The unintended consequences of financial reform

The new reality is a world where business is profoundly global but governing is largely national. Not unexpectedly, this divergence can lead to unintended consequences, and reforms to the global financial system in the wake of the financial crisis are a case in point.

The financial crisis was largely a Western affair, centred in the banking systems of the US, the UK and the euro zone. But its impacts were pervasively global and stubbornly long-lasting. Indeed, despite the massive regulatory repair effort, financial systems are still not running on all cylinders and this is reflected in a global economy that is mired in underperformance more than five years into the recovery. An additional worry is that the implementation of some global financial reforms may be inadvertently sowing the seeds for future problems.

Consider, for example, the divergence between many of the common global regulatory reform principles, collectively agreed by the G20, and their translation into highly prescriptive, specifically tailored and often dissimilar regulations by national authorities. The consequence is a worrisome rise in regulatory fragmentation and its negative implications for the efficiency of global financial markets and for regulatory arbitrage. The regulatory differences in whether to ring fence certain activities of banks, such as proprietary trading, among the US, the UK, the euro zone and a number of other countries exemplify this fragmentation risk. And, this is much more than a technical issue: these regulatory divergences affect financing for companies, decrease financial sector resilience and increase risk, and ultimately reduce jobs and growth.

What is needed is strengthened global financial sector policy coordination by the G20, with a focus on bringing national regulatory practice more in line with agreed international principles. As part of this enhanced governance oversight, it also has to clarify who “rules past the border”, with cross-border recovery and resolution regimes highlighting the challenges of how and who deals with “too-big-to-fail” banks that operate in numerous jurisdictions in an interconnected global financial market. And, as reform extends beyond banks to other core financial institutions such as insurers, there will be a temptation to apply a “one-size fits-all” approach whereas differences in regulatory implementation between banks and insurers may be warranted consistent with common principles and objectives.

Another area where we need to distinguish between common international principles and “one-size-fits-all” global implementation is when countries are at different stages of the maturity and development of their capital markets. Surely there is more scope for simpler rules and requirements, consistent with common regulatory principles, in those emerging markets with limited regulatory and supervision capacity, particularly for those institutions engaging in less complex financial businesses and simpler financial products? Should not the objective of Basel III in emerging markets, for example, be effective regulation rather than complex regulation regardless of its implement ability? We have to avoid confusing the “means”, the plumbing of regulations, with the “ends”, a safer, more resilient and more efficient financial sector that contributes to sustained economic growth.

No issue is more at risk of confusing means and ends than shadow banking. Shadow banking is “credit intermediation involving entities and activities outside the regular banking system”. By doing so, it provides competition to banks and alternative ways for savers and investors to meet their financial objectives. This should contribute to financial sector innovation and market choice. However, by definition, shadow banking is less regulated than the banking sector, and with the wave of banking regulatory reform since the financial crisis, this regulatory wedge has increased markedly as has the market share of shadow banking. This raises the important question of whether increased regulation of the banking sector is driving financial intermediation into the shadow banking sector and, by doing so, is undermining efforts to reduce systemic financial sector risk. It also calls into question whether the rise of shadow banking has affected the ability of central banks to influence credit growth. With massive liquidity in capital markets as a result of unprecedented monetary easing, and regulatory reform focused almost exclusively on banks and not the entire credit intermediation system, the risks of unintended consequences are heightened.

Despite the progress in rebuilding regulatory systems and capacity, dynamic tensions remain in the global financial system and we ignore them at our peril. The reality today is rising unilateralism, increasing fragmentation, escalating complexity, diminished public trust and reduced multilateral coordination. Without a reboot in international policy cooperation and coordination to tackle these issues, today’s “trust deficits” and “regulatory gaps” will hamper the goal of governments to revive economic activity and employment, and they will foster frictions between advanced and emerging economies.

Authors: Kevin Lynch, Vice-Chairman, BMO Financial Group, and Chair, Global Agenda Council on the Global Financial System. Liao Min, Director-General, China Banking and Regulatory Commission (Shanghai Office), and member, Global Agenda Council on the Global Financial System

Image: A man looks at an electronic board displaying stock prices outside a brokerage in Tokyo November 10, 2011. REUTERS/Toru Hanai