While important regulatory and reform progress has been made in the wake of the Global Financial Crisis, Domenico Lombardi argues that standards need to be upheld, cooperation increased and that securities and banking watchdogs need to remain ever-vigilant.

Under Australian leadership, the G20 has an important opportunity 
to sharpen the focus of world financial regulators to ensure that the global community reaches the aims of the post-crisis reform process. As that process evolves, there remain important issues that require further work by policy makers, financial regulators and domestic and regional legislatures. Regulatory concerns that warrant attention include building the resilience of banks; helping to prevent and manage the failure of financial institutions; making derivatives safer; and improving shadow banking oversight.

Straying from the Path

The core challenge facing regulators is an emerging divergence of capital adequacy regimes. The primary concern is that
 the European Union’s proposed banking laws diverge from Basel III’s “soft law” regulatory standard in a number of ways, including the treatment of government debt and loans to small businesses. This rift highlights the difficulty of implementing new financial standards in the context of domestic political pressures and a tenuous Eurozone recovery. It is easy to lose sight of the implementation process after a financial standard is created. However, it is important for the G20 to focus on ensuring effective implementation of Basel III’s capital adequacy standards to ensure that non-compliance due to domestic political pressure does not become accepted regulatory practice.

Regulators and policymakers have also sought to improve the resolution of financial institutions through a host of measures. Basel III has helped mitigate the likelihood of financial institutions failing by improving the quality of capital that banks set aside in case of failure. Regulators have also sought to address the too-big-to-fail problem through a specific regulatory framework for systemically important financial institutions (SIFIs). The Financial Stability Board (FSB) and the respective standard setting bodies have developed
a set of regulatory recommendations that would aim to reduce both the likelihood of a SIFI failing and the exposure of taxpayers. Regulators have proposed that SIFIs be subject to intensified supervision, additional high loss-absorbency capital requirements and the preparation of living wills to foster effective resolution.

While there have been significant advances in strengthening financial institutions to prevent their failure and to improve resolution, more cooperation 
is needed between national regulatory authorities in the resolution of cross-border firms. For example, while the Federal Deposit Insurance Corporation (FDIC) in the US and the Bank of 
England signed a Memorandum of Understanding in January 2010 to enhance cooperation in monitoring and resolving the failure of cross-border firms, similar agreements between foreign regulators have been slow to accumulate. Michael Gibson of the US FDIC concurs: “Further progress on cross-border resolution ultimately will require significant bilateral and multilateral agreements among US regulators, key foreign central banks and supervisors for the largest global financial firms.” It is critical that a clear division of labour between national regulatory authorities is established before the next financial crisis erupts.

Threat of Market Fragmentation

When it comes to derivatives, regulators have likewise sought to make these markets safer through central clearing requirements, margin requirements for non-centrally cleared derivatives and improvements to the transparency of both types of derivatives markets. But the core challenge is market fragmentation. The US, EU and others are at different stages of regulatory development for derivatives markets, while jurisdictions in East Asia see an opportunity to expand their market share of the global derivatives trade. For example, in the US, the Commodity Futures Trading Commission’s aggressive pursuit of extra-territoriality has resulted in a fragmentation of national markets 
for over-the-counter derivatives. Since October 2013, derivative trading between the US and the EU has fallen by 77 per cent in response to uncertainty about 
the consequences of US rules. The balkanisation of derivatives markets globally has made markets shallower and has raised the cost of hedging. Ironically, the costs of US extraterritoriality may outstrip the benefits to US markets. The G20, under Australian leadership, should promote dialogue between major jurisdictions to foster a greater level of harmonisation in market regulation.

A Safety Net against Shadow Banking

Through the FSB, the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions, the international regulatory community has sought to make shadow banking safer. Regulators have sought to mitigate the impact of shadow banking by requiring banks to reduce maturity mismatches through Basel III’s Net Stable Funding Ratio. In order to reduce their run-risk, securities regulators have proposed capital buffers and redemption gates for money market funds and have worked together through the FSB to propose regulatory standards for shadow bank entities that include limiting asset concentration, creation of liquidity buffers and leverage limits. These proposals have made important advances in formulating an appropriate regulatory framework.

Yet the main challenge for regulators 
and policymakers is securing effective implementation. Despite the development
 of regulatory recommendations, authorities appear a long way off developing shadow banking reforms even though the systemic threat of these institutions continues to grow; whether the recommended reforms can be effectively designed and implemented will be the truest test of willingness to govern the shadow banking sector or whether domestic political pressure to ease credit will forestall regulatory reform. In the US, the Securities and Exchange Commision has yet to finalise rules for money market funds, while in the EU, fund reform is still in the proposal stage. In China, the systemic risk of shadow banks continues to intensify. China’s Central Bank Governor, Zhou Xiaochuan, recently tried to allay concerns about the threat of its shadow banking sector, but until an appropriate and effective regulatory framework is adopted those concerns will remain. The G20 should urge further progress in implementing shadow banking reform across all member states.

It’s heartening that the post-crisis 
reform process has resulted in a substantive overhaul of the governance of the international financial system and that progress has been made in identifying how to strengthen the resilience of the global financial system. However, the 
main challenge facing politicians, policymakers and financial regulators is ensuring that these standards are adopted and that there is meaningful follow-through with domestic legislative and regulatory reform.

Domenico Lombardi is Director of the Global Economy Program Centre for International Governance Innovation.

This is an extract from G20: Words into Action Brisbane 2014, to be published by Faircount Media in association with the Australian Institute of International Affairs in October 2014.