Regulation and the money supply in a global economy

Overview

Regulatory arbitrage, shadow banking and offshore financial centres weaken domestic financial regulation.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is regulatory arbitrage?

   Model answer

   Regulatory arbitrage is the practice of restructuring an activity so that it falls under a lighter set of rules while its economic substance is unchanged. A bank may book business in a subsidiary in a jurisdiction with lower capital requirements, move an exposure off its balance sheet into a separate vehicle it nonetheless supports, or reclassify an asset so that it attracts a lower capital charge. Because financial contracts can be reassembled from components almost without limit, the same risk can usually be reproduced in a form the rules do not capture. It is the central practical difficulty of financial regulation: rules written in terms of legal form are avoidable, so regulators are driven towards judgement about economic substance, which is harder to apply consistently and harder to defend when challenged.

2. 2

   What is shadow banking, and why does it complicate regulation?

   Model answer

   Shadow banking is the performance of bank-like functions, in particular maturity transformation and credit intermediation funded by short-term borrowing, by institutions that are not banks and therefore fall outside banking regulation, such as money market funds, finance companies, securitisation vehicles and some investment funds. It complicates regulation because the same fragility exists without the safeguards: these entities can suffer the equivalent of a run when their short-term funding is withdrawn, but they have no deposit insurance, no access to the lender of last resort and no capital requirement. They are also closely connected to banks, which sponsor them, lend to them and buy their paper, so their distress lands on the regulated system anyway. And because tightening bank rules makes shadow banking relatively more attractive, regulating banks harder can enlarge precisely the sector that is hardest to see.

3. 3

   Analyse why a bank operating in many countries is hard for any single national regulator to supervise.

   Model answer

   The group is one economic entity but many legal ones, so no single regulator sees the whole balance sheet or the way risks offset and accumulate across it. Supervision is divided between the home authority of the parent and the host authorities of the subsidiaries and branches, and their objectives differ: the host wants assets ring-fenced locally to protect local depositors, while the home authority wants capital and liquidity managed centrally. Information sharing depends on cooperation that may fail exactly when a crisis makes it urgent. Losses can be booked where the rules are lightest while the risk is really borne elsewhere. And if the group fails, no one has agreed in advance which taxpayers pay, which is why cross-border resolution remains the least solved part of financial regulation.

4. 4

   How do offshore financial centres weaken domestic financial regulation?

   Model answer

   They offer light regulation, low or no tax and, often, secrecy, and because capital moves freely a transaction can be booked there while the parties, the risk and the economic activity remain elsewhere. A domestically regulated group can therefore place activities in such a centre to escape capital requirements, disclosure or lending limits, while retaining the economic exposure and, implicitly, the domestic guarantee. Secrecy also prevents the home regulator from seeing the size and nature of the exposure, so the risk in the domestic system is understated. Their existence puts competitive pressure on other jurisdictions to relax their own rules, and because their business model depends on the differential, they have every incentive to resist coordinated tightening.

5. 5

   Why does financial innovation tend to outrun regulation?

   Model answer

   Rules are written in response to problems that have already occurred and are expressed in terms of instruments and institutions that already exist. Innovation creates instruments that were not contemplated when the rules were drafted, so they either escape them entirely or fit a category that misprices their risk, and the reward for creating such an instrument is largest precisely where the regulatory saving is greatest. Legislating takes years, requires consultation and must be justified, while designing a new product takes months. New instruments also lack a history, so neither the market nor the regulator can measure their behaviour under stress until stress occurs. Regulators respond by moving to broad principles and to judgement about economic substance rather than exhaustive rules, which mitigates the problem but cannot remove it.

6. 6

   Why is there pressure on national regulators not to be stricter than others?

   Model answer

   Financial business is mobile, so if one country imposes tighter capital requirements, higher taxes or more intrusive supervision than its competitors, some activity, and the employment, profits and tax revenue that go with it, can relocate to a lighter regime without any change in the underlying economics. Governments value a large financial centre and are lobbied heavily on this point, so they hesitate to move first. The result is a collective action problem in which every country would prefer a common high standard to a common low one, but each has an incentive to undercut, and the outcome is weaker rules than any of them would choose together. This is the fundamental argument for internationally agreed minimum standards, and also the reason such agreements are slow, heavily negotiated and unevenly implemented.

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