The agenda for cross-jurisdictional regulatory enforcement and coordination—as promoted by the G20, International Monetary Fund (IMF), Financial Security Board (FSB), International Organization of Securities Commissions (IOSCO), Basel Committee on Banking Supervision (BCBS), International Association of Insurance Supervisors (IAIS), and other international bodies—is still in the making and faces several challenges. Cross-jurisdictional regulatory enforcement and coordination targets the problem of regulatory arbitrage, whereby firms skirt undesired regulation by exploiting legal loopholes. It is also intended to help maintain an efficient global financial system. The Transatlantic Trade and Investment Partnership (TTIP) between the European Union and the United States aims to implement better financial regulatory practices and set more homogenous regulatory standards. The sixth round of TTIP negotiations, which took place between July 14 and 18, included talks over market access but did not table commitments on financial regulatory coordination. These negotiations illustrate that the U.S. Treasury does not currently consider financial regulation a trade issue, and believes that convergence can continue to be pursued through other channels, such as the Financial Markets Regulatory Dialogue (FMRD).
Nevertheless, pressures from the Financial Services Forum (FSF), Financial Services Roundtable (FSR), Institute of International Finance (IIF) and Securities Industry and Financial Markets Association (SIFMA), coupled with the European Union’s strong position, could very well result in a formal agreement over financial regulatory coordination after future rounds of TTIP negotiations. At first glance, TTIP appears to be an effective tool for responding to current conflicts between the EU and the United States over cross-jurisdictional enforcement in the regulation of derivative instruments, accounting, and insurance and banking oversight and supervision. Before considering how cross-jurisdictional financial regulatory coordination could be enforced, however, it is necessary to assess the risks posed by increased control over cross-jurisdictional financial regulatory coordination in line with the insights of TTIP. Imposing a cross-jurisdictional financial regulatory framework could induce new systemic risks as opposed to promoting stability and efficiency.
Apart from the obvious argument that cross-jurisdictional financial regulatory framework would fail to fit all financial services firms, categorizing these firms into distinct levels of systemic risk, and requiring them to apply similar rules and practices, may increase homogeneity. This risk already exists because of the Dodd-Frank Act (DFA) of 2010 and the European Markets Infrastructure Regulation (EMIR) of 2012, but its magnitude would significantly increase under TTIP’s proposals. Homogeneity, by its very nature, discourages firm-level organizational experimentation and innovation, and therefore hobbles financial services firms by requiring them to predominantly offer certain services and investment products. This affects the general equilibrium of supply and demand across different tradable assets and exposes certain market participants that are less agile in adapting their offer to potential profit losses. In addition, as explained in Lawrence J. Kotlikoff’s 2010 book Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking, categorized financial services firms can become exposed to the same asset classes through the mechanism of limited purpose banking, and their performance can become correlated. This ultimately leads to an increased financial instability risk. Furthermore, homogeneity entails a high cost for financial services firms because they are constrained to operating within an ever-increasing competitive landscape. In this environment, the key for differentiation moves outside of the high-risk, high-returns operating model, and new metrics must be developed.
One main factor behind the Global Financial Crisis of 2007 was fast-paced financial innovation facilitated by technological improvements and reduced costs (including lower transaction costs). The pace of financial innovation has since been reduced, as financial regulation incurs three main costs: additional financing cost, margin for over-the-counter derivatives, and clearing fees. Despite these costs, financial innovation continues now and will continue in the future—and, while key to for driving growth, it can also be a catalyst for driving systemic risk. Because of this, TTIP’s recommendation to convert soft law into binding international legal obligations has raised considerable criticism. Financial services firms have the capacity to create new products and strategies within very short timeframes, as well as to undertake business model changes quickly. In addition, the speed of financial markets in terms of their behavior is significantly high and, as a result, it is vital that any financial regulatory framework be agile rather than binding. Moreover, renegotiating the terms of the DFA and the existing European Union financial regulations to achieve a transatlantic consensus would be very laborious and, in the interim period, pose a serious risk to the effective supervision of financial markets.
How, then, could cross-jurisdictional financial regulatory coordination be enforced while at the same time promote stability? The first focus of any such coordinated effort should be to further highlight the importance of reputation to the overall value of financial services firms and their capacity to generate additional profits and market share. This would decrease the risks of financial regulatory arbitrage. The second focus should be to enforce the monitoring capabilities of regulatory agencies over financial innovation and ensure that this is conducted responsibly to drive growth. The first stages of financial innovation (as with any other type of innovation) offer the greatest opportunities for control. At the same time, these first stages are characterized by a higher level of uncertainty about the nature and significance of potential market impacts, which can impede regulators’ capacity to impose higher controls.
So far, multi-level and de facto governance structures have been implemented to attempt to respond to this control dilemma. Apart from using these forms of governance, however, regulators should also turn their attention to blending big data with game theory so as to devise behavioral models with an increased level of predictability. By looking into past and present cases of financial innovations that have led to increased systemic risks and regulatory arbitrage, regulators can identify behavioral patterns across multiple jurisdictions and use these to inform their regulatory strategy. Identifying these patterns will prove to be especially useful for instances of financial regulation in which regulators have a common interest in coordinating their actions.
Consequently, future TTIP negotiations should focus on two aims. First, the inclusion of financial regulatory convergence within TTIP would reduce current disharmonies between the United States and the European Union as well as lessen the costs of compliance for market players. Second, moving forward, negotiators’ main focus should be to gather data on financial innovation in order to support a robust financial regulatory design. As a formal agreement, TTIP would have the necessary enforcement capabilities to implement a macroprudential financial regulatory framework with well-defined incentives to reduce correlation risks. It will be up to these future negotiations to secure market stability and efficiency across the United States and the European Union by implementing such a framework.
Alexandra Dobra is a Ph.D. candidate in the Department of Politics and International Studies at the University of Warwick.