Will regulation redraw the international financial centre map?

The worst financial crisis since the 1930s has led to some of the most significant reviews of financial regulation in generations. The aim is to make financial institutions stronger and to contain systemic risk. Unsurprisingly, the most hard-hitting regulations have been introduced in the regions most affected by the crisis.

The US and the EU have been at the forefront of the regulatory reform, with the US enacting the Dodd-Frank Act and the EU implementing Basel III. In the US, the focus has been on over-the-counter (OTC) derivatives, while in Europe the primary concern has been the capital strength and leverage ratios of the region's banks. New rules have also been introduced in the insurance and asset management sectors in the form of Solvency 2 and the Alternative Investment Fund Managers Directive.

Squeezed out 

Few argue against the fact that the banking sector needs better regulation in the aftermath of the financial crisis, but there is widespread worry that going too far will cause unintended damage to the competitiveness of established financial centres.

London-based Laura Cox, a partner at PricewaterhouseCoopers, says: “One of the concerns we have is that making sure that London retains its competitive advantage compared to other centres is not included in the objectives of the Prudential Regulation Authority [which will take over part of the UK Financial Services Authority’s duties] or the Financial Conduct Authority. That could mean they will make decisions without taking into account whether London will remain on a level playing field with other jurisdictions.”

EU countries will be the first to adopt Basel III, and the introduction of the fourth Capital Requirements Directive will require banks to hold equity Tier 1 capital of 4.5% and total Tier 1 capital of 6%, compared to the 2% and 4% currently required, which will mean raising a combined total of about €460bn in extra capital by 2019. 

The UK is going a step further. The Independent Commission on Banking's recent Vickers report suggests equity capital requirements of 10% and the ring-fencing of retail banking from investment banking.

Pastures new

With the appeal of centres such as London or New York potentially diminished by more restrictive regulation, threats of banks and other financial institutions’ relocating have surfaced in the press. But how credible are such statements?

“For the world’s largest financial institutions it is not difficult to move their head office and change their place of incorporation,” says one professional. “But the implications and pressures on the local government and local regulators go up exponentially and become a big burden potentially.”

The size of banks relative to the economies of the countries in which they are based is a particular problem for some countries, such as Switzerland. The combined total assets of UBS and Credit Suisse – the country’s largest banks – represent more than 450% of the Swiss gross domestic product as of the end of 2010. The country's government now requires that the two lenders hold levels of Tier 1 capital of 19% of their risk-weighted assets.

There has been some movement into Switzerland, however, especially among asset managers. But this trend does not seem to have a significant impact on other European financial centres.

“Switzerland will continue to be an offshore centre for wealthy people but, in terms of people relocating there, it is predominantly a centre for people who want to keep their wealth rather than people who are making their way up,” says Barney Reynolds, partner at law firm Shearman & Sterling. “The asset management business has always been very mobile. It also follows fashions – Luxembourg attracted some movement in the past but still has limited traction. Ultimately the managers want to be close to the markets and other factors have to be extreme to overcome that imperative.”

Regulatory arbitrage

The regional disparity of the new regulations means that there may be some movement, as banks and other financial institutions look to carry out different operations in different regions, basing departments where regulations best suit that area of the business.

The US has traditionally been a large market for OTC derivatives, and the Dodd-Frank Act pays particular attention to OTC to force a large proportion of these contracts to be traded on exchanges and be centrally cleared. Meanwhile, other jurisdictions are either focusing on different issues – such as the capital requirements of Basel III – or are simply waiting before implementing their own regulations. This has left space for regulatory arbitrage.

For a New York-based trading business with an interest in, say, Brazil, it would make sense to carry out some OTC derivative trading operations from São Paulo while the country has yet to introduce any reforms in that space.

“There will be a transitional window during which there will be considerable opportunity for arbitrage between the US and Europe – which are implementing stringent reforms – and countries such as Brazil where a less restrictive regime will continue to apply for an interim period,” says Shearman & Sterling’s Mr Reynolds.

Keeping pace

The US is, of course, aware of this and is exercising mounting pressure on other jurisdictions to follow their lead, say experts. “The US has been critical of Europe and Asia, saying they are not going as fast with OTC regulation,” says Mark Penney, HSBC's head of capital management for global markets. “The danger for the US is that if it goes a lot faster than others, people may be more inclined to do OTC business outside of the US.”

In Europe, the review of the Markets in Financial Instruments Directive (MIFID 2) on dark liquidity pools, high-frequency trading and the classification of trading platforms is adding strain to trading operations. On top of this, traders are having to deal with significant decreases to their pay packets. “You can see [that] the pressure posed by heavier regulation, combined with issues of remuneration of traders, could mean that moving your trading operations to another jurisdiction becomes very attractive,” says Ms Cox. “In Asia, for example, you do not have those restrictions.”

Following the lead

The long-term effect on leading international financial centres is uncertain, however. The US and Europe are heavyweight markets, and carrying out any business that concerns them outside of their jurisdictions seems improbable. It is also likely that larger centres will use their influence to compel smaller jurisdictions to adopt new rules once they have been finalised, effectively ending regulatory arbitrage games.

“The world’s global powers are debating what the rules are and how they should be implemented, and once they’re finalised, there is going to be huge pressure on everybody else to copy them,” says Mr Reynolds. “There [are] clearly global business realignments taking place and in the short term there will be room for arbitrage between parts of the world applying the old-style rules and parts applying modernised regimes.”

However, Mr Reynolds adds that there is no evidence of such short-term regulatory anomalies shifting businesses between centres yet. “I have yet to meet someone who [has] said that you can do a credible amount of European business from outside Europe, for example from Singapore,” he says. “And likely regulatory changes to do with MiFID2 will make European business even more difficult to sustain outside Europe, regardless of the time zone issue.” 

New centres

Since the start of the financial crisis, it has been apparent that not even smaller financial centres were going to be spared by the collapse of certain financial products.

In the case of Dubai in the United Arab Emirates – the most successful example of a fast-growing international jurisdiction – the collapse of the real estate market put the growth of the emirate's economy on hold. Indeed, many emerging markets, which had been growing in the years preceding the financial crisis and establishing significant financial centres, were negatively affected during the market downturn.

It seems, however, that their ambitions are mounting again. In stark contrast to the world’s largest centres, where recovery is slow, even jurisdictions emerging from conflict – such as Iraq –are developing a financial infrastructure.

“During the past year, I have seen a lot of activity, some of it public, some of it not public,” says Ms Cox. “They are thinking ‘now is the time to start working again to build a financial centre’.”

Changing regulations in the world’s leading financial centres may temporarily shift some international business towards smaller jurisdictions, but a permanant shift can only occur if these developing centres offer fertile ground for innovation too. But in the current international climate this is hard to implement. “I do think that you will find smaller centres now being a bit more sophisticated about which businesses they might be able to win by the others making mistakes,” says Mr Penney.

“If you had an environment where people were happy to see new structures, new ideas on how businesses should work and imposed a little less heavy regulation, I think you would see new centres coming to the fore, though obviously not as big as London or New York. But the question is whether any of these new places are open for real innovation. I think there is a lot less openness to real innovation anywhere at the moment.”