Preliminary version

STEPHANY GRIFFITH-JONES
A New Financial Architecture For Reducing Risks and Severity of Crises

Recent financial crises have- in the most affected countries - eroded the gains in prosperity of many years of economic development and led to major increases in poverty. The depth of these crises and the speed of contagion were not at all foreseen. In fact, the volatility of short-term capital flows has emerged as a potential Achilles' heel of the globalised economy and of the market economy in developing countries. Steps have to be taken to prevent future crises and to manage them better, if unfortunately they do occur. Some of these steps can be done within existing institutional arrangements, or with some development, expansion and adaptation of existing international institutions. It is urgent to fill regulatory gaps (in particular relating to mutual funds and hedge funds) and improve the regulation of bank lending, to help prevent excessive surges of capital inflows. In addition, new mechanisms within the IMF, adapted to cope with Balance of Payments crises generated by problems in the capital account are needed. "Shadow programmes" with preventive conditionality established before crises explode, accompanied by rapid disbursement without additional conditionality if a crisis occurs seem to be an appropriate avenue. A new financial architecture that would meet the development needs in the context of the new globalised economy would have to go further. Fully developed, it would have to include a world financial authority, which carries out prudential regulation of capital flows in a consistent way (across countries and financial sectors). Such a world financial authority could build on existing practice, as developed under the aegis of the BIS and IOSCO. A very important, though as yet incomplete, step in this direction was the creation of the Forum for Financial Stability, to coordinate regulation globally. An appropriate financial architecture would also have to make sure that more official liquidity is available for countries in distress. To this purpose, the institutional mechanisms of providing such liquidity have to be developed further. One possibility would be that the BIS channels funds from the G-10 Central Banks. Conditionality in crises should be designed in ways that strengthens, rather than undermines, market confidence. Last, but not least, it is necessary to develop methods and institutions for orderly debt work-outs and standstills, which avoid debtors carrying all the burden of crises. Though international actions are crucial, clearly countries must themselves adopt their own policies to prevent and better manage currency crises. This includes more counter-cyclical macro-economic policies, better regulatory policies, the strengthening of domestic financial systems, as well as a more prudent opening of capital accounts, accompanied where necessary by market-based measures to discourage excessive surges of capital inflows.