Meeting a need

Competing international financial ­centres (IFCs) may share largely common goals but it is unusual to find two that have an overtly common background. Furthermore, the international financial services marketplace within which IFCs compete is relatively heterogeneous. All of this leads us to suggest that IFCs should not seek to replicate the success of other jurisdictions by importing their regulatory models from other jurisdictions without significant thought. Rather, IFC planners should identify their real opportunities, strengths and vulnerabilities before initiating regulatory reform, and set these within the requirements of the regional and global structure within which they operate.

During our work for IFCs, we have developed a number of constructs for assessing the appropriateness of regulation and the organisational structures that create and administer them. One useful model is based upon the ‘hierarchy of objectives’ for IFC regulation. In this article, we will explain and explore this model, which can be used to identify and categorise the developmental needs for regulators. Following a brief overview of the approach, we give a detailed description of its structure, followed by an exposition of how it can be applied to two theoretical scenarios.

A regulatory hierarchy

The model in Figure 1 provides the ‘regulatory hierarchy’ framework within which the regulatory needs of an IFC can be assessed. Each level builds on the strength provided by the preceding one, facilitating an assessment of needs from ‘fundamental market stability’ to building an international ‘identity’.

The framework does not represent a menu. One cannot simply address a single level and ignore the others. All the levels are important and highly inter-related at all times during the development of an IFC. However, different centres, at different points of their development, will need or may choose to invest more heavily in one level than another.

We will now consider each of the levels in more detail.

Level 1: Stability

Fundamentally regulation must ensure the stability of an IFC’s economy (and ensure it contributes to the stability of the world economy). The Core Principles for Effective Banking Supervision¹ lists the precedents for a country’s financial stability and soundness, including:

• Sound and sustainable macroeconomic policies

• A well-developed public infrastructure

• Effective market discipline

• Procedures for efficient resolution of ­­­pro­b­lems in banks

• Mechanisms for providing an appropriate level of systemic protection (or public safety net)

There are similar principles developed by the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) for capital markets and insurance. The Basel principles focus on regulatory capacity and delivery:

• Regulations and legislation

• Regulatory independence and accountability

• Effective enforcement powers

• Simple regulation that is easy to administrate

• Clear regulatory objectives

• Adequate regulatory resources

• Comprehensive regulation built on a ‘pro-business’ ethos

• Culture of strong corporate governance

Changes at this fundamental level have a significant effect on financial services markets and reform should be made cautiously. (If ever there was an area of business that has the potential for demonstrating the ‘law of unintended consequences’ this is it.) These economic and regulatory choices are the foundations upon which markets can be made or destroyed.

Level 2: Control

The second level focuses on market control, in particular the proportionality of regulatory oversight of the risks that firms face and that they pose to other market participants, consumers and the economy. Regulation here supports business activities by ­identifying and mitigating risks through the setting of standards that firms must meet.

Effective market interaction is important in attracting and retaining firms to an IFC. In a recent review of the New York ­experience, Bloomberg and Schumer state: “Business leaders increasingly perceive the UK’s single, principles-based financial sector regulator – the Financial Services Authority (FSA) – as superior to what they see as a less responsive, complex US system… Regulatory enforcement style also matters, with the UK’s measured approach to enforcement seen as more results-oriented and effective than a US approach sometimes described as punitive and overly public.”²

Here then, heavy-handed regulations may provide a means to meet ‘risk minimisation’ regulatory objectives but may also stifle innovation and growth and drive business to more nimble regulatory jurisdictions. We have seen the growth in funds in Ireland and Luxembourg partly due to the regulatory focus on this sector. Effective regulation carefully balances the need for prudence and limits the burden of regulation on low-risk activities through considering the actions, objectives and risks associated with business activities, and which interventions will be most effective.

Risk-based regulation provides a good example of aligning regulation to business activities. Both Dubai’s Financial Services Authority and Qatar’s Financial Centre ­Regulatory Authority have adopted risk-based approaches to regulation designed to determine the risks a firm poses to their regulatory objectives: ^3,4,5

• Foster transparency and market efficiency

• Maintaining market confidence

• Promoting public awareness

• Financial stability

• Consumer protection

• Reducing the incidence of financial crime

At a high level, the processes follow a series of logical steps:

• Step 1: risk identification

• Step 2: risk assessment

• Step 3 prioritisation

• Step 4: risk mitigation and monitoring

The rationale for adopting a risk-based approach is:

• An acceptance of failure in firms

• The financial service market is too large to regulate in a homogenous manner

• A risk-based approach allows regulators to incorporate differing methodologies appropriate to the needs of different sectors

• Regulators, by their nature are risk-based (for example, larger firms will always attract more attention)

We recognise that IFCs may find it difficult to develop an approach to supervision and enforcement that firms will admit to liking. However, they should seek to keep pace with, or gain a comparative advantage over, other jurisdictions if they want to maintain or grow their market share.

Level 3: Outlook

The third level considers regulatory outlook – in particular, the ability to anticipate market change and market risk, and the willingness and confidence of the regulator to allow market participants to engage and participate in regulatory change according to their ability to do so. To encourage debate, regulators should engage in regular, close and transparent consultation with market participants, allowing regulators to stay abreast of market issues as well as providing a space for market participants to raise concerns and suggest ways of resolving issues and risks.

Providing space for innovation is key to the long-term success of an IFC. For example, Cayman has grown the number of captive insurers from one (1976) to 542 (2008), through an industry-facing regulatory outlook that has encompassed fundamental regulatory change (for example, the 1979 Insurance Law); constant revision of this law under a task force structure that takes a ‘holistic view’ of changes that can attract more captives and reinsurers; the Cayman Islands Monetary Authority’s (CIMA) responsive regulation of the sector via government working groups; and specifically CIMA’s primary strategy to engage with (if not always agree with) international ­standard setters such as the IAIS.

Regulators should also expect and plan how they will deal with particular market failures. A strong system needs to stress-test its resilience to the failure of a large firm and anticipate what the authorities are likely to do, even if fundamental change is required as part of the reaction. Some degree of market failure appears to promote a more effective approach to regulation as it ensures emerging risks are identified, understood and dealt with, as opposed to being hidden until a catastrophic fault occurs. For example, many Asian regulatory systems are stronger because of the response to the recent Asian economic crisis, which although painful for the market to absorb, did allow regulators to identify significant problems in their approach to overseeing financial risk management. The actions taken in light of the collapse helped to make the wider market and the region more secure.

This supervisory approach needs to be conducted at a detailed level so that emerging issues within specific sub-sectors can be managed without unnecessarily hampering the market as a whole. For example, the regulatory reaction to an emerging hedge fund market should differ significantly depending on where the funds are domiciled, where they are investing, the nature of investors, the contract terms and rights, how leveraged the funds are, and whether failure delivers systemic risks.

Level 4: Optimisation

The fourth stage focuses on optimisation. Once a jurisdiction has a strong and stable financial services market contributing materially to national gross domestic product, IFCs should consider means to reduce the cost of regulation. These take the form of both direct costs (for example, industry levies) and indirect costs (for example, time firms spend dealing with regulators. A recent equity markets study by Deloitte shows for that market at least, beyond a certain level of regulatory ‘burden’ there is little or no additional value created for the market (see Figure 2).

During optimisation, IFCs should consider the potential benefits and costs associated with differing regulatory structures. A rationalised, fit-for-purpose regulatory structure can be set up to help an IFC meet regulatory objectives while reducing regulatory costs.

A wide range of regulatory models can be found throughout the world designed to meet these needs. In their 2006 paper, The Structure of Cross-sector Financial Super­vision, Herring and Carmassi identify five basic supervisory models⁶: sectoral; by object­ive; by function; unified; and integrated. Until the 1990s, sectoral and/or functional supervision was the most common approach in the major markets. From that point on, an increasing number of countries adopted unified regulatory structures as illustrated in Figure 3.

The increasing number of single regulatory systems is driven by a range of factors, including⁷:

• Market developments dictate the need for a single approach to large financial conglomerates and the blurring of the boundaries between financial products make sector-based regulation increasingly less viable

• There are economies of scale and scope available to an integrated regulator, allowing scarce regulatory resources to be allocated efficiently and effectively

• A single regulator can set clear and consistent objectives and responsibilities, and resolve trade-offs between these objectives objectively

• A single regulator can be made more clearly accountable for its performance against its statutory objectives, for the regulatory regime, for the costs of regulation and for regulatory failures

Despite its seeming popularity, however, unification may not be suitable for all markets, and it should be recognised that, of the 151 jurisdictions studied by Barth, Caprio and Levine in their 2006 study Rethinking Bank Regulation, only 46 were considered to be supervised by a single authority across the financial sector⁸. (NB, the small discrepancy in total single authorities and total unified regulators for 2006 identified by Barth, Caprio and Levine [2006] and Herring and Carmassi [2007] is due to definitional differences.) Local conditions (for example, market structure) and needs should dictate if and how regulatory structures should be reformed. A number of balancing arguments against unification have been put forward. Abrams and Taylor provide a good overview in a working paper written for the IMF from 2000⁹. In our view, there are three major potential drawbacks to unification under a single regulator:

• Vesting too much power in a single institution may damage effectiveness.

• Meeting the whole range of regulatory objectives may require a wide variety of skills that may be difficult to manage under one structure (for example, conduct of business versus prudential supervision).

• Limiting number of senior posts may lead to a skills shortage as potential future leaders seek opportunities outside the regulatory system.

Structural reforms must pay close att­ention to local needs and should only be ­undertaken after a robust benefits analysis. The trend towards unified or integrated regulators may be a valid response to the growth and spread of large corporations that operate across sectors, but some of the argument in the public domain does appear to be based on fashion. This should not be the driving factor.

Level 5: Identity

The final level focuses on developing an identity for the IFC, effectively explaining to the global financial services community the benefits of using the IFC for appropriate classes of business and acting as an additional mechanism for developing a pro-­business approach within the centre. If a jurisdiction is comfortable in terms of its stability, control, outlook and optimisation for certain classes of business, a regulator can (and should) actively engage in promoting their jurisdiction on the international stage with the aim of encouraging market growth.

Central to the success of building a strong identity is ensuring that the actions of an IFC match its intentions. A strong and stable IFC should welcome innovations and a wide range of market participants, and be flexible enough to deal with their needs. International market participants will learn to understand and respect the regulatory mechanisms of an IFC if regulators interact intelligently with the market.

Regulators must seek to build a system they genuinely believe out-competes other IFCs and then ensure that the unique benefits offered by the IFC are recognised throughout the international community. Offering charismatic leadership, supporting business and promoting innovation can go a long way to building an identity that is respected internationally.

For clarity, however, it must be stated that a regulator is not a marketing arm of a commercial body ‘drumming up’ business at all costs. Quite the contrary; it is the unique role that a regulator plays in developing, within its compass, the appropriate balance of risk and return that – when appropriately communicated – can form the core of the identity for the entire financial centre.

We contend that long-term regulatory success is correlated to the amount of time the regulator can spend on building the IFC’s identity on a global basis.

Planning tool: mapping development

In practice, the theoretical framework described above can provide a useful lens through which to view an IFC’s regulatory history. Figure 4 provides an overview of how the model has been applied to a theoretical jurisdiction.

In phase A, the IFC is focused on building market stability, control and outlook while also conducting significant structural optimisation. Towards the latter part of this phase, emphasis shifts towards outlook and optimisation. In phase B, the IFC operates under beneficial market conditions. It is able to increase emphasis towards developing its identity and drive market growth. However, it maintains a strong commitment to resourcing outlook and control initiatives to ensure it regulates effectively. Issues relating to stability do not pose a significant concern and as such are monitored but not actively engaged with.

The final phase, C, represents a fundamental shift in market dynamics, for example, the 2007/08 credit crunch. The changing market conditions require the IFC to refocus its resources on fundamental needs to promote market stability.

The above example highlights how the approach can be used post hoc. However, regulators can also use the framework to consider current and expected conditions as a means to plan how resources should be allocated across ongoing needs.

Strategy tool: sector analysis

The regulatory hierarchy approach also provides a means by which to consider the allocation of resources for new and developing markets by sector. For this example we will consider an IFC overseeing the emergence of a hedge fund market and an oil derivatives market.

The local market has a strong non-financial services oil market and the IFC is concerned about the potential systemic threat that hedge funds might pose to the wider market.

In this case, the IFC will need to focus a greater proportion of resources at the fundamental levels (for example, stability and control) for the hedge fund markets than for the oil derivative markets. For the latter, the IFC may be able to make only minor changes to its approach to control and outlook for the sector and focus significant resources on building its identity from an early stage (see Figure 5).

Following this line of thought, specific objectives can be developed for each level with a clear roadmap laying out future developments and desired targets.

Conclusion

Building a sound regulatory regime is a vital part of developing a successful IFC. Creating a fast-growing market that fails within a few years due to fundamental market instability would have disastrous consequences for any country – and possibly beyond. Building firm foundations and ensuring the correct sequencing of regulatory developments is of critical importance.

While the stages in our hierarchy are presented sequentially, regulatory development is not a one-way trip. As macroeconomic conditions change, IFC regulators need to be responsive to the current market, building and tending the basis of their regulatory and legislative infrastructure. However, during stable growth periods, when the right foundations are in place, successful regulatory regimes can focus resources on building an international identity to support market growth and aim for recognition as market leaders in their chosen areas.

Finally, while the model presented here is neither all-encompassing nor enough in itself to describe required regulatory change to any level of detail, it may prove to be a useful tool for observing and guiding the principles for change for regulators around the world.Notes:1 Core Principles for Effective Banking Supervision, Basle Committee on Banking Super­vision, 1997: http://www.bis.org/publ/bcbs30a.pdf2 Sustaining New York’s and the US’s Global Financial Services Leadership, Bloomberg and Schumer, 2007: http://www.nyc.gov/html/om/pdf/ny_report_final.pdf3 Dubai Financial Services Authority website: http://www.dfsa.ae/Pages/DoingBusinesswithDFSA/BeingSupervised/BeingSupervised.aspx4 Regulatory Law DIFC Law No.1 of 2004, Consolidated Version, DIFC, 2007: 5 Qatar Financial Centre website: http://www.qfcra.com/whatdo/Objectives1.php6 The Structure of Cross-sector Financial Supervision, Richard J Herring and Jacopo ­Carmassi, 2007: http://fic.wharton.upenn.edu/fic/papers/07/p0734.htm7 Revisiting the rationale for a single national financial services regulator, FSA, 2002: http://www.fsa.gov.uk/pubs/occpapers/op16.pdf8 Rethinking Bank Regulation: Till Angels Govern, JR Barth, G. Caprio, R Levine, ­Cambridge University Press, 20069 Issues in the Unification of Financial Sector Supervision, IMF, 2000: http://www.imf.org/external/pubs/ft/wp/2000/wp00213.pdf