loan decisions, but it is more ambiguous whether the main source of the problem lies with the critical shareholders or with the IMF management and staff. Fratianni (2003) argues that both elements are present. Consider IMF conditional lending. The single most important goal of conditionality lending, seen from the viewpoint of the IMF, is to restore external balance while preserving long-term internal balance. Governments of borrowing countries, instead, consider external balance a constraint on their domestic economic policies, which have a plethora of political, social and economic objectives. Also, governments want to remain in power or win the next election. Thus, it may pay off politically for a government to ignore temporarily the balance-of-payments constraint and embark on fast-growth policy, which implies above-average output growth rates, balance-of-payments deficits and a rising inflation rate. An unsustainable external deficit will put an end to the expansionary policy and will start an adjustment program financed by the Fund. For an interesting case study, 1986-1987 Peru, see Boughton (2001, p. 612).
The logic of conditional lending is to set restrictions that translate into costs in terms of output and employment. Costs of the program occur typically before benefits. Most borrowing governments are aware of the intertemporal cost-benefit tradeoff implied in conditionality lending. They may accept the conditions set by the IMF but find them unpalatable politically and are ill disposed to implement them. This outcome is consistent with the view of those critics typically from the politically left who claim IMF conditionality lending is too costly for the borrowing countries. There is, however, a second possibility. Governments of borrowing countries are aware of the intertemporal cost-benefit tradeoff but feel they can improve it by claiming extenuating circumstances. This outcome is consistent with the view of those critics typically from the political right- who claim that IMF conditionality lending ends up encouraging repeated lending and moral hazard behavior.
It is plausible that both paradigms co-exist because the IMF discriminates between rich and poor, large and small, geopolitically important and irrelevant members. This discrimination is to a large extent driven by the preferences of the critical shareholders who use the IMF as a multilateral agency of foreign policy and foreign aid. Critical shareholders bear heavily on IMF management when their interests are at stake; otherwise, for small and unimportant countries, their monitoring activity is low and opinions of Fund staff have a much larger influence on outcomes. An illustration of the selective activity exercised by critical shareholder at the IMF is provided by Blusteins (2001, pp. 101-102) account of the IMFs mission to Indonesia during the 1997 currency crisis:
"The reason for the turnaround was pressure from members of the IMF board representing Western industrial countries. Karin Lissaker, the U.S. representative, was particularly assertive. ...The mission went out [to Jakarta] with the usual recipe tweak a little on monetary policy here and fiscal policy there, Lissaker recalled. We stepped up the heat, the more we found out about the issues, hearing about these massive subsidies to cronies and family members This was clearly pushing the outside of the envelope."
Conflicts of Interest and Standards Non-Compliance
So far, we have stuck to a positive analysis of governance. We have seen that governance structure deals with the control of residual rights. These rights are exercised by IFIs critical shareholders and management, the distribution between the two being a function of how important borrowing countries are to the interests of critical shareholders. The obvious extension is to ask whether this state of affairs is desirable, or whether improving governance can yield better outcomes.
We start with the premise that the status quo is not desirable. According to Tarullo (2001, pp. 618-9), participants in the international financial reform debate agree on two fundamental propositions. The first is that the frequency and size of currency and banking crises in the last two decades suggest that the international financial architecture needs at least a face lift. The second is that the current practice of handling crises on adhoc basis has to be revisited. Reforms of the international financial system cannot ignore governance structures: performance and governance are intricately linked through incentive systems that influence decisions made by IFIs and their member governments and the reaction of economic agents to the signals emitted by these bodies. Moral-hazard behavior is a good case in point. For many critics the signal quality and frequency of IMF loans fuel moral hazard risk (Fratianni 2003). Would the IMF approve such loans to countries affiliated with its own directors if it had a board of independent directors? Not likely; if they did it in the private sector, beyond certain safe harbors defined in law, they would be subject to disciplinary actions and punitive damages by bank regulators and the courts.
Conflicts of interests
Private-sector governance strives to eliminate, minimize or manage conflicts of interest between directors and management, directors and large shareholders, directors and firms customers and directors and firms suppliers. Why should the same principles not apply to IFIs? The absence of profit motive in IFIs is not a valid reason for ignoring conflicts of interest. Shareholders and directors of IFIs represent national taxpayers. As corporate directors have a fiduciary responsibility vis-à-vis the stockholders, so do directors of IFIs have a fiduciary responsibility vis-à-vis the national taxpayers. Both private shareholders and taxpayers expect a rate of return for their investment and both delegate a specialized group of individuals to devise a business strategy and monitor management effort to that end. While the objectives of IFIs differ from those of privately owned corporations, the essence of the delegation mechanism does not change fundamentally.
We consider three types of conflicts of interest in IFIs and, for the sake of brevity, we use the IMF as the IFI prototype. The first conflict of interest involves IMF staff and management giving advice and lending, which is analogous to the conflict between security analysis and investment banking housed within the same financial intermediary, or, in a related comparison between marketing a bank loan and making a credit decision. As remarked by Fratianni (2003, p. ), "the potential bias of security analysts is to be optimistic about the equity valuation of a business that is either a current or prospective client of the investment side of the firm. The potential bias of Fund staff is to provide country advice in line with the conditions set in a current Fund program." Executive Directors do not, and possibly cannot, monitor properly management and staff; and biases, rather than being compensated, are reinforced. The already mentioned Report on external surveillance is quite explicit in noting that "[Executive Directors] tended to be defensive about the countries they represent and that other [Executive Directors] deferred to this, partly because they expected the same deference in return in due course peer pressure can become peer protection" (IMF 1999, p. 34). Mussa (2002, pp. 80-1) accuses IMF staff of indulging in advocacy instead of hard-nose analysis with respect to Argentina and spurs the Executive Board to exercise its rights of supervision. But the Executive Board is not independent since it is chaired by management, an arrangement that:
"Some [Executive Directors] regarded as anomalous, potentially putting management in a difficult position if a staff paper is strongly criticized Internal disagreements are generally not divulged to the Board. Some Directors thought it could be healthy for this to happen more frequently" (IMF 1999, p. 34).
The second conflict of interest arises between directors and IMF customers. No private bank would be allowed by its regulators to have directors that represented the interests of those to whom funds are lent. Yet, all IMF member countries are represented by IMF directors. In 2001, the Independent Evaluation Office was created to reduce agency costs to the IMFs shareholders. The Office is independent of IMFs management and reports directly to the Executive Board on the various activities of the IMF. But the Office is chaired by a member of the Executive Board, and its budget and its Director are approved by the Board as well. Such a structure may lead to self-serving decisions about the review of internal practices at the level of the board or board committees. In contrast, an important focus of private sector governance is to improve the independence, objectivity and functioning of the audit committee.
The third conflict of interest arises between the promulgation and the assessment of international standards (Fratianni and Pattison 2002a). The IMF has issued standards on the quality and timeliness of macroeconomic data through its General Data Dissemination System and the Special Data Dissemination Standard. Furthermore, it has codes of good practices in the areas of monetary and fiscal policies. The reasons for this conflict are the same as those outlined in the previous paragraph: the IMF is economic adviser, standard setter, credit analyst, lender, auditor, and crisis manager. Too much for an institution, even with the best intentions, and without safeguards that are monitored and tested to protect shareholders.
In addition to setting its own standards, the IMF endorses standards issued by bodies such as the Basel Committee on Banking Supervision, the International Accounting Standards Committee, and the International Organization of Securities Commission. Is the IMF compliant with these standards?
Take, for example, the standard that all international banks should be supervised by a home country authority that capably performs consolidated supervision (BIS 1997a). While the IMF eminently qualifies as an international financial institution, to our knowledge it is not subjected to an independent oversight or review of its risk management, internal controls or direction. In fact, as a result of not having independent directors, the IMF does not benefit from the work of independent audit committees chaired by independent directors, a fundamental practice in the private sector. The consequence is that possible weaknesses and outright failures of IMF lending policy are not subject to the type of scrutiny that is typical in a private sector bank. Supervisory independence is no small issue. For John Hawke (2002, p. 9), the U.S. Comptroller of the Currency, notes "the absence of supervisory independence has been implicated in almost every national financial crisis that the world has recently seen In each case, supervisors became instruments of government or central bank policies that subordinated the safety and soundness of financial institutions to other goals."
Consider a second set of principles codified in the "Core Principles for Effective Banking Supervision" (BIS 1997b, p. 19): "an essential part of any supervisory system is the independent evaluation of a banks policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios;" "banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and reserves;" and "in order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arms-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks."
Such a framework is not in place at the IMF, at least not yet. The Meltzer Commission (p. 28) gives examples of the long term use of IMF credit for which its facilities were never intended. Boughton notes (p. 44): "When quotas were not raised in line with demand for Fund credits, the Fund used this borrowed money (from surplus countries) to stretch its resources by agreeing to approve credit arrangements that were larger in relation to quotas than had previously seemed prudent pushed the Funds balance sheet and income flows into a precarious position." All of this occurred without any of the supervisory oversight and regulation that instead applies to private sector financial intermediaries.
Take a final example on repeated borrowings by the same client. Bank supervisors become justifiably concerned about client status and quality of the loan when a bank advances new funds to enable the borrower to pay interest on an existing debt. The standard on "Sound Practices for Loan Accounting and Disclosure" (BIS 1999, paragraph 70) states that "interest on impaired loans should not contribute to income if doubt exists concerning the collectibility of loan principal or interest." IFIs do not comply with this standard, loans to Argentina being the most blatant example (Graham and Masson 2002). In December of 2001, the IMF refused to disburse to Argentina a loan tranche of $21.6 billion because the countrys failure to comply with loan conditions. Then, Argentina defaulted on a World Bank loan in November 2002; two months later, Argentina was approved a new transitional funding arrangement by the IMF. Does such an obvious disregard for credit quality, recognition of impaired loans and disclosure of loan provisions on the balance sheets, and untransparent accounting practices serve the reputation of the IMF and its shareholders? Does it serve to contain moral hazard?
The earlier answer of the Meltzer Commission (2000) was a resounding no. The Commission wanted to refocus the IMF as a short-term lending IFI and force critical shareholders and management to pre-qualify potential borrowers with the intent of reducing, if not eliminating altogether, moral hazard. Elsewhere (Fratianni and Pattison 2002b), we have analyzed the differences between the Meltzer Commissions regime of ex-ante pre-qualification and the current regime of ex-post conditionality lending. Neither one is a panacea. Under pre-qualification, there is the risk that the lending-of-last resort agency may either lend too much or too little to the non-qualifiers, instigating either moral hazard or welfare losses. Under ex-post conditionality lending, the IMF has a conflict of interest between setting conditions and monitoring them. In either case, good governance would dictate that the qualification standards be set by a different IFI.
Groups that control corporations can often profit from lapses in governance. Indeed, flaws in governance procedures, such as multiple voting shares, are often created to increase disproportionately the influence of groups of shareholders. Similarly, large countries may appropriate a disproportionate share of the benefits generated by IFIs. The consequences for economic efficiency are likely to be negative. It is precisely this point that guides our concern for improving governance structures in IFIs. The governments of the most important industrial countries have the clout and the incentive to use IFIs for their own purposes, a tendency that is enhanced by weak governance structures.
Conflicts of interest between directors and management, directors and large shareholders, directors and firms customers and directors and firms suppliers are carefully monitored in the private sector. Abuses are disciplined by competition and legal safeguards. There is no counterpart in IFIs. Furthermore, IFIs have not yet adhered to the codes of good financial behavior that apply to internationally active financial intermediaries, such as operational independence, large exposure limits and segregation of duties. It is ironic that IFIs have been at center stage in the promulgation of international financial standards and that there is an ongoing debate as to what IFI should enforce these standards (Fratianni and Pattison 2002a); yet, the same IFIs have themselves turned away from adopting the rules.
Therefore the path forward must seek other organizational avenues. There are a number of choices. One suggested by this article is through governance techniques to resolve the conflicts of interest and the disparate levels of influence of small shareholders and large shareholders in the IFS. This is a promising avenue since it builds upon existing structures. Nonetheless the earlier discussion also indicated that the current structure is missing direction at a high level. Another alternative, suggested in Fratianni and Pattison (2001b) is to recognize the growth of regional associations and to utilize them in the international policy making framework.
The dissatisfaction with the current state of the international financial architecture can be attributed, in no small part, to outdated governance structures. One step, among several, to modernize these structures would require that directors of IFIs take their fiduciary responsibilities seriously rather than acting as cheerleaders of the governments they represent.
One caveat to our recommendations for change is in order. According to club theory, international cooperation does not occur spontaneously; a few large countries take the leadership and incur a disproportionate share of the cost and benefits of cooperation (Fratianni and Pattison 2001b). The implications of this theory are at odds with the requirements of legitimacy and full participation of all member countries on an equal and democratic basis. For example, Aglietta (2000, p. 7) notes: "All prior world conferences failed Paris in 1865, Genoa in 1922, and London in 1933. So did the grand design to overhaul the [international monetary system] launched after the Smithsonian Institute Agreement in December 1971." Nonetheless, proposals continue to be advanced to legitimize the international financial architecture through a more democratic process. But the wider is participation, the more difficult is the achievement of meaningful cooperation. The postulates of club theory may set the ultimate limits of governance reform in IFIs.
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