Global Regulatory Standardization: A Critical View
By Dan Gallagher, Patomak Global Partners
Introduction: Regulatory harmonization sounds like a noble goal. But instead of facilitating cooperation among regulators from different jurisdictions, it has morphed into the imposition of one-size-fits-all regulatory standards.
In the wake of the financial crisis, regulators around the world rushed to take action – any action, as long as it allowed them to appear to be responding with alacrity to the greatest financial system upheaval in decades. In 2010, a U.S. congressional majority that was determined not to let a good crisis go to waste passed the Dodd-Frank Wall Street Reform and Consumer Protection Act with almost no minority party support. Dodd-Frank predated Congress’s own investigation into the causes of the financial crisis, as well as that of the Financial Crisis Inquiry Commission.
When it became clear that Dodd-Frank would be a partisan, runaway train of legislation, policymakers and special interest groups filled the statute with decades’ worth of pent-up wish-list items – including corporate disclosures related to conflict minerals and resource extraction. Issues central to the crisis – such as government-sponsored enterprises and the government’s role in housing finance – were left virtually untouched. (Note: Instead, Dodd-Frank focused on issues such as proprietary trading, which even former Federal Reserve Chairman Paul Volcker has acknowledged was not central to the financial crisis.) As a result, the act is untethered to the actual causes of the financial crisis. And despite its 2,000-page girth, the act punted even the rudiments of implementation to putatively independent regulatory agencies.
What Dodd-Frank does on a domestic level, the Group of 20 and its implementing arm, the Financial Stability Board (FSB), are doing on an international basis. Over the last several years, U.S. policymakers have worked closely with the FSB in what amounts to a multilateral effort to regulate the world financial markets. In doing so, they hijacked what used to be referred to as “regulatory harmonization” to meet their own ends.
On its face, “regulatory harmonization” sounds like a noble goal: If jurisdictions could coalesce around a single set of high-quality standards, compliance burdens could be reduced with no real reduction of investor protections. Since the crisis, however, “regulatory harmonization” has taken on a worrisome meaning. Instead of facilitating cooperation among regulators from different jurisdictions, regulatory harmonization has morphed into the imposition of one-size-fits-all regulatory standards on sovereign nations by opaque groups of global regulators. This “one world, one government” approach to regulation does a disservice to well-established concepts such as national sovereignty and the consent of the governed.
In 2009, the G-20 directed the FSB to coordinate the work of national authorities and multinational standards-setting organizations in the development of financial services regulation, with an emphasis on promoting financial stability. However, the FSB has been doing far more than merely coordinating the efforts of national regulators. As revealed by a memorandum to FSB members from its chairman, Bank of England Governor Mark Carney, the FSB has shown its real purpose: to direct national authorities to implement FSB-created policies. Carney explained in his memo that the FSB’s decisions must receive “full, consistent and prompt implementation” in member nations, as this “is essential to maintaining an open and resilient financial system.” And to make sure member nations know the FSB means business, Carney warned that the FSB’s key findings would be regularly reported to the G-20. In other words, fall in line or we’ll report you to your leaders.
As revealed by a memorandum to FSB members from its chairman, Bank of England Governor Mark Carney, the FSB has shown its real purpose: to direct national authorities to implement FSB-created policies.
It’s wrong to assume that not only is there a single regulatory solution to any given problem facing our markets, but that an opaque international forum can find those perfect solutions. In reality, while such regulators may get some things right, they will most certainly get some things wrong – and, having pressured the world to do it all one way, it will go wrong everywhere.
There is no better example of the peril of this type of regulatory groupthink than the capital standards set by the Basel Committee. In the precrisis era, these standards classified residential mortgage-backed securities as being lower-risk instruments compared with corporate or commercial loans. Banks naturally responded to the incentives set under the Basel rules in constructing their balance sheets, resulting in homogeneous – and disastrous – business strategies and asset concentrations. When the housing bubble burst, the banks realized too late that these assets were toxic. Simply put, regulators all over the world distorted the incentives of market participants.
As for the FSB, it successfully coerced cooperation from its members. Its decisions have been adopted with no obvious pushback or dissent. And FSB member nations are now moving to implement the FSB standards into their domestic law. In the United States, for example, in every case where the FSB made a decision or announced a policy, the Dodd-Frank-created Financial Stability Oversight Council (FSOC) has followed suit.
When the FSB announced that it was examining whether to extend its global systemically important financial institution, or G-SIFI, framework to non-bank, non-insurance (NBNI) financial institutions such as asset managers, FSOC’s research arm at the Department of the Treasury rushed out, in November 2013, a fatally flawed report portraying the asset management industry as a ticking time bomb of systemic risk. The FSB, together with the International Organization of Securities Commissions (IOSCO), proposed a framework for designating NBNI companies as G-SIFIs in March 2015, establishing a road map to designate individual asset management firms. But IOSCO later pushed back, concluding that regulators need to consider whether asset management is even systemically risky before imposing extra regulation.
The FSB then begrudgingly announced in July 2015 that it would postpone finalizing the NBNI framework until it completes a holistic review of risks posed by asset management activities; however, the FSB has by no means ruled out the possibility of eventually designating asset managers as G-SIFIs. To make matters worse, the only entities that would be picked up by the FSB’s proposed criteria are U.S.-based. And recently, Treasury Secretary Jacob Lew stated that the FSOC has been looking at asset managers’ liquidity and redemption risk and leverage, and would continue to undertake its analysis and determine whether further action is needed.
Indeed, the actions of the FSB seem tailor-made to provide the FSOC with justification to institute centralized command and control over the asset management industry. When the FSB designated four non-bank U.S. financial firms as G-SIFIs, the FSOC quickly moved to do so as well, for example.
No one should be surprised by this. Both the Treasury and the Federal Reserve are members of the FSB – probably its most influential members – whereas capital markets regulators represent a powerless minority of the FSB’s voting members. It is inconceivable that the designations of U.S. institutions as G-SIFIs would have gotten through the FSB without the express approval of the Federal Reserve and the Treasury. As such, even as the FSOC was conducting its supposedly independent analysis, the Treasury and the Federal Reserve had already approved designating these institutions as G-SIFIs. It’s reasonable to conclude that the results of the FSOC’s so-called deliberations on whether to designate G-SIFIs as SIFIs were preordained.
The FSOC’s own independent insurance expert, Roy Woodall Jr., arrived at the same conclusion in his dissent to the FSOC’s designation of MetLife – which designation was recently rescinded in a noteworthy case that calls into question the designation process used by the FSOC and may lead to much-needed changes. Woodall expressly urged his fellow Council members “to not again allow the FSB to ‘front-run’ or pressure decisions that must be made first by the Council as a whole.” He stated that “to do otherwise seems to me to undermine confidence in the Council itself; to be inconsistent with the intent of Congress; and to be patently unfair to those nonbank financial companies under review that must be afforded due process and fair dealing.”
It’s no wonder the FSOC has been reluctant to provide more transparency as it hastens to implement the decisions of the international standards-setting bodies, including FSB, IOSCO, and the Basel Committee. These decisions have not been ratified by the U.S. Senate, and these international bodies are not answerable to the U.S. Congress, much less the public. In addition, though the FSB, for example, explicitly states that it “operates by moral suasion and peer pressure” to set international standards that its members may implement at the national level, FSB decisions (and those of IOSCO and the Basel Committee) are not legally binding. Nevertheless, such edicts have caused a profound change on the U.S. economy. However, the more that these international bodies become seen as a means of foisting decisions on a citizenry lacking any buy-in into the process, the less effective they will be in the end.
I am not calling for the disbanding of international financial regulatory organizations. Rather, we must return these entities to their original precrisis purposes of facilitating cooperation among regulators from different jurisdictions. The concepts that steered these efforts were regulatory equivalence and substituted compliance. The ultimate goal was for regulators in each jurisdiction to recognize that many of their foreign counterparts had regulatory goals similar to their own, and that their regulatory approaches were of a high quality despite their differences. Indeed, there is usually more than one way to achieve any given regulatory objective, and it’s not always clear which way is “best.”
Having acknowledged that there is more than one way to achieve the same goals, regulators could voluntarily choose to deem compliance with a high-quality foreign regulatory regime to qualify as a substitute for compliance with our own domestic requirements. In doing so, we could avoid complicated, cross-border regulatory disputes and lend greater certainty and predictability to cross-border transactions. By avoiding layered, duplicative, and sometimes incompatible regulations, we could facilitate more efficient interactions between our respective capital markets, and by allowing and even encouraging heterogeneity of regulation, we could foster robustness and innovation in our capital markets.
I am not calling for the disbanding of international financial regulatory organizations. Rather, we must return these entities to their original precrisis purposes of facilitating cooperation among regulators from different jurisdictions.
The current coercive approach to regulatory harmonization, on the other hand, is flawed as a matter of policy and will become increasingly impractical as the number of nations needing to be convinced grows. It is difficult enough to reach agreement on matters between the U.S. and Europe, despite their many similarities. Other markets, particularly in Asia, the Middle East, and other parts of the developing world, will undoubtedly consider going it alone, and some already have.
Weakened Capital Markets
The mindset in many developed markets is to regulate first and ask questions later. This stifles entrepreneurs, their enterprises, and their employees and customers.
Take the United States, for example. We have seen a precipitous decline in the competitiveness of the U.S. capital markets dating back to before the financial crisis. In 2007, a report issued by a bipartisan U.S. Chamber of Commerce committee noted that the U.S. capital markets were steadily losing market share to other international financial centers. The report cited, among other things, internal, self-inflicted factors – such as an increasingly costly regulatory environment– as problems that urgently needed to be addressed.
Around the same time, the Committee on Capital Markets, an independent and nonpartisan research organization, issued a pair of reports also calling attention to the declining competitiveness of the U.S. securities markets. These reports cited a significant decline in the U.S. share of equity raised in global initial public offerings and a legion of statistics indicating that foreign and domestic issuers were taking steps to raise capital either privately or in overseas markets rather than in the U.S. public equity markets. In November 2014, the Committee on Capital Markets concluded that, as of the third quarter of 2014, the global competitiveness of the U.S. primary markets was at a historic low. In fact, foreign companies are choosing to raise capital outside U.S. public markets at rates far exceeding the historical average – in 2015, the Asia-Pacific region accounted for 55% of global IPO deal numbers and 46% of global capital raised. In addition, foreign companies that raise capital in the U.S. are doing so overwhelmingly through private markets, rather than through IPOs. While I’m a firm supporter of robust private markets, their popularity should not be the artificial result of extreme burdens we place on public companies. Some of this decline in U.S. competitiveness may simply be natural. As certain areas of the world continue their development, it’s unrealistic to think that the traditional finance centers would continue their capital markets dominance indefinitely. A large part of this shift, however, is neither natural nor inevitable; rather, the wounds are self-inflicted.
Not all jurisdictions have bought into the mentality that it’s best and safest to layer on law after law, regulation after regulation, as the United States and the European Union have done. For example, Asian markets did not experience the full brunt of the financial crisis, nor the resulting regulatory overreaction prevalent in many Western countries. So rather than trying to smother their capital markets with new regulations in a misguided attempt to “de-risk” them, they have instead been spending their time enhancing their competitiveness. (Note: But see China’s Trading Day Only Lasted 29 Minutes, describing actions taken by the Chinese government to restrict its stock market operations in mid-2015, when, amid a market collapse, it banned short-selling, suspended new IPOs, told banks to fund more share buybacks, banned sales by large shareholders, and allowed 1,400 companies to stop trading).
The U.S. and Europe must now compete with major markets such as Hong Kong, Singapore, and Shanghai. And there are new, emerging international financial centers, such as the Dubai IFC, designed to promote their countries’ financial sectors and the development of their capital markets through regulatory regimes intended to entice issuers and investors.
The U.S. capital markets are significantly more developed than those in Europe. They provide approximately 80% of business financing, with the remaining 20% coming from banks. The exact opposite ratio applies in Europe. Recently, however, Europe has been taking some very interesting and hopefully beneficial steps toward expanding its capital markets.
Specifically, the European Commission (EC) is looking at how member nations can build an efficient capital markets union. In September 2015, it adopted an action plan setting out 20 key measures to achieve a single market for capital in Europe and to unlock investment in Europe’s companies and infrastructure. The EC is looking to develop stronger capital markets and is trying to remove the barriers to doing so. Similarly, the EC has issued consultations to determine if there are ways to simplify capital formation, particularly for smaller companies, and to review rules related to venture capital funds and social entrepreneurship funds to facilitate capital formation without reducing investor protection.
The EC’s goals – including encouraging high-quality securitization – are at odds with the FSB’s agenda to increase the amount of capital banks must hold (and thereby not lend), as well as its agenda to crack down on “shadow banking,” which is simply another name for capital markets financing. It remains to be seen how the EC will address the incongruity between its pro-capital markets initiatives and the FSB’s efforts. For example, although late last year, the Basel Committee released a consultation potentially to reduce the minimum capital requirements for banking institutions with respect to holdings of “simple, transparent, and standardized” securitizations, this regulatory intervention may end up concentrating risk in government-approved investment structures and lead to future market instability.
The FSB also has started to evaluate whether financial technology (FinTech) innovations – such as distributed ledger technology or blockchain – pose systemic risks to financial stability. During its March meeting in Tokyo, the FSB proposed a framework for categorizing different components of FinTech and assessing their potential risks. In a recent letter to G-20 finance ministers,Chairman Carney recognized – at least for now – that regulation should not stifle innovation. SEC Chair Mary Jo White also has indicated that the SEC may consider blockchain regulation.
Do No Harm
Commissioner Christopher Giancarlo of the Commodity Futures Trading Commission, however, recently laid out the counterpoint, explaining that it is imperative for the FSB and other regulators to embrace a “light-touch” regulatory approach to blockchain and other promising FinTech developments that are a key source of innovation in the private sector. Blockchain, for example, may prove to be an innovative solution for the financial industry to increase settlement speed, link recordkeeping networks, reduce transaction costs, and increase market access.
Regrettably, the FSB also has allowed social activism to creep into its agenda, diverting its attention from pressing systemic risks to politically motivated causes. For example, the FSB recently established a “Task Force on Climate-related Financial Disclosures” to encourage businesses to disclose climate-related financial risks, which seems like a misguided distraction from the goal that we should be working toward: to rejuvenate, not overregulate, our capital markets.
Internationally, we must find a new way: We must swap our regulatory hubris for humility and work to find common ground with our international counterparts on areas where cooperation based on mutual respect and recognition can bear the most fruit.
When regulators do find a need to impose new regulatory burdens, those burdens must be tailored as narrowly as possible to address clearly identified problems and achieve the regulation’s stated goals. Doing so will require continued improvement of cost-benefit analyses to account not only for the direct and indirect impacts of the rule being analyzed, but also the burdens of the overall regulatory framework imposed on market participants. Furthermore, we need a renewed focus on eliminating duplicative or counterproductive regulation. We must increase our efforts to root out existing rules that place unnecessary requirements on market participants. .
Internationally, we must find a new way: We must swap our regulatory hubris for humility and work to find common ground with our international counterparts on areas where cooperation based on mutual respect and recognition can bear the most fruit. After all, if financial services regulation is considered important enough to command the full-time attention of the G-20 and the FSB, then why not cover these issues legitimately and legally in a treaty ratified in the U.S. by the U.S. Senate? Halfway into a “lost decade” of stagnant growth, low job creation, and popular dissatisfaction, we must start to address these issues, and we must start now. n
About the Author: Dan Gallagher is President of Patomak Global Partners, LLC. From November 2011 to October 2015, he served as a Commissioner of the U.S. Securities and Exchange Commission. Before being appointed Commissioner, Gallagher had the honor and privilege of serving on the Staff of the SEC in numerous capacities, including as counsel to SEC Commissioner Paul Atkins, and later as counsel to SEC Chairman Christopher Cox. He was the SEC representative to the Financial Stability Forum (predecessor of the FSB) Crisis Management working group.
Prior to public service and following law school, he joined the law firm Wilmer Cutler & Pickering. He later returned to Wilmer (now WilmerHale). Gallagher also served as Senior VP and General Counsel of Fiserv Securities. Gallagher received his B.A. in English from Georgetown University and his J.D., magna cum laude, from the Catholic University of America, where he was a member of the Catholic University Law Review.