Regulating Capital

Setting Standards for the International Financial System

David Andrew Singer

• Publisher: Cornell University Press
• Year: 2015
• Print ISBN: 9780801445255
• eBook ISBN: 9781501702297
• Topic: Politics & International Relations
• Subtopic: International Relations
• Index: Politics & International Relations

Financial instability threatens the global economy. The volatility of capital movements across national borders has led many observers to argue for a reformed "global financial architecture," a body of consistent rules and institutions to prevent financial crises. Yet regulators have a decidedly mixed record in their attempts to create global standards for the financial system. David Andrew Singer seeks to explain the varying pressures on regulatory agencies to negotiate internationally acceptable rules and suggests that the variation is largely traceable to the different domestic political pressures faced by regulators. In Regulating Capital, Singer provides both a theory of the effects of domestic pressures on international regulation and a detailed analysis of regulators' attempts at international rulemaking in banking, securities, and insurance. Singer addresses the complexities of global finance in an accessible style, and he does not turn away from the more dramatic aspects of globalization; he makes clear the international implications of bank failures and stock-market crashes, the rise of derivatives, and the catastrophic financial losses caused by Hurricane Katrina and the events of September 11.

Chapter 1

Introduction: Financial Regulators and International Relations

Dramatic episodes of financial instability have become increasingly common in the global economy. Since the collapse of the Bretton Woods international monetary system in the early 1970s, the movement of capital has become both more international and more volatile. In the early 1980s the debt crisis in Latin America roiled the global economy and nearly brought down some of the world’s most venerable commercial banks. Later in the decade the “Black Monday” stock market crash in 1987 reverberated throughout the largest securities markets, from New York to London to Tokyo. More recently, speculative currency attacks on several Asian countries in 1997 led to wide-scale economic contraction throughout the region, along with fears of “contagious” crises in other countries. Even insurance markets are subject to cross-border influences. The September 11, 2001, terrorist attacks—which constituted one of the largest insured losses in history—created financial strain on insurers throughout the world, and their aftermath served as a reminder that insurance market instability can have a global reach.

Episodes of global financial instability lead inexorably to heated debates about rules and regulations. If the collapse of a financial institution in one country can lead to the sequential collapse of financial institutions in other countries, then should these institutions all be subject to the same regulations? Some scholars and policymakers believe the answer is a resounding yes, at least with regard to a set of minimum prudential standards.¹ However, there is no global financial regulator to set these standards. Financial markets have certainly become internationalized, but national regulators—such as the U.S. Federal Reserve and the Japanese Ministry of Finance—retain the ability to set the rules in their own jurisdictions. Therein is the preeminent tension in international finance: the interdependence of financial markets challenges the domestic locus of regulatory policymaking.² Global markets, it seems, require global regulation.

This is a book about global regulation in the three traditional pillars of finance: banking, securities, and insurance. Global regulation in these areas implies cooperation (or “harmonization”) among national regulatory agencies, generally within international forums such as the Basel Committee (for bank regulators), the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). The emphasis throughout the book is on capital at the level of industry and firms. Firm-level capital requirements—also known as capital adequacy—are at the foundation of the debates over international financial standards. To mitigate the possibility of a cross-border domino effect in financial instability, firms must hold enough capital to sustain themselves against outside shocks. Capital adequacy regulations, however, go to the heart of a financial institution’s operations and can affect profitability, foreign competitiveness, corporate strategy, and even survivability. Negotiations over capital adequacy, whether at the domestic or global level, are therefore invariably contentious.

This book focuses on the capital adequacy negotiations of regulators in the world’s most powerful financial centers in the 1980s and 1990s, namely, the United States, the United Kingdom, and Japan. Developments within the European Union are also addressed where appropriate. The choice to focus on these countries implicitly acknowledges the importance of market power in international regulatory harmonization.³ Clearly, the preferences of, say, Swedish financial regulators will be far less consequential than the preferences of regulators from larger markets. However, I emphasize throughout the book that power alone does not dictate national preferences. Indeed, regulators in the United States—representing the world’s largest financial market—have found themselves advocating international standards at certain times and opposing them at others.

I focus on two related puzzles. The first, high-level puzzle is that international regulatory standards have emerged in some financial industries and not in others. The most prominent regulatory standard is the 1988 Basel Accord, which established an international capital adequacy rule for the banking industry.⁴ Policy analysts often herald the Basel Accord as an exemplar for other industries, both within the financial realm and beyond.⁵ Political scientists and legal scholars note its importance as an international agreement between unelected bank regulators and therefore as a new form of global governance.⁶ Yet a similar agreement has not emerged in the securities industry—despite vigorous negotiations in the late 1980s and early 1990s—or in the insurance industry.

The second puzzle sits at the core of this project: why are certain regulatory agencies strong proponents of international standards whereas others are adamantly opposed? This puzzle captures the variation within each financial industry. During the Basel Accord negotiations, for example, the U.S. Federal Reserve and the Bank of England were the leading advocates of an international capital adequacy standard for banks whereas the Japanese Ministry of Finance (MOF) was a vocal opponent. A similar set of negotiations over capital standards for securities firms resulted in a different configuration of preferences, with the United Kingdom’s Securities and Investments Board the aggressive leader and the U.S. Securities and Exchange Commission and the MOF in the opposition. Finally, insurance regulators, with few exceptions, have yet to assert themselves as proponents of international standards. The two puzzles—variation in the emergence of standards across industries, and variation in the preferences of regulators toward international standards—cannot be examined in isolation. Indeed, a compelling explanation of outcomes across industries requires an explanation of the preferences of individual regulators.

Financial regulators in the developed world must maintain a precarious balance between the regulated industry’s stability and competitiveness. Costly regulations, such as firm capital requirements, may be necessary to prevent financial instability and to shield regulators from the scorn of elected leaders. However, in a global economy such costly regulations can prove inimical to the international competitiveness of the domestic industry.⁷ As a result of this tension, regulators must continuously adjust the stringency of their regulations—tightening with bouts of financial instability, loosening as foreign competitors gain market share—to maintain a politically acceptable balance.⁸ In most cases, the cycle of regulatory adjustment occurs quietly and unilaterally. However, when a regulator faces exogenous shocks to stability and competitiveness simultaneously, it is unable to adjust appropriately without asserting itself on the international stage. Through international regulatory harmonization, regulators can impose sufficiently stringent regulations on domestic financial institutions—and shore up stability—while relaxing the international competitive constraint that normally prohibits such costly tightening.⁹

A primary goal of this book is to analyze the rise of financial regulators as international actors. Indeed, regulators have been called the “new diplomats” because of their increasing visibility on the international scene.¹⁰ However, I part company with past observers by focusing on variation in regulators’ preferences for international harmonization. Just as the enormous body of scholarship on international relations has grappled to explain variation—in war and peace, alliance formation and dissolution, and state preferences over a variety of issues—so too should the emerging scholarship on transgovernmental relations focus on variation in regulators’ preferences and behavior across borders. The contemporary empirical record demonstrates substantial differences in regulators’ patterns of cooperation and discord. Negotiations within the Basel Committee, IOSCO, and IAIS provide ample evidence of variation in regulators’ desires to coordinate their policies. Clearly, not all regulators are at the vanguard of international cooperation; in fact, some are vehemently opposed to tying their hands with an international standard. And contrary to conventional power-politics arguments, U.S. regulators—representing the world’s largest financial markets—are not always eager to assert themselves (and their rules) on the world stage. The “new diplomats” are an irresolute bunch, and this fact has not yet received adequate attention in the field of political science.¹¹

Why do some regulators take the lead in establishing international regulatory standards while others adamantly resist? First, it is important to note that the creation of an international standard ties the hands of a regulator by limiting its ability to adjust to changing domestic (or international) circumstances. Given the importance of regulatory adjustment in avoiding political pressure and enhancing competitiveness, no regulator will voluntarily accede to an international standard without careful consideration of its domestic environment. I argue that regulatory agencies are more likely to press for international harmonization—and assert themselves as international actors—when they are in a precarious position domestically. When financial instability, such as firm collapses and asset market volatility, occurs alongside a rising competitive threat from foreign financial sectors, regulatory agencies face angry pressures from all sides. An attempt to tighten regulations domestically will simply augment the competitive position of foreign firms, yet doing nothing will render the domestic industry unstable and spark the indignation of consumers and politicians. The regulator’s weakness stems from the fact that it is not able to adjust to its environment unilaterally by modifying the stringency of its regulations. In short, preferences for international harmonization emerge only when a regulator is unable to balance stability and competitiveness with unilateral domestic regulation. A regulator under fire at home is more likely to emerge as an aggressive player on the international scene—and a strong advocate of international standards—than a regulator presiding over stable and competitive financial institutions.

International Regulatory Harmonization

There are several excellent country studies of domestic financial regulation in the global economy. For example, Steven Vogel and Henry Laurence, in separate books, chronicle and compare the regulatory changes in the United Kingdom and Japan brought about by the globalization of financial markets.¹² Vogel in particular notes that foreign competition created pressures to deregulate financial services but also led to counteracting pressures to “re-regulate” markets with new prudential regulations.¹³ Frances Rosenbluth also analyzes Japanese regulatory reform and argues that financial institutions themselves were the driving force behind domestic market liberalization. These prior studies underline a key theme of this book—the difficulties that regulators face in balancing competing interests in a global economy—but their purpose is not to address regulators’ international activities.¹⁴ This book could therefore be viewed as the international extension of the literature on financial regulatory policymaking in the developed world.

The literature on international regulatory harmonization in the global economy is dominated by studies of the Basel Accord, an agreement that established a global capital adequacy standard for internationally active banks (and the subject of chapter 4 of this book).¹⁵ Many scholars and industry representatives view the accord—established by bank regulators from the G -10 countries in 1988—as a public good that promotes global financial stability. Ethan Kapstein, for example, argues that regulators from the industrialized world developed a shared understanding of the risks of undercapitalized banks and created the accord to address a worldwide market failure in the wake of the less-developed country (LDC) debt crisis in the early 1980s.¹⁶ When applied beyond the specific case of banking regulation, Kapstein’s argument implies that regulators will seek international regulatory harmonization when they can realize joint gains from a global standard.¹⁷ This logic is pervasive not just in analyses of regulatory harmonization but in the study of international institutions more generally. Robert Keohane’s seminal study of international cooperation emphasized the functional purpose of international institutions, which enable countries to realize mutual benefits in an otherwise conflictual environment replete with information asymmetries, transaction costs, and enforcement problems.¹⁸ In short, the functionalist framework attributes the creation of an international institution to the underlying global need that it putatively addresses.¹⁹

From an analytical perspective, functionalist approaches are less successful in explaining variation in the emergence of international regulatory standards because nearly any standard—actual or proposed—can be justified on international functionalist grounds. More important, functionalist arguments are not helpful in explaining cross-national variation in regulators’ demands for international standards within a given industry. For example, some scholars believe that banks are especially vulnerable to systemic instability, with the ineluctable result being the creation of international prudential regulation. As demonstrated in chapter 4, however, such a functionalist view cannot explain the stark variation in preferences among the major powers for international standards within the banking sector.²⁰

Because of the widespread association of banking markets with systemic risk—the possibility of a cross-border contagious spread of losses across financial institutions with harmful effects on the real economy—scholars have overlooked cross-border risks in other financial markets, such as securities and insurance.²¹ In theory, systemic risk in banking may be especially severe, but this is not to say that such risk does not exist in other areas.²² Important episodes of systemic instability in banking, securities, and insurance demonstrate that they alone are not capable of explaining the resulting patterns of international regulatory cooperation or discord.

In the broader literature on cooperation, scholars such as Geoffrey Garrett and Stephen Krasner have added sophistication to the functionalist argument by acknowledging the distributional nature of most international institutions.²³ Even when we assume mutual gains from cooperation, there may be many ways of dividing up the benefits among the participants. This complication to the functionalist logic incorporates additional concepts such as ideas, beliefs, and focal points, which can guide politicians to agree on an acceptable distribution of welfare gains. Institutions, according to these arguments, still address global problems and enhance the welfare of all participants, but their distributive effects necessarily complicate any discussion of their origins.

Thomas Oatley and Robert Nabors have taken the distributional effects of institutions one step further, challenging the assumption of mutual gains and the functionalist logic of earlier scholarship.²⁴ They argue that international institutions may be “redistributive,” intentionally reducing the welfare of at least one participating country. Redistributive institutions are proposed by politicians who find themselves in the uncomfortable position of appeasing two opposing groups in the electorate. If voters demand the promulgation of policies that will hurt import-competing producer groups, politicians...

Table of contents

• Preface
• 1. Introduction: Financial Regulators and International Relations
• 2. Capital Regulation: A Brief Primer
• 3. Regulators, Legislatures, and Domestic Balancing
• 4. Banking: The Road to the Basel Accord
• 5. Securities: Financial Instability and Regulatory Divergence
• 6. Insurance: Domestic Fragmentation and Regulatory Divergence
• 7. Conclusion: The Future of International Regulatory Harmonization
• Notes
• References