In my paper, The Political Economy of International Financial Regulation, forthcoming in the Indiana Law Journal, I examine the current system of international financial regulation (IFR) from a historical and political perspective. In contrast with conventional theories of IFR, which see the current system of informal regulatory networks and non-binding standards as overall rational and efficient, I argue that historical path dependence and political economy play a major role in shaping outcomes in IFR. As a result, it produces mixed results—while it adequately addresses some international regulatory challenges, it is relatively ineffective at others, and avoids some altogether. This state of affairs has several important implications; perhaps most worrisome, it raises doubts that IFR can live up to the G-20’s ambitious post-crisis promises to address the international dimensions of systemic risk and moral hazard.
As readers of this blog will no doubt appreciate, there are substantial difficulties involved in developing a general account of IFR. The field is deeply fragmented, as international standards address a broad range of issues: accounting and disclosure rules, fraud, capital adequacy, prudential supervision, and cross-border resolution, to name but a few. All of these areas present different challenges and outcomes vary substantially across them. This being said, one recurrent feature of IFR is its informality. Instead of legally binding treaty obligations and formal international organizations, IFR relies almost exclusively on non-binding standards developed by networks of national regulators, such as the Basel Committee, IOSCO and IAIS. This feature is striking in comparison with many other areas of international governance where more formal mechanisms loom larger, such as trade, investment and the environment.
For their part, scholars and policymakers disagree in their assessments of the current IFR system. A significant body of scholarship argues that it is a rational and efficient response to the unique challenges of regulating a fast-paced, globalized financial industry. In this view, networks and soft law provide effective cooperation while preserving the benefits of speed, flexibility and expertise. In light of the substantial regulatory failures revealed by the subprime crisis, however, skepticism has grown. Some commentators have even called for a World Financial Authority—a formal, treaty-based international organization to regulate finance. There is, however, a fundamental difficulty in this debate: since we lack a convincing account of the objectives of IFR, we also lack a benchmark to assess its current achievements and evaluate proposed reforms.
This observation provides the starting point for my analysis. Given that until recently financial regulation was seen as a domestic concern, I ask what is properly international about it. In other words, why is unilateral regulation by individual states suboptimal, so that they can achieve joint gains by cooperating? Are these gains in fact achieved? In response, I identify five such collective objectives and find that the current IFR system has been largely successful at two of them: facilitating basic cross-border supervision and enforcement assistance among regulators, and removing some barriers to international finance by harmonizing national rules, for instance in disclosure and accounting. In three other areas, however, IFR has performed poorly. First, it has encountered numerous setbacks in its attempts to raise regulatory standards in states where powerful domestic constituencies resist reforms, like OFCs and some of the countries targeted by the post-Asian crisis financial reform agenda. Second, it has struggled to secure durable collective action among major jurisdictions to raise prudential standards, like capital adequacy rules. Finally, it has largely failed to create credible collective mechanisms to address situations where unilateral action is counterproductive, like cross-border bank resolution.
In light of this uneven success, I turn to the question of why soft law and networks dominate IFR. The first part of my answer draws on historical path dependence— the idea that past institutional choices shape current options in ways that can produce inefficiency. In fact, the current IFR system has been profoundly shaped by history. The designers of the postwar Bretton Woods monetary system—principally John Maynard Keynes and Harry Dexter White—contemplated strict and permanent limitations on capital mobility and a marginal role for private international finance. Thus, the new postwar international economic order did not include any rules or institutions to regulate it alongside the new trade and monetary regimes. The Bretton Woods delegates even demanded that the one limited institution already in existence, the Bank for International Settlements, be abolished “at the earliest possible moment.” As a result, after the fixed exchange rate system collapsed in the 1970s, national regulators had to face financial globalization with the limited tools at their disposal: informal networks and non-binding standards. This approach remains, for better or worse, the cornerstone of IFR.
The second part of my answer draws on political economy by examining how the interests of political actors shape IFR. It argues that the growth of informal IFR has empowered three categories of actors: regulatory agencies, the financial industry, and great power governments. It shows that each can exercise considerable influence to advance and protect its interests. Looking across the major areas of IFR mentioned above, it finds that the current system accommodates the regulators’ desire to preserve their extensive domestic authority and discretion, the industry’s desire to achieve some harmonization without incurring costly new prudential regulations, and the great powers’ preference for fragmented international governance over strong collective institutions. In brief, the argument emphasizes the extent to which principal-agent problems, interest group politics and international power relationships may actually shape outcomes in IFR, in contrast with the conventional account’s view of the current system as rationally designed to achieve collective public objectives.
In the last section, I examine some of the post-crisis reforms in IFR, including the new role of the G-20 and FSB. I conclude that despite important substantive advances in some areas like capital adequacy, several pre-crisis patterns persist. Since the paper emphasizes the historical and political constraints under which IFR operates, its goal is not to argue for radical reform. Instead, I argue that change is likely to happen slowly and incrementally in response to specific failures and crises. To be more effective, however, reforms should take into account the substantial structural limitations of the current system. The paper concludes by making recommendations to that effect.
The full paper is available for download here.