Dr Scott James is a Senior Lecturer in Political Economy at King’s College London.
Following the 2008 financial crisis, there’s been a lot of pressure to enhance financial and banking regulations. How has this regulatory process played out over the last decade, and are the regulations in the public interest? How much power do banks and financial firms have over the regulatory process?
Since the crisis there has been a proliferation of new financial regulatory and supervisory reforms in the public interest – aimed at restoring financial stability and protecting taxpayers from future bank failures. This has included attempts to address ‘too-big-to-fail’ banks through new recovery and resolution regimes; structural reform in banking, including bans on proprietary trading and the ‘ringfencing’ of bank retail activities; the strengthening of micro-prudential supervision and new macroprudential powers to manage systemic risk; tougher regulation of the non-banking sector, including hedge funds and ‘shadow banking’; and efforts aimed at improving banking standards and culture, such as the use of bonus caps and criminal sanctions. Despite many of these initiatives originating at the international/EU levels, in order to promote greater harmonisation and prevent regulatory arbitrage, significant variation in regulatory standards continues to exist at the national level. This reflects the fact that the financial industry continues to exert significant influence in regulatory reform debates, but also that it has been more or less effective in resisting reform in different national contexts.
There has certainly been significant resistance to regulation and, more recently, the first signs of regulatory rollback. Yet this is shaped as much by political, as economic, imperatives. In the US, the debate about post-crisis financial regulation remains deeply polarised along partisan lines. President Trump has made his opposition clear to the Obama-era Dodd-Frank legislation adopted in the wake of the crisis, and has set about relaxing the Volcker Rule which prohibits banks from engaging in proprietary trading. The administration has also appointed a former bank lawyer as the new head of the main bank supervisory body, the FDIC — a move interpreted by some as indicative of a less rigorous approach to supervision. In Europe, by contrast, post-crisis regulation has been far less polarising in domestic politics, but different countries have pursued very different trajectories. At the height of the crisis, the UK took the lead in driving forward much more stringent regulatory approach to banking, given the financial stability implications of hosting one of the world’s largest financial centres. It remains a prominent champion of tougher capital and resolution rules as a solution to ‘too big to fail’. Yet other EU member states have significantly watered down proposals to implement higher capital requirements. In spite of several high-profile bank failures in France and Germany, defending the competitiveness of ‘national bank champions’ has often taken precedence over financial stability concerns. Who precisely is ‘capturing’ whom, in this context, is almost impossible to decipher. (See here for my recent article on post-crisis UK financial regulation).
What’s an example of “good” financial regulation? Empirically, what kinds of governance structures best constrain bad behavior?
In my view, ‘good’ financial regulation is clear, concise and simple to understand and implement. Efforts by UK and US policy makers to address moral hazard and ‘too big to fail’ banking provide contrasting examples of good and bad legislation respectively. Both have adopted stringent new legislation designed to separate higher-risk investment banking activities, which in theory should be permitted to fail, from retail banking, which is underpinned by an implicit state guarantee. In the UK, the newly-elected Coalition Government appointed an independent expert committee, chaired by the former Bank of England Chief Economist, Sir John Vickers, to make recommendations on bank structural reform and served to depoliciticise the issue. The committee’s recommendation, that retail banks be ‘ringfenced’ or operationally separable from other activities, and subject to higher capital requirements, therefore enjoyed broad cross-party support. It was also a relatively simple and robust solution to the so-called British dilemma of balancing the competitiveness of the City with domestic financial stability. By contrast, in the US the development of the Dodd-Frank legislation, and the design of the Volcker Rule that restricts US banks from making certain speculative investments, prohibits banks from trading, was a long and tortuous process fought between Democratic supporters and Republican opponents. The outcome, a staggeringly long piece of legislation running to over 2000 pages, presented a headache for regulators and left it vulnerable to political attack by opponents who sought to repeal the changes. (For more information on the UK banking reform process, see here.)
What are the implications of Brexit for the City of London?
Brexit potentially poses a profound challenge to the City of London. The UK financial sector has benefited greatly from financial services integration through the EU single market, allowing it to position itself as Europe’s leading global financial hub. Access by UK-based financial firms to the EU market is underpinned by lucrative ‘passporting rights’, enshrined in EU legislation and covering a vast swathe of financial services, from retail and investment banking to hedge funds and derivatives trading. Following the UK Government’s decision to withdraw from the single market, the EU has made it clear that UK firms cannot retain full passporting rights into the EU. This means that UK firms will have to establish (higher) capitalised subsidiaries in the EU27 to continue trading across the single market, rather than simply relying on smaller branches or cross-border trading.
Unsurprisingly, the majority of financial firms in the City – and, more importantly, the largest and most vocal (often US) banks – strongly supported EU membership in the run up to the referendum, and have actively lobbied for a ‘soft’ Brexit to preserve their passporting rights. When it became clear that this was not politically feasible, they shifted their position to push for a ‘bespoke agreement’ based on the mutual recognition of UK-EU financial regulations. Industry’s capacity to shape the Brexit negotiations has been fatally weakened, however, by internal divisions – around a third of firms, concentrated in the hedge fund and insurance sectors, are relaxed about Brexit or even openly supportive. Moreover, UK negotiators are severely constrained by the domestic political context (i.e. the ability of Eurosceptic MPs to force the government to pursue a hard Brexit) and the preferences of regulators (specifically, the Bank of England has effectively ruled out EEA membership by stating their opposition to becoming ‘rule takers’ in perpetuity).
Negotiations over financial services are now effectively stalled. But the widely anticipated outcome is a minimal financial services deal based on ‘enhanced equivalence’, whereby UK firms are forced to rely largely on the EU’s existing third country rules – which provide a much weaker and politically contingent basis – to access the EU single market. Recognising this, and prompted by UK regulators, City firms have drawn up detailed contingency plans for Brexit which anticipate relocating staff (precise numbers vary widely, depending on business models, between thousands to just tens of staff) to new EU27-based subsidiaries. (Further reading on Brexit and the City of London can be found here).
Let’s talk a little more about the future of financial regulation. With the rise of fintech and cryptocurrencies, how can we build a legal infrastructure that is just as agile as these technologies? Can the current regulatory regime handle rapid changes in a digitized world?
Recognising the opportunities that fintech provides for the City, particularly in a post-Brexit context, UK regulators have been pioneers in developing a progressive approach in recent years. This revolves around the regulatory ‘sandbox’ which allows firms to test innovative products, services and business models with customers in a ‘controlled environment’. In practice, these tests are conducted on a small scale, for a limited duration and with a limited number of customers. They serve the dual purpose of facilitating financial innovation by the private sector, while enabling regulators to identify and assess new potential sources of risk. In my view, this approach strikes me as a sensible and proportionate approach to both harnessing the potential and managing the challenges generated by fintech. But there are also potential causes for concern. First, many have heralded the so-called ‘co-production’ of fintech regulation as a positive development. But everything we know about finance tells us that this will constitute a particularly fertile environment for regulatory capture, underpinned by acute information asymmetries (owing to the genuinely new nature of products and services being developed) and increasing revolving doors (as regulators are enticed by the potentially lucrative returns that fintech offers). It is therefore imperative that sufficiently robust institutional structures, and adequate resources, are provided to insulate regulators from vested interests. Second, the sandbox approach adopts a micro level perspective focused on assessing risk primarily to customers. The danger is that this ignores the bigger macro picture – namely, how small decentralised fintech markets may pose a systemic risk to financial stability. Regulators are slowly waking up to this, but we are still a long way from finding an answer.