A new architecture for global financial regulation

At the G20 summit in Washington this month, it was agreed that global growth will require sound new global regulation of financial markets. But what would it take to achieve such regulation?

The summit offered few answers. We argue that nothing less than a new global architecture for the regulation of banking and finance is required to ensure success. Such architecture comprises three elements: broad representation in the rule-making process, proper monitoring, and systematic enforcement.

First, a better and more impartially-informed process for setting the rules is required. The existing rules were written by the Basel Committee on Banking Regulation which comprises officials from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the UK and the US.

They were wrongly persuaded by banks that complex derivative instruments could improve risk management and distribution as well as enhance market efficiency and resilience.

Indeed, the financial sector argues its case extremely effectively. Recall how quickly and effectively their July 2008 report argued against any new or further regulation by detailing instead “best practice reforms” for the industry. Regulators who resist the finance industry’s well-honed case have been accused of stupidity, incompetence, and over-zealousness by those whose profits and personal gains are at risk by new rules.

Effective new regulation thus requires participation by a broader range of countries and stakeholders in rule-making. The recent crisis shows that some of the costs of poor regulation fall on emerging and other economies whose voice would add a different and balancing set of stakes into rule-making. Equally important is the range of agencies involved in rule-making.

The Basel Committee is dominated by central banks (many of whom have bank supervisory duties). They do not represent the broad range of interests likely to be affected by bank failure. They are not politically accountable; most are independent. And for their own operational reasons, many have a culture of discretion and secrecy, rather than of transparency and openness to public scrutiny.

One possible way to strengthen the rule-making process would be to use the Financial Stability Forum which represents central banks, finance ministries, and regulators, but to widen the countries represented in the forum and to vest it with formal authority to make rules.

A second requirement of a new architecture is robust monitoring of regulators and those they regulate. New global rules – once agreed upon – need to be implemented and obeyed in the face of well-organized and richly-resourced firms and groups who try to avoid this.

Robust monitoring requires “watching the watchdog” bodies such as have emerged in environmental regulation, sometimes financed by public grants or compulsory fees paid by firms. Voluntary private contributions to such a system are not inconceivable.

Indeed, the current crisis has shown that some healthy and responsibly-run banks have lost out as a confidence crisis engulfed the entire industry. These banks will want to rebuild reputation and legitimacy, including by demonstrating they are distinct from their less-reputable peers. A few large financial services firms have already announced that they support the establishment of an effective new regulatory system to level the playing field with competitors in other jurisdictions.

Such “watching the watchdog” bodies at the national level must be complemented by global supervisory agencies. A proposal made during the G20 Washington summit to establish international ‘supervisory colleges for all major cross-border financial institutions’ is a step in the right direction.

A third essential element of the new architecture is the creation of a special-function international judicial institution charged with assisting the enforcement of the new rules in banking and finance, adjudicating disputes, and offering uniform authoritative interpretations of the rules.

Such an institution would be made up of independent experts whose decisions would be subject to public scrutiny. This judicial body would be open to lawsuits by any affected individuals (much in the same way as the American chapter nine bankruptcy provisions permit filings by “parties in interest”) – without governments  acting as gatekeepers.

The problem here may be that affected individuals are willing but not able to sue for lack of resources. They thus will need public or private support. One model is the Advisory Centre on World Trade Organisation law.

Leading trading countries including Canada, Denmark, Finland, Ireland, Italy, the Netherlands, Norway, Sweden, Switzerland and the UK have funded the Advisory Centre which gives advice to developing countries on WTO law and assists them in bringing dispute settlement proceedings (including against those countries funding the centre).

It is clear now that an urgent need exists for a new architecture at the international level. This will not remedy all failings at the national level, but it could create powerful incentives for effective regulation within countries.


Originally published at the FT blog and reproduced here with the author’s permission.