[N.B.: This post, while intended to stand on its own, should be understood as part of a sustained analysis that we have been carrying on over a series of posts. Readers who find themselves baffled by this post may want to start with earlier posts in the thread: specifically here, and here.]
Why is the IMF getting involved in the Eurocrisis, and why is its involvement taking the form of lending to individual member states of the Eurozone? One reason, which is the focus of most commentary, is the IMF’s long-honed reputation for “conditionality” as a condition for lending. The ECB is simply not in a position to insist on conditionality, so if you think conditionality is needed, then you think you need the IMF.
But there is a second reason also, which has been neglected in most commentary, and that has to do with solving the collateral crunch currently underway in the Eurozone. The breakdown of unsecured interbank markets has meant that whatever interbank lending is still taking place involves a transfer of collateral. But this is only one source of the demand for collateral.
A second source of demand for collateral is the discount lending by national central banks to their own private bank clients.
And a third source is the Eurosystem lending between national central banks, which takes place more or less automatically through the operation of the TARGET2 payments system.
That’s a lot of collateral! Some of it can probably be used more than once, but each time it is used there is another haircut, and the haircuts are getting bigger all the time. Consequence, collateral crunch.
So here’s where the IMF can help. If the surplus NCBs (Germany) shifted their lending to the IMF instead of the Eurosystem, they would not require collateral. And if the IMF in turn bought the sovereign debts currently held by private banks, then those banks would not need to finance their holding, and hence would not need collateral to do so.
One consequence of such a refinancing would be to shift existing TARGET2 imbalances off the balance sheet of the Eurosystem—the accumulated stock is not going away soon and so long as it sits on TARGET2 it blocks current flows. Thus the refinancing itself will restore the ability of TARGET2 to absorb temporary imbalances, and so restore normal functioning of the Eurosystem. Good thing in itself.
But a second consequence would be to free up collateral that is now frozen. A LOT of interbank lending is required to support sovereign debts on the balance sheets where they now sit, and in current circumstance ALL of that interbank lending soaks up scarce collateral that is needed, and in normal times used, for other purposes. All the collateral freed up by the IMF intervention would immediately be free to support other activities of the financial system, such as market-making in securities, and non-financial lending.
Would that end the collateral crunch? Would it also end the price distortions caused by that crunch? Would it, pray God, maybe even reverse the payment imbalances that are the source of the interbank lending stresses in the first place. Personally, I think there are other, more systematic reasons for collateral shortage—let me cite here the latest Pozsar and Singh working paper—and so expect it be a recurring problem. But the IMF trick is a start, and perhaps shows us the way.
In sum, what the system needs is someone to do some unsecured borrowing. If it isn’t going to be the ECB, then maybe the IMF will do.
For both the ECB and the IMF, ECB for the banking system and IMF for the sovereigns, the borrowing should probably be thought of as unsecured borrowing of last resort (UBLF?). The EFSF, and now ESM, seem intended to serve as first resort, but their success depends crucially on the backstop provided by ECB and IMF.