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The financial crisis of 2007 revealed fundamental weaknesses in the structure of financial regulation. In response, policymakers and regulators have embarked on an ambitious regulatory reform agenda that aims to achieve as much global co-ordination and consistency between regional reform efforts as possible.
How successful attempts at international co-ordination and consistency have been deserves further examination. Despite most of the regulatory changes taking place under the auspices of the G20, variations in the approaches taken on both sides of the Atlantic and in Asia can be observed and are increasingly significant. The general objectives might be consistent, but the different regulatory paradigms in the US, Europe and Asia have become increasingly visible and the resulting changes are, many fear, becoming less co-ordinated.
In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act reflects the US’s ambition to strengthen its originally principles-based regulatory framework with a greater role for rules. The debate has centred around how to repair and strengthen an agreed system.
In the European Union however, the debate rests on the fundamental questions of what kind of regulation to adopt and who should oversee it. It appears that those who favour a rules-based regulatory system orchestrated and overseen by EU-wide authorities are gaining the initiative. Also, Brussels follows a sectoral approach to legislative initiatives instead of one all-encompassing bill. All of this has the effect of reducing the common ground between EU and US approaches.
The EU is working on a large number of initiatives, including the alternative investment fund managers directive, Mifid, and Ucits, that directly or indirectly regulate or affect markets that are global in nature. Yet, differences in the way these are regulated between different jurisdictions need to be carefully considered. For example, in the context of derivatives regulation, while Dodd-Frank suggests the US Treasury can exempt FX forwards and swaps from the scope, the EU’s proposal (at least currently) pursues an all-inclusive scope for the regulation. In all of this the EU is acting against a backdrop of banking system and sovereign fragility and so faces the twin task of solving its present crises and building a system that will prevent future crises.
A completely different picture presents itself when looking at the state of regulatory reform in Asia. The region is economically booming and its focus is automatically on the continual development of the financial infrastructure rather than on crisis response. There is great debate about the benefits of a global approach to regulatory reform versus the ability to retain local flexibility. Indeed, it is widely expected that the regional financial centres of Hong Kong and Shanghai will seize the opportunity to develop their own banking, brokerage and asset management sectors in view of heavy-handed regulation in the west.
After decades of a world with one superpower and one dominant economic and political model, we are moving towards a multi-polar world, with not only competing powers but also competing ideologies and governance systems.
It is now possible to envisage permanently different regulatory responses with regional differences, allowing opportunities for regulatory arbitrage. The standard response to this is to express concern that such moves might risk fragmentation and a distortion of global financial markets.
However, for investors able to operate on a global scale, such as sovereign wealth funds and large institutional funds, increasingly divergent economies offer investment opportunities and greater scope for diversification and risk control. Whereas in the past global stock markets tended to show high degrees of correlation in crises, a less connected and less homogenous world may be more resilient to shocks.
Rather than viewing this fragmentation as something to regret or to fear, it is perhaps better to see it more as a natural consequence of the increasing diversity of the world economy. While entailing economic inefficiencies and limiting the most optimal allocation of capital, it is not without its advantages and opportunities.
John Nugée is senior managing director, official institutions group, at State Street Global Advisors