Just as natural science developed out of a natural philosophy we are hopefully moving toward a science of regulation, both in the sense of being well-established knowledge and drawing on political science and quantitative economics. With globalization, so many interests at the table and plentiful information to use, the days are long gone when a regulatory policy proposal would be adopted only on basis of a battle of vested interests.
Globalization, as with European integration before and alongside it, has blurred any regulatory policy focus. Nationalism brought many problems but did allow for clearer political, economic and social objectives that could be balanced to a reasonable degree. During the last decade in the continuing globalization of financial services, even domestic financial markets are now impacted by the global financial system.
Given a choice between national markets and globalization I choose the latter, but I remain to be convinced that we have a reliable methodology to devise regulatory and supervisory policy for that.
What is more, once we rise above national boundaries and authority it is less easy to see the power behind decisions. It is of course more political but where is the accountability; judicial or political?
As was once predicted; “European or international policy having a multitude of objectives to be held in some kind of balance may cease to be workable or programmable through the legal structures.”1
The EU Commission’s “Economic Review of the Financial Regulation Agenda” which accompanied its communication “A reformed financial sector for Europe” was published on May 15, 2014.
The reforms seek to address regulatory failure in that the accumulation of risk in the financial system leading up to 2008 was not appreciated or addressed, prudential surveillance allowed excessive asset growth, supervision and regulation did not adjust for the economic cycles and, of course, whilst the financial system was increasingly globalized, its regulation remained largely national.
The main concerns being addressed as part of the reform agenda are that governance and risk management was weak and not monitored or controlled, there was inadequate regulation of credit rating agencies and auditors and financial products relevant to stability and systemic risk (derivatives including CDS) were unregulated as was non-bank credit intermediation (shadow banking) which was prone to liquidity runs.
Most financial system players want globalization but with that it seems inevitable that regulation and supervision will become more complex, even if rules are harmonized, as the regulatory infrastructure becomes deeper and wider. International institutions and agencies are setting policy and providing oversight and their roles must be reviewed and clarified, always with an eye to consolidation. The bodies should have clear life-cycles and leadership and staff must be accountable against the legal authority creating the body.
The financial crisis raised problems that call for a range of fiscal, monetary and structural measures, as well as a financial regulatory reform. Arising from this, there is some evidence of a dominant objective for regulatory policy, that being stability. Stability can effectively dominate as an objective in relation to political, economic and social objectives and the need to correct macro-economic imbalances, deal with high private and public debt and address financial fragmentation to facilitate growth and jobs touches on all three.
Consistent with this, the first listed objective of European Commission in the recent staff paper and communication is to enhance stability and resilience followed by restoring the single market, securing market integrity and confidence, and improving efficiency.
As noted, unregulated products have been identified as relevant to stability, systemic risk and liquidity and conversely regulatory arbitrage may be considered a driver of shadow banking which thus affects the stability and leverage of the system as a whole. It is reported that it was the exploitation of gaps that contributed to a build-up of risk and leverage and that there was an increase of liquidity and maturity mismatches outside the regulatory perimeter.
Shadow banking is a phenomenon that defies institutional and geographic boundaries and since it has consequences for stability requires the attention of the G20 and the Financial Stability Board.
Alternative Investment Funds (AIFs), including hedge funds and private equity funds, are considered to have amplified, not smoothed, the boom and bust economic cycle. The main criticism is that AIFs had inadequate liquidity and capital and relied on counterparties “trend following” rather than sound risk management and due diligence.
If this is correct, are we then assuming too much of market forces when regulatory arbitrage is a natural consequence of a competitive market? Clearly International Financial Centers (IFCs) are relevant to the shadow banking concerns and one can expect the political pressure to engage in and conform to the regulatory reform agenda to continue.
On the other hand, IFCs must surely perform an important role as a balancing device. Transactions conducted in IFCs are political, tax and consumer protection neutral. Many of the market abuses of the last decade contributed to the increased indebtedness of households, inadequate consumer protection was then a trigger and a magnifier of the financial crisis.
After it unfolded it was tax payers’ money that was used in the bailout and all in all there was an impact on growth and employment. IFCs are almost entirely outside of this process as there is no tax payer money or political aspect at play.
It is only a decade since I was writing about governments leashing and manipulating business to serve its objectives, and yet today that seems quite implausible. Further back, in the 1930s, U.S. lawmakers believed that unregulated business often led to injustice and inefficiency; in the 1960s and 1970s, concern shifted to regulatory capture. Now regulation appears to be the mainstay the only question is how much more it can be increased before some greater negative effect will result.
There are good reasons for regulation that extend beyond job creation, power shifting and revenue-raising but it seems that we could lose sight of this as regulation becomes the undisputed solution for all sectors. I believe that proportionate regulation is necessary in many markets but the point is that it seems harder today to believe in the existence of truly competitive financial services markets that can achieve efficiency and economic welfare without regulation. Even if a sector is so, it seems its connection with the financial system gives rise to an externality that must be addressed.
Whilst regulation of the financial system is necessary because of asymmetric information, externalities, market power and abuse, regulation brings with it the risk of regulatory failure, meaning a failure to curb or rectify the market failures together with moral hazard as consumers over-rely on the regulation and also bad regulatory policy or supervision which can create or exacerbate the market failures.
The stability objective is primarily driven by political, economic and social reasons, but in some cases this will be at odds with competition and incentivizing market players. In 2013, a Financial Stability Board thematic review resulted in a report that of 36 banking groups in the G20 there was improvement in corporate governance best practice that exceeded national guidance and concluded that this was due to the banks seeking to restore and attain the confidence of the market.
Just as air will rush into a vacuum, business will be drawn to lighter regulatory environment but will resist if it needs the more dense conditions for other reasons, like securing the confidence of consumers and investors.
Many jurisdictions and markets have successfully capitalized on market trust and confidence and perhaps this quality can only be driven by the market and not regulation since where regulation is needed, market confidence may decrease.
If regulators want to continue to use market forces to provide solutions it may be necessary to rethink. Some ideas for a simpler approach are to require players to properly price risk including externalities in their financial products and/or in the case of shadow banking and alternative investments focus on controlling abuses and impose obligations on banks as the gate keepers between the sectors. I am not yet convinced that a “one size fits all” regulatory approach that does not promote competition including regulatory competition will achieve the overall objective.2
International institutionalization – risking a disconnect.
The EU cooperates with G20 partners and seeks to ensure a balance between sectors and objectives. G20’s objective is to strengthen the global economy, improve international institutions, improve regulation of financial system and promote economic reforms and it works with the IMF, the Financial Stability Board, World Bank and the Organization for Economic and Cooperative Development, amongst others.
In November 2013, yet another international body, the International Financial Consumer Protection Organization (FinCoNet) was created to focus on banking and credit consumer protection and it will also collaborate with other international bodies to advance the G20 financial consumer protection agenda.
So with the plethora of bodies that currently include the “regulation of financial system” as an objective, once regulation becomes so entrenched in the system, then we may lose sight of the rationale for regulation and there being so many bodies with overlapping objectives, the accountability of institutions will be harder to track.
- See Daintith TC “European Community Law and the Redistribution of Regulatory Power in the United Kingdom” (1995) 1 Euro LJ 134, at p139
- In relation to regulatory reform, Breyer submitted that an unregulated market was the norm and any case for government intervention should be made out by establishing an important public objective. In the first place, market failure should have occurred.