Regulation: the West's new competitive disadvantage

Is it really the solution?

Regulation and more regulation have become the siren calls of governments and the general public across the Western world. The curtailment of banking freedoms and greater government oversight of the sector has been deemed by experts and laymen as the most effective way to prevent another financial crisis.

Whilst the banks were undoubtedly reckless in their pre-crisis activities, their behaviour did not occur in a vacuum and reflected the prevailing government and public sentiment of the time. Easy credit was a vote winner for both President Clinton in the US, where more African Americans were able to buy their own homes, and the Labour Party in Britain  who were buoyed by a property and credit boom in the traditionally poorer areas of the country. Governments were more than willing to tax banking profits and collect stamp duty revenue from house purchases and consumers were happy to spend money they didn’t have.

Despite efforts to hold the banks solely culpable for the financial crisis, governments across Europe have still fallen, swept away by disillusioned electorates. Against this backdrop, insufficient questions are being asked about the efficacy of the new regulation, its impact on trade and investment and the rebounding of the US and European economies. Far from being the salvation of Western capitalism, regulation may further accelerate the movement of the world’s economic centre of gravity eastward, a trend that increased in vigour during the economic crisis.

Whilst the US and the EU floundered under the burden of sovereign debt and banking failures, Asia rebounded from recession much more quickly thanks to its more robust banking system and debt dynamics. Cash-rich Asian banks seized the opportunity to ramp up their businesses and expand market share while Western banks retrenched.

In the wake of the financial crisis, growth has become the mantra of Asian markets whilst Western governments have adopted an ambitious programme of regulatory reform to address the fundamental weaknesses in the structure of financial regulation. The objective is to provide cohesion, consistency and coordination between countries and to ensure greater oversight of the financial sector and activities of private corporations. In the quest to achieve this noble objective little has been said about the impact tighter regulation will have on Western competitiveness.

The implications of this omission were quickly revealed when the panic associated with the global crisis dissipated and the emphasis on coordination and cohesion receded. While most regulatory changes are taking place under the auspices of the G20, significant differences are present between the EU, the US and Asia. The EU and to a lesser extent the US, are acting against a backdrop of fragility in the banking system and the sovereign debt markets, and are confronted with the unenviable task of solving the current problems whilst designing a regulatory system that will prevent future crises. All the while, the governments are facing increasing pressure from the public and large sections of the media to take action against the banking sector.

Europe’s reality stands in stark contrast to that of Asia. The region is booming and the focus is on the unimpeded development of the financial infrastructure rather than on crisis response. The debate centres on the benefits of a global approach to regulatory reform as opposed to the ability to retain local flexibility. Indeed there is a prime opportunity for the regional financial centres of Hong Kong and Shanghai to develop their own banking, brokerage and asset management sectors independently of the restrictive regulation of the West and to secure a competitive advantage in doing so. .

Capital adequacy and liquidity standards for banks are a key area to be targeted as a result of the crisis. Basel III, adopted in 2010, effectively triples the capital reserves for many banks to 7 per cent as compared with the 2 per cent required under Basel II. The Liquidity Coverage Ratio (LCR) will also be tightened to ensure banks apply adequate capital to all their exposures, including those off balance sheet, to offset forecast cash outflows during a 30-day crisis. Such a system should prevent a future financial crisis from spreading beyond the financial sector into the real economy, thereby limiting the impact and making a crisis more containable.

The threat to Western competitiveness posed by Basel III derives from the fact that the accords will fail to create a truly global level playing field among international banks. They lack the binding force of a treaty and their adoption is likely to be limited to European banks. Basel III regulates the amount of lending that a bank can do - in conjunction with the central bank reserve requirements - and as a consequence also ends up partially regulating the money supply expansion for the entire economy. The impact on trading activity will be particularly severe because the application of the new leverage ratio to the trading book, with a 100% credit conversion factor for trade related business, will make trade and asset secured lending much more capital intensive. There is a real possibility of a significant drop in trade and a further reduction in the developed nations’ GDP, particularly in the Eurozone.

Laws and norms governing financial regulation generally reflect the ideological leanings of those at the highest levels of government. What is palpable at present is that the historically capitalist and entrepreneurial spirit of the UK and the US is being dampened by regulation and in reversal of its strong commitment to economic and financial liberalisation, the US has led efforts to nationalise its financial and some aspects of its manufacturing sectors, to an unprecedented degree. As many EU governments become increasingly left leaning, the efforts to restrict the operations of the financial sector intensify.

After the dominance of the West, we are moving towards a new economic paradigm characterised by competing ideologies and regulatory systems of governance. It is highly possible that different regions of the world will adopt contrasting regulatory systems, creating opportunities for regulatory arbitrage. While this may create a competitive disadvantage for sovereign states, investors who are not restricted by borders will be well placed to benefit from the investment opportunities increasingly divergent economies have to offer, with a greater scope for diversification and risk control. Over time, such diversification may reduce the high degree of correlation between stock markets in times of crisis and a more diverse regulatory world may be more resilient to shocks.

The creation of economic inefficiencies and limiting the optimal allocation of capital will impact Western markets more keenly than their rising Asian peers and it appears that the growth of Western economies will be stymied by regulatory restrictions.

Photograph: Getty Images

JLT Head of Credit & Political Risk Advisory

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Leader: Trump and an age of disorder

Mr Trump’s disregard for domestic and international norms represents an unprecedented challenge to established institutions.

The US presidency has not always been held by men of distinction and honour, but Donald Trump is by some distance its least qualified occupant. The leader of the world’s sole superpower has no record of political or military service and is ignorant of foreign affairs. Throughout his campaign, he repeatedly showed himself to be a racist, a misogynist, a braggart and a narcissist.

The naive hope that Mr Trump’s victory would herald a great moderation was dispelled by his conduct during the transition. He compared his country’s intelligence services to those of Nazi Germany and repeatedly denied Russian interference in the election. He derided Nato as “obsolete” and predicted the demise of the European Union. He reaffirmed his commitment to dismantling Obamacare and to overturning Roe v Wade. He doled out jobs to white nationalists, protectionists and family members. He denounced US citizens for demonstrating against him. Asked whether he regretted any part of his vulgar campaign, he replied: “No, I won.”

Of all his predilections, Mr Trump’s affection for Vladimir Putin is perhaps the most troubling. When the 2012 Republican presidential nominee, Mitt Romney, warned that Russia was the “number one geopolitical foe” of the US, he was mocked by Barack Obama. Yet his remark proved prescient. Rather than regarding Mr Putin as a foe, however, Mr Trump fetes him as a friend. The Russian president aims to use the US president’s goodwill to secure the removal of American sanctions, recognition of Russia’s annexation of Crimea and respect for the murderous reign of the Syrian president, Bashar al-Assad. He has a worryingly high chance of success.

Whether or not Mr Trump has personal motives for his fealty (as a lurid security dossier alleges), he and Mr Putin share a political outlook. Both men desire a world in which “strongmen” are free to abuse their citizens’ human rights without fear of external rebuke. Mr Trump’s refusal to commit to Nato’s principle of collective defence provides Mr Putin with every incentive to pursue his expansionist desires. The historic achievement of peace and stability in eastern Europe is in danger.

As he seeks reconciliation with Russia, Mr Trump is simultaneously pursuing conflict with China. He broke with precedent by speaking on the telephone with the Taiwanese president, Tsai Ing-wen, and used Twitter to berate the Chinese government. Rex Tillerson, Mr Trump’s secretary of state nominee, has threatened an American blockade of the South China Sea islands.

Mr Trump’s disregard for domestic and international norms represents an unprecedented challenge to established institutions. The US constitution, with its separation of powers, was designed to restrain autocrats such as the new president. Yet, in addition to the White House, the Republicans also control Congress and two-thirds of governorships and state houses. Mr Trump’s first Supreme Court appointment will ensure a conservative judicial majority. The decline of established print titles and the growth of “fake news” weaken another source of accountability.

In these circumstances, there is a heightened responsibility on the US’s allies to challenge, rather than to indulge, Mr Trump. Angela Merkel’s warning that co-operation was conditional on his respect for liberal and democratic values was a model of the former. Michael Gove’s obsequious interview with Mr Trump was a dismal example of the latter.

Theresa May has rightly rebuked the president for his treatment of women and has toughened Britain’s stance against Russian revanchism. Yet, although the UK must maintain working relations with the US, she should not allow the prospect of a future trade deal to skew her attitude towards Mr Trump. Any agreement is years away and the president’s protectionist proclivities could yet thwart British hopes of a beneficial outcome.

The diplomatic and political conventions embodied by the “special relationship” have endured for more than seven decades. However, Mr Trump’s election may necessitate their demise. It was the belief that the UK must stand “shoulder to shoulder” with the US that led Tony Blair into the ruinous Iraq War. In this new age of disorder, Western leaders must avoid being willing accomplices to Mr Trump’s agenda. Intense scepticism, rather than sycophancy, should define their response.

This article first appeared in the 19 January 2016 issue of the New Statesman, The Trump era