The harm of regulatory disharmony

Howard Davies Former Chairman of Britain’s Financial Services Authority, Deputy Governor of the Bank of England, and Director of the London School of Economics In the alphabet soup of institutions involved in the regulation of global financial markets, the FMLC – the Financial Markets Law Committee – is not very prominent. Given that it is based only in London, having grown out of an initiative by the Bank of England 20 years ago, and that most of its members are lawyers, most banks have not even heard of it (though some of them are represented on its Council). But the services provided by the FMLC have never been more necessary. The FMLC’s mission is to identify and propose solutions to issues of legal uncertainty in financial markets that might create risks in the future. As a recent FMLC paper showed, the wave of new regulations implemented since the global financial crisis – many of which were poorly planned or inconsistent across countries – has left a jumbled landscape of legal uncertainties. Consider banks’ capital requirements. The Basel 3 Accord, adherence to which increased the liquidity of all banks and decreased their leverage, is viewed as a firm standard in some parts of the world. But, in others, it is regarded as a minimum to which additional rules may be added. Such “super-equivalence” or, more colloquially, “gold-plating” creates inconsistencies across jurisdictions, thereby facilitating regulatory arbitrage. Likewise, the European Union, in contrast to the United States, regards the leverage ratio as a supervisory optional extra, known as a “Pillar 2 measure” (which permits supervisors to add additional capital buffers to address a particular bank’s idiosyncratic risks). And, though both the US and the EU prohibit proprietary trading, they each define it differently. There are also inconsistencies between the US and the EU in derivatives-market reform, which the Financial Stability Board has warned could undermine the objectives, set out by the G-20, of greater standardization of contracts and enhanced transparency. And, whereas the Basel standards continue to refer extensively to credit ratings as the basis for assessing the creditworthiness of borrowers, the Dodd-Frank Act in the US moves away from reliance on ratings. Such differences – and the FMLC Council lists many more – reflect a dangerous shift in the world’s approach to regulation. The early post-crisis enthusiasm for new, globally agreed regulatory standards has given way to a range of national initiatives, driven by domestic political agendas, with little regard for cross-border compatibility. More problematic, the peer-review procedures that have been introduced so far will do little, if anything, to resolve the problem. Nor do the memoranda of understanding drawn up by national financial regulators offer hope of salvation. According to the FMLC paper, “they are usually the subject of interpretative disagreement, are not legally binding, do not benefit from any binding dispute-resolution mechanisms, and do not prevent national authorities from acting unilaterally.” So what can be done? The FMLC makes four important recommendations. First, the Financial Stability Board should help to reduce avoidable inconsistencies across countries by propagating a set of high-level principles to which all member countries would be expected to conform when introducing new regulations. Indeed, the need for such principles should have been recognized in 2009, when the wave of re-regulation began. Second, to address existing regulatory conflicts, the FMLC recommends establishing a “conflict of regulation” framework to determine which legal regime – that of a global firm’s home country or that of its local subsidiary’s host country – has jurisdiction in a specific cross-border dispute. The alternative of relying on a third-party multilateral organization to act as mediator in such disputes, the report explains, has little support from G-20 countries. Third, the FMLC proposes expanding the Financial Stability Board’s mandate. That body, which emerged from the old Financial Stability Forum in 2009 with few powers and no formal status, has only recently become a separate legal entity. Strengthening its powers – to include, for example, the establishment of principles for addressing cross-border legal inconsistencies – could go a long way toward addressing the problems raised by regulatory disparities. Finally, the FMLC calls for the establishment of a permanent G-20 secretariat to improve continuity and coordination across G-20 presidencies. As it stands, political priorities are constantly in flux, with individual dossiers losing their centrality, and even vanishing, from year to year. Regulatory uncertainty may not seem like the most exciting topic, which is probably why the FMLC report has attracted so little attention. But, as the 2008 global financial crisis starkly demonstrated, it can render markets dysfunctional, with ambiguity about different regulators’ responsibilities making it difficult, even impossible, to address the problems caused by failing firms. (Former US Treasury Secretary Tim Geithner’s crisis memoir makes that point painfully clear.) When I chaired the United Kingdom’s regulatory body, the Financial Services Authority, I believed in the idea that lawyers should be on tap, not on top. But they should always be heard. The FMLC’s influential lawyers have spoken. The world should listen. Project Syndicate