The efficient resolution of capital account crises: how to avoid moral hazard

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 26 October 2004

Working Paper No. 233 
By Gregor Irwin and David Vines

This paper presents a model of capital account crises and uses it to study resolution mechanisms for both liquidity and solvency crises. It shows that liquidity crises should be dealt with by a standstill combined with IMF lending into arrears, whereas solvency crises should be resolved by debt write-downs. Dealing with solvency crises by lending would require a subsidy and this creates moral hazard, such as incentives for excessive borrowing, for too little equity financing and for investment in projects that are inefficient. The analysis underlines the importance of accurately assessing whether a crisis is rooted in a liquidity or a solvency problem. 

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