On February 11th, 2013, The Fordham Corporate Law Center and the Fordham Journal of Corporate & Financial Law, in conjunction with the Max-Planck-Institute Luxembourg for International, European and Regulatory Procedural Law, held a symposium on global financial regulation. The theme was Harmonization Versus Diversification of Global Financial Regulation. Among those in attendance were students, practitioners, and even a few public figures. The symposium was moderated by Marco Ventoruzzo, Director, Max Planck Institute Luxembourg for International, European and Regulatory Procedural Law.
The symposium began by providing panelists ten minutes to present their views on the issue. The first presenter, Michael S. Barr, Professor of Law, University of Michigan School of Law, gave a history of the global financial regulatory system and an overview of its current condition.
Mr. Barr identified the key goals served by global regulations and their evaluative criteria. For example, global financial regulations are aimed at preventing global financial crises, creating cross border institutions, setting appropriate levels of capital buffers, regulating capital markets, and establishing appropriate resolution mechanisms. These regulations should be evaluated by their efficacy, legitimacy, accountability, democracy, transparency, and sovereignty.
Mr. Barr then provided a history of the global financial regulatory system, which he divided into three phases. The first phase was the post World War II – Bretton Woods system. During this period key international institutions were established including the IMF, the WTO, the World Bank, and various UN agencies. The underlying theme was that there was national treatment for international firms meaning that if a German firm wanted to transact in the United States, it would have to comply with American regulations.
Phase two, which Mr. Barr dubbed the rise of the networks, began in the 1970s with the collapse of the fixed exchange rate system and lasted until 2008. During this period, the alphabet soup of agencies proliferated and set global standards, but there was a national choice in implementation. For example, some sovereign loans were conditioned on compliance with the Basel Accords. This left the system of global financial regulations to wield soft as opposed to hard influence. Mr. Barr also found it significant that a World Financial Organization, a financial regulatory institution that would parallel the World Trade Organization’s role in trade, was not established.
Phase Three began after the financial crisis in 2008. This is arguably a period of true global finance with global as opposed to national players. The emerging trend in this period is a hardening of the soft law. For example, the G20 makes financial decisions and directs the Financial Stability Board to execute its directives. Both of these institutions wield more global influence as opposed to bilatateral agreements such as the Basel Accords. One way that these institutions are gaining more global influence is through their inclusiveness. For example, the G20, which represents 80% of the world’s GDP was originally the G7 until it was expanded as a result of the need for greater global coordination after the financial crisis.
Tying in nicely with Mr. Barr’s presentation, Donato Masciandaro, Professor of Economics, Bocconi University provided a history of global financial regulation from an economist’s point of view. He indicated that there were three prevalent trends in global financial regulation before the financial crisis: supervisory consolidation, specialization of central banks, and independence/accountability of regulatory agencies.
Supervisory consolidation was a trend that developed through the evolution of financial institutions. Historically, financial regulatory agencies were organized by type of financial instrument or market. This undermined the functional efficiency of these agencies since financial instruments and markets are intertwined and this approach did not account for externalities from one market to the other. The supervisory consolidation trend was a result of agencies attempting to manage these spillovers. This was achieved by establishing regulatory mandates that were either consolidated into one central supervisor (a unified model), or goal based (a peaks model) so that regulations were drawn on a functional rather than a formal basis.
The second trend, specialization of central banks, was also significant prior to the 2008 crisis. By specializing, central banks were able to focus on their role in setting and implementing monetary policy. A body outside of the central bank would set financial regulations. Arguably this specialization allowed each body to perform its tasks more effectively since its goals were not confused by competing purposes.
Finally, the third trend mentioned by Professor Masciandaro was the increased independence of central banks. Decreased political and economic influence over central banks and regulatory agencies arguably led to better policy and governance over this period.
Professor Masciandaro concluded by discussing how these trends have reversed since 2008 in a period, which he dubs as the “Great Reversal.” Until the financial crisis there was a great convergence in financial regulations, which was beneficial to global financial regulation. He indicated that it is key to distinguish convergence from harmonization. The former is bottom up synchronization where regulatory systems converge because they each independently adopt effective policies. The latter, harmonization, is top down synchronization where policies, whether effective or not, are imposed upon regulatory agencies. At the end of the day he indicated that the Great Reversal may be a net negative for global financial institutions as their convergence towards effective systems ends.
Pierre Schammo, Reader in Law, Durham University, School of Law Palatine Center, provided further context to the debate by qualifying the issue in three ways. First, he indicated that regulation should be field or issue specific. Second he indicated that regulators should differentiate the fields that give rise to systemic risk. Finally he indicated that regulators should differentiate supervision of these different areas.
Dr. Schammo provided a European view of the crisis. He indicated that a key theme in regard to financial regulation is the tension between the idea that “if I have to pay for market failure, I should be able to monitor the markets” and the ability of the EU to intervene in supervisory matters when issues arise. He then provided a summary of three approaches that Europe has taken to regulation after the financial crisis: Escalating, Widening and Cascading.
The Escalating regime keeps the regulation at the national level. However, as crises develop and become more severe, governance can be escalated to European Authorities. Widening on the other hand attempts to ex-ante recognize where the spillover effects are likely to occur. It provides a limited mandate to members of a college of supervisors to regulate these externalities. Finally, Cascading establishes a central regulator in the EU who then delegates execution to national competent authorities.
In conclusion, Dr. Schammo points out that in the EU context each of these proposals provides its own set of problems in striking the right balance between maintaining national sovereignty and the influence of those countries which will ultimately foot the tab for regulatory and market failures on the one hand and the ability for the EU to intervene on the other hand. He also indicated that voting arrangements and constitutional questions may cripple progress and the adoption of any of these regimes.
The debate of Harmonization versus Diversification was framed nicely in the presentations of Jonathan Fiechter, Former Deputy Director, Monetary and Financial Systems Dept., International Monetary Fund (IMF), and Roberta Romano, Sterling Professor of Law and Director, Yale Law School Center for the Study of Corporate Law, who took opposing positions on the issue. Mr. Fiechter began by outlining the case for Harmonization. He outlined four reasons why uniformity in financial regulations is preferred.
First, he discussed how harmonization provides a roadmap for countries with developing economies on how to develop their markets. It prevents them from having to make a complex policy decision on what type of regulatory system to follow and makes implementations of reforms much easier.
Next, he indicated that harmonization provides a way for financial institutions to communicate in the same language and speak on apples-to-apples terms. Many issues in financial markets are caused by different standards and applications preventing meaningful comparisons.
Third, Mr. Fiechter indicated that harmonization prevents spillover effects and negative externalities by allowing sophisticated players to enter into multiple markets. As a result those players import their sophisticated private ordering systems into the new markets creating additional stability.
As a corollary to the third point, Mr. Fiechter indicated harmonization would level the playing field and would allow for global companies to compete against each other. This increased competition would prevent a race to the bottom.
Finally, Mr. Fiechter concluded by saying that one of the most important features of a regulatory system, whether it is achieved through diversity or harmonization, is that it is simple. Complex rules tend to be fragile and difficult to interpret ultimately harming the financial system. Arguably simplicity would be easier to accomplish in a harmonized as opposed to a diversified system.
Professor Romano then provided the argument for diversification of financial systems. The argument for diversity is summarized in three main points.
First, diversity decreases systemic risk. Harmonization channels financial players into the same course of action and magnifies the consequences of whatever residual risks there are in the system. For example in the 2008 financial crisis financial players loaded up on Mortgage Backed Securities because they were Basel approved investments. Ultimately this proved to concentrate Mortgage Backed Securities risk onto bank’s balance sheets increasing systemic risk.
Second, diversification increases information about which regulatory systems are working and makes the regulatory system robust. As financial conditions evolve, a diverse group of regulatory systems allows each system to be tested in the current financial environment. Paralleling Professor Masciandaro’s argument about convergence, regulators would thus be able to converge to the system that appears to provide the most benefits as they would see a variety of systems in practice.
Finally, diversification allows for regulations that are tailored to individual markets. Each country may be facing different macro-economic and financial challenges. Diversification allows regulators to help resolve the issues in their economy.
Professor Romano concluded her presentation by providing a framework for how regulatory diversification may work. It would being with an oversight committee that would allow for departures from the global standards. The departing country would provide a proposal, which would be subject to peer review by the committee, and so long as it is functionally effective it would be approved. The regulatory system would require ongoing review of the systems that depart from the global standards and they would be reviewed if any red flags were raised. Finally, this “departure system” would be conditioned upon regulators making documentation available for public review, thereby increasing transparency in the system.
Charles K. Whitehead, Professor of Law, Cornell University School of Law, built upon Professor Romano’s comments by talking about the “Sync” phenomenon. He began with a colorful illustration of Sync through positive feedback loops. The Millennial Bridge in London was regulated by a building code which assumed that the steps of the pedestrians who cross the bridge would be randomized and would cancel each other out. On a windy day, however, pedestrian’s steps were haphazardly synchronized. As a result the bridge began to sway and pedestrians further synchronized their steps. This resulted in a positive feedback loop which required the bridge to be shut down and retrofitted. Ultimately this was seen as a failure of the building code to account for random synchronization.
This example extends to the financial crisis. The VAR metric that was implemented by financial institutions during the crisis also provided an example of random synchronization. When an unexpected sell-off occurred, volatility increased increasing portfolio VAR. This would require financial institutions to sell off assets to increase capital buffers. Since this activity was synchronized, however, this further decreased asset prices and increased volatility. This increased VAR prompting the cycle to repeat itself.
Professor Whitehead concluded that any attempt at harmonization must therefore take into account the systemic increase of risk from the “Sync” phenomenon which results from increased global coordination.
Sean J. Griffith, T.J. Maloney Chair and Professor of Law and Director, Fordham Corporate Law Center, concluded the presentations by building on Professor Romano’s and Professor Whiteheads comments. He provided a specific example of how diversification could be applied to the regulation of global derivatives.
In response to the financial crisis the G20 began to coordinate global regulation by requiring central clearing of derivatives. The US implemented central clearing of derivatives through Dodd-Frank § 752, which allows the CFTC and the SEC to coordinate on global financial regulation, and § 715 and § 722 which allow the CFTC and SEC to bar institutions from countries who have inadequate financial regulations from transacting in US markets.
Recently, the CFTC provided operational guidelines on cross border SWAP transactions. The CFTC allows parties that enter into U.S. facing transactions to either meet the regulatory requirements of the CFTC or provide for substituted compliance. Professor Griffith argues that the substituted compliance is defined on formal grounds of structural similarity. A more appropriate approach would be to define substituted compliance on functional grounds where regulators focused on whether the alternate system was as the American system.
Professor Griffith highlighted that there were at least three systems other than central clearinghouses that could be implemented to regulate derivatives. The first, a proposal made by Conrad Voldstad, the former president of the ISDA, would be to license third parties to monitor risk and collect variation margin. The next proposal by IMF economist Manmohan Singh, would be to tax residual derivative liabilities. Finally, the third system, proposed by Professor Lynn Stout, would be to invalidate speculative trades.
Ultimately Professor Griffith argued that all of these systems could be implemented through a substituted compliance peer review panel which would operate along the lines of what Professor Romano outlined in her presentation. This would be one way to address the risks of Synchronization presented by Professor Whitehead. Further, a substituted compliance regulatory system would also allow for beneficial convergence as defined by Professor Masciandaro. Ideally such a system would capture the benefits of diversification, as presented by Professor Romano, and harmonization, as presented by Mr. Fiechter, while minimizing the costs. One way to do this, while also preserving national sovereignty, might be to establish a global peer review substituted compliance system modeled after one of the Federalist models described by Dr. Schammo.
In conclusion, the panelists provided a robust debate over whether global financial regulations should be allowed to diversify or be further harmonized. The FJCFL thanks all of the speakers for coming to Fordham Law to provide insight on this vexing debate.