IIF: regulatory fragmentation ‘risks tearing markets apart’

What is happening?

Diverging interpretations of global standards and the focus on national regulatory initiatives are damaging global markets, according to the Institute of International Finance (IIF). It is calling for the G20 and the Financial Stability Board (FSB) to address these trends for fear they could result in even more damage.

The IIF argues that bank capital is being balkanised because national regulators insist that global lenders hold high levels of capital if operating in their jurisdictions. Additionally, they charge that liquidity is being drained as foreign institutions retreat from certain financial markets due to overwhelming regulatory regimes.

The institute fears these trends threaten to increase the cost and availability of capital to the real economy, which puts jobs at risk.

A recent IIF report identifies four specific areas of fragmentation. These are local supervisory measures and ring-fencing; diverging standards; extraterritoriality; and obstacles to cross-border co-operation and information sharing.

The UK has the strictest rules when it comes to ring-fencing retail deposit operations from investment banking, while France has unique laws separating trading activity from the banking business to protect depositors.

The US and EU also have their own particular requirements for dealing with foreign banks operating within their jurisdictions, which the IIF says do not reflect internationally agreed rules for resolving financial institutions.

One area where regulatory divergence is really having an impact is around total loss-absorbing capacity requirements. Differing national interpretations are piling up the costs for global banks.

Why is it happening?

Market fragmentation is not new, although it gathered momentum not long after the 2007-09 global financial crisis when some countries rushed to make their financial systems safer regardless of the cross-border consequences. However, with the crisis in the past, the political will to make international co-operation work has ebbed away.

Additionally, politicians have taken over from the technocrats, meaning that regulators, who generally favour international co-operation, are having to work within the boundaries set by their political masters.

What do the bankers say?

There is broad agreement among bankers regarding these concerns, and the industry wants to see them quickly addressed.

Compliance with a slew of different regulations – some of them purely national, such as the UK’s Senior Managers and Certification Regime – is making it increasingly expensive to operate across borders. The temptation is to simply retreat from some more marginal markets, which undermines competition and choice for consumers.

Aside from piling on costs, the need to have different systems to handle different local requirements also fragments a global bank’s reporting and monitoring systems, which increases the risk of potential threats going unnoticed until it is too late. In fact, it allows the siloed nature of banks to persist at a time when they need flatter corporate structures to adjust to the presence of new tech-driven competitors and to reduce their costs while increasing their flexibility.

Will it provide the incentives?  

Warnings from the likes of the IIF should carry some weight because they are influential bodies. However, one former regulator told The Banker that it is hard to see these organisations being able to foster global political consensus around resolving regulatory fragmentation. “That horse bolted some time ago,” he warned.

He added that the situation could lead to the FSB pressurising regulators at a national level to be more consistent in their interpretations and implementations of global standards, particularly the more technical aspects, within the bounds set by respective governments. 

EU authorities are increasingly centralising rule making and as such are steadily having more influence abroad: Asian and US financial institutions are being drawn into the EU’s Markets in Financial Instruments Directive II and the benchmarks directive.  

This could lead to clashes with the US, which has long practiced extraterritoriality, particularly around anti-money laundering rules. The risk is that these two big jurisdictions, maybe eventually challenged by some Asian up-and-comers, could clash in their attempts to impose their own regulatory views across the world.

Just one of them doing so is arguably beneficial as it creates a de facto global standard, but two or more at work leads to fragmentation.

This reflects the emerging multi-polar system centred around the US, the EU and China, with India expected to join the ranks of the great powers. However, those two Asian giants have yet to make much impact on global financial regulation and their interests and priorities might differ significantly from those of the US and EU once they become more active. Regulatory fragmentation is therefore likely to remain on the agenda for quite some time.