Regulation in the Making:

Crafting New Financial Rules May Not Be a Sausage Factory, but More Akin to Lesson in Making Cheese

Originally published May 11, 2009

NEW YORK — The efforts of policymakers and governmental groups such as the G20 and the European Commission, central banks, and financial regulators such as the UK’s Financial Services Authority and the US Securities and Exchange Commission to draft new regulation for the banking, securities and investment industry have not yet yielded any concrete views. But their ideas are already coming under fire from industry advocacy groups.

Separately, the US and Europe each are struggling to put their own houses in order, much less figure out ways to achieve compatibility with each others’ proposed regulations, according to industry participants, some of the regulators themselves, and the industry’s advocates. At its meetings in early April, the G20 proposed a Financial Stability Board representing its member nations, members of the previously existing Financial Stability Forum, Spain and the European Commission. The Board would collaborate with the International Monetary Fund to provide early warning of major market risks and act to address them, as well as re-shape regulatory systems to identify such risks. It would also help extend regulation to systemically important financial institutions, instruments and markets, including systemically important hedge funds.

“The coordination of regulators is certainly an existing and ongoing challenge and has led to concerns in the industry about limits being placed that hinder the free flow of capital,” says Travis Larson, a Vice President at the Securities Industry and Financial Markets Association (SIFMA). “Certainly, the industry recognizes the need for regulation given recent market events, but we would hope and expect regulators to communicate in an effort to reduce distortions in the marketplace.” He points to European Union legislation concerning credit ratings agencies as an example of regulation done without global coordination, that was inconsistent with IOSCO [International Organization of Securities Commissions] best practices for these agencies.

The proposed Financial Stability Board (FSB) and any proposed new regulation also can overreach, according to Colin Melvin, Chief Executive Officer, Hermes Equity Ownership Services (EOS), a unit of the Hermes Group that offers advisory services and acts an agent for pension funds internationally. “There was enthusiasm [at the G20 meeting] for some form of global financial services regulation; I doubt that this would work,” he says. “It’s not possible to resolve the current crisis and prevent the next one through regulation, because if you try to regulate for good behavior, the regulation is generally inflexible and behavior will change and evade the regulation. A good example is Sarbanes-Oxley — regulation that didn’t help prevent a further crisis.”

Yet the FSB does have a good foundation based on previous regulatory recommendations made as the Financial Stability Forum, according to Barbara Ridpath, Chief Executive of the International Centre for Financial Regulation (ICFR), an advocacy and training organization backed by 19 financial institutions and professional services firms from the City of London. “There’s such an entrenched bureaucracy among existing financial institutions that it was easier to give the mission to the FSF, now the FSB, than to start with pre-existing, shareholder-based international organizations,” she says. “The harder issue is all this macro-prudential supervision, who coordinates it, how they talk to each other, where it is in each country and how to give it teeth?”

The example may not be completely analogous to securities trading, but as an example of trans-Atlantic differences, food safety regulations for cheese differ greatly between the US and France, notes Ethiopis Tafara, Director of the Office of International Affairs at the US Securities and Exchange Commission. Where French consumers themselves assess cheese by sight, smell and feel, US regulation errs on the side of safety by requiring pasteurization so the cheese is no longer a living entity once in the market. “We on the different sides of the Atlantic bring to the conversation different sets of assumptions, experiences and preferences,” he says. “Yet in the context of the current crisis, we find that we share the same concerns with our brethren in Europe. We agree on what the central issues are, how important they are and that we all stand to gain or lose depending on our collective action.”

Tafara names several principles that ought to find common agreement between countries and regions:

  • Investigating increased systemic risk while not suppressing risk taking per se. “The essence of our financial system is letting people taking chances with their money,” he says. “However, if we’re in a world where financial entities are too big, too indebted and too interconnected to fail, those entities will have incentive to take on excessive risk at the ultimate expense of the public.”

  • Addressing misaligned incentives. “Part of the answer will lie in finding better compensation schemes,” says Tafara.

  • Better disclosure of counterparty risk. “Basic disclosure requirements with respect to any type of financial product that achieves a certain purpose.”

  • Accounting for fungibility of financial products. “Market participants search for the path of least regulatory resistance,” he adds.

  • Responsiveness to the mobility of capital. “We need to ensure that our regulation is optimal in providing the best process for protection for investors and at the same time, is comparable across developed markets,” says Tafara.

Lack of common regulatory principles has made it possible for firms to engage in regulatory arbitrage, which could continue without coordination concerning regulation, notes Robert D. Hormats, Vice Chairman, Goldman Sachs International.

“The guidelines given by the leaders of the G20 meeting make sure there’s much greater coordination and cooperation among regulators to identify where systemic risk is likely to occur and find ways to avoid it, and to shine a light on individual countries and individual financial institutions that are doing the right or wrong thing to make sure there isn’t a huge regulatory gap between one country or one group of countries,” he says. “That has happened and needs to be avoided. A country with a major deficit in how it regulates a certain part of the system has to be the object of focus other than financial stability.”

Still, reducing regulatory arbitrage supports cross-border standardization, observes Ridpath of the ICFR, and while eliminating arbitrage is impossible, reducing it raises the bar of the “level playing field” for the industry, she explains. “[Various countries’ financial industries] can’t have it both ways. They can’t get rid of regulatory arbitrage and also not cooperate with each other,” says Ridpath. “Although, with [criticism] of offshore financial centers, there may be a race toward the most conservative approach among the countries. That makes it harder — firms can do arbitrage but will be doing it at a much higher level. It’s going to be arbitrage to try to get the least worst treatment as opposed to the best treatment.”

Furthermore, the crisis encompassed more than just unregulated portions of the markets, stresses Hormats of Goldman Sachs. “When you look at some of the assets that were put on the books of very regulated institutions, you can’t make that blind distinction at all,” he says. “If we operate on that basis, we will miss a lot of the changes that need to be made throughout the system. The G20 is focusing on the gaps in regulation. Over time, the G20 will insist that standards converge, even if they’re not precisely the same and the institutions that administer them are not managed exactly the same.” For pension funds operating in this climate, coordination is necessary to respond to regulatory demands, according to Melvin. “Pension funds or other long-term owners should work together and pool resources to be better owners, to be responsible managers and owners of the assets that they invest in,” he says. “If they try to do it themselves individually, the resources will be atomized, duplicating the effort.”

The most likely outcome is incremental changes in regulation, according to Ridpath. “I don’t think there will be a ‘new Glass-Steagall Act,’” she says. “The problem is there is not one cause and effect. Every link in the chain weakened at the same time. You need concerted actions in several different directions — on governance and the responsibility of boards, on transparency. You can’t just fix it with regulation. It’s the resources given to supervision and enforcement. The complexity requires a multi-faceted solution.”

In discussions with other nations and standards bodies about global harmonization of securities industry regulation, the SEC can only agree to provisions consistent with US securities laws and bills before Congress, observes Tafara.

“The closer you get to details, the more conflict you may have between the laws you can administer and enforce — or the more conflict you may have with what Congress is contemplating in a particular area,” he says. “We try to find an international consensus that is detailed as possible but not so detailed that it actually causes problems.” The challenge, both for regulators and the firms they oversee, will be to reach agreement on new rules that aren’t as dead on arrival as pasteurized cheese. 


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