I’ve been busy (to put it mildly) with Fintech Week, but I did take some time to peruse the Treasury Department’s new report on financial regulation. It really is an interesting document, and deserves a read, in part since it covers the entire spectrum of the activities of financial regulation, and provides an overview of the priorities of the new Administration.
Given my own background in international finance, I took particular interest in the Department’s philosophy and reasoning behind its approach towards financial regulation. After all, in stark contrast to trade, the Trump Administration seems to accept the prospect of international coordination, especially in banking, and withdrawal from a major regulatory agreement like the Basel Accord appears unlikely. So I was curious—what does international financial regulation look like in the (post-)post-crisis regulatory cycle?
The answer appears to lie in an emphasis of ‘market access’:
Cross-border financial integration enhances capital markets efficiency through better allocation of savings while stability is enhanced through better risk sharing. Because of these economic benefits, capital markets are increasingly global in nature, becoming highly integrated and interdependent. However, integration of capital markets also increases the potential for the cross-border transmission of shocks. is underscores the need to accompany the increasing role of nonbank financial intermediation and market-based financing with adequate regulatory and supervisory frameworks to safeguard financial stability.
Generally, given the size and global stature of U.S. capital markets, the U.S. regulatory approach is to provide investors and firms with a U.S. presence equal access to our markets on national treatment terms. Cross-border access is allowed to foreign registrants and financial institutions in a manner consistent with prudential and other public policy objectives. is provides a level playing field for market participants wanting to access and be active in our markets, the largest and most vibrant nonbank financial sector in the world. Regulatory frameworks that encourage diverse approaches with respect to products, investment strategies, and investment horizons help create vibrant markets, and variation across jurisdictions is not only acceptable but desirable. At the same time, conflicting frameworks, whether it be within a jurisdiction or between them, can fragment markets, lead to unnecessary costs, distort price discovery, and reduce consumers’ options. In some cases, regulation can have far reaching and often unintended consequences for market participants in other jurisdictions that may have little connection to the jurisdiction promulgating the regulation or the issue being regulated. Internationally active financial institutions may be subject to overlapping, duplicative, and sometimes incompatible national regulatory regimes. Appropriate regulatory cooperation in bilateral and multilateral forums can advance U.S. interests by promoting financial stability, leveling the playing field for U.S. financial institutions, and reducing market fragmentation.
Since the financial crisis, regulators have worked to address these shortcomings by agreeing on common standards, where appropriate, and depending on a jurisdiction’s preference, through findings of substituted compliance and regulatory equivalence. Findings of substituted compliance and regulatory equivalence are recognitions (generally unilateral) that foreign regulatory regimes achieve similar goals and that national regulatory approaches, while diverging in certain respects, were of a high quality. For example, after consultation with the SEC in 2012 the European Securities and Markets Authority eventually reported to the European Commission (EC) its conclusion that the U.S. regulatory regime for credit rating agencies was equivalent to the EU’s own system. Several months later, the EC formally rendered its equivalency determination for the U.S. credit rating agency regulatory regime.
After these observations, the report goes on to embrace bilateral and multilateral forums as means of advancing U.S. interests, including preventing “unnecessary regulatory standard-setting that could stifle financial innovation, and assure the competitiveness of U.S. companies and markets.”
This framing left me with a couple of thoughts. Now, I’m no enemy to the idea that cross border coordination can reduce duplication and costs associated with operating in multiple jurisdictions—and I have the record of backing it up in my own writing. And in some cases financial regulation can certainly help enable market access by creating clear, transparent and fair expectations of foreign financial services providers. But I think there is a serious opportunity missed in the report to address an even more central (and in my view, obvious) purpose of international financial regulation—raising standards abroad to prevent dangerous forms of regulatory arbitrage that can, if unchecked, undermine the safety and vibrancy of US financial markets.
The fact that arbitrage wasn’t mentioned at all is a bit eye-catching considering the history of international financial regulation. To be sure, since the failure of the Herstatt bank in 1974 the impetus behind international regulatory coordination (embodied foremost in the Basel Committee) was the specter of payment risks in the banking sector—the “shocks” to which the report correctly alludes. But since then, the focus quickly grew to include broader prudential and supervisory concerns—from the questionable supervision of capital adequacy of Japanese banks in the 1980s and Latin American debt crises to dangers of inadequate financial supervision in East Asia following their financial crisis in 1997. And it was done with the idea of protecting Western (and in particular US) banks and taxpayers from overseas regulatory failures. Indeed, for well over a generation, the US has been the major actor in international financial regulatory system, and has dominated standard-setting to ensure that rules are written, if not with a US pen, at least with American ink—and by extension, forwarding US interests of financial market stability and economic growth.
This is all critical to keep in mind since potential foreign regulatory risks are, in fact, growing. And it’s not due to incongruent rules. The internationalization of the renminbi could introduce risks where capital account liberalization is not supported by a sufficiently robust regulatory infrastructure. Brexit will create incentives for some countries to undercut standards to attract business. Even fintech can create risks if foreign regulators go too far out of their way to attract firms and untested technologies at the cost of their domestic market integrity. Proper surveillance and international standard setting will be key to addressing these dangers head on, and in my view, deserves its due attention.