Financial regulation must deal with borderless finance industry
Globalisation requires a common, consistent and focused approach to the framing of regulation
THE RECENT FINANCIAL crisis has led to a substantial rethink of many economic matters which had hitherto been seen to be settled. They include market efficiency and the benefits of a global marketplace where goods, services and capital could move freely.
But nowhere is the rethink more profound than in finance, not least because recent economic research has noted that while the integration of financial markets was expected to bring greater financial stability, it has in many cases led to greater instability.
As the severity of the crisis had much to do with the “integratedness” of financial markets, approaches to the framing of new regulation need to have regard for virtually borderless markets and for internationally mobile financial firms.
Moreover, it is even more important to focus on the pure economic rationale for regulatory intervention in such a globally integrated marketplace. This matters in a time when there is so much in the regulatory pipeline which will affect investment firms, banks, fund investors and service providers, market infrastructure providers and credit rating agencies to name but a few.
In thinking about how regulation comes about, it is helpful to consider some of the key drivers:
1. We are all familiar with situations where “something must be done” following a disaster. Subsequent debate can often generate more heat than light leading to new regulations which are sometimes ineffective or even counterproductive. Further corrective regulations may then be required.
2. The relentless drive “towards a single market” started with the creation of the European Coal and Steel Community in the 1950s, and culminated in the Maastricht Treaty in 1992 and the European Monetary Union in 1999. In this instance, new regulations were part of a framework to foster prosperity and peace through the creation of a single European marketplace.
3. In the face of the emerging European single market, individual countries have struggled to resist the impulse to use their respective regulatory regimes to protect local interests. In European financial services, this has led to the development of a “single rule book” to promote consistency, reduce barriers to entry and eliminate opportunities for regulatory arbitrage.
4. This leads to the fourth driver for regulation, which has attained greater importance as a result of the financial crisis: the need to tackle the sources of what economists term “market inefficiencies” or “market failure”.
The financial crisis has shown that the consequences of market failure can be extremely costly and can last for generations. As such, financial authorities and market participants have a responsibility to think about the ways in which financial markets do not perform efficiently.
The “economic frictions” which impede market efficiency and contribute to market failure have been well studied since the 1970s.
In financial regulation, there are four frictions which frequently prompt regulatory intervention.
First, “principal agent costs” often arise when one party delegates responsibility to another, eg shareholders charge the chief executive with running the firm. Second, the actions of one party may harm another where there is “incentive misalignment”. Third, “information asymmetries” arise when one party has an informational advantage over another, eg a borrower will know more about his/her credit record than the lender. Fourth, “agent behavioural issues” arise when investors find it difficult to process information and deal with uncertainty – there is a burgeoning literature of behavioural finance looking at the many phenomena in this area.
Sometimes some or all of these frictions exist within the same market phenomenon. Recall the “originate and distribute” model at the heart of the US sub-prime crisis. This was characterised by mortgage brokers who were paid commissions based on the number of loans they made to borrowers with weak credit histories; banks which bundled these loans together and issued mortgage-backed securities; and investors who bought these risky securities (principal-agent problem).
Investors relied on highly-aggregated and infrequent data about the quality of the loans (information asymmetry) and on credit ratings issued by agencies who were paid by the issuers – not the investors (incentive misalignment). The complex pay-off structure of the mortgage-backed securities and legally untested aspects of the prospectuses challenged investors’ ability to assess the risks they faced (agent behaviour issues).
When thinking about the body of financial regulations, it is helpful to fix one’s frame of reference on these frictions in order not to be overwhelmed by the tsunami of directives, regulations, technical standards and guidance. Increasing globalisation requires a common, consistent and focused approach to the framing of regulation.
By way of example, there are differences between the proposed US and EU hedge fund regimes in relation to the protection of client assets and the validation of monthly performance returns. Such differences may lead firms to cherry-pick regulatory regimes or strategically locate parts of their operations across a range of regulatory jurisdictions. Apart from potentially adverse systemic consequences, this poses significant day-to-day challenges to regulators.
In the past, countries have sought to regulate so as to achieve competition and economic growth. At times, the increasing scale of the financial industry on both sides of the Atlantic Ocean and in Asia has seemed like an arms race. But we have seen the effects when the financial industry outstrips the real economy in terms of size and importance, and where economic frictions are not addressed. By allowing regulations to be crafted within regional blocs without these underlying economic frictions in mind, we risk creating misaligned regimes which have unanticipated and undesirable spillover effects.
In this more mature phase of financial sector evolution, a common regulatory agenda focused on the economic frictions which impede market efficiency is necessary. Among the G20 countries, the Financial Stability Board has sought to provide direction across a number of issues. In some areas like bank capital, where the incentives towards global co-ordination are strongest, the Basel Committee for Banking Supervision has forged ahead with new standards.
But this is the tip of the iceberg. Below the waterline lies a mass of issues requiring a co-ordinated approach to framing regulation with a determined view to mitigating the risk of market failure.
Gareth Murphy is director of market supervision at the Central Bank. He previously worked at the Bank of England and in investment banking and hedge funds in London. This article is an abridged version of a speech delivered at the InvestoRegulation conference in London on January 25th.