PUBLISHED:October 03, 2012

Baxter discusses financial regulation in Europe, Asia

Professor Lawrence Baxter

Professor Lawrence Baxter recently spoke at three-high level conferences on international financial regulation and reform in London and Seoul, respectively.

At the third annual International Regulatory Summit of the International Centre for Financial Regulation in London on Sept. 25, Baxter addressed the question of how international regulation should be made, appearing on a panel alongside Robert Jenkins of the Bank of England’s financial policy committee, Terri Vaughan, CEO of the National Association of Insurance Commissioners, and Secretary General David Wright of the International Organisation of Securities Commissions.  During the discussion, presented as the ICFR Private Members’ Policy Roundtable, Baxter focused on his concerns over the expansion of “target regulation” of banks as typified by Basel III, the global regulatory standards recently set by members of the Basel Committee on Banking Supervision.

“Basel III is becoming more and more tangled in a web of bureaucratic targets that I believe ─ as do many others ─ plainly violate ‘Goodhart’s Law,’” Baxter said in an interview, explaining that the principle, named for economist Charles Goodhart, posits that any economic regulation that sets a specific target will be self-defeating.  “Complexity theory indicates that participants in the economy, be they banks, regulators, or individuals, always act strategically and adapt to any targets that are set within the economy.  And to the extent that the Basel rules are setting specific risk weightings and specific capital limits, they can and will be ‘gamed’ by the financial institutions.  It’s only natural for there to be an adaptation of conduct to optimize their position under those rules.” 

Instead, Baxter stressed the need for both simple rules, “not the complex, bureaucratic labyrinth that is being created,” and for simpler organizations, calling the vast very largest financial institutions overcomplicated and too big to manage.  “And a corollary is that instead of target rules, which betray a deep distrust of regulators, we need to restore to regulators the discretionary judgment that they should exercise in their supervision of financial institutions,” he said.

Banking regulation “optimizes locally,” unlike capital markets, which “optimize globally,” added Baxter.  “National and state regulators need to be able to supervise financial institutions properly.”  For that reason, he told the gathered international regulators and economists, a European Commission plan to implement a Europe-wide regulatory regime that could trump national regulators, may well be too ambitious and even misdirected. 

In Seoul, Baxter addressed two conferences on international banking and financial regulation, at the Glokal Science and Technology Law Institute of Sung Kyun Kwan University (SKKU) and the Korea Institute of Finance, respectively; both were co-sponsored by the Korean Banking and Financial Law Association (KBFLA).  Both gatherings, he said, were motivated by ongoing reform of the Korean regulatory system and the extraterritorial impact of U.S. regulatory reforms such as those mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

“They are concerned both by how Korean banks operating in the U.S. are affected and how their transactions elsewhere will be affected,” he said.  “For example, if you take over-the-counter derivatives reform, transactions that involve a U.S.-based counterpart, even if undertaken overseas, will be hit by things like new margin and registration requirements. And under the Volcker Rule, the only way to avoid the prohibition on affiliations between proprietary trading organizations and insured depository institutions would be for the foreign institution to have no U.S. based operations.  In practice, the rule will impact any global bank because all banks of significant size are now global.”

At the academic SKKU conference, Baxter offered a theoretical review of a range of fundamental forces affecting financial reform.  These forces include the long term impact of financial crises; the growth of an excessively “financialized” element in the economy; the dramatic increase in financial interconnectedness worldwide; the “human factor” in finance (largely ignored by neo-classical economics); the growth of the shadow banking system; the deep global technology revolution; and the convergence of global economic development coupled with the increasing divergence of wealth distribution.  These factors combine, he said, “to make the possibility of global financial harmonization and regulatory reform very challenging.”  At the Korea Institute of Finance conference, which was co-chaired by Do Won Ko SJD ’95, the president of the Korea Banking and Financial Association, Baxter targeted his presentation to practitioners and bankers, focusing more on the “nuts and bolts” of extraterritorial impact of U.S. financial reform. 

Both events offered clear evidence of Korea’s commitment “to be constructive and eager participants in the global system,” Baxter observed.  From other attendees, such as leading academics from Japan and China, he also emerged with a better understanding of attempts at ─ and failures of ─ regulatory reform elsewhere in Asia. 

Baxter, who also offered workshops at two other law schools in Seoul, said his recent round-the-world travels will be enormously helpful as he prepares for his spring-semester classes on international and domestic financial regulation.  “They gave me a tremendous hands-on sense of various views around the world and the dynamism of the Asian financial sectors.  You can’t get it just from reading.  The talk over dinners and luncheons offers a sense of what people are actually thinking.  The papers are valuable, but it’s the interaction that really makes all the difference.”