Paper on Intermational financial regulation

I am posting a short paper of mine summarizing recent financial reforms in the UK and Germany in the market for financial services (insurance, securities and banking). When I first started on work on this, I thought Germany would have gone much further than the UK, but it has not. The UK has adopted a single regulator model for the all of these services.

I: INTRODUCTION: While trade in goods and services across countries has exhibited robust expansion in recent years, cross-border flows of capital (including  foreign direct investment and portfolio capital) have grown much more rapidly. Illustrative figures for trends in growth in trade, capital flows and some other key measures of global integration (such as international tourist travel) can be found by examining figures reported by various United Nations agencies, such as the UNCTAD.[1]

Just as trade flows (in response to shifts in production and cost patterns occasioned by specialization) promote global (and in most cases, national) welfare, free capital movements are commonly believed to allocate the available fund of aggregate savings to their most productive uses and destinations. Unimpeded capital flows are not only “efficient” in an allocative sense in the short term, but may have a permanent and dynamic benefit as well. In times of domestic financial shortfalls, capital inflows or borrowing from abroad may permit smoothing of domestic consumption and external financing of needed domestic investment. Prudentially utilized, similar to any other form of leveraged investment, external finance can well pave the way to more rapid domestic growth than reliance on domestically-generated savings alone.

In the early euphoric days of the Reagan-Thatcher privatizations followed by the dissolution of the former Soviet Union in early 1991, both domestic and external account liberalization in rapid order was actively promoted by both academics and international organizations. Little attention was paid to the differing consequences of trade liberalization versus capital account or domestic financial sector liberalization until a series of financial crises in the closing years of the twentieth century.[2] Scholars have documented several instances of financial “meltdowns”, such as the Mexican peso crisis of 1994-95, the Asian “contagion” (which lead to precipitous declines in economic activity almost simultaneously in several southeastern Asian countries and the bond defaults in

Argentina

, and

Russia

among other nations.[3]

Not surprisingly, the international financial community, including governments, non-state actors and inter-governmental organizations retreated from their initial enthusiasm for early external financial sector liberalization. A new literature on prudential financial regulation and sequencing of reforms rapidly developed.[4] At the same time, a number of advisory standards proposing a new and more transparent international financial architecture were drawn up by several bodies, including the International Monetary Fund, OECD, IOSCO (International Organization of Securities Commissions).[5] A series of

Basle

Accords (including the latest revision in 2003) dealing with adequacy of capital reserves were promulgated under the auspices of the Bank for International Settlements (BIS).[6] None of these standards qualify as international treaties under public international law or even as an authoritative source of law, stricto sensu and are intended instead as models for international administrative cooperation. However, they have had an influential effect upon recent financial sector reforms across a wide spectrum of countries.

In what follows, I briefly discuss and compare recent legislative and administrative financial reforms in the

United Kingdom

and

Germany

in Section II. In Section III, I outline the debate and principal arguments concerning international financial regulatory competition versus cross-country harmonization of standards.

IIA: FINANICAL REFORMS IN THE

UNITED KINGDOM

: By the late 1980s, if  not earlier, the

United Kingdom

had dismantled the last vestiges of external capital controls. Over the next decade, rapid financial de-regulation in the US and other developed nations along with the technological and informational advances (in particular, electronic trading) led the British government to enact sweeping changes in financial regulation via the Financial Services and Market Act (FMSA) administered by a single unitary body, the Financial Services Authority(FSA).[7] The days of local self-regulation and crony capitalism in any form, were over in

Britain

, swept away by the winds of cross-border acquisitions and control by a non-UK institutions. Indeed by the year 2000, none of the leading banks in

UK

investment markets were home-owned.[8] Unlike the supervisory self-regulation authority still remaining in the

US

(and in fact, solidified recently to some extent, by the Sarbanes-Oxley legislation), the

London

Stock Exchange had already ceded most its supervisory role to international competitive forces such as alternative trading systems and market discipline. The unitary regulator scheme of the FMSA was intended to eliminate duplicative regulatory oversight common in the previous Balkanized financial regulatory structure and to promote transparency and investor confidence by replacing an uncertain and self-regulated regime by clear statutory guidance.[9]

By itself the FSMA is only a blueprint with the details of implementation to be filled in by the body over time with accumulated experience. In fact, preparations for the FSMA had been ongoing in

Britain

for some years earlier; the enabling statute was first proposed by the Labor government as early as May 1997. Unlike the predecessor statute, Financial Services Act of 1986, the current statute borrows liberally for its aspirational principles from the IMF Code of Good Transparency Principles, the IOSCO Objectives and Principles and the Basle Core Principles for Effective Banking Regulation.[10] 

As constituted, the FSA, much like the Securities and Exchange Commission in the

US

, combines legislative (rule-making), administrative and enforcement powers.[11] Enforcement actions are purely civil in nature, involving imposition of fines and may be imposed in case of a finding of “market abuse”. Market abuse is a term that is very broadly defined in the FSMA (straddling offenses commonly proscribed under the antitrust and securities laws of the

US

).[12] The test for market abuse is entirely based upon “effect” in the

UK

or its markets and there is no requirement for the FMA to prove intent or even recklessness in seeking civil penalties.[13]

Consistent with the unitary single regulator model, the reach of the FMSA, both with respect to activities and territory is very broad. Specifically, the FSMA applies to any “regulated” activity in the

UK

or having an effect upon

UK

financial markets. The requisite effect may be found even if the foreign-based activity is electronically accessible in the

UK

.[14] Regulated activities are defined by the British Treasury rather than the FMSA and include banking, securities regulation, as well as, insurance and re-insurance activities.[15]In sharp contrast, these activities are regulated by separate bodies in the US; in fact, national banking in the US is subject to oversight by at least three separate bodies and the US insurance industry is regulated at the level of the several states by the various State Insurance Commissioners. Financial entities with “passporting rights” under the EEA (European Economic Area) or the European Union under various single market directives are automatically deemed to be permitted to carry on the regulated activity in

UK

markets under home country mutual recognition principles.

The FMA is ultimately accountable to the British Treasury (and Parliament) with respect to its general activities and broad polices. Unlike the

US

model, the FSA is funded entirely by industry levies rather than the general exchequer. Routine administration including enforcement is almost fully committed to the sound discretion of the FSA similarly to some semi-autonomous administrative bodies in the

US

such as the FTC, FCC, the Federal Reserve and others.[16]

Finally and unlike the US in which judicial review is liberally available, FSA actions can in principle be challenged in the courts but early indications are that such review is likely to be extremely deferential. Initial review can be obtained by an administrative court (similar to an Article I court in the

US

), the Financial Services and Markets Tribunal. In particularly egregious cases, there is the possibility of challenge in the European Court of Human Rights under the Human Rights Act of 1998 (which implements the European Human Rights Convention in the

UK

). As of this writing, there appear to be no published cases under the FMSA that have been reported out of the European

Human Rights Court

.

IIB: FINANCIAL REFORMS IN GERMANY: Germany began its financial reforms somewhat earlier than the UK by successively enacting four acts in 1990, 1997, 1998 and 2002 respectively, but they have been more limited in scope.[17] In contrast to the

UK

and certain Scandinavian countries, the German reforms were administrative and organizational in nature and collapsed three regulatory bodies (dealing with banking, insurance and securities) into a single executive body, the Bundesanstalt für Finanzdienstleistungaufsicht (BaFin). The creation of the new executive body was not accompanied by substantive statutory reforms of the underlying separate frameworks governing banking, insurance and securities regulation.[18] In other words, Bafin merely administers the pre-existing regulatory regimes for these financial sectors and whatever benefits or efficiencies that result, will have to be derived from administrative re-organization rather that through creation of a single unified legal framework as in the

UK

.

The new executive body (BaFin) does have a separate legal personality but is subject to close and continuing oversight by the Federal Ministry of Finance and the Bundestag (through appropriate committees). In addition, it is required to cooperate closely with the Bundesbank (German Central Bank) regarding regulations and ordinances affecting adequacy of capital reserves of banks. Consistent with the strong cultural tradition of German constitutionalism and administrative powers, judicial oversight is far more limited than in common law countries such as the

UK

.[19]

Insurance against unforeseen losses has always been a feature of the German no-fault legal regime and it is not surprising that the insurance industry was the first to be regulated in

1901. In

addition, due to the fundamental importance of life and health insurance to the social welfare net, issuers offering life and health insurance are not permitted to offer other forms of insurance (such as legal malpractice insurance or flood insurance for example). This separation still remains and is intended to assure the adequate funding of insurance contracts.

Unlike the detailed supervision of insurance, German banking is principally concerned with the overall health of historically sound German banking system. Supervision of individual banks is not the primary goal of the Federal Banking Act and BaFin is under no obligation to apprise the public at large of its findings regarding solvency of individual banks.[20] 

Securities regulation has been the latecomer in

Germany

, particularly with respect to insider trading and manipulation of market operations through incomplete or misleading statements and rumors. In fact, it was not until 1994, that comprehensive legislation (the Securities Trading Act) regarding activities bourses and their participants was enacted. Further reforms were enacted in 1997, 1998 and 2002, tightening up market surveillance and extending the regulations to other financial products such as money market instruments and derivatives.[21]

Like the British FMA, the German agency BaFin does not have criminal enforcement powers which are left to public prosecutors. It may however, demand documents, conduct searches for documents of a concerned entity during business hours, levy fines and in extreme case, revoke licenses. As with other national authorities in the European Union, criminal prosecution of financial market participants can only be brought by public prosecutors for offenses committed in Germany or committed by German nationals abroad concerning securities that are traded in the EU or EEA.[22] However, the FSA has negotiated a number of bilateral agreements with various foreign securities commissions in several OECD countries, such as the SEC, to facilitate the exchange of information and cross-border cooperation.

In conclusion, while the German financial landscape has undergone sweeping change in the last decade, these have been only organizational in nature and have not involved the creation of a single unified legal regime as in the

UK

coupled with centralized administration.

III: COMPETITION OR HARMONIZATION: In this Section, I briefly discuss the arguments for or against increased regulatory competition for financial services. In the area of banking services and at least within the OECD countries, a significant degree of harmonization and convergence has taken place via the Basle Core Principles and the

Basle

Accords with respect to capital adequacy. There is however, no comparable harmonization of security or insurance regimes across developed countries. In particular, stock exchanges (and exchanges for other products such as futures, options or commodities) retain differing listing and other requirements and that differ widely across countries. Some authors such as Romano have argued that not only is harmonization of securities regimes undesirable on efficiency grounds, but in fact, increased regulatory competition in securities markets would be of positive benefit.[23] In part, this conclusion is derived from experience with state corporate charters in the

US

. Unlike the dire forebodings of many, state regulatory competition for corporate regimes in the several states of the

US

has not led to the feared “race to the bottom” at the expense of investors and ultimately, consumers. In fact, it may have provided the impetus to several states to raise their standards to “

Delaware

levels” (the leading state of incorporation in the

US

) in bids to attract corporate business.

Why might a global regulatory regime offering investors a choice of regimes be superior to a single regulator or a cartel model? Various arguments are commonly adduced. One suggestion is drawn from political economy and is based upon political accountability. While national regulators are not elected, they are appointed by elected officials in the executive branch and to that extent, may be responsive to the discipline of voters’ preferences. However, international regulators (or international lawmakers) do not stand for election (with the limited exception of EU Parliament delegates) and may be more apt to rent-seeking behavior because of “capture” by narrowly drawn interest groups.[24] Secondly, with the existence of regulatory competition, if firms and investors are able to choose the national regulatory regime they prefer, national regulators will be less likely to engage in wasteful wealth-transfer activities by favoring selected sectors or industries.[25] Next, regulatory competition is more likely to foster innovation and improvement because of the possibility of inter-jurisdictional flight of security issuers and capital.[26] All of these and other arguments too numerous to detail here may be expected to lower issuance costs for underwriters and hence, the cost of capital. In turn, lowered capital costs might be expected to stimulate investment and growth. Correspondingly, the establishment of a single, unified regulatory global or regional regime, if pursued, may not be a desirable objective. 

---

[1] In particular, see the HANDBOOK OF STATISTICS 2005 (UNCTAD

Geneva

,

Switzerland

), WORLD INVESTMENT REPORT (UNCTAD Various Issues) and TRADE AND DEVLOPMENT REPORT (UNCTAD Various Issues).

[2] Some writers repeatedly warned against undue enthusiasm for external capital account liberalization in advance of domestic financial “deepening” and reforms. See for example, Jagdish Bhagwati, The Capital Myth: The Difference Between Trade in Widgets and Dollars FOREIGN AFFAIRS (May/June 1998).

[3] The Mexican peso crisis occurred in 1994-95, coming shortly after the entry into force of the NAFTA accords. Imprudent government spending coupled with a lax banking system “connected lending” lead to a precipitous decline in external value of the peso as investors engaged in massive capital flight from

Mexico

. In part, the loss of dollar reserves was due to the dollar-denominated bonds issued  by the Mexican federal government to finance dubious expenditures and to cover mounting bank losses. See for example, GARY HUFBAUER et al, NAFTA REVISITED (Institute for International Economics,

Washington

DC

2005). The Asian flu refers to the virtually simultaneous financial collapses in

1997 in

Thailand

,

Malaysia

,

Indonesia

and

Korea

. For a non-technical summary of the Asian crisis, see The Asian Crisis: Causes and Cures, 35 Fin. & Dev. 2 (International Monetary Fund 1998). The Russian bond default on GKO foreign currency denominated bonds occurred in 1998 and contagion effects quickly spread to

Argentina

and

Brazil

. See John Merrick, Crisis Dynamics of Implied Default Recovery Ratios: Evidence from

Russia

and

Argentina

25 J. BANKING AND FIN. 1921 (2001).

[4] There is very considerable literature (both in development economics and in law and development) on the “sequencing” of reforms, with most mainstream economists (and legal policy makers) recommending trade or current account liberalization first, followed by domestic financial reform (including the domestic banking system) and only then, external capital account liberalization. Current account liberalization refers both to the reduction of tariffs, as well as, the elimination of restrictions on payments for current account transactions. Domestic financial reform includes elimination of “financial repression” (repressive regulations that inhibit free competition), “crony capitalism” (the practice of permitting or requiring state-influenced banks make loans of dubious quality to uncreditworthy cronies of government bureaucrats) and the maintenance of adequate capital reserves against outstanding loans. Capital account restrictions are those that implicitly or explicitly tax or limit outflows or inflows of capital and are not prohibited under the IMF Articles of Agreement. See IMF Articles of Agreement, Art. VI (3) (stating “Members may exercise such controls as are necessary to regulate international capital movements, but no member may exercise these controls in a manner which will restrict payments for current transactions.”).

Id.

Cross-border movements of short-term “speculative” capital can be especially de-stabilizing and can lead to the “twin crises” of currency and stock market collapse, accompanied by banking failures. More advanced treatments can be found in several sources including the following: Sequencing Financial Sector Reforms: Country Experiences and Issues (R. Barry Johnston & V. Sundarajan eds., 1999); Pierre-Richard Agenor & Peter Montiel, Development Macroeconomics (2d ed., Princeton Univ. Press 1999); Handbook of International Economics, VOL. III (Gene Grossman & Kenneth Rogoff eds., Elsevier Science 1997); Capital Flows and Emerging Economics: Theory, Evidence and Controversies (Sebastian Edwards ed., Univ. Chicago Press 2000); Preventing Currency Crises in Emerging Markets (Sebastian Edwards & Jeffrey Frankel eds., Univ. Chicago Press 2002).

[5] The IMF Code of Good Practices and Fiscal Transparency is at http://www.imf.org/external/np/fad/trans/code.htm. The OECD documents may be found at http://www.fatf-gafi.org/pages/0,2987,en_32250379_32235720_1_1_1_1_1,00.html, while the IOSCO principles may be found at the web site of the IOSCO at http://www.iosco.org/library/index.cfm?section=pubdocs.

[6] The various

Basle

Accords and Core Principles and related documents may be found at the main web site of the Bank for International Settlements. The comprehensive version of the

Basle

II Accords is at http://www.bis.org/publ/bcbs128.htm.

[7] Financial Services and Market Act of 2000 (effective December 2001). Even before the enactment or implementation of the FSMA, some supervisory functions such as regulation of banking had been transferred from the the Bank of

England

to the FSA in 1998.

[8] Ferran at note 1 supra.

[9] An important rationale for the unified regulatory model was the necessity of coping with the reality oversight over multi-service financial conglomerates. Financial innovation in derivatives and securitization of an ever-increasing array of financial instruments had come to mean that a single company might well be potentially subject to multiple regulators.

[10] See notes 5 and 6 supra. Some of the stated objectives in the FSMA relate to consumer protection, improving public accountability and to exposing wrongdoing. Notably, there is no reference to promotion of competition among financial institutions in the

UK

market. Some commentators find the absence of an explicit competition-promoting mandate (suitably nuanced with investor protection) in the FSMA to be an inherent weakness of the new legislation. See for example, E. Ferran and C. Goodhard (eds.), REGULATING FINANCIAL SERVICES AND MARKETS IN THE TWENTY FIRST CENTURY (

Oxford

University

Press 2001).

[11] Enforcement powers of the FMSA are specified in Part VII of the Act.

[12] Criminal prosecution of serious cases such as insider trading can be sought by the FSA by referral to prosecutors. See FMSA section 130.

[13] The definition of “market abuse” under the FSMA is contained in Section

118. A

reasonable but mistaken objective belief as to the lawfulness of the challenged action is a defense to civil liability. See Sections 123(2) and 118(5). Observe that the “standard of reasonableness” is necessarily an evolving one and persons/entities subject to the Act must continue to be diligent in monitoring evolving standards. 

[14] Although not specified in the statute or in any published decisions, it is reasonable to assume that electronic access in the

UK

alone without more, will require at least an interactive web site, as opposed to a passive and informational site.

[15] By contrast, merger and takeover activity in the

UK

is not within the purview of the FSMA and remain largely subject to self-regulation and only general oversight by the Takeover Panel. This is in sharp contrast to the supervisory authority of the Federal Trade Commission and the Department of Justice in the US, both of which have concurrent jurisdiction over mergers under the Clayton and Sherman Acts.

[16] Some semi-autonomous bodies in the

US

, such as the FTC, share both rule-making and enforcement authority with a plenary executive branch, for instance, the

US

Department of Justice. By contrast, the FSA does not share such authority with the Treasury.

[17] These are the respective Financial Market Promotion Acts. For further details see, Rainer Grote, The Liberalization of Financial Markets: The Regulatory Response in Germany in RAINER GROTE AND THILO MARAUHN (eds.), THE REGULATION OF INTERNATIONAL FINANCIAL MARKETS (Cambridge University Press, 2006). 

[18] The three regulatory regimes for these sectors are the Gezetz über Kreditweden (Banking Act), Gezetz über Versicherungaufsicht (Insurance Companies) and Wertpapierhandelgezetz (Securities Trading Act). Legal innovation in these regulatory regimes, to the extent that it has occurred, has taken place through periodic amendments to the existing separate laws.

[19] See for example, M. Singh, GERMAN ADMINISTRATIVE LAW IN COMMON LAW PERSPECTIVE (2d ed. Springer 2002). The German Constitution as interpreted by the

Federal Constitutional Court

assigns a plenary oversight role to the legislative branch rather than to the courts in determining all “essential questions” by statute. “Essential questions” include those that concern “fundamental rights”, encompassing not only human rights but also that are economic or financial in nature. Thus, regulatory changes that affect economic rights and related contractual obligations can easily fall within the category of fundamental rights. Readers with little familiarity of German law may consult JOACHIM ZEKOLL, INTRODUCTION TO GERMAN LAW (Kluwer 2005).

[20] Federal regulators in the

US

maintain a list of “problem banks”, but the identities of the latter are not disclosed for the obvious reason that such disclosure would only cause a run on the bank and further jeopardize its liquidity position.

[21] Some of the new securities regulation was included in the portions of the Financial Market Promotion Acts mentioned at note 17 supra.

[22] See the German Criminal Code, Section 7(2). The application of criminal jurisdiction over German nationals abroad is based upon the nationality principle. It is noteworthy that automatic criminal jurisdiction does not extend to German nationals committing securities offenses with respect to securities traded only in the US, for instance.

[23] See Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation 107 YALE L.J. 2359 (1998) and The Need for Competition in International Securities Regulation (Research Paper 258,

Yale

Law

School

, 2001).

[24] See Paul Stephan, The Futility of Uniformity and Harmonization in International Commercial Law 39 VA. J. INT’L. L 743 (1998).

[25] The regulatory regime in the

US

and of several countries such as the

UK

or

Germany

does not permit such an option. A

US

issuer cannot avoid SEC jurisdiction by listing stock say, on the

Frankfurt

bourse if such stock is subsequently purchased by US investors.

[26] An example, is the loss of substantial Swiss banking business in secret accounts to Luxembourg, the Grand Cayman Islands and other jurisdictions as Swiss banking secrecy laws began to be relaxed in response to heavy international pressure.