Market Rules

New layers of complexity make international financial oversight more challenging every day

The financial crisis of 2007–08 gave everyone a crash course on how incredibly complicated the world of global finance has become. Financial products many people had never heard of were suddenly causing the entire system to teeter terrifyingly on the brink of -collapse.

The world survived that battering, although six years later many economies are still nursing their wounds and some remain too weak to get off the floor.

Why this is so and what can be done about it is the subject of Transnational Financial Regulation after the Crisis, a collection of essays by international political economy scholars, edited by McMaster University’s Tony Porter, that delves deep into the growing intricacy of financial markets and the equally complex system of trying to regulate them across borders. The question those contributors attempt to answer, with some limited success, is whether national and international regulators are doing enough to prevent another shock from threatening the stability of the global system.

Most of the book concerns itself with regulatory issues. But it is interesting to look briefly at an example of the scale of what the regulators have to deal with. A chapter by Eric Helleiner and Stefano Pagliari focuses on the tremendous growth in the over-the-counter market in derivatives.1 This is the kind of trading you can do from your home computer, without the use of an exchange or clearing house, as well as bank-to-bank trades or any trade done directly and without an intermediary. With the growth of the internet, this market has exploded. In 2008 the notional value of outstanding OTC derivatives contracts was estimated at $592 trillion (the total U.S. government budget for 2012, by comparison, was about $3.5 trillion). And yet, prior to the crisis six years ago, the OTC market was barely even considered from an international regulatory standpoint.

Helleiner and Pagliari provide several reasons for the recent expansion in the regulation of OTC derivative markets. For one, 2008 did away with the argument that direct buyer-seller interaction without any use of a clearing house or exchange should be free of regulatory oversight. The result has been strong political pressure in favour of regulation in both the United States and the European Union, where public officials have responded with collaborative efforts to prevent the routing of trades through different national jurisdictions in order to discourage regulatory arbitrage, the play-off of national regulations against each other in order to achieve maximum profits.

The sea change in how markets work largely reflects a broad historical trend, rather than the handiwork of any particular group or regime. Rapid development in technical and communications technology is the common denominator. In the world of global finance, data and complex financial derivative products can travel faster and farther, and human beings can interact over greater distances and with much more immediacy than ever before.

These innovations have now become entrenched in much of human reality, affecting our perceptions of distance and connectivity. Governance mechanisms have flattened; hierarchies have become networks; and identities are more often multiple and hybrid than singular and homogenous. And ever since capital started to become increasingly mobile, the impetus has been on regulators to play catch-up to ensure the stability of the system.

So Who Are the Regulators?

The oldest international financial organization in the world is the Bank for International Settlements in Switzerland. Set up in 1930 to handle reparation payments imposed on Germany at the end of World War One, it now acts as a bank for central banks and, more importantly, a place where central bankers and regulators can collaborate. In 1983, following several payment crises, the BIS created a supervisory committee to bring together central bank officials from eleven countries, including Luxembourg as an associate member, to establish rules for regulating and supervising banking activities, acknowledging that financial practices in one country could have effects on other jurisdictions.

As financial markets became bigger and increasingly complex and the extent of individual bank losses became greater, the committee, which later became known as the Basel Committee on Banking Supervision, created the 1998 Bank Capital Adequacy Accord. This was the first time that banks were obliged to set aside capital to safeguard themselves—and their clients—against potential losses in their risk-weighted assets. That accord was the basis for the updated Basel II accord, which started to be implemented after the 2008 crisis, and now the more updated Basel III accord. Tony Porter shows how complex transnational financial governance has become when he notes that while the Basel I agreement took up 30 pages, Basel II ran to 347, and Basel III is 600 pages longer than Basel II.

Under the umbrella of the BIS, there are also task forces to deal with terrorist financing and money laundering, as well as the Committee on Payment and Settlement Systems. And the G7 set up the Financial Stability Forum in 1999, now expanded to the G20 countries as the Financial Stability Board.

The 1998 capital adequacy rules were somewhat controversial in that they created a system that would allow those with the resources to put aside what is essentially the collateral necessary to participate in the largest markets in order to reap the benefits of participation in those markets. This does protect the system from collapse, which is to everybody’s benefit, but the structure may deny smaller, less wealthy market participants the opportunity to participate in the first place, except as participants in syndication arrangements.

Indeed, some would argue that in contrast to the international legal system, the mechanisms that have evolved over time to manage global financial operations give too much power to private actors and the most powerful states, and that these actors’ influence over the direction of international rule-making privileges the interests of those already possessing power and wealth.

New Layers Added to an Already Complicated System

If anything, regulation of the global financial system has grown more complicated since the 2008 crisis. Some of this has to do with the popularity of some newer financial instruments, such as OTC derivatives. But also new laws have been passed in some jurisdictions and new powers have been given to bodies that lack the clearly defined rules of the International Monetary Fund or the BIS.

The most significant U.S. regulatory reform to come out of the crisis is the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by the U.S. Congress in July 2010. As Kathryn Lavelle’s chapter points out, the Volcker rule, which is a -provision of the Dodd-Frank Act, is turning out to have significant transnational effects.

Simply put, the Volcker rule segregates trading activities from bank deposits in U.S. banks. The significance of the rule is that it separates the significant risk taking that investment banks undertake from the deposit-taking activities of commercial banks. The goal is to protect bank deposits, which are insured by deposit insurance, funded by taxpayers, and thus to minimize the effect on -taxpayer-backed deposits in the event of a crisis that necessitates a taxpayer-funded bailout.

Lavelle shows how the Volcker rule affects outsiders, such as Canadians. Every major Canadian bank has banking operations located in the United States, and the U.S. government holds a considerable amount of Canadian debt in the form of bonds. Implementation of the Volcker rule in the United States affects the price of Canadian debt, and the liquidity in the market for Canadian national debt in both Canadian and U.S. bond markets. Furthermore, Canadian banks with affiliates or branches in the United States can be prevented from purchasing Canadian federal or provincial government bonds for their own account. Canadian bankers and public officials have been vociferous in their objections to having their chartered institutions subject to U.S. laws, which affect market prices, spreads and liquidity.

On the regulatory side, the two newer transnational financial governance bodies that have risen to prominence in the wake of the global financial crisis are the G20, formed after the Asian financial crisis of the late 1990s, and the Financial Stability Board.

These two bodies are very different from international organizations that were pulled into the various crises since the Mexican peso crisis in the 1990s. Unlike the IMF and the BIS, which have clearly defined rules, processes and conventions, the G20 and the FSB have informal rules, procedures and relationships with national regulators and private actors. They also have very limited institutional memories. Interestingly, in the case of the FSB, its chair is none other than Bank of England governor Mark Carney, who continues to serve in his FSB role on a part-time basis.

The G20 is an entirely new manner of organization initially proposed by former Canadian prime minister Paul Martin, bringing together the finance ministers and central bankers of the 20 systemically most important economies. Responsible for about 85 percent of the world’s total economic activity, the very existence of the G20 demonstrates recognition by its members that the world needed a new type of organization, one dedicated to helping navigate the complexities of the global economy, and one that allows those responsible for economic and financial matters in the G20 members to have a forum for meeting and discussion.

Porter points out that the nature of these two bodies makes it difficult to evaluate or assess their performance in order to make them function better than they do. Their common fundamental goal is to prevent financial crises, but that raises a question: is the absence of crisis sufficient evidence that they are carrying their work out effectively and successfully? And should we be so quick to condemn these organizations if or when another country is wracked by financial crisis in the future? It does seems surprising that, in a world so wedded to performance assessment, no international mechanisms have been constructed to evaluate organizations such as the G20 or the FSB. Their informal nature and lack of actual staff networks makes it difficult to design traditional evaluation models for them. (There is, however, a research group at the University of Toronto headed by John Kirton, which tracks the implementation of the policy recommendations of the G20 and, thereby, the effectiveness of its member governments.)

We Don’t Want an International Lender of Last Resort

The proliferation of regulatory bodies has yet another cause, which is both fundamental and intractable: the world does not, and cannot have, an international lender of last resort. The presence of such a lender—an international fund that would provide liquidity in the case of a problem in the payments system due to the troubles of an institution that overextends itself, would create the risk of moral hazard. Moral hazard is the potential—indeed, the likelihood—of increased risk-prone behaviour in the presence of a body standing by to supply the liquidity in case of a problem in the flow of payments.

The world has moved far beyond debates of the 1990s centred on whether the IMF should step in as an international lender of last resort when sovereign countries experienced balance of payments issues. With the prevalence of the “too big to fail” phenomenon due to the interconnected nature of the global financial system, we may need to acknowledge that moral hazard is endemic to the system. This problem supports Porter’s central assertion that more complexity, not less, is integral to transnational financial regulation. In fact, complexity needs to be a defining characteristic of the system due to the fact that the system cannot—and should not—simplify toward an international lender of last resort.

Where Do We Go from Here?

The answer to the question of whether regulators are doing enough is an emphatic no. There is action—quite a bit of it, in fact—but more focus is needed on big picture risks and better coordinated strategies through a globally representative group such as the G20.

During a visit to Canada in 2012, Christine Lagarde, managing director of the IMF, referred to Canada as a leader when she talked about the “management of big picture risks, what we now call macroprudential policies” to manage system-wide risks related to the economic cycle, market structures and to individual institutions.

Macroprudential policy emerged in the aftermath of the Asian crisis in the 1990s as an approach to mitigating risk in the financial system. It arose out of the need that international economists saw to treat the financial system as a whole, interpreting risk as endogenous and systemic, rather than exogenous and due to individual (discrete) activities. The focus of macroprudential regulation, therefore, is on maintenance of the stability of the system as a whole, rather than on the soundness of individual institutions in it.

In his chapter on this subject, Andrew Baker refers to the emergence of a “macroprudential paradox.” The paradox is that macroprudential regulation is technocracy—rule by technical experts—yet technocracy is also the principal source of weakness in macroprudential regulation. Technocrats tend to become victims of their own technical thinking, creating a path dependence in regulatory thinking that could be dangerous as new threats may lie outside the vision or consciousness of the technocrats. Although technocracy rose to prominence after the 2008 crisis, and in spite of its reliability and stability, by its very nature it slows knowledge development: technocrats think in terms of their own specialized knowledge, producing a “conservative and incremental dynamic,” which in turn can stall policy and institutional development which, ironically, macroprudential regulation is designed to propel.

Much technical expertise is the result of private sector innovation in pursuit of greater profits. As a result, the regulators are put in the position of “catch up” as they are not the ones who devised the financial products in the first place. This means that effective governance needs to combine private sector expertise with public sector accountability. It means that effective governance needs to defend itself against thinking that becomes boxed in. The work of research institutions, academics and think tanks is absolutely vital for the generation of new thinking and fresh perspectives. The danger of thinking in silos is increasingly accepted as real, and real steps are being taken to guard against doing so by regulators. Mark Carney, for example, is restructuring the Bank of England, warning against working in silos and the danger of not recognizing threats outside one’s area of expertise.

The G20 needs to pave the way for its survival as a useful body beyond issuing bland recommendations for cooperation. At the last summit in St. Petersburg, G20 leaders directed their finance ministers to “develop further comprehensive growth strategies for presentation to the Brisbane Summit” next November. Really. In the absence of a crisis, the G20 process seems in danger of losing its credibility.

In a world of shifting power dynamics, what Canada—along with other G20 middle powers—needs is a G20 that fills a meaningful role forecasting and preventing crises, stepping in to manage crises that occur and fortifying the G20 network to make the best possible use of its informal nature to develop deeper understanding among member countries. G20 members should be thinking hard about how to enhance understanding of each other’s national financial systems, structures and regulatory frameworks.

While the G20 is not institutionalized, its existence offers opportunities for institutional learning. For example, a residency exchange program for junior central bank officials could have a deepening effect on working relationships between central bank economists in various regions.

Transnational Financial Regulation after the Crisis, while undoubtedly too dense for lay readers, is a first-rate contribution to both international political economy academic literature and to our understanding of the complexity and the urgency of crafting multifaceted regulatory mechanisms. The dreadful economic, social and political consequences of a financial system collapse cannot be overstated.

Sir Jon Cunliffe, deputy governor for financial stability at the Bank of England, summed up the regulators’ dilemma rather well in an interview he gave the Financial Times in March. The failure of agencies to work together effectively could undermine regulatory standards and trigger a fragmentation of global markets, he said. “If we don’t hang together, most assuredly, one way or another, we will hang separately.”


  1. A derivative financial instrument is the combination of two or more types of tradable financial products to create a new, unified one; for example, in a currency interest rate future, you are betting on both the price of the currency in the future and the interest rate it will earn at that time.