Mending the Seams: International Regulatory Reform
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As the global economy begins to find its way back from the brink following the financial crisis, the impetus is shifting from the day-to-day efforts to keep the system afloat to the long-term fixes that are needed to maintain and increase its stability and flexibility. All eyes are on the national governments and regulators who continue to shape a structure that either will be up to the task of managing an increasingly globalized economy or will fall short of the mark, resulting in the lack of a sustainable recovery, further crises, or both.
It is no easy task. As the financial system has globalized, the regulatory system has not kept pace. Even within national borders, fragmentation of oversight and lack of effective regulation have resulted in catastrophic failures, which multiplied as this recent crisis spilled across the globe. While central banks took strong steps to shore up liquidity and restore confidence in the financial system, not much has been done to overhaul the patchwork of systems that was barely able to avert a second Great Depression.
The key is more effective regulation and international cooperation. As the BIS (Bank of International Settlements), home of the Basel Accords, noted in its 2008–2009 annual report: “For all their enduring virtues, markets have failed in some very important ways. It is now apparent that as the financial system has grown and become more complex, it has come to need a more comprehensive set of rules to ensure that it functions smoothly. Ensuring that a decentralized financial system operates safely and efficiently does not simply mean more regulation or more centralisation; rather, it means better regulation and better supervision that induce the private sector to improve incentives, risk management and governance” (BIS 2009).
For now the leaders of the G-20 (Group of 20) nations are relying on a revived FSB (Financial Stability Board) and older, existing cooperative initiatives to begin to shape an improved and more flexible supervisory and regulatory structure. Whether governments, with their sensitivity to shifting internal political winds, will actually follow through with the recommendations that will flow from these international financial organizations is open to question, especially as the crisis fades further into memory.
“In the wake of the crisis last fall, there was a chorus of calls for major global regulatory change,” says David Rothkopf, visiting scholar at the Carnegie Endowment for International Peace. “The Germans, the French, the Chinese, the Russians—lots of people were calling for a big change in global regulation, and that’s not come. And it seems that, thus far, it’s unlikely to come. And ultimately I think we’ll see even less change than what’s been called for, which, for the most part, is in terms of incremental adjustments.”
And adjustments, however admirable and widely supported they may be, may not be enough to get the job done. “Clearly in some future period the same sort of speculative excess may well occur, and if you let institutions continue to be unregulated with their off-balance-sheet activities and other financial innovations, we may be building ourselves into another financial crisis,” states Paul Masson, a research fellow and adjunct professor at the Rotman School of Management at the University of Toronto. “Some economists think, well, they are inevitable, and we should not cry wolf, but clearly some steps need to be taken to make the situation better, and there is a danger that we are going to revert to the status quo.”
Current Structure Builds on Ad Hoc Groups
Existing international regulatory structures are composed of organizations and committees established by governments, industry groups, and associations. They mostly operate by consensus, establishing regulatory standards in a variety of areas. None of these bodies has ultimate regulatory authority, although many national regulators have mandated standards designed by these organizations in areas such as banking, accounting, securities regulation, and insurance.
In April the G-20 tasked the FSB with designing a reform plan focused on three areas:
- Monitoring systemic risk in the global economy
- Working with the IMF (International Monetary Fund) to watch over member countries’ economic health
- Reporting threats to global financial stability to the G-20 finance ministers, the IMF, and central banks
Originally called the Financial Stability Forum, the FSB was founded in 1999 by the G-7 (Group of Seven) nations in response to the Asian financial crisis of 1997–1998. The FSB provides a high-level mechanism for the G-20 nations to share information, coordinate policy, and manage crises. It is notable that the expanded mandate for the FSB came from the G-20 rather than the G-7, as the G-20’s membership includes both developed and developing nations, signaling the importance to the global economy of such up-and-coming powers as China, India, Russia, and Brazil.
Most of the other international organizations function at a lower level that involves either government, corporate, or association staff attending meetings, discussing policies, and issuing standards. These voluntary standards are subject to interpretation by individual countries, meaning that standards that were agreed on by a group representing wide-ranging interests may be altered into rules shaped by national self-interest and legal traditions.
The varied implementation of IFRS® (International Financial Reporting Standards) is one example of how international regulations are interpreted differently by nations. IFRS are a set of accounting standards that are promulgated by the IASB® (International Accounting Standards Board), an independent global standard-setting board. More than 160 countries have adopted IFRS, but accounting standard setters and regulators in many countries have carved out areas in which national standards differ from IFRS. Such carve-outs, especially on vital issues, render IFRS potentially less valuable. The US allows internationally based companies to report under IFRS but has yet to adopt it for US publicly traded companies. (For more information on the SEC’s push for the adoption of IFRS, see "SEC in a Quandry over Its Push for IFRS.") IFRS differs from GAAP (Generally Accepted Accounting Principles) in that IFRS is principles based while GAAP is rules based. In September the G-20 set a June 2011 deadline for convergence of GAAP and IFRS.
In addition, doubts about the independence of the IASB have arisen in light of controversies about such issues as fair value accounting, which was under fire during the height of the financial crisis when asset prices were falling and financial institutions were forced to write down the value of the assets they held.
Just as questions dog many regulatory agencies about the politicization of decision making, controversies over independent boards linger, in part because their funding mechanisms are not as clear-cut as those of government agencies. Many of these independent boards receive their funding from corporations—which, critics charge, makes them too vulnerable to pressure from corporate lobbyists to ease unpopular and potentially expensive standards.
“Just as it is important in the United States that standard setting not become politicized, it is important that steps be taken to enhance the independence of the IASB,” remarks Henry Keizer, CPA, global head of audit at KPMG International. “In the end, we believe that capital markets and market participants are all better served by accounting standards that are set by an independent standard-setting body based on an established and open due process that permits all market participants to engage in the process. Doing so should lead to the establishment of high-quality standards that can be applied globally, which can contribute to greater confidence in and access to capital markets.”
While IFRS is a less-mature standard than the banking standards promulgated under the Basel Accords, both are controversial—although the Basel II standards have received more criticism than IFRS following the global financial crisis. Basel I capital requirement standards for banks were issued in 1998 by the Basel Committee on Bank Supervision (a group of central bankers and banking supervisors) and were adopted by the G-10 (Group of 10) nations shortly thereafter. Basel II standards, a follow-up to Basel I standards, were initially published in 2004 and are based on three pillars:
- Minimum capital requirements designed to address market, operational, and credit risk
- Supervisory review of risks to determine whether minimum levels of capital are adequate in response to the first pillar
- Increased public disclosures about banks’ capital adequacy, risk management, and capital structure, which are designed to improve market discipline
These standards, which had been adopted by a number of countries and were in the process of being implemented in many other parts of the world when the financial crisis struck, are currently under revision. Critics charge that the Basel II standards did not ensure that banks were adequately capitalized during the crisis, although the magnitude of the liquidity crunch that the markets and banks experienced at the time was something few experts could have predicted. Specifically, Basel II is faulted for (1) depending on a bank’s internal risk assessment model to determine asset riskiness, (2) allowing lower capital requirements for the residential mortgages on a bank’s books and off-balance-sheet vehicles, and (3) failing to provide for sufficient disclosures for complex structured financial products.
Peter J. Wallison, the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, believes Basel II has failed. “The banking system is in a catastrophic condition even though Basel has been in effect for all these years. Basel I regulation did not work, and Basel II is now in the process of being abandoned because it is very clear that it would not solve any of the problems that became evident in the financial crisis. We are going to have to go back to the drawing board with Basel II.”
While Wallison sees problems with Basel II, Edward Kane, the James F. Cleary Professor of Finance at the Carroll School of Management at Boston College, believes the standards failed due to a lack of accountability among regulators. “Basel II is a product,” Kane says. “It didn’t come out of nowhere. It was set up to be the excuse when things failed.” Efforts to reform Basel II will likely produce some improvements, Kane predicts, but major adjustments are unlikely because of the difficulty of establishing tough standards in negotiations among national regulators.
Despite the limitations of the current structure, Roel Campos, a partner with Cooley Godward Kronish and a former commissioner at the SEC (Securities and Exchange Commission), believes that the international regulatory structure provides a sound framework for further global cooperation. “There’s an international structure already there that the public doesn’t know about but that has existed for a while, and there are more resources being dedicated to it by the US Treasury and by agencies like the SEC. Through organizations like the International Organization of Securities Commissioners and the Financial Stability Board, they’ve been meeting at the ministerial level and lower levels to talk and come to some conclusions about big picture issues.”
Complex Issues Beg for Resolution
The list of issues clamoring for regulators’ and legislators’ attention is long and headache-inducing. It includes everything from derivatives to credit rating agencies to systemic risk to executive compensation. While the monitoring and reduction of systemic risk tops most lists as the most important issue to be dealt with, the others are not far behind, mainly because they are so intertwined with each other as they ooze across porous international borders.
There is no universal definition of exactly what systemic risk is and what events might precipitate it, which makes the task of monitoring and stopping it before it spreads even more difficult. Still, because government officials, even across borders, are fairly unified on the need to contain systemic risk, there is a greater likelihood that there will be more cooperation in this area going forward. The FSB is in the process of working on detailed recommendations in this area and plans to report to the G-20 finance ministers and central bankers when they meet in November.
The role that credit rating agencies played in the financial crisis makes them a prime target for reform. Investors around the world relied on top-notch credit ratings given to many CDOs (collateralized debt obligations), especially mortgages, only to later discover that these investments were worth much less than they thought when homeowners began to default on their mortgages. David Reiss, a professor of law at Brooklyn Law School, believes that at a minimum regulators should force credit rating agencies to identify conflicts of interest and prohibit those that would compromise ratings quality and transparency.
“Probably the most radical proposal would be to either disconnect compensation from the provision of ratings or disconnect regulation from rating,” Reiss says. “In other words, to say that government regulations cannot incorporate ratings. There would have to be some other metric for what they could invest in. That’s a pretty dramatic change, and it might be a good change, but I don’t see it happening.” The Basel Committee has been tasked with addressing the issue of inappropriate incentives that may arise from the use of credit ratings by regulators, with recommendations expected by December.
In the areas of executive compensation, many believe excessive risk taking was linked to an overly short-term focus on corporate earnings. “One approach that is being suggested is to make incentives more aligned with long-term goals,” observes Peter Went, senior researcher at the Global Association of Risk Professionals. “Another is to make compensation more risk adjusted as well, because the short-term profit motive is an incredibly strong incentive.” In September the G-20 endorsed the FSB’s executive compensation standards, which include limiting multiyear bonuses and requiring a large part of variable compensation to be deferred and subject to clawbacks.
Misalignment of incentives was also rampant in other areas of the international economy, such as in the mortgage origination and securitization process, contends Ira Peppercorn, president of Ira Peppercorn International and a former US deputy federal housing commissioner. “If you look at almost every point along the chain, you have to wonder who had skin in the game.”
“I think it’s really important when you are talking about designing a more effective regulatory system to figure out ways in which the people along the chain have some skin in the game, have some responsibility, have something to lose,” Peppercorn continues. On the other hand, Went notes that securitization has a very important role to play in the reduction of risk, and without it banks would not be able to make the same amount of mortgages and other loans, potentially crimping the international economy.
Hedge fund and derivative regulations are another hot-button area. “In Europe, in particular, there is a deep distrust of hedge funds,” notes Campos. At a minimum, registration of hedge funds and setting up centralized clearinghouses for derivatives are seen as needed reforms. The G-20 has called for the centralization of OTC derivatives trading and clearing by the end of 2012.
There is always the danger that a period of overregulation will follow a period of underregulation. If derivatives are too tightly regulated, there could be unintended consequences, predicts Jiro Okochi, CEO of Reval. “If the pendulum swings too far, corporate end users of derivatives will either stop using OTC derivatives or pare back, which isn’t good for overall risk. We’d be transferring one kind of systemic risk out of financial institutions into other areas, such as to shareholders.”
In addition, regulation is costly, especially for multinational companies, notes Anna Monteiro, senior director of regulatory products at Wolters Kluwer Financial Services. This is especially true when new rules involve a major shift in regulatory and enforcement philosophy, such as a shift from a rules-based system such as GAAP to a principles-based system such as IFRS. Even narrowly focused changes have consequences. “Just look at the Patriot Act and the impact it had on businesses in the US, not just from the cost perspective, but from the competitive standpoint.”
If regulation is extended too far, financial innovation will be the victim, imperiling both the global and the US economy, maintains Wallison. “My perspective is that if we regulate all of these large financial institutions the way we regulate banks, we will cut the growth of our economy substantially. We will have much more unemployment, much less innovation, and a much less dynamic economy. That’s not what we want here.”
Significant Barriers to Cooperation Remain
The context in which these vital issues need to be dealt with could not be more challenging. Regulatory traditions and frameworks in the US and Europe are very different, making a meeting of the minds that much more difficult. Multinational companies make the most of differing traditions and standards by using regulatory arbitrage to play jurisdictions against each other in an effort to find the most accommodating regulator. Both inside and outside of the US, regulators are also subject to regulatory capture by their constituent companies, as regulators seeking to capitalize on their expertise move into positions at businesses they formerly regulated, and vice versa. As if all this were not enough, many politicians and citizens of individual countries are extremely suspicious of international regulatory efforts, fearing it will compromise or ultimately abrogate national sovereignty.
Bridging the gap between differing legal and regulatory traditions in the US, the United Kingdom, and Europe is a major task, says John Allan James, an adjunct professor of management and corporate governance at the Lubin School of Business at Pace University. In Germany, for example, legal traditions dating back to the 1870s provide stakeholders such as labor unions with rights to cooperatively manage a business with the company’s board of directors. While stakeholder law in other parts of Europe is not as robust as in Germany, it is still much stronger than in the US. “Because of the way they’re organized in Europe, they say that they really don’t need an SEC because all the functions taken care of by organizations like the SEC in the US are already taken care of because the stakeholders are part of ongoing aspects of board and management decision making,” James adds.
Contrast the European approach with the regulatory traditions in the US, where corporations can choose what state they register in and tend to register in states with the most business-friendly regulations. The excessive fragmentation of the US regulatory structure bears a lot of responsibility for the financial crisis and makes it extremely difficult to cooperate internationally in any effective manner, asserts Hal Scott, the Nomura Professor of International Financial Systems at Harvard Law School and director of the CCMR (Committee on Capital Markets Regulation). And because corporations, Congress, and regulators all have a stake in maintaining the system the way it is, change is unlikely.
“First of all, no one in any of the regulatory agencies wants change because they don’t want to lose their jobs or their power,” Scott says. “Then, secondly, Congress profits from all this because the more different agencies there are, the more committees there are, and the more campaign contributions they can get. Then, each industry wants its own regulator. They all like having their own regulator because they can influence their own regulator more than they could influence a superregulator.”
Without reform both in the US and in the global financial regulatory structure, future crises are bound to occur, Scott contends. “We’re just asking for it again. I’m not saying that a better structure will allow us to avoid all crises in the future, because nothing can. You can’t have the perfect system, but you can substantially decrease the probability that it will occur again, and if it does occur again, you can take more effective action.”
In an era of global markets and multinational corporations, national regulators are having an increasingly hard time keeping up with financial innovation even when there is a national and political will for significant reform, remarks Rothkopf. “With global markets, you need global regulations and global regulatory institutions. The problem is that it is the third rail in politics to say ’Let’s cede some of our sovereignty to some supranational entity.’ What happens is that political systems lag [behind] the development of economic institutions, and in this case the political system is definitely lagging the reality of the economic system. This has created a reluctance to make the changes that are necessary and opens the door to future problems.”
Finally, regulation, by its very nature, is usually reactive to crises, rather than proactive. “I call it the regulatory dialectic, which is the idea that regulation immediately begets avoidance,” Kane says, “and there’s much more creativity on the avoidance side, much more opportunity to play, to make moves that the regulators have to address. So we’re always behind, until we get new regulation, which addresses some of the problems of the past, but that immediately starts the process all over again.”
Recommendations Focus on the Way Forward
So what should a robust, flexible, transparent, and sustainable international financial regulatory system look like? There is no shortage of ideas on that score. Suggestions range from the creation of supranational regulators with authoritative mandates to reforming and strengthening the institutions that now exist. Even the most dedicated proponents of a supranational regulatory system admit that it is not possible to create such a structure in the current political and economic environment, and the best that can be hoped for is significant reform of the current system.
The CCMR, an independent nonprofit dedicated to improving financial regulation in the US, stated in a May report on the financial crisis that “in such an interconnected world, there is a particular need for an effective system of international financial oversight. We believe such a system would perform three distinct tasks. First, it would provide the capacity to harmonize basic global rules. Second, it would serve as an early warning system that could coordinate swift responses to brewing crises with systemic implications. And third, it would provide some sort of process for efficient dispute resolution when conflicts among regulatory regimes arise” (CCMR 2009).
The FSB made a number of preliminary recommendations in April designed to strengthen the global financial system. These recommendations are:
- Address procyclicality by limiting interactions between businesses that amplify business cycles and have the potential to create instability. Recommendations focus on ways to more effectively measure risk and formulate sound standards in the areas of bank capital frameworks, bank loan loss provisions, and financial institution leverage and valuation.
- Provide for sound compensation practices that will align corporate employees’ incentives with the long-term—rather than the short-term—profitability of a company.
- Seek increased cross-border cooperation on crisis management by requiring financial regulators and authorities to meet regularly and cooperate in making high-level preparations for managing financial crises.
The G-20 has tasked the Basel Committee with refining bank capital standards and developing standards to mitigate procyclicality by the end of 2010, with such standards to be phased in by the end of 2012. The Basel Committee will also refine and implement a bank leverage ratio by 2011, and members of the G-20 have committed to adopt the Basel II capital framework by 2010. From the perspective of the BIS, systemic risk is the most important issue; the G-20 has tasked the FSB to develop proposals to reduce system risk posed by the largest multinational financial institutions by September 2010. The BIS notes in its annual report: “Officials must insist that institutions be comprehensible both to those who run them and to those who regulate and supervise them. And, in the future, a financial firm that is too big or too interconnected to fail must be too big to exist” (BIS 2009). Rothkopf believes that the task of shrinking these too-big-to-fail institutions is going to be extremely difficult, despite its necessity, saying, “As a prominent, thoughtful observer of the system said to me, ’We live in an era in which global enterprises require big global financial institutions to serve them. Too big to fail is not an aberration from the system, it is the system.’”
Standards such as IFRS and the Basel II framework are designed to increase the transparency of financial institutions, financial intermediaries, and the financial statements of publicly traded companies in an effort to give investors the most up-to-date, comprehensive information available so they can make better decisions. A lack of disclosure in areas such as off-balance-sheet vehicles, derivatives, and unregulated financing firms such as hedge funds exacerbated the financial crisis, critics assert.
Kane believes regular widespread disclosure of the safety-net subsidies that financial institutions use to lower their costs and shift risk would increase transparency, helping consumers and policy makers understand the benefits that financial institutions enjoy from these subsidies in terms of their actual costs. Because of regulation and protections such as deposit insurance, financial institutions are able to raise capital less expensively, increasing their profits. “I think every country should make their regulators and their major financial institutions measure the flow of safety-net subsidies. We need to know how much they are losing from government regulation and how much are they gaining from it.”
Ultimately, the price of increased international financial stability may be decreased market and institutional efficiencies, the BIS report concludes, stating, “As officials look forward they need to balance stability with efficiency. Reducing moral hazard, keeping institutions simple and small, and reducing their international reach will come at the expense of economies of scale and scope. In the end, a safer and more stable financial system may very well be a less efficient one. Hence it is critical that policy makers work to build a system that is as efficient as possible for the maximum tolerable level of risk they choose.”
As international leaders move forward with reform plans, the stability and future economic prosperity of the world is at stake. Without significant reform, the global economy may very well recover from the economic crisis, but the regulatory, economic, and political infrastructure that supports it will be more vulnerable to future crises and instability, resulting in less economic growth and a lack of confidence, which undermines market economies.
Markets cannot operate without the investor confidence that effective regulation generates, Campos stresses. Consumer investors in the US and those from around the world need to be reassured that there is a level playing field here and elsewhere. “Regulation and regulatory enforcement doesn’t operate just for its own sake,” he adds. “We need confidence in our markets that Main Street investors can invest with faith in their 401(k)s and so that foreign investors want to stay here. If there isn’t confidence in our markets, we lose the biggest advantage that we have, the thing that distinguishes our market from almost every place else.”
Beyond investor confidence, bigger issues are at play, and the potential risk of failing to resolve these issues is dire. “Further delay in repairing the financial sector runs the risk of weakening the efforts on other policy fronts,” the BIS warns in its annual report. “Fiscal and monetary policies are surely less effective when financial intermediation is impaired. And as long as global financial institutions are hesitant to finance economic activity in emerging market economies, the prospects for growth and development in what has been the primary engine of worldwide expansion over the past decade is at risk” (BIS 2009).
Bank for International Settlements. June 29, 2009. Seventy-Ninth Annual Report: 1 April 2008–31 March 2009.
Committee on Capital Markets Regulation. May 26, 2009. The Global Financial Crisis: A Plan for Regulatory Reform.
–Amy Buttell is a journalist working in Erie, Pennsylvania. She analyzes trends and policy in an effort to help consumers and professionals place financial, health care, and legal issues in context.
Illustrations by Mark Andresen