The global financial regulatory system: taking stock

International financial institutions were an innovation of the second quarter of the twentieth century. In particular, the Bank for International Settlements (BIS) was created in 1930 and the IMF was created in 1945. But international arrangements on financial regulatory matters remained minimal until the early 1970s. At that time, and in the context of incipient internationalisation of financial markets and financial turmoil in advanced economies, several new international bodies were created: notably the Euro-currency Standing Committee of the BIS (1971), now the Committee on the Global Financial System (CGFS); the International Accounting Standards Committee (1973), now the International Financial Reporting Standards Foundation (IFRS Foundation); the Inter-American Regional Association of securities regulatory authorities (1974), expanded in 1983 to become the International Organisation of Securities Commissions (IOSCO); the Committee on Banking Regulations and Supervisory Practices at the BIS (1974), now the Basel Committee on Banking Supervision (BCBS); and the Group of Six (1975), now the G7. More specialised bodies were created in the 1980s and 1990s, particularly in the wake of the 1997-98 Asian Financial Crisis. That crisis led to the emergence of the G20, which at that time (1999) was a group of finance ministers and central bank governors, and of the Financial Stability Forum (FSF), also in 1999.

Further change and strengthening came in the immediate aftermath of the financial panic of September-October 2008. In November 2008, the G20 held its first summit meeting of heads of state and government, in Washington DC, with an agenda that was dominated by financial regulatory issues (Rottier and Véron, 2010). The FSF was subsequently enlarged to include most major emerging economies and non-Western international financial centres, and was renamed the Financial Stability Board (FSB) in April 2009 at the G20’s second summit meeting in London. At the subsequent G20 summit, in Pittsburgh in September 2009, the US Treasury Secretary described the FSB and its constituent international financial bodies as a “fourth pillar” of the global economic architecture, complementing the IMF, the World Bank and the World Trade Organisation (WTO)2. The Washington, London and Pittsburgh meetings defined an ambitious and, at the global level, unprecedented agenda that has come to be referred to officially as “G20 financial regulatory reforms” (FSB, 2015b).

In this context, the global financial regulatory system can be defined as being formed by the FSB and its members that have a global (as opposed to national, or in the case of European institutions, regional) remit. In addition to the already mentioned BCBS, BIS, CGFS, IFRS Foundation3, IMF, IOSCO and World Bank, the system thus defined also includes the BIS’s Committee on Payments and Market Infrastructures (CPMI), the International Association of Insurance Supervisors (IAIS) and the Organisation for Economic Co-operation and Development (OECD). Additional relevant bodies, which are not formally members of the FSB but participate in the global system, include the Financial Action Task Force on Money Laundering (FATF), Global Legal Entity Identifier Foundation (GLEIF), the International Association of Deposit Insurers (IADI) and the International Forum of Independent Audit Regulators (IFIAR)4. As Table 1 illustrates, these bodies vary widely in terms of membership and mandate.

Table 1: The global financial regulatory system

Source: Bruegel based on institutions’ websites, consulted May 2016. See main text for the explanation of acronyms. Notes: a Jurisdictions include sub-sovereign entities (eg Guernsey, Hong Kong SAR, or US states and territories) and regional groupings (such as the European Union). b There is one member per jurisdiction at the BIS, IMF, World Bank and OECD. In other bodies, some jurisdictions have several members, such as the US Federal Reserve Board and Federal Reserve Bank of New York in the CGFS and CPMI. Global institutions such as the IMF and World Bank are members of bodies such as the FSB and IAIS, but are not counted as separate jurisdictions. c The IFRS Foundation is incorporated in the United States (Delaware), but its operations are almost entirely in London. d The IFRS Foundation and GLEIF are not organised across jurisdictional lines. e Only ordinary members. f The establishment of a permanent secretariat in Tokyo was announced by IFIAR in late April 2016, and is expected in 2017. NB The People’s Republic of China is a member of all jurisdiction-based bodies except IADI and IFIAR.

Eight years on from the Washington Summit, the G20 financial regulatory reforms can be judged as having mixed results. Assessing the success of financial reforms is always somewhat judgmental to start with, as there is no objective way (yet?) to measure financial stability. Furthermore, many of the reforms entail long transition periods and have thus not yet been fully implemented. There have been a number of successes (see also GAO, 2014; Véron, 2014). In particular, the BCBS’s Basel III accord of 2010, with new rules for capital, leverage and liquidity, and complementary reforms such as requirements for additional loss-absorbing capacity at large financial institutions designated by the FSB as Global Systemically Important Banks (G-SIBs; see FSB, 2015a), have significantly strengthened the prudential framework for large internationally active banks. The BCBS has also developed a pioneering framework to assess to what extent the laws and regulations adopted by individual jurisdictions are compliant with its standards, thus greatly enhancing its authoritativeness5.

Other reforms have had questionable impact, or have failed entirely. One failed reform was the global convergence of financial accounting standards, initially heralded by the G20 as an important objective but later quietly abandoned after several successive deadlines were missed6. The implementation of the G20’s ambitious reforms of over-the-counter (OTC) derivatives markets has been delayed in many jurisdictions, and it is therefore too early to assess its full impact. Specifically, the G20-fostered move towards more central clearing is leading to the concentration of systemic risk in derivatives central counterparties (CCPs) or clearing houses (eg Boissel et al, 2016), creating new forms of systemic risk which in turn call for policy responses still to come, and may also lead to initially unintended market fragmentation across currency areas. Separately, the reporting of OTC derivatives transactions to trade repositories is still far from fully delivering on its promise to help supervisors assess developments of relevance for financial stability (DTCC, 2015).

Perhaps unsurprisingly, the success or lack thereof of G20 financial regulatory reforms is strongly correlated with the strength of the corresponding global institutional framework (Rottier and Véron, 2010). In particular, the long-established cooperation between the world’s main central banks through the BIS and its various committees has generally resulted in decent effectiveness of reforms within their remit, such as Basel III. By contrast, cooperation between securities regulators is of a more ad-hoc nature, and IOSCO has generally found it difficult to agree on strong common standards and ensure their general adoption, as is illustrated by the G20’s failure on financial accounting standards convergence7. One of the reasons why the design and implementation of OTC derivatives reforms have been so lopsided is because there is an awkward overlap of responsibilities in this area between central banks with a financial stability mandate (represented in CPMI) and securities regulators with a market integrity mandate (represented in IOSCO). Some standards have been jointly issued by CPMI and IOSCO (eg Principles for Financial Market Infrastructures, first published in April 2012), but they have often been less specific and/or effective than global standards in other financial regulatory areas.

The global financial regulatory system retains North Atlantic characteristics

The panic of September-October 2008 led to a welcome shift of venue from the G7 to the G20 for the global coordination of economic and financial policy. This shift was echoed in early 2009 by the enlargement to major emerging economies and non-Western financial centres of the membership of the FSB (succeeding the FSF) and of several key BIS committees including the BCBS, CGFS and CPMI.

Nevertheless, the membership and governance of many of the bodies that form the global financial regulatory system remains deeply unbalanced. There is abundant analysis of this issue with respect to the IMF (eg Truman, 2015). Similar and sometimes even greater distortions exist in other bodies. For example, even after the 2009 enlargement, European Union (EU) member states, plus the EU itself, represent no fewer than 10 of the 28 jurisdictions represented in the BCBS. Of these, seven are euro-area countries whose representation in the Committee no longer appears justified, since the European Central Bank (ECB) has been in charge of setting supervisory policy for the entire euro area since November 2014, as part of the broader EU reform known as banking union8.

Similarly, Europeans are overrepresented in the FSB’s Steering Committee (FSB, 2015d), both among the member jurisdictions (especially those with more than one representative, and with similarly questionable inclusion of euro-area national central banks as noted above about the BCBS9) and among the global bodies, whose 10 representatives include 8 Europeans, one American, one Australian, and no Asian at all.10

The system’s North Atlantic bias is even more pronounced, indeed overwhelming, when looking at the bodies’ leaderships, as opposed to memberships. Table 2 illustrates this by listing all top positions in the bodies mentioned in Table 1, including the chairs of decision-making bodies (such as an executive board) and heads of permanent staff, where separate. The right-hand column does not require much comment.

Moreover, another distortion inherited from history is that, as Table 1 indicates, all these bodies are also headquartered and mainly based in the North Atlantic region (Basel, Paris, Madrid, London and Washington DC), with the only exception being IFIAR’s still-to-be-established secretariat in Tokyo11.

Thus, the global financial regulatory system retains a North Atlantic bias in its governance and operations that has only been very partly eroded by initiatives since 2007. A separate question, however, is whether this bias results in regulatory outcomes and decisions that are tilted in favour of North Atlantic interests. On this, the evidence is far from clear. While the G20 has regularly paid lip-service to the notion that regulatory outcomes need to be better tailored to the specificities of developing and emerging economies, this aspiration has mostly been rhetorical rather than practical. There is no clear case, for example, that Basel III is less beneficial to emerging economies than it is to the European Union or the United States. Moreover, there are also cases of successful advocacy by non-Western jurisdictions of special interests in global financial regulatory processes: examples include the exception made by the IASB for long-held shares from fair-value measurement in the IFRS 9 standard on financial instruments accounting, which was a Japanese request, and the exception made for large banks from emerging economies in the FSB’s term sheet for Total Loss-Absorbing Capacity (TLAC), a request made in particular by China (FSB, 2015c).

Table 2: Leadership positions in the global financial regulatory system

Source: Bruegel based on institutions’ websites, consulted July 2016. See main text for the explanation of acronyms. Notes: a GHOS: Group of Governors and Heads of Supervision. b Mr Adler heads the Hong Kong Securities & Finance Commission, but is a British citizen. c The head of IFIAR’s future permanent secretariat has not at the time of writing been appointed.

Even so, the extent of the system’s North Atlantic bias, more than seven years after the shift from G7 to G20, remains remarkable. There is no question that the willingness of incumbent participants, especially Europeans, to preserve a status quo that they perceive as beneficial to them is one of the reasons for this situation. But the lack of change is probably not attributable only to resistance from incumbents. Evidence is missing of any strong advocacy for rebalancing coming from the other stakeholders, especially large emerging economies, many of which – including often China – have acted as status-quo participants, in financial regulatory matters (Walter, 2010; He, 2015) and more generally on global governance reform (Swaine, 2016). Instead, the evidence rather points to China taking global financial regulatory standards ‘off the shelf’ for use as a lever for domestic financial reform (Kempthorne, 2015), similarly to what was often the case in the EU before the crisis, for example in its adoption of IFRS in the early 2000s (Véron, 2007).

The global financial regulatory system needs a Chinese dream

The state of affairs described in the previous section might be acceptable if the North Atlantic region was expected to dominate the global financial system for the foreseeable future. But this is no longer a valid assumption. The pace of financial development in China has been so rapid in the last few years that, on some indicators, the move of the global system’s centre of gravity towards China has already happened. For example, and as Table 3 illustrates, China is now the world’s largest single banking jurisdiction in terms of total assets, ahead of the euro area, a fact that few would have predicted only a decade ago. This is even more striking when keeping in mind that ‘shadow banking’ assets are mostly excluded from this calculation12.

Table 3: Banking systems in comparative perspective, end-2015

Banking system	Total assets (US$ trillion)	Domestic assets (US$ trillion)	Foreign assets (US$ trillion)
China	32.1	30.7	1.4
Euro area	31.6	25.9	5.7
United States	16.3	14.8	1.5

Source: Schoenmaker and Véron (2016). Calculations based on SNL data and ECB (2016b) for the euro area, China Banking Regulatory Commission (CBRC) for China, and Federal Reserve for the United States. Notes: total assets comprise consolidated assets of domestic banking groups and domestic assets of subsidiaries and branches of foreign banks. To calculate the size of the respective banking system (labelled as domestic assets), the foreign assets of domestic banks are deducted. The concentration ratio of the largest five banks (CR-5) is based on their domestic assets as percentage of total domestic assets.

China’s increasing heft in the global financial system is not limited to banking. The aggregate market capitalisation of its listed companies has become too large to ignore, as has the size of its corporate bond markets. Furthermore, China’s financial development should not be seen only from a quantitative standpoint. While capital allocation remains largely policy-driven, there have been significant moves towards more market discipline in recent years, including liberalisation of bank deposit rates and the more recent willingness of the authorities to tolerate corporate defaults even of state-owned companies. One also assumes that lessons from the massive government intervention in China’s equity markets around mid-2015 will lead to a more restrained future stance in this area as well, allowing equity prices to be increasingly driven by the interplay of supply and demand. It is also unlikely that the recent dramatic rise in indicators such as China’s share of global banking assets or of global market capitalisation could be entirely reversed by future adverse market developments. Even in a scenario of systemic crisis, the evidence from past experience suggests that total banking assets would stop growing but would remain broadly at their current high level over an extended period of time13.

Furthermore, China’s financial system will most likely become increasingly interconnected with the rest of the global financial system. Size is a major driver of this: even if the Chinese banking system is less open to cross-border activity than the systems of other jurisdictions (as also illustrated by Table 3), its sheer magnitude implies global systemic significance. Furthermore, Chinese banks are increasingly active outside mainland China, together with non-financial companies driven both by individual firm strategies and by policy projects such as the Belt and Road Initiative. Meanwhile, Chinese authorities are gradually lifting restrictions on international investors’ access to its domestic equity and bond markets, including the Shanghai-Hong Kong Stock Connect, started in 2014, and the forthcoming Shenzhen-Hong Kong Stock Connect. International financial integration is gradually linking China together with other countries like a financial ‘Grand Canal’ that interconnects different economies, fosters cross-border interdependencies and increases aggregate wealth, but can also be a channel for the propagation of shocks – very much as China’s own Grand Canal has linked its provinces together since ancient times14.

China is also, and increasingly, at the frontier of some aspects of contemporary financial development, ahead of North Atlantic jurisdictions. This is particularly the case for internet- and smartphone-enabled financial services business models (referred to in China as internet finance), several segments of which are more developed in China than in Europe or the United States. Internet finance, like cross-border financial integration, illustrates the reality that with financial development comes great wealth creation but also the possibility of increased financial disruption, including the risks of fraud, cybersecurity violations and uncontrolled herd behaviour in a market downturn.

For all these reasons, the current fairly peripheral (or at best, discreet) role of China in the global financial regulatory system is increasingly problematic. The system needs a guiding vision in which China becomes much more central – a ‘Chinese dream.’ The system’s (largely North Atlantic) protagonists should not count only on China’s initiatives aimed at increasing its own salience in global financial-services policy discussions, but should rather be proactive in introducing reforms that give China a position and responsibility commensurate with its present and predictable future importance. Not doing so will increasingly carry risks for all stakeholders involved, such as being caught unprepared by a globally relevant materialisation of risks that involve Chinese financial system participants among others. A foot-dragging approach, encapsulated in the Chinese expression yu guo ji jie gui (与国际接轨, ‘catching up with the world’ – see He, 2015), will not be sufficient to address this challenge. Front-loading the rise of China in global finance in the global financial regulatory infrastructure is evidently a challenging political proposition, for different reasons in Europe (collectively the most overrepresented incumbent), in the United States (given domestic political dynamics at the time of writing) and perhaps even in China itself. But there is little doubt that it would ultimately be in the best interest of the North Atlantic jurisdictions, as well as of China and of the rest of the world.

Making the dream come true

The vision of a global financial regulatory system in which China holds a major position can of course not be realised in one single step. It may entail at least three clusters of initiatives, to be developed and implemented over an extended period.

First, the relevant global bodies should reform themselves to increase the presence and prominence of Chinese participants in their operations, and specifically in their membership, leadership and location. As for membership, national central banks from the euro area, which in the aftermath of banking union no longer have significant policymaking autonomy, should renounce their individual representation in the Basel Committee for Banking Supervision and in the Financial Stability Board, thus freeing space for a more balanced discussion in a more compact format; conversely, the FSB should welcome the China Securities Regulatory Commission (CSRC) as an additional member organisation, perhaps together with the US Financial Deposit Insurance Corporation (FDIC); and China’s quota at the IMF should further increase beyond the implementation of the 2010 reform package15. As for leadership, relevant global financial regulatory bodies should promote qualified Chinese officials to succeed the current North Atlantic incumbents when their terms expire (see Table 2), and should actively nurture a growing cadre of Chinese professionals among their staff. As for location, further steps should be envisaged to rebalance the current landscape, including the relocation of the FSB’s permanent secretariat to a suitable jurisdiction in Asia, eg Hong Kong or Singapore (Véron, 2014).

Second, greater Chinese engagement is also needed. While observers often refer to the age-old precept of tao guang yang hui (韬光养晦, ‘hide brilliance, favour obscurity’), China’s authorities actually need to be more assertive in their participation in international financial regulatory bodies. This should include presenting suitable candidates for leadership positions, for the global system’s common good. The adoption by China of relevant global standards, including IFRS, should be completed, if not in full then with a much more limited number of exceptions and variations than is currently the case. China should also reform its public auditing policy framework to enable its participation in IFIAR and to allow effective professional cooperation with other jurisdictions’ audit oversight authorities. More generally, progress is needed on a range of issues involving the sharing or exchange of financial data, both in terms of the willingness of China and its international partners to give each other data access, and in terms of their respective abilities to guarantee each other that data that needs to remain confidential will stay so.

Greater Chinese engagement could help unlock reforms in key areas of the global financial regulatory agenda. For example, as mentioned above, the centralisation of derivatives clearing in CCPs is creating new types of systemic risks, but initiatives to oversee and manage these risks are hampered by special interests and turf considerations among North Atlantic financial authorities. Since China is exposed to these risks even as it does not have (yet) a significant derivatives market on its own, Chinese officials would be ideally placed to play a constructive ‘honest broker’ role to advance an effective reform agenda in this area (see also below). Similarly, China could push for steps towards international supervision of financial firms that are pure information intermediaries, such as credit rating agencies, trade repositories and audit firms. These do not carry a fiscal or quasi-fiscal risk in case of failure, unlike banks, and their public supervision can thus be entirely disconnected from matters of fiscal sovereignty16. Such a push would be in line with past suggestions by Chinese officials, eg the proposal made in 2010 by the head of China’s banking supervisor for dealing with systemically important international financial firms with “an international treaty which sets fundamental rules for information-sharing, equal treatment of stakeholders across jurisdictions and depositor protection” (Liu, 2010). Of course, China should simultaneously continue on its path of vigorous domestic financial reform to enhance market discipline in its financial system and more efficient capital allocation in its economy (Posen and Véron, 2015).

Introducing the Chinese presidency of the G20 in late 2015, President Xi Jinping wrote that “China will work with all other parties to pull in one direction in the spirit of win-win partnership. We should pool wisdom, form synergy (…) and jointly advance international economic cooperation” (Xi, 2015). Formulating and achieving a ‘Chinese dream’ for global financial regulation would be a prime application of these principles, involving the world’s major jurisdictions. As presented above, such an ambition would preserve the bulk of financial regulation and supervision under national sovereignty, bound by the international rule of law. But it would also require vision, courage and perseverance to put the global financial regulatory system on a sustainable path – one in which China plays a major role.

References

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