After months of emphasizing the need to coordinate a global regulatory response to the global financial crisis, the Administration has done an about-face. Instead of working in concert with international partners, the Administration now wants to enact reform unilaterally so as to “set the global agenda.” The supposed first-mover advantage would allow the U.S. to shape “a level playing field on terms that play to our strengths.” In reality, regulatory reform at the national level is unlikely to work because of the size and breadth of the institutions. And rather than stimulate international cooperation, unilateral action is likely to result in regulatory competition that ultimately disadvantages U.S. firms.
In the wake of the financial crisis, most policymakers spoke of the maddening “fragmentation” of the existing regulatory system. Secretary Geither blamed lax regulation on fragmented oversight that “invites corrosive competition in regulatory laxity.” President Obama lamented how fragmentation allowed “some companies to shop for the regulator of their choice.” New York Federal Reserve Bank (FRBNY) President Bill Dudley explained that “the financial system is simply too complex for siloed regulators to see the entire field of play.”
However, as each of these speakers made clear, the crisis-generating regulatory fragmentation was not limited to the multiplicity of agencies inside the U.S. In fact, President Obama pointed to the challenges posed by the regulatory “gaps that exist not just within but between nations.” Secretary Geithner called for nations to “coordinate regulation” so as to “prevent geographic regulatory arbitrage” caused by unprecedented capital mobility. NYFRB President Dudley probably thought he was stating the obvious when he explained that reform required “intensive work internationally to address a range of legal issues.”
Earlier this month, the Bank for International Settlements (BIS) released a must-read report for anyone who believes effective regulatory reform could be accomplished on a nation-by-nation basis. It explains that the “Lehman Brothers group consisted of 2,985 legal entities that operated in some 50 countries.” Lehman consisted of both “regulated and unregulated entities” organized in such a way that “a trade performed in one company could be booked in another.” Subsidiaries operated in jurisdictions like Switzerland, Japan, Singapore, Hong Kong, Germany, Luxembourg, Australia, the Netherlands and Bermuda, each of whose governments served as the “home” or “host” regulator to differing pieces of the business.
The fate of the individual subsidiaries was largely determined by “internal” capital market relationships that spanned the globe. The London prime brokerage failed spectacularly, creating unanticipated insolvency issues for regulators and clients whose assets and collateral went missing. At the same time, the New York-based broker-dealer was acquired rather uneventfully by Barclays. The client or counterparty may not even have recognized which of the units he or she was dealing with, as geography played little role in determining which of the 2,985 entities served as creditor or counterparty. Indeed, a U.S.-based fund manager trading through Lehman would have been more likely to deal with the London investment subsidiary than the New York broker dealer.
More than simply unworkable, a U.S. “first mover” approach is likely to be detrimental to U.S. interests. Over the past 50 years, U.S. economic growth has been driven by the value-added by the financial sector. Between 1952 and 2006, the financial sector’s total contribution to U.S. gross domestic product (GDP) increased from 5% of the nonfinancial sector’s value-added to 17%. Financial services are also one of the lone bright spots in international transactions data. In the fourth quarter of 2009, the U.S. ran a $36.5 billion trade surplus on services, driven by large increases in “business, professional, and technical services, insurance services, and financial services” provided by large, integrated banks and like institutions. Acting first invites large global institutions to shift economic, value-generating activities to foreign subsidiaries or allow foreign competitors to gain market share.
Expecting foreign governments to react to U.S. “leadership” with similar restrictions of their own belies experience. U.S. leadership on the “Volcker Rule” was met by unanimous European opposition. Not only were such restrictions viewed as ill-advised, European Union (EU) Finance Ministers explained that the Volcker Rule ran contrary to the founding principles of the “internal market.” Perhaps EU officials really were troubled on a deep philosophical level, but it would be foolish to think that the competitive interests of behemoths like Societe Generale, BNP Paribas, Deutsche Bank, Barclays, RBS, and the other enormous financial institutions across the continent (including non-EU headquartered Credit Suisse and UBS) played no role in their reaction.
The Obama Administration’s pivot to a full court press on unilateral financial regulation reform is inconsistent with past statements, ineffectual given the international breadth and complexity of large institutions, and likely to place U.S. firms at a competitive disadvantage. This current push is not only counterproductive, but entirely out of character for a President that campaigned on his eagerness to work cooperatively with international partners through multilateral institutions.