Faculty Research: Arvind Krishnamurthy, Finance
Kellogg Professor Arvind Krishnamurthy urges proactive
strategy to avoid financial crisis
By Rebecca Lindell
Before he arrived at the Kellogg School, Professor
Arvind Krishnamurthy enjoyed a front-row seat to the drama of the
world's financial markets.
As a bond trader focusing on risk management, Krishnamurthy
watched various international financial crises unfold, including
the devaluation of the British pound in the early 1990s and
the Mexican currency crisis in 1994.
Intrigued by the dynamics surrounding the events, Krishnamurthy
decided to gain a deeper understanding. After earning a doctorate
in financial economics, he joined Kellogg as an assistant
professor of finance in 1998.
Now Krishnamurthy researches, lectures and writes about
financial crises, with a particular interest in those that
occur in emerging markets.
Among his conclusions: that nations tend to avoid dealing
with financial crises until it's almost too late.
Prime examples include the Argentinean and East Asian currency
crises in the late 1990s. Both were foreshadowed by rising
foreign debts and problems in the banking sectors. And in
both cases, the governments took corrective actions only
after the crises had reached the boiling point.
"In good times they over-borrow and over-invest," Krishnamurthy
observes. "Then they're sitting in a crisis and they ask
themselves, 'How do we get out of this?' That's when the
financial press and the IMF come in, after everything has
more effective would be a "crisis avoidance" approach,
where countries would structure their debts to minimize the
possibility of a liquidity crunch. As an example, Krishnamurthy
cites Chile, which imposes liquidity requirements on banks
receiving foreign investments. Any bank or firm that borrows
from foreign investors sets aside a portion of the funds
borrowed in an account with the central bank. The liquidity
acts as a buffer if capital flows reverse.
Fundamental to that approach is a reorientation of the
banking system, Krishnamurthy says. In most countries, banking
requirements promote the banks' internal stability. Krishnamurthy
urges governments to take a broader view and impose rules
that bolster the system's overall economic stability.
"You need more developed, more transparent financial markets,
more oversight of the banking system, and some management
of the borrowing in the private sector, as well as for the
country," Krishnamurthy says. "Banks, firms and the government
all need to coordinate the way they are borrowing."
In the United States, a bank's liability structure is linked
to its asset position. The government will require a bank
with many risky loans to reduce its debt and shore up its
equity capital. Krishnamurthy advocates that this approach
be more widespread among nations.
Without such regulations, companies and governments are
less likely to behave prudently, he believes. Assuming that
other institutions have ample cash on hand, public or private
entities may take greater risks with their capital, piggybacking
on their counterparts' perceived stability. One possible
result: a situation like that in Argentina, where regional
governments were running significant deficits, along with
that of the central government. The result was an unsustainable
total debt burden.
Other countries have found ways to bolster their liquidity,
Krishnamurthy notes. Norway, for instance, is heavily dependent
on oil exports. The nation operates a fund into which it
deposits a portion of its oil revenues, with the funds earmarked
for leaner times. The fund protects the nation from shocks
to its oil profits, helping the country avoid the recessionary
conditions that gripped Scandinavia in the early 1990s.
"It requires a lot of foresight," Krishnamurthy acknowledges. "Here
in the U.S., we have a large prospective budget deficit,
and there's a lack of foresight in the current administration
as to how to manage it. It's a hard question to ask them
to address, but things can be pointed out."
Krishnamurthy has found a willing audience for his ideas
at the International Monetary Fund, where he spent three
months as a visiting scholar in 2002. The organization is
entertaining ideas, such as the establishment of a sovereign
bankruptcy court, that could head off future financial crises.
"That's a good example of how the thinking has changed," Krishnamurthy
says. "Fifteen years ago, the IMF was more concerned about
whether a country had a fixed or floating exchange system.
Now, it is thinking more about crisis avoidance.
"The main idea is that financial stability is a public
good, and the whole country benefits," he adds. "A stable
corporate and banking sector provides a country with an environment
for economic growth.