Written by: Philip Booth | Capco
In the last 30 years there has been a huge movement towards the internationalisation of financial regulation. This manifests itself at the EU level but also more widely.
We have the Basel Accord, the EU’s Solvency II, International Accounting Standards (the IAS), the International Organisation of Securities Commissions (IOSC), the European Securities and Markets Authority (ESMA), all the EU financial markets directives (for example MiFID), the International Association of Insurance Supervisors (IAIS). Some are just vehicles for co-operation but in all cases, the trend goes in one direction only – more international harmonisation of regulation and more regulation.
There are many reasons given for this trend. One is that it is supposed to prevent regulatory arbitrage. This means it is supposed to prevent financial institutions trying to do business from less-well-regulated jurisdictions, though the reality is that it may just make more complex the methods by which regulation is avoided.
A second reason is that international regulation is said to promote free trade, globalisation and the development of a truly international market in financial services. There is something in this, but we should note that, back in the late nineteenth century, the UK was also part of a great globalised financial system and there was very little statutory regulation at all. And the system was really quite stable.
The Problems of Regulation Harmonisation Are Too Often Ignored
When regulation is taken to higher international levels, by its nature it becomes more complex because it has to cope with a wider variety of situations. We see this in the way the Basel Accord developed. The Basel Accord of 1988 was the first international prudential regulatory agreement for banks. It was just 30 pages long. Because the accord had to deal with so many different and complex situations across diverse banking systems – and because it could therefore be gamed it became unsustainable. Its successor, Basel II was 347 pages. Basel III was agreed in 2010 following the crisis and weighed in at 616 pages – twenty times the length of Basel I.
Unfortunately, complexity begets more complexity and, quite soon, only experts in the subject understand regulation. Some of the strongest supporters of complex regulation then become those big businesses that are able to spend large amounts of money on lobbyists and who play an active part in the process of developing regulation or regulators themselves. In other words, there is a classic case of regulatory capture – either by the regulatory bureaucracy or by the businesses being regulated.
Receipe for Bad Regulation
I believe this is a recipe for bad regulation; for anti-competitive regulation that makes it more difficult for small players to enter the market; and for regulation that is incomprehensible to anybody but the expert. If regulation is hard to grasp, risk management and compliance processes will become more complex and it will become very difficult for directors, shareholders, financial analysts and so on to hold companies to account. We can contrast this situation with the 1870 Insurance Companies Act. This simply required that insurance companies published information to the market and published the basis upon which it was calculated. It was the markets’ responsibility to discipline companies. And it worked. Only two life insurance companies were wound up for reasons of insolvency in the 100 years after the act and in neither case did policyholders suffer.
Indeed, Solvency II, the EU framework for harmonised insurance regulation provides another amusing example of regulatory complexity. The list of typographical errors alone in one tiny part of the Solvency II regulations: “the technical specifications for the preparatory phase” is longer than the whole of the 1870 Insurance Companies’ Act.
The Principle-Agent Problem of International Regulation
There is, indeed, a huge principle-agent problem at the heart of internationalised financial regulation. The agents (the regulatory authorities) are supposed to be regulating in the public interest. But by what mechanism are they to be held to account? There is no obvious way by which the European Commission, the Bank for International Settlements and so on and can be held to account by those on whose behalf they are regulating.
Encouraging Common Stocks and Herding
Instead of the financial system being made up of institutions that see things differently, do different things, try different approaches to managing risk, and so on, we are promoting a system in which institutions behave in more similar ways and manage risks in more similar ways so that the system will fail catastrophically if it does fail.
Indeed, the classical approach to regulating banks is that you should try to regulate them so that they fail safely, without bringing down the financial system. The new approach to financial regulation requires institutions to hold so much capital that they will hardly ever fail (that is an explicit objective of policy). But, because they all have their regulatory capital determined in similar ways, when they do fail the whole system will fail at the same time.
As Avinash Persaud, former director of the Global Association of Risk Professionals put it: “Regulators must dare to consider what a resilient financial system would look like. I would venture that it is one where a shock in one part of the system can be absorbed by another part, and not spread and amplified across all the others. For this to happen, we need a financial system in which the different parts assess, value, hedge, and trade the same assets or activities differently”. He further argues that it is herd-like behaviour and not risky assets that creates catastrophic risks. Such heterogeneity is nurtured by not having prescriptive and uniform regulation.
The way in which shocks can be amplified if firms have similar systems of risk management, similar asset liabilities structures and similar methods of accounting was shown in the financial crisis, before which and then during which International Accounting Standards, encouraged similar behaviours amongst affected banks. This behaviour then reinforced the problems caused by the crisis.
Evolution in Regulation
People might want harmonisation of regulations around the “right” rules – though I would be wary even of that for the reasons I have explained. However, we do not know the “right” rules in advance. And, if regulators get regulation wrong, it can promote, herding towards behaviours that are especially risky.
For example, there are concerns that Solvency II will artificially encourage investment in government bonds and, if these prove to be of questionable credit risk, there is a danger of large insurance companies across the EU, encouraged by regulation, making the same mistake simultaneously.
We also saw this in the banking crisis. The Basel bank capital setting regime provided relatively high capital weights for mortgages even if they were not especially risky, but it had lower capital weights for securitised mortgages, especially if they had a strong credit rating. Sovereign bonds were also favourably treated. This distorted the activities of ratings agencies and of banks; it encouraged securitisation (which was already encouraged by US government guarantees); and it encouraged opacity. Indeed, it is a curiosity that we now look at one country which did not do too badly out of the banking crisis – Canada – because it did not follow the international approach to regulation and argue that Canada’s approach should be adopted internationally!
In conclusion, I cannot summarise the problem much better than Yale law academic and NBER scholar Robarta Romano. As she put it: “Recent experience suggests that regulatory harmonisation can increase, rather than decrease, systemic risk. By incentivising financial institutions worldwide to follow broadly similar business strategies, regulatory error contributed to a global financial crisis…there are bound to be regulatory mistakes, both large and small. Moreover, an internationally-harmonised regime impedes the acquisition of information concerning the comparative effectiveness of differing regulatory arrangements, lowering the quality of decision making, as nations are discouraged from experimenting with alternative regulatory arrangements.”
If International Harmonisation is the Problem, What Should We do?
We should take more risks with under-regulation. Ever since 1980, we have been trying to control financial institutions with ever-more regulation. It has not been a success.
Secondly, we should recognise that we do not need international regulation for the free flow of capital and free trade in services. Many financial institutions do work on an international basis in a relatively unregulated environment and, where regulation is necessary, the most successful regulatory practices are often developed by market institutions themselves.
Thirdly, we might have to recognise that banks – including within the EU – should have to have separate legal personalities in different countries, especially if they are the beneficiaries of deposit insurance. This is not regulation as such, and it is not an impediment to free trade – though it may raise the costs of trade – but it may be an essential requirement to ensure that banks can be subject to proper winding-up procedures. In short, there are alternatives to the never-ending attempts to create more and more complex and prescriptive international financial regulation.
Repost from Philip Booth - Professor of Insurance and Risk Management, Cass Business School - based on his presentation to the Cass Capco Conference: Risk Rebooted in June 2015.