The Meltzer Commission recommendations for reform of the International Monetary Fund, the World Bank and the regional development banks has come in for heavy criticism.

Richard Gephardt, the Democratic leader in the House of Representatives, decries it as "neo-isolationist". That is hard to square with the commission's proposals to increase funding for development bank programmes and to cancel the debts of the poorest countries. Professors Barry Eichengreen and Richard Portes (FT, March 9) mistakenly claim that, in some cases, the commission advocated unlimited IMF lending - which would increase moral hazard costs. In fact, the commission made it clear that IMF lines of credit must be limited to ensure their senior status.

The commission recommended that the IMF limit itself to short-term finance for countries facing liquidity crises, leaving poverty alleviation to development banks. The ide a is to strengthen the IMF's effectiveness, while limiting the intrusiveness of IMF conditionality. Proposed measures include charging a penalty rate to borrowers and lending to countries that meet financial soundness preconditions.

At present, the IMF lends at a mark-up over its cost of funds. That is not a penalty rate. On the contrary, many countries perceive it as a substantial subsidy. The proposed lending rate will separate the wheat from the chaff. Countries facing a bona fide liquidity crisis would benefit from the new scheme because it would allow them to avoid unnecessary financial collapse. Conversely, a penalty rate would discourage those countries which seek financial assistance for bank bail-outs.

Countries facing both a liquidity and a banking crisis would still be expected to access IMF lending facilities, but the new rules would discourage fiscally costly bail-outs of banks. Borrowing senior IMF debt at a penalty rate would not channel subsidies to a country that chose to expand its public deficit; indeed, it would hamper its ability to raise and retain private funds.

The commission recommended that the IMF offer liquidity assistance on the basis of pre-qualification. Liquidity crises happen very quickly, with no time for protracted nego tiations. Nor can countries readily demonstrate that they are innocent victims of external shocks - which bars them from tapping the IMF's contingent credit facility. If the IMF is to focus on effective liquidity assistance, there is no viable alternative to having countries pre-qualify for credit.

The proposed pre-qualification requirements include the adherence to prudential banking standards to ensure banks maintain adequate capital and liquid reserves. That would reduce the likelihood that borrowing countries would access IMF lending to sponsor bank bailouts.

For the same reason, countries should permit the free entry of foreign financial institutions. More than 50 countries have agreed to do just that, within the framework of the World Trade Organisation. The transition to this pre-qualification system will take five years, which will allow nearly all emerging market countries to meet the new standards.

Pre-qualification is designed to avoid, rather than increase, the IMF's intrusion into the sovereignty of borrowing countries. IMF conditionality has always taken the form of customised, ex post micromanagement.

This intrusion is to be avoided. Instead, the IMF's liquidity assistance should be based on clearly specified rules that would apply to all countries. For instance, requiring countries to open their financial sectors to foreign investment would protect their citizens from bearing the costs of IMF-sponsored bailouts. Prequalification and lending at a penalty rate would have avoided the IMF's complicity in the Mexican and Asian bank bail-outs. Facilitating bailouts was itself an invasion of sovereignty. The price of observing the rules proposed would have been much smaller.

What would happen if the stability of the global financial system were at stake because a large developing country in need of liquidity assistance had not pre-qualified? The commission recognised that the pre-qualification requirement could be waived in such circumstances. But the lending limits, the IMF's senior status and the penalty rate would still apply.

The commission advocated targeting only the poorest countries for poverty assistance. This does not mean that poverty assistance to middle-income countries is undesirable, but rather that these countries are better able to fend for themselves. There is little value in continuing to subsidise investment-grade countries through development bank resources, which amount to 1 per cent of their foreign capital inflows. There would be much greater value in using those resources to build sound legal systems and improve education and health services in the poorest countries.

Charles Calomiris, a visiting scholar at AEI and a professor of finance and economics at Columbia Business School, served on the International Financial Institutions Advisory (Meltzer) Commission.