International Harmonization of Financial Regulation?

The Politics of Global Diffusion of the Basel Capital Accord

Hyoung-kyu Chey

• Publisher: Taylor & Francis
• Year: 2014
• Print ISBN: 9780415812429
• eBook ISBN: 9781134500949
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

It is often argued that international financial regulation has been substantially strengthened over the past decades through the international harmonization of financial regulation. There are, however, still frequent outbreaks of painful financial crises, including the recent 2008 global financial crisis. This raises doubts about the conventional claims of the strengthening of international financial regulation.

This book provides an in-depth political economy study of the adoptions in Japan, Korea and Taiwan of the 1988 Basel Capital Accord, the now so-called Basel I, which has been at the center of international banking regulation over the past three decades, highlighting the domestic politics surrounding it. The book illustrates that, despite banks' formal compliance with the Accord in these countries, their compliance was often cosmetic due to extensive regulatory forbearance that allowed their real capital soundness to weaken. Domestic politics thus ultimately determined national implementations of the Accord. This book provides its novel innovative study of the Accord through scores of interviews with bank regulators and analysis of various primary documents. It suggests that the actual effectiveness of international financial regulation relies ultimately on the domestic politics surrounding it. It implies as well that the past trend of international harmonization of financial regulation may be illusory, to at least some extent, in terms of its actual effectiveness.

This book may interest not only political economists but also scholars working on the intersection of law, economics and institutions.

1

Introduction

International harmonization and domestic politics in passive adopters

The world economic system as reconstructed after World War II deployed strong controls on cross-border capital movements as a primary means of achieving growth and stability. As time went by international financial flows began to increase, however, especially with the emergence of the eurodollar market in London in the 1960s and the collapse of the Bretton Woods system in the early 1970s. And since then international financial integration has accelerated dramatically. Cross-border financial flows have benefited the world economy in several ways. At the same time, however, they have also led to substantially higher instability in the global financial system. A series of severe financial crises have broken out, beginning with two great bank failures in 1974—of Germany’s Bankhaus Herstatt and the Franklin National Bank in the United States—and followed by the Latin American debt crisis of the 1980s, the 1994 Mexican peso crisis, the Asian financial crisis of 1997 and, most recently, the 2008 global financial crisis originating from the US subprime mortgage crisis in 2007. In response to financial globalization, governments have thus sought to strengthen prudential regulation, with the aim of fostering financial stability.

Remarkably, such efforts to strengthen financial regulation have proceeded in many areas through international regulatory harmonization, driven by the creation of so-called “international standards” or “international best practices,” rather than through pursuit by individual countries of their own distinct regulatory paths.¹ The beginning of this phenomenon was the establishment in 1988 of the Basel Capital Accord (the Basel Accord hereafter), now dubbed Basel I, by the Basel Committee on Banking Supervision (often simply called the Basel Committee), that set the rules governing capital adequacy at banks.² International standards creation spread thereafter into other sectors as well, expanding substantially after the 1997 Asian financial crisis in particular (see Walter 2008: 16–18). The Key Standards for Sound Financial Systems listed by the Financial Stability Board (FSB), a principal international financial standards setter, for example, currently cover 12 policy areas: banking supervision; securities regulation; insurance supervision; crisis resolution and deposit insurance; insolvency; corporate governance; accounting and auditing; payment, clearing and settlement; market integrity (money laundering and the financing of terrorism and proliferation); monetary and financial policy transparency; fiscal policy transparency; and data dissemination. International regulatory harmonization in the realm of finance has been one of the most significant trends in world economic governance over the past few decades, although the degrees of harmonization do vary across different financial sectors.³

This trend of international regulatory harmonization carries two notable implications for world economic governance in the present era of globalization. First, it effectively rejects the “race-to-the-bottom” thesis that the fierce competition generated by globalization of the world economy tends to lead to regulatory laxity across countries, since stringent regulation in a country reduces its international competitiveness.⁴ International regulatory harmonization has in contrast aimed generally at the strengthening of prudential regulations.⁵ This is clear counterevidence to the thesis, especially with finance being the area in which global integration has advanced the most.⁶

It should be noted, moreover, that a large number of countries have adopted “international standards” for financial regulation even despite having no formal obligations to do so. A majority of such international standards are what Drezner (2007) calls “club standards.” Most international standard-setting organizations—including the Basel Committee and the Financial Stability Forum (FSF), the predecessor of the FSB—have been “club organizations” with very restricted memberships dominated by developed countries, particularly the Group of Seven (G7) or the Group of Ten (G10), especially prior to the 2008 global financial crisis.⁷ Non-member countries of these organizations have typically been excluded from the processes of international standard establishment, and as a result had no formal obligations to follow them. Such standards are moreover in fact only so-called “soft law,” meaning that even the club member countries setting them are not legally bound to comply (Ho 2002: 650; Singer 2007: 9–10).⁸ A large number of non-club member countries nevertheless have adopted club standards, and international regulatory harmonization of this kind thus represents a new form of global economic governance.

A good number of students in international political economy (IPE) have devoted much analytical energy to explaining how such international regulatory harmonization has been able to emerge. This literature has two significant limitations, however. First, most studies tend to suppose, either implicitly or explicitly, that once a few great powers—particularly both the United States and the United Kingdom or, more broadly, the European Union (EU), the dominant states in the financial arena—have agreed on a certain regulatory standard, and have interest in its global expansion, then this will in fact be realized. In this regard, much research stresses the external pressures—either from the great powers that initiated the international standards or from the markets—as the main mechanism generating international regulatory harmonization. These arguments are in reality largely theoretical, however, without strong empirical evidence. Especially, there has been little systematic research on the process of international regulatory harmonization from the standpoint of passive adopters of international standards— countries, that is, which do not endogenously favor them. Passive adopters can be either “insiders,” i.e., members of the club creating the standards concerned, or non-club member country “outsiders.”

Second, most research on international regulatory harmonization tends to limit its analytic focus to the adoption of international standards or, even if going a bit further, to formal compliance with the explicit rules of international standards only. Such a narrow focus has difficulty however in linking analysis to the issue of international standard effectiveness, which is the fundamental point of international regulatory harmonization, and can overestimate such harmonization’s significance. In certain circumstances, the national regulatory authorities do adopt an international standard, but then manipulate its implementation in ways that help domestic actors to formally comply but in practice still defeat its objectives. In this situation, the country is in formal but also only cosmetic compliance with the standard. And where such cosmetic compliance is prevalent, international regulatory harmonization means little, as the regulatory regime thus cannot solve the problems it was established to solve. Passive adopters of international standards may have especially strong incentives for cosmetic compliance in their standard implementation. Notwithstanding this problem, their compliance with international standards has been to date vastly underexplored.

This study suggests that the extent of international regulatory harmonization in finance over the past decades may have been exaggerated. It does so by providing a deep analysis of compliance with the 1988 Basel Accord in the three passive Accord adopters of Japan, South Korea (hereafter Korea) and Taiwan. It demonstrates that compliance with the Accord in these countries was in fact largely cosmetic, and argues that even though external pressures—either from foreign states or from the markets—may induce formal standards compliance, they are likely to be much less effective in restricting cosmetic compliance. This research stresses the ability of national regulatory authorities to manipulate the implementation of international standards in their jurisdictions, and that the effectiveness of international regulatory harmonization toward a certain international standard is thus likely to be ultimately determined by the domestic politics in the countries adopting it.

The willingness and the capability of national regulatory authorities to substantively comply with international standards are accordingly critical to the actual effectiveness of international regulatory harmonization. Yet, even when the national regulatory authorities are willing to implement standards in earnest their implementation capacity and, in turn, the actual compliance outcomes, are affected by other domestic factors as well, and involuntary compliance failure can as a result sometimes arise. In particular, this study argues that cosmetic compliance is more likely to occur in three types of cases: when the government lacks the capacity to deal with formal compliance failures, when the costs of compliance are diffused from the regulatory target sector to other sectors that are politically influential and when the independence of the regulatory authority is low.

Politics of international regulatory harmonization

The IPE literature has presented diverse explanations for the great evolution of international regulatory harmonization in finance over the past decades, initially focused mainly on the banking sector—especially on the 1988 Basel Accord— but gradually encompassing broader areas such as securities, insurance, accounting, auditing, payment systems, money laundering, etc. These explanations can be grouped into four broad categories: centering around either the domestic politics, the interstate politics or the transnational politics involved, or the market-based perspective.⁹

Domestic politics perspective

Most of the studies adopting this perspective attempt to analyze why and when a certain state proposes an international regulatory standard by examining its domestic politics.¹⁰ In practice, the states that have initiated international standards have been dominant in international finance—especially, in most cases, the United States. The studies from this perspective accordingly pay greatest attention to the effects of domestic politics in these states on formation of their preferences toward international standards. In their analyses, these studies note the tradeoff inherent in the unilateral tightening of domestic financial regulation: an increase in domestic financial stability but a coincident decline in the competitiveness of domestic financial institutions vis-à-vis their foreign rivals. And it is argued in these studies that, given this situation, the national regulatory authorities have strong incentives for pushing international regulatory harmonization, which can allow them to increase domestic financial stability without damaging the international competitiveness of domestic financial institutions since the same regulations are then applied to foreign financial institutions as well. A good number of studies present the 1988 Basel Accord as one example here, arguing that the United States instigated creation of the Accord in order to strengthen US banking regulations without undermining the international competitiveness of US banks.¹¹

As to the main domestic actors that initiate international standards, however, there are notable variations in these studies. One group, including for example Oatley and Nabors (1998), focuses on the electoral incentives of politicians, particularly legislators. In this view, legislators are assumed to act to maximize their probabilities of reelection, and thus to act in response to pressures from both the public, which demands domestic financial stability, and domestic financial interests which demand protection of their international competitiveness. Legislators thus initiate international regulatory harmonization in attempts to satisfy both sides. Another group, exemplified by Singer (2004, 2007), in contrast emphasizes regulators as the primary actors driving international regulatory harmonization. Singer argues that regulators seek international standards only when the probability of legislative intervention in financial regulation increases, as a means of preventing such intervention and thereby maintaining their autonomy. The probability of this increases when the regulator is unable, through unilateral domestic regulation alone, to meet the legislators’ demand for both domestic financial stability and preservation of the international competitiveness of domestic financial institutions. The regulator is likely to turn to international regulatory harmonization in such a situation, as this will ensure a tightening of domestic regulations without hurting domestic financial interests.

Interstate politics perspective

The interstate politics perspective deals mainly with the question of how international regulatory standards are actually established after being proposed by dominant states, and explains this as due to the exercise of power by these states.¹² A dominant state exercises its power when foreign states resist cooperation and thereby cause it significant negative externalities.¹³ This perspective particularly highlights the financial market power of these dominant states—their structural power in the world economy, in other words, stemming from the international importance of their financial markets and institutions—and holds that they use their financial market power as a primary means of creating and promoting the international standards that they prefer. The concept of power or dominance in international finance is itself, in fact, defined based upon the relative sizes and efficiencies of countries’ financial markets. In practice, accordingly, it is generally perceived that there are only two dominant states in international finance—the United States and the United Kingdom, or more broadly the EU.

The financial market power of dominant states enhances international regulatory harmonization in ways favoring their preferred standards, since they are able to control foreign access to their important financial markets. For instance, Kapstein (1992, 1994), Simmons (2001), Singer (2007) and Oatley and Nabors (1998) attribute the agreement on the 1988 Basel Accord in the Basel Committee largely to threats from the United States—together with the United Kingdom—to close their markets to banks from noncooperative foreign states, arguing that these threats changed the set of regulatory choices available to the foreign states. Drezner (2007: 63) also interprets the global promotion of international financial standards by the FSF as having stemmed from cooperation between the United States and the EU. According to these arguments, insofar as they have strong financial market power dominant states have no need to put direct pressure on foreign states to cooperate.

The interstate politics approach does not of course neglect the possibility of more overt dominant state pressures on other states. According to Simmons (2001) this can be exerted either directly, or indirectly through international institutions, depending upon which method minimizes the costs to the dominant state. When the sources of negative externalities due to noncoordination are distinct, or if the externalities are divisible, dominant states are more likely to apply such pressures themselves. When the negative externalities have uncertain sources, however, or are not easily targeted, they are more likely to rely on international institutions as more efficient means of pressing for foreign regulatory changes. Simmons (2001) for instance notes how, to ensure international regulatory harmonization for anti-money laundering, the United States led the creation of the Financial Action Task Force, which exerted strong peer pressure on states to comply, and argues that its choice of this method owed to its difficulties in targeting the high negative externalities it was facing from weak foreign anti-money laundering regulations.

Within the interstate politics perspective we find two conflicting views on this exercise of power by the dominant states. One group of studies, such as Kapstein’s (1992, 1994) analysis of the 1988 Basel Accord, understand it as mutually beneficial leadership, with international financial stability seen as a public good providing joint gains. The other group in contrast highlights that international regulatory harmonization can sometimes be “internationally redistributional,” with transfers of income from other states to the dominant state that has led harmonization. Oatley and Nabors’ (1998) study of the Accord, for example, argues that its creation transferred wealth from foreign—in particular, Japanese—banks to US ones.¹⁴

Transnational politics perspective

The transnational politics perspective meanwhile emphasizes the roles of the increasingly dense transnational networks of actors in international regulatory harmonization, transcending the traditional division between the international and domestic spheres.¹⁵ One group of such studies addresses primarily the trans-governmental networks of technocratic public officials, particularly regulators. The domestic politics perspective also stresses the role of regulators in international regulatory harmonization, as discussed earlier, but in contrast to it the transnational politics approach emphasizes the autonomy of regulators from their own states, arguing that they form “epistemic communities” with common knowledge and shared norms and beliefs. This autonomy of regulators stems largely from the technical complexity of financial affairs. One example in this perspective is Kapstein’s 1989 study of the 1988 Basel Accord, which attributes the Accord’s creation partly to the formation among bank regulators of “consensual knowledge” of systemic risks in the international financial system.¹⁶

Other studies in this approach pay more attention however to transnational private actors—above all, large financial institutions and their associations— and t...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of illustrations
• Preface
• List of abbreviations
• 1. Introduction: international harmonization and domestic politics in passive adopters
• Part I: Harmonization
• Part II: Compliance
• Notes
• References
• Index