Effective Regulation - Part 2: Local Rules, Global Markets
The second installment in our series on effective regulation
A regulatory overhaul is essential
An overhaul of global financial regulation is essential if capital markets and the world economy are to recover from the current crisis. Regulatory reform is a complex topic that we discuss in a series of papers. This, the second, looks at the specific but important issue of where financial market activity takes place, and why this matters.
Capital is mobile, regulation is local
Capital is mobile and, as a result, financial market activities are inherently cross-border. But regulation is local, and the location in which financial market activities occur is critical. Regulatory choices have allowed some countries – notably the United Kingdom, Hong Kong and Singapore – to develop outsized capital markets. Different choices have limited others – notably Germany, Japan and to some extent the United States – to markets that are undersized relative to their economic weights.
Good regulatory systems attract activity
Good regulatory systems not only monitor and control financial activity, but also attract it. Hosting financial markets provides economic gains, but – just as importantly, if not more so – allows for better control of risk. If the controls enacted in the wake of the current crisis simply cause financial activity to move to less well regulated and well-supervised environments, then these controls will have failed. After all, if we have learned anything, it is that financial problems move across borders. Rules that force activity to flee often have the unfortunate effect of reducing oversight without reducing risk, leaving regulators to clean up a mess that originated elsewhere, often with limited ability to address the root problem directly. Containing risk to areas where regulation is best structured and applied is, therefore, the optimal long-term solution.
Markets value clarity and certainty, not laxity
We demonstrate that governments should focus on regulations that cause markets to function well, and avoid those that cause activity to flee. Key positives include transparency; legal clarity (especially regarding bankruptcy and financial counterparties); reliable accounting standards; and regulators with the desire to help markets succeed. In contrast, legal uncertainty, politically motivated regulators or courts, and harsh tax treatment tend to drive activity away. Laxity is not a competitive advantage, because financial transactions are two-sided, and both sides need to feel secure.