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'The Big View' July 2012

Regulatory reform in financial markets: time for the EU to “go it alone”?

Daniel Mügge, University of Amsterdam

5 July 2012

The current predicaments of the Eurozone have focused public debate on formalized pan-European burden-sharing and binding fiscal commitments to tame the financial crisis. These institutional reforms have drowned out an equally contentious debate that had dominated international discussions until the single currency got into trouble: the re-regulation of financial markets and the need for structural reforms of financial institutions.

At its 2009 summit in London, the G20 proudly declared the commitment of its members, including the European Union, to comprehensive global reform. The rationale for global cooperation in financial governance sounds convincing. Countries are eager to implement best practice rules that emerge from a global dialogue of experts. Harmonized rules may ease the flow of capital around the globe. They may also bring regulatory laggards into line and prevent global contagion. And most importantly, in theory international cooperation allows jurisdictions to set relatively high rules without putting domestic firms at a competitive disadvantage.

In spite of such considerations, the progress made in the three years that followed the original G20 declaration has been limited. The Basel 3 accord that specifies bank capital buffers was overhauled, but full implementation is planned only in 2019. Doubts persist whether it will be consistently interpreted by the EU and the USA, its main sponsors. And in any case, the USA will only apply Basel 3 to its very largest banks. Efforts to harmonize accounting standards across the Atlantic have stalled. And rules in key areas like derivatives trading, banker bonuses, credit rating agencies and hedge funds were effectively set unilaterally with an eye to domestic imperatives; other jurisdictions were left to adapt if they feared a negative domestic impact of new rules elsewhere.

What should the proper EU response be to slow global progress? Should it redouble its efforts to foster strong global financial governance? After all, European policymakers and politicians alike frequently argue that the EU cannot afford to adopt much tougher standards than other big markets. The alternative to high standards for all, they claim, is a forced convergence on the lax rules of a large regulatory laggard. And in any case, what good are tough European rules if financial instability can still affect the EU through lax rules elsewhere? The EU may not be equally ambitious across all areas of financial regulation. But the need for a level playing-field across the Atlantic is heard often enough as a retort to calls for tougher standards to deserve closer scrutiny. As it turns out, the case for global financial governance as the only viable alternative to a regulatory “race to the bottom” is weaker than often assumed. In many domains of financial regulation the EU should be less hesitant than it often is to “go it alone”.

Revisiting the case for global financial governance

The attractiveness of global financial governance depends on the costs and benefits it entails. The most important potential benefits have already been listed – the spread of best practice, a facilitation of capital flows, the avoidance of competitive disadvantages for domestic financial firms, and the prevention of crisis-contagion. What is less clear, however, is how heavy any of these arguments weigh. For diverse ideas to emerge so that the best ones can be picked, it is useful if different reforms are tried in different places. And it is not necessary for regulators to be bound to a single rule-set to learn from one another. Bodies like the Financial Stability Board can function as clearing-houses of ideas. Any regulatory design that is really convincing should be able to count on voluntary take-up by policymakers, without the need to enforce it.

Harmonized standards as facilitators of global capital flows do not convince, either. Even without such harmonization, capital flowed around the globe with stunning ease; the marginal contribution that a single global rule-set could make is necessarily limited. More importantly, recent crises in Europe and beyond have shown that seamless global capital flows can do harm as well as good. They may lull investors into a false sense of safety as enormous local differences are veiled by apparently seamless global integration.

The remaining two arguments seem weightier. Consider first the issue of financial firm competitiveness. In domestic debates, politicians or regulators who explicitly advocate policy to support financial firms can count on little sympathy from their citizens. In contrast, defending such interests in international regulatory harmonization is considered normal and commonly cloaked as the necessity to preserve a “level playing-field”. Many bold proposals for re-regulation are dismissed because they cannot count on support elsewhere in the world, notably in the USA.

But why exactly is a level playing-field necessary? If the imperatives of financial stability and bank competitiveness collide – and they often do – surely regulators should favour the former. What business is it of public authorities to support the success of domestic firms in market places abroad that adhere to overly lax standards? Does it matter to the European economy or its citizens how prominent European banks are on Wall Street? In most cases, the answer is no.

The advice to EU regulators to ignore competitiveness issues and focus on financial stability instead knows one exception. Tight regulation should not mean that foreign firms that follow lighter rules squeeze European ones out of their home markets. The resultant principle is clear: financial firms operating in Europe have to follow European rules or foreign ones of equivalent stringency. It is unfortunate if that excludes some that are already active in Europe. But given the massive damage that the financial crisis has caused so far, and is bound to cause for years to come, drastic measures are appropriate. If Europe believes in tighter rules, it should be willing to stand up to international partners to defend them – with or without global agreement.

The most forceful argument for globally harmonized rules is the prevention of spill-over from shoddily regulated markets to Europe. But global financial governance as we know it is a weak tool to prevent such contagion. Effectively, the logic of global financial governance since the Asian financial crisis in the late 1990s has been to elbow “emerging markets” into the use of global standards. In practice, however, the actual implementation of these standards around the globe has been lacking, never mind solemn pledges from all involved. More importantly, arm-twisting other jurisdictions into compliance is ineffective precisely with those countries that are big enough to pose serious threats to global financial stability: the USA, China, India, etc. The selective application of Basel 3 in the USA, in spite of EU protests, is a case in point. Finally, where white spots on the global regulatory map matter most – in offshore financial centres – both the European and the American authorities have so far dragged their feet. Calls for globally tight rules ring hollow if European authorities are unwilling to crack down conclusively on offshore centres that undermine the whole system.

A time may come to “go it alone”

On both sides of the Atlantic, calls for more substantial regulatory reform are consistently rebuffed by reference to the need for global rules or, in any case, adaptation to low standards elsewhere to protect financial interests. Politicians and regulators hesitate when asked to reform financial rules in the name of stability, even if other countries disagree. But the arguments for global standards or a globally level playing-field get more attention than they deserve. The damage to be expected from unilateral European reforms is much smaller doomsday scenarios of an exodus of European banks suggest. If global efforts to put financial markets on a solid regulatory footing, spearheaded by the G20, do not yield the necessary results, the EU should not hesitate to “go it alone”. EU policymakers and politicians should not get away with the excuse that they stand still because others are not willing to follow.