Recent speeches by US and UK regulators support the idea of regulatory “Balkanization,” or multiple regulatory rules and jurisdictions covering the same market participants and activities. This seems like backwards momentum to us and could be avoided. Today we look at recent comments from Federal Reserve Governor Daniel Tarullo, UK senior financial regulator Sir Jon Cunliffe, and a throw-back to an earlier speech from IOSCO General Secretary David Wright.
It appears that global regulators have bought into the idea that different regulations are acceptable in the global financial markets. This is in spite of the fact that the same actors are engaging in the same activities in each locale. The door has been not only left ajar, but remains fully open to regulatory arbitrage. While this will provide work for financial engineers and lawyers well into the next decade, on a theoretical basis we think this is a net negative for global financial markets.
Speaking last week at a Harvard Law School symposium, Mr. Tarullo noted that “there is no realistic prospect for having a global banking regulator and, consequently, the responsibility and authority for financial stability will continue to rest with national or regional authorities.” And that “nations should be able to adjust their regulatory systems based on local circumstances and their relative level of risk aversion as it pertains to the potential for financial instability.” Mr. Tarullo was initially talking about the US regulation of foreign banks, which itself has caused a fuss, but the principal is broadly applicable.
Mr. Cunliffe, meanwhile, recognizes the comraderie that existed in the middle of the financial crisis in 2008: “That Washington summit, and the ones in London and Pittsburgh that followed in quick succession, were extraordinary in many ways. Most striking, there was no rancour, no finger pointing between the leaders of the G20. Rather, the dominant mood was that we were indeed “all in it together”, or in Franklin’s words, would hang separately if we did not hang together.”
Fast forward to today, and Mr. Cunliffe notes that “progress in this area has not been without setbacks. Although there has been now agreement on an international standard, implementation in the US and EU has differed in a number of key respects. At times these differences have threatened to balkanise what is now a global market.” We find him to be more optimistic than Mr. Tarullo however: “I am pleased to say that both the US and the EU appear now to be inching toward recognition of each other’s implementation of the standards. The threat of fragmentation of the market seems to be receding, even if success is not yet assured.”
Much of the trouble boils down to trust: “Regulators and supervisors who cannot trust the implementation of standards in other jurisdictions will defend stability in their own jurisdictions by raising barriers. So without mutual trust, the danger is either slipping back into weak regulation and supervision and regulatory arbitrage risking further crises or fragmentation of the international financial sector – a rolling back of financial globalisation that will damage global growth.”
Both regulators recognize that they have difficult challenges no matter what. Mr. Tarullo: “the job of regulating and supervising large, globally active banking organizations is a tough one. Issues of moral hazard, negative externalities, and asymmetric information are, if not pervasive, then at least significant and recurring. The job is made only harder by the fact that these firms cross borders in ways their regulators do not.”
We wonder then why these institutions are not thinking more along the lines of IOSCO’s recommendation that there be one global regulatory institution. Yes, this would reduce the ability of domestic regulators to lock in their domestic preferences, but the trade off would be a global playing field with much fewer opportunities for “moral hazard, negative externalities and asymmetric information.”
Looking back to a smart speech made in December 2012 by David Wright, Secretary General of IOSCO, there are three options for a global regulatory organization:
1) The law of the jungle and the survival of the fittest… from a global financial stability perspective this would be highly prejudicial and dangerous;
2) The Status Quo we have today – loose forms of cooperation, hope for the best, best efforts and of course prayer;
3) A global institutional framework, probably established by International Treaty, that has some enforcement authority, binding disputes settlement and sanctioning possibilities.
Mr. Wright has a clear preference for Option 3, but it looks like we’ve set sail on The Good Ship Option 2. Without one set of rules on the global playing field, equally global financial institutions including banks, hedge funds and asset managers can simply relocate or reallocate activities to one legal entity or another. Maybe we’re missing something here, but wasn’t Basel III supposed to prevent this? Paraphrasing Benjamin Franklin, it looks like the current plan is to hang separately.
Mr. Tarullo’s speech at the Harvard Law School Symposium is here.
Mr. Wright’s speech is here.
Sir Jon Cunliffe, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee and Member of the Prudential Regulation Authority Board, made his speech “Is the world financial system safer now?” at the Chatham House City Series Conference, Global Financial Markets, new rules on market structure, trading and funding, London Monday 17 March 2014. The link is here.