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How Regulation Designed to Prevent Another Financial Crisis Could Drive Jobs to Other Countries

Congress enacted Dodd-Frank, which created the Financial Stability Oversight Council, to guard against a recurrence of the financial crisis and to protect American taxpayers. The initial intent of this legislation was to coordinate various regulatory agencies and instill joint accountability for the stability of the financial system. However, with today's highly-interconnected global financial markets, there is a risk of over-regulation or what some are calling "regulatory arbitrage" that carries with it real impact.

It means the potential loss of jobs in the American financial sector if firms seek to move overseas where regulation is weaker. It means a "race to the bottom" for standards and protections. And it may increase the possibility of future financial instability if riskier activities migrate to areas with less transparency, looser regulation, and laxer supervision.

Some members of the financial industry have stressed that it would be disadvantageous to U.S. firms if the United States were to apply higher capital standards than regulators abroad impose upon their peers.

On the other hand, major causes of the recent crisis included factors such as too many financial institutions having too much leverage, too little liquidity, and inadequate loss absorbing capacity. This led to a downward spiral in confidence among counterparties globally.

In July 2009, as a direct result of lessons learned in the crisis, the Basel Committee issued updates to the market risk framework, known informally as "Basel 2.5". These revisions strengthen standards for measuring market risk and holding capital against those risks, and improve transparency, especially with respect to securitization activities. The United States is committed to implement Basel 2.5 by the end of the year, as internationally-agreed.

In November 2010, the G-20 Leaders endorsed a new framework for bank capital, known as Basel III. It will help to ensure that banks hold significantly more capital, that the capital will truly be able to absorb losses of a magnitude associated with the crisis without recourse to taxpayer support, and that the level and definition of capital will be uniform across borders.

This G-20 action was a direct response to President Obama's call for strengthening both the quality and quantity of bank capital around the world.

A second issue to be considered is reducing the systemic risk from large, interconnected financial firms.

Prior to the crisis, many large, interconnected firms held too little capital relative to their risk-weighted assets, posing risk to the global financial system, and in the end necessitating significant government intervention when their balance sheets deteriorated rapidly.

The Financial Stability Board and the Basel Committee are currently discussing how capital surcharges should best be structured. The United States has been clear about its priorities.

First, it is critical that additional capital consists first and foremost of high quality and loss absorbing common equity. Common equity is the strongest defense against financial stress. Shareholders, not taxpayers, must absorb losses that a bank incurs. Lower quality alternative instruments cannot absorb losses as readily in a crisis and pose unlevel playing field concerns depending on how other countries apply the requirements.

Second, it is equally important that the surcharge be well calibrated to balance the imperatives of financial sector and macroeconomic stability.

Third, it must apply to a wide range of the large, interconnected banks across the globe to promote a level playing field. And it must be mandatory and comparable across jurisdictions.

AUTHORGeorge Mentz Insider Comment
  • Jo
    12 July 2011

    It's good to see the Financial Services lobbyists hard at work trying to strike fear into the public with the goal of watering down regulations. Banks exist solely to make money and as a result need to be regulated. Don't get fooled again.

  • To
    6 July 2011

    The issue is not merely greater or lesser regulation, but also smarter vs. otherwise. Costly regulation that either provides little protection against or even increases systematic risks should be rightfully avoided.

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