Citation for published version:Avgouleas, E 2013, 'Effective Governance of Global Financial Markets: An Evolutionary Plan for Reform',Global Policy, vol. 4, no. Supplement 1, pp. 74-84. https://doi.org/10.1111/1758-5899.12041
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Effective Governance of Global FinancialMarkets: an Evolutionary Plan for Reform
Emilios AvgouleasSchool of Law, University of Edinburgh
AbstractTwo questions remain widely open when it comes to global financial markets. First, what is the raison d’etre of openglobal markets? Second, is it possible to foster open markets without an international governance structure supervisingthem? Post-crisis regulatory reform presents an acute paradox. While the content of international financial regulation ischanging rapidly, the reform of governance structures is painfully slow. There is no formal governance structure dealingwith cross-border supervision of global financial institutions. In addition, there is no crystallized institutional capacity atthe international level dealing with cross-border crises and the resolution of global institutions. Other areas of concernare the global supervision of systemic risk and the absence of a reliable finance research watchdog dealing with theproduction of regulatory standards. This article outlines an international governance framework to deal effectively withthese concerns. The adoption of the proposed plan would lead to breaking down the territorial link in the supervisionof large financial institutions and of systemic risk, without causing intolerable loss of sovereignty. In addition, the pro-posed structure is premised on a set of explicit values. These would provide a strong signal to global markets that theyneed to shift their focus from speculation to development goals.
Policy Implications• Building a new governance framework for global finance• Meeting the supervisory challenge of cross-border banking• Addressing the risk of financial innovation• Global systemic risk monitoring• Fostering global financial stability• Fostering sustainable economic development
It is generally accepted that free flows of (mostly) privatefunds, whether in the form of capital investment or creditfrom one corner of the globe to the other, can prove tobe strong development and poverty eradication tools. Inaddition, global financial markets must operate toenhance the management and diversification of risk origi-nating in these flows of capital; fostering, rather thanundermining, financial stability. Naturally, a derivativesmarket that supports the information efficiency andliquidity of international markets and allows market actorsto hedge attendant risks is a welcome development. Infact, financial innovation can become a strong agent ofeconomic growth if used properly (Buckley, 2009). Butwhat about the myriad of speculative finance techniquesand instruments developed over the last 30 years? Dothey also serve any welfare enhancement goals? And howdo we account for the fact that financial markets mightbe inherently unstable? The reasonable answer to thesequestions is to make global markets and large financial
institutions safer by improving their regulation. However,would that be enough, or is there also a need for interna-tional structures employed to build risk roadblocks andinitiate remedial action throughout the finance chain toprevent interconnected global markets from exacerbatinga systemic crisis? Shouldn’t there be appropriate bodiesmonitoring the way different risks correlate at the globallevel and supervising financial institutions’ market behav-iour and compliance with prophylactic regulations?
In the aftermath of the global financial crisis (GFC), anumber of significant reforms have been adopted toimprove the regulatory framework. These include newcapital and liquidity requirements for banks, measures tobattle interconnectedness in the financial sector, new res-olution regimes that would allow banks to fail withoutcausing systemic disruption, and more strict frameworksfor bank supervision and the monitoring of systemic risk(Avgouleas, 2012). Yet limited progress has been madewith respect to governance structures. Specifically, global
Global Policy Volume 4 . Supplement 1 . July 201374
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Article
financial governance needs a radical enrichment of itsstructures and objectives in four areas:
1. effective supervision and monitoring of systemic riskin global markets, especially risk originating in theshadow banking sector;1
2. effective supervision of big cross-border institutions,so-called globally significant financial institutions(G-SIFIs);
3. effective understanding and management of risk inthe financial sector, especially risk attached to finan-cial innovation, and the production of astute regula-tory standards;
4. effective resolution of cross-border financial institu-tions (G-SIFIs) and, more importantly, of cross-borderfinancial groups.
In this article I sketch a tighter, more hierarchical andmore encompassing model of governance for globalfinancial markets that could further the effectiveness ofrecent reforms protecting the ideal of open global mar-kets and enhancing their legitimacy. To many this pro-posal might have the sound of an unrealistic academicexercise that inevitably requires reform, significant loss ofsovereignty, and expenditure of the grandest scale. Yet itis the duty of academic commentators to think of possi-ble ways to overcome/bypass these obstacles in order tomobilize constituents that could influence the currentlynegative attitude of large economies to internationalgovernance structures for global finance.
The proposed global governance structure would havefour pillars supported by a similar number of global
administrative agencies: a global macroprudential super-visor; a global microprudential supervisor; a global finan-cial policy, research and regulation authority; and aglobal resolution authority (see section 2 and Figure 1).The establishment of such a governance system presup-poses the negotiation and signing of an (umbrella) inter-national treaty governing the most important aspects ofinternational finance. Arguably, international endorse-ment of this plan does not lead to intolerable institu-tional disruption and expenditure, as it makes full use ofexisting structures and contemporary regulatory develop-ments. These properties give the proposed plan a distinc-tively evolutionary profile.
1. Soft law financial governance ‘is notworking’
Overview
Arguably, the global financial governance system is pre-mised on four central pillars that incorporate a diverse‘legal’ and organizational universe of rules and actors.The first pillar comprises the international treaties onwhich the most important international financial institu-tions (IFIs), such as the International Monetary Fund(IMF), the regional development banks and the WorldBank, have been founded. The second pillar encom-passes state-to-state contact and coordination groups,such as the groups of seven (G7) and twenty (G20) mostdeveloped countries. The third pillar is based on ‘infor-mal’, consensus-based (soft law) structures, normally
Macro-Prudential Global Systemic Risk Supervisor
Micro-PrudentialAuthority
Global Financial Policy,
Regulation, and Knowledge
Organization
Global Resolution Authority
Macro-economic developments
State of global financial system :
incl. na onal, regional,
interna onal banking sec on, shadow banking
sector
UMBRELLA TREATY
G-SIFIs with large cross-border
asset/liability base
Global deriva ves and securi es
markets
BISsans
Research Division
BIS Research Division
Produc on of new
regula on
Evalua on of emerging
risk
Resolu on of cross-border financial groups
Governing Council
+ +
Top 3 Non-G20EU UN
Members
Coordina on
Proposal by Emilios Avgouleas, Governance of Global
Financial Markets (2012)
Figure 1. The proposed global governance structure.
Macro-Prudential Global Systemic Risk Supervisor
Micro-PrudentialAuthority
Global Financial Policy,
Regulation, and Knowledge
Organization
Global Resolution Authority
Macro-economic developments
State of global financial system :
incl. na onal, regional,
interna onal banking sec on, shadow banking
sector
UMBRELLA TREATY
G-SIFIs with large cross-border
asset/liability base
Global deriva ves and securi es
markets
BISsans
Research Division
BIS Research Division
Produc on of new
regula on
Evalua on of emerging
risk
Resolu on of cross-border financial groups
Governing Council
+ +
Top 3 Non-G20EU UN
Members
Coordina on
Proposal by Emilios Avgouleas, Governance of Global
called transnational regulatory networks (TRNs), whichcomprise regulatory agencies and central banks ratherthan governments and act as standard setters. The mostwell-known international finance TRNs are the BaselCommittee on Banking Supervision (BCBS), the Interna-tional Organization of Securities Commissions (IOSCO)and the Financial Stability Board (FSB). The fourth pillar ispublic–private sector partnership, which mostly refers tothe influence of private-sector bodies and trade organisa-tions with regard to the content and direction of interna-tional financial standards (IFSs) issued by the requisiteTRNs (Avgouleas, 2012).
IFSs are generally accepted principles, practices (actingas ‘default rules’) and guidelines, ranging from account-ing standards to disclosure rules for securities issuers andcapital adequacy requirements of banks. Most of the IFSsare incorporated into TRN member and nonmemberjurisdictions through national implementation (Brummer,2012; Weber, 2009; Giovanoli, 2009, p. 84). Both TRNsand IFIs are involved in monitoring compliance with theIFS, either through peer-review procedures or throughthe IMF’s and the World Bank’s Financial Sector Assess-ment Program (FSAP) and Reports on the Observance ofStandards and Codes (ROSCs). Finally, the enforcement ofcooperation is premised on bilateral and multilateral(quasi-binding) memoranda of understanding.
Advantages of TRNs: flexibility and cooperation
TRNs and their soft law standards have been hailed asimportant mechanisms to resolve the regulatory coordi-nation and enforcement challenges posed by globaliza-tion in a number of areas ranging from the governanceof biogenetic research to financial regulation. TRN theoryhas its origins in a ‘soft power’ view of international rela-tions, which was pioneered by leading liberal politicaltheorists Robert Keohane and Joseph Nye (Koehane andNye, 1975, 2001). Their analysis was reconceptualizedand applied in a number of areas, where internationalcooperation is of the essence, by Anne Marie Slaughterand other international relations scholars, who have pro-posed a ‘soft form’ of international cooperation throughTRNs as an effective solution to global problems (Slaugh-ter, 2004a, pp. 12–14; Raustiala, 2002).
TRNs and soft law present, according to their propo-nents, two distinct advantages. They lower the cost ofcontracting (Abott and Snidal, 2000) and entail reducedloss of sovereignty, as they are less restrictive and easierto defect than a (hard law) international treaty (Epsteinand O’Halloran, 2008; Lipson, 1991; Chinkin, 2008). TRNsare also assumed to be a better mechanism to resolve,inter alia, cross-border coordination and enforcementconundrums, especially where issues of sovereignty andnational interest protection are of paramount concern.
Shortcomings in regulatory coordination
The view that TRNs are the solution to the regulatorychallenges facing financial markets is not universallyaccepted. Strong objections have been raised highlight-ing the multitude of weaknesses associated with theoperation of TRNs as global financial regulators. First, anational regulator’s principal concern is not furtheringglobal policy objectives but the protection andadvancement of the interests of its national industry.There is no evidence of the suggested (Slaughter,2004b, pp. 159–163) dual duty of regulators withinTRNs to both domestic and global interests. But evenif we could find evidence of such a duty, national reg-ulators would still not be entirely impartial actors dedi-cated to the protection of global public goods such asfinancial stability. Yet every rule or standard proposedby TRNs in the realm of international finance is boundto have distributional consequences that might affectdomestic interests and, above all, domestic financialstability and fiscal outlay.
The fact that TRNs are institutionally ill-equipped toresolve conflicts that entail distributional consequencesis a matter of great significance because internationalregulatory cooperation often involves significant con-flicts over the distributive consequences of new stan-dards. As developed countries dominate the TRNs, it isnot surprising (albeit inequitable) that such conflictsare resolved in favour of the industries dominated byTRN members – even where this is at the expense ofbetter regulatory outcomes. The most significant distri-bution concerns are raised by capital markets disclo-sure, market integrity rules and cross-border crisismanagement and bank resolution operations. The latterbecame rather common during the GFC. Evenapproaches to the regulation of systemic risk may dif-fer according to national economic interest and thedesire to protect key economic sectors or the domesticfinancial services industry (Gadinis, 2008). In such cases,in the absence of a predetermined legally bindingframework, regulators have very little incentive tocooperate and adopt more stringent regulatory stan-dards or, for instance, take prompt corrective action(PCA).
Moreover, international standard setters do not alwaysprovide clear or effective guidance for emerging chal-lenges or risks. Their pre-2008 standards, especially theBasel capital adequacy framework, proved inadequate inmany ways; this included a total failure to appreciate theinadequacy of credit risk agency (CRA) models and theirglaringly apparent conflicts of interest. Yet lack ofaccountability structures has meant that the failures ofBasel I and especially of Basel II had no impact on thestanding of the BCBS.
Another big concern associated with TRNs is their (lackof) legitimacy and the identification of actions that couldbe taken to remedy this defect. I adopt here Buchananand Keohane’s definition of legitimacy of global gover-nance institutions. Under this definition, legitimacy hasboth a normative and a sociological meaning:
To say that an institution is legitimate in thenormative sense is to assert that it has the rightto rule – where ruling includes promulgatingrules and attempting to secure compliance withthem by attaching costs to noncompliance and/or benefits to compliance. An institution is legiti-mate in the sociological sense when it is widelybelieved to have the right to rule (Buchananand Keohane, 2008, p. 25).
Essentially, the normative view of legitimacy askswhether an international body was established by stateactors and/or organizations recognized under interna-tional law. The latter must in turn have the requisitecompetence under national and/or international law. The‘sociological’ perception of legitimacy (‘believed to havethe right to rule’) is, arguably, the most pertinent to glo-bal finance TRNs. Viewed from this angle, lack of politicalcontrols (Underhill and Zhang, 2006; Wolfrum, 2008) inthe operation of global finance TRNs is no longer themost important question. Heads of state and ministersparticipate in the G20 and treasury departments are rep-resented in several TRNs. It is more an issue of lack ofaccountability mechanisms: soft law structures do notallow for the establishment of lines of accountability sim-ilar to those in place for the UN or the World TradeOrganization. Moreover, to meet the test imposed by the‘sociological view’ of legitimacy, global governance insti-tutions need to provide benefits that cannot be providedby states. However, soft law structures proved to be inef-fective, or at best ‘marginally helpful’, in preventing andmanaging the 2008 GFC (Zaring, 2010, pp. 477–485;Giovanoli, 2009, pp. 83–85).
First, Basel capital adequacy standards were seriouslyflawed and are widely assumed to have contributed sig-nificantly to both the build-up and the severity of theGFC. Second, the lack of formal structures for cross-bor-der crisis management and the resolution of failingbanks generated gigantic amounts of confusion anduncertainty. In turn, these developments led to a general-ized collapse of confidence in the markets, especiallyafter the messy collapse of Lehman Brothers.
The flawed capital adequacy regulations
It has been argued accurately and consistently that thefocus of Basel standards on individual institutions’ market
behaviour and financial standing (microprudential regula-tion) was flawed (Brunnermeier et al., 2009, pp. 6–10).Basel capital regulations also proved to be problematicin many other areas, mostly because: (i) capital standardswere very procyclical; (ii) the capital standards tended tofoster regulatory arbitrage; (iii) the Basel I and Basel IIframeworks totally neglected liquidity risks in the bank-ing sector, and (iv) the provision of incentives to adhereto the risk modelling approach encouraged leverage,allowing banks to assume large amounts of short-termdebt.
Basel capital requirements also showed a poor appreci-ation of the importance and cost of strong equity cush-ions. This was the result of both regulatory arbitrage,whereby riskier assets attracting a higher capital cushionwere securitized and taken off balance sheets, and poorcapture of actual risks by the models used – especiallyBasel II – which were based on industry-developed riskmanagement models. For instance, the so-called value atrisk (VaR) had serious shortcomings for a number of rea-sons and probably constituted a flawed way to captureasset riskiness (Avgouleas, 2012, pp. 242–245).
Supervision of cross-border financial institutions
There has not been a clear distinction between the twodifferent functions of regulation – rule making and stan-dard setting on the one hand and supervision on theother – even in the domestic context (Pan, 2010; Lastra,2003). Nevertheless, supervision is roughly defined as theday-to-day monitoring of regulated firms’ compliancewith applicable regulations and the imposition of sanc-tions. The supervision of financial markets has predomi-nantly been confined within national borders. TRNs haveno supervisory capacity of their own. However, the lackof any capacity to supervise cross-border institutions andof any clear crisis management (and burden sharing)framework at the international level, which could recon-cile home and host country interests, became a seriousproblem during the GFC.
There are good reasons to believe that the Icelandicauthorities at least (and possibly Irish regulators as well)were particularly permissive regulators, viewing theirbanks as their national champions. Icelandic banks main-tained a very widespread geographic distribution ofassets that was rather disproportionate to the size of thecountry’s GDP. Host country authorities had no effectivetools for early intervention under the prevailing frame-work. But early intervention was exactly what wasrequired in order not to place the host countries’ bank-ing systems under serious threat (FSA, 2009, pp. 16, 56,154).
Moreover, where national authorities faced colossalcross-border bank rescue dilemmas and expensive
conflicts of interest, memoranda of understanding andother soft law structures played no meaningful role.Characteristic examples are the acrimonious cross-bordertreatment of the failure of Icelandic banks and the messyrescue of Fortis, a large European bank with a strongpresence in three countries (BCBS, 2009, pp. 10–12). Bothcases are surprising examples as they happened withinor just outside the borders of the EU, the region with thehighest level of integration of banking markets and har-monization of national banking laws.
Resolution of cross-border financial institutions
Arguably the most important lesson learned from thecollapse of Lehman Brothers is that, while the businessof international banking groups is run on an integratedglobal basis, their corporate structures are highly frag-mented and labyrinthic. Corporate complexity is normallythe result of regulatory and tax arbitrage or of local legalrequirements, or is employed in order to evade legal lia-bility spilling over from one corporate entity to the otherwithin the same group (Herring and Carmassi, 2010;Basel Committee on Banking Supervision (BCBS), 2009,pp. 14–16). The Lehman and Fortis cases have high-lighted the incompatibility of cross-border group struc-tures with national resolution regimes and insolvencyprocedures (Claessens et al., 2010). This is one of the big-gest threats to financial globalization: it has becomeobvious that, in the absence of clear cross-border super-visory structures and a single insolvency regime, theoperation of systemically important financial institutionson a cross-border basis entails serious dangers (CEPS,2010).
The EU has moved towards the adoption of a harmo-nized approach to bank resolution and insolvency (EUCommission, 2012a) as the only realistic alternative tothe coordination chaos and risk of systemic collapseobserved during the Lehman failure and the Fortis res-cue. On the other hand, the FSB has published a docu-ment containing the key attributes that all bankinsolvency regimes ought to present and advocating amutual recognition approach to cross-border resolutions(Financial Stability Board (FSB), 2011). However, themutual recognition approach that it champions essen-tially means that most of the existing obstacles to cross-border resolution remain.
Another very thorny issue is how to share the burdenin the case of rescuing a cross-border bank or otherfinancial institution. Using taxpayers’ money in one coun-try to bail out the institutions of another is an unjustapproach and is often politically untenable. Thus, in theabsence of an international convention (statute) govern-ing the resolution of cross-border financial institutionsand financial groups, which would be backed by explicit
and legally binding burden-sharing arrangements, pro-gress in this area should be regarded as limited, in spiteof the occasional hype.
All is not well with private-sector input
Some of the aforementioned failures should, in part, beattributed to the quasi-regulatory role assigned to privateactors. The input of the latter is sometimes based onrather imperfect science and is motivated by privateinterests (Partnoy, 2006; Schwarcz, 2002); TRNs’ excessivereliance on private actors’ knowledge and expertise isoften misplaced (Hellwig, 2010, p. 9). For example, thestrong push by industry to base capital adequacy stan-dards on a risk modelling approach translated intorelentless equity reduction practices in favour of debt,which of course led to overleveraged and severely under-capitalized banks (BCBS, 2010; Hellwig, 2010, pp. 2–4).Uncritical endorsement of private-sector expertise andpolicy preferences also fostered self-regulation in deriva-tives markets, which proved inadequate to prevent alarge-scale financial crisis.
Uncritical endorsement of private-sector input in inter-national finance regulation is based on the unfoundedassumption that private actors’ knowledge is complete.In fact, it is very fragmentary and often unheeding oftrue market conditions (Black, 2010, p. 6). Private-sectorinput is subject to two limitations that are inherent tosuch input beyond the obvious credibility gap relating toprivate actors’ legitimate desire to promote their ownagenda. First, private actors, who are deeply entrenchedin the constantly changing currents of the markets, donot have enough incentives to gather diverse pieces ofcostly data that would provide a more complete pictureof the markets, when such data covers areas beyondtheir immediate business needs. Second, market condi-tions often differ from what is expected in equilibrium.However, disequilibrium conditions are as much theproduct of market actors’ own behaviour as of anythingelse.
Private actors’ inadvertent myopia in disequilibrium iswitnessed beyond reasonable doubt by their frequentinability to either identify an asset bubble or react prop-erly to it. For instance, private actors’ cognitive biasesand sociopsychological pressures distort valuations andtrigger strategic trade behaviour (herding), which in turnintensifies disequilibrium conditions (Hirschleifer, 2001;Avgouleas, 2010). Furthermore, the actions of privateactors themselves create the market conditions underscrutiny, a phenomenon known as reflexivity (Soros,1994). In those cases, requesting private actors to accu-rately observe the impact of their own actions and inten-tions in relaying their analysis of market conditionsto their regulatory masters/partners is stretching
perceptions of private actors’ cognitive ability beyondthe limits of credulity. Therefore, TRNs’ informationadvantages due to wider private-sector participation maynot be overestimated, and the global regulatory commu-nity should look at the establishment of more formalstructures when it comes to identifying risks and espe-cially the risks arising from innovative financial tech-niques and instruments.
Summary
Soft law and TRNs are very important and useful compo-nents of global governance, especially in areas where astrong pooling of sovereignty would be regarded asintolerable by states. They also have several shortcom-ings, as explained earlier. In many ways this form of gov-ernance for international finance proved largelyineffective. On the other hand, criticism of soft law struc-tures should not ignore the valuable benefits that coop-erative forms of governance bring in a number of otherspheres of transnational interaction, chiefly informationsharing.
2. A new governance framework for globalfinance
Rationale
Arguably, current reforms provide limited comfort whenit comes to: the global supervision of systemic risk; thecross-border supervision of big cross-border financialinstitutions; the identification and management ofemerging risks due to unpredictable combinations or cor-relations of forces unleashed by financial innovation withother market and real economy forces; and the resolu-tion of cross-border financial groups. Therefore, in theabsence of a new governance system for global financeaddressing these shortcomings, the effectiveness ofrecent regulatory reforms will be greatly undermined.
Despite recent reforms, many gaps remain in thesupervision of large financial institutions and groupsoperating on a global basis. These fractures would almostcertainly lead to three insurmountable problems thatwould make the operation of systemic cross-borderfinancial institutions, so-called G-SIFIs, a continuoussource of moral hazard, notwithstanding the importantnew regulations that are underway to limit it. First, whilethe cross-border operation of financial institutions cangive rise to cross-border contagion leading to a general-ized financial crisis, the incentives of the home supervisorto prevent this outcome could be weak. As the collapseof the Icelandic banks has shown, home-country supervi-sors are certain to face weak incentives to intervenepromptly, when the main asset or deposit base of the
institution in trouble is in another jurisdiction. The recentintroduction of supervisory cooperation structures suchas the so-called supervisory colleges might makeexchanges of information smoother, facilitating supervi-sion, but they are unlikely to prove an effective crisismanagement and resolution mechanism. Because col-leges do not have power of intervention, especially as itrelates to PCA and resolution, it is unlikely that homesupervisors will be forced to act when they stand to losereputation and money (from the deposit insurance fundor the resolution fund, or due to a public bailout) inorder to protect or rescue depositors or other creditorsof the financial institution concerned when these arelocated in other jurisdictions.
Moreover, the need for a global financial policy andrisk research and regulation body is even greater in lightof the marked and continuous criticism directed at creditrating agencies (CRAs): CRAs are the key private proces-sors and assessors of financial risk knowledge in the glo-bal marketplace. Apart from the multitude of other flaws,CRA ratings also seem to be unpardonably procyclical ortend to de facto dictate international public policy. In thecontext of the ongoing sovereign debt crisis, CRAs havebeen accused plausibly of creating a string of self-fulfill-ing prophecies with their aggressive downgrading of EUsovereign borrowers (OECD, 2011).
Finally, US and EU reforms in the field of systemic riskmonitoring and bank resolution (Avgouleas, 2012), aswell as requisite FSB resolution proposals (Financial Sta-bility Board (FSB), 2011), constitute a significant step for-ward, especially with respect to the orderly resolution oflarge financial institutions to minimize moral hazard. Yettwo big problems remain. First, there is no internationalbody dealing effectively with the monitoring of the sha-dow banking sector and of systemic risk building up atthe global level. Second, recent reforms have made lim-ited progress with regard to the resolution of cross-border financial groups. The absence of a single legalregime (statute) dealing with the resolution of cross-border financial groups on a unitary basis, instead ofholding separate proceedings for each group entity (withdifferent legal personality) in a variety of jurisdictions,further exacerbates this problem.
General principles of governance
It is suggested that a new international treaty is the bestmeans to effectively reconfigure the present nexus ofrelationships between national regulators and globalfinancial institutions and markets. Arguably, the sameresults could be achieved by national authorities con-tracting over their powers to the proposed global gover-nance bodies. Yet an international treaty would providea level of certainty that would be lacking in bilateral
arrangements. In order to build strong accountabilitylines, the same treaty would make the four organizationsaccountable to a new treaty-established governing coun-cil (see Figure 1). This arrangement would extend to theexisting international bodies involved in the proposedsystem, whose statutes would have to be amended.
The global financial governance council would comprisethe G20 members (ministers or heads of state), the EU (asan organization separate from its members), the UN (as anorganization separate from its members), the World Bankand the three most important national economies that arenot represented in the G20. The governing council wouldbe convened every six months or whenever importantmatters have to be discussed. In addition, key NGOsshould sit on the board of the financial policy authorityand even be given voting rights when debating issueswithin the NGOs’ areas of expertise.
Within the proposed structure, the four authoritieswould be of equal status and they would be mandated tocooperate in full, especially when it comes to theexchange of information, the initiation of joint regulatoryaction or the processing and evaluation of data (see Fig-ure 1). The important decisions of the suggested systemof global financial governance would be decided jointlyby the heads of the four authorities. However, eachauthority would have the decisive vote in its respectivegovernance field: systemic risk supervision, micropruden-tial supervision, regulation production and resolution.Any critical disagreements would be referred to the chair-man of the governing council or the council plenary, butthis right would cover only planning decisions and notinstances where speedy action would be required such asthe imposition of sanctions, the prevention of an activitythat threatens systemic stability or initiating resolutionproceedings. Naturally, more detailed rules would have tobe instilled in the process to allow the system to takeeffective and responsible action without fear of abuse.Thus, the system would eventually develop its own set ofglobal administrative law rules. These arrangementswould provide clarity in the relationship between thedifferent authorities of the proposed scheme.
Unsurprisingly, if all G20 economies and the rest of theEU subscribe to the new governance scheme, followingthe signing of an international agreement, it would beimpossible for the rest of the world not to join. Apart fromthe quality and credibility mark lent to institutions super-vised under the scheme, the new governance systemwould provide a further advantage. I suggest that thescheme would provide to institutions falling under itsremit full freedom of establishment in foreign jurisdictionsand freedom to offer services on a cross-border basis, sub-ject to local rules of conduct. Namely, it is proposed togive institutions governed by the scheme a ‘single pass-port’ facility similar to that granted by EU member statesto any financial institution licensed in the EU.
The scheme would only be able to provide this facilityif World Trade Organization signatories agreed to a mod-ification to the General Agreement on Trade in Services,rendering the ‘prudential regulation carve-out’ inapplica-ble for financial institutions governed by the proposedgovernance scheme. This should not prove an insur-mountable problem: with the implementation of the sug-gested scheme, authorities would be taking importantsteps to safeguard systemic stability.
The establishment of a set of commonly acceptedshared values is of cardinal importance for the effective-ness and legitimacy of a multilayered governance struc-ture (Cottier, 2009; Weber, 2010). Thus, the departurepoint for holding the regulatory bodies of the new struc-ture to account would be their compliance not only withtheir charters but also with a set of general principlesthat should govern their actions. Several attempts havebeen made to first identify those principles (Lastra andGarricano, 2010; Weber, 2010) and then define them, andwith reference to the general principles governing theoperation of the leading international finance soft lawbodies such as IOSCO (IOSCO, 2010). In this context, Iview three principles as beyond dispute. These are theneed to:
1. safeguard the global public good of financial stability;2. protect the robustness of financial infrastructure, and3. safeguard the integrity of global markets and protect
the investors and consumers of financial services fromabusive practices and products that may be unsuit-able for their risk profile.
I also suggest that a fourth principle is added, eventhough it may be used only as a supplement to the prin-ciple of financial stability. All actors of the new systemshould be cognizant of their impact on the ability ofopen and competitive financial markets to foster eco-nomic growth when the objective of financial stability isnot compromised.
The macroprudential supervisor
The first pillar of the proposed governance system, theglobal systemic risk (macroprudential) supervisor, wouldmonitor both macroeconomic developments and thestate of the global financial system, seen as encompass-ing national, regional and international financial systemsand the shadow banking sector. This duty would beassigned to a revamped IMF (Lastra and Garricano, 2010)by means of an international treaty. Doing so makesgood sense, given the IMF’s monitoring role with respectto national balance of payments and sovereign indebted-ness. In fact, the entanglement of financial-sector stabilityand solvency with sovereign indebtedness and vice versameans that only a revamped IMF could effectively dis-charge the duties of a global macroprudential supervisor.
In addition, the IMF should be given the tools to moni-tor closely the shadow banking sector in order to closethe current supervisory discontinuity. A possible way todo this would be to require all shadow banks and hedgefunds to register with the IMF and file regular reportswith it. The scheme should be properly calibrated interms of asset thresholds to capture all important sha-dow banking vehicles. Thus, it should provide for deminimis exemptions to avoid the registration of smallfunds.
Finally, the IMF should be entitled to recommend tonational regulators or the proposed global micropruden-tial supervisor the right course of action against anemerging systemic threat. It should also be consideredwhether, in the context of the same treaty, it would befeasible to give the IMF the power to directly requirefinancial institutions to act upon emerging systemic risks.The global macroprudential supervisor would only inter-vene when the emerging risk constitutes a threat tomore than one country and has the potential to create across-border crisis, thereby minimizing interference withdomestic financial systems.
The microprudential supervisor
Political objections and realities notwithstanding, theonly effective solution to the regulation of G-SIFIs is tosubject G-SIFIs with a strong cross-border asset or liabili-ties base (50 per cent and higher over total assets) tothe direct supervision of a global microprudential author-ity to minimize the scope for regulatory arbitrage. Therole of the microprudential supervisor could graduallyevolve into a fully fledged global markets regulator,which could eventually be asked to exercise oversightover mega-exchanges and wholesale derivatives markets.
The microprudential supervisor could exercise directoversight over G-SIFIs, and its remit could graduallyextend to cover certain wholesale segments of the globalderivatives and securities markets (Langevoort, 2010),resolving the problem of regulation of mega-exchanges.Thus, it is suggested that this role should be assigned toa reconstituted and expanded FSB, where all G20banking and capital markets regulators are already repre-sented. The Bank of International Settlements (BIS), minusits research division, would have to merge with the FSB.Accordingly, the new microprudential supervisor wouldessentially operate from existing BIS premises in Basel,ensuring its neutrality.
This pillar of the proposed governance system is likelyto be opposed fiercely. Strong national interest dictatesthat each country that serves as the home jurisdiction ofa big bank or other important financial institution wishesto be the principal regulator of this institution. This is sofirst for reasons of national economic interest, including
job preservation and credit growth in the national mar-kets, and second for reasons of prestige and influenceover global economic affairs. Yet the logic of the pro-posal is too strong to be dismissed out of hand. It elimi-nates the scope for regulatory forbearance and providesa framework for the consistent application of the newinternational regulations. At the same time, sharing ofsovereignty over the supervision of the financial sector islimited to the international operations of big cross-borderinstitutions.
Global financial policy and risk regulation authority
The third pillar of the proposed governance structure is aglobal financial policy body that would oversee the TRNs,including the Basel committee, and IOSCO underarrangements that should be more binding than thoseunderpinning the FSB, which currently performs this role.The suggested arrangements would not obliterate theimportance of the Basel committee or of other TRNs, northeir value as importers of private-sector knowledge andinterlocutors with the private sector. This approachwould make the proposed scheme a truly multilayeredand hierarchical governance structure.
Accordingly, the third pillar should comprise the Orga-nisation for Economic Cooperation and Development(OECD) and the research functions of the Bank of Inter-national Settlements. It should deal with the productionof new regulation and the examination of emerging risks,especially by means of various financial innovations. Thenew body should be the directing mind of internationalfinancial regulation.
TRN standards would have to pass a public interesttest set by the financial policy body, which would focusprimarily on financial stability and the ways the draftstandard serves the other general principles of the pro-posed governance system. Once endorsed, the standardswould become binding, automatically or through manda-tory implementation legislation, to all jurisdictions thathave opted into the proposed scheme and signed thetreaty.
The rule-making committees of the InternationalSwaps and Derivatives Association (ISDA), the standard-setting committee of the International Accounting Stan-dards Board (IASB), and other important private-sectorrule-making bodies would also come under the umbrellaof the financial policy regulator; their standards wouldhave to be endorsed by the regulator, provided that theymet a public interest and financial stability test. Thisreform would secure coherence in standard setting andrule making in the field of international finance, eliminat-ing the scope for rule conflict or uncertainty. The samebody should play the role of global risk knowledge bankand manager. For example, neither the risks nor the
potential benefits of financial innovation in open globalmarkets can be managed properly in the absence ofpainstaking research and the testing of innovative finan-cial instruments and techniques in real (or stimulated )market conditions. The proposed authority would havethe mandate and resources to engage in authoritativeresearch and disseminate its findings widely.
A global resolution authority
The fourth pillar of the proposed system of governanceshould be a global resolution authority. The resolutionoperations of this body should be supported either byburden-sharing arrangements between member coun-tries, probably using assets-to-GDP ratios as a basis forcontributions (Goodhart and Schoenmaker, 2009), or by aglobal resolution fund financed by levying a tax on G-SI-FIs. The best way to calculate such a levy would be onthe basis of the assessment of institution riskiness usinga risk matrix developed jointly with the proposed finan-cial policy authority and TRNs, such as the BCBS, thatwould work under its umbrella. Calibrating a levy onG-SIFIs in this manner could satisfy the objective offinancing resolution and curb excessive risk taking.
The establishment of a global resolution authoritytasked exclusively with carrying out the resolution of G-SIFIs would be expected to address issues of impartialityand mistrust that all cross-border resolutions are boundto face due to the multitude of conflicting interests(creditor, shareholder, employee and national) involvedin the process.
Furthermore, the global resolution authority may onlyoperate effectively if participating countries and institu-tions accept its competence to intervene through theimplementation of attendant modifications to theirdomestic laws. These ought to allow the global resolu-tion authority to operate a single resolution and insol-vency law for G-SIFIs. Country members of the schemecould create a special statute that would apply exclu-sively (lex specialis) to the resolution of G-SIFIs (Avgou-leas et al., 2013). Finally, all financial institutionssupervised by the proposed scheme would have toamend their statutes to incorporate the changes necessi-tated by the single-resolution model in order to minimizethe threat of shareholder and creditor litigation.
3. Evolution or revolution?
The global financial governance model I outline in thisarticle constitutes a global regulatory ‘big bang’, but it isnot a new Bretton Woods. It provides answers to severalof the pressing challenges linked to open global markets,but it does not tackle all of them. It also uses, to acertain extent, existing institutional infrastructure andemerging lines of responsibility in the field of global
financial governance. Arguably, once the fragmented andfluid governance structures and areas of expertise deal-ing with international finance are pieced together, theyprovide a strong guide as to which is the right path forreform. The governance model presented here has alsoconsidered efforts to chart a global financial governancemodel originating from other academic works (UNExperts Report , p. 87; Alexander et al., 2006). Yet it issharply different and more far-reaching than previousproposals. This radical shift is premised on experienceand knowledge we now have about: (i) the workings ofglobal finance; (ii) the causes of the GFC and the con-tours of the financial revolution; and (iii) the other chal-lenges modern markets/economies face, such as thewidespread moral hazard to which too-big-to-fail institu-tions give rise and the development objective.
Essentially, the prosperity of global markets and thestrong management and regulation of the risk emanatingfrom them has reached a critical junction. Since the post-war years, whether it was matters of monetary stability,or of war and peace, or the promotion of internationaltrade and protection of the environment, or the recon-struction and development effort, whenever a majorcomponent of global welfare has been in grave danger,rational states have pooled sovereignty through interna-tional law structures. They have done so in order toeffectively manage the requisite crisis properly and allevi-ate the conditions giving rise to the problem. It is nowthe turn of global finance to acquire a formal interna-tional governance infrastructure dealing with the chal-lenges raised by the operation of open global markets.The proposed governance plan has the distinct advan-tage of requiring the pooling of sovereignty only when itcomes to large cross-border financial institutions andmostly with respect to their cross-border operations.Thus, loss of sovereignty is kept to a reasonableminimum.
Recent reforms in the eurozone intended to establisha European banking union, under which the EuropeanCentral Bank will supervise the 6000 banks operating ineurozone member states, are particularly instructive (EUCommission, 2012b). They lend strength to the argumentthat an international governance structure for globalmarkets is the only effective defence against a return tofinancial protectionism.
Conclusions
Since 2008, the entire project of economic globalizationhas been in grave peril. Nonetheless, in terms of globaleconomic growth, this is the worst time possible toreturn to a closed-markets system. World requirementsfor credit and investment to finance development,sustainability and increased food production projects areon the rise (Rolwey, 2011). These additional funds may
only come from free and open global financial markets,notwithstanding the need, in certain cases, for veryshort-term capital controls in order to curb speculativecapital flows.
The multitude of complex challenges that financialglobalisation creates may not be resolved in the absenceof solid and effective supranational regulatory structuresdealing with them. Building binding international struc-tures for the governance of global finance is a naturalconsequence of the operation of open global marketsand essential protection against risks emanating fromthem. The model of governance proposed in this articlehas the potential to prove a much better guardian of theglobal public good of systemic stability than national orregional regulators and the existing transnational regula-tory networks.
The existence of a set of commonly accepted values isthe foundation of any multilayered system of governanceand the material that holds it together, reinforcing itslegitimacy (Cottier, 2009, p. 657). Thus, the proposedarchitecture is based on a set of shared values (in theform of general principles and sub-principles of gover-nance). These would secure its coherence. They are alsomuch more cognizant of an additional (to financial stabil-ity) global public good: sustainable growth.
The inclusion of the development objective in the newgovernance structure, notwithstanding the supremacy ofthe financial stability objective, would signal a reorienta-tion in the operating values of global finance. The newgovernance model would signal to global finance opera-tors and developing nations the possibilities that globalfinance holds in resolving development problems. This,in turn, is a very good way to create a community ofinterests between the two and thus broaden the legiti-macy of the proposed governance system.
NoteI am grateful to Professors Charles Goodhart, Lawrence Baxter and Ste-ven Schwarcz for critical comments on earlier versions of this article.
1. The FSB has offered the first authoritative and formal definitionof ‘shadow banking’. It has described it as ‘a system of creditintermediation that involves entities and activities outside theregular banking system, and raises i) systemic risk concerns, inparticular by maturity/liquidity transformation, leverage andflawed credit risk transfer, and/or ii) regulatory arbitrage con-cerns’ (FSB 2011, p. 3).
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Author InformationEmilios Avgouleas is Professor of International Banking Law andFinance at the School of Law, University of Edinburgh.
