Yesha Yadav, the Specter of Sisyphus: Re-making International Financial Regulation After the Global Financial Crisis

• Citation: Vol. 24 No. 1
• Publication year: 2010
• topic: Banking and Finance Law

THE SPECTER OF SISYPHUS: RE-MAKING INTERNATIONAL FINANCIAL REGULATION AFTER THE GLOBAL FINANCIAL CRISIS

Yesha Yadav*†

INTRODUCTION ................................................................................................ 85

I. RATIONALES FOR REGULATION ............................................................ 87

A. The International Marketplace in Financial Services and

Products ....................................................................................... 87

B. Key Reasons to Regulate the Financial Markets .......................... 88

C. Managing Externalities ................................................................ 89

D. Consumer Protection and the Correction of Information

Asymmetries .................................................................................. 90

E. Moral Hazard ............................................................................... 92

II. THE CURRENT INTERNATIONAL FINANCIAL REGULATORY

FRAMEWORK ........................................................................................ 95

A. Standard Setting ........................................................................... 95

B. BCBS ............................................................................................ 96

C. IOSCO .......................................................................................... 96

D. IAIS ............................................................................................... 97

E. G-20/FSB ...................................................................................... 98

III. LESSONS FROM THE CRISIS ................................................................... 99

A. American International Group .................................................... 100

B. Kaupthing ................................................................................... 103

C. Lehman Brothers ........................................................................ 106

IV. RE-CONSTRUCTION AND REFORM ...................................................... 109

A. Systemic Risks ............................................................................. 109

B. Standard Setting ......................................................................... 114

C. Prescription Versus Principles ................................................... 115

CONCLUSION: CRISIS AND RE-CONSTRUCTION .............................................. 117

INTRODUCTION

The spread of the global financial crisis from its beginnings in the United States to economies around the world has necessitated extraordinary and concerted action by regulators to contain the fallout.¹As the dust settles, the crisis provides a unique opportunity to more accurately understand the operation of the international financial marketplace and the regulatory mechanisms that have been put in place to oversee its workings.²While the actions of domestic regulators have given much cause for examination, the globally contagious spread of crisis has turned the analytical spotlight on the international regulatory framework and its ability to act to exert control over an increasingly consolidated financial market in products and services.³

Domestic regulators have undergone a period of institutional soul-searching to critically evaluate their performance in predicting the market turmoil and reacting to it once the seriousness of the disruptions became apparent. Reform agendas have been developed and remain works in progress, as the causes of the crisis come into sharper focus and expose the vulnerabilities within national regulatory frameworks.⁴While this work continues within domestic fora, the globalized aspects of recent events necessitate an examination of the international dimension of financial regulation.⁵As evidenced by recent events, the presence of international financial firms, combined with a dispersal of complex financial products across jurisdictions, has resulted in an international interweave of risk-both economic and legal-that cannot be fully understood from a domestic perspective alone.⁶Further, in addition to better grasping the patterns of risk developing across borders, international oversight mechanisms become especially salient where multi-jurisdictional firms fail outright (e.g. Lehman Brothers),⁷or otherwise, where emergency regulator assistance is deemed necessary to avert cross-border systemic spillover (e.g. the failure of Fortis or ING).⁸Finally, effective international oversight and the application of common rules to comparable practices are desirable to act as a counter-weight to the incidence of regulatory arbitrage by firms seeking to exploit differences between country laws to turn handsome but potentially risky profits.

This Article examines the legal workings of international financial regulatory mechanisms from the perspective of how these have performed in the lead up to and during the global financial crisis. In particular, the Article analyzes normative rationales for regulation and applies these to the specific context and challenges posed by the international regulatory framework. It then discusses how this framework can be reformed to better reflect these rationales within the constraints imposed by a supranational legal system and to mend the cracks exposed in the course of the crisis.

This Article argues that the crisis has shown the present international regulatory architecture to be poorly adapted for tackling the risks arising from the increasingly dynamic and complex international financial marketplace. While international regulators are necessarily constrained by their dependence on domestic legal systems for application and enforcement of international rules and standards, their role is nevertheless significant in light of the emerging distinctness of the international financial market and its own unique patterns of risk. Therefore, oversight of this market can be based on, and justified by, the important rationales for regulation generally advanced in support of domestic regulatory mechanisms. This Article seeks to propose a new design for reform that better reflects these rationales as well as the increasing interconnectedness of the international marketplace.

Part I of this Article sets out some key rationales for regulation together with a discussion of the specific challenges faced by international regulators versus their domestic counterparts. Part II examines the outlines of the current system. Part III critically analyzes the operation of international regulatory mechanisms during the crisis, while Part IV proposes a design for reform.

N cemented and extended this trend to include a broader weave of country players within the financial marketplace.17While this trend has enabled firms to generate considerable wealth through investment,18it has also created increasingly stark financial and economic vulnerabilities between countries, such that risks affecting one jurisdiction have the ability to spread quickly to others, taxing the regulatory resources of several country regulators simultaneously (e.g. the failure of Dexia, Fortis, ING, Kaupthing, or Lehman Brothers).19 In light of the very active market in cross-border financial services, and the risks it creates that cannot be controlled by any one domestic regulator, the international market can be seen as distinct from the sum of its various domestic parts. In this context, its regulation ought to seek to institutionalize the normative policy rationales traditionally advanced to support the better function of market regulation. B. Key Reasons to Regulate the Financial Markets Certain economists, notably Kevin Dowd,20George Benston, and George Kaufmann,21have suggested that regulation itself can lead to market crisis by muffling the incentives at work for market players to regulate their own behavior. Criticism has also focused on the costs of regulation that may not be sufficient to cover the multiplicity of market risks.22However, a large body of academic and theoretical consensus has coalesced around some key rationales justifying the development of rules or standards to govern the markets and the deployment of state resources to see to their application.23An important assertion in support of regulation cites the collective action dilemma whereby individual firms, while appreciating the desirability of attaining a common good, are either unwilling or institutionally unable to act to appropriately regulate the risks arising from their own behavior and that of their peers.24 Broadly, the key rationales for regulation can be summarized as follows: 1. the management of externalities, notably systemic risks;25 2. consumer protection and the correction of information asymmetries;26 3. limitation of moral hazard.27 C. Managing Externalities Regulation for managing systemic risk is necessary where one player or another is unable or otherwise insufficiently equipped to act to prevent the spread of risk through the financial markets as a whole.28This can occur, for example, where a shock disruption affecting one firm leads the market to believe that other similarly situated firms may also be impacted, prompting contagion and investor runs on the firms implicated; or where a sudden event affects the market as a whole, leading to widespread loss of confidence and panicked runs on financial institutions.29In these scenarios, in order to meet their obligations, firms can find themselves becoming tightly wound into a spiral of losses, where they must rapidly fire-sell their assets to satisfy creditor and depositor demand during a run, depressing asset values and prompting further runs as balance sheets weaken across the market.30As a result, firms are rapidly drained of liquidity and unable to access affordable credit in the absence of assets that may be used as collateral.31In such cases, systemic risk can take on a multitude of concurrent guises.32Specifically, where firms evidence a high degree of...