Chris Brummer, C. Boyden Gray fellow with the Council’s Global Business & Economics Program, submitted a written testimony for a House Financial Services Committee hearing on financial regulation and US competitiveness.
The competitiveness of a country’s financial sector is a function of the quality and integrity of its financial services professionals, the credibility of its regulatory supervision, and its ability to meet domestic and international market needs. As such, the question of competitiveness concerns to what degree the United States enjoys a safe and vibrant capital market, and to what degree the United States has successfully promoted high quality, first-rate and compatible regulatory best practices among its leading trading partners.
Fortunately, there has been enormous progress in implementing the G-20 agenda for financial reform, which was embraced by the world’s leading economic powers in the wake of the 2008 financial crisis. And this implementation is proceeding in a way that for the most part has been consistent and harmonious. This is an achievement that cannot and should not be overlooked, especially given the different regulatory and market infrastructures in the United States and European Union, and the varying degrees of reliance on banking and capital markets in both jurisdictions. Indeed, the list of accomplishments is in many ways unprecedented, including, and just to name a few:
- Increasing the amount and quality of capital held by banks and systemically important financial institutions
- Restraining the amount of leverage assumed by banks and non-bank financial firms
- Moving large swaths of OTC derivatives to stable, resilient and transparent pre- and post-trading environments.
- Requiring clearing for some of the most volatile financial transactions and contracts
- Outlining a framework for coordinating cross-border bank failures
This is all the more impressive when one considers the varied rule-making processes in both the United States and European Union, with the delegation of authority to independent agencies like the SEC and CFTC in the United States by the Congress as compared to more prescriptive legislative action taken by the EU Commission, Parliament, and Council.
But there are differences, differences that though at times may appear only on the margins, can have outsized implications for financial stability and U.S. competitiveness. These are issues that I have spent some time reflecting on, and which I have summarized in a highly regarded, bipartisan report for the Atlantic Council.
The topic of this hearing is competitiveness and financial regulation. Before getting into the challenges before us, it is worthwhile stating for the record that the regulation of our domestic financial system is not in itself a competitive disadvantage for the United States. Indeed, the financial crisis illustrated to an unprecedented degree the devastating consequences that can be wreaked on economic growth, job creation, and innovation by under-regulated domestic and international financial markets lacking comprehensive rules and sound supervision.
Instead, risks to U.S. competitiveness arise where efforts to buttress our financial system end up being inoperable with reform efforts of likeminded countries such that we end up unwittingly undermining international reforms, complicating our own attempts to better safeguard our markets, or unnecessarily hampering commerce. The challenge before us is thus how to make our reforms as prudently as possible alongside our major trading partners in ways that both 1) bolster regulators’ supervisory efforts and 2) minimize the costs and operational burdens for our firms tapping foreign capital markets, and vice versa. It is also useful to think about how these twin goals can be achieved in ways that do not end up descending into games of “chicken” or “first to blink loses” with other financial authorities that can end up damaging our larger strategic interests. If done right, cooperation between the US and its key regulatory allies can enhance not only prospects for sustainable growth, but also financial stability.
Coping with regulatory diversity is, however, tough work. To understand some of these differences in substance, I think it’s useful to recognize that the path of international regulatory reform has passed along the path of least resistance. We’ve seen this, in particular, with the G-20, where some of the easier issues were tackled first and, conversely, the more difficult issues have been saved for last.
For many people, this could be a somewhat disconcerting observation when one considers that the lower-hanging fruit involves the issue of bank capital and bank capitalization and moves along the spectrum to topics like banking structure and organization, derivatives regulation, accounting, and finally to cross-border bank resolution, which is arguably the most formidable global challenge of all.
And so, what we see are issues of convergence and divergence that roughly reflect these levels of difficulty. Regulators have, for the most part, come to what can be viewed as a consensus on the rules and standards that should relate to bank capital. It is true that there are differences in some ways with regards to what kinds of assets constitute capital, and I have some lingering concerns about trade finance, but for the most part the regimes are highly consistent with one another.
Instead, the difficulties have come from operationalizing the reforms. Meeting enhanced Basel III capital standards, for example, is about more than just rules; in point of fact, it requires the recapitalization of banks—a process that is taking longer in Europe than in the United States. This difference is partly because the U.S. crisis erupted earlier, and was met by a swifter policy response, and partly because the Eurozone has had to negotiate funding mechanisms for banks and cash-strapped governments among sovereign countries. These delays have, however, raised doubts in the United States about the EU’s commitment to reform.
Concerns about bank structure have additionally accompanied core issues of bank capital. However, unlike capital, bank structural reform was not really a matter presented at the G-20 for serious discussion. Instead, structural reforms have been undertaken independently in the United States, as well as in Europe and other parts of the world. At this point, we now know the contours of the Volcker Rule in the United States, though it is unclear just how the EU and UK will respond. It is highly likely that they will diverge in both substance and emphasis from the Volcker Rule, choosing “stricter” approaches in some areas like scope and proceeding more leniently in other areas of substance. Meanwhile, the newly released rule on foreign banking organizations (FBOs) has found no immediate counterpart in Europe, although it has already prompted threats of retaliation by the European Union. Still, some jurisdictions in Asia have already implemented their own versions of the approach.
Returning to the G-20 agenda, derivatives were addressed at the 2009 Pittsburgh summit. To summarize the results as simply as possible, at that summit it was agreed to regulate the derivatives market along the lines of three basic elements: pretrade transparency, central counterparty clearing, and post-trade reporting. Limiting the analysis to just the European Union and the United States, one can conclude that both jurisdictions are actively implementing their G-20 commitments. The US has done so through Title VII of the Dodd-Frank Act and the implementing regulations promulgated by regulators such as the CFTC, whereas the EU has agreed to the European Markets Infrastructure Regulation and a review of the Markets in Financial Instruments Regulation and Directive.
Yet despite their similarities, EU and US rules are not fully compatible. To address overlaps, gaps and conflicts of law, in the summer of 2013 both jurisdictions reached (ostensible) agreement in the Path Forward communiqué as to how to operationalize the commitments such that they could function in a cross-border context. This process then took several steps back as to how to operationalize the high-level commitments with regards to trading infrastructure (the Swap Execution Facilities); yet even with a new substituted compliance accord reached, the smooth implementation of a cross-border framework remains to be seen.
Progress on accounting has slowed considerably. Without getting into the weeds, we see in the coordination of U.S. GAAP and IFRS a range of challenges, especially where IFRS itself has not consolidated varying approaches and multiple treatments among its own user jurisdictions. This is extremely unfortunate since varying accounting standards complicate the ability of firms and regulators to evaluate and compare financial institutions’ health and compliance with key regulatory metrics (like leverage). Furthermore, the absence of a single yardstick to measure the performance of U.S. firms compared to their international partners substantially increases costs of doing business as well as costs for accessing capital. But deeper progress, such as the harmonization or easy conversion of accounting standards, remains a distant goal.
Finally, cross-border bank resolution, arguably the most important mechanism needed to address the too-big-to-fail problem, remains elusive—but a must-have. Indeed, many of the sources of friction in and between transatlantic regulators are exacerbated by the lack of a mechanism for addressing effectively the downfall of one or more systemically important financial institutions. Much has been done to begin this process via bilateral accords, or at the least discussions, with key financial centers like the UK and Switzerland. But to the extent to which such mechanisms can be created and fully operational, many of the concerns and pressures driving geographically based or seemingly unilateral measures (such as the FBO rule) would be eased.
With that in mind, I have several modest suggestions.
First, a reinvigorated process of coordination and cooperation would be helpful. The G-20 agenda was broad and ambitious but also often vague as to how and when many core benchmarks were to be achieved. This is, of course, only to be expected when you have so many jurisdictions talking to one another. But the United States and the European Union, the two most demanding standard-setting jurisdictions, can do better.
In addition, there is ongoing and intensifying debate as to how formal different kinds of obligations should be and whether trade initiatives should tackle the challenges of international finance. This is an extremely complicated question, in part because it depends on just what provisions a trade agreement would include. For instance, some procedural innovations to synch administrative processes could be quite helpful, while attempts to introduce substantive rules or water down regulatory reforms could prove fatal to financial stability.
But whichever way you come out on the issue, virtually everyone agrees that traditional substitute compliance and mutual recognition programs have not typically spoken to a regulatory context in which not one but two or more, or indeed nearly all authorities are seeking to upgrade their financial systems. This presents a number of novel challenges, particularly where countries have a range of different goals or even varying intensities of policy preferences. For instance, one jurisdiction can be looking to tackle banker compensation (like the European Union), while the other may focus more on derivatives (like the United States), yet due to their different policy goals and intensities they may accuse the other of being “soft.”
Consequently, I think it would be wise for the tools and mechanisms of cross-border diplomacy to acknowledge this challenge and begin to establish benchmarks for ensuring a synchronized approach towards tackling different issues—to quite literally keep regulators and firms on the same page. Administrative processes and priorities can be better coordinated and integrated into substituted compliance mechanisms, which would allow implementation to move apace while ensuring earlier—and ongoing—regulatory and public interactions as new challenges arise. Recognition of “equivalence” should not comprise the finish line or conclusion of cross-border talks and information sharing.
Along these lines, and especially given its interface between financial supervision and monetary relations, the Financial Markets Regulatory Dialogue, the main meeting of EU and U.S. regulators, should be revived alongside G-20 meetings of treasury officials and central bankers. Regulators should be at the table when big market-supervisory decisions are made so that they can understand their role and the expectations of other parts of the U.S. government. This would also help with international consistency insofar as EU and U.S. regulators could be encouraged to present joint solutions and reforms for wider international consideration at the Financial Stability Board, instead of litigating them there after conflicts arise.
Finally, to make any of this happen, you need resources on the ground. Diplomacy isn’t cheap, and you need to empower your regulators (and for that matter trade officials and diplomats) to do their job if you really want an efficient transatlantic marketplace. Freezing travel accounts and slashing diplomatic resources won’t help U.S. competitiveness. We need to look at economic diplomacy as not a cost center, but as an investment that pays dividends for taxpayers and market participants alike.