Kellogg World Alumni Magazine, Spring 2004Kellogg School of Management
In DepthIn BriefDepartmentsClass NotesClub NewsArchivesContactKellogg Homepage
From the Dean
Faculty Vita
Faculty Hires
Faculty Bookshelf
Faculty Research: Arvind Krishnamurthy, Finance
Faculty Research: Deborah Lucas, Finance
Peterson Chair of Corporate Ethics established
Jerome Lamet '52
Robert Dotson ' 89
James Weis '93
Steve McDougal '95
John Strelecky '97
In memoriam: Prof. Robert Neuschel
Address Update
Alumni Home
Submit News
Internal Site
Northwestern University
Kellogg Search
  Prof. Arvind Krishnamurthy
© Evanston Photographic
Professor Arvind Krishnamurthy

Faculty Research: Arvind Krishnamurthy, Finance

Cash crunch
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 blown up."

Far 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.

©2002 Kellogg School of Management, Northwestern University