Public Information Notice No. 04/16

Public Information Notice: IMF Executive Board Discusses Financial Risk in the Fund and the Level of Precautionary Balances

March 5, 2004

On February 25, 2004, the Executive Board of the International Monetary Fund (IMF) discussed financial risk in the Fund and the level of precautionary balances.¹

Background

The Fund's precautionary balances provide protection against the risk of an income shortfall and losses of a capital and general nature. Precautionary balances include the Fund's reserves and the special contingent account (SCA-1). Precautionary balances are accumulated through retention of net income, surcharges, and allocations to the SCA-1 under the Fund's burden-sharing mechanism. ²

In 2002, the Executive Board discussed the Fund's policies on precautionary balances and called for a doubling of the target for precautionary balances to some SDR 10 billion, and the maintenance of the present system of accumulation. At that time, Directors recognized that credit risk to the Fund is mainly from large arrangements with middle-income countries and the Fund should be prepared for the possibility of payments disruptions due to the increased and more concentrated credit outstanding. Directors called for a further review to determine whether analytical approaches for assessing the appropriate level of precautionary balances could be formulated.

The Executive Board also reiterated the broad principles that had been adopted in 1993 to assess the adequacy of precautionary balances: (i) they should fully cover credit outstanding to members in protracted arrears; and (ii) these balances should include a margin for the potential exposure to risk related to the credit that is in good standing. Further most Directors underlined the need for judgment in determining the appropriate level of precautionary balances though a number of Directors thought that more analytical approaches would be useful.

In considering the paper "Financial Risk in the Fund and the Level of Precautionary Balances," the Executive Board examined the decision taken in 2002 in the broader context of the Fund's role in promoting global stability, its financial structure and its risk containment policies and the characteristics of the Fund's exposure. An accompanying background paper examines how credit risk and concentration are assessed in other financial institutions and reviews analytical approaches that might shed light on the size of the precautionary balances.

Executive Board Assessment

Executive Directors had a broad-ranging exchange of views on financial risk in the General Resources Account of the Fund and the role of precautionary balances, following up on their discussion of this topic in November 2002. They agreed that mitigating financial risk at the Fund rests heavily on rigorous implementation of the policies governing the use of Fund resources and careful management of the Fund's liquidity, along with an adequate level and pace of accumulation of precautionary balances. Recognizing that credit risk to the Fund stems mainly from large arrangements with middle-income countries, Directors stressed that sound risk management requires the Fund to be prepared for the possibility of payments disruptions, which could arise from the increase and concentration of its outstanding credit.

Directors emphasized that the Fund's preferred creditor status-that is, members giving priority to repayment of their obligations to the Fund over other creditors-is fundamental to the Fund's role in the international financial system and to the Fund's financing mechanism. They noted that the preferred creditor status has allowed the Fund to take the necessary risk to provide financial assistance to members in exceptionally difficult balance of payments situations, in support of their efforts to implement strong adjustment policies without resorting to measures destructive of national and international prosperity. Directors observed that Fund members have a long history of supporting the Fund's preferred creditor status, which benefits the Fund's membership, official and private creditors alike.

Directors viewed the Fund's policies on access to, and the use of, Fund resources as the most important element of the Fund's risk management framework, along with effective crisis prevention and conditionality in support of strong country-owned programs. They also highlighted the importance of the Fund's safeguards assessments as valuable ex ante mechanisms to prevent the possible misuse of Fund resources.

Directors noted the profound changes in the Fund's lending policies in recent years in response to the changing global environment and the growing financial interdependence of members. They saw the framework for exceptional access approved by the Executive Board in 2003 as a key pillar of the Fund's enhanced risk management framework to cope with the challenges of this new lending environment. In particular, Directors stressed the need for firm application of the criteria governing exceptional access to Fund resources, and for rigorous assessments of the risks to the Fund arising from high access and the member's capacity to repay. They also noted the importance of Fund policies on access to include incentives for members to repay the Fund as their balance of payments improves, including the presumption that exceptional access will be on SRF-terms. Directors will further discuss exceptional access policies, including incentives to repay the Fund and exit strategies from exceptional access, before the Spring 2004 IMFC meetings.

Directors highlighted the increased Fund exposure and concentration of that exposure with a few large borrowers, which is inevitably associated with instances of large access to Fund resources. They also observed that Fund credit now represents a substantial proportion of the total external debt of the largest borrowers. Directors stressed that this large and concentrated exposure calls for close monitoring, in view of the financial risks to the Fund and the costs to the membership that could arise from large arrears. At the same time, Directors recognized that high concentration does not embody the same overall risk for the Fund as other financial institutions, and that, in view of the cooperative nature of the Fund and its public good role in promoting global stability, diversification of lending is not, and cannot be, an objective of the Fund.

Directors underlined the critical importance of precautionary balances in safeguarding the Fund's financial basis, as part of a multi-layered framework that also includes the Fund's arrears strategy and burden sharing mechanism. They viewed precautionary balances as an essential buffer to help protect the value of reserve assets that members place with the Fund and safeguard the Fund's unique financing structure, which is based on exchanges of reserve assets.

Directors expressed a range of views on possible approaches to refine the framework for determining the target level of precautionary balances. They recognized the difficulties in quantifying the credit risk that the Fund faces. While quantitative approaches can deepen the understanding of the risks facing the Fund, most Directors observed that these approaches have significant shortcomings when directly applied to the Fund. In light of the Fund's role in the international financial system and its cooperative nature, as well as the Fund's unique financial structure, Directors agreed that judgment must necessarily underpin decisions on the level of precautionary balances.

While recognizing the limitations of quantitative risk assessment approaches, many Directors, nevertheless, suggested that possible ways to strengthen the analytical underpinnings for making judgments about the level of precautionary balances be kept under review. Many Directors encouraged more in-depth scenario analysis of the financial impact on the Fund-and explicit recognition of the potential costs for borrowers-of members incurring arrears to the Fund. This should be done annually or when making specific decisions on exceptional access to Fund resources. A number of Directors also felt that credit risk models, which are best practices in other financial institutions, should be used to inform the Board's judgment.

Directors reconfirmed as broadly appropriate the decision taken in 2002 for a target level of precautionary balances of some SDR 10 billion, with a few Directors suggesting that a higher level may be called for. A number of Directors saw a need for further consideration of a range of options that would allow the Fund to achieve a faster pace of accumulation, given the potentially large financial risks that the Fund faces and the uncertainties regarding the availability of surcharge income. Overall, Directors agreed that the adequacy of the level of precautionary balances and the pace of their accumulation, as well as the application of the burden sharing mechanism, will need to be kept under close review.