The systemic risk of international financial regulation (Part 1)
There are many reasons given for this trend. One is that it is supposed to prevent regulatory arbitrage: that is, 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 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 this process 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. German banks are very different from British banks, for example, and a regulatory standard that can cope with both is necessarily more complex than would be either of two regulatory standards designed to deal with banks in the two countries separately.
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 complex situations across diverse banking systems – and because it could therefore be gamed – it became unsustainable. Its successor, Basel II was 347 pages long. This clearly did not avert the financial crisis; indeed, it probably contributed to it. 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. It is not possible for regulators to be held to account by politicians, by the democratic process, by academics or, indeed, by anybody other than those who are regulated or private sector consultants who work full time on the subject. 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.
This is very dangerous. It 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 incomprehensible, 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. The only criterion by which we will be able to judge firms is by whether they have ticked all the regulatory boxes.
Furthermore, as regulation becomes more complex, the methods by which regulations are gamed become more complex and the whole financial system becomes more opaque which itself increases risk.
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.
There is, indeed, a huge principal-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 can be held to account by those on whose behalf they are regulating.
Regulatory capture is a huge problem with the internationalisation of financial regulation but perhaps a bigger problem is that it encourages herding and the making of mistakes on a huge scale. These will be the subjects of (Part 2) of this blog.
Prof Philip Booth is the IEA’s Editorial and Programme Director and Professor of Insurance and Risk Management at Cass Business School.