High standards of governance will be essential to convince local investors to participate in the regional financial centres that are springing up around the world. And London looks set to benefit from business with those centres as they adopt EU-style regulations, writes Brandon Davies.
Worldwide, financial architecture is changing. The growth of new financial centres is universal (for example, Mumbai, Shanghai, Bahrain, Dubai) and many established centres are rapidly expanding the scope of their business, such as Singapore, Hong Kong and Tokyo.
The reasons for this are many but one dominates: the recycling of global imbalances is leading to a rapid growth in regional financial centres, be it the recycling of petrodollar surpluses through Bahrain and Dubai or the recycling of trade surpluses through Shanghai, Hong Kong, Singapore, Mumbai or Tokyo.
In several instances, the recycling of surpluses is also being supplemented by the growth in the roles of such centres as hubs for inward and outward investment in an increasingly global world. Increasingly, the traditional roles of New York and London as the dominant centres of financial liquidity are being supplemented by a growing number of regional centres of liquidity, which perform a role of recycling financial surpluses both into the local economy and into the international markets – in the latter case, primarily through New York and London, although increasingly London appears to be the bigger beneficiary.
The rise of the regional centres is in some ways surprising. In previous times when there were large petrodollar surpluses to be recycled, the recycling mainly took place directly through New York and London, the growth of the Eurodollar markets in London being a direct result. The reasons why this direct effect is not so great this time are both economic (there is a greater demand for direct investment in the economies generating the surpluses) and political (as well as some distrust of the US political system, there is a significant competitive element between countries that is leading to the establishment of these regional centres).
Global regulation
Whatever the reasons for the growth of such centres, the national authorities responsible for them almost universally recognise that their long-term success will in large measure be predicated on their convincing local investors that the institutions can reach high standards of governance and the authorities can create high standards of supervision – standards comparable to those exhibited by New York and London. It is here that change in the supervisory structure in London (the establishment of the UK financial regulator, the Financial Services Authority) and the rise of EU-wide regulatory legislation is handing a competitive advantage to the UK capital.
The new regional financial centres are looking to adopt EU-based regulation and a supervisory authority structure that closely resembles that of the UK or of other EU states.
Why this is the case is obvious. EU regulation – driven by the desire to create a single financial services market from 27 disparate ones – is new and, in large measure due to the need to be ‘fit for purpose’ in London, is risk based (where this is necessary) and recognises the important role played by innovative financial instruments (largely derivatives). It also addresses market and institutional governance and supervision issues as well as safeguarding the interests of market participants, be they professional institutions or private individuals. At the same time, the remaining 26 EU states have less (and in most cases far less) sophisticated financial markets than London.
In pulling off the trick of making its financial markets regulatory legislation as applicable in Riga as in London, the EU is doing a huge favour to the world, for here is a set of financial regulations that can be adopted ‘off the shelf’ (or with minimal change) that can suit any emerging market and that can demonstrably grow with the market to meet any level of sophistication to which it can aspire.
London’s advantages
The adoption of EU regulation by so many regional centres as well as by London produces an important result for London: the city becomes the obvious global centre to which such regional centres will look. London is easy to do business with because of the commonality of its regulation with the regional centres.
The standards themselves are:
- Basel II (the Capital Requirements Directive) – banking and financial services;
- International Financial Reporting Standards (IFRS) – accounting standards;
- Solvency II – insurance;
- Markets in Financial Instruments Directive (MiFID) – financial markets;
- UCITS 3 – collective investment schemes.
And it is highly likely that others will be added over time.
Policy implications
The message for London is that it needs to recognise more than it does today how important the rise of EU standards as global standards is to its current and future success. To be fair, London is far more engaged today in the development of EU regulation than it was a year or two ago, but both London and Brussels regard this mainly as an opportunity to grow a large and sophisticated domestic EU market and neither is as aware as they should be of the opportunity that the globalisation of this regulation is creating.
Such a realisation should improve the atmosphere of this engagement. In rightly fighting its corner for the freedom to allow markets and institutions to develop under the watchful eye of a sophisticated supervisory authority, there needs to be more recognition that the needs of less sophisticated markets and less experienced supervisors must be taken into account. It is in London’s interests to do this if it is to develop as a preferred supplier of global financial services to an ever-growing number of regional financial centres, as well as the dominant domestic EU financial market.
Watch out New York
The message for New York is that its success will increasingly require it to accept these global standards and politics (in the broadest sense). That should not be difficult because Basel II was largely the product of the inspiration of William J McDonough, chairman of the Federal Reserve Board of New York and subsequently chairman of the Basel Committee. Moreover, IFRS has much of its intellectual underpinning in US Generally Accepted Accounting Principles (US GAAP). The warning for the US, however, is that this is not about the Sarbanes-Oxley Act, which while something of an own goal (based mostly on over-zealous interpretation rather than stemming from the legislation itself) is in danger of becoming a diversion from the real issue.
The US regulatory structure is also highly idiosyncratic and will make the necessary reforms more difficult. The adoption and adaptation of Basel II is the most obvious example of the problems this can create. The recent (April 30, 2007) agreement between the US and the EU to “promote and seek to ensure conditions for US GAAP and IFRS to be recognised in both jurisdictions without the need for reconciliation by 2009 or possibly sooner” is a positive sign for New York that things can change, but possibly not sufficiently without significant reform of US regulatory structures in both banking and insurance.
Brandon Davies is managing director of GARP Risk Academy, an affiliate of the Global Association of Risk Professionals. He is a former deputy group treasurer of Barclays Bank.
