Avoiding Regulatory Arbitrage in times of TTIP – Challenges for Supervision in International Finance
Paul P. Maeser is a APSA Congressional Fellow for the German Marshall Fund of the United States. He is with the Democrats in the House Committee on Financial Services. Prior, he worked as an expert on capital markets for Deutsche Bank in Germany and in the Netherlands.
The views expressed in this essay are those of the author alone and do not necessarily reflect those of AICGS or any other affiliated organizations.
In mid-June 2013, the EU member states will decide whether they intend to open negotiations on the Transatlantic Trade and Investment Partnership (TTIP) with the United States. While all observers expect that the Europeans, as well as the United States, will formally launch the negotiation round, trade experts on both sides of the pond have already started to discuss potential issues for the newly designed trade framework. Among others, we have the chance for a new momentum in financial markets regulation if this sector becomes part of the agreement. In order to obtain a more resilient financial market, policymakers in the United States and in the European Commission agree on one goal in particular: How can we avoid cross-border regulatory arbitrage?
New regulatory standards require coherent legislative action between the United States and Europe. New legislation, however, needs to be safeguarded by appropriate enforcement measures. Here, autonomous regulators play the most significant role, especially from an international perspective. Financial institutions, though, have challenged regulators’ independence ever since they have been subject to regulation and will continue aiming to be heard. While the desire of these financial institutions is perfectly legitimate, we must ensure that financial regulators are protected from outside pressure. In the context of TTIP, how can we redesign regulating agencies in such a way that we can minimize the influence of financial institutions and decrease the risks that come along with weak enforcement?
Regulating agencies will probably never be fully insulated, nor should they be. But as TTIP is likely to lead to further liberalization and mutual recognition of regulatory regimes, new ideas are worth being discussed. Consequently, I briefly present three major challenges in international financial regulation to be considered in the framework of TTIP, as well as ideas that might help mitigate the risk of weak financial regulation and its consequences in the United States and Europe.
Agency Funding and International Quality Standards
The first channel to indirectly challenge regulators’ independence is the agency’s funding source. Technically, Congress or parliaments in Europe can assign an amount that is widely perceived as acceptable for the agency to fulfill its mandate. However, this procedure can result in a strong dependency on legislators’ decisions. If a regulator continually makes decisions that displease legislators, Congress or EU parliaments might become less supportive of the agency. Thus, the agency’s funding can become subject to political pressure. If financial institutions oppose a certain piece of regulation, they might lobby the members of the responsible authorization or appropriation committees. Then, the lobbied members put public pressure on the chairman of the regulating agency by asking him critical questions. In cases where such public pressure is not sufficient, the responsible committees might cut the agency’s funding in such a way that the regulator is not able to execute its mandate in a reasonable way. In short, advocates in the financial industry can use legislative committees as their first lever to influence their regulator’s behavior.
In order to minimize threats for the global financial system, how can we improve the mechanisms of agency funding in such a way that weak regulation does not water down international standards? First, a solution must focus on systemically important financial institutions (SIFIs), since these entities can cause a potential spill-over of financial crises. Second, we must ensure that every country enforces international agreements on SIFIs appropriately.
One potential answer to this issue is to outsource the regulation of SIFIs, thereby reallocating supervision to a body independent from parliamentary budget authorities. In the European Union, policymakers are in the process of transferring the oversight of SIFIs from national agencies to the European Central Bank (ECB) will take over the regulation of SIFIs from national agencies. As a result, financial interest groups cannot set incentives for members of a parliament to cut the funding for financial supervisors. In addition, the ECB possesses a high level of trust among all participating governments since it is independent from national institutions.
For political reasons, such an approach can hardly be transferred to the United States. Merging all regulators under the umbrella of the Federal Reserve is too complicated, costly and time-consuming. Facing TTIP, policymakers could pursue a less rigorous strategy. For instance, the U.S. and the EU can strive for a wider mandate of the Bank for International Settlements (BIS). The BIS could use its profound expertise in banking regulation and serve as an auditor to national regulating agencies both in the EU and in the U.S. The BIS could also release a warning when one side neglects the regulation of SIFIs, whether it is politically motivated or due to insufficient agency funding. Domestically, such a new standard would strengthen those policymakers in American and European jurisdictions who advocate enhanced agency funding. Internationally, a BIS warning gives the U.S. government or the EU Commission time to react before weak financial regulation on the partners’ side causes damage to their own economy. One example for potential countermeasures is to allow restrictions on market access for financial institutions regulated by the non-compliant partner.
Regulatory Shopping and a Global “Hotel California” Provision
Another challenge for regulators on both sides of the Atlantic is the mobility of financial capital. Financial institutions can shift their business activities to offshore entities where regulatory standards are less restrictive. Over the last several years, shadow banking has played a significant role in the credit industry; new legal options allowed financial institutions to outsource business in special purpose vehicles and take risks off their balance sheets., In some extreme cases, financial institutions might even move their headquarters to other countries. Both strategies have been employed by a number of institutions to escape from regulation.
What can regulators do in order to prevent the financial industry from circumventing regulatory reach? When financial risks are moved out of a well-regulated jurisdiction like the United States or Europe, the country’s financial sector might appear more resilient. From a global perspective, however, the hazard still exists and, given that the same risk is probably less monitored at the new location, it can endanger macro prudence even more. The Dodd-Frank Act provides us with a new approach in the domestic arena. Under current legislation, certain bank holding companies can sell those assets that make them eligible for financial regulation. But after they have done so, they can still be subject to regulation through their supervisors. In other words, such a bank-holding company might be not engaged in financial services but can still be regulated as if it were one. This way, regulators can ensure that systemically relevant institutions cannot operate unregulated. This principle behind the so-called Hotel California provision—that “You may check out any time you like, but you can never leave”—can also be transferred to an international stage when banks try to relocate business to another jurisdiction.
Usually, banks have strong business relations to clients in their home market. While several countries loosened restrictions for foreign banks to conduct business in their home market, corporate and investment banking, as well as retail banking, is mostly in the hands of local banks., With banks earning a relatively large share of their revenues domestically, they have a dependency on their home markets. Even if a bank decides to move its headquarters to another country in order to avoid tougher restrictions, the bank still needs a banking license for its former home market. This is the point where TTIP can set a new global standard in financial regulation. If a bank wants to move to another country, it is free to do so. However, it will only maintain its banking license within the U.S. or the EU if it still meets the country’s regulatory standards for a period of, for instance, ten years. In other words, a bank can only continue operating in its original home market if it is cooperating with its regulators.
Such a policy will certainly bring practical challenges, as diverse regulatory regimes are different and can sometimes be contradictory across countries. However, there is a lower incentive for financial institutions to move to another country in order to escape regulation. A transatlantic standard for a “Hotel California” provision would remove the threat that supervised companies move out of certain jurisdictions if their regulators do not comply. Altogether, they may check out any time they like – but they can hardly leave.
Agency Officials and the International Revolving Door
A third issue in agency design is how to minimize conflicts of interest between agency officials and the financial industry. Through their work, agency officials become insiders; they gain many first-hand insights in procedures, decision-making processes, and intentions of regulating agencies. Their knowledge is of great value to supervised institutions. After agency officials leave their employer, their previous experience could qualify them for a new position in a supervised company.
On a national level, countries can establish legal constraints that forbid former agency officials to look for employment in the previously regulated sector until a certain pre-defined cool-off period has passed. Such a policy, however, is hard to enforce in an international context. On the other hand, the agency official was probably not acting as a main regulator over the foreign entity. For this reason, we can expect a relatively low overlap between the interests of both the regulator and the foreign bank. Potential conflicts of interest can appear when the hiring bank acquires or merges with an entity that is under the supervision of the former official’s agency. This scenario is unforeseeable while the agency head is operating as such and can therefore be neglected.
Literature often debates how to minimize the lever domestic banks have on agency heads, as they can offer future career chances to these regulators. Since agency heads have hardly any incentive to cooperate with foreign banks while he or she is in office, the permission to work for a domestic bank in another jurisdiction might constitute a partial solution to resolve conflicts of interest. Despite the solution’s imperfectness, foreign entities open up new career opportunities for agency officials and other staff. These opportunities do not remove, but rather mitigate the incentives for agency officials to cooperate with those banks that he or she should supervise in order to find an appropriate job placement afterwards.
In the wake of TTIP, the United States and the European Union can facilitate the issuance of work permits for highly qualified personnel of the respective other nationality. Such a step would allow a foreign bank to hire a former agency official. This way, both parties can circumvent legal constraints for cool-off periods and lower potential conflicts of interests at the same time.
In a new regulatory framework for financial business, we will most likely see a system that relies on further mutual recognition of regulatory regimes between the United States and Europe. However, this strategy requires the introduction of countermeasures against regulatory arbitrage – both within the TTIP and together with external markets.
Here, it is not only important how detailed TTIP’s specifications for financial business will be. Even more, we need to ensure that the challenges of trade liberalization in the financial services sector will be appropriately addressed. Regulatory instructions, as well as their enforcement, are crucial in order to regain international investors’ confidence. The goal should not be protectionism but a level-playing field for financial services on both sides of the Atlantic. In fact, the debate in the United States about higher capital standards for subsidiaries of non-U.S. banks shows that we are in need of strong, yet innovative approaches. In this essay, I discussed only three challenges in agency design that policymakers need to consider—a list that is far from being complete.
The United States and Europe have a vibrant market power in financial services. The examples demonstrate that they can—in the best sense—use their dominant position to avoid new financial instabilities to the financial sector by preventing regulatory arbitrage. All three suggestions are not solely applicable in the transatlantic realm; the ideas are widely WTO-consistent and can be fairly easily expanded to other, interested jurisdictions.
Influence through financial institutions can, but does not necessarily have to, increase the weakness of the financial system. Also, it would be illusionary to assume that regulators can be completely insulated. Given that TTIP will change the environment for the financial services industry, policymakers are supposed to watch out for required changes to reshape the regulating agencies’ design. Whether or not the presented ideas can serve as a starting point, the TTIP negotiations require policymakers to permanently monitor the financial industry’s strategies. They must react quickly when agencies’ independence is challenged.
 International Monetary Fund, “Should Financial Sector Regulators Be Independent?”, http://www.imf.org/external/pubs/ft/issues/issues32/index.htm.
 Barkow, Rachel E. 2010. “Insulating Agencies: Avoiding Capture through Institutional Design.” Texas Law Review 89 (1): 22-23. http://search.proquest.com.proxygw.wrlc.org/docview/822923807?accountid=11243.
 While there is no standard definition of what a SIFI is, we assume for our purposes that this term includes all banks and other financial institutions that have the potential to trigger an international financial crisis.
 Countries might weaken regulation (hidden action) because foreign governments have a lack of information on how the country enforces international accords.
 The Federal Reserve Bank of New York, “Shadow Banking”, http://www.ny.frb.org/research/staff_reports/sr458.pdf, 1.
 Bank for International Settlements, “Strengthening the resilience of the banking sector”, Basel Committee
on Banking Supervision, Consultative Document, http://www.bis.org/publ/bcbs164.pdf, 1.
 The New York Times, “Prudential of Britain Considers Moving Headquarters”, http://dealbook.nytimes.com/2012/02/27/prudential-of-britain-considers-moving-headquarters/.
 The Bank for International Settlements highlights the danger of regulatory arbitrage from a sightly different perspective. Bank for International Settlements, “Macroprudential policy – a literature review”, http://www.bis.org/publ/work337.pdf, 22.
 Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, 12 U.S.C. § 5327 (2010).
 Lissa Lamkin Broome, “The Dodd-Frank Act: TARP Bailout Backlash and Too Big to Fail”, http://www.law.unc.edu/documents/journals/articles/951.pdf, 10.
 The Eagles, Hotel California, Asylum Records B000002GVO. Originally released 1976.
 Financial Times Deutschland, “Ausländische Banken stürmen an die Spitze”, http://www.ftd.de/finanzen/maerkte/:geldanlage-auslaendische-banken-stuermen-an-die-spitze/70036806.html.
 International Monetary Fund, „Foreign Banks: Trends, Impact and Financial Stability“, http://www.imf.org/external/pubs/ft/wp/2012/wp1210.pdf, 1.
 Barkow, Rachel E. 2010. “Insulating Agencies: Avoiding Capture through Institutional Design.” Texas Law Review 89 (1): 48. http://search.proquest.com.proxygw.wrlc.org/docview/822923807?accountid=11243.
 Ibid., 46- 47.
 The New York Times, „E.U. Objects to U.S. Regulations on Capital Requirements “, http://www.nytimes.com/2013/04/23/business/global/eu-objects-to-us-regulations-on-capital-requirements.html?_r=0