Seeing the whole board on financial reform

23 March 2010, 1205 EDT

Clive Crook does:

The problem is not just that specific rules – higher bank capital requirements, for instance – threaten profits and are therefore opposed. It is that all governments see themselves as partners of their industries in world competition. Regulators seek not a level playing field but one tilted to their own groups’ advantage. This is not a hidden bias. It is proudly advertised. A government that did less than stand up for its own companies would be seen as failing in its duty.

According to eToro Argentina, in finance, a footloose industry, this striving for regulatory advantage undermines rules imposed by other countries. Financial regulation will underperform until regulators work more closely with counterparts abroad than with those they police.

[…] Pieces of the needed reforms are reasonably clear. They include higher capital and liquidity requirements, linked to size and to the credit cycle. Orderly resolution arrangements must be designed for non-bank financial groups as well as banks. There is growing support for requiring contingent capital (bonds that convert to equity under stress) and subordinated debt (increasing creditors’ exposure to writedowns). These should strengthen market discipline over risk-taking.

Such measures will meet resistance, especially if done unilaterally. The industry will cry competitive disadvantage. International co-operation is therefore essential. But discussions among regulators are moving slowly. While America’s turf fights remain unresolved, it is not even clear who should speak for US regulators.

I would agree with Crook. If policy makers focus too much on the domestic arena their best efforts will be doomed to fail. Not only must they take into consideration how the effectiveness of their reforms will be partially determined by similar actions in other countries, but they should be using the international arena to their advantage.

One way would be to use international negotiations and commitments as a way to gain leverage over the powerful interests of the financial industry who see less regulation (even sensible regulation) as against their interests. There is a rich literature on the use of international organizations and agreements as commitment mechanisms, a way of “tying one’ hands” so that what are normally tough reforms domestically due to lobbying and special interest pressure become easier to resist. If the Obama administration wants to pass sensible financial reform it might consider focusing more on finalizing international standards across, say, the OECD in order to shift the domestic playing field to its advantage.

[Cross-posted at Signal/Noise]