In November 2008, China, India, and Brazil moved from waiting in the corridor outside as world powers met to being invited inside.¹ This broadening legitimacy of the world’s steering committee, from the G-7 to the G-20, is right and to be commended. It is not without difficulty. The shift in influence is to a group of countries that share little other than economic power. They have diverse experiences, challenges, cultural perspectives and starting points. This is particularly apparent in the field of financial regulation. Reflecting this, the developments in financial regulation across these countries since the Global Financial Crisis (GFC)—despite the triumphalist language of global regulation—is increasingly local. The prospect of the new global being quite local has dismayed “internationalists.” It need not. This chapter challenges the traditional dichotomy of more global vs. more local. It argues that financial internationalism—greater cooperation by nations for the benefit of all—is better served by institutions that help to integrate diverse systems than by those that try to enforce the one-size-fits-all approach to countries as different as Austria and Zambia.

Champions of global regulation often portray the banks, or at least think of them, as being opposed to it. However, the big global banks were the ones to persuade regulators of the benefits of global rules. They argued that global rules, to be applied by a single home-country regulator across banks’ international operations, were necessary for a level playing field. They knew that the benefits of global regulation would largely accrue to them as opposed to smaller national banks. They could better afford expensive regulatory requirements and were able meet them by passing a proportionally small amount of capital between branches and subsidiaries in different countries. One of the downsides of this is that big banks then proved to be an avenue for worldwide contagion during the crash. Local regulation may be a safer way to regulate a system of connected, national financial systems for a host of reasons we shall shortly discuss. That said it is likely that a shift back to “host” from “home” country regulation will also act as a drag on international capital flows.² Economists consider that a bad thing, but it may be less bad than more frequent international financial crises.

National regulation by the host country, as opposed to global regulation by home country regulators, does not preclude a role for international institutions such as the Financial Stability Board (FSB). Rather, it suggests a more nuanced role. It potentially encompasses the policing of international market infrastructure, financial protectionism, information free-flow between regulators, the convergence of regulatory principles and a consolidation of regulatory instruments. Experience has taught me that an informed and collegiate process of integrating different financial systems will produce a more resilient system than one that tries to enforce a single rule book across inherently dissimilar countries.

From G-7 to G-20 and the FSB

New global-governance arrangements were forged in the white heat of the GFC. Following the G-20 leaders’ conference in November 2008 and April 2009 and the creation of its mirror image in regulation, the FSB, the locus of international economic governance, appeared to have slipped naturally from G-7 to G-20.³ A narrow assessment of the origins and displacement of the crisis would not automatically have suggested such a development. The brunt of the financial part of the financial crisis was confined to the United States and Europe, that is, the core of G-7 rather than the expanded G-20. India and China felt the after-shock of the GFC, but their banking systems were largely untouched and their economies quick to recover. Meanwhile the G-7 recoveries failed to respond to massive fiscal injections until three or four years later.

The conspiracy yarn holds that the crisis was too big for the “old” powers to afford. They needed the “new” powers to “bail” them out either through imports or financing. Buying that bailout by distributing seats at the summit of global powers was the solution and locking America’s creditors into it’s recovery plan made a less painful recovery possible for America.⁴ This is in contrast to the “cock-up” theory that suggests President Bush was unaware that the G-20 was a group of central bank and finance officials when he asked G-20 political leaders to meet him in Washington in November 2008.⁵ Human evolution was driven by random mutations so maybe in the evolution of international governance we can accommodate an element of arbitrariness.

Although many iissues emerged from the tangled web of the GFC that demanded an international response, the geography of these issues did not coincide with the G-20 countries.⁶ The logic of the G-20 requires a perspective beyond the financial crisis. There was the earlier food crisis, the energy crises, and the specter of substantial global imbalances between the United States and commodity producers and manufacturers such as Germany, China, Russia, Saudi Arabia, and Brazil. Of this group of countries with the surpluses that could ease the adjustment, only Germany was a member of the G-7. Its surpluses were mainly within the EU and were (wrongly) considered to be lacking in wider significance.⁷

Whatever the actual reasoning, G-20 leaders met in November 2008. They signed up to common commitments and communiqués and repeated the refrain that global problems necessitated global responses. Later they established the Financial Stability Board (FSB) to oversee new global rules on financial regulation.⁸ Unquestionably the numbers and words of global governance have been transformed. But is this a change of substance and for the better? Is financial regulation under the 60-member FSB going to be markedly different than the more exclusive Basel Committee of the 1990s? Regulators from the bigger emerging-market economies already had greater influence at the expanded Basel Committee prior to the FSB’s establishment. The real changes afoot in global organization of regulation need to be ascertained and assessed to determine if they will lead to better or worse outcomes.

Stretching the span of global governance from its north westerly corner is every internationalist’s dream but in financial regulation the process has quickly hit an unexpected hurdle. G-7 was narrowly homogenous; G-20 is wildly heterogeneous. Global leaders now cover a more diverse group of countries, economies, financial systems and cultures with broader perspectives. The instinct of G-7 leaders was that a single regulatory prayer book is possible. What was right for them was right for everyone. G-20 leaders such as India, Brazil, and Russia do not share this uniformity. Agreeing a common approach to regulation, much less a common set of rules will be challenging—especially given the politicization of national and international financial regulation.

Moreover, national electorates are less willing to accept a process determined beyond their borders. On any given day, a finance minister at an international forum is likely to preach that finance is a global industry in need of global regulation. Back home the local press will hear the same minister militate against any foreign entity muscling in on the regulation of their banks. For most G-20 leaders, the new global approach they queued up to sign was not about being one of twenty voices developing a single set of rules. The unspoken, underlying hope was for global recognition and acceptance of their own sensible, domestic regulation. The Wall Street Reform and Consumer Protection Act (Dodd-Frank) of 2010, the UK Financial Services (Banking Reform) Act 2013 or the provisions on banker’s pay in the 2014 Fourth European Capital Requirements Directive⁹ make no concession to the needs of India, Brazil, and Russia. To even suggest that the pilots of these initiatives ought to take these expanded viewpoints into consideration would raise eyebrows and prompt smirks. Across a wide set of issues such as financial regulation, bankers’ pay, bank taxes and competition policy, national regulators are taking different paths from their international colleagues. These differences, while appearing subtle and nuanced are often quite fundamental.

Different Perspectives

In the United States, faith in the goodness and wisdom of free markets remains powerful. The prevailing view among policy makers and academics is that the real problem was institutional. Banks had become too big to fail. Had they been smaller, failure would not have necessitated huge taxpayer bailouts. In the words of the mid-Atlantic Governor of the Bank of England, Professor Mervyn King, if “a bank is too big to fail, it is too big.¹⁰” Too big to fail, or TBTF as it has become known in the United States, is at the core of Dodd-Frank and other post-crisis US policy initiatives. The thinking is that banks grew too big because they were able to convince regulators that big is beautiful.¹¹ In response, the recent focus of bipartisan regulatory initiatives from the US Congress has been to curb the size of financial institutions, curtail their activities, and improve winding-up rules.¹² Large banks (and insurance companies)—the so-called 30-odd Globally Systemically Important Institutions (G-SIFIs)—face additional capital-adequacy requirements in the order of an extra 2 percent of risk-weighted assets. The oft-mentioned “Volcker rule,” named after the report chaired by former Chairman of the Federal Reserve Paul Volcker,¹³ is a much distilled, modern, version of the Glass-Steagall Act that tries to re-assign riskier trading activities away from deposit and loan-issuance institutions.¹⁴ In Chapter 9 we discussed other proposals to ban derivative instruments not traded on exchanges or not centrally cleared or settled. In a pro-market vein, US policy makers want to be make market institutions more robust. They have not come to bury the previous system, with its emphasis on the judgment of markets, but rather to save it.

Ironically, as a ratio of bank assets to home-country tax revenues, the truly big banks are in Europe, not the United States. The assets of Bank of America, the largest US bank, represent 50 percent of national tax revenues. The assets of UBS or Fortis are many times home-country tax revenues. The assets of Barclays, not even the UK’s largest bank, are well over 200 percent of UK tax revenues. In Europe, the belief in market solutions, always a tad fragile, has been dealt a body blow. The prevailing view is that there should be tighter, more centralized rule-based regulation and a focus on correcting market failures with its tendency to boom and bust.¹⁵

The notion of countercyclical capital charges has its greatest proponents in Europe’s universities and Finance Ministries. Ironically they most often cite a long serving, US Fed Chairman from another era, William Martin, who said that the central banker’s job was to take “away the punch bowl when the party is getting good.”¹⁶ At the heart of the notion of countercyclical capital charges is that crashes happen because the markets have got it wrong.¹⁷ Similarly, Europe is concerned about banning market speculation regarding economically sensitive products such as commodities and banning the short selling of bank stocks and government bonds. The European approach at its most gentle is to reform the market and at its most brutal is to switch off the market in certain areas. It is no surprise that this perspective has given birth to pressure for an EU-wide financial transactions tax¹⁸—a proposal we discuss in Chapter 12 and of which boom-era American regulators would have dismissed as self-evidently wrong.

Asia is a more diverse region. If there is a prevailing postcrisis conscensus, it is that too much tinkering with existing regulation would be a mistake. Many jurisdictions had only recently introduced Basel II before the GFC. Consequently, this region lays blame for the crisis squarely with lax US and European supervision and less with faulty regulation.

It would be erroneous to suggest that these fundamentally different regional perspectives do not also have some important points of convergence.¹⁹ There is widespread agreement among the world’s regulators that leverage, the ratio of a bank’s loans to its own capital, was too high. Remember that one of the few banking regimes not to collapse was the Canadian system where a leverage ratio was comprehensively applied. A cap in the leverage ratio of assets to capital of between 20 and 30 times now enjoys global consensus. Initiatives to strengthen market plumbing such as centralized clearing and settlement also have cross-regional support.²⁰

But divergences persist. Given the size of its banks, Europe will remain reluctant to take on the US emphasis on too big to fail. America will resist adoption of countercyclical capital charges, as this would be a case of regulators second-guessing the market. The “Asians” will, for their part, be resistant to changes to Basel II after the painstaking process of adopting the previous rules.

A New Internationalism

Many of these regional differences occur behind the scenes in the arcane world of technical advisors and regulators. Some differences have also surfaced in the politically charged area of bankers’ pay and competition policy. Despite a stronger convergence of belief, principle, and intention than exists elsewhere, US, British, and continental European politicians still decided to go their own way in creating limits to bankers’ pay and bonuses.²¹ Pay and competition may seem to be marginal issues compared to the importance attached by some to an international agreement on minimum capital adequacy. Yet as we argue in Chapters 9 and 11, these micro incentives are critical influences on macro behavior. All of this is indicative of an increasingly national approach to regulation. The surface veneer is of global agreement and action but beneath there is a palpable shift toward more nationally derived decisions. This is reflected in the important debate over whether the lead regulator of an international bank should be its “home” or “host” country regulator in each jurisdiction.

In the pre-crisis years, the locus of regulation had shifted to the home-country regulator following global rules. More national decision-making would arrest this ten-year trend and herald a return to the host-country regulator being in the driving seat and following national rules. This scenario causes “internationalists” dismay. However, it is time we see this issue through prisms other than traditional ones of level playing fields, banks arbitraging local regulators or a race to the bottom in standards. In the sections that follow, we also look at the role of regulatory capture in the prominence of home-country regulation. It is my contention that a better goal of internationalism would be to foster institutions that help with the integration of diversity rather than impose an inappropriate one-size-fits-all solution.

Home vs. Host: Why Home?

When the concept of home-country regulation is raised, the usual initial response from both bankers and regulators is along the lines that banking is global, so banking regulation must be global. But this is poetry not prose. Many industries with systemically important supply chains like food, copper and oil are global but they are not globally regulated.

When the mantra of global banking needs global regulation is unpacked, one of the arguments employed is that the alternative would be a backward step, one that forced banks to “subsidiarize”, that is, to set up separately in each country with separate capital and assets. This we are told would reduce capital flows. Capital-short countries will starve and capital-rich ones will overheat. Investment will be constrained by national savings. It is also suggested, in modest contradiction to the viewpoint above, that it will lead to regulatory arbitrage. Capital would begin flowing to those jurisdictions with permissive regulations and away from those with tighter rules. Some fear the national route will “Balkanize” banking supervision with no one assessing the overall risk of a bank. Further, host-country regulations are often perceived as excusing financial protectionism. Countries clinging to host-country regulation such as China, India and Russia tend to have limited local penetration by international banks. Some have even whispered that it is in everyone’s interest to have J. P. Morgan’s activities in a small, developing country regulated by sophisticated and knowing (sic) New York regulators rather than where regulatory capacity is more limited.

The Experience of Home-Country Regulation

There are several examples where the local banking system is dominated by international banks whose behavior is primarily regulated by the headquarters country rather than the host. Baltic and Eastern European banking is largely regulated by foreign regulators in Sweden, Austria and Switzerland. Australian regulators are the lead regulator for institutions dominating New Zealand’s banking system as well as that of some Pacific Island states. Canadian regulators play a similar role for banks that dominate the sector in parts of the Caribbean.

At first glance, the arguments in favor of home over host-country regulation are persuasive. They certainly succeeded in persuading regulators prior to the GFC. Back then countries like India were considered outdated outliers for their resistance to home-country regulation. However, the recent crisis shed a new light on the workings of home-country regulation. Having a common minimum capital-adequacy requirement across countries at different stages of the boom or bust cycle creates perverse pressure on capital flows. In boom countries, capital-adequacy levels are low relative to the apparent profit opportunities. Increasing lending appears more profitable when it should appear more risky. For countries in recession, a common international capital-adequacy requirement makes lending unprofitable relative to other countries. There is less lending even though it is likely to be safer in the long run because valuations of bank collateral are depressed or undervalued. Most lending mistakes are made in the boom. Single and fixed capital-adequacy requirements are procyclical.²²

Who is best placed to recognize and respond when excessive lending is chasing a boom—home or host country regulators? I would argue it is the host country regulator. Assume Swiss banks are financing a property bubble in Hungary. Is it better for the Swiss or the Hungarian regulator to ascertain what the right amount of aggregate lending should be in Hungary? Bear in mind that the size of lending to Hungary by our archetypical Swiss bank may be important to Hungary but less so for the Swiss bank.

Different regulations across countries or regions could create the conditions for regulatory arbitrage but this is not really a home-host issue. It is actually about de facto control and enforcement. If all lending and borrowing activity within the country is done by nationally regulated entities, then excessive lending or borrowing will be controlled by the local regulator, It does not matter if this is driven by regulatory arbitrage, profit, or opportunities. Could regulators really stop cross-border lending and borrowing? Bankers and home-country regulators portray an image that finance is immune from the laws of gravity and all else and cite the GFC as evidence. In reality much of the problem with bank behaviour prior to the GFC was that regulations were followed to the letter rather than the spirit of the law. We know today that local legislation can be potent. For example, US regulators have been able to impose heavy fines on international banks headquartered outside the US borders when they tried to circumvent US sanctions using branches in non-US jurisdictions.²³ However, if any activities took place outside nationally regulated entities, contracts could be made unenforceable. In our earlier example, however potentially lucrative, no Swiss lender would assist a Hungarian borrower if the borrower could set aside her obligations at will through Hungarian courts.

One of the unintended consequences of home-country regulation is what might be termed “regulatory arbitrage” by regulators. When Lehman Brothers was on the verge of going bust, the US-based investment bank, watched over by its home-country regulator, pulled its capital back home. This left its foreign branches and subsidiaries considerably short of capital. Host regulators in the UK responded with calls for the national ring-fencing of capital and assets. There are mechanisms to achieve this, including international bank branches becoming nationally regulated subsidiaries. Regulatory approved “living wills” can also be imposed which dictate what happens to capital in the case of a terminally ill institution.²⁴

Far from being concerned about foreign overreach undermining a home bank, it appears that national regulators acted as global champions for the institutions in their jurisdictions as a whole. Iceland is frequently cited in this regard and with good reason. But the most enthusiastic champion must be the UK. UK regulators practiced “light touch” application of global rules and shouted it from the rooftops hoping to attract more overseas business. London’s role as one of the world’s preeminent financial centers owes much to its ability to lure businesses away from other centers with the prospect of lighter regulation or taxation and often both. Examples include the migration from New York to London of international bond trading in the 1970s and hedge funds in the 1990s.

When the GFC erupted, many commentators concluded that international finance was “unfettered.” While significant gaps existed, the paradox is that finance was heavily regulated and a significant experiment in global regulation. It was not the quantity of regulation that was lacking but its nature and organization. Home-country organization failed. The return to greater host-country regulation is the lesson of the GFC for while “banks may be global in life[,] they are national in death.”²⁵ The bailouts have cost taxpayers billions nationally and trillions globally. Perhaps an even-bigger cost is that domestic policy, social agendas and welfare narratives have been completely derailed. Public deficits have risen to unprecedented levels and public debt levels have doubled. Given they bear the cost, national taxpayers do not want regulation in foreign hands. As long as the bailouts are national, they will insist regulation is similarly national.

Regulatory Capture

Given the logic of host-country regulation the question is why did regulators move to home-country regulation. The benefits to big banks are clear. Setting up local subsidiaries with locally ring-fenced capital and assets is considerably more expensive and inefficient than having a single regulator with single reporting, accounting and capital adequacy rules. The single regulator would be able to move capital around the branches to wherever it is most needed. Large international banks campaigned for home-country regulation and, within the context of liberalization and globalization, were able to persuade Basel regulators of its merits.²⁶ It was those same countries utilizing home-country regulation that were largely responsible for the spread of trouble during the early phase of the GFC. India, Brazil, Russia, and other emerging markets, with their largely host-country regulation, continuously criticized, and viewed as backward, were largely untouched by the first waves of financial contagion.

It might seem logical that host-country regulation, with different capital-adequacy regimes and ring-fenced capital, would lead to a sharp curtailment of global capital flows. The height of globalization and global capital flows coincided with the lowering of regulatory borders and the aspiration of level playing fields. It would be natural to assume that cross-border capital flows would decline in response to a rise in these regulatory boundaries. However, one of the essential problems in international finance is that international capital flows only seem to come in two speeds: too fast or too slow. Neither is good. Host-country regulation may conceivably lead to more moderate and sustainable flows.

Additionally, the Chinese and Indian “economic growth model,” appears to be a successful one for economic growth.²⁷ Their trade barriers have fallen more rapidly than capital barriers, and their capital flows are not primarily international banking flows, but FDI or private equity. Economists are far less certain of the benefits of the free movement of capital than they are of the free movement of goods and services.²⁸ This may be a big country narrative. A drying up of international liquidity will present significant challenges for smaller countries less able to rely on local savings. Smaller countries could well make different choices than India, China or other large states. They may want more rapid convergence of their regulatory regime with others to promote greater bilateral capital and banking flows. Hong Kong has benefitted from being a financial satellite orbiting China. Mauritius plays a similar role for India and Singapore acts as a financial satellite of both giants. Luxembourg is Europe’s financial satelite. Small, open economies will make different choices on exchange rate and trade regimes from large economies. It would not be surprising if they also make different choices regarding capital regimes.

The New Internationalism and the FSB

Adopting host-country regulation does not signify an end to global cooperation and coordination. Varying levels of intensity of global coordination are possible across diverse areas. The FSB can play a number of critical roles, many of which are easier than the task the original Basel Committee of bank supervisors and regulators set themselves. What follows are four such roles of increasing intensity.²⁹

1. Facilitating the free flow of information to support the national monitoring of internationally systemic developments and assisting regulators everywhere to observe dangerous international trends between seemingly innocuous national activities. In this regard, the FSB would be acting more like a broader International Organization of Security Regulators (IOSCO), than the Basel Committee of Bank Supervisors.
2. Policing financial protectionismthrough peer review. The FSB, with its broader legitimacy, could facilitate peer review of host-country regulation to ensure that national regulation does not discriminate against financial institutions based on national origin as opposed to activity. This function could be a specialised version of the work of the WTO. Macroprudential rules could be used to limit systemically dangerous lending as opposed to discriminatory capital controls.
3. Regulating the infrastructure of markets whose reach goes beyond national boundaries, such as those in commodity, foreign exchange and derivatives. The London Metal Exchange (LME) and Chicago Mercantile Exchange (CME) are examples of markets regulated domestically but are global in scale. Wherever domestic consumer protection or local systemic risk is not the major concern, it is sensible that domestic regulators yield the regulation (and regulatory costs) of these markets to the FSB. This could include the regulation of global benchmarks like LIBOR, credit ratings and other non-bank institutions critical to the functioning of global markets such as centralized clearing and settlement houses. Because these institutions can be located anywhere physically there is a temptation to locate them where regulation is lightest.³⁰ Even when this is not the case, having global markets regulated locally creates a social externality, as local regulators are incentivized to underinvest in global stability if that investment is being made in national “tax dollars.”
4. Promoting a convergenceof principles and a consolidation of instruments that are controlled locally while fostering a transparency and predictability in regulation that supports greater cross-border activity, entry and market competition. The risk of a return to host-country regulation is that regulation becomes a closed jungle of obtuse, local regulations where visibility is low and passage tough. In such an environment, international competition would be crimped and comparisons difficult. It need not be so. At one extreme, host-country regulation could simply mean the adoption of a single set of rules with a common definition and national discretion on the value of key parameters. For example, countries could agree on what counts as capital but different countries might apply different, time-varying, levels of minimum capital requirements. They may also apply different data standards where it makes sense to do so. (Under Basel II, one of the data standards is seven years minimum of data on defaults. However, this data is both problematic to access and far less relevant in an emerging economy growing at 5–10 percent per year. There could be an agreement on how defaults are defined but differences on how far back the data must be in each country to be equally relevant.)

While these four functions for the FSB are significant, they preclude the kind of level playing field that international banks want.³¹ It is arguable that a version of host-country regulation with a common definition of a capital requirement, with countries pursuing different limits, is compatible with global regulation and common rulebooks. However, host-country regulators must feel sufficiently empowered and responsible to exercise greater discretion than they do today. There is a strong tendency to converge to a single international norm or minimum. The cry of level playing fields tends to give these norms a life force of their own. Take for example, the 60 percent public-debt-to-GDP norm which is a rule lacking any real scientific basis. The norm is actually wholly inappropriate for many countries or times.

Europe as a Special Case

Within the European Union taxation is still largely a domestic power. At the same time, European politicians want to create a single financial space with a single regulator.³²

The prospective European banking union is designed to reduce the likelihood of member states going bust from bailing out their financial systems.³³ It does this by spreading the cost of a national bailout across all members of the union. This in turn demands that a common resolution authority and common funds be essential pillars of the banking union. The quid pro quo of sharing the banking crisis costs is greater centralization and standardization of banking regulation. Enter the European Central Bank, the single supervisor as per the home country model we previously discussed. My fear is that a single supervisor, just as with home country regulators, will make it harder to quell the national credit booms that lead to banks going bust in the first place. Bigger booms with attendant bigger crashes, however evenly costs are shared, are a more existential threat to the euro area than the odd sovereign default.

Having the strongest finances in the euro area after the GFC, Germany has been, and is expected to continue being, the chief paymaster of the euro area’s new stabilization structures. For this we should all be grateful. Having paid the piper, Germany will call the tune. Today, Europe’s evolving regulatory structures reflect German views. Yet Germany’s perspective on the GFC is quite different from those who suffered the boom and bust. Germans believe they have prospered because they followed the rules while others did not—a view that conforms to their self-image.

My observations advising and speaking at gatherings of European and international regulators make me conclude that the operational emphasis of the single supervisor will be on strict enforcement of uniform rules across the euro zone. This is exactly how home-country regulators of international banks have worked. The new EU supervisor is likely to be charged with leveling out any unevenness to ensure that the banks it supervises are safe. This will make macroprudential regulation harder. National regulators, pressing for easier capital-adequacy rules for lending within their jurisdictions, would be viewed suspiciously. Are they trying to undermine the banking union by giving local banks an unfair advantage? And if national regulators seek to tighten lending criteria by, for example, implementing lower loan-to-value ratios to booming sectors, the affected sectors would complain. A sympathetic lone supervisor might agree that this diversity was fragmenting the single market. The supervisor and the banks would be united in the mantra of a single lending space underpinning the single currency area.

The underlying premise of this setup is wrong. Yes, rule breakers should be brought to book. It is also true that there were some spectacular supervisory failures in the boom-bust European countries. The list includes supervision of the UK’s Royal Bank of Scotland, Ireland’s Anglo Irish Bank, Belgium’s Fortis, and Spain’s Cajas. Even German supervisors were not blameless regarding the Düsseldorf-based IKB, an early victim of the crisis. More importantly, even if bank supervision had been uniform across the euro zone, the lending booms in Ireland, Spain and Belgium would still have taken place and the busts would still have followed. It might even have been worse.

Between 1997 and 2006, Irish house prices rose by 247 percent, while Spain and Belgium experienced house-price inflation of 173 percent and 96 percent respectively. Once the expectation had taken hold that property prices in these countries would rise by at least 10 percent every year, bank lending to the Spanish, Irish, and Belgian housing markets appeared to be a low-risk venture. Modest economic growth in Germany, France, and Italy kept euro zone inflation low and interest rates at 3 percent or less. This, added kindling to the lending fire. A euro zone banking union adhering to common lending rules would still have incentivized bank lending to flow to these markets because rising property values justified the increased borrowing. Remember that prior to the crash, banks in Spain, Ireland, Britain, and America appeared well capitalized based on boom-time asset valuations rather than off-balance-sheet shenanigans.

The solution would have been for the authorities, observing their financial systems in this self-feeding credit frenzy, to impose tighter lending criteria on a country-by-country basis. Supervisors could have required banks set aside additional capital against their lending, specifically in the housing or construction sectors. Lending contracts that did not comply with these rules could have been made locally unenforceable. Of course, national supervisors failed in this task before. (Some tried during the GFC, notably the Bank of Spain.) Equipped with clearer mandates, greater independence, and a hell of a history to avoid repeating, they may do better in the future.

A single euro zone supervisor’s perspective on safety would be mono-dimensional. Boom-bust cycles are more of a national than a euro-wide phenomenon because of greater national interconnectivity with housing markets, investment, consumption, employment and lending. What seems safe from the perspective of a bank operating across Europe might look dangerous through the lens of a national economy. Recall the example of mortgage lending denominated in Swiss francs by Swiss and Austrian banks in Hungary. This would be obviously dangerous for Hungary but was not considered dangerous for either Swiss or Austrian banks.

There Can Be Unity in Diversity

Whenever Europe stumbles, a stark choice materializes crying out for either “More Europe” or “Abandon Europe.” The shortcomings of the single currency are seen as proof that it must be augmented by a single everything. Yet, in this case, the opposite actually makes better sense. In spite of the benefits a single interest rate brings, an acknowledged cost is the issue of managing differing credit conditions in member states. Differentiated regulatory policy—tightening rules in booming regions and loosening them in others—addresses this failing and buttresses the single currency. A common regulatory policy, alongside a common interest rate, risks amplifying booms and busts which will ultimately undermine the single currency. Circumstances sometimes necessitate saving Europe from the Europhiles.

Germany’s recent economic success has less to do with superior bank supervision and everything to do with selling superior engineering eastward and southward. What came back in the opposite direction was borrowing to help finance importation of these goods. It is a pity that the borrowing was not accompanied by any philosophy. In Eastern philosophy, systems such as nature or the human body are supposedly made stronger by dualities. Forces that appear in opposition are often actually complementary. Similarly, the resilience of the financial system also requires some diversity. European unity cannot be achieved by assuming away differences but by recognizing them. When it comes to regulating credit across Europe, we need high regulatory standards and sensitivity to different financial conditions rather than an insensitive application of uniform lending rules.

Conclusion

Broadening global governance to include the largest economies in the G-20 has deepened the democratic legitimacy of the Gs. However, it has also created a shift away from a group of countries with common experiences and problems toward a group with wildly disparate experiences, challenges, and starting points. In these muddied waters, the Gs previous course of adhering to globally agreed rules of single “home-country” regulators has run aground. Despite the global language of regulation, action is increasingly local. Dismayed internationalists had hoped the crisis would to lead to a strong set of comprehensive rules applied and enforced globally. They already view the GFC as a “missed opportunity.”

But the old dichotomy between global and local may be outmoded. Is “internationalism” about a one-size-fits-all approach to regulation, or is it about how we integrate diverse systems? Host-country regulation may prove safer as it allows greater responsiveness to national economic conditions and cycles.³⁴ It will also prove politically palatable when local taxpayers are called upon to finance a bailout.

Host-country regulation can include an important, if more subtle role for international regulatory institutions. Parts of the financial infrastructure, such as exchanges, central clearing and settlement institutions, are global not local. The FSB could play a key new role of global police for such truly international markets. Host-country regulation is vulnerable to local institutions hiding behind obtuse local regulations to avoid foreign competition. The FSB could facilitate and discuss peer review of member states local rules to reduce protectionism. Converging regulatory principles and consolidating regulatory instruments would increase the competitiveness of local markets and lower barriers to entry. At the extreme, countries could express their differences simply through different capital-adequacy requirements rather than using a complicated set of different regulatory instruments. The FSB should also be the central information node for financial sector developments both nationally and internationally. Information sharing may not seem tremendously glamorous but the most frequently cited defense of regulators and bankers in every crisis to date has been a lack of knowledge. They all claim that they did not know what was going on. Better information and analysis will not stop financial crises but it will better arm those trying to do so.

The benefits of greater liberalization of capital flows were best extolled by the international banks who benefitted from the notion of a level playing field for themselves. It allowed them to hold small amounts of capital that they moved to whichever markets were most profitable. A shift back to host-country regulation may prove a drag on international capital flows. The economic repercussions of this have to be examined soberly, set alongside the consequences of highly contagious financial crashes and the relative safety of host-country regimes in the past. My instinct is that we are more certain—rightly or wrongly—of the long-term economic benefits of openness in the trading of goods and services. The benefits of openness in financial markets are conditional, complex, and in places suspect and should therefore not be the altar upon which we sacrifice host country regulation of finance.

An informed and collegiate process of integrating different financial systems will create a more resilient system than one made up of single rules being applied across many countries. In finance, systemic resilience requires a foundation of heterogeneity.³⁵ We have already discussed the systemic dangers of homogeneity in previous chapters.³⁶ An international heterogeneity of financial systems will generate opportunities for capital flows and a richer set of examples and experiences to inform policy makers around the world. The new international order may be more local than many had hoped for. All things considered, that might make it better.

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¹The ideas behind this chapter were developed through conversations with Andrew Baker, Mark Blyth, John Eatwell, Louis Pauly, Charles Goodhart, Eric Helleiner, Len Seabrooke, Andrew Schrumm and Paola Subacchi. I first presented these ideas in my article, “The Locus of Financial Regulation: Home vs. Host,” International Affairs 86, no. 3 (May 2010), pp. 637–46.

²The “home country regulator” is the term used to describe the regulator in the country in which the bank is headquartered. Home country regulation would see this regulator, supervising a banks’ global operations in accordance with a global rule book. The “host country regulator” is the term used to describe the regulator in the country in which the bank is operating. A bank operating in seven different countries will have seven different host country regulators. Each may have a different approach to regulation and requirement for parental support of its foreign subsidiaries.

³Arguably, the Financial Stability Board (FSB) had a stronger line of ancestry than the G20. Its forerunner, the Financial Stability Forum (FSF), established in 1999 in the aftermath of the 1997-1998 Asian Financial Crisis, was made up of finance ministries, central bankers and international financial bodies. The FSF, though tasked with monitoring the international financial system, was focused on the spread of codes and standards and acted as a forum for disseminating information on developments in international financial flows. The Basle Committee remained the preserve of financial regulation. However, around the same time as the creation of the FSF, the Basle Committee membership had widened beyond the original G10 industrial country central banks to include the larger emerging markets. At a meeting of the FSF in Rome on March 28-29, 2008, in preparation for the April 12, G7 meeting, the FSF proposed a number of ideas to strengthen surveillance of the international financial system that paved its evolution into the FSB.

⁴An agreement to redistribute voting shares was agreed, but never passed by the US Congress, contributing perhaps to the recent proliferation of international economic institutions led by China (e.g. the China-led Asian Infrastructure Investment Bank, AIIB) or narrow groups of emerging market countries (e.g. the New Development Bank, NDB).

⁵The first G-20 meeting took place in Washington, DC, on November 14–15, 2008. The second meeting took place on April 2, 2009, in London. In 2009 and 2010, the countries met twice a year, and subsequently once a year. The current schedule is for annual meetings every November.

⁶Carmen M. Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly, (New Jersey, USA: Princeton University Press, 2011).

⁷The euro zone credit crisis of 2010–11 had as one of its root causes large current account imbalances within the Euro zone between Germany, the main surplus country, and major deficit countries including Greece, Italy, Ireland, Portugal and Spain and Ireland.

⁸At the April 2009 meeting, issues other than global issues were assigned to different institutions. Tax transparency was sent to the OECD and the multilateral development banks were entrusted to support a “green” recovery.

⁹See Chapter 10 on bankers’ pay for a description of this plan to cap bonuses to 100 percent of a banker’s annual salary or 200 percent with shareholder approval.

¹⁰Governor King may have been quoting US economist, Allan Meltzer, who was fond of saying this.

¹¹See Andrew Baker, “Restraining Regulatory Capture? Anglo-America, Crisis Politics and Trajectories of Change in Global Financial Governance,” International Affairs 86, no. 3 (May 2010): 647–63, for a greater discussion of regulatory capture ahead of the GFC.

¹²These include rules on how a bank in serious trouble manage capital held in subsidiaries which are referred to as “living wills”.

¹³Group of Thirty, “The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace,” (Washington, DC: Group of Thirty, 2009).

¹⁴The UK’s Vickers Report (The Independent Commission on Banking) published on June 19^th, 2013 had similar recommendations. It can be downloaded from www.gov.uk/government/policies/creating-stronger-and-safer-banks.

¹⁵Claudio Borio and William White, “Whither Monetary and Financial Stability: The Implications of Evolving Policy Regimes,” (BIS Working Paper 147, Basel: Bank for International Settlements, February 2004); Claudio Borio, “Monetary and Financial Stability: So Close and Yet So Far,” National Institute Economic Review 192, no. 1 (2005), 84–101.

¹⁶1970 February 2, Time magazine, Section: Business, The Martin Era, Time Inc., New York. http://content.time.com/time/magazine/article/0,9171,878186,00.html.

¹⁷Charles A. E. Goodhart and Avinash D. Persaud, “How to Avoid the Next Crash,” Financial Times, January 30, 2008; Charles A. E Goodhart and Avinash D. Persaud, “A Party Poopers Guide to Financial Stability,” Financial Times, June 5, 2008.

¹⁸See Chapter 12 in this book and Avinash D. Persaud, “The EU Financial Transaction Tax Is Feasible and If Set Right, Desirable,” VOX: CEPR’s Policy Portal, www.voxeu.org/index.php?q=node/7046, September 30, 2011.

¹⁹Avinash Persaud, “Do Not Be Detoured by Bankers and Their Friends, Our Future Salvation Lies in the Direction Of Basle III,” VOX, www.voxeu.org/index.php?q=node/7018, September 23, 2011.

²⁰Though some like Benoît Cœuré of the European Central Bank have rightly expressed concern that a regulatory requirement to use central clearers needs to be matched with requirements that make the central clearers more resilient to a systemic crisis. See Benoît Cœuré, “Central Counterparty Recovery and Resolution,” (keynote speech, Eurex, London, November 24, 2014), www.ecb.europa.eu/press/key/date/2014/html/sp141124.en.html.

²¹See Chapter 10.

²²See Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash D. Persaud, and Hyun Shin, “The Fundamental Principles of Financial Regulation,” (Geneva Reports on the World Economy 11, Geneva: International Center for Monetary and Banking Studies and Centre for Economic Policy Research, 2009).

²³In 2014, US regulators forced France’s largest bank to fire 13 employees and pay a fine of $9 billion for allegedly violating US sanctions against Sudan, Iran and Cuba, using a complex international network of payments. In 2012, UK-based HSBC and Standard Chartered banks were fined $1.9 billion and $674 million, respectively, for hiding transactions with countries the US has sanctions against.

²⁴Adair Turner, “The Turner Review: A Regulatory Response to the Banking Crisis,” (London: Financial Services Authority, 2009).

²⁵Mervyn King reportedly made this comment in 2008 after the collapse of Iceland’s Lansbanki in October 2008.

²⁶Before the GFC, regulators were dismissive of concerns over regulatory capture. I recall more than a few of them responding in the strongest terms against an “op-ed” I had written for the Financial Times in October 2002 arguing that Basel II was difficult to comprehend without considering regulatory capture by large banks. See “Banks Put Themselves at Risk in Basel,” October 17, 2002, Financial Times, reprinted at the end of this book. For further analysis of regulatory capture, see Andrew Baker, “Restraining Regulatory Capture? Anglo-America, Crisis Politics and Trajectories of Change in Global Financial Governance,” International Affairs 86, no. 3 (May 2010), 647–63.

²⁷Sustained growth in both countries is at historically unprecedented levels.

²⁸See Carmen M. Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly, (New Jersey, USA: Princeton University Press, 2011).

²⁹For a more in-depth study of alternative roles, see Eric Helleiner, “What Role for the New Kid in Town? The Financial Stability Board and International Standards,” (draft memo prepared for the workshop New Foundations for Global Governance, Princeton University, January 8–9, 2010).

³⁰See Kern Alexander, John Eatwell, Avinash Persaud, and Robert Reoch, Clearing and Settlement in the EU (IP/A/ECON/IC/2009-001, Brussels: European Parliament, 2009).

³¹See, The Warwick Commission of Financial Reform: In Praise of the Unlevel Playing Field (Coventry, UK: University of Warwick, 2009).

³²The following section follows closely the argument and language I used in “Vive La Difference,” a guest article I wrote for the Economist, published on January 26, 2013.

³³See Jacques de Larosière, The High Level Group on Financial Supervision in the EU (Brussels: European Commission, 2009).

³⁴United Nations, The Commission of Experts on Reforms of the

International Monetary and Financial System (New York: United Nations, March 2009).

³⁵Avinash Persaud, “Sending the Herd off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Systems,” (First Prize, Jacques de Larosière Award in Global Finance, IIF, 2000, Reprinted in BIS Papers, 2002).

³⁶In particular in Chapter 8, but also in Chapters 3 and 4.